Dodged One Bullet, But More Remain

Bill Ehrman profile picture
Bill Ehrman


  • We remain concerned that Trump believes that tariffs are the right path to resolve long-term conflicts.
  • While tariffs may be initially inflationary, once the supply chains are moved, prices will come down once again and may be deflationary in the end.
  • Our current view remains that growth in the U.S., China, Europe, Japan as well as in the emerging market is slowing.
  • The Fed and Bank of China still have some bullets left in their holsters to stimulate growth but not so in the Eurozone and Japan.

We were pleasantly surprised that Trump tweeted Friday night that the U.S. and Mexico had reached a last-minute deal on immigration to avoid tariffs that would have begun Monday. While that removes any risk to the all-important supply line between our countries and Canada, we remain concerned that Trump believes that tariffs are the right path to resolve long-term conflicts with friends and foes. Unfortunately, Trump may well take his apparent success with Mexico as proof that tariffs work.

Herein lies huge risks for Trump when negotiating with China, the Eurozone and Japan. Trump is too impulsive and does not sufficiently consider the overall risks of his strategy by threatening the party on the other side of the table. There are no real winners and lots of losers. Yes, the United States has less to lose but is that a real victory? While tariffs may be initially inflationary, once the supply chains are moved, prices will come down once again and may be deflationary in the end.

How many times have we mentioned how difficult it is investing in VUCA environment where there is excessive volatility, uncertainty, complexity and ambiguity? Most everyone has become traders, changing their positions based on the most recent soundbites. Just look at what occurred last week when our market had the strongest advance in a year despite everyone turning even more bearish just a week ago based on prospective tariffs with Mexico.

What changed overnight to cause such a violent market reversal last Tuesday? Market participants finally concluded that our economy had weakened sufficiently to push the Federal Reserve to cut rates sooner rather than later. While we have long stated that the Fed Reserve should at least take back their December hike as inflation was continuing to run well beneath their 2% target, we also adjusted our growth forecast down substantially several weeks ago as the spring rebound simply failed to materialize. And then we factored in the risks of escalating trade conflicts on our overall assessment of the global economy.

While we were growing more concerned about global growth, it was clear to us that Fed action would go a long way to stabilizing our economy at a minimum boosting business/consumer confidence knowing that the Fed was their friend with monetary policy to their backs. It is very hard being bearish in this environment. Remember we still expect Trump to do everything in his power to stimulate growth as we enter 2020 attempting to boost the stock market too going into elections so that he may win. Maybe he is as sly as a cat taking his hits now so that things turn around next year before elections.

We continued to adjust our portfolios over the last few weeks to reflect less economic growth here and abroad; the Fed cutting rates at least once in the second half of the year; and the risks of escalating trade conflicts. There are cross currents everywhere so we created a portfolio that will survive/thrive no matter what happens. Not easy, but we do not want to get whipsawed in this environment. Remember the impact of Trump's tweets breaking off trade negotiations with China? How about the one threatening tariffs against Mexico unless the immigration issue was resolved? Now it is resolved a week later. If you sold last Monday, you may feel awfully foolish today. What happens if Presidents Trump and Xi reach a ceasefire on added tariffs and open talks once again in a few weeks when they meet? And what if they don't and the tariff war escalates? That's what we are dealing with today.

So, we sold calls around our core holding giving us 8% upside (plus dividends) with an equal amount of downside protection over the next four months. We also kept the flexibility to adjust the spreads based on future data points and market action. Even though we had this portfolio protection on this past week, we still outperformed the averages when including the decline last Monday. And we moved up the spread later in the week giving us more upside as the market gained along with continued downside protection.

Our current view remains that growth in the U.S., China, Europe, Japan as well as in the emerging market is slowing. The Fed and Bank of China still have some bullets left in their holsters to stimulate growth but not so in the Eurozone and Japan. Let's look at the most recent data points to support or not our current view.

1.) Economic data reported last week continued to show an economy slowing down meaningfully: the ISM manufacturing index fell to 52.1 in May, the lowest reading since October, 2016; the ISM production gauge fell to 51.3, the lowest level since August, 2016; supplier deliveries fell to 52; U.S. construction spending was flat despite a big gain in government spending; the U.S. Manufacturing Purchasing Managers' Index fell to 50.5, the lowest level since September, 2009; factory orders declined 0.8% after a downward revision to the previous month; the trade gap narrowed in April to $50.8 billion as both exports and imports fell(lower Boeing sales is hurting exports); worker productivity was revised downward slightly to 1 3.4% increase(still pretty good); April wholesale inventories were revised slightly higher while sales dropped so the inventory/sales ratio rose; and finally U.S. May nonfarm payrolls increased by only 75,000 despite sharp downside revisions to the prior two months payroll growth. Wage gains cooled too with hourly earnings climbing 3.1% from year ago.

On the other hand, the non-manufacturing sector continued to grow in May for the 112th consecutive month: the business activity index was at 61.2; the new orders index was at 58.6 and the employment index was at 58.1 While growth remained strong, it is leveling out at these levels. The Fed Beige Book revealed continued modest growth in April and May with growing concerns over trade policy.

We do not expect the Fed to change rates at their June 18-19th meeting but will cut rates in July for sure unless Trump/Xi reach a ceasefire at their meeting at the end of June. If so, the Fed may wait an additional few months to see if growth benefits from a ceasefire/deal. We think a ceasefire is highly likely at this time as the alternative to both economies is not good no matter what each side may say. Both sides need a deal to bolster business/consumer confidence and economic growth.

We continue to expect 2nd quarter real GNP to come in around 1.5% followed by 2% growth for the rest of the year led by strong consumer demand. The Fed is likely to lower rates twice this year unless the U.S. and China reach a ceasefire. If so, we would expect only one cut in rates. We remain optimistic that growth will accelerate in 2020 as Trump pulls out all stops.

2.) Growth in China has continued to slow in the second quarter as businesses/consumers are negatively impacted by escalating trade conflicts. China says on one hand that it has lots of policy room if trade wars worsen but the government has clearly softened its criticism of the United States at the same time making noises that it wants to negotiate a deal through dialogue and consultation. It is interesting to note that both President Xi and Trump continue to say good things about each other. We would not be surprised to see a cease fire on additional tariffs announced when they meet at the G-20 later this month.

3.) The European economy continues to weaken as Germany industrial output plunges. We would be surprised if economic growth reaches 1% in Europe this year down from an initial forecast of 1.8% just 6 months ago. European inflation continues to drop and was up 1.2% in May with core inflation up only 0.8% as compared to 1.7% and 1.3%, respectively, a month ago. How much more can the ECB do? Nada! Don't look for Europe to reach a trade deal with the U.S. unless agriculture is included. Not likely. And what will happen with Brexit? The picture for the Eurozone remains poor.

4.) The economic environment in Japan is worsening too, despite a slight increase in the coincident index of business conditions in April. It is time that the government officially drop its plan to increase the consumption tax to 10% in October from 8% currently. Japan desperately needs the U.S. and China to reach a trade deal followed by Japan reaching one with the U.S..

The bottom line is that global growth is continuing to slow. While the United States dodged a bullet no longer threatening tariffs against Mexico, trade conflicts still exist with China, the Eurozone and Japan. No one knows for sure what will happen when Presidents' Trump and Xi meet the end of the month. We remain hopeful that they will agree to begin negotiations once again postponing any additional tariffs. At a minimum, corporations will continue to move more and more production out of China to even lower cost areas. We remain optimistic that the U.S. and Japan will reach a trade deal but it won't be meaningful enough to move the needle on either country's growth rate. Finally, we continue to doubt that the U.S. and Europe will reach a trade deal unless agriculture is included. Will Trump put tariffs on European autos? It is doubtful as it would negatively impact our economy in 2020.

There is no place like home.

We have concentrated our investments in companies whose businesses won't meaningfully be impacted by tariffs. Each company that we own has superior management; business strategies that will win in a globally competitive environment; improving volume, revenues, operating income, cash flow and free cash flow; dividends above the 10-year treasury rate and large share buybacks. Finally, each one sells well beneath its intrinsic value especially with yields so low.

Our portfolios are concentrated in healthcare; technology, housing related, cable with content, consumer; industrials and capital goods; some financials and many special situations. We are flat the dollar and own no bonds although we would expect the dollar to weaken and the yield curve to steepen once the Fed lowered rates and/or trade deals are reached. We have written calls against a good part of our portfolio offering our accounts 8+% percent upside and an equal amount of downside protection over the next four months.

Remember to review the facts; pause, reflect and consider mindset shifts; look at your asset composition and risk controls; do independent research and… Invest Accordingly!

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

This article was written by

Bill Ehrman profile picture
Managing partner of Paix et Prosperite LLC, educator, mentor and consultant.  Former Senior partner and CIO at EGS Partners, Soros Fund Mgt and Century Capital Associates. Experience over 50 years  successfully managing money, investment banking, consulting and mentoring. He incorporates a top down global economic, financial and political view with bottoms up independent research industry by industry and company by company.

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