The financial markets have been held hostage as of late by the possibility of Greece defaulting on its debt obligations and the Fed raising rates and beginning its journey toward normalization. The markets hate uncertainty.
Personally, I don't fear either event and know when and if each finally occurs, will impact the financial markets in different ways. We will relate each possibility to our core beliefs and discuss a path to profitable investing.
The first thing worth mentioning is that a Greek default, which appears more likely day by day, may delay the Fed from raising rates in the early fall, as many believe.
I wrote earlier that Carl Icahn, who I tremendously respect, is historically better at stock calls rather than market calls; that Greece was coming to a head one way or another and would lead to major positive fundamental changes in the Euroland and that my core beliefs would prove out.. I concluded that one needs to invest only in companies making the right strategic changes to win no matter what the global economic landscape may be; the bond bull market was over; and finally, to be patient and let these key events play out.
Let's look at the key events last week, compare them to our beliefs around this economy and conclude with a discussion on asset allocation, regional emphasis, stock selection and risk controls:
1. Clearly Greece and the Eurozone took the spotlight last week, as the news was ratcheted up day by day. The most recent information is that Prime Minister Alex Tsipras called a referendum on July 5th for the Greek people to vote on the terms of the latest "demands" from the ECB, IMF and other Eurozone governments but the Eurozone finance ministers rejected the extension beyond Tuesday in a vote on Saturday. Clearly the Greek government wants its people to formalize his decision to default and exit the Euro. It is clear that the ECB and IMF have circled the wagons and are preparing for a Greek default along with its implications to supply added money to the system and to precipitate a further near term decline in the Euro. A key question is whether the ECB will maintain its emergency funding for the Greek banks that may have to take a bank holiday and extend capital controls if the run on deposits accelerates. Greek banks will be closed Monday as negotiations continue.
The Greek crisis has illumined the weaknesses that exist in the Eurozone. Jean-Claude Juncker, President of the European Commission, proposed last week needed financial and regulatory reform policies to bring true monetary and financial union, which would hopefully prevent an event like in Greece from occurring again, and make countries in Europe a more competitive global economic force. We believe that Greece exiting the Eurozone may be the beginning for a new, more competitive and stronger Eurozone. Something we have been saying for over one year.
By the way, the index for euro-area factory and services rose to a 4 year high in May led by Germany and France. And sanctions against Russia were extended until January 2016.
2. The economic data points in the United States showed an economy slowly picking up steam with muted inflation. Last week's key data points that the Fed watches closely included: 1. The University of Michigan Index of Consumer sentiment rose to 96.1; 2. The PPI, ex-food and energy, rose only 0.1% in May; 3. The Consumer Comfort Index rose to 42.6 last week despite higher gasoline prices at the pump; 4. Consumer spending rose 0.9% in May, the largest gain in 6 years; 5. The fast track trade bill was passed; 6. U.S Home sales rose to 2.2% in May to a 7 year high; and 7. U.S auto sales remain at a multi year high.
I have to mention two key Supreme Court Decisions: 1. Affirming Obamacare; and 2. Affirming same-sex marriages. While I support health care for all Americans, I also recognize that key parts of Obamacare are bad for businesses and employment. The winners, however, were the millions of people who could not afford health care coverage, and healthcare providers and insurance companies which will lead to another round of consolidation.
3. China's Central Bank lowered interest rates to record low and also lowered reserve requirement ratios for lenders on Saturday in response to a relatively sluggish economy threatening employment and the recent sharp correction in the stock market. A good part of the market decline has been orchestrated by the Central Bank itself as it has tightened margin lending several times to reduce speculation and build a sounder foundation for the future. China is playing long ball and I remain optimistic regarding its future.
The Bank of Japan has committed to extending its aggressive QE program for the next year to stimulate growth and higher inflation. Japan's closer alliance with the United States will be a major plus down the road. Passage of the Fast Trade Act will help, too.
4. Commodity prices have stabilized at lower levels and have probably bottomed out for this cycle at close to marginal cost of production. It appears that rather than added capital expenditures to boost lower cost capacity, the major players are looking at mergers and consolidation to reduce duplicative costs and boost profitability. The seeds are being sown for the next up cycle in prices but it is well down the road. It all depends on demand growth outstripping supplies and lower inventories .The rig count has stabilized in the United States now that prices have held around $60 per barrel which is close to marginal cost of production.
Virtually all of my beliefs remain intact. I stay up at night considering the opposing views, which is something that Warren Buffett recommends as one of his rules of thumb. Let me repeat some of my core beliefs and let's consider the opposing views: 1. Monetary policy is easy everywhere and the supply of funds exceed the demand for funds boosting financial assets; 2. The dollar will remain king; 3. The yield curve will steepen as the global economies improve and fears of deflation abate; 4. A new conservatism permeates government, corporations and individuals; 4; Profits will surprise on the upside as growth improves and cost stay contained; 5. Financial leverage and capital ratios will continue to improve; 6. M & A activity will stay strong, as the positive economics of deals are overwhelming; 7. Corporate managements are acting as their own activists recognizing that change is a necessity to thrive in a global competitive environment; 8. Commodity prices have bottomed but gains will be limited until growth accelerates relative to supplies; 8. A Greek default will be contained; 9. The fed will begin raising rates by 2016 but overall policy will remain easy; 10. The economic cycle will be extended; 11. Speculation exists in real estate, private equity and art.
My biggest concern is no growth and an inverted yield curve but strong consumer demand here and abroad mitigates that risk. I also worry that corporations and individuals are so concerned about rising rates shutting the economy down, that the first fed rate increase may cause them to over react and cut back immediately and prepare for the next downturn. Finally, I am always gauging various political risks whether from Russia, China or terrorist groups in the Middle East.
Currently there is a shift going on in asset allocation away from bonds into other asset classes that will benefit from a pick up in global growth and a steepening yield curve. I am investing more stock-specific than ever before as managements in today's global environment make all the difference. The key to successful investing is finding and investing in companies whose margins and incremental rates of return on capital are improving and short those companies whose margins and incremental rates of return on capital are flat or falling. It is a rather simple rule but works over time.
It remains as always a time to review all the facts, step back, pause and reflect, decide on proper asset allocation and specific company selection and finally control risk by maintaining ample liquidity at all times. Clearly this a time for active over passive management. Ironic, isn't it!