The global economy, including the United States, is muddling through with growth well below potential, but better than a year ago. The global consumer is the winner while the global producer is suffering from excess capacity, excess inventory and much lower prices. Lower prices for the producer means higher disposable income for the consumer as long as his income is at least constant and hopefully, rising. There are clear winners and losers out there due to this conundrum. It's not so hard really to construct a long/short portfolio in this environment if you use common sense and in-depth research.
It is most interesting to see how managements are reacting to this environment. If they bite the bullet and make the right strategic changes, they will come out stronger and their stock price will reflect it; but if they keep their head down and maintain the status quo, their business and stock price will erode away over time. The portfolio manager who uses historical analysis and does not listen to or see what is happening out there will not see the change. But the one with an analytical proclivity, an open mind and who puts in the hard work will see the change or lack thereof and construct a winning portfolio accordingly. This is an analysts' delight. My strength! This is a worldwide phenomenon so you need a global perspective and knowledge. That is what we at Paix et Prospérité are all about.
The financial markets continued to move up last week on the "wall of worry" that we have been discussing in previous blogs. Our view was, and remains, that the Fed is out of the way until at least December, and most likely next March, and this has become the prevailing wisdom on Wall Street. You could hear the sigh of relief around the world. The global financial markets acted accordingly: stock markets for the most part rose, led by China and the emerging markets; bond yields remained ridiculously low as fears of deflation override fears of inflation; commodity prices, including oil, fell for the week; the dollar held constant after falling over the last two weeks; a huge deal was announced in the beer industry; Dell bid over $67 billion for EMC which was under attack from an activist; and corporate earnings season began. Quite a busy week! Our portfolio continues to outperform by a wide margin.
I have spent a lot of time over the last year declaring that this is a market of stocks, not a stock market. Step back and think about this for a moment. Historically, investors rotated industry sectors based on where you were in the economic cycle. For instance, you would want to have the stable growers like food and drug stocks when the economy turns down and parenthetically you would want to own the economically sensitive stocks late in a cycle as capacity utilization increases to the point that prices increase, accelerate and stick. Not now! What is different today? Globalization! The lowest common denominator, for the most part, sets prices. For example, Chinese steel imports have forced tremendous pricing pressure here and in Europe. Some nations do not have the same profit motive as we do and may be nationalized. It could all be about jobs over profits. Currencies play a major role here too. It used to be that our high-energy costs penalized our chemical industry in competing globally. Not anymore as our feedstock costs are as low as any country, including in the Middle East. Products move globally and if you do not have a competitive advantage either in price or technology, you will lose out over time. It is our job to find them. We are pretty good at that.
Change can take many forms. Take a look at Amazon, Netflix and Uber as three examples whose business models turned their respective industries upside down. Just ask Wal-Mart and the networks. We will discuss all of this in more depth later but you can guess where I am going with this. Do the work; do not follow the chart, as that is history; and find the future winners as your longs and the losers as your shorts. I waited over a year for Nelson Peltz to wake up the analysts and investors in GE. Be patient and let the thesis play out. Do not forget to maintain your liquidity and control risk too.
Let's quickly take a look at the events of the week by region, see if there any changes in core beliefs and then turn to asset allocation and specific recommendations.
1. As I mentioned last week, the U.S consumer is in great shape and continues to support the economic expansion more than offsetting industrial weakness most prevalent in weak export numbers. Specifically, consumer confidence rose to 92.1 in October from 87.2 in September; consumer expectations out six months rose to 82.7 from 78.2 in September; the consumer view of their personal finances rose to 106.8 from 101.2 last month; consumer comfort index rose to 45.2 and is up 5 points in a month and retail sales rose a mere 80.1% in September from August. The surprise for the week was that the Consumer Price Index fell a seasonally adjusted 0.2% in September and was unchanged year over year. Excluding food and energy, the core CPI actually rose 0.2% in September and 1.9% year over year. Social security recipients, over 56 million strong, will not get an increase in the cost of living index in 2016. Tell them there is no inflation in the country!
Relative strength by the consumer is being partially offset by continued weakness in factory output, which declined 0.1% last month. Manufacturing comprises only 12% of the economy and will remain a drag for quite some time. By the way, capacity utilization declined to a three month low of 77.5.
Finally, the Beige Book came out and supported only a "modest expansion" at the end of the third quarter. Many of the districts blamed the strong dollar saying it was hurting exports and tourism. Clearly the Fed is on hold for now and maybe longer than we think despite several world central bankers asking for the Fed to end the drama and to finally lift rates. Waiting has been unsettling to the global economies, as we have mentioned many times too. Since estimates of future global growth are still falling, the Fed is on HOLD.
2. The big news out of Europe is that Switzerland is set to impose 5% leverage ratios on its largest banks which include Credit Suisse and UBS up from around 3.7% as mandated by Basel III. The Swiss authorities are following the lead of U.S. regulators who set the same levels for our biggest banks. It is quite simple: higher capital ratios means less lending. Dodd Frank and Basel III have certainly reduced financial risk in the economy at the expense of growth.
While growth in Europe has clearly bottomed, it will not reach earlier estimates due to weakness in foreign economies impacting exports. But the European consumer is clearly doing better, which bodes well for 2016.
3. China is set to report its third quarter GNP on Monday and the general consensus is that growth will be around 7%, which is the weakest quarter in 6 years. China Premier Li has been vocal recently committing to moving forward on market oriented reforms to open up the country more to foreigners, ongoing urbanization, more transparency and increased infrastructure spending. Services and consumer spending are supporting growth while manufacturing and exports are relatively weak. A familiar story! By the way, credit growth has accelerated recently as monetary easing has spurred loans. The CPI increased 1.6% in September from a year earlier while the PPI fell 5.9%. There is more room for further monetary and regulatory initiatives to stimulate growth as has occurred elsewhere.
4. Japan's government recently lowered its targets for growth this year as output/industrial production is weaker than anticipated due to slower growth overseas. Here again, consumer spending is holding up as employment and wages are slowly increasing and lower energy costs are boosting disposable personal income.
Catch a theme here? The global consumer is holding up well while the global producer is weaker than anticipated.
So why does muddling through work for me?
Let's get back to our core beliefs: the global economy, including the U.S., will continue to grow, albeit slowly, and there will be lower highs and higher lows as imbalances are contained and a conservative bias permeates at every level from government to business to the individual; interest rates will remain surprisingly low as global competition will keep a lid on inflation along with lower energy prices; the dollar will remain the currency of choice as this country's global competitive situation continues to improve and energy independence remains a possibility down the road; earnings, excluding commodity related industries, will surprise on the upside despite relatively sluggish global growth; speculation is limited to real estate, art and private equity; the stock markets are undervalued as 10 year bonds are around 2.1%, the risk factor should be around 3 as leverage ratios keep falling; and S & P earnings are slightly higher in the aggregate and much higher x-energy and commodity companies. It's hard to imagine M & A getting any stronger. Another of our core beliefs.
Finally this is all about asset allocation, stock selection and risk controls. I listened to or read the transcripts of at least a dozen companies last week starting with Alcoa and ending Friday with GE and Honeywell. I really suggest that you take the time to read some of these transcripts as managements are really doing some amazing things. Alcoa is splitting into two companies; GE is selling most of its financial assets and reinvesting in its higher margin, higher return industrial businesses; Honeywell is churnings out 10%+ growth and generating 110% free cash flow; Citi, Bank America, JP Morgan, PNC etc., are all making great strides not relying on a rising yield curve to make money; Intel is upgrading its mix. I could go on and on.
My portfolio is comprised long with companies going through positive change, short those with their heads in the ground, a few Larry Tisch value plays and there is no industry concentration. It really is stock specific. I remain around 93% net long, no bonds and no dollar currency trading position.
Take the time to understand the strategic goals of the management of each company in your portfolio, step back and reflect hard and long on it, pause once again and consider all that could go wrong and also right, control your risk by maintaining ample liquidity and be patient as change doesn't occur over night. There are clear winners and losers out there. Perfect for a hedge fund like ours.
Change is a global phenomenon.