The financial markets reacted violently last week to what was so evident for many weeks.  We stated in "Countertrend Rally in the Euro" that the euro would reverse course and have a counter-trend rally against the dollar for the next month or so until the U.S. economy picked up steam after its weak first quarter.
Well, it all happened with a vengeance last week after the report that the U.S economy expanded by only 0.2% in the first quarter while growth in the Eurozone was accelerating. The euro advanced to 112 to the dollar, up 8% in the month, European interest rates rose and the European stock markets fell. Our markets got hit, too, but some sectors suffered much worse than others, especially the high fliers with exceedingly high valuations, which we avoid or are short. This all comes back to the increasing globalization of the financial markets as capital moves freely across all borders searching for the best risk-adjusted returns. As we said in that blog, long the dollar was a crowded trade and deserved a hiccup to bring everyone back to reality. Sometimes the markets have to take one step back before making the next advance forward—a stutter step.
It is interesting to note that our portfolio, comprised of companies going through positive change, with strong financials and dividend yields over 2.5 percent, advanced to new highs last week and is up over 20 percent year to date after a 36 percent advance last year after fees. We remain around 95 percent net long. Our turnover is low.
Investors appeared on the wrong foot last week, struggling with all the implications of the news on asset allocation and investing. Let's review the events and put them in their proper perspective:
1. There were several key data points in the United States to chew on: 1. First quarter GNP came in at a disappointing 0.2% annual rate of gain; 2. A Fed meeting concluded that many parts of the economy were weaker than anticipated. but Fed officials felt that the weakness was transitory; 3. Consumer sentiment was at its second highest level since 2007 (the consumer is now about 72 percent of our economy; 4. Jobless claims fell to a 15-year low and 5. Factory orders improved in April, with signs of strength in 15 of 18 industries reporting.
This is not a time to look in the rear view mirror; it is our job to project forward. It is interesting to remember that first-quarter economic stats have shown the slowest rate of gain for the year as compared to the last several years and this year will not be an exception. Both corporations and individuals are in very strong shape financially. By the way, first-quarter corporate profits exceeded expectations despite headwinds from a strong dollar, a weak economy globally and a sharp drop in profits and spending in the energy patch. Consumer spending, depending on your gauge, rose near 2 percent in the first quarter as most of the reduction in energy costs was stashed in the bank one way or another. Inflation stayed muted.
The bottom line is that our thesis for an accelerating economy moving forward remains intact, but not written in the stone just yet. And that is the good news, as the Fed will have to stay on hold until there are many months of an improving economy, job creation and wage gains. If the Fed does move, it will be gradual and probably begin in the fall of this year. Don't worry as it won't stop the economy nor profit growth but it will cause some consternation in the markets and asset allocation. We are making a few adjustments in our portfolio, adding more industrial companies leveraged to the economy while reducing stable growers, including health care stocks.
2. The good news is that the economic recovery in Europe is broadening out, but the bad news is that the euro has rallied 8% off the bottom, which caught market participants by surprise, and both the bond and stock markets fell sharply last week. A strong euro, just like a strong dollar, hurts exports and translation of overseas sales and profits. Is this the counter-trend rally we predicted or something more? I believe it’s the former, so don't get overly concerned. The euro will be in a secular decline unless there is financial and regulatory union among the countries to go along with currency union. The ECB will maintain its form of QE and interest rates, meaning the euro will fall again.
There was some good news out of negotiations between Greece and the ECB. It appears that the American-trained leader of negotiations for Greece, Yanis Varoufakis, was demoted as he seemed to irritate just about everyone. Euclid Tsakalotos took over as lead negotiator for Greece. It appears that the Greek government really does want to reach a deal to get funding and stay in the Eurozone. The one problem could be if the Greek populace will be permitted to vote on any agreement as Prime Minister Tsipras indicated. I still doubt that the government will be able to abide by any agreement even if one is reached. If Greece exits the euro, I expect the currency to rise after an initial dip.
3.     China's economy continues to increase at a modest pace by Chinese standards. The Purchaser's Managers Index remains slightly above 50, meaning sluggish growth at best. The Chinese government realizes the need to maintain growth near 7 percent so that the economy can create enough jobs to keep the country's unemployment rate from rising. We expect further easing measures from the Bank of China as well as implementation of additional government sponsored programs to stimulate domestic consumption and growth. Other countries in Southeast Asia are displacing China as the world’s low-cost manufacturer. Bet on China, along with India, for the long term.
4.     The Bank of Japan left its policy of aggressive easing in place despite a reduction in its inflation forecast for the next year. The BOJ, like other central banks, have all targeted a return to 2 percent inflation as their goal. Quite amazing, isn't it? The Japanese economy has improved as domestic demand and exports continue to rise, albeit slowly. Watch closely the improved relations between Japan and the United States to counter China's global ambitions. Japan could be a real beneficiary of this expanded relationship longer term.
We have entered a period for the first time in many years where the global economies appear to be improving across many regions. Monetary policies are easy across the globe and the creation of money far outstrips the economic needs, which is favorable for financial over hard assets. That is not to mean that commodity prices, including oil, cannot bounce back, as they can and will from oversold positions. It will take far greater demand than exists today to reduce inventory levels sufficiently to let prices rise on a sustained basis, as production still outstrips demand. While a price increase in commodities will present a good trade, like the counter-trend rise in the euro, it is not the place to be longer term without far more changes in strategies of energy and commodity companies. It will surely be survival of the fittest, as many of the secondary and tertiary companies will have problems and merge or go out of business.
It remains our belief that global economic growth will have lower highs and higher lows longer term for all the reasons discussed over the year. Financial and fiscal conservatism from governments to companies to individuals is pervasive and good for financial assets. These tighter bands extend to all financial and commodity markets.
Global growth means a shift in asset allocation, industry emphasis and company selection. We have reduced our exposure to the stable growers, including pharmaceuticals, and increased our exposure in economically sensitive sectors and companies that have great management, strong financials, changing strategies to excel globally and a dividend yield over 2.5 percent. Names range from Alcoa down to United Technologies.