Listening to the pundits, media and some of the interviews out of Davos early last week probably had all of us heading for the bomb shelter as the global economy, along with the financial markets, appeared headed for the dumpster. Did any of your hear and read Cramer's nightly comments? He is always one step behind and a dollar short.
However, something happened along the way. Mario Draghi talked about further ECB easing in March and energy prices rallied above $30 per barrel, and lo and behold, the global stock markets turned on a dime ending up a few percent for the week, the first weekly gain this year. Was this a counter trend rally in a bear market or was the market discerning between "perception vs. reality; emotion vs. reason," last week's topic? Let me again state that I am aghast how everyone looks in the rear view mirror rather than anticipating change and, moreover, how everyone has now become a trader rather than an investor. Even Larry Fink, head of BlackRock, who was so bearish short term looking for a 10% correction turned more positive, so he said, after only a 2.5% move down. Remember that he also had stated that the market would recover and hit new highs later in the year. How does his firm trade multi-trillions of AUM anyway?
I know a lot more wealthy investors than I do traders! Most of them go against the grain as times of adversity create opportunities. They have done their homework and maintain excess liquidity to take advantage of panics in the marketplace.
One theme was crystal clear out of Davos, which happens to be one of our core beliefs, which is that conservatism exists at all levels from governments to corporations and down to the consumer. No one is really that optimistic and therefore is operating close to the vest, which means no excesses, no speculation and extremely tight budgets. That is why I continue to believe that there will be lower highs and higher lows in economic activity without inflationary pressures for several more years excluding an external event. Is that all that bad? I don't think so as the cycle is extended, there are clear winners and losers, and there will be great opportunities to profitably invest in those companies changing to thrive in this new world economic environment. Remember, too, that banks here and abroad continue to increase their capital ratios and liquidity thereby reducing financial systematic risk, which exacerbated the 2008 downturn.
I am not saying that there are no problems in the world that need to be addressed, but I am saying that the environment is not nearly as bleak as many are painting and there is value everywhere for the investor who has the liquidity and patience to take advantage of panic selling by traders who are more focused on the next quarter rather than the next few years.
I look forward to and take advantage during periods of stress, like when the U.S market was down 500 points last Wednesday, to utilize some my excess liquidity to pick up some new stocks and even average down on some of my holdings at extremely good values. I also did expect Mario Draghi to discuss further monetary easing the next day. To be honest, I did not see such a big rally in energy prices that occurred almost simultaneously to Draghi's comments. I still remain bearish on energy prices as long as supply growth outstrips demand growth and politics over rides economic reality.
The biggest fear in the marketplace is that global economic growth has stalled out and the risks are to the downside. I continue to try to comprehend where the $3 plus trillion in energy savings has gone over the last year as it appears that the boost to consumer spending has been muted, corporate operating margins have not been helped nearly as much as expected (I will address this point later) and the savings rate has not risen as much as one would have expected based on the relatively small increase in consumer spending. The truth is that there really has been some benefit in each area. On the other hand, the energy producing countries have had a huge drop in income and have had to eat into their foreign reserves by selling assets to sustain their budgets. But this is a really NOT a zero sum game as the number of winners is far larger than the number of losers. Net net, lower energy prices supports global growth with low inflation and is helping us through this period. Don't forget that monetary policy is easy virtually everywhere, too, and don't think for a moment that the Fed does not have their fingers on the pulse and will act too, if needed, to stimulate domestic growth. After all, inflationary pressures are really nonexistent. Last week I mentioned that I see two or less fed rate hikes this year, far less than anyone else expects, the Fed included.
Listening to corporate conference calls last week support my view of the global economy, the financial markets and, most of all, that change is everywhere. Every company is "cautiously optimistic" for 2016 running very tight ships not expecting tailwinds to growth but most all have plans to succeed in furthering their strategic plans to enhance their global competitive position, increase volume and average price realization, increase operating margins, operating earnings and returns on capital while maintaining tight capital budgets so as to increase free cash flow for the benefit of shareholders one way or another. Expectations are low and zero budgeting is being utilized meaning that downside risks are minimized and the potential for upside surprises exist. Clearly low energy prices have helped boost operating margins somewhat. Is any of this the precondition for market tops? Don't tops occur when there is rampant optimism, over valuation and even speculation and bottoms occur when pessimism is everywhere and price/valuation doesn't matter regardless of how low?
Let's look at what happened last week beginning with the United States, the engine of global growth today: retail sales as reported by Master Card grew 7.9% during the holiday season, excluding cars and gas; existing home sales rose 14.9% in December to an adjusted 5.46 million annual rate and hit 5.26 million for the year, a 10 year high; the median price of home sales rose 7.6% in December to 224,100; homebuilder sentiment remains at 60 in January; the consumer price index fell 0.1% in December and rose 0.7% over the last twelve months and increased only 0.1% in December and 2.1% over the last year excluding food and energy; and the budget deficit will climb to $544 billion or 2.9% of GNP for the year ending September 30th, the first increase since 2009 partially due to lower than economic growth. The budget deficit is $130 billion higher than initially estimated also due to the recent tax and budget deals. A rising deficit adds to growth as long as the treasury doesn't crowd out other borrowers causing higher rates.
I found listening to several railroad management conference calls most interesting last week as freight volumes have been unusually weak which normally parallels growth in industrial production. Needless to say, fourth quarter tonnage was dismal and the only two areas of growth out of 9 categories were cars and lumber. Weakening exports, a huge drop in coal volume and a significant decline in movement of oil all sharply penalized volume. Railroad management acted quickly by downsizing trains, crews and other costs such that earnings ranged from up a few percent year over year to down 10% in the fourth quarter. Rails, as a group, are well managed and are cash machines. Operating results will improve as the year unfolds and many of the stocks will be outstanding value plays. Remember Berkshire Hathaway owns Burlington Northern, the second largest rail.
Weakness in rail tonnage supports my view that the production side of the U.S. economy remains weak and higher retail sales, higher auto sales and higher housing sales support that the consumer side (over 67% of GNP) remains relatively strong such that over all economic growth will be around 2-2.5% for this year.
Mario Draghi and the ECB took center stage last week. The ECB President confirmed Thursday that officials will review their program in March and that there were "no limits" on how far they're willing to deploy measures within their mandate. He also mentioned that "we are adapting our instruments to the changing conditions and that the credibility of the ECB would be harmed if we weren't ready to revise the monetary policy stance." His comments set off the expected chain reaction in various markets; stocks rallied, the Euro fell dramatically and commodity prices rose. Clearly his remarks reflect concern that global and Eurozone growth this year will be less than earlier anticipated and inflation will remain non-existent.
China's officials set out at Davos to affirm their optimism for the Chinese economy and their support of the Yuan. Heretofore, the Yuan was pegged to the dollar but now the Yuan will be considered part of an international basket of currencies, something that world economic leaders have wanted for a long time. The Yuan stabilized last week. Chinese growth came in at 6.9% for all of 2015 and 6.8% for the fourth quarter, the slowest rate of gain in 25 years. Industrial production rose around 6% for the year while retail sales increased by over 11% year over year. The transition from a production led economy to a consumption led economy is progressing according to plan unfortunately with bumps and all along the way. I still am looking for growth this year between 6-6.5%, which is nothing to sneeze at for sure. Again, I compliment China for actually having a five-year plan to establish better footing for more sustainable growth for the future while reducing systematic risk. Something other nations, including the United States, are lacking!
China Central Bank injected 600 billion Yuan or approximately $91billion to ease liquidity squeezes that normally occur before the Lunar New Year in early February.
It was ironic that oil had a huge rally last week right after Iran's nuclear agreement was approved permitting oil exports and the IEA said that oil could "drown in oversupply." Clearly traders got caught short and ran for cover to minimize trading losses and exposure. It is one thing to invest in a fundamental trend while maintaining ample excess liquidity at all times, and quite another to trade one. I still believe that oil has more downside until supply and demand come into better balance. Global inventories have risen by over 1 billion barrels over the past two years and are estimated to increase by another 285 million barrels this year, testing storage capacity.
Davos was again a news worthy event where both political and business leaders meet to discuss virtually all issues pondered in the world. Clearly, immigration in Europe, the Middle East turmoil, terrorism, Britain having a referendum to stay in the Eurozone, the global economies, China, monetary policy, business and politics took center stage. Change is in the air everywhere so it was quite a freewheeling event. The IMF cut its global forecast right before the event began now looking for growth in 2016 at 3.4% up from 3.1% in 2015. There is a need for regulatory and financial reform universally to stimulate job creation, investment, higher growth and inflation. We concur!
So where does all of this leave us? Our core beliefs remain basically in tact although we acknowledge that economic activity in the United States has hit a soft patch after such strong second and third quarters. We continue to believe that the underlying fundamentals will support 2-2.5% growth for the year with inflation remaining below 1.5%. In addition, corporate earnings and cash flow will accelerate as the year progresses versus 2015 results and the 10-year bond will remain beneath 2.5%. Net, net the market has upside and specific stocks going through positive change will significantly outperform the averages. Remember that this is a market of stocks, rather than a stock market. Our investments are stock specific rather than emphasizing any one sector and we remain less than 95% net long maintaining fire-power to take advantage of panic in the marketplace and the lack of professionalism by investment managers. Take the emotion out of your decision and base it on facts.
William A. Ehrman is managing partner at Paix et Prosperite LLC. He served as head of the Investment committee at Century Capital Associates, followed by head of investments for Worldwide Equities and Private Equities at the Quantum Fund. He was George Soros’ first partner.