12/15/2018

Looking Backward and Forward on The Market – October 2018

Below is an excerpt from the quarterly review of our flagship strategy, The AFG50. The AFG50 is a large core, sector neutral, low turnover strategy that has consistently delivered strong performance vs. the S&P500 with less than 20% turnover. Firms that implement this strategy also receive written research support on each stock, updates that reflect the overall outlook/attractiveness, and detailed proforma models with target prices. If you would like to learn more about the AFG50 please fill out the web form below and we can schedule a brief conversation.

Looking Backward and Forward The third quarter headlines are all about the accelerating trade battle with China but market participants seem to be interpreting the events differently from the mainstream media. After all, the tariff tit for tat between the US and China have heated up but the US equity market was up strong in the quarter, with the SP500 up 7.4%.

Likely, investors have focused on positive news in the US, including: 1) The U.S. economy grew at the strongest pace in nearly four years in Q2 at an annualized 4.2%, powered by a rebound in consumer spending, strong exports and healthy business investment; 2) Inflation appears stable and August CPI rose 0.2% from July, less than the expected 0.3%. The core CPI rose 2.2% in August from a year earlier, compared with the 2.4% expected by economists; 3) On the corporate front, 80% of the S&P 500 companies have reported a positive EPS surprise for their 18Q2 earnings and 72% have reported a positive sales surprise. The blended earnings growth for the index is ~25.0%, the highest earnings growth since 10Q3. The unemployment rate is at a 48 year low, and consumer confidence hit an 18 year high in September.

The bull market since March 2009 is among the longest in history, so is the current US economic expansion. There is growing hope that maybe, the Fed will be able to engineer a soft landing, which will push the recession even further down the road. In the first Fed’s officials’ forecasts for 2021, it called for US GDP growth of 1.8% with an unemployment rate of 3.7% and core inflation of 2.1%, which is different from many pundits’ views that a financial crisis or recession will take place in the next 18-24 months.

Moving on to the trade war. As we had expected, trade tension intensified with China in the quarter and there are more worries it may actually turn into a long lasting trade war. The difference between the US and China are practical but also ideological, and both nations have lots of ammunition to fire shots at each other, so it is not surprising this dispute will take longer to resolve. It is important to note, however, the US has made good progress on trade in Q3.

1. In late July, President Trump and EU President JeanClaude Juncker reached a pact in which they pledged to work toward negotiating a broad reduction in tariffs on industrial goods and to cooperate against unfair Chinese trade practices. A report should be created in 120 days that establishes a framework for future negotiations toward a trade deal.

2. In late August, the US and Mexico signed a new trade pact which includes new agreements on auto production, the sourcing of materials, wages, rules of origin, digital trade, dispute resolution and agriculture. On September 30, the US successfully completed negotiation for a new USMCA agreement with Canada and Mexico, removing the possibility of a trade war on the North America continent.

3. Last Wednesday, President Trump and Japanese Prime Minister Shinzo Abe also agreed to hold bilateral talks aimed at reaching a trade agreement, as the US has withdrawn and refused to rejoin the Trans-Pacific Partnership (TPP).

With the US making strides with its major trading partners, China is essentially cornered. Being a socialist country with just 60% of the size of the US economy, China never had a real chance to become a true, trusted ally to Europe, Japan, and it contributes little to the economies of Mexico and Canada. We believe the US is in a strong position to negotiate with China, now it has more or less cleaned up ex-China trade policies. The new USMCA, importantly, contains provisions protecting trade secrets and barring government officials from sharing them inappropriately, would allow any party to terminate the agreement if one country enters into a freetrade deal with a “non-market economy, and curb exchange rate manipulation. Those rules could serve as a template with US’ Asia-Pacific trading partners, to potentially build a new, rules-based trading bloc to counter China. In addition, the new USMCA would likely make north America a more attractive place for investments, with provisions which liberalize digital trade in North America and encourage services trade, provide better protection for intellectual property, and alleviate financial institutions the burden of having to host data on servers in local markets. Should the tariffs placed on Chinese goods become permanent, incentives will be even higher for companies to relocate out of China and move to other better cost countries which have trade agreements with the US.

Regardless, people are closely watching and hoping for a breakthrough in late November, when President Trump and Xi meet at the G20 summit in Argentina. If no progress is to be made, the trade friction might indeed accelerate into a war, as in January 2019 the US will likely impose a new 25% tariff on the $200 billion Chinese goods which are currently subject to 10% tariff. China will follow up with revenge. Then, the US might apply tariffs on $260 billion more Chinese goods.

The US mid-term election is around the corner, which will garner more market attention in the coming weeks. We don’t think any likely outcome from the mid term election will change the major factors that have been positively impacting corporate America, namely, the US corporate tax cut and deregulations. A divided congress, should that happen, could cause other Trump agenda such as immigration reform, and healthcare reform, to stall, which have less of an impact on US corporations as a whole. That said, we can imagine a divided congress will make Washington even more nasty and politics an even more bloody sport. There will be little civility among the power struggles, and the country will remain as divided as ever. That is a sad prospect.

Whether or not the current economic expansion is overextended due to monetary and fiscal accommodations, the next recession will come sooner or later with 100% certainty. We argue, however, the next recession doesn’t have to be a financial or economic crisis as some pundits are forecasting. US households, which account for nearly 2/3 of the economy, are well positioned to weather higher interest rates, for example. They largely deleveraged after the recession, and locked in extraordinarily low interest rates. The effective rate for all mortgages, as some reported, is just 3.8%. Higher interest rates will curb consumers’ consumption, without a doubt, but there doesn’t seem to be extreme excess in any pocket of the consumer economy that is capable of creating a crisis. For US corporations, some sounded the alarm that aggregate debt for nonfinancial firms has reached a record $6.3 trillion. However, U.S. companies also have a record $2.1 trillion in cash to offset the debt. Speculative-grade borrowers, do warrant caution, as their cash-to-debt ratio was just 12% in 2017, below the 14% reported in 2008, but speculative corporate borrowers are not big enough to create a crisis for the economy either, in our view.

It is important to point out with an average turnover rate of approximately 12% a year, the AFG50 has an average holding period of 8 years, which is long enough to cover most economic cycles from bottom to peak or vice versa. We aim to own strong companies in their respective sectors that can survive and thrive in any economic conditions, with attractive valuation as our best defense. We also favor companies with solid balance sheets and ample debt coverage, so they can carry out their corporate strategy under any interest rate environment. Recession is a normal part of the economy. The good thing is economic recovery and growth follow afterwards.

If you’d like to read our thoughts from this market commentary piece from previous quarters, see the links below:

Looking Backward & Forward on the Market – July 2018
Looking Backward & Forward on the Market – April 2018
Looking Backward & Forward on the Market – January 2018


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