Investment Management

EARNINGS BULL MARKET … P/E/ RATIO BEAR MARKET

The first part of the above title has to do with fundamentals. The second part to a large extent has to do with emotions. Corporations around the world, and especially in America, have been doing very well in 2018. In past commentaries, we have documented their success. But to underscore the point one last time this year, please look at the following chart regarding company dividend payments:

Corporate dividend payments are authorized by a company’s Board of Directors, who typically are a conservative group of people. In other words, dividends are not authorized “in a vacuum” or without consideration of a corporation’s future. Boards never want to cut a dividend because it sends a terrible message about the Board’s perception of the company’s future. In this vein, dividends are raised conservatively as Boards do not want to increase a payment and then must cut it because they were too aggressive in raising a dividend. In 2018, US companies are paying out a record amount of dividends. Since most Boards of Directors know more about a company’s health than the average outsider, and we are talking about a broad swathe of the American corporate landscape which has decided to pay more to its shareholders than ever before, we take this as an important sign that corporations are doing well, and fundamentals are strong.

The valuation (i.e. P/E ratio) consideration of the market’s equation really has to do with “animal spirits”. Are investors optimistic or are they pessimistic? Is the glass “half full” or “half empty”? Until mid-October, the markets seemed to focus on the flow of fundamentals. “Political noise” was filtered out. Then the price of oil, which seemed to be going to $80/barrel, reversed course sharply as several major oil importers were surprisingly given waivers by the Trump administration to buy Iranian oil, which was about to be sanctioned on November 2 by the Trump administration. Consequently, the oil complex was quickly discounted to around $50/barrel and the rest of the markets shook. Presidents Xi and Trump met in Buenos Aires to discuss trade. Fireworks before the meeting unsettled traders. Lack of coordinated communications between the two groups (i.e. whose story coming out of the dinner was the accurate one) after the meeting unsettled traders. Prices in markets fell and continue to fall over trade worries. The US Treasury market inverted in the 2/5 year curve. In short, investors were being paid slightly more (return) if they bought a two-year Treasury than the five-year. This according to some was a signal that a recession is on its way. These “bits and pieces” were enough to scare investors into ignoring the fundamentals and becoming pessimistic.

Let’s now deal with each of the “pessimisms” in turn. First, the Iranian sanctions are still scheduled to be implemented – only 180 days later (May 1,2019). With that, approximately 2 million barrels/day of production will be removed from the market. This removal tightened oil markets before, so why not 180 days later? By the way, there has been no major oil discovery since the waivers were put into place to replace the disappearing Iranian production and OPEC has recently met in Vienna, Austria and committed to an additional 1.2 million barrel/day cut in production. With the world still expected to grow in 2019, oil should be in demand, supply should be a little “tight” and prices should recover. Second, there is a “deadline” of March 1, 2019 when the Chinese must have a plan in place to address American trade concerns. We believe that the trade negotiations between China and the US will be successful, as both Xi and Trump need a political “win”. Each leader is under pressure as their respective economies are under some stress. China is slowing and there are some in the leadership that think that Xi “got out a bit too far over his skis” with his 2025 industrial policy bravado and South China Sea expansions. Mr. Trump needs to “score one” to divert attention from the other issues surrounding his Presidency well in advance of the 2020 US elections. Thus, we think both leaders are motivated to compromise – to save face, to “declare victory and move on”. Otherwise, if Xi and Trump settle into trench warfare, then we think the markets will deliver a resounding verdict which could demand their “political scalps”. Third, as to the 2/5 Treasury curve inverting, we think it a bit specious. The traditional curve for watching has historically been the 3 month/30 year Treasury. This has flattened, historically associated with strong equity returns, but has not inverted. Even if it does invert, a recession might occur two years in the future, with markets rallying before according to history. So, this is not a very timely “predictor”. Moreover, the Treasury market is not its usual self these days and has not been for some time. As a result of the “Great Recession”, the Fed had to do some extraordinary things to help support the US and world economies. Even today, some 10 years hence, the Fed is still mightily involved in the American bond market. The Fed’s balance sheet has “ballooned” as it has purchased bonds over the years. It is only now allowing its monetary policy to approach “neutral” from an easy state. Next year (2019) will present the Federal Reserve with a more problematic analysis of the economic “cross currents”. We believe that the Fed Governors will become (and will state publicly) more “data dependent” in reaction to evidence that the American and world economies are slowing with inflation under control, which should mean fewer interest rate increases in 2019.
Around the world there are “tugs” on policies which will probably mean slower growth in 2019 than this past year. In the US, the tax reduction flush should have one more push when people get their refunds in the spring after over withholding. Nevertheless, the American economy is due for a fall back to +2% GDP growth, which is a familiar trajectory. If the Chinese trade “skirmish” does not become a war, then US growth could edge up to around 3%. Likewise, Chinese national growth will probably fall to between 6 and 6.5%. The Eurozone will plod along at 1% – 2%. Germany will continue as the “star”. France, Italy and Spain are having political spasms which will retard economic progress. In Great Britain, the English are still trying to find the formula for Brexit. Worries are climbing that Brexit will be “hard”, which might push the UK into a slight recession. Finally, Japan will continue under Abe to “putter along”. The Japanese prospects grow brighter with no “trade war” – so let’s put them in at 1% – 2% growth for 2019. Most importantly, if the daily headlines of an impending trade war go away, then we think investor “animal spirits” will be restored. While we do not think that a trade war would have any meaningful long term economic impact, the upset of established corporate supply lines would increase operating costs until new logistics were well established. Transition periods are always “bumpy” and investors always prefer a “smooth ride”. The threat of a trade war has captured traders’ minds. We will know by March if Trump and Xi will find a way. We are betting that they will, and this should spur markets.
Foreign markets are some in particular need of a bit of “spurring”. Readers may remember that at year end 2017 we wrote that international markets were especially cheap as compared to history. As a group, foreign exchanges spent 2018 only getting less expensive and the emerging category even cheaper. In comparison to US indices, the abysmal relative performance became more pronounced, reaching a divergence not seen since 1988, except that international indices vastly outperformed the US that year.

We still believe that there will be a reversion in market performance which more accurately reflects national economic share of the world economy. We expect the blue line to rise in the chart above and international markets to outperform relative to the American index going forward.

Predictions – So How Did We Do In 2018???

  1. Inflation will rise above 2%, using the Fed’s favorite Measure. – Yes/No – at 2%
  2. U.S. GDP >+3% & International GDP Growth will accelerate. – Yes – US GDP >3%, International up a bit.
  3. U.S. unemployment will decline to 3.6% & ex-U.S. unemployment will decline. – Yes – Unemployment down to 3.7% – so directionally correct, but didnt quite get to 3.6%
  4. U.S. corporate profits =12% with higher profit growth ex-U.S. – Yes – >20% growth in profits.
  5. The dollar will drift lower. – No – Dollar has been stronger than expected.
  6. The U.S. bond curve will get “flatter” but not “invert.” – Yes
  7. Investment spending will rise again. – Yes
  8. Republicans will take a “political beating” in the midterms. – Yes – Republicans took a “drubbing” in the house.
  9. Consumer confidence in the U.S. & abroad will stay strong. – Yes – low unemployment.
  10. Equity markets will do well, while bond markets will stagnate. – No – A Very rare “recessionless” bear market.

Predictions for 2019

  1. U.S. inflation, using the Fed’s favorite measure, will “remain around” 2%, giving the Fed some “room” to pause interest rate increases.
  2. U.S. GDP growth 2%-3%; rest of world range 1% (think Eurozone) – 7% (think India).
  3. U.S. unemployment will stay low.
  4. U.S. corporate profits +6%-9%.
  5. West Texas Intermediate crude oil will recover to a range of $60-$70/barrel.
  6. The dollar will drift lower.
  7. U.S. consumer sentiment will stay strong.
  8. Corporate chiefs will become more timid spending money; state governments will spend more.
  9. The U.S. and China will do a trade deal.
  10. Equity markets will do well.

A Final Thought

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.

We recommend that you compare our statement with the statement that you receive from your custodian.

A list of our Proxy voting procedures is available upon request.

A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinmgt.com/disclosure/