Cautious optimism was the catch phrase of the week for the BOJ, ECB and corporate managements on second-quarter earnings calls. Monetary authorities are puzzled and concerned that growth forecasts have gone up while inflation remains so low. Concern remains more about the potential of deflation if economies sputter rather than inflation if growth continues to accelerate. At the same time, second-quarter earnings reports started to roll in last week. As expected results were better than expected and managements remain positive about the second half and cautiously optimistic about the future. Most companies lifted the low end of earnings estimates for this year at a minimum. Higher earnings, low inflation and lower than expected interest rates are not a bad recipe for higher stock prices.
On the other hand, political news out of DC continues to keep a lid on the markets as, unfortunately, it just does not get any better. Healthcare is a dead issue and the Trump administration will focus on passing tax reform and an infrastructure bill in the fall. Without the tax benefits of healthcare overhaul, future corporate tax rates will not come close to 15% as the administration hoped but will most likely fall to around 20-22% from a blended rate of 27.5% today, as we anticipated months ago.
We expect tax relief for individuals with virtually all of the reduction going to the middle and lower income tax levels along with additional capital gains/investment incentives but with longer holding periods. There may be some tax relief on estates less than $25 million too. The administration will continue to take a hard line at unfair trade practices. Expect rulings that will be favorable for the domestic steel and aluminum industries soon where there is clear dumping from abroad and not just from China. Listen to the Nucor and Alcoa second-quarter management calls, as you will learn firsthand why dumping is real and not just a political issue. Still, both companies reported year over year gains of 60% in EBITDA. Not too bad, and it will only get better with fair trade policies out of DC.
Eurozone industrial output rose at the fastest rate in six years last quarter. Japan raised its forecast for economic growth this year and next with business optimism hitting a multi-year high. China will likely expand at 6.9% for the year which is higher than earlier projected. And at the same time, inflationary expectations stay muted.
Even though positive productivity has not kicked in yet to reduce labor costs per unit, why has inflation stayed so muted? The answer is that globalization is a fact of life increasing competition; the disruptors are everywhere causing the established companies to rethink pricing, distribution and the need to further increase efficiency; and corporations are just learning to make the products better, distribute more efficiently and for less. It does not hurt that rising supply and alternate, low-cost, sources of energy cap prices. Historically low inflationary pressures during an extended economic expansion are not transitory as many of the pundits think. This is great news for financial assets!
Stock price moved down for Lowes and Home Depot last week after Sears announced that it was going to sell appliances over Amazon. Appliances account for approximately 11% of each of their sales and the market is anticipating more price competition. It seems that Amazon will continue to move into new areas disrupting the status quo increasing competition and lowering prices. While great for the consumer and for future inflation, it is not good for the box stores and manufacturers. Let’s hope that Amazon enters drug distribution at some point. The key take away here is to stay away from any market Amazon can enter!
I want to digress for a moment to discuss a company that continues to under go a massive transformation for which the market has lost patience. No company has transformed itself more than General Electric over the last few years. The company has divested over $190 billion worth of mostly financial assets; taken its industrial businesses from 45% of total revenues and profits to over 90%; invested well over $6 billion in the GE store while increasing earnings per share along the way and maintaining a $0.96 dividend per share. Just this past year the company closed on the Alstom and Baker Hughes acquisitions while making a number of major dispositions including the remaining financial businesses, water and lighting. Have there been hiccups and disappointments along the way? Absolutely, as well as many successes. Now that the vast majority of the transformation has been completed, there is a management transition taking place too from Jeff Immelt to John Flannery as CEO effective August 1. The market naturally will take a wait and see attitude since the company announced on Friday that the new CEO would not present his vision for GE until November. The company maintained its forecast that earnings will increase but to the lower end of its $1.60-$1.70 per share band in 2017 up from $1.49 per share in 2016; free cash flow of $16-$20 billion including asset sales and over $20 billion returned to shareholders including buybacks and dividends for the year. Real growth should accelerate to 3-5% and margins will expand by 100 basis points assisted by a $1 billion dollar cost reduction program for the year. The problem is that reporting is much too complicated to comprehend, and there still are too many moving parts as the company concludes this mammoth transformation by the end of this year.
I expect that the new management team will simplify reporting, narrow its focus, institute growth initiatives, emphasize increasing free cash flow, further pruning the portfolio while making bolt on acquisitions. The current dividend is sacrosanct! The yield is currently 3.7%. Don’t forget the GE is leader in virtually all of its businesses and has correctly anticipated the move to the web for sales, distribution, productivity and innovation. The stock today sells at a 32% discount to Honeywell and UTX, which should narrow over time as Flannery implements his strategy. The incoming CEO has a 30-year record of success at GE including head of GE Healthcare. He is a proven winner and the right man for the job. It does not hurt that Nelson Peltz, a long time friend and former business associate, is deeply involved here, too. So look through that proverbial windshield while others look through the rear-view mirror and be patient as the best is yet to come.
Let’s wrap this up!
The global economy continues to accelerate without the normal inflationary pressures. Interest rates have stayed tame, as the yield curve has only slightly steepened. The dollar remains weak as growth overseas has surpassed growth here and Trump’s continued political problems weigh on confidence in the dollar. Earning growth continues to exceed all forecasts and estimates for 2017 and 2018 continue to rise. It is clear and important to note that all the monetary authorities are concerned most now about the low inflation rate; therefore they will tread lightly and remain one-step behind in lifting rates and removing monetary stimulus. All of this is the recipe for rising stock prices but be careful, as there are a lot of pitfalls too. Don’t invest in an industry/company that Amazon or any other disruptor can enter for all the reasons discussed above. Stay with best in class with strong management and a well-defined plan to profitably grow in a globally competitive market. Invest in companies willing to transform themselves to succeed in this new environment but be patient as it will take most likely more time to succeed but the rewards will be well worth it for the investor.
Dividend/yield play an important part in the investment process, as interest rates remain low. Our portfolio continues to emphasize financials, mostly large A center banks; global industrials like GE, HON, UTX and others; low cost industrial commodities with strong cash flow including highly profitable American based steel and aluminum companies; technology; and special situations undergoing profitable change.
Remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset allocation with risk controls; do independent research; be patient and…
