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What Were They Thinking

The Week Ahead:
Quieter economic week. The dollar holds the key.  

Stocks had a good week…again. The S&P 500 was up around 2.6% bringing the post-election rally to 12%. Is this all about unbound enthusiasm for economic policies that are months away from implementation? Not really. The first leg in the market was simply removal of uncertainty. This accounted for the first rally. Stocks then stayed in a holding pattern from mid-December to early February. It was the same for bonds. First, the initial spring upward of rates from 1.8% to 2.6% then a gradual pull back to 2.4%. If you were invested in a 25-year Treasury, the price fell from $130 to $109. It’s now $114.

So the first leg was all about uncertainty removal. The second leg is all about policy, re-regulation and a faith in reflation. This is where it gets tricky. U.S. stocks are pricey. If it turns out that the sound and fury signify, well, not very much, stocks are going to have a tough time holding these levels. It’s interesting to note that Small Company stocks have not had the second leg rally. And that International and Emerging Markets have strongly outperformed U.S. stocks this year. This makes sense. The strong dollar, reforms and some good numbers from Germany, South Korea and China all point to a healthier outlook for non-U.S. markets. Here’s the chart:

This shows all non-U.S. markets against just the U.S. market. In the last 10 years, U.S. stocks have returned around 60%. Non-U.S. stocks around 0%. But if you look closely at the top right, you can see this has begun to reverse. Year to date, International stocks have kept up with the U.S. while Emerging Markets have pulled ahead. We think this will probably continue.


1.  Rates: Chair Yellen gave a cautious testimony to the Senate. It seems like the Fed is waiting to see what economic policy brings. This is the key line: “Among the sources of uncertainty are possible changes in U.S. fiscal and other policies...productivity growth, and developments abroad”. That's one unknown, one known (productivity growth is way below its 30 year average) and one “who knows what’s up with the EU. But we do know this. With all the talk about rate increases, borrowing costs are low - really, really low.  Here they are:

That bottom line shows the 10-Year Treasury less the latest, raw inflation rate. It’s negative. If real borrowing costs are negative, any positive rate of return makes business sense. This is another reason U.S. companies have a reason to remain bullish. Debt is cheap and the investments hurdle low.


2. What the cuss were they thinking: It’s not often we talk about individual stocks but this was too good to pass up. So Kraft Heinz, which was cobbled together a few year ago from, er, Kraft and Heinz, and which is 50% owned by a private equity firm and Berkshire Hathaway, launched a bid for Unilever on Friday. There are three things going on here. 1) The hostile bid was triggered by a weak sterling, so good if you raise money in dollars 2) there was going to be a lot of debt around as Kraft Heinz is worth around $117bn and Unilever $140bn and 3) it was going to be the mother of all contested take overs because Kraft can't find growth to save its life and its net income is one quarter of what it was a few years ago.

By Sunday, it was all over and Kraft Heinz retreated with some nonsense about “utmost respect”. Here’s the graph:

The reason this gets into the blog is to ask: is Warren losing it (probably not) and are we going to get a run of mega cross-border mergers, because that’s top of the market stuff.


Bottom Line:
Earning season is 90% done. It's the first time since 2014 that we have seen two consecutive quarters of positive growth. One forgets how deep was the energy and financial earnings recession in 2015 and 2016. Again, look at international markets for bigger moves.


Other:

How economic populism works

Declining home ownership

The Whipsaw Song


--Christian Thwaites, Brouwer & Janachowski, LLC

Questions or comments? Email me: cthwaites@bandjadvisors.com


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

All charts from Factset unless otherwise noted.