Boomtime for the American economy
In September 2018, 9 years into the second longest economic recovery in modern history (think of it as like entering into a 5th quarter of an AFL game), the non-manufacturing PMI for the United States hit 61.6, essentially the highest reading in a generation. That is, just as the economy (and the players) should be slowing down, the numbers continue to be hotting up.
In the years before Obama handed the Presidential reins over, the US economy had been in a cantering recovery, but under Trump the US has broken into full gallop. Small business optimism has never been higher with consumer confidence recently surging to 18 year highs. Wages have finally broken above 3% annual growth and the unemployment rate for the past two months of 3.7% is the lowest it has been in 49 years. In fact, ScoMo was in swaddling clothes when US unemployment was last this low!
Global challenges cloud the scene
In the background the spectre of tariffs and trade wars looms large. Whilst it is easy to think of Trump’s tariff obsession as a temporary indulgence by a single individual, this is evolving. A tidal shift in thinking is underway. For some time, the US defence community has identified China as a strategic threat and now the political class is joining in via Trump. Maybe Trump is still angling for a big deal, but the recent United States-Mexico-Canada-Agreement (USMCA) deal with specific clauses to exclude members from striking any agreement with non-market economies (i.e. China) shows how serious the Trump Administration has become and that Sino-American cooperation may be giving way to ruthless big power competition.
Meanwhile, in Europe, sick banking systems, fractious politics and Brexit all combine to make this region a fertile source of potential problems. Troubles in Turkey recently highlighted how extensive and horizontally exposed the European banking system could be whilst Italy’s huge debts and febrile politics highlight geographic fissures as well. Brexit is another extremely difficult problem where the desires of the population appear to be on a collision course with economic reality. The UK and EU are hurtling towards a resolution one way or the other on 29 March 2019.
The Fed holds the keys
The Fed holds the keys to pretty markets from here. In the years since the GFC interest rates were slashed and the balance sheet of the US Federal Reserve grew from $1 trillion to over $4.5 trillion. Since the end of 2015 they have been gradually applying the brakes by slowly but persistently raising interest rates and draining nearly half a trillion dollars from the financial system.
As we move into 2019, the Fed is fast approaching a critical juncture. With unemployment touching 49 year lows, inflation creeping above their 2% goal, wage rises hitting 3.1% per annum and the Fed ditching “accommodative” references from their statements, at what point will the Fed reach its “neutral” policy rate (currently considered to be about 2.5%) and tighten policy to head off overheating in the economy? With US equity valuations already stretched, the next few decisions by the Fed will have a profound impact on financial markets.
Quality and value to weather the storm
All this begs the question of where do investors hide? There are pockets of value for those seeking out good quality equities and as always, these opportunities come in many shapes and sizes:
Sum of the parts plays:
News Corp (ASX:NWS)
Whilst most investors would not see a newspaper business as an ideal investment, News Corp runs some of the best and most profitable in the stable. But more importantly, News Corp is not what it used to be. Its most valuable asset is not a newspaper, but a 62% stake in REA Group, which owns realestate.com.au. Adding all the individual assets up reveals a stock trading below our estimate of fair value.
Turnaround/bottom of the cycle plays:
Woolworths has certainly been the turnaround story of the past couple of years. Flat on its back two to three years ago, it is now well and truly back in business. Whilst we were always sceptical of the $38 valuation of 2014, WOW fell to just $20 two years later which now looks absurdly pessimistic as the stock moves closer to $30.
Undervalued growth plays:
Premier Investments (ASX:PMV)
Whilst not looking like a conventional low P/E stock, Premier has been an astounding retail success. A stable suite of core retail brands is coupled with two growth powerhouses; Smiggle and Peter Alexander. Such is the phenomenal growth of Smiggle that it alone appears likely to double EBIT margins in the business over the next 3 years. Combined with overall revenue growth, this should power net earnings to new heights. Worth paying that little bit more than average for it.