The ticking clock on trade has now struck an alarm for investors as tariffs on $260 billion in products that pass between the United States and China rose from 10% to 25% on June 1st, penalizing importers and exporters on both sides of what was once the biggest economic partnership in history.
While negotiations currently look stalled for the next few weeks, we suspect blowback will be brief and corporate fundamentals will be more resilient than a lot of people think. That’s good news because people are evidently thinking the global economy is going over a cliff.
Futures markets now indicate that just about everyone is convinced the Fed’s next move will be to cut interest rates to keep easy money flowing. As a result, the Treasury yield curve is a mess, with 1-year bills now paying higher effective interest rates (2.21%) than their 10-year counterparts (2.14%) and 2-month yields barely 0.01% below the 2.38% that 20-year bonds pay.
Add a sense that corporate earnings have stalled for the next few quarters and for many investors the near-term rewards of holding stocks no longer seem adequate to compensate for a season of elevated risk and headline exhaustion. The CBOE Volatility Index (^VIX: 18.71, up 15% last week) is once again within sight of levels we saw in early October, giving those who remember a queasy sense of déjà vu. People are tired of not knowing what each week’s news cycle will bring. They’re tired of having to pivot as the narrative flows.
While we understand the frustration, we’ve had the psychological cushion of our High-Yield, Healthcare and REIT portfolios to support our resolve while the market as a whole works out its moods. BMR subscribers never had to rush for safe havens because you always kept one foot in some of the most reliable and recession-resistant segments of the global economy.
Want a higher dividend than anything you’ll get in the bond market while the Wall Street pendulum swings? These stocks collectively pay 7% a year to buffer the dips. After a month when every major sector lost ground except for the Utilities (up a scant 0.24%), we’re grateful for even the limited clarity that cash flow provides.
And it’s been enough to shield the BMR universe as a whole from the worst of the ongoing weakness. Our stocks declined 3.5% last month, which stings but it’s nothing compared to the 5.7% pain the S&P 500 suffered or the 6.0% drop on the Dow. Technology, Energy, Consumer, Industrials, Commodity and Financial stocks all led the retreat, leaving only Real Estate and Healthcare (and those Utilities) holding up relatively well.
That’s where we always were, and it’s where our subscribers will make money if the market mood gets worse and more money flows into “defensive” themes. But this is more than simply gyrating with shifts in sentiment. Our Technology portfolio lost only 1% last month, beating the sector by more than 7%. In the nearer term, our Aggressive stocks are collectively up this week, thanks to one of our hottest names in that group (up 64% YTD) and its post-earnings surge.
(Which stock is it? Only subscribers know.) Either way, Wall Street is still rewarding the most dynamic business models and companies that prove quarter after quarter that they can grow faster than economic headwinds can blow. These companies are the future. And their performance in BMR portfolios proves that investors haven’t given up on that future yet. Let the rest of the market reel. We’re still where the upside is.
There’s always a bull market here at The Bull Market Report! This was a great week to check in on a few of our more “defensive” positions, but here we're only going to talk about Alphabet.
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BMR Companies and Commentary
The Big Picture: China and the Curve
We’ve done a lot of work in recent months to quantify the real impact of rising trade barriers and a flat yield curve so some of this will feel like a review. Nonetheless, having a sense of how much the fundamentals change gives us a better sense of what only adds up to noise.
Even if all trade with China breaks down, the world as we know it will not end. This is not just our sense of human resilience, but also a factor of the corporate results we read every day. More than 70% of what the U.S. economy consumes is made here at home and while global supply chains get messy, Chinese imports in particular counted for just 3% of GDP last year.
While Americans run a massive trade deficit, it’s because we buy from the entire planet: Cars and appliances from Europe, semiconductors from Taiwan, more cars and more appliances from Korea and Japan, meat from South America and so on. As long as trade deals hold with these partners, the flow of most essential products continues.
Rare earth minerals can be mined and even processed in North America. Taiwanese factories can produce iPhones as easily as those in Mainland China. Corporate managers will continually search the planet for the best and most stable long-term places to plant their factories and lock down their supply chains. In that respect, it isn’t so much how much “China risk” a particular company represents as how much the market as a whole is exposed to international markets around the world. Sector by sector, it lines up like this:
Technology and Materials producers are obviously more dependent on foreign customers than Utilities or Real Estate. The question with these companies is how much of their output goes to Mainland China as opposed to elsewhere in Asia or other regions of the world entirely. The best numbers we’ve seen indicate that companies that break out their results send as much to Asia as a whole (including India, Japan and Korea) as they do to Europe. Losing China will sting but it won’t be fatal.
Who is most exposed? On a regional basis, only Apple in our universe has anything substantial to lose in Asia, and even then, China is barely 20% of that company’s overall revenue footprint. Again, it stings, but it isn’t fatal. More to the point, with Apple down 20% from its peak, a catastrophic loss of the entire Chinese market is already built into the stock. You can’t go lower than zero. You can only go up again in relief when a trade deal finally happens.
On the other hand, you evidently can go lower than zero where interest rates are concerned, but we aren’t running scared of the yield curve yet. Admittedly, it’s disquieting to see 3-year Treasury bonds paying what they did a year ago (about 2%) despite four 0.25% Fed hikes in the intervening time. However, this feels more like the 1998 inversion than what we saw leading up to any historical recession.
The fundamentals are similar to 1997-8. Back then, the Fed got a little ahead of itself to combat “irrational exuberance” and keep wage inflation under control, but the economy was in racing gear. Cutting rates after the Russian debt default and prominent hedge fund implosions wasn’t an admission of desperation or even surrender. It was simply a realistic pause in the tightening cycle to give the market a little breathing room.
Stocks rallied for another 18 months. That’s a long time to sit on the sidelines waiting for apocalypse. It’s not our position at all.
Alphabet (GOOG: $1,104, down 4%)
Although the Search giant is up 6% on the year, we’d like it to be more and are expecting as much over the coming months.
The company has been posting 20% revenue growth every year since 2016, so investors grew accustomed to that metric being hit. 1Q19 brought in 17%, which – though still quite strong – is considered a miss for the company. The miss can be contributed to the company’s emphasis on diversification away from its traditional ad-focused revenue model. Alphabet is looking to monetize platforms not named Google, such as YouTube for example. The company doesn’t disclose YouTube’s profit/loss numbers, but did notify investors that the platform was the second largest revenue contributor, behind only mobile search.
This is a company sitting on over $113 billion in cash, around 15% of its total market cap, with only $12 billion of long term debt. The company has enormous flexibility going forward in terms of acquisitions, R&D, or stock buybacks. Even with the lower growth rate, Alphabet will continue to post double-digit revenue growth for the foreseeable future, and the company banked $7.5 billion in free cash flow last quarter alone. That’s astonishing for a nearly $800 billion behemoth.
BMR Take: With dominant positions in a slew of industries, from search (the company is essentially a monopoly here), to content distribution (YouTube), to autonomous driving (Waymo), to digital advertising (AdSense), to Internet of Things (Google Home and Nest), Alphabet is and will be a fundamental fixture in the backbone of our economy for decades to come. The revenue growth (albeit lower than in previous years but still relatively high), coupled with the mountain of cash and free cash flow production tells us its only a matter of time before the company joins the $1 trillion club.
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