US Labor Market Report February 2018

The US Labor Market Report for February 2018 shows an increase of 313,000 added jobs to the nonfarm payroll employment. The unemployment rate was unchanged at 4.1% (Chart 1). Both numbers were reported by the US Bureau of Labor Statistics on 09 March 2018. This compares quite favorably with economists’ estimates who thought the number would be closer to 200,000. This is the highest increase in a single month since July 2016 (Chart 2). Total employment rose by 785,000. Year-to-year average hourly earnings have increased by 2.6%. This latter number was lower than the 2.8% economists expected.

The markets took this as indications that the economy continues to grow nicely while wages do not grow as fast as anticipated. This was interpreted as allowing the Fed to continue their gradual approach towards raising interest rates. If the wages growth is lower, it is expected to create less of an upward trend on inflation. As a result the markets responded with gains of major indexes of between +1.74% for the S&P 500 and +1.79% for the NASDAQ.

Our take on this is: we believe that although this may take some pressure off the Fed it nevertheless means that interest rates will continue to rise. The rate of unemployment is already low, the participation in the labor market is increasing and therefore employers will have to offer more money. This puts upwards pressure on wages. Growing wages in turn create more demand and that may push prices further up which is what we call inflation. It remains to be seen if the Fed is able to let inflation run to the value they feel comfortable with and then bring it to a stop with the currently planned measures.

We continue to believe that the higher and increasing interest rates are not sufficiently reflected in the valuations of the share markets yet. Some companies have increased their profits and/or their dividends and share buybacks, but some of the profits were windfall profits because of the tax reform and some of the dividends were special dividends that won't repeat. While we remain fully invested with our US portfolio we believe that the overall growth for this year will be more on the more moderate end of the spectrum. We are convinced that the Optarix US Portfolio continues to be well-positioned for the current scenario.

Happy Investing!

Source for images: Bureau of Labor Statistics, U.S. Department of Labor, https://www.bls.gov/news.release/pdf/empsit.pdf (retrieved 10 March 2018)

Realizing Gains as an Instrument for Portfolio Management: The Example of Brown-Forman

Managing your own portfolio can be exciting in particular when you invest long-term and your strategy pays off. Long-term usually means that you buy shares (or other securities) that meet all your requirements and are (relatively) low in price and then keep them for the foreseeable future. "Foreseeable future" is a bit abstract. We mean by that a minimum investment term of 10 years. At least that is the plan for each position we start.

Having said that, at times it pays off to not just site and wait but to realized gains if a stock had a really good run. Factors that influence the decision are various. For us this includes if a particular position has grown too large in proportion to the overall portfolio. We have a simple set of rules that guide us in respect of this factor. Other factors may be significant events that may have an impact on a particular company, e.g. being the target of an acquisition, an investigation by market authorities or even allegations of illegal actions like "cooking the books".

Brown-Forman (BF.B) is a solid company and we created our position in October 2016. We bought the initial shares at a price of about USD 46.00. At a time in February 2018 the price had increased to about USD 69.20, a plus of about 50.4%. At that point this position had grown faster than the average portfolio, giving BF.B more weight than we liked. Therefore we sold a portion of the position. We deduct the sales proceeds from the total costs of the position. This reduces the unit costs. In our case the unit costs decreased from USD 46.00 to about USD 32.70.

In the meantime BF.B also executed a 5 for 4 stock split. Our unit costs decrease further to about USD 24.90. Of course the stock price decreased in line with the stock split, so as such we didn't "gain" anything from the stock split.

However, what makes all of this significant is the news about the possible trade war between the USA and the EU. The EU is considering to put tariffs on Kentucky Whiskey which would affect Brown-Forman's brand Jack Daniels. As a result their share price declined by over 5% today in response to those news. However, given a unit cost of about USD 24.90 and a current share price of about USD 52.90 this means that also because of realizing gains before the news our US portfolio still has an unrealized gain of about 112%. Not too shabby at all!

While we certainly do not enjoy the 5% decline of the BF.B share price, there are two things that confirm our approach:

1. Spread the risk over a large number of positions and 
2. Realize gains to re-balance your positions according to your appetite for risk

Taking this advice to heart will help enjoy long-term success with investing in the share market.

Happy Investing!

Disclaimer: We own shares in BF.B. We have no intentions to add or reduce our position within the next 24 after publishing this post.

Thoughts on Steel and Aluminum Tariffs

US President Donald Trump has announced that he is going to impose tariffs on import of steel and aluminum. This has seen the shares of US producers of these materials increase quite significantly. In our view if those tariffs become a reality, then there are a number of things that can happen.

Just looking at the initial step, this would mean that any products made from steel or aluminum will increase the price. The price will go up, even if the manufacturers manage to buy domestic instead of importing. The reason is very simple: The supply of US produced steel and aluminum will stay fairly the same but the demand increases. As a result the prices will go up. If tariffs stay in place for longer periods, then two main courses of actions are available to the consumers of those materials: They can use alternative materials. For example, instead of putting beer in an aluminum can, you could put it into a glass bottle. In other words: you replace it. The other option might be that the producers may increase their capacity. The problem with both of these options are that you can't change these over night. But both are definitely options to consider long term. Even if the producers increase the capacity the question remains, how many additional jobs does this really create? We would argue that it probably would be a very small number compared to the overall number of people who are in work already or are actively seeking employment.

Other businesses may have to increase prices because certain types of steel are not produced in the US at all. For example in car manufacturing you need special types of steel that need to be imported and are hard to replace with domestic materials.

Once the tariffs are in effect, there is a high likelihood that affected countries will retaliate. About 50% of the US steel exports go to Canada. That might not be much but Canada could impose the same tariff on those. It is also our understanding that Mexico has a trade deficit in terms of steel. Tariffs imposed by Mexico on US steel at the same level would potentially generate more money for Mexico than for the US. The European Union is an even more formidable opponent. They have already indicated that they have plans prepared to retaliate with import taxes on Harley-Davidson, Kentucky Whisky and other products that come from areas with a Republican majority. President Trump has already threatened to then impose tariffs on German cars. He has long questioned why the Europeans do not buy more US cars. Perhaps the question should really be: Why are US cars not as attractive as German cars despite a substantial price advantage? BMW, Mercedes, Audio: They are premium brands who can ask a premium price. Despite that, US citizens and US residents seem to have a preference for these over the US brands if they can afford it. It is unlikely that a German consumer will prefer a Chevrolet over a VW Golf any time soon.

The entire matter can certainly spiral out of control into an outright trade war. Perhaps it would make sense for the Europeans and Japanese to consider slapping tariffs on services and products from Google, Facebook, Microsoft, and other high-tech companies. And then take the money collected to give their own high-tech industry a tax credit. It just doesn't make sense. On a very simple, even trivial level, international distribution of work using market mechanisms benefits everyone. No-one would try growing pineapples in Alaska or Bananas in Europe. Equally there are industries that are better suited for other geographies. It makes sense to manufacture specialty steel at a massive scale near cheap energy to reduce costs. Arguing that putting tariffs on Canadian steel in the interest of "national security" doesn't make any sense. There is no record in the history books that the Canadians every attacked or threatened to attack the US. On the contrary: Canada is a partner in the five-eyes group of spying nations.

Let's hope that reason prevails in the long run. Paul Ryan, republican speaker of the house, has already broken with Donald Trump about the planned tariffs on steel and aluminum. There are more level-headed politicians that hopefully reign in a president who at times appears to act without thinking through the possible consequence of his actions.

Long-term investors have "survived" other presidents already. We will survive this president as well, no matter how good or bad he runs the United States. We just have to out-wait him. His term is limited to a maximum of 8 years, and that is only if he is reelected so it might be only 4 years. So stay calm and carry on!

Happy investing!

US Interest Rates Are Rising

Over many years investing in shares benefitted from falling and low interest rates. The yield on 3-Month Treasury Bonds was between 0% and 0.2% from January 2010 to about September 2015. From then it started to increase moderately, then faster. As of market close on 02 March 2018 this number is 1.63%. This still appears to be a small number but the diagram shows how this actually does indicate a sharp rise in short term interest rates. The yield on 3-Month Treasury Bills is often used as the reference for the yield of a risk-free investment. There is a general opinion that the likelihood of the US government to default is close to zero for a three-month time frame.

Another metric worth monitoring is the yield on 10 Years US Treasury Notes. These have been falling until about March 2016. Since then they have been moving up as well with the latest number being 2.862% (as of market close 02 March 2018).

Why is this important? Yields increase as the price for bonds and bills decrease. For investors it means that as the yield on investments with a lower risk increases, they either pull out money from investments with higher risks or they need the investments with higher risks to create a higher return. Shares are generally considered to be an investment option with a higher risk than T-bills or government bonds. Given that the US share markets have enjoyed gains of almost 20% in 2017, their valuations have now reached lofty levels. Rising interest rates will put pressure on shares prices as gradually more investors will tend to sell shares and invest in lower risk assets.

So far, some companies have been able to stem the tide somewhat in that they have raised dividends and share buybacks. Both are ways to return money to shareholders. The total return, being the combination of share price increases plus dividend payments and other distributions (e.g. stock splits), improves. However, this works only so far. Some of the dividends are special one-off dividends. And even though the tax reform in the US helps companies to reduce their tax bill, the amount of interest they have to pay increases. The low interest rates over many years was a big incentive to take on more debt in the balance sheets. As the interest rates increase, this can backfire and offset the gains from reduced tax payments.

Also, some companies experienced windfall profits as they need set aside less reserves for future tax obligations. Some have opted to give their employees a pay increase which also increases the cost base.

And then there is the Federal Reserve. It is expected that they will continue to increase the interest this year. Most commentators seem to expect three or four increases in 2018. We don’t know yet by how much. In any case they have several reasons to increase the interest rates. Inflation is picking up and this is driven by several factors including the low rate of unemployment in the US driving wages up and also the weak dollar that drives up prices on everything that needs to be imported. And that is even before tariffs are imposed, tariffs currently known (steel and aluminium) and potential future ones. Even the “most American” of cars consists of at least 50% parts that are imported.

Inflation, the weak dollar and tariffs are potential topics for future posts, so we won’t go into further details here. Suffice to say, interest rates are more likely to continue to rise than they are to stay flat, let alone fall. And this is likely to be a factor for the time being that puts a downward pressure on the US share markets.

We believe, though, that our Optarix US Portfolio is in a good position to do as well as its benchmarks if not better. Stay tuned and observe how all of this will play out. It’s exciting times!

Happy investing!