Hall Capital “Market Views” Newsletter July 2019

This is the 37th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

How Important Are Interest Rates?
- very, very important

The Fed has been on center stage with investors for the last several quarters. The swoon last December was attributed to Fed tightening, and the market rally in the first half of this year was due to dovish speak from the Fed, e.g,"patience".  All long term asset prices are sensitive to general interest rate levels.  We figure from these interest rate levels a half point down would mean a 15% boost for stock prices  -- all other factors equal. The "all other factors equal" is a loaded and hardly minor consideration which distorts meaningfully those expected price changes.

There are all the geopolitical factors that have nothing to do with interest rates, but could very well negate the interest rate effect.  Also, if interest rates are rising due to increasing economic activity, then earnings growth could offset some of the headwind associated with rising interest rates. And vice versa if rates are falling due to slackening economic growth. 

While we stand by our assertion that all long term assets are sensitive to changes in interest rates, there are exceptions, in addition to "all other factors equal". One is if the change in interest rates is so widely anticipated that asset prices have moved in advance of the change in interest rates.  This is where we are today. Interest rate cuts by the Fed later this year, as soon as this month, are so widely anticipated that odds are high that there will be no meaningful boost to stock prices when the Fed actually cuts.  Over the next six months, geopolitical factors and the contour of economic growth will likely be greater drivers of stock prices than changes in interest rates.

How Important is Tax Policy?
- very

Much of the stock market gains since the change of administration has been due to the lowering of the top US corporate tax rate from  35% to 21%. While the effective rate drop is more muted, the slashing of the top nominal rate by 40% was indeed significant and a boon for investors.  

The economics of this tax cut are straight forward: lowering US corporate tax rates makes US companies more competitive in the global market.  However, politics complicate the picture.  When you hear something is done for "political reasons" that means a policy is undertaken that is good for a candidate or party in the short run, but bad for the country in the long run.  Otherwise, one would not say it was done for politics, but simply that it was a good move for the country.  

Lower corporate tax rates are good for the country, but cutting taxes without cutting spending is risky in the long run. The willingness to take on more national debt rather than cut spending was done for "political" reasons.  Spending cuts are felt during the current tenure of the political party in power.  The impact of raising the national debt is a problem for someone down the road. Yes, that's the same road the can is kicked down.

Since the tax cuts were not paid for, we have to be consider that in a couple of years  the boon we have enjoyed could be reversed.  There is already talk among presidential candidates of raising taxes on corporations. The rationale is that the lion's share of the benefit of the tax cut went to the top 1%.  That is true.  And income inequality is a serious problem that needs to be addressed.  Many prominent members of the top 1% agree.  But taxing corporations is counter productive and one of those things done for political reasons. It would be better to keep low tax corporate rates and allow our corporations to remain competitive globally, but tax the owners of the corporations -- yes, that would be us -- at a higher personal tax rate.  The proceeds could  be used to lower the Federal deficit and for retraining those who have lost jobs due to technology or globalization. We would be better off with more competitive companies less growth in national debt and higher stock prices -- even with a higher tax rate. This requires true leadership, doing something for the country, rather than for political reasons. 

So corporate tax policy is obviously important to profits, but there is another benefit not so obvious. I reported last quarter that the persistent low inflation and interest rates during this long recovery have baffled many economists.  I noted that technology played a role.  I will add another factor contributing to the surprisingly low and persistent inflation rate despite tight labor markets: significantly lower corporate tax rates.  Lower taxes not only allows companies to invest in more capacity, it also allows them to pass on some of the tax cost savings in the pricing of their product or service to the consumer. While the logic of this relationship seems compelling, I have never heard anyone relate lower corporate tax rates to lower inflation.

Focus List Edges Higher
- driven by Walmart

Walmart ripped higher 14.6% in Q2 boosting the return YTD to 20%.  Walmart was in our original Focus List nine years ago. It is a fine company and one of the few brick and mortar retailers that has performed over the last several years.  However, with the recent price appreciation the stock now trades at 22x forward earnings.  While a great company, it is no longer a bargain stock. So after nine years, we are taking profits in Walmart and removing it from our Focus List and adding Carnival Corp instead. 

Carnival is the largest player in the cruise industry with over 100 ships. It is the parent of cruise brands such as Carnival, Princess, Holland and Seaborne.   The stock is down 15% over the last year and below where it traded in 2005.  Considering Carnival is a strong competitor in a growing -though cyclical -  business, the stock trading at 11x trailing earnings appears undervalued.  Note the stock also sports a juicy 4.3% dividend yield. 

Would it be prudent to buy a cruise line if we are on the verge of a recession? Not really, as vacations are discretionary purchases.  While there is certainly a recession in our future, with consumer confidence high and unemployment low, we don't see recession risk this year. 

The Focus List edged 2.2% higher in Q2. The S&P 500 was up 4.3%.  The Focus List continues to dominated the S&P 500 over the long term,  up 15.8% per annum since inception in 2010 vs 14.7% for the S&P 500.

For individual stocks as well as selection strategies, past performance is not necessarily indicative of the future.

Hall Capital Focus List

Follow Up – from our letter one year ago

"It appears that investors have become inured to protectionist rants and are awaiting more meaningful signals before running for cover."
- Stock and bond prices rose over the last year.

"The House will likely flip to Democrat control come November. This will mean gridlock until 2021."
- Even a popular infrastructure bill has yet to pass.

"...bull markets do not die of old age..."
- Indeed. This one has broken the record and is still intact.

NOTE: Now in addition to ALL our quarterly letters, on our website is a tab with just the Follow Ups.

About HALL CAPITAL

HALL CAPITAL, LLC is a registered investment advisor and was formed by Principals from Arcturus Capital in 2010.
For more information, contact Donald Hall 626 578 5700 x101 dhall@hallcapitalmanagement.com

HALL CAPITAL | 199 S. Los Robles Ave | Suite 535 | Pasadena | CA | 91101