Unemployment

Stagflation risk and what this means for stocks

As the outlook for growth continues to deteriorate, whilst the price for goods and services remain stubbornly high, the risk of stagflation returns. This would be a tough scenario, where policy options tackling one of these issues would only worsen the other. This creates substantial downside risk for stock valuations based on bullish growth forecasts, whilst making it more prudent to invest in price makers able to pass on rising input costs.

Lower growth outlook

The outlook for growth is bleak. The IMF has reduced their forecasted expansion of Europe from 2% to 1.6% and Goldman Sachs swiftly followed suit predicting France and Germany will fall into recession next year, with the EU stagnating. The data looks supportive of this view. German retail sales disappointed expectations, with a contraction of -4.3% in July vs. -0.5% expected. With Europe still our largest trading partner, the effect on the UK could be severe.

Outside the EU, countries aren’t immune. China’s Purchasing Managers Index has fallen below the 50 mark, the line separating expansion from contraction and GDP growth came in at 9.1%, falling from 9.5% and below expectations.

QE increases stagflation fears

In an effort to boost the economy, the Bank of England surprised many commentators by increasing their purchases of UK government bonds, from £200bn to £275bn.  However, this is not without its risks. It is not a guaranteed strategy to boost growth and crucially create jobs. Instead, it is more likely to increase inflation.

Taking bonds out of the market and pumping cash in their place only reduces the value and purchasing power of the currency, making goods and services more expensive. Inflation is already above the 2% target set for price stability, hitting a rate of 5.2% at the latest measure this week. In the EU the value jumped to 3% in September, the fastest increase in 3 years and potentially a reason behind their Central Bank’s decision not to cut rates.

Unemployment in stagnating economies is an issue and highlights the threat. Spain is struggling with 1 in every 5 of their people without a job, increasing to 45% of the youth population, and Portugal’s jobless level has reached highs not seen for over two decades. The US’s September figures are stuck at 9.1%, although CPI came in below expectations. Here in the UK the level might ‘only’ be 7.9% but this is still high and stubbornly so, with inflation surprising on the upside.

The stagflation quandary (where stagnation and inflation meet) is that to tackle unemployment and boost growth, interest rates would be cut, however not only are they already low, but that would boost inflation even further. Likewise, to tackle inflation, interest rates might be increased but this would only hurt growth and employment.

A lose-lose situation.

Risk of Stock Downgrades

So what has this meant for stocks? Firstly, there is downside risk to stock valuations. With many valuations based on forecasted growth, downgrades could negatively impact and seem more expensive. Analysts are 10 times more bullish on the growth outlook than economists. Although, always more optimistic, that is twice the historical average.

Secondly, it may be more prudent to invest with those that are price makers not price takers, as well as with a protected demand base, in order to be able to pass on rising costs.

‘Operation Twist’ – What is it? How could it help? But why will it not?

As the US launches $400bn ‘Operation Twist’ in a desperate attempt to kick-start the economy, concerns arise over how effective this will be. It’s true that something needs to be done and inflation restricts the options open to the Fed but the strategy has a poor track record in terms of effectiveness. We will be in a lower growth environment for longer and should prepare accordingly.

 

The Economy Struggles: Something needs to be done

The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds. Unemployment is stuck at 9% and even more worrying are the ‘under-employment’ figures which include those that have been forced to cut their working week rise as far as 18.5% of the population. In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.

But inflation restricts options

So what can they do? When conventional monetary policy has become ineffective, since short term interest rates are already low, that’s where quantitative easing steps in.  With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%. Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to and you get less ‘bang for you buck’. Things seem more expensive and inflation has been boosted.

Operation Twist to the rescue?

There is hope. One form of quantitative easing avoids the problem of inflation – Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short term bonds. This avoids flooding the market with cash which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extending of the maturity of Fed’s bond portfolio. Buying these long dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer term rate makes for example mortgages (long term borrowing) more affordable which would hopefully encourage spending.

A Poor Track Record

History teaches that Operation Twist may be of limited use.  When it was applied back in 1961, it only reduced rates by 15bps! This would not be enough to encourage spending, hiring and boost the economy sufficiently.

What can you do?

Prepare for a lower growth environment for longer. Pay attention to the type of customer a company in which you’re interested in investing services. A strong balance sheet, pricing power and protected demand will serve firms well.

The US Debt Ceiling: The How, Why and What Could Happen?

The deadline for delivering a deal to allow the US to continue to borrow and spend, August 2nd, is approaching. Mirroring issues in the EU, a problem of debt cannot be solved by yet more debt. With the threat of a downgrade looming, any rise in interest rates could make the situation worse, hitting the tax payer and US exporters. Moreover, an increase in this ‘benchmark’ rate could impact the UK and hurt our property market, and a weaker dollar could result in job losses in our export sector. Further afield, with China the largest holder of US debt, the concern could spread globally towards countries relied upon to drive future growth. But failing to raise the ceiling isn’t an option and may cause an eventual default further down the line. Therefore, a deal will be struck and a balance found between demands for more spending cuts and aspirations for tax increases.

The US has ‘maxed out its credit card’

The US debt ‘ceiling’ is the maximum amount of bonds the US can issue, i.e. the maximum amount the US can borrow to finance its spending. The limit is currently set at $14.3tn but with the country spending approximately $120bn more than it takes in terms of revenue each month, after funding its participation in 2 world wars, rescuing the financial system post-Lehmans and pumping the economy with new capital to boost economic growth, the debt limit was reached on May 16. Put another way, the US has maxed out its credit card.

The issue echoes EU troubles: Debt cannot solve the problem of debt

Instigated in 1917, the debt ceiling has in fact been raised 74 times since 1962 alone. It should be noted; raising the limit does not increase fiscal spending but merely allows current obligations to be met and annual deficits to be financed. Nevertheless, in the current environment, with sovereign debt crises in Europe, investors and rating agencies are becoming acutely aware that cannot solve a problem of debt with more debt and the extent to which the ceiling would have to be expanded is troublesome. Obama’s proposed budget will require a ~$2.2tn hike just to meet next year’s obligations.

A lose-lose situation could hit tax payers and US exporters

Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA’ status and ‘stable’ outlook’, any downgrade would threaten its role as the safest place to store savings. To retain their position, the US needs to address how it will not only plug this short-term gap, but also meet longer-term challenges. A hit to confidence would increase the rate of interest demanded by investors to compensate for a higher perceived risk of loss. This would increase borrowing costs for the US, worsening their debt burden and further limiting the amount of new debt they would be able to issue. It has been estimated that even an increase of 25 basis points could cost tax payers $500m more per month. With less demand for US treasuries, there would be less demand for the dollar to fund these transactions, making the products the country exports more expensive abroad and again hitting their balance sheet.

The issue could hit the East and future global growth

In its extreme, uncertainty could spark another financial crisis as well as put the dollar’s status as the world reserve currency at risk. (Interestingly, a McKinsey investigation reported less than 20% of business executives expect its dominance to continue to 2025). For this isn’t an isolated incidence. Dollar-denominated US debt is held world-wide (especially $1.1tn by China), spreading the problem towards the very countries many are lauding as growth drivers of the future.

UK jobs, home prices and recovery could be hit

There could be dire consequences felt even in the UK. The US is our largest export partner, spending $50bn for our products last year alone. A weaker dollar would damage American buying power, making these products more expensive and damaging demand. This would cause companies producing these goods to suffer and jobs would be lost. Furthermore, if fears over the ability of the US government to repay its debts led to investors demanding more to lend to the UK government, mortgage rates would become more onerous and it could be harder for buyers to purchase a property. With less investors able to buy and therefore lower demand, sellers may be forced to lower asking prices to get a sale.

Failing to raise the ceiling wouldn’t cause an immediate but an eventual default

In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits. Furthermore, some of their debt could be rolled over so long as the overall amount of treasuries outstanding didn’t rise. However, this is unsustainable in the medium to longer-term and would lead to an eventual default.

With too much at stake a deal is likely to be reached

The issue is currently being used as a negotiating chip by Republicans to get deeper cuts and long-term reforms whilst refusing to raise taxes, versus the White House aiming to cap tax exemptions and reduce ‘inequalities’ benefitting big business. Nevertheless, with such serious ramifications possible, it is unlikely a deal will not be struck.

Europe and a New Form of ‘Decoupling’ – How to React

The problem with international meetings is politicians are often “more interested in their next job than the next generation” – Anonymous source via Anthony Hilton, Evening Standard

Political turmoil has hit the three largest European economies in recent days. Portugal’s Prime Minister resigned, Merkel’s party was ousted from the most prosperous state in Germany after an almost 58 year uninterrupted rule and at France’s recent election, abstention reached a new high at 54% of the population. What are the main issues to be watching, how are they affecting investments and why is the term ‘decoupling’ now being used to describe countries within the EU?

Headline of Germany's biggest newspaper, Bild, 12 May 2010. Source: http://read.bi/cZa0of

Berlusconi ‘Flirting’ With Protectionism

In reaction to recent French takeovers of Italian companies, Italy is threatening to draft a bill to curtail the trend. France maintains the bill will go beyond measures conceived by Paris and tensions look to worsen as the French EDF, the largest shareholder of Italian energy company Edison prepares to replace the Italian CEO with a French counterpart.  Indeed with David Cameron concerned about maintaining an open and competitive continent, the issue is one to watch. Nevertheless, with a high savings rate and exposure to German and Emerging Market economies, the outlook for Italy remains strong. In a recent auction, the maximum amount of index-linked bonds targeted was sold on Tuesday, €6bn year to date. Domestic demand remains strong.

Spanish Growth Downgraded

Another European country with issues of its own and yet resilient market reaction is Spain. The Central Bank sees a growth outlook of 0.8% for this year, lower than the government’s expectation of 1.3% growth. Unemployment is still among the highest in Europe at ~20% and they are implementing some of the deepest austerity measures to bring their deficit inline with that of France. Nevertheless, markets are forward looking and are reacting well to the aggressive policy implementation. Spreads on Spanish bonds over the equivalent German versions continue to narrow.

Even more worrying is the 43% youth unemployment (as quoted in The Guardian), higher than both Egypt and Tunisia - leading Gregory White at The Business Insider to call Spain "The Next Egypt" http://read.bi/i7fKOu. Source of chart: Miguel Navascues, an economist who spent 30years for the Bank of Spain following a posting for the US http://bit.ly/fDGb6k

Germany Facing a ‘Blocking Majority’

After another disappointing election result, the governing party of Germany could face a ‘blocking majority’ if they lose one more state in the September elections. Inner-party opposition is looking likely to intensify and after abstaining in the UN’s vote on the ‘no fly zone’ over Libya, fears of a return to isolationism have returned. Together this could compound the indecision that has dogged Merkel’s leadership so far. Nevertheless, the country’s deficit is set to fall as low as 2.5% of GDP.

 

Equally applicable for France with their 54% abstention rate as to Germany's indecision - The once opinionated cocktail hour has gone quiet! Source: http://www.zundelsite.org/cartoons/german_party.html

A New ‘Decoupling’

Therefore, the markets are starting to differentiate between countries. Spanish and Italian equity markets are almost 9% higher than they were at the start of the year while others are still struggling.  Most interesting is the lacklustre return of Germany’s equity market despite stronger fundamentals. Although this can be explained by the idea that markets move not by information on an absolute basis but relative to past performance and most crucially – expectations. With this in mind, Italian and Spanish economies are seen to be improving and doing well versus investor-set benchmarks.

The Investment Insight

There are many more hurdles along the way. The yield on Portugal’s 5-year notes surpassed 9% for the first time since Bloomberg records began (1997). The average yield across maturities lies at 4%, but the trend is upwards and once a 6% level is reached, it is argued it will become near impossible to reduce the countries debt-to-GDP ratio. In the immediate future, today’s results of Ireland’s banking stress tests will reveal the additional capital required for adequate solvency. As always, it is wise to maintain context, exploit contagion to your benefit and focus on quality for the longer-term.

Stagflation – A Risk Worth Noticing

The supreme art of war is to subdue the enemy without fighting – Sun Tzu, The Art of War

Much is made in the news of the risk of inflation. We can’t step far outside our doors without being faced with the challenges it brings. From shockingly high petrol prices to rising agriculture costs hitting our shopping bills, the fear is setting in. However, when we strip out these volatile elements, just how much of a problem is core inflation? Instead, with economic growth precariously fragile, when it does become a concern, won’t we be left fighting a ‘war on two fronts’? It’s time we start to notice the ‘Elephant in The Room’.

An Anaemic Recovery

The economic recovery remains weak. Still driven by the consumer, the environment for spending is tenuous. Retail sales for December were downgraded and January’s figures can only be described as “unspectacular”. We saw the first increase in the claimant count in four months (which would have been even higher had people not given up the job search entirely). Moreover, earnings growth slowed to the lowest rate in six months (from 2.5% to 2.0%). With Hometrack, the property analytics business, foreseeing homebuyers facing a continued struggle to obtain mortgages in 2011, the outlook for spending and GDP growth looks tough.

Source: Capital Economics “UK Labour Market Data” Regular pay growth slowed from 2.5% to 2.0% (Published end Feb 2011, data to end Dec / Jan)

Consumer Companies Highlight the Headwinds

Highlighting the problem were the many consumer companies missing Q410 earnings estimates and downgrading their forecasts for this year. Diageo, Colgate-Palmolive and P&G were among those that struggled to meet expectations. Falls in demand were blamed, with the situation looking none the rosier going forward. Renault predicts the demand for cars in their home market of France will fall by 8%. In addition, rising input costs is adding to woes. Pepsi is budgeting for a whopping 8 – 9.5% increase in the amount of capital they will spend on oil and agriculture commodities, which contributed to the firm lowering their forecast for earnings growth from low double digits to high single digits. The question on everyone’s lips is – can they continue to pass on higher costs to the consumer? With the aforementioned weakness, the most likely answer is “no”.

Source: Bloomberg. Next share price (white) and the Cotton price (orange) + >10% YTD already.

Inflation ‘Illusion’ Tempting Risky Action

So just how much of a problem is inflation, when compared to the weakness of the recovery? True, headline Inflation has held stubbornly above the Bank of England’s target at 3.7%. However, stripping out food and energy prices, core inflation falls to 2.9% and recent reports show that after excluding taxes, we hit the 2% jackpot. Regardless, the political environment poses a risk. The MPC (Monetary Policy Committee) is under immense pressure to defend its credibility after keeping rates on hold for 23 months consecutively. Markets are now pricing in a 25bps rise in May. Crucially, these expectations alone have consequences. In one week alone, more than 10 mortgage lenders pulled their best fixed rate deals – hitting credit availability to the already weakened consumer ‘spenders’.

Only an idiot fights a war on two fronts. ~ Londo Mollari, Babylon 5

Stagflation – A ‘War on Two Fronts’

This is the crux of the problem – promoting growth can at times risk inflation and fighting inflation can risk weakening growth. Currently the biggest challenge of the two is strengthening growth. If the recovery remains weak, then when inflation rises and poses a far more serious challenge, the government will not be able to implement policies to fight it without dragging the economy into another recession. The possibility of stagflation is real. In this situation the government will feel even more pressure to raise rates but unemployment will still be high and so if rates rise, many will suffer. At the moment the MPC have a “wait and see” attitude – let’s hope this continues and they don’t succumb to ‘peer pressure’ too soon.

Hedge Funds – The Root of All Evil?

“We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies.” – Dr. Mahathir Bin Mohamad, (former Prime Minister of Malaysia, during the emerging market crisis).

The Hedge Fund industry has come under major scrutiny in the past few years. Blamed for stock market crashes, manipulating the markets and threatened with a ban on short selling, if a scapegoat was needed, they were ‘shortly’ targeted (!). Chargers of high fees and notoriously opaque – people naturally fear the unknown, and an expensive unknown even more so. Nevertheless, as Richard Wilson pointed out in his blog – back in 2007 the head of the Financial Services Authority (FSA) said that:

hedge funds were not the catalysts or drivers of (that) summer’s events.”

Hedge funds trading in the financial markets can increase liquidity and aid price formation. Jed Emerson wrote a great piece at the end of last year taking he argument away from a debate between “good” and “evil” and instead concluding:

“fundamental fund of hedge fund investment strategies, when managed appropriately, may represent an emerging though as yet not realised opportunity for investors to pursue both full,  commercial  rate  returns  and  affirm  relevant  aspects  of  Sustainable  investment practice.”

Although I question the assertion the fund of hedge funds industry is emerging – since in some cases it seems to be retracting, I agree they offer an opportunity for returns and the claim of affirming sustainable investment practice balances the opposition’s argument.

What seems to be a rarely discussed topic is the value the industry provides the wider economy, outside the financial markets. Below I highlight some impressive information, sourced from a great article by Open Europe….

BOTTOM LINE: Job and tax contributions should not be under-estimated.

Benefits of PE / HF Industry to EU Economy

  • Contributed ~ 9 billion (£7.9 billion) in tax revenues in 2008 – could fund the EU’s overseas aid budget for twelve years, or the regional budget for Poland,
  • Directly employ 40,000 people in the EU – 18,000 of whom are employed in the UK (before taking those involved in real estate funds or dependent on the industry)

Benefits to UK Economy

  • €6.1 / £5.3 billion tax income raised in the UK alone
  • Enough to pay for over 200,000 nurses or 165,000 teachers.
  • Tax revenues generated over 2 years could pay for the entire 2012 London Olympics.
  • If the revenues were lost, would take 20% increase in av. council tax bill to make up

SK

The EU – Without growth how can we prosper?

Without continual growth and progress, such words as improvement, achievement, and success have no meaning.” Benjamin Franklin

There has been much debate about whether the EU should be classified as a success or failure – no prizes for guessing in which camp the majority lie! We’ve heard calls for the dissolution of the euro and a public outcry from the German people [see their newspaper headline “we are once again the schmucks of Europe” (Bild, May 11th 2010) in reply to their hefty contribution to the fiscal package which gave support to the fledging Greek community and the subsequent hammering Chancellor Merkel then received in the regional election.] In terms of growth, the EU has an envisaged growth rate of 1% this year (World Economic Forum 2010). So lets look at what the data is telling us by the same criteria we judged the UK in the previous post…

  1. Stimulus? Are we seeing money growth feeding through to the wider economy?  NO

    Source: Bloomberg – although ticking up, still posting only a 4+ decade low annual growth rate

  2. Spending? NO – Domestic demand is suffering

Source: Capital Economics. EC Consumer Sentiment – low / falling (most hurt unsurprisingly in the periphery) - not the environment of encouraged and motivated spending.

3. Job creation and self sustaining recovery? NO! Structural issues remain

Youth unemployment rates EU.PNG. Source: European Commission – Eurostat. Euro-Zone Unemployment – remains a key structural issue

 

Note – most worrying is that this chart refers to youth unemployment! Who will drive the economy going forward?

Source: Capital Economics. EC Consumer Sentiment – low / falling (most hurt unsurprisingly in the periphery) - not the environment of encouraged and motivated spending.

INVESTMENT INSIGHT – the conditions for a self-sustaining recovery in the EU are also not in place. But in every “crisis” one can find “opportunities” and as requested by Shira at Seeking Alpha – I enclose a stock tip to implement my insights…

In Chinese the word for crisis is composed of two characters, one representing danger, the other opportunity – which is quite apt since my stock pick focuses on the opportunity the growing Chinese top-end consumer will offer to a certain European company whilst I continue to recommend caution with respect to the amount of beta exposure you take – protect from market pullbacks!

The type of stock to pick would be similar to a Rolls-Royce, (now owned by BMW and hence the vehicle to play this theme through – excuse the pun! BMW GR Equity). Please note – this is a theme to be expolited, not an intense bottom-up fundamentals- and valuation-based pick. The theme is exposure to the growing Chinese market, in particular the super-rich – price-insensitive and focused on the prestige purchase. With Rolls-Royce cars positioned as the world’s most expensive, they are “a symbol of wealth and personal success that simply has no real competitor”. (Matthew Alabaster, an automotive expert at PricewaterhouseCoopers)

A good article to explain the other virtues of the company is Sarah Arnott’s report in the Independent, Rolls Royce: The flying lady looks to the east

Chinese Demand: “this year the market for the Phantom in China alone will outstrip total sales in the first year of production in 2003”

Sales versus history: In June of this year, production topped 300 cars for the first time in Rolls’s history, the waiting list was backed up until October at the earliest and the company expects to more than double its sales for the year as a whole.

Sales versus competitors: Well insulated: Demand dropped by 17 per cent in 2009 “versus 50% for some others” (chief exec Torsten Muller-Otvos) and in comparison to the “Detroit giants General Motors and Chrysler file for bankruptcy protection, and a rash of takeovers and job cuts as demand dropped through the floor”. Every car is made to order, as demand drops, so does production – providing some insulation.

Outlook going forward : “Baby Rolls”, the Ghost, aims to take the producer into a broader market – smaller, lighter and cheaper than the traditional Phantom (although still early to determine its success, 30 orders for the car within days of the Chinese launch at the Beijing Motor Show in April is a good sign)


The UK – An impaired lending capacity – What’s the outlook for investment opportunities?

“A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain” (Mark Twain)

Back from a business trip to South Africa. I was flown over to present my investment ideas and during my time being the key note speaker and from the conversations with investors, I noted a recurring question – “what data should I watch?”. Now I always maintain one must not focus too heavily on one data point or information from one source / point of view. Nevertheless, to help give some clarity, I’ve managed to boil down global economic insights into just a handful of key points. Starting with the UK… Short term growth restrained, drivers of growth later on uncertain…

In terms of the three stages required for a self-sustaining recovery…

1. Stimulus – yes, we’ve seen quantitative easing but are we seeing LENDING (to businesses, consumers etc – remember consumption still accounts for a large % of GDP)?

2. Inventory Rebuilding – yes we’ve seen temporary re-stocking but are we seeing consumers SPENDING?

3. Job Creation – are jobs no longer at risk i.e. a SELF-SUSTAINING recovery?

Conclusion: The UK “aint there yet!”

1. Versus stimulus we are to see – THE LARGEST FISCAL SQUEEZE SINCE WW2…

Planned fiscal tightening (2010-13). From adding 0.8% to GDP to subtracting 0.2%

And lending remains muted:

“Despite various forms of support from the Bank of England and from Government, it is clear that the lending capacity of the banking system, in the UK and elsewhere, is impaired and will take some years yet to recover. Some banks need to continue de-risking and de-leveraging.” Paul Fisher – Executive Director Markets and member of the Monetary Policy Committee

Source: Bloomberg. UK Money Supply Growth (yoy) at 3 decade low

 

2. Instead of spending, governments, households and companies are DE-LEVERAGING, CONFIDENCE IS LOW, household spending restrained

In Rebecca Wilder’s article in her blog Household leverage: what does the US have that the UK does not? in News N Economics (her answer: they still have expansionary fiscal policy) the chart featured below highlights the extent to which households still need to de-lever (and a comparison of the heightened problem in the UK vs. the US)

UK Household leverage (blue) - further to fall, especially when compared to the US (red)

3. Job creation? Following on from the government’s public spending review – 750k public sector jobs are at risk

INVESTMENT INSIGHT – Conditions for a sustainable, strong recovery are “still not there yet”

Returns are to be generated opportunistically – in a lower growth environment, index moves may be range bound – capture alpha from the volatility – quality stocks that are over-punished during pullbacks. Instead of investing in companies focusing on UK sales, invest in those more internationally focused (especially EM).

Stock example – RR/ LN: Rolls Royce Group PLC (more on the car manufacturer next), the global power systems company, “signs agreement with STX Engine Company to further strengthen position in Asia” October 2010 (Rolls Royce Announcement)

“STX Engine, based in Korea, will become a packager of Rolls-Royce industrial gas turbine generating sets in the Asia Pacific region to better serve the growing demand for electrical power generation technology and will further strengthen our position in important Asian markets such as Bangladesh, Philippines, Taiwan, Vietnam and also Korea”.


A Sustainable Recovery? “What’s driving the markets and how should I invest?”

The recovery is “neither strong nor balanced and runs the risk of not being sustained,” (Olivier Blanchard, the IMF’s chief economist)

INVESTMENT INSIGHT: Closely monitor the economy/markets – look to exploit overreaction on the downside, but with protection against future market pullbacks (E.g. via managers able to short / hedge exposures quickly).


Highlights

SENTIMENT DOMINATES: Markets driven by sentiment, cash on sidelines desperate to be invested

STIMULUS TO DECREASE: Earnings growth driven by cost cutting (a limited stimulus), to fall

INVEST WITH PROTECTION: Investing but with downside protection

 

Answer

The aggressive fiscal policies we have seen and the possible stabilisation or even turnaround in some data points have given fuel to the bullish. Nevertheless, with markets rallying so far from their lows, strongly driven by sentiment and perhaps ahead of fundamentals with investors focused on good news only, the possibility of a pullback is even higher. The market is moving from pricing in stabilisation to looking for a sustainable recovery, which is very risky. Further support for the possibility of a pullback comes from the fact that the rally which took the market to its current level, from March to year end last year, was arguably a low-quality, high beta and short-covering rally driven by discretionary consumer names which should be the most negatively affected in a recessionary environment (see charts below). Notice that since this point, the World Equity Index is flat, but the sector disparity has continued to widen. Nevertheless, I am also aware that there is plenty of cash on the sidelines and many managers judged against a benchmark cannot afford to miss out on another rally.

MSCI World Index +73% since 2009 low. Source: Bloomberg

During the 2009 equity market rally, the MSCI World Index (white) appreciated in value by ~70% from March low to year end. US Consumer Discretionary (orange) rallied ~90% whilst Consumer Staples (yellow) rose ~41%. Source: Bloomberg

What drove this rally? Markets rallied on better-than-expected corporate earnings but

  1. analyst estimates were so low that companies were bound to beat them;
  2. they were driven by cost cutting which companies cannot continue indefinitely;
  3. there has been talk of a “new normal” with growth in earnings reaching only 3% instead of the 5% we have been used to (Bill Gross)[1]

Bill Gross cites a move to a high persistent level of unemployment as support for his view. With lower income, higher savings, rising foreclosures and a credit restraining banking system, there still remains a strong case for the Bears to cling to. Across the “Pond”, the fragility of the UK market was highlighted when the BoE unexpectedly announcing massive expansion of quantitative easing program back in May of last year.[2] Many are now focusing on the possibility of a “double dip”, questioning how governments will be able to exit from their fiscal stimulus programs without dragging a muted recovery back into recession. This is before we discuss Europe which is widely believed to make a slower exit from the crisis.

US Unemployment Rate (%) at a heightened level. Source: Bloomberg

President Obama himself was given a stern warning from investment guru Warren Buffett about the severity of the situation. “He said, ‘We went through a wrenching recession. And so we have not fully recovered. We’re about 40, 50 percent back. But we’ve still got a long way to go’,” (Obama, July 2010)[3].

The situation remains unclear. At present there is enough data out there for Bulls to find reasons to be bullish as well as enough for Bears to find support for being bearish.

 

INVESTMENT INSIGHT: Until clarity returns, continue to closely monitor the situation to look for good entry points to exploit overreacting on the downside, but with the ability to protect from future market pullbacks (E.g. via managers able to short / hedge exposures quickly).

 

“Isn’t the consumer dead..?”

 

“American households have shifted their cash flows from illiquid real estate and consumer durables to paying down mortgages and consumer debt…It is this rapid rise in aversion to illiquid risk that explains a large part of the anaemic recovery in the US.” Greenspan

 

Highlights

DRIVER OF REVIVAL: The US consumer has historically been a crucial driver of economic renewal

PRECARIOUS POSITION: Many worried about employment, have under-saved for retirement

STIFFLED STIMULUS: The propensity to spend (and boost the economy) will be limited

 

 

Answer

The importance of the consumer and the concerns surrounding the structural headwinds they face are undeniable. Consumer spending accounts for approximately 70% of US GDP (although I’ve read an interesting piece by Darren Marron arguing this figure is actually nearer 60% when spending on imports are dealt with more appropriately[1] but nevertheless, this is still a significant percentage). The magnitude of the problem has been well described by John Maudlin who pointed out that versus the last recession, we have seen “double the asset deflation, triple the job loss, coupled with a collapse in credit.” It doesn’t look likely that the consumer will be bouncing straight back!

 

Conference Board Consumer Confidence Index down 57% since 2007. Source: Bloomberg

 

On the subject of unemployment, although it is universally monitored, what has been missed by many is what the rate does not take into account. Salaries have been cut and working hours reduced. This adds to the misery of many consumers. Furthermore, it is these people who are working part-time that will be hired back into full-time employment before companies reach out to the many unemployed. This must be assessed within the context of an expanding labour force where a substantial amount of new jobs are needed every month in the US.

 

Looking forward, another key limiting factor on the consumers’ propensity to spend is the move to save instead, as they look to fund their retirement / non-wage earning years. The “Baby Boom” generation is expected to account for nearly 60% of net US wealth by 2015, according to a study by McKinsey,[2] and their turnaround from spending to focus on saving will be magnified by the fact that they have historically under-saved. The aforementioned report identified that as low as only 25% are “financially prepared for retirement”, thus the decrease in the spending habits of the vast majority will be significant.  Inside Europe the story isn’t much brighter and the UK pension gap (the difference between the income needed to live a comfortable retirement and the actual income individuals can expect from their current pensions) has been heralded as the “biggest in Europe”[3] by national papers. The OECD sets an average pension at around 59% of the earnings built during a full working career, a stark comparison with the UK’s 31%[4]. With relatively small public pension, an individual will need to make extra savings to ensure their standard of living does not drop dramatically as they move into retirement. This is not an outlook that will encourage the spending that will boost or even support the economy. (For a deeper insight into the ageing populations of the developed world see What is a \”Structural limitation to growth\”? How can I exploit it?)

 

 

Savings Rate, US. Source: McKinsey Global Institute analysis

 

ECONOMIC IMPACT: This points to a muted recovery instead of a “V” shaped bounce-back.

INVESTMENT INSIGHT: Look at companies which aren’t as heavily reliant on the Developed Consumer but with an international reach and operations within Emerging Markets. To exploit the ageing of the “Baby Boomers” within Developed Markets, see What is a \”structural limitation to growth\”? How can I exploit it? and invest in companies positioned to benefit from an increased reliance on healthcare, nursing homes etc.