Goldman Sachs

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.

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Strategic Stock Selection by Gemma Godfrey on CNBC

Follow this link: CNBC Clip for a 3-minute run down of where you should be investing and what to avoid.

Incl: headwinds facing the banks (a “Tale of Two Cities: Goldman Sachs and Credit Suisse); opportunities for firms ‘ready for change’ (Apple versus Nokia) and the inflationary pressure on consumers (Pepsi and Coca-Cola)

Bank Rules: Stability Up, Profitability Down  21 Apr 2011

“I’m a little bit cautious about the sector and it will be interesting to see how (banks) are reacting to the regulation,” Gemma Godfrey, head of research at Credo Capital said of the banking sector. She added there would be more stability with higher capital requirements, but profitability would be reduced, as in the case of Credit Suisse.

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Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.

The Ags Appeal – Commodities with upside potential leaving demand undimmed…

“If there is no struggle, there is no progress. Those who profess to favor freedom, and yet depreciate agitation, are men who want crops without plowing up the ground.” Frederick Douglass

In an environment of high correlation, where can we gain diversification benefits? And with such a significant divergence of returns within the commodities space, which ones look interesting and why? With so much focus on China, which investment opportunities have the strongest demand outlook?

Correlations High

By the end of last year the 12 month correlation between asset classes had risen to a near record high of almost 0.8 against a historic average of 0.5 (according to Goldman Sachs using data from Datastream and MSCI). Whereas the increase in speculators in the oil market led to the commodity being traded inline with other risk assets, the speculators in the agriculture space (now amounting to around 80% of the market) have continued to trade according to weather patterns.

 

Crude oil price (yellow), commodity index (orange) and the msci world index highly correlated, in contrast to agriculture (green). Source: Bloomberg

 

Attractive Supply and Demand Characteristics

In addition to the portfolio construction benefits of investing in this space, the supply and demand dynamics for certain crops are attractive. 3 years of poor yield (due to weather disruptions) has limited the supply of many. China, the focus on the demand side, has just started to import corn (2 – 3% of total consumption but the beginning of a trend) and signed a $1.8bn deal to import soya beans from the US. How strong is this demand? The USDA (United States Department of Agriculture) reported that despite increases in the price of corn, consumption will be left “undimmed”. With the EU proposing to loosen import restrictions, the case strengthens. Moreover, in addition to having a limited “shelf life”, the capacity for storeage is limited. India left a third of their food to rot last summer due to this fact.

Less Downside Risk to Demand

Finally, comparing the demand dynamic with that for certain metals highlights another key point. Keeping in mind the already high inflation figures coming out of EM (suspected to be higher than published figures in certain cases), some countries will be under pressure to reign back infrastructure spending which would dampen demand for commodities used in construction.  However, with China having 14 million new mouths to feed each year (more than twice Ireland’s population), the question is do you think the higher risk is that China will cool their economy or let any of their people starve?

THE INVESTMENT INSIGHT

In addition to price targets, pay close attention to supply, demand and correlation characteristics of individual commodities. For example, sugar is now trading with a substantially higher degree of correlation to oil and equities – implying it is now perceived as an “energy commodity” with the significance of its use in ethanol production. In contrast to passive, energy focused ETFs, actively picking commodity exposures (or investing with a manager that does so) seems a smart idea. Despite the strong rally so far, agriculture exposure remains attractive…