Reviewing our library of investing and business publications this morning, it’s striking how rapidly global economic sentiment can change. As case in point, the April 12th issue of Businessweek magazine carried side-by-side articles titled, “Drill, Baby Drill,” about the planned expansion of offshore oil drilling off both the Atlantic and Gulf coasts; and “Things Are Looking Up,” which discussed growing confidence levels from the stock market expansion. Six weeks later, on the heels of the largest oil spill in US history, the Eurozone debt crisis, and some mixed economic data, Businessweek is singing quite a different tune. Was Businessweek too optimistic in April? Is it too pessimistic now? Why the perpetually manic vacillation between the glass being half full versus half empty?
In light of recent equity market and currency market volatility, domestic flashpoints surrounding immigration and environmental disasters, and international tensions on the Korean peninsula and in Thailand, the expression, “May you live in interesting times,” certainly comes to mind. Is the expression a blessing…or a curse? It depends upon your point of view. Does “interesting” mean dangerous or turbulent? Or exciting and ripe with possibility? At BSW, we aim to cut through the hyperbole and white noise of general media blather and distill out the most probable investment outcomes, their impact on your portfolio, and how to be best positioned for long-term success. As such, we would like to share with you our current thinking on a few recent issues.
What Happened to the Recovery?
Since its April high, the S&P 500 has fallen about 12 percent, the end result of a domino effect triggered by the Eurozone debt crisis. As concern about Greece’s solvency grew, the faltering, impotent response of the European Union and the European Central Bank failed to reassure markets of the monetary union’s solidarity. Further, many economists worry that the harsh austerity measures meted out to Greece and its spendthrift peers (Portugal, Ireland, Italy, and Spain) would be an immense drag on European economic growth and, hence, global economic growth (the European Union is the world’s largest economic zone by GDP).
Fears about the Eurozone’s viability caused a flight from the Euro to the US Dollar (and the Japanese Yen), driving the Euro down to its lowest levels against the US Dollar in nearly five years. In many ways, the Dollar (and certainly the Yen) is simply the winner of the “least ugly” contest of major world currencies. But while the dollar’s strength may be good news if you are traveling to Europe this summer, it is likely bad news for the fledgling US economic recovery. A strong dollar makes American goods and services more expensive abroad, resulting in less demand. Unfortunately, according to US Federal Reserve data, the US is still only utilizing about 69 percent of its industrial capacity – versus its 38 year historical average of 81 percent. Until businesses see sustained demand, they are unlikely to utilize additional capacity or expand hiring, and without job growth, consumer confidence wanes and spending stalls. It’s a vicious cycle with the potential for deflationary conditions if prices fall for an extended period. Investors’ rush to safety also lowered US bond yields, which enables the US, fortunately or unfortunately, to continue cheaply financing its monstrous structural debts – and to kick its very problematic debt can down the road, at least for now.
New York recently passed Sydney, Australia and Hong Kong as home to the world’s most expensive retail rents, at $1,725 per square foot per year. Oddly enough, though, the highest profile retail lease signed in Manhattan recently was a record-breaking 15 year, $300 million dollar lease on 5th Avenue by the Japanese clothier Uniqlo. Uniqlo, which is a bit like a Japanese version of The Gap, is famous for its budget-conscious styles. Uniqlo’s success, however, has also made it infamous and emblematic of Japan’s twenty-year battle with deflation. Japanese economist Noriko Hama caused quite a stir in 2009 when she blasted Uniqlo’s cheaper-is-better model of yasuuri kyoso (low price competition), which she argued was “destroying society” and “self-strangling.”
The Uniqlo anecdote is indicative of a broader deflationary trend. Based upon consumer price index measures, inflation fell to a 44-year low in April, yet another sign that high unemployment and excess productive capacity are stifling pricing power. The consumer price index, however, is a wildly manipulated number, which excludes food, energy, and healthcare, not to mention the garbage-in/garbage-out methodology it utilizes for housing costs. Although low European inflation readings mirror those in the US, developing Asia is struggling to contain high inflationary pressures. Many Asian countries, particularly China, have budgetary surpluses rather than deficits and continue to grow at a robust clip. By effectively tethering their currencies to the US Dollar, however, they also expose their economies to US interest rate policy, which currently hover near zero. In April, the US Federal Reserve’s Open Market Committee voted to keep the Federal Funds rate at “zero to 0.25 percent.” As a result, economies like China’s risk overheating due to continued growth plus stimulative monetary policy.
Moreover, due to their manufacturing base and large infrastructure projects, emerging economies are much more influenced by commodities prices, which have eased off relatively recent peaks but are still well above their February 2009 lows. For instance, China’s consumer price index rose a blistering 2.8 percent in April while year-over-year urban property prices climbed a staggering 12.8 percent from 2009. In an effort to cool their economy, especially the real estate market, the Chinese Central Bank has increased bank reserve requirements, raised down payment requirements, and is widely anticipated to tighten its monetary policy soon. Meanwhile, raw materials exporter and China-centric Australia continues to hold interest rates steady at 4.5 percent in an effort to combat inflation and speculative bubbles.
Where do we go from here?
At this point, the global recovery still faces some significant risks: the sovereign debt crisis that began in Greece and spread to Europe could further spread to Japan and even the US; a property bubble in China could burst and drag down one of the world’s strongest growth engines; the US’s stimulus-driven expansion could fade and its housing market could slump; politicians everywhere will continue to exercise terrible judgment. Again, though, BSW’s aim is to identify the probable, not just the possible. Many indicators suggest that the still nascent recovery is sufficiently rooted enough to continue growing. The US Labor Department recently revised down first quarter productivity gains to 2.8 percent, suggesting that companies have wrung about as much out of their lean staffs as possible. Service sector job growth also expanded in May, its fifth consecutive monthly gain; while the Institute for Supply Management reported that their jobs measure rose for the first time in more than two years. Pent up demand for autos, business equipment, and restocking inventories should provide a modest to robust undercurrent of spending and job creation, while the May 2008 index of consumer confidence rose to its highest level since March 2008.
So, are the risks real? Absolutely, but so is the recovery. We live in interesting times, to be sure, though “interesting,” from BSW’s perspective, suggests opportunities for patient and diligent investors.
-David Wolf, Chief Investment Officer