Structural headwinds caused by deficit/debt problems will continue to trump cyclical tailwinds of solid US growth and earnings/revenue improvement for a while. I wonder if this is like the 12 step process in AA: first you have to admit you have a problem. All countries are in the process of admitting their addiction to debt. Even Paul Volker said today that the US should learn from Greece’s problems that unfettered deficit spending must eventually be addressed. I suspect that the issue in Greece is both a solvency and a liquidity issue. With the exception of possibly Greece, Portugal, and Spain, I wonder if it was more about liquidity than solvency near term. Long term, isn’t it really about solvency in California, the UK, and the US as well as most other developed nations?
Is this a temporary bump or a more significant turning point? I would say it has the potential to be bigger than a bump in the road. Globalization has taught us one thing: decoupling is gone for good, so the US cannot grow at an above normal rate indefinitely while Europe is in recession and Asia is touching the monetary brakes. Though all parts of the world are not necessarily at exactly the same point in economic expansion, eventually they are more likely than not to be moving in the same direction. Are all regions still moving in the same direction? Not exactly.
Low inflation is here for even longer. Low interest rates are here for even longer. Is deflation now back on the table?
Leading Indicators:
If we think back to February of 2009, near the lows, what indicators were we paying attention to that told us that perhaps the US stock market might be about ready to turn around? Commodity prices, performance of Asian stock markets, leading economic indicators, and monetary policy were among the most important. Most of our thinking was focused on the macro picture, as all stocks, regardless of quality, were being hit the same (analysts estimated at the time that over 90% of any stock’s movement was attributable to the market, and only 10% attributable to the company’s prospects). Commodity prices had turned up, Asian stock markets (particularly China and Korea) had turned up, leading economic indicators looked as if they stopped going down at a rapid rate, and monetary policy was highly accommodative. The first two (commodity prices and Asian stock markets) historically had led US stock market direction by as much as six months. Leading economic indicators began to turn not too long after the US stock market turned. And, of course, the lagged effects of monetary policy characterized by quantitative easing had begun to kick in.
Now, let’s look at those same four indicators today. Commodity prices rolled over in late April, breaking through their 200 moving average in May; the Chinese stock market is down 24% from its cycle peak in August 2009; the Empire Manufacturing PMI (a leading indicator) turned over in May vs. April; and monetary policy around the world started, before the Greek debt problem, to move toward tightening (China, India, Australia, Brazil and others having actually raised rates). Granted, we have a whole rash of additional LEIs to watch for over the next couple of weeks, so one data point does not a trend make. However, the Chinese stock market performance combined with the commodity rollover should give us pause. What works best in an environment that looks more like “late expansion” and “early contraction” rather than “early expansion”? Defensive stocks like staples and healthcare.
Europe:
We have frequently said that the European mess is noise negatively affecting our market and that the ways in which the EU, IMF, and ECB have tried to deal with the sovereign debt issues in Europe have changed daily (sounds a bit like the US response with the TARP funds’ quick shift from buying toxic assets to recapitalizing banks) and therefore make the effects on our market difficult to anticipate—musical chairs, I think, was a phrase someone used to describe it.
I would contend that what is happening now in Europe was something we in the investing world were well aware of, but thought would not materialize for a while. Excessive debt as a % of GDP is something that plagues all developed countries around the world, some worse than others. In the PIIGS, in the rest of Europe, in over 40 states in the US, in the federal government of the US, and in the UK, we all are struggling with the effects of Keynesian economic theory. Thinking that we would eventually grow our way out of the deficit/debt problems, we tried to fix a debt originated problem with more debt (our CIO Scott Schermerhorn wrote about that in an Insights piece a couple of months ago!). But we haven’t had enough time to grow our way out of the debt. All developed countries are wrestling with large public sector wages and social welfare obligations. Reining those expenses in will instigate generational and cultural conflicts, the magnitude of which is another unknown.
What will European countries do? Greece is trying to institute austerity measures; Spain and Portugal have already passed tighter budgets. However, think of what these tighter budgets will do to economic growth in these countries: slow them down. Spain already has a 20% unemployment rate; severe austerity measures will exacerbate already difficult employment and growth issues throughout the weaker countries of Europe. We can expect slower GDP growth from the region of the world least likely to have had a modest recovery in the best of circumstances. How will this potential economic weakness affect those companies who have a significant portion of its sales in Europe? Given the strength of the dollar vs. the euro (another headwind for US exporters), it cannot be positive. As an example, MCD gets 43% of its revenues from Europe, KO is at 33%–and these two names are in our higher quality, decent dividend, more visible earnings category.
We watch the bonds of these weak countries as the best indication of what the bond vigilantes are thinking the prospects of success in the IMF/EU/ECB rescue package is going to be. Much as the Fed’s massive purchase of government and agency bonds in 2008-2009 provided a bid for US Treasuries, the ECB’s recent open market purchases of European sovereign debt has kept rates on those bonds under control. Ed Yardini’s (Yardeni Research) sources tell him that “foreign holders of Greek and Portuguese debt have seized on emergency intervention by the ECB to exit positions, leaving Eurozone taxpayers exposed to the credit risk.
This situation is pretty complicated. But, the bonds of these countries may well start to show stress if the markets do not think the rescue package will be successful. It didn’t really help when the Germans today prohibited short selling of euro denominated sovereign debt. Different cultures, different economies, one currency dominated by Germany and France. Should be interesting.
Inflation:
The recent weakness in commodity prices erases the last vestige of pressure in the CPI near term. So the Fed, watching resource utilization and inflation in the US, should feel no immediate pressure to raise rates. The problems in Europe should act as a deterrent to higher rates anytime soon as well. Until there is more clarity in Europe, those countries who have raised rates may take a break near term.
All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned.
A Note to Portfolio Managers
Structural headwinds caused by deficit/debt problems will continue to trump cyclical tailwinds of solid US growth and earnings/revenue improvement for a while. I wonder if this is like the 12 step process in AA: first you have to admit you have a problem. All countries are in the process of admitting their addiction to debt. Even Paul Volker said today that the US should learn from Greece’s problems that unfettered deficit spending must eventually be addressed. I suspect that the issue in Greece is both a solvency and a liquidity issue. With the exception of possibly Greece, Portugal, and Spain, I wonder if it was more about liquidity than solvency near term. Long term, isn’t it really about solvency in California, the UK, and the US as well as most other developed nations?
Is this a temporary bump or a more significant turning point? I would say it has the potential to be bigger than a bump in the road. Globalization has taught us one thing: decoupling is gone for good, so the US cannot grow at an above normal rate indefinitely while Europe is in recession and Asia is touching the monetary brakes. Though all parts of the world are not necessarily at exactly the same point in economic expansion, eventually they are more likely than not to be moving in the same direction. Are all regions still moving in the same direction? Not exactly.
Low inflation is here for even longer. Low interest rates are here for even longer. Is deflation now back on the table?
Leading Indicators:
If we think back to February of 2009, near the lows, what indicators were we paying attention to that told us that perhaps the US stock market might be about ready to turn around? Commodity prices, performance of Asian stock markets, leading economic indicators, and monetary policy were among the most important. Most of our thinking was focused on the macro picture, as all stocks, regardless of quality, were being hit the same (analysts estimated at the time that over 90% of any stock’s movement was attributable to the market, and only 10% attributable to the company’s prospects). Commodity prices had turned up, Asian stock markets (particularly China and Korea) had turned up, leading economic indicators looked as if they stopped going down at a rapid rate, and monetary policy was highly accommodative. The first two (commodity prices and Asian stock markets) historically had led US stock market direction by as much as six months. Leading economic indicators began to turn not too long after the US stock market turned. And, of course, the lagged effects of monetary policy characterized by quantitative easing had begun to kick in.
Now, let’s look at those same four indicators today. Commodity prices rolled over in late April, breaking through their 200 moving average in May; the Chinese stock market is down 24% from its cycle peak in August 2009; the Empire Manufacturing PMI (a leading indicator) turned over in May vs. April; and monetary policy around the world started, before the Greek debt problem, to move toward tightening (China, India, Australia, Brazil and others having actually raised rates). Granted, we have a whole rash of additional LEIs to watch for over the next couple of weeks, so one data point does not a trend make. However, the Chinese stock market performance combined with the commodity rollover should give us pause. What works best in an environment that looks more like “late expansion” and “early contraction” rather than “early expansion”? Defensive stocks like staples and healthcare.
Europe:
We have frequently said that the European mess is noise negatively affecting our market and that the ways in which the EU, IMF, and ECB have tried to deal with the sovereign debt issues in Europe have changed daily (sounds a bit like the US response with the TARP funds’ quick shift from buying toxic assets to recapitalizing banks) and therefore make the effects on our market difficult to anticipate—musical chairs, I think, was a phrase someone used to describe it.
I would contend that what is happening now in Europe was something we in the investing world were well aware of, but thought would not materialize for a while. Excessive debt as a % of GDP is something that plagues all developed countries around the world, some worse than others. In the PIIGS, in the rest of Europe, in over 40 states in the US, in the federal government of the US, and in the UK, we all are struggling with the effects of Keynesian economic theory. Thinking that we would eventually grow our way out of the deficit/debt problems, we tried to fix a debt originated problem with more debt (our CIO Scott Schermerhorn wrote about that in an Insights piece a couple of months ago!). But we haven’t had enough time to grow our way out of the debt. All developed countries are wrestling with large public sector wages and social welfare obligations. Reining those expenses in will instigate generational and cultural conflicts, the magnitude of which is another unknown.
What will European countries do? Greece is trying to institute austerity measures; Spain and Portugal have already passed tighter budgets. However, think of what these tighter budgets will do to economic growth in these countries: slow them down. Spain already has a 20% unemployment rate; severe austerity measures will exacerbate already difficult employment and growth issues throughout the weaker countries of Europe. We can expect slower GDP growth from the region of the world least likely to have had a modest recovery in the best of circumstances. How will this potential economic weakness affect those companies who have a significant portion of its sales in Europe? Given the strength of the dollar vs. the euro (another headwind for US exporters), it cannot be positive. As an example, MCD gets 43% of its revenues from Europe, KO is at 33%–and these two names are in our higher quality, decent dividend, more visible earnings category.
We watch the bonds of these weak countries as the best indication of what the bond vigilantes are thinking the prospects of success in the IMF/EU/ECB rescue package is going to be. Much as the Fed’s massive purchase of government and agency bonds in 2008-2009 provided a bid for US Treasuries, the ECB’s recent open market purchases of European sovereign debt has kept rates on those bonds under control. Ed Yardini’s (Yardeni Research) sources tell him that “foreign holders of Greek and Portuguese debt have seized on emergency intervention by the ECB to exit positions, leaving Eurozone taxpayers exposed to the credit risk.
This situation is pretty complicated. But, the bonds of these countries may well start to show stress if the markets do not think the rescue package will be successful. It didn’t really help when the Germans today prohibited short selling of euro denominated sovereign debt. Different cultures, different economies, one currency dominated by Germany and France. Should be interesting.
Inflation:
The recent weakness in commodity prices erases the last vestige of pressure in the CPI near term. So the Fed, watching resource utilization and inflation in the US, should feel no immediate pressure to raise rates. The problems in Europe should act as a deterrent to higher rates anytime soon as well. Until there is more clarity in Europe, those countries who have raised rates may take a break near term.
All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned.