“This is like déjà vu all over again.”
Perhaps Yogi Berra’s most famous quote, this could be turned into a theme song for the financial markets. US economy slowing down with a double dip likely…China’s growth slowing rapidly…Europe caught up in the problems of excessive debt, unified currency and disagreeable governments. All of these have been market themes in the summers of 2010 and 2011 and now 2012.
Here at home, the Citigroup Economic Surprises Index (which measures the trend in economic data exceeding or falling short of expectations) has turned sharply lower, just like it did in each of the last two years. Indeed, a raft of data from ISM manufacturing reports to regional Fed surveys to non-farm payrolls have all been soft in the last two months. The question is whether these soft readings congeal into negative GDP reports later this year or early next.
We believe the chances of recession have inched up to 50/50 for two main reasons: (1) actions by the Federal Reserve (like so called QE1 and QE2 in 2010 and 2011) are likely to be less effective this time and (2) it is highly unlikely that Congress will act by year end on the massive tax increases and spending cuts that take effect January 1. In the face of this uncertainty, we think businesses will pull back on hiring and investment plans and consumers will choose to save more and spend less.
Fortunately, there are some countervailing trends. Gas prices are following the price of oil, which has fallen about 20% from its peak earlier this year. Lower gas prices leave consumers with more cash in their wallets at month end. And, two stalwarts of a typical post-recession recovery – housing and autos – which were all but left for dead in the Great Recession are now showing signs of life. Auto sales recently rose above a 14 million annual rate, a more than 50% increase off the trough in 2008. We expect this production rate to keep rising driven by the replacement cycle and demographics.
After four years of torturous price declines, housing inventories are now very low, affordability is exceptionally high and prices are starting to reflect this dynamic in most cities. Unfortunately, housing is now such a small percentage of GDP that the impact of renewed strength will be muted for some time. More important, however, is the positive psychological effect stable home prices will have on consumers.
If it weren’t for the self-inflicted wounds of the coming tax hikes and spending cuts, we believe the US economy would continue to bump along at 1.5 to 2.5% growth. With so much riding on the outcome of the November elections, we find it hard to be confident of the environment we will face in 2013.
“If you don’t know where you’re going, you might wind up somewhere else.” (Yogi Berra)
European “summits” are piling up faster than we can count them. The latest, at the end of June, resulted in some apparent movement toward a single pan-Eurozone bank regulator. This is one of several very important steps toward a comprehensive “solution” to Europe’s debt problems. However, the timetable is aggressive, the hurdles high and the written agreement weak. After a day of euphoria, the equity and debt markets fell back to pre-summit levels.
We have said many times that we believe the Eurozone will survive, largely on the will to keep it alive. That said, this is a political process, involving many democratic countries with unique perspectives, so it will be a long, uncomfortable ride and it may appear at times that they have no direction or destination. The risk of failure is high but all of the players know that failure comes at a greater cost than union.
In the meantime, Europe will stay in a modest recession as the south deals with deep recessions built on austerity plans and the north maintains the status quo, benefiting from the weak currency. We believe the biggest risk is that the bond market loses patience with the political process and causes a crisis in which individual countries are forced to protect their own interests, leading to a disorderly unraveling of the currency union.
“You can observe a lot just by watching.” (YB)
A personal visit to mainland China in May provided some much needed perspective on the economy, which has been the subject of so much hand-wringing about whether the growth story is ending. Are there excesses? Certainly. Unused highways, bridges to nowhere, partially built apartment complexes, the list goes on. No doubt some will end up as waste, others were just built in anticipation of future needs. But there is a bigger picture.
There is a rapidly growing middle class which has no desire to turn back the clock. The sheer power of the market economy that has been unleashed in a very short time (just a little over three decades) is hard to fathom. We had the benefit of talking to many young people who are truly excited about the opportunities in front of them and are prepared to work hard to succeed. These young people have seen firsthand how much better their lives can be than those of their parents and grandparents and they want to ensure that the same is true for their children.
Bottom line, China’s export engine is slowing sharply – there is no doubt about that. But the seeds have been sown for strong domestic growth (by Western standards) for many years to come. The transition may be bumpy, but for those businesses positioned to benefit, the tough ride will be worthwhile.
“When you come to a fork in the road, take it.” (YB)
In a period of high uncertainty involving all three major economies, it would be easy to conclude that holding cash is a good strategy. But by providing no nominal return whatsoever for the next couple of years, we believe cash provides a negative real return we prefer not to accept.
We believe there are opportunities for solid, if not spectacular, returns. Among stocks, we like companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices. While the drama in Europe continues to play out, we have significantly underweighted investments exposed to that region. However, our dedicated exposure to Asian equities remains in place.
Finally, we continue to avoid US Treasury bonds. These now trade entirely on the basis of demand for a safe haven or temporary demand from the Federal Reserve. At the current level of yields, the risk to principal, once rates begin to rise, is astonishingly high. Quality corporate and municipal bonds still trade at attractive levels, relative to inflation, so our fixed income investments are focused in these areas.
July 11, 2012 © Essential Investment Partners, LLC