Global Market Commentary

January 12, 2015

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Executive Summary

1. Short-term fears, long-term prospects. Once again, we see some short-term volatility led by various market fears: of a Greek departure from the Euro, of a collapse of European banks or even of the common currency itself; of a “collapse” in the price of oil; of financial stresses among commodity-dependent emerging-market economies. We do not feel that these fears are rational or well-founded, and we see market declines caused by such fears as buying opportunities.

2. Genetically modified organisms (GMOs): New techniques are bypassing regulatory scrutiny. The U.S. produces a lot of commercial GMOs — more than any other developed market. Approval for GMO crops is not terribly onerous in the U.S., but can be time-consuming and expensive. However, a new suite of genetic modification techniques is being deployed that doesn’t fall under the regulatory purview of the Environmental Protection Agency (EPA) or the Food and Drug Administration (FDA). As with all GMOs, there are arguments pro and con about these organisms from proponents and critics — but there could be a wave of new smaller-cap crop science companies, since the outlay to pass the regulatory gauntlet will be so much less. We will watch the space closely — including the ongoing debate about GMO safety that is driving many consumers into the natural and organic arena.

3. Big changes in the Eurozone. Greece is in the front pages — again. A new Greek government will be elected on January 25, and it may tear up the debt agreements its predecessor made with the European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF). Some voices — including that of Germany’s Prime Minister Angela Merkel — are saying openly that a Greek exit from the Euro would no longer be a disaster, since European banking systems have been strengthened since 2012 — although Merkel continues to emphasize that her preference is for Greece to stay. At the same time, ECB chief Mario Draghi has said ever more clearly that the ECB can start buying Eurozone sovereign bonds, and is making the technical preparations to begin doing so very soon. All of this promises turbulence for the Euro and the Eurozone — with the potential for European stock markets to perform very well if events fall into place.

4. Market summary. We’re bullish, but for now, only in the U.S. If we see substantial QE launched in Europe, we could get bullish on Europe, but for now, we would not be buyers of European stocks. We believe Japan has just about completed a large move, and we are waiting for a correction. Most emerging markets will remain under pressure due to falling commodity prices, and we don’t view them as attractive at this time. China and India may both prove to be good long-term investments, but both need corrections before an entry would be attractive. Gold continues to build a base according to some technical analysts; others believe it could fall further.

 

Oil’s “Collapse” and Europe’s Issues — Déjà Vu All Over Again

We are seeing the same pattern that we have seen repeatedly over the last five years. Ever since the bear-market bottom of April 2009 we have seen periodic panics due to fears of a collapse of Greece, Ireland, France, Spain, Italy and or Protugal. And following each and every panic has been a big rally taking markets back up to higher highs. We believe that the current panic about lower oil prices, Greek instability, European QE, and potential problems for Spain and Italy will follow the same playbook.

We are happy to report that over the last five years, both Ireland and Portugal have taken genuine and sincere action to improve their economic well-being. In France and Italy partial measures have been taken and anti-capitalistic opponents have stopped the move toward more rational economic actions. This combined with existing favoritism toward existing companies and other bureaucratic obstacles to entrepreneurs make Italy, France, and Spain less than successful.

In Spain, good measures have been taken but they have also taken a political toll on the ruling centrist party, and they may be replaced by the Socialist party in coming months. The Socialists say that they will not continue the measures that have brought more economic stability and strength to Spain.

Greece will probably vote for an anti-Euro party that has stated on occasion that they will move to repudiate debt and quit the Euro. Greece’s exit from the Euro willl probably be a good thing in the long run, and may not shake the underpinnings of world financial markets. However, if Spain or Italy joins them in the sick ward, things will get complicated.

We are seeing a repeat of the panic that we have seen repeatedly for the last five years. Such panics have led to volatile market declines, which eventually are corrected by bail-outs and restructuring of debt — leading all investors to plunge back into the debt of the offending countries.

In other words, short-term fears and market declines lead to buying opportunities and over the longer term to much higher stock prices.

It is annoying to face the same old problems again, but it is also reassuring when we see it, because it clearly indicates that the complacency and over-optimism that characterizes a stock-market top is not at all present in the world today.

We have addressed the fears of an economic collapse of Greece, Spain, Italy, and France repeatedly in these pages for the last few years. Here is our summary in a nutshell. No major central bank on earth will stand by and let this region of the world collapse, even if the European Central Bank (ECB) fails to buy Eurozone government debt. Other world central banks will provide liquidity, and there will be no global economic meltdown.

As for Oil, No Need to Panic — Oil Prices Have Always Been Volatile

Lower oil prices do not necessarily indicate a global economic collapse, as some fear. Oil prices have not fallen because global demand is currently inadequate. Rather, they have fallen because of higher production and a supply glut which was developing for months before the price decline began.

Demand for oil has been quite good. In the U.S. and China, demand for oil is up from last year, and in many other parts of the world, demand for oil will increase as 2015 progresses. The fact is that global oil production has actually been increasing as prices have fallen, as OPEC and non-OPEC exporters (such as Nigeria, Venezuela, Russia, Iran, Iraq and Kazakhstan) have increased their production, even with lower prices, in order to get the revenues that extra sales will bring. So we see that thus far, global oil prices are falling due to an increase in production — not a lack of demand.

There is no doubt that lower oil prices will hurt the oil-exporting countries. which make up about 15 percent of the global economic pie. However, lower oil prices help all of the major economies of the world — the U.S., Europe, Japan, China, India, and many other non-commodity-exporting countries, both emerging and developed.

We Do Not Expect the Emerging World to do Exceptionally Well in 2015

Most emerging nations are exporters, and the demand for imports, while strong from the U.S., will be weak from Europe and mediocre from Japan. So most opportunity will be found in the U.S., or in markets that sell off irrationally due to well-publicized panic. Clearly, the media attracts more eyeballs with sensationalistic headlines such as “Oil Prices Collapse,” etc.

Commodities Are Volatile and Have Always Been, and Oil Is No Exception

The reality is that oil is volatile — like other commodities. Oil, and commodities in general, are notorious for 100 percent rises and 50 percent falls that occur with some regularity.

Oil, for example, since 2004, has risen from about $26 per barrel in mid-2003 to about $55, from which it fell to $40 in late 2004. From $40 it rose to $78 in 2006 , and then fell to about $50 in early 2007 . From $50, it rose to over $145 in mid-2008. From there it fell to below $35 in less than 9 months. Next it rose to $85 in 2010, and then rapidly fell to $65 about three months later. In 2011, it went from $65 to $115, and then reversed itself, falling back to $75 before the year was over. In 2012, it went to $110, then fell to $78, and then rose to over $105 in 2014 — and down to below $50 in a few months.

The following chart shows oil’s volatility.

Oil Graph

Source: MacroTrends

The historically most interesting comment about oil that we have heard recently was by our friend Tony Dwyer, the wise and prescient chief portfolio strategist for Canaccord Genuity.  Tony pointed out this week that there have been two recent oil price declines that are historically somewhat like the present decline.  Both occurred outside of a recession, and clearly the U.S. is not in a recession.
 
Case #1

In 1985 to 1986, oil declined 69 percent in five months. Then, as now, Saudi Arabia decided to over-produce in order to maintain market share and force non-OPEC production shutdowns.  In that case, other OPEC members also expanded production and offered pricing arrangements to maintain market share and to partially offset declining revenues per barrel.  U.S. crude oil production peaked in early 1986 and began dropping.  Additionally, the sharp decline in crude oil prices encouraged an increase in U.S. petroleum demand, which rose steadily for the second half of the 1980s. U.S. stocks rallied.
 
Case #2 

From 1996 to 1998, the price of oil declined by 61 percent over a 23-month period.  Tony points out that this is somewhat like today because the U.S. dollar was strengthening, U.S. economic growth was accelerating, and global growth was slowing (we see global growth rising in 2015, but Europe slowing), while stock market valuations were expanding.  U.S. stocks were rallying.
 
If the current oil price decline follows the path of either of these two cases, stocks will do well moving ahead.

Undoubtedly oil, like all commodities, is volatile.  We also know that the current volatility is only part of a much bigger and longer-term pattern of volatility for oil and all commodities — and in most cases this volatility is not tied to economic activity.  It is tied to the supply produced of a commodity as well as to the amount demanded.  Oil demand has been rising for years on a global basis, and production has been rising as well.  Oil prices have been falling and much of the price decline is due to increased supply.  Thus far world oil demand is holding up well.
 
        Copper Also Has Supply Issues
 
Those who claim that copper is a predictor of economic growth or shrinkage should also check the current chart.  It is well-known that the world economy has been growing steadily since 2011 while copper has been falling.  Sorry — maybe copper once was a predictor of global economic growth, but it is no longer.  Especially since the world has opened or expanded many mines, which has greatly increased global copper supply in recent years.

Copper

Source: Bloomberg

In general, we do not look for big export growth from the emerging world, whose economies are very export-dependent. We do not look for big opportunity in Europe, unless they change their attitude about QE. On the other hand, we look for benefits to countries and regions such as the U.S., China, Japan, India, and Europe from lower oil prices.

Investment implications: Fears of a European banking meltdown, fears of global deflation, fears of financial market chaos from “collapsing” oil prices — all are converging to spook stock markets. We do not believe that any of these fears are rational, or that they will prove well-founded. We regard the present correction as a buying opportunity in view of the strong fundamentals of the U.S. economy. Europe will cope with Greece without collapsing, and European markets will have a chance to perform well if the European Central Bank embarks on large-scale buying of government bonds. Commodities may be exhibiting volatility, but historically, we can see they often exhibit volatility — present developments are no cause for panic. Nevertheless, on the whole, we’re happy to see a market that can show a little fear — this tells us that we’re not yet at a market top.

 

When Is a GMO Not a GMO?

The development and marketing of genetically modified crops has typically fallen under the regulatory oversight of the Environmental Protection Agency (EPA) and the Food and Drug Administration (FDA), depending on the crop and the technology. The process has been controversial, with ongoing battles about the potential mandatory labeling of GMO foodstuffs, and polls showing deep consumer mistrust of GMO safety. Nevertheless, GMOs are widespread in the North American food chain — most processed and commercial foods contain corn and soy, and virtually all corn and soy in the food supply are genetically modified.

Sometimes the modifications allow crops to remain fresh longer, to be more drought tolerant, or to express toxins that function as insecticides; sometimes they make crops immune to broad-spectrum herbicides, so that chemicals such as glyphosate (sold commercially as “Roundup”) can be used freely to kill weeds without damaging the crop itself.

While the U.S. has embraced GMOs and has a liberal regulatory pathway for commercial production, other developed nations, and many developing nations, have been far more skeptical. European regulatory regimes in particular are much more stringent, with some EU nations banning GMOs outright.

GMO Technologies

So far, the predominant technologies for developing GMOs have involved the creation of “transgenic” plants — so called because they involve the transfer of genes between organisms of different domains, for example, the transfer of genes from a bacterium to a plant. That’s actually one of the most common, and was one of the first GMO crops to go into commercial production: corn which had a gene inserted from the Clostridium botulinum bacterium, so that the plant’s tissues expressed a protein that is toxic to insects. (Basically, a built-in insecticide.)

Critics and GMO skeptics have worries on several fronts. First, ecological systems are extraordinarily complex. Skeptics argue that since GMO crops are open pollinators, their genetic material will inevitably find its way into the wild, where it could have unpredictable long-term effects. (The risk of transmission has proven well-founded, with samples of heirloom maize from remote regions of Mexico testing positive for genetic material from strains of GMO corn.) They argue that more extensive testing and more careful evaluation of the systemic impact of a GMO crop needs to be done than is required under present laws.

Further, critics note that the evaluation of GMO toxicity follows the same regime as required for any crop-protection chemical — and that this battery of tests may not capture potential chronic effects. We recently noted a study examining unusual brain metabolites in various animals fed a diet of transgenic corn; GMO skeptics are concerned that the rapid, almost pro-forma approval of GMO crops may prevent such an effect from coming to light before unexpected and widespread damage has already been done. They also note that the widespread use of glyphosate-tolerant transgenic plants has allowed the use of greater quantities of glyphosate herbicides, and think that those herbicides may be found to have negative health effects and environmental impact.

From our perspective, the jury is still out on GMOs, and we anticipate further tussles among manufacturers, regulators, and consumers.

New Techniques Open Even More Doors

It’s not difficult to get a new GMO crop approved in the U.S., but it is very expensive. Anyone who has seen the dossier that needs to be submitted for such a product is aware of the hundreds of studies that need to be performed. One industry report showed that the development of a GMO crop costs $136 million on average, including $35 million in regulatory costs. The time-frame for approval can also be arduous, sometimes years long (some longer-term studies of teratogenicity and carcinogenicity require years-long studies or generations of animals to complete).

So many companies, large and small, have been finding a way to bypass the approval process altogether, and produce GMOs that don’t fall under regulators’ purview.

How are they doing this?

Simply with new technology. The regulations covering GMOs apply to transgenic crops created with particular technologies, for example, the use of viruses to introduce new DNA into the target organism. But new technologies are being developed that are outside the scope of existing regulations (such as so-called “gene editing,” which changes an organism’s genome without introducing DNA from any other organism). GMO developers are also eschewing transgenic crops, keeping the sources of new DNA from within the plant kingdom, rather than fetching DNA from bacteria or animals. That also puts the resultant organism outside EPA and FDA scrutiny.

dna drawing

“Gene Editing” Promises Less-Regulated GMOs

Proponents argue that in these cases, GMOs are really not fundamentally different from conventional hybridized plants. Skeptics counter that the consequences of the introduction of novel genes aren’t known — and that in any event, the process is escaping from regulatory scrutiny simply because the technology has outrun the regulators. (Of course, it always does, in every field.)

Investment implications: The development of GMO crops has until now fallen to the biotech arms of the big agricultural and crop-protection companies. The introduction of new GMO development techniques is taking some GMOs out from under the scrutiny of regulatory agencies — and potentially opening GMO production to a wide range of smaller companies as regulatory and development costs decline. We will watch for new entrants in the space — as well as keep our eyes on the ongoing conversation among regulators and consumers about GMO safety, and the potential impacts that may have on the share prices of GMO developers. Be careful about GMO foods until they have been proved safe for human consumption over a period of at least 20 years. It will take time for science to identify that allergic or metabolic problems or other damaging side-effects of GMO crops are developing within the population. There is no mystery why GMO-free organic foods are growing so popular with the U.S. consumer. Many shoppers realize the potential for unintended side-effects from GMO foods.

Europe: Will It Be “Yes” to QE, and “Good-Bye” to Greece?

In three rounds of voting during December, Greece failed to choose a new President, setting the stage for snap elections at the end of January. Polls indicate that the likely victor will be a party called SYRIZA. Syriza, whose name is an acronym for “Coalition of the Radical Left,” was founded in 2013 when it gathered together the vestiges of Greece’s old Eurocommunists and welded them together with populist outrage at years of austerity and recession. Its leader, Alexis Tsipras, is a young, charismatic lawmaker who promises to rip up the agreements Greece has made with the European Commission, the European Central Bank, and the International Monetary Fund to deal with its crushing debt.

The whole thing is making Eurozone officials remember the dark days of 2012. Once again, Greece is threatening to bring chaos to the Eurozone.

Is It a Catastrophe For Greece to Leave? Vielleicht Auch Nicht!

This time, though, officials are more sanguine about this possible outcome. It was thought in 2012 that if Greece defaulted on its debt and left the common currency, the result could be a systemic failure of the Eurozone banking system, as well as the potential collapse of other highly indebted European countries, such as Ireland, Portugal, Italy, and Spain. Now, Eurozone officials and politicians are saying openly that there have been enough reforms since 2012 that the Eurozone can cope with Greece’s departure. German Prime Minister Angela Merkel — the leader of Europe’s strongest economy and the woman widely regarded as the most powerful European policy string-puller — has basically said that if Syriza wins in Greece and demands concessions, they should simply be refused, and Greece should leave the Euro. That’s a serious change of tune since 2012, when she said that a “Grexit” was “unthinkable.”

Many analysts now think that (1) other fragile Eurozone economies have strengthened; (2) there is a new European Stability Mechanism (ESM) in place to bail out stressed member states; (3) most Greek debt has found its way into big institutional hands like those of the IMF, who are always capable of writing it down; and (4) pan-European banking ties have strengthened.

So the possibility of Greece’s exit may rile markets… but it is perhaps not the worrisome specter it was two and a half years ago. Indeed, some even think that the Eurozone could find better economic footing with Greece charting its own path back into the arms of the Drachma.

QE Is Coming

Additionally, the head of the ECB, Mario Draghi, continues to state that the Bank is ramping up preparations for full-scale QE — with analysts expecting an official announcement at the Bank’s meeting on January 22. (Greece’s snap election, scheduled for January 25, could cause the ECB to delay the announcement until the results are known.) With fuel costs falling, the Eurozone officially tipped into negative inflation in December, with prices registering 0.2 percent those in the same period in 2013. (Not taking energy into account, inflation ran at 0.6 percent — still a very low figure.) These data are expected to provide further stimulus for Draghi to finally take action. We hope that action will be as powerful and decisive as his words have been over the course of his tenure as ECB chief.

We read an interview he recently gave to Handelsblatt, the leading German business paper. We noted especially his insistence that he and Jens Wiedmann, the President of the Bundesbank, are in full agreement that the purchase of sovereign debt is a tool available for the ECB to use in fulfilling its mandate.

The prospect of QE is not popular in Germany. But we think it is probable that nascent deflation, the rise of populist parties in countries across Europe, and continued European economic malaise will finally push the ECB into action.

Investment implications: Greek woes and the prospect of large-scale QE from the ECB both put the Euro under stress. For now, we continue to view the Euro as an attractive short, although the trade is a very crowded one. If large-scale QE is implemented in Europe, we will look favorably on European stocks, which have become quite inexpensive relative to their developed-world peers — and many with attractive yields. As usual, we would always hedge our Euro exposure to protect against the continued decline of the currency.

 

Market Summary

The U.S.

The U.S. is attractive and the only market that we feel confident about recommending at the current juncture. The U.S. has many fundamental positives on the economic and corporate-profit fronts. We don’t buy the scare talk about how a lower oil price will melt down the world economy. Longer-term, lower oil will definitely help the world economy. In the short term, lower oil is not a negative except for the frightened who take it to heart and panic out of their investments. Lower oil is a positive for many industries; the obvious beneficiaries are auto sales, consumer-related, and transportation.

Europe

Europe could become attractive if a sincere and long-lasting QE takes place. Until Germany agrees to something like that, we will stay away from Europe except to short the Euro for aggressive clients.

Japan

Japan’s stock market looks like it has finished its move and we do not see Japan as attractive.

Emerging Markets and Base Metals

The oil-price panic has made it hard to own any commodity or any emerging market. We believe that longer-term, India is attractive; but it is currently correcting, so we will wait to re-enter. China is rallying, but is vulnerable to government edicts intended to slow down speculation. China may be a good longer-term investment, but not until we see a correction. Other emerging markets are being hurt by poor exports to Europe and by a global correction in the price of commodities.

Gold

Gold is still in a base-building phase. Our technical advisors differ; one thinks gold will fall to below $1100, and another two see a continuing consolidation.

Thanks for listening; we welcome your comments and questions.

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