Global Market Commentary

October 17, 2013

Global Economics Provides Reasons to Be Bullish, But Politics Poses Downside Risk

As we write this, Capitol Hill’s partisan bickering and rancor have reached the conclusion we anticipated. We don’t believe that the conflict which monopolized headlines for the past two weeks is of lasting import.

From our perspective, the fundamentals are in place on a global level to support medium-term optimism in most of the world’s markets. We certainly see this to be the case in the world’s advanced economies, especially in the U.S. and Japan, and to a lesser degree in Europe.

We could sum up the positives for the advanced economies in this way: inflation remains low; interest rates remain low; monetary policy remains highly accommodative; corporate finances are healthy, with corporate profits rising at close to 10 percent year over year, and confidence of both producers and consumers is high.

In the developing world, we have been expressing our own skepticism about the China skeptics since well before the talk of China’s “hard landing” came to an end, and we continue to see reasons to be optimistic about China. We even see encouraging signs in Asia outside China and Japan — in spite of the hit that these economies have taken from the uncertainties of U.S. monetary policy. And the same holds true for parts of Latin America, where Mexico’s potential is brightening under President Enrique Peña Nieto and where positive data are becoming more visible.

However, despite the causes for optimism, we do see risks — primarily risks from the fundamental role that government can take. It can either support growth and wealth creation through pro-growth policies that establish a stable and predictable economic environment, or it can demoralize and hinder growth and wealth creation by establishing itself as an adversary of business.

Our own policy is to watch positive economic trends to find short- and medium-term opportunities, and to include the downside risk of destructive policy in our long-term view.

U.S. Housing: “It’s Pretty Much Inevitable at This Point That the Crisis is Going to Be Over”

With most U.S. citizens having their homes as their single largest purchase and as the psychological and financial linchpin of their asset portfolio, there is good news continuing to emerge on the foreclosure front. The long crisis in the economic epicenter of the downturn is inarguably drawing to a close, according to the opinions of most analysts.

Foreclosure starts in the third quarter of this year fell to their lowest level since the second quarter of 2006, and were down 33 percent from a year earlier. Other measures of mortgage stress — serious delinquency and shadow inventory, for example — fell to near five-year lows.

As we’ve observed before, this recovery is patchy, with high local variation within the U.S. But as a national pattern, it bodes well for consumers and their capacity to drive growth. (Improvements have often been most dramatic in the areas initially hardest-hit by the crisis.) The normalizing of foreclosure rates also removes the weight of a “dead hand” from housing prices generally, and the figures bear this out. A Zillow analyst noted that U.S. home values in August had appreciated 6.6 percent from a year earlier, compared to a typical annual appreciation rate of “3 to 5 percent.”

Foreclosure Filings: Continuing to Drop Back to Normal Levels








Source: RealtyTrac

Defaults and foreclosures are also benefitting from an improvement in lending practices. Lenders’ standards have become more stringent, and as a consequence, the performance of loans made over the past two years is twice as good as the historical average. So as we move forward, the combination of stricter lending standards and improving household finances will choke off the supply of potential defaults and foreclosures.

As we noted above, the process is nationally uneven, and there’s also some way to go to normalization — a larger-than-normal percentage of homeowners is still underwater, and analysis from RealtyTrac suggests that it might be more than three more years before that number returns to normal levels. But the direction is clear.

Consumer Sentiment Continues to Improve

Hand-in-hand with an improvement in the finances of homeowners, thanks in large part to the winding down of the foreclosure crisis and the return of mortgages to above-water status, is a rise in consumer sentiment.

We noted the most recent consumer sentiment data from Thomson Reuters and the University of Michigan. Despite the apparently looming threat of Beltway dysfunction, those data show continued improvement — most notably a five-year high in median income expectations for the next year.

Those are just two recently noted examples of positive data from the U.S. We continue to believe that other fundamentals will be working for U.S. growth — for example, the revolution in energy production from shale, the reshoring of manufacturing, and the application of new artificial intelligence, robotics, and big data technologies. In concert with the deep entrepreneurial tradition of the U.S., these fundamentals give us many reasons to expect U.S. growth.

Consumer Income Expectations: Best in Five Years







Source: Credit Suisse

Politics Is Holding Back Growth

The current grandstanding going on in Washington on both sides of the aisle is transitory. But it’s a symptom of a deeper problem that threatens the positive data points and trends noted above.

It’s often said that the engine of growth in the U.S. economy is small business. This claim is probably exaggerated; but it contains a germ of truth. The real engine of growth is start-ups. Start-ups account for almost all of U.S. net job creation, and 90 percent of that happens after they go public.

But start-ups’ growth prowess has been in decline in the U.S. They created 2.7 million jobs in fiscal 2012 compared to 4.7 million in 1999. This is a phenomenon that predates the financial crisis.

Entrepreneurs surveyed by the authors of a recent book on the subject (Where the Jobs Are by John Dearie and Courtney Geduldig) blamed a number of factors, all policy related. First, the bias of the immigration system against start-ups, who can’t provide the same employment guarantees that large companies are required to in order to secure visas for qualified immigrants.

Second is simply the burden of compliance with complex regulatory schemes — such as the Sarbanes-Oxley accounting regulations enacted in 2002. Large companies can dedicate legal resources to compliance that a startup would find prohibitive, and this holds true for the never-ending stream of expensive legislation that continues each year under both Republican and Democratic administrations.

Third is taxation, with the U.S. corporate tax burden among the world’s highest.

And of course, Washington’s endemic brinksmanship and ideological dogmatism — so abundantly displayed during the latest manufactured crisis — can only generate an environment of uncertainty which suppresses the willingness of entrepreneurs to create start-ups and take them public.

Fed Policy to Remain Accommodative

With Janet Yellen poised to take over the chairmanship of the Fed after Ben Bernanke’s departure, we see the likelihood of continued monetary stimulus, a continued focus on unemployment in the absence of strong inflation risk — and even the potential of such measures as nominal GDP targeting. This is because of the liberal position of most voting members on the Fed Open Market Committee.

So although we remain fundamentally positive on the U.S. economy, and although we see immediate data suggesting renewed strength, and longer-term trends showing great promise for a renaissance of technical and industrial prowess, we are watching political developments carefully. What would be best for jobs and economic growth is for the U.S. government to become more friendly to U.S. businesses — and especially to U.S. entrepreneurs.

Once Again, Positive Signs in Japan

Japan ranks with the U.S. in our generally bullish view of economic fundamentals, a stance we have maintained since Shinzo Abe’s election last year, and which we recently reiterated in this newsletter. We drew attention to a number of near-term positives that we believe will continue to buoy Japanese equities — mostly centering on policy moves to “encourage” Japanese individual and corporate savers to push the funds hidden in their mattresses into the Japanese equities market. We also noted that Haruhiko Kuroda, the governor of the Bank of Japan, stands as ready as Janet Yellen to continue — perhaps dramatically — the unprecedented monetary stimulus he initiated earlier this year.

We noted two signs recently that Japan’s emergence from its long and punishing deflation is spreading wider than its equity markets. Credit Suisse noted August’s 5.4-percent month-on-month increase in machinery orders as an indication that capital expenditure may be on the upswing — exactly what we indicated in last week’s comments that we’d like to see. Likewise, we read that confidence among large manufacturers is at the highest level since the beginning of the global crisis in 2007.

How this trend progresses, and whether the recovery takes hold in real increases in capital expenditure and higher wages, depends on the effectiveness of Abe’s “third arrow.” That means the structural reforms he’s promised, which will decrease the protection of some sectors of the economy. An unwillingness to confront farmers, physicians, and other groups with entrenched political interests has caused previous would-be Japanese reformers to stumble.

China Continues to Show Positive Data

The last economy in our bullish triumvirate is China. We are more bullish on China’s economy than on its stock market. China is the world’s second largest economy and a bellwether of Asian business psychology. A strong China encourages many other nations. As we noted above, we were positive on China at the height of fears of a “hard landing,” and our views have been vindicated. We saw a few interesting data points on China this past week that continued to bolster our opinion — not necessarily on Chinese equities at this time, but on the Chinese economy.

Recently we read comments on Chinese inflation — driven mostly by food prices, which are more significant for the consumer basket in China than they are in the developed world (and this is of course true for other developing nations as well). We see both this, and September’s 0.3 percent downward tick in exports, as typically transient seasonal effects.

More interesting to us were the figures we saw concerning Chinese tourism during the National Day Golden Week — one of two week-long holiday periods in China.

Visitors to China’s top tourist spots during the National Day Golden Week were up 18.8 percent over
last year. Total tourist revenue was up 26.6 percent year over year.

Tourists Willing to Spend Yuan at Holiday Time










Source: Bank of America/Merrill Lynch

This ongoing robust growth in tourist trips and tourist revenue suggests that the now-proverbial “rebalancing” of the Chinese economy towards a model more oriented on consumer spending is not just a pipe-dream of Beijing bureaucrats, but that it is showing signs of concrete manifestation.

As we read in a research note, it implies that Chinese consumers are confident about their employment and their wages; it implies that consumers are willing to spend those wages on “non-necessities” and, for example, on cars; and it implies that infrastructure growth in roads and tourist facilities is robust enough to handle to constantly increasing influx of visitors. The “wealth effect” is also likely to be in effect among Chinese consumers, who saw property values that were 9.5 percent higher this September than a year previously.

Finally, we saw that the vice-governor of the People’s Bank of China announced last week that Chinese growth would likely finish the year at 7.5 or 7.6 percent annual rate. After 7.5 percent in the third quarter, some analysts believe it will hit 7.9 percent in the fourth. As we have pointed out before, this is not 10 percent, but it is very healthy growth, and shows China’s continued resilience — especially as it benefits from the recovery in the U.S., Japan, and Europe.

Europe Begins to Emerge From the Fog

Now on to the economies where we are slightly less bullish, but still see good reasons for medium-term investment optimism — with our eyes clearly focused also on political pitfalls.

We wrote a few weeks ago about Europe’s “green shoots” when we commented on Germany’s recent elections, and we continue to see reasons to believe Europe is slowly emerging from crisis.

Europe’s home-grown troubles may have been influenced by global contagion, but were rooted in longstanding and long-concealed problems within the Eurozone itself — namely the unlikely marriage of very different northern and southern economies in a fiscal union without enough political glue. That crisis had an inflection at the point where Mario Draghi, the president of the European Central Bank (ECB), pledged to do “whatever it took” to save the Euro. The progress made since is not as robust as the progress in the U.S., but it is real and notable, and we (along with others) are watching some European equities with renewed interest.

Eurozone retail sales rose 0.7 percent month-over-month in August, bettering a 0.5 percent rise the previous month. Not only are retail sales a driving force of growth in advanced economies, but they also show that in spite of persistently high unemployment (12 percent for the Eurozone as a whole, with still alarmingly high figures in the periphery) and in spite of continued austerity, Europeans are willing to spend. Portugal and Spain registered particularly robust increases — perhaps due to tourism.

The Markit PMI, a survey measuring business activity, hit a 27-month high in September, at 52.2 (figures above 50 being indicative of expansion). And although employment remains high, the absolute number of unemployed Europeans fell for the third consecutive month.

European equities are also attracting attention, and not just from us; as we have noted in recent letters, some European companies are beginning to seem inexpensive and attractive compared to their U.S. counterparts. Current and six-month expectations of investors, measured by the Sentix index, strongly improved and brought the index into positive territory for the first time in more than two years. Large asset management funds are increasing their holdings of European equities (see last week’s Recommendation Tracker for our own thoughts on how to take advantage of rising European equities).

Last but not least, we saw some good news also from the U.K. The IMF now sees the U.K. economy expanding at 1.4 percent this year, and 1.9 percent in 2014. And Markit’s U.K. PMI declined a notch in September — but did so coming off a 30-month high in August.

But Europe’s Banks Remain Weak

Europe’s woes, as we have observed in recent letters, center to our mind on the glacial pace of its progress towards effective Eurozone-wide bank regulation. If the ECB credibly takes on its new role as supervisor of Europe’s most systemically important banks, and acts to ensure their adequate capitalization — and if its upcoming “asset quality review” proves more stringent and accurate than previous “stress tests” — that will be because the political will is present among European nations to face the needs and implication of the whole project of European unity. Whether this political will can eventually emerge, we will watch closely to see. While waiting, we remain willing to buy attractive European equities in the near term.

ASEAN: Uptick in Global Economy Helps Asian Exporters Stabilize After June Outflows

We’ve seen some good news as well in economies that were hit severely by currency outflows and anxiety over the future course of Fed tapering. With that panic past, Asian currencies ex-Japan are stabilizing.

Singapore is highly trade-dependent, and very sensitive to growth in the developed world. So a strengthening picture in the U.S., Japan, and Europe bodes well for Singapore. According to analysts, a change of one percent in developed-world growth correlates to a 1.8-percent change in Singapore’s GDP growth. It’s also sensitive to China, where the ratio is one to 1.4. Singapore’s growth is seen as bellwether for an ex-China and Japan Asian growth tailwind from a pickup in developed economies and in China.

Other ASEAN nations are also seeing improvements after the June foreign exchange meltdowns prompted by investors’ alarm at Fed tapering talk. Expecting Fed tapering to have a devastating effect on investment inflows into Asia, funds flowed out dramatically, stressing local currency exchanges. India’s stock market is improving, as the recent currency decline has quieted; some technology companies in India are benefitting.

Some Asian equities may be cheap, but we are not currently making recommendations for any country except Japan.

Singapore: Heavily Influenced By U.S., Japan, Europe










Source: Wall Street Journal

Mexico Continues to Inspire Hope

And to return again to the western hemisphere, we note again the potential for Mexico to capitalize on the renewed growth of its northern neighbor, shake off the lethargy of its state energy company, and escape the fate of other Latin American economies that have squandered their capital in misguided experiments in statism. Mexican industrial production, which is typically closely correlated to U.S. growth, rose 0.49 percent in August from July, raised by construction and manufacturing. Mexico produces many vehicles for the U.S. automotive market, which has seen recent dramatic recovery as consumer sentiment opens the floodgates of suppressed demand. We are holding judgment on Mexico until next year, when we expect constitutional changes to have been made to open Mexico’s energy sector, and we will watch closely to see if crucial secondary legislation is what the international oil majors want to see.

Our View: Optimism About the People, Skepticism About the Politics

So overall, we continue to be bullish on prospects for the U.S., Japan, and Europe, provided that politicians can be supportive of business and of growth, rather than destructive. Fortunately, consumers in the U.S. seem to be shrugging off the spectacle of Washington’s political theater for now; and Japan, so far, is providing its economy with “the right stuff,” though we will see whether Abe can deliver on his more difficult promises of structural reforms. We’re happy to profit from Europe’s recovery, even while we believe that banking reform and pan-European financial regulation needs to become more robust. News of the demise of Chinese growth has been greatly exaggerated, and we see the fruits of everything we’ve mentioned peeking out even among ASEAN nations and in Latin America.

We’re happy to see growth happening where it is happening, and contrary to some, we do not see imminent

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