US Market Should Outperform Emerging Markets
01/31/10
The markets suffered a nasty spell of selling for the second week in a row. January closed at its low and the January barometer definitely looks gloomy. China’s Shanghai Index is one one of the worst performing indices so far this year, after peaking on November 16th 2009 at 46.66. The rest of the emerging markets followed one by one over the ensuing two months. Just like the world followed China on the way up, it is following China on the way down. Or is it? Risk aversion is definitely on the rise, 1-month T-bill yields are in negative territory and the US $ Index broke above its 200-day moving average and is still climbing relentlessly. Does this remind you of something from your recent past ... like summer 2008 perhaps? The names are different of course. It is no longer Lehman because Lehman is long gone. These days it is Greece, Portugal and Spain that cause upheaval in the financial markets. Unlike Lehman, however, sovereign countries are not going to disappear. They may default but they will stick around. This may be reassuring to some but not to others. If countries refuse to disappear, they may also refuse to cease making a nuisance of themselves. Welcome to the world of sovereign risk, where bad management is not being punished by the laws of the jungle because the law of "Every Man for Himself" supersedes it. Consequently, corporate earnings may in the future be less important than national budgets. Just think about it. When was the last time that you dreaded the pronouncement of the national budget plan of ... Portugal? When was the last time European investors looked at Greece’s public spending plans, only to pronounce them "not feasible" and flee back under the Teutonic apron? The last time was probably in 1997 or 1998. The point is that years like 1997/98 and 2008 constitute nightmares for money managers and so they chose to sell first and ask questions later. US markets fell along with the rest of the world, despite good news on economic and corporate fronts.
The US economy is cranking. Real gross domestic product jumped at an annual rate of 5.7% in the fourth quarter 2009, against a consensus expectation of 4.5%. My 7% target needs to be reached this current quarter or we are not going to get there. Right now it looks doubtful. But in my 25 years in this country I have learned never to underestimate the American spirit. So I will be patient and wait one more quarter before declaring victory or defeat. Stocks, as described above, reacted to a whole different kind of news. Worries about Chinese tightening and sovereign risk will continue to be serious headwinds for markets and consequently currency talk is likely to be the flavor of this year. Currency issues simply will not go away, and the fighting over exchange rates and import/export advantages is likely to get worse, not better. Greek national bonds for example continue to be under severe pressure and the cost of servicing its debt takes an ever-larger chunk out of the Greek budget. Greece needs help but Europe has no mechanism for dealing with situations like this. Therefore it seems inevitable that a solution will be found that massively bends if not totally circumvents European rules. Consequently the Euro is being dragged down by the prospect that weak members (think Spain, Portugal and possibly Italy) will not be able to escape their massive debt loads without German help. You can imagine that German politicians are having sleepless nights, because they must ponder the possibility that sometime this year they may have to sell their constituents on yet another bailout. This time however, it is not the domestic banking system but another country. The IMF involvement may be face-saving to the European idea, but otherwise only muddies the waters. Investors are clearly seeing through this scheme. The Euro currency system faces a serious challenge and the common currency is being re-priced accordingly. How far can the Euro drop? I have read that purchasing parity for the Euro lies in the area of US $1.15. It may not get there at all but it would be indeed a long way down. A rising dollar (falling Euro) has in recent history not been good for equities. Does this mean that US stock markets are equally doomed to suffer through a long steep correction? Not necessarily, even though at the moment it looks like it. There are important differences between the Lehman collapse of 2008 and the looming Greek debt crisis. In September 2008 for instance margin calls occurred all over the world all at once due to excessive leverage in almost all financial institutions. Today, financial market participants are operating with far less leverage. Risk managers are on high alert around the globe, watching their positions and their traders, making sure that nobody goes "rogue". Systemic risk is an expression that now even politicians have understood all over the globe. This also means that no corporate entity can be so big as to cause a global meltdown. That is why corporate yields have not risen at all while sovereign debt and currency markets are in turmoil. Greek bonds are tanking, the cost to insure against a Greek default is soaring, while corporate bonds outside of Greece are remaining stable.
The chart above shows you the yield difference between 10 year corporate bonds as assembled by Moody’s and ten year T-bonds. You can see that yield-spreads peaked in the fall of 2008 and have since been on a downward slope. As we discussed before, corporations are in good shape and low interest rates reflect that fact. Greece however is in bad shape and high interest rates (10 year Greek bonds yield more than twice as much as German 10-year bonds) reflect that fact. It seems that investors are differentiating now between risk and risk. Institutions have reduced their extreme leverage and systemic risk is no longer a problem. What is left therefore is a heap of individual risks that can be assessed one situation at a time. Therefore, yes the Euro is declining against the dollar but only because Greece is putting the spotlight on Europe’s unique challenge. The difficulty of bringing 27 nations together under one umbrella with one set of rules and then enforcing those rules is indeed herculean. This new risk differentiation is good, but it brings up one question: are we witnessing the start of a bear market or is the recent selloff the beginning of a rotation? Are investors turning away from the reflation favorites "Emerging Markets and commodity producers" and turning more positive on "developed markets and commodity consumers"? The gold chart above seems to indicate that gold as the crisis metal either 1. ran up in anticipation of the Euro-challenge and now sells off on the news or 2. never served as an alternative currency and now is falling along with all other cyclical metals like copper and aluminum. My bet is on the latter. It seems to me that the reflation trade is over. Domestic non-resource related stocks could become the new favorites. Regional banks fit that mold also. They are the most distrusted group, they are in general undervalued and nobody wants to show them in their portfolio. They are, in other words, a contrarian’s delight.
Hermann Vohs
"The government who robs Peter to pay Paul can always depend on the support of Paul."
George Bernard Shaw
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
