Balkanization of Europe is but a Symptom
02/15/10
The markets were held hostage by headlines from Europe all month long. Greek default risk dominated everybody's thinking. On days when the headlines were dire and Greece seemed closer to default, the Euro sold off against all currencies including the dollar. This made all commodities cheaper in the currency they are usually priced in (USD), which then hurt the basic materials and energy stocks, which in turn seemed to indicate that basic material stocks were actually reacting to Chinese monetary tightening. Whether Greece or China are the reasons or symptoms, it seems that the dollar carry trade is no longer productive. For that matter, most macro-trades seem to lose their effectiveness too. Europe is no longer one single block with a uniform credit risk profile for every country. Greek telecom shares have a different risk profile than Deutsche Telekom shares. Money managers can no longer recommend "Emerging Markets" and then allocate according to geographic region and industry. These macro factors worked last year but in the future, one has to differentiate between individual risks. Economic trends also need to be examined with a discerning eye. It is no longer sufficient to allocate funds to "South America". Brazil is almost a developed country now whereas Argentina is still a third world basket case. Chile could be called the Switzerland of South America, whereas Bolivia is - well Bolivia still. Risk and return on every continent must be looked at individually. This is true especially in Europe, which sadly is being balkanized rather than unified on so many fronts these days. Accordingly, the Euro is being punished almost daily as money managers come to grips with the new facts on the ground. The US economy meanwhile continues to improve, thank you very much. The Commerce Department Friday reported that retail sales rose 0.5% in January. Gains were widespread across major retail categories. The results implied that consumer spending in the current quarter could rise at an annual rate of about 2% - subpar, but respectable.
Everybody knows that "the New Normal" is supposed to mean slow growth due to overextended consumers, deleveraging, deglobalization and reregulation. If this new normal means that consumer spending can grow by 2% then it is not so bad. However, the US consumer is not going to pull the world economy up the hill again. Not this time. In the past, the usual course used to be that the US economy, led by the consumer, would expand, imported more than could be exported and thereby reinvigorated the world economy by running up its trade deficit. No, in this sense the consumer is overextended. Stimulus this time is coming from the corporate sector. Rather than being consumption led, this recovery is "production led". The best illustration I could find is the overall ISM Non-Manufacturing Index (second chart above). This index was started only in January 2008 but it illustrates very clearly how sluggishly the expansion of the service sector is proceeding. Only now is the index peaking hesitantly above the expansionary line. The non-manufacturing part of the economy, which is the consumer led part, is expanding very slowly. Yet, expanding it is, finally. The true growth part of the US economy belongs to the manufacturing sector, however. We know already that companies are flush with cash and that inventories are low. We also know that corporations have not exactly been falling over themselves to upgrade plants and equipment. Capital investment is hovering at the level it first reached in the 1st quarter of 2004, whereas Corporate Net Cash Flow increased by 25% since then. The upgrade cycle in equipment and software is long overdue and it is slowly gathering steam. The best illustration that I could find is ... you guessed it ... the ISM Manufacturing Index.
Now, we all know why corporate balance sheets are flush with cash. In the past year, we have seen very efficient cost-cutting and as a result, earnings have expanded on the back of improved margins and productivity. In the current US earnings season, in which nearly half of S&P500 companies have reported, the average share weighted YoY earnings growth is +184% vs. consensus expectations of +62%, according to Bloomberg data. Nearly 10% of all S&P 500 companies have raised their dividends this quarter and the good news is not stopping there. According to GaveKal, the same is happening with corporations around the globe. In India, for example, most firms on the 50-member Nifty index have already reported for the quarter ending in December, showing an average profit increase of +22%. Cash piles are building in Korea too, where the 15 biggest firms saw their liquid assets jump nearly 50% to KRW 42.8 trillion ($36 billion) at the end of 2009, from KRW 28.6 trillion a year ago. GaveKal calls it a "classic, Austrian-style production-led recovery". The cycle works like this: Companies cut costs, profits expand, these earnings are re-invested in order to improve market share and operations, this in turn creates new jobs, which ultimately leads to increased consumption. In this cycle, the consumer comes last, not first. Domestic small cap companies should fare better than multinational companies in this environment. So much for the macro-picture, which of course needs micro-checking, before we can use it for investment purposes. The last chart above shows you the improvement in the current account. US consumers have retrenched and the current account has improved dramatically. This trend should continue throughout the year. Chinese exporters will have a tougher time selling in this country. On one hand they have to fight with diminishing demand from the US and on the other hand they see rising input prices. Steel prices have risen by 40% and salaries are rising at double digit rates. It looks like Chinese consumers, not Chinese exporters are the new winners. The old investment rules need to be questioned and themes need to be re-learned. The narrative goes like this: The dollar carry trade is dead, because it relied on US consumption to make sense. Every investment aspect that depends on the US consumer in order to work, is suspect. Therefore, sectors and countries that sold to the US consumer are suspect. Chinese companies that export consumer goods to the US are suspect. Chinese (or US ) companies that cater to Chinese consumers are not. Global dynamics of trade, consumption and production are shifting. Last year's simple investment mantras have lost their validity and investment themes are becoming balkanized. The balkanization of European investment flows are only symptoms of this New Normal.
Hermann Vohs
"Faced with changing one's mind, or proving that there is no need to do so, most people get busy on the proof."
John Kenneth Galbraith
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.
