Rudi's View | Aug 10 2011
(This story was originally published on Tuesday, 9th August 2011 and sent in the form of an email to paying subscribers at FNArena).
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In line with my analyses and commentary in recent months, I hope that everyone who has been buying more share market exposure throughout recent turmoil has used the opportunity to stack up on cheap, solid dividend paying stocks.
With many yields blowing out to 8% and higher, often fully franked, this month's rapid sell-off has provided long term investors with unique opportunities from which their portfolio returns will benefit many years into the future.
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By Rudi Filapek-Vandyck, Editor FNArena
Judging by the emails and the questions FNArena received over the week past, there appears to be one big misunderstanding amongst investors as to why exactly global risk assets went into meltdown in August. It's not because the world has given up on any reasonable prospect that sovereign debt problems might ever get fixed in the US and in Europe, it's because investors realised these countries are running out of time and politicians were seen paying lipservice only, at best.
This is how Blackrock, one of the world's largest managers of investment funds put it on Monday: "Addressing the fiscal challenges that confront the United States is a long-term undertaking. Those challenges cannot be overcome through short-term fixes but will require efforts extending over many years. The U.S. economy has historically been the world's most resilient, but its future depends on policymakers coming together to make the hard decisions needed to arrest the growth of the U.S. public deficit. There is time to address these challenges, but if policymakers fail to do so, this weekend's credit downgrade [by Standard and Poor's] will be a sign of continued fiscal deterioration."
In simple terms: Go on! Do something! And if authorities remain stubbornly impotent, we'll make them jump into some urgent, long overdue, unambiguously positive action.
This also immediately clarifies why so many economists and other expert voices went the extra mile in trying to explain as to why financial markets were not reliving the Lehman Brothers failure shock experience all over again. But are we reliving the mid-2010 groundhog experience? That is a completely different proposition. Remember how the world got really, really scared post April in 2010 as the Fed's QE1 came to an end and economic data and indicators started deteriorating at relatively speedy pace?
There are quite a few similarities this year. Let's see… equities peaked in April, QE2 ended in June and economic data and indicators have been in a downtrend since May…
We also have some key differences and they are not all positive:
– Even if we agree that QE2 has had a positive net impact, it can hardly be denied it failed to match QE1
– Assuming there still is fiscal room for manoeuvre in the US and Europe, whatever is left will be smaller than it was last year
– This time, peripheral Europe’s fiscal crisis has spread, while policy responses have become more constrained; more radical approaches could bring the integrity of the banking system itself into question
– Emerging economies, led by China, provided strong support post Lehman and in 2010, but these economies today are battling with inflation, which either limits their options in the short term, or will create bigger problems in the longer run
The one stand-out difference is that corporate balance sheets are in much better shape, with less leverage and less debt and with more cash and higher profits (though not for everyone in Australia).
A healthier corporate sector may well be the last remaining ace for developed countries in this battle between fiscal restraints and economic growth, so this is not an unimportant observation.
Market analysts at GaveKal see a similarity with the early nineties when several countries went through a similar struggle, including the US, France and Scandinavian countries where troubled banks went bankrupt or were nationalised.
"As a result, companies moved into large positive cash-flows and self-financed their growth. This came in handy as, by the mid 1990s, companies had to lay out a lot of cash to keep up with the abrupt change brought about by the mass commoditization of the PC, the Internet, mobile telephony, etc… All of a sudden, and with little forewarning, capital spending had to go through the roof", recalls GaveKal.
We all know what happened next: a new bull market carried by the internet and automation, subsequently turned into the next bubble, one that violently burst a few months into the new millennium.
Are we repeating the nineties? GaveKal observes a similar dynamic in its early stages with companies around the globe embracing far more automation and robotics in their factories than in the past. China is doing it too.
Before we can start talking about a new bull market at some point into the future, however, we first must see governments dealing with their debts, while the US and Europe have to also avoid falling into economic recession. What are the odds for a Double Dip in the US?
Probably higher than most of us would like to contemplate.
As pointed out by economists at IHS Global Markets last week, a recent study by a Federal Reserve researcher concluded that when real GDP growth drops below 2% year-over-year, a recession follows within a year roughly 70% of the time. The latest set of GDP data shows year-over-year growth dipping to just 1.6% in the second quarter of 2011.
Also, since the Second World War, whenever the three-month-moving average of the unemployment rate has risen by more than 0.3 percentage point, a recession has always followed. Note: always. The three-month moving average hit a trough at 8.90% in March and April, and as of June had crept up to 9.10%. If the unemployment rate just creeps slightly higher, to 9.3% and stays there for a couple of months, the three-month moving average rate will hit 9.3% and the recession signal will be triggered.
In the same vein, the monthly US non-manufacturing ISM index is signaling the odds for a Double Dip recession in the US have increased significantly, but it is as yet not a fait accompli.
Research by IHS Global Markets has revealed that on two previous occasions when this index fell below 50 after a prolonged period of expansion, these moves into negative territory coincided exactly with the first month of recession in April 2001 and in January 2008 respectively.
The US non-manufacturing index is not infallible, and the index did give some false signals in the nineties, but historical research shows apart from the index declining below 50, the speed at which this decline occurs is often equally important. Here this year's track record thus far seems rather ominous. After peaking at 61.4 in February, the index has rapidly fallen to 52.7 in July. Still in positive territory, but given the many weak forward looking components, August or September could potentially provide the dip below 50, especially with uncertainty ruling in Washington.
The last time we saw a similar move was in 2004 when the index equally peaked above 60 and then gradually gravitated to sub-50 into the next year. The US narrowly escaped a technical recession that year.
But, and as accurately pointed out by analysts at Deutsche Bank this week, the immediate danger is that financial market distress continues for too long as this in turn creates the danger of financial events driving real economy trends. This is also why investors shouldn't be too complacent about the causes and solutions for this month's meltdown. There is at first the complete and utter embarrassing impotency of politicians and governments in the US and in Europe, but once this has been fixed, there remains the problem of their economies flirting with too big a loss in momentum.
Which is probably why Citi interest rate strategist Mark Schofield opened his latest market analysis with the observation: "The problem markets face is not to decide whether or not there is a crisis to deal with, but rather; which crisis is the most pressing?"
Economists at JP Morgan formulated their fears as follows on Friday: "We do not believe the US economy is going to slide into recession as the forces that normally form the basis for a break -rising interest rates and tightening credit conditions in the face of elevated levels of credit-sensitive demand- are noticeably absent. However, a slower-growth economy is at greater risk in the face of additional shocks. Moreover, we are concerned about lasting damage if the economy is unable to generate above-trend growth and strong job creation for an extended period of time. Persistent underutilized resources will weigh on potential growth, limit budget improvement, and risk a reemergence of disinflationary dynamics."
To put all of the above into perspective for the Australian share market: market strategists at Goldman Sachs have now (again) lowered their targets for the ASX200 to 4450 for December this year, from 5125 earlier. The index is now expected to cross the 5000 by December 2012 (earlier projection: 5600).
In case of a recession, these projections will need to be further lowered to 3600 for December this year and to 4335 by June next year, at least on Goldman Sachs estimates.
(This story was written and published on Tuesday, 9th August, 2011. It was sent in the form of an email that day to paying subscribers at FNArena).
