The same old story: borrow to buy
As we have consistently stated, the main event (or the main problem) in the world’s economy has to do with the social/business model that has been adopted and promoted by many western-oriented societies during the last 20 years — the act of borrowing capital to bolster spending.
This has been a common theme for individuals within the U.S. (people borrowing capital by using secondary mortgages on homes and using this capital to purchase consumer-oriented goods), certain companies (internet-oriented organizations mainly during the 1990s evidenced with consistent talk of “burn rates”), and finally, countries utilizing the bond market to finance consistently rising fiscal spending plans driven by transfer payment schemes and other projects.
Whether country, company or individual, the story has remained the same – leveraging a balance sheet, transferring the increased liability to the income statement and spending the capital for short-term purposes. While the transfer occurs, and the money continues to roll in (debt markets obliging the process), the “game” continues. When the lenders eventually stop playing the game, the conclusion to the game ends violently. People and countries don’t like to be forced to assume a lower level of lifestyle.
The world’s savers (as represented by the bond market) provide discipline to the process as it starts to become evident that the game needs to end. In many cases, the threat of default frightens bond purchases away from excessive situations.
This process has been building since the early 1980s, and in particular, since the late 1990s. This process has affected entire societies, companies as well as individuals. The excessive use of debt has become so common and ordinary that people, companies and entire countries are now considering or declaring bankruptcy with seemingly few to no ramifications. Many still believe declaring bankruptcy a personal failure – my, such a quaint thought.
Shorter-Term View – The European problems and worldwide contagion
At the start of this year, our general economic and market theme was “Standing on Shifting Sands,” with an emphasis that flexibility needed to be built into all investment and business plans. We have been calling for economic expansion to last through at least the end of the year. We stand by that call. However, recent events entice us to take another view as to the strength of the economic rebound. The underlying factors which make us believe the economy will continue its positive GDP growth profile is centered primarily on central banking policies. However, confidence has been damaged over the last month with the developments in Europe and the weakening of the economic growth engine in China.
Is all of this due specifically to Greece? The quick answer is no. Financial markets are no longer concerned specifically about Greece, but rather the future of the Euro, and a developing worldwide economic slowdown. Lastly, many are rightfully concerned about the impact from a new financial- services bill passed last week in Washington. Greece is casting shadows as to the outlook for the Euro – is it going to hold together?
Our best answer to this is yes, it will probably hold together but the Euro will look different in the future than it has in the past. It has become apparent that monetary controls with no fiscal authority are not a winning combination. The late Milton Friedman said it best that the first crisis which confronts the Euro means the end to the Euro. While perhaps not the end, the Euro may be altered going forward. Our best guess is some of the less fiscally-disciplined countries may not be included as members of the EU over the long term.
All of this is leading to uncertainty as to the world’s currency outlook and effectively Europe’s ability to create economic growth. Europe in total represents 27.0 percent of overall worldwide economic power. The near-term (and some would say longer-term) economic growth assumptions of this major economic power are currently in question. As this question is not yet answered, the world’s risk-oriented markets swoon.
It is becoming more obvious that the central bankers in Europe need to start a meaningful quantitative easing program, but inflation fighting is still the watch- word in most quarters. Germany may be key to European Central Bank (ECB) policy, as the Bundesbank is having a big influence on the ECB’s decision not to implement quantitative easing.
This is raising risks as to the European bankers’ willingness to supply a sufficient amount of stimulus/liquidity to keep the economic engine in Europe running. With the need for many countries to tighten fiscal spending plans (due to the bond market not wanting to continue the financial merry-go-round), it is believed that most central banks will err on the side of continued financial ease. Look for interest rates (German, U.S., and Swiss) to remain subdued going forward.
What about the U.S. and our economic exposure to Europe? We are highly intertwined with Europe in many ways – economically, politically and militarily. However, from purely a corporate profit measurement, it is important to know that the direct impact of a falling euro and economic stagnation in Europe is not particularly large. The exposure of all U.S. corporate profits to the European economic area is about 9.0 percent. About 14 percent of the S&P 500’s operating earnings come from Europe. So while meaningful, Europe is not the profit driver for U.S. corporate profits many would think.
China – Still Growing?
Which part of the world received the most imports from China? The U.S.? No, the answer is Europe. With the economic growth forecast in Europe now in serious question, what does this mean for China? Well, it can’t be good news. However, the growth in China is so strong, that slowing in their economic growth rate indeed may be manageable. As a matter of fact, the central planners in China have recently been attempting to slow overall economic growth.
Authorities in China have become very aggressive in reining in real-estate speculation. Chinese stock prices have declined by more than 25 percent and construction stocks have taken serious downward pressure. By most estimates, Chinese economic growth is slated to slow to the 8 percent to 9.0 percent range, down from 12 percent recently. Also, commodity prices have declined sharply, reflecting slowing demand trends within Asia. China appears, on the margin, to be contributing to the slowing economic momentum, while still growing much more rapidly than most of the world.
Back in the U.S.
With all the above being mentioned, we can only suspect that global growth may be decelerating. There is no real firm evidence as of yet to support this view. We should not confuse growth deceleration with recession. Business cycles recoveries tend to go from an initial acceleration phase to a deceleration phase in order to allow the economic expansion to enter a steady state. Recession, however, is when output contracts.
That being said, we are witnessing the awakening of sluggish economic developments within the U.S. Among these developments are:
1. Retailers’ surveys have recently fallen sharply.
2. Homebuilders’ surveys have hooked down and mortgage applications have plunged – driven by the end of tax credits.
3. The decline in unemployment claims has recently stalled.
4. Corporate earnings revisions have declined.
5. The Leading Economic Indicators declined slightly in April and is on track to be down in May.
6. The U.S. manufacturing PMI probably declined in May.
7. Consumer net worth probably declined in 2Q – due to lower stock prices.
8. China’s economic growth rate is contracting.
9. Greek contagion is likely to slow Europe (the manufacturing PMI declined from 61.5 percent to 58.3 percent in May).
10. Copper prices have declined and credit spreads have widened substantially.
11. In general, loan growth remains very weak, the money multiplier is falling and business and consumer confidence remains frail.
These negatives are offset by recent strong vehicle sales (up 16 percent from the prior year). Additionally, recent surveys point to the view that more CFO’s plan to boost capex and employment going forward. According to the folks at International Strategy and Investment (ISI), 49 percent of CFOs expect to boost capex in 2010, up from +26 percent last November. Also, 41.0 percent plan on increasing IT spending vs. only +13 percent late last year. Also, the Federal Reserve is starting to expand its balance sheet again.
On balance it appears from economic models that U.S. GDP growth rates may be roughly 0.5 percent to 1 percent lower in 2Q than originally thought (from 3.6 percent growth to 2.6 percent to 3.1 percent) due specifically to concerns which have been created due to the malaise radiating from Europe.
What about the rest of the year and into 2011? It is too early to make a specific call as to what may be happening, as the economic environment is extremely fluid and subject to change. However, we are comfortable at this time with the call that the economy will grow at rates below-historical trend. Confidence and sentiment are fleeting. We anticipate the possibility of a sluggish economic environment with limited upside pressure on interest rates.
Uncertainty levels have risen substantially over the last few weeks. We have long held the view that debt levels are unsustainably high. Going through the process of deleveraging economies is very difficult and painful. Risk-oriented markets don’t like uncertainty. Deleveraging brings high levels of uncertainty and economic volatility. Our sense is that stock markets will remain volatile over the next few months as the questions of the future of the euro and European economic growth rates are answered. During this period of uncertainty, expect the world’s stock markets to display periods of extreme volatility – both on the up and downsides.