The recovery has run out of steam and the West is heading for a double-dip. The East isn’t in much better shape. John Stepek reports.
It’s been a terrible few months for global stockmarkets. The rally that began in March 2009 is well and truly over. Since peaking in April at 5,825, the FTSE 100 is down by around 15%.
As for the key US index, the S&P 500, it has fallen by a similar amount from its peak of 1,217. Talk of a ‘healthy correction’ has rapidly given way to a rather gloomier prognosis. Followers of Dow Theory, a prominent school of technical analysis, even believe we’ve now entered a bear market once again.
So what’s gone wrong? Investors were initially thrown into turmoil in April as Greece’s woes came to a head. That hammered the euro and European stockmarkets, as the European Central Bank scrambled to put together a rescue package. But the malaise goes way beyond the Parthenon. Another lurking concern – which we’ll return to below – is the state of China’s economy.
The Shanghai Stock Exchange index has been sliding since August last year. It’s well within bear-market territory, having shed 30% since then, amid a tightening monetary policy. But the focal point for investor fear is now the US. Quite simply, the ‘recovery’ has stalled. Given that America is still by far the world’s largest economy, that’s a problem for us all.
The ailing US ‘recovery’
“The notion that the global economy is in great shape and in the midst of a self-sustainable V-shaped rally is a delusion. We are more likely to see a flying saucer,” says Robin Griffiths of Investment Research of Cambridge. American economic data from the past few months backs him up. Americans are gradually realising that without government stimulus to prop up the figures, the underlying economy still looks pretty rotten.
First we had the most recent US housing-market data. A government tax credit – offering an $8,000 subsidy for first-time buyers – expired in April. As a result, sales of ‘previously owned’ homes fell hard in May – by a record 30% in fact, far more than the 12% drop forecast by analysts. The housing market is not the only thing being propped up by government stimulus. The government has been on a temporary hiring spree, taking on hundreds of thousands of staff to conduct the ten-yearly census. However, like the tax credit, that’s coming to an end now too.
The bad news is that the private sector shows no real sign of compensating for the resulting job losses. In June, total US payrolls fell by 125,000, as census workers were laid off. This was broadly in line with expectations. But the big disappointment came from private-sector hiring. Firms were expected to take on around 110,000 staff, but only 83,000 were hired. Meanwhile, the employment rate – a more realistic gauge than the unemployment rate (which doesn’t include ‘discouraged’ workers who aren’t actively seeking work) – has fallen from 63% three years ago to 58.5% now.
Given rising joblessness and the spectre of another house-price crash, perhaps it’s not surprising that growth in both the US manufacturing and service sectors has slowed markedly in recent months, again disappointing analysts’ expectations. Goldman Sachs’ economists said that the weak services sector survey “confirmed that the second-half slowdown in US GDP growth appears to have started”. Their analysts reckon American GDP will grow at a 1.5% rate in the third and fourth quarters, from 2.7% in the first quarter.
It adds up to quite a bleak picture. But does it point to a double-dip? One key indicator drawing a lot of attention right now comes from the US Economic Council Research Institute (ECRI). The ECRI weekly leading indicator takes a swathe of economic data and wraps it into one index. Albert Edwards at Société Générale noted back in April that the ECRI’s year-on-year rate of change had peaked. By last week, the index was falling at an annual rate of 7.7%. The ECRI group itself is not yet forecasting a recession (as the institute has been very keen to point out). However, historically speaking (as the chart below shows), any time the index has fallen by 10% or more year-on-year, a recession has always followed. Clearly, the sample size is too small to be statistically significant. But it’s another bit of evidence to add to the pile.
The shipping news
The US remains the world’s largest and most important economy. But even a slump there might not be such a problem if the rest of the world was healthy. Sadly, it’s not. One of the clearest signs of this is the collapse in the Baltic Dry Index (BDI) over the past month. At the time of writing, the BDI had been falling for 29 straight sessions. The index measures the cost of shipping raw materials around the world.
It’s a volatile index – a 50% fall in a month might sound appalling, but it’s nowhere near as bad as the 93% plunge seen at the height of the credit crunch in 2008. And the drop isn’t just down to falling demand for commodities. A huge oversupply of ships – as shipbuilders were encouraged to boost supply by soaring shipping rates in the years leading up to the crunch – is hitting the market. So the fall in the BDI is at least as much to do with too much supply as with too little demand.
But at the same time, it’s unquestionable that China’s demand for raw materials has fallen. Iron-ore shipments in particular have been hit hard, as tighter monetary policy has hit the construction industry, which in turn has hammered domestic steel prices. There’s no reason for this to turn around soon. Property prices in China are expected to fall hard this year, with Standard Chartered predicting falls of around 30%.
Views on China vary wildly, from those who believe the apocalypse is around the corner to those who expect nothing more than a mild slowdown. We suspect that reality will fall somewhere inbetween – the rise of the East is a durable long-term trend, but it won’t happen in a straight line. There will be plenty of booms and busts along the way. But whatever happens, China can’t single-handedly save the global economy from a downturn in the West. “The good news,” says Griffiths, “is that we do not expect the entire world to have a depression. The growth in the emerging markets will prevent that. However, the mature giants of the Western world will have a double-dip in 2011. Count on it.”
Stocks are not cheap
Perhaps none of this would be a problem if stocks were desperately cheap. But they’re not. While recent falls have left them looking more reasonably priced, they’re still hardly in bargain territory. Andrew Smithers of Smithers & Co reckons that if you take the Shiller p/e (which adjusts for earnings over a ten-year cycle) or the ‘q’ ratio (which, broadly speaking, looks at how expensive companies are compared to their replacement value), then the S&P 500 remains roughly 50% overvalued.
He’s not the only respectable analyst who thinks so. Jeremy Grantham at GMO, for example, reckons that fair value for the S&P is between around 800 and 875.
So the summer months are likely to be tough going. The New York Times reports that Ralph J Acampora at US wealth management firm Alverita reckons the market will fall by another 10%-15% until around September or October. He then expects to see an “old normal market”, something more like the sideways-moving markets of the 1960s and 1970s, “characterised by relatively short-lived swings that will provide many opportunities for smart investors”.
The return of quantitative easing
What does all of this mean? Well, what has been the typical Western central bank’s stock response to every economic downturn of the past 20 years or more? That’s right – to ease monetary policy. Interest rates may be at, or near, zero, but we’ve now got the printing press to play with. Concerns over deflation, and pressure from voters as asset prices on both sides of the Atlantic keep stumbling, will make it hard for governments to resist the lure of printed money.
Goldman Sachs is already calling for ‘QE II’, while Andy Lees at UBS says: “It is becoming increasingly likely that [the Fed] is required to do something. It is becoming increasingly obvious that fiscal policy in the West has reached a limit and that stimulus now has to come… through monetary stimulus, the whole purpose of which is to lift asset prices and therefore strengthen people’s effective balance sheets and thereby increase spending.”
We look at what the Fed’s ‘QE II’ might look like below.
This all makes it tougher for investors to work out what to do next. It’s one thing to worry about the next crash, but it’s hard to plan for it if any government from China to UK could announce a new stimulus package any day now. We look at how to protect your wealth and hedge your bets below.
Buy defensive stocks and gold
The investment outlook is even cloudier than usual. But keeping it simple, investors need to worry about two things. One is that stockmarkets will be more volatile than usual in the months and years to come. Another big crash is possible; but a steroid-induced rebound isn’t out of the question either, if central bankers (notably in China and the US) plump for more stimulus.
The other related issue is the havoc that all this quantitative easing could eventually wreak on the value of paper money. Governments around the world are still competing to have the weakest currency. Right now the European Central Bank and the Bank of England are content to let the euro and sterling tick higher. Indeed, we’d close any remaining short positions you have on the euro versus the dollar for now. But there’s no reason to expect this apparent complacency to last, particularly if other banks start up the printing presses again.
So what can you do? We have no quarrel with the idea that government debt in America and Britain may rise in value even further. Fear of deflation is high right now and as the Japanese experience showed, government bond yields can easily fall much further than you could ever believe. But despite this, we’re not comfortable buying into a market in which the central bank (and therefore the government) is so heavily involved. There’s also the threat of sudden spasms of fear over sovereign-debt default risk rattling the markets. We’d be happier to buy defensive, high-quality stocks paying solid dividend yields. We’re talking about big brand firms that have been around for a long time and will stay around, in sectors such as pharmaceuticals, tobacco and utilities. And don’t just stick to UK listings – getting exposure to a spread of these firms around the globe lessens the danger that you’ll be overly exposed to one currency or one stock (such as BP).
We’ve been regularly tipping such stocks since the market began to rally last March – examples include drug groups GlaxoSmithKline (LSE: GSK) or Pfizer (NYSE: PFE); food group Nestlé (SIX: SA); and healthcare giant Johnson & Johnson (NYSE: JNJ). As Jim Grant notes in Grant’s Interest Rate Observer, the latter has been around since 1887 – if it survived the 1930s, it can get through whatever lies ahead too.
And if we do get another crash, these stocks will fall with everything else. There’s no getting around that, and we’ll be looking at ways to protect your portfolio without selling all your holdings in next week’s issue.
But as long as you are getting paid a decent dividend yield, you can afford to wait out any market upheaval. These sorts of firms are best-placed to survive any severe downturn. Their size means they can dictate prices to an extent; their global exposure means they aren’t overly dependent on any one income stream; and the products they sell are necessities rather than luxuries, so don’t suffer as much in a downturn.
A global slowdown doesn’t bode well for commodities. We’d be wary of investing in mining right now, and also cautious on adding any new money to big oil stocks. But one commodity we still like is, of course, gold. A deflationary scare may well send gold lower. But as fund manager Guy Monson of Sarasin & Partners puts it, gold is “a very effective hedge against a failure in some of the more radical fiscal and monetary policy being adopted globally”. You can buy physical gold (either through a bullion dealer or online, via the likes of Bullion Vault or GoldMoney), or get exposure via an exchange-traded fund. London-listed ETF Securities Physical Gold £ (LSE: PHGP) is denominated in sterling, making life a bit easier for UK investors, but bear in mind that although it’s priced in pounds, you still have exposure to the sterling/dollar exchange rate.
America set to sail on with QE2
US states are in trouble. In California, the Governor, Arnold Schwarzenegger, is cutting pay for 200,000 state workers to the $7.25 an hour minimum wage to try to help tackle the state’s $19bn deficit. And the state of Illinois, which has a deficit of $12bn, owes $5bn to “schools, nursing homes, child-care centres and prisons”, reports Ambrose Evans-Pritchard in The Daily Telegraph. State comptroller Daniel Hynes warns: “We are not paying bills for absolutely essential services. That is obscene.”
The problem for the states is that, unlike the Fed, they can’t just print money. They can raise taxes, or borrow to meet any budget shortfall by issuing ‘muni bonds’ (MBs). But right now, tax revenues are falling. And the more they borrow, the higher their interest costs rise. The danger is that at some point they simply won’t be able to afford to service their debt. And while Illinois is one of the worst, there are plenty of other states in trouble. As Bloomberg reports, “state budget deficits have now swollen to $140bn, the most since the start of the recession”. Yet US banks have also piled into MBs – their holdings are at “a 25-year high”.
One concern is that banks with high holdings of what are potentially dud bonds may have to raise more capital as their value falls. But maybe they know something we don’t. Ed Harris on Credit Writedowns reckons the Fed may kill two birds with one stone by using printed money to buy MBs. After all, “the European Central Bank has begun to buy up Greek, Portuguese, Irish and Spanish debt”.
As Warren Buffett notes, the Fed couldn’t let a state go to the wall, given that it rescued banks and car-makers. As Harris puts it: “The states could re-enter the picture if the Fed went QE2 and started to buy municipal bonds the way they started buying mortgage-backed securities in 2009. That would give the states the green light on more spending.” The trouble with this is the issue of ‘moral hazard’ that applies to every bail-out: you reward profligacy and punish prudence. But past events have shown the Fed doesn’t concern itself with such matters.
• This article was originally published in MoneyWeek magazine issue number 494 on 9 July 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don’t miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.