What are we to make of the conflicting fundamentals that have brought heightened volatility to global investment markets?
Here are the negatives, as I see them:
The credit squeeze
Although the immediate panic is over, this is a slow-burning crisis that is going to take a long time to unfold, having an adverse impact on economic growth for years to come.
Banks will hurriedly revert to conservative lending policies to digest their own toxic waste, rebuild their balance sheets, placate angry politicians and activist regulators, and shore up the confidence of their shareholders.
One example of how much further revaluation of structured-credit assets still has to go is that Merrill Lynch was recently forced to cut by 57 per cent the value of one chunk if its mortgage products that had been given the highest credit rating, AAA.
Lots of toxic waste remains buried in packaged investments scattered around the world in the portfolios of conservative financial institutions such as pension funds. It will be take years for the losses to become apparent, when the lower market values of those credits are recognized and taken to book.
However, more damaging than the losses themselves – which could well turn out to be not all that great, relative to total assets – will be the damaging impact on sentiment of ongoing uncertainty and the drip-feed of continual announcements of losses. A serious outbreak of caution.
Housing collapse
The bubble in the residential property markets of the US and other afflicted countries such as the UK, Australia and Spain has only just started to deflate, and has much further to go.
Stephen Roach, chairman of Morgan Stanley Asia, has raised the prospect that in America, for example, home prices overall could “decline in both 2008 and 2009 – an unprecedented development in… modern-day experience.”
If that happens – and I think it is almost certain – it must have a devastating impact. The most powerful force that has been driving US economic growth is disappearing. The well-known economist Joseph Stiglitz estimates that direct and indirect spending linked to housing accounted for two-thirds to three-quarters of all growth in the US economy since the end of the technology boom.
Earnings collapse
Banks and other financial businesses have been providing a third of all the profits of companies listed on US stock exchanges. Much of those profits have been derived from lending money to poor risks, recycling dodgy credits to naïve institutional investors, and financing speculation or high-risk takeovers in various forms.
Much of that business is evaporating, and with it the fancy profits. Banks will be forced to revert to unexciting and low-profit activities such as lending money to blue-chip companies (most of which are cash-rich and won’t wish to borrow).
Financial companies are not the only ones starting to experience tough trading conditions. Early indicators suggest that the years of corporate earnings growth, which took profits in the US to an all-time high relative to GDP, have come to an end.
The implications for equity investors are likely to be unpleasant. The Financial Times reported recently: “The seven earnings slumps since 1947 have all hit fast (an average of 31 months from peak to trough profits) and hard (cutting a third or so from profits).”
Inflation
Years of profligate money creation by central banks, supply/demand imbalances that have driven up the prices of key resources such as oil, the fading impact of unusually-high tech-driven productivity gains, and shortages of high-level skills in many sectors such as global mining and Chinese manufacturing, are combining to bring back the inflation problem.
Central banks have awakened to the risk. But now they are stuck between a rock and a hard place. They want to boost interest rates to combat inflation – but need to cut them to ease the pain of the credit squeeze and reduce the risk of major bankruptcies in the financial sector.
Given mounting political pressures and the risks to economic growth from the crisis in the credit markets, it’s likely that the central banks will give first priority to cutting interest rates.
Consequently, inflation is likely to worsen.
Currency instability
The US needs to attract an extra $3 billion in foreign capital every business day to finance its foreign trade deficit. If foreign governments, institutions and private investors become less willing to provide that capital, the dollar will remain under pressure – continue falling in value in terms of other currencies.
Among the adverse consequences will be pressure on US investment markets to offer higher yields to attract foreign money, making it more difficult for the Fed to cut short-term interest rates. Exporters in other countries with costs based in stronger currencies, such the euro, will find it increasingly difficult to compete.
However, the negative fundamentals I’ve listed will be countered by some positives, especially for investors:
Strong growth in developing nations
Emerging markets now generate more than half the world’s economic growth, and the proportion is rising fast.
Although any slowdown in the US economy will have global consequences, both softening demand for internationally-traded products and undermining business and investor confidence, the scale of the damage must be less than in the past in a global environment where America is less important than emerging markets as a whole as a source of demand.
It’s true that exports have become primary engines of growth for developing nations, providing markets for almost half their production. But…
– The US is not as overwhelmingly important as buyer for those exports as you might think. Globalization has expanded all export markets. Developing nations increasingly export, not only to America, but also to Europe, Japan, and regional trading partners.
Take a look at these interesting figures from Morgan Stanley Asia:
| Nation | Export share of GDP | US share of exports |
| China | 37 | 21 |
| Japan | 15 | 23 |
| Korea | 37 | 13 |
| Taiwan | 59 | 14 |
| ASEAN* | 73 | 14 |
* 10 Southeast Asian countries with a combined GNP of $1 trillion
– Emerging markets are increasingly driven by their internal dynamics. Hundreds of millions of people are moving from rural areas into cities where they can earn much more. Enormous numbers of them are moving up the income scale into the middle class, with the spending power to acquire decent homes, equip them with nice furnishings and modern gadgetry, and buy cars.
High savings ratios, sound public finances (low spending, low taxes), and foreign reserves running into several trillion dollars, provide the firepower for many governments to stimulate domestic demand to offset falls in export sales.
The focus will probably be on physical infrastructure such as power stations, roads, ports and public buildings, as that provides the foundation for even higher economic growth in future, as well as for provision of better public services.
Cheap money
The greater the risk of global recession and of deflation, the more central banks will force down short-term interest rates to combat that risk.
In Japan the central bank offered credit to commercial banks at virtually no cost, and even now charges only ¾ per cent. With policy rates in the 4 to 5 per cent range, the central banks of the US and Europe still have great potential to cut rates and flood their systems with near-free credit, should they deem that necessary.
Although printing money isn’t guaranteed to stimulate growth if consumers and businesses don’t want to borrow cheaply to finance their spending, it does provide strong underpinning to economies in trouble. Japan’s experience proves that.
Fiscal stimulus
If economic slowdown becomes worrying, it won’t be just central banks that throw money at the problem. Governments will do so, too, by increasing their spending on whatever interests the politicians currently favour.
It is not only developing nations that will be investing in infrastructure. Countries such as the US, the UK and Australia badly need to do so in any case to replace worn-out and inadequate facilities.
World trade
The progress of globalization won’t cease because of lower growth in the world economy, even though that progress will be slowed somewhat by rising protectionism in the developed nations, where whole swathes of job classes are under increasing pressure from foreign competition.
The process of global integration has gone too far for it to be reversed. Every nation, including the most advanced ones, has become heavily dependent on inflow from abroad of materials, components and finished goods.
Some commentators even argue that with economic slowdown putting corporate profits under severe pressure, managements will be even keener on reducing their costs by shifting manufacture of their products and provision of their business services to cheaper locations in the emerging economies.
Although a weakening dollar will mean greater problems for nations with stronger currencies – especially those in the Eurozone – it will favour a rebalancing. For the US, for example, it will make exports more competitive and discourage imports, reducing the horrific foreign trade deficit.
Negatives will outweigh policy
The negative factors are likely to outweigh the positive ones for a while, generating major difficulties for all the advanced economies. The devastation wrought by the credit crisis will turn the financial services and housing sectors into no-go areas for investors for many years to come, and make life difficult for small and even midsized enterprises, which tend to depend more on credit.
The emerging markets should largely escape unharmed. In the case of Asia, for example, Stephen Roach suggests that a US demand shock could be “serious trouble” for Japan, but not for the rest of Asia. China would actually welcome a forced slowdown of economic growth from 11 per cent to, say, 8 per cent. In India and the ASEAN countries “underlying growth appears strong enough to withstand a shortfall in US consumer demand.”
The Asia-Pacific excluding Japan remains my favourite region for investment. In the case of equities, I would not disagree with the recommendation of CLSA’s strategist Christopher Wood that a five times overweighting – 37 per cent of a global portfolio – would be a good idea.
Resource-focused economies such as Australia, South Africa, New Zealand, Canada, Brazil, and the oil/gas producers, should also not suffer any serious damage from the downturn in the world economy, because of the probable persistence of shortages in supplies of commodities relative to demand.
Donald Coxe, the eminent adviser at BMO Capital Markets, suggests that “reliquification” of the global economy by a weaker dollar “has the potential to unleash a new round of commodity inflation, led by gold, base metals, foodstuffs, and to a lesser extent energy.”
The agricultural sector remains his favourite commodity sector for new money commitments, with fertilizer, farm equipment and seed companies “excellent value for long-term investors.”
By Martin Spring in On Target, a private newsletter on global strategy