The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

History Rhymes

As we pointed out in a previous post, the action on the S&P 500 reminds us of a similar period in May 2008. Investors tried to rally the market above its 200 day moving average (see faint red circle) and failed…leading eventually to a 40% drop.

S&P 500 in 2008

S&P500 in 2008

Source: Bloomberg

This year, we are faced with a similar pattern. There is good news in the S&P 500 (75% of the companies have exceeded expectations in 3Q numbers) and the US economy is still growing (albeit at a sluggish 2-3% pace). When this pattern appeared in 2008, the US economy was already in recession (started from December 2007, declared on December 1st 2008).

This time around, while there is a significant risk that the US economy is already tipping into recession (ECRI declared one in September), the two big issues dominating the market continue to be the European Sovereign Debt Crisis and the Political Gridlock in the US.

The Euro Crisis impacts the largest economic area in the world on a combined basis. Unfortunately, the central design flaw of the Euro (monetary union without fiscal union) has been exposed. There is too much sovereign debt in Europe and too much of it is owned by European banks which in turn have too little capital to absorb any losses. Germany is the only player with the economic and political clout to resolve the problem and it has yet to decide on which expensive resolution to adopt.

The US continues to struggle with political gridlock which in normal economic circumstances might not be such a problem. However, with such tepid consumer demand growth and a corporate sector keener to horde cash than invest in new projects and employees, the issue of the federal budget is causing deep anxiety amongst investors. For the middle of the road voter, who will once again swing the election next year, the choices are stark and surprisingly well understood. The Republican plan emphasizes spending cuts and will translate into an immediate reduction in GDP. The Democratic preference for stimulus spending financed with higher taxes will lead to a more gradual reduction in GDP but runs the risk of blowing out the deficit and attracting the negative attention of the bond market.

Neither outcome is particularly good for corporate profits and stock market performance. This is why we are seeing the October rally start to fade.

S&P 500…last six months.

S&P500 Today

Source: Bloomberg

What should investors do?

The System continues to favor short ETFs, short term US government paper and Gold. In other words, there is no underlying momentum in risk assets that should give one confidence at this time. The fate of the macro-economic foundations of half the globe’s GDP is in the hands of politicians who are faced with no easy choices and one of the leading forecasters of business cycles has called for a recession in the US.

We have often observed that the Bull Market slogans of the 80’s and 90’s (Buy and Hold…Buy the Dips) have served investors poorly since the dawn of the new millennium. At this juncture, we would remind investors of that observation continue to maintain a cautious investment stance.

One Eye on the Exit

Although the S&P 500 has managed to break through its short term obstacle, setting up a Bear Market Rally, the fundamental picture darkened just a bit more over the weekend.

The Economic Cycle Research Institute (ECRI) is now calling for a recession. While there is a chance that they are wrong, the ECRI has a pretty impressive track record both for calling the major turns in the economy and for not issuing false alarms. For those of us without a full membership, we need to rely on articles from the New York Times. But, the ECRI calls are generally ahead of the pack so even hearing about them a few days late puts one ahead of market concensus.

ECRI Weekly Leading Indicator

Source: ECRI

As you trade the Bear Market Rally, be ready to head for the exits as soon at momentum starts to fade.

May You Live in Interesting Times

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.

Risky Business

After 30 years of a mummified political existence, the Egyptian political scene exploded into protests and unrest last week, threatening to destabilize the Arab world’s largest country.

Although the Egyptian financial markets barely register from a global perspective, the unrest reminded investors that the world remains a risky place. The US dollar rose, gold perked up and oil, which is not a big Egyptian export, was back on the rise.

If you read’s excellent coverage of the crisis, you will note that the most likely outcome for this crisis is a fresh face from the military who will rapidly move to:

  1. close down the Muslim Brotherhood,
  2. shore up the US alliance, and
  3. quietly assure Israel that the 1977 Peace Deal is still in effect.

But the fireworks along the Northern bit of Africa are not the only worry in the world.

US Growth

In a detailed letter this week, John Mauldin takes apart the latest US GDP numbers and finds that there were more statistics than recovery in the numbers. It makes for interesting reading, especially when one considers how the inventory numbers change because of the change in oil prices over the quarter. The issue of US growth is tremendously important because much of the world’s monetary policy (in particular, the fast growing developing markets like China) are tied to the FED through fixed or nearly fixed exchange rates. Weak growth means that the FED will continue to err on the side of accommodation, which means that US interest rates will remain low until the bond market rebels and/or inflation becomes too obvious to hide.

The US economy is starting to pick up but at a growth rate well below that of previous post recession recoveries.


Related to the sluggish US growth rates and resultant accommodative monetary policy, it looks like we will see commodities surge ahead once again. In this week’s rankings, Silver (SLV) and Food (DBA) score highly with Base Metals (DBB) and Oil (OIL) putting in lower but respectable scores. Commodity Related ETFs like Russia (RSX), Global Energy (IXC), and Fidelity Funds like Select Energy (FSENX) and Natural Resources (FNARX) are also near the top of our various portfolio lists.

The strength is due to the solid demand for these commodities which is driven in no small part by the massive supply of dollars floating around the globe. The desire to turn the seemingly unlimited supply of dollars into more supply restrained commodities looks set to remain a theme for the foreseeable future. Higher prices will eventually entice more suppliers onto the market but the lag should be prolonged enough to make some money from the next leg of the commodities rally.

Sovereign Debt Crisis: Japan

Another story that should have caused more concern than it did was the downgrade of Japan’s long term debt by S&P. The rating drop from AA to AA- doesn’t seem momentous compared with some of the sovereign crises we have experienced over the past couple of years. However, two things bear watching. The first is that ratings agencies historically have been behind the curve in downgrading sovereign debt. If S&P is downgrading now, this may be the start of a more serious cycle. The second question to ask is: “Who will buy Japanese debt?” In the past, this was not a terribly interesting question because the bulk of JGBs (around 94%) were absorbed domestically. With the aging of Japan, it is not unreasonable to expect that the robust savings rate, which allowed Japan to self fund its government debt, will shift into reverse. Last year the Japan Post Bank (the biggest owner of JGBs at more than 20% of the total) announced that it would no longer be a net buyer from 2011. According to the Economist, gross debt to GDP is an eye watering 190% and rising (although other sources already quote figures in the 200% plus range) so having a major buyer like the world’s largest bank (by deposits) pull out of the market is not a small issue. The pricing mechanism for JGBs looks set to change as foreign investors are asked to bid for bigger slices of Japanese debt. On the negative side, it will not take much of an interest rate hike to overwhelm Japan’s fiscal budget with interest expenses. On the positive side, the pressure from the bond market could be enough to spur Japan to enact much needed but unpopular reforms that could set the stage for an escape from two lost decades. However, any good news will only come after a period of painful adjustment.

So what should an investor do?

We think the best approach is not to run away from risk but to manage it. The recovery from the Global Financial Crisis has been rocky and looking around at some of the overheating in China, the rolling sovereign debt crises along the rim of the EU and now the turbulence in the Arab world, it is obvious that some of these trends will lead to trouble down the line. We think the solution lies in identifying and monitoring a fairly broad universe of asset classes and recognizing that the institutional money in the market will be draw towards and scared away from different asset classes at different times. By deploying one’s investment funds in the asset classes that are benefitting from the rising tide and avoiding those where sentiment is draining away, we think one can achieve a solid return on one’s portfolio despite the generally directionless but highly volatile overall direction of the financial markets.

CIVETS anyone?

We have received a number of questions about the CIVETS market (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and how they compare to the previous emerging markets grouping, the BRICs (Brazil, Russia, India and China). We decided to see how far along in the cycle we might be by using the System to pick when and where to invest in each grouping.

CIVETS markets

So, if you were wondering if it was too late to jump on the bandwagon, this chart suggests that there is still some money to be made in CIVETS.