Market Review: September 2009 London Commentary
The China story has been well debated since our August comment. Andrew's caution was warranted, with a 20% plus decline in their stocks in August. In the US, September has the dubious historical record as the worst month in the year for stocks, with the Dow Jones Index on average since 1928 losing 1.30%; many commentators are introducing caution into their expectations.
Tuesday, September 8th 2009, 11:21AM
Accepted Facts and Reality
In 1936, no doubt while rueing some of his own investment losses, the famous economist John Maynard Keynes noted that the business of financial forecasters was not to correctly predict what was going to happen to the real economy at any given time but to predict what the consensus would believe was going to happen at that moment.
Ultimately, the consensus will predict correctly what will happen but for surprisingly long periods of time it is quite possible that the perception of reality can differ from the true situation (often with the help of a credit boom or bust) and thereby cause a sustained movement in share and other asset prices away from what might seem to be their fundamental position. As Keynes noted, financial forecasters should at least attempt to incorporate this behaviour into their models.
As an investment strategy, we suspect that this approach still has much to commend it. For example, six months ago - and perhaps even only a month ago - it clearly paid to believe in the China growth story because the consensus believed in the story regardless of the rather mixed - but generally negative - landscape portrayed by the reliable parts of the Chinese economic data.
Quite simply, there was sufficient faith and credit growth in China to support the story of China's supposed ‘structural recovery' despite the evidence to the contrary. However, when China's authorities hinted that they might curtail the rise in credit late last month, the consensus expectation shifted dramatically and some Chinese share prices tumbled by 40% in a matter of days. Of course, little had changed in China's underlying economy between July and August - in both months it was a credit dependent economy with little consumer demand in high inventories - but changes in investor expectations caused dramatic reversal in fortunes for those invested in the concept.
Of course, in theory, it is possible that expectations vis-a-vis China may once more swing into more positive territory again in due course, and so provide a new rally in the share market, but ultimately we believe that the ‘truth will out' and that the structural flaws in China's growth story will continue to constrain long term investor returns, at least until they are resolved. However, it is not only in the case of China that we should be aware of a critical divergence between accepted fact and reality.
According to popular wisdom, US companies are facing a credit crisis that is forcing them to raise money from wherever they can (including by liquidating their inventories of goods) and to economise on their expenditure. In reality, this is certainly true for small companies who are indeed struggling and being obliged to shed labour as well as their stocks but large companies - the household names - are at the same time enjoying unparalleled access to the corporate bond markets.
Despite the credit crisis, US large companies have managed to issue record quantities of corporate bonds so far this year, so much so that they have been able to afford to continue to ‘buy back' their own outstanding shares, a policy which we can assume will have helped their share prices. Far from being cash constrained, these large companies have evidently had ‘cash to spare' and hence have been able to indulge in what the Japanese used to call ‘Zaitech' or financial engineering, albeit at the cost of a further rise in the level of debt on their balance sheets.
Intriguingly, since much of the fall in share markets in 2007 and 2008 was attributed to US companies and individuals having borrowed too much, it would seem a little strange that share markets should now be welcoming a new borrowing binge by US large cap companies but nevertheless they are and we can assume that this will continue for some time - at least until fears of a US credit tightening re-emerge at some point in the future. At the very least, we expect investor attitudes regarding US corporate financial health to prove very sensitive to any tightening rumours from the Federal Reserve, although these noises may still be some months away.
However, perhaps the greatest apparent divide between accepted economic fact and reality revolves around the current state of consumer demand in the global economy.
At present, there is a relatively strong belief in financial markets that, because equity and other risk asset prices are recovering, a global recovery must soon be forthcoming. In fact, we have noticed over the years that rising asset prices do often tend to create a self reinforcing expectation within financial markets of an imminent recovery, although this may not always be the case.
Indeed, if we conduct a survey of current consumer trends within the major economies we find that, aside from a surprising partial recovery in Italy, the only significant consumer spending growth that we could find was what we might describe as ‘previous-momentum-led-growth' in countries that were still wringing out the last parts of the previous cycle, most notably Australia, India and Brazil.
During the latter stages of 2008 and even the early part of this year, there clearly was a very dramatic reduction in global consumer spending in many countries and primarily in what we might describe as the ‘deficit countries' (i.e. those in which consumers were spending more than they earned - the US, UK and Spain being obvious examples).
We firmly believe that the falls in consumer spending in these countries were the result of an enforced rise in the savings rates - when the global credit crisis caused the supply of credit to dry up, these consumers simply had to spend less (and therefore to arithmetically save more) because they could not finance their cash flow deficits. Interestingly - and perhaps crucially from a forecasting point of view - disposable income growth in many of these countries was quite rapid at the time but this could only partially offset the damage done by the credit crisis. Stage one of the consumer retrenchment was therefore credit crisis / savings rate driven.
Now, however, the credit crisis is easing in places and there is some - albeit reduced - credit supply available to households that has allowed consumer spending to stabilise vis-a-vis household disposable incomes. This suggests that stage one of the consumer crisis has passed, as indeed many have recently noted. Unfortunately, we wonder if stage two is now about to unfold.
As we note above, the weakness in consumer spending during stage one occurred against a background of positive household income growth, partly because government fiscal measures were effective in mobilising funds to the household sector (particularly the Bush & Obama tax rebates and the Brown VAT reduction in the UK) and partly because in most countries outside the US the employment situation was relatively slow to react to the slowdown in global growth. However, as we look into the second half of 2009 and on into 2010, we are left with the inescapable fact that the employment situation is now becoming much weaker in Europe and Japan, and that it is still soft in the USA.
Moreover, we must also be aware that the period of government fiscal largesse is clearly coming to an end - the ‘cash for clunkers' and similar schemes in many respects mark the last ‘direct injections' into the consumers' cash flow situation; any remaining benefits from fiscal policy will have to come through the roundabout income effects of the various public works projects that are still in the pipeline. Therefore, it seems to us that over the next six months we will see a marked degree of weakness in consumer disposable incomes (in fact, this has already begun in the US and is beginning in the UK).
The weakness in household disposable incomes implies that in order for consumer spending to now rise in the way that the consensus apparently expects (following the rise in asset markets), savings rates will have to drop precipitously and certainly back to 2006-7 boom-like levels.
Of course, rising asset prices and a probable stabilisation in US house prices do indeed suggest the potential for some degree of a rise in consumption trends / decline in saving from current incomes but we would argue that with consumer confidence still absolutely weak, job uncertainty still rife and credit still relatively hard to come by (it is difficult for society to save less without some form of credit boom), a sharp drop in the savings rate that is sufficient to lift consumer spending is unlikely. In practice, we do expect US and other savings rates to now drop passively as incomes come under pressure but we do not expect them to rise proactively by enough to force consumer spending to rise in absolute terms as incomes fall.
Therefore, far from expecting a consumer recovery in 2010, we expect that stage two of the consumer slowdown process (i.e. that caused by weak incomes) may unfold from late 2009Q4 onwards, something which might even challenge the optimism currently prevalent within today's liquidity-driven financial markets.
For investors, the trick will be in attempting to decipher when the consensus will switch from its current faith in a consumer recovery to acknowledging that all is indeed not well in the household sector and we suspect that the Thanksgiving / Christmas sales numbers may be instrumental in this regard, as indeed could a seasonal rise in bond market yields and hence mortgage rates in the latter part of the fourth quarter.
As China proved, taking the consensus view on trust can produce spectacular short term gains but to protect one's capital, it does pay to look the ‘gift horse' in the mouth occasionally and a good time for this examination may soon be upon us.
In the long term, we do have considerable faith in the highly flexible US economy's ability to recover but we fear that at the current time, financial markets may have got a little ahead of themselves in predicting the recovery and this divergence between expectation and reality could prove temporarily destabilizing if the right (or wrong?) catalyst intervenes as the year draws to an end.
Andrew Hunt
International Economist
London
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