THE CASE FOR THE BEARS
1. UNEMPLOYMENT. Although the market was closed on Friday in the U.S., the Labour Department said nonfarm payrolls rose by 162,000 in March, the largest gain since March 2007, although nearly one-third came from temporary hiring for the Census and behind estimates of 200,00 gains. But U.S. unemployment remains stubbornly high and is likely to remiain so for some time as the rate stayed at 9.7% last month, in line with economists' expectations. It is sobering to think that 1 in 10 Americans is out of a job and given corporate America's drive to keep costs low and productivity high, this is unlikely to drop sharply any time soon. f you take into account part-time workers looking for full-time jobs, unemployment is about 17%. In Europe, U.K. unemployment is 8%, German is 7.5% and French is 10%.
2. MORTGAGE ARREARS. Around one in four U.S. home owners are in negative equity on their mortgages (i.e. they owe more than there home is worth to their mortgage lender) . Then their are the "shadow inventories" where lenders are unwilling to foreclose on properties because they will have to declare losses on their books and so they are allowing owners who are not paying anything to stay in the property.
3. DEBT. Government debt continues to grow at a significant rate. The U.S. deficit since the beginning of the fiscal year in October now stands at $651.6bn, meaning the goverment are on track for an annual deficit of$1.4tn, more than 10% of GDP, and the highest level since World War II. The US government recorded a budget deficit of $221bn (£147.6bn) in February - the largest monthly deficit in its history. In the U.K., Chancellor Alistair Darling confirmed that the UK budget deficit is likely to be around £167 billion this year with UK national debt balloon to well over £1 trillion. Current UK public sector net debt is £848.5 billion or 60% of GDP. Excluding Financial sector intervention (i.e the bail out Northern Rock, Lloyds and RBS), public sector debt is £743 billion or (52.7% per cent of GDP). Though to put things into context, Japan for example have a National debt of 194% of GDP, Italy 117%, Greece 108%, Germany is 77% and the U.S. is 71% of GDP.
To date, government debt has been able to be financed by countries such as China with large fiscal surpluses who have been buying up bonds like U.S. Treasuries. Whether this continues if credit agencies move to downgrade countries from Triple A status is another matter. Recently, the problems of the PIIGS (Portgual, Ireland, Italy, Greece, Spain) debt has worried the bond markets. A Greek debt bail out was fashioned last week by the euro zone countries after it struggled to roll over its borrowing requirements as investor appetite for its bonds wained.
4. CHINA.
In 2008 the Chinese government instituted a $585bn economic and infrastructure stimulus package, helping to continue strong economic growth in 2009. The country now has a population of 1.3 billion people, with income per capita roughly one-tenth of U.S. levels. After the collapse of commodity prices in 2008, aggressive Chinese buying of iron ore, Copper and other industrial products have helped propel commodity stocks like BHP Billiton and Anglo American. Copper prices are up a 160% in the past year and a half. 2/3 of the growth in many of these commodities is expected to come from China. Although, But is there cause to be concerned?
We often hear that speculative bubbles are impossible to forecast until after they have popped. Edward Chancellor's "10 Sign Posts of Manias and financial Crises" has compelling similarities to what we are seeing in China.
"Great investment debacles generally start out with a compelling growth story."
"Blind faith in the competence of the authorities." (do we really trust the Chinese government?)
"A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear."
"Great booms are invariably accompanied by a surge in corruption."
"Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward." (Money supply grew by nearly 30%, interest rates maintained well below nominal growth rates)
"Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts." (Chinese currency, the renminbi, is pegged to the U.S. dollar)
"Crises generally follow a period of rampant credit growth."
"Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned."
"A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious." (Chinese banks are particularly reluctant to report problematic loans)
"Dodgy loans are generally secured against collateral, most commonly real estate."
5. TIGHTENING OF MONETARY POLICY
After a period of extraordinary low interest rates around the world it is likely that interest rates will begin to rise in late 2010 or 2011. China and Australia have already begun tightening.
THE CASE FOR THE BULLS
1. LOW INTEREST RATES AND BENIGN INFLATION FOR NOW
Interest rates around the world look set to remain low for the foreseeable future as inflation remains low despite the huge increase in money supply in countries such as the U.S. and U.K.. This means companies can borrow money cheaply and invest in growth.
2. CORPORATE PROFITABILITY
As workers work harder as they fear for their jobs, productivity is continuing to rise. For example in the U.S., productivity rose 6.9% in the fourth quarter of 2009. This together with job cuts means costs have been slashed and earnings enhanced.The S&P 500 companies (excluding financial companies) hold almost $1.2 trillion in cash, or more than 10% of assets, the largest amount since the 1960s. Corporate earnings over the next couple of quarters will be strong particularly if firms deploy this cash to increase dividends or increase share buy-backs.
In 2008 the Chinese government instituted a $585bn economic and infrastructure stimulus package, helping to continue strong economic growth in 2009. The country now has a population of 1.3 billion people, with income per capita roughly one-tenth of U.S. levels. After the collapse of commodity prices in 2008, aggressive Chinese buying of iron ore, Copper and other industrial products have helped propel commodity stocks like BHP Billiton and Anglo American. Copper prices are up a 160% in the past year and a half. 2/3 of the growth in many of these commodities is expected to come from China. Although, But is there cause to be concerned?
We often hear that speculative bubbles are impossible to forecast until after they have popped. Edward Chancellor's "10 Sign Posts of Manias and financial Crises" has compelling similarities to what we are seeing in China.
"Great investment debacles generally start out with a compelling growth story."
"Blind faith in the competence of the authorities." (do we really trust the Chinese government?)
"A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear."
"Great booms are invariably accompanied by a surge in corruption."
"Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward." (Money supply grew by nearly 30%, interest rates maintained well below nominal growth rates)
"Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts." (Chinese currency, the renminbi, is pegged to the U.S. dollar)
"Crises generally follow a period of rampant credit growth."
"Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned."
"A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious." (Chinese banks are particularly reluctant to report problematic loans)
"Dodgy loans are generally secured against collateral, most commonly real estate."
5. TIGHTENING OF MONETARY POLICY
After a period of extraordinary low interest rates around the world it is likely that interest rates will begin to rise in late 2010 or 2011. China and Australia have already begun tightening.
THE CASE FOR THE BULLS
1. LOW INTEREST RATES AND BENIGN INFLATION FOR NOW
Interest rates around the world look set to remain low for the foreseeable future as inflation remains low despite the huge increase in money supply in countries such as the U.S. and U.K.. This means companies can borrow money cheaply and invest in growth.
2. CORPORATE PROFITABILITY
As workers work harder as they fear for their jobs, productivity is continuing to rise. For example in the U.S., productivity rose 6.9% in the fourth quarter of 2009. This together with job cuts means costs have been slashed and earnings enhanced.The S&P 500 companies (excluding financial companies) hold almost $1.2 trillion in cash, or more than 10% of assets, the largest amount since the 1960s. Corporate earnings over the next couple of quarters will be strong particularly if firms deploy this cash to increase dividends or increase share buy-backs.
3. LOW INVENTORY LEVELS
Many companies have worked hard to work down inventory levels during the recession meaning that any increase in consumption will quickly increase orders and hence revenues.
The U.S. government still has two-thirds of the $863 billion stimulus money to spend over the next 18 months which is good news for infrastructure companies in particular.
CONTRARIAN INVESTOR U.K.'s VIEW
On balance, I am a little worried about things. There are some strong indicators that the second quarter may be strong as productivity and cost cutting continues to feed through. But the second half of 2010 may be more challenging especially if the Chinese "economic miracle" comes off the rails. It will be increasingly a traders market not a "buy and hold". In 2009 you could have bought almost any stock and seen its share price increase and perhaps double or triple but in the later part of 2010 things are going to get tougher especially if the Federal Reserve, European Central bank start to curtail "cheap money" by increasing interest rates.I will not be committing significant new funds to buy and have plenty of cash on the sidelines to take advantage of any move down. Although stocks are not expensive on traditional valuation metrics such as price/earnings, they are not at bargain levels so although I expect a move up in the U.S. S&P and DOW over the coming weeks, the upside potential is not so high to justify 100% holdings in stocks. Better to have cash for a 5-10% correction to take advantage of any opportunities that arise in favoured stocks.
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