The US market is no longer the only highly liquid, highly regulated and highly transparent market in the world. Several of the developed markets would argue that they are better regulated or more transparent and just about as liquid. Some of the emerging markets are closing fast on one or more of those criteria. So, the US is not the only game in town. That is reason number one.
We think that the outlook for a lot of the globe is more amenable to investors than here at home. The outlook for the US economy and US corporate profits (and so US stock markets) isn’t as favorable as it once was. The demographic argument that we just aren’t creating as many highly skilled, highly motivated and highly productive workers as we once did is a big piece of this. We used to grow by 3% or more a year in population. Now, we grow barely 1% and largely due to immigration (legal and illegal). Productivity adds to that and gives us a potential, long-term GDP that is lower than our history and lower than many, more promising opportunities. That is reason two.
Workers in many other countries earn less than their US counterparts. Availability of land without harsh environmental and other regulatory hurdles means faster development. Capital is cheaper in some other places, though that is not a universal point. Many governments are welcoming of industry and jobs, while the environment in the US and many other developed countries isn’t so welcoming. Taxes and other costs are generally lower in developing nations. So, if you were a business executive wondering where you would plant your next plant, would you choose Muncie, Indiana or Mumbai, India? Peoria, Illinois or Guangzhou, China? Portland, Oregon or Sao Paulo, Brazil? We think you know the answer to all those questions and it isn’t favorable to the US outlook. That is reason number three through about six.
On the back of that last bunch, there is the virtuous cycle that develops once a China or India or Turkey wins that new plant and the concomitant jobs. Those jobs raise living standards in the community where they start. The higher living standards work their way into neighboring towns and cities as shopkeepers and service providers benefit from the factory workers’ spending. We get an emerging middle class in one country after another and those middle class people spawn whole new industries to service them. As these middle classes swell, they demand more and more products and services, helping the employment, productivity and incomes in these countries one by one. They are going to see the same benefit to development that showed up on our shores from about the end of the Great Depression through the 70’s. This will go on for a long time and it is something that the US won’t enjoy because we’ve already had this phase of development. That is reason seven and maybe even reason eight.
After these reasons there are several minor ones: like access to specific companies in specific industries that will bring obvious benefits over time; many resources are more available overseas than at home; riding a wave of interest in these markets and companies now. But these benefits are more tactical in nature rather than the strategic benefits above. The last reason is more abstract. We will get far more diversification from investing a little bit in some emerging markets than we get from investing a lot in developed markets. The correlation between US and European and Japanese markets has risen inexorably over time. That may become the case with the major developing markets, but not for a while we hope. That adds up to reason nine through twelve or so.
There are also risks. Probably the one we are most familiar with is volatility in many foreign markets. That is both a good thing and a bad thing. As we are wont to say, only half of volatility is bad, the part that means going down (the other part we call performance). Foreign markets have different economic cycles, different fiscal and monetary policies, different interest rate regimes and different currency impacts. All those present risks and opportunities. They are also why we get diversification as noted above. As the developed economies begin to act more in concert, this difference will become even more important.
Please do not frame this move in terms of a tactical play against the dollar or against the current administration (even though those may help in making the case) but as a reminder of how different the world is today versus the 60s or 70s. The real reason is above in those first few big issues. The risk-return relationship between US investors and foreign markets is different today than it has ever been before. We think this is a big opportunity for our clients, not a tactical move that appeals to the idea that the US is declining or that we fear the socialist tendencies that many see.
Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days, maybe not this week so much.)
Retail Sales were surprisingly good; most of the credit goes to car sales. Since we’ve gotten out of the shadow of the ‘cash for clunkers’ program, car sales were supposed to stay very low, but instead they have been just poor, rather than awful. The guesses were that retail sales would rebound 1% in October from September’s decline of 2.3%. They were 1.4% higher instead. Ex-auto sales, retail sales were only 0.2% higher, which was less than expected.
Producer Prices rose by 0.3% in October. The core version of this index, which eliminates volatile food and energy prices, fell by 0.6%. This somewhat surprising shift in core prices was probably caused by car prices. Every October the new model year change-over impacts car prices as new models and upgrades to old models hit the price series. Usually this largely reverses the next month as we don’t have model change-over month after month after month. The headline number was driven by higher food and energy prices, especially energy prices as the price of crude oil went from $70 a barrel to $80 a barrel over the month. PPI has fallen 1.9% in the past year while the core PPI has risen by 0.7%.
Industrial production rose by 0.1% in October. Factory output fell by 0.1% but utility output rose by 1.6%. This is the fourth straight month when industrial production rose.
Capacity utilization rose to 70.7% in October from 70.5% in September. We’re watching capacity utilization as one indicator of inflation potential. Near 70% we probably don’t have a lot to worry about, but as we get closer to 80%, better yet 85%, we will have lots to worry about.
Consumer prices rose 0.3% as energy prices and car prices lead the gains. We hit this topic above, but does anyone else think car prices are going up? The annual quality and cost adjustments are the demon here, so this is a one-off for the inflation case. The core CPI, without food and energy prices, rose 0.2%. In the past 12 months, consumer prices have fallen 0.2%, while the core reading is 1.7% higher.
Housing starts fell in October from September. The decline of 10.6% was quite the surprise to Wall Street, which was expecting a flat number. We started only 529,000 homes (at an annual rate) in the month, down from 592,000 the month before. Most folks had thought that housing had hit bottom and would begin to trend up sooner or later. Well, sooner didn’t happen, so we guess it will be later. Once again, we will remind you that we are creating about 1.7 million new households a year, so we are rapidly consuming the existing housing stock. At some point, those million-plus households are going to need a place to live that isn’t someone else’s old home. There aren’t enough of those to last forever. Also, there is the inexorable shift of people from the north and east to the south and west, which means a lot of those homes aren’t where people need them. Housing will come back, someday
Leading indicators rose last week. This came as no surprise, which is good. The gain of 0.3% is the seventh straight month of gains. This index is designed to predict changes in the direction of the economy with a lead time of three to six months. Since we probably turned in either June or July, it worked reasonably well. Since it is still rising, it predicts continuing gains in the economy over the next three to six months, which is even better.
We usually start off with stock markets. Those are the sexy ones. But something happened in Treasury bills that needs to be noted. The two-month bills, those issued about a month ago but which mature in early 2010 had their yield fall below zero percent last week. That is something that is rather odd. Why would anyone lend money even to the government for less than nothing? There is a fairly simple answer to this question and it is that we are getting up toward year-end and all the banks and other financial companies have to report what they are invested in at year-end. They also have to report at quarter-end, but in those reports they don’t have to go into the depth of detail that they do at year-end. These companies want to show that their investments are very high quality and very liquid because of the environment we are currently in. This corporate window-dressing will go on until year-end and might even get crazier. In simple fact, there aren’t enough Treasury bills to go around in the maturities that everybody wants. If the Treasury wanted to borrow some money real cheap, they’d issue a cash management bill that matured on January 4th and they’d issue tons of them.
What we are liable to see are high grade money market rates head closer to zero while middling quality will get higher in rate. This year-end spread widening is common in money markets, usually accounting for a 20 to 30 basis point widening most year-ends. At year-end last year, quality spreads in money markets were at several hundred basis points, but last year was a little different in a lot of respects. We could see wider quality spreads this year due simply to the huge volume of money that wants to look high grade just for year-end reporting purposes.
The real losers in all this aren’t junk issuers, it is the single A to double A issuers who aren’t quite high grade enough. Their paper will be cheap between now and year-end and then just as suddenly as it came on, the quality trade will come off and those parts of the market will bounce back. Smart managers will take advantage of this trade, but there are few of them, or else this whole thing wouldn’t work.
Another strange thing is happening in our markets, the ‘carry trade’. This was once a problem only for Japan, but now it is here on our shores. Traders and hedge funds have globbed onto the idea that the dollar is going to be chronically weak. Therefore, it pays to borrow dollars because our rates are rock bottom and when you pay back a tiny bit more money than you borrowed, it actually costs you less than nothing. The decline in the value of the dollar will offset the carrying cost on the cash and then some. So, huge amounts of money are being traded in the carry trade. The people who borrow the dollars are investing them in oil, gold, emerging markets, anything that has been going up and does not rely on dollars to make them work. That also helps explain why the prices of oil and gold have fluctuated wildly on occasion. When the dollar is down on a given day, these carry traders are selling dollars and buying oil. If the dollar goes up on a given day, they hustle and try to cover these positions and reverse the whole trade.
So, you get days when the dollar is up and the markets go wild to the downside in gold, oil, stocks, emerging market stocks, nearly everything. Then there are days when the dollar goes down and oil is up, gold is up, nearly everything else is up. This little wrinkle explains so much of the daily volatility it is scary.
Even with some of that daily volatility, the markets managed to not get whacked last week. The bears tried several times to drive down the major indices but over the course of the week we were largely unchanged in large caps. The up days offset the down days and most of the down days closed higher than one would have guessed an hour or so before the close, funny price action with little real news to drive prices one way or the other. But, the positive bias in the markets hangs on week by week, kind of.
Overseas indexes were also mixed. Most developed markets were lower, most emerging markets also but the emerging markets had enough exceptions to keep their losses smaller overall. By and large, Latin America a Asia did better than Europe.
Bonds were generally higher across the board. Both domestically and internationally, the outlook for benign inflation and weak economic rebounds reasserted itself as the recent inflation scare continues to recede.
Real estate securities were generally lower. Though there hasn’t been any important news on the commercial property front, the securities take their clues from the financial stocks and so they fell last week.
Commodities were generally higher, with precious metals, industrial metals and some softs in the lead. Energy prices were volatile but ended the week about where they started.
Have a really great holiday week.
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.