Is the Economy on a Precipice?
WHITE HOUSE IN DENIAL AS GLOBAL ECONOMY APPROACHES TIPPING POINT
Five years after markets crashed, with the stand-off in the Crimea driving oil prices up, China facing a significant economic slowdown and with White House Economic advisors calling for economic brinkmanship against Russia, many are wondering if another crash is in the offing.
Not so, says US President Barack Obama. He would have all believe that the U.S. economy is on track to strengthen and add more jobs in the next two years because many of the impediments to faster growth have subsided.
The economy has never been Mr. Obama’s forte. His strength is legal scholarship, research, and political as well as community activism, that is before he went into politics. Other than a brief stint at a company called Business International, an advisory firm, which was acquired by The Economist after his departure, Mr. Obama has no real experience in economic policy or management.
Though both lawyers by profession, whatever his other shortcomings, his democratic predecessor, William Jefferson Clinton’s command of the economy was rarely questioned not only by the press but also by his opponent, and contrasts sometimes alarmingly with a man whose economic policy is talked about in terms of what his advisors are saying. ‘Team Whitehouse’ was recently used in the press to describe them.
Despite a threat level that left yellow in the dust, Team Whitehouse is beaming. The unemployment rate has dropped to the lowest levels in more than five years, deficits have been cut by more than half, housing is on the rebound, manufacturers are adding jobs for the first time since the 1990s and exports are accelerating, Obama said in an annual economic report to Congress.
“After 5 years of grit and determined effort, the U.S. is better-positioned for the 21st century than any other nation on Earth,” Obama said in the report released Monday.
The 410-page document is being released as the campaign season begins for the November elections for all 435 seats in the U.S. House and one-third of the 100 seats in the Senate. Obama’s economic record will be one of the issues Republicans use in their campaigns as they seek to increase their control of the House and gain a majority in the Senate.
Obama’s economic advisers drew on economic data that they said shows the gross domestic product expanding by 3.1 percent this year and 3.4 percent in 2015, which would be the best performance since 2005. The economy grew 1.9 percent last year.
The jobless rate will average 6.9 percent this year, declining to an average of 6.4 percent in 2015, the White House economic team said.
The annual Economic Report of the President highlights forecasts that were part of the fiscal 2015 budget released on March 4. The administration also released historical documents and analytic material in support of the budget.
Still, many experts are concerned as they are reminded, this month of a crash that left that left Dow at 50% of its five year old incarnation. With ‘bubbles’ being identified in technology and housing, again, and China’s tremendous credit risks while ratcheting of tensions and rhetoric over sovereignty in the Crimea has sent stock markets sliding and oil prices souring.
Is Mr. Obama hiding his head in the sand? Let’s take a measure of the major economic issues facing the world during the ides of March.
BAD CHINESE DEBT
Perhaps the most concerning issue is the credit in China.
The risk issues of a bank (let’s be clear – a bank as distinct from its brokerage and investment dealing arms) all boil down to the debt it takes on, which is why Loan Review is the most important section in the audit of a bank by a public accounting firm. And Chinese banks have taken on a lot of risky loans.
The growth of the Chinese economy in recent years has been leveraged on credit that has been given on fairy dust and the wave of a magic wand. It’s no wonder that China’s four-biggest lenders, which reported $126 billion of earnings in the 12 months through September, sank to the lowest valuations on record in Hong Kong trading yesterday. The MSCI China Financials Index dropped to an almost decade low versus the global industry benchmark while the market value of Industrial & Commercial Bank of China Ltd., the nation’s largest lender, fell below net assets for the first time on March 12.
ICBC, China Construction Bank Corp., Agricultural Bank of China Ltd. (1288) and Bank of China Ltd. were stock-market darlings as recently as 2011, when the world’s second-largest economy was growing at close to 10 percent and banks reaped profits from a $3 trillion lending spree during the previous two years. Now investors are concerned that those loans will turn sour at an increasing rate as growth slows toward 7.5 percent, the weakest annual pace since 1990.
At the same time, the ruling Communist Party’s plan to increase the role of markets in China poses a threat to state-owned banks that have benefited from tightly regulated interest rates. Central bank Governor Zhou Xiaochuan said on March 11 that the government will free up deposit rates within two years, while the China Banking Regulatory Commission said the same day it has approved a trial program to establish five privately-owned banks.
But, the more the Chinese government moves to free up financial markets, the more their banks must compete on more level terms. And, this requires a robust regulatory environment like the one in economies such as Canada whose banks were insulated from the sub-prime meltdown of 2008 largely due to the regulatory framework set down by the Office of the Superintendent of Financial Institutions (OFSCI).
As Michael Aronstein, whose $2.1 billion Mainstay Marketfield Fund (MFLDX) has outperformed said to Bloomberg, recently, ““They are not prepared to do that. It’s like releasing your house cat into the jungle.”
Concerns over China worsened this week after government figures showed that industrial production rose at a rate lower than analysts expected. Remember: China has come to be known as the ‘factory of the world’ with an ever-increasing variety of goods being made there but the latest figures show that other countries have demonstrated that they can provide more efficient labour in recent years, and this is starting to show.
“At this stage, investors are linking the negative data points coming our of China – and they don’t like what they see,” said Lawrence Creatura, a portfolio manager at Fedarated Investors.
Malcom Duncan MacDowell at the small but international renowned consultancy, Global Trade Advisory Canada (gbltrade.ca) agrees. “Indeed, the China story is moving into a new chapter.”
The negative data points have painted a picture of an economy on a slowdown, potentially a spiral-down if a Lehman Brothers type bank failure were to occur.
THE NEW TECH BUBBLE
On the heels of Facebook CEO, Mark Zuckerberg’s acquisition of Whatsapp for a total consideration including cash and equity valued at $19 Billion, prominent money managers are warning of a bubble in some technology stocks.
“The high probability is when you look back on this period five years from now, you’ll say some of these companies grew into their (earnings) multiples … but I think biotech and other areas in tech have seen multiple expansions beyond what we can justify beyond any kind of reasonable cash flow expectations,” Doug Silverman, co-founder of $6.7 billion hedge fund firm Senator Investment Group, said Monday at the Portfolios with Purpose Awards Night in New York.
“You can only call it a bubble. But I have not guessed when it will end,” Silverman added.
Rich Pzena of $23.7 billion Pzena Investments agreed.
“Yeah, I think we are in a bubble. I don’t know if I would say it’s broadly in tech stocks. I think it’s in certain stocks. But the hype feels like we’re in another Internet-type bubble like 1999,” Pzena said.
“I agree it’s not predictable when it will end. But what is predictable is that most of the companies won’t grow into their multiples. And shorting them with guts and not looking at the portfolio for three years is probably a smart thing to do,” Pzena added.
In his quarterly investment letter, Seth Klarman, the unassuming manager of $27 Billion Baupost Hedge Fund signaled alarm, claiming capital markets are in the grip of a wild bubble.
“Any year in which the S&P jumps 32 per cent and the Nasdaq 40 per cent while corporate earnings barely increase should be a cause for concern,” he wrote, pointing to “bubbles” in bond and credit markets, and “nosebleed stock market valuations of fashionable companies like Netflix and Tesla”.
It might sound reminiscent of the dot com bubble in 1999 when “fashionable” technology stocks last soared on this scale. But there is a twist: today it is not equities but bond markets that may yet be the most significant cause of concern.
In recent years an astonishing amount of money has quietly flooded into fixed income funds, which buy corporate bonds, emerging markets bonds and mortgage debt. And as the US looks more likely to raise interest rates, creating potential losses for bondholders, the flows could reverse – creating destabilising shocks for regulators and investors alike.
Given the reckless appetite of Chinese Banks, and the volatility in emerging markets, this twist is troubling, indeed, and indicative that the current technology bubble may well be more dangerous than its predecessor.
Consider the numbers. Just after Mr Klarman issued his warnings, the investment research group Morningstar produced analysis that suggests US investors have put $700 Billion of new money into the most mainstream taxable US bond funds since 2009. Since bond prices have risen, too, the value of these funds has doubled to $2tn. That is striking. But more notable is that these inflows to fixed income have outstripped the inflows to equity funds during the 1990s tech bubble – in both absolute and relative terms.
Given this, it is no surprise that investment grade companies have been rushing to sell bonds at rock-bottom yields (this week General Electric, Coca-Cola and Viacom were just the latest). Nor is it surprising that junk bond issuance hit a record last year; or that Moody’s, the US credit rating agency, warned this week that investors are so desperate to gobble up bonds that they are buying instruments with fewer legal protections than ever before.
But the $2 Trillion question is what might happen if, or when, those flows change course. Until recently it was often presumed that corporate bond investors were a less skittish group than equity investors; fixed income funds were not prone to quite such wild sentiment swings. However, the four economists who penned the Chicago Booth paper argue that this is no longer the case.
Analysing market data since 2008, they conclude bond market investors have an increasing tendency towards volatile swings and herd behaviour. That is partly because of fears that the US Federal Reserve could soon raise rates. But the sociology of asset managers is crucial, too. “Delegated investors such as fund managers are concerned with relative performance compared to their peers [because] it affects their asset-gathering capabilities,” they note. “Investing agents are averse to being the last one into a trade [which] can potentially set off a race among investors to join a sell-off in a race to avoid being left behind.” And while such behaviour can affect all fund managers, the Chicago analysis suggests bond fund managers have recently become much more skittish than their equity counterparts.
One sign of this occurred last year when bond markets, fearing the Fed was about to tighten monetary policy, had a “taper tantrum”, the Chicago Booth authors say. They warn that “bond markets could experience another tantrum” when the “extraordinary monetary accommodation in the US is withdrawn”. And since it is now the bond funds, not banks, that hold the lion’s share of corporate bonds, if another taper tantrum does take hold that could be very destabilising.
Today, as in 1999, nobody knows when that turning point might come. But the more money that floods into fixed income, the more dangerous any reversal could be. Investors and policy makers alike need to heed the message from the Chicago paper – or from Mr Klarman. History may not repeat itself; but, when bubbles occur, it does have a tendency to rhyme.
Despite this, market makers such as Morgan Stanley are still bullish on tech stocks. They say buy, buy, buy… Pay no mind to those dot-com era valuations on some tech stocks today, says Morgan Stanley. That’s where the growth is just beginning, the firm says.
Amid Facebook stock price doubling the past year, the media firestorm surrounding Twitter initial public offering, and Alibaba going public, and share rallies for dozens of corporate technology firms focused on hot areas like “cloud computing” and “big data,” investor chatter about a potential bubble in these investments has resurfaced of late.
Amid the buzz over cloud computing, the one on the bottom right briefly traded at nine times sales.
But many companies with eye-popping stock performance are also among the few seeing robust revenue growth amid a generally tepid economic recovery. Dividend-oriented stocks and other assets like bonds have become richly valued in recent years, so investors are left with relatively few options if they want a shot at returns, Morgan Stanley says.
“We get why investors want to sniff out this bubble the day before everyone else and become rich and famous. That sounds awesome,” Morgan Stanley’s Adam Parker wrote in a note to clients Monday. “But, the truth is, portfolio managers typically want exposure to growth, and when you scan the list of the top ten fastest revenue growth industries in the market in the next two years, Internet and catalog retail and Internet software and services are prominent among them.”
As a result, “having some exposure to trends like big data and analytics, social, mobile, etc., does seem prudent,” Mr. Parker writes.
The tech sector is top-of-mind for professional investors lately, as many are preparing to meet executives at San Francisco conferences sponsored by Morgan Stanley, JMP Securities and Pacific Crest this week.
The past year, tech stocks in the large-cap S&P 500 have gained 25%, outperforming the overall index’s 22% advance. Small-cap tech stocks in the S&P 600 are up a more-impressive 38%, according to FactSet.
As a result, about 40% of tech stocks are trading above 5-times sales, a level seen briefly during the 1970s and otherwise only in and around the late-90s tech bubble, Morgan Stanley says.
But the brokerage points out that unlike in 1999, most of the highly priced tech stocks are not those with large market capitalizations. The prospect of investors getting burned by sour bets on some small, fast-growing firms seem less troublesome than potential selloffs in mega-cap stocks with a heavier weighting in market benchmarks.
Meanwhile, valuation may not be predictive of future performance. Since 1978, fast-growing stocks that are richly valued have actually outperformed those that are “cheap,” Morgan Stanley says. One potential explanation for this phenomenon is that investors are rightly discounting less-sustainable businesses.
Translation for lay folks: Fx@# you, Warren Buffet and your button downed boring Value Investing! That sexy beast, the unknowable, unattainable tech queen is back, and we’re going to ride her all the way to the bank. We won’t lose our commissions when she stops flying; we’ll just move on to something else.
THE CRIMEA: A NEW CHAPTER IN THE POST SOVIET ERA COLD WAR
The Obama Administration has assembled a team that is working full time on preparing anti-Russia measures, and the team is said to be convinced the US is capable of “badly damaging the Russian economy.”
President Obama is determined to move against Russia and administration hawks counsel moving as quickly and harshly as he can possibly muster, and he and Vice President Joe Biden have been courting nations around the world that might go along with demands to seize Russian assets or sever business ties with them.
Other officials within the administration, particularly those actually involved with economic policy, warn the move is liable to alienate allies who are harmed by the measures, and could provoke a cycle of tit-for-tat retaliation.
The European Union seems broadly split on the issue, with British Prime Minister David Cameron insisting he doesn’t care how much damage sanctions do to his own capital city of London so long as they can stick it to the Russians. Germany, on the other hand, has noted that they and much of central Europe are dependent on Russia for energy purchases, and aren’t willing to see their entire economy crippled by shortages just to spite Russia.
We will damage you, we will punish you – this can’t be good for the world economy, much less the US economy, right? Let’s check out how the markets are doing as of today:
U.S. stocks fell, after the Standard & Poor’s 500 Index lost the most in five weeks yesterday, as talks with Russia failed to end a standoff over the Crimea ahead of Sunday’s referendum.
Bank of America Corp. dropped 2.1 percent amid a rate-rigging lawsuit by the U.S. Federal Deposit Insurance Corp. Aeropostale Inc. tumbled 20 percent after mounting losses and a $150 million loan raised concern the company is running out of cash. Yahoo! Inc. climbed 1 percent, increasing for the first time in six days.
The S&P 500 lost 0.3 percent to 1,841.13 at 4 p.m. in New York. The equity gauge had its biggest weekly decline since January, after closing at an all-time high on March 7. The Dow Jones Industrial Average fell 43.22 points, or 0.3 percent, to 16,065.67. About 6.7 billion shares changed hands on U.S. exchanges, in line with the three-month average.
“I think we’ve been kind of expecting volatility right now,” Jerry Braakman, chief investment officer of First American Trust in Santa Ana, California, said in a phone interview. His firm manages $1.1 billion. “There’s a lot of different stuff going on in the world.”
The S&P 500 erased its gain for the year yesterday as weaker-than-forecast economic data from China and escalating tension in Ukraine overshadowed reports showing
an improving U.S. economy. The index fell 2 percent for the week, and is down 0.4 percent for 2014.
U.S. Secretary of State John Kerry and Russian Foreign Minister Sergei Lavrov failed to make progress on ending the Ukraine crisis in six hours of talks in London, as the Crimea peninsula prepared to vote on joining Russia.
Russian President Vladimir Putin “is not prepared to make any decision regarding Ukraine until after the referendum on Sunday,” Kerry told a news conference today. Russia “will respect the will of the Crimean peoples” when the peninsula votes in two days on seceding from Ukraine, Lavrov told a separate news conference, in which he said there was “no common vision” on resolving the crisis.
The U.S. and the European Union are threatening sanctions against Russia if it doesn’t back down from annexing Crimea. Ukraine’s Kiev-based cabinet says Russia has taken over the southern region and is massing troops on its border.
“Everyone is watching this Ukraine situation, not knowing what to make of it,” John Carey, a fund manager at Pioneer Investment Management Inc., a Boston-based firm that manages about $220 billion worldwide, said by phone. “Consumer confidence was a little low, although I think people still need to coincide what the weather has done to the data. People are realizing the market is OK if we don’t have a real setback internationally.”
Meanwhile, consumer confidence is waning. In fact, it’s at a four month low, indicating household spending may be slow to pick up from a weather-related setback earlier this year. The Thomson Reuters/University of Michigan preliminary index of sentiment fell to 79.9 this month from 81.6 in February.
A separate report showed producer prices dropped in February, held back by the biggest decrease in the cost of services in almost a year.
The Federal Reserve is trying to determine how much recent economic data has been affected by weather. Chair Janet Yellen said last month the U.S. economy was strong enough to withstand measured reductions to the central bank’s monthly bond purchases.
The Chicago Board Options Exchange Volatility Index, a gauge for U.S. stock volatility, rose 9.9 percent to 17.82 today, capping a 26 percent gain for the week. The measure has advanced 30 percent this year.
Four of 10 main industries in the S&P 500 fell today, as technology and financial shares erased more than 0.5 percent.
Bank of America slipped 2.1 percent to $16.80. The lender, Citigroup Inc. and Credit Suisse Group AG were among more than a dozen banks sued by the FDIC for allegedly manipulating the London Interbank Offered Rate from 2007 to 2011.
Credit Suisse decreased 2.5 percent to $30.25 in U.S. trading and Citigroup fell 1 percent to $46.88.
Aeropostale tumbled 20 percent to $5.83, the lowest level since 2003. The teen apparel retailer forecast a loss of as much as 75 cents a share for its first quarter, more than the 17-cent loss estimated by analysts. The company also said it has entered a strategic partnership with Sycamore Partners, which will provide the $150 million loan.
This is hardly the picture of health that the President says has been painted..
But are we on the precipice? Nah…. There’s always tomorrow, that is, until tomorrow never comes.