Thursday, 27 August 2009

Macro-Level Trends – Global Economic Outlook – The Need to Heed Roubini's 'Fundamentalism'.

The 6 month stock-market rally that began in March has been so warmly welcomed by investors that it could be said to have mirrored the rise in climate temperature graphs in the northern hemisphere. Better than expected Q1 and H1 earnings news (ie “less bad”) combined with the desire to jump upon any positive economic indicator news (no matter how simplistic) combined with the good weather saw stock graphs the world-over climb, climb, climb.

On January 4th investment-auto-motives presented the case for concern regards the timing and speed of any substantial recovery, stating that even a mid-year pick-up – as we've expectantly witnessed - appeared too soon given the weight of negative forces apparent across the board – from the innately weak structure of the majority of the banking sector to the 'consumer fall-out' to come.

The nature of this unprecedented, de-stabalised, era means that the reactive and ongoing opposing forces of basic economics, corporate retraction, government demand interventionism and capital market's sentiment (driven by trader frustration) has set the scene for constant re-shifting of focus and so changing expectation. The fundamentals for a return to global confidence were not in place back in January and, whilst the storm has waned and liquidity has started to pump very slowly through the system, those fundamentals are still not truly in place these 8 months later.

March to date's upswing – from stock prices to consumer confidence - looks to be misplaced probably largely driven by irrational behavior driven by 'recession fatigue' and 'blind faith'. And for capital markets, the drive to move stagnant liquidity across various asset classes.

Unsurprisingly, the near 6 month rapid stock rally has divided opinion between the 'fundamentalists' best extolled by academia and the 'sentimentalists' best typified by fund management firms. Opposing viewpoints perhaps best showcased by the recent (23.08.09) FT article by Nuriel Roubini “vs” Lazlo Birinyi's (26.08.09) WSJ rebuttal. In summary “dead-cat bounce” vs “1st phase of bull market”.

As professional market-watchers understand, the reality is that the stock graph path (whether singular company, sector or cross-sector index) is created by the ongoing tussle between macro- micro fundamentals ('assisted' by theoretical valuation metrics) and sentiment. However, at present, the 2 are diametrically heavily opposed. And since fundamentals are the effectively the 'centre of gravity' for markets – the rationality – we can only assume that there will be an inflection and a trending downward at some point when present stock-holders recognise the 'hot air' of the market and sell through the 'greater fool theory' to lock-in amazing gains.

Obviously, much of the buying has been in the belief that company stock is undervalued, but was there really that much previous undervaluing for the market to jump so high so quickly? (ie S&P500 YTD from bottom of 666 to present high of 1,028). Or is it really ultimately a case of the 'old dogs' of the market, who've seen it all before, recognising and riding the (rare but typical) post-melt-down re-active rally?

It is indeed a moment of sunshine amongst the storm clouds, but the distant horizon still looks very murky, as described by Roubini in that FT article.

Unfortunately, but realistically, “on the same page” as the NYU professor, investment-auto-motives
now takes a look at his comments and provides additional (often auto-sector centric) comment.

Nuriel Roubini – Market Outlook 23.08.09

“3 prime questions”:
1.When Bottom-Out?
2.Shape of Recovery?
3.Possibility of Re-lapse?

To paraphrase ...

1. When Bottom-Out?
Roubini - “Q408 & Q109 mirrored contraction seen in early stages of the Great Depression”... “it appears that market will bottom-out in Q409”...”Asia, Latin America, France, Germany, Japan & Australia re-growing now”...”but: US, UK, Spain, Italy other Eurozone members (mostly CEE) will not see positive growth until 2010”.

Asia's sustainable self-propelling growth capability and ability to 'weather the storm' has proven it's level of de-coupling from the west, and though present regional GDP growth, consumption and capital investment is lower than the previous headiness, the acute-nature of the massive Asian populace to spend and save rationally – this dictated by circumstance and aversion to credit - provides the strength for balanced continued growth through consumption and investment. In contrast, the US and Europe will continue to be undermined by 'real-world' ongoing credit retraction and 'virtual' consumer incentive packages as seen in autos and now consumer durables. The latter “positive manipulation” ultimately disruptive to market and production planning and so capital investment planning, with the potential of creating a false-bottom that quickly dissipates.

The key for the West is still the structure and true fragility of the banking system, something which has been subtly masked by the support of systemic big-name players (socialised losses), recent 'stellar' & 'better than expected' results. Banks have been forced into 'liquidity retention' through preservation of government 'bail-out' cash, calling-in debt and formulating onerous lending policies.
This perfect-storm combination allowed for recent 'good-news' earnings, but it is short lived. Thus the financial system is still largely effectually 'seized' until it can draw in further sector investment (ie PE and elsewhere) that allows the brakes to be released.

Such additional monies will largely come from investors who will want to see their bank's loan book' consisting of sound customers (possibly government guaranteed) and possibly assured lending to associated interests – either to broad sector relative industrial holding companies or to the more promising (perhaps dominant) sector players.

Thus the complexity is in re-organising both the west's banking system and the core of its industrial structure. And that can only be done properly and efficiently when a period of rational 'fundamentalism' prevails over 'sentimentalism'. The sentimentalism drives stock volatility but unfortunately also undermines focus on the much needed banking and industrial re-structuring.

2. Shape of Recovery?
Roubini - “we'll see a more U-shaped recovery than V-shaped”.
investment-auto-motives believes it will verge on “slanted J” with very slow recovery due to the aforementioned inter-woven structural complexities and their widespread relative issues:

A. Unemployment Drag
“<10% > affecting consumer demand and bank losses”...” and loss of 'skills capability' amongst the workforce in turn affecting productivity growth”.

That figures could rise higher than the 10%, and well above the 9% or so in general international official statistics. As with the UK's 3-day week in the 1970s, there will probably be a re-calibration of working hours for the individual and a division of labour across the typical working week. Unemployment will rise and stay high until the industrial re-structuring occurs and new working templates are drawn-up which allow for labour flexibility (via part-time work) and suppress / contain overhead costs.

B. Case of Solvency not just Liquidity
Roubini - “de-leveraging has not yet fully 'worked through the system”...and so...“confines the ability of banks to lend, consumers to buy and companies to invest”.

The western stimulus packages have acted as a temporary fix, socialising seeming swathes but in reality only a portion of lost value. Continued uncertainty and sporadic use of 'marked-to-market' valuations on corporate balance sheets mean that there has not been a clean process of 'downward re-ratcheting'; aswell as the concern regards still properly unidentifiable 'toxic asset' types. And the inherent necessary act of moving portions of these losses from private sector to public sector in turn
limits both transparency and the basic financial transmission mechanism.

C. National Budget Deficits
Roubini - “countries with current account deficits badly positioned as populace needs to save more set against context of falling asset prices, shrinking incomes and unemployment threat”.

The US and UK are obviously prime instances here, the former running a (conservative) $1.58 trillion deficit, with expected (conservative) $9 trillion over the next 10 years. Having reached the limits of public spending and precious little private investment incentive, such countries appear to face a period of economic stagnation; Keynesian 'prime-pumping' a used and now unavailable alternative.

D. The Financial System
Roubini - “despite support, still heavily damaged”...”the shadow banking system largely disappeared, traditional (retail) banks still have $ trillions of bad debts & securities to swallow whilst still being under-capitalised”.

An issue highlighted previously, but a worst case scenario – not out of the question – is partial banking seizure as more bad news surfaces and investors big & small decide to hold off supporting the banks. Bloomberg reports that the FDIC has identified 146 'problem banks' which could deplete already shrunken FDIC reserves. More bank failures result in yet further sector contraction and more M&A consolidation as geographically useful 'bolt-ons' are acquired by often including foreign firms (BRIC+) seeking targeted US & western market coverage – see Brazilian ambitions. Furthermore, the examples of previous privately funded US, UK and German bank re-capitalisation that burned the fingers of GCC and other investors, mean that yet stricter financing demands will need to be met; including amongst other requisites, the continuation of more 'covenant-rich' agreements behind convertible bond deals which offer swaps to not common but preferential shares.
(Those supporting the banks will want the 'Buffett-esque' agreement Berkshire Hathaway gained from Goldman Sachs).

E. Weak Profitability
Roubini - “caused by poor earnings from incurred low growth caused by debt repayment”

Earnings also effected by reduced credit ratings and so in-coming investment which was possibly partially re-cycled into dividend payment for Q209's good results. Therefore the generally increasing cost of capital (ie risk premium) when available, and other deflationary headwinds could act as disincentives so lowering productivity through skeleton staffing and the likelihood of minimal &/or deferred investment.

F. Public-Private Sector “Re-Leveraging”
Roubini - “the public sector creates large fiscal deficits and risks 'crowd-out' of private expenditure”
The stimulus effect will fizzle-out by early 2010 thence requiring replacement by greater private investment contribution to continue any prevailing growth. This may well not be in place.

G. Global Imbalance
Roubini - “there is expectation of a continued narrowing of the global deficit-savings imbalance”...[ie western deficit excluding Japan & German vs the general EM surplus)....
“But if demand does not grow in surplus countries, then counterpoint growth will not occur in deficit countries, so delaying global upturn”.

The concern is that Asia and EM regions do not maintain the 'demand-pull' previously seen for western goods and services. This is a real concern, not because the consumer demand or investment demand is not there, but because western products and knowledge can be replicated either domestically or by other regionally close-by nations. EM regions may well have reached a self-reliant 'tipping-point' in everything from car production to electronics R&D to beyond, the Japanese and South Koreans acting as the new 'Pseudo West' in growing areas of technology and skills transfer.

He states there are also 2 further reasons (X & Y) giving rise to a 'drop-back' and so W-shaped recovery:

3. Possibility of Re-Lapse?

X Quantitative Easing
Roubini – “the inherent risks associated with exit strategies from massive fiscal and monetary easing mean administrations are between a rock and a hard place”

If policy-makers raise taxes / cut spending / re-absorb QE liquidity... to fight the budget deficit and PSBR over-spend they will strangle consumer confidence, so raising the spectre of stag-deflation.
But if they maintain large deficits and over-spend then bond-markets will naturally expect a rise in long-term inflation, and so charge higher bond yield rates as a risk premium to off-set the probability of monetary devaluation. Increased bond yields will produce a domino-effect on capital borrowing interest rates and so stifle recovery, possibly leading to stagflation.

However QE - a blunt but useful monetary policy instrument for demand management– is an inexact science, given its typical use as a last resort. And whilst certain elements of the QE mix can be theoretically managed, the reality is that much of the economic boost is largely unguidable in the complexities of a mixed-economy and once in place hard to track. Thus it has a history of either little identifiable downstream effect or creates the overt-boost that economists fear leads to rapid inflation. Just as the UK and Gordon Brown lead the G20 in its answer to the crisis – including the prominent use of QE - the BoE's Monetary Policy Committee maintains on-going belief in the tool by injecting a further £175bn, with possibly more to come in November.

The QE moves are viewed as successful thus far in quelling the financial fall-out, but it is hard to truly gauge its real affect. One thing is clear, that QE statements tend to weaken the homeland currency in the FX war which is so prevalent at the moment, so helping the argument for much needed export led growth. That puts pressure on maintaining free and open bi-lateral and multi-lateral trade agreements, which are in turn presently under subtle but intense protectionist pressures - let alone the general global fight for currency devaluation - and so create additional concerns regards national QE exit strategies.

Y – Commodity Inflation
Roubini - “concerns that Oil, Energy & Food prices are now rising faster than fundamentals warrant, and could be driven higher by excess liquidity”.
Unworked capital is a concern for all money managers, especially those in SWFs and the downsized hedge fund sector. Thus there is an argument to say such dormant capital is being 'over-allocated' to defensive plays such as Commodities (both in material purchase and hold and futures contracts) that are directly linked to relatively buoyant EM consumer demand. .So inadvertently prices are driven higher and higher with the potential to reach a shock-point before collapsing, as we saw previously with $145 p/b oil.

The argument set forward is that the new shock level is a more sensitive $100, would damage confidence if a similar re-bound contraction occurred. For the moment larger than expected US oil reserves have knocked the Texas Intermediate spot price back to $71.43, indicating a $75 ceiling at present. However, if stocks keep unfathomably rallying it would send signals to traders to keep piling into oil and other base commodities, and as we saw previously the greater it climbs the harder it will fall – to the detriment of market confidence and the case for rationality that so badly needed.

Roubini summarises that “the recovery is likely to be aneamic and below trend in advanced economies, and there is a big risk of double-dip 'W' recession”.

investment-auto-motives believes that economists will have to add the term “slanted J” to truly reflect the scenario being played out between 2007-2012. But in all actuality the semantics pale into insignificance relative to the need for the market to act with true objectivism. And that may be harder than ever given the pressure that hedge funds are under to provide investor returns, even with their lesser fee models - for they may relish a period of “range-volatility” and the 'double plays' and 'high-spreads' such a financial climate offers.

To summize, excluding hedge-fund market antagonism, investors will need to understand the very foundations of their business interests, to ascertain the very 'nuts and bolts' of typical enterprise construct to gauge its present, near-term and long-term worth. Rather than the grandiose (generally y opaque) investment plans of old, this new era demands old style 'bread and butter' business evaluation that in turn demands company transparency. That means seeing the acute detail of the big picture.

As many will know, investment-auto-motive's own marketing strap-line from its 2006 beginning has been to implore clients to “think small” - referring not only to its boutique size and level of 'focus' - but as an important guiding philosophy when analysing the myriad of critical criteria of a company and/or sector.

Uber-conservatism is the order of the day, required when reviewing trading businesses of any age or indeed the hypothetical business models that this historical juncture will see emerge. Let's hope most market constituents (primarily institutionals & PE) are on the same page as investment-auto-motives.

Since stability must be put back into the market, and that can only come from sensibly formed MarketCap and p/e ratios, with such valuations based upon a firm's true operating revenues and true 'marked to market' asset-backed worth. Stability will not come from the 'sentimentalism' of promiscuous sector-jumping speculators or over-nervy desperate traders that have created the recent, effectively baseless, over-confidence.

All must return to the premis of economic and financial 'fundamentalism', if we are to create real traction, a smaller but healthier economy and the prospect of well supported long-term growth.