 |
General Outlook
Compression
Unless you were fortunate enough to be long Moroccan stocks (+34%), the odds are that your equity portfolios lost money during the first quarter. The market decline was very widespread and differentiated little among geographies and market caps. International and domestic large cap stocks declined about 8%-9% in dollar terms, while the more dynamic U.S. small cap and emerging market stocks dropped 10%-11% on the same basis. The strongest recent performers slid the most, with growth underperforming value and the Chinese and Indian stock markets plunging about 25% each.
Unlike last year, when the market differentiated among winners and losers based on exposure to the imploding housing bubble, the market proved far less discriminating during the first quarter. Many of last year's winners, whose valuations had expanded as interest rates declined, were disgorged by the market as fear grew that domestic consumer weakness would spread. The Bear Stearns failure underlined the significant risks to the U.S. financial system, while losses by financial institutions around the world highlighted just how widely bad American mortgages had spread. While the financial crisis has proved far more severe than economic deterioration thus far, the depressed housing market has begun to infect more than just the consumer discretionary and financial sectors and international growth has begun to wane.
Return to top
Blowing Bubbles
The short, painful solution to the housing crisis would be to allow prices to find their equilibrium levels, necessitating the write-off of lenders' mistakes and permitting unsuccessful financial institutions to fail. The social consequences of such "tough love" are difficult to accept, however, and the potential for a domino effect among weak financial institutions is difficult to predict, causing central bankers and politicians to opt for a less risky way out. When an asset's price deflation is too painful to accept, the alternative is to institutionalize higher prices by inflating other assets instead. This destruction of purchasing power lowers the real living standard, but reduces the risks of a severe recession. Unfortunately, it also risks spawning future bubbles.
While no policymakers are describing current policies as intentionally creating inflation, the reaction by commodity prices and exchange rates suggests that that is exactly what is happening. Money supply growth has accelerated to double digit rates, both in the U.S. and abroad, significantly exceeding real economic growth rates. The result is that real assets have started to appreciate based on their store of value, rather than on normal supply and demand calculations. Oil prices have topped $100 per barrel despite softer demand growth and incremental supply. Gold, which acts as an impartial arbiter of monetary policies, recently hit record prices just as the dollar was setting record lows – down almost by half from its peak against the Euro just six years ago. China and other countries that maintain a managed peg to the dollar will almost certainly have to allow their currencies to appreciate faster in order to avoid importing more of our inflation.
Return to top
Throwing Caution to the Wind
During 2007, the Federal Reserve attempted to cure the credit crisis by injecting large sums of liquidity while holding interest rates at levels that would prevent inflation from accelerating and defend the dollar from declining. By late January, however, with credit spreads widening further in judgment of each inadequate Fed move, it became clear that the financial crisis was snowballing and threatening to cause harm to the real economy. It was at that point that the Federal Reserve chose to throw inflation caution to the wind. From late January through the end of March, the Fed cut the Funds rate 200 basis points, the discount rate 225 basis points, facilitated a shotgun marriage of Bear Stearns to J.P. Morgan, bailing out Bear’s creditors in the process, and opened the discount window to brokers for the first time since the Great Depression.
One result has been some easing of the financial crisis, with credit spreads narrowing and a general sense that the worst may have passed. Another result has been serious inflation warning signs. Commodity prices have jumped sharply and the dollar has declined to record lows against many foreign currencies.
Return to top
Everything Must go
The equity clearance sale during the first quarter mimicked that of a wide variety of real merchandise over the last several months. Following poor Christmas sales, consumer sentiment has continued to deteriorate, causing many retailers to miss their first quarter sales targets and cut their earnings forecasts. Home builders have slashed prices to move unsold homes and raise cash, while weak auto sales inspire discounts, especially on larger vehicles. As we have written in the past, the consumer is overextended, as measured by his near-zero savings rate, and his home-equity piggy bank is broken. The odds are high that he will have to shrink his share of the U.S. and world economies by underspending his income for several years in order to restore his liquidity.
Such an environment bodes very poorly for the run-of-the-mill businesses that serve the consumer, such as retailers and banks, whose previously buoyant businesses are now caught in what may come to seem like a never-ending downdraft. And, since it runs contrary to human nature to simply give up without a fight, the competitive environment in these weaker industries is likely to intensify, depressing profit margins as companies try to gain share of a fixed pie. Eventually, and inevitably, mergers motivated by cost cutting are likely to take place, reducing the bricks and mortar (and people) that are the capacity of these service industries.
Return to top
Beggar Thy Neighbor
Fortunately, the other clearance sale in America is that of our goods and services and assets as foreign buyers respond to the bargains created by the very weak dollar. According to Merrill Lynch, the 40% decline of the dollar against a basket of currencies over the last six years has given the U.S. among the lowest unit labor costs in the OECD, a fact that is rapidly becoming apparent in our improving exports of goods and services. Those who spend any time on the streets of New York City or on ski slopes or at other tourist destinations can't fail to notice the large number of foreign accents, representing a tidal shift in the trade deficit. While the price of imported oil has camouflaged much of the improvement, the underlying trend is increasingly favorable and likely to grow even more so due to the incremental drop of the dollar against major currencies during the first quarter. Already, improving trade is adding about one percent to economic growth, helping to partially offset consumer weakness. And, just as consumer related businesses stand to suffer from excess capacity and weak demand, industrial firms are seeing a renaissance, buoyed by stronger sales atop cost structures made lean by years of restructuring.
Return to top
General Outlook
Although the Federal Reserve continues to pump liquidity into the market and the Bear Stearns failure will probably go down in history as this cycle's cathartic financial crisis, the resolution of the economic problems caused by the housing crash is likely to be measured in years. Even after home prices stop declining, consumers will find themselves with smaller net-worths than that to which they had become accustomed and their low savings rate will require more conservative spending patterns to restore liquidity. At the same time, rising prices caused by excess liquidity and the weak dollar will erode spending power. In the 1970's, periods of sluggish economic growth and rising prices were called stagflation. A repeat of such conditions may, unfortunately, be in store for us again.
In such an adverse environment, vendors of consumer goods and services are likely to struggle with weak demand and rising costs and financial institutions will probably experience poor credit quality and weak loan growth. Conversely, the weaker dollar, which has already lowered our global living standard, is helping make U.S. companies the most competitive in years, suggesting that exporters will continue to experience stronger results.
While the negative impact of the U.S. economy on global growth will almost certainly shake confidence in both the export and emerging market stories periodically over the next several quarters, they are both likely to prove durable on a multi-year basis. The retreat, or even elimination, of the U.S. trade deficit due to the weak dollar is the natural counterbalance to consumer retrenchment, and the fundamental strengths and growing internal trade among emerging market countries are likely to prove sufficiently robust to provide staying power.
Although Columbus Circle Investors' positive momentum and positive surprise discipline continues to be driven by a bottoms-up, stock-picking process, the financial implications of these ongoing changes in the environment are likely to influence company fundamentals and impact our stock selection for some time to come. In addition, the appeal of strong secular trends may increase further as a shield against the small, but not negligible risks of global recession.
Return to top
|
