Beginning with an overview that noted that the US and world economy is growing, that the recession has officially ended and that the markets are up across the board, BIAS CEO Robert Pires, asked: “But why is not everybody celebrating?”
Although the “waiting to exhale moment” surrounding the political uncertainty in the US has ended with the overwhelming win of the Republicans, new risks will emerge, Pires noted.
Until the mid-term election businesses were not ready to invest and consumers not ready spend. The election results and a Republican controlled Congress should be positive, he said, in the sense that tax cuts remain in effect.
Overall market performance has not been bad in 2010 and year-on-year portfolio performance for any investor should have been very good, Pires argued, pointing out that most indexes including bonds and shares and commodities, in particular gold, had gained substantially this year.
However, several factors still give reason for concern, according to BIAS: “OECD growth is still very weak, there is structurally high unemployment and debt levels have been soaring.”
In addition many governments around the world need to deleverage, but as the most recent discussion over the bailouts of Eurozone member Ireland indicates this will take time and other countries such as Spain and Portugal may be in a similar situation soon.
At the same time currency and trade tension that have recently emerged will become a defining factor with countries attempting to debase their currencies to support their economies’ exports, Pires stated.
The US economy
The US saw a sharp decline in GDP growth between March and November of 2008. Since then the economy has recovered but, Pires noted, GDP growth started to decelerate again in November 2009, “which is somewhat worrying”.
The rebound was largely generated by one-off factors including huge stimulus programmes by the US government, and other governments around the world, that were injected into the economy. Another factor supporting the economy was the rebuilding of inventory, he explained. During the recession businesses in the US had allowed their inventories to deplete and at some stage these had to be rebuilt.
Without the increase in government spending and the injection of $787 billion as a result of the American Recovery and Reinvestment Act of 2009 as well as $607 billion worth of inventory rebuilding, the growth in the US economy “would have been much lower and still probably be at recessionary levels”, Pires said.
Moreover, despite these inputs in the economy, consumer spending, which makes up 70 per cent of GDP, “is still challenging”.
One reason for this is the high level of unemployment in the US. While some economists feel that actual unemployment is considerably higher, somewhere around 15 per cent, than the official figures of 10 per cent, the last time the US had to face unemployment levels that high was in 1980. Given that the natural level of unemployment would be around the median level of 5.2 per cent, unemployment remains “unacceptably high”. This puts a damper on consumer spending, although there is some indication that this is coming back, said Pires.
Meanwhile mortgage delinquencies have reached the highest level in 30 years at 10 per cent. “So there are still problems on the credit side,” he noted, and at the same time a scandal surrounding foreclosures and titles has “put the banks in the dog house”.
In order to manage the currently several thousand foreclosures per day in the US, title transfers are usually executed by computers. It is believed that tens of thousands of titles have been improperly recorded, never re-recorded or are missing altogether. Loans were often packaged and sold with no clean transfer documentation.
This will mean that the housing crisis will continue at least for the big banks with potentially up to $126 billion in financial losses and is “a reason to underweight the financial sector”, according to BIAS.
Worldwide governments will have to try to deleverage their balance sheets. The US deficit to GDP ratio dropped slightly from 10 per cent to 9 per cent, but still remains high.
BIAS asserts that forecasts of 2.5 per cent GDP growth for the US and less for the EU, UK and Japan are fairly good. However, “countries would really like to see 3 or 4 per cent to feel comfortable about their economic growth,” said Pires, adding that at 5 or 6 per cent growth inflation would become a concern.
The US dollar
With regard to currencies, BIAS noted an incentive to devalue the US dollar, referring to the second round of quantitative easing. Pires outlined that most of the typical measures governments can take to respond to a recession have been exhausted. On the fiscal policy side the US government has significantly increased spending to stimulate the economy, while the alternative of lowering taxes is very limited given the need to reduce the high levels of public debt.
On the monetary policy side cutting interest rates is no longer an option as interest rates are virtually as low as they can be.
The only alternative is to print money as exercised in the second round of quantitative easing, where the Federal Reserve creates money on its balance sheet and uses the funds to buy US Treasuries. The idea is to increase the amount of money in the financial systems, which increases the amount of bank deposits and thus the amount of money that banks can lend to businesses and consumers.
The side effects are that printing money inflates asset prices and inflation erodes currency purchasing power. The weaker currency in turn should boost exports and create jobs. Many export-oriented countries around the world have also bought into this theory.
“The problem is, if all countries devalue [their currencies], who wins the race?” asked Pires.
The race to debase
“There is a currency war going down,” added Bryan Dooley, senior investment strategist with BIAS.
“The tools to fight each other are currencies now and whoever will be able to devalue their currency the fastest will supposedly have an export advantage.”
To illustrate which currencies may be overvalued or undervalued, Dooley used the Big Mac Index developed by the Economist magazine. The index which compares the prices for a Big Mac in 120 different countries suggests that, based on the theory of purchasing power parity, currencies of those countries that charge more for the Big Mac tend to be overvalued, whereas those that charge less may be undervalued.
“The theory behind assumes that a currency ultimately drifts towards the level that equalises the amount of goods that it can buy,” Dooley explained. This means if a Big Mac burger costs $7 in Switzerland but just $2 in China the Chinese yuan will ultimately rise against the Swiss franc. “The yuan is cheap, the Swiss franc is expensive or both,” the BIAS presentation noted.
There are of course other factors impacting the differences between currencies such as interest rates differentials, liquidity or currency controls, strength of the economy, budget deficits and price stability among others.
If these are also considered the US dollar, the Canadian dollar and the Australian dollar were favoured by BIAS during the last quarter.
Pires emphasised that by highlighting the concerns he does not want to come across as overly negative, but “investing is not only seeking the opportunities but also to control the risk”.
Among the many opportunities that do exist, BIAS sees for example equities of high dividend payers, innovators, such as Apple, Google and Microsoft, and US multinationals in general, which are on an all-time low and should benefit from a falling US dollar.
“We also think it is important to be in the right sector,” said Dooley, mentioning technology and telecom stocks. At the same time BIAS remains cautious with regard to the financial sector.