No Growth Wanted
By Yiannis G. Mostrous
MCLEAN, Va.–“Toward this end, and taking full account of the lags with which monetary policy affects the economy, the Committee will seek a trajectory for the economy that aligns economic activity with underlying productive capacity.”
These were some of Federal Reserve Chairman Ben Bernanke’s closing words in his speech to the International Monetary Conference in Washington on Monday. In other words, buckle up.
For those unfamiliar with the term,”underlying productive capacity” is the famous trend growth of the US economy, which is usually assumed to be around 3 to 3.5 percent. With first quarter growth coming in strong at 5.3 percent, Bernanke is indicating that the Fed will do whatever’s necessary to make sure that growth will slow down, especially amidst well-known worries regarding inflationary pressures stemming from the increases in oil and other commodity prices. If the chairman stays true to his word, even weaker economic data should not derail the Fed’s current action plan of increasing interest rates.
The chairman’s thinking is based on a very simple fact. Since the US is an importer of oil and commodities, which have been inexorably rising in price, someone’s income is being squeezed. We don’t know yet who this development will hurt more: consumers or producers.
If it affects producers, prices should rise; if it affects consumers, higher wages will be needed to maintain buying power. Since monetary policy is still viewed as accommodative, such an increase will also increase the probability that materially higher inflation is in the cards.
Although I’ve stated my views on the inflation issue before (see SRI, 17 May 2006, Debating), I’ll be the first to admit that it’s possible an outcome of this sort will occur. And yet the main driver of inflation in the US, unit labor costs (ULC), remains quite subdued. ULC was revised down for the past two quarters, bringing the year-over-year rate down to 0.3 percent–the slowest rate in two years, as the chart below indicates.
In three weeks, we’ll know if the Fed will raise interest rates again, but the outcome is still anyone’s guess. The main goal here is not only to forecast a possible increase in rates, but also to contemplate the possibility that a recession could follow an interest rate peak. If this happens, we’ll need to view the markets in a different light. At this time, I don’t think a recession will follow (despite the yield curve indicating otherwise), but the facts could change, causing us to re-evaluate.
Source: Bloomberg
On the other side of the world, Chinese authorities are also trying to slow down their red-hot economy. In China, growth in wages is a reality and–together with the high commodities prices–has been eating into companies’ margins, pushing inflation to a higher, albeit low overall, level. This level of inflation is also due to government price controls, on public utilities and gasoline and diesel prices in particular. (See chart below.)
Source: Bloomberg
As mentioned above, high commodity prices have become a big problem for Chinese manufacturers, with raw material and semi-finished goods accounting for around 70 percent of total costs. Since manufacturing makes up 42 percent of GDP, China is one of the countries most vulnerable to a rise in commodity prices.
China is currently negotiating prices with iron ore vendors in an effort to create a 15 percent price increase ceiling. This will be difficult given that other deals have already set a higher precedent: Brazilian producer Companhia Vale do Rio Doce has already settled for 19 percent with two of the world’s biggest steel makers.
According to industry estimates, a similar rise in prices would increase Chinese steel makers’ production costs by 3 percent. As these costs pile up, the Chinese economy will reach a point at which it will not be able to absorb them. There are indications that this point has been reached, and an adjustment is needed and can be expected.
The information above indicates that the two most important economies in the world are not really welcoming extremely strong growth at this point. The question now is whether or not they will be able to engineer a soft landing. If not, the world economy is set for an ugly surprise.
Commodities remain the biggest question mark in the markets, as their parabolic ascent has created an unsustainable trade that should correct more. If it doesn’t, the final correction will be extremely brutal, affecting not only the current market cycle, but also potentially destroying the new commodities bull market that started in 2001 and should otherwise last beyond 2010.
To update a favorite comparison, take a look at the following two charts. The first is the commodities index daily short-term chart where the current correction is visible. But if one takes a look at the longer-term chart, the current correction is hardly visible.
Source: Bloomberg
Source: Bloomberg
Turning to the markets, it should be clear by now that pure price momentum strategies, which have performed spectacularly well for the past two years, are losing ground fast. It ‘s expected that we’ll once again need to turn our attention to fundamentals.
As the markets continue to correct, the main question is whether this is a pure market correction incident or whether it’s an indication of a significant deterioration in the world economy that will consequently warrant a more sustained market move lower. My impression is that it’s a correction, as I outlined in last week’s issue (see SRI, 31 May 2006, Looking For Answers).
I hope investors acted on the recommendation in the May 15 Flash Alert. India and portfolio holding Dr. Reddy’s Laboratories (NYSE: RDY) were specifically mentioned in that note as extremely vulnerable to the selloff. The forecast was right as the Indian market has corrected substantially, and is now trading below the 10,000 level.
India remains one of my favorite long-term investment themes. First quarter GDP growth came in at a strong 9.3 percent with the agricultural sector–India’s secret weapon–showing an increase of 5.5 percent. The funds have been funneled into the rural sector, giving it the opportunity to participate in the economic growth that’s sweeping the country and surpassing expectations.
The story in India remains intact, and I’ll be adding some exposure to it in due course. The market is a good buy between 8,000 to 8,800. Although this indicates more downside, a recommendation can be made before that in the context of a balanced portfolio.
Source: Bloomberg
As the end of the quarter is approaching, I’m taking a detailed view of our portfolio holdings; some changes are to be expected.
A forewarning on one of my weakest recommendations: Shinhan Financial Group (NYSE: SHG) has lost value since the day it was added to the portfolio. I hope readers followed the advice on the Flash Alert and trimmed positions, as the stock is down significantly since the original recommendation. The addition was made in the context of a balanced portfolio theoretically able to absorb the hit. This is not intended as an excuse. This is the reason the Flash Alert was sent.
The reasons the bank was selected are still valid, and it remains a stock to own in Korea, as it represents a solid organic growth story with attractive valuations (price-to-earnigns, 9.0; price-to-book, 1.5). Although I don’t expect lending-fueled spending in Korea, household borrowing–led by mortgage loans–is still growing at a healthy rate, thus benefiting well-run financial companies like Shinhan.
Finally, the short recommendations of BHP Billiton (NYSE: BHP) and iShares MSCI Brazil ETF (NYSE: EWZ) are still working. Last week I recommended setting the stops at break even. In an effort to start capturing some profit, I’m changing my recommendation to set the stops at $45 for BHP and $41 for EWZ.
Source: Bloomberg
MCLEAN, Va.–“Toward this end, and taking full account of the lags with which monetary policy affects the economy, the Committee will seek a trajectory for the economy that aligns economic activity with underlying productive capacity.”
These were some of Federal Reserve Chairman Ben Bernanke’s closing words in his speech to the International Monetary Conference in Washington on Monday. In other words, buckle up.
For those unfamiliar with the term,”underlying productive capacity” is the famous trend growth of the US economy, which is usually assumed to be around 3 to 3.5 percent. With first quarter growth coming in strong at 5.3 percent, Bernanke is indicating that the Fed will do whatever’s necessary to make sure that growth will slow down, especially amidst well-known worries regarding inflationary pressures stemming from the increases in oil and other commodity prices. If the chairman stays true to his word, even weaker economic data should not derail the Fed’s current action plan of increasing interest rates.
The chairman’s thinking is based on a very simple fact. Since the US is an importer of oil and commodities, which have been inexorably rising in price, someone’s income is being squeezed. We don’t know yet who this development will hurt more: consumers or producers.
If it affects producers, prices should rise; if it affects consumers, higher wages will be needed to maintain buying power. Since monetary policy is still viewed as accommodative, such an increase will also increase the probability that materially higher inflation is in the cards.
Although I’ve stated my views on the inflation issue before (see SRI, 17 May 2006, Debating), I’ll be the first to admit that it’s possible an outcome of this sort will occur. And yet the main driver of inflation in the US, unit labor costs (ULC), remains quite subdued. ULC was revised down for the past two quarters, bringing the year-over-year rate down to 0.3 percent–the slowest rate in two years, as the chart below indicates.
In three weeks, we’ll know if the Fed will raise interest rates again, but the outcome is still anyone’s guess. The main goal here is not only to forecast a possible increase in rates, but also to contemplate the possibility that a recession could follow an interest rate peak. If this happens, we’ll need to view the markets in a different light. At this time, I don’t think a recession will follow (despite the yield curve indicating otherwise), but the facts could change, causing us to re-evaluate.
Source: Bloomberg
On the other side of the world, Chinese authorities are also trying to slow down their red-hot economy. In China, growth in wages is a reality and–together with the high commodities prices–has been eating into companies’ margins, pushing inflation to a higher, albeit low overall, level. This level of inflation is also due to government price controls, on public utilities and gasoline and diesel prices in particular. (See chart below.)
Source: Bloomberg
As mentioned above, high commodity prices have become a big problem for Chinese manufacturers, with raw material and semi-finished goods accounting for around 70 percent of total costs. Since manufacturing makes up 42 percent of GDP, China is one of the countries most vulnerable to a rise in commodity prices.
China is currently negotiating prices with iron ore vendors in an effort to create a 15 percent price increase ceiling. This will be difficult given that other deals have already set a higher precedent: Brazilian producer Companhia Vale do Rio Doce has already settled for 19 percent with two of the world’s biggest steel makers.
According to industry estimates, a similar rise in prices would increase Chinese steel makers’ production costs by 3 percent. As these costs pile up, the Chinese economy will reach a point at which it will not be able to absorb them. There are indications that this point has been reached, and an adjustment is needed and can be expected.
The information above indicates that the two most important economies in the world are not really welcoming extremely strong growth at this point. The question now is whether or not they will be able to engineer a soft landing. If not, the world economy is set for an ugly surprise.
Commodities remain the biggest question mark in the markets, as their parabolic ascent has created an unsustainable trade that should correct more. If it doesn’t, the final correction will be extremely brutal, affecting not only the current market cycle, but also potentially destroying the new commodities bull market that started in 2001 and should otherwise last beyond 2010.
To update a favorite comparison, take a look at the following two charts. The first is the commodities index daily short-term chart where the current correction is visible. But if one takes a look at the longer-term chart, the current correction is hardly visible.
Source: Bloomberg
Source: Bloomberg
Turning to the markets, it should be clear by now that pure price momentum strategies, which have performed spectacularly well for the past two years, are losing ground fast. It ‘s expected that we’ll once again need to turn our attention to fundamentals.
As the markets continue to correct, the main question is whether this is a pure market correction incident or whether it’s an indication of a significant deterioration in the world economy that will consequently warrant a more sustained market move lower. My impression is that it’s a correction, as I outlined in last week’s issue (see SRI, 31 May 2006, Looking For Answers).
I hope investors acted on the recommendation in the May 15 Flash Alert. India and portfolio holding Dr. Reddy’s Laboratories (NYSE: RDY) were specifically mentioned in that note as extremely vulnerable to the selloff. The forecast was right as the Indian market has corrected substantially, and is now trading below the 10,000 level.
India remains one of my favorite long-term investment themes. First quarter GDP growth came in at a strong 9.3 percent with the agricultural sector–India’s secret weapon–showing an increase of 5.5 percent. The funds have been funneled into the rural sector, giving it the opportunity to participate in the economic growth that’s sweeping the country and surpassing expectations.
The story in India remains intact, and I’ll be adding some exposure to it in due course. The market is a good buy between 8,000 to 8,800. Although this indicates more downside, a recommendation can be made before that in the context of a balanced portfolio.
Source: Bloomberg
As the end of the quarter is approaching, I’m taking a detailed view of our portfolio holdings; some changes are to be expected.
A forewarning on one of my weakest recommendations: Shinhan Financial Group (NYSE: SHG) has lost value since the day it was added to the portfolio. I hope readers followed the advice on the Flash Alert and trimmed positions, as the stock is down significantly since the original recommendation. The addition was made in the context of a balanced portfolio theoretically able to absorb the hit. This is not intended as an excuse. This is the reason the Flash Alert was sent.
The reasons the bank was selected are still valid, and it remains a stock to own in Korea, as it represents a solid organic growth story with attractive valuations (price-to-earnigns, 9.0; price-to-book, 1.5). Although I don’t expect lending-fueled spending in Korea, household borrowing–led by mortgage loans–is still growing at a healthy rate, thus benefiting well-run financial companies like Shinhan.
Finally, the short recommendations of BHP Billiton (NYSE: BHP) and iShares MSCI Brazil ETF (NYSE: EWZ) are still working. Last week I recommended setting the stops at break even. In an effort to start capturing some profit, I’m changing my recommendation to set the stops at $45 for BHP and $41 for EWZ.
Source: Bloomberg