Recession Fears
By Yiannis G. Mostrous
MCLEAN, Va.–The prevailing view is that the US economy is slowing–taking its cue from the housing sector–and that the probability of a 2007 recession has risen significantly. Some say the likelihood is up to 40 percent.
My view is a little more sanguine, although signs of slackening growth are clearly visible. The case for a recession is based on the fact that the yield curve remains inverted–admittedly an alarming development–but other economic indicators show nothing more than a slowdown. Hence, nothing more than some strategic hedging to offset potential disappointments is required right now. I’ll have more on that below.
For investors who have a large part of their portfolio in Asian equities, the issue is how much a US slowdown will affect the Asian economies. It all depends on the magnitude of the weakness–i.e., whether it’s a slowdown or a recession.
If the US falls into a recession next year (while this isn’t my forecast, it’s a strong possibility), economies around the world will be negatively affected. The dominant view among knowledgeable observers is that Asia will suffer the most.
But it won’t hurt as much as is commonly believed. I offer no vote of confidence–yet–to those who state that Asian economies have decoupled from the US. But Asian nations are better prepared than ever before to deal successfully with a US economic slowdown.
As the chart below depicts, the US is gradually becoming less important to Asia’s well-being. Total Asia-ex China exports (including indirect exports to the US through China) have decreased from a high of 26 percent of total exports to a low of 18 percent currently, the same as the European Union (EU).
Source: Merrill Lynch
It’s well-known that consumption represents 71 percent of US GDP. Of that, 22 percent represents expenditures in goods (ex cars, food and energy) where Asia’s exposure is greatest. Keep in mind that American businesses account for 75 percent of US tech spending, where the majority of Asian exports are concentrated. If capital spending doesn’t collapse, Asia will do just fine. And the US’ share of global imports has also steadily declined to 17 percent from a high of 21 percent in 2001.
If the US housing slowdown (see SRI, 13 September 2006, Condoflip.com) brings with it a total collapse of the US economy and a deep recession, all bets are off, no matter where you’ve invested (expect maybe gold bullion). But, I reiterate: This isn’t the base-case scenario I envisage.
What about China? Most observers–and I agree with this part of the thesis–expect its economy to slow. But they lose me when they argue that China’s slowdown will be severe enough to damage long-term growth prospects, and that, coupled with a crippling US recession, it will devastate the global economy.
My view is that China will weather the storm, proving more resilient than those observers anticipate. One of the main reasons is that it has policy flexibility–currency reserves, surpluses, renminbi appreciation, etc. For the month of August, China’s trade surplus reached a record of USD18.8 billion. Given how the rest of the year has gone, the surplus could surpass USD150 billion by the end of 2006. And China’s foreign exchange reserves should surpass the USD1 trillion mark by the end of the year.
Most of China’s exports to the US are to the lower end of the market and should therefore hold up better and maintain momentum, as they did in Japan during the prolonged recession in that country.
As the US and the global economy slow, China will follow. There are already signs of it happening: Industrial output slowed down during the summer months and should continue to do so. This doesn’t mean economic activity in China will collapse, but the market will feel the change.
Chinese leaders will eventually have to pass measures intended to boost domestic demand, which will lead to a stronger renminbi and lower surpluses. Until then, China will have to find ways to absorb investment growth that will often be directed to ill-advised projects.
This is why US-China cooperation remains at the center of the global economy–a mutual understanding will solve each other’s and the world’s problems.
The US will play a vital role in this transition because the two countries have reached such a level of economic integration that cooperation is the only viable alternative. As US Treasury Secretary Henry Paulson recently said, “The relationship between the US and China is the most important bilateral economic relationship in the world today.”
And as I noted last week:
It looks as though the US administration now understands what’s at stake and has brought in people who can deliver. The US-China Strategic Economic Dialogue, the creation of which was announced during Paulson’s recent visit to China, is a step in the right direction. According to the official press release, the Dialogue “will be the first of its kind and will occur at the highest official level, with Paulson and Wu (Chinese Executive Vice Premier) at the helm.” (Visit the US Treasury Dept for more.)
Given China’s importance to the world economy, don’t underestimate the efforts by Secretary Paulson and President Bush to work with China as a strategic partner rather than an adversary. And although short-term domestic political tricks (prevalent now, given the upcoming elections) create some disturbing noise, serious, long-term investors will understand it for what it is: just noise. The US and China will be the dominant players in the foreseeable future; the sooner you realize the implications of this world order, the sooner you can make the appropriate investment decisions.
Turning to the markets, plummeting oil and commodities caught a lot of people off guard. Speculators have had very large positions in natural gas and crude based on their assessments of certain meteorological phenomena. We all know how that’s worked out.
I’ve written on commodities many times, most recently early this summer. As I noted then (see SRI, 7 June 2006, No Growth Wanted):
There’s no doubt the correction has started, as the following chart depicts. From a long-term perspective, the hope is that the correction will be orderly.
Source: Bloomberg
I see the current correction primarily as an unwinding of speculative positions and secondarily as an issue of weaker anticipated growth. My assessment would certainly change if facts prove me wrong, but for now, don’t abandon structural bullishness on oil. Lower per barrel prices are in fact positive for Asia as the region is overall an oil importer.
Market participants are more bearish now than circumstances warrant; all the economic indicators I follow indicate a slowdown, but nothing more than that, and market indicators continue to point upward. I therefore reiterate the view I expressed in August (see SRI, 23 August 2006, Fall Rally?) that the global markets could run higher as we approach the end of the year.
I noted in August that you should “concentrate your Asian portfolio holdings in domestically oriented companies. In that respect, banks are prime candidates, and the SRI Portfolio includes several from the sector based in Asia: Thailand’s Bangkok Bank, India’s ICICI Bank, South Korea’s Shinhan Financial and Singapore’s United Overseas Bank.” Domestic-related themes should remain the core of your portfolio’s Asian holdings.
The Taiwan-based technology stocks I recommended (again, as a side bet to your main holdings) in August have performed, in the aggregate, much better than the S&P 500. I continue to recommend exposure to them, as there’s a strong probability they have another 10 percent to the upside.
On another note, I’m planning to offer a second SRI Portfolio that will include my shorter-term recommendations as well as the permanent hedges I’ve initiated. This will make it easier to glance at Portfolio recommendations and continue your research from there.
Speaking of permanent hedges, the position in US Treasurys (see SRI, 8 March 2006, Hedge Your Bets) has been performing well; it’s matched the S&P 500 with less risk. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF) as a permanent hedge position for your portfolio.
Source: Bloomberg
Finally, I’d like to offer an explanation of the way I view the investment process.
The first step when you become an SRI reader–with its emphasis on global markets, emerging markets in particular–is to understand the argument that Asia will be a very important economic region in coming years. The next step is to contemplate that evolution and then act in a long-term fashion. Many investors have tried the “smart” way of trading Asian markets or have searched for the latest “hot” story to make a quick profit. These people ignore the big picture, and their profits are relatively small.
Long-term readers know that I haven’t positioned the SRI Portfolio in that manner and that I didn’t work like that when I was responsible for stock selection and sector allocation for another financial advisory. In other words, generating long-term, positive returns while avoiding short-term downside is the theory upon which I’m constructing the SRI Portfolio.
That said, I make every effort to alert investors when I see moves to the upside or the downside or any other special situations (see SRI, 15 May 2006, Silk Road Investor-Flash).
The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while I also offer hedging ideas for more complete advice.
A characteristic common to the Portfolio companies is suitability for the new realities of a changing world. They’ll benefit the most from the changes taking place in the global economy.
No one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game isn’t by losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.
It’s important that you look at the SRI Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories may offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.
Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done more easily this way. There’s always another week, and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.
MCLEAN, Va.–The prevailing view is that the US economy is slowing–taking its cue from the housing sector–and that the probability of a 2007 recession has risen significantly. Some say the likelihood is up to 40 percent.
My view is a little more sanguine, although signs of slackening growth are clearly visible. The case for a recession is based on the fact that the yield curve remains inverted–admittedly an alarming development–but other economic indicators show nothing more than a slowdown. Hence, nothing more than some strategic hedging to offset potential disappointments is required right now. I’ll have more on that below.
For investors who have a large part of their portfolio in Asian equities, the issue is how much a US slowdown will affect the Asian economies. It all depends on the magnitude of the weakness–i.e., whether it’s a slowdown or a recession.
If the US falls into a recession next year (while this isn’t my forecast, it’s a strong possibility), economies around the world will be negatively affected. The dominant view among knowledgeable observers is that Asia will suffer the most.
But it won’t hurt as much as is commonly believed. I offer no vote of confidence–yet–to those who state that Asian economies have decoupled from the US. But Asian nations are better prepared than ever before to deal successfully with a US economic slowdown.
As the chart below depicts, the US is gradually becoming less important to Asia’s well-being. Total Asia-ex China exports (including indirect exports to the US through China) have decreased from a high of 26 percent of total exports to a low of 18 percent currently, the same as the European Union (EU).
Source: Merrill Lynch
It’s well-known that consumption represents 71 percent of US GDP. Of that, 22 percent represents expenditures in goods (ex cars, food and energy) where Asia’s exposure is greatest. Keep in mind that American businesses account for 75 percent of US tech spending, where the majority of Asian exports are concentrated. If capital spending doesn’t collapse, Asia will do just fine. And the US’ share of global imports has also steadily declined to 17 percent from a high of 21 percent in 2001.
If the US housing slowdown (see SRI, 13 September 2006, Condoflip.com) brings with it a total collapse of the US economy and a deep recession, all bets are off, no matter where you’ve invested (expect maybe gold bullion). But, I reiterate: This isn’t the base-case scenario I envisage.
What about China? Most observers–and I agree with this part of the thesis–expect its economy to slow. But they lose me when they argue that China’s slowdown will be severe enough to damage long-term growth prospects, and that, coupled with a crippling US recession, it will devastate the global economy.
My view is that China will weather the storm, proving more resilient than those observers anticipate. One of the main reasons is that it has policy flexibility–currency reserves, surpluses, renminbi appreciation, etc. For the month of August, China’s trade surplus reached a record of USD18.8 billion. Given how the rest of the year has gone, the surplus could surpass USD150 billion by the end of 2006. And China’s foreign exchange reserves should surpass the USD1 trillion mark by the end of the year.
Most of China’s exports to the US are to the lower end of the market and should therefore hold up better and maintain momentum, as they did in Japan during the prolonged recession in that country.
As the US and the global economy slow, China will follow. There are already signs of it happening: Industrial output slowed down during the summer months and should continue to do so. This doesn’t mean economic activity in China will collapse, but the market will feel the change.
Chinese leaders will eventually have to pass measures intended to boost domestic demand, which will lead to a stronger renminbi and lower surpluses. Until then, China will have to find ways to absorb investment growth that will often be directed to ill-advised projects.
This is why US-China cooperation remains at the center of the global economy–a mutual understanding will solve each other’s and the world’s problems.
The US will play a vital role in this transition because the two countries have reached such a level of economic integration that cooperation is the only viable alternative. As US Treasury Secretary Henry Paulson recently said, “The relationship between the US and China is the most important bilateral economic relationship in the world today.”
And as I noted last week:
China has demonstrated that it won’t respond to outright pressure, something Paulson well knows; he’s been doing business with the Chinese for a long time. He’s currently visiting China again, and I expect an understanding to be reached during his time there. China’s leadership (especially its central bank officials) knows what needs to be done, but it also knows it needs more time than the G-7 would allow.
It looks as though the US administration now understands what’s at stake and has brought in people who can deliver. The US-China Strategic Economic Dialogue, the creation of which was announced during Paulson’s recent visit to China, is a step in the right direction. According to the official press release, the Dialogue “will be the first of its kind and will occur at the highest official level, with Paulson and Wu (Chinese Executive Vice Premier) at the helm.” (Visit the US Treasury Dept for more.)
Given China’s importance to the world economy, don’t underestimate the efforts by Secretary Paulson and President Bush to work with China as a strategic partner rather than an adversary. And although short-term domestic political tricks (prevalent now, given the upcoming elections) create some disturbing noise, serious, long-term investors will understand it for what it is: just noise. The US and China will be the dominant players in the foreseeable future; the sooner you realize the implications of this world order, the sooner you can make the appropriate investment decisions.
Turning to the markets, plummeting oil and commodities caught a lot of people off guard. Speculators have had very large positions in natural gas and crude based on their assessments of certain meteorological phenomena. We all know how that’s worked out.
I’ve written on commodities many times, most recently early this summer. As I noted then (see SRI, 7 June 2006, No Growth Wanted):
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.
There’s no doubt the correction has started, as the following chart depicts. From a long-term perspective, the hope is that the correction will be orderly.
Source: Bloomberg
I see the current correction primarily as an unwinding of speculative positions and secondarily as an issue of weaker anticipated growth. My assessment would certainly change if facts prove me wrong, but for now, don’t abandon structural bullishness on oil. Lower per barrel prices are in fact positive for Asia as the region is overall an oil importer.
Market participants are more bearish now than circumstances warrant; all the economic indicators I follow indicate a slowdown, but nothing more than that, and market indicators continue to point upward. I therefore reiterate the view I expressed in August (see SRI, 23 August 2006, Fall Rally?) that the global markets could run higher as we approach the end of the year.
I noted in August that you should “concentrate your Asian portfolio holdings in domestically oriented companies. In that respect, banks are prime candidates, and the SRI Portfolio includes several from the sector based in Asia: Thailand’s Bangkok Bank, India’s ICICI Bank, South Korea’s Shinhan Financial and Singapore’s United Overseas Bank.” Domestic-related themes should remain the core of your portfolio’s Asian holdings.
The Taiwan-based technology stocks I recommended (again, as a side bet to your main holdings) in August have performed, in the aggregate, much better than the S&P 500. I continue to recommend exposure to them, as there’s a strong probability they have another 10 percent to the upside.
On another note, I’m planning to offer a second SRI Portfolio that will include my shorter-term recommendations as well as the permanent hedges I’ve initiated. This will make it easier to glance at Portfolio recommendations and continue your research from there.
Speaking of permanent hedges, the position in US Treasurys (see SRI, 8 March 2006, Hedge Your Bets) has been performing well; it’s matched the S&P 500 with less risk. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF) as a permanent hedge position for your portfolio.
Source: Bloomberg
Finally, I’d like to offer an explanation of the way I view the investment process.
The first step when you become an SRI reader–with its emphasis on global markets, emerging markets in particular–is to understand the argument that Asia will be a very important economic region in coming years. The next step is to contemplate that evolution and then act in a long-term fashion. Many investors have tried the “smart” way of trading Asian markets or have searched for the latest “hot” story to make a quick profit. These people ignore the big picture, and their profits are relatively small.
Long-term readers know that I haven’t positioned the SRI Portfolio in that manner and that I didn’t work like that when I was responsible for stock selection and sector allocation for another financial advisory. In other words, generating long-term, positive returns while avoiding short-term downside is the theory upon which I’m constructing the SRI Portfolio.
That said, I make every effort to alert investors when I see moves to the upside or the downside or any other special situations (see SRI, 15 May 2006, Silk Road Investor-Flash).
The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while I also offer hedging ideas for more complete advice.
A characteristic common to the Portfolio companies is suitability for the new realities of a changing world. They’ll benefit the most from the changes taking place in the global economy.
No one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game isn’t by losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.
It’s important that you look at the SRI Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories may offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.
Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done more easily this way. There’s always another week, and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.