By Dr. Hans Black
Interinvest Review & Outlook
Having spent some time traveling during the past few weeks, both in Asia as well as in North America, one gets the unmistakable impression that optimism is back in vogue. Led, of course, by journalists in the electronic media, rays of sunshine that we witnessed during the second half of 2008 as well as the early months of 2009. Many markets have rebounded from their lows and indeed some are even up marginally year to date. Importantly, the S&P Index is still down approximately 40% from its peak in October 2007 while many similarly broad global measures of equity performance are also still down substantially from their highs.
Nevertheless, optimism and indeed occasionally giddiness have returned to certain segments of the global financial markets. The election in India, rightfully so, has been seen as a positive, but do we really believe that the 25% rally in a very short period of time is justified by the fundamentals? Equally so, the thin, narrow and illiquid markets of countries such as Vietnam, India and the many South American markets have surged upwards in recent weeks, reflecting a view that they are the place to be. Given the general gloom of late 2008, we can understand a certain amount of optimism returning to emerging markets but we are afraid that they are getting ahead of themselves and that, ultimately, disappointments lie ahead.
The problem, as we see it, is that we have likely seen a momentous change in the attitudes of G10 consumers. Note that this is a global phenomenon and is not merely limited to the U.S. consumer. The long and short of it, as we see things, is that after years of enjoying a consumption-centric lifestyle, the global consumer has decided to rebuild his balance sheet for a whole host of reason. We refer to these as "the end of the sacred cows."
First, the concept that home is integral to one's personal balance sheet has been seriously compromised. Many consumers, whether in the U.K., Ireland, Europe or continental North America, have seen a "sacred cow" of real-estate investing evaporate, namely, the view that the value of housing can only go up. Although much has been written on this subject, we believe it has much further to go and will be increasingly painful. While we have seen some statistical stabilization of housing markets in recent weeks, we are exceedingly mistrustful of the attitude which seems to prevail, namely that the bottom might have been seen. While foreclosure transactions have clearly become a factor in elevating the housing sales numbers, in our opinion, we are far removed from a meaningful recovery. One need only look at statistics that are available for homes in the upper ends of the economy. In the U.S. data show that are much as a four year supply of homes valued above $750,000 are up for sale. Statistics in some trendy cities in Europe are quite similar. This supply will take a long time to be moved.
Another sacred cow that has been severely compromised in recent months has been the entire area of 401K, RRSP, and similar retirement savings accounts that have been the mode in so many countries. The concept of putting in a small amount of money every year and watching it grow over many years in order to fund one's retirement was a perfectly wonderful way to introduce tax-code motivated savings. The problem, however, is that so many participants have watched ten years of savings disappear in a period of perhaps just one year. In large part reflecting the underlying average - the S&P is comfortably back at levels seen ten or eleven years ago - the typical user of such vehicles has to be disappointed. Years of sending money to a leading mutual fund house has returned little. The combination of the serious erosion in housing values, as well as the value of savings (invested through a 401K plan, for example), is a double whammy on the backs of consumers which will take years to sort out.
The final sacred cow which has been seriously questioned is the relative value that governments will be able to transmit to pension holders in the years to come. Interesting polls recently have shown that in all of the G10 countries there exist serious reservations as to the long term ability of governments to maintain the relative purchasing power of pension schemes or indeed healthcare schemes. Is there any wonder? Major governments around the world have injected enormous amounts of money in order to save banks, bailout banks, or save insurance companies, like AIG, and more recently auto companies such as General Motors, in order not to propel the system even further down the slippery slope. But it is not unreasonable to ask once all this money has been spent by governments, how will they fund the social obligations of the future? This last sacred cow is of course a highly politically charged one, and it will remain to be seen how this works out. While I recognize that any discussion on this final sacred cow will probably leave many snarling, we only need to look at California and the very intense budgetary situation it now faces to see what may happen. No matter how you cut it, the current governor of California is calling it the way it is. How do you adjust at state and local levels when your receivables plunge? Homes in foreclosure do not pay taxes and indeed a consumer that is spending less generates far less in sales taxes. This situation will be discussed for many years to come and is the reality that not only major governments must deal with but, importantly, states, provinces, departments, councils and towns.
All of this returns us to the fact that G10 consumers have changed their lifestyles and are making serious new decisions for perfectly understandable reasons. The transition process is painful and will become more so, and there should be no doubt as to the reality of the situation. Recent economic reports are quite telling: savings rates have begun to rise in a number of countries and notably in the United States; at the same time, personal spending numbers remain disappointing despite even more buoyant headlines and the insistence of the electronic media that things are getting better. More people are saving and fewer are conspicuously consuming. We were shocked recently to see that even the mighty retail player Costco announced disappointing earnings. We conclude that if Wal-Mart and Costco are having problems, the rest of the retail industry faces immense challenges. Many malls are chronically empty and the prospect of anything changing there seems minimal.
Optimists will say that one needs simply to manage this transitionary period. Candidly, however, we are already trying to manage this transitonary period as best we can. Governments recognized that with a loss of global wealth approaching $50 trillion by late 2008 (a combination of stock, bond and real estate losses), the global economy needed enormous amounts of stimulus. This we have now seen. In our view, this is unfortunately only the first step. We anticipate chronic difficulties for banks and other issuers of credit, particularly those who facilitate the flow of consumer credit. Despite somewhat better markets for the past three months, default rates remain extremely high and many measures of consumer optimism remain depressed. It is interesting, for example, that the weekly ABC consumer poll recovered into early April and has since fallen down again. My travels and my many conversations with people I meet (and particularly my favorite indicators - taxi drivers) reveal that most see no recovery at all. Restaurants remain empty or under-used and most airports feel quiet. Interestingly, in late May the CEO of British Airways came out and said that he saw no global recovery for his airline at all. Should one believe, therefore, the CEO of an airliner who could just as easily not have made this comment, or the many optimists one now hears on Wall Street as they try to peddle their wares?
It should, therefore, be no surprise to our friends and readers that we have done some selling in recent weeks and that we are once again focused on becoming more defensive in preparation for what might indeed be a volatile and difficult fall and winter. Headlines would have you believe that the bankruptcy of General Motors is a non-event. We would, however, differ. The continued erosion of consumer confidence along with disappearing jobs is a very real issue. No matter where one looks these days, job cuts are the norm and many companies have had to resort to these reductions simply to maintain some profitability. But the real cost to the economy and the banking system, as we have tried to show, will come from the new behaviors of global consumers, whose sacred cows have been wounded, and who are retrenching in the face of investment losses and lay-offs. Finally, we are not proponents of the decoupling theory Version 2009. Should our observations about the G10 consumer be correct - and we are talking about roughly 30% of global GDP - then we have an extremely hard time believing that emerging markets are embarked on anything other than a wonderful mirage.
Our portfolios are becoming more liquid and still contain healthy doses of healthcare companies, biotech companies and, increasingly, companies sensitive to the price of gold.
Editor's Note: Dr. Hans Black is editor of Interinvest Review and Outlook, P.O. Box 51462, Boston, MA 02205, 1 year, 12 issues, $125, published by Interinvest Corp., a money management firm. www.interinvest.
