I am often asked, “How can you square weak economic numbers with strong corporate profits and a good investment environment?” Though seemingly contradictory, it is not as strange as it sounds. First, economic numbers, like GDP growth, are seasonally adjusted and compared to the previous quarter, while corporate profits are generally quoted on a year on year basis. The numbers actually correlate quite well when viewed on the same time periods. More important though, is the fact that about 50% of the S&P 500 revenues come from overseas, while only about 10% of GDP is from exports. With many economies now faring much better than our own, and enjoying friendlier governmental policies, it is likely the disconnect between our economic numbers and our corporate profits may continue for some time, with the possibility of an even greater divide.
At last week’s FOMC meeting, Bernanke and company indicated that the economy was slower than previously anticipated. Mr. Bernanke has been often quoted on his belief that quantitative easing (Fed money-printing) is preferable and necessary should deflation become a problem. Other Fed governors, most notably the one from St. Louis, have recently come out to suggest that is exactly what they believe should be done now. It appears that the Federal Reserve will embark on a program of buying 10 and 30-year Treasury bonds, ironically strengthening the dollar and lowering the long rates – at least for a while. It is ironic since one would expect quantitative easing to weaken the dollar (more money / less value) and ultimately it will, but in the short-term the bonds will rally and the rates will fall. Once again, homebuyers will have another chance at historically low mortgage rates, hopefully giving the real estate market a much needed shot in the arm.
It is estimated that the Fed may purchase as much as $2 Trillion of Treasury bonds, so rates could be low for a while, but when the Fed ultimately must withdraw from the market, you can expect rates to rise, perhaps quickly. If you have a 401(k) or a 529 plan with bond funds, you will want to sell them before that occurs. It will likely be the last chance before bond fund investors get slammed. Even Pimco funds, the largest bond fund manager in the world, has indicated they believe the same. For 30 years Pimco has been bond funds only, yet in recent months they have begun to add stock funds to their offerings – clearly a survival move, hoping that their investors will not just vanish as bond funds may have a decade or more of decline as interest rates rise.
The Dollar, Gold & Other Commodities:
Sovereign debt problems in some of the European countries, as well as potential problems in others, along with the U.S. and Japan, underscore how government credit quality has eroded while corporate balance sheets have improved. Many cash-rich companies, like Apple, Exxon and McDonalds are arguably better credit risks than many countries. This continuing credit erosion with the corresponding currency depreciation makes gold a must for any portfolio, even at $1200/ounce. The flight from fiat currency to real assets has never been as overt as in the last few months. I know I’ve mentioned this many times, but the dollar index is no real indication of the dollar’s strength, as it only indicates the dollar’s relative strength to the euro, yen and pound (the three make up most of the index). With all four currencies in decline, the relative winner is still a loser and you can expect the long-term fiscal imbalances to reinforce the inverse relationship between paper currencies and real assets.
The weakening fiat currencies are but one factor in the long-term bullish outlook for commodities. Underlying supply and demand drivers are also clearly supportive of higher prices. Even with gold at $1200 and oil at $85, annual production is shrinking while demand is growing. The same holds true with most important commodities, many of which may simply run-out of new supply in the next few decades. With global infrastructure aging in developed countries and still inadequate in most emerging markets, demand will continue to grow while new resources are being found in more remote areas and countries are increasingly protective of critical resources.
We have recently rotated our portfolios to a more China centric allocation. For years we have maintained a full allocation to China, only rotating away from China when the world economies became embattled with major problems (2008 financial crisis and the March 2010 Greece sovereign debt debacle). Recent selloffs have made many sectors within China’s economy very attractive, both in the short-term and most certainly in the long view. With the recent announcement by Chinese authorities to allow the yuan to appreciate, I believe you can take that as a signal of their confidence that they can continue to compete with other low-cost countries thru increased efficiency and/or it can move its economy up the value-added chain.
Even so, the yuan’s appreciation will hurt low margin industries like textiles and clothing by competition from Vietnam and Bangladesh, but companies that import commodities to manufacture goods to Chinese citizens will benefit twice. First by the relatively lower prices of the materials used, and then by the relatively richer citizens whose currency will buy more goods.
A stronger yuan means that commodities and other imports will be more affordable to more of their citizens, helping many companies that cater goods and services to the citizenry, whether they be Chinese airlines selling tickets or McDonalds selling burgers and fries.
Interestingly, Wal-Mart may be the big loser. Most of their goods are manufactured in China, and a stronger yuan will make Chinese exports more expensive, making Wal-Mart a little less of a bargain. So there are certainly winners and losers, but that is why sector rotation will always be a better way of investing.
Low interest rates, growing demand for materials with diminishing supply, combined with a growing Chinese economy, may not make for a smooth ride but it should make for a profitable one… at least in the right sectors.
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