By Joseph Hogue, CFA
Pacific Investment Management Company's (PIMCO) Neel Kashkari released the firm's equity focus report a few weeks ago. In truth, the report does not break much ground on new information, but is a particularly interesting and entertaining read compared to the typically dry, statistically-driven report from the finance community.
Using an analogy with Western medicine, Kashkari questions whether the recent few years of stimulus and resultant positive economic growth have only relieved the symptoms of the recession, instead of curing the disease.
Liquidity and Stimulus: The cure for what ails you
The Federal Reserve has pumped an enormous amount of cash into the system through various rounds of quantitative easing and policy maneuvers. While it's hard to blame the Fed for its aggressive policies over the last few years - it has arguably benefited the U.S. economy relative to the more restrictive policies in Europe - we are now faced with a much larger debt burden and no cure for what Kashkari calls the, "30-year addiction to debt-fueled consumption."
The increased liquidity may keep the financial system from running out of cash, but it does nothing to address reliance on debt or to nurture growth in those lagging sectors of the economy.
Consumption and Household Debt
Consumer spending as a percentage of the total economy has risen consistently since 1954 and now accounts for about 70% of GDP. Household debt relative to disposable income has also risen steadily since the 50s and topped out at 130% just before the crisis. This means that consumers were spending 30% more than they had available, fueled mainly by rising home equity values and investments. While the debt ratio has come down to around 110%, it is still somewhat off the long-term trend of 100% debt-to-disposable income.
What does this mean for investors? First, there is still some room for consumers to pull back on spending before the debt levels become more realistic. Retail sales have been strong lately as the employment situation rebounds, but some of the improvement has been fueled by lowering the savings rate. Two long-term issues should be obvious. Even if the household debt ratio falls to its trend at 100%, this is still too high. Americans cannot continue to live above their means indefinitely without sacrificing future economic growth.
As it stands, we cannot sustain economic growth and more responsible consumption at the same time. If consumers continue to deleverage, the general economy will suffer. If the general economy does not undergo a structural shift, relying more on other sectors for growth, then consumers must continue to increase their debt burdens.
Reading through the report, I couldn't help but see the comparison between the U.S. and China's current economic shift. Consumer spending in China is about a third of the economy, approximately 35%. With slower growth in exports attributable to a sluggish world economy, the government has made it a primary goal of nurturing domestic consumption. It will not be an easy transition, as resources and policies once devoted to exports will need to be reallocated, but it will help the country continue on its path of economic growth. The U.S. must do the same, but by focusing on external growth and investment rather than consumption.
The report further details some employment and spending dynamics and is well worth spending a few minutes to read. Towards the end, the firm's equity strategy is revealed with:
Until we see sustainable, real economic growth here in America, we believe equity investors should consider high quality global companies with strong balance sheets that are selling into higher growth markets.
I do not see American consumers changing their spending habits anytime soon. Even if household debt moderates somewhat over this year, the long-term trend will remain intact and consumers will continue to live outside their means. Emerging markets will fund our spending through treasuries, continuing the long-term decline in the value of the dollar. All this means that investors must look outside the U.S. for long-term growth and stability in purchasing power.
American Depository Receipts (ADRs) of foreign companies listed on the U.S. exchanges should be included in your stock screens. These shares will benefit not only from strong external growth, but also from appreciating currencies relative to the dollar. Emerging market debt, both sovereign and corporate, should be added to your fixed-income portfolio.
Among U.S. shares, investors should take heed of PIMCO's note and look for companies that can leverage a strong global brand and a strong balance sheet for growth in emerging markets.
Kashkari singles the sector with a bolded and underlined, "investors should carefully scrutinize the assumptions underlying consumer discretionary stocks." If U.S. consumers are unable to stabilize or increase their overall debt spending, even at trend it is bumping up against 100%, then companies selling to the sector may not be able to rebound with the rest of the economy.
Shares of The Gap (GPS) have rebounded sharply since the end of January, with a gain of almost 40% on lower materials prices and stronger retail sales. The stock is trading for more than 16.5 times trailing earnings and may come under pressure unless the consumer can keep up their appetite for debt. Quarterly revenue growth and earnings are both down on a year-over-year basis.
Stronger options are consumer discretionary stocks with sizeable revenues from the emerging consumer.
McDonald's (MCD) operates more than 33,000 restaurants in 119 countries, with one of the best brands in the world. Growth is strong in emerging markets, especially China and Latin America. Quarterly revenue growth and earnings are up almost 10% on a year-over-year basis and the shares trade relatively cheaply at 18.3 times trailing earnings.
Yum Brands (YUM) planned to open about 1,500 new international stores in 2011, including 600 in China. The owner of brands like KFC, Pizza Hut, and Taco Bell has seen sales stabilize in the United States, but most of the growth is coming from overseas markets. Shares are up almost 20% since the beginning of the year and trade for 25.6 times trailing earnings. I have been following the growth story in the shares and detailed the long-term perspective in an article last month.
Agricultural Machinery & Fertilizers
Strong options for long-term investments exist in agricultural machinery and fertilizer companies. While these companies may not be seeing large revenue growth directly from the emerging markets, they are a beneficiary of the emerging market growth story.
Population growth and consumption in the emerging world will support agricultural prices over the coming decades. While land prices may moderate somewhat, the American farmer is in a strong position. Investors hesitant to look at foreign companies or U.S. companies relying on emerging market consumer growth could look to firms selling to the agricultural sector. The sector plays into Jeremy Grantham's long-term resources strategy, something I detailed in a previous article.
Deere & Company (DE) is a strong play on the theme, with 75% of its sales from the agricultural and turf segment. Future earnings could see support as the dollar weakens and exports become relatively cheaper. Shares have underperformed the market slightly, but are still up about 6% since the beginning of the year and trade around 12.0 times trailing earnings.
Chemical producer Agrium (AGU) will continue to benefit from strong crop prices and the increasing need for higher crop yields. The company is a global producer of crop nutrients like nitrogen, potash and phosphate. Fourth quarter earnings more than doubled over the same period a year ago and beat expectations by 17%. Shares have jumped almost 30% since the beginning of the year, but still trade for under 10.0 times trailing earnings.