The Real Economy Vs. The Financial Economy
This quarter, the financial economy (interest rates, foreign exchange rates and stock prices) stopped being reflective of the real economy (profits, growth, and job creation). This isn’t the first time this has happened. Navigating these waters requires a different set of charts than what we normally use, but we’ve been down this road before.
There are two fears that haunt the financial economy right now: Fear of recession and fear of sovereign default.
Both of these fears are triggering a flight to US dollars that is creating both a tremendous buying opportunity in some asset classes and tremendous levels of volatility as bargain-hunters give way to panic sellers, and then more bargain hunting. A few quarters from now, the prices paid for assets in September 2011 will look like great deals. But, in the short-run, those buying decisions may seem hard to justify.
We are actually getting good news on the real economy side of the equation:
- In the USA, the pace of layoffs is slowing and is below its long-term average; year-over-year retail sales are up over 7%; and corporate profits continue to grow.
- The Baltic Dry Index, an indicator of global shipping demand (and thus of the overall level of global growth) has jumped in recent months and is at its highest levels of the year.
- Chinese electricity production is up 12% over last year, consistent with its 10-year average growth rate indicating that the Chinese economy (a major driver of global growth) is still running on all cylinders.
So a recession seems unlikely, but the financial economy is sending different messages. Although sovereign debt is seen by many as toxic sludge, debt/GDP levels and economic growth rates will be ignored in setting exchange rates.
|
| Change in Value of Currency in Sept ‘11 | Debt/GDP Level[1] | IMF Growth Forecast 2012 |
Indonesia | ↓3% | 25% | 6.4% |
Brazil | ↓17% | 37% | 3.6% |
Chile | ↓13% | (3%) | 4.7% |
Russia | ↓12% | 12% | 4.3% |
New Zealand | ↓12% | 8% | 3.8% |
Korea | ↓10% | 31% | 4.3% |
USA | ↑3% | 73% | 1.8% |
In a world where sovereign defaults are being discussed as a ‘definite possibility’, interest rates should reflect the ability of a government to service its debts in the future, but countries with low debt aren’t necessarily seeing lower interest rates.
|
| Yield on 10-Year Gov’t Bonds | Debt/GDP Level1 |
Germany | 1.9% | 57% |
USA | 1.9% | 73% |
Korea | 3.9% | 31% |
New Zealand | 4.4% | 8% |
Italy | 5.5% | 100% |
Indonesia | 6.8% | 25% |
Russia | 8.7% | 12% |
Brazil | 11.6% | 37% |
Greece | 20.0% | 153% |
The 2008 financial crisis was triggered by the concern that many of the financial intermediaries of the global economy had become insolvent as a result of exposure to the US mortgage market. The concern now is that these same global financial giants may run into trouble as a result of their holdings of government bonds.
By mid-2009, stock valuations had risen 66% from their 2008 lows. They are cheaper now than they were then.
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| Forward P/E | |
|
| Sept ‘11 | Oct ‘08 |
US Financials | 9.8 | 11.5 |
US All Sectors | 11.2 | 12.8 |
EU Financials | 6.0 | 8.3 |
EU All Sectors | 8.7 | 11.1 |
Global Financials | 8.2 | 8.5 |
Global All Sectors | 10.1 | 9.2 |
But re-testing 2008 levels doesn’t necessarily mean that we have necessarily seen a bottom. The sovereign debt crisis is far from solved.
There is a time to focus on fundamentals and ignore the noise of daily volatility and there is a time to be “aggressively defensive.” We moved to being aggresively defensive over the last few weeks and it softened the blow of the sell-off in global equities. At some point, the real economy will resume its rightful place as the driver of asset prices, but not for a while yet.
Source:
[1] IMF; Debt/GDP is Net Debt, except for Indonesia and Russia which is Gross Debt.
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