Quarterly Q & A
Q: What is your take on current market valuations?
A: Based on forward P/E ratios, the market looks quite compelling at current levels. Unfortunately, we don’t think current earnings estimates are likely to be realized given the weakening trajectory of global economic growth. Instead, earnings estimates are likely to spend the second half of the year being steadily revised downward. Credit markets are also likely to play a larger role in determining fair value until the situations in Europe, the housing market, and commercial real estate improve.
Q: Where do you think there is value in the market given your take on valuations?
A: Despite our concerns about the domestic economy and credit markets, we see pockets of promising value within the equity market. We are sticking to those equities with pristine balance sheets, rock solid business models, reasonable valuations, and solid dividend yields. Johnson and Johnson, AT&T, and Microsoft all fit this profile and are examples of companies that we initiated positions in during the quarter. Given the array of risks facing equity investors in today’s markets, an orientation towards high quality firms is likely warranted.
Q: What are you monitoring as far as potential macro-level risks in the last half of the year?
A: There continues to be a wide range of potential problems that we are keeping an eye on across the global macro-economy. The obvious one given what took place in the second quarter is the unfolding sovereign debt crisis and associated austerity measures in Europe. We are also concerned about the likelihood of slowing global growth, the evolving challenges inherent in structurally imbalanced State budgets, the lack of credit availability (particularly for small businesses), risks of recession in China, and anemic job growth in the U.S. and across Europe.
Q: Let’s start with Europe. What concerns you there?
A: Obviously Greece’s recent sovereign debt crisis brought sovereign debt risks to the forefront of investors’ minds during the second quarter. Banks and governments, especially those in France and Germany, are highly invested in the sovereign debt of other European countries (See Top chart). Given the inter-dependent nature of this type of debt structure, the probability of wide-spread contagion is quite high if sovereign debt defaults occur. The resulting “domino-effect” would likely have broadly negative implications for the financial system across Europe, and, as a result, could be a significant risk to global growth as a whole.
Second, we’re concerned that the austerity measures that European governments are rapidly undertaking in Greece, Spain, Italy, etc…. have the potential to significantly reduce European growth levels in the near and medium term, even though these changes are the right thing to do over the long term. This is especially true for areas like pension reform and reductions of public sector employment. Spending cuts in these areas are likely to force many European countries into a “double-dip” recession and will have negative consequences for countries that export heavily to Europe, including the United States and China.
Finally, we are very much concerned that Spain could be the next domino to fall in the evolving sovereign debt story, perhaps as early as the end of this summer. Spain is struggling with 20%+ unemployment and an unsold housing inventory that is six times greater per capita than our substantial housing crisis in the United States. The recently enacted austerity measures are likely to further weaken already anemic growth, leading to another economic contraction within the next twelve months, and quite possibly toppling the current government. Given this scenario, it is not difficult to envision that Spain will have to go hat in hand to the European Central Bank (ECB) and greater European community for assistance sooner rather than later. Spain’s Credit Default Swap rates, the technical indicator most commonly used to gauge country-specific default risk, continue to rise, indicating that the probability of this event occurring is also rising.
Q: Let’s move on to your next concern. What are your worries about global growth levels?
A: In May, it became apparent that growth in the global economy was beginning to decelerate. From the obvious challenges to growth associated with European austerity measures and fallout from the sovereign debt crisis, to China’s policy-based restrictions on real-estate associated lending, poor U.S. retail sales in May, as well as continued anemic job growth throughout the developed world; global growth is slowing from the first half of 2010. Two of the leading growth indicators we are watching closely are the Economic Cycle Research Institute’s (ECRI) weekly Index growth report and the Baltic Dry Index. The ECRI has seen a marked contraction over the last few months and now stands at -7.7%. Historically, readings at this level are strong indicators that recession is fast approaching.
The other index that we are monitoring and are very concerned about is the Baltic Exchange Dry Index (BDI) report which has dropped over 40% over the past 6-8 weeks. This index measures shipping rates for shipping dry goods -- primarily dry bulk commodities demand from developing nations. Given this substantial drop in activity, we are worried that the demand from China that has been such a strong driver of global growth in recent years may be substantially waning.
Given these forward-looking indicators, we are hoping that worldwide growth moderates, but does not dip back into recession in the second half of 2010. If the global economy is able to avoid outright recession, we think that markets are fairly valued at current levels. If, however, global growth slips into negative territory, markets are likely to experience another material and painful move to the downside.
Q: Okay, let’s move onto the challenges faced by the States in balancing their budgets.
A: Actually this is a major concern for us. It is an area we spent quite a bit of time exploring in our last quarterly Q&A. In recent weeks, most states were mandated to submit budgets for their next fiscal year (which begins for most on July 1st). As discussed in the previous quarterly report, the drastic measures required to balance state budgets will result in tax increases, reductions in services, furloughs, and wide-ranging job losses in the state government sector. As of the end of June, best estimates quantify expected resulting job losses in the several hundred thousand range. When combined with job losses associated with the completion of the 2010 census, which employed approximately 600,000 temporary workers, it is clear that we face severe headwinds for job growth for the rest of the year. Given the continued weakness of state tax receipts, additional mandates included in the Federal stimulus programs, and the lack of structural change within most state budgets (i.e. addressing state employee pension and healthcare costs), this will likely be the first of many rounds of spending cuts and tax increases from the states.
Q: Let’s move on to China. What is your main concern other than the potential impact on trade of a slowdown in global growth?
A: We are primarily concerned about the scale of their property bubble and its likely impact to their growth projections as well as any impacts to the soundness of their banking system. A large portion of their enormous stimulus program found its way into the property market, both commercial and residential. There are cities where office vacancy rates exceed 40% and yet skyscrapers are still being built. The residential market might be worse. Year over year gains have been averaging double digits for several years and in a number of cities the average price of a condo is over 25 times the average resident’s median income. Imagine Chicago, if the average price of a condo was over 1.3mm. In response to the dangers associated with a runaway real-estate bubble, the Chinese government has introduced a series of measures targeted at curbing real estate related speculation and lending, though they may already be too late given the rate and duration of recent growth. As most of the developed world can attest to, property-related bubbles have severe consequences for economic growth, consumer confidence, and the stability of the domestic and international banking system. The implications for China could be particularly intense, as most Chinese banks have yet to develop mature credit risk analysis/management capabilities, therefore making it extremely difficult to quantify the potential risks associated with a downturn in an asset class as large as consumer and commercial property. Similar to the United States, a material correction in Chinese real estate values will have wide ranging implications for their federal and state budgets, as nearly 1/3 of all government revenues come from land sales.
Q: Transitioning to domestic issues, how is the lack of credit availability impacting the economy?
A: Two ways. From a consumer side, the reduction of credit (see below) and the need to shore up consumer balance sheets has impacted consumer spending. It is likely that consumer spending would be down even more, if the impact of “strategic defaults” in residential housing (aka, “Jingle Mail”) was included. On the small business side, the lack of credit availability is negatively impacting the ability of small businesses to expand and hire. Lack of access to credit has consistently been cited as the first or second most significant concern for small businesses in surveys for over a year now (lack of sales being the other significant concern). Unfortunately, given the major banks need to strengthen their balance sheets, the cost/restriction of credit incorporated into recently passed and proposed legislation, and lack of administration focus on addressing lending to the small business community, we see little hope of this improving in the near future.
Q: The last concern you listed was related to domestic job growth. Would you like to expand on that?
A: Sure. Job growth at this point in the recovery has been disappointing by any measurement. Historically, anytime you have a sharp and sustained contraction in economic growth like we experienced in late 2008/early 2009, it is almost always followed by a corresponding large upturn in economic growth thereafter. A perfect example is the recovery following the 1980-82 recession, where realized quarterly growth rates ranged from 7%-9% for 4-5 quarters. The recent bounce back from this recession has been lackluster to say the least. Over the last three quarters we have averaged ~ 3% growth and it appears that growth in the second half will likely struggle to match even these modest levels.
There are many reasons for this. This recession was triggered by a credit crisis, which typically takes longer to recover from than one induced by inflation or excess inventory buildup. In addition, the policy responses so far have failed to achieve their objectives and have in a number of cases have had the opposite of their intended effects. In fact, the uncertainty created by recent and proposed legislation has had a direct (and negative) impact on private sector job growth. In addition, small businesses have been negatively impacted by the lack of availability of credit; which we have done a poor job of addressing so far. The situation with the State budgets also does not help matters. Finally, consumer deleveraging is likely to remain a challenge to growth for a sustained period of time as consumers rebuild their balance sheets. This will have a direct impact on consumer spending and job growth. All in all, this “jobless recovery” will likely be with us for quite some time with broad implications for consumer spending, job growth, and the overall economy.
Q: Sounds like you have a long list of major “Watch-Outs” right now. Do you see any positives for the market right now?
A: There are a few. As previously discussed, we think that current market valuations are reasonable and even compelling if earnings estimates hold up for the rest of this year and into 2011. We are also impressed that countries have not slipped into the type of wide-ranging protectionism that often follows an economic downturn of this magnitude. Longer term, the development of China, India, Brazil, and even Africa are going to be positive for worldwide economic growth, trade, and global stability. We also think that government expansion will likely wane after the mid-term elections later this year. Gridlock is usually positive for markets, and a major political course correction in November is likely. As a result, we are hopeful that such a change would lead to a more thoughtful focus on the economy and job creation, as well as making meaningful progress on reducing current deficit levels.
On a personal note, being based in Miami, having Lebron James, Dwayne Wade, and Chris Bosh on the same team should make for an extremely interesting kickoff to the basketball season this fall...
Disclosure: Long JNJ, T, MSFT