McKinsey says China will grow more slowly than expected. Barclays comments that bad news on U.S. core capital goods does not indicate a sharp slowdown and that Latin American countries’ finances look sound. Janney Scott sees stock buys in Japan. Among mutual funds, S&P has high marks for Berwyn Fund, Wells Fargo Advantage Growth Fund, and Loomis Sayles Small Cap Growth Fund.
Gordon Orr, McKinsey Quarterly
What might happen in China this year?
Inflation in food prices will take longer than expected to control. The drivers of inflation are much more structural than cyclical. Indeed, the entire system is now so highly stressed that one snowstorm brings large spikes in food and energy prices as coal runs short. When ice shuts down the roads, as it does today in much of southwestern China, agricultural products simply cannot get to market.
Chinese consumption patterns are shifting as people become wealthier—more meat eating requires more cereals to feed the animals. The food supply chain, running at the limit, is close to breaking, and the pressures this problem creates will lead to further food quality crises. What’s more, price caps won’t be effective in creating a better balance between supply and demand. Rising food prices are a pan-Asian issue: inflation has recently surged in Indonesia (chilies), India (onions), and South Korea (cabbage and now beef as a result of foot-and-mouth disease). China, given its large absolute demand for so many agricultural products, will shape food prices across Asia.
A major second- or third-tier Chinese city will see demonstrations over food price rises, unemployment, or both, on a much larger scale than anything that has occurred in recent years. The demonstrators will probably be satisfied quickly by local action to increase financial support for them and to replace local-government leaders. Yet concerns over copycat actions elsewhere will lead to a nationwide preemptive program to support the urban unemployed.
Middle-class bankruptcies will expand dramatically. Buyers have aggressively bought multiple properties with every penny of free cash flow. All that is needed for a wave of bankruptcies is further interest rate rises (targeting inflation) that result in a blip down in house prices just as mortgage payments rise. We have seen this before across major cities in Asia. The government will probably decide that it cannot bail such people out, as that would be seen as rewarding recklessness among the haves at the expense of the have-nots. There is already significant noise on the Internet to the effect that government leaders are completely out of touch with the true cost of urban housing. These leaders must take material action to show that they are aligned with the hopes of people just getting on the real-estate ladder.
Minimum wages will rise, but productivity gains will outstrip labor costs. The profitability of industrial enterprises remained high at the end of 2010—indeed, higher, in many cases, than it had been a year earlier, despite the minimum-wage increases rolled out in 2010—and will probably remain high. Yet a government seeking to enhance its stature with lower-income workers will find that increasing minimum wages, perhaps by 15 to 20 percent, is an easy lever to pull. Once again, multinationals, especially Asian multinationals, will find themselves being monitored first for compliance. More broadly, 2011 is likely to see further increases in the number of complaints that blue-collar workers bring in the legal system against employers for failure to pay overtime and to give employees the required time off from work.
China’s economic growth will be lower than expected. The rollback of subsidies to consumers will, in 2011, lead to a slow start for consumption, which will never quite catch up during the year. In recent months, for example, automotive purchases accounted for 20 percent of consumption. With the rollback of subsidies, the imposition of quotas in Beijing (and probably other cities), and increased prices for license plates and parking, car sales are likely to plateau if not fall in 2011. This problem will be exacerbated by food price inflation, which will cause lower-income workers to cut back on nonfood and other discretionary expenditures.
China will step up its “invest out” program in the new five-year plan. The government may well seek to double the country’s cumulative outbound investment within the next five years. There will be resistance by governments in some countries (probably in Africa, Eastern Europe, and Latin America) where public opinion is not yet convinced that so much Chinese ownership of key assets is really attractive. This opposition will visibly upset China’s leaders, who may decide to sell the bonds of the reluctant governments and to increase the challenges that enterprises from these nations face in selling to Chinese state entities.
The state will again try to reduce its ownership role in business. If the government relaunches its program to sell off more of its stake in companies, domestic share prices will probably decline or at least remain flat. The program will also soak up much of the liquidity currently supporting Chinese IPOs, thus reducing the ability of entrepreneurs to cash out quickly through them. Also, private-equity firms that have been investing in pre-IPO growth stocks in China may hold on to these investments longer than planned.
Dean Maki, Barclays Capital
After posting solid 3.1% GDP growth in Q4 10, the US economy began Q1 11 on a weaker note. Our tracking estimate for Q1 11 now stands at 2.0-2.5%. Data released this week showed that real consumer spending rose only 0.3% in February after being unchanged in January, putting real consumer spending on a relatively weak trajectory early in Q1 11. Core capital goods orders and shipments were also soft in January and February. The strength of consumer and business spending were the main reasons we remained optimistic that the economy would keep expanding when fears of a double-dip recession intensified in the summer of 2010, so it would be worrisome if these pillars of the recovery were starting to deteriorate in a sustained way. However, our reading of the data is that the softening in high-frequency measures does not reflect a fundamental deterioration in the economy, and that any worries generated by this softening will prove short-lived.
Durable spending suggests the recent consumption softness is transitory. When consumer spending deteriorates in a sustained way, it is typically led by drops in spending on durables. This is because durable goods are among the most discretionary purchases made by consumers, since they can easily be postponed if prospects become cloudy. Declines in real consumer spending in recent decades have been led by drops in consumer durable spending. By contrast, in the recent slowdown in real consumption growth, durable spending has continued to rise at a double-digit rate. Indeed, the recent slowdown has been partly led by declines in spending in such categories as utilities consumption, which is less discretionary and more subject to weather conditions.
This suggests that unless durable spending starts to slow significantly, the recent softness in real consumer spending is unlikely to last. We have noted in recent weeks that the spike in food and energy prices does pose some risk to consumer spending, so we believe it is worth monitoring durable spending particularly closely over the next few months. The point we are making here is that we do not interpret the January-February softness as evidence that the trend in consumer spending is rolling over.
Slowdown in core capital goods orders not reflected elsewhere
Core capital goods orders also started Q1 11 on a weak note, falling 5.9% m/m in January and 0.7% in February. These readings put the 3m/3m annualized change in this series at only 3.2%, the softest reading since the recession; this would be worrisome if it reflected a fundamental downshift in business equipment and software spending, which has been one of the main drivers of the expansion to date. However, these are extremely volatile data, so we believe it is important to cross-reference them with other data to see if they are consistent with a downshift in business spending. One important measure is the ISM manufacturing index. Sustained downtrends in core capital goods orders are accompanied by a slowdown in this index, but the ISM index has been moving higher, not lower, in recent months. Similarly, another important signal, manufacturing production, has been accelerating in recent months, inconsistent with a sustained slowdown in core capital goods spending. Also, private payroll growth has remained on a solid trend, whereas it usually deteriorates when the business sector is pulling back. Indeed, the March employment report signaled a continuation of the trend toward solid business expansion, with overall payroll growth of 216k, private payroll growth of 230k, and another 0.1pp drop in the unemployment rate.
The bottom line is that other major indicators of business spending and hiring do not signal that the softness in core capital goods means that a sharp slowdown is underway.
None of this is meant to suggest that there are no potential potholes ahead. Indeed, events in the Middle East, the earthquake in Japan, and the ongoing rise in commodity prices may all have disruptive effects in coming months. Rather, the message here is that we do not believe the softness in the early Q1 11 data should be interpreted as the start of a significant slowdown.
Barclays Capital, Latin America
Rapid credit growth in Latin America has often been a source of concern among policymakers as potentially indicative of overheating risks, excessive leverage by domestic agents, and/or vulnerabilities in the financial system. Typically, the policy response to such risks has been monetary tightening, though sometimes also macro-prudential measures concerning the liquidity and capital requirements of financial intermediaries. This has not been the exception in the current recovery cycle, as central banks in most inflation-targeting economies have embraced monetary normalization, often citing credit growth, while some have also delivered a few macro-prudential measures.
Just this week, Brazil announced further restrictions on capital inflows by extending the 6% IOF tax to short-term loans and security issuance. Although we see this mainly as intended to limit BRL appreciation, the government stated that its intention is also to limit credit expansion. This follows measures announced last December (reserve and capital requirement hikes) oriented to the same aim. Although credit granting slowed significantly in December and January, the February report (also out this week) showed a rebound of new credit and raised questions as to the lasting effectiveness of these actions.
With tight labor market conditions and high readings of inflation expectations, the risk is that these measures may not do enough to cool down demand.
In its Q1 inflation report, the BCB already made it explicit that it would be too costly to bring inflation down to its 4.5% target this year. So the focus is now 2012. We continue to think that upcoming tightening will be based less on interest rate hikes and more on macroprudential measures. However, we remain skeptical that this new strategy will succeed in bringing inflation back to the target next year.
In the rest of Latin America, the other big user of ad hoc tightening measures has been Peru, which increased its reserve requirements several times during the recovery cycle, most recently in January 2011. The other central bankers have been more traditional. Even Colombia, which has often used reserve requirements, skipped them in the current cycle.
The degree of substitution between interest rate hikes and reserve requirement measures as a counter-cyclical device is, in any case, an increasingly relevant question in the region.
From a theoretical standpoint, they operate in very different ways. That is, under inflation targeting, the central bank fixes the interest rate and lets money demand determine the supply of money. By contrast, reserve requirements change the money multiplier, but in the end, money demand is left unaffected, as is the equilibrium in the money market. The channel through which reserve requirements operate is the gap they open between deposit and loan interest rates, making credit a little more expensive and, through the cost of capital, affecting investment demand. But the extent of this effect is not clear. There may be other effects – such as an increase in adverse selection or, on the brighter side, a boost to the confidence in the banking system – but these seem, in general, more indirect.
In the end, the merits of reserve requirements for counter-cyclical purposes are a non-trivial empirical question. In a recent macroeconomic report, the Inter-American Development bank advocates their use as a complement to monetary and fiscal policy, though not specifying empirical relations. Meanwhile, a study by the Peruvian Central Bank estimates albeit relying on the rather strong assumption that banks only change the loan interest rate) that a one point increase in bank reserve requirements is equivalent to a 25bp hike in the policy rate. The matter, overall, remains open to debate, in line with the varying attitude toward these instruments across Latin American central banks.
Beyond their counter-cyclical appeal, it is important not to forget, precisely, the “macroprudential” aim of these macro-prudential measures. This brings up the question of whether, beyond the challenge of overheating risks, strong credit growth in the region may be underscoring other vulnerabilities. Though the standard snapshot of financial stability indicators tends to conceal the kinds of vulnerabilities that become apparent when crises hit (eg, the quality of loans), available metrics of financial soundness for the region remain quite reassuring . At least in this regard, the region deserves ongoing credit.
Mark Luschini, Janney, Montgomery, Scott
The stock market advanced last week, as worsening fears of a disaster coming from the headline-grabbing problems of the Fukushima nuclear facility in Japan and the unrest in Libya receded. The reprieve allowed investors to refocus on domestic economic news and corporate announce-ments that collectively were quite positive. Unfortunately, the housing market continues to suffer from too much supply intersecting with too little demand, so the news in that sector remains very soft. However, reports on manufacturing activity and jobless claims posted encouraging figures. And the final figure on economic growth for the fourth quarter of 2010 was revised upward to a decent if unspectacular 3.1%.
Along with equity prices, commodities regained some of the ground lost during the correction in risk assets that occurred from mid-February through mid-March. Today, most of the major global indices have recouped to price levels above where they stood ahead of the tragedy in Japan. At home, the Dow Jones Industrial Average rose 362 points on the week, or 3.1%, to 12,221. On the other hand, government bond prices surrendered some of the gains made during the recent instability in stocks. The 10-year Treasury bond closed Friday with a yield of 3.44%, up 17 basis points from the week before.
Along with other equity indices, Japanese shares rallied last week by 3.6%. We had advanced our opinion more than a week ago that the decline in the Nikkei will be transitory if the Japanese are able to stabilize the Fukushima reactors. We expect the Bank of Japan to print the necessary money in order to begin the reconstructive process which should be a stimulus to Japan’s GDP in the coming quarters. Since the global impact of a slowdown in Japan’s economy in the short term is relatively small, we think growth will resume and/or continue amongst their exporters and their stock market will respond favorably.
In reviewing the aggregate characteristics of the companies listed on the Nikkei stock exchange, we find valuations very appealing. The 10-year average price-to-earnings ratio of the Japanese stock market today is around 14, a level last seen more than forty years ago. Stocks in Japan have on average a double-digit free cash flow yield (almost 50% higher than the U.S.), trade at a price-to-book almost 50% cheaper than global equity markets, and have cash on the balance sheets equal to approximately 30% of market capitalization. While the issue of nuclear radiation remains open-ended, the risk for investors is waiting too long to make selective purchases. We were among many that pointed to the Kobe incident in 1995 as a road map to recovery for the Japanese economy and their stock market. Then, after an initial sharp decline, prices regained the level set before the earthquake within 12 months. Forgotten by many, though, is the fact that the average price-earnings ratio was more than 90 times in 1995, and the Japanese economy was still early in its process of unwinding the excesses of the late 1980s. We expect global growth to continue, and within it, the Japanese economy to recover to a positive pace (if it even experiences a decline for a quarter or two) by year-end. Equity markets will be moving higher, and may already have begun to – in anticipation of that – long before.
Todd Rosenbluth, S&P
April is here, which means the beginning of the baseball season and a new chance for advisors and mutual fund investors to look at what did and didn't work in the first quarter of 2011 in their prior asset allocation decisions.
Of course, three months is too short a time period to make a judgment, so to help sort through the top performers, we leverage S&P's mutual fund ranking system that includes not only longer-term past performance metrics, but other relevant holdings-level and fund-level characteristics.
According to MarketScope Advisor, there were 345 domestic equity mutual funds open to retail investors that rose more than 10% in the first quarter, but only 80 of them are currently ranked by S&P Equity Research as a four- or five-star fund. Many of these highly ranked funds were energy-focused portfolios, including Rydex Energy Fund, up 16% year to date, and Invesco Energy Fund, up 15%. These two funds and their underlying holdings were helped by the increased price of oil thus far in 2011, but their S&P four-star rankings were also aided by relatively low expense ratios and ownership of a number of stocks that S&P Equity Analysts currently view as undervalued, such as Apache and Anadarko Petroleum.
The strong success of energy funds is not surprising considering that the S&P 500 Energy sector rose 17% in the first quarter of 2011 outpacing the gain of every other GICS sector by over 800 basis points. S&P Equity Analysts are still recommending a number of energy stocks (44 such stocks receive Buy or Strong Buy recommendations), believing these companies will benefit from strong oil prices amid Middle Eastern geopolitical uncertainty and recovering global demand. However, as we shall see below, a number of the better-performing more diversified mutual funds this year do not appear to be riding only the high oil price coattails.
S&P five-star ranked Berwyn Fund, a small-cap value fund, climbed 14% in the first quarter of 2011 and, as of latest holdings info from January 2011, had assets largely spread across the financials, industrials and information technology sectors; energy was just 11% of assets. Top-10 holdings included semiconductor equipment company Advanced Energy Industries and insurance provider American Equity Investment Life, both of which are considered undervalued according to S&P Fair Value calculations. BERWX has a top-quartile one, three- and five-year total returns compared to peers, along with a below-average expense ratio and relatively high Sharpe ratio.
Meanwhile, Wells Fargo Advantage Growth Fund is a multi-cap growth fund that is up 13% this year, continuing its strong track record that includes top-quartile one, three and five-year annualized returns. As of January, the fund's largest sector exposure was in information technology, consumer discretionary and health care, while energy comprised just 8% of fund assets. SGROX's two largest holdings, Apple and Alexion Pharmaceuticals, are among the ones in the portfolio that S&P Equity Analysts view as undervalued. Also helping the fund's five-star ranking is its below-average standard deviation and expense ratio.
Lastly, there is Loomis Sayles Small Cap Growth Fund, which is up 12% this year and had only 8% of fund assets recently invested in energy stocks, but 28% in information technology stocks, 18% in health care and 16% in industrials. Top-10 holdings as of January included S&P Buy-recommended IHS and Informatica. Like others mentioned above, the strong performance thus far in 2011 does not appear to be a fluke; LCGRX outperformed its small-cap peers in four of the last five calendar years, and S&P views favorably the fund's above average Sharpe ratio.
As you can see, while energy-focused mutual funds have been top performers, diversified funds across various peer groups have also started the year out impressively. But we believe investors should look at the longer-term record, underlying holdings and other fund characteristics when making asset allocation decisions.
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