Barclays sees the U.S. economic growth picking up again; Schroders thinks U.S. bonds will keep their AAA rating; Janney, Montgomery, Scott predicts precious metals prices will keep rising; and T. Rowe Price is bullish on Internet stocks.
Michael Gapen, Barclays Capital: Chairman Bernanke: Patience is a virtue
An acceleration in headline inflation caused real consumption and output to slow in Q1 11; we believe the slowdown will prove temporary.
The FOMC decided to conclude asset purchases in June, while Chairman Bernanke said the reinvestment policy will remain into the second half of the year.
FOMC participants expect economic slack to remain elevated over the forecast horizon, suggesting the Fed will remain patient before tightening policy.
The advance release of Q1 11 GDP revealed real economic growth of 1.8%, down from 3.1% in Q4 10. The slowdown was driven primarily by a softer pace of real consumption growth of 2.7% and declines in structures investment (-21.7%) and government spending (-5.2%). Although this is a disappointing report, particularly relative to expectations after the passage of the fiscal package last December, we believe the slowdown will be temporary. The decline in real consumption growth reflects the effect of higher prices, as headline CPI rose 5.2% q/q (annualized) in Q1, double the rate in Q4, and the PCE price index jumped 3.8%. Therefore, while nominal consumption growth accelerated in Q1, the surge in headline inflation dragged real consumption growth lower (Figure 1). We forecast that headline inflation will ease notably on a q/q basis as the rate of increase in food and energy prices moderates. In addition, household spending on durable goods rose 10.6%, which does not indicate that the trend in consumer spending is taking a turn for the worse. We also believe the declines in residential and structures investment partly reflect adverse weather early in the quarter, and we look for positive contributions from both in Q2. Business investment in equipment and software, which is less sensitive to weather conditions, grew at a healthy 11.6% (Figure 2). Furthermore, government spending, which provided a 1.1pp drag on GDP, was driven primarily by an 11.7% decline in defense spending, which is unlikely to be repeated. Altogether, we continue to forecast real consumer spending and real GDP to grow 3.0% and 3.5%, respectively, in Q2 11.
Asset purchases to end in June; reinvestment policy to remain At its April meeting this week, the FOMC declared that the current round of asset purchases will end in June, and in the press conference that followed the release of the statement, Chairman Bernanke said that the Fed will “continue to reinvest maturing securities” so that securities holdings "will remain approximately constant" into the second half of this year. In addition, he stated that allowing securities holdings to shrink through passive run-off is equivalent to a tightening of policy. This is important, since the removal of the reinvestment policy is likely to be the Fed's first step in the normalization of monetary policy and will signal that the tightening cycle has begun.
FOMC participants revised their forecasts to reflect slower growth, higher inflation, and lower unemployment in 2011, while leaving the rest of the forecast largely unchanged The consensus view of the committee is for a modest recovery, underpinned by household and business spending, that gradually returns employment and inflation to mandate-consistent levels over the forecast horizon. Regarding risks to the outlook, the committee acknowledged that higher oil and commodity prices have led to an acceleration in inflation, but participants continue to believe that such pressures should be transitory and characterize measures of underlying inflation as "subdued." Were long-term inflation expectations to become elevated, the chairman said “there is no substitute for action” and the FOMC would respond through a tightening of policy. The chairman suggested that the main risk to the outlook from the earthquake and tsunami in Japan is likely to be through disruptions in the supply chain, but he said any negative effect would be moderate and short lived. In this environment, we continue to expect the Fed to remain patient before beginning to normalize monetary policy, and we do not expect an increase in the federal funds rate until July 2012. In the Fed’s eyes, patience is a virtue that will be rewarded. Yet patience and its ultimate reward are, in part, based on FOMC participants’ view that the natural rate of unemployment is about 5.5% and economic slack remains elevated. In addressing this issue, the chairman said that estimates of the natural rate of unemployment (and potential GDP) entail a high degree of uncertainty and that these measures are subject to revision. Basing policy on forecasts of these measures, therefore, is not an exact science. He said that hysteresis, or the process by which job skills atrophy from extended stays on unemployment, is a process that happens very slowly. In addition, the central tendency of FOMC participants’ projections for the unemployment rate did not come down as much as the actual unemployment rate has since the January FOMC meeting, suggesting that members see the current unemployment rate as artificially depressed, perhaps due to perceived business cycle effects on labor force participation rates. Our own view is that the natural rate of unemployment is about 7% and that the current level of the unemployment rate sends an accurate signal about the state of labor market conditions and the level of economic slack.
Keith Wade and Azad Zangana, Schroders Global: Will the US remain AAA?
The decision by S&P to put the US Treasury’s AAA rating on negative watch was a reminder of the problems facing many advanced country governments. In this case though, the move was triggered by the lack of progress being made by Congress on agreeing a plan to achieve fiscal sustainability and the urgent need to lift the debt ceiling to avoid the possibility of a technical default. More generally, the S&P move is a reminder that in tackling the financial crisis, governments have taken a lot of debt onto their own balance sheets. Many see the S&P move as a positive for bonds as it could galvanise US politicians into taking a more responsible approach toward the government deficit. US Treasury yields are now back to their pre-announcement levels, although the US dollar is lower in trade-weighted terms. In this month’s Viewpoint, we look at the macro factors which will determine the success of policies to reduce government debt, not just in the US, but more broadly. It must be said that outside the US, governments are taking deficit reduction more seriously, particularly in Europe where programmes are already underway to bring down government deficits. The UK is a case in point where the government recently updated its plans to deliver a reduction in borrowing from around 10% of GDP to 1.5% of GDP over the next 5 years The first factor is growth. Whilst much of the budget deficit in advanced countries is structural, and so will not improve with economic recovery, the ability of governments to tackle structural deficits is much greater when the economy is growing. Reducing entitlement programs is more palatable when employment and incomes are buoyant.
History bears this out, as periods where budget deficits have been significantly reduced have been associated with healthy if not strong growth. For example, according to the Bank for International Settlements during the last period of successful US fiscal adjustment between 1993 and 2000 where the budget deficit was cut by nearly 5% GDP, the economy grew 4% per annum. Similarly, the UK achieved an even greater reduction in borrowing of 7.7% of GDP between 1994 and 2000 against a backdrop of 3.5% annual growth.
Today, the prospects look far less promising as US growth forecasts are being cut to less than 3% for this year, whilst the UK is looking at less than 2%. The difference is that during the 1990s both the US and UK benefited from a strong tailwind as credit and property markets boomed. Loose monetary policy helped to accommodate the tightening of fiscal policy.
In the present environment, post the financial crisis, households are still deleveraging and consequently the boost from domestic demand is considerably less. The combination of tax increases and the rise in inflation makes it difficult to see how consumers can support the economy as real incomes fall. In the UK, real incomes are some 2% lower than a year ago and real consumption growth has only been maintained by a drop in the savings ratio.
Going forward the savings rate may fall further as in the official forecasts, but there is clearly a risk that households decide to save more thus reducing consumption. The latest dip in consumer confidence suggests this is a real possibility. Note how the savings rate fell during the last fiscal consolidation phase in the nineties. Like many countries, the UK is looking to overseas demand to support growth and 0.7 percentage points of the 1.7% GDP growth expected by the Office for Budget Responsibility this year is forecast to come from net trade. The fact that many of the UK’s trading partners are also engaged in fiscal consolidation makes this less achievable.
The US is in a similar situation with weak real income growth, although the savings rate has probably adjusted further and employment growth is beginning to support household incomes. However, the willingness of the US authorities to see the US dollar slide is an indication of their need to draw in demand from overseas. The second factor is interest rates and investor confidence. Highly indebted borrowers require a low rate environment to sustain their finances. In general, an economy facing a real interest rate in excess of its long-term trend rate of growth faces considerable problems. Here the prospects are more favourable as despite an increase in government debt to GDP of some 25% for the advanced economies since 2007, real yields remain low. This is something of a puzzle as econometric analysis by the IMF suggests that such an increase in government borrowing would push up real yields. It would appear that in accepting such yields investors are confident that governments will be able to service their debts.
Two explanations can be made. The first is simply that policy rates are low and act as an anchor on longer-term rates. Given real short rates of less than zero, long rates of 2% still imply a steep yield curve. From an investor point of view, the cost of shorting bonds is expensive The second explanation is that the overall demand for borrowing is low. To see this look at the US flow of funds data which shows that private demand for credit remains weak, the de-leveraging story discussed above. This means that the government is effectively the only borrower in town and consequently can pay relatively little. In practice, what we see is a banking sector facing little demand for funds from its corporate or household customers, finding it has excess reserves which are then invested in the Treasury market by default.
Whichever explanation you favour, the threat from this perspective is economic recovery brought about by an increase in demand for credit and tightening of monetary policy. Short rates would rise, pushing up bond yields and the government would find itself competing harder for funds. This is certainly true ceteris paribus and a reason why rates will probably not rise rapidly as growth returns. However, we should also recognise that not all things are equal and that economic recovery will also bring lower unemployment and benefit payments and stronger tax revenues, thus helping to cut the deficit. There will be some cyclical improvement in deficits as real rates rise.
The more dangerous situation is one where interest rates rise without any cyclical improvement. In other words, risk premiums increase as lenders begin to fear a default. This of course has been the story in Greece, Ireland and Portugal as investors gradually recognised that government finances were on an unsustainable path.
Could something similar happen in the US? Some investors have already acted to hedge portfolios for such a scenario and it remains difficult to see how the divide between the Republicans and Democrats can be bridged. Given the size of the structural budget deficit, cyclical improvement alone will not be sufficient and the solution will probably mean significant action on entitlement spending and taxes.
The politicians seem some way apart at this stage. However, they do agree on the need to cut borrowing. Moreover, the outcome really depends on the attitude of those who fund the US government. If creditors keep funding at close to current yields the show can go on.
Recently, of course the US government has been largely funded by Quantitative Easing with the Fed effectively printing money to buy Treasuries. However, although significant this has always been seen as temporary and the more durable source of funding to the US comes from overseas, the counterpart to the current account deficit, particularly central banks in Asia and the Middle East. Around 30% of the US Treasury market is held by foreign central banks, if we just count those reserves held in custody at the Federal Reserve (see chart front page). This represents the “exorbitant privilege” of the US: due to its status as a reserve asset there is a natural demand for the dollar. For this reason it is difficult to see the pattern of rising risk aversion and increase in default premiums which have undermined countries in peripheral Europe. Consequently, the US should have considerably more leeway to put its fiscal house in order and retain its AAA rating.
Of course, this could change but it would require countries like China to alter their foreign exchange policy and stop pegging the Chinese Yuan (CNY) to the dollar. We do not see this happening in the near term, beyond the minor adjustments being made by the authorities at present to allow the CNY to appreciate.
Overall, while S&P might make the headlines it is clear that the real power over US Treasury yields lies with the central banks and particularly the biggest holder of foreign exchange reserves, China.
Mark Luschini, Janney, Montgomery, Scott
The 1964 classic, “Silver and Gold,” was performed by Burl Ives and was part of the music track for the holiday favorite – Rudolph the Red-Nosed Reindeer. In it he sang: “Silver and gold, silver and gold Everyone wishes for silver and gold How do you measure its worth? Just by the pleasure it gives here on earth.”
While we are not suggesting he was ruminating about the price of silver coins or gold bullion, today investors think silver and gold are worth more than at almost any time in history. We have advocated holding a position in precious metals for a number of years, recognizing the changed sentiment toward these instruments. The growing interest and appetite for commodities – along with the store of value precious metals offered over the last few years as global authorities near-simultaneously launched stimulus programs to reflate their economies -- provided the rationale for why these metals could see spectacular gains.
Just last week, silver was hovering around $47 an ounce, near the all-time high of roughly $50 reached in 1980 when the Hunt brothers attempted to corner the silver market. Gold, on the other hand, just achieved a record nominal high of more than $1,500 an ounce. Other commodities have risen dramatically as well, as global growth and a weakening dollar boost the need for and cheapen the cost of commodities in markets outside the U.S. Where will this all end and when? It will likely end with values perhaps well below today’s levels, because some of what is driving prices higher at the moment is speculation. Instruments like SLV and GLD, exchange-traded funds that represent the value of actual silver and gold prices but are traded like common stocks on the New York Stock Exchange, are among the largest exchange-traded products in the market today. When it will happen we think largely depends on the normalization of fiscal and monetary conditions. Gold and its cheaper cousin silver have been treated as currencies that hold value against the decline in the dollar and fears of a financial crisis like that which is still a developing story in the Euro zone. Until strengthening domestic economic conditions warrant a more restrictive Fed policy and other geopolitical risk premiums fade, we expect the precious metals to be measured by the markets as even more valuable in the days ahead.
T. Rowe Price: A New Era of Internet Investing
Not since the Internet craze of the ‘90s have technology investors shown the ardor generated by the latest wave of social media, e-commerce, and other digital companies blooming on the increasingly ubiquitous Internet.
Sparked by the introduction of Apple’s iPhone four years ago, the convergence of computing andcommunications—enabling wirelessInternet access virtually anytime, anywhere—is not only changing lifestyles and spawning dynamic new companies, but also providing new growth opportunities for established industry leaders. This Internet boom is different than that of the latter 1990s, when many companies with no earnings or prospect of earnings went public at stratospheric valuations and their businesses proved unsustainable. Unlike that dot-com bubble, which burst in March 2000, these new trendsetters generally have far more viable business models, and some have grown rapidly. They are capitalizing on the growing capacity of wireless networks to support expanding mobile communications— trends that have enabled a new era of innovation.
Though still private companies, the upstarts are attracting lots of attention and investor interest. They include social media firms (Facebook, Twitter, and LinkedIn) that are fostering huge Internet communities, location-based e-commerce companies (Groupon and Living Social) that bring local businesses and consumers together online, such social gaming developers as Zynga, and online consumer referral companies like Angie’s List.
In contrast to the last Internet boom, “the profitability or potential for profitability is already there,” says David Eiswert, manager of the Global Technology Fund. “It’s not like they are burning cash. They have scaled their revenue and they were able to keep growing despite the massive global recession. “Also, the first Internet bubble was a lot about conceptualizing connectivity—what it would be like to have a phone in your pocket that gives you Internet access from anywhere,” Mr. Eiswert says. “We got that in 2007 with the iPhone. Now, there are 3G [third generation] networks all around the world. So the infrastructure has caught up with the business models.”
Ken Allen, manager of the Science & Technology Fund, adds that the rapid ascent of Facebook and Twitter simply would not have been possible with just desktop computers and laptops. “The value of such social media firms is tremendously enhanced when people can access them from anywhere on portable computing devices, which they could not have done just a few years ago,” he says.
Indeed, the sudden success of these companies is fulfilling the early promises of the Internet. “What we’re seeing now is what fueled much of the optimism and ultimately much of the speculation in the 1990s,” says Robert Sharps, a large-cap growth manager. “And now there are companies with sustainable business models and solid financial characteristics. “The way businesses reach consumers and the way consumers reach each other is changing so quickly and the magnitude of the change is so different that whole business models are being turned over and new ones are being created. Change creates opportunity.” Adds Mr. Eiswert: “The rate of change is on steroids. If you have a good idea or new product, you now have a very rapid rate of adoption around the globe.”
Mr. Sharps cites Blockbuster, a video store chain that went from large profits to bankruptcy in just three years as consumers shifted to downloading videos. Borders, a bookstore chain, is exploring bankruptcy as consumers shift to downloading e-books. “Three years ago there were no e-readers,” he notes, “and now Amazon.com is selling more e-books than paperbacks.” Another indication of the pace of change, Mr. Sharps says, is that Apple is expected to derive 60% to 70% of its earnings this year from products that it had not even introduced before 2007—principally the iPhone and the iPad tablet computer. The new media have already marked some impressive milestones:
In just seven years, Facebook has amassed more than 600 million users and was valued at $50 billion in a private financing in January. It has surpassed Google as the most popular site on the Internet in terms of “time spent.”
Twitter, an online service and microblogging company, has accumulated 175 million registered users in just four years.
Groupon is among the fastest growing companies in Web history, according to Forbes.com.
Apples iPhone has sold roughly 100 million units in four years, and Google’s Android operating system for mobile phones is activating users at a rate of 300,000 per day.
Apple has sold more than 15 million iPad tablets since their introduction in April 2010.
There are now some 350,000 software applications on the Apple App Store that can be accessed with an Apple product.
With some of these companies expected to go public within the next year or two, there already are concerns about another potential Internet bubble. “Not all of these companies are going to be winners,” cautions Anna Dopkin, co-director of T. Rowe Price’s North America equity research. “However, with extensive research and analysis, you can increase the likelihood of determining which ones will be successful and which ones will likely fall short.” Mr. Sharps adds: “We can’t say whether the valuations of these private companies are reasonable or not. Some may be overvalued based on the hype surrounding all this. But based on the strength of positioning of some of these firms, there is a reasonable chance that they can become much larger companies over time.” Paul Greene, a T. Rowe Price media and Internet analyst, cautions that some companies “are getting a lot of venture capital funding and don’t have a lot to show yet. But some of these companies have real business models, are growing very fast, and their valuations don’t seem anywhere near what some companies reached in the 1990s.”
To illustrate the point, he notes that Priceline.com in 1999 had a $19 billion market capitalization with just $58 million in gross profit. After the dot-com crash, the company did not attain that market cap again until November 2010, but its gross profit last year was $1.9 billion. “The fact that Priceline’s valuation is roughly the same now as it was 11 years ago but its profits are 33 times higher shows how excessive the valuation was then,” Mr. Greene says. Portfolio managers also note that companies with dynamic growth opportunities can grow into what seem to be excessive valuations at the time. Mr. Greene observes that the market cap of Google at the end of 2004, the year it went public, was about $52 billion with only $2 billion in net revenue. That valuation seemed excessive, but a year later Google was valued at $121 billion. It is almost $200 billion today, and net revenue last year totaled $22 billion. “The question is, what is the potential for these companies longer term,” says Dan Martino, manager of the Media & Telecommunications Fund. “Good growth investors stick with companies that are well positioned even when the valuation appears to be full, and that takes a lot of courage, research, and experience.”
Some T. Rowe Price funds have made small investments in a few of these private, new media companies, recognizing their potential growth. The firm’s technology strategy, however, remains focused on such industry stalwarts as Apple, Google, and Amazon, which are all driving change and benefiting from new opportunities. Apple, of course, has been at the forefront of the shift from fixed to mobile computing. Its explosive growth has driven its market capitalization to $321 billion, second in size only to ExxonMobil. With an 80% market share, Google dominates search on the Internet globally and has been successful with its Android operating system for mobile phones, introduced in 2008, which is driving more traffic—and advertising revenue—to its site. “In the Internet bubble, stocks traded at 40 to 50 times expected earnings or more, and today you have companies like Google and Apple that trade at less than 20 times forecasted 2011 earnings,” Mr. Sharps says. “These are real businesses that are well positioned to take advantage of substantial changes in how we live, and they are trading at valuations that we believe are not onerous at all given their current growth rates and the opportunities they should have over a long period of time.” Mr. Martino says both Apple and Google potentially could reap more benefits as “interest in connectivity continues to grow, especially with the advent of fourth generation (4G) networks. With 4G, data transmission speeds are faster, and software developers will come out with even more exciting applications.” Mr. Martino expects that Apple’s share of the global mobile computing market will increase over its present level of just 5% and that Google “could be the leader in the mobile ecosystem in terms of software.” Mr. Eiswert adds: “Investors have underestimated the revenue potential of Apple’s iPad, and in the years ahead we expect to see mass adoption of the Apple platform of products by businesses, the government, and private and public education arenas.” Amazon also is well positioned to benefit from the continuing global migration to online commerce, fund managers say.
Moreover, Amazon, along with Google and Microsoft, is also positioning itself to become a key player in the nascent field of cloud computing, in which businesses outsource their data centers to a central network that stores and delivers data over the Internet, Mr. Greene says. Mr. Allen believes that cloud computing and mobile communications are the two dominant trends in technology today. “Cloud computing is more about companies and mobile communications is more about individuals,” he says, “but they tie together because a lot of what we do on smartphones and tablets relies on cloud computing. Without these data centers in the cloud, you could not do as much on your smartphone.”
T. Rowe Price managers are also finding attractive opportunities in a range of infrastructure companies and component manufacturers that serve the wireless community. These include such companies as Juniper Networks (networking and switching equipment), Qualcomm (semiconductor chips for mobile devices), American Tower (cellular towers), Corning (the damageresistant “Gorilla Glass” for all high-end tablets and smartphones), and several software business developers that stand to benefit from the growth in mobile connectivity. And then there are even more opportunities in emerging markets, especially Asia, to invest in such companies, because of the rapid growth of consumer classes in India and China. “Valuations are compelling among many companies in the region that have strong exposure to mobile computing, including Digital China, Baidu.com, China Unicom, and Tencent,” Mr. Eiswert says. The changing technology landscape is unfolding at such speed that fund managers say vigilance is in order. While closely tracking these new digital companies for potential opportunities, they also are watching out for possible threats to established leaders. “For Apple, Google’s Android is a threat,” Mr. Sharps says. “For Google, Facebook is a threat because it could attract more advertising dollars as people spend more time on the site. So you have to be on the lookout for whatever threats could emerge from any of these new players. “No one is immune to the effects of rapid change,” he adds. “The odds are that some of these leading companies will continue to take advantage of the magnitude of this change, but the pace of change suggests they have to anticipate and be highly innovative. If Amazon had not invested in the Kindle and the iPad came along and e-books took off, Amazon would have been in trouble.”
Managers expect a stream of other dynamic companies to come to the fore. “The Goupon business model and the Twitter business model didn’t exist a couple of years ago,” Mr. Sharps says, “so it would be foolish of us to think we are going to go through this period of innovation right to maturity just riding existing companies.” Mr. Eiswert concurs. “This is a great time to be a tech investor, considering the potential opportunities,” he says. “Five years ago people thought tech was dead. And that may be true for some parts of it. But for other parts we’re just at the beginning.
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