I’ve just updated my Current Market Tactics page, taking a look at the implications of breaking through to new highs on the S&P 500.
Monthly Archives: July 2016
the EU today: structural adjustment needed
Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.
How should an equity investor proceed?
There are two schools of thought, not necessarily mutually incompatible:
–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd. This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention. If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services. These will almost certainly outperform the market.
The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.
–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well. The result is that they don’t do as well as similar companies elsewhere. I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.
It may be that the local market is offended by brash upstarts. It may be that local portfolio managers deal only in book value and dividend yield as metrics. It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock. One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.
The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time. Because of this, and because of Brexit, the UK assumes greater importance for me. So, too, Hong Kong, as an avenue into mainland China. And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.
A final thought: one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices. Both areas have relatively old populations. If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade. I don’t think this is correct, but as investors we should all be attentive to possible signs.
internal/external adjustment and the EU
Yesterday I wrote about the tools a country has available if it faces a combination of sluggish GDP growth, excessive borrowing/weak banks and non-competitive industry (processes are outmoded and costs are too high). Greece is the poster child among EU countries …but Italy is the major EU economy that this description calls to mind. France is riding a compartment or two away.
What can an EU country whose economy is structurally out of balance do?
Well, external adjustment–meaning currency depreciation–is out, since it’s part of the euro.
That leaves internal adjustment, which can take three forms:
–tariff or other regulatory barriers. Yes, the EU can, and does, erect barriers to protect local industries against imports. But most EU countries trade more with each other than the outside world. So, say, Italy can’t bar imports from super-competitive Germany or lower-cost eastern Europe.
–slowing the borrowing, which is intended to maintain the current (unsustainable) lifestyle, by raising interest rates in a way that will cause a recession. This is the German “austerity” solution, which few, if any, other countries (nor any politicians concerned about being reelected) will willingly adopt. The EU experience after the 2008-09 recession shows austerity doesn’t work particularly well, either.
–that leaves structural reform.
This gets me to why I started writing about this. Paul Krugman recently reviewed a book I haven’t read, The End of Alchemy, by the former head of the Bank of England, Mervyn King. In the review, found in the New York Review of Books, Krugman says of King:
“He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.”
What grabbed me is the “imbalances in production costs” part. In other words, despite almost two decades of having the euro, plus all the time before its debut when companies knew it was coming, inefficient EU countries have done very little to bring their production costs down. In addition, the reason Mr. King gives for this is “the lack of will.” In other words, the forces of the status quo, aimed at preserving local fiefdoms (both political and industrial), are so strong that no progress can–or will–be made.
Sounds a lot like Japan, with a twenty-year lag.
Tomorrow: investment consequences, if the King/Krugman analysis is correct.
internal and external economic adjustment
This is ultimately about the euro and the EU. Today’s post is about creating a framework for thinking about this issue.
It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested). Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today …and potentially the US, at some point.
imports and exports
The residents of any given country typically don’t consume only items made in that country. They buy imported goods as well. In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.
paying for imports
The country as a whole gets the money to pay for imports in one of a number of ways: it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.
imbalances
In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases. That’s seldom the case, however.
chronic deficit
Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells. To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners. At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.
This situation sets the stage for a potential foreign currency/trade/economic growth crisis.
internal/external adjustment
Here’s where we get to internal/external adjustment.
There are two ways of dealing with this issue:
internal
–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services
–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)
–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea: look at the US auto industry since the mid-Seventies)
None of these actions are likely to win unanimous applause from voters. And if legislative action produces negative results, it will be completely clear who is to blame. So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them. Instead, they most often opt for the external adjustment route.
external
–This means to encourage or embrace a decline in the local currency versus that of trading partners. That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners. Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached. It’s those horrible foreign exchange markets instead.
More tomorrow.
mutual funds/ETFs in time of stress
As I mentioned last week, since the Brexit vote some property-based mutual funds trading in the UK have had to suspend redemptions while they attempt to raise the needed cash through asset sales. This raises the question about how US mutual funds and ETFs might fare in a similar time of stress.
We have, of course, the large downturn of 2008-09 as a recent example. The US survived that period of significant stress with scarcely any issues. T
he worst experience of my working career, in terms of redemptions was in the aftermath of Black Monday in 1987, when the US stock market lost almost a quarter of its value in one day. In the load fund I was running at the time, which also had a strong record, I lost about 5% of my assets under management over a few weeks. Colleagues running no-load funds at other firms lost up to a third of theirs. Again no very serious issues that would have required suspending redemptions.
The entire US stock market was closed for several days following 9/11. But that was because US trade-clearing banks had their recordkeeping computers, including backups, all located in or around the World Trade Center; it took them several days to get back on their feet. The banks have since established backup systems at more remote locations, so that presumably won’t be problem again.
It may be, then, that our potential worry is only about specialized funds that hold highly illiquid assets like property.
One significant source of regulatory worry has been the rapid growth since 2009 of passive products–ETFs and index mutual funds, which don’t have large staffs of portfolio managers and traders used to making lots of transactions.
Experience with ETFs has been, to my mind, surprisingly positive from a redemption point of view. That’s because the theoretical idea that the brokerage houses that trade ETFs would move their bids to such a low price that all desire to panic-trade would evaporate, has so far worked every well in practice.
The only thing we as investors should note is that during several “flash crashes,” the brokerage bid price for affected ETFs that I’ve seen has been as much as 15% below net asset value. That’s a clear warning not to use market orders for these vehicles in bad times–or not to sell them at all.
To my mind, the one unanswered question is how liquid index funds might be in a future crisis. The worst that happens, I think, is that big indexers do the same thing as the UK property funds and suspend redemptions for a time. On the other hand, my entire working experience is that it’s institutions, not individuals, who panic during crises. And these tend to cash in actively-managed products in times of stress, not index funds. So maybe they’re not a big worry after all.
Something to think about and plan for, though.