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.


is the US job market taking on a European look?–why this is important


The Wall Street Journal is arguing in its Monday print edition that the US job market is–at least in the sense that the US may be facing the type of chronic high unemployment that has bedeviled Europe for decades.

In an earlier online version of the same article, the WSJ pointed out that, despite an unemployment rate approaching double digits, there’s actually a shortage of workers in some specialties in the US.  Wages in these areas are rising significantly, meaning employers can only fill these positions by poaching from rivals, not from dipping into the sea of unemployed.  It also gave machinery-related examples–but it’s now lost in cyberspace.

The JOLT (Job Openings and Labor Turnover Survey) complied by the Bureau of Labor Statistics points out the same phenomenon.  As of the latest JOLT reading (September 2011), there are 3.4 million unfilled job openings in the domestic labor market.  That figure has risen pretty steadily since July 2009, when there were 2.1 million such openings.

Also, the head of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota, made a much-publicized speech on this topic in August 2010 (see my post), in which he said that the Fed doesn’t have the means to change construction workers into manufacturing workers.  Retraining does this, not easy money policy.

Of course, the roots of European unemployment have been mostly caused by very rigid labor laws that make it very time-consuming and expensive to fire a worker, once hired.  In the US, in contrast, (the smaller) part of the issue is that scared Baby Boomers have stopped retiring at normal rates, and are thus not freeing up jobs for younger workers.  In addition, globalization has moved unskilled labor jobs to emerging markets.  This has been going on for a long time, but adjustment in the US was put on hold during the housing bubble that lasted half a decade.  So the US labor force has a lot of catching up to do.  That’s the main problem, in my view.

why is this important?

Two reasons:

economic policy

It’s probably right to use money policy to stabilize the stock market, so that Baby Boomers will move into the retirement phase of living, freeing up jobs for younger workers.  But, as Mr. Kocherlakota observes, low interest rates can’t retrain workers.   Legislators can–but so far won’t.

stock market

The main reason I’m writing this is that I think most American investors believe the domestic economic recovery is somehow broken because it isn’t following a typical post-WWII pattern.  They continue to think that high unemployment is a business cycle signal that all is not well.  As a result, they’re suspicious of any strong corporate earnings reports and are only willing to pay low multiples for what they regard as “broken” profits.

I think the WSJ article I cite above is interesting because it suggests that, as I’ve been writing for a year or more, that for 90% of the US, the economy is expanding, jobs are secure and the future is bright.  I think that’s why Black Friday and Cyber Monday have been so strong this year.

If this is correct, we should see resumption of wage increases on a wider scale next year.

Frictional unemployment is, say, 4% of the workforce.  This means that 5% of the workforce wants work and can’t get it (I know this figure excludes the underemployed and discouraged workers).  Normal retirement patterns by Baby Boomers might clip 1% from that number, leaving 4% of the workforce to receive government support and retraining assistance.  Yes, that’s still a big number.  But it’s doable.  And denial–or nostalgia for the 1950s, when the US had the only industrial base untouched by WWII–won;t help.

From a Wall Street point of view, however, I think recognition of the structural nature of current high unemployment would mean the gradual expansion of the price earnings multiple investors award to the market.

Balance of Payments (II): internal and external structural adjustment

The BoP accounts should balance

In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.

a simple example

This is a common sense notion.  It’s easiest to see if we take a simple, theoretical example.  Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)

Further, call the currency of A the $ and the currency of B the @.  Let’s take the initial exchange rate as $1 = @1.

a trade/current account deficit…

Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million.  It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.

Where does this extra @100 million come from?  Not from today’s income-earning activities in country A.  Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad.  If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million.  This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.

…isn’t sustainable forever

This situation can’t go on forever.  If nothing else, at some point country A will run out of assets that country B will desire to buy.   In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want.  Initially, it will “recycle” extra $ into country A’s bonds to get some interest income.   But there’s a limit to that, as well.  Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.

The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports.  If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried.  So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter.  But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.

In any event,  a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency.  Country B will demand a premium for continuing to hold $.  What happens then?


One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around.  That is, the government of A takes action to defend the $1 = @1 exchange rate.  It may also have help from country B in doing so, since the government of B may be satisfied with the status quo.  In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.

Two possibilities remain–external structural adjustment or internal structural adjustment.

Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods.  In practical terms, this means the government raising interest rates and inducing a recession.  How so?  The problem country A faces is typically that government economic policy is too stimulative.  As a result, the country is living beyond its means.  Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.

The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible.  It’s also very clear to voters exactly who has taken away the punchbowl.

External adjustment means standing aside and letting the currency markets achieve a new equilibrium.  In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.

This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed.  Why this path?  It’s easier politically.  Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad.  And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.

In academic theory, adjustment through currency devaluation is an illusory process.  The economy reverts to its prior state of disequilibrium, only with inflation at a higher level.  For smaller countries, I think that this is true in reality as well.  In the case of large countries like the US, the reality is more complicated.  More about this in later posts.