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 March 2011 International Issues Globalization's Plusses and Minuses Have Come Together
But not everything predicted in the 1960 has occurred -- or worked out for the better. We don't yet fly around in cars like George Jetson. Countries have not come together as one "Earth" community, and perhaps more importantly, the economic and political fate of each is now more than ever dependent on that of others because of the increased interaction. Japan needs U.S. consumers to keep buying its exports, the U.S. would most certainly face a financial crisis should China and/or other big Treasury purchasers step away, and without technological innovation, manufacturing and exporting countries would lose a major chunk of their economy. This interdependence as vividly demonstrated with February's uprisings in the Middle East. Although most affected countries were not major trading partners of the U.S. and the rest of the Western World, all were impacted. Not only that, events in the Middle East showed just how fragile the developed countries' economic recoveries really were.
Good Signs at Home
Consumer spending which powers about two-thirds of the national GDP remains steady, but not overwhelming. January retail sales posted a decent 0.3% gain, but that was only half of the 0.6% that was expected. December's number was stronger, registering a 0.5% increase. All in all, the Christmas season was favorable for retailers with lean inventories and early sales. Year over year, fourth quarter retail sales rose an impressive 4.4%. Again, not a blow-out but steady, non-inflationary growth. And speaking of inflation, consumer prices increased 0.4% in the month of January. That was 0.1% more than anticipated, yet still left the headline number up 1.6% from the prior year. For a Fed targeting a 2-3% inflation rate, there's still time for easy money. In fact, core inflation, the Fed's favorite measure which excludes volatile food and energy prices, was up an even more modest 0.2% in January. The higher -- yet still relatively low -- inflation numbers suggest the Fed can put the fears of deflation to rest and focus on goosing the economy without excessive price increases. And in that regard, now that interest rates have been near record lows for the past two and a half years, the Treasury Department finally decided it was time to take advantage of them. Not only that, they need to take advantage of them given the mushrooming funding needs from the President and outgoing Congress' deficit spending. In the final week of February alone, the Treasury auctioned of almost $100 billion in 3, 5, and 7-year Treasury Notes. Investors, sensing a growing supply, were a little skittish, but still stepped up to buy Uncle Sam's IOUs. The question is, "How long will they be willing to do so?"
Getting Crude About It
Or can you? Stocks were just wrapping up a robust earnings reporting season as the Middle East unrest was just beginning. Through mid-February, roughly three quarters of the S&P 500 stocks had reported fourth quarter earnings and the results were running 6.2% ahead of analysts' estimates at the beginning of the year. Most impressive was the fact that earnings improvements were broad-based, not limited to just a few early cycle sectors. Yet even this wasn't enough to support the market when turmoil spread from Tunisia to Egypt and finally to bloodshed in Libya. Crude oil still carries a lot of weight so worried investors may be seeking safe trades for quite some time. Interestingly, statistics from Deutsche Bank AG suggest investors may be right about the potential short-term impact on oil prices, but wrong about the lasting effects. Going back to the Six Day War in 1967, there have been fourteen events often labeled as "crises" in the Middle East. The average increase in oil prices has been around 85%. If the current crisis follows that course and if gas prices move in tandem with oil (both admittedly questionable assumptions), gas prices will top out around $5.50/gal. But where investors may be wrong is in the duration of the crisis. Looking back over the same statistics, most Middle East crises aren't long-lived. In fact, if you define the duration in terms of a drawdown in U.S. stocks, the average is thirteen and a half trading days. That's right, less than three weeks. Even ruling out what transpired in Tunisia and Egypt and assuming the current crisis began when violence erupted in Libya, if it's around the average it will be over at the end of the second week in March. Oil and gasoline prices may still be elevated, but stocks should be free of its grip. And speaking of drawdowns, the average U.S. market drawdown during a Middle East crisis has been a mere 5.8%. To be sure, there were two double-digit drawdowns (13.9% in the 1973 October War, and 14.0% when Iraq invaded Kuwait in 1990), but these actually skew the results higher given the median drawdown, 5.1%, is lower than the average. Is that really a good reason to lock in 3.5% for ten years in a Treasury Note? So far equity investors have weathered the storm. Yes, there's been days of selling, particularly when oil prices spike, but there's not yet been a day when panic led to a major decline. It seems investor appetite for equity returns is still intact, but their desire for risk is considerably lower. Early in the year semi-conductor stocks of the Nasdaq led the way, but by the close of February, old-line Blue Chips were seeing more interest. Could this be from a renewed interest in dividends? Possibly so.
The Global Answer Yet this may not be so frightening in concrete terms. For example, a study from the University of California recently concluded a $20 increase in the price of a barrel of oil (as of this posting, we're already about halfway there from mid-February) should result in U.S. consumers spending an additional $70 billion for energy products this year, amounting to a half-percent drop in GDP. That's not the best-case scenario, but it's certainly not a doomsday one, either. A drop of that magnitude from the fourth quarter level would still leave GDP up a respectable 2% or more.
Investors may also be misguided in their fear of soaring interest rates. As suggested above, the concern is that China will curtail its debt purchases, leaving the Treasury with a major overhang of unsold notes and bonds. While fear of an oversupply (or a lack of demand) is a legitimate concern, worries about catastrophes from a Chinese walkout isn't. There are two reasons for this. First, if China was to suddenly stop purchasing or even sell U.S. debt, they would be the biggest loser in the resulting rate increases. As the largest holder, they would take the greatest hit as prices declined. Secondly, China has already cut back it's purchases without any catastrophic effects. Five years ago, the Chinese treasury's dollar balance was at 74%. It fell to 68% in 2009 and then to 65% in 2010. Despite this, the Treasury has been able to conduct successful auctions even with historically low yields. Which also helps explain investors new-found interest in large cap domestic stocks. These are shares of the largest, most globally diversified companies that stand to benefit the most from a recovery abroad. Even if rising oil prices cause a hiccup in the U.S. recovery, companies that derive a significant amount of their revenue overseas can still benefit. Not only that, with the Fed keeping interest rates and the dollar low relative to our trading partners, any repatriated earnings well get an additional boost from the exchange rate. Couple that with rejuvenated dividends associated with large caps and it's not hard to see why they're coming back into favor. So many of today's economic concerns may come from abroad, but globalization also offers the answers for alert investors. We can't yet fly around like George Jetson, but we can take advantage of market conditions both here and abroad. Who knows, if the effects of the Middle East crisis are as short-term and benign as suggested above, we may look back at this as a buying opportunity. Right now domestic large caps are a good way to hedge that bet. Search this site! Just enter you key word or words:
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ORTY YEARS AGO AS the Space Race was getting off the ground, pundits were projecting the impacts of rapidly developing technological innovation. Some of those prognostications have come to pass. Worldwide communication has arrived and with it, a deluge of information most of us now take for granted. Global trade has also increased with Japan counting on the U.S. to buy its cars, the U.S. depending on China to fund its deficit spending, and the whole world is more dependent now than ever on new technologies, many evolving from the U.S.
