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Whilst the UK economy cautiously continues to improve following significant fiscal and monetary stimulus elsewhere in Europe, the German economy, the long-serving export king of Europe, continues to struggle. The ZEW Centre for European Economic Research has reported deterioration in its forward looking confidence measure. The index declined from 44.8 in June to 39.5. German economists predict GDP for the year will contract by -6.0%, more or less in line with last week’s IMF prediction of a -6.2% fall. The Euro currency weakened on the news. Euro rates are currently 1.0% compared to 0.50% in the UK and a narrow range of zero to 0.25% in the US.
The German Chancellor Angela Merkel is under pressure to increase stimulus above the current pledge of 85 billion Euros to prevent Europe’s largest economy, already suffering the worst recession in 65 years, from contracting further deep into 2010.
EWG Germany iShares to 14th July
Europe continues to trail the field in the race to escape recession. The US, Asia and UK all appear better equipped to formally report positive GDP data, before the Euro-zone. The reasons for this are many. A single financial and monetary framework, for the 16 member states of the Euro-Zone, has created a one size fits all policy which inevitably fails to address the unique needs of individual countries as diverse as Ireland, Cyprus and Finland. In particular, the process of establishing a single Euro-zone interest rate across such a large economic region is just an efficient recipe for the manufacture of asset prices bubbles, and as now, a sustained recession. The Irish property market bubble is the easiest example to highlight, though the same can be said of the price of homes and commercial land in Spain. Both countries enjoyed an inappropriately lax monetary policy for years. This incorrect policy combined with flawed banking sector risk controls made the recent property price rally, and subsequent crash, inevitable. Credit (mortgages and loans) should be cheap, but difficult to obtain and only provided extensively to proven and prudent borrowers or those with significant collateral. Incorrectly allocated (and priced) credit always leads to economic turmoil as it corrupts the perceived fair value of risky assets. The reason is simple but often forgotten and is worth investigating.
Although the financial system contains innumerable types of financial instruments there are only two distinct groups; risk free assets and risky assets. Risky assets need to offer a premium to the buyer, a potential of excess return above the risk free rate, to compensate investors for the possibility they will lose all or some of their capital. In times of high confidence and strong economic growth buyers are generally willing to take a lower premium as the probability of loss is theoretically smaller. In periods of uncertainty and economic weakness investors seek a higher premium to reflect the increased possibility of capital erosion. The exact premium over the risk free rate will depend on the individual characteristics of the risky security. For example, the risk premium of shares in a newly listed technology company with growth potential but unproven revenue needs to be higher than the risk premium embedded in the shares of a mature utility company with secure cash-flows. The principle is the same however. Investors need to understand the risk of a transaction, correctly identify a likely return, and decide whether the risk/return profile is attractive relative to the return provided by a risk free asset, such as cash. Investors as a whole have consistently failed to accurately identify the risk/return profile of risky assets.
There is also widespread confusion between creation of real economic wealth and financial paper wealth. Few financial transactions create economic wealth. (The velocity and circulation of money is a different issue). Sustained economic growth is achieved via the creation of real wealth. A financial transaction, for example the buying of gold, listed shares or in-circulation bonds is not the creation of new and real wealth. It is the transfer of wealth (an investment opportunity cost) from those who executed the transaction at an unfavourable time to the opposite party who bought/sold at a time where the asset was mispriced in their favour. Let’s use Microsoft shares as an example. The company is listed. If you buy Microsoft shares from your broker, Microsoft doesn’t get the money. The seller of the shares receives the proceeds. Post-transaction there are only two scenarios. The shares will go up or down. If they go up the buyer is profiting at the expense of the seller (who should have held). Wealth has not been created, all things being equal. Likewise if the shares fall, the excess profit above fair economic value, received by the seller is off-set by the buyer’s losses. If there are more buyers than sellers then the price will rise, but new real wealth is not being created. It’s just paper wealth. Nominal paper wealth, unless supported by real assets of similar economic value, is always vulnerable to collapse.
Now add into this paper wealth environment banks with weak risk controls, who lend consumers, investors and institutions cash some of which is used in the purchase of paper assets. Buying increases, asset prices are inflated, bubbles are generated and the only winners are the few who through luck or rare judgement sell their assets at the inflated (incorrect) prices.
Of course some financial transactions, a minority, can potentially create wealth. When a financial transaction gives entrepreneurs or companies additional cash and that cash develops a new product, a new drug or an asset that produces a new revenue stream then real economic wealth is created. But most financial transactions do not. Successful stockbrokers, who trade in listed securities buying and selling assets at the optimum time, are therefore not creating new economic wealth. They are reallocating society’s existing wealth from shareholders who buy or sell at the wrong time, to their clients.
Some economists will nominate the circulation, or velocity, of cash generated by these paper financial assets as having economic benefits. My response is the circulation of cash in mispriced financial transactions is less useful, in fact it’s positively harmful, when compared to the other option available which would be to circulate the cash through the economy via consumption of goods rather than in flawed ‘asset bubble’ investment practices.
In conclusion, returning to the examples of Ireland and Spain. Both countries, burdened with an inadequate Euro-zone monetary framework and a flawed banking sector, allowed the manufacture of paper wealth to out-strip real economic growth by a dangerous margin. In the depths of a European recession, the ECB is evidently ill-equipped to identify the difference between paper wealth and real economic wealth or tackle the problems generated by the gap between the two.
The Global Economy
Last week, for the first time in over 2 months, investors significantly reduced their exposure to risky assets. The flight to safety was a primarily a result of equity index technical factors with markets very overbought in the short-term. Weak corporate and economic data on a number of fronts further encouraged profit taking. Most technical analysts suggest this reversal of the recent upward momentum is likely to continue for one or two weeks further, before markets enjoy another leg up lasting several more weeks. At that point, with equity markets having gained substantially from early March lows markets will be reliant on complete Q2 and early Q3 economic data before clarifying the direction of the next multi-month trend.
Beyond the considerations of technical factors, ongoing US data is increasingly indicating the trough of the US recession is behind us. Consumer confidence in May is highest level post-Lehman. Other recent data, including the Q1 GDP contraction of 6.1% (annualised), as well as the decelerating rate in the decline of industrial output also indicates the economy is moving closer to the recovery phase. Another key measure is the industrial capacity utilisation rate which fell to 69.1% in April, the lowest figure since organised records began. This rate, and business inventory data, confirms US businesses have very aggressively reduced production to meet lower demand. Reduced production output has also helped firms to lower their marginal costs. Lower inventories can actually be good for the economy going forward, as when consumers and firms do increase spending, production has to be scaled up quickly to both build low inventory levels and meet growing demand.
The International Monetary Fund (IMF) predicts the US economy will contract by 2.8% in 2009, before stabilising at zero or marginal growth next year. This forecasted rate of growth, low as it is, may well be superior to European growth next year as the US authorities have been more aggressive in both monetary easing and the introduction of stimulus packages. This view is supported by Q1 GDP data within the Euro-zone. The single currency economic area contracted 2.5% in the first three months of the year relative to Q4 2008, according to initial Eurostat predictions.
Economic activity in Germany, long the export champion of Europe, fell at a sharper pace than the Euro-zone average, retreating 3.8% quarter on quarter (QoQ). The fall, appalling by any measure, is the worst decline since 1970 and is the 4th successive quarterly decline. French GDP also contracted, though less aggressively at 1.2% QoQ. Spanish and Italian GDP output also retreated. Similar to the US economy, European inventories are at very low levels so Q1 will probably represent the low-point in the economic cycle for the Euro-zone, but the recovery may be delayed relative to the US, and Asia, for reasons discussed above, despite tax cuts and monetary easing (rates now 1% from 3.25% in October 2008). The IMF forecast GDP to contract 4% in the Euro region this year with a marginal retreat next year of 0.1%. Unemployment usually continues to worsen deep into a recession and even if GDP stabilises and returns to positive territory earlier than anticipated the European Union jobless rate is still likely to deteriorate further to 11% (9.9% now), with Spain likely to suffer most. Euro equities fell around 3% on the week, but remain approaching 30% from the early March low.
The Global Economy Hope has turned into expectation. Through Q4 2008 and Q1 2009 commentators and analysts were steadily downgrading their economic forecasts and pushing back deeper into 2009/10 their predictions for an economic recovery. However, early in March we saw equity markets fall to new lows, then rally on bargain hunting, and since then cautious optimism has gradually returned to the banking sector and wider economy. Investors and economists increasingly feel there is light at the end of the economic tunnel and the bottom in the economic cycle occurred in Q1, or at worst in the current quarter. The unanswered question is will the global economy stabilise at current levels and provide flat to modest economic activity (an ‘L’ shaped recovery), or will the massive stimulus packages provided by G8 Central Banks spur the global economy into a ‘V’ shaped recovery accompanied by a new bout of inflationary pressures? Equity markets, particularly in the US, seem to be leaning towards to the latter scenario with further gains made this week leaving the 2-month equity rally intact with improved risk appetite spreading from speculators to more mainstream and conservative long-term equity investors.
Ironically, the foundation for improving confidence is not a new, and surprising, trend of good economic news. It’s because certain key data announcements have not been as bad as predicted. In fact it’s near impossible to find any data releases year-to-date, outside of China, that even the most cheerful economist could describe as good but when expectations and investor moral is so low, as it was at the turn of the year, quite bad economic news particularly from the US, still the world’s most influential economy, is greeted with relief and a new bout of equity buying.
A perfect example relates to US employment data, released on Friday, which indicated a further 539,000 jobs were lost during April, compared to a negative 590,000 consensus forecast. The figure, depressing by any normal measure was actually the best, or to put it more accurately, the least worst figure in 6-months encouraging commentators and even President Obama to articulate optimism that the recession was easing in its severity. However, many of the upbeat commentators omitted to mention the data was flattered by a 60,000 temporary boost to US government payrolls relating to contract workers employed for the 2010 census count. Nevertheless confidence is a crucial ingredient in any recovery and as long as the press and investors hold onto their cautious optimism we should see, later in 2009, stabilisation in US housing market which will thereafter encourage US consumers, the backbone of the US economy, to return to what they do best; shopping.
In Canada, the employment news was also better than predicted with a small increase, 35,900, in payroll numbers. Closer to home, the European Central Bank cut Euro-Zone interest rates for the 7th time since summer 2008 reducing the cost of borrowing 0.25% to 1.00%, an all-time low. The European economy is highly likely to recover later than the US due to the ECB being behind the curve on monetary easing but the latest rate cut is welcome nevertheless, though is widely viewed at best as ‘better late than never’.
UK The FTSE ended the week higher, tracking US equity gains. The recent better than expected UK banking sector updates also supported sentiment. The headline UK index has now progressed around 13% in the 5 weeks to-date during Q2. Inevitably some sectors continue to fair better then others. Resource and financial stocks continue to out-perform house builders, property and industrial related equities. This trend, many commentators suggest, is likely to continue with key analysts, Goldman Sachs and Morgan Stanley, downgrading leading property companies or advising clients to sell, whilst house builders remain vulnerable on the expectation that the sector will need further injections of capital to strengthen beaten-up balance sheets. News that house prices declined 1.7% in April (Halifax data) also encouraged equity investors to allocate cash elsewhere on the presumption that the UK property market may be the last sector to enjoy a recovery. On a more upbeat note regarding the affordability of homes, the sharp decline in prices over the past year, (17.7% lower) has improved the house prices to earnings ratio, which is now at a 6 year low of 4.26 according to Halifax. Lower interest rates have certainly helped but with rising unemployment and mortgage availability still not back to normal (pre-Lehman) levels the picture for the rest of 2009 is mixed at best.
Other UK specific news included a hold on interest rates. The Bank of England Monetary Policy Committee opted for no-change to the current rate of 0.5% but did announce an expansion of the £75 billion quantitative easing program adding a further £50bn to help the UK recover from the “deep recession”. The BoE also indicated that it did not consider inflation to be a threat hinting borrowers can expect to enjoy low interest rates for some time yet, certainly into 2010, based on current data.
Look forward, the FTSE is likely to track the S&P 500 pretty closely so the wealth of diversified UK equity investors remains at the mercy of US market sentiment. However, only the most pessimistic market analysts suggest the current rally is a false dawn, and predict a return to new fresh lows. The consensus forecast predicts flat performance or further gains through Q2, with inevitable bouts of short-term profiting taking when markets progress too-far, too quickly.
BHP Billiton PLC (BLT) 1544.00p BHP Billiton, the largest mining company in the world, enjoys balance sheet strength and financial security that most global companies, indeed most countries, would keenly like to replicate. The 2008 annual report, released before the global recession hit, is almost impossible to fault. Seven consecutive years of profit increases, an EBITDA* interest coverage of 49x and $32.1bn returned to shareholders via dividends and share buy-backs, since the BHP and Billiton merger in 2001. Clearly the company efficiently captured the growth in demand, primarily from Asia, for iron ore, copper, nickel, coal and oil, and rewarded shareholders handsomely. The headline figures point to an extremely well run company but hardly scratches the surface of the firm’s operations. BHP Billiton has an impressive portfolio of over 100 mining operations in 25 countries with (as at the end of the last tax year) a further 28 projects either in development or undergoing feasibility studies. The current operations have accumulated $60bn of net operating cash flow in the last 5 years. Commentators have typically associated the terms “China” and “BHP Billiton” in the economic articles for some years now and for very good reason. Their future prosperity and growth are aligned not just in the demand and supply of commodities but fundamentally and politically. China, committed to a unique style of capitalism within a controlled economy needs resources to maintain high economic growth rates thus allowing the spread of wealth through its enormous population. When BHP Billiton was honoured with the task of producing the 2008 Beijing Olympic medals, it confirmed the company was not just another trade partner but was fundamental to the well-being of China, its economy and was in the thoughts of the highest echelons of Chinese political circles.
So the question for investors, considering the long term fundamentals remain excellent for BHP Billiton, how has the worst global recession in 75 years hit current year demand for commodities and BLT profits? Casual observers may be surprised. The firm, in its recent production update, surprised markets with record year-to-date output of iron ore and oil. Interestingly, iron ore shipments cancelled by some customers were sold on the spot market without discomfort. Looking forward, there is further evidence, if any was needed, of the competence of management. The Q1 2009 exploration update should be renamed the “on schedule and on budget project update”. All the oil, gas and LNG projects, (Shenzi, Atlantis North, Pyrenees, Angostura, Bass Strait and North West Shelf) are on target. The Canadian potash project covering an incredible 7,000 square kilometres also highlights the firm’s determination to build on its current portfolio of products and secure new revenue streams. Even in the absence of merger and acquisition activity, BHP Billiton can look forward to growth from expanding the output of its current portfolio of long life, low cost, upstream assets and even a sharp recession seems unable to hold back the success story.
*Earnings before interest, tax, depreciation and amortisation.
