Market Outlook: October 07, 2011

OPPORTUNITIES IN A GLOBAL DELEVERAGING CYCLE

Equity markets declined sharply in the third quarter (Figure 1) reacting to a global economy evidencing a slowdown in real growth in virtually every country in the world (Figure 2).  While a slowdown does not necessarily result in an economic contraction, the global economy is in a vulnerable state with the developed world pursuing fiscal policies of austerity and few levers available to policy makers.
 

At the heart of the problem is the necessity to delever the sovereign balance sheets of the developed world. Debt to GDP for the combined countries of Europe, U.K., Japan and the U.S. total 300% of GDP (Figure 3). As Rogoff and Reinhart point out in their book, This Time Is Different, when debt levels approach 90% of a country’s GDP, growth slows considerably (100 to 150 bps below potential) and employment increases ever so slowly, resulting in unemployment levels well above historical norms. Furthermore, with sovereign nations of the developed world deleveraging, is it any surprise that a slowdown in emerging countries is also occurring given their mercantilist economic models that rely so heavily on exports?

What we have now is a full-fledged delevering cycle that has gone global. History teaches us that balance sheet recessions are not the same as plain vanilla manufacturing inventory cycles. Deleveraging implies debt reduction, asset deflation and rising savings rates. In the midst of this slow-growth global economy, if one throws in the crisis of the euro and the potential for a hard landing in China, we have the ingredients for a sudden shift from a “slow-grind” economy to a global recession.
 

The greatest potential for a recession-inducing shock is centered in Europe. The sovereign debt crisis is on the verge of becoming a banking crisis that could choke off credit to a struggling economy and possibly end in the dissolution of the euro. The magnitude of such a dislocation would be extraordinary. A positive outcome is far from certain, increasing the likelihood for volatility across the capital markets.

The basis for a solution lies in the recognition that if the euro zone remains on its current course, there are no winners. While any step toward a fiscal union is a touchy subject with voters, several policy hurdles were overcome in September. Germany’s courts upheld the legality of euro bailouts while its parliament ratified enlarging the European Financial Stability Facility to €440 billion and allowing it to be used for purchasing sovereign debt and recapitalizing banks. Policymakers appear committed to providing the euro with a firmer foundation, even if the political process appears slow to outsiders.

Although constructive acts, these actions are far too little for the size of the problem and more steps are necessary including the possibility of a “Euroland” bond guaranteed by the members of the European Union. The only answer for the euro problem is default or fiscal union in some fashion. Time is running short but it is our belief the authorities will act simply because the cost of not saving the euro vastly exceeds the cost of saving it.

Fear of a hard landing in China is exacerbating concerns about economic growth as well. The fact that their economy is slowing directly reflects what happens to an export led economy dependent on growing economies in the developed world. Fears have centered around a property bubble and inflation. Problems for sure, but we believe they are manageable, barring an implosion in Europe. According to Morgan Stanley, for 46 of 70 Chinese cities, property prices declined or stayed the same in August compared with only 31 cities in July. China still expects 15 million people per year to move to the cities from the country side and this should address the “ghost” cities often discussed in the media. Inflation is a problem but the Chinese have raised their benchmark policy interest rate five times in the last 12 months and it is now above the August inflation rate of 6.2% by 30 bps. A slowdown is coming for sure, but a hard landing is far from a certainty at this moment.

While the risks to economic growth are evident, it is trickier to assess the degree to which financial markets have already discounted a poor operating environment for companies. As markets sell off, we see a growing number of high-quality companies that generate free cash flow, have very strong balance sheets, possess management teams with sound capital allocation policies that reward shareholders and are reasonably priced given a long-term outlook. We continue on the same course, favoring businesses that have the brand or intellectual property that enable them to raise prices and preserve margins in an environment of slow growth and elevated costs.