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Monday, 11 February 2008 11:12 |
The U.S. Economy and Markets in 2008Synopsis of speech given by Frank Cappiello at CBIC Annual Business Forum
December 6, 2007
Essentially, the course of the U.S. economy and the U.S. stock market depends on four factors whose direction tells us how solid or precarious the economic climate is:
MOOD – The confidence of consumer and businessmen in the future of the economy. This depends on profits for corporations and financial prospects for consumers.
A. A year ago, consumers were confident and buying. Businessmen while cautious, were recording impressive earnings
B. Now – Consumer mood is significantly less positive. Slower retail sales reflect worry about oil prices, inflation, Iraq, and worries about the price of their biggest asset – their house. Businessmen cautious as the stock market plunges, but still maintaining record levels of cash.
MONEY
A. A year ago
Money in circulation. Recycling of enormous flood of “Petro Dollars”
Cost of credit up – interest rates were rising
Weak dollar – helped exports
Federal Budget Deficit increasingly dramatically
B. Now
Money in circulation rising as Fed tries to head off recession
Long term interest rates (10 year treasury) are going down as investors flee stock markets for security of U.S. treasuries. Worries about dollar’s continuous decline.
Short term, Fed seeks to get Fed Funds rate down to a level to cushion a slowing the economy and banking crisis
Federal Budget Deficit: again at record levels this year. Situation is bad long term with accumulated deficits adding the total national debt. (What we as a country owe.) Foreigners (China, Japan, etc) now own more than 50% of our national debt and rising. China is diversifying its dollar holdings to a basket of currencies and OPEC wants to make the Euro the standard for oil purchases. Unlikely short term but long term?
Weaker dollar (weaker than last year) continues to grow exports to China and Europe, although less than their peak.
MOMENTUM
Economy has lost significant momentum since January.
Housing continues to fall. Housing prices going down. Oil prices falling below $90 a barrel but gas prices at the pump still high are affecting consumers and retailers.
Stock market continues to be negative. S&P500 has fallen 16%. The stock market is usually a good indicator of the economy and right now it is indicating confusion, worry, and a likelihood of recession.
MERGERS
Mergers positive for the economy. Mergers usually make corporations more efficient, eliminating redundancy. In the stock market, mergers excite “animal spirits” (Who’s next?). 18 months ago, big mergers were Proctor & Gamble and Gillette; K-Mart acquiring Sears. 6 months ago, the merger deals were bigger -- $50 – 60 billion. That’s all ended for the time being.
ECONOMY
The U.S. is more than six years into an expansion that officially started in November 2001. The economy is showing weakness as the stock market declines and inflation rises.
Economists can’t predict recessions for the same reason stock markets analysts can’t accurately predict market crashes. Both kinds of events by their nature are not predictable events. Almost all the postwar recessions were preceded by a shock, like a spike in short-term interest rates, or a sharp rise in oil prices. It's impossible even for the experts to see these shocks coming.
Further, the very infrequency of recessions in the U.S. also makes it more difficult to detect their imminent arrival. An entire generation of economists has grown up believing that the business cycle is largely something of the past, like black-and-white TV. Since March, 1991, there has been only one recession, which lasted eight months. It’s like asking people who spend their time in Alaska to start forecasting tropical storms.
The powerful impact of globalization and technological change on the American economy over the last three decades has changed our lives, our business and our money. Overall, the impact has been positive. Lower costs of production and increased market opportunities. However the sharp stock market declines of the past ten months is the “dark side”.
The U.S. economy. Economic growth has slowed and is rotating –shifting from retailing and housing construction and toward business, manufacturing and exports. Contrarily as the dollar weakens, exports are rising reducing our balance of payment deficit. Almost 100% of the U.S. slowdown has been due to the housing industry and housing is an intensely local and national industry – from the real estate broker to the mortgage lender, from Home Depot to interior decorators. This slowdown is occurring against background of robust growth overseas.
Weaker dollar = bigger U.S. exports
Weak dollar also raises inflation fears (imports cost more)
Domestic demand has improved in Japan and Europe bolstering U.S. exports. This is one plus from a weaker dollar.
The dominant financial worry of 2008 is a recession the result of the sub-marginal lending and worry about liquidation and the housing crisis. The current paralysis is sub-marginal bond and other junk bond markets has led to businessmen worrying abut liquidity (the ability to finance long term and short term cash needs) as well as the consumer worries about the value of his or her biggest asset. A worried business man may decide to slow expansion, a worried consumer could curtail or cut retail purchases. Since 70% of our GDP relies on the consumer “buying”, you can see the dimension of worry.
The second problem lies in the dollar and its constant fall in value day-by-day, month-by-month.
The third worry is the fear of a protectionist U.S. – seeking to limit imported goods to save jobs and industries. This includes illegal immigration.
How Bad is the economy?
Retailers reported Christmas sales at the slowest pace in 5 years
U.S. consumer confidence fell in November to the worst level since the recession of 2002 and continues to stay down.
The Quarterly Survey of Chief Financial Officers of Corporations (Duke University) is more pessimistic than retailers or consumers.
72% of the CFO’s surveyed were more pessimistic than the last quarter. Their worries include:
Cost of fuel going up
Cost of labor
Slower capital spending in 2008.
Finally what worries the consumer is:
Energy biggest. 36% increases in heating oil, gasoline, inflation. Visible signs of higher costs.
Weak dollar
Recession possible
Housing (value of their house decreasing)
Geopolitical – Iraq, Iran, Russia
Political uncertainty in 2008
Concern over the U.S. economy has largely centered on the spending habits of consumers who figure to tighten their purse strings amid worries over housing, credit and jobs. Less attention has been paid to the spending habits of U.S. corporations. That might change if companies start slashing their investments in technology capital equipment and infrastructure.
The 2002 recession (the last recession) and sluggish early recovery was largely a product of a sharp drop in business investment. Consumers kept spending and the housing boom was just getting stared.
Today, housing is suffering its worst slump in decades, with consumers starting to pull back.
Capital spending hasn’t been a huge worry this year, mainly because so many American companies are spending so much cash overseas. But as the credit crisis worsens and banks rein in lending, there are fears that capital expenditures will take a big hit – especially in the U.S.
These huge write-offs by the financial companies, banks and so on, will create more difficult lending standards. That, in turn, could lead to a slow-down in commercial real estate and capital investments.
For now, we expect U.S. firms to keep spending heavily in foreign markets, where economic growth has driven demand for all manner of goods and services. Exports have hit record levels in recent months. It also helps that the weak dollar props up profits overseas.
The greater worry is how the credit crunch and weakening economy will impact the commercial real estate market. Plenty of risk there. Commercial real estate is likely to turn down very sharply. Historically nonresidential investment tends to follow residential invest. During the third quarter, the number of delinquencies in the commercial real estate market rose above the highest level reached during the 2002 recession.
GDP numbers in business investment has been one area of the economy that’s been holding up pretty well. We have an ongoing exports boom and companies are ramping up to take advantage of that.
Good news for companies in foreign markets they operate in. But it won’t do much to ease fears about capital spending in the U.S.
Capital goods orders excluding aircraft and defense – a proxy for business investment – has been dropping registering continual negative reading in the past 12 months. That’s nowhere near double-digit declines in much of 2001 and 2002. But the soft October data added to signs that the overall economy is slowing in the final quarter of the year.
Conclusion on the economy
The credit crunch is serious and becoming critical…and we are probably entering the “eye” of this storm of sub-marginal and housing crisis.
The Fed will play a key role and odds are they will cut Fed Fund rate and the discount rate all during the first half of 2008. By summer of 2008, the rate will be 3 ½ to 3 ¾ %
We are about to enter a bear market. (S&P down 20%+)
The remainder of this report will focus on 5 major problems facing the U.S.:
housing
the dollar
international problems
energy
the stock market
HOUSING
House is the biggest asset. Housing is a significant factor in U.S. economic growth (about 12% of GDP) in terms of commodities (copper, lumber, cement) but also furniture, rugs, appliance air conditioners, and heating equipment, to name only a few. It also represents the average consumer biggest asset which continues to erode in price. The current slow-down has already affected some retailing activities and employment and consumer confidence. A continuing slowdown will effect job growth, consumer confidence, and could push the economy into a recession.
Some perspective on why the housing market boomed:
Until 2007, home prices have gone up nationally every year since the 1960’s with one exception. Housing was viewed as a good investment!
Easy financing
Tax benefits – the IRS allows writing off capital gains on the sales of a home up to $500,000 every two years. Further, interest on the “home” mortgage is deductible as an expense.
The subprime mortgage market is one sector of housing that has made financial news all year with bad loans owed by people unable to pay even the interest due and thus losing their property. It’s been easy for people buying a new house to borrow hundreds of thousands of dollars by simply telling the bank how much money they make without any proof. It’s called a stated income loan, sometimes called “liar loans”. Some 40% of these subprime mortgages were issued in 2006. That’s up from 25% in 2001. The continual worry is that the problems are far broader than just subprime and will affect not only the entire home mortgage industry, but also the overall economy.
Historically, we’ve had bubbles before but only regionally. California 1980’s – early 1990’s. Prices up 90% in 6 years in California but in the 90’s we had a slowdown in defense spending and a recession in California. Accordingly, prices fell for 5 years and then took 4 years to recover. Now things are different. The busted bubble is shrinking in terms of home values mainly on the East and West coasts, and states bordering the Gulf of Mexico. Currently, the Mid-west and Deep South have experienced relatively mild housing price declines.
The state of the housing market is still clearly negative. We still haven’t seen the worst of the decline in overall residence constructions, employment and housing and related manufacturer products. Nor have we witnessed the bottoming on the sub-marginal loan crisis.
Two examples of price declines, year-to-date.
Tampa, Florida area – a high growth 10.6%
Detroit, Michigan area – a low growth –9.5%
Also, 8 states have housing that is overvalued by more than 30% and two of the most overvalued are Washington State and Maryland. One scary forecast by Goldman Sachs experts predicts housing prices nationally to fall on average of 15% over the next 3 – 4 year from the top of the market in 2006. I don’t believe the reports but the people at Goldman are pretty smart!
The Declining Dollar
A bit of history: What $100 bought in 1800, it would still buy in 1900. But what the dollar bought in 1914 now costs over $2000! Since the end of World War II (1945), the dollar has lost 93% of its purchasing power, gone in 60+ years and the trend continues. How about that thought for your future retirement!
Despite the rise over the past few days, the dollar decline, both long term and short term, is why Wall Street is now uneasy about the recent sharp drop at a 26 year low against the British pound and a 2 year low against the Euro. (4/20/07).
The U.S. dollar is entering the seventh year of underperformance versus the majority of the world’s currencies particularly the non-managed ones. The euro, given its depth, has been a natural beneficiary of this weakness, as has been the British pound. Back in 2002, you needed less than USD0.90 to buy EURI; currently you need USD1.36 to purchase EURI. But Asian currencies (excluding the Japanese yen) have also gained substantially, not only because their currencies have been kept artificially weak for so long in order to boost exports, but also because the Asian economies offer superior growth. This change is a fundamental one and you should expect Asian currencies to continue to strengthen and become more flexible versus the U.S. dollar. Consequently, U.S. based investors who put money to work abroad will continue to reap the benefits of this relationship. Regarding the Chinese currency, Beijing will likely allow a modest increase in its appreciation versus the U.S. dollar.
So far this year, the dollar has lost an additional 4% against the euro. This is one reason that profits among companies in the S&P 500 have been exceeding expectations. These companies are bigger and on average get 40% of their profits abroad. Small companies tend to generate most of their business domestically, so they are less likely to enjoy this tailwind.
Does the plunge in the dollar and the weak currency spells catastrophe for the U.S. economy? Like much conventional wisdom, this isn’t true. Nor is it true that the dollar, to use one favorite recent word, has “collapsed”. The week’s Economist magazine known for its cool-headed discussion of economic events, has this on its recent cover: "The Panic About the Dollar.” Others see in the dollar slump a metaphor for America’s future – one of decline and waning influence in the world. To be sure, the dollar is down more than 40% against the euro since 2001. Against the pound, it’s off almost 44%. It’s even down against the yen, by nearly 13%. But put in perspective, these declines are neither dangerous nor even undesirable. Over the long-term, the dollar is well within normal bounds. After years of rallying due to massive flows of investment into the U.S., the dollar has simply come down to Earth. To say it has “collapsed” or “plunged” is simply wrong.
Look at the dollar weighted against all its trading partners, not just a cherry-picked few commodities, and you see the dollar hasn’t plunged at all. It's about where it was 10 years ago—during the Internet boom. It rose sharply in the late 1990s, thanks to the outsized returns offered in the U.S. markets compared with elsewhere.
When it comes to currencies, a higher value neither brings national success nor predicts future prosperity. The measure of a nation’s worth is the goods and services it provides not the relative standing of its currency. Take a look at 1985-88, when the dollar lost more growth than in the last few years. Those were goods times, and the next decade was largely prosperous as well. Today’s lower value for the dollar reflects the success of other regions. Europe has shown it can make the European Union and its unified currency work, and thus the euro has become stronger. The Canadian union appears increasingly stable, and that means a higher value for the Canadian dollar. Over all, these geopolitical developments are good for America even if the dollar becomes weaker in relative terms.
A shopping trip to London will give an American tourist the feeling that all prices have doubled or even worse. A weekend vacation or conference in nearby Toronto or Montreal may no longer feel like a bargain. But from a broader perspective, the value for the dollar hasn't fallen quite as much as it might seem. Since President Bush started his second term in January 2001 to the beginning of this year, the dollar has dropped more than 20% – if we weight the dollar by how much America trades with individual countries. That is a noticeable decline, but it is hardly a radical economic event.
A falling dollar does mean price inflation in the United States. Just as it costs more for an American to buy a fancy meal in Paris so do French wines and German cars have a higher markup however imports are only 16 percent of the American economy, and most foreign suppliers have been reluctant to risk their position in the American market by raising prices a great deal. Wal-Mart serves a more working class clientele and is stocked with goods from Asia, where currency values have remained weaker against the dollar
The lower value of the dollar also makes American exports more competitive. Longer term, manufacturing has been expanding as new orders and production improves. While other segments of the economy are struggling, manufacturing continues to grow due to continuing strength in new orders, and a recovery in production from last month. Much of Middle America is booming because of its ability’s to sell tractors, food stuffs, and other products abroad at favorable prices. Even after a serous real estate decline, the American economy continues to expand and this is largely because of the strength of our export sector, as encouraged by the low value for the dollar. Also, manufacturing is up due to dollar and exports.
The worry is that a falling dollar puts the United States at the mercy of China. Chinese hold about $1.2 trillion in dollar-denominated assets. China is likely to slowly diversify into other currencies but Chinese leaders have no interest in encouraging a run on the dollar or a fire sale of dollar-denominated assets. China is in a more vulnerable position than the United States, if only because China is a poorer country and has underdeveloped capital markets.
It would be naïve to argue that a weak or falling dollar can never hurt the U.S. Extreme volatility can increase general anxiety and discourage economic commitments. If the dollar went into a true free fall, it would damage the reputation of the U.S. as a desirable place for foreigners to invest. That would hurt; but on the other hand a low dollar would mean bargains for foreigners, thereby attracting investment and limiting the potential negative fallout from a dollar collapse.
But over the long term…next ten to fifteen years, a declining dollar is dangerous for the U.S. The long term threat to the U.S. dollar is the rising federal deficit over the next ten years. We’ve had serous deficits before, but this one is different. That’s because it comes at a time when the retirement of the Baby Boomer generation is looming on the horizon.
With fewer people working to support more retirees, and fewer tax dollars going to government in the years ahead, it is difficult to see how the massive structural deficits in Social Security and Medicare will be alleviated. Sooner or later, a burgeoning deficit will affect people’s faith in the dollar. We used to say its’ not anything we need to be overly concerned with right now , that if the deficit continues to grow for another four or five hears, it will be time to worry. The slide of the dollar against the euro and the yen over the last year means we’ve got to work to reduce Congressional spending.
Short term, the dollar should recover. The euro looks overvalued, just as the dollar did back in 2002. Europeans now fly to New York to go shopping. Canadians are also streaming into America to shop. The differential is enough to pay for the trip and still end up with savings. American assets, including real estate, also look cheap. Capital in the hands of global consumers and investors will flow to where the bargains are. That’s the U.S.
Outside the U.S.
The best place to invest over the past 2 years has been outside the U.S. – China, India, Europe, Russia and Brazil.
The figures on China’s growth are awesome: China consumes:
55 of the worlds annual cement production for buildings and its new highway system of expressways that in 2015 will rival the U.S. – 46,400 miles of interstate expressways
40% of the world’s steel
30% of the world’s coal
20% of the world’s copper
19% of the world’s aluminum
And oil….demand up by more than 400% in last 10 years
But there’s still room for more infrastructure growth
Railroads – China has 1/3 of the amount of U.S. railroad trackage and 4X the people of the U.S. China’s land size about the same as the U.S.
Airports – China’s 1/15th as many airports
But China also is the reason for 30% of our trade deficit
Cheap labor. Wage rate 3% of the U.S.
And that trade deficit and the ownership of Treasury bonds is the result of China’s production of products, mainly cheap labor. How cheap? China’s hourly wage rate is 3% of the U.S. workers average wage. Will the gap close. Eventually but not in the next 30-40 years!
Further, the Chinese economy is not as strong as it appears since their economy is completely “export driven”. China has a limited number of domestic consumers able to afford the goods their country provides. Therefore, their entire economy is at the mercy of foreign economies, namely the US and, to a lesser extent, Europe. Accordingly, if either the US, Europe or both were to suffer a recession, the Chinese economy would be in trouble as well as its stock market.
Essentially, the US represents a consumer-based nation while China and Japan act as our enablers, supplying US consumers with low interest rates (through the purchase of our Treasury debt), thus the disposable income to keep on shopping. For the most part, that is what the “Goldilocks” economy – not too hot, not too cold – is all about.
In summary, China’s growth is great but prices are great, too. Long term, not short term investments. Short term, be cautious…take profits on rises. Volatility is high.
INDIA
India is second to China in world population; 1.1 billion versus 300 million in U.S. India is the very young nation. More than 2/3s of the population is under 35. English is a common language in India, spoken by professionals, businessmen, and politicians. A democracy since the end of World War II, its legal systems is British, as is ours. India is the best investment bet, long term. India is where China was in the late 1980’s – somewhere between emerging and developed. India’s real GDP has more than doubled in the past 10 years and during the past 3 years; the Bombay Stock Exchange (SENSEX) has gone straight up with only minor dips reflecting a growth rate of 8%.
The growth of India’s highly educated middle class has increased, as industries like software and pharmaceuticals flourish in service –industry hubs like Bombay, Hyderabad, and Bangalore. The expanding middle class is now bigger than the entire population of the U.S. This has fueled a boom in consumer spending propelling growth in other segments of the economy.
Viewing this potential, institutional investors have poured more money into the Indian stock market over the past three years than in the preceding 11 years put together. At the root of this change is a reappraisal of the country’s economic potential. India could be the third largest economy in the world by 2020!
In contrast to China, India has given greater weight to stability than efficiency, an investment that could pay significant dividends but only in the long run. China has built its infrastructure at a breathless pace, but India has painfully forged an independent judiciary, a free press, and a vibrant pluralist society, institutional advantages that may mean “the Indian tortoise will eventually overtake the Chinese hare”.
The buzz on Wall Street makes India’s rise seem inevitable. Yet there are some problems. India still has limits on foreign investment ownership and doesn’t have a tradable currency. Much depends on sustaining a growth rate of 7% to 8%, the minimum needed to create jobs in what will (by 2050) be the world’s most populous country. The risk is that a timid coalition government might miss the chance to fulfill India’s potential.
But India is also a contradiction; almost 300 million Indians live on one dollar a day and can never be sure where their next meal will come from. There are soaring billion dollar information technology industries and yet millions of wooden plows in the fields outside of the cities. Finally, while 170,000 engineering graduates are trained every year, nearly 1,000,000 malnourished children die annually from contaminated water. India claims to graduate 400,000 engineers a year. However, if you define “engineer” by U.S. standards, the figure is 170,000 a year; versus the U.S. graduate total of 200,000.
Overall, in India and China together, we’ve unleashed 40% of the world’s population on the road to capitalism.
China looms behind India and the dance between the two rising Asian powers and the US will grow even more intricate and intimate in time…certainly in the next decade… and the relations between India, China, and the US will outweigh all the others.
JAPAN
Next to the U.S., this is the 2nd largest economy in the world. Japan has been recovering from deep-seated economic problems that started after the collapse in the early 1990’s of a stock and property bubble that left banks with trillions of dollars of bad loans on their books. The bad loans jammed up the financial system, putting more drag on growth and triggering an economy-shrinking deflation. Japan has dozens of huge companies with superior technical and capital strengths (Toyota, Honda, Hitachi, and Fujitsu). From a 1989 high of nearly 40,000, the NIKKEI Dow traded well under 8,000 at its low in 2003! Since then the market has slowly recovered into the “high teens”. The Japanese market under-performed most global markets in 2006, but we believe will over-perform by late 2007. Japan is a buy. Preferred method of participation is by buying the Exchange-traded Fund (EWJ) that replicates the Nikkei Index.
Latin America
Brazil is the better market in Latin America. Political situation friendly under President Luna. Recently, Moody’s increased Brazil’s credit rating. Mexico is second best market. New president has been more business friendly – 80% of its exports to U.S which is slowing due to housing bust and stricter border controls. Mexican state-run oil company (Pemex) is a “mess”. Peru with its new trade agreement with the U.S. could be interesting in the next two years.
Europe
European stocks are still in strong uptrends reflecting improving confidence of business mangers and consumers. The Dow Jones Stoxx 600 index, which represents Europe, is in its fifth year in a row of double digit total returns in dollar terms. Some investors view Europe as a bureaucratic region with limited growth opportunities.
Not so. Europe is host to many world-class multinationals that do business all over the globe. For example, companies like Siemens, Nestle’, Danone, and BMW have expanded extensively overseas. In addition, investors need to recognize the pro-growth, less regulated and market-oriented wing of Europe best represented by Ireland. Americans like to think of themselves as the leaders of global capitalism but a number of other nations are right behind the U.S. and gaining ground.
The 2006 Index of Economic Freedom, which is an annual analysis of how free an economy, is measures 161 countries in ten broad factors of economic freedom. Last year, Ireland ranked third, Luxembourg fourth, the U.K. fifth and Denmark eighth. The U.S. tied for ninth place with Australia and New Zealand.
Presently, European stocks trade at an average multiple P/E of 13.3 times 2007 consensus earnings per share compared to the US multiple of 15 - 16 times. The euro zone stocks should continue to benefit from the same favorable conditions as in 2007.
Eastern Europe
One of the great investment stories has been the outsourcing of jobs from the U.S. and Europe (and even Mexico) to cheaper Asian labor; particularly to China and India. The main attraction has been cheap labor but equally important is that nearly all educated Indians understand and speak English and work at a fraction of Western labor costs. But there are also other non-Asian countries that offer the same advantages: relatively cheap labor and well-educated workers who speak English as a second language. Meet India East – Eastern Europe; the combination of countries such as Czech Republic, Slovakia, Hungary, Poland, and soon, Rumania and Bulgaria. Here you can hire 4 employees for one German employee. Outsourcing in Eastern Europe is estimated at about $2 billion a year – a mere fraction of the global outsourcing business at about $386 billion. However, the annual growth in the next four years is estimated to expand 30%.
Outsourcing is one of the smallest visual signs of this burgeoning area of a highly educated multi-lingual pool of talent at ease in English, French, German, and Russian as well as their local languages. The rapidly growing affluent population which is forming a new consumer base with their income from industrialization and service spent on refrigerators, ranges, wide television screens and bigger cars. This represents one of the greatest untapped markets for services and consumer goods.
Relatively low wages spur the pace of industrialization. Employees in Hungary and the Czech Republic earn a quarter of what employees in Western Europe make. Slovakia’s salaries are only a fifth. Further, their governments are offering fiscal attractions like simplified tax structures and subsidies for office construction.
Further, the major cities of Eastern Europe such as Prague, Budapest, Warsaw and Bucharest are significant population complexes with culture and the amenities of civic life that are smaller copies of London, Paris and Berlin.
Finally, Eastern Europe represents a stable political and economic environment.
ENERGY (mainly oil)
Supply – most of the major oil fields in the world outside of the Middle East have peaked. Norway just peaked – the North Sea and the U.S. has peaked, at least for now. Still left outside the Middle East and growing are Angola, Gabon, Nigeria and Brazil, with a new 9 billion barrel discovery.
More than 18 billion barrels of oil have been sent down form Alaska and still pumping. Next to Prudhoe Bay, the Alaskan northern wilderness lie reserves estimated at 10 billion barrels still untouched.
Still to be exploited is the oil off the coast of the U.S., and especially the Gulf of Mexico.
Oil & Dollars
China’s share of world oil consumption now stand at 8%, double what it was not all that many years ago, while its appetite for copper, coal, iron ore, steel, you name it has grown apace. Working on the assumption, apparently, that if you build, they’ll come, the country has been building highways like made and auto output was up something like 25% last year.
The picture in oil is much brighter than the price of the shares and the recent action of crude suggest, and $50 a barrel looks like a firm floor. For one thing the cheapest alternative fuels and extraction of petro from oil sands aren’t profitable below that level. For another: several OPEC members are suffering from a budget pinch. Iran and Venezuela prominently among them, and anything less than $50 exacerbates their financial woes.
The big price run in corn, fueled obviously by the hype about ethanol may well have far-reaching implications and not all them happy. Among other things, the resultant sharp run up in food prices could m ore than offset any benefits the consumer might enjoy from lower energy costs.
Energy
Major Western oil companies are struggling to adjust. Ninety percent of the worlds’ untapped conventional oil reserves are in the hands of governments or state-owned oil companies, far more than was the case several decades ago. It doesn’t appear that the planet is running out of crude, as proponents of the “peak oil” theory have argued. But some oil experts foresee the big Western oil companies running out of easy-to-tap oil and most of them are already turning to harder-to-recover reserves.
Royal Dutch Shell PLC and Exxon Mobil Corp are making gargantuan bets on liquid fuels derived form natural gas. Shell and Total SA of France are extracting fuel for m the gooey tar sands of Canada. ENI SpA, the Italian oil major, recently paid $900 million for the right to explore for oil off the shores of Angola. The search for new reserves has become “a nightmare”.
Oil accounts for 98% of the fuel used by the world’s cars, trucks, and planes. With new crude supplies lagging behind demand growth, a new energy economy is emerging in which a mosaic of other fuels will supplement crude, some energy experts contend. Bio diesel, a specialty processed vegetable oil that is often mixed with petroleum, and clean-burning liquid squeezed from natural gas are among the resources that will become essential for keeping the world humming. The transition away from oil may take 20 or 30 years, but it has to start now.
Crude-oil production by nations who aren’t members of the Organization of Petroleum Exporting Countries (OPEC) is widely expected to peak round 2010. Outside of Russia and the Middle East, the biggest opportunities today are in deep waters off politically volatile Africa and in the Caspian Sea, not in the West. The forecast is that world oil demand will rise 37% by 2030, to 115 million barrels a day from about 85 million today. But the oil-producing nations with the greatest pumping potential either will not or cannot tap their resource sufficiently to meet those projections.
Producing nations also face booming demand at home. Gasoline use in Iran, where the capital city is clogged with cars, is rising by 10% a year. Oil demand in the Middle East has risen by 13% since 2003; a growth ate nearly as high as in China.
Saudi Arabia which sits on a quarter of the worlds oil reserves, also intends to consume more crude at home. The world’s largest oil exporter is beginning new industries that rely on petroleum in an effort to leverage its primary resource, much as China did when it harnessed its vast labor supply to become a global manufacturing power. One goal is to create export-oriented fertilizer and aluminum industries.
Ecuador expelled Occidental Petroleum Corp over a contract dispute. Bolivia’s president nationalized his country’s gas fields, dispatching troops to 53 fields and ordering foreign firms to renegotiate contracts. In April, Venezuela seized fields from Total and ENI.
Divide oil history into three epochs. The first was a 100-year ear of plenty and U.S. control that lasted until 1970, when prices averaged $13 a barrel in 2004 dollars. The second, an era of transition and rising OPEC influence, lasted until 2004 and saw price average $36 a barrel over that period. The current era – just two years old – looks to be a messy one, with more potential for supply shocks and clashing over resources. Prices are likely to stay volatile as consumers try to outbid each other for constrained and vulnerable flows of crude. Rising prices tend to act as a rationing device, knocking some consumers out of the market altogether. But rising oil prices also encourage alternatives: tar sands, ethanol, etc.
ENERGY – OIL
At the start of 2004, a barrel of crude oil was trading in the low $40’s. Today it is significantly higher (recently $78)! Why? First, less supply with OPEC quotas. Secondly Iraq production not as good as expected. Iraq has been a major producer. Political tension in Nigeria and Iran; unrest in Indonesia, all major oil sources. Further, continued stringent environmental regulation reduces drilling offshore of U.S., the most likely area for oil.
Demand has been increasing. China has doubled consumption since 1990 and that consumption is rising. Add to that rising oil demand in U.S. and the rest of the world. Finally, insufficient refinery capacity in the U.S. significantly adds to the price of gasoline.
All of the above leaves the U.S. open to political blackmail or terrorist disruption of supplies en route to the U.S. Extra security at oil fields and refineries increases costs. Further threats against oil fields and pipelines raises the “disruption premium” which is now close to $20 a barrel of oil. Nigeria, Venezuela, Indonesia are current examples of unstable oil suppliers. As a nation, we have done very little to reduce our dependence on oil and we continue to finance those nations that are seeking to destroy us!
GLOBAL RESERVES
Interestingly, the world has plenty of oil but none of it is cheap. The largest known reserves, of “conventional” crude are in the Middle East. Saudi Arabia possesses the largest reserves followed by Iran, Iraq and the smaller Gulf States. Non-Mideast sources include Indonesia, Mexico, Venezuela, Nigeria, and Norway. Note that a country’s reserve figures, as opposed to oil companies, are not completely reliable and should be viewed in that context.
Canada’s tar sands have a proven recoverable reserve (by U.S. Dept of Energy estimates) of more than 174 billion barrels. However the heat and steam necessary to extract oil and the transportation costs make this oil more expensive but increasing viable at current prices and oil production is increasing. Incidentally, the Canadian tar sands rank second to Saudi Arabia reserves.
The Orinoco River basin and tar sands in Venezuela are estimated to have 1 trillion barrels of oil and 80 billion of conventional oil reserves. Because of accessibility and cost, these reserves are potential but uneconomic.
Alaskan Wilderness – highly controversial but could help reduce U.S. oil dependency. If drilling started this year, 900,000 barrels a day by 2013! That would be 2/3’s of what we import daily from Middle East. Incidentally, Prudhoe Bay Alaska, another once disputed project, recently delivered its 15 billionth barrel through the Alaska Pipeline.
The Straits of Florida contain a significant amount of oil, estimated at 20 billion barrels. In 1977 the U.S. and Cuba signed a treaty dividing the oil-rich straits down the middle; half to U.S. and half to Cuba. Environmental regulations ban drilling on America’s half. Cuba, however, has allowed drilling with 8 oil discoveries so far.
Finally, there is no shortage of oil but a growing shortage of cheap oil. Just one oil shale formation in Western Colorado – the 1200 square mile Piceance Basin – contains an estimated 1 trillion barrels, more than all the proven reserves in the world. Unfortunately, it is oil imprisoned in shale rock which has to be crushed processed to extract this oil. Expensive but doable in the next decade, probably.
Other sources of energy …. Wind, sun, etc. too expensive or unreliable (wind, water, sun). For example solar energy requires battery storage after sunset, yet battery storage technology is lagging and woefully inefficient at present time.
Some unpopular comments regarding energy: One of the most effective ways to solve our energy problem is nuclear power. No nuclear power plants have been built in a generation yet today more than 8% of U.S. energy consumed is generated by U.S. nuclear plants. Nuclear is the cheapest fuel based on energy content. The large upfront costs of building plants are due largely to delays and regulatory requirements based more on fear than fact. And the relation between "nuclear" and "bomb" has frightened the average U.S. citizen. Yet Japan which has had a more intimate connection with nuclear weapons gets 25% of its energy from nuclear energy; France 80% and aside from the Chernobyl nuclear accident (which was due more to Russian mismanagement than nuclear technology, there have been no problems from radiation or accidents.
Coal Liquefaction is another interesting alternative for both the US and China. The Germans used coal liquefaction during World War II when their wartime supplies of oil wore thin. So did apartheid South Africa in the 80’s and 90’s when it was under global embargo. Other major projects are on tap in Australia, Japan and the US. The state of Montana alone has coal reserves equal to one quarter of Middle East liquid reserves!
Coal gasification was once widely used by US utilities. Most sites now are shuttered, but rising gas costs have increased potential for rebirth.
ETHANOL
A Cornell University study found that it takes more than a gallon of fossil fuel to make on gallon of ethanol – 29% more. That’s because it takes enormous amounts of fossil-fuel energy to grow corn (using fertilizer and irrigation), to transport the crops and then to turn that corn into ethanol.
Comparing the U.S. drive for energy independence with Brazil, note that the American automobile market is about 23 times larger. To produce enough ethanol for the entire U.S. car market would mean planting over much more of the country than Iowa and setting up an infrastructure – filling stations and transportation.
Further, U.S. taxpayers today pay twice for ethanol: once in crop subsidies to corn farmers and again in a 51-cent subsidy for every gallon of ethanol. Without such a subsidy, ethanol simply wouldn’t be cost competitive with gasoline. Then last year, Congress went further and passed a new ethanol mandate, requiring drivers to use at least 7.5 billion gallons annually by 2012.
Ethanol must also be carried by truck or rail, rather than through pipelines, and it requires special blending facilities. The hope is that every gallon of ethanol will supplant a gallon of gasoline imported from tyrannical Mideast and Venezuelan oil regimes. Thus, a la Brazil, ethanol can help the U.S. achieve the miracle of “energy independence.”
Three major factors in viewing the stock markets’ condition are:
investment psychology
monetary conditions
stock valuation
Investment Psychology
Very negative especially in the case of individual investors. The American Association of Individual Investors Bullish and Bearish Survey is one of the best indictors of the individual investors’ psyche. In October (October 15th), the bullish sentiment was high…very bullish. Now, in late January, it is at an extreme negative level – the lowest in 20 years since the survey started!
In terms of valuation: Corporate insiders (executives and directors) are buying their company stocks at the highest level of any time in the past four years. One final point about valuations of stock in the U.S. markets. The S&P 500 is selling at about 15 X 2008’s “expected earnings”. Further, the large cap stocks represented by the S&P derive 40% of their profits from outside the U.S.
Monetary Conditions
The Federal Reserve has increased money supply in the banking system since August. It has also lowered both the Fed Funds rate and the Discount Rate a number of times since last summer and more cuts are indicated.
Why is the Fed so important? Because interest rates always matter for equities as well as bonds. The influence of interest rates on the equity market is profound. While some experts argue that interest rates are not that important to the stock, the historical facts argue otherwise.
Interest rates have been a major factor for stocks over the past 50 years. Indeed, a quick breakdown of the two major contributors of equity prices shows that corporate earnings have been accountable for about 60% of the price of equities since 1980, while the decline in interest rates, and the subsequent expansion in the market’s multiple, has contributed the other 40%. Interest rates are of greater concern to equities at this time, since the S&P 500 is more rate-sensitive in terms of financial stocks today than it has been in several decades. A sustainable rise in the long end of the bond market would at the very least dampen equity returns going forward. The direction of interest rates rise depends on the course of the economy and especially energy and commodity costs.
The Fed will cut the Fed Funds and the discount rate this month and several times in the first six months of 2008. We expect the Fed Fund rate to be below 3 % by this summer (2008).
Our confidence in a series of rate cuts and its positive effect on stock prices is based on the history of such cuts. In the last 28 years the Federal Reserve launched five rate-cutting cycles. These were under Chairman Volcker and Greenspan. No 5 and Bernanke’s debut started Tuesday, 9/24/07. Under Volcker and under Greenspan, six months after the first rate cut, the U.S. stock market was higher in four of the five periods.
The exception was in 2001, when the NASDAQ bubble burst and a 2001 recession became extended by the shock of 9/11 terrorist attacks. We believe that the 2001 experience is an outlier because of the terrorist shock. Exclude it.
Investors with a six-month time horizon must not ignore this history; if they do, they risk underperformance. Even with the excluded periods of a first rate cut in January 2001 investing now is not such a bad risk to take. The market was down 8% then. So history gives us four of five successes with the cost of failure estimated as an 8% loss. Theses are compelling odds, which favor being fully invested at this time.
Stock Valuations
The correlation between the 10-year Treasury yield and the S&P 500 12-month forward earnings yield. It shows that money goes where it is treated best. Compared with the yield of the 10-year Treasury note, stocks are about 42% to 43% undervalued. The market has only been this cheap five other days in 28 years. These five days marked the closing lows of the bear market in 2002 and the days of the successful retests and bear market end in March 2003. The market was up more than 30% 12 months after the 2002 lows and more than 40% from the March 2003 lows in the next 12 months. When you get too much pessimism people expect earnings will come down, and when that happens, people will not pay much for earnings, and so they’ll buy the bond instead. When you get too much optimism, as happened in 1987 and 2000, people expect earnings to grow to the sky and they will pay more for them.
In summary, the U.S. economy faces significant economic and financial headwinds in 2008 as well as high volatility in stocks. All seems gloomy at the moment (January 2008) but remember that the financial world is susceptible to alarmist rhetoric…fear sells. Here are some headlines from the L.A. Times:
Feb. 5th “Stocks Take Worst Dive in Two Months
March 19th “62 Economists Believe Inflation Will Get Worse”
March 29th “Interest Rate Fears Weigh Down Stocks”
May 9th “U.S. Faces Mounting Trade Problems!”
Sound familiar? – they should. But all of these headlines are from 1974 not 2007. Headlines don’t seem to change. People read these headlines and worry, unable to move ahead…bunker mentality.
Highly volatile and unstable stock markets make investors fearful. Emotion overtakes financial logic. In any other business, markdowns of 30% - 40% in price would be embraced as bargains – time to buy! Unhappily in the stock market, even sophisticated investors are frozen into inaction. That is why making money in stocks (or any other commodity) is so difficult.
Happily, the record since 1900 for stocks (New York Stock Exchange) shows that the market goes up 70% of the time. Good odds for sensible people.
For more information from Frank Cappiello regarding this commentary or his firm, please contact him at
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