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May 29, 2009

Bear Market Rally or Real Rebound?
by William Thomson

OVERVIEW

THERE is a great divide among economists on whether the global economy has begun a sustainable recovery from its worst recession in 70 years or is simply slowing its rate of contraction. Are the so-called 'green shoots' of recovery firmly rooted, or just frail seedlings destined to wither again in an economic climate of prolonged stagnation and deflation? For investors, this translates into a question of whether stock prices are poised to enter a new bull market or are simply in a classic bear market rally. BT gets the views of four pundits.

PARTICIPANTS

Moderator: Anthony Rowley, BT's Tokyo correspondent

PANELLISTS

Eisuke Sakakibara, professor at Waseda University and formerly Japan's vice-finance minister for international affairs

Mark Mobius, executive chairman, Templeton Asset Management

Jesper Koll, president and CEO, Tantallon Research

William Thomson, chairman, Private Capital Ltd, and senior adviser to Axiom Funds

Anthony: Prof Sakakibara, you took a bearish line on prospects for global stock markets when you spoke at an investment seminar in Bali during the Asian Development Bank annual meeting there a few weeks ago. Do you still feel the same way?

Eisuke Sakakibara: After two quarters of very sharp economic decline, it is only natural to have some kind of rebound and that is what is happening now. Stocks have rallied but this is what could be called a bear market rally. Look at the Nikkei - it has gone above 9,000 towards 9,500 but it has now hit the ceiling and is coming down and it will again break 9,000. People try to cling to any sort of good numbers and there are some good numbers here and there after a very sharp decline. But I think this will be a fairly deep and prolonged recession. This is what could be called a 'balance sheet recession'. A financial bubble has accumulated during the course of the past 10 or so years and it burst in 2007. Asset prices have come down, both in real estate and in equities. Although there was a rebound in the equity market, house prices are still coming down and will continue to come down for another year or so. That has really hurt the balance sheets of individuals and corporations. It takes time to adjust balance sheets and this is exactly what we experienced in Japan in the 1990s. It is now happening to the US.

Anthony: Mark, you fired up the audience at the same seminar with your bullish views. How are you seeing things now, and when do you expect a resumption of sustainable growth in the global economy?

Mark Mobius: I think that growth has already begun and that it will continue as long as governments around the world continue to stimulate their economies and to increase the money supply.

Anthony: On which side of the divide do you stand, Jesper?

Jesper Koll: The global economy started a cyclical recovery around March-April 2009. Three factors are at work. First, the cumulative effects of the unprecedented mobilisation of public resources is starting to bite and is now sufficient to counter the negative pull of private demand. Second, the drop in global energy and commodity prices brings a very welcome boost to the terms of trade for industrial countries. And finally, corporate managers are seeing positive results of their very dramatic cost-cutting and restructuring actions taken since last fall - inventories are back under control and breakeven points have been cut. The last point is key because this is why business confidence is beginning to improve. Last autumn, corporate managers did not know what hit them, the shock was unprecedented. Now, they are back in control. Excess debt, excess capacity and excess jobs have been cut. The question now is whether anybody in the private sector will step-up to actually raise investment, build new factories, new call-centres, new supermarkets. Bold entrepreneurs will be much better off buying distressed assets, distressed companies on the cheap, rather than building new facilities from scratch. I expect a boom in mergers and acquisitions, massive industry consolidation, be it steel, shipbuilding, refrigerators or flat panel screens. In other words, the private sector will get 'leaner and meaner', rather than adding new capacity. It will be a golden age for entrepreneurs, but the overall economy will suffer because the public sector will have to start the payback for the massive intervention. Everywhere, from China to America, taxes will go up, interest rates will go down.

Anthony: And you, Bill?

William Thomson: The omens are not good. Sustainable economic recovery in the wake of a banking crisis takes longer than a standard cyclical adjustment. Japan stuttered along for a dozen years before 'enjoying' five years of sustained, substandard growth. In a sense, it has never fully recovered to its pre-crisis conditions. After a dreadful winter, spring has arrived and the US economy seems to have pulled out of its nosedive; however, it is a second derivative phenomenon; the rate of decline has slowed but the direction is still down. With the huge amounts of bailout money being pumped into the economy through both the budget and monetary operations, we are closer to stabilising things. Inventory adjustment is largely complete and restocking at some level must recommence. De-leveraging, unfortunately, still has a way to run. In summary, the road ahead will be bumpy. We may see a positive quarter or two by the end of 2009 or early 2010. But that should not be confused with renewed sustainable growth. We are all Japanese now!

Anthony: How soon is recovery likely to translate into improved corporate earnings and thus higher stock prices - or has the market rally fully discounted improved prospects?

Mark: (The recovery) is already beginning to impact corporate earnings. It is important to note that not all companies are seeing decreased earnings. A number have already announced increased earnings. The market is looking to 2010 and it apparently likes what it sees. Of course, there will be overshooting and corrections along the way.

Jesper: Everywhere, the terms of trade for corporations are improving - wages are being cut, unemployment is rising, commodity prices drop, supply-chains are being streamlined. And even the big Japanese conglomerates are finally beginning to sell off non-core divisions to focus on core-competence. In my view, corporate profits will explode and analysts estimates are far too pessimistic. This is true for the US, for Japan, and especially for the Asia-Pacific. Europe and Latin America will lag behind because corporate managers there are relatively more complacent.

William: The recent rally has been quite strong, as would be expected after the crash of 2008/2009 when the market was dramatically oversold. In my view, it provides investors with a great opportunity to adjust their portfolios and perhaps build liquidity for better opportunities ahead in the coming months. 'Sell in May and go away' continues to have validity. It is too soon to know whether we are in a bottoming process or an interlude before going to new lows. I tend towards the bottoming process viewpoint because the money being printed has to find a home and there are values around for the careful stock picker although the experience of 1929-32 would indicate we could still go to new lows from here. I would expect earnings to be higher in 2010 than this year, more because costs are being reduced so savagely than revenues are rising.

Anthony: How do you view the prospects for new credit creation by banks and non-banks, since this is presumably critical to any pick-up in consumer demand in the US and other advanced economies?

Eisuke: All the major banks have received public money and that is why they are surviving. They have to continue to rely on public money for some time to come. Some of the positive results we are seeing are at least partly the result of change in accounting rules. Mark to market rules have been relaxed somewhat. We should be careful in assessing what is now happening.

Jesper: Bank credit growth is accelerating smartly and the balance sheet constraints are largely an issue of the past. Whether borrowers are credit worthy is really the only constraint we have now. Now, bankers are back to being traditional bankers and, whether you like it or not, a significant part of US households simply do not qualify for a long-term mortgage or loan. Clearspeak - until now, it was the banks' balance sheets that had to get cleaned up. From now, it is the consumer balance sheet that needs to show real improvement. Only when 'Joe Sixpack' has paid back debt and brought liabilities back in line with assets and future income stream, will we see growth in the stock of mortgage credit and consumer credit. Probably, this balance sheet clean-up will take at least another 12-18 months. In the meantime, a big opportunity for banks will be the coming wave of privatisation - the massive purchases of credit by governments and central banks will start to be sold back to private investors. In my view, the valuations of these coming deals will be key to future financial performance.

Mark: The prospects for new credit creation are very high in view of the increased money supply and lower interest rates. Banks will be hard pressed to continue conservative lending policies.

William: Banks have funds to lend but credit has contracted in the economy as a whole largely because of the severe contraction of the shadow banking system. Two years ago, for instance, hedge funds had US$2.5 trillion under management; today, that is about US$1 trillion and de-leveraging is still underway. The result is that banks are now more cautious and requiring larger downpayments as housing prices remain under pressure. In addition, a form of financial protectionism is occurring worldwide. As governments have assumed more influence over their banking systems, they are forcing banks to keep up lending at home with the result that they are reducing their overseas activity.

Anthony: Even if banks become more accommodating, do you think people will be prepared to borrow in order to finance consumption before they have paid down existing debt and cleaned up personal balance sheets?

Eisuke: No, they are now adjusting their balance sheets. They have borrowed too much and they have borrowed against assets, prices of which have risen quite dramatically during the past 10 years. Now, asset prices have come down and they have to repay their debt and that is why the savings ratio is increasing. This will at least continue for another year or two. The corporate sector will remain in a defensive mode. I do not see any dramatic signs of increasing investment on the part of the corporate sector in the US.

Mark: I doubt that people in the US are willing to give up their lending patterns and deprive themselves of the things they see in the department stores and supermarkets. The US is a consuming society and as long as credit cards are available, the spending will continue. Of course, there will be some downturn in view of the banks' more conservative policies.

William: This is very much a balance sheet recession for the consumer. Their jobs have been lost or are under threat, many have lost their homes and their retirement savings have been halved or worse. The glory days of the American (and British) consumer are well and truly gone. Globally, there has been a wealth loss of over US$50 trillion or one times world GDP and in the US, it is more like 1.5 times GDP. There has to be an extended period of savings build-up before new debts can be taken on. It is a new paradigm.

Anthony: What about the outlook for bond markets given the massive accumulation of government debt in the US and elsewhere and the intense strain on corporate balance sheets. Is there anything to go for in the bond markets?

Mark: Bond market prospects for emerging market bonds are good in view of the declining interest rates and declining interest rate spreads for emerging markets bonds and US Treasuries.

Jesper: Yield curves are steep and particularly long-term bonds offer good value, in my view. The rally in bonds will start the moment the government starts raising taxes or cutting spending. And the Fed beginning to talk about an exit from quantitative ease will, in my view, also be good for long-term bonds. Why? Because it is highly likely that the Fed will do exactly what the BOJ did in Japan - start tightening too early. Timing-wise, I think this will become a very interesting play from this autumn.

William: It seems quite possible that the next bubble that is being created is in government debt. The US went into this recession with a balance sheet debt of around US$6 trillion. It has just about doubled in the last year if you count Fannie Mae and Freddie Mac debt, now they are effectively nationalised. Then, you have a further US$45 trillion off-balance sheet liabilities, according to the Peterson Institute, of largely untouchable entitlements such as Social Security, bringing debts to about 350 per cent GDP, which compares with 250 per cent GDP at the peak in 1929. The US budget deficit this year and next is estimated by the Congressional Budget Office to be US$3.1 trillion, or 22 per cent of GDP. The UK is in much the same situation and, indeed, there are sensible voices warning the country may once again be forced into the arms of the IMF. Government bond prices went to unsustainable levels over the winter and spring and are now reacting to the expected flood of issues. Since a bout of inflation is an unspoken, but probably essential, element in working out of the present situation, I would not buy long-term governments. Intermediate term maybe and inflation indexed bonds certainly. For those capable of an analysis of corporate resilience in today's turbulent times, there are opportunities given their unduly large spreads over governments.

Anthony: Which areas of the equity market are likely to see more than a temporary 'relief rally' in advanced and emerging (Asian especially) markets?

Eisuke: Corporate earnings are down. Look at the earnings of major Japanese corporations. Most of them are in deficit. This is the worst experience during the course of the past two or three decades.

Jesper: Prospects for corporate earnings are best in Emerging Asia, Japan and the US. Europe and Latin America are lagging behind. Key here is how aggressive corporate managers are in restructuring their business, much more so than what government policy is doing. This recent rally, in my view, is not a bear market rally, but the beginning of the new reality - markets will be highly volatile and much more range-bound, rather than trending upwards. You have to be stock specific, company specific. While there are many uncertainties, one thing is clear - the gap between the good companies and the bad ones is going to widen dramatically in the next couple of years. This is true for Emerging Asia, China, Japan or the US.

Mark: Most interesting are the consumer and commodity areas. Per capita incomes continue to rise in Asia and emerging markets in general, so the prospects for consumer-oriented stocks is good. With growth continuing in the most populated countries in the world, China and India, commodity prices will continue to recover.

William: Let me start with gold. It remains an essential insurance element in portfolios today as a hedge against inflation, currency devaluation and general chaos. I look for higher prices over the next few years. The US dollar's position as the sole reserve currency is being called into question as never before and the Chinese are putting their heads above the parapet for the first time. They quietly doubled their gold holding between 2003 and 2007 and I believe they have continued to build them since then. It is the same for the Russians and must only be a matter of time before other Asians and Middle East governments do the same. Commodities were dumped in last year's meltdown and prices have recovered somewhat as inventories, especially China's, are rebuilt. They have a place in portfolios, especially agricultural ones where prices remain depressed. Ditto natural gas. I continue to prefer some Asian emerging markets, including the Asean ones which are commodity exporters and do not have problems with their banking systems. Taiwan, with its improving relations with the mainland, is an interesting recovery play. I do not like Eastern Europe which still has a horrendous adjustment to undergo. Brazil, with its increasing ties to China, is very interesting. In developed markets, the US is probably further through the recession cycle than Europe. There are probably opportunities there in the areas that Obama's economic policies favour, including green and renewable energy, medical care and biotech and infrastructure.

Anthony: Prof Sakakibara, or perhaps I should address you as 'Mr Yen', I can't resist the temptation to ask you, in closing, for any comments you may have on the outlook for currency markets.

Eisuke: Currency market will be quite volatile. For the time being, the yen will appreciate and it is perceived as a safe haven. Despite the fact that the performance of the Japanese economy and the Japanese market is not good, I see some further appreciation towards 95 in the dollar-yen. The dollar will be strong against the euro. The yen may strengthen somewhat further, both against the dollar and the euro.

Anthony: Thank you all for sharing your wisdom with us.

KEY POINTS

Bold entrepreneurs will be much better off buying distressed assets, distressed companies on the cheap, rather than building new facilities from scratch.

Sustainable economic recovery in the wake of a banking crisis takes longer than a standard cyclical adjustment.

There has to be an extended period of savings build-up before new debts can be taken on.

It seems quite possible that the next bubble that is being created is in government debt. Government bond prices went to unsustainable levels over the winter and spring and are now reacting to the expected flood of issues.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2009 William R. Thomson

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