Chinese Economy and Stock Market Rebounding

In our October 1 Outlook, we rejected the then fashionable prediction of a hard landing for the Chinese economy and, rather, we forecasted GDP growth accelerating from 7.4% in this year's 3rd quarter to about 8.5% in 2013. Since then there have been numerous indications that this economic rebound is already underway and is gaining momentum. Investors have taken note. The iShares FTSE China 25 exchange traded fund (FXI), which represents the performance of 25 of the largest company stocks that are available to international investors, has jumped 22.0% since September 5, whereas the S&P 500 Index has mustered only a 1.9% gain. We think the Chinese economy has turned the corner, and in 2013 its stock market will likely lead other emerging economy markets to a strong absolute and relative performance.

Earlier this year, the Chinese economy was slumping in response to aggressive steps taken by policy makers in 2011 to curb rising inflation. As the consumer price index retreated from over 6% in 2011 to below 2% by last September, the government increasingly shifted to accommodative policies of tax reductions, interest rate cuts and infrastructure investments. International Strategy and Investment (ISI) in November counted 63 stimulative policy initiatives over the prior year. They are clearly having an impact following a 7-quarter slowdown:

• Retail sales rose 14.2% in September with additional gains of 14.5% in October and 14.9% in November (the fastest pace this year).

• Industrial production beat forecasts with impressive year-over-year increases of 9.6% in October and 10.1% in November.

• The Purchasing Manager's Index (PMI) moved above the critical 50 level in both October and November; the latter report triggered the largest rally in the Shanghai stock market (4.3%) in 3 years.

• Fixed asset investment, a widely followed measure of capital spending, is again on the rise. Commodity imports, especially copper and iron ore, are rising and infrastructure development is experiencing upward momentum.

• Steel production, electricity demand and production, and rail freight are rising.

• Bank loans increased a blistering 15.6% year-over-year in November.

• Housing sales have picked up, indicating that the downturn in residential and commercial property has stabilized.

• Exports grew a surprisingly strong, above-consensus 9.6% in September and 11.6% in November.

Heading into 2013, the Chinese economy has the strong support of the new political leadership in Beijing as well as considerable momentum. The government's preoccupation with economic prosperity is rooted in their conviction that economic growth and political stability go hand in hand. They know that they can no longer rely on robust U.S. and European demand for Chinese exports to create adequate employment demand. A recent study by the Boston Consulting Group concludes that the potential is huge: by 2020, the middle class in powerhouses China and India is estimated to reach 1 billion and consumer spending is expected to triple to a combined $10 trillion a year.

Not surprising is the rising optimism for China's economy and stock market. A poll of 862 international investors taken by Bloomberg in November indicated that confidence in China's economy is at the highest level in more than a year: 72% of respondents see the economy improving or remaining stable - up from 38% in a September survey. They also view the Chinese stock market as the 2nd more attractive (behind only the U.S.) in 2013.

Global Investors Turning More Optimistic

        The latest Bloomberg Global Poll (November 29) indicates that investors are increasingly optimistic due to China's improving prospects and a rising expectation that the U.S. will avoid the so-called "fiscal cliff." Highlights from the 862 poll respondents are:

• The world economy is in its best shape in 18 months. Two-thirds of investors polled think the global economy is either stable or improving (up from just over half in September).

• Three out of four respondents expect Washington politicians to reach an agreement to avoid the fiscal cliff.

• Stocks are the asset of choice, with the U.S. and Chinese markets the most attractive and European Union markets the least. About half of the investors plan to increase their exposure to stocks in 2013.

• Home prices as well as stock prices will rise in 2013, which will improve the wealth effect and boost consumer confidence and spending.

• Bonds are the least appealing asset (trailing stocks, real estate, and commodities) and almost half of those polled intend to reduce bond holdings in 2013.

        The above views expressed by participants in the Bloomberg poll echo Marietta's October 1 Outlook, indicating that our forecast has been adopted by a majority of the international investor community.

U.S. Economic Outlook

            Prospects for the U.S. economy in 2013 are brightening …unless the politicians permit the economy to go over the “fiscal cliff” (the combination of government tax increases and spending cuts scheduled to take effect at the end of the year unless the Congress and the Administration take preventive action).  We do not expect this to happen, and there may well be a significant stock market gain if a political compromise removes the danger.     

            In our last two Outlooks, we highlighted the progress underway in the multiyear restoration of consumer confidence and spending, the housing market, and the banking industry.  We emphasized that each of these three key sectors was crippled during the 2008-09 recession.  From the outset of the recovery, we referred to them as “structural impediments to growth,” which would take years to heal fully despite pro-growth fiscal and monetary policies from Washington.  Our point was that whereas they restrained recovery over the past three years, we now expect each to support growth in 2013. 

            A number of recent reports and developments lead us to conclude that the U.S. economy is already strengthening:

·                Consumer confidence is at a 5-year high.

·                Consumer spending, bolstered by 2 consecutive upbeat employment reports, is resulting in better than expected retail sales. 

·                A retreat in gasoline prices further supports consumer confidence and spending.

·                The housing market has clearly bottomed in response to rising demand, reduced foreclosure pressure, and record low mortgage rates. 

·                Bank profits are up, balance sheets are much stronger, and loans are increasing.

·                The Federal Reserve has stated unambiguously its top-priority is economic growth and has promised to keep interest rates low until recovery is assured, which many expect to be 2014 at the earliest.

·                U.S. exports may well benefit from the continuing initiatives taken by central banks around the world to stimulate growth.  International Strategy and Investment (ISI), a highly respected economics research firm, has counted 296 easing steps by central banks over the past 14 months.

The mostly positive economic news of the past 1 1/2 months supports our above-consensus October 1 forecast of 2.0-2.5% GDP growth in 2013.  This would not qualify as healthy growth, but nevertheless represents an improvement over 2012.                    

Hurricane Sandy has inflicted significant human hardship and misery, and has caused near-term economic disruption.  However, in the long-term we expect the recovery efforts and the resilience of the people and businesses affected by this tragedy to rebuild, thus mitigating the overall economic impact.

The major threat to our generally favorable outlook for continued economic expansion is the “fiscal cliff.”  We continue to think there will be a political compromise because neither party can afford the risk of being blamed for an avoidable recession.  We are encouraged that leaders of both political parties have expressed a willingness to compromise.  Nevertheless, we do not underestimate the impact of partisan politics and recommend that investors maintain vigilance and flexibility.

We encourage our clients to contact us and let us know their views.

Marietta Thanks Clients

For the 3rd consecutive year, Portfolio Managers John Evans and Kathy Klein have been named 2012 Milwaukee Five Star Wealth Managers.

“Milwaukee Magazine and Five Star Professional partnered to find wealth managers who satisfy 10 objective eligibility and evaluation criteria that are associated with wealth managers who provide quality services to their clients. Among many distinguishing attributes, the average one-year client retention rate for this year’s award winners is more than 96 percent. The 2012 Five Star Wealth Managers are a select group, representing less than 4 percent of the wealth managers in the Milwaukee area.”

- Milwaukee Magazine (July, 2012)

Marietta's mission is to provide the highest-quality professional, personalized, and customized service to our clients. Although the awards are in the names of two of our managers, the credit must go to the entire Marietta team of 12 dedicated professionals. We thank our clients for their loyalty and friendship.

Global Market Developments

The long-term positive case for global stock markets remains persuasive despite building evidence of a synchronized economic slowdown in the U.S., Europe, and the leading emerging economies of China, India, and Brazil.

Similar to last year’s “soft patch,” this year’s slowdown has provoked a debate over how severe and how long the slowdown will be and how financial markets will react.

In May, the initial negative response of investors triggered a “risk off” retreat of global common stocks and a flight to the perceived safety of U.S., German and Swiss sovereign bonds.

The near-term outlook for the global economy and equity markets is uncertain and volatility will likely be elevated.  By year end, however, we expect that the key economies will reaccelerate, as they did last year, and their stock markets will recover, as they did last year.

Long term investors should keep in mind the positive case, which includes:

• Policy makers around the world are responding with stimulative, pro-growth measures
• Oil and commodity costs are declining significantly
• Inflation remains low and is declining
• U.S. and European interest rates are at historic lows
• In the U.S., two major impediments to growth during the recovery are improving:  banks are much stronger and the housing industry is bottoming
• Global stock market valuations are very attractive and the corporate profit outlook remains positive

We will continue to monitor global markets will update our blog as developments unfold.

IMF Supports Marietta Global Growth Forecast

In an encouraging update to its January World Economic Outlook, the International Monetary Fund (IMF) stated last week that “global prospects are strengthening again…” and boosted its 2012 global GDP growth estimate from 3.3 to 3.5%.  In its upbeat assessment, this prestigious and influential organization rejected worrisome gloomy predictions of another “soft patch” in the U.S., of sovereign debt crises and austerity budgets in Europe triggering a descent into a serious recession, and of economic hard landings in China and other leading emerging economies.  The expected gradual reacceleration in growth is attributed to “improved financial conditions, accommodative monetary policies, a similar pace of fiscal tightening as in 2011, and special factors (reconstruction in Japan and Thailand).” 

Further, the IMF raised its forecast for 2013 global growth to 4.1%, and projected accelerated growth increase in the U.S. (from 2.1 to +2.4%), the Euro Area (from -0.3 to +0.9%), and the major emerging countries (from 5.7 to +6.0%).  We note that this positive forecast agrees with Marietta’s Outlooks since mid-2009 that the global economy had entered a multiyear global expansion of about 4% per year led by the emerging economies with the U.S., Europe, and Japan trailing with supportive albeit subpar GDP growth (see, e.g., our April 5, 2010 Outlook).

The IMF economists are hardly pollyannaish, and emphasize that “…the global economy remains unusually vulnerable.”  At the top of their list of risks is renewed escalation of the euro area crisis followed by concern that geopolitical developments in the Mid-East will trigger another spike in oil and gasoline prices.  They acknowledge that their forecasts assume that “spillovers from the euro area are likely to have limited effects on economic activity [elsewhere] for as long as the euro area crisis is contained” and that the price of oil will average “about $110” per barrel.  We at Marietta are also well aware of these and other risks, but we continue to believe that future investment prospects remain.

Although the financial media is preoccupied with downside risks, the IMF also discusses the upside risks.

There are also upside risks: growth might turn out stronger than projected if there is more rapid recovery in the United States and the euro area, thanks to a stronger policy response to the euro area crisis and improved confidence, and if the geopolitical tensions recede and the risk premium in oil prices dissipates. Greater confidence and waning supply-side disruptions could also foster a more forceful rebound in global durables consumption and investment, helped by generally healthy corporate balance sheets and less costly capital.

Good reading: Too Big To Fail: How Wall Street and Washington Fought to Save the Financial System—and Themselves

Good reading: Too Big To Fail:  How Wall Street and Washington Fought to Save the Financial System—and Themselves by Andrew Sorkin (Viking, 2009) 544 pp.

Four years have passed since the collapse of Bear Stearns, which ushered in twelve months of economic recession and financial market upheaval. To historians of the economic history of the United States and its financial markets, the importance of this period is rivaled only by the Crash of ’29 and the Great Depression. The causes and consequences of the 2008-09 crisis will be debated and continue to be controversial for decades to come, but the definitive narrative will likely remain Sorkin’s Too Big To Fail. In 544 pages of gripping day-by-day description of the major participants and developments, Sorkin admirably captures the pulse of Wall Street and Washington during these unforgettable months. The passage of four years provides a fresh perspective for a re-read of this to-be classic, and the book should be required reading for young professionals entering the investment industry.

The most dramatic and historic events of this chaotic year occurred in September of 2008.  In less than 30 days, the financial landscape was forever altered. Mortgage giants Fannie Mae and Freddie Mac were taken over by the government. Lehman Brothers filed for bankruptcy. Merrill Lynch was sold to Bank of America in an eleventh-hour rescue. American International Group, the largest insurance company in the U.S., was put on government life support. Morgan Stanley and Goldman Sachs, in a desperate effort to avoid a similar fate, rushed to become bank holding companies thereby gaining unlimited access to the Federal Reserve’s discount window. The failure of Reserve Primary Fund triggered a panic run on money-market funds that threatened to disrupt the entire financial industry. The Dow Jones Industrials commenced a plunge with unprecedented volatility that by March of 2009 measured 50%.

Sorkin’s narrative centers on the indefatigable and at times frantic efforts of Treasury Secretary Paulson, Fed Chairman Bernanke, and New York Fed head Geithner to steer the financial system through this perfect storm. As they were painfully aware, their actions constituted the biggest intrusion of the U.S. government into free-market capitalism in the country’s history. For this they were and continue to be condemned by many politicians and market commentators. Their defense is that their actions were necessary to prevent financial and economic Armageddon. Bernanke stated in a critical meeting with skeptical congressional leaders:  “I spent my career as an academic studying great depression. I can tell you from history that if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.” In an oval office meeting with President Bush, Paulson said:  “If we don’t act boldly, Mr. President, we could be in a depression deeper than the Great Depression.”  Sorkin sides with Bernanke and Paulson:  “To be sure, if the government had stood aside and done nothing as a parade of financial giants filed for bankruptcy, the result would have been a market cataclysm far worse than the one that actually took place.”  

If Paulson, Bernanke, and Geithner were driven by a determination to save the U.S. economy, the heads of the major Wall Street firms and U.S. Banks were motivated by less lofty considerations.  These titans of American finance worshipped at the altar of personal status, money, and power.  On occasion they expressed concern for their shareholders and employees, but there is no mention of a desire to protect the public good. An example occurred in October, when the CEO’s of the 9 major firms were summoned by Paulson, Bernanke, and Geithner to a make-or-break meeting to approve an injection of taxpayer money into the financial system as a desperate step to restore stability. With tens of millions of American jobs at stake, the initial reaction of Merrill-Lynch CEO John Thain was to complain that such a step might result in changes in Wall Street executive compensation policies.

In an insightful epilogue penned in 2009, Sorkin offered the sober conclusion that the big Wall Street firms and banks remained too big to fail. He asserted further that ego, greed, and a “vulture capitalism” that abuses clients, which were a major ingredient in fomenting the turmoil, were still salient characteristics of Wall Street. Nevertheless, much has changed since the years and months leading up to 2008, and the likelihood of a similar financial upheaval is now remote. The overheated housing market and abuses in the mortgage industry, which precipitated the crisis, now seem to be a unique phenomenon of the past. The banks and investment firms are much better capitalized, much more sensitive to risk, and far more heavily regulated. The government has also learned from the experience, and is far more vigilant and better equipped to identify and respond to excesses before they imperil the entire financial structure. In retrospect, the cataclysm of 2008-09 created widespread economic suffering for millions of Americans, but it also provided a beneficial wake-up call. Sorkin’s book will be a reminder to generations to come of how perilous the situation was and thereby serve as a deterrent to a future crisis.     

Kathy Klein Presents Positive Case for Global Equities

On January 31, Marietta portfolio manager Kathy Klein presented an optimistic outlook for global stock markets to about 90 retirement professionals attending a luncheon sponsored by the Greater Milwaukee Employee Benefits Council.

Kathy opened with a brief review of the challenging market conditions of 2011, when a relentless flow of negative news events convinced many investors that Europe and the U.S. were headed for a double-dip recession. Most of the world’s stock markets declined: the All Country World Index excluding the U.S. slumped 13.7% and the leading emerging-economy markets crumbled more than 18%. The U.S. faired better, not so much because the U.S. economy was attractive, but rather because it was viewed as a safe haven in troubled times. Within the S&P 500 Index, the defensive industry sectors of utilities, consumer staples, and health care were the major winners, and the biggest losers were the economy-sensitive, cyclical industrials, materials, and financials.

Kathy then pointed out that conditions in early 2012 have improved dramatically. The U.S. economy is accelerating, the European policy-makers seem determined to deal effectively with their sovereign-debt crisis, and declining inflation in the emerging economies is permitting their central banks to adopt pro-growth initiatives. Market trends have correspondingly reversed. Global stock markets, led by the emerging-economies, have surged. Within the S&P 500, last year’s leading industry sectors are now the worst performers and vice versa.

The obvious question posed by this reversal is: can the positive market trends of January extend through 2012? Here, Kathy emphasized the importance of the current synchronized global accommodative policies of central banks. It was just such a synchronized global stimulus that was the most important catalyst in lifting the global economy out of the recession of 2008-09 and triggering a new bull market.

Kathy also noted that in many leading global markets the fundamentals and technicals are positive. Time did not permit her to explore these conditions in all of these markets, so she limited her discussion to the U.S. market. In particular, she identified nine indicators which historically have been associated with bull markets. These included GDP growth, strong corporate balance sheets, compelling valuations, subdued inflation, low interest rates, an accommodating Fed, and large cash reserves.

A very interesting and relevant observation made by Kathy was that sluggish GDP growth of 2-3% in the U.S. should not necessarily lead investors to conclude that prospects for U.S. stocks are at best modest. To the contrary, since 1960 periods of weak-to-moderate growth have provided the best S&P 500 gains.

Key to Kathy’s positive case for the U.S. market is continuing profit growth coupled with a very attractive valuation. A high-single digit profit gain in 2012 by S&P 500 stocks in combination with P/E multiple expansion to a non-recession level could produce a solid, double-digit advance for this benchmark index. P/E valuations for the international markets are even lower, and the prospect of a very considerable market advance in the emerging markets is pronounced.

Kathy pointed out that negative news events could again upset the positive case, but concluded with Marietta’s 2012 upbeat investment recommendations:

1.       Be open to the positive case for equities

2.       Take a longer-term view (avoid excessive responses to headline news)

3.       Adopt a global perspective (take advantage of international opportunities)

4.       Watch for risk-on, risk-off decoupling

5.       Beware of macro investing (watch the policy makers)

6.       Track closely the fundamental progress of your securities

Global Stock Markets off to Strong Start in 2012 Led by Emerging Markets

So far this year global stock markets have risen at a rapid pace; extending the rally begun in the fourth quarter of 2011.  Since January 1, the S&P 500 gained 4.5%, a starting year rally not seen since 1987. Over the same time period, the iShares MSCI Emerging Markets Index Fund (EEM) gained 9.1%, the fastest rise since 2001.

Articles in the Financial Times and Bloomberg have noted a pattern in this rally. The biggest decliners last year have led the charge this year. Year to date the EEM, which lost 21.1% in 2011, has gained twice as much as the S&P 500. On a sector basis within the S&P 500, financials, industrials, and materials have been leading the recent rally. These same sectors have greater exposure to emerging markets and were among the worst performers last year. Utilities, health care, and consumer staples had been the best performing sectors in 2011 but have been among the worst performing sectors in 2012.

Economists attribute the surge to a number of reasons:  in the U.S., positive economic data continues to flow, manufacturing is growing, jobless claims are falling, and the unemployment rate is ticking down. Corporate profits remain high and Fed policy continues to be accommodating. Earnings season has begun with 60% of reporting companies beating expectations. Many global central banks are lowering rates in order to promote growth after two years of raising rates. As mentioned in Marietta’s blog Promising News from China, recent events in China indicate that economic stimulus and easing will likely come soon to this engine of global economic growth.

Three weeks do not make a year, but a continuation of current trends could result in 2012 being dramatically different from 2011.

Promising News from China

On January 17, China announced that its economy expanded 8.9% year over year in the 4^th quarter. The news triggered a 4.9% jump in the Shanghai stock market, which was the largest single session gain since October 2009. On this news, the U.S., European and other global markets also rose.

The 8.9% GDP growth is the slowest advance in 10 quarters and is attributed to slowing export demand and a weakening property market. This increases the pressure on Premier Wen Jiabao to ease monetary policy, which would be viewed by investors as a strong positive for the Chinese stock market. On the other hand, the 8.9% was above the 8.7% median estimate of a consensus of economists, and well above the 8% that policy makers consider necessary. This supports the argument that the Chinese economy will experience a “soft landing,” which would also be very positive for the Chinese and other global stock markets.

A “soft-landing” in China and other leading economies is very important to the positive economic and market forecast presented in our January 3 Outlook. Emerging economies now account for 50% of the world’s GDP and approximately 70% of GDP growth. Healthy and sustainable growth in the Chinese economy is thus necessary for a global economic expansion requisite to support a resurgence of international markets. The news is very promising, but not decisive.