Market Comment Q1 2011
This is a time of wonder in investing. Only two months ago business news media and our own writings were filled primarily with details of the progress of economic recovery, both in the U.S. and around the world. Now the news cycle is dominated by radiation in Japan, warfare in Libya, and spreading unrest in Yemen, Syria, and other Arab nations. Both nature and human behavior have produced a spate of sudden and remarkable lurches around the globe that remind us once again how quickly moods and issues can change. For better or worse, all of it will connect in ways not yet fully known. The citizen revolts in the Middle East will have some economic impact in the U.S., and the unfortunate situation in Japan is already affecting business around the world.
Global integration: good news and bad news. It has long been an article of faith that economic integration around the world brings many benefits. In classical economics the term “comparative advantage” describes an ideal in which one party (be it a nation, company, or individual) produces goods or services where it is relatively more efficient, trading that output for other goods and services from other parties that are more efficient in other areas. The world does work this way, though certainly not perfectly. It is true that Chinese factories can manufacture things for Wal Mart to sell cheaply because costs – especially wages – are much lower there. Consumers outside China are better off because they pay less and can stretch their money further. In theory, people here can earn better livings by devoting their efforts to tasks that involve higher skills. This was working fine until the deep recession we are still feeling.
But this equation ignores the effects of natural calamity. Because of the natural disasters in Japan, General Motors has temporarily closed a Louisiana factory that makes pickup trucks, and other automakers in the U.S. and in Europe have curtailed production for lack of a specific part made in a damaged and closed Hitachi factory. Dentsply said that a supplier providing products that comprise 9% of revenues is within the evacuation zone, and Texas Instruments says that a chip plant accounting for 9% of sales will be closed for repairs until summer.
Going in the other direction, several U.S. based companies face potential shortfalls in sales because the Japanese economy may falter. Japan represents 9% of sales for 3M and about 4% for Procter and Gamble. Intel estimates that Japan represents about 10% of global semiconductor demand. The company does not directly manufacture in Japan, but several of their suppliers have facilities there.
Business in Tokyo and the surrounding area has been disrupted even though the epicenter of the tsunami’s destruction lies in Northeast Japan, many miles away. To escape possible drifting of radiation, some people in the Tokyo area sent their families to the southern part of the country, and some workers – especially foreign nationals – left town themselves. There is anecdotal evidence that the city is already getting back to normal, but we are likely to hear more examples of how Japan’s plight is having negative impact on global companies.
Uprising in the Arab street. Remember when Western pundits worried about the reaction of the Arab street to invasions of Afghanistan and Iraq? There were some negative reactions, some demonstrations, but not enough to leave lasting images in most of our memories. That will certainly be different now. The revolts by the people in the streets against their own oppressive governments will be remembered for a long time regardless of the ultimate outcomes.
It is incredible that the spark of one man’s protest suicide in Tunisia could ignite conflagrations that quickly took down seemingly impervious long-term governments in Tunisia and Egypt, put at risk oppressive governments in Yemen and Bahrain, brought riots to Syria, and sudden openings to reform in the heretofore peaceable kingdoms of Jordan and Morocco. The civil war in Libya brought a UN response in fair measure because the violence there so quickly escalated far beyond what had occurred in the other countries (and, except for Egypt, with greater media coverage!)
As gratifying as all this is to freedom lovers everywhere, there are obvious risks. Several ranking American officials have pointed out that we and the rest of the coalition went into Libya to defend the rebels without having much if any knowledge about them. Who are they? Are they freedom seekers or terrorists or something in between? We won’t know unless or until there is an end game that includes Gaddafi’s departure. Among other countries where the situation is more advanced, Tunisia seems to be hanging together, and Egypt has successfully concluded its first post-Mubarak election – though with results more favored by the Muslim Brotherhood than the reformers.
When we think about the Middle East, oil is usually the next word that pops into most of our minds. Of the countries in the throes of citizen uprisings, only Libya is meaningful to global oil supplies, and output there is only 2.4% of global production. The rest of the Arab nations named above in total produce only 1.5% of world output. These numbers are not large enough to cause problems in world markets. So long as oil keeps flowing from more important producers – especially Saudi Arabia – demand can be met.
Curious twists in currencies. Surrounding the recent misery have been currency moves that are not intuitive. Typically, open market currency valuation levels are determined by a mixture of comparative interest rate levels, relative economic strength, and relative inflation outlook with a dose of speculative whimsy thrown in. In Japan, interest rates are even lower than in the U.S., and the tsunami is obviously a disaster for that economy. So what happened? The value of the yen increased against the dollar.
This happened also after the massive Kobe earthquake in 1995. The explanation for the move both times derives from the fact that Japan continues to enjoy a positive balance of trade with the U.S., leaving them with large dollar balances. After natural disasters, some speculators believe that Japanese residents will swap dollars for yen that will be spent locally on re-building. If true, such actions could increase yen demand at the expense of the dollar. Thus the speculators push the yen up as they try to get in front of the local investors.
The relationship between the dollar and the euro as well as between the dollar and the yen have been volatile in recent years. The euro traded higher than $1.50 late in 2009, fell below $1.20 in the summer of 2010, and is just above $1.40 today. The earlier slide was an understandable response to the debt and cash flow problems of first Greece, then Ireland. The euro improvement is surprising because the same problems continue in those countries, and now threaten Portugal and perhaps Spain. Worries about default by one or more of these countries have waxed and waned. A partial explanation for the euro improvement lies in the fact that most eurozone nations offer higher interest rates than the U.S., but the best explanation lies in the strength of Germany. Currency markets seem to believe that Germany, with some help in a bailout fund from France and a others, has both the will and the financial power to hold the eurozone together and avoid default by any of the problem nations.
The markets speak. We are hearing one question more and more often: Why hasn’t the stock market reacted more negatively to the daily diet of wrenching news? When the revolt began in Egypt on January 25, the Dow-Jones Industrial Average stood at 12,008. It rose through mid-February as least partly on euphoria over Egypt’s liberation, but fell sharply for a few sessions on news of the tsunami and its aftermath, then recovered. At this writing stock prices broadly speaking are roughly even with their late January levels.
Interest rates have behaved similarly. The U.S. Treasury five-year note moved to a higher yield during the Egypt euphoria, fell after the tsunami in a renewed flight to safety, and has now traded back to a yield roughly even with late January levels.
Viewed with two months’ hindsight, markets have seemed remarkably calm. With regard to stocks in particular, investors are again accepting more risk in search of better returns. We have seen money flowing out of bond funds and money market funds and into stocks in recent months. One reason may be that investors must reach out five years in U.S. Treasuries to gain interest yield greater than only the dividend yield of the S&P 500.
Further, stock valuations remain low. Prices have not kept up with earnings gains. Before the news from Japan and the Middle East, there were plenty of knotty problems including longer-term inflation fears, default risks in the European Union, Federal and state budget problems, and on and on. This litany certainly explains why stocks are and may continue to be underpriced relative to their theoretically proper valuations. The fact that stock prices are already discounting so many global problems may explain why they seem able to shake off the addition of a few more.