Written by Michael Waring
Friday, 30 June 2006

Equity markets and investors have been singularly focused on the U.S. Federal Reserve, inflation rates and interest rates. Uncertainty on both inflation and interest rates in the second quarter led to a significant sell-off in equity markets worldwide. While the correction has been significant, we do not believe it is necessarily an indication of a major economic downturn not yet anyway. The pullback, while painful is not at all abnormal and simply wrung the excesses out of markets after the strong gains of the past two years. And in our view, this correction is also partly due to the end of very low cost money, particularly in Japan. To be sure, the U.S. economy is now modestly slowing thanks to the efforts of the Fed to drain liquidity thought higher interest rates (See Chart One). And no doubt, the American psyche has turned negative with President Bush’s popularity plummeting in the polls and the situation in Iraq apparently without an obvious solution. Hardly a recipe for higher stock multiples in the near term.

Chart One: U.S. Leading Economic Indicator: Slowdown Ahead

Growth in corporate earnings in the next few quarters ahead will likely slow and the now obvious weakness in the U.S. housing market will negatively affect consumer spending. (See Chart Two)

Chart Two: Housing And The U.S. Economy

Yet it is our view that slower growth in the U.S. economy (and perhaps globally) will likely temper inflationary fears thereby alleviating the need for further interest rate hikes. (See Chart Three)

Chart Three: Slower Global Growth Should Temper Inflation Fears

We suspect that the part of the recent weakness in global equity markets is related to the end of quantitative easing in Japan. This shift has altered “the cheap and available capital for cross border and cross asset carry trades, which led to speculative excesses in emerging markets and natural resources (energy and commodities” (Tobias Levkovich, Citigroup). Again, we do not believe at this point that the current correction in May and June is anything more than just that, a correction. But near term direction in equity markets is crucial and must be monitored very carefully.

Bearish vs. Bullish

In a recent Merrill Lynch Survey, nearly 40 per cent of professional fund managers were holding more cash than usual. Investors have quickly become more risk adverse over the past eight weeks. The average large cap growth fund in the U.S. lost 4.7 percent in the second quarter while the average large cap value fund only fell 0.1 percent. The average U.S. small cap growth fund declined 6.7 percent in the quarter. Professional money managers have begun shifting assets back towards larger cap stocks as a result. A June survey of U.S. money managers by Russell Investment Group revealed that a vast majority are now bullish on larger cap stocks in general while the majority where bearish on smaller-cap holdings.

Investors are also shifting away from Emerging markets as evidenced by the sizeable declines in markets such as Brazil (down 24 percent from its peak to its low) and India (down 34 percent from its peak to its low).

While economic and corporate growth may be slowing somewhat, the underlying health of the global economy remains strong. Corporate balance sheets remain very healthy and profit growth, while slowing, still remains robust. Again, for the time being, we do not believe that the current setback in equity markets foretells a coming global recession.

China

For the moment, China’s growth appears set to continue unabated. The continuing rural to urban migration is fuelling growth throughout the country. The infrastructure build-out is becoming more and more comprehensive, even in the remote provinces. This will provide a long-term sustainable boost to growth. Domestic Chinese consumption appears set to explode with coming availability of consumer credit. A recent CLSA report suggests, “It is the basic proposition of this report that the Chinese people are about to be offered material access to consumption credit for the first time…It is important to stress that there has never been access to consumption credit in any material size in China before.” This represents a structural change in Chinese society. A move to a consumer economy fuelled by the availability of consumer credit that has recently accelerated due to a flow of foreign capital and influence into the Chinese banking system. “The leading credit card issuer is China Merchants Bank, which issued around four million credit cards by the end of 2005. China Merchants plans to issue a further three million cards in 2006!” “the best estimate is that there are about 20 million credit cards in China and they account for about 4 percent of consumer expenditure compared to 18 percent in Korea or the global average of 8.6 percent.” (CLSA, Brave, Brave New World) (See Chart Four)

Chart Four: Credit Card Issuance in China

Yet despite these positive developments, we are for the first time, concerned about the developments in China. Labour costs are rising. Environmental concerns are gaining headlines. Civilian unrest is growing and so too is the number of protests. The strength of the Chinese economy suggests that it may be veering out of control and tighter monetary policy may be required. In our view, real estate projects in particular seem to be excessive and need to be reined in. Whether the Chinese economy can experience a soft landing or not is critical to equity investors in our opinion. This situation requires close attention.

Commodities

With respect to commodities inventories for most of the metals have trended down to critical levels. (See Chart Five) As such, there is little cushion in copper, zinc and nickel inventories in the event of a supply disruption. And precious little new supply is likely to come on-stream any time soon. Prices for most commodities have been depressed for many years resulting in a shortage of new exploration projects. Permitting and environmental challenges assure long lead times for any new projects to get the go-ahead. While we expect an easing of metal prices from their current lofty levels, metals prices will have to remain higher for longer than equity markets are currently discounting. Cost inflation and changes to foreign tax regimes are wreaking havoc with the economics of mineral development. This can only be offset by higher commodity prices if new supplies of copper etc. are to be brought to market. We expect Chinese demand for metals to stay strong and that metals prices will remain at least 25 percent about the long term averages for some time to come.

Chart Five: Metal Inventories

Overall, for the moment, we remain bullish on the longer term. But we acknowledge that a slowing global economy in the short term, will pose a significant challenge to equity markets over the next 1-2 quarters. And the very recent developments in the Middle East between Israel and the Hezbollah could spill into a full-scale war. This sudden turn of events has the potential to be very unsettling to global markets. Equity markets certainly seem to be facing a wall of worry.
We believe that energy and gold are two sectors that will outperform and we have positioned our portfolios accordingly.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

Copyright:
All content included on this site, such as text, graphics, logos, button icons, images, and software, is the property of Galileo Global Equity Advisors Inc. or its content suppliers and protected by Canada and international copyright laws. The compilation of all content on this site is the exclusive property of Galileo Global Equity Advisors Inc. and protected by Canadian and international copyright laws.