Right In Our Own Backyard


12-22-2011-1

While daily headlines reiterate the ongoing debt woes plaguing the European economy, it’s difficult for investors to assume any sort of positive outlook for global growth. Meanwhile, political agendas and egoism have consistently impeded a resolution to the crisis. As a result, volatility in markets has remained rampant in recent months amid uncertainty and fear.

Although investors should not overreact to this daily news, it is just as important to not diminish the scope and realness of the global financial crisis. Several European Union (EU) countries currently face significant debt burdens as well as stagnant or shrinking economies. Since these countries are unable to reduce debt through economic growth, governments have continuously issued more debt to alleviate the deficit. However, the market is rapidly ratcheting up the interest rates that these countries must pay to fund their governments, only making the problem worse. Eventually, the cost to fund the debt will surpass the cost of operating the government itself.

Based on recent prices of EU sovereign debt, countries across the Eurozone are being forced to pay high rates of interest on their debt relative to Germany, which is considered the strongest economy in the region. As shown, though France still has a ‘AAA’ debt rating, the country’s borrowing costs are currently 60% higher than Germany. In Spain, borrowing costs are nearly three times higher than Germany, and in Italy, 10-year borrowing costs are more than three times higher. Finally, Greece is already a lost cause, as 10-year interest rates are higher than 30%.

12-22-2011-2

With global investors unlikely to continue to fund these debts by purchasing more, governments can only realistically alleviate the burden through monetization and devaluation. However, under the current structure of the EU, unlike the U.S., countries within the EU have no individual power to regulate the money supply. Therefore, the entire EU must start monetizing the debt, but the leaders of these countries have been unwilling to agree on a plan. There is also a possibility that some countries opt to abandon the EU altogether. Unfortunately, both of these solutions will result in undesirable outcomes.

In recent weeks, some have suggested that China could come into the market and buy up European debt, alleviating the credit crisis in the short term. Similar rumors surfaced during the U.S. financial crisis, when Middle-Eastern sovereign wealth funds reportedly prepared to buy up distressed assets to prop up prices. Back then, these rumors would surface practically every week, and each time, the market would stage a furious rally only to give back the gains when the rumors failed to materialize.

The Chinese do have significant reserves from their foreign trade surplus that they could use to buy up foreign assets, but China doesn’t seem to have any significant incentive to buy up toxic assets above market price amid such global uncertainty. The Chinese government is anything but naive, and if it were to buy up European assets, it would be done on its own terms, which would likely be well below already depressed current prices, and not purely out of benevolence. However, China’s economy is export-driven, and a slowdown in demand for its products will negatively affect the country’s overall economic growth. Therefore, it’s possible that Chinese action to prop up the European economy would act as a backdoor stimulus for the Chinese economy. Nevertheless, China could execute more efficient and direct ways to stimulate its economy than via a handout to Europe (i.e., a handout to its own people instead).

Chinese exports account for about 37% of total GDP, according to the US Bureau of Economic Analysis and Economist Intelligence Unit.1 Of that, 19% goes to Europe. So, on a net basis, Europe accounts for 7% of China’s GDP. If the EU entered a major recession and the region’s GDP dropped by 10% (twice the decline during the 2008 financial crisis), all else being equal, the net effect on China would be 0.7% of total GDP–hardly a reason for panic.

12-22-2011-3

Although China has the means to come to the aid of Europe, it must contend with its own potential problems domestically before even considering a bailout of Europe. Economic growth in China has rapidly lost steam over the last several months.

In mid-December, the Chinese government released Industrial Production statistics for the month of November, which showed a 12.4% year-over-year increase. While this kind of revenue growth would be significant for many countries, it represents the slowest rate of growth for China in more than two years.

12-22-2011-4

The Chinese housing market has also hit a rough patch; some areas of the country contain entire cities that are now almost uninhabited. The city of Kangbashi, built in inner Mongolia to house more than one million residents, “currently sits empty,” according to a recent Reuters article.2 Kangbashi is an extreme example of weakness in the Chinese housing market, but for the country as a whole, real estate prices are down in each of the last six months, while the index that tracks the overall real estate climate is at its lowest level since April 2009.

12-22-2011-56

If the recent performance of China’s equity market is any indication, China’s economy could remain weak. Five years ago, the Shanghai Composite Index was one of the world’s strongest equity markets, rising 416% from the start of 2006 through October 2007. The index then crash landed during the global financial crisis, falling 72%. The rebound off the 2008 lows, however, has been anemic. While the S&P 500 is up more than 80% since its lows, the Shanghai Composite is up less than half that, at 32% and falling.

12-22-2011-7

With Europe struggling and China not exactly booming, where can investors look for solid growth and minimal risk? Although it may seem surprising, recent trends in the U.S. suggest growth is at least beginning to gain traction. After seeking other global opportunities amid the financial crisis, investors may now want to reconsider the idea of investing in domestic markets. The chart to the right shows the most recent Manufacturing PMI readings for 10 of the largest global economies. Readings above 50 indicate expansion in the manufacturing sector, while readings below 50 indicate contraction. Of the 10 economies highlighted, the U.S. is the only country in which the manufacturing sector is growing. All other areas of the world–from Europe to Asia and even Brazil–currently have manufacturing sectors in varying degrees of contraction.

12-22-2011-8

The strength in the U.S. Manufacturing PMI Index is hardly an outlier either. For the last two months or more, U.S. economic data has not only surpassed expectations, but has shown sustained growth. Of 32 different manufacturing, employment, housing, and consumer related economic indicators, 23 improved momentum in year-over-year readings relative to the last month, while only nine lost momentum, according to a recent analysis by Bespoke Investment Group.3 At a net level of +14, this is the highest monthly reading in more than a year.

Investors are beginning to realize that the tide may be shifting back toward U.S. equities. While the 1990s were the decade of U.S. dominance, the tables began to turn in late 2001, when the strength of the S&P 500 relative to the MSCI World Ex US index peaked and embarked on a multi-year descent. At the depths of the financial crisis, however, U.S. equities bottomed relative to the rest of the world, and have since quietly trended higher.

12-22-2011-9

Even within the U.S. equity market, the effect of domestic and international sales is significant. During the period in which international markets outperformed U.S. equities, U.S. companies that generate the majority of their sales outside of the U.S. (internationals) outperformed U.S. companies that obtained all of their revenues within the U.S. (domestics). However, just as the S&P 500 rebounded relative to the rest of the world, U.S. domestics have now started outperforming U.S. Internationals.

The chart below highlights the year-to-date performance of an equally weighted basket of U.S. domestics versus U.S. internationals so far in 2011. On a year-to-date basis (through Dec. 14), the basket of domestics is down less than 1% on the year. The international basket, on the other hand, is down more than 8%.

12-22-2011-10

The current global economy remains weak and vulnerable, and investors should remain as cautious as ever. Daily headlines about the plight of Europe make it difficult to find any reason to stay positive about the economy and our own financial futures. But while the U.S. is certainly not fully insulated from these events, the economy is literally and figuratively oceans apart from the debt crisis in Europe and a potential slowdown in China. For the last several years, investors have been traveling around the world looking to maximize returns, but at times like this, the best returns may be right in our own backyard.


Cited Sources
1 “Is China’s Rise Sustainable?,” http://www.futureofuschinatrade.com.
2 Lucy Hornby and Langi Chiang, “China’s Ordos property bust offers warning sign,” Reuters, 12/5/11.
3 “Matrix of Market Indicators,” Bespoke Investment Group, 11/30/11.


Disclaimers
This market commentary is an advertisement and was written and produced by Michael W. Conway of Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel: 973-285-3600, Fax: 973-285- 3666 with assistance from Bespoke Investment Group, LLC . Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding markets or other financial information, are obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.

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