Friday, April 13, 2007

Weekend Reading: No Place for Ostriches

For those investors who still believe that the Fed’s next move is to lower rates, perhaps it’s time to take their heads out of the domestic economy sand and get a more complete global picture as to what’s really going on with growth and inflation. As the just issued IMF World Economic Outlook report along with today’s PPI data make abundantly clear, demand for goods and services are driven by global, not US, forces.

As the chart to the left shows, expectations for global growth for both this year and next remain robust. This despite an expected slowdown (not recession) in the US. Which brings us to one of the risks to this scenario: decoupling.

As the IMF report references, one of the uncertainties is whether other regions of the world economy can grow at the projected rates in the event of a US recession. In this regard, as the demand source of last resort the capacity of the American consumer to shop ‘til he/she drops is a vital factor to be decided on (capex, notwithstanding). And, one that makes metrics on the consumers’ well being (such as today’s consumer sentiment report) so important.

Investment Strategy Implications

Given the added fact that capital is abundant, liquidity and leverage (along with my other four thematic forces – McVey’s “Misalignment Triangle, unregulated money, innovation (technological and financial) and Globalization) stand at the ready to sustain world growth. And, to step into the markets and buy the dips. This is the so-called “floor under the market”. But what should not be forgotten, however, is the fact that this floor is not made of concrete, nor wood, but of sand. Ever shifting with the relative performance wind.

The delicate balance that is the current world economy should be understood by all investors. Issues, such as decoupling (the world economy grows while the US drifts, slows, or declines), should be appreciated for they impact not only global growth but capital flows and valuation inputs – most notably interest rates.

The world economy and markets, driven by the five forces noted above, are a complex, interactive, highly dynamic set of conditions that far outstrip the domestic-only debate. For those investors who wish to grasp this reality, I believe the just issued IMF report makes for a productive read.

Have a good weekend.

1 comment:

Jay Dean said...

I am sympathetic to your “avoid the ostrich” approach.  I note that from the IMF graph that global growth is forecast to decrease slightly in 2007-08 but remain robust.  The questions are the source of the drag on global growth, and how serious the downside risk is for investors, especially those whose predominant exposure is to US assets.
You note that there is downside risk of decoupling US growth from the global trend.  Refer to the chart below the Global Growth Forecasts on page 13 of the IMF World Economic Outlook report (2007), which indicates the percentage components of the risks to growth.  In the view of IMF economists, the one downside risk to global growth that has expanded since September 2006 is financial stability.  The proportion of downside risk due to global inflation, the US housing sector, oil supply and disorderly unwinding of global imbalances has decreased during the same period.  Domestic demand in Europe has shifted from a downside risk to an upside risk, and the upside risk due to emerging market growth has increased.  In my view, globalization is still decreasing production costs and probably continuing to stimulate innovation.  The broad brush that I see is that inflation pressures are present but stabilizing, so that the Federal Reserve will not need to increase interest rates in the foreseeable future.  However, the value of the dollar will continue to be under pressure, and the cost of borrowing money will be relatively higher in the United States.  Although a falling dollar may eventually benefit US exporters, you have been noting that the profit outlook going forward is not nearly as robust as it has been for the past several years.  The net effect is that downside risks predominate in the financial markets.
Jay Dean, CFA