weekend commentary - A Professional Investment Counselor's Investing Ideas for 2012
from
(snip)"In order to prospectively position themselves for success in 2012 and beyond, investors must first put recent events in context and develop a framework to understand how the market is reacting to them. My framework is based on several broad theories: that military and economic power expand and contract together, economic growth happens where capital is invested, lower prices drive economic expansion and improve productivity, and stable growth comes from focusing on margins and operating efficiency.
Developed economies are weak, and their power is being challenged both internally and externally. The solution to the debt crisis, thus far, consolidates economic power into regional authorities that are not accountable to voters. In contrast, there is a greater overt expression of democratic principles around the world. Whether it is in Egypt, Greece, or the United States, the protests we are seeing will gain strength, until a transition occurs or growth resumes. When economic growth slows, the ability of the population to improve their quality of life slows, and economic inequality becomes more difficult to justify.
In Europe while many think the monetary union will break up, I would not underestimate the probability that the eurozone follows the US example by devaluing its currency and consolidating economic power into organizations like the European Central Bank. After all, we have seen Greece, Ireland, and Italy adopt austerity measures, and while the leaders that passed the measures were removed from power, the legislation has not been reversed. Whether Europe stays together or breaks apart, understanding that these transitions have happened throughout history allows us to optimistically embrace the uncertainty of our future, rather than fear the inevitable volatility that follows major shifts in political and economic power.
Following the collapse of the Soviet Union, the US and NATO expanded their military and economic power through two decades as the unchecked global “super power.” It is no surprise that the political establishment, which is viewed as inept and enormously unpopular in our own country, is even less popular in nations where we have troops on the ground engaged in military actions. So even if democratically elected regimes come to power in Middle East nations like Egypt, Iraq, and Libya, we should not be surprised if those regimes fail to embrace US objectives and actions in the region. In fact, there is popular support across the Middle East for Iran’s nuclear program, as many fear the unchecked aggression of the US. The Iranians are leveraging distrust of American actions to entrench themselves as a regional power that stands as an alternative to Western powers. Whether Iran becomes nuclear or not is secondary to their partnership with Russia, which allows them to exert significant influence over global energy prices, one of the most powerful economic weapons in the world.
Both times oil prices climbed over $100/bl (and gasoline $4.00/gallon), it stamped out the ability of the economies to grow. The world was paying attention and discovered that economic expansion becomes increasingly difficult when energy prices increase and the economy becomes less efficient and productive. For all of the discussion about the widening Output Gap in the US (the difference between the potential economic output and the actual level), little attention has been paid to the impact of energy prices on that disconnect in productivity.
Carrying this farther, the Federal Reserve’s Quantitative Easing Program (called QE2) was a failure, because the impact was the inverse of what was intended. Instead of lowering interest rates, they climbed higher and triggered inflation at the same time. While many in the market are looking for another round of QE, I think the Federal Reserve rightfully realizes the negative impact that higher interest rates and higher inflation had on the fragile economy. With the Federal Funds Rate at zero, the price of oil becomes the new mechanism to transmit monetary policy into the economy. Unfortunately, this is not under the direct control of the Federal Reserve.
Throughout history, cheap energy has yielded greater economic productivity, which is why it has been at the heart of many geopolitical battles. Europe originally unified, in part, to secure collective access to energy resources. If the EU breaks-up, the northern countries will be cut off from the oil supplies on the Middle East and Africa, and the Southern countries lose the financial and military backing to secure access to oil resources in the Middle East. This makes the north much more dependent on North Sea production, which has been steadily declining since peaking in 1999, and Russia, which recently completed a pipeline delivering natural gas directly into Germany. We have seen the European and NATO alliance begin to split, as Germany sided with Russia in failing to support the US sponsored resolution on Libya proposed to the United Nations Security Council. However, those calling for a break-up of Europe because of financial issues, ignore that a united Europe is considerably more powerful than a divided Europe.
Whether one agrees with theories of peak oil or not, the statistics show that the world is becoming more dependent on oil from less efficient, “unconventional,” sources. The chart below, adapted from data compiled by Dr. Tom Murphy of the University of California San Diego, shows that any alternative energy source will be less efficient than conventional oil. The consequence of this is that energy is becoming more expensive and those with access to cheap energy will have a productivity advantage. In conjunction, those nations that export energy gain greater economic and political power because they can influence the performance of larger economies that have to import oil and gas. Higher energy prices act like a tax that slows the economy by reducing productivity, and transmits wealth from the consumer to the producer. In addition, the Federal Reserve also influences prices, as devaluing the dollar increases the value of energy resources, all else equal.
http://image.minyanville.com/assets/...ergyreturn.png
Throughout economic history, military power has supported trade and economic growth. In fact, the military is too expensive to support unless the profits from trade bring tax revenue that pays for the military expansion. For the last decade, the dramatic increase in US military spending has not been offset by an increase in tax revenue, because trade is not balanced, and the profits are flowing to emerging economies or off-shore subsidiaries of domestic corporations which are sheltered from US tax authority. The US government has been more aggressive in its efforts to pressure those benefitting from exporting to the US to purchase US goods and bring trade into balance, but has not had tremendous success. The recent announcement of a permanent US Naval Base in northern Australia is an indication that the US intends to remain a powerful military force around the globe.
The question arises, who will pay for this military presence? The US is already running deficits that are 10% of GDP and, as baby boomers reach retirement age, entitlement programs are consuming an increasing percentage of the Federal Budget. With trillions of dollars, and the incalculable human cost, spent in Iraq, Pakistan, and Afghanistan, what has been won? What is the US interest being protected at such an exorbitant cost? While there hasn’t been another terrorist attack, that objective could likely have been accomplished with fewer dollars and less bloodshed by improving boarder security. This is not to say that US citizens don’t benefit from the military, but if the primary benefactors of safe trade are corporations that outsource jobs and shelter profits in off-shore tax havens, supporting a $1 trillion annual appropriation to the DoD/DHS becomes politically more difficult in an environment of 10% unemployment, with 15% of the population on Food Stamps, and an economy struggling to grow.
That brings us full circle to Asia. The vast majority of US Treasury reserves are held by China and Japan, who operate export-driven economies. Any economic slowdown in Europe or the US will negatively impact Asia as well. The primary vulnerability is that these export economies do not have the military power to secure the trade routes that so vital their national interest. Having invested heavily to secure access to the food, energy, and materials needed to support its population, China has been investing in its military to ensure safe delivery of those goods to its ports. While China’s history has resulted in a justified distrust of outsiders -- and they will surely paint any internal weakness as the fault of non-Chinese -- the logical path forward is to move toward greater engagement and more balanced trade with the West. China is working hard to reorient its economy to one driven by domestic demand, but the country has vastly over-built its manufacturing capacity, as half of the country still makes less than $2,200 per year, and will have to continue supporting external demand to ease that transition. Doing so through balanced trade will allow external demand to support the Chinese economy as purchasing power migrates from the State Owned Enterprises to the Chinese consumer.
This presumably shifts the balance of consumer purchases in China, from the high end to those with broader appeal. Investors would also be wise to remember that it was US investment banks that recapitalized the Chinese banking system in 2002, when they were buried under a mountain of bad debts. That option will not be available this time around, should defaults rise amid a global economic slowdown.
The themes presented above lay out the framework driving public and private investment for 2012. While I do not expect an escalation of military conflicts in 2012, I do expect increasing distrust of others. Fear mongering in the press will likely focus on Iran, Russia, and China, but I expect the cyber security and Defense Intelligence industries to be significant beneficiaries of this attention, even as the traditional Military Industrial Complex suffers from budget cuts and unfunded pension liabilities.
Further, domestically sourced, cheap energy (natural gas and coal) will be increasingly important. Regardless of what the Consumer Price Index is reported to be, inputs costs are rapidly rising, and it is becoming difficult to pass those costs along to customers. The North American industrial base will increase its investment in alternatives to oil based power, transportation, and inputs. In addition, increased global tensions could disrupt trade lines and again expose the problems with just in time supply chains. While global trade will advance, triggering investments to expand port and rail capacity, corporations must begin addressing plans to mitigate structurally higher energy and input costs, which are increasingly beyond the control of the Federal Reserve.
In general, the return of capital, via share buybacks and dividends, will drive investor returns in 2012 (especially in the materials sector). The political inertia in Washington should continue until the end of 2012, when a lame duck Congress passes a bunch of spending projects. Gridlock means government support for the economy will decline and asset prices will fall. Lower prices will drive an increase in demand in the second half of 2012, as investors with cash begin putting it to work by consolidating for scale and pricing power. Investors should focus on those companies that lower the cost of doing business, have pricing power, or are the low cost providers.
If American companies want to compete globally, they will need to massively reduce their cost structures to profitably sell products to consumers living on $50 a week, so beware of conglomerates married to a massive cost structure. Disruptive technologies begin as niche products, serving an unattractive market segment, but evolve into more efficient platforms that displace entrenched technology. Corporations will continue investing in technology to reduce operating costs, and those dependent on external financing will be at a disadvantage in this environment.
Forgive the length, but I hope you gleaned some insight into how I am positioning my clients’ portfolios heading into 2012"(snip)
Re: weekend commentary - A Professional Investment Counselor's Investing Ideas for 20
^^ very interesting, and touched on a LOT of issues that I'm interested in.