Phillip E. Colmar
Sr. Editor, Global Fixed Income Strategy, BCA Research
Transcription of Audio Interview, January 13, 2007
JIM: Well, we’re only in to the second week of trading in the New Year, and I can tell you the pessimism is mounting. In fact, the number of negative articles I read are almost 5 to 1. Armageddon, the end of the world – you name it, it’s out there. Well, not everybody feels this way – joining me on the program is Phillip Colmar, he’s Senior Editor of Global Fixed Income Strategy for BCA Research. They’ve just issued their outlook for 2007: Another Year of Riding the Liquidity Wave.
Phillip, one thing as you look at the markets today – and this is what the bears are saying – you have the classic signs that the bull market is late in the game: we’ve seen the surge in M&A activity, increased optimism on the part of investors, rising margin debt, a general increase in risk-taking. Why are you fundamentally bullish on the market?
PHILLIP COLMAR: Jim, I think there are a lot of structural reasons to be fundamentally bullish. Your point is well taken: we are well into this equity rally. And after the gains after the few months ending 2006, people are genuinely nervous. We’re seeing some portfolio shifting and some profit taking perhaps, and it’s gotten people extrapolating to the downside at the moment. We have been bullish for a number of years, and we stand back on a positive structural story. We also think the cyclical story won’t be too bad in 2006.
But I will for a minute take a look at the structural story, in the sense that the positive backdrop of it are low inflation, and the strong growth backdrop still persists. The pillars behind that are obviously globalization and the rapid expansion of the free market system. And the other pillar is the rapid adoption of new technology, and particularly, like industrialization, within many parts of the world. We’ve also had restructuring within Japan and Europe, of course, and we’re still seeing gains from the technological revolution. That on its own, I think it’s important to see how we see the world as why we’ve taken a bullish view. And that structural backdrop lends itself to strong productivity gains which we’ve seen in recent years, and strong profit growth in recent years. And productivity is a bit of a win-win scenario, in the sense that you’re able to grow at rapid paces and generate strong profit growth, and yet not face the offset of inflation. In fact, if anything, you get disinflation in that type of environment.
And the story is not new obviously: globalization has been going for a decade. But the important point is it is not about to end soon and will continue to provide this bullish underlying current for asset price inflation. For example, China still has about 60% of its laborers, or citizens, still within the rural areas; India, 70%. And these are strong contrasts to about 20% in Korea, which has already done some industrialization; and probably less than 5% in the developed world. So that move in coming years will create this environment which is fairly bullish. And by definition, industrialization, for example, in China, means you get a rise in the capital to labor ratio – or another way of saying, productivity. What we’re seeing is for every unit of growth that China is generating, we’re seeing that it’s employing less and less labor. So what it means is in order to employ 150 million excess laborers, which we will see over the next 10 years, there’s going to be a huge expansion in excess capacity, particularly in manufactured goods. But of course, that’s not limited to manufactured goods, it spreads to services and other things, but what we’ll see is we’ll see continuous downward pressure on inflation and price pressures which will allow the economy to grow very fast which is positive.
I think – back to the bullish argument – that structural story adds 3 elements to the story. One is that inflation pressures when they pick up, you should probably lean against them. This was a heated debate we had with many people last year, when we were bullish and said inflationary pressures would dissolve quickly. And many thought that they were extrapolating to the upside, much like people are extrapolating to the downside on the stock market at the moment. But in reality, what we saw is after the 9/11 crash and the unwinding of the tech boom, there was a tremendous amount of liquidity pumped into the system by global central banks and fiscal policy, and yet it really didn’t lead to a lot of inflation. I think OECD inflation on aggregate is about 2.2%. And in the recent months, we’ve seen a modest slowdown in growth, and inflation has already come off provided the stimulus. So what it does is by doing that is it provides an environment where you get excess liquidity by definition – which we can talk about – and you end up with low economic volatility. And both of these things are inherently bullish for asset price inflation, and lead to potential bubbles or manias potentially later in the decade. Now that’s more of a structural story. There’s a cyclical argument as well. [5:12]
JIM: Let’s talk about where your conclusions were at the beginning of 2006. For example, back then, you said it would be a decent year for the global economy; the Fed would likely go on hold around 5% (they did it at 5 ¼) – that was pretty close; sustained growth with low inflation; structural forces holding down real bond yields. So you made a lot of good calls.
PHILLIP: We did. And I think a lot of it, as I said, flips back on the structural story. If you envision the world in this context, then we weren’t as concerned about inflation. The rise of inflation we saw back up in yields and inflation earlier in the year, our indicators and models said that it was overdone. People were worried about it. We leaned against it hard, and in the bond market we played the rally. As a consequence, we expected yields to come down and support conditions. They have.
And one other thing that I might add to that story, is that where you have an environment where inflation doesn’t get out of control and away from you, like many of the inflationists would suggest, you end up with stabilized conditions – and that’s back to your stabilized growth suggestion that we had made. And the reason for that is – well, I believe anyway – that financial markets are inherently self-regulating – particularly when inflation is not an issue. So you get a bit more modest growth, and you get the currency prices being able to adjust lower on the upside; you get stronger growth, and you get the bond market to adjust that way and moderate conditions. So you end up with less volatility. And that provides a nice environment for asset prices in general. So I think that was the foundation for a lot of our calls.
We did call for a slowing in growth which we saw in the second and third quarter – below trend growth in the US. And we were expecting that, along with inflation coming off, would help the Fed go on hold. It took a little bit longer, probably because we had a new Fed Chairman, who wanted to prove himself on the inflation side and make sure it was behind him before he went on hold. But, you know, 5 ¼ versus 5 wasn’t that bad. [7:09]
JIM: One thing that you state in your forecast, which I highly agree with, and that is you doubt that asset inflation has come to an end. There’s still a lot of money out there that’s hunting desperately for returns. In fact, asset prices generally do well in an economic environment where there’s adequate liquidity. I think one of the amazing stories about this – and this gives evidence to this liquidity issue – is if you look at 2006, up until about August, all asset classes did well. I mean, oil was doing well up until August; bonds did well; stocks did well. It was pretty hard finding something that wasn’t doing well, other than real estate which was starting to soften.
PHILLIP: And that’s true and I think that again, you’re right, it does fold back onto a liquidity cycle or liquidity conditions (excess liquidity). One is that I guess the reasons for liquidity is probably important and that’s why it’s not going to dry up quickly. In the environment I expressed there, the structural environment which we’re in with rapid industrialization in many of these countries, is that you’re getting excess liquidity being built up in the places that are growing rapidly. Emerging Asia is a good example of that. A lot of growth in potential is occurring in emerging Asia; they’re building tremendous amounts of profit and therefore excess savings. And this is a region of the world, unlike the US, that saves a tremendous amount. So you have China, for example, over the last 5 years, savings rates have gone up from about 35% to 50%, which is not uncharacteristic with the rest of emerging Asia. At the same time, you’ve had windfall opportunities within the oil-based countries in the Middle East, and they today haven’t spent to accumulate the excess savings. And for both of these reasons – emerging Asia and the oil countries – haven’t, while investing, invested nearly enough to absorb the excess savings. And as a result, the excess savings get recycled back into asset prices, and financial markets worldwide. But they’re not the only places. Latin America is also a net lender these days.
And other reasons for it is financial sector health is very strong worldwide, and they’re being able to fund a lot of their Capex expenditures out of cash flows. They’re not needing to go to the markets and borrow money. And they’re not using up the savings, which then stay within asset prices.
And I guess the final reason really for the liquidity story, which has been tremendously bullish in recent years, is financial innovation, if you will. Maybe to put it another way, these financial innovations have allowed corporations and consumers to really optimize their balance sheets – let me put it that way – and extract liquidity, or take on more leverage in assets they haven’t been able to before, such as housing, or elsewhere.
As well, when you end up with a stable environment, as I characterized at the beginning where growth is inherently self-regulating and somewhat stable, we’ve seen volatilities in growth worldwide decline dramatically. It encourages businesses – and will, as we see through M&A activity and LBOs – to take on more leverage to optimize shareholder value. And it allows the consumer to take on more, because they’re not worried about losing their jobs, and potentially not making mortgage payments. So that unleashes a lot of liquidity, which has been pretty bullish for asset prices in general. Combined with the fact that central banks, without inflation, they don’t need to overdo it – they don’t need to knock these economies over the head and extract liquidity rapidly. So we’re left with fairly abundant liquidity conditions worldwide which will feed into asset prices. [10:44]
JIM: Let’s talk about the powerful interaction of a supply-side expansion, and buoyant liquidity, which gives rise to what I call asset inflation. There are many people that have distrust of some of the inflation numbers. They think they are understated. They basically distrust a lot of the data. Let’s talk about the inflationary aspect of, let’s say, asset prices versus what we’re seeing in real goods which is coming on with this globalization, increase in industrialization, and the supply side of the equation. [11:51]
PHILLIP: Yes, and I think that’s an important distinction, because we get challenged on our inflation view. And we certainly did last year quite a bit. There’s a lot of definitions of inflation out there. Maybe it’s best if I characterize what we define as asset price inflation, because this is an area where we’ve been challenged a number of times in recent years. Especially, I guess last year when there was a pick up in inflation and people were starting to extrapolate.
We mean, when we say inflation, we mean traded goods and service prices. We’re not talking about asset price inflation. We differentiate that into a separate camp. And many people have pointed out in recent years that energy prices and asset price inflation has occurred, and therefore that’s leading into a tremendous amount of inflationary environment worldwide. We would argue that really, high energy prices, say, have been the flipside of the same coin. Energy prices this time around, unlike the 1970s, and the supply side shock, is a demand shock. And the shocks coming from emerging Asia which is demanding energy, pushing up energy prices to produce cheap goods which is exporting deflation to the rest of the world. So it’s more of a relative price shock if you will than actually inflationary pressures. You’re getting strong oil prices but you’re getting deflation within emerging Asia to offset it. And on balance your traded goods prices are much weaker, or at least inflation is holding low. So, sure you can point to certain elements of the inflationary picture, and mistrust it or suggest it’s going higher, that it’s creating inflation. But we can point to the traded goods within Asia, and suggest that it’s not – that it’s not a supply-side shock, it’s a demand shock. And therefore, inflationary pressures really aren’t building.
Now, that on its own – I mean, people can debate the data, we’ve had this argument with people too – but I think that gets into a bit of a mug’s game. So assuming that that is right, which we do (we largely think it’s mostly accurate, there’s an issue with every country, every CPI numbers worldwide, but in general we think it’s providing a fair picture), and now we’re seeing inflation melt and many of the people who are pro-inflation and higher inflation off of energy prices are starting to retreat at this point.
And the other thing that I would point out is with asset price inflation, is that when you have low inflation worldwide, there’s still plenty of inflation out there. But it doesn’t come through in traded goods prices. What it comes through in is in asset prices: home prices, equity prices, other asset prices. So I think you really need to differentiate that, because if you have inflation you have lower asset prices because central bank policy becomes more restrictive and those kind of things. So I wouldn’t want to confuse those two issues. I think the reason why you have asset prices is that you have low generalized goods price deflation, or low inflation in general. [13:59]
JIM: Let’s talk about these structural forces that you’ve talked about that are in place. It hasn’t prevented inflation from going up in the US: you’ve got core inflation rates of 2.6% - the highest in a decade (and that compares to only 2% a year ago). How does that factor in to your analysis?
PHILLIP: The structural story I outlined at the beginning, it is that: it is a structural story. That’s not preventing cyclical upswings in inflation by any means. What it does mean though is that given an amount of liquidity, given our structural backdrop, you’re going to get less of a rise in inflation than you would otherwise be. I would say if you wanted to start off this decade, and say how would you really crank up US inflation? Well, let’s take the policy rates and drop them down to 1%, and hold them there for a really extended period of time; and then blow the fiscal policy, and provide a tremendous amount of stimulus. Then let’s throw a weaker dollar into the equation which we had earlier in the decade. You would have expected in that environment a tremendous amount of inflation. And yet, as you pointed out, I think core hit a peak of 3% last year. So we really didn’t get it. And then in return, because of disinflationary environment that we’re sitting in, when we get a modest weakness we get a dramatic drop in inflationary measures, and inflation across the board. We’ve seen each of the leading indicators of inflation melt. And we’ve seen core inflation in the US, in a 3-month annualized period, as of November (the latest numbers), came out to 1.6. So we are seeing the structural backdrop. That’s not saying you can’t get cyclical swings in inflation. It’s just that they’ll be more muted when you get them, and they’ll dissolve quicker to a given slowdown. [15:44]
JIM: You’re seeing this whole global liquidity thing which you’re talking about, and it tends to be one of the central themes, not only for BCA last year, but also this year. Phil, how important is the yen carry trade to this liquidity story? And what are the risks it could all blow up? You do hear talk about the Bank of Japan wanting to raise interest rates. Although, if interest rates go up to 1 ½, or 2% in Japan, I’m not sure that’s a threat to the yen carry trade.
PHILLIP: Yeah, I think that’s an important issue. Now, I’ve laid out a bullish scenario here, I mean we’re bullish on the structural backdrop. That’s not to suggest by any means that we’re complacent, and that we don’t see risks on the horizon. I think there are a lot of things for investors to be nervous about. And probably we can go through a list of them: including geopolitical concerns, leverage, protectionism. But I think one of the important ones is probably the yen carry trade. It’s the one, that if any which keeps us up at night, it would be that. It’s a real issue. It’s grown dramatically. There’s no real way to measure it accurately, but all indications of it researched: for instance, call loans from Japanese banking system accounts have surged in recent months, back up to levels of really around up to 1998 levels when the yen carry trade unwound the first time and blew up a couple of hedge funds. So we know the pervasiveness of this trade has grown dramatically.
And probably one of the most concerning issues about it is that we’ve now got reports that Indian and Korean banks are borrowing billions of dollars of yen, and then refunding domestic loans based on it. So the risks are not only within capital markets, but potentially spreading to banking systems – at least in these countries. So there are risks there.
Now, that being said, currency markets can move for abnormal reasons and that’s one of the things that worries us at times. I mean, afterwards people try to justify why, but they can have periodic moves. But the economic case, if you will, for why this yen carry trade would blow up, just isn’t present at the moment. Basically, in order to see it blow up, what you’d want to see is global growth bottoming – we still think global growth is growing below trend in the US, global growth is decelerating. It will probably decelerate until mid this year into 2007. And the yen is a pro-cyclical currency, largely because the Japanese economy is so leveraged to global growth in general, and reliant on export demand. So in order for the yen to get up, first of all you need a stronger global growth backdrop – which we don’t have yet. We may get it later in the year. But the other important element to it is you need the central bank to be able to give the impression that they will deliver several rate hikes in a row. We’re still at a 25 basis point base rate within Japan. So we would need several in order to encourage the yen higher. And the case for that is not there yet. Now, the central bank, the BOJ is very hawkish, and still remains quite hawkish. And in my opinion it’s a mistake if they hike too aggressively – also talk about later. But the economy isn’t there to justify a series of rate hikes, and I don’t think the market will buy into it at the moment. The consumer has basically retrenched all year, or all 2006, and continues to be very soft. External growth by our indicators have already rolled over and start to decelerate over the next few months. So the economic case isn’t there.
At the same time, there’s a significant amount of deflation still within the Japanese economy. The economy is very deflationary in general, and we’re sitting with national headline numbers at less than ½%, and core (excluding food and energy) still deflating. So you really need inflation breaking into positive territory and heading higher to justify why the central bank could get away with doing a series of hikes. And then you could see the carry trade unwinding. The question is it’s probably one of the biggest risks for later this year, or maybe 2008. But I think an immediate unwinding is probably not in the cards. [19:46]
JIM: Let’s talk about this forecast where you see the economy slowing down but still growing – sort of your midcycle slowdown thesis. You also see the markets ending higher this year and inflation moderating. In any forecast, there’s always the wildcard. You just talked about one now that you’re concerned with which would be the unwinding of the yen carry trade. Let’s get into what could possibly go wrong with your forecast.
PHILLIP: I think that’s a fair question. Right now, there seems to be an issue of whether growth is really going to slow down enough for the central banks to start cutting – the Fed in particular. I think you’re running into a risk scenario in the equity market, anyway, heading into the first quarter. We are bullish throughout the year, we expect it to have gains. The risk scenario for the first quarter is that coming off of a strong second half of 2006, we’ve had good gains in the equity market to start with, so there could be some portfolio shifts and just profit-taking in general. And then you come in to a period where you get slower growth – when right now it seems to be we’re getting an up-rating potentially in growth. Really it’ll have drifted higher. But I think the risk is that maybe what we get is a slower growth, maybe led by the retailers after dramatic price cutting at year-end, trying to sucker in consumers to make Christmas purchases. Probably the consumers did get suckered in and now are going to have to retrench in the first quarter. So we’ll see some weaker consumer data coming in the first quarter. Maybe the retailers will lead it, and then the rest of the cyclicals. We may get a surprise on the downside. That’s one of our concerns the moment: you get a surprise on the downside on the profit picture.
Now, that on its own is not so bad, we’ve published a report recently that goes back 50 years and looks at every time profit margins have peaked and the growth picture slows, and we find that the year after profit margins peak that you actually outperform in equities – you know, 10% instead of 9% average. If you take out the inflationary periods, of the 60s and 70s, you’re actually outperforming by about 21%. But the caveat there is, although it sounds counterintuitive, the reason why is that you get the interest rate relief. Usually when profits are slowing, provided they don’t go negative, it’s okay, as long as you get the central banks slicing into it, or cutting into it, and providing some stimulus.
The problem this time around, and this is the risk scenario in the first quarter, is that you end up with a profit surprising to the downside at least on the margin which gets investors concerned. And yet, the central bank is pushed off a bit further towards mid year. And the reason for that is that we just had this strong employment report on Friday. And although I’d argue that employment is definitely a lagging indicator, you’d see the consumer weakened, then you’ll see profits, then you’ll see it feed through to employment. The central bank has historically not cut unless the unemployment rate is at least edging higher. So if we don’t see some response to the employment, while being a lagging indicator, the Fed pays attention to it, and we might not get that interest rate relief.
That’s one of the bullish points I guess for the equity markets for this year is that we expect the re-rating in stocks. And we think stocks are relatively priced attractive in both absolute terms and relative – we can talk about that. But you usually don’t get a re-rating in stocks until the Fed starts cutting.
Now, all that means is if we’ve got a risk or a vulnerability it’s in the first quarter, we get a shakeout, a bit better buying opportunity. I think my base case is still for gains this year in the equity market. Most of it will be after the first quarter if that scenario plays out – banning that we don’t get a major blowup in a hedge fund or a dramatic unwinding to the yen carry trade, or something disastrous. But in that scenario, that’s a pretty deflationary scenario where the Fed would be quick to move on any financial accident, and afterwards you would get a lot of stimulus pumped in to the system. But those are clearly your risks, or your vulnerabilities. So there’s a number of them.
I wouldn’t chalk up terrorist attacks – that’s always another risk, that’s something that can throw off our outlook for sure. The problem we’ve had with that, and geopolitical in general is we’ve listened to a lot of experts, and it’s hard for anyone to really figure out how it works in asset markets and how it will price out. If you were worried about another 9/11 – after 9/11, or at least since 2003 on – and were conservative on asset prices you would have underperformed dramatically. So it’s a clear risk. You can’t rule out something that disrupts oil supplies or causes another problem, but these are things we can’t put a probability to, and therefore we don’t factor it in to our investment decisions I guess.
The other issue is protectionism. The scenario I laid out before where globalization is the key to this low inflation, strong growth environment – protectionism would be a real disaster. But sentiment towards protectionism really doesn’t pick up or doesn’t gain momentum until the economy is really weak, in recession, and jobs are being shed dramatically and politicians are looking for a scapegoat. So we’re not really in that environment.
So I think maybe the end of the yen carry trade would be the final one.
So there’s some risks out there, but on balance I think when you look at them, if they come out, most of these risks come into the system, they’re going to be met with some more stimulus and ultimately equity prices will head higher. [25:00]
JIM: Phil, let me throw this scenario out. In the first six months of the year you see real estate prices continue to weaken. In addition to that, you see other asset prices weaken – as we have since the beginning of the year with the stock market. And then by the time we get to the second quarter, you have a deceleration in economic growth. In that scenario, I almost call that disinflation, you then have the Fed respond to that which would be reinflation. Is that in some way a degree of how that could play out this year?
PHILLIP: Yes, I think so. Our base case scenario is the US economy…yeah, certainly, it slowed in the second and third quarter, we’re going to see below trend growth. We saw it in the second and third, we’ll see it in the fourth, see it in the first. And we may see until mid-year the economy really not rebound back to trend. I mean trend being in real terms slightly below 3. You know, the economy is probably chugging along at 2 ½. So we’re not well below it, but we are below, which brings inflation down even further. The economy grows below trend because the consumer continues to retrench. Most of our consumer indicators are calling for further weakness.
One of the reasons is the housing market which looks by a lot of indicators suggests there’s a bit of stability – at least initial signs of it on recent data. We’d be cautious about that because maybe potentially a lot of the activity measures of the housing market are because homebuilders have stuck with a lot of inventory, and a lot of people walking away from it, and they’re having to dump it, creating some activity. But one, there’s still a lot of inventory in the system and not all that bullish, I guess, story for housing. I think we still have a lot of existing home buyers who haven’t been forced sellers because employment still remains firm. They’re able to hold on it, they’re waiting for Spring to turn round when it’s typically a better housing market and dump into it. And I think the surprise might be really just that it’s persistently weak, and there’s a lot of supply comes on to the market and it takes a while for supply and demand really to balance out.
So I think, yeah, you could have a weaker economy, but that will bring forward the rate cut by the Fed and probably put the other central banks on hold. They don’t tend to like to hike at the same time that the Fed is cutting. So you get a liquidity response from it, which then sets the ground work for the next upleg in the second half I would say, although stocks tend to lead economic growth probably by a quarter. So maybe by the second quarter upward they’ll start to get a bid and start to do well. [27:36]
JIM: Let’s talk about what comes in the second half which I think is reinflation. And I want to talk about rotating asset inflation. The past couple of years you’ve talked about the potential for a financial mania in the second half of the decade. Certainly we saw that in the 80s, we saw it also in the 90s. And Phil, your prime candidates are asset plays related to the growth of emerging Asia: principally, for example, equities in the region; and natural resources. And the trend in resource prices in the past couple of years has certainly fit into that thesis. Have you altered your thinking on this, or do you believe we’re on track to achieve that?
PHILLIP: I think we’re definitely on track to achieve that. You typically get this kind of a shakeout, some stability, which, you know, our midcycle slowdown which you end up with we’ve had some consolidation in these resource plays. And we’ll get probably some further, well onto the mania. I’d just like to say in the equities side in particular, we play many of the resources. I think there is still strength in the resource play but we tend to play them through equities. As a mania candidate, you can’t push up oil prices or commodity prices to infinity without causing some economic pain. You can’t extrapolate the stocks to astronomical valuations and not cause the economic pain. So it would be within there.
Equities in general, we do see this asset rotation. We’ve seen it in housing which has done very well, and bonds have done extremely well, and spreads in corporate bonds have come down. The area that hasn’t been bid up…equities have done well in the past year – the last few years – but valuations are still fairly cheap. I mean given where interest rates are, PEs in the US are sitting at 18. They could be at according to our models close to on an interest adjusted basis more like 22. Relative to the other assets they’re very cheap. So we think equities in general do well. Emerging Asian equities in particular, they are extremely cheap, they have a bullish tailwind behind them. And when it comes to the resource plays energy stocks are now massively discounted to the overall benchmark, and provide real upside.
Now, onto the mania theme. That’s a cyclical argument that we think there’s a lot of valuation within these assets and you can buy them basically just on valuations and liquidity will pump them higher. On the mania theme, we have this long standing theme that every decade has a mania. And the idea behind that is you typically come out of a recession at the beginning of the decade, central banks flood the system with liquidity, offset the downward price or deflationary pressures with liquidity, reinflate the system and create asset bubbles. And so usually somewhere through the decade you have some major displacement which encourages investors to extrapolate some theme that the masses can buy into. And so we’ve seen this every decade really. And the 1950s had the nifty-50 stock mania; then the 1970s it was gold; then the 1980s it was the Nikkei Japanese stocks; in the 1990s it was the tech mania.
So this mania is no different. We had a recession at the beginning, we had a tremendous amount of liquidity flood into the system sloshing around and it’s looking for a theme-based stuff. Energy stocks – or emerging Asian equities are definitely one of those things where you could envision the displacement this decade is China’s and India’s industrialization. That’s a massive shock this decade because it grabs the average investor’s interest, gets them to start to extrapolate gains and see upside. And so we think you could really get that late here, but at this point you almost don’t even have to bet on that because energy stocks are dirt cheap and they become cheaper – I mean everybody is a little worried about the oil price correction here, we don’t have a weather man on staff so we weren’t expecting to see there the $6 price drop in a few days, but what it has done is the underlying fundamental variables haven’t changed. The demand is there, the structural demand out of Asia both from an industrial side as well as a commercial side. You’ve got China with 24 cars per thousand people, when the US is at 480, and Japan is at 450. So I mean it’s not going to match it, but even a move in that direction is going to be a disproportionate amount of demand – especially with China and India are already demanding 12% of oil worldwide (of total oil) that’s accounted by them, and commodities is a very similar picture.
So there’s a structural demand story. We’re not seeing it met with supply in either of those things, particularly oil is having a hard time to find supply. Potentially you could find another commodity at some point, we haven’t seen any investment or enough investment there. But you’re not getting the supply response. So we think that these companies we don’t see much lower oil prices at this point. We think technically it looks pretty ugly on a chart: it could go down to $50. But at $50 you’re still getting a very bullish environment for profit growth in these companies. And without looking at the mania candidates you still have a real valuation picture of why you would want to hold these companies. So I think you’re getting an opportunity for those that haven’t been in to really buy, and for those who are in to add to position. I think that’s what you’re seeing right now. [32:38]
JIM: Let’s talk about the stock market in general because generally investors have been cautious towards stocks. In fact, it’s very hard to read anything since the beginning of the year that isn’t negative. However, if you look on the other side, the sell side equity strategists – I think it was the Wall Street Journal poll of equity strategists, the same thing with BusinessWeek – it was really hard to find a bear amongst them. Does that trouble you?
PHILLIP: It does trouble us. And it troubled us going into this year when we set out the Outlook. And you know we don’t like to sound like we’re with the consensus on the strategy, we start to question our theories when we are, but there’s no sense in being contrarian for the sake of being contrarian. We did see one of the things that, as you pointed out, which is more important see what investor skepticism is, rather than purely analysts and speculators. And we did see a lot of worries about housing, we saw a lot of worries about the Fed, we saw a lot of worries about how the economic environment will play out. People have fought it, equity rally in particular, the whole way up, which is probably why it has done well, and they still continue to be concerned. And we are seeing the strategists on the Street, although a lot of them were bullish coming into year end, a lot of them in recent days have switched pretty dramatically I think from chasing the recent trend. And so we find that encouraging I think. Again, we don’t like for personal uses to venture ourselves on where we differ, we just don’t want to disregard any of the other strategies on the Street. But it doesn’t worry us.
We think in the first quarter again it’s your risk opportunity, if you’re going to get a shakeout or correction it’s going to be here. Afterwards, the environment is still very positive towards equities. And like I said, if you support valves for equities heading forward. One is that valuations as I said were very attractive. And another area is really this whole corporate leveraging: people worrying about M&A activity and LBO activity being at extreme highs. But part of that is just because yields in corporate yields are extremely low in comparison to value. It’s pointing out the opportunity in the value within a lot of these equities and how in this environment a lot of those equities should be more leveraged, and that’s why the LBO activity is occurring. That is probably fairly bearish for corporate bonds and one of the reasons why we’re cautious – certainly cautious to corporate bonds. But it’s a bullish argument to equities heading forward and we think some of these large caps – US equities, in particular – could do well, or emerging markets. And our portfolio, our asset allocation model has still been favorable, it’s still overweight equities and it’s really recently ratcheted up emerging market positions. So it’s taking an aggressive approach in the wake of this weakness, and it’s had a pretty strong track record in the last decade – outperformed every year. So we don’t take it lightly. It’s only one measure we use but nonetheless. [35:26]
JIM: You say that stocks are probably one of the last major asset classes to be re-rated in this asset inflation. Phil, are there any other assets that also have a lot of catch-up potential?
PHILLIP: Yes, I think so. Stocks are one of the largest asset classes with the most liquidity. It’s remarkable how it hasn’t been re-rated as much yet, and that there’s real opportunity there still. But there are other asset classes for investors. In particular, I can think of, within the emerging market theme, there are a lot of emerging market real estate markets: in particular the Chinese market, Vietnam. There are a few real estate markets that have really lagged behind house price inflation everywhere else. We’ve had a bubble everywhere else. I mean German real estate is another good example. We’ve had a bubble-ish pricing everywhere else, and yet these ones have really lagged behind both houses prices elsewhere, and economic growth within these regions. They really haven’t kept pace. Now, there’s some issues with capital controls in China, or investment controls in China on some of the main cities, but there are a lot of second tier cities that have opportunities. So there’s opportunities certainly through there, that I would think, anyway. [36:36]
JIM: Let’s talk something about this liquidity cycle. And you’ve written in the past about what you call the debt supercycle: and that’s a long term decline in balance sheet liquidity and the rise of indebtedness. Could you summarize for our listeners very quickly the debt supercycle.
PHILLIP: Sure. I think the debt supercycle is a term coined by BCA probably before I was born, decades ago. I mean it’s been in existence for a long time. It’s a way of framing how to think about policy action, especially during a recession. And the idea being after the 1930s depression, many policy officials thought at the time it was appropriate after the run up of the 1920s to let the financial markets cleanse themselves and wipe away the excesses. And that’s partially why we ended up in a great depression. And since then, they determined that it’s not the appropriate [cure] and it all means in this environment we’ll try to avoid having deflation, and having a major shakeout. I mean we saw that with the consequences of within Japan over the past 15 years, actually dipping into deflation. It’s a doomsday, so to speak, scenario.
So the argument goes that every time you have a difficult downturn that potentially leads to a recession the Fed, or fiscal policy for that matter, will come to bail out and get some automatic stabilizers and they will come to support conditions. And we saw that in every crash so far – certainly from the 60s on. So that’s why you end up with these mania type candidates. Basically, the idea is that you can postpone today’s problems by pushing them off till tomorrow by flooding the system with liquidity and creating more leverage, and increasing leverage and balance sheet leverage. I mean assets go up as well so it’s not quite as bad as if you just look at one side of the equation. But that’s the general picture of the argument.
Now, in today’s environment we have US policy makers, for example, who have a lot of stimulus. It would be wrong to think they couldn’t flood the system now. I mean the policy rate has gone from 1% to 5 ¼. And they’ve shown a willingness to slash them and hold them down for an extended period of time. So that could be done well. The fiscal deficit has narrowed recently. It could be widened back out; and the US dollar could fall further if needed. So there’s lots of ammunition, if you will, to provide that that’s not going to end. So it’s a framework we use, and especially during recessions, to analyze the world, but it’s not something we would expect to come and unwind, and it really comes to unwind when confidence in the dollar completely deteriorates and it’s no longer a reserve currency, and people won’t buy them anymore. I mean, that’s a long ways from occurring. So there’s a lot of things investors should worry about – in the current environment that’s probably not one of them. But it is an interesting framework in which to picture the world and how things evolve and why debt levels have increased so much over the recent years. [39:35]
JIM: You bring up a point in this – probably a word of caution to those that are super bearish – is the Fed has sort of reloaded the chambers so to speak, because you have interest rates back up to 5 ¼, the budget deficit has dropped from 4% of GDP down to 2%, and we’ve got a bit of a dollar rally. And certainly, as we saw in the 2001 recession, all 3 of those tools were used to reflate the economy. And as I look at it the chambers are reloaded.
PHILLIP: Yes, I would agree – at this point they’re completely reloaded. There’s lots of room to provide this support if needed. One of the things you brought up there was the dollar and we are seeing dollar strength. There are a lot of questions on the dollar constantly about that. We’ve argued it should trade firm and will be firm – we’re seeing it now. One of the valves is obviously a weaker dollar to provide the stimulus. The thing is the structural backdrop I laid out at the beginning of a low inflationary world, when you have that world, everyone (particularly the emerging markets) they first of all rely on the US for demand. And a weak dollar deteriorates that demand – it really hurts them. But when you’re stuck in an environment with very low inflation there’s no risk to depreciating your currency. So what you end up with – and what characterizes currency markets really well over the last few years – has been competitive devaluation. You end up with that. And so they cut interest rates providing the stimulus, drops their currencies and resupport their economies without the risk of creating inflation or domestic inflation for them. So that’s the other escape valve where you get some stimulus in the system is you either get a dollar drop and provide stimulus, or you can also get a lot of liquidity from central banks worldwide who slash interest rates to prevent that. So I think there’s lots of room to have liquidity and stimulus and support worldwide. It’s in nobody’s interest to see these conditions fall apart, either here or in emerging Asia. So I think policy will be fairly stable and accommodative. [41:35]
JIM: Let’s talk about something that could possibly change and I want to get your views on real estate. I know you’ve written that the downturn has further to go. Recently we had Alan Greenspan who said that it’s stabilized and we’ve hit bottom. I don’t see a bottom in real estate at this point. Do you?
PHILLIP: No, we don’t. At most we would agree that the rate of change of decline in many of these have bottomed. But that’s not saying a lot given how rapidly they’ve declined. I mean real estate in general we saw real prices decline in the 70s and 80s, and both of those episodes saw real prices decline, not only over months, but really over years – 2 to 3 years of declines. So it’s a long story that has a long way to play out but even some of the rate of change measures haven’t bottomed to levels like that – permits on an annual basis haven’t hit the lows that it had in the previous six times. So we still see some pain there.
We’ve seen the consumer come off, and we haven’t seen the implications in a full way on the consumer yet and I think that’ll start to continue to see true. Like I said, inventories are very high. We had some of the comparisons I guess between the UK and Australia is the housing markets came off and the consumer came off and since they’ve stabilized and even picked up. A key difference though is they didn’t have the inventory overhang that the US has. And I think it will take a while to clear that. I said before the worst case scenario if you have unemployment come off which we don’t think will come off in a major way, but if you did and you had forced sellers that would liquidate in a hurry. But banning that, it may take a while for supply and demand really to match up again, and we may see a weak Spring season coming out. So no, we don’t think we’ve seen the bottom in housing at this point. We think that will continue to be a drag. [43:23]
JIM: So your thesis that you’ve been predicting of a mid-cycle slowdown in the US economy – and certainly that played out last year – you see that playing out this year as well. In other words, maybe we get to 1 ½% to 2% growth rates in the economy but not a recession.
PHILLIP: We do think the mid-cycle slowdown has got a bit further, probably the first two quarters of this year. Probably in real growth terms I guess growth has dropped down to 2 ½-ish – it’s running at about now. Although we don’t do point forecasts. I mean in general we expect it to trend here, or maybe marginally weaker in the fourth quarter. So it’s not a real massive drop in any way – enough, because it’s below trend, to bring down inflationary pressures further; enough to encourage the central bank over time to ease. So I think it’s there. Maybe it doesn’t hit below 2 – gets down to 2 or something. But nonetheless, below trend for the next couple of quarters. I think that’s kind of where we see the environment, which isn’t that bad for profits: you get a bit of a disappointment and a couple of quarters from where expectations are, but you get the interest rate relief as I said to support conditions. And then ultimately, it will lead to a re-rating in equity prices. [44:35]
JIM: What about the other reasons of the world. Certainly the US has been one of the drivers of economic growth but also Asia – in particular, China. Recently, looking at China, they’ve been raising interest rates; both credit and broad money supply have rolled over – they’re now down in the low double digits; and annual growth in capital spending has slowed 32% to 22% in the past several months. This slowdown or mid-cycle slowdown that you’re seeing here, are we going to see the same thing, for example, in Europe where exports have been strong, and also in Asia?
PHILLIP: Yes, I think we definitely will. We’ve seen that as you pointed out, China has cooled. And that’s an important distinction because most investors and clients we talk to they have either a boom scenario for China or a bust scenario for China. It doesn’t ever seem to be the happy medium scenario for China. Which I guess historically has been good. But China has shown much more ability in fiscal and monetary policy in recent years. And what they’ve been targeting is a much more gradual slowdown to remove some of the excesses that were occurring within capital spending growth; and the overheating – they wanted to remove it. As you pointed out capital spending growth has slowed from 32 to 22. I think it’s in the direction that they want. They may want to see modestly more slowdown; but I think they’re looking to fine tune and engineer. They’re not going to cause any problems there.
And without inflation, there’s many pockets of the Chinese economy still in deflation and overall consumer prices are overall very, very low. There’s really no inflation there. Without that, there’s no incentive for them to knock it over the head and slow it down. I mean, they should want it to continue growing. So all they’re doing is fine tuning. So we’re not so worried about China – that’s one of the growth engines of the world’s economy. So we’re optimistic we’re not seeing the volatility within China.
On Europe – that front – Europe tends to lag the US by 6 to 9 months, and our growth indicators do indicate that the Europe is probably peaking out here, and will decelerate heading in to this year. But different scenarios there is that Europe is going to slow towards trend, but it’ll still stay above trend. So in other words, growth will come off a notch in Europe but it will stay relatively firm and the central bank continues to hike and probably will until the Fed goes on hold which will cause further drag to cause their economy to slow as well. But we’re not looking for a terrible picture – we are looking for it to slow a notch.
And the Japanese economy – our indicators are suggesting well, the consumer has already retrenched and we’re seeing it start to come off the boil now. The external demand has already rolled over and it should over the next 6 months. The Japanese economy in general we’re a little worried about in the sense that there’s some fiscal restraint at the moment, and monetary policy already seems to be aggressive in wanting rates higher. I just wrote a recent special report on the deflationary tendencies within Japan. And so we’re nervous that they may be making a minor policy mistake. Now in this environment of low inflation and relatively stable global growth, it’s very forgiving in the sense that other asset markets like the yen at the moment is working to bail out the economy by drifting lower to offset monetary hawkishness there. And up until recently so have the bond markets. So it’s forgiving in the sense that there’s other valves to support things, but nonetheless it’s not a vote of confidence for the central bank there.
So yeah, I think we will see on the margin some of these other economies coming off. And that’ll probably lead to relative performance in equities markets. Some notable difference in the US, we expect US equities to probably to outperform Europe and Japan particularly heading to the first part of this year. Because as we get closer to the interest rate cuts you’re going to get some stimulus – a relative liquidity boost – unlike what we saw when the Fed started hiking rates early on in the cycle. And so, say US versus European equities, US should probably outperform as the ECB still remains hawkish.
Against Japan, it’s a tougher picture. It’s outperformed – the US has. Japan’s equity market is very pro-cyclical. So in the first quarter, it’ll still be under downward pressure. It’s had a little bit of a bounce recently. There’s some risk there until the global growth stabilizes, at which time then Japan could be a good story for the second half of this year. Now, there’s still a lot of value in Japan – valuations are cheap. From a PE perspective they’re always high, but relative to where they have been historically, and relative to other markets historically, they’ve come down quite a bit. So there could be another upleg to the Japanese stock market later this year. But until global growth stabilizes it’s probably pretty vulnerable. [49:18]
JIM: Let’s talk about the bond market and your views on interest rates. Certainly, this is one of the longest periods that we’ve seen the bond market in inversion here in the US. And there’s a lot of stories – there was one this week in the Wall Street Journal, talking about inversions in terms of track records, and predicting recession. Now, although it doesn’t do it every time, the majority of the last several decades every time we’ve seen an inversion it’s been followed by a recession. Given your views, I think you would disagree with that.
PHILLIP: Yes, we certainly would. And that’s one of the questions we get quite frequently. A lot of people are nervous about how much inversion or any inversion suggesting of a recession. We’ve leaned against that in recent years quite a bit. The reason for it is that we think in this environment – as we’ve characterized it – you’ve fairly stable economic growth which essentially brings down long bond yields. You have low inflation to start with and relatively stable growth. So there isn’t much of a premium justified on the long end of the curve. So you should be running roughly on aggregate at a flattish yield curve. And during economic slowdowns which we’ve had just now you should probably get a modest inversion as the long end of the curve comes down to support it and prior to when the Fed cuts. When the Fed cuts a bit then you get it steeper. So we’ve argued in recent years that a good indication of neutrality from the global perspective is probably a flat yield curve. And so when you’re running that flat then just with normal business swings you can end up with modest inversions.
Now, that being said, that’s probably the US market or global as a whole – but within individual countries you can end up with massive inversions or steep yield curves. And the reason for it being is the long end of the curve globally has become much more correlated. As you bring down volatility worldwide, and more interaction between capital flows worldwide, you end up with a higher correlation in economies and a higher correlation in the long end of the curve. So what happens is in New Zealand and some of the other countries, say Australia or the UK, where policy rates have been jacked up quite a bit to a restrictive level, the long end of the curve is still moving with global prices of capital. So you can get significant inversions in some of these countries, and it certainly doesn’t herald and certainly hasn’t been a great indicator in recent years of a recession. You would have thought the New Zealand economy clearly slowed, but then other asset prices – currency and the bond market – adjusted lower at one point bail it out. So we think that the inversion of the yield curve is probably not a great indicator any more anyway of a recession. And probably on aggregate at the global level, it should be flat. [52:11]
JIM: Phil, as we come to a close, taking a look at how this year should be played, you expect a mid-cycle slowdown. You think that as we do, we think the Fed has plenty of room in its chambers to be reloaded if the economy weakens more than anticipated. Last year at this time, you recommended a bar bell portfolio in US equities holding a mix of cyclical and non-cyclical sectors. What is your strategy for this year?
PHILLIP: Our strategy for this year I guess largely hasn’t changed that much. We are favorable towards I guess industrial or capital-goods intensive sectors, whether it be industrials or parts of the tech sector, and underweight those that are consumer related because we expect some weaker consumer numbers to come in, housing numbers to weaken. So we’re overweight those that are reliant on business demand and overweight those, and underweight consumer related holdings. The difference is, I guess, the other thing we would be favorable on would be many of the global plays because the US is at the moment through the first part of the year is relatively weaker. So that lends itself to some of the consumer staples and healthcare as well. As well as the US economy slowing down, those things which are historically defensive do okay. So it is still a mix.
The two big categories separate from that are financials which we have been underweight banks which have been a good trade. However, we’re getting as we approach Fed rate cuts that will lead to a steepening of the yield curve – at least a marginal steepening of the yield curve which is historically quite positive for banks. So we’re really in this last legs of this banking sector underperformance, and we could see outperformance some time later this year in that. And the other difference is energy stocks. As I said, they’re weakening but this is quite a bullish story both from a cyclical and a secular perspective –and a potential mania candidate. We think there’s some weakness clearly going into this year which has got a lot of investors worried but we think it’s just putting them in a good buying opportunity, or a good opportunity to add to positions. [54:21]
JIM: I want to get on to that because you’ve done a graph – we’ve seen this almost every single decade going back for almost the last half century, which is every decade has its own mania candidate. And the reason I’m bringing that up is – rather than trying to time [the market] – for example, oil stocks are going through a correction right now as oil has; and we’ve seen gold do the same. A lot of people will jump out – it’s almost like when you read what the financial media is saying a lot of people are jumping out of windows right now. But if a sector, as you guys have pointed out is a candidate for a mania – energy being one, gold being another – wouldn’t an investor be better off just holding on and enjoying the ride rather than trying to figure every bottom and top in the cycle going up?
PHILLIP: I agree completely. I mean that’s one of the arguments –that’s one of the reasons why at the beginning of this decade we started pointing towards energy, and we were sitting back at the end of the decade and saying what is our mania candidate. I mean it usually reveals itself somewhere in the first half a decade. People are not quite sure when it gets some sort of correction of whatever, but later in the decade when it really gets bid up, when you look back at it you can say, wow, it’s really been the play for most of the decade. And I think that’s really the case. So finding and identifying what the mania candidates are – especially in a world of lots of liquidity – essentially the job of a longer term investor can be is find those mania candidates early on in the decade after the recession where we’ve finally bottomed in the market, buy them, hold them, and by mid-decade when you’re sure they’re right, which we think on these ones, you lock your positions in or have them locked in at that point and take off the rest of the decade. So, almost - I mean it’s a bit of an exaggeration but it certainly has paid dividends.
But playing cycles, as you pointed out, in these mania candidates with structural benefits, in particular, in asset classes that has such valuation advantages at this point – trying to pick the tops and bottoms typically what happens is you miss good chunks of it because you’re out and you’re looking for the correction to buy back in and you end up missing it. Right now, I think we’re getting that correction and a bit of a gift. But typically as we get on through the decade we don’t get those kind of corrections. You keep looking for corrections that don’t happen, and you make yourself bitter by wishing that you were still in them. So I think you’re right. Certainly longer term investors can play that strategy. And I think yeah those are probably our top candidates. As you mentioned, gold is another one of them in particular.
Gold - I think we need to differentiate that area. I wrote a report last year on gold. Many people still view it as an inflation play. I don’t – I think it’s quite the opposite. It think it’s a liquidity play and lots of excess liquidity is beneficial for it. In fact, I think inflation is a negative for gold because what it encourages is central banks to become overly hawkish and remove liquidity. So we saw that actually: a big run up in gold prices, when inflation started to show its head last year we had the correction in gold prices; inflation has come off and gold seems to have stabilized and maybe edged up in the latter part of last year. So I think the world is still full of liquidity and I think heading forward we’re probably going to see a bigger run up in gold prices. I mean a lot of people would say it’s had one heck of a run up, could we not get a big shakeout? That may be the case, but I think these things typically when they’re in a big bull market shakeouts tend to be more lateral than down. And so that’s the risk I think because of trying to be timing it too much. [57:55]
JIM: Well, Phil, as we close, why don’t you tell our listeners about Bank Credit Analyst Research. And if they wanted to get information about the services you provide how they could do so.
PHILLIP: Excellent. I appreciate that. Bank Credit Analyst Research we’ve been around since I believe 1940s. We’re an independent research house that’s been providing independent research since the late 1940s. So our views are clearly our views and not biased elsewhere. We have a vast array of products that cover the whole globe basically – every region as well as every asset class from the fixed income to the equities. We’re starting up an energy and commodities based service this year. So we cover the majority of the world and a long track record. And the best way to get a hold of us is we’re Montreal based, and we have offices everywhere including California for California based listeners. But our main office where the research is done is over at Montreal. And you can get a hold of us here at 1-800 724 2942, and either one of our analysts or sales people would be happy to talk to anyone. [59:01]
JIM: Alright, Phil. I want to thank you for joining us here on the Financial Sense Newshour with your Outlook 2007. Once again, the theme: another year riding the liquidity wave. All the best to you and a prosperous New Year.
PHILLIP: Well, thank you very much, and I appreciate you having me. Best of luck in trading for you too.
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