CFO Survey Indicates Good Growth Ahead

The latest Duke University Fuqua School of Business CFO Survey came out recently and it made pretty positive reading. First of all top line data in the States suggests an uptick in confidence...



source: cfosurvey.org

However, we see a slightly different story in the Rest of the World


source: cfosurvey.org

Essentially, what we are seeing here is confirmation of good growth in the US and in particular in retails sales. Ultimately, this has a concomitant positive effect upon those Asian countries that peg their currency to the US Dollar and are structured to export to the US. A classic example being Taiwan and how they rely on the US semiconductor industry via their manufacturing foundries.

China is not as strong and I suspect this reflects some macro economic concerns relating to the housing market and/or the Government trying to rein in inflation by increasing the banks reserve requirement ratio. Even so, Chinese business still forecast 19.1% earnings growth in the next year, as well as 11.3% increase in capital spending. Both of these numbers were above last the last quarters forecast.

In Europe, the numbers are noticeably weaker. This reflects the fears of pressure on the financial system from the European Sovereign Debt crisis. Earnings growth forecasts were reduced to 10.4% annual growth  but capital spending plans increased to 6.8% Worryingly, hiring plans were reduced to an anaemic .2% growth.

Returning to the US, we see that earnings growth is now forecast at a stonking 19.8% with capital spending plans increased to 8.9% Technology spending is predicted to increase by 4.8% and employment by 2% The employment number seems low, but it is actually the highest since March 2006!

Bullet Points on the CFO Survey

A few bullet points here

• Perhaps there is more to run in the capital goods sector?
• US Employment growth looks better
• Asia ex-China looks set for growth, but can they cope with any slowdown in China?
• Europe is reacting to Sovereign Debt fears

Conclusions on Duke CFO Survey

In conclusion, I think this survey perfectly encapsulates the dichotomy in the Global Economy. Growth in the US is getting stronger, but perhaps the differential between the US and Europe is explained by the relative sentiment of Sovereign Debt? If so, than should US Municipal Bond fears flare up than the solidity of the recovery will be called in to question. I think 2011 is delicately poised.

It looks like Spain is in trouble and I expect more action will be necessary by the ECB. I would not rule out the creation of 'Euro bonds' before the end of 2011. Whether the US Municipal Bond Market falls victim to negative sentiment is anybody's guess. However, I note that, whenever I check it on CMA Datavision, the market is pricing in the probability of default in California as being similar to that in Italy.

Moreover, any slowdown in the US housing market will hurt revenues in California and Florida. There are also question marks over the probability of China engineering a soft landing for its housing market.

With regards asset allocation, I still consider market neutral to be the optimal strategy for 2011.

European Sovereign Debt Spreads Before and After ECB Action

After a few days of the markets backing off of fighting the ECB, I thought it would be interesting to review some European Sovereign Debt metrics. Whilst equity markets and are enjoying a relief rally and a return to the bias towards risk assets (propelled by Quantitative Easing 2) it is far from clear whether the underlying fundamentals have been dealt with. This could take time.

Firstly, looking at Spain/German Yield 10 Year spreads...



reveals that they are still elevated. Similarly, Spain 5 Year Senior USD CDS



Portuguese 5 Year Senior USD CDS



However, it appears that the Federal Reserve at the ECB were entirely right to act quickly to avert 'Ireland' turning into 'Greece'. It is my opinion, that there were liquidity problems with some European Banks in Q2 and, some stress metrics for the banking system reflect this. Here is the 'Ted' Spread. In other words, the difference between short term interbank loans (LIBOR) and US Government debt (3 month T-Bills)



So it appears that QE2 was entirely justified!

I think there is a risk that this sort of game could continue in 2011. Spain's recent PMI numbers were signalling contraction recently and their housing market is far from being out of the woods.

I run a hedged portfolio with a bit of a discretionary element by which I play with delta. Right now I have the portfolio positioned with a cautious stance.

UK Banks Counterparty Risks and Exposure to European Sovereign Debt

UK Banks Counter party risk and exposure to European Sovereign Debt. According to the Irish Times the amount that Britain contributed in a direct loan to Ireland, is equivalent to what the British banks are paying their staff in bonuses this year. On top of the previously mentioned £7bn there is also the possibility of an additional £3bn UK taxpayer contribution  as part of an IMF deal.

All of which throws light onto the problem of how the banks were and, still are given incentives to create this mess. The principle of taking on the returns whilst shuffling on the risk to the taxpayer has gone on undiminished in its vigour. The last time around, the public were sold the story that all of this had hit the banking sector by 'surprise'. Is that the case this time around?  

I doubt it.

 Even as recently as June the Bank of England had highlighted the banks counter party risks in their bi-annual Financial Stability Report. I recommend a reading, particularly as it came at a time when the markets were dealing with the de-risking effect of the Greece bailout plus concomitant ECB Sovereign Bond purchase program. The risks were clear. Not lease for the risk to UK banks over European Sovereign Debt difficulties. On page 21-22 of the report

"UK banks’ direct claims on Greece and other small European economies facing economic pressures are modest relative to their capital (Chart 2.6).They are also small relative to UK banks’ other foreign claims (Table 2.B). But the interconnectedness of the financial system amplifies the credit risk faced by individual banking systems. In the euro area, a number of banking systems have significant exposures to countries under economic pressure — including countries in Central and Eastern Europe (CEE) and the Balkans.

Together, French and German banks have large exposures to borrowers in Spain, among which credit risk remains elevated. The IMF reported in its April World Economic Outlook that it expects Spain to grow more slowly than the euro area during 2010 and 2011. UK-owned banks are particularly exposed to the French and German banking systems, which account for around one quarter of their claims on banks globally"

There is no doubt the banks understood these counterparty and sovereign debt risks. In addition, the close proximity of the dramatic rise in Greek bond yields was a clear warning to the potential exposure to counter party risk, should sentiment turn against certain countries Sovereign Debt. The response of the banks to this risk has been to raise their Tier 1 Capital Ratio and hoard cash (in other words they are not loosening credit conditions)  whilst awarding their staff huge bonuses.

This has the effect of holding back the economic recovery-loans are not being made- which ultimately hurts the banks as it puts pressure on their assets. However, their staff are awarded bonuses for benefiting from the recovery in the economy. A recovery which was only put in place by taxpayer largesse in the first place. The banking sector stocks have underperformed massively, so the shareholders (including the UK taxpayer) are not benefiting, as usual.

In a sense, nothing has been learnt. The financial services sector is still gaming the system at the taxpayers expense and, will continue to do so unless legislative action is taken.

Source:

Bank of England, "Financial Stability Report" http://www.bankofengland.co.uk/publications/news/2010/054.htm June 2010

Irish Times Article, "Rescuing Irish banks costs same as UK bonuses"http://www.irishtimes.com/newspaper/finance/2010/1124/1224284027417.html Nov 24, 2010

China's Foreign Exchange Reserves and its Effect on the Global Economy

For foreign exchange investors one of the key issues facing the currency markets will be the future behaviour of China, India and the rest of the Far East. They hold huge foreign currency and gold reserves, particularly, if measured against their GDP. They maybe holding them in order to provide China stimulus. Similarly, it may be part of a movement toward a one world currency.

Whichever the reason, they are hoarding reserves and the implications are significant. The hoarding creates a global structural imbalance between countries that are savers and investors. As a consequence,many see the need for the Asian countries to start spending and stop saving, in order to bring the imbalance back.

China Foreign Currency Reserves and GDP. One World Currency?

This article explores the issues of how and why they are saving. Firstly, here is a selected table of foreign exchange and gold reserves as a share of GDP (trillions) courtesy of the CIA:

                FX & Gold Reserves                GDP       Reserves as % GDP
China                  2.42                               4.8                  50.3%
India                     .28                               1.1                  25.4%
Japan                 1.02                                5.1                    20%

S Korea               .27                                 .8                     33%
Brazil                   .24                                1.5                    16%
Germany              .18                                3.3                   5.4%
USA                    .13                              14.4                      1%

China is the outlier and will be the focus of attention. In addition, India reserves are large and growing rapidly.

The Growth in Emerging Market Banking

In 2009 the Financial Times ran a cover story about how Asian bank ICBC had recently become the world’s largest bank by market cap and deposits, but yet held only about half of the assets of JPMorgan. This illustrates the fact that the amount of credit available and savings rates, is related to the relative sophistication of banking systems.The Asian banks tend to have lower assets/deposits ratio.

Indeed, the ideal ‘halfway house’ solution to the banking crisis could have been extensive investment and involvement into the banks by the Asians. The banks get the cash, the Asians buy the expertise. Unfortunately, Lehman Bros failed to pull off the deal with the Koreans and, the rest is history.

No one would argue for a repeat of the sub-prime debacle in Asia but there needs to be some changes. The point is that spending/savings rates are directly affected by the availability of credit and the nature of the banking system. As Asian banks become more experienced at securitising loans, then it is likely that decreased savings rates will follow.

Culture & Demographics in China and Far East

Demographic issues are obvious issue, particularly with the population aging, in Japan. Japanese pension funds needing to match liabilities and older people require short term, low risk assets. If compounded with their conditioning towards bonds (in particular US Treasuries) after being in a long term deflationary economy, then the result is a willingness to save at low yields.

More subtle is the understanding that the continental Europeans and Asians have differing cultural orientations to the Anglo-Saxons. They are more egalitarian in wealth distribution, and the Japanese seem to be entirely happy to preserve their cultural predispositions at the expense of economic growth.

This facet of wealth distribution has implications for relative spending patterns between egalitarian & Anglo-Saxon economies. The evidence suggests that it is the wealthier individuals (who hold a larger share of wealth in the Anglo-Saxon economies) that take the larger part of debt, so it is hard to see a structural shift here, anytime soon.

The Asian Financial Crisis and Foreign Currency

The most problematic of the savings patterns is the Chinese and other Asian growth economies. Objectively, they are nuts to buy US Treasuries. Why would anyone swap investment in their own higher return economy for lower return US debt?

The first answer is that they are buying US Dollar assets in order to weaken their currency and thus support export demand for their industries. The second is in understanding the policy intent following the Asian Financial Crisis. China currency manipulation in order to peg to the dollar is a clear policy objective,made, in order to protect against the mayhem caused in 1997.

However, what happens if the Chinese get emboldened from the use of their reserves to generate domestic demand, as opposed to paying for the bail outs? What if they- in the face of slowing US consumption- decide to pull out of buying US Treasuries, and encourage the (increasingly economically interlinked) Japanese to follow them? Many see this is a possible scenario.

China Stimulus and Government Spending

Who is spending what is also a critical concern. For example, free marketeers believe that the private sector is usually more efficient. It is not just about matching savings and investment. It is also about who is doing the saving and investment. Economic liberals don’t like Government spending, whether it’s in the US or China.
They would see hiking public spending (at the expense of private) as a portion of GDP is a drag on growth, in itself.

The big China story is about realizing the nascent energy that was held back by Communism. In doing so, they allowed the influx of Western know-how and, Chinese consumer demand was critical in that process. The China story is not about how wonderful the central command economy was, so ‘let’s have some more of it.’

China Domestic Demand

In addition, what happens when the Chinese/Asians start generating significant domestic demand? Will they operate an open economy in this regard, and contribute to global growth, or will they replicate the Japanese corporate model? This involves internal competition, but also doing anything they can to avoid competing with each other in foreign markets. Meanwhile, the Government protects them from foreign competition, by engaging in restrictive trade practices. It is not clear that increased Chinese spending will boost western export markets.

Global Economy

So in conclusion, the global economy does need the savers to start spending, but the outcome of it, is far from clear. The west may have been free market oriented and universal in its outlook, but it doesn’t mean that the Asians will be. However, given the interlinkage in the global economy the likelihood is, of continued international coordination. The graduated shift in approach from the Asians (in relation to buying US debt) should enable piecemeal restructuring elsewhere, however it does suggest risks of low global growth over the next few years.


Source:
CIA "The World Factbook" CIA website