Market Commentary
by Byron Wien
 
09/06/2012

A Constructive View as Summer Ends

For several decades I have organized a series of “Benchmark” lunches on Fridays in August for serious investors who spend their summer weekends in eastern Long Island. About 75 attended the three sessions, including leaders in hedge funds, private equity, real estate and venture capital. There were many billionaires and many others whose net worth hasn’t quite gotten there, but whose views are widely respected throughout the investment community. For the past two years the mood has been decidedly downbeat, but, looking back on it, I have to wonder how much the performance of the equity market during the weeks leading up to the lunches had something to do with how the participants viewed the outlook. If you recall, the slogan “Sell in May and go away” worked pretty well in 2010 and 2011. This year, however, the United States market hit its recent low on June 1 and stocks traded higher during July and August.

This has all taken place against background fundamentals that have not been particularly positive. Economic news in the U.S. has been mixed at best. While the European Central Bank (ECB) has been there to provide the liquidity necessary to keep the European Union together with the euro as its currency, the structural changes that would be necessary for any long-term solution to Europe’s problems have not been implemented. China is clearly slowing, and while it is still the consensus that a “soft landing” is likely, it has become clear that strong policy measures on both the fiscal and monetary fronts will be necessary to keep the economy growing at 7% or more. The outcome of the U.S. election is uncertain, and much of what could be accomplished by either candidate will be dependent on the composition of Congress and its willingness to compromise. There are other problems facing investors, but looking at the full range of issues, it is hard to understand why the market is doing so well.

Professional investors have responded to this reality by being risk averse throughout the year in spite of the market’s rise. As a result, many money managers are underperforming the major indexes, and so, as the group assembled to discuss what might happen over the coming year, they were looking for reasons to maintain their caution or to become more aggressive, knowing that the generally negative conclusions of the discussions during the past two years were followed by strong equity performance in the fourth quarter. Perhaps the generally constructive view of investors at the sessions this year means more trouble for the markets lies ahead.

Many thought that the United States economy had a lot going for it. Housing was bottoming, oil prices had a good chance of declining further because of increased North American production and reduced international demand, balance sheets were strong and productivity improvements had made American manufacturing extremely cost-efficient. There were plenty of cheap stocks around. Quite a few thought the economy could show growth of 3% between now and next August, although a small number believed the possibility of a recession in 2012 was real. Some thought the rising taxes associated with the “fiscal cliff” might be responsible for the slowdown. We debated whether manufacturing that had been relocated abroad would come back to a significant degree and concluded that a major renaissance was unlikely because Asia still had a considerable advantage in terms of hourly earnings per worker, although American workers were more productive. There was a lot of enthusiasm for innovation in knowledge-based and social networking industries, but there was general agreement that the impressive growth of companies in these fields was not likely to make a major impact on the U.S. unemployment problem. Those workers without technology skills would have a tough time finding permanent employment. Many of those out of work required retraining, and there seemed to be limited funds available for that. A revival of housing construction could provide some jobs for the less-skilled unemployed, but one of the real estate people pointed out that technology was moving forward there as well, putting increased demands on the qualifications of construction workers.

At all three sessions, most of the group thought the Standard & Poor’s 500 would hit 1500 before year-end. A few even thought 1600 was possible by next August. A small minority saw the index returning to 1250 (where it started the year) within twelve months.

I was surprised that most participants believed the European Union would remain together over the next year. The ECB would continue to provide the liquidity necessary to keep 10-year yields for Italy and Spain below 7%. It would also be there to enable Greece and Portugal to meet their obligations, keep their governments running and pay their employees. Some were impressed with the adjustments the weaker countries had made in their government cost structures. Most believed that pressing severe austerity on the weaker countries was a mistake because growth would be necessary to unwind excessive leverage. Many thought that Angela Merkel had played an effective role as a leader in trying to preserve the European project, risking her political capital in the process. Since Germany has the most to lose if the European Union breaks up because its currency would appreciate and its trade surplus would decline, Merkel probably is now in a stronger position politically at home than she was earlier in the year. Many believed the banking system in Europe was broken. There is no cross-border lending, and Basel II and III required the banks to raise more capital and reduce lending to corporations, which hinders growth. There was considerable concern about France, which has shifted to an anti-business stance under François Hollande with proposals for an increased wealth tax and high income taxes on big earners. Several familiar with the situation there saw France becoming a country with problems similar to those of Italy and Spain. The trade deficit was worsening and racial problems could become severe. There was agreement, however, that Hollande had not been an obstructionist in negotiations concerning the survival of the European Union and the euro.

There was again great concern over the economic situation in China. In the past two years this focused on the overbuilding of apartments and office buildings, but those familiar with the situation were less worried about that now. What did trouble them was that the slowdown in the economies of Europe and the United States had reduced demand for Chinese manufactured products. Inventories were piling up and production schedules had been reduced. The resultant demand for the raw materials had declined, creating problems generally for Australia and specifically for Brazil, a main supplier of iron ore. One participant suggested shorting Australian stocks because of the Chinese slowdown.

There was a feeling that the coming regime change in China would not be as seamless as those of the past thirty years. Corruption was a major issue now and the new leadership might be tougher on ties between government officials and private business people and more favorable to state-owned enterprises. There was agreement that the effort to rebalance the Chinese economy had not been successful. The five-year plan announced in late 2010 outlined an objective of increasing consumer spending and reducing the importance of export-oriented industries and infrastructure. Because China lacks the social safety net of Europe or the United States, the Chinese feel a need to save for their retirement and healthcare. The government is trying to get its people to spend more by providing incentives. One person pointed out that the leadership change about to take place will do so with several previous leaders still alive and with their factions still around to influence policy and create dissent.

The group overall believed that the risks of a hard landing were too great for the government to allow it to happen, and China had both the fiscal and monetary tools to prevent a serious slowdown. There were already thousands of incidents of social unrest and if the economy did not grow at 7% or more, these were likely to increase. There were a number of participants who believed that significant political change would come in the next five years. The people are dissatisfied with the lack of social programs. When the economy was growing more rapidly and millions of jobs were being created, they were willing to put up with the lack of healthcare and retirement support. Now, with the economy slowing, there is more pressure for the government to provide more services. While it is unlikely that China will move sharply in the direction of Western democracy soon, many believed the political system would become more liberal within a decade, with some even seeing the possibility of limited elections.

Naturally there was plenty of controversy over the coming election in the United States. While most of the participants were going to vote for Romney, the majority at all three sessions thought Obama would win in November. As you might expect there were a number of people who supported Obama in 2008 who were strongly in favor of Romney in this election. One of those said he thought Obama’s first term was a failure.  He was divisive and unproductive. He had failed in his objectives and had no idea of what it takes to create jobs. While he may be on the right side of a number of social issues, these are secondary to the economic problems America is facing. The leaks out of Washington were disgraceful. Obama has been a poor leader and a weak administrator. One who served on a presidential committee said he doesn’t listen to outsiders. He has this group of four – two Davids, Axelrod and Plouffe, Valerie Jarrett and Peter Rouse – who are the insiders, and few others have much influence. He doesn’t involve his Cabinet (other than Hillary Clinton) or Congress in decisions.

Speaking in Obama’s defense, some pointed out that the Republicans had thwarted everything constructive Obama had tried to do. He had accomplished some economic objectives by creating four million of the eight million jobs lost in the recession. The United States was performing better than any other developed country even though our growth was slower than we would prefer. His foreign policy achievements were uneven. He got Osama bin Laden, but he failed to protect Mubarak, although many in the group said the level of unrest in Egypt was so great that there was nothing the United States could have done to save him.

On the election itself, almost everyone was dissatisfied with the negative tone of the campaigns of both parties, but it seemed that the negative advertisements were working, particularly in the “swing states.” Most believed Paul Ryan was a good choice as Romney’s running mate. He has a specific program for reducing entitlements even though the budget wouldn’t come into balance for some time. Romney had been too vague on what he planned to do if elected. The choice of Ryan might also benefit the Democrats though, because his stand on the social issues may bring out the liberal vote. Many thought Ryan’s influence would make it less likely that Romney would move to the center if elected. That would make any compromise with the Democrats less likely. This is unfortunate because it is improbable that we will be able to reduce the budget deficit without both cutting entitlements and raising revenues. Most thought the whole tax code needed to be revised and many suspected that reducing the top rate from 35% to 25% would make the deficit worse even if all deductions were eliminated. There was a strong feeling that special interest groups would step in to preserve some deductions.

There was widespread impatience with the inability of the government to get anything done. Some hoped that there would be either a Republican or Democratic sweep of both the presidency and Congress so more legislation would pass. Gridlock was bad and changes need to be made, but with the economy slow, cutting entitlements could turn out to be a bad thing. The government accounts for 25% of Gross Domestic Product. How fast would the economy grow if the government cut back sharply? For this reason most believed the “fiscal cliff” would be deferred no matter who won the election.

Many believed the Israelis would bomb Iran if they thought the country was close to developing a nuclear weapon, although they would probably wait until after the U.S. election to do it. Some, however, believed a strike on Iran would help Obama because voters would not want to change leaders if the Middle East conflict was escalating. Some felt that while the clerics were in control of Iran now, the people of Iran were suffering under the sanctions, and most did not see what was to be gained from the country’s nuclear program. Several felt the “Arab Spring” would erupt in Iran over the next few years because the country had a basically modern, well-educated populace that eventually would overturn the present repressive regime.

On other issues, there was general feeling that gold had become overextended at $1900 and was consolidating now. At some point in the next several years it would resume its rise because monetary policy was easy and currencies in the developed world were being debased. We discussed alternative investment fee structures. Most thought that fees might come down somewhat but the best performers would still demand something close to the current structure and poor performers would go out of business. Some activists in the group felt they were gaining acceptance as a force for good. It was a clear case of democracy at work, with the shareholders demanding change. The government wasn’t getting in the way and some boards of directors were actually welcoming activists. 

There was general agreement that India and Brazil were slowing, but would still grow more rapidly than the developed world. The group felt the price of oil was headed lower because of increasing sources of supply.

While there was plenty of discussion on both sides of every issue, the conclusions overall were positive. What was clear was that the United States, with all of its problems, was still a better place to invest than Europe or Japan, although some real values were developing in Europe. I will be curious to see whether these lunches prove to be a contrary indicator this year.

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