Material Market

Are we seeing a materials breakdown?

Copper prices have been falling for weeks. Stocks tied to materials prices, like mining and metals companies, have gotten clobbered. These company’s fortunes rise and fall with the commodities that they extract. As commodity prices rise, earnings from mining go up, and vice versa. Is it time to jump in?

For patient investors, now may be a good time. It’s often profitable to buy when prices have fallen significantly, and a broad index of basic materials stocks has fallen over 25% in the past two months. Some well-managed mining stocks are currently trading at only five times their current earnings levels.

But in the near term there may be some further choppiness. These companies are tied to growth in Asia, and Asian currencies have been falling. The current message is of diminishing activity and lower inventories. Additionally, a survey of Chinese purchasing managers indicates that their factory production is easing. This is important, since their heavy industries have been building inventories for over a year, so they aren’t positioned for a slowdown in demand.

The story is clear: since we don’t know what the future holds, buying high-quality stocks that are currently trading at depressed levels is often a good strategy. But you need to be careful. Long-term investing usually rewards patient, price-oriented research, but those stocks are cheap for a reason. Short-term price swings can give anyone agita. A bargain isn’t a bargain if it kills you.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Get Out of Debt Free?

So how do you get out of debt?

There are really four possibilities: save, default, inflate, or grow your way out. Saving is a possibility—the Irish seem to be doing that now. It worked for Canada, Mexico, and Sweden in the ‘90s. But it really works best with a small country with strong exports. And it’s hard: the public sector has to shrink, and wages fall.

Default is another option. Russia defaulted in the late ‘90s, as did Argentina in ’01. After some disruption, the economy begins to grow again. And creditors don’t seem scared off for very long: Russian debt is now investment grade. But default works best when a country has a lot of natural resources. That encourages lenders to come back.

Inflation can work by making today’s dollars less valuable than yesterday’s debt. But because of the global inflation of the ‘70s and ‘80s, many governments index taxes and pension payments to inflation. Also, inflation-linked bonds mean that government liabilities rise in line with inflation. So inflating away debt would require changing—or defaulting on—some of those agreements.

The last option is growth. If an economy grows faster than the interest being paid on the debt, the debt is a smaller portion of the economy. But growth isn’t a painless solution either. It means the public sector needs to be smaller so entrepreneurial energies get unleashed. It means regulations may need to be easier so businesses can devote more energy to innovative products and processes. It may mean privatizing some state-owned enterprises.

There’s no painless way out of debt—the each option involves political decisions. But one way or another, those decisions need to be made.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Luck of the Irish (Part 2)

Can Ireland show the way forward?

Ireland has dramatically reduced its deficit, and growth seems to be returning. Is this a model the US could follow?

The intuitive appeal is visceral. After all, when families get into a hole, they need to tighten their belts, cut back on the lattes and leased BMWs, and live within their means. Could “expansionary contraction” work in a larger context?

The US economy certainly could use some help. Government debt held by the public is now 450% of government receipts. Because interest rates are so low, the cost of servicing this burden hasn’t hit us very hard, but this is a heavier debt load than almost any other developed country.

But economies aren’t families. When families get big and complex, saving gets complicated. You might cut back on steak every night, but still have the latest iPhone, iPad, and web-based hosting solution in order to grow a small business. Similarly, expansionary fiscal contraction has worked in the past—in Sweden in the early ‘90s and Canada in the mid-‘90s—but those countries are fairly small, and their turnaround came in the midst of global economic growth.

Austerity is intuitive as a way to get out of debt, but that appeal comes from a faulty analogy. Rather than being like a family, countries are more like complex ecosystems, adapting to new circumstances, interacting in complex ways, and either growing or declining.

Austerity works best when everyone else is growing. For the US, that isn’t the case right now.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Luck of the Irish

Can Ireland show the way forward?

A year ago the failure of Irish austerity was widely expected. Irish interest rates were similar to Greece’s; public sector pay was cut by 5-10%; and social welfare payments were cut for the first time since 1924. As unemployment hit 14%, many liberal bloggers commented that contractionary fiscal policy was, well, contractionary. They expected budget cuts to lead to higher unemployment which would lead to lower consumer spending and more layoffs, perpetuating the cycle.

But a funny thing happened on the way the Armageddon: the Irish economy turned up. Ireland has had two quarters of stronger-than-expected growth, unemployment has stabilized, domestic demand is up, and borrowing rates are down. Their economic expansion is broad based, growing in the areas of manufacturing, agriculture, transport, and communications.

Does that mean we can save our way to prosperity? Not necessarily. The Irish economy is highly dependent upon exports. Half of Irish industrial production is computers and pharmaceuticals. Their residential and commercial real-estate markets, which had a much bigger bubble than ours did, remain stuck in the doldrums.

But it does point to one thing: Irish austerity did calm the bond markets. Amid the current discussion of a possible Greek default and ring-fencing bad assets, Ireland isn’t part of that picture. As the only English-speaking country in the Euro with a well-educated workforce and low corporate taxes, Ireland has a lot going for it.

Austerity has worked at other times. Let’s hope it does here. The Irish deserve that much luck.

Douglas R. Tengdin, CFA
Chief Investment Officer
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What Now?

What should investors do now?

Whenever the markets get crazy people ask how they should react to the craziness. But that’s the wrong question. The question is not how folks should respond—it’s what should investors have done to prepare. Investment is a forward-looking process. Markets try to anticipate the next set of data. Sometimes they get it wrong, which is why the stock market has predicted 10 of the last 5 recessions. But if you react to the markets’ craziness, you’ll go crazy yourself.

Stressing out over the economy is no way to invest—and it’s no way to live. A portfolio should be your servant, not your master. It should provide the income, or growth, or stability to help you do what you want in life—not the agita or heartburn or anxiety to cut your life short.

Cycles happen. Businesses get overconfident and overinvest when demand doesn’t justify the capacity, then they cut back and get overly cautious. The truth, as always, is somewhere in the middle. And so we cycle through bouts of optimism, mania, contraction, panic, skepticism, and optimism again. Investors should have a plan that anticipates these regular cycles.

Managing money is really about managing risk. And the first step in managing risk is managing yourself—what your needs are, what your goals are, and what your resources and limitations are. A sensible investment plan takes all these things into account. So when times like these hit and people wonder how you can be so calm you can smile to yourself.

Investment isn’t so hard; it’s planning that’s the real work.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Greek Fire?

Are we headed for another recession?

That’s what the markets seem to be saying. Global stock markets are down over 20% from their highs in July, and global bond markets yield almost nothing. If you don’t like 10-year US Treasuries at 1.76%, you could try German bonds at 1.69%. Some fundamental data are troubling as well: Chinese manufacturing appears to have contracted for two months in a row, now; US employment growth seems to have stalled out.

Most significantly, there are concerns that the debt crisis in Europe will “spill over” to the United States. If the Greek government defaults and European banks have to take losses on those bonds, they may lose so much money that they need to cut back on lending. A lot big corporations borrow from these banks because of their global reach. If they can’t borrow, they may have to cut back.

That’s what many are thinking. But there are some holes in the theory. For one, European governments aren’t shy about propping up their banks. The French nationalized many of their banks in the early ‘80s, privatizing them again after about 5 years. And the US Treasury’s TARP program prevented a systemic failure here in 2009.

Also, recessions usually begin with a shock to the system—people are surprised by some negative event, and so they pull back. That’s what happened in 2008 when residential property values began to fall. There’s very little about the European situation that is a surprise. As a result, cutbacks are less unlikely. Where would you cut?

There’s always a chance that the economy could stumble. But for now, the chances appear slim.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Silver Linings

Does every cloud have a silver lining?

We’d like to hope so. We’d like to hope that bad experiences can build strength of character or push us to make needed decisions so that in the end we’re better off. Is that what the global stock markets are facing?

First, the bad news: the Fed botched its two-day meeting, and came up with a confusing, contradictory statement that satisfied no one and resulted in a global equity rout. Inflation hawks don’t like the time-focused low-rate guarantee. Inflation doves think that inflation is too low now—what’s needed is 3% or 4% price increases (along with wages) to get animal spirits going again. Neutral observers read the statement and asked, “Is that all there is?”

The truth is we’re in a debt-deleveraging slowdown; consumers are saving more, businesses are saving more, and political gridlock means that government is saving more. Increased investment isn’t the solution: it runs the risk of creating capacity where there’s no demand—like quirky solar energy tax-credits for installing panels in cloudy climates. How do we get out of this funk?

The good news is that the debt crisis could push both Europe and the US to reform our retirement systems. Longer life-expectancy means that people can work longer, and that’s a good thing. More experienced workers tend to be more productive. And we will need that productivity, because continuing development in Asia, South America, and Africa will shift global demand from the North to the South. And as that happens, global incomes will rise.

Not every cloud has a silver lining. But hopefully, the current crisis does .

Douglas R. Tengdin, CFA
Chief Investment Officer
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Reruns?

We’ve seen this movie before.

Europe moves towards greater unity. Economic tensions develop. Speculators challenge the weaker countries. Markets are volatile. The call goes out for the strong countries to support the weak. The Germans resist, a crisis ensues, and eventually, a new structure is enacted.

The year is 1998; the structure is the ERM, or exchange-rate-mechanism. European currencies traded within narrow bands, supported by their central banks. Inevitably traders would test support for the “soft” currencies like the Lira or Drachma, and the call would go out for Germany to defeat them by buying unlimited quantities of Lira. The Germans resisted, on the grounds that the new Deutschmarks would eventually find their way back and stoke inflation.

Eventually, they developed the Euro. Now all the countries had the same currency, which would stop the attacks. And it did for a while—until speculators discovered that they could raid the “soft” countries’ debt instead of their currency. Once again Germany is being called upon for support. Month-after-month they are being asked to provide funding for the European Financial Stability Fund. But this support cannot be unlimited.

This explains the growing excitement over Eurobonds. Replacing eurozone national debt with obligations recognized by all euro-governments is a replica of the Euro-currency. This would cost each country control over its credit—which explains why the AAA countries are nervous. The concessions necessary to get them to participate will be enormous. People don’t easily relinquish their wallets—but that’s what it will take.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Palliative Care

“Do you want to fix things or just feel better?”

This question was recently put to me by a doctor. But I was thinking about the same issue when it comes to the economy. It’s frequently asserted that if we extend unemployment insurance, the people on unemployment are likely to spend the money rather than save it because they need the funds for basic necessities. The idea is that if you spend ¾ of any money you get, and the next person spends ¾, and so on, $1 billion of stimulus can become $4 billion of economic activity.

The idea of using stimulus to jump-start the economy has been with us a while. But it didn’t work this time. The problem is that people tend to save a one-time windfall, while they do spend permanent changes in their income. So when Microsoft paid $3 / share it didn’t stimulate the economy, and when Katrina destroyed $80 billion it didn’t trash us. Temporary factors make temporary changes.

I’m not saying that the stimulus wasn’t needed: pain-killers are necessary sometimes when you’re sick. But you if you’re seriously ill you can’t just take Tylenol—you need to think about what’s causing the illness. And it seems to me that what’s making our economy run slowly is a lack of incentive to innovate. We’ve got all kinds of new, neat-o gadgets and unprecedented connectivity. There are lots of entrepreneurial ideas. But if the structure of taxes is going to change and future marginal rates could go up to 75%, why knock yourself out?

Palliative care may be justified on humanitarian grounds—like extended unemployment benefits. But the only time it’s the main part of a medical program is when the patient is terminal. Hopefully our economy hasn’t come to that.

Douglas R. Tengdin, CFA
Chief Investment Officer
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