Possibly more so than at any other time in history, all parts of the world are simultaneously feeling the impact of what a globalized world we live in. The impact of the globalized economy to transmit shockwaves from one part of the world to another is unparalleled. As corporations have begun releasing their earnings for the first quarter of 2012, the markets are starting to get a sense of just where things sit with respect to the economy. As the economic recovery continues to wobble along, every negative eventseems to get magnified and ripples across the world.
US Economy – A Beacon of Hope
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Possibly more so than at any other time in history, all parts of the world are simultaneously feeling the impact of what a globalized world we live in. The impact of the globalized economy to transmit shockwaves from one part of the world to another is unparalleled. As corporations have begun releasing their earnings for the first quarter of 2012, the markets are starting to get a senseof just where things sit withrespect to the economy. As the economic recovery continues to wobble along, every negative event seems to get magnified and ripples across the world.
Recent academic studies have looked at the idea of whether or not international investing provides the diversification that it once did. Most of them have come to the conclusion that about twenty years ago, diversifying by country stopped providing the benefits it once did. A large part of this is because of the increasingly global and interconnected nature of the world economy brought about by the increase in trade and financial flows. What is interesting is that while every corner of the globe is impacted by the goings on in the other parts of the world, each continent has its own challenges.
US Economy Leads the Way
Traditionally, North America is the first continent to bounce back after a global economic slowdown. Said another way, it is the US that leads the world economy back to growth mode. This time seems to be no different. When the financial crisis ended, most market strategists seemed to be hanging their hat on the idea that as long as the rest of the world (primarily Asia) was able to carry the US towards economic recovery, things would be fine. Two years later, hopes are being hinged increasingly upon the US economy and its ability to assume its traditional role of leading the world economy towards economic growth.
While the US economy is still trying to achieve escape velocity from the clutches of the economic slowdown, it is moving forward at steady yet humble 2.2% annual growth rate. This is despite the fact that the fiscal and monetary policy framework is providing all of the muscle it can.
The US auto industry has accounted for about 1.6% of American economic growth as US consumers move to replace the US automotive fleet which sits at a record average age of 11 years. Part of the reason that vehicles as a whole have aged is because sales fell sharply during the last recession to about 10.4 million units. For comparison, US auto sales achieved a record in 2005 at about 17 million cars and trucks sold. This record was in part achieved due to the excesses in the credit markets which allowed consumers to increase their borrowing and in some cases buy “more car than they could afford”. As a comparison, the average age of vehicles in Canada is a little over 8 years.
US auto sales are especially important to Canada because about 80% of the cars manufactured in Canada are exported to the US. In their most recent earnings announcements, North American car companies stated that domestic sales were strong but these were being offset by slowing sales in Europe.
Aside from autos, housing is another major contributor to the US economy. Recent data continue to add credence to the idea that US housing has seen its lows. From here, it will take time but clearly US real estate is on the mend and should be able to continue to underpin the US economic rebound.
With the US consumer accounting for almost 70% of the US economy and about 16% of the world’s economy, the US consumer holds significant clout over the level of global economic growth. It is worth noting that US consumer confidence has been rising—defying a great many observers’ expectations.
US Companies Maintain Record Profit Margins
As for other US industries, most companies have finished reporting their first quarter 2012 earnings and on average they have managed to beat analyst expectations. Although the expectations that had been beaten were lowered in advance by market analysts to reflect concerns of the global economy.
One data point that is often forgotten about in the earnings season crush is profit margins. Simply put, profit margins can be thought of as the portion of each dollar of sales left over as profits. As the shows, currently, profit margins as a percentage of the economy are running at very high levels.
At some point, as we have highlighted in the past, profit margins cannot continue to rise at their current rate and will begin to revert back to the long term average. According to market data provider FactSet, analysts expect that 105 of the S&P 500 companies will see their revenues rise but earnings reduced this quarter due to higher costs. The moderation in oil prices and many commodities in recent weeks may help to offset the cost increases that are expected.
An important contributor to profit margin growth has been the ability of companies to run lean operations and opportunistically use the weak labor market to hold wage costs in check. But recent data shows that labor costs have started to firm and productivity (output per worker) has started to decline. In the first quarter of 2012, US government data shows that the total hours worked was up 3.7%, outweighing the growth rate in the economy. Unfortunately for the average US income earner, it should be noted that it is not that wages that are rising but instead the output per worker is falling, which means unit labor costs are rising.
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Europe: Confronting Challenges
For the bulk of the European financial crisis, speculation had revolved around whether or not Greece would be allowed to default on its government debt payment obligations. This was thought to be the worst case scenario. But as we had highlighted in prior comments, the market had already priced in the default scenario. When Greece did eventually negotiate a cut to its debt obligations, the markets marched forward.
In addition, an injection of about €650 billion ($1 trillion USD) from the European Central Bank (ECB) into the financial markets helped to bring the markets into line for a time. But it seems that a trillion dollars does not go as far as it used to. Markets are once again grappling with Spain’s and Italy’s debt issues primarily and sending the yields (interest rates) on these countries’ bonds upwards. They are the two largest members of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) group of countries with the largest debt loads.
Moves by some PIIGS nations to partake in austerity measures in order to reform their economies have also seen bitter resistance by locals. This culminated in recent elections in Europe that saw the governments of Greece and France replaced by new ruling parties. Greece has seen a rise in support for the far left and the far right; two political fringes that have a common desire for Greece to stop the Franco-German push for austerity. Germany has led the push for the weakest economies of Europe to tighten spending and raise taxes.
The outcome of such a policy was rather predictable as most of Europe is back in recession this year after a brief and feeble attempt at economic growth. An economy that is not growing has little chance of paying its debts – not to mention the political instability that comes with double digit unemployment.
Europe’s Impact on China
We have written more commentary questioning the Chinese economy’s foundation than almost any other topic.
When too many people chase the same thing – in this case safety – the paradox is that it is risk that they are buying. Then it was not mainstream to talk about such things. Today, the issues and challenges facing China are in fact mainstream discussion topics.
Therefore, equities continue to offer more upside than other asset classes over the long-term. Investors will have to continue to be patient but the rewards are there. When these long drawn-out cycles of volatility and seemingly never ending crises end, investors who were able to stay the course are rewarded. That being said, it is never easy but history proves that “this too shall pass”.
After years of relying on government directives to increase production and a shadow banking system that was churning out loans that should not have been issued, the Chinese leadership is trying to confront the problems that years of strong economic growth were able to mask.
If that were not enough, Europe’s plight is impacting China because of the significant trade relationship that exists between the Old World and the Middle Kingdom. According to Eurostat, the statistical office of the EU, Europe imported about €290 billion of Chinese goods and services in 2011. The slowdown in Europe and its return to recession will therefore impact China. As an offset, the odds have risen of more easing on the monetary and fiscal policy fronts by Chinese authorities as they are becoming increasingly focused on growth once again. Fixing longer term structural imbalances might have to wait .
We believe that monetary authorities will continue to do what it takes to continue the battle with a stubborn economic crisis but the political leadership of the leading world economies must work together in a more concerted, longer term effort. No nation is strong enough to confront these challenges on its own. Equities continue to be fairly priced and the mania for bonds has continued causing them to be bid up beyond fair value. We continue to view government bonds to be a risky asset class as they are quite expensive due to the fear that has induced investors to abandon risky assets for so-called safe assets. We say “so-called” because any asset that is overpriced becomes risky.
Pacifica Partners – Capital Management Navigating a Sea of Opportunity
This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance.Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.
Copyright (C) 2012 Pacifica Partners Inc. All rights reserved.
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Thank for a successful fund raiser!
Pacifica Partners is proud to announce our sponsorship of the White Rock Players’ Club performance at the White Rock Playhouse (Coast Capital Playhouse) on April 9th 2012 of “The Lion in Winter”. Pacifica Partners has reserved all 218 seats to this exclusive performance night and will be hosting a pre-performance social at 7pm on Monday April 9th. Click here for full story.
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