Navigation on the 2013 Slope

Wednesday, February 20th, 2013

The possibility of going over the fiscal cliff produced many dire predictions and also served as a theme for many New Year’s Eve bashes but like Y2K at the end of the last century, it did not cause the expected severe dislocation.  What was a cliff has become more of a slope and now the discussions on both the political and investment front concern navigation and not preparing for a fiscal tsunami.  Lost in all the noise at the end of last year was some encouraging news on the state of the global economy.  The featured article in Bloomberg Markets year-end issue is entitled “A Case for Optimism,” and points out that the trade and current account imbalances which grew prior to 2008 and helped trigger the global recession are correcting faster than expected.  As we all well know, the US and Europe consumed too much, went deeper and deeper into debt while China manufactured, exported and accumulated more than $1 trillion in US Treasury bonds. In 2007 the US current -account deficit which measures trade balances and income from foreign investments was 6% of GDP while China’s surplus stood at 10.1%.  At a tense meeting held at a beach resort in South Korea in 2010, an agitated Treasury Secretary Tim Geithner lobbied the world’s central bankers for an agreement which would commit the largest economies to keep their surplus or deficit at 4%. To say he was greeted with the Group Of 20 version of a Bronx cheer is an understatement.  Large exporters China and Germany wanted none of it and the German Finance Minister added some insult to injury when as a parting shot he lectured Geithner on the virtues of promoting “a market economy rather than a command economy.”  Yet two years later the targets are being met:  the US even as it suffers a budget crisis and has yet to address entitlement reform will according to the IMF have a current account deficit of 3.1% in 2013, effectively cutting in half the 2007 number while China  will reduce its surplus to 2.5% down from 10% in 2007.  More importantly if the IMF forecast is correct, the 4% surplus to deficit targets for the largest economies will hold through 2016.   Some and perhaps most of the initial correction is a function of weaker demand in the US and Europe and China being better than expected at fostering domestic consumption.  However there are two components in the US which are encouraging:  the US is manufacturing more because of lower energy and labor costs. According to rather conservative projections, the US by 2015 will have a significant edge in production costs over Germany and Japan (15% and 21%) especially as a result of the boom in natural gas.  Another equally significant but less noticed factor is the lower cost of capital.

Most if not all of the media coverage about lower US interest rates is focused on the Fed responding effectively initially to a global economic crisis and then to a weak recovery. We see reports about resulting lower mortgage rates for those who can get a loan and the problems of savers coping with non-existent bank deposit yields.  Charles Schwab, a pretty devout free market capitalist, even wrote an Op-Ed in the Wall Street Journal calling on the Fed to raise interest rates in order to rescue senior savers.  But here is a noteworthy item not receiving much fanfare: a few days ago investment managers (myself included) received an email from a bond underwriter with information about a new large debt offering from IBM:  a senior note with a five year maturity at an interest rate of 1.25%– a record low for one of the most closely watched US companies for trends in the broader economy.   In its most recent earning report IBM’s profits and revenue again exceeded expectations, and as reported in the Wall Street Journal the CFO sounded a positive note both about the quarter and future prospects.  He noted that much of the growth in earnings came from software where profit margins are the highest and that IBM, best known as a mainframe computer company spent $11 billion on acquisitions and $19 billion on research and development, trends which he expects to continue.  So how did IBM finance their earnings growth? Large companies accomplish this through their cash on hand or raising capital through a stock or debt offering.  In the last quarter of 2008, however, raising capital was not the easiest task given the tremulous state of the credit market. IBM issued a ten year note at 7.625% at a time when their stock price was below $100.  Their investments in R&D and acquisitions have paid off handsomely, and now they will be able to continue that game plan in a recovering economy (albeit slowly) at 1.25% and the stock is above $200. No wonder the CFO smiled a bit more than usual at the press conference.    This of course did not capture public attention as much as Apple’s recent precipitous stock drop because of a slight revenue miss, but it is worthy of attention and similar stories of  the ability to finance growth on the cheap as the global economy begins its recovery will be an important investment theme.

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