Scared New World

Brave New World, written by Aldous Huxley in the depth of the Great Depression (1932), depicted a threatening new order that was all but utopian. In fact, it possibly foreshadowed the rise of Nazism and Fascism later in the decade. Still, we survived the Great Depression and World War II, and the stock markets had significant rallies in the midst of each of them. Today, the global political and economic order that emerged after the fall of the Berlin Wall (1989) threatens to unravel, with rogue states and terrorist networks adding to the general uncertainty.

Hopefully, the future will not turn out to be the as dark or as imminent as the “Scared New World” which political and economic seers promise us. Yet, it is that future which the world bourses seem to be anticipating.

In the last three years, the S&P 500 index has shed nearly 50 percent of its value while the NASDAQ composite index, which is generally made up of younger and more dynamic companies, lost 75 percent. It is not surprising that a majority of investors is either paralyzed or outright panicked. But in matters of investments, one must always weigh the fundamental outlook (dark or ebullient as it may be) against the market’s perception of that outlook – as reflected in prices. From that viewpoint, I would argue that early 2000, when the stock market bubble was about to burst, was a much better time to panic than today, after three years of devastating losses. (See: First The Silver Lining, Now The Cloud, written in January 2000).

One of the things that strikes me, in this uncertain market, is that there is a marked contrast between the attitudes of old investment pros and those of younger investors who grew up, professionally, during the great bull market of the 1990s. By old investment pros, I mean those who have lived through many political and financial crises and survived the associated market vagaries well enough so that they still have their jobs today (no small achievement, as so many hedge fund stars of the 1970s and 1990s can attest). That older group tends to view today’s market as one in which to look for opportunities, even if it is not always as sanguine about the economy. The younger group tends to be as gloomy as it has ever been -- partly because it faces the unknown, and partly because its members also fear for their careers.

The difference, I believe, is that old investment professionals have lived through crises that must have been as scary then as the situation is today. I am not so old as to remember the great Depression of the 1930s or Pearl Harbor in 1941,which happened on the heels of Germany’s invasion of France, Belgium and the Netherlands. I also missed the panic of the 1950s, when thousands of American families built shelters and stocked up provisions in anticipation of a nuclear attack by the Soviet Union. And, frankly, I hardly remember the Cuban missile crisis of 1962 or even John Kennedy’s assassination in 1963. But many of these old pros do, and they have learned that crises pass and that the world adapts.

In the economic and financial arena, it is true that we are still working out problems that built up during the bubble years: banks in Japan, derivatives globally, consumer debt in the United States, distrust of business and the profits they report, etc. But similar obstacles to a recovery exist at all major market bottoms. They are like the aftershocks following a major earthquake: scary, but mere sequels to the main event.

The only real obstacle to even more bullish stances by experienced investors is the stock market’s valuation, as Warren Buffet stresses in his company’s most recent annual report. I would argue that this concern is not a global one.

As I hinted in my recent personal piece about current Franco-American relations (see: The Teen Age Of Old Europe), the world is changing. Politically, we are seeing sometimes-awkward attempts to assert independence from what has been perceived as America’s hegemony since the fall of the Soviet Union. These attempts can come from individual nations or entire blocs (now Europe, but soon Asia). The paradox, and one that is understandingly frustrating to Americans, is that these attempts at “independence” are still being made under the comfort and safety of America’s military umbrella (hence my teen-age parallel).

On the economic front, it can be said that the globalization boom of the past decade or two has also been made possible by America’s leadership. Not only has the United States promoted the ideals (and advantages) of free enterprise and global trade, but it also has provided an economic umbrella by acting as the world’s consumer and lender of last resort. This helped to avoid deeper recessions in Japan, Europe and elsewhere. Yet, here too, we may soon witness increased tensions: within the World Trade Organization first, and eventually at the International Monetary Fund and the World Bank.

I do not view this with optimism. Historian Charles Kindleberger has repeatedly warned about the risks of a void in world leadership, and I fail to see today who could possibly replace the United States in that essential stabilizing role. At the very best, an evolution toward multilateral leadership will be a succession of trials and errors, scattered with scary episodes. But, in investments, it can be dangerous, or at least sterile, to mix the secular with the cyclical. The move to multilateralism in world affairs, probably unavoidable in time, should serve as a backdrop to understanding current affairs – not as a forecasting tool.

So, we are left with a world where a number of economies are flirting with recession and the geopolitical environment is potentially explosive – a situation not unlike those at previous major stock market bottoms. Which brings us back to the fact that, unlike the experience at other major troughs, and despite historical declines, the world’s main stock market indices do not seem to exhibit rock-bottom valuations. But that does not mean that there are no values around.

We believe that the next several years will reflect some broad new trends.

Probably the major one will be some reversal of international capital flows. In the 1990s, the dynamism of the U.S. economy and the associated, perceived attractiveness of investments in it (including the tech bubble in the financial markets) transformed the American economy into a vacuum pump for the world’s savings. The inflow of money boosted domestic demand, which explains both the collapse of America’s saving rate and its zooming current-account deficit. Any lessening of these flows, which is almost certain, will restrain the growth of domestic demand in the United States – especially demand associated with consumer spending, the main source of growth in recent years. This will be partly offset by some reversal of the trade balance and a revival of capital spending in some areas of the corporate sector.

The sharp deterioration of the U.S. trade balance over the last decade reflects more the boom in imports (closely associated with consumer spending patterns) than a weakness of exports. In spite of the rising dollar and economic weakness in their traditional markets, U.S. exports have actually remained exceptionally strong.

For capital expenditures, the situation is more complex. There has been a well-publicized excess of investment in the TMT sectors (technology, media and telecommunications). This will be worked out over time, including through bankruptcies and write-offs of assets that were purchased too dearly, or investments that resulted in unmanageable overcapacity. But there are many sectors in more traditional and basic industries where there has been a dearth of investments over the last decade and where capacity closures have actually taken place. Now, the existing plant is aging and requires at the very least modernization and maintenance expenditures. Meanwhile demand for many of these industries’ products (natural resources, machinery, etc.) is global in nature, and has been creeping up toward world capacity. Corporate cash flows also have been improving, making it possible to finance new investments in these industries when necessary.

In sum, the United States is likely to experience slower overall growth in the next several years than in the 1990s, and the drivers of that growth are also likely to be very different. That creates opportunities for discerning investors, even in a less ebullient environment.

On the other side of the world, another major trend reversal is shaping up. Until recently, and even more so after the Asian crisis of the mid-late 1990s, Asia developed mainly as a source of cheap manufactured exports toward Japan, Europe, and especially the United States. By now, however, the damages of the Asian crisis have been largely repaired: most corporate balance sheets in the region have become light on debt and rich on cash; government reserves of foreign exchange are at or near record highs; and, with still very high savings, Asia is shaping up as the next great source of consumer demand for the world. Whoever has recently visited the region cannot help being awed by the voracity of its consumers, but also by their growing numbers as living standards improve. This is true not only of China, but also of Thailand and to varying degrees throughout the region.

As a result, domestic demand (consumers and infrastructure) is about to replace exports as the main growth driver in Asian economies, a change that is aided by government fiscal and monetary policies. Exports remain important, of course, but the sharp and steady increase of intra-regional trade, a less well-recognized trend of recent years, is giving the region’s expansion a degree of insulation against cycles in the old economies. Asia would not be immune to a deep recession in the West, of course, but it can sail through a slowdown better than at any time before.

To satisfy this new domestic demand on top of the ongoing needs of the export sector will require from Asia an important effort in terms of equipments and infrastructures. The goods necessary for that effort will, to a large degree, be purchased from Japan, Europe and the United States. So, the investment game is changing, but there will be some benefits for all the main regions and economies.

In Asia, the new opportunities, rather than among exporters, will be in companies that have a chance of capturing some of the region’s burgeoning markets. Unfortunately, they are few and far between, and their success in a constantly shifting domestic market place cannot be guaranteed. On the other hand, many have strong balance sheets (net cash) and P/E ratios well into the single-digit range.

In “old” Europe, where German manufacturers often brag (somewhat tongue-in-cheek) of “still making the best 19^th century machinery”, the best old-line companies have survived several years of recessions with strengthened balance sheets, better-controlled costs and weakened competitors. Many of these companies also sport P/E ratios in single digits, just as demand for their products may be re-accelerating.

In Japan, where progress comes slowly, the export opportunities toward the rest of Asia have already begun to be realized, initially to follow the relocation of Japanese manufacturing facilities in cheaper locations. This is now accelerating, while Japanese manufacturers also plan to aggressively push their consumer brands into China. The value potential in Japan only appears when one calculates what profit Japanese companies could achieve if they approached the return on invested capital (ROIC) of their European counterparts, let alone their American ones. And they are on a slow but sure path toward that goal.

Finally, in the United States, the cheapest stocks also belong to companies in the more basic sectors of the economy, especially the ones with truly global markets, such as natural resources and machinery. After several years of streamlining and consolidation, these companies have achieved low break-even levels and high operating leverage. A small increase in volume, and the resultant pricing power that would result in tight world markets, could boost their profits well beyond any current expectations.

Investment value always results from a combination of good or improving fundamentals with low investor expectations. There is no lack of value in stock markets today. It’s just not where it has been…

François Sicart

March 17, 2003
^©Tocqueville Asset Management L.P.