The Other Recovery
....from Canadian Business Magazine Oct 2003
...see bolded below
Domestic economic data paint only part of the picture. For the rest, look east
After a couple of very difficult years, the global economic recovery appears to be gaining traction. In October, upbeat third-quarter earnings reports in the United States arrived like a refreshing rain after a long drought. The Bank of America reported record earnings, a 31% gain over the previous year. Merrill Lynch, owner of the world's largest brokerage, said profits climbed 50%. Chip giant Intel Corp. said its third-quarter profit more than doubled. Even downtrodden U.S. publishers saw an improvement in earnings growth, reflecting a modest rebound in the advertising market.
Profits have been beating estimates across the board. Earnings reports in Canada have been reasonably strongas well, although the rising loonie has had a dampening effect. (For example, Canadian National Railway Co. recorded a 10% increase in third-quarter profit, but claimed the higher dollar cost it $100 million in sales and $14 million in net income.) There are tentative indications that manufacturing and the labour market in the United States are finally starting to turn around. Multinational shipping firms are busy, suggesting trade is picking up. Meanwhile, commodity prices are surging. All of this is proof, some analysts argue, that the global economic recovery is for real.
But how broad is the recovery? Will it last? And what's driving it? In some sectors, the pleasing profit reports are
illusory--a consequence of the fact that earnings were severely depressed; hence, year-over-year comparisons look good. Moreover, some critics have observed that U.S. firms--especially in the tech sector--are benefiting from
cost-cutting, which provides a one-time upward shift in profits but should not be mistaken for the kind of earnings
growth that comes from increased sales. However, the bearish argument may in fact be taken as a hopeful sign. If
firms have used the recession to get lean and mean, the growth in profits will be that much more impressive when
sales finally take off. In a recent report, BCA Research in Montreal notes that economic indicators point to higher
nominal GDP growth in North America over the next six months.
Focusing on North American economic indicators may be missing the point. There is an important global element to the recovery--the rise of a new middle class in the East Asia co-prosperity sphere--which could sustain the economy for a while to come. Donald Coxe, chairman of Jones Heward Investments, pointed out in a recent conference call that the middle class in East Asia is 350 million strong now and headed for 500 million by the end of the decade, with average incomes rising to match those in Taiwan and Korea. The average per capita income in China (in real U.S. dollars) has tripled since 1987. We are witnessing a "once-in-a-lifetime event," observed Coxe, in which hundreds of millions of people are moving from a quasi-subsistence level to middle-class status in the space of a few years. Those people will want durable goods, he argued. Ergo, overweight metals in your portfolio.
The growth trend in Asia bodes well for Canadian resource producers and for North American-based multinationals,
who are shipping massive amounts of machinery and equipment to new factories in China. The firms use their
brands, management and technology, while benefiting from cheap Chinese labour and relaxed trade laws.
One area where the growth in consumption is evident is in China's automobile sector. Car sales have exploded over the past three years, growing at more than 25% per year. A recent study by Martin King at FirstEnergy Capital Corp. in Calgary found the Chinese have bought about 12 million new vehicles since 2000. (Those are first-time purchases, not trade-ups.) The result? Fuel consumption in China is soaring. By 2004, the country is expected to surpass Japan as the second-largest consumer of crude oil in the world after the United States. Even under conservative growth scenarios, China is expected to have a significant impact on global oil demand and prices over the coming decade.
King notes there are probably less than 100 million privately owned cars in China, and at least 500 million people
eligible to drive. Even if a significant number cannot afford a car right now, the potential for future sales seems
unlimited.
But it's not just oil. Any commodity needed to produce durable goods will be in high demand. This helps explain why the Commodity Research Bureau's raw industrial sub-index--which includes basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions--has surged since early September (sparking talk of inflation, an interesting reversal from the deflation worries of last year). The commodity price gains are widespread and thought to be a consequence of persistent strong demand for materials in Asia, and of the rebound in industrial activity in the major developed countries (although the weak U.S. dollar is also a contributing factor). The CRB metals sub-index is up 27% since the start of the year.
What does all of this mean for stocks? BCA Research says it is cyclically bullish on equities and expects the current bull run to persist for the next three to six months. Beyond that, however, there is less reason for optimism. The fact remains that stocks are not cheap, even with the uptick in earnings. (Much of the anticipated growth is already reflected in North American stock valuations.) Although Canada has room to cut interest rates, the United States does not. The current short-term rate there is 1%, and BCA says long-term yields are unlikely to fall back to the 3% range unless the economy slides back into recession or a severe deflation scare erupts. "Investors must play the cycles because a buy-and-hold strategy will not work," argues BCA, noting that the Dow Jones industrial average may stay mired in a broad range around the 10,000 level for several years. The firm recommends that investors "be prepared to sell after the next sizable up leg."
That may be sound advice for people who buy broad-based U.S. index funds, but another approach is to focus on
sectors of the economy with upside potential, especially metals and energy. In late October, BCA stated that the
raw-materials market was getting overbought, but added that "cyclical prospects for the underlying commodities and related equity sectors remain positive, providing solid investment opportunities in this long-forgotten market segment."
The global economic recovery and the fact that gains have occurred in all three sub-indexes (metals, textiles and other raw materials) increase the odds that the bull market will continue, according to BCA, ending a deep and prolonged bear in commodities that lasted from the mid-1990s until late 2001.
Sounding a note of pessimism, Stephen Roach, chief economist at Morgan Stanley in New York, wrote in a recent
note to clients that the resurgence in commodity prices may be driven primarily by temporary factors, including
"inventory restocking, binge-buying of U.S. consumer durables and a credit-induced surge of excess of Chinese
industrial activity." There could be an unwinding of these forces in early 2004, he argued.
Nevertheless, there could be more upside in base-metal miners and other cyclical stocks for long-term buyers. The
movement to date in the mining and commodities indexes is not that impressive if you put current prices in a historical context, observed investment strategist Coxe. Nickel, for example, has gone over US$7 per pound and was recently trading in the US$5 range. Copper, which was priced at US$1.50 per pound in 1995, is still cheap at 90¢US. And zinc is trading in the 40¢US-per-pound range; it was over 60¢US in 1997.
In short, the investment theme du jour for this economic recovery can be boiled down to one sentence: Buy stuff China needs. There are risks, of course. (China's banking system is wobbly.) But for now, the opportunity Asia presents seems too great to ignore. For investors as well as for the resource-heavy Canadian economy, that's good news, indeed.
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