Monday, September 6, 2010

Neuberger Berman's Recent Outlook

The following is Neuberger Berman’s (NB) 2nd quarter 2010 economic outlook.  It is very thorough and well conceived.  In these challenging economic times, it is worth a review:
Neuberger Berman’s MLG Group’s Current Outlook 
August 18, 2010

Over the last decade, so much has structurally changed on Planet Earth that we believe the only informative perspective from which to view the world is…“upside down.” We first introduced this concept in our third quarter 2009 client letter and, as we think about the investment landscape currently, we believe this “paradigm shift” is underappreciated by investors.

Our team spent much of the second quarter 2010 pursuing an extensive global research effort to determine if this view of the world is still relevant. As you might expect from the title of this letter, our answer is yes!  Our research travels took us to China, Singapore, Indonesia, Mongolia, Australia and Brazil. Below, we share our takeaways from this research, some investable themes we have identified and how we are navigating this volatile and challenging investment environment...
The “developing” countries are on top of the world. In general, the countries on “top” of the world have high savings rates and low debt, are growing their economies between 5% and 10% per year and, in most cases, are disseminating credit effectively via unimpaired banking systems.  Loan growth in India, Singapore, Indonesia and Taiwan is still, in fact, accelerating.  And, in many cases like China, India and Indonesia, economic growth is so strong that governments are implementing policies to slow things down.

Meanwhile, the bottom half of the upside-down world is in a very different place--low savings and high debt have taken a serious toll.  In the US, for instance, we are having what might best be described as an unusual economic “recovery” with record low housing starts and little, if any, job creation.  More disturbingly, this has been the first decade in more than 50 years in which the median income in the US declined.  This, coupled with no net new job growth in almost a decade, despite extraordinary low interest rates, has made the grim reality of many developed countries quite evident.  Signs of deleveraging are everywhere and this implies slow growth in the bottom half of this map for a few more years as savings are rebuilt and confidence returns.

We believe the contrast between the two halves of the planet is the source of much of the volatility seen in the financial markets over the past two years.  The stock market volatility is reflecting the realities of the necessary adjustments that are occurring; just as aftershocks are quite common after earthquakes, we’re in the midst of the aftershocks of the financial crises that hit the system in 2008.  Unfortunately, we think this volatility may continue for some time.  Governments in the US, Europe and Japan need to provide fiscal stimulus to keep their economies recovering while maintaining financial discipline, minimizing transfer payments and reaping the highest taxes possible to pay for the current stimulus and past debts incurred over several decades.  The problem is that these actions are often at odds with each other.  The combination of political uncertainty, slow growth and the prospects of higher taxes make some international markets more appealing. Higher taxes may also impinge on domestic growth in the private sector; this is something we continue to monitor.

The US economic recovery to date has been equally “upside down.”  In the post-WW2 era, there has not been an economic recovery that has not included a housing recovery.  We were shocked to read that the housing industry in the US was the source of over half of the jobs created between 2000 and 2007.1  As seen in the chart below, new housing starts peaked in 2006 at 2.2 million homes and have collapsed by over 75% to the current run rate of 550,000.  This is startling when you consider that over 400,000 homes, on average, suffer serious structural damage from fires each year. The problem, as you may have guessed, is the oversupply of homes built during the boom years.  With more than 4 million homes for sale and many more delinquent mortgages, it is no wonder that the US is having a “jobless and houseless” recovery.  The bust is a consequence of the boom, and it will take time to work through the adjustment.  We believe that growth in the US will be in the range of 1-2% on a normalized basis, slower than the 3-3.5% growth seen during the last decade.  What is called an economic recovery could feel like a continued recession for many.
1 Source: Empirical Research Partners.

Ironically the “medicine” of extraordinary low interest rates in the developed markets is driving even faster growth in the developing markets.  No place better represents this phenomenon than Hong Kong.  Many decades ago, the Monetary Authority of Hong Kong elected to peg the HK dollar to the US dollar. When they did that, they essentially pegged Hong Kong’s interest rates to the (now low-yielding) US Treasury market.  The result is that the easy money policy of the US is cascading into HK. With mortgage rates of 1%, is it any wonder that real estate prices in Hong Kong have been soaring?  Essentially, keeping the patient alive in the developed economies is only making the emerging economies more vigorous.  Currently, China is putting the finishing touches on a plan to create 5.8 million new housing units and Australia will experience labor shortages unless they have 200,000 immigrants enter the country each year.

Our team remains bullish on US and global companies we believe are poised to take advantage of the growth in certain developing markets.  There are several investment themes within the portfolio that we view as long-term and structural.  Our goal is to find those companies that have a distinctive comparative advantage or a sustainable competitive advantage to capitalize on these themes.

One investment theme that has been represented in the portfolios for several years is the belief that commodity prices are likely to head higher.  The Economic Cycle Research Institute coined the phrase "Bull Whip Cycle" in 2008 as an analogy.  With a bull whip, a small flick of the wrist can result in a significant crack at the other end.  Given the very low inventory-to-sales ratios now seen in the commodity producers, we are seeing how minor changes in demand by end-users can create even larger swings in intermediate production and in the pricing of the commodity.

With a Bull Whip Cycle, the cycle tends to be very short and sharp  --  amplitudes of these cycles are high, but of short duration.  When a cycle reaches an extreme level, producers tend to overreact, sowing the seeds of the next change in direction.  We believe this volatility in commodity prices (and in the stock prices of commodity producers) makes for interesting investment opportunities.  Further, we believe that companies such as Norfolk Southern and UPS could be beneficiaries of sharp demand shifts.  

We believe a longer-term structural bull market may be underway in coal; both metallurgical and thermal.  Coal is the source of at least half of the world’s electricity generation and is among the least costly ways of producing electricity.  Our team has conducted extensive research on this global commodity for nearly a decade.  Our interest stems from a turn of events in the world coal market.  In 2006 we became extremely bullish on metallurgical coal, a key ingredient in steel production, when China quickly turned from being a net exporter to a net importer. Supply was limited and prices adjusted upward to encourage more production of met coal.  In 2009, we identified a structural shift in thermal coal – it was another instance in which China swung from being a net exporter to a net importer of 80 million tons from the global seaborne market.  India has also emerged as a large coal importer and we expect that trend to accelerate over the next three years.

In order to gain clarity on the dynamic of Chinese supply and demand, we spent a week traveling to several coal-producing regions in China and met with coal-producing companies and government experts in the field.  We also traveled to Indonesia and Mongolia to investigate the potential new supply that can be brought on within the next several years.  Our conclusion from the trip is that China’s marginal cost of coal supply is currently higher than the global seaborne coal price.  In addition, most of the new coal supply being brought on in Indonesia, Columbia, the US and China is of a lower quality than the existing coal supply.  Where high-quality coal deposits are known, such as Mozambique, Mongolia and Central Kalimantan (Indonesia), there are large infrastructure investments that will be required to bring the coal to the international markets.  Increasingly, we believe this means that high-quality coal will be in high demand as more blending is done to offset the lower coal qualities.  We believe this is extremely positive for the US Central Appalachian and Northern Appalachian coal producers as well as those companies involved in bringing on new high-quality coal production. 

You've got to be passionate about your work, to end up here … Sandy Pomeroy and Tony Gleason visiting a coal mine in Mongolia.

Asian consumption is another theme evident in some of our investments.  There is growing middle class in several densely populated countries like China and Indonesia.  Gross Domestic Product per capita, which measures the total value of goods and services produced in a country, divided by the population, has recently crossed $3000 in China and is about to cross that mark in Indonesia.  Historically, this has been an inflection point where consumption begins to accelerate.4  If we look back at past examples of emerging countries like Japan and Korea, once they hit $3000 GDP/capita consumption really began to soar.  That consumption can include everything from better diets to automobiles, consumer electronics and increased travel/leisure spending.  We believe it is a sign that things have changed when General Motors is now selling more cars in China than in the US.  We own and will continue to look for companies that can benefit from this long-term structural trend. 

Agriculture is another of our themes that takes advantage of rising GDP/capita.  As incomes improve in many emerging market countries, the first thing people want to do is improve their diet.  This is likely to drive grain, protein, dairy, fruit and vegetable demand higher for the foreseeable future.  In addition, arable land continues to shrink as more land is being used for other purposes and the water supply in many areas of the globe is on the verge of crisis levels.  From an investment perspective, there are many ways to capitalize on this demand. First, more mechanization will allow farmers across the globe to increase grain yields.  Grain production is key for the production of more proteins.  It takes an estimated two pounds of grain to produce one pound of chicken, four pounds for a pound of pork, and six pounds for a pound of beef.5  Secondly, irrigation is becoming increasingly valuable as an agricultural tool especially as water resources become scarcer.  Lastly, good soil management will be a large factor in meeting higher levels of demand, so fertilizer applications are likely to increase on a structural basis.  We are also intrigued by China’s recent swing from corn exporter to corn importer.  With other commodities we have studied over the last several years, like iron ore and coal, China’s shift from net exporter to importer has been a precursor to a structural shift in demand and pricing.  We believe this dynamic may be underway in corn and are monitoring it closely. 

Because of the many cross-currents in the world today, it is more important than ever to take a long-term view and resist the urge to overreact to media headlines and day-to-day volatility. Investors tend to be overly optimistic when things are trending well and overly pessimistic when the environment seems bleak.  This short-term focus is driving huge volatility in stock prices. The recent character of the equity market has been “panic on/panic off” and this is leading investors to believe there is inherently more risk in the equity market.  Our team’s view is to acknowledge that there are both economic and market cycles, and recognize that extreme optimism or pessimism can create opportunities to take advantage of resulting stock price dislocations.

Despite the world being “upside down,” we believe that the global economy is on a slow, but steady path to recovery.  Our base case is that the emerging markets are going to continue to power ahead on a growth path that is becoming increasingly less dependent on economic growth in the developed markets.  A disappointment could be that growth in the developed markets is even lower on a normalized basis than the 1-2% we expect if the United States, Japan and Europe slow their consumption, bring down leverage and get their “fiscal houses” in good order.  While not our base case, our greatest concern is the risk of a series of government policy errors that could manifest themselves in substantially weaker economic growth than we expect.   As such, we continue to follow government policy and regulatory developments closely both in the US and abroad.

4 Source: CLSA.
5 Source: USDA, FAO.
Sincerely, The MLG Group
For two troubling forecasts and an Op-Ed on government decisions written by Mr. David Farr, Chief Executive Officer of Emerson Electric Co., see: "Troubling Economic Predictions"