September 11, 2012
I am not pointing out these problems because I enjoy being critical but because the failure to effect meaningful regulatory change is something that is likely to affect investors in an extremely negative way in both the short and long term. A weak economy coupled with systemic fragility and insufficient regulatory architecture is a combination that requires investors to proceed with caution in their investments. These dangerous conditions offer little in the way of support for the view that stock prices should move higher from here on any sustained basis. At some point investors will reach the top of the wall of worry and fall off. Economic fundamentals are sluggish at best. 2Q12 GDP growth was revised to 1.7% from its initial 1.5% reading, which was actually better than I expected (I thought it would be lowered to about 1.2%). But a closer look at the numbers is hardly cause for confidence (thanks to friend David Rosenberg for this analysis). One sign of unexpected strength was higher consumer spending, but it turns out that most of this came in the form of higher spending on utility bills resulting from the hotter summer and higher air conditioning bills. The trade deficit was also slightly lower than expected thanks to a combination of stronger exports and weaker imports. In particular, import growth was only 2.9%. Inventory accumulation slowed and actually subtracted 0.2% from growth, while business capex dropped grew at only a 4.7% rate from 7.2% prior to the revision. Of more concern is what we will see in 3Q12. Exports will likely be weaker as Europe falls deeper into recession and China’s economy weakens further. Businesses are likely to continue to sit on their hands as they wait for the outcome of the election. The odds of 3Q12 growth coming in higher than 2Q12 growth are about as high as the odds of Joe Biden not putting his foot in his mouth from now until Election Day.
The media and many pundits were making a great deal of fuss about Federal Reserve Chairman Ben Bernanke’s speech at Jackson Hole on Friday, August 31 (it was a slow August for news I guess). Mr. Bernanke’s speech has come and gone and as I expected he suggested he stands ready to step in if the economy falters. That said, I doubted before the speech and continue to doubt that the Federal Reserve will act before the election for several reasons. First, as I’ve said before, the stock market may have performed its own intervention with its summer rally. High stock prices arguably remove the urgency for action, and it is certainly clear that Mr. Bernanke is highly conscious of stock prices. In his speech, he said the following: “it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. The effect is potentially important because stock values affect both consumption and investment decisions.” Second, while the economic data has been flaccid, it has arguably not been sufficiently weak to meet the high hurdle that would be necessary two months before a Presidential Election. The risk of appearing to be acting politically, which could harm the central bank’s legitimacy (and despite criticism it still maintains great legitimacy in the market’s eyes), is greater than the risk of waiting two or three more months before acting. Third, it appears that opinion on the FOMC is not uniform with respect to the efficacy or wisdom of engaging in further quantitative easing, and it would be prudent to wait for a couple of months of additional data before acting. For these reasons, I believe the Fed will err on the side of inaction in September, which effectively takes it out of the game until after Election Day on November 6. This, by the way, is a good thing since further quantitative easing would likely have a limited effect and would extend policies that were unwise in the first place.
China is more than doing its part to complete the global slowdown trifecta. In his most recent report on China, ISI’s Donald Straszheim writes the following: “We are still using 7.0% y/y real GDP in our 3Q12 forecast because we still believe that is about the number that Beijing will announce. China’s GDP data are opaque at best. But when we go through the exercise of trying to add up the pieces that get to 7% we fall a couple of percentage points short. Bluntly, a 7% y/y real GDP growth number announced for 3Q12 will severely strain Beijing’s credibility among essentially independent outside observers.” Mr. Strazsheim is more polite than me. A 7% GDP print is nonsense. Those pouring over China’s PMI reports like Zen masters reading koans are wasting their time. The numbers are phony. If you want to really know what is going on in China, you are much better served by looking at the prices of the key commodities that China uses like iron ore and steel (according to The Gartman Letter, steel futures in China have moved to new life-of-contract lows), or listening to multinational companies such as Joy Global, Siemens, BASF, United Technologies, or Hitachi, all of whom have announced lower results and profits warnings attributed to lower Chinese demand. Some of China’s domestic consumer products companies are hurting as well such as Suning Appliance and Gome, two of the country’s largest electronics retailers, or Air China, who reported that profit will drop more than 50%. Profits at state-owned enterprises dropped 11.6% in the first half of the year from a year ago (which likely means they dropped even more since the source of this information was the state-owned companies themselves). Donwu Cement, which went public only a couple of months ago, has issued a profit warning (and cement along with electricity is a key indicia of economic health in China). It is little wonder then, as Figure 4 below illustrates, that China’s stock market is back to 2009 levels.
There are all kinds of reports about the heroic stimulus efforts in which the Chinese government is about to engage. China’s government took extraordinary steps during the financial crisis to prop up its economy as well as the world economy. The result has been even more overcapacity than what existed at the time. Stephen Roach, for whom we hold the highest respect, argues that China must build ahead in order to be prepared for the shift of hundreds of millions of people from rural areas to the cities. This is no doubt true, but the interim period before the newly built real estate and other capacity is absorbed is still likely to require adjustment and involve some degree of slowdown. This doesn’t mean that China’s economy has to fall off a cliff, just that the 10% growth rates that were seen in the last decade may be cut in half for a period of time. The problem is that growth in the U.S. and Europe is so sluggish that the loss of 4 or 5% of Chinese growth will be extremely damaging to a global economy that can’t pick up this lost growth from somewhere else. Rather than acting as a shock absorber for the global economy as it has been in the past, China will be reinforcing the slowdown. The question then becomes how to identify another source of global growth.
Chinese Stocks – Back to the Future?
Iran’s nuclear centrifuges continue to spin while the Obama administration continues to rely on sanctions to stop them. Unfortunately, while the sanctions may be making life difficult for Iran, they appear to be doing little to stop their nuclear progress. The International Atomic Energy Agency (IAEA) issued its quarterly report on Iran’s nuclear program on August 30 and the news was alarming. The agency accused Iran of cleansing the military site south of Tehran known as Parchin to prevent the agency from inspecting it. Iran has also reportedly been moving more of its nuclear fuel production into an underground facility known as Fordow near the holy city of Qom. This site is buried in a mountain and is seen by many experts as impregnable to attack. The IAEA believes that Iran has doubled its capacity to enrich uranium to 20% purity at Fordow over the last three months, and the number of centrifuges there has risen to 2,140 from 1,064 over that period (although most of the new ones are not yet purifying uranium gas). Iran has now produced about 190 kilograms of uranium enriched to 20% purity since 2010, of which 71 kilograms have been used to power Iran’s research reactor. Experts believe that Iran would need about 250 kilograms enriched to 20% purity for one atomic weapon.
Israel is running out of patience. Iran has been very clear that it would like nothing better than to wipe Israel off the face of the earth. The New York Times reported on September 3 that the United States is rushing to take additional steps short of war to reassure Israel that it is serious about restraining Iran (“To Calm Israel, U.S. Offers Ways to Restrain Iran,” p. A1). Among the actions that the U.S. plans to take are naval exercises in the region, installation of new antimissile systems in the Persian Gulf, more forcefully clamping down on Iranian oil revenues, and potentially new declarations by President Obama clarifying what would prompt American military action. As always, what is right is being governed by what is political. “The question of how explicit Mr. Obama’s warnings to Iran should be,” writes the Times, “is still a subject of internal debate, closely tied to election-year politics.” No doubt Mr. Obama’s amanuensis, Valerie Jarrett, will be guiding that debate, which means it is likely to sell Israel short.
Frankly, none of these mooted next steps impresses me in the least. If the U.S. wants to demonstrate real support for Israel, the next step it should take is to lead an immediate land and sea blockade of Iran. The U.S. should ask other Western nations to join in this blockade, but should not wait for them to debate the matter. Moreover, when Russia and China object to this action and run to the United Nations to block it, the U.S. should smile and tell them to take a hike. The blockade should not allow for any exceptions – not food, not medicine, not any type of humanitarian aid. If Iran challenges the blockade with military force, the U.S. should be prepared to use whatever force is necessary to defend itself and insure that Iran is confined to its borders. When the Iranian people revolt, the U.S. and other Western nations should provide whatever military and other support they can. The U.S. should not repeat the mistake of waiting as long as it did in Libya or doing nothing (as it is doing today) in Syria as Bashar Assad butchers his people in plain sight. America needs a president who understands that allowing a radical Islamic regime to gain nuclear capability is simply unthinkable. Frankly, I find the fact that this issue is open for debate further evidence that America has entered a lapsarian state from which it may never recover. If the U.S. does not do more and prevent Iran from getting the bomb, we will all look back at this period not only with regret but with a burning anger that we allowed something so obviously contrary to our interests to occur when we could have stopped it.
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Michael E. Lewitt
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