Summary of CFA Society of Los Angeles’ Annual Forecast Dinner
(February 28, 2008)
Dear Subscribers and Readers,
Before we go on to the summary of last night's CFA LA Society's annual forecast dinner, I would like to make a few comments about crude oil. As I mentioned in last weekend's commentary, and as again confirmed by the latest crude/gasoline inventory numbers, the build-up of domestic oil inventory over the last two months continues to be very impressive, even though the amount of inventory as of Wednesday is still slightly below that of where it was 52 weeks ago. While crude imports are responsible for a significant chunk of the build-up, we still do not know for sure whether this “excess crude” is coming into the U.S. at the expense of crude oil inventory in other OECD countries, such as the UK, the Euro Zone, and Japan. At this point, speculators are betting that this is the case (meaning that total OECD oil stocks are either stagnant or not growing by a significant amount) – but we do not know that for sure (preliminary OECD oil inventory numbers won't be released until a few weeks from now). Moreover, many speculators are still looking for: 1) A cut in OPEC production at the March 5th meeting, 2) more short-term supply issues going forward, and 3) crude oil as a hedge for a falling dollar. These three assumptions are all question at best.
However, what we do know is that the economies of the Euro Zone, UK, and Japan are also dramatically slowing down. Furthermore, we know that many governments – if oil should rise further – will start to cut fuel subsidies, thus collapsing demand in those countries. Vietnam has started to cut fuel subsidies and will completely eliminate them (equal to 1.4% of GDP) by the end of this year. Other countries that are running unsustainable subsidies with crude oil at $100 a barrel include Pakistan ($2 billion), Malaysia ($12.4 billion), and Indonesia ($11.7 billion). This continues to bear watching, as for every $10 billion not spent buying crude oil in any given year – all else equal – demand declines by approximately 275,000 barrels a day annually at today's prices. Given that crude oil and other commodities are priced at the margin, 275,000 barrels a day is a significant number – especially when compared to the projected increase in Chinese demand in 2008 (400,000 barrels a day).
Given near-record high inventories in the US, a slowing OECD, as well as an inevitable cut-back in fuel subsidies and a decline in purchasing power throughout the world due to higher food and other commodity prices, my sense is that the risk is to the downside when it comes to oil demand and oil prices. Finally, at today's prices, many institutional investors are no longer interested in “blindly” going long commodity mutual funds or commodity hedge funds. As Russell Read – CIO of CalPERS – mentioned in a recent CFA publication, they are now selectively looking for investments in oil/energy infrastructure (such as new pipelines, power plants, and so forth), as well as in the alternative energy areas, through private equity or partnerships with public companies. While CalPERS currently has a long-only commodity investment program, they are also going to use commodities as a hedge going forward. E.g. If CalPERS decides to invest in a biofuels program that could only be profitable with oil at $70 a barrel, then CalPERS would not hesitate to hedge that potential risk by shorting oil at $70 a barrel. In other words, while crude oil and commodity demand will continue to increase, institutions such as CalPERS are now investing in this “secular story” from an infrastructure perspective – and thus going forward, higher commodity prices in general will no longer be a guarantee. In fact, one can argue – with CalPERS investing significant funds in alternative energy going forward – that crude oil prices may actually start to come down as the U.S. reaches “grid parity” without any subsidies before the current target of 2015.
Now, let's quickly review what was discussed on Wednesday evening. While this year's CFA LA Annual Forecast Dinner wasn't as insightful as last year's (last year's speakers includes Abby J. Cohen, Paul McCulley, and John Taylor of “Taylor Rule” fame), it was still a must-see event, nonetheless. Following is a list of panelists, as well as their titles. I also summarized each individual's point of views with regards to topics such as the general economic outlook, the financial sector, and commodities. Please feel free to email me or post a thread on our discussion forum should you want to discuss any of their viewpoints.
- Donald Straszheim, Vice Chairman, Roth Capital Partners
- Alison Deans, Deputy Head of Private Asset Management, Neuberger Berman, a Lehman Brothers Company
- Tony Crescenzi, Chief Bond Market Strategist, Miller Tabak + Co. LLC
General Economic Outlook
- Believes US is already in a recession that began in December. There are many indicators that currently suggest weakness in the economy, such as the lack of consumer confidence and overall consumer nervousness/caution. Important in that consumer spending makes up 70% of the economy.
- More pain to come over the next several months, but don't believe this is a record-breaker by any means, given the amount of easing done by the Fed and the overall low level of interest rates.
- Back in the late 1970s/early 1980s, economic cycles were more violent, given the dominance of the manufacturing economy as well as inventory cycles. Today, this is no longer the case.
- Official forecast of Neuberger Berman is no recession – but a dramatic slowdown with approximately 0.5% real growth in the U.S. economy.
- Sees the lower dollar helping exports significantly – which would in turn add to U.S. economic growth.
- Has not made a forecast of whether the U.S. economy is in a recession or not.
- However, inventory control is much better in the current cycle – even compared to the last economic cycle during the early 2000s. Even in the “Great Moderation” leading up to 2000, there was an unusual increase in inventory build-up as companies gear up for “Y2K” spending. This lack of inventory is reflected in consumer goods across the spectrum – in particular, automobiles (which wasn't the case in the time period leading up to the 2001 recession).
- The exception is the inventory level in housing. However, if you look at population trends – given that members of the Y-Generation (or the “echo boomers”) are starting to buy homes, housing inventory levels should be worked off relatively quickly compared to pass housing cycles. Moreover, the number of people over 55 years old is continuing to increase – and many of these folks tend to buy second or vacation homes.
- The last housing bust in the early 1990s coincided with the peak of home purchases as baby boomers stopped buying homes – which exacerbated the decline in home prices. We will not see this “double whammy” effect in the current cycle.
- However, in the interim, there will still be a lot of pain for house prices.
On Financials and the Banking Sector
- In the last cycle (during the early 1990s), bank charge-offs did not end until 1992/1993, but bank stocks bottomed out in the fourth quarter of 1990.
- Believes that financials are now making a bottom.
- Deans is now buying – focusing on the businesses that are well-managed and that will gain market share as other banks are forced to divest their assets in order to raise capital or cut back risk.
- Total bank credit (as compiled by the Federal Reserve) is currently around $9.3 trillion, and has been increasing at a 15% annualized pace over the last 6 months. This is a very high rate and is supportive for illustrates that the banking system is still working fine and is continue to lend money. It also signals that banks still have a very high capacity to lend despite the current credit crunch. Sees bank credit growing another trillion over the next 12 months.
- Believes that banks such as Sovereign Bank, Back of America, and Bank of New York Mellon will do well over the upcoming year. Also don't believe that many banks will fail compared to past cycles. IN a couple of years, the banking sector will be flourishing again.
- Commodity prices are inherently cyclical and will be no different this time around. While China continues to be the main factor, and while the secular story is still intact, he believes that prices will come down this year.
- Believes that commodities are in a secular run-up – no prediction as to where prices will be this year.
- Believes some kind of bubble is forming – also believes there is a lot of speculative activity in commodities right now, especially from retail speculators. E.g. There is now a 6-to-1 ratio in small specs longs vs. small specs shorts in the latest COT report for gold derivatives.
Where will the Leadership be coming out of the Global Slowdown?
- Does not believe in the “de-coupling” theory given that it doesn't go together with globalization – especially since the latter has contributed to significant global economic growth over the last cycle.
- E.g. GM, Toyota, Nokia, etc, are now all global companies, and are no longer regarded as a US, Japanese, and Finnish company, respectively.
- With regards to China (Henry's note: Don Straszheim is the local investment expert in China), he believes that China will continue to grow at about 10% for the next 20 years, with 1% coming from population growth and the remaining 9% from productivity growth. Much of the rural population migrating to the urban areas were contributing next-to-nothing in terms of productivity to the overall economy, as the agricultural sector continues to experience a labor surplus. This trend will sustain itself for the next 20 years.
- While there is excess capacity and while resource allocation is still very inefficient (especially since banks are really official lending arms of the government), China should continue to enjoy sustainable economic growth. If China can experience 10% economic growth with inefficient resource allocation, imagine how quickly she can grow if resource allocation was conducted in an efficient manner!
- Outlook on the Chinese currency, or the Renminbi: Currently at around 7.14 to the dollar, the forward market believes that RMB should rise to 6.5 to the dollar next year. Believes that this “consensus” is wrong – as China is now experiencing a slowdown in export growth (48% of exports go to the US, the Euro Zone, and Japan). Believes the Chinese government will try to stop the appreciation of the currency once it hits 7 to the dollar. Do not see huge inflationary concerns going forward, given that the majority of it came from food costs (core inflation is still around 1.5%).
- With regards to Vietnam, he believes that the story is similar – but that Vietnam is similar to the China from 10 to 15 years ago. Vietnam doesn't have the necessary infrastructure to compete with China or India but they will going forward. Moreover, Vietnam's labor costs are very, very low.
- Believes malaise in auction rate securities – as well as in the subprime market – are overblown right now. Would buy auction rate securities as a short-term play. Sees the equity markets rising this year. The successive appointments of Arthur Burns and William Miller as Fed Chairmen during the late 1970s were very unfortunate – as they implemented very bad policies that sustained high inflation during the late 1970s and early 1980s. Miller, in particular, was very popular within the Fed. At one meeting, he was actually outvoted by the other Fed governors. In general, he sees the Fed as having learned from that experience and so far, they have not proven otherwise.