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A more positive view on the world economy

by Starvid Sun Dec 30th, 2007 at 08:07:27 AM EST

There are few signs in the world economy that we are heading towards a depression. Weak economic development in the US, and partly in Europe, is being compensated for by a continued good rate of growth in the rest of the world. When the credit fear abates, and all the skeletons finally fall out of their closets, the sun will shine again.
With the credit crunch and almost $100 oil arriving pretty much the way Jerome predicted they would, the feelings of doom and gloom are spreading. Some people are even talking about the Depression. I'm not saying this won't happen (or that it will), but it never hurts to look at things from a different perspective.

(With graphs!)

Diary rescue by Migeru

So I thought we were going to look at the latest Market Report of Skagen Funds.(pdf!)

What is Skagen Funds? It's a Norwegian stockpicker managing savings in the form of mutual funds. That's not a very unique thing, so why should we listen to these people, who anyway have a vested interest in saying everything will be fine?

Because they are probably the most successful fund company in the world today. For example, their top rated fund, Skagen Global, has beaten its index (MSCI World) every year for the ten years the fund has existed, and returned more than 20 % per year on average. This evens out to more than 700 % and that is actually better than even the best stock exchange in the world in the last 10 years, the Botswana stock exchange which is up about 700 %. This is supposedly impossible according to the efficient market hypothesis, which tells you everything you need to know about the relevance of said theory.

They couldn't be this sucessful if they were completely stupid, could they? Another, if maybe minor, feather in their cap is that when I idly talked about energy issues with some of their representatives, they immediately brought up the subject of Peak oil.

So, what are their arguments for a bright economic future?

Much fear and little substance for the time being

Strong leading indicators are still being reported from the U.S. economy, but the expectations here, as in Europe, are on their way down. Of the key ratios that provide snap indicators of economic health, it is worth mentioning a minor weakening of the U.S. labour market. Earnings reported by business are still positive, pulled up by exporters profiting from the weak U.S. Dollar. However, it is a free-falling property market that is the major drag on the U.S. economy.

In Asia, key economic figures are generally better than expected. China continues to steam ahead, in spite of tightening credit policies. It is worth noticing that even though exports to the U.S. have shown weak growth for several quarters, the trade between the countries in the region is increasing at a record pace. Recently, inflation has been increasing globally, due to strongly increasing prices of food commodities and energy. Global core inflation, however, which does not comprise these items, is moderate, but headline inflation remains high enough for the central banks to maintain a cautions approach.

If the danger of recession is indeed significant, it is not yet visible. We consider it more likely that there will be a short term growth pause in some countries, rather than a global recession. This is partley due to leveraged consumers, but also the fact that increased investments in capacity and infrastructure will not take place due to increased interest rates for borrowers. However, since August, borrowing costs have mainly increased for financial and not industrial borrowers.

Mixed fare

As already mentioned, the prices of energy and food commodities increased strongly in October and November. Meanwhile, the prices of industrial raw materials, such as metals and cotton, have fallen. This is probably primarily due to a reversal of previous speculative positions, rather than overproduction. Most inventories are still small, and supply side growth remains modest. The prices of primary commodities, such as iron ore and coal, remain strong, and may be leading indicators for the whole supply chain.

Within shipping, we have seen record rate levels in dry bulk, continued tightening in the container market and an unexpected record jump for tanker rates. None of these are factors that immediately come to mind as indicators of an imminent fall in global economic activity.

Lifted tanker rates on high volume indicate that more oil is on its way to the markets, through higher oil production by OPEC. It is likely though, that the oil price has passed its peak for this year. This is an assumption that is strengthened by the fact that the major investment banks have raised their oil price estimates strongly for both the short and the long term (they generally make the wrong call).

All the skeletons have to fall out of the cupboards

The finance industry has been really alarmed by continually rising interbank rates and risk premiums on other financial players. And financial scandals are not exactly helpful with respect to dousing fires. Perhaps the biggest confidence breaker is the strong underreporting of losses incurred by the financial industry from August up to November. The financial sector is allergic to making provisions for losses, especially after seven good years. Such ugly creatures undermine both bonus and equity, growth and dividend base. However, the process that will make bank managers face reality, has fortunately started.

So far, financial companies have recorded USD 40 billion in losses. More will be recorded in the fourth quarter. Primarily by U.S. financial institutions, but also by some European and a few Asian companies. At the end of the first half of the year, the special financing instruments infected by rotten U.S. subprime
mortgage loans amounted to around USD 1,300 billion. Now the amount is approaching USD 700 billion, and several institutions, such as HSBC, have announced that they will now record them in their own balance sheets. The bailouts of Citibank and E-Trade also demonstrate that there is still determination to make deals in this sector.

The above explains the strong increase in the interbank rates compared to the discount rates of individual countries. At the same time, we see how finance sector earnings have been overblown because the real financing volume has only been reflected on the income side of financial statements (the big losses have been off the balance sheets). However, just as when the technology boom burst after the turn of the millennium, many now believe that the world will come to an end. But, as the period after 2000 has demonstrated, the world continues on and the valuation of assets will continue to follow value creation.

Thus, it is more important than ever that sound fundamental criteria are used to select investments, and not short-term, speculative and emotional arguments. In our assessment, global value creation will continue, but probably at a somewhat slower and less inflation-driving pace. Meanwhile, global imbalances will lessen, with lower consumer spending growth around the North Atlantic.

Crisis rates

Risk-free rates of interest now provide very low real returns. U.S. Treasury yields have fallen to a level previously associated with long-term economic decline, or very low economic growth. Corrected for inflation, the current interest rate level corresponds to a 10-year real rate of interest of 1.5 percent, down from closer to 2.5 percent this summer. Some of it can be attributed to the flight to safety, if it is appropriate these days to call fixed income securities denominated in U.S. Dollars, safe. Some of it may also be due to a great supply of central bank liquidity. Nervertheless, this is a poor long-term investment option, unless you expect deflation and depression to be the global perspective going forward.

We also notice that the risk spread versus less liquid sovereign securities has increased. This is due to a desire for liquidity, which might be a good buying opportunity. For more aspects, please see our comments under "The fixed income market and our fixed income funds".

Globally, the equity markets seem to be relatively disconnected from the drama on the fixed income markets. The reason why is that the low interest rate climate we have had since 2002 has only to a very limited extent been translated into company revaluations. In this decade, global corporations have generally enjoyed very good returns on capital in a period of economic expansion. Few analysts have believed that this is a phenomenon that could last. Meanwhile, corporate risk has fallen, due to ever-lower corporate leverage.

This last thing is something I don't think is mentioned very often - the steadily falling levels of corporate indebtness, especially as all eyes are on consumer and mortage debt.

Modest valuation of equities
Consequently, corporate valuations are modest, by the standards of the last 20 years, and this has clearly acted as a buffer this year. Global earnings growth for the fourth quarter and into 2008 has now been heavily cut by analysts, but this is largely due to the problems in the financial sectors, and is directly related to companies in these sectors. Fortunately, the SKAGEN equity funds are heavily underweight in finance. We are still considering the risk in the financial industry to be considerable.

As is the case with the major asset classes, we are now also seeing a decoupling of geographic regions in the equity markets. Shares in Europe and the global emerging markets have behaved well in a market climate that, based on what has historically been "normal", should have led to a flight towards dollar denominated assets. However, in light of the fact that the risk is principally associated with the U.S. financial system, this seems rational enough. The combination of a falling U.S. Dollar and lower U.S. equity market valuations may in the longer term lead to a better climate for stock pickers - even in the U.S.

As the the credit worries is the main big argument for a recession, we'll take an extra look on what Skagen thinks of the credit markets.

The interest rate market and the fixed income funds
Credit markets out of sorts

The strong unrest we experienced in the credit markets in August flared up again in November. The U.S. housing market weakened further during the autumn and the losses on home mortgages and mortgage-linked bonds increased. Losses are spread over banks and financial institutions worldwide, but it is the major U.S. financials that are bearing the brunt. However, there is still great uncertainty regarding the scope of these losses and where they are located.

Sky-high interbank rates
The banks' uncertainty regarding their own balance sheets and scepticism regarding each other have pulled up the interbank rates - the interest rate that banks charge on loans to each other. The 3-month U.S. Dollar interbank rate has increased 26 basis points since the U.S. Federal Reserve (the "Fed") cut the Federal Funds Rate by 25 basis points at the end of October. The swings have been of about the same size in the Euro zone, and even bigger in the U.K. In Norway the 3-month interbank rate is 5.9 percent, a fair bit above the discount rate of 5.0 percent.

The Federal Reserve and the European Central Bank (ECB) have increased the supply of central bank money to the banking system in order to try to keep a lid on the interbank rates. So far this has only contributed to restraining the rise of the interbank rates.

Some of the lift of the interbank rates is a turn of the year effect. However, for these rates to return to a normal level the confidence of banks in each other has to return. How quickly this will happen is dependent on further developments in the housing market, and bank policies regarding the valuation of problem loans.

Pricey safe sovereign securities
In parallel with the ascent of the interbank rates, yields on U.S. treasuries have fallen sharply. The yield on the 10-year U.S. Treasury bonds is now 3.9 percent. That is 0.6 percentage points lower than at the end of October, and 1.4 percentage points lowerthan at the start of June. U.S. Treasury Note yields have also fallen sharply. 3-month yields are currently barely 3 percent.

The sharp decline in U.S. Treasury bond yields is due to investors selling off fixed income securities encumbered by uncertainty and buying what they assume to be the safest of securities. A fear of losing principle means that many are willing to accept low yields and great risk of price declines. Generally the same developments have been seen in many of the other Western countries, the U.K. and the Euro zone in particular.

Further cuts from the Fed
The market expects the Fed to cut the Federal Funds Rate further at the next three meetings of the Open Market Committee, and that it will end up at 3.75 percent by the middle of March next year. Expectations are due to clear signals from the Fed that it is ready to maintain an accommodating monetary policy in order to help the financial market, and to prevent the U.S. economy from slipping into a recession.

Monetary policy has resulted in a devaluation of the Dollar in the currency markets. The risk is that inflation ends up higher than the Fed comfort level. Inflation is 3.5 percent and is expected to increase further in the coming months. Core inflation, however, seems to be under control. It was 1.9 percent in October. This is in the upper range of what seems to be the Fed's implicit inflation target of 1.6 to 1.9 percent.

What are the other central banks doing?
The European Central Bank (ECB) has kept the discount rate at 4.0 percent and until recently, the attitude in Frankfurt was that it was on its way up. However, the credit market unrest and fear of the combination of lower U.S. growth and a weaker Dollar seems to have made the ECB change its mind. The financial markets are discounting an interest rate cut to 3.75 percent by next summer. Also the U.K. market is pricing in a lower discount rate. It is assumed that the Bank of Japan will wait a bit before the discount rate is increased from the current 0.5 percent.

To wrap it all up or if you didn't stand reading all of this rather long text, in the words of Skagen boss Kristoffer Stensrud.

At the start of 2008, the world of capital has segregated into two camps. Some are preaching the end of the world, as a consequence of falling U.S. home prices, possible drop in consumer spending and the possibility of a U.S. recession. They receive support from diving confidence indicators in developed countries. The other camp preaches "a dangerous thought": that it is different this time. Overall, the world economy has never before in history been less dependent on the developed countries. The years 1989- 1993 showed that it was possible for the global emerging markets to have a long period with different equity development than the developed countries. The final result was a quite dramatic overvaluation.

Naturally, the financial sector regards the problems of the financial sector as the key issue. This may perhaps contain an element of overestimation of their own worth, and a small element of putting the cart before the horse. Even the most snooty financial acrobat has to realise that is impossible to defend the finance industry constituting around 25 percent of global equity capitalisation (as it has in recent year), by the mere fact that a corresponding share of global value creation stems from this sector (has fallen recently, as mentioned above).

The most probable scenario for what will happen to the world economy going forward, is somewhere between the two above-mentioned camps. We have not seen the end of the bad news from the financial sector, and we have a heavy fourth quarter reporting season ahead of us. The finance industry has quite a tradition of skeletons falling out of the closets all at the same time. And the closets are still far from empty.

The general experience from the past 30 years is that, unless you are caught by a speculative cycle, it pays to be invested in shares. Now that the financial bubble has been burst, global equities are again relatively free of speculation. Best rewarded will be the equity investors who have put fresh batteries in the calculator they keep on the nightstand.

And as someone is bound to wonder, these are the current main investments of Skagen Global.

For disclosure and stuff, I have investments in Skagen Global.


Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Sat Dec 22nd, 2007 at 03:55:51 AM EST
When someone says there will be a growth pause rather than a recession ...

... what that means at best is a recession "somewhere else but not here".

I saw three such growth pauses in Australia ... the Asian Economic crisis, the introduction of the Australian VAT (named GST in Oz) and accompanying overly aggressive RBA interest rate rise, and the 11/9 synchronised global recession.

The middle growth pause ... actually "economic downturn that did not last long enough to qualify as a recession" was a recession that was short-circuited by a backing off of the RBA combined with a plunge in the Ozzie dollar that led to a boom in non-conventional exports (eg, wine, movie production).

The other two were external shocks that were offset by domestic credit booms ... in the first instance, a consumer finance credit boom as previous prudential controls on consumer credit were removed, and in the second instance, a housing boom as federal and state governments competed on who could get credit for offering first time home buyers grants.

The best prospect for the US economy at the moment is more or less the first scenario, but rather than a boom in "unconventional exports", a boom in "long languishing conventional exports" as a result of a cheaper dollar, which may drive new investment in productive capacity precisely because they have been languishing for so long.

Other than that, however, if the US slides into recession, the Chinese and other neo-mercantalist economies would have to shift their primary focus to Europe ... as well as likely increasing their secondary focus on providing products on credit to low-income raw material exporters ... and the question will be whether that will be enough to offset the US downturn.

So for y'all, you are two plausible stories removed from participating in a synchronized global downturn ... by contrast, we here in the US are only one plausible story away from a serious domestic recession.

If they both happen to be 50/50 propositions, that would mean we over here are 50/50 for a recession, while y'all are 25/75.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Dec 23rd, 2007 at 11:32:37 AM EST
[ Parent ]
Siemens will almost certainly be pulling out of the network merger with Nokia. They have tried and tried to integrate the two cultures, but it just hasn't worked. My guess is that Siemens will not try to get back into their own network business up against Nokia. Thus they will take the money and go and buy something outside the mobile business - something more industrial/electrical. Be interesting to know what!

You can't be me, I'm taken
by Sven Triloqvist on Sat Dec 22nd, 2007 at 08:13:29 AM EST
But Skagen are forecasting a PE change in 08 for Siemens

You can't be me, I'm taken
by Sven Triloqvist on Sat Dec 22nd, 2007 at 08:16:32 AM EST
[ Parent ]
Very good diary, really interesting analysis. Seems like a good assessment really.The world economy is not so tied to the US so the chances of recession/depression are currently not huge, across the globe. In the UK/US however, there's definitely a strong chance of that happening. Whilst the global market is more sheltered from that than it used to be, I'm sure the world economy would take a pretty hefty hit if recession hit the western economies.

It's a very interesting time.

by darrkespur on Sat Dec 22nd, 2007 at 10:54:02 AM EST
Send an email one day  to 1000 people - 500 saying "the stock market will go up today", 500 saying, "the stock market will go down today". The next day, send only 500 emails, to those who received the correct prediction, and do the same again: send "up today" to 250, "down today" to 250.

And so forth. After 10 days, you'll have sent the correct prediction for 10 consecutive days to one person. There's a good chance that this person will listen to your advice for the next day.

Overperformance by one fund over 10 years is not necessarily significant. It is likely, to a large extent, to be luck. A lot of luck, sure, but it is normal for a small number of investors, as shown above, to have that kind of luck.

The past is not a predictor of the future on the markets

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sat Dec 22nd, 2007 at 11:19:38 AM EST
We'll just have to see, won't we?

I feel very comfortable with the way they work (Undervalued, underanalyzed, impopular), their investment philosophy (value investor), low basic fees with higher compensation only as a result of higher returns, and so on. Just the fact that they seem to work to enrich their customers instead of fooling them and enriching themselves, rare for the industry, or that they work out of Stavanger instead of London/Oslo, away from the madness of the financial industry, is a good sign. Reminds me of Buffet staying in Omaha. I also read an interview with Stensrud, who seems to be a genuinely nice guy, inspite of having become very rich (€200-300 million).

One thing that might make Skagen feel pretty happy about the world economy is of course that they focus in individual companies, not the economy as a whole. Also their dislike of the financial industry and it's excesses makes the subprime mess look less important, maybe even a good, and definitely a deserved, thing. Something people around here might well identify with... ;)

Some Stensrud quotes from the interview.

The world would not become a worse place to live in if JP Morgan or Morgan Stanley disappeared. This is a healthy and long awaited correction.

The world lives on even if finance dies.

(As in several hundred millions of Asians waiting four housing, energy, infrastrucuture and welfare being extremely more fundamentally relevant than a ten million Americans not being able to pay the interest on their mortages.)

The USA will never become as strong as it earlier was. The USA used to be the worlds biggest democracy, the worlds greatest industrial power and had the worlds biggest oil industry. Today India is the worlds biggest democracy, China the worlds biggest industrial power and the USA is an oil importer.

By the way, they began working with Skagen 14 years ago. They have three funds. All have beaten the market every year. That's just not luck. The efficient market claptrap would have it be luck, but markets aren't efficient, they are insane.

I almost feel like I'm doing PR here for Skagen instead of talking about the world economy, but then so be it. It's fun. :)

The ten biggest holding of their second fund, Kon-Tiki, which is more focused on emerging markets, is below.

The biggest holding, Eletrobras, seems like a great investment. It's the big semi-state owned hydropower company. The power markets are being deregulated, and we all know what results that have on power prices and corporate profits. As a matter of fact, the dams themselves are worth three times as much as the market value of the entire company...

What they used to say of Petrobras...

They are now saying of Eletrobras...

Now this sounded awfully much like a sales pitch, and I'm sorry for that. But Eletrobras is being listed in New York in 2008, easy to invest in for ordinary people... I thought it would be a little selfish not to give you people a heads up.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Sat Dec 22nd, 2007 at 11:15:44 PM EST
[ Parent ]
And they are invested in Petrobras and Brazil has just discovered big petroleum deposits off its coast.   Pretty good luck.  
by gobacktotexas (dickcheneyfanclub@gmail.com) on Mon Dec 24th, 2007 at 06:57:05 PM EST
[ Parent ]
  • Forward P/E ratios are pointless, as they look at future numbers, which in current times are pretty hard to predict given the overall uncertainty and the ways a recession will play out;

  • And excluding financials from the ratio is disingenuous, given how they made up 40% of overall corporate profits in recent times

  • Betting on lower oil prices has been the conventional contrarian wisdom every one of the past 5 years. I'l still not convinced that even a recession will bring them down;

  • corporate defaults are at record lows precisely because of all the easy financing they could get before the credit crunch. Now that credit is no longer available (at all, or on such favorable turns), it's not clear how things will turn out. Many companies have sound balance sheets and no need for finance, but many do have that need, and the market won't provide.

Their last sentence says it all: 'the experience of the past 30 years'. The past 30 years have been one long bull market. How relevant is that as we move to another phase of a very long term cycle?

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sat Dec 22nd, 2007 at 11:26:01 AM EST
Many companies have sound balance sheets and no need for finance, but many do have that need, and the market won't provide

As we have said in previous threads, it's start-ups and SME's who are going to be hardest hit.

Credit - as well as equity - is necessary for development: since banks won't be providing it, we'll have to think of something else......

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Dec 22nd, 2007 at 11:39:23 AM EST
[ Parent ]

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