Stiff Upper Lip

By Yiannis G. Mostrous

LONDON, UK–It’s pleasantly sunny in London, a perfect backdrop for interesting meetings with old acquaintances in the money management industry. My long-held view that London is–by far–the place to be when one wants to be close to a truly stimulating international investment environment has only been reinforced this week.

It’s a diverse group of people that can be found here, fairly free of half-truths in their thinking, something that New York seems to occasionally lack these days. This makes for stimulating conversation on international finance and geopolitical developments alike. The perspective in London is truly global.

Sitting in a cozy Italian restaurant in Notting Hill, we began with a discussion of Hu Jintao’s visit to the US. Quite a few people seemed unable to understand US policies toward China and, more importantly, no one could see the ultimate strategy behind these policies.

Although some observers admitted they thought the US wouldn’t be so friendly to the Chinese president, most were quite perplexed when the US proved to be a somewhat discourteous host. I offered an assessment on the then-upcoming visit two weeks ago (see SRI, April 12, 2006, Mr. Hu Goes To Washington), noting,
[T]he economic/trade friction between the US and China makes this one of the most polarized visits of a foreign leader in recent memory. The issues are well known, but the final outcome and its effect on the global economy remain unknown.

The Chinese president has bad luck, for his visit takes place just three weeks after the latest trade numbers were released in China. Its trade surplus came in well above expectations at $11.2 billion–or $120 billion annualized, up from $102 billion in 2005.

Although I went on to forecast that politeness would prevail, the opposite, to a certain degree, won out. As my friends pointed out, the US government classified the Chinese leader’s visit to Washington as an “official” visit rather than a “state” visit. A “state” designation would have been more appropriate given the important relationship between the two countries as well as China’s rising significance in the world economic and geopolitical stage.

China’s official name was also summarily changed during a ceremony on the White House grounds–it was announced as the “Republic of China,” a name Taiwan uses for itself, rather than the correct “People’s Republic of China.”

At the end, the Chinese rejected pressure to implement a major revaluation of the renminbi that the majority of the US-based economists and politicians have been demanding for sometime now. Nevertheless, the view here remains that the renminbi–along with the rest of the Asian currencies–will continue to appreciate against the US dollar for the rest of 2006 (see SRI, March 1, 2006, The Butterfly Effect).

Hence, the dollar will remain weak for the rest of the year, especially against the Asian currencies, as well as against the euro (EUR) and the British pound (GBP). I expect other deficit countries (e.g., the UK and Australia) to see their currencies weakening against Asia, including Japan. This development will be good for US-based investors with overseas holdings.

Returning to trade issues, one of the participants noted that the US has imbalances with almost every trading partner. As an example, he suggested taking a look at the US-EU trade balance figures. I did; the chart below shows he was right.


Source: Bloomberg

Although a stronger EUR can hurt European Union exports, the majority of our friends–even those who work for US investment banks in London–thought Europe should be able to register a growth rate above 2 percent this year, a good development in light of 1.4 percent growth in 2005.

Our “panel” expects global economic growth to remain solid for the rest of the year, though some expressed concerns regarding the negative influence a slowdown in the US housing market, and accordingly US consumption, would have on the global economy.

A more conservative SRI can only agree, since many indicators still point toward sustainable global economic growth. While I remain concerned on the nature of the eventual economic slowdown (soft landing or hard?), this should be more of a late 2006, early 2007 story.

For someone who deals with international markets, London is always very informative and useful. I’m looking forward to more meetings, as well as a ballet performance I’m attending tonight at the Royal Opera House (Covent Garden).

I’ll share both experiences with you next week.

Hedging & Bonds

US Treasuries remain, along with gold, the permanent hedges in the SRI model portfolio. The position in bonds was introduced in March (see SRI, March 8, 2006, Hedge Your Bets). As I noted then, “This is the time to take a position in bonds. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF). Even if there is short-term risk, now is the time to gain exposure to the Treasury market.”

Since then, there’s been much talk among financial talking heads–yours truly included–regarding the negative consequences the rise in bond yields (along with higher oil prices) will have on the global economy.

The view here remains that although investors should not be wildly bullish on bonds, for hedge purposes their exposure should be significant. I continue to believe that bonds have sold off because growth expectations remain high among market participants, especially as the rest of the world (i.e., besides the US) has been increasing its contribution to economic growth- a secular change that will eventually (mandatory ups and downs notwithstanding) transform the way we view the world and, consequently, investing.

That said, US GDP growth will not show anything better this cycle, and later in 2006 or early in 2007 a slowdown should take place. Hence, if bond rates rise further–to 5.3 percent on the 10-year–SRI’s recommendation will be an increased position in bonds.

In the March 8 SRI, I suggested shorting Brazil through the iShares MSCI Brazil Index Fund (AMEX: EWZ). Investors who acted should have been stopped out as the ETF traded above the suggested stop-loss of $44. Note that the main recommendation was to either take some profits or tighten the stop on the long positions, as the market, although vulnerable, exhibited good momentum.

The other permanent hedge, gold, is an investment story for which I have a clear preference for the next five years. Gold will be the biggest beneficiary of the eventual problems the global economy will face in the future, which are, in turn, gifts of the policy excesses of the past decade.

Gold is one of our permanent hedges because it’s expected to preserve its purchasing power in deflationary and inflationary economic environments (see SRI, March 29, 2006, Right You Are (If You Think You Are)).

Portfolio Talk

As this is earnings season, Portfolio companies have been reporting–I’ll undertake a detailed examination of results in the next week or so.

That said, one of the highest-profile announcements was that of Ericsson, to which the market reacted quite negatively. My first impression is that this was nothing more than profit taking, and the long-term fundamentals of the company haven’t changed.

Ericsson revealed strong sales growth of 24 percent, though its margins were hurt somewhat as the company was absorbing the depreciation and amortization charges associated with the Marconi acquisition. More important, the company presented high network rollout sales, meaning higher returns for the future. The view here remains that Ericsson continues to demonstrate superb sales growth and maintains a leadership position on the technology front. The company is therefore in great position to reap substantial benefits from the continuing development in the wireless communication sector. Ericsson remains a buy.

While abroad, I’ve been briefed on a strong trend in mergers and acquisitions taking place in Europe. The numbers are staggering and could surpass the aggregate value of deals done in 2000.

The sector where the most activity is taking place, and where it’s expected to continue, is the financials. European banks and insurance companies are consolidating while structurally reforming. They’re also thriving as the European consumer (especially ex-UK) continues to expand its balance sheet (i.e., borrow more).

At the same time, some of the biggest players are still undervalued (sometimes rightly so), but the point is that the whole industry is going through a cycle of improvement.

One turnaround play I’ve identified is Netherlands-based ABN Amro (NYSE: ABN). The company has been feverishly restructuring, cutting costs while trying to improve performance. In addition, it recently expanded in Italy through the acquisition of Antonveneta, an Italian bank. I expect ABN Amro will eventually become an acquisition target of the likes of HSBC, BBVA and Deutsche Bank.


Source: Bloomberg

Buy ABN Amro, a new member of the SRI model Portfolio.