Still Going

By Yiannis G. Mostrous

MCLEAN, VA–In the early days of The Silk Road Investor, I pointed out that world markets would eventually have to deal with many uncomfortable issues, including the inevitable resolution of the current account deficit; the climax of the red-hot housing action in the US; increasingly sensitive geopolitical risks; the parabolic action in commodities; and rising interest rates. I could name more. SRI therefore monitors leading and other indicators to gauge potential changes in the economic environment that can affect market sentiment.

Looking at the global economy, my assessment remains that it’s performing quite well and can continue its current positive course for some time.

In late February (see SRI, 22 February 2006, Still Looking Good), I introduced some forward-looking indicators. Given the market’s solid performance since, a fresh look is in order.

The first is the Economic Cycle Research Institute’s (ECRI) weekly Leading Indicator for the US, which leads GDP by two quarters. Although the indicator caused some concern last year, it’s rebounded smartly and looks healthy.


The Conference Board’s Leading Indicator series for the US also looks good, obviously not pointing to a recession as of yet.


In Japan–long a SRI favorite–the Organization for Economic Cooperation and Development’s (OECD) leading indicator is also pointing to good growth.


In Europe, things look even better, with leading indicators strongly rising. The OECD leading indicator for Belgium, which generally leads the rest of Europe, has been rising at a healthy pace, while the German IFO business survey is at a 15-year high.



These indicators can change at any time (and then perhaps inspiring a different attitude toward the market). For now, though, these measures indicate that the global economy has more life.

Markets could, however, decline for a number of other reasons (e.g., high valuations, loss of momentum, external shocks). But a decline attributable to economic weakness or corporate performance doesn’t seem likely, at least not yet.

As the economy remains in a growth mode, global inflation is also cooperating by remaining low, especially at the core level. Yet there’s much talk lately that core inflation isn’t a true measure of inflation because it excludes food and energy. Food and energy are very important in our everyday life, and inflationary pressures there can have adverse consequences for consumer expectations.

SRI looks at the core number to determine if inflation pressures from energy and food feed through to the rest of the Consumer Price Index (CPI) basket. If they do, the situation is worth studying.

Due to the strength in oil prices, the core inflation debate has returned with a vengeance. The fact of the matter is that energy accounts for just 9 percent of the CPI, weakening the energy argument. On the other hand, food accounts for 14 percent of the CPI–it’s obviously a more important factor. Nevertheless, a cursory look at food price indexes (e.g., the Producer Price Index [PPI] for food, farm and import prices) shows clear deceleration, if not outright deflation.

That said, the ECRI future inflation gauge growth rate continues to point downward, indicating that inflationary pressures should remain benign.


At the same time, core CPI in the US and the European Union (EU) also show that inflation remains under wraps, something that makes central banks’ work easier.



As far as SRI is concerned, the global economy is growing at a satisfactory pace and inflation is still low. Both circumstances are positive for markets and investor sentiment.

Speaking of the latter, some additional observations on the UK and Europe in general following my visit there are in order.

While in London I had the opportunity to talk with a group of people in the hedge fund industry, mainly account managers. The bottom line is that, based on our conversations, there’s no fear in their thinking. They’re prepared to buy the dips, and they’re always open to listening to new investment ideas.

Although this is a good sign–in the sense that the market is supported–it’s also a reminder that greed rules the market. You should be a little conservative, as a sudden change in mood can hurt the markets meaningfully. Keeping your powder dry now will only help enhance performance as the year unfolds.

(And if you find yourself in London with your young child or grandchild, make sure you take him/her to see Mary Poppins at the Prince Edward Theater. It will be an unforgettable and thrilling experience.)

Looking at the markets, the mood remains bullish, with commodities leading the pack. My expectation remains that commodities will take a breather; although I’d like to believe it would happen before they become so overpriced that a slowdown would undercut the market, this is very difficult to know. I tried to anticipate a downturn with the BHP Billiton short recommendation, but the market took the opposite view.

There are also quite a few market observers floating the idea of US outperformance this year (note in absolute terms investors did make money in the US market in the past three years, just not as much as those who opted for overseas investing). I disagree with this assessment, even though I concede that US financial stocks–the biggest market segment–are looking very bullish right now.

I expect foreign markets to continue to outperform the US for years to come. With respect to Asia, 1998 marked a real bottom for the region’s markets, and a new bull market commenced based on superior growth prospects. Furthermore, although global trade remains one of the key drivers in Asia’s economic growth, the region’s future is rooted in urbanization and domestic consumption. Trade remains one important aspect of domestic consumption, but not the only one.

That said, a slowdown in Asian exports can’t be ruled out. Combined with continuing weakness in the US dollar, such a slowdown would lead to a preference for domestic-oriented companies in the SRI Portfolio. Greenback weakness has traditionally been a negative for exporters in Asia ex-Japan, as a strong US dollar implies more overseas consumption as consumers have more purchasing power. And it also implies weak Asian currencies, a situation that makes US dollar-denominated revenue rise in local currency terms, thus helping earnings. Given SRI’s previous assessment of the US dollar’s performance against Asian currencies (see SRI, 1 March 2006, The Butterfly Effect), the Portfolio has been positioned accordingly.

Thailand remains a preferred market. As anticipated (see SRI, 29 March 2006, Right You Are (If You Think You Are)), the political crisis there is on the path to resolution after King Bhumibol Adulyadej’s intervention via a televised address last week.

King Bhumibol Adulyadej’s call for the courts to resolve the political issues should have a positive effect. The King has shown the way; Prime Minister Thaksin Shinawatra’s opponents will be forced to participate in the election process, and Mr. Shinawatra has a legitimate chance to win again. He’d then be able to continue implementing his economic program, which would be bullish for the market. Despite recent weakness Bangkok Bank remains SRI’s favorite in Thailand, though it’s a more speculative play.

Finally, Singapore has performed well as investors are more and more impressed with its success in creating new growth sectors while strengthening its financial services sector. Singaporean banks remain the main way to play the revitalization of Singapore’s economy, and investors should also take advantage and own one of Singapore’s solid dividend-yielding stocks. The SRI Portfolio includes recommendations for both strategies.