Killing Me Softly – McLean, VA

On February 24, the Fed released the results of the Survey of Consumer Finances, a study the Fed conducts every three years of “the balance sheet, pension, income, and other demographic characteristics of U.S. families.” The latest results are as of 2004.

The results show–among other things–that the richest 10 percent of Americans account for 43 percent of income and 57 percent of net worth. The net worth-to-income ratio for the richest 10 percent of Americans increased from 7.4 in 2001 to 8.4 in 2004. The rich are getting richer, while the not so rich are not getting any better.

Two weeks later the Fed also released its fourth quarter flow of funds report. Household debt-to-income ratio is at a record high of 129 percent; it was 100 percent in 2000. Household debt-to-net worth stands at an all time high of 22 percent; it was 15 percent in 2000.

Before these two surveys were released, the former Chairman of the Federal Reserve, in testimony February 16 before Congress, said, “In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic policies that work to the detriment of the economy and society as a whole.”

No, this is not your weekly companion on social science. But since the Fed is supposed to be doing its best to keep the economy in good shape, and since the economy is the people, it seems only natural to mention these statistics—they matter because of the intensity with which investors are currently speculating about when the Fed will stop raising interest rates. Assorted talking heads are predicting three different outcomes: the Fed stops at 4.75 percent, 5 percent or–the consensus estimate–5.5 percent. This talking head has no horse in that race, but will offer some observations (with less social science).

As the following chart shows, the pace of wage growth has been accelerating, albeit in nominal terms. This indicates additional inflationary pressures for the Fed to consider, and which could allow them to tighten for longer than most investors expect.


At the same time, productivity is nowhere near as strong as it once was, as the chart below illustrates. Together, these two pieces of data indicate a rise in labor costs at a time of falling productivity–a bad sign for profit margins.


The main reason the Fed and other central banks around the world are rising rates is because of strong economic growth. In that regard, questions concerning the withdrawal of liquidity are not material since the central banks are not doing anything more than going from expansionary to neutral monetary policies.

Problems can occur if the strength of the economy is not as buoyant as everyone seems to think. In other words, the Fed could get carried away and raise more than it should; it’s done this before. If that happens, the markets and the economy will suffer, as limited access to easy money will curb investors’ speculative enthusiasm.

The Fed also faces a political dilemma: Going beyond neutral could also severely damage the housing market. Residential property represents 38.7 percent (as of 2004) of household assets. Alan Greenspan’s successor, Benjamin Bernanke, can’t afford to kill the engine of the US economy, the American consumer. The situation is quite challenging for the new chairman, and investors should be prepared for both bearish and bullish outcomes.

The view here remains that the US economy will experience a slowdown in the second half of this year, while 2007 could be extremely challenging. Rate cutting should commence sometime toward the end of 2006 or early 2007. Nevertheless, a slowing economy is the bond market’s real friend: a Treasury bond selloff would be cause to add to the hedging position introduced last week (see SRI, 8 March 2006, Hedge Your Bets).

As an aside, the following chart is the Economic Cycle Research Institute’s (ECRI) future inflation gauge for the US. History shows that when it begins to roll over from elevated levels, it’s a good time to allocate some funds to US Treasuries. Buy iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF) as a hedge position.


As the first quarter of the year is coming to an end, focus is shifting to Q2 and the rest of the year. The preliminary view here is that the European Union economy will do much better than the majority of observers expect and that Japan will continue its economic expansion. Of the other two important economies, China should gradually slow and India will continue to be strong. Nevertheless, expect some profit taking, especially in Japan and India.

Finally, the US dollar (USD) will continue to weaken against Asian currencies. The Chinese renbinbi (RNB) in particular continues to strengthen against the USD (see SRI, 1 March 2006, The Butterfly Effect). Today the RNB strengthened to 8.0375 against the USD from 8.0473, the biggest single-day gain since the decade-old peg to the USD ended last July.

The US has been pushing the Chinese to allow their currency to fluctuate more freely, as American politicians–and a large segment of the public–believe that China’s “manipulation” of its currency is hurting American businesses and is responsible for the grotesque US current account deficit. The view here is that stronger Asian currencies are a positive for the region and will go a long way toward helping domestic demand in Asia. At the same time, an RNB appreciation will do almost nothing to meaningfully alter the state of the US economic imbalances.

Portfolio Talk

I’m adding two new stocks to the Portfolio. One is the France-based food company Groupe Danone (NYSE: DA), reflecting my long-held view that Europe will perform much better than many think. Because I expect some profit taking along the way, I recommend a balanced portfolio.

Groupe Danone’s main businesses are fresh dairy products and beverages (mainly bottled water). It’s gone through a major restructuring during the last 10 years, resulting in the divestiture of much of its non-core business. What’s left is a more concentrated portfolio. Asian bottled water operations–concentrated in China and Indonesia–are a key part of a business segment that accounted for 15 percent of profits. And Groupe Danone dominates the yogurt business, another fast-growing segment of the food market.

The stock has performed well during the past twelve months, but there’s more upside for Danone. It also offers some stability during times of market weakness. And the company could be an acquisition target; legitimate speculation on that front has surfaced from time to time. Buy Groupe Danone.


United Overseas Bank (OTC: UOVEY), a play in the positive changes taking place in Singapore, is also added to the Portfolio. Singapore remains one of the most defensive markets in Asia, especially in its telecom and bank sectors. The market boasts one of the highest dividend yields in the region at 3.6 percent (see SRI, 22 February 2006, Still Looking Good, for more on Singapore).

UOB has been steadily improving operations and asset quality while expanding overseas (e.g., into Thailand and Indonesia), which is very good for growth. The bank has achieved a healthy mix of non-interest and interest-based income, with non-interest income growing strongly–always a good thing. During the past year the non-performing loan ratio (NPL) dropped from 8.5 percent to 5.6 percent.

UOB is expected to continue its share buyback program. Out of the ongoing S$600 million (US$370 million) program, it’s completed a little more than S$72 million (US$44 million). Add to this a dividend yield of 3.76 percent and investors are basically getting paid to wait while management continues to improve operations and expand the business. UOB is also attractive on a valuation basis at 1.75 times price-to-book and 12.5 times forward price-to-earnings. Buy United Overseas Bank.


A Note To Readers

This being a new service, I’ve received many questions about portfolio construction and stock selection. Let me take an opportunity to reiterate an explanation from last week’s issue:

The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while we also offer hedging ideas for more complete advice.

A characteristic common to the Portfolio companies is suitabilitiy for the new realities of a changing world. They will benefit the most from the changes taking place in the global economy.

That said, no one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game is by not losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.

It is, therefore, important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories might offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.

Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done easier this way. There’s always another week and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.

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