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Welcome to Low Returns
Interview with Martin Barnes, Economist, BCA Research
By SANDRA WARD
A LOW-INFLATION, LOW-RETURN WORLD sounds rather dull to us, but to the highly regarded economist at Montreal's BCA Research, these are "strange" and "fascinating" times. Strange, because despite so many inflationary pressures, the good times continue, according to Martin Barnes, who is also the managing editor of the equally acclaimed Bank Credit Analyst report on investing and business trends. Fascinating, because it seems the economy can keep moving at a decent clip for the foreseeable future. As for low returns, get used to it. We'll let him explain.
Barron's: How big a deal is the revaluation of the Chinese currency?
Barnes: It wasn't a big move and we weren't expecting a big move. We've been in the camp that, from an economic perspective, it doesn't make any sense for China to revalue. They've got very low inflation and, if anything, a bit of a deflation problem in some sectors. In that environment, you don't want a strong currency, you want a weak currency. But, of course, with all the protectionist pressures building up in the U.S., they had to do something. They were backed into a corner.
We thought they'd do as little as possible just to get the U.S. off their back and to try to minimize the impact on their economy. That's just what they've done. A 2% move is enough for the U.S. as a good start, and it holds out hope they will do more down the road. They won't be in any hurry to do anything else for quite some time, so the economic impact of it is not going to be much at all, but it was a big, important political gesture.
Do you think the Unocal bid by CNOOC had anything to do with it?
That, too, was tied up with this protectionist movement in the United States, against China in particular. I don't think this is going to clear the way for that takeover, but the opposition was sending a strong message to China that they needed to do something to show they were prepared to try and help reduce the huge trade imbalance.
Is this a wake-up call to those who thought China would continue to invest in U.S. Treasuries?
I'm not sure it changes that story a whole lot. The key issue here, and the Federal Reserve has bought into this view, is that there is tremendous excess savings globally, not just in Asia but in OPEC countries as well, at a time when there is weak demand for credit in most countries. That savings was going to find its way into the bond market, and that doesn't change a whole lot with the Chinese revaluation.
To the extent people are now thinking this is the first of many moves to revalue China's currency, you could see some speculative capital inflows moving into China on the back of expectations the currency is going to move up. If that is the case, and China needs to neutralize the effect of that, they will continue buying bonds. But it doesn't have to be U.S. bonds; it could be European bonds or other kinds of bonds. But to the extent that there are speculative inflows into China, China will have to keep recycling that money. The story of global money available to keep bond yields down isn't about to change anytime soon.
For Barnes, the biggest imbalance is the current-account deficit, which "can be sustained for years."
You have referred to the current economic climate as strange. Did it just get stranger?
We have a situation where the near-term picture looks not bad at all. There are more people talking about a Goldilocks economy, though there are way too many issues out there such as housing bubbles and financial imbalances for me to use the term Goldilocks. But near term, we are going to have a decent economy. We've got low inflation. We've still got relatively low long-term interest rates, and the stock market is doing well.
These conditions could well persist for yet another year. In another year's time we will still be worrying about these imbalances, which will be even bigger. Eventually, the long term does become the short term. But as long as Asia is going to recycle its money back into the U.S., then this situation can persist.
And the unsustainable is further sustained.
The current account is the big imbalance out there, and that is the one most people talk about in terms of being unsustainable but which can be sustained for years. As long as people are prepared to buy dollars for whatever motive or reason, then this situation goes on. OPEC, Asia central banks and, more recently, private investors have been willing buyers of dollars, and so the show goes on.
The current account now is running at almost an $800 billion annual rate, or 6.4% of gross domestic product. It's in new territory for the U.S., at least.
How sustainable is the strength in the dollar?
It's sustainable for as long as the Fed is tightening and the U.S. economy is perceived to be strong. The next leg down will come when people revise their expectations about the economy. That will be when the Fed stops raising rates and we see interest spreads look less dollar-friendly.
That might not be until next year, though, so the dollar should have a relatively firm year this year, barring some unexpected shock. I do see this as a countertrend move within a longer-term downtrend. I'm conventional enough that I believe there can't be a trade deficit of this magnitude without having a cheap currency at the end of the day. Although the dollar has fallen a lot, it has still not fallen enough to have any meaningful impact.
And currency moves can't do it alone. A weaker dollar has to be only part of the story. The real adjustment to the U.S. current account has to come from narrowing the growth rate and from the absence of boom times in the rest of the world, which I don't really see. We are going to have to crunch U.S. demand, and savings are going to have to be rebuilt, and that is going to be very, very painful, but it could be years away.
Down the road, there is a U.S. consumer recession lurking and a big housing downturn. It could be five years down the road. The world does not move to a precise rhythm, but it is interesting how well the four-to-five-year cycle has worked the last few decades. If we continue with that pattern, you would expect another recession in 2009-10.
Doesn't a slowdown in money-supply growth foreshadow trouble brewing in the economy?
Some people have assumed the very weak money growth points to a sharp slowdown in the economy. But money is not as tight as it seems. There was so much liquidity created in previous years that there is still a large monetary overhang.
Bank lending is growing at double-digit rates. House prices are through the roof. There is money available for deals. None of these trends are consistent with tight money. Money policy is not yet restrictive. The monetary overhang will eventually disappear as the Fed continues to raise rates.
What's your view on oil?
We haven't been very successful in forecasting it going to $60. We've been structurally bullish on oil for some time, but that was when oil was $30 a barrel and we thought, gee, it could go to $40-$45 in a couple years. It has gone far beyond what we expected.
The bullish case for oil is very compelling. We all understand China's demand going through the roof. Chinese demand for gasoline, for example, rose 35% in the three years to 2004. That's huge. And auto sales in China continue to rise. But, at the same time, I believe the price mechanism works, and as prices rise it brings on more supply and, at the margin, it squeezes demand in some areas. I take the view there is a huge speculative premium in oil at these levels -- maybe it is $15 -- so oil will come back down again by quite a lot, potentially.
Even oil at the $40 to $45 level is quite a high price compared to what people might have expected a few years ago. It is a high enough price that oil companies would still make a lot of money. It will still make energy a good sector to invest in. It is certainly one of our favorite sectors from a long-term structural point of view.
Is there any sense it has dampened consumer spending?
Not directly, because consumer spending has held up very well. That takes us into one of the other big stories here, which, of course, is housing and low interest rates. With one hand, rising oil bills takes away from people's pockets, but an even bigger amount is given back to them in terms of housing wealth.
When you look at the overall picture for consumers, they've got higher oil bills, but employment is rising -- not as fast as we would like, but it is rising; wages are rising -- perhaps not as fast as we would like, but they are rising; so incomes are growing, and you are giving homeowners huge wealth gains. Add it together, and consumers are better off. It is hard to detect, therefore, any real pain from oil. Also, it helps to put it into perspective.
The average family drives around 12,000 miles or so a year, and the average car does 20 miles to the gallon. Let's say a household uses 600 gallons a year. If the price of gasoline goes up a dollar, it's $600 a year extra for their gasoline bill. I don't want to diminish the impact of that on low-income families, but for your average consumer, it is not crippling, especially if their home is going up by tens of thousands potentially. Housing has clearly been a huge, huge support to the consumer sector.
So you don't see any major cracks at the moment in the consumer story?
I don't. The savings rate is obviously extraordinarily low at 1%. But at the same time, the increase in home equity last year was worth 16% of income. A lot of consumers would probably think of their savings in terms of the change in their net worth as very, very high. So the question is: Will that savings that comes from rising asset prices evaporate just as quickly as it went up? That leads to questions such as when the housing bubble is going to burst, and whether house prices are going to come crashing down.
The answer is not anytime soon, it seems -- although there are some signs that gravity is taking hold in some markets.
There is an arbitrage between owning and renting, and the data that compare the costs of buying a median-priced home to the average rent of an apartment have changed dramatically. It is so much cheaper to rent now than to own.
That doesn't affect necessarily somebody who is buying a home to live in, but it should affect those making a decision about buying a house for investment purposes.
What's your view on inflation?
Inflation is going to be low for the foreseeable future. The global savings-investment backdrop is going to be in place for some time, and that's not going to push up yields.
There would be an issue if people lost confidence in the long run or started demanding higher risk premiums for investing in long-term securities.
Why do you see inflation staying low?
Yeah, we've had the almost perfect conditions for inflation in the last few years.
The Fed has run a very stimulative monetary policy. We have run big budget deficits. We have driven the dollar down. To top it off, oil prices are up. We've had the perfect inflationary mix, and yet we haven't really had any inflation despite that.
If you look around the world, there is no evidence of inflation at all. China is perhaps the best place to prove it. Here is a country that has been growing at 9% to 10% and effectively adopted U.S. monetary policy by pegging its currency to the dollar. Yet there is no inflation in China at all. In fact, there is deflation, and that tells you there is something very powerful going on there in terms of a supply-side boom.
In the U.S., there are tough competitive conditions. And the Internet and technology in general is still a very powerful force for disinflation. There are pockets of inflation, but the overall picture isn't all that bad. The Fed's view is there is still a problem. They are worried about labor costs going up. But a lot of the inflation indicators we look at are rolling over. Producer prices are easing.
If the economy was to continue growing really strongly here, at a 4% clip for the next year, of course, there would be pressures on resources and the unemployment rate would fall and wages would go up.
But that's not likely. The economy is going to do OK -- but I don't see it growing much above trend over the next year.
Would you expect to see capital expenditures stronger than they have been?
The corporate sector is still in a post-bubble world after the information-technology boom. The Enron and WorldCom scandals have also shaken up the corporate world.
Corporate executives are worried also about housing bubbles and trade deficits and protectionism. It is not an environment where companies feel that they want to be great heroes and strongly expansionist.
They are investing to become more efficient, but not expanding capacity in a big way. They could have invested more strongly, given how healthy cash flows have been, but they've been focusing more on repairing balance sheets and getting their financial house in order, taking the view that the markets are rewarding them more for stronger finances than they would for being expansionist.
That attitude might change gradually the longer the economy stays OK. Then the problem becomes slowing profit growth. It is hard to make the case for capital-spending growth to accelerate. It is probably going to weaken a bit. You end up with a decent economy, but it is not going to be growing at an inflationary pace, in my view.
Are stocks more appealing to you then bonds?
Bonds look pretty anchored at these levels. They are going to fluctuate, but we don't see a risk of a sustained rise in yields. Stocks in this world look like pretty good values at this level of interest rates.
But you have got the Fed still raising rates. You've got peak earnings and peak profit margins. Maybe stocks should be cheap in this kind of world. It is a risky world with a lot of issues out there, and you would expect the risk premium should be high. So stocks will outperform bonds over the next few years by grinding higher.
But all of this is against a backdrop of a low-return world. A world of low inflation, say 2% inflation or thereabouts, is not conducive to great returns for financial assets. Stocks may get 5% or 6%, and bonds get 4%, and cash will get 3% returns. Those are the returns I see in the next decade, on average. Of course, there will be cycles around that. A balanced portfolio could get 5%, maybe -- a portfolio of 60% stocks, 30% bonds and 10% cash could give you those kind of numbers, on average.
It is not the end of the world, but it is nothing like what people got used to in the last 20 years. The journey toward low inflation from high inflation gave us the great returns, and now that we are at the destination, it is not half as much fun.
What sectors will deliver the best returns?
The emerging markets look pretty good to us, although it is not an undiscovered story. But they are still generally small, and they are going to get bigger as more money flows into them, and they are relatively good value so we would certainly have a long-term position there.
The energy sector is compelling. Health care will be a defensive sector and there is a demographic case to be made there, as well.
Good, I-fund
The good data just keepsrolling in............. The jobs number could be a mover this week.........
Spaf
