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Is Euroland Headed for Trouble?
Since late 2000, the euro has appreciated versus the U.S. dollar by approximately 79 percent — and nearly 10.0 percent since the start of the U.S. financial crisis last summer. Several factors have contributed to this strong performance at various times during that period:
| • | Euroland's position in its business cycle and the market's corresponding bullish perception of strong growth; |
| • | Predictable central bank behavior in response to economic activity/inflation prospects versus financial market dislocations; |
| • | Financial pressures originating from the balance of payments; |
| • | Diversification of official reserve holdings; |
| • | Fundamental equilibrium valuation; and |
| • | Market risk appetite |
Recently though, the Euroland growth outlook is seen to be deteriorating amidst a sharp U.S. slowdown and growing sluggish domestic consumption. General consensus for GDP growth in 2008 has been a downward-moving target, starting the year at 2 percent, but as the economic outlook continues to deteriorate, 1.5 percent growth rates have reinforced the expectation of eventual monetary policy actions by the European Central Bank (ECB).
The ECB has, in the past, focused its attention primarily on inflation, more specifically, on the near-term wage inflation and has implied that monetary policy will remain on hold for at least the next few months. Reflecting these near-term worries, some ECB officials are seen to be distancing themselves from the Fed's actions in the last couple of weeks, arguing that Euroland fundamentals are comparatively solid. Non-ECB officials, though, have been quoted recently that the local "slow growth" story is real and point to the deeper-than-anticipated U.S. slowdown this year as the catalyst. Expectations of ECB rate cuts totaling 50 bps this year are appearing to be the market consensus, with the first 25 bp installment happening sometime in 2Q, as the actual downside risks begin to materialize in official economic reports and surveys.
The worsening economic outlook partly reflects doubts about a meaningful rebound in consumption this year. Current employment growth is moderating, the 2005 to 2007 "normalization" of interest rates practiced by the ECB to maintain growth hasn't spread its full impact on domestic spending, and the increased household savings rate has contributed to the weaker corporate profit expansion picture. Those factors have contributed to a recent ECB survey that has detected an across-the-board tightening of lending standards by local banks, leading to anemic loan demand and, ultimately, may solidify the forecasted slow-growth environment in 2008. On the consumption front, local consumer's anemic appetite for goods and services is elevating the negative confidence levels on a monthly basis. A sharp slowdown in Spain, for example, was expected given the excessive housing exposure; corresponding retail sales of household goods have been particularly weak, and a slowdown in construction has been reflected in a rise in the local unemployment rate. The big surprise, though, has been in Germany. Rising food and energy prices have contributed to extremely weak German consumer spending. The impact of very high inflation (by German standards), on real wages and consumer purchasing power, has diverted the normal growth patterns the economy would have experienced via higher wage growth, strong employment, and business cycle position.
Last week's Royal Bank of Scotland's Euro-region Services Index, a major indicator for the service sector, dropped unexpectedly to 50.6, which was the lowest since July 2003 (a reading above 50 indicates growth). The Euroland December Retail Sales Report also showed a steep decline of 2 percent from a year earlier, a record for that report. These weakening indicators are now beginning to mirror the trouble brewing in the U.S. data. The U.S. January Non-farm Payroll Report now reflects a negative job growth picture in 2008. That report, coupled with downwardly revised housing data and the related credit market securities linked to U.S. subprime loan portfolios, is now reinforcing the view that external economic environments are speeding along Euroland's troubles.
Finally, the continued reluctance by the ECB to lower rates proactively this year (even as they threaten to actually raise rates!) may prove to be a very costly strategy. While their hawkishness could provide a temporary boost to the EUR on the near-term, it's unlikely to give lasting support against a backdrop in which global growth concerns reign supreme.
— Mark Noble, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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M&A an Attractive Exit
Although worldwide M&A activity grew by 4.6 percent in 2007, spending to acquire Silicon Valley startups grew almost 50 percent to $27.1 billion from $18.1 in 2006, according to The 451 Group. Contributing to the uptick are a large stable of high-quality startups, the deep pockets of private equity firms, and plenty of mature technology companies on the prowl for innovative technologies to keep them relevant. Corporate acquirers are willing to pay large sums for tech startups, making acquisitions more attractive to entrepreneurs, who are increasingly planning for mergers and acquisitions as their exit strategy. However, experts note more tech companies are being founded than large companies can buy, creating opportunity for both acquisitions and IPOs. (Silicon Valley Business Journal)
Northwest Nirvana
Seattle is developing a vibrant start-up ecosystem. Its entrepreneurial climate is fostered by the University of Washington's strong computer science and electrical engineering departments, local tech veterans from Amazon and Microsoft, and a growing community of technology innovators who are willing to take risks. Venture money is supporting the boom — in the last 12 years, venture investment in the region has more than tripled to about $1 billion annually. Washington is now tied with Texas as the third-largest destination for venture capital money nationwide, behind California and Massachusetts. (New York Times)
FDA Must Keep Up
Recent investigations have concluded that the FDA can't adequately monitor U.S. food and medical supplies. The lapse may be due to a lack of agency funding as Congress hasn't increased the budget in proportion to the soaring regulatory burden which has expanded FDA responsibilities 127 times in 20 years. The more significant finding is that the FDA evaluation methods have not kept pace with scientific advances, particularly in complex fields like genomics. (Wall Street Journal)
Rapid Diagnostic Tests
Hospitals are using rapid molecular-diagnostic tests that identify organisms using genetic information rather than growing them in a dish. They can detect not only what strain of a bug is present more quickly than traditional tests, but also whether it is resistant to one antibiotic or vulnerable to another. The hope is that doctors could run these tests in their offices, allowing them to treat a patient before results come back from the lab and reduce the likelihood that inappropriate medications will be given. Use of the costly tests is still limited, but the number is likely to grow, due to changes in reimbursement structure, such as Medicare's recent decision to stop paying for treatment that is the result of blatant medical errors. (Wall Street Journal)
Credit Crunch Limits PE
The global credit crunch has made it difficult for private equity groups to use cheap debt to buy into biotech developers and then flip them. As a result, big private-equity players are settling for lower returns on smaller deals. At the same time, pharma giants looking to bolster their pipelines are wielding their cash-rich balance sheets to snatch the most promising companies. VCs are contributing to the heated competition for the best investments, pouring a record $9.1 billion into privately held biotech startups and medical device makers last year and holding on to their shares in upstart companies longer. (New Jersey Star-Ledger)
Rational Venture Climate
Fourth quarter 2007 venture numbers demonstrate an "extremely rational" investment pattern, says Mark Heesen president of the National Venture Capital Association. Investments totaled $7 billion in 963 deals, making it the fourth consecutive quarter of investment exceeding $7 billion. Life sciences and cleantech were the standout growth industries. Life science represented a record 31 percent of the $29.4 billion total. (San Jose Mercury News)
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February 11, 2008
Gung Hay Fat Choy!
As the Chinese begin their celebration of the Year of the Rat, they may wonder about the rat that is gnawing away at their economic growth model. In recent months, the economic catch phrase was "decoupling," that is, the world is no longer riding on the same economic roller coaster with the U.S. Clearly, inconsistent with the obverse notion of globalization, decoupling is now being tested in a real world laboratory. According to Stephen Roach at Morgan Stanley, the U.S. buys some 21 percent of all Chinese exports. With our economy hitting the brakes, some sources estimate that Chinese GDP growth will slow from 11 percent to 8 percent this year. That, of course, ignores other collateral damage. For example, if global stock markets continue to decline and Asian investors turn to gold for comfort, domestic consumption in Asia may fall as well.
As any child that has tried his hand at blowing bubbles knows, you can't shrink one. You may be able to catch one and hold it for a bit, but, ultimately, they all burst. And the bigger they are, the quicker they will explode. The analogy holds true in asset prices as well. Although the holy grail of the soft landing is much desired, when was the last time we actually experienced one? Alan Greenspan noted that for central bankers it's impossible to recognize an asset price bubble until after it has formed. If we accept that wisdom, are we then able to spot a bubble about to burst? 
Source: Bloomberg
Considering the 372 percent rise in the Shanghai Index — or the 481 percent rise in Shenzhen Index — in the past two years, they sure seem bubble-like to us. Both have retreated in recent weeks and are now 10 to 20 percent off their all-time highs but are sporting P/Es above 40. Now, we've never been a fan of chartist mumbo jumbo (other than that it might reflect some market sentiment or psychology), but the recent movement in Chinese equities is hauntingly familiar. It takes us back to that shudder in the Nasdaq in the spring of 2000 when the first cracks appeared and the prices dropped 17 percent in a few days.
Suppose the Chinese got to experience a little mean reversion in the next 12 to 18 months, how will industry and the emerging consumer sector react? If history is any guide, job losses in the cities will force de-urbanization, putting extreme pressure on rural villages. That type of strain may be difficult to sustain politically. China's Gini coefficient, which measures income disparity between the haves and the have-nots is 0.46, basically on par with the U.S. at 0.47 — with the important difference that the bottom of the economic ladder in China is a subsistence farmer who can barely feed his family. Aid to the rural sectors will be critical. With the world looking over their shoulder during this year's Olympics, PRC leadership will likely reach for their $1 trillion in foreign exchange reserves to ease the discomfort of the populace. As we all know, that is a worrying scenario for U.S. bond buyers.
We are already seeing diverse reactions to the U.S. slowdown among central bankers in Europe, with the UK easing and ECB hanging tough. So far any adjustments in Asia are, as they say, inscrutable. Or as Warren Buffet put it, "It is only when the tide goes out, that you discover who has been swimming naked."
Happy Valentine's Day, Mr. Chairman
The sickening drop of the Institute for Supply Management Non-manufacturing Index from 54.4 to 41.9 served notice on those few hopeful souls that the next few quarters may be ugly indeed. The index is based on surveys of supply managers and reflects activity in about 90 percent of the industrial economy. There has not been a drop to this level since just after 9/11. Clearly, corporate America is losing its nerve. Meanwhile, retail data came in very weak, with same store sales dropping across the board (in some cases by as much as 8 percent).
The Fed Funds futures market is currently expecting a 2 percent rate by late summer. We may soon discover if that jibes with Chairman Bernanke's view when he is dragged before the Senate Banking Committee on Valentine's Day. We doubt they will be serving those little heart-shaped mints at the witness table.
Much to our surprise, the Senate came together on a stimulus bill. In the typical version of D.C. hold 'em they felt compelled to raise the House bid by about $23 billion. According to a survey conducted at the University of Michigan in 2001, the last time our esteemed representative tried this idea, fully 78 percent of recipients said that they used the cash to add to savings or pay off debt — not the spending spree the government is hoping for, but that may be okay. We're sure Citibank could use an extra $50 billion in deposits.
Fort Sumter West?
Every now and then (well, actually, every election) there is a proposition on the ballot in San Francisco that seems as if the director of elections simply wandered the halls of the psych ward at Laguna Honda Hospital taking dictation. These "declarations of policy" propositions are wonderfully expansive admonitions to the city government that take the form: "Shall it be the City policy that . . . fill in the blank." On February 5, we were given the opportunity to authorize a city takeover of Alcatraz Island, the site of the famous federal prison. After the takeover, we would build a "Global Peace Center" to "activate powerful forces for cooperation, reconciliation, and healing . . . giving birth to a new a peaceful paradigm for all humanity." It wasn't clear exactly how we were to conquer this bit of federal territory stuck in the middle of our bay. Unfortunately, the measure failed 72 percent to 28 percent. Now we have to contemplate what path the 55,880 supporters will follow. Given their ideology we trust that they will not proceed by force of arms.
Lesson Learned
According to the astute observation of one of our readers, there is at least one key take away from the $7.1 billion in trading losses produced by Jérôme Kerviel at Société Générale: "One man can make a difference."
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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Fed Still Wary of Inflation
Dallas Fed President Richard Fisher, who voted against cutting interest rates last week, warned that aggressive reductions in response to a weak economy may "juice up" inflation. "The Fed has to be very careful now to add just the right amount of stimulus to the punchbowl without mixing in the potential to juice up inflation," Fisher at an economics conference in Mexico City. Atlanta Fed President Dennis Lockhart and Philadelphia Fed President Charles Plosser both said in remarks this last week that policy makers must watch inflation carefully. (Bloomberg)
Economy Rebounds before Election, Treasuries Show
Whoever wins the White House may have Fed Chairman Ben Bernanke to thank for cutting interest rates and President Bush and Congress for a proposed $168 billion stimulus package. This forecast is based on the rise in the 5-year Treasury yield from its lowest level relative to 2- and 10- year notes since 2001. The last two times that happened was during the recessions of 1990 and 2001, and the economy began to expand within nine months. If past is prologue, then the 5-year note's yield indicates the economy will be on the mend by the Nov. 4 general election. (Bloomberg)
Inventories Are Piling Up
Inventories at U.S. wholesalers built up at the fastest pace in more than a year in December as sales slumped following four months of strong gains, the Commerce Dept. reported Friday. Inventories increased 1.1 percent in December, the biggest gain since August 2006. Sales at wholesalers dropped 0.7 percent, the biggest decline in 11 months. The data show wholesalers may be finding themselves with too much inventory on hand as retail sales stagnate. It's also possible that these businesses are building up their inventories on purpose, feeling that their stocks were too low to keep their customers satisfied. (MarketWatch)
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Path to More Rate Cuts Is Clear
Economists are now saying that nothing is standing in the way of further Fed rate cuts. Since the last formal Fed meeting, events have raised the likelihood of even more rate cuts than had been expected, economists are saying. A markedly poor Institute for Supply Management services survey showed a contraction in the services sector. Many are predicting a 50 basis point cut, and markets are even toying with odds of a three-quarters-of-a-percent rate cut by the next formal Fed meeting on March 18. (Market Watch)
Bond Insurance Woes Affect Auction-rate Munis
Bond insurance sold by MBIA Ambac Financial Group and Security Capital Assurance is backfiring on auction-rate securities issued counties, universities and hospitals across the U.S., more than doubling borrowing costs in some cases. Investors are shunning insured bonds after three of the biggest guarantors (owned by Ambac, Security Capital and FGIC Corp.) were stripped of at least one AAA credit rating amidst losses on debt tied to subprime mortgages. Interest costs on floating-rate bonds sold by more than 100 governments, hospitals, and colleges rose as much as seven percentage points since the beginning of January. (Bloomberg)
Citigroup, Merrill Most at Risk of LBO Loan Loss
Citigroup Merrill Lynch and JPMorgan Chase face the biggest risk of write-downs on $148 billion of unsold LBO loans as the value of the debt plummets, according to Goldman Sachs research. Citigroup may need to write down $2.2 billion, on unsold loans, causing a 5 percent reduction in 2008 EPS. Merrill may lower earnings by 6 percent and JPMorgan faces a 2 percent cut in income. Banks can't find buyers for loans they underwrote to finance record buyouts last year as losses sparked by the collapse of the U.S. subprime mortgage market sap demand for all but the safest securities. (Bloomberg)
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