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Cappiello: A Global Tour
02/18/2005 12:00 am EST
In a truly global presentation, money manager Frank Cappiello provided attendees at The World Money Show with a rather remarkable and concise economic tour of the world, providing an overview of prospects in Japan, Europe, China, India, and the United States.
"In Japan, the deflation problem has disappeared and the outlook for positive GDP growth should be mirrored in the stock market. Business problems remaining include timidity by Japanese management and investors. Much of the pessimism is related to the continuing high price of oil and the country’s banking problem. We think Japan has exited its deflation spiral, with positive longer-term growth and investment implications. However, its economy has been burdened by expensive oil and stubborn business caution despite strong corporate profits. Nevertheless, the Japanese economy and stock market should do much better this year than last. The Japanese market remains one of the most attractive globally, based on risk versus reward.
"Europe, constrained by socialism and unemployment, usually grows at about half the US rate. It didn’t achieve that in 2004, but this year we expect an increase in Europe’s growth back to normal levels as a result of lower oil prices and increasing trade with Eastern Europe. For the first time in years, economists are starting to speak of Germany as a potential engine of growth for Europe, rather than a dragging anchor. Last year was the second year of a significant rally in the European markets despite record oil prices and a much stronger euro against the US dollar, worries about terrorist attacks, geopolitical risk, unease about both inflation and deflation, the prospect of higher interest rates, fears that the Chinese boom could become an Asian bust, and concerns over a slowdown in corporate earnings. Amazingly, the markets recorded above-average results and in some cases, double-digit returns. The best bets for 2005 are for the German and United Kingdom markets.
"In China, we expect many current trends to continue such as fast GDP growth, rising interest rates, strong non-urban consumption growth, financial market innovation, liberalization of capital outflows, and increasing regulatory constraints on fixed investment. We expect the currency to remain relatively stable and trade tensions to increase a bit as the US continues to run a large bilateral trade deficit with China. Despite the expected good news on the Chinese economy and corporate earnings, we view the Chinese market as overvalued on a short-term basis, and not as attractive as Japan or India on a risk-reward basis.
"India, with the second-largest population in the world (1.1 billion people versus China’s 1.6 billion), is a different story. India’s technology, particularly in software and telecom, is already reaching ‘world-class’ status. Further, Indians, like the Chinese, work cheaply versus their American counterparts. Indian software engineers earn $35,000 a year against their Silicon Valley counterpart’s salary of more than $100,000 a year. Further, most Indian professionals speak and write English, which has now become the language of finance. Finally, the British legal system, particularly of contracts and patents, is honored in India, unlike China. India is probably where China was in the late 1980s. As with Japan, this is a market with somewhat more risk, but even greater reward.
"This year the US will have a solid 3½% and possibly 4% GDP growth with mild inflation and higher interest rates. Further, rate increases will not slow growth. The level of interest rates probably matters more than the change in rates. The initial interest rate hike of 2004 reversed the deflation insurance the Fed took out in 2002 and 2003. Current rate hikes are moving toward "neutral," so monetary policy will still be loose but not as loose as before. Concern about rate hikes--timing, market impact, unwinding of distortions--will dissipate over the next six months. The low rate environment of the past 12 months has allowed many middle-class households to lengthen their liabilities, particularly mortgages. Corporations also issued debt or lengthened maturities. The result: a redistribution of long-term capital in a way that makes the economy more stable.
"Financial stocks, particularly banking, should see a rise in acquisitions and mergers. For several years, large banks have built up cash waiting for opportunities to make acquisitions. Foreign banks, in addition to cash hoards, may see the weakness of the dollar and the strength in their currency as an additional plus. Once before, in the mid-1990s, foreign banks saw the repeal of limitations on interstate banking as a green light to merger activity. The highlight of 2005 could be a repeat of that period. We believe US corporate profits will average an increase of 10-15% this year (S&P 500 Index). With this performance and relatively low inflation, the multiple applied to these earnings should increase modestly. We are in the early stages of what is a multi-year expansion of the US economy. What began as a recovery from the recession of two years ago has turned into a solid expansion. With the US in the lead, we expect faster global growth than in the 1990s, energized by reflation, freer trade, and a surge in developing-country growth and investment."
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