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Royce Funds Charlie Dreifus on the Global Economy And Its Impact on Stocks
Posted by: CanadianValue (IP Logged)
Date: September 20, 2012 10:53AM

From the Royce Funds website, a Q&A with Charlie Dreifus:

How do you see the current global economic situation?

The big picture remains marked by too little employment growth with low inflation, with the exception for food and fuel, which I believe will likely decline before employment shows any meaningful improvements, in the U.S. and for much of the world.

Central bank mandates around the world are calling for full employment, low inflation, or both. In most of the world, with the possible exception of China, it would appear that easing is possible or likely given the mandates. Measures beyond lowering rates to foster easing in the eurozone still seem to be works in progress right now. ECB President Draghi's recent statement that the bank would do "whatever it takes" still seems to be working to some degree, despite no concrete evidence yet on implementation. The markets are expecting some action.

Another mounting European problem, which has not received much attention, is the increasing flight out of the euro. Earlier this year, owners of euros moved their funds from weaker nation banks to stronger nation banks, in the eurozone. Now individuals, corporations, and even sovereign wealth funds are moving funds into British pounds, U.S. dollars, Japanese yen, and lesser amounts into the Norwegian krone and Australian dollar. It has gotten to the point that the Bank of England has been considering whether to impose taxes on foreign inflows to limit the appreciation of the pound.

Are you concerned about China?

China's exports rose only 1% in July. This was clearly unsettling news that raised valid questions about that country's current economic prospects. While the Chinese authorities know they should stimulate their economy, they are also rightly concerned about their housing bubble and food inflation, all of which puts them in a difficult spot. Food price inflation has become an unexpected supply-related problem around the world, with the worst impact still months away. Food commodity inflation represents a much bigger problem to the emerging market economies as food is a much higher percentage of their consumer price indexes. To the extent this problem was weather driven, it is reasonable to assume that it will self-correct.

The discouraging data coming out of China of course affects other nations, such as Australia. In fact, Australia's resource minister recently declared the end of the mining boom. It further appears that China is having a considerable inventory build as a result of weaker than anticipated sales. China's leading index has declined for six consecutive months and peaked 25 months ago. The Shanghai Composite Index recently fell to its lowest level since 2009, as Beijing has not instituted any material easing due to inflation concerns in general and the housing bubble specifically.

Amidst all of this uncertainty, how would you gauge the state of the U.S. economy?

While not immune from what is happening in the rest of the world, and despite all the talk of globalization, the U.S. remains a remarkably closed, consumer-focused economy, with more than 70% of GDP the result of consumer spending. Employment, therefore, is much more of a hot-button issue in the U.S.

Our consumers are less leveraged than in the recent past, while the cost of borrowing is materially lower. Consumer net worth is up 25% from its 2008-2009 low, but still below its 2007 high. Nevertheless, this has been a positive development for the U.S economy. In the developed world, the U.S. remains the choicest nation in which to invest. Europe has its obvious problems, while Japan is being challenged by an expensive yen, ongoing deflation, and declines in earnings.

Fed Chairman Bernanke seems intent on not letting the U.S follow Japan's path where nominal GDP is at the same level as it was two decades ago and prices have declined roughly 20% over almost two decades. Europe, with its high domestic savings rate, could become like Japan, using those savings to finance the public debt.

What are your greatest concerns about the U.S. economy?

The issue that ultimately needs addressing is the divergence between the strength of the U.S. equity markets and the economic prospects that may have stabilized or even improved a bit, but have not shown that they are sustainable. Housing also remains key. If it continues to improve, I believe it will go a long way toward offsetting the potential headwinds caused by rising oil and food commodity prices. Manufacturing data has weakened, which will make it increasingly difficult for manufacturers to maintain prices in order to maintain margins. This is also an item that needs to be carefully followed regarding possible elevated expectations.

While quite boring, on balance the economic data over the past six weeks has been better than expected, but still at levels that are too low to push us over a stall speed level. The data does suggest, however, that it is less likely we are moving into a recession. Yet the global slowdowns in nominal GDP growth pose real headwinds to keeping, let alone increasing, corporate profits. And without wage inflation, it is very hard to imagine sustained price inflation.

Are you surprised with the Fed's announcement of another round of quantitative easing?

The surprise in the announcement to me was the implied movement away from the Fed’s dual mandate of full employment and maintaining price levels. Their objective is clearly to boost employment, which is critical, while they are also willing to err by potentially increasing inflation. This is consistent with the knowledge gained from the Great Depression – that you can always come back to cool things down once you have gained economic momentum. Currently, with the exceptions of food and energy, which have risen for other reasons, inflation is tame. The world is awash in supply of virtually everything, and money velocity is significantly down. The Fed can do this now with some comfort that it is not necessarily going to have a negative, that is, inflationary, outcome.

Of course, from an investment perspective the issue now is how one assesses the degree to which QE3 has already been discounted and what further impact it will likely have. Despite criticism, the previous QE programs in the U.S. did help to reduce unemployment claims and improve credit conditions.

Link to remainder of the Q&A:

Guru Discussed: Chuck Royce: Current Portfolio, Stock Picks
Stocks Discussed: SPY, DJI, QQQ,
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