Global Stock Market BLOG - Mike Burnick

The American Economy: Call it the Teflon Econ

In Washington D.C. the Federal Reserve meets again today to discuss U.S. monetary policy, and if pundits in the financial media are to be believed, the fate of global growth (and liquidity) hangs in the balance.

Of course what takes place in the American economy has huge implications around the globe. Make no mistake, the U.S. remains the world’s engine of economic growth – apparently it’s the little engine that could. That’s because to paraphrase Mark Twain, rumors of the U.S. economy’s demise have been greatly exaggerated – for some time now – call it the Teflon Econ!

• An inflation scare in 2005 (now apparently subsiding) couldn’t stop it …
• A well documented housing collapse didn’t derail it (so far at least) …
• Even record high crude oil prices, and 325 basis points of Fed-induced interest rate hikes -- both at the same time -- just briefly slowed it down.

The American economy has remained resilient throughout. And economists widely believe the Fed will stand pat on monetary policy again today, as they have since last summer. In fact, financial markets are still looking forward to the possibility (with the odds now down to about 25%) that the Fed’s next move will be to cut rates sometime later this year.

Financial markets around the globe owe their buoyancy in recent years to excess (or excessive; take your pick) liquidity sloshing around the world. And the resilient U.S. economy plays no small part in fueling this asset appreciation party. You only have to glance at America’s record trade deficit with China to understand that point.

China’s trade deficit with America widened to a record high US$214 billion in the year 2006 (through November) as China shipped a record US$1 trillion worth of merchandise to American shores – most of it destined for your local Wal-Mart store, or so it seems.

Should the U.S. economy slow more than expected and the resilient American consumer stumble, economic tremors will certainly be felt in Beijing, and Tokyo, and Toronto, and in the EU, etc., etc.

Fortunately, recent tea-leaf readings on the U.S. economy show signs of reaccelerating growth. Retail sales were robust in November and December (see graph above), industrial production is on the rise again after a brief slump, and even real estate shows renewed vigor, with housing starts up the last two months straight.

As a result of this data, the Fed has cautioned us in well choreographed public pronouncements, not to expect lower rates anytime soon. Just a few months ago, Wall Street fortune tellers held a nearly unanimous expectation of a Fed rate cut in the first-half of 2007. It was regarded as a “sure thing” in fact.

Today, Fed funds futures (a sort of book-making operation betting on the direction of short term interest rates) suggest only a 2% chance of the Fed easing before June – and just 1 in 4 odds of a rate cut by September. 

But with overnight interest rates apparently on hold in the U.S. at 5.25% (see graph above) -- among the highest in the developed world – the question is just how restrictive this is to economic growth already.

Headline inflation numbers have been trending downward of late. This means that even if the Fed remains on hold the effective (or “real”) rate of interest borrowers must pay keeps climbing.

For instance, when headline inflation peaked at 4.7% in 2005, with Fed fund rates then at 4%, the “real” rate of interest was effectively zero after subtracting inflation (-0.7% to be exact).

But at the end of December, consumer price inflation dropped to just 2.5% year over year. This means that today’s real interest rate is up to 2.2% -- and will climb still further if inflation continues to trend lower.

Now granted, a 2.2% real rate doesn’t seem too restrictive. But it’s not out of the question for the Fed to reverse field (and surprise financial markets) with an unexpected rate increase down the road, should the U.S. economy rebound faster than expected.

This is the really BIG question … stay tuned.

Is Uncle Sam Bottom-Fishing The Energy Sector?

The U.S. government is making a bullish market-timing call on crude oil, and stepping up to the plate to buy, at what appears to be attractive prices – at least in the eyes of value investor George W. Bush!

Last week President Busch announced plans for the Department of Energy to double the size of the nation’s strategic petroleum reserve – albeit incrementally over the next two-decades. But it was enough to trigger fresh concerns about the tightness of global crude oil supplies. And the news put an immediate bid under oil prices in commodity trading, triggering the biggest single day run-up in crude prices since Hurricane Katrina roiled energy markets in 2005.

Within the next two months Uncle Sam will begin siphoning 100,000 barrels per day off global oil markets, to expand America’s emergency stockpiles, which according to one analyst could add “significant upward pressure on oil prices”. The timing of the move is interesting since crude oil prices have been in a freefall of late – down more than 30% since peaking last July just north of $77 per barrel. In fact, crude prices had swooned more than 15% this year alone prior to last week.

Of course declining crude oil and lower prices at the pump, are seen as a net positive by consumers and businesses around the world (with the exception of oil exporting nations of course), lowering the “energy tax” we have all been paying in escalating increments over the last several years. Additionally, lower oil quotes should help reduce fears of accelerating inflation, a reason sighted as a convenient pretext for global central banks to raise interest rates. But the speed with which crude oil has declined from recent highs also suggests to many economists that global growth is perhaps slowing more rapidly than desired.

There are two-sides to every coin, although consumers and businesses may generally welcome lower energy costs, there’s also a potential downside to lower crude prices.

One of the most attractive factors favoring U.S. stocks is relatively modest current valuation, coupled with stellar corporate profit growth in recent years. S&P 500 profits are expected to climb nearly 15% year over year for all of 2006, once all the fourth-quarter results are tallied over the next few weeks.

And the oil stocks are a big reason for such robust gains. Energy sector profits are expected to surge nearly 26% higher in 2006 compared to 2005, the biggest gain for any of the ten S&P market sectors.

But this year, the rate of S&P 500 profit growth is finally expected to return to a more terrestrial trajectory, with earnings forecast to grow a milder (but still above trend) 9.5% in 2007. Once again, the energy sector is expected to be a big culprit in this projected earnings slowdown, with profit growth in the oil patch expected to decelerate to just 6.2% year over year – a very sharp slowdown from nearly 26% last year.

So lower crude oil prices, while providing some economic releif to businesses and individuals, might also contribute to worries about corporate profits in the U.S. and elsewhere, a factor which could lead to greater volatility in global financial markets during 2007. 

Still, amid signs of firming economic growth, and with global crude oil capacity still tight enough to allow little margin for error, the stock market doesn’t seem worried about current oil prices. Since its July 14, 2006 peak, crude oil has fallen about 30%; but the 33 stocks that make up the S&P 500 Energy Sector index have actually gained 3.4%. That’s a strong signal of stable-to-higher oil prices ahead.

What Happened in Vegas Didn’t Stay in Vegas: It Moved to China

Lost in all the talk of soaring U.S. trade deficits, and record imports from China, is the fact that there are also some significant value-added services that America is good at exporting. Case in point: casino gambling.

Of course the U.S. did not invent the vice of gambling – nor even the casino industry. But as with many areas of commerce, it took American know-how to perfect its commercialization – viva Las Vegas!  Westward across the Pacific lies what perhaps may soon be a casino gaming destination that far exceeds even Vegas’ excess.

As has been the case in other industries from steel to construction – China’s gaming sector has exploded from humble beginnings to first-rate global status almost overnight.

The tiny island municipality of Macao (Macau), along the coast of China last year surpassed the Las Vegas Strip as the world’s #1 casino gambling destination. This former Portuguese colony (returned to Chinese sovereignty along with Hong Kong in 1999) is attracting millions of eager gambler’s from Southeast Asia – mainly China – thanks to the unique fact that it’s the only place in China where the government has legalized gambling.

 

Macao boasts 24 casinos with over 2,700 tables. Gaming revenues soared 22% in 2006 alone to nearly $7 billion as Macao attracted more than 22 million players. And analysts estimate that the house’s top-line revenue take in Macao could exceed $8 billion this year. By comparison, Las Vegas raked in about $6.5 billion in 2006 revenue, although exact year-end figures are not yet available. But the best may still be yet to come for Macao.

One big advantage Macao has over Las Vegas in spades in that the average house take at its gaming tables is seven times that of casinos on the Vegas Strip. This speaks volumes about just how popular a pastime gambling is in Asia.

Another thing the Vegas of the Far East has going for it is long-term growth prospects. In fact, Macao may have just scratched the surface of its potential market penetration.

The vast majority of Macao’s casino patrons come across the border from China. So it’s worth noting that the per capita income in Chinas stands at just $1,700 per year, that’s only 8% of the U.S. per capita income of $21,587. And of course China has a much bigger population, four times that of the U.S. in fact, which means a lot more potential gaming customers.

Still in it’s infancy, Macao’s gaming industry already exceeds that of venerable Las Vegas. In fact, some are predicting that in just the next three or four years, this key Asian gaming destination could be twice the size of Vegas … Viva Macao!

From an investment perspective, there are some interesting ways for global investors to tap into this long-term growth potential.

> Shares of Galaxy Entertainment, which owns and has plans to develop casino and hotel properties in Macao, are listed in both Honk Kong and over the counter in the U.S.

> Closer to home, the Las Vegas Sands Corp., and Wynn Resorts Ltd have built two new Vegas style casinos in Macao. Both companies are listed on U.S. stock exchanges, although neither is a pure play on Macao’s growth potential, since they also own properties in Las Vegas.

> And Sir Richard Branson’s Virgin Group just inked a deal to build a $3 billion casino-resort in Macao.

These casino operators are akin to the actual gold miners hoping to strike it rich for their shareholders by mining Macao’s growing gaming sector, but there’s also a path to potential profits through one of the industry’s leading providers of “picks and shovels”:

> International Game Technology, another U.S. company, supplies slot machines and state of the art video gaming devices worldwide, and should certainly cash in on Macao’s gaming industry expansion.

The Chinese have a voracious appetite for gambling and Macao may be perfectly positioned to capitalize. This still relatively small gaming destination has already eclipsed Las Vegas in revenues, and Macao may one day far surpass anything that Las Vegas casino operators imagined possible in their wildest dreams. So it’s worth keeping an eye on Macao’s growing casino gaming market.

It seems that even high-ranking Chinese Communist party officials can’t get enough of the games of chance offered in Macao. Unfortunately, some of them are taking this vice too far.

It seems that since 2005, Beijing has officially reprimanded nearly nine thousand party members for excessive gambling. And still they come. It seem that getting too much of a good thing is not just an American monopoly either.

Signs of Creeping Inflation … in Popcorn and Taco Prices

Call it yet another exhibit in the chain of evidence that points to the continued likelihood of rising inflation and commodities prices, notwithstanding the broad-based commodity correction currently underway. As global emerging markets continue to industrialize at a rapid pace, surging demand for commodities around the world (and especially in emerging Asia and Africa) continues to put upward pressure on prices, in spite of increased supplies.

This is a secular (as opposed to cyclical) trend that’s likely to play out over the next several decades – rather than the next several days. Regarding myself as an investors who considers long-term as being an investment view that extends somewhat beyond the next six-months, a story I heard recently on National Public Radio piqued my interest.

The Skyrocketing Cost of Tortillas

It seems that the good citizens of Mexico find themselves under siege by signs of creeping inflation in the agricultural-commodity sector, which is hitting a bit too close to home. The price of tortillas – a mainstay of the country’s diet – has increased dramatically in recent weeks – jumping more than 50% in some areas of the country. According to the story, tortillas are not merely a staple of the Mexican diet, but are more like a cultural icon of gastronomic proportions – think rice in Asia, potatoes in Ireland, or Starbucks in the US.

Mexicans consume an average of 10 tortillas per person per day – a staggering sum. So a 50% jump in price in a matter of weeks really puts a dent in the family food budget (and perhaps in the waistline as well). Mexicans are understandably outraged, and the government has ended tariffs on imported corn in response.  Officials in Mexico City were quick to blame “speculation and hoarding by unscrupulous traders” as being at least partly to blame for the recent sharp rise in the spot price of corn.  But the real reason is a more familiar one – rising supplies just aren’t keeping up with surging demand.

Record Corn Crops … But Even Stronger Appetites

The US is still the world’s number-one corn producer and exporter, harvesting a bumper-crop last year – the third largest ever at 10.5 billion bushels. In spite of this, exports of American maize still won’t be enough to prevent global supplies from falling to the lowest levels since Jimmy Carter occupied the White House.

Meanwhile China, the world’s second largest corn grower and another key global exporter (especially to its neighbors in Asia), should harvest its largest crop ever this year. In fact, Chinese farmers are expected to bring at least 141 million tons of corn to market. Ah, but surging domestic consumption is likely to eat-up all of it – leaving global supplies as tight as a drum. This supply-demand imbalance, even in the face of record corn production, is keeping steady upward pressure on corn … and tortilla prices. Beside a growing global appetite for corn, this agricultural staple has found another handy use that’s adding to demand, alternative energy.

Also, the world is growing more concerned about global warming, not to mention the still high price of crude oil imports. Ethanol production is surging on a global basis as a result, and one of the key ingredients used to brew this cleaner-burning fuel is corn (as well as sugar cane). After the result of last year’s mid-term elections here in the US, Congress is finally beginning to come around too, proclaiming that the true path to domestic energy independence runs through the cornfields of the Midwest. Even with the price of crude falling back near $50 a barrel, corn-based ethanol production is still profitable. The additional fact of ethanol being embraced as a “greener” alternative to crude oil only adds fuel to the fire; stoking increased demand for corn.

The national energy bill passed last August mandates production of 7.5 billion gallons of ethanol in the US by 2012. None other than the chief economist of the US Department of Agriculture recently said that demand for domestic corn for use in ethanol production would rise nearly 50% in the year ahead, to more than 3 billion bushels. As such, the domestic ethanol industry will account for about 30% of total US corn crop demand this year, and growing fast. Yet another indication of creeping inflation, and higher commodity prices to come.

Bottom line: “headline” commodities such as crude oil, base- and precious metals are undergoing a sharp (if not way overdue) correction at present. In fact, the commodity slump now underway has seen both crude oil and copper plunge by almost one-third from their 2006 highs. But while energy traders wring their hands almost daily on CNBC, the game goes on for investors in agricultural commodities like corn and wheat futures.

But brace yourself … we’re all likely to pay a lot more for popcorn and nachos at this year’s Super Bowl party.