21 Apr 2006 Where’s the Risk?

The Fed may be near the end of its long-term tightening process according to minutes released from their last Open Market Committee meeting.  Since the release the equity and commodity markets have soared. The CRB index of commodities was up 5% in the following two days, led by petroleum, gold, copper, and platinum.  The stock market gains were boosted by materials, energy, and industrials.  Extra lift came from some superb earnings reports from individual companies in the groups just mentioned, as well as from some leading technology companies, banks, brokers, and pharmaceuticals. Is the return of “irrational exuberance” in our future?  One could argue that it already exists in the commodities and metals markets as well as the related company stock prices.  They are up huge this year following a two-year bull market. 

The stock market’s rise following the Fed’s news is confirmation for the bulls who have argued that the Fed would likely stop tightening while the economy remained strong.  Historically, before 1995 the more typical pattern was for the Fed to overshoot with their interest rates policy, stopping only when they saw recession looming.  That change in policy sent the signal that declining earnings and stock prices were just ahead.  Today, earnings are signaling just the opposite as companies continue to beat Wall Street analysts’ estimates.

Many believe the Fed is near the end of their tightening because they want to avert a housing-led recession.  Back in the fall of last year there was concern that the housing bubble would burst and send housing and thereby the economy into a tailspin.  That fear has not been realized as the air from the bubble has been let out gradually.  Tuesday’s report showing that housing starts were down 7.6% continued to prove the case that housing was slowing from its breakneck pace in an orderly and healthy manner.

However, as economist Ed Yardeni points out, the Fed’s reluctance to go further with rate hikes for fear of crushing housing may be causing another bubble in commodities.  Traders are given virtually a free hand to continue driving up prices if they feel that interest rates are about as high as they will go.  Alternatively though, if commodity, especially oil prices continue to soar, then they will slow global economic growth.  Ed points out that energy supply shocks have caused three recessions in the past and it could happen again if the Fed undershoots with rates.  Fast growing economies would continue to stress already tight oil supplies making them more vulnerable to supply disruptions that seem increasingly likely.

Add to the mix the significant number of problems out there; from Iran’s boastful nuclear ambitions, Nigeria’s instability, Venezuela’s march toward socialism, North Korea’s nuclear threat, Russia’s lack of solidarity with the US and Europe, Bush’s tumbling domestic support, near civil war in Iraq, China’s economic (if not more serious) threats, and seemingly on and on.  We seem so far from the euphoria of the 90’s with images of the Berlin wall crashing down, the pervasive rise of democracy and the promise of rising standards of living all over the world brought by freedom and capitalism.

Investment risk-taking seems to be at low ebb throughout the American economy.  Businesses are sitting on huge piles of cash.  The stock market is driven primarily by traders.  Over half of the New Stock Exchange volume is program trading, which is very short-term and low risk by nature.  The real estate boom is winding down and attracts fewer and fewer speculators.  Venture financing, while growing, is a mere shadow of what it was in the late 90’s.  Hedge funds have ballooned to the point they are chasing the same limited opportunities marginalizing returns.

If the story ended here the picture would be pretty bleak indeed, but it doesn’t.  There are new spark plugs in the global engine that add tremendous power –Brazil, Russia, India, and CHINA- the BRIC countries.  They have tasted capitalism and rising standards of living and they like it.  Their growth combined with some improving European economies supports the global expansion in a way that traditionally fell to the US alone.  American leadership is now challenged from the four corners of the globe.  No industry is safe from it and complacency or risk-aversion will only result in extinction.

Here in North Carolina we have witnessed the virtual disappearance of both the textile and the furniture industries.  It is highly likely that if managers had been more aggressive in using technology to compete against the cheaper labor of China, Malaysia and India, they might have saved their domestic factories.  I fully believe that to be the case and could give examples beyond the scope of this Brief.  In short, managers in these industries couldn’t balance the risk with the reward.  Let’s hope that managers of General Motors, Boeing, Caterpillar, Microsoft, or Hewlett Packard don’t make the same mistakes.

The signs we are looking for are the ‘bet-the-company’ kinds of initiatives we saw in the late 90’s, not merely the mergers of equals of late.  These bring a false sense of security and complacency through size and economies of scale.  The dot com and tech bubble of the late 90’s scared a lot of businesses into their shells.  It can be argued that the downsizing that companies went through, the resulting cost savings, and the productivity gains had much to with their latent fear of extinction.  But cost savings and productivity gains bourn out of fear of losing one’s job can only boost business performance so far.  Risk taking and bold new initiatives drive the big gains.  The Chinese, Indians, and South Koreans don’t carry the weight of the bubble burst.  They love risk and are reaping its rewards.  We hope and watch for the spirit of risk to return to American business.  It is in full view among a few notables such as Apple, McDonalds, Starbucks, and Corning.  We believe it will become pervasive again. It has to.