Mutual Fund Investing - Markets, Economy Scraping Bottom

As one economic number after another signals says that the economy is slowing even more, the worry grows that the economy is gradually sliding into another recession - a "double-dip," if you will. Is that where the U.S. economy is now heading? We have said more than once recently that we do not think so. Our thinking about a double-dip was reinforced recently by the economists at Goldman Sachs, who directly took on the issue. They put the chances of a double-dip at 25%. As we see it, the number is arbitrary. We would rather put it, yes, there is a chance consumers and business will spend even less than they are now, but the chance is very slim.

The Goldman thesis makes one fundamental point that is generally overlooked 'mid all the noise about this or that indicator, let alone all the technical heavy breathing. The group reminds us that a recession is caused by an imbalance or imbalances that build up in the economy. Something triggers a correction of the imbalance, and a recession ensues.

Just think of the last recession and the enormous leverage that built up in the housing market. The housing boom slowed, and once it did, leverage caused the great unraveling of the financial sector and with it, the Great Recession.

Whatever one may say about today's economy, a major imbalance is not one of its problems. The consumer sector is certainly struggling with debt high and income growth low, but consumers have already cut back. There is no consumer balloon stretched to the bursting point. A similar story is true throughout the economy.

The facts please... As one goes through the sectors of the economy, the only conclusion is that spending in much of the economy is running at something like a minimum rate. Can spending go lower? Of course it can, never say never. Will it? We doubt it.

Two examples will help. Take housing. The Goldman economists, and others as well, have been pointing out that housing starts are running well below the rate of household formation. Household formation represents the foundation for housing demand. Considering this relationship it is hard to see housing sales falling much further and contributing to another recession.

The second example is business spending for capital equipment. According to the Goldman paper, business net investment for equipment was at the lowest level since WW II relative to GDP. Equipment and software spending, a major portion of business investment, has recently been running below depreciation. In other words, even though business investment has picked up, it is still not enough to maintain the capital stock. Nothing prevents business from cutting back again, but the odds are strongly against it.

There are other examples. In other words, a good case can be made that the economy is scraping bottom. This provides comfort when it comes to the issue of a double dip. However, it says nothing about when the economy's growth will pick up from its current unsatisfactory level.

Neither we nor anybody else can pinpoint exactly when the indicators will send a positive message. But with interest rates extremely low and the Fed beginning to act, we believe that the next important move of the economy will be up. If we are right, the market offers excellent opportunities at current valuations.

Asia: Still growing... As the U.S. recovery from the recession gathered steam earlier this year, we changed our portfolio allocation adding to the domestic allotment and subtracting from the international. While we certainly have not ignored international market developments since then, we have not said much about them.

However, market behavior has been changing during this late spring and summer. Take a step back. Markets worldwide were clobbered during the Euroland crisis of May-June. It appeared nobody wanted paper assets then. Since then stock markets have been recovering in fits and starts. What is striking is that the recovery is by no means uniform. Relative to its previous peak before the European troubles, the Hang Seng Index (Hong Kong) has done considerably better than the S&P 500. India is tickling a high for the past twelve months. Here in the U.S., the S&P 500 has recovered but nowhere as robustly as other indexes. (The Shanghai Composite has hardly recovered, relatively speaking. The Chinese investor is still wary.)

The recent outperformance of many Asian markets naturally caught our eye. For a feel of the Asian markets now we spoke to Robert Horrocks, Chief Investment Officer, Matthews Funds.

Earlier this year, the Matthews team turned cautious on the red-hot Asian emerging markets. They kept pointing out that valuations were no longer cheap; in fact they had become somewhat expensive. Is this still true, after the sharp declines the markets have undergone? In his understated way, Horrocks replied, referring to China, that the market was "not hugely expensive." Certainly valuations have come down, he allowed, but he would not call the Chinese market cheap. "They are cheap compared to long-run valuations." Of course, what that implies depends on one's definition of the long-run. Horrocks concluded this segment by saying that he was more comfortable with current valuations.

An issue that any investor in Asia, or in the broad area of emerging markets, must face is relative valuations. Given the outlooks for the developed world and the developing world, where should the markets sell relative to one another. Generally, emerging markets have sold at a discount to developed markets.

There are good reasons for this, Horrocks pointed out. Speaking broadly, emerging market financial markets are thinner than developed markets and considerably more volatile. (Considering the recent volatility of Wall Street, this point will raise eyebrows.) But, deep down, we know this is the case. Another reason for the lower valuation of developing markets is the risk of political instability. The lack of depth in these markets is another reason.

On the other hand, just concentrating on Asia, the fact stands out that Asia will grow considerably faster than the developed world over the intermediate-term. We are talking about numbers such as 3% for the developed world compared to numbers such as 6-8% for the developing world. Apart from growth, the fundamentals underlying the earnings from the developing world are improving. Return on equity is rising and the quality of earnings is increasingly getter better. There is continued improvement in corporate management. Put it all together and you do get a picture of convergence (our words). The appropriately restrained Horrocks thinks that the trends will lead to a narrowing of price-earnings ratios over time.

Country selection... When it comes to Asian investment, the investor is presented with a menu of options. There are the regional funds say, such as Mathews Pacific Tiger or T. Rowe Price New Asia. Then there are the single country funds such as Matthews China or Japan or India, et al. In general, we have avoided the country funds, preferring to let the Asian specialist running the broad funds to decide the appropriate allocation among the countries in the region. The only exception we have made is for the behemoths in the region (Japan, China, India) where the information flow is sufficient for the non-specialist investor.

Does country selection make a difference in performance? Horrocks view is that it does, but only over the relatively short-term. Over time, the country effect disappears. The reason for that is because the economies are linked. One obvious example is Australia and China. Australia has performed very well basically because is it is a prime exporter to China. Another example is the now existing ties between China and Japan.

Changing landscape... Until fairly recently China was the center of investors' attention when it came to Asian investment. That is changing. China's answer to the Great Recession (and a huge shrinkage of export demand) was its stimulus package. In some ways the stimulus succeeded too well, particularly in real estate. With the threat of overheating, China has stepped on the brakes. Economic growth is slowing and forecasts have come down. The markets are now betting that China will ease off the brakes over the short-term, and 8% growth will resume. Still for the longer-term, the old Chinese export machine can no longer return to its old ways. China will still be a rapid grower, but not as rapid as before.

Then there is the other rapid grower, India. India too is hitting the brakes by raising interest rates, with inflation the issue. As Horrocks reminds us, India has the one thing everybody wants, domestic demand. Exports have not been the key to India's growth.

Adding to the longer-run outlook for India is its favorable demographics. The working-age population of India will be growing rapidly, while that of China, because of the one child policy, will not. A recent forecast by Morgan Stanley's Asian managing director calls for India to be growing more rapidly than China in a few years. Investors are not blind to India. The Indian market is will valued.

The balance of investor interest among the world markets is changing. Asian growth is standing out again as a rare commodity. The question now is when the monetary brakes will be relaxed in China and India.

Walter S. Frank has been the Chief Economist and Chief Investment Officer for Moneyletter for the past 25 years. He has had a long and distinguished career as an economist, financial advisor, and money manager. Mr. Frank is a regular contributor to Barron's and The Economist magazine. For more information on the Moneyletter, visit our website http://www.moneyletter.com