……………..Thoughts and Comments

Economic Update

China’s economy is obviously slowing – it is no longer a discussion of “if.”  The new orders index has fallen to its lowest level since March 2009, the employment sub index is at a 41-month low and there are record inventories.  Banks are reporting increasing loan defaults. Commodities, which have been used as collateral for loans, have dropped in value, making the value of the loans questionable. And a number of industries reported dramatically increasing accounts receivable, meaning people aren’t paying as quickly as they used to. Corporate debt is rising rapidly and now stands at 109% of GDP according to one source, which would make it the highest corporate debt level in the world.

There is a glut of steel and large building equipment.  Since China’s whole plan has been to build infrastructure as a way to grow their economy, a glut in these areas suggests a significant drop in building – one of only two legs to their economy.  The other leg is export, and that is falling as well.

What does this mean for the rest of the world?  As the world economies are pretty closely linked, the impact will be felt everywhere.  Walking through a few industries can give us a good roadmap.

Oil prices are up from their lows, but have actually been trending down over the past year (see Chart 1), and demand is not keeping up with supply.  Short term, prices are up because of a combination of unrest in the Middle East, worries about hurricanes in the U.S., and questions about another round of quantitative easing in the U.S. and Europe.  But make no mistake: growth in worldwide consumption has been slowing, especially in Asia and Europe.


Chart 1 – Oil prices since 2009.  Notice that oil peaked in 2011and the highs keep getting lower.


Steel is in a similar situation.  China, one of the world’s largest producers of steel, is facing a glut of inventory which means there is more for export, but building isn’t growing anywhere else either.  The result is lower steel pricing and therefore lower pricing for iron ore (a raw ingredient in steel). Both BHP and Rio Tinto recently announced shut-ins of mines and reduced capital spending on mines because of reduced demand.  The same is also happening in coal and metals.  Another indicator is the recent report from the Edison Electrical Institute which reported that power production (electricity use) is down 2.3% year over year in the U.S., is down in six of the last seven weeks, and is down across all nine regions of the U.S (see Chart 2).


Chart 2 – Thanks to Andy Lees and Bloomberg for the chart.


Less demand for oil and for commodities means lower exports for countries like Australia, Canada, Brazil and China, which will continue to put pressure on bank loans and on their economies, as much of their GDP is dependent on this source of revenue.

All of this has been exacerbated by political decisions around the world that have little to do with economics and a great deal to do with politics.  For instance, China has been raising the minimum wage for several years in an attempt to get consumers to consume more.  However, it is hard for them to do so when the cost of living rises at least as quickly. The unintended consequence, however, is that China no longer has the advantage of cheap labor to help drive their economy.

In Brazil, where they have been feeling the pinch of a slowing economy for some time, the government has been providing short-term tax-breaks and incentives to get consumers to borrow money and consume.  This has led to the Brazilian banks reporting the highest level of bank loan defaults in three years, which, of course, is slowing the economy further.

In the U.S. and Europe, the home of the “spend now and pay later” concept, we have seen the results for several years: anemic growth.  The only change in Europe is now Spain is requesting a bailout while Greece is asking for a restructuring of their latest bailout.

The result of the uncontrolled spending by governments has been anemic growth, unstable banking systems, and more recently, the introduction of barter systems.

According to a recent article in the Washington Post, in Barcelona, the second largest city in Spain, a parallel economy is developing.  The same is true in other cities in Spain, Greece and Portugal (and other countries to a lesser degree), allowing people on the fringes to afford to live.  Rather than using the legal currency of the land, they are using various 21st century forms of barter systems to pay for goods and services.  Such barter systems are actually not all that rare during times of economic stress and were used in France during WWII and the U.S. during the Depression.

Governments’ immediate concern, according to the article, is the “implications for taxes, the effect on local wages, and the potential for fraud.”  What we find most interesting is governments’ concern for taxes.  The over-spending and promise of everything in life is the cause of the economic stress forcing people to use barter, and yet their worry is how they will collect taxes so they can continue to provide all the services!

So What To Do?

We continue to believe that a diversified portfolio still is the most sensible approach, utilizing gold, equities, and fixed income.  While less may be made in the good times, less will be loss in the bad as well.

In the equity world, we continue to focus on companies that combine great management with products that are in demand.  Thus, we are searching for sectors where there are growth opportunities even in uneven economic times.

Two examples are Stepan Company and Balchem Corporation.  Both are under-followed companies with great management teams.  Both companies control their costs and debt levels carefully, have room to pay dividends, which have increased over time, and have continued investing in future growth, even during these less-than-clear economic times.

Both are in industries that are in demand in good times and bad, plus have plenty of cash to take advantage of opportunities without leaving them at risk when cyclical slowdowns occur.

Stepan is a specialty chemical company that primarily provides surfactants – the chemicals that makes suds (cleaning products use suds to clean things).  Balchem manufacturers essential nutrients needed in both animal feeds and human nutritional supplements and processed foods.

We continue to hold Apple at this point and believe there is another year of good earnings.  With plenty of cash, and one of the few companies in their sector that has some creative ideas, we believe the stock still has attractive upside potential.

In the gold area, we have been adding to our gold stocks in the past month, focusing on GoldCorp, Yamana, GDX (Major Gold Miners ETF) and GDXJ (Junior Gold Miners ETF).  As both Europe and the U.S. continue to talk about expanding the money supply in order to stabilize and stimulate the economy, gold will continue to rise – as it has been doing for a little while now.

It is fairly likely that both the Fed and ECB will provide additional stimulus in hopes of reviving the flagging economies.  Both will be failures if attempted.  However, the announcement will lead to strong moves in gold.  At the same time, we are in the part of cycle that is strongest for gold (September – February) and China and India are likely to be large buyers.

At the same time, the economies of the world are suggesting that next year might not be much fun and so we continue to remove stocks that do not offer much upside and add fixed income as a defense against potential recessions.  Those that laugh and say how foolish to own bonds, need only look at the past four years of outperformance (see Chart #3).


Chart #3 – Courtesy Bloomberg Inc. and Fidelity Capital Markets.


The Bottom Line….

Little has changed dramatically since we last wrote two months ago and this is the reason we did not publish last month – as Thumper Rabbit’s mom might say, “if you don’t have anything new to say, don’t say anything at all.”

We continue to stay defensive, adding stocks as we find companies that offer long term opportunities at good prices, add to gold on weakness, and add to fixed income to hedge a recession.  Having cash will be a good thing going into 2013, and opportunities will surface after some pain.


Alan E. Rosenfield, Managing Director

September 2012


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