Saturday, January 10, 2009

Manufacturing Weakness Spreads to Germany

Earlier this week I pointed out the atrocious numbers coming out of the Far East in Asia Coming Unglued. However, Asia is not alone in experiencing dramatic symptoms from the American consumer shift in psychology. Europe is being hit hard as well. But the areas one would expect to be the hardest hit, countries that experienced US-style binges on consumption (UK & Ireland, Spain primarily) are not where the only pain is being felt. Germany came out with a slew of horrific news this week. Their situation is an interesting one in it's own right, and I'll cover as much of that as I can today in addition to what it may mean for investment opportunities in the future.

First came the unemployment number, which was a worse than expected 7.4%

Then we learned that German exports fell by 11.3% year over year, and that factory orders fell by 27.2% compared to last November.

Paradoxically, the economies that had been operating with a trade surplus, and responsibly producing their way to increased prosperity are the ones being hit first by the credit crisis. We have seen this in Asia, and now Germany (Europe's most advanced economy and 3rd largest in the world). Common logic would have one assume that these economies would be relatively immune to a slowdown (this was the logic behind the decoupling theory). However, their economies being more oriented toward manufacturing, they are more vulnerable to sharp slowdowns when discretionary spending abroad screeches to a halt - not less. Germany is a manufacturer of advanced heavy machinery, pharmaceuticals and other high-tech devices. When businesses in the US need to trim their balance sheets, large capital expenditures like reinvestment in plant and property is one of the first to go. So we are now seeing the lagging effects of a manufacturing slowdown in German numbers. In contrast, consumption numbers in the US, although bad already, have not yet begun to feel the effects of rapidly increasing unemployment - payroll being the next major expenditure US firms are likely to cut back on.

From what we have seen, it appears that US firms and consumers began to rapidly decelerate their discretionary spending in the summer of '08. This has led to fewer overseas purchases of discretionary imported goods. The next step was for US firms to drastically reduce payrolls starting in November. The resulting joblessness is currently starting to have an effect on the bottom line of many US retailers (as evidenced by Wal-Mart this week) and the stunning declines in US consumption are sure to lag by a month or two after that. US Retail Sales numbers for December are scheduled for release on Wednesday the 14th. The consensus estimate is for a 1.1% decline. The number could surely be far worse than that, however it is the following month that I have my eye on; scheduled for release on the 12th of February. This is when I expect the numbers to start looking truly disastrous. I'm also watching the February 2nd employment number, as it will be restating much of the second half's fallacious birth/death assumptions.

So while the news out of the rest of the world appears to be worse than in the US (where the crisis apparently originated), I don't have any sanguine expectations that they will be less affected in even the short term. The relative strength they have shown to date is likely more a result of the type of service oriented economy they have as opposed to the manufacturing economies we see dramatically slowing today. As the effects of rising unemployment filter through the economy, the shocking numbers are sure to follow in the US as well.

However, even though the manufacturing numbers look horrible in Germany and Asia right now, it is to their long-term benefit that their economies were at least based on something tangible (even if that something was unsustainable US consumption.) The main difference between the suppliers of the US binge and the consumers is not in increased foreign exchange reserves as is often said. Rather it is in the capital that is found in the spare productive capacity. It is something that can either be used itself at some point in the future or it can be used as collateral for some other investment. Because of that, there is a chance the manufacturing hubs are the first ones to exit the depression whenever that may be. Additionally, the balance sheets of individual and corporate participants in Germany and Japan especially are in far better shape than those in the US. Therefore, it will take them far less time to repair themselves from falling asset prices.

From my perspective, the real issues determining how Europe and Japan (and to a lesser extent Canada, S.Korea, Australia and the US) emerge from the depression are more demographic in nature. Birth rates in these areas have been anemic over the last generation. And an aging population is typically a drag on an economy as higher taxes are required to support the elderly. This is especially problematic given the enormous amount of promises politicians have made in terms of social security and health benefits. Governments in many of these countries are going to have to massively cut their obligations to senior citizens. How feasible this will be is hard to say. Voters are not often known for electing themselves less money. To be sure, these problems have not just come out of the blue. They are expected. But they were not expected to come to a head for another 5-10 years. Now, with a worldwide depression setting in, government tax revenue projections are likely to fall short, accelerating the zero-hour date. This is something I expect to become a large issue over the next few years. It will be pitting the young vs. the old. Those that accept fewer benefits will likely be able to use their stronger capital position to rebuild and perhaps lead the recovery. Those that instead choose to raise taxes on the young, will not only see weak investment but they'll likely see their already small younger population move somewhere else - compounding the problem.

In summary, there are important differences between the world's major economies and how they are expressing the slowdown in their own ways. Somewhere, there will be a screaming investment opportunity. It will come from somewhere that a) has a large educated and robust young population b) has strong corporate and individual balance sheets c) low tax rates and d) open and accessible capital markets. I will be looking for opportunities in areas that demonstrate a good combination of those characteristics. Parts of South America (Chile especially) are looking good as of now. But any country can conceivably help themselves in most if not all of those areas. However, doing so may take some unpopular short-term decisions. I will be watching keenly where those correct decisions are being made and where they are not. When the time is right to take risk again, I'll be allocating my investments based on that. The world that emerges from all this will not closely resemble the old world - neither will my investments.


Gil said...

It's ironic that it appears to me that countries that produce real stuff are going to be more effected then the the US by the world wide slowdown.

The US produces nothing but dollars and those dollars are needed in order for the world financial system to function. And the world's financial system must funtion in order for the bankers to get their cut.

They may actually pull this thing off. Don't laugh. I'm shocked that deflation is possible with fiat.

Of course, there will be pain and suffering but no EOTWAWKI scenario. Maybe the shredding of the US dollar does happen. But then the bankers just roll out another reserve currency.

Matt Stiles said...

An article today from Ambrose Evans-Pritchard basically reaffirms my sentiments:

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