Northern Exposure

In the business world, the rearview mirror is always clearer than the windshield.
-Warren Buffett

Reading our papers and looking at our markets, it is hard to be anything but gloomy. We now have irrefutable evidence that the new administration does not have a magic wand. If anything, they seem to be afflicted with the same communication challenges as the previous administration. While we wait for the stimulus package to pass and the financial rescue package to take shape, the financial sector remains in turmoil, jobs are being lost at a record pace and housing remains in the doldrums.

However, the picture is not quite as bleak everywhere. Clearly, most nations have been impacted by the U.S. led slowdown and the resultant demand destruction. Economies like Taiwan, which are heavily export dependent, have slowed dramatically, while most of Eastern Europe is struggling as well. However, there are glimmers of hope in China, possibly India and even Brazil. In China, for example, even though imports and exports have been impacted by the global slowdown, retail sales, industrial production and the PMI indices are showing resilience. That is not to say that a rebound is on the horizon; however, maybe the pace of decline is slowing, and if that turns out to be the case, the economy could bottom sooner than most expect, which would be an unexpected but welcome boon for the global economy.

The main downside drivers of this recession were housing and the banking industry. They in turn generated a series of byproducts, notably de-leveraging, risk aversion, unemployment and falling demand by both businesses and consumers. As the recession worsened, its impact spread to most regions of the world.

In Asia, banks have been impacted minimally by the housing correction and losses on structured assets. In many of those countries, consumer savings rates are high while debt is low. Therefore, the problems that they face are for the most part external in nature and the best defense is a cushion in the form of domestic demand. On a relative basis, that favors countries like China and India and hurts Taiwan and the Philippines, though arguably all of them have an advantage over us. Brazil enjoys many of the same benefits; despite the price declines in commodities and energy which hurt the economy, there are reasons to be more upbeat about Brazil than many other parts of the world.

The message here is that the drivers for recovery in each country or economic region will include domestic demand and external perceptions about the future of the region. Countries enjoying balance of payment, budget and trade surpluses will do better, as will those with high savings rates and better growth prospects. The ones that will struggle are those that will take time to work themselves out of the morass of deficits and sagging domestic demand. Everyone knows by now that decoupling is generally a myth, but while absolute economic growth might remain subdued until the U.S. economy bottoms, relative growth rates could differ widely.

When markets recover, recovery tends to be led by equities and other risky assets. Equity markets focus on forward-looking indicators and often start rallying two or three quarters ahead of an economy coming out of recession. With an increasingly global economy and plenty of cash on the sidelines, investors have many choices. I believe those investors willing to invest in overseas markets will begin to see signs well ahead of the U.S., though they may be sporadic and unreliable at first. When that happens, expect those markets and currencies to lead the global recovery, while our markets and the dollar lag.

Looking Ahead

Not much has changed in the two weeks since I last wrote this column. Most major currencies have been in a range, except for the JPY, which is slightly weaker. Asian and Latin American emerging market currencies have shown some stability as their equity markets have performed somewhat better, while Eastern Europe continues to be in turmoil. This relative stability and improved performance of risky assets reflects a degree of optimism about the resilience of the "BRIC" economies (ex-Russia) and others. While they have undoubtedly been impacted by the global recession, their underlying fundamentals remain sound and there are reasons to believe they will start growing sooner and at a faster rate than most developed economies.

For now, hedging most payables and receivables is the conservative approach in this time of uncertainty. As I said above, I believe we will see more differentiation in economic and currency performance as the year unfolds. The U.S. and the USD will lag, followed closely by the Europe and the EUR. The JPY has benefited from risk aversion and capital flows, largely an unwinding of carry trades. However, the economy is in terrible shape and the bounceback likely to be slow or nonexistent, which argues for JPY underperformance over time.

As time goes by, it would be wise to pay increasing attention to currency payables, with a focus on emerging markets. When the global economy finally recovers, we could possibly see a multi-year trend of emerging market outperformance of the developed world - that is, for the most part, where growth, savings and capital surplus resides.