The equity market ended the first quarter of 2005 on a sour note, with the S&P 500 down over 2%. This lackluster start to the year reflects investor concerns about the widening trade deficit and the rising price of oil. Let’s try to put these concerns into perspective.
To begin, it is clear that the trade deficit has continued to expand, but it is not clear what it means for the long-term health of the global economy. On one hand, some economists worry that the reliance on foreign financing of the trade deficit makes us vulnerable to the potential of foreign investors pulling back on U.S. dollar-denominated investments. On the other hand, some argue that foreign investors buy U.S. assets not to finance the deficit, but primarily because they have confidence in the relative growth, return potential, and stability of U.S. economy. This endless and confusing debate makes me wonder if there is a more important point related to world trade.
Think real big picture and really long-term… The world is increasingly becoming one global, interconnected economy largely driven by two powerful forces. First, the proliferation of technology and the Internet has leveled the playing field with regard to access to information while facilitating the global exchange of goods and services, as well as commodities, labor, and intellectual capital. Second, the liberation from political repression in Asia, the Middle East, and Eastern Europe, has given birth to individual freedom, and it takes only a small taste of freedom for individuals and society as a whole to know there is no turning back.
China, Inc…. The tremendous economic growth in emerging countries around the world, especially China and India, will provide a powerful tailwind for international trade over the next few decades. Many large U.S. multinationals will participate in this explosive growth. In fact, in 2004, profits of U.S. corporations earned domestically increased approximately 7%, while earnings generated internationally rose over 25%. Whether it is providing consumer goods to over a billion Chinese, or whether it is building power plants, highways, or other infrastructure, U.S. multinational companies are poised to benefit from globalization.
At the same time, one risk to this positive view is China’s propensity toward reengineering, the politically correct term for copying, stealing, and/or pirating U.S. products and technology. China is notorious for utilizing their cheap labor to produce knock-offs of products engineered and developed elsewhere.
Sounds unfair, but China doesn’t play by our rules. Still, first mover advantage, technological superiority, deep pockets, and political pressure, may give the most astute companies a fighting chance. Ted C. Fishman offers insights into these issues in his book China Inc.
Back to the trade deficit… In our view, the record trade deficit is likely to exist for the next several years. Over the long-term, however, the emerging economies will start to consume more relative to the U.S., which will reverse the trade deficit, although the timing and rate of reversal is difficult to predict.
Meanwhile, on the oil front… We see controversy on the oil front as well. Some analysts predict oil prices will eventually fall. There is even an intriguing theory that the supply of energy is infinite, which is proposed in a book called The Bottomless Well by Peter Huber and Mark Mills.
Others predict the price of oil will soar to $100 per barrel and gasoline to over $4 per gallon! I do think that at least in the near-term, the probability of oil prices moving higher is greater than the potential for a big pull back. Unfortunately, higher energy costs intensify inflationary pressures throughout the economy. It becomes critical from a stock selection perspective, to understand the magnitude of these cost pressures and also each company’s ability to pass on higher prices in order to maintain margins. The relative ability to control costs and effectively raise prices varies between industries and more importantly within industries. A company’s prowess in the area of global sourcing and their ability to deliver innovative new products greatly determine relative success in the face of inflationary pressures. Over the long-term, some executives within the oil industry predict that economic forces will push the price of oil to a reasonable level through increased efficiency and the development of alternative technologies. For example, Lee Raymond, CEO of Exxon Mobil, has reminded people many times that oil is a commodity and no commodity has ever sustained high prices over the long-term.
A challenging year?... It all adds up to what could be a challenging year for the equity market. Stock selection may be even more important this year than it was last year. More specifically, there are three keys to successful stock selection in 2005. First, focusing on quality companies that have pricing leverage and effective cost control. Second, utilizing disciplined valuation analysis, in order to take advantage of short-term market volatility. And third, selecting companies that will dominate on a worldwide scale in this developing global economy.
