Wednesday 12th Aug, 2009

Business Times - 12 Aug 2009

MONEY MATTERS
It's just a business cycle as usual

Pushing break-even points down will ensure profits, which will lead to re-investment and re-hiring - and thus growth

By JOSEPH CHONG

I AM gratefully astonished by the very positive response to our last BT contribution of June 24, 2009 - 'Harnessing the ETF revolution'. Searching on Google with the key phrase 'ETF revolution' two days after publication, I was surprised that of 85,000-plus articles listed, 'Harnessing the ETF revolution' was number one, besting similar pieces from far larger media houses such as FOX Business. It remained that way, until the piece was archived a week later. Readers, who wish to access the article can still do so at www.ni.com.sg. Perhaps the marketing experts at SPH may have some thoughts about monetising such articles, instead of archiving them?

Apropos revolutions, the good recent second-quarter announcements from global bellwether companies such as Intel, Apple, ABB and Honda were treated like revolutions in the business media. It is not a revolution - it is the business cycle at work.

We had a financial crisis that precipitated a deep recession. Companies globally reacted swiftly, throttling production and shedding excess inventory, production capacity and excess labour and benefits, thus pushing revenue break-even points down. At micro-level, we saw this in our general insurance business, as companies cut back coverage and benefits. Labour, which is in excess now, has little bargaining power.

Pushing break-even points down is the needed pain for the economy. This will ensure profits, even in a weak revenue environment. Profitability will eventually lead to re-investment and re-hiring - and thus growth. No revolution here, just the business cycle.
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Profit announcements have shown other key traits besides cost cuts - better revenue estimates in the second half and margin expansion. This bottom-up perspective is congruent with the macro view that we have had for some time. We knew that revenue would be better going forward from the PMI sub-indices for new orders from the major economies, led by China.

From the macro perspective, we expected margins to improve because of the divergence in CPI and PPI around the world. The PPI, producer price index or a measure of input costs for businesses, has been falling far faster than the CPI, consumer price index or a measure of what businesses charge consumers, in most major economies. When PPI lags CPI, it is normally good news for businesses and the equity markets as it generally signals improving margins.

LThe accompanying chart shows the trend of CPI less PPI over the past 20 years for the US. Readers will notice that periods when CPI less PPI was positive have correlated with improving corporate margins and healthy equity markets.
We are now entering a sweet spot in the business cycle for equity markets - expanding margins and revenues. Corporate profit growth is back. Throw excess liquidity (M3 minus nominal GDP growth) into the cocktail and that's a recipe for very strong equity markets, as we had predicted in our contrarian call in BT of April 8, 2009 ('No, the recovery isn't a mirage any more'). Readers who want to access the article can still do so on www.ni.com.sg. Indeed, the Shanghai stock market's 90 per cent climb from the bottom could be a precursor for developed markets.

The improving demand picture and corporate profits are also correlated to the performance of the Singapore residential property market. When we stuck our neck out with our bullish contrarian call in BT on Dec 10, 2008 ('A city of two tales') amid widespread fear, we had an internal forecast of 25 per cent upside in 12 months. It looks as if we may have been too conservative.

Even without the expected additional demand generated by the integrated resorts in 2010, annual average take-up has been around 8,100 units since 1995. With the recovering global economy, we should at least see this number in 2010. Unfortunately - or fortunately, if you are an investor - there will be only 5,500 completions in 2010. This shortfall will push the rental vacancy rate down.
I estimate that this will fall from the current 5.9 per cent to below 4.9 per cent. The last time this happened, in early 2007, rents and capital values surged. Unlike in 2006, the cushion of surplus HDB flats is probably no longer there. I say probably because HDB, unlike URA, has yet to publish data on the inventory of unsold flats.

It looks like quite a party for the residential property market in the next 12 months, barring an external shock or government action. It is strange that when the Straits Times Index jumps 80 per cent in five months, no one screams speculation. However, when the residential property market prices begin to turn around (according to most recent URA data), many are calling for a change to the rules and the guillotine for 'speculators' while demanding 'affordable' prices.

What signal are we sending to those brave investors who take risk and prop the market (and banking system) in the despair of the first quarter of this year, when even the government was issuing statements full of gloom? In future, we may find no buyers at any price when things turn down because we acquire a reputation as rule changers. Curb 'speculation' with care. Otherwise, we may regret what we wish for.
 

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions