Confluence of Capital Budgeting Decisions

While seamless recovery versus double dip into recession has an elegant simplicity, the real investment world is messier. Thus in recent weeks, we have focused on topics ancillary to economics. One such is that today’s capital markets have a confluence of capital budgeting decisions that individually, in any other cycle, would have been major events. This cycle is likely see substantive government re-budgeting post the November U.S mid terms and G-20 meetings. The credit crisis did lead to massive efforts but in many ways, the cyclical change is happening now in 2010, epitomized by the just released Basel III proposals. Despite low interest rates, the capital budgeting for corporations is likely to be stringent for longer than generally recognized. For instance, the 2010 Gulf of Mexico oil spill has not only increased focus on environmental issues and engineering change but could also lead to onerous funding for smaller resource companies, triggering amalgamation. The capital budgeting decision of the investor, institutional and individual is likely changing not least by demographics versus advanced economy mutual funds but also by quiet money derived from entrepreneurial Asia and sovereign wealth funds versus overt hedge funds. We expect quality to be an important consideration, unlike the last two cycles. Sector wise, from these capital budgeting decisions, we anticipate opportunity in strong or well backed financials and energy as well as more generally in information technology for growth, industrials for cyclicality and healthcare for restructuring. Range bound equity markets since late 2009 have strengthened, not changed, our disposition.

In addition to august institutions like the IMF, the OECD and the US Federal Reserve pointing to potential industrial countries’ GDP growth reductions for the second half of 2010 to 1 ½% there is potential for, in our view, slower but continued growth in the first half of 2011 versus perceptions of 2 ½% for the year as a whole. Concurrently, India reported with 13.8% y/y industrial output growth through July and through August 2010, China reported 13.9% y/y testifying to strong capital goods demand. China and India with reported 9% GDP growth characteristics annually with Brazil and Russia potentially at global annual GDP growth of 4% contrast many industrialized economies at annual GDP growth closer to 1 ½ – 2 1/2 % with unemployment stubborn and savings rates closer to 6% pointing to a frugal consumer in the crucial United States economy. This fundamental imbalance between capital goods/infrastructure growth and consumer fragility in the existing base of the global economy represents variance that needs to be managed versus general market expectations when governments commenced stimulus.

In addition, the management of politics is changing with impact on government finance or public sector capital budgeting. In China, as currently the major country with the strong sustained growth akin to Germany in the 1950s or Japan in the 1960s or the Asian Tigers in the 1980s, politically crucial has become management of expectations stymied due toe credit driven housing gain that benefitted comparatively few. In Europe the focus through most of the summer of 2010 was on fiscal imbalance but strains in the coalition in Germany, demonstrations in France over retirement reform that belie fears of repeat of the 1995 political cost to government of attempts to perform the same. Malaise remains strong in the countries most directly affected by fiscal rectitude, like Greece and Spain . Many democracies globally have veered to fragile coalitions. In the run-up to the U.S. mid-term elections, dire protestations of the consequences of inaction have less fervor versus the lack of demonstrable gain from stimulus spending. It has brought tax choices to the fore, despite low funding costs currently in government bond markets and the political desire to defer such considerations to after the elections in the United States and for that matter in Japan . Much like pre-Thatcherite Britain or the Asian Tigers of the early 1990s but without asset sales as part of the solution (excepting many emerging economies), this cycle is likely to be one of substantive government re-budgeting post the November U.S mid terms and G-20 meetings.

In finance as has been classic in the markets, excess in one cycle is often followed by restructuring in the next, such as information technology in pre and post 2000 in the last cycle. The credit crisis that commenced in 2007 did lead to massive rescue and reflation efforts in global finance that is still ongoing. However, in many ways, the cyclical change is happening now in 2010 and epitomized by the framework of the just released Basel III proposals. In sum, we see the impact of these guidelines as likely to benefit the strongest with first mover advantage accruing to those raising capital early as well as those with government backing, either due to prior policy as in China or those due to reluctant rescue as in many advanced economies. However for those institutions in the amorphous middle the challenge of being forced to deleverage and raise capital is likely to accelerate amalgamations or takeovers, even if requiring a 4.5%core tier one capital of 4.5% and an additional buffer of 2.5% is implemented over eight years to 2018. In particular, we believe the more diffuse banking regimens need monitoring for change such as Germany with its hitherto widespread landesbank system and the United States with its numerous small and mid sized essentially local financial institutions.

Despite currently lowered interest rates, the capital budgeting decision for corporations at large is likely to be far more stringent for longer than generally recognized. Notwithstanding the striving to unclog credit by governments and central banks alike, banking amalgamation, higher capital requirements and lower leverage have the potential to meter out financing for smaller and mid size businesses towards higher quality, much more than was the case in the last cycle. With sustained multi trillion dollar financing requirements from government deficits in advanced economies and sovereign debt restructuring needs in emerging economies in Asia, Europe and Latin America below the mega country level, it is hardly surprising that corporate treasurers have chosen to refinance now in 2010 by expanding capital market financing markets to take advantage of both fund availability and low interest rates, such as 1% over three years. However, below the macro level, we also anticipate ongoing increased metering of credit in terms of cost and availability for corporations. For instance in natural resources in general and energy in particular, the Gulf of Mexico oil spill of 2010 has not only increased focus on environmental issues and likely to lead to technological change (much as the Alaskan oil spill led to double hulled tankers) but could also lead to onerous funding costs for smaller drilling and exploration companies, triggering amalgamation. In the last cycle, the still ongoing restructuring of information technology has been as much related to business change as to sharply changed availability of finance for the sector post 2000. In healthcare today, we expect similar business constraints to drive financing change due to under performance in the last cycle and even early in this cycle. In consumer related industries, the demographics of emerging economies do point to acceleration for instance in the automobile industries with China now the largest market. However in the installed base of advanced economies, conditions remain tight for staples and discretionary companies alike- once more pointing to more constrained capital budgeting.

Last but not least the capital budgeting decision of the investor, institutional and individual is likely changing not least by demographics versus advanced economy mutual funds but also by the likely rise of quiet entrepreneurial money from Asia and sovereign wealth funds versus overt mutual funds. One dimension that we have recently underscored has been the evolution of markets coming from transactional cost decline sparked by negotiated commissions to now increased focus on the downside of unfettered high frequency trading brought about by that four-decade old change and the more recent explosion of information technology in the process of transactions itself. However, a demographic dimension has been that much as the baby boom generation in industrial economies effected industrial/societal activity from schools and hula hoops in the 1960s to housing and aspiration driven discretionary spending into the 1990s, the sharp rise in market volatility in the 2000s has coincided with a graying of that generation from Japan at extreme to Europe in the middle and to North America arguably least but with still evolving changes in investment preferences. The massive middle class growth cohort of the emerging countries is generally still too youthful to instantly assume that investment baton. Instead, Asia in particular has experienced a sharp increase in millionaires and billionaires that are very much driven by entrepreneurial activities but who as a result of internal societal tensions also are likely for their investment portfolios to prefer discretion and conservatism. At the institutional level, not withstanding the headlines being made about resource partnerships including sovereign wealth funds, the same could be said for asset allocations by myriad and large sovereign wealth funds without political intent, in contrast to the often more overt functioning of hedge funds that were the growth industry of the last two decades in finance funds flow.