Written by Michael Waring

Over the past six weeks, the seemingly ever-growing weight of negative news has sent global equity markets into a tailspin. The sell-off appears indiscrimanent and even stong sectors year to date (ie.agriculture and energy), have now been beset by profit-taking. At the moment, its seems difficult to envision any good news for markets anytime soon. The pessimism is almost palpable.

The consensus has turned decidingly negative but we have learned over the years that the consensus view is usually proven wrong. The challenge, as we have mentioned in past letters, is one of timing. Market action can always get over done at tops and bottoms. Are we at the bottom yet? Our visceral instinct is to say no. While pessimism is pervasive, we have not sensed panic. Thus far, investors seem to be taking 200 and 400 point down days in stride, which has surprised us. In our experience, market bottoms typically are registered with higher volumes and a sense of panic.

However, we do note that with the recent drop in share prices, bargains are now starting to appear for investors with a one to two year time horizon. The contrarian in us senses that a relief rally is at hand after the pummelling of the last six weeks. An investable rally? Probably not. But a tradeable rally? Certainly.

Of all the negatives that have piled up in the last six months, two that concern us the most are food and energy prices. We believe that the one-two punch of higher food and energy prices is now biting consumers to the point of a change in consumer behaviour. Miles driven in the United States is declining and SUV sales have dropped sharply. Shopping patterns have moved downscale (witness the rise in Wal-Mart shares) and the U.S. consumer appears to finally be in retreat.

We do not believe that the current level for a barrel of oil is sustainable at $140. In our view, the price of oil needs to decline to a level of $100-110 per barrel before equity markets can enjoy a meaningful  rally. And we actually think a lower oil price would be positive for energy stocks in the longer term since a lower price would mitigate demand destruction resulting in higher price to cashflow multiples. And in this U.S. election year, we would not rule out the politically motivated release of oil reserves from the U.S. Strategic Petroleum Reserve as a means to reduce U.S. gasoline prices.

China and Asian Markets

In May, we spent two weeks on a business trip visiting China, Cambodia and Singapore. Before we left on the trip, our thinking was that inflation was more of a cyclical phenomenon in emerging economies. During our visit, we sensed otherwise, that inflation in these economies is more structural in nature. Higher food and energy costs are hitting emerging markets hard as they simply do not have the ‘depth’ in their economies to deal with pricing pressures on basic needs. Inflation is soaring in many countries from India to China, South Korea, Indonesia and Vietnam. With rising inflation, the risk of a monetary policy response is growing. This need to tighten means that 2H08-1H09 may be characterized by weaker Asian economies and lower profit margins later this year.

As a result, for the time being, we have trimmed or eliminated our Chinese/Asian holdings from our portfolios to their lowest weightings in years. We are still enormously bullish on the long term secular outlook for these markets and will search for the right re-entry points in our selected stocks.

To be clear, we expect strong growth in GDP to continue in these economies but at a lower level then in the past several quarters. The need for infrastructure build in these countries continues unabated and will remain a key driver in Asian economies going forward.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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