David Townes, managing director and co-founder, Needham & Co., presented a somber analysis of the world financial system at the recent Industry Strategy Symposium (ISS) in Half Moon Bay, CA, cautioning assembled executives about a shake-out he believes is inevitable. He warned of the potential for a future sharp jump in inflation, but still found a silver lining — a basket of selected blue chip equipment stocks that might even ride out a potential financial tsunami.
His concern is that outstanding global debt and derivatives have accelerated to unsustainable high growth rates. All the world’s currencies are issued by government fiat, and if excesses build up, restructuring will be necessary, he pointed out. Data presented from the Bank for International Settlements showed that credit default swaps rose 109% last year and 99% in 2006, while global over-the-counter derivatives of all types are increasing rapidly — rising 40% in 2007, 31% in 2006, 28% in 2005, and 30% in 2004.
While debt and derivatives have been exploding, many countries including the US face rapidly growing unfunded entitlement liabilities. There is huge political pressure almost universally to avoid cutting back these obligations, Townes pointed out. Meanwhile, he suggested, central banks have to race faster and faster over ice that gets thinner and thinner.
Making matters worse, he charges, are deceptive methods used by US agencies to measure and report the cost of living. He identified changes in statistical techniques from the 1980s and the mid-90s that effectively understate the real rate of inflation (see Fig. 1). He showed a number of factors that have been steeply rising for years — the Rogers International index of 36 highly diversified commodities has a 17% CAGR since 1998, while housing, education, and hospital services have 7% CAGR since 1980 — yet inflation has seemingly been under control. The “stealth inflation” divergence is so great that Townes now estimates that the real rate of return on 10-year Treasury bonds is actually -6%! (see Fig. 2).
In Townes’ view, information is being manipulated to prevent panic, and despite recent restatements, he believes that the risks in the world financial system are far from priced in. Investors are beginning to catch on, he believes, which is driving up the price of gold — in fact, he believes that US currency has been so weakened that the price of gold should actually be a whopping $5000/ounce!
The dollar has become much weaker than many other currencies, and what Townes calls “reflation” is going to lead to high inflation in his view (see Fig. 3). He suggests that financial events will be beyond the capacity of political institutions to cope, and that there will be unfair, politically dangerous unjust outcomes for large numbers of people.
Eventually, real interest rates must rise enough to give positive returns to long-term bond holders, he believes. Thus, there is a risk of a violent upward adjustment of nominal rates in the future to compensate for past excesses. There also may be a “seismic shift” away from the US dollar as a reserve currency, Townes said, but he is uncertain whether it might be to gold or a diversified basket of other world currencies.
The most solid nations under this future scenario are those that are major exporters of basic materials or commodities, and low cost manufacturers, he believes.
Still, despite the projected magnitude of the coming financial shifts, he believes a few companies in our industry could tide an investor through readjustments that could even push 10-year Treasuries up to 14% returns. These new “blue chips,” with high and growing market shares enabling them to generate profits of 27%-28% of revenues, would include Applied Materials, Cymer, Varian Semiconductor Equipment, KLA-Tencor, and ASML, with others such as Novellus, ASM, FEI and ATMI close behind, Townes said. — B.H.