Corner of Wall & Main: Far Flung Ideas

 | Aug 06, 2014 | 4:00 PM EDT
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The past week has seen the markets taking a long-awaited pullback, with all the major U.S. indices down.  

Economic news is getting grim as today we learned that Italy is again in a technical recession, with real GDP contracting 0.2% in Q2 after a 0.1% contraction in Q1.  German factory order volume fell 3.2% in June after having experienced a 1.6% drop in May. Expectations were for a 0.9% increase, so tomorrow's data release on German industrial production is going to get a lot more attention than usual as we could be seeing flat-lining or even contracting GDP in the region. The situation over Ukraine is likely adding unwanted pressure on already struggling European economies and could end up affecting the U.S. recovery as well. 

Over in the U.S., a just-released NBC/WSJ poll found that 64% believe the recession is still impacting them. And 71% believe that much of the country's economic woes are caused by the inability of those in D.C. to get anything meaningful accomplished, with Congressional approval ratings down to 14% and Obama's approval rating on foreign policy at 36%.

As we mentioned last week, we are seeing a shift towards more liquid securities as the potentially final round of QE comes to a close in October. This shift brings to mind another rather strong correlation that has been widely discussed, the correlation between the excess reserves at the Federal Reserve and the S&P 500.

Investors would be wise to be cautious with U.S. markets as QE comes to a close.  Regardless of the reality of any causal relationship, the narrative of QE driving the stock market rally has become a predominant one. The consensus view is we are several months away from an actual rate increase, but given the forward-looking view of the stock market, all eyes and ears will be tuned into the Fed's Jackson Hole conference at the end of August. The growing view is at that event or at the Fed's next policy meetings on September 16-17, Fed Chairwoman Janet Yellen could revisit her view on the timing of interest-rate hikes. Hopefully, Yellen will choose her words carefully, lest we have a repeat of when former Fed chief Ben Bernanke attempted to describe the conditions of when the Fed might taper its stimulative efforts back in May of last year.

We offer a word of warning. As we all recognize (and if you don't you should), what the market thinks to be true, at least near term, does become true. We also note that we've seen this relationship between stimulus and upward market movement outside the U.S. and you don't have to look farther than announcements concerning government stimulus in Japan and the upward movement in the Nikkei for validation.

For investors who would like to play with this theme elsewhere, South Korea recently announced a $40 billion stimulus program to help bolster growth, which could similarly be a boost to Korean equities. The WisdomTree Korea Hedge Equity ETF (DXKW) is a good way to take advantage of this trend as it uses currency hedges to neutralize the impact of exchange rate moves, holds 45 stocks and has a lower weighting to Samsung (only 10%) than many other ETFs.  Investors should be aware that while the Korean economy grew 3% in 2013 and is now forecast for around 3.7% growth in 2014, the economy is very export-dependent, with about 50% of its GDP coming from exports. This stimulus package is focused on boosting domestic demand, reducing the nation's dependence on exports.

On Aug. 14 the Bank of Korea meets again and may decide to cut interest rates, which have remained unchanged since May of 2013. If we go with the prevailing narrative in the U.S., this would also be seen as a boost to the economy and likely to Korean equities.

Meanwhile, tensions between Russia and the West over Ukraine continue to rise.   There is reportedly a buildup of around 20,000 Russian troops along Ukraine's eastern border. This has helped drive European markets to four-month lows with above-average volumes, never a good sign.

This caused a rather dramatic drop in the share price for Gazprom (OGZPY), the state-owned Russian energy giant. The stock is currently trading with around a 2.5 P/E and a dividend yield of more than 5%, making it one of the best-priced energy stocks out there. The median P/E for the major energy companies such as Chevron (CVX), Shell (RDS.A) and BP (BP) is around 13.6x with a dividend yield of around 2.7%. Gazprom is the fourth-largest provider of gas to U.K. businesses, including Oxford University and even the Chelsea Premier League soccer club.  Gazprom currently meets about 30% of Europe's gas needs, which means that even if the situation over Ukraine continues to deteriorate, it will be very difficult for Europe to resist Gazprom supplies for very long.

Eventually Europe may be able to shift to alternative suppliers, but this is not something that can be done quickly. Russia also closed a deal in May to supply gas to China worth nearly $400 billion. Equity investors must be willing to hold on through a potentially bumpy ride, given all the geopolitical realities, but at a 2.5 P/E the downside risk relative to the potential upside gains if and when everyone hugs and makes up makes this an investment worth considering. For those who aren't too keen on riding that equity train, Gazprom bonds are currently yielding more than 7% and given its balance sheet, its default risk looks better than a lot of other bond options out there that yield a lot less. 


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