Wednesday, August 27, 2014

The rout of the doomsters - it's all about credit spreads

I have a grudging degree of admiration for the doomsters who continue to forecast that significant falls in global stockmarkets are mere months away. One of the more high profile ones was on Bloomberg TV the week before last predicting exactly that. The trouble is, he's been predicting exactly the same thing since the back end of 2012, since when global stockmarkets have risen by a mere 37%. At the same time, the guy's been a long standing bull on gold, which has fallen by 22%. 

I can only assume that he hasn't followed his own advice and been short equities and long gold, since if he has, he'll be feeling a little battered and also a little lighter of wallet.

It does however, beg several questions:

(a) Why have people like Mr. Doomster got it so spectacularly wrong for such a long time,
(b) Does anybody still give any credence to these views, and, more importantly,
(c) What would it take for guys like him to be proven right...?

On (a), Mr. Doomster and his ilk would seem to stubbornly refuse to acknowledge any validity in John Maynard Keynes's alleged observation on being criticised for "flip-flopping" (although it wasn't called that then), "When the facts change, I change my mind. What do you do Sir....?".

Although economic growth remains relatively anaemic, especially in Europe and Japan, actions by central banks around the world since 2008 have certainly staved off the implosion of the financial sector, propped up credit markets, and helped economies to move out of recession more quickly than they would have been able to be able to do on their own. 

On (b), It is not to say that it's all been rosy, and this is the reason why the Doomsters are still given a hearing: the radical and unusual measures adopted by global Central Banks have not yet had the widespread effect that were hoped for. The level of government debt is still unconscionably high in many countries, the uncertainties created by ballooning central bank balance sheets have not been dealt with, unemployment levels - especially among the young - are socially and politically toxic, low interest rates have not resulted in companies increasing long-term capital expenditure by any significant measure (so far), and corporate earnings growth still looks fairly thin.

However, it's extremely difficult to extrapolate these difficulties into anything approaching the conceptual melt-down forecast by the Doomsters. A short-term sell-off caused by profit taking after a long run-up? Maybe. A major melt-down, however? For that we think there would have to be a qualitative change in the global economic environment - and that looks very unlikely. The risk is, we think, that the Doomsters' continued focus on the negatives ignores the proverbial elephant in the room.

And what's that?

We are regular reading of Grant Williams' "Things That Make You Go Hmmm..." which is now published by Mauldin Economics. Grant's weekly (see   is always worth reading for its thought provoking analysis, even if he does harp on about gold a little. This week however he included a piece from David hay of Evergreen in Seattle, which gave this gem:

"Very recently, though, another piece of the puzzle of where we are in the market and economic
cycles has fallen into place. This involves the exceedingly vital element of credit spreads.
For those who are perplexed whenever they read this term in the financial media, or hear it
bandied about on CNBC, it’s actually a most simple metric. It is merely the difference between
the yield on US treasury bonds and non-government debt of the same maturity."

"Up until the end of July, credit spreads were continuing to tighten as they have done
persistently since March of 2009, with a few hiccups along the way. There is little doubt this
tremendous spread compression has played a crucial role in levitating stock prices and many
other risk-assets as well."

"As I’ve conceded before, I really haven’t given the devil his due in this regard. While I’ve
repeatedly carped that the Fed’s serial QEs have failed to achieve their main goal of lowering
mortgage rates, I’ve failed to emphasize how successfully our central bank has crushed credit
spreads. This process has been a prime catalyst in forcing investors to venture into areas they
would normally avoid, like the gamiest stocks and bonds, in search of higher returns."

It is this issue - credit spreads - that I think Doomsters are wilfully ignoring, and it is this issue which has been the reason why they have managed to get their call on the markets so wrong. 

On (c), It is also this factor that will need to change before they have a chance of being proved right.

....and when's that going to be?

Recent commentary from the Fed and the Bank of England are suggesting the the US & UK will be the first to start implementing interest rate increases as their economies continue with steady expansion. In advance of this happening, markets will fret about the effect that such higher rates will have: the last time this happened back in 2011, markets fell by 10% or more in the space of 2 months (before recovering).

Since then, economic growth has been patchy - reasonable in the US, UK and Asia, poor in Japan and generally awful in the Eurozone. 

Even in the US, interest rate futures are pointing towards and eventual rate level of just over 3% for Fed Funds. When you compare that with zero, that's a big jump, and if proved right would hit the bond markets hard whilst they adjust to this new paradigm. However, in absolute terms, a rise to the 3% level still seems pretty small. It's also worth noting that this figure would only be reached if central banks felt that growth was strong enough to withstand such gradual increases. The key here is "gradual", which is a word that could almost be engraved onto the Central Banking plinth these days. 

Whilst the US and the UK might conceivably start edging rates up later next year, it will be so gradual as to make a snail feel that it's breaking the sound barrier by comparison. Conversely, the Europeans and the Japanese will be resolute in resisting rate increases for some years to come.

The issue of narrow credit spreads therefore means that the choices to investors will remain limited and still driven by the attractiveness of the least worst: equities might have run up a long way and might no longer look particularly cheap, but compared with the alternatives of cash, longer dated bonds, commodities, property etc., equities still look way more preferable.

We don't see that changing for the remainder of this year, and therefore we continue to base our approach - simplistic as it is - on an assumption that the Doomsters will be just as wrong this year as they have been for each of the last 4 or so.



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Thursday, August 14, 2014

Second half telescope...

In our weekly asset allocation meeting today, we mulled over our model portfolio positioning. At present, we have 37% of our equity choices allocated to the US, 28% to Europe, 21% to Asia Ex Japan, 10% to Japan. This  means that we are underweight the USA (almost 48% of global market cap), overweight Europe (23% of global market cap) and heavily overweight Asia Ex Japan (8.4% of global market cap.).

This underweight in the USA cost us last year when the US market took off, whilst the overweight in AAXJ was painful when Asian markets did nothing, shrugging off their past track record as the high beta play on global growth, which would have normally meant that in any such global "growth" pick up, Asian markets - being export focused as they are - would outperform. In the event, in 2013, they did the exact opposite, and underperformed badly (by more than 20%).

Why was this?

Firstly, the growth in the US & Europe was more financial than real - cheap interest rates were a function of relatively low risk appetites and sluggish growth, and simply encouraged portfolio investors to venture more aggressively into equity markets in the chase for yield. In so doing, they opted to stay close to home, and ignored the charms of emerging markets: why take the additional currency risk when cheap domestic interest rates meant the story would be domestically focused?

Secondly, low interest rates exacerbated the structural problems of Asian & EM's where an excessive focus on fixed capital investment over many years had paid little heed to the prospects for returns on that investment over the cost of capital. This resulted in excess capacity in a number of areas (Chinese property, steel manufacturing, commodities etc.), and not enough capacity elsewhere (resulting in labour shortages, rising wages etc.). 

The effect on markets was clear, since these were still dominated by the growth drivers of old - banks, property companies and state owned enterprises - where the problems of excess capacity were most acute. Conversely, those areas in which growth was still respectable were under-represented, and thefore difficult to invest in.

This meant that concerns about potential rises in global interest rates hit Asian & EM markets hard, leading to capital flight and plunging currencies.

The story in 2014, so far, has been rather different. US, European and Japanese markets are either flat or down for the year, whilst Asia and some EM markets are up (in India's case, by more than 22%). 

Again, this seems counter-intuitive, since over the same period, the Developed Markets are down on the back of more sluggish than expected growth, and over worries over geo-politics. Asia however seems to have shrugged all of this off and has focused on its home grown growth dynamic.

Again the real story is rather more nuanced. The poor performance in Asia and EM markets in 2013 was partly due to the lack of any significant impetus for badly needed economic reforms: low global interest rates meant that companies had plenty of capital available at low prices and therfore did not need to worry too much about the cost of that capital. The sharp sell off in mid-2013 - caused by a short-lived panic about global interest rates - drummed home that this complacency was both ill-advised and systemically dangerous.

In 2014 however, the reform agenda has moved front and centre in India, China, Indonesia, Korea, and to a lesser extent in Malaysia and Thailand.  This suggests that the usual penchant for global asset allocators to lump Asia and EM together is mistaken - Asia's moving ahead more smartly as a result of "getting it", whilst other EM regions such as Latin America and parts of Africa are still stuck in discredited business models of old and remain too reliant on hot money flows. 

Also highlighted is the tendency of many investors to view Asia through the prism of their experiences in 2008 with crashing western property markets etc. This as caused them to be far more negative on some key markets in Asia than is justified. 

Take China. 

A few weeks ago, I was on CNBC with a fund manager who was patched in from the US. His view was that China was about to slide into a property driven collapse that would crash its financial sector and with it the Chinese markets. I disagreed on the basis of a much simpler analysis: government reforms were progressively working their way through the system which would make the over-supply of residential property much less of an issue outside of certain peripheral areas. The core coastal markets and those in the major inland cities, such as Beijing, would thefore be a lot more resilient as a result of reforms to previously very restrictive ownership and residency rules. Predictions of a crash therefore seemed unduly alarmist, and ignored the fact that the market had - in my view - already discounted much bad news.

Since then, these very same marklets have actually risen by about 15%. Perhaps painful for CNBC's US fund manager whose portfolio was probably short.

This anecdote merely serves to highlight that global markets last year and this appear to be driven more by regional issues rather than global ones, and Asia's looking more attractive as a result. Obviously it will be vulnerable to a significant uplift in interest rates, but it is increasingly looking as though rates in the US, Europe and Japan could remain lower for much longer than punditry suggests: current economic data is pretty sluggish as shown by recent figures from the Eurozone and Japan.

Another comment came this week from another well-known perma-bear who - once again - was making dire predictions of a 10% to 20% crash in markets by year end. If geo-politics swirl out of control I suppose he could be right, but it seems unlikely if the current status quo is maintained. There remains too much money sitting on the sidelines looking for any sort of yield to believe that his predictions this time round will be any more successful than the same ones he's been making every three months or so for the last three years: that sidelined cash moves back into markets too quickly (even if it can prove a fickle supporter).

Lower global rates and on-going reform combined, produces a compelling argument in favour of Asian markets, which still have some catching up to do after their underperformance in 2013.

On that basis, we're comfortable with remaining overweight in equities generally, whilst retaining our overweight in Asia equities specifically. We will however, be trimming our European equity overweight slightly in the face of weaker data, and ahead of forthcoming Eurozone banking sector stress tests. This could change if the ECB rides to the rescue with a Euro version of the Fed's QE, but at the moment Mario's horse is still tied up in its stable and seems content to remain so for a while.



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