Thursday, December 18, 2014

Santa Claws...

December has proved to be anything but the fluffy end to the year that most were hoping for, particularly after a strong performance in November which sent many markets through yet more all-time highs.

So far this month we've had - in no particular order - a plummeting oil price, a stronger USD, a submergent Rouble and Russian stockmarket, re-emergent political risk in the Eurozone in the shape of Greece, poor economic data from Germany, China and Japan, and worries over a more aggressive Fed stance on interest rates.

It's instructive that, as noted in this week's edition of "The Economist", the last time  a number of these things were in similar alignment was shortly before the 1998 Emerging Markets crash. A strong USD, a strong US economy contrasting with weakness elsewhere, commodity price weakness, deflation in Japan, etc. The recent rally in US stockmarkets also has parallels in the market run up before the dotcom slump of late 2000, even if valuations today are not as stretched.

The one big difference this time round is that in reaction to the LTCM collapse of 1998, the typical central banker's response was to cut interest rates: not an option that's readily available this time round with interest rates hovering barely above zero in most developed economies.

Whilst we feel that this month at least, the sell-off looks overdone and should be bought back into, there is room for concern next year, and that the potential for mis-steps correspondingly greater. The core points on which to focus will be:

(1) US interest rates - On this we are more sanguine than we are on much else. The Fed has been every bit as consistent in its message about 'focusing on the data' as market commentators have been every bit as inconsistent in choosing to misinterpret that message. Yesterday's comments from Janet Yellen merely underscore more of the former - interest rates will remain low for a while and these will only change when the data does. Since lower oil prices and a stronger dollar are dis-inflationary by definition, the signs are that inflation will be held in check for the next 12 months or longer. Interest rate policy will therefore take this into account, by focusing on more of the same.

(2) Growth - Central banks in the Eurozone and Japan will have their work cut out for them in the face of politicians who talk a good game but seem unable to balance the need for stimulative policies with structural reforms. In Japan, much will rest on Prime Minister Abe finally getting to grips with the latter in the face of entrenched structures and opposition from various interest groups. In Europe it rests on the German government finally acknowledging that the Eurozone will cease to function if it does not give some of the peripheral nations some breathing space as they struggle to cope with high structural unemployment. The odds in favour of a return of the Eurozone crisis in 2015 look high.

(3) China - Unlike 1998, China will be a big swing factor for Emerging Markets in 2015. A sniff of easing has resulted in the local market in Shanghai surging by a 1/3rd since the beginning of October, but the benefits of such easing need to be reflected in improving data, which - so far - we have not seen.

(4) USD - The rise in the USD, if continued, will cause significant issues for many markets from Russian through to Brazil and foreign borrowings become more expensive to service and repay. Whilst the size of offshore borrowing is not as extreme as was the case in 1998, it still has the potential to cause problems.

(5) Geo-politics - This seems to be an example of a Rumsfeldian "known unknown". At what point, for instance does Vladimir Putin choose to either reverse course or double down in his so far fruitless confrontation with the West. History is replete with examples of leaders who, when pushed into a corner, react in extremis. There are however very few examples of leaders who recognise that costly mistakes have been made and that the only course is once of moderate compromise (largely because admissions of failure tend to be career ending). With the Eurozone economy in disarray, the opportunity for macro mischief making is high.

(6) Valuations - Global stockmarkets and the US market in particular - have benefited from a liquidity driven re-rating. Corporate share buy-backs have contributed to this. In 2015, we will arrive at a point at which the beef needs to be produced - on a global basis - and earnings from higher revenues need to start showing through. Whilst this seems likely to come through in the US, the position elsewhere is more difficult to predict.

(7) Oil prices - Lower oil prices are a positive for the major economies which are net consumers of oil, even if oil dependent producers such as Russia, Iran and Venezuela pay the price.  However, the sharpness of the recent move will throw up risks in debt markets at a  sovereign and corporate level which could likely bleed into other asset markets as risk appetites fall overall.

The net result of all the above is that we enter 2015 with a sense of much greater caution. Although low interest rates will remain in place and therefore continue providing support for markets on an opportunity cost basis (in this scenario equities remain the least unattractive option), it is clear that volatility will be much higher as a result of enhanced tail risks. Strong stomachs will be needed, and this will argue in favour of gradually increasing cash holdings to take advantage...



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Monday, September 22, 2014

Moody Blues

Perhaps we're overdoing it, but it seems that the biggest danger to markets is not so much the issue of interest rates or economic cycles but a generalised feeling of dissatisfaction - even grumpiness. This is manifesting itself in a myriad of different ways:

(1) Short term squabbling between global politicians of all different stripes as they jostle for short-term advantage, whilst their electorates are ever more disconnected from what is increasingly seen as a self-serving political process,
(2) A "recovery" that has been seen to benefit a limited few at the expense of the many
(3) A lack of willingness to address longer-term structural issues which simply increases the longer term costs of addressing such issues
(4) A host of geo-political brushfires which, taken separately, have a negligible global impact, but when taken together point towards a shortage of the leadership momentum that has been so important in keeping such issues under control since the end of WW2.

If you take all these issues together, you have a situation in which the "system" is creaking under the the cumulative weight of dissatisfaction and the possibility of a self-inflicted, knee jerk short term shock rises significantly. Grumpy or stressed investors will react more emotionally than they otherwise would. Bear in mind also that leverage within markets is fairly high - the Asian fixed income market is heavily supported by investors who have relied on cheap debt as a means of plying interest rate arbitrage - and therefore potential margin selling on any correction will magnify selling volumes. Remember too that, unlike the early part of 2008, the ability of banks to provide market making capacity in the fixed income market is now much more heavily constrained by capital a regulatory restrictions.

Our stance on stockmarkets has been that these continue to be the default investment option if only because the alternatives: cash, bonds, commodities etc., look much less palatable. However, we also know that when markets have risen for a long time, nervousness around the central theme of "how much further can they go?" increases, regardless of whether or not they continue to provide reasonable investment value.

We seem to be edging closer to the point at which markets could indulge in a period of self-inflicted blood letting, which is likely to be short but sharp as we have seen on previous occasions in  2011 and 2013. The catalyst seems likely to be political: the US mid-terms at the beginning of November will end an uneasy short-term truce between Republicans and Democrats, and if the former take control of the Senate, their objective will be to reopen old wounds over the debt ceiling and the budget. Remember the "fiscal cliff"? 

In the background will be political rumblings in Europe and the UK, which will once again call into question the integrity of the EU and the Euro.

When that happens, Asian and Emerging Markets will get hit hardest (because they always do), since the combination of falling markets and falling currencies will mean bigger declines for foreign investors, and therefore faster moves for the exit as a way of preserving capital. Obviously such moves are self-defeating unless you are one of the fortunate few to have moved early.

The point here is that overall risks are rising, even if the alternative to investing in stockmarkets is non-existent on anything other than a very short-term view (which would favour cash, and specifically USD's). It's obviously going to be impossible to predict the exact timing, so perhaps investors should start adjusting their risk/reward expectations over the next six months: accepting the lower returns that come from holding more cash or very conservative fixed income products, in the interest of preserving longer-term value.

To say that this will be a tricky act to pull off is an understatement, but the downside risks are certainly larger than they have been for a very long time, and prudence suggests that a gradual increase in cash weightings over the next few months would be sensible.

Does this now mean that we think the "perma bears" now have a point - after at least 3 years of howling in the wilderness during which stock markets have risen by a third or more? Even a broken clock is right twice a day...



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