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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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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Javelin Wealth Management supports the global microfinance philanthropy initiative, the education charity,, and the Singapore Children's Cancer Foundation, New clients to the firm can nominate any or all of these charities for a donation we make on their behalf.