While the “great black swan” event of 2008 has past, the aftermath has left us in a changed world. The investment landscape is more heterogeneous than in the past. From a global macro point-of-view, some economies are prospering, some are failing and some are struggling with the new realities. This presents a more complex set of opportunities and risks than we experienced historically. Indeed as we look forward "there are many wild cards in the deck" for 2011 and beyond which present challenges for even the most sophisticated investor. While we may form a position on the likely scenario going forward, we must keep in mind that these "wild cards" can show up at any time.
Inflation: A Contrarian View?
At least 90% of all investors polled expect inflation to emerge in the US economy. One only needs to look at a recent auction of treasury inflation-protected securities (TIPS) which sold at a negative yield to know where investor sentiment is on this issue. Imagine that, paying someone to hold your money and give it back later. It is easy to understand why most might hold this view. The monetarists' theory asserts that when the US prints money (particularly the high quantities that the Fed is today) then inflation follows.
I hold a contrarian view. In the US, deflation is a bigger risk and a much more frightening scenario to contemplate. We know how to deal with inflation and it’s not so bad in modest doses. On the other hand, if deflation gets entrenched, it is very difficult to contain (as Japan, ravaged by deflation for two decades, has learned) and can be devastating as asset values drop, family wealth disappears and leveraged assets (such as real estate) go underwater. Our current circumstances demand that we look beyond the simple monetarist theory. I believe that the Fed is very worried about this and it is one of the unstated reasons that they are printing so much money. If deflation gets traction, it can be very “sticky”; it acts like a spiral down.
In order to examine the contrarian argument one must look at the fundamental forces that influence the inflation rate. Such observations reveal many potent deflationary drivers in the US economy:
Unwinding The Credit Binge
The US economy is undergoing a massive deleveraging in the aftermath of a decades-long credit “binge” (consumers, banks/lending entities, investors & businesses: virtually all components of the private sector). Why are banks stingy with lending? It is because they are reducing the ratio of their loan portfolio assets to their capital (deleveraging). Consumers are paying down their credit cards and walking away from underwater mortgages.
In deleveraging economies there are more sellers than buyers; causing asset values to fall and final demand to decline. As aggregate credit contracts the economy shrinks. This is a very deflationary force. Seeing asset prices fall (real estate is, of course, the big one) buyers tend to delay their purchases, waiting on a lower price and not wanting to own something that will decrease in value. The purchase of a new home is typically accompanied by a surge in other consumer purchases (household appliances, tableware, furniture, insurance, etc.). So delayed asset purchases also decrease other consumer spending and this slack demand leads to a loss of pricing power by producers. All of this is a closely linked, integrated syndrome.
Real estate prices will be under long term pressure for other reasons: a big pipeline of forclosues, a large shadow inventory of sellers that have not yet put homes on the market, an increasing practice of homebuyers simply walking away from their underwater mortgages/homes leaving them vacant and owned by lenders and a huge inventory of unoccupied homes resulting from years of overbuilding (2nd homes and spec homes). Approximately 11 million homes in America are unoccupied at this time.
The situation is only slightly better in the commercial, retail and industrial sectors of the real estate market where a long period of overbuilding has left the US with excess capacity and a flat to negative absorption rate trend. We simply have too many stores, too much office space and too much industrial space. This surplus in real estate assets must be worked off over time, a process that is likely to take years.
The economy is flush with idle capacity (labor markets and industry) and weak final demand. This leaves producers without pricing power at the point-of-sale and backward through the supply chain (wages, facilities, suppliers, etc.). Unemployment is, perhaps, the biggest negative catalyst in our economic system. It is not likely to get better for a long time.
Commodities are the only area where prices are firm because they are portable between economies and elsewhere (emerging markets) on the planet demand is strong. However, the commodities component in the US inflation picture is overwhelmed by the other, larger forces.
Consumers are worried about the economy and businesses are cautious about expansion. Both are saving at unprecedented rates, rather than spending. Consumers in mainstream America are reigning in their spending and moving down market on item price points. This is not necessarily a bad thing, except that it means that the economy will not grow. Nothing will change on this in any substantial way until/unless there is an improvement in the unemployment situation, a scenario that looks quite unlikely. However, we can expect a modest improvement in spending in some of the better-off consumer categories as people have become a little less concerned about losing their jobs and are a little more optimistic about the future.
A Mixed Landscape
While America and the EuroZone may face deflation, those nations that have growing economies (China, India, Brazil and other Emerging Nations) face inflation pressures. Even in the US it will be a mixed issue since we are likely to see prices firm or up in some categories (energy, agricultural commodities and industrial metals (iron ore & copper). On the other hand… housing, labor, consumer & industrial goods and other items are likely to see falling prices.
Currencies: a Growing Issue
What will happen to the US dollar? What will happen to the Euro, the Yen and others?
To be sure, this is a growing issue between nations. There is growing talk of “currency wars” as some endeavor to keep their currencies from rising or to lower their value in order to help them compete in the world markets…so that they can keep their own domestic economies healthy.
Except for the rare economies that have capital controls and/or fixed exchange rates (China, Saudi Arabia and a few others) this is a futile effort. The world’s markets will move the exchange rates as they wish.
If the USD was not the world’s reserve currency, it would decline severely. There is little to support its value from a fundamental stand point (profligate government spending, public debt, weak economy, unfavorable trade balance, etc.) Offsetting this is the international demand for US dollars. Oil is bought and sold in dollars across the world. The same is true for most other commodities. When mines in Australia sell/ship iron ore and other industrial metals to China, Japan and Korea they are paid in US dollars. This creates a demand for US dollars and our Fed is happy to print more to serve the needs in the growing parts of the world.
Perhaps the biggest driver of the dollar’s direction is the level of fear and uncertainty in the world. When fear rises, money flows into the USD. When fear wanes, the dollar falls (as it is driven by unfavorable fundamentals). If there is a break out of war on the Korean peninsula, the dollar will move up. If more European nations (Portugal, Spain, and Italy) fall into financial jeopardy, the dollar will rise. In the absence of these, the dollar will fall…particularly against
Emerging Market currencies of nations that have political stability. Near term, that is the most likely case.
When one contemplates the direction of the US dollar, it is essential that we ask “versus what?” With currencies, it is a relativity issue. The US dollar may hold its own or strengthen against the Euro, Pound and Yen…but weaken against the Asian currencies (e.g. Singapore, Indonesia, Korea) and natural resources-rich nations such as Australia, Brazil, Norway, Chile and Canada.
In an economic paradox Germany, the world’s second largest exporter (only last year passed by China) is benefitting greatly from a weak Euro, dragged down by other troubled European countries. The favorable exchange rate has boosted the competitive position and profitability of its industries (autos, industrial/equipment, chemicals, pharmaceuticals, etc.).
A huge amount of the support for the US dollar also comes from the economic fear that is widespread across the planet…largely resulting from the credit/liquidity crisis of 2008, but now exacerbated by the financial crisis facing Europe. This fear drives capital into “safe havens” and the US is the primary beneficiary. If fear wanes and an appetite for risk returns, capital will flow out of the USD and its value will decline.
The Euro is doomed!
The biggest risk to the world’s economy is Europe and the Euro. In my opinion it is highly unlikely that the euro will survive as a currency. The economies, political conditions, financial strength, and values of the different nations that make up the union are simply too different. The huge public debt load of the Club Med countries, Ireland and others is an overwhelming burden that cannot be solved without massive restructuring. Currently, member countries are happy to “kick the can” down the road and implement austerity measures in an effort to solve the problem. It will not work and eventually they must face the fact that the debt cannot be repaid. In Ireland, the public debt load is about 170,000 euros ($220,000) for every man, woman and child. There is no chance that bond holders will get paid in full. In Greece, the austerity measures, high taxes and declining economy are causing a massive exodus of businesses, wealthy families and investment capital. The problems of Greece and Ireland, with Portugal, Spain and Italy at risk promise contagion across the region as European banks are forced to write off sovereign and other debt, leaving their balance sheets wasted in the process. If they had their own currency, they would devalue it, but they are lock stepped together which limits their individual options. The EU will vigorously defend the euro, because unwinding it would be traumatic. However, ultimately the huge challenges of defending it by the few strong nations may mark the demise of the currency.
This is not a good scenario for the world as we are all interdependent to some degree.
Bond Market/ Interest Rates
In most of the world’s markets interest rates are determined largely by market conditions (credit quality, duration, currency risk). Rates in the US have been pushed down artificially by public policy initiatives of the Fed. While this is an effort to stimulate the economy, it is also self-serving in that the Fed’s big brother, the US Treasury, is the biggest borrower on the planet. So the Fed & Treasury want to keep borrowing costs low in order to feed the huge deficit spending activities of our government.
The other motivation is to avoid exacerbating the mortgage and banking crisis. If interest rates were to rise, more mortgages would go under, foreclosures would accelerate and the hit to bank balance sheets would be devastating. Even now, if these mortgage assets were marked to market values, perhaps all bank capital would disappear. Therefore, we can expect that monetary policy will continue to be “accommodative” for years to come. Also holding down rates is the fact that there is little private demand for credit, due to sluggish economic growth and the deleveraging of the consumer sector and lending institutions.
The mood of the Fed may be changing, however. Many members are becoming more conservative and the three new members expected in 2011 will probably be conservative leaning, thus Bernanke strategy may come under pressure. Furthermore, QE2 may be his last instrument for holding down rates. Then the market, a much more powerful force, will take over.
Investors are now confronted with a dilemma: US Bonds with investment grade credit quality pay very little yield. To get yield, investors must go out on the maturity curve to longer durations. That territory is loaded with risk since rates are near decade-old lows. If rates go up, bond prices will drop like a rock. If they invest in short duration instruments, the yield is paltry. Bonds with lower credit quality have had a good run as the economy has improved and liquidity has returned to the capital markets. However, it is likely that such gains have come to an end. The great bull market for bonds is likely to be near its peak.
A cautionary consideration regarding this belief is that, if deflation becomes entrenched for an extended period of time, bonds could appreciate, even from this elevated point.
One possible answer to this dilemma is to invest in foreign bonds that trade at market rates without excessive public policy manipulation. While one must have the “stomach” for currency risks, intelligently placed bets offer a currency attribution opportunity that can add to the returns of those international bonds…and provide diversification away from the US dollar. However, one must be very selective in the selection and vetting of such foreign bonds.
Will The European Union Implode?
Perhaps the biggest risk facing the markets and the world economy in the near term is the financial instability of the Eurozone. In that arena there is a lot to be concerned about. Earlier we addressed the euro’s risks, but the region’s economic challenges go well beyond its currency. For the most part the economies of old Europe are inefficient, uncompetitive and burdened by restrictive labor laws, a profligate welfare system, declining fertility rate and a population that values leisure more than work effort and entrepreneurial initiative. It must be a huge concern that the contagion of this economic disaster spreads from Greece to Ireland, to Portugal to Spain, to Italy…and brings down “the Union”. There can be no question that this leads to a bad outcome.
Germany is the lone exception. They make good products, work hard, have conservative economic values and are one of the most amazing exporters on the planet. Think of a nation only one third larger than the size of Ohio that is so productive and competitive that they out-export the United States, Japan and stand equal to China. The time will come when they grow weary of propping up retirees in Greece and the other people enjoying the good life in the club med countries of the European Union. If the “sugar daddy” pulls out, the euro sinks. Eventually, they will want the deutschmark back.
Is China a “Bubble”?
Many say “China is a bubble.” I have a contrasting view. My opinion is that the growth of China will continue for decades. Perhaps not at the same rate but certainly at a very high rate compared to the nations of the developed world.
The reasons for this are simple and powerful:
1. China has a strong balance sheet. It has no sovereign debt, a huge trove of foreign reserves and substantial natural resources (although it has little in the way of oil reserves).
2. Its people are hard-working, industrious, self-reliant and entrepreneurial.
3. The middle class is growing rapidly. According to the IMF about 300 million in China can be classified as in the middle class. Their way of life is getting better and they have an optimistic view of the future.
4. Chinese consumers are unleveraged, most have zero debt. They rarely use mortgages when purchasing real estate and most do not have credit cards. On the rare occasions when they purchase a home with mortgage financing, they must put down a minimum of 30 percent.
5. The consumer economy is beginning to “boom” in China. Retail sales are growing at the impressive rate of 18% annually and every major retailer across the planet is opening stores there. Demand is very strong. China auto sales this year were 16 million units vs. 10.5 million in the US and they are not just buying small inexpensive cars.
6. Government policy action is very constructive for the economy. In America, stimulus to fight the downturn flowed mostly into unemployment benefits, bail-outs and other spending type uses of the funds. China also deployed a “stimulus” but it was an “investment” type of expenditure…putting funds into infrastructure, modernizing the power grid and building power generation facilities, expanding the school system (and building new universities), upgrading the communications network…and many other things to make the China economy more efficient and more competitive. China has a long term view and it’s recently announced 5-year Plan is a very thoughtful roadmap for the future.
7. In spite of its communist political system, the Chinese government is very business-friendly. It will often support or partner with private enterprise on development activities and, for the most part, will allow companies a great deal of freedom from burdensome regulation. Things tend to get done fairly quickly without a huge debate.
Despite these positives, any investor in China or business entering that market should be aware that you are “playing on their home court…by their rules”. A Western investor or business man would be naïve to approach their endeavors without understanding the differences in the cultural, business practices and the political/legal system.
Certainly, China is not without risk considerations also. The rapid construction rate is not sustainable over the long term and will surely slow. Real estate prices could decline, but because buyers typically do not finance their purchases, there is virtually no chance of a mortgage market driven collapse such as occurred in the US and some other developed nations. There is also a legitimate concern over the aggressive lending practices of China’s regional banks. This could lead to a problem, but because they are state owned, a collapse is unlikely. The government recognizes these risks and is in the process of tightening controls on speculative activity while moving forward with infrastructure investment at the same time (95 new airports, 200 new universities, a fast rail system to interconnect key parts of the country, power generation and grid, etc.).
China is not alone in this track to prosperity. Much of Asia (ex Japan) is on a similar trajectory. Also, other developing/emerging nations are also on a very positive track (Brazil, India, Israel and others). Even some “Frontier Nations” are showing good economic growth. What they have going for them is that they are relatively unleveraged with consumer or public debt, have strong growing middle classes, people with a strong entrepreneurial work ethic, have little legacy entitlement social welfare programs and supportive governments. The emerging story of these countries is less today their export dependency (and competitiveness) but the strong growth of their internal, domestic economies.
The Equity Market Outlook
My general opinion is that the equity markets will move up in 2011. A key consideration is investor’s appetite for risk. We have been in a period where that appetite has been low for a few years now. Investors have been “hunkered down” primarily focused on capital preservation strategies. That is beginning to change. There is a huge amount of money on the sidelines, earning essentially nothing. The flood of money into the bond market has caused it to be overbought. If bond prices start to fall, there will be a “stampede for the door” which will accelerate the decline. We may look back on this as a “bond bubble” in the future. A significant portion of those funds will move into the equity markets…which now look comparatively inexpensive.
While there is trouble brewing in Europe, the US economy is showing a few signs of firming. Economic data is showing a positive trend. No one reasonably expects a strong recovery, but likewise the threat of a “double dip” seems to be waning. This makes investors more comfortable moving into risk assets.
We are also seeing volatility decline. The VIX (volatility index) has dropped from a peak of 60+ to 17.25 over the last two years. This signals a drop in the anxiety level of investors and therefore, a move to equity exposure.
While many companies are stuck in neutral, many are financially strong and beginning to show top line growth. Among the vast number of public companies there is a cohort that is doing incredibly well. So some observers look at the correlation of S&P stocks at 80% and say, there is no way to add alpha by stock selection (which has been true for large funds limited to S&P market cap size companies). However, it is not true across the wider spectrum where many excellent companies are prospering, while others struggle. Share prices are now making this distinction. Furthermore, within the large cap sector, it seems likely that the correlation trend will reverse going forward as fundamentals are beginning to drive market prices once more.
With stock prices trading at reasonable levels (most estimates put the S&P 500 at a 13.4X multiple), the aversion to risk showing some signs of waning and capital beginning to move back into the market from the sidelines, there is good reason to expect equities to move up in 2011.
As a prognosticator, I would expect the stock market to be up at least 15% by the end of the year.
Most investors share a common view of the principle risk factors that form part of the landscape as we move forward in 2011. Bear with me to list them.
1. Expansion of the financial trauma in the Eurozone.
2. Deceleration of the growth engine in China, lessens its effect of lifting the world economy
3. Financial problems of US State & Local governments may magnify
4. Fed policy of accommodation may shift with the likely addition of three new conservative members to the Board (filling vacancies).
5. Unemployment may move back up over 10%
6. Geopolitical risks from rogue nation actions (N. Korea, Iran, etc.) or a growing realization that we will not succeed in Afghanistan.
7. Terrorist attacks
8. Public policy changes arising out of political power shifts.
Even though the credit crisis has past, we are reminded that we live in a world with many dangers.
Investment Themes and Strategies
Reflecting on the landscape conditions discussed above, the question becomes “What action should an investor pursue in this environment?” The following are a few thoughts on that matter.
1. In an environment that presents a higher degree of uncertainty, it is best to maintain a higher degree of flexibility (less illiquid exposures). It is also a good idea in the actively managed part of portfolios to place funds with skilled managers in structures that provide those managers with decision making flexibility. Obviously long-only funds in equities, bonds or other asset classes do not have this attribute, since they are pure directional “bets” that cannot dynamically adjust market exposures when conditions change. The hedge fund structure does provide this flexibility.
2. Currency exposures have become increasingly important in investment strategies. It seems wise to diversify away from the USD, Euro, Pound and Yen (currencies of nations with very high sovereign, consumer and bank debt) and gain exposure to currencies of economies that have low debt, solid growth, abundant natural resources and are competitive in the world markets. One could also trade weak currencies short, or pair-trade them against more favorable currencies.
3. Investors should lower their interest rate exposure. With treasuries selling at decade long highs the risk is elevated that long bonds could steeply decline in value if interest rates rise. With bonds being massively over bought any movement of capital away from this asset category (as we have seen in the last week or so) would bring prices down quickly. So it is time to be cautious about longer duration bonds.
4. As an alternative to fixed income exposure (that has interest rate risk), seek exposure to absolute return-type hedge fund strategies with low equity beta characteristics (low market correlation). There are a wide range of hedge fund strategies; some which are correlated to markets to varying degrees and some that offer little or no equity or bond market exposure. The latter offers a portfolio alternative, which is a proxy for bonds, but without exposure to interest rate cycle risk. Such strategies seem attractive in market conditions such as is likely to exist in 2011.
5. The likelihood that equities will move higher in 2011 implies that investors should maintain some good degree of equity exposure during the year. While there are a number of “wild cards” out there that could “spook” the market, the trend seems toward more stability and therefor more accommodative for risk (the VIX has been on a trend down for the last two years). This should favor equities as investors move away from low yielding “safe” assets.
6. While there are a good many “bottom fishers’ in the real estate category, I believe that it is unlikely that there will be any rebound in prices for many years to come. So, keep exposures low and heavily targeted in this asset class. Investors should select investments in real estate for income purposes, not appreciation and should have a long term investment horizon.
7. In the private equity sector favor buyout funds over venture capital, unless you are able to gain access to top quartile funds. As always, in this asset class, manager selection is critical since performance spreads are very high in this industry.
When forming a view on the direction of the economy or the markets, an investor must always ask themselves “What if I am wrong?”. For that reason it is important to examine multiple scenarios, even those that one believes are less likely. It is a part of good investment discipline.
On the downside, there is a measurable risk that the sovereign debt crisis in Europe accelerates during the year, reaching crisis proportions. This would drag down the world economy and adversely impact the markets. Austerity action by troubled countries may not work. In fact it may have the pejorative effect of exacerbating the problem by throwing those economies into a downward spiral.
The mood of US and EU investors (particularly individuals) remains quite pessimistic. The evidence of this is everywhere you look. There is an unprecedented amount of investment capital on the sidelines (earning nearly nothing). The bond market for the highest credit quality securities (US Treasuries) is at a decades-long peak. It is an extremely crowded trade. Any negative event (skirmish in Korea, financial troubles in Ireland, etc.) leads to a big rush into “safe haven” instruments such as treasuries or gold. Projections for the US economy are very weak and worries are high that the economy will sputter once the stimulus winds down. No one believes that a recovery might be poised to perform better than expected.
That might be wrong. It is possible that the recovery might go better than expected. Even if it follows a weaker track than other post-recession recoveries, it could surprise many investors and observers. Perhaps the biggest driver of investor psychology is unemployment. If unemployment improves more than expected, the stock market will take off. Retail sales during the upcoming holidays may surprise the markets on the upside. Consumer confidence has been steadily improving. If this scenario unfolds, investors will be fearful of getting left behind. All that capital on the sidelines, earning near nothing will get tired paltry yields and move toward equities boosting the markets unexpectedly.
Nevertheless, we are navigating through “uncharted waters” where there will be a much higher variability in performance among asset classes and strategies. The macroeconomic landscape is more complex and demanding for investors.
Perhaps 2011 will show some improvement in the US economy, but our obdurate political leaders have not faced up to the longer range, fundamental issue that public sector spending is simply out of control and not sustainable. We are putting off the pain of doing the right thing today to push our problems down the road into the future. As John Henry Boetcheu said in 1016 “A nation cannot spend its way to prosperity”.