Market commentary

‘Dancing around the Fire of Hell.’ 

Byron Wien's close encounter. 

For years I’ve been telling you that the accumulation of debt was going to be the ending of the developed world and for years you have been telling me my views are too extreme. The problem is you are an optimist and I am a realist. You go around with a smile on your face thinking that there are serious problems facing us, but that everything will turn out favorably because the policy makers will do what they have to do to avoid disaster, and so far you have been right. The developed economies and their stock markets have plodded along and investors haven’t made or lost much money in spite of the challenges. At a certain point, however, the temporary measures that the policy makers put in place to avoid financial catastrophe prove insufficient and that’s where we are now. I’m not saying that it will happen tomorrow but events are falling into place that will take the smile off your face.

The Smartest Man is a Firedancer

When the New Democracy party in Greece defeated the anti-bailout Syriza, I was anxious to learn what The Smartest Man in Europe thought of it all.  The next day I flew across the Atlantic to meet him and we had a long discussion about the world financial outlook.  


Many of you remember The Smartest Man from earlier essays; I have been writing about him annually for more than a decade.  He has been a friend for thirty years, and during that period he has shown an almost uncanny ability to see major events affecting the financial markets before other observers.  Among these were the fall of Japan as an economic power in the 1980s, the economic changes in China and their significance the early 1990s, and the serious consequences of excessive borrowing in the developed world in the last decade.


His DNA endowed him with a certain amount of business acumen.  His ancestors operated canteens along the Silk Road, selling food, weather protection and supplies to travelers to India and China.  He apprenticed in finance in New York, but returned to Europe to take advantage of opportunities created during the post-war recovery there.  Along the way he has acquired the ABC’s of European wealth – an airplane, a Bentley and a house on a Cap in the French Riviera.  The depth and breadth of his art collection is impressive, but material things are not what gives him a high.  He gets his thrills from identifying a problem, thinking it through and being right in determining how it gets resolved. In his ninth decade, he is an inspiration to me.


He started out by saying he had done some preparation for our visit.  “I think the title of your essay should be ‘Dancing around the Fire of Hell.’  For years I’ve been telling you that the accumulation of debt was going to be the ending of the developed world and for years you have been telling me my views are too extreme.  The problem is you are an optimist and I am a realist.  You go around with a smile on your face thinking that there are serious problems facing us, but that everything will turn out favorably because the policy makers will do what they have to do to avoid disaster, and so far you have been right.  


The developed economies and their stock markets have plodded along and investors haven’t made or lost much money in spite of the challenges.  At a certain point, however, the temporary measures that the policy makers put in place to avoid financial catastrophe prove insufficient and that’s where we are now.  I’m not saying that it will happen tomorrow but events are falling into place that will take the 
smile off your face.


“The problem is that most investors think incrementally.  They don’t step back and look at the whole landscape, which includes how we got here and where we might end up.  In democracies the people always want the government to do more for them, but they don’t want to pay higher taxes.  Politicians get elected by promising benefits, not by raising the revenues necessary to avoid increasing debt.  In a developed economy real growth should equal the population increase plus productivity.  


For Europe and the United States that’s about 2%, but people there want their economies to grow more than that so the government provides the stimulus to create faster growth and takes on the debt necessary to do it.  Everything is fine as long as the cost of ten-year debt doesn’t exceed the nominal growth rate, but when it does the cost of servicing the debt becomes an unsustainable burden, and that’s where Spain and Italy are.  The United States isn’t quite there yet.
“When governments finally get around to recognizing they are in trouble, what do they do?  They accept the fact that they cannot produce more growth by providing fiscal stimulus because that would only increase the debt problem, and they can’t take the risk of a recession that might clean out the legacy debt obligations because that would prevent future borrowing, so they do the only thing they can do: they print money.  


That’s what the Federal Reserve did in 2008 when they increased the Fed balance sheet from $1 trillion, virtually all in the U.S. Treasurys, to $2.5 trillion, with the increase mostly in mortgage-backed securities.  That’s what the European Central Bank (ECB) did in 2011 when the sovereign debt problems of the weaker countries became severe.  The balance sheet of the ECB increased from €2.0 trillion to €3.0 trillion, and the increase was mostly made up of the sovereign debt of the weaker 
countries.


“This may go on for a while, but it can’t go on forever.  In Europe’s case Germany will stop backing the monetary expansion and the U.S. Fed will get uneasy as well.  As Milton Friedman persistently argued, inflation is always and everywhere a monetary phenomenon.  So far, however, inflation has remained tame because house prices and wages haven’t risen in most places in Europe and the United States (except real estate in London and New York, where foreign capital has flowed in).  At some point, however, inflation will become a factor.


“Right now we’re witnessing a kind of convergence.  The standard of living in the developed world is declining and the standard of living in the developing world is increasing.  Debt to Gross Domestic Product (GDP) ratios in the developed world are about 100%, where, as Ken Rogoff and Carmen Reinhart have pointed out in This Time Is Different, growth becomes modest.  In the developing world debt to GDP is only about 35%, so these countries have a long way to go.


“When you think about it, there are a lot more people producing things these days than there were thirty years ago.  Up until 1980 the United States was a major manufacturer and accounted for the dominant share of world GDP, about twice as much as it does now.  By 1980 Europe was producing goods for export and Japan was selling cars, cameras and consumer electronics to everyone.  Now China is the second largest economy in the world and is a major manufacturer, having come from nowhere in the 1970s.  With so many places producing so much and some doing it at relatively low cost, is it any wonder that a lot of people in higher labor cost areas like Europe and the United States are out of work?  The U.S. today is primarily a service economy with a trade deficit.  Germany is a manufacturing economy with a trade surplus.  Do you have to ask why one is doing well and the other isn’t?


“Going back to the Greek election, I think it will prove to be a non-event.  Antonis Samaras will agree to adhere to the austerity program the previous government signed in March in exchange for financial relief, but it will be hard for him to deliver as required.  The Greek people won’t tolerate the pain they will be forced to endure.  They are hot-blooded and want to see results quickly.  There are only two ways to solve the problems of the weaker countries:  austerity, which would mean a 10% contraction in GDP (and Greece is already doing worse than that) or default, which is the route that Russia and Argentina took to get back on track.  Ireland is a good example of a country that successfully took the austerity route.


“Before we experience widespread defaults the authorities will pull out every trick in the book to prevent catastrophe.  That’s because there is a general belief that the European Union was a good idea.  In order to compete against the United States and Asia, the European countries had to hang together.  It was as much a geopolitical decision as an economic one.  There needs to be more cooperation among the European leaders.  The first step is to create a coordinated banking system to prevent a run on the banks.  Deposit insurance won’t do the job.  It’s too much to expect the various governments to agree to a political union at this time, but there could be a banking union to prevent the European banking system from collapsing. 


“The next step will be for every central bank in the world to keep printing money.  Ultimately this will bring on a higher level of inflation, but I think the world is ready to accept that.  World leaders will agree that growth should be their objective and inflation will be the price they will have to pay for it.  This may result in some instability among currencies.  Before this happens there will have to be more suffering.  Spain and Greece will default.  There won’t be outright financial disaster because by the time the defaults take place the banks will have sold most of the troubled sovereign debt on their balance sheets to the European Central Bank.  France’s deficit will get worse as Hollande implements some of the programs he talked about in his campaign.  Human beings and governments have an unlimited imagination and they will use it to delay the day of reckoning.  In the longer term the crisis may turn out to be a good thing because the pain of what we are about to go through 
will prevent it from ever happening again.


“In the short term interest rates should keep rising because debt is increasing faster than GDP.  This should be true in the United States also, but capital is moving there for perceived safety reasons.  After the defaults occur, there will be slow growth.  The defaults will ultimately create a banking crisis, and that will result in a World Economic Conference where the leaders will agree on an objective of 7% nominal growth made up of the 2% real growth and 5% inflation.


“The Federal Reserve has to keep printing money to prevent a recession.  Europe is already in a recession and the ECB will keep printing money, but the Fed may be more aggressive and that could weaken the dollar further.  What we are experiencing is an accumulation of bad decisions.  The worldwide banking system was able to work together effectively to deal with the financial crisis of 2008 but hasn’t done so well since then.  The banks need more capital.  Their loans are being written down.  Their government bond holdings are declining in value.  On top of this, Basel III is imposing additional capital requirements.  How does that make sense?  It’s impossible.  I don’t know whether a default or an economic conference comes first, but in democracies, a crisis usually causes a conference.  In the meantime, capital in Europe will continue to flee to Germany, Finland and the Netherlands.




“So what am I doing with my money?  It is hard to hide in stocks.  Even Danone is reporting disappointing earnings; people are so worried they aren’t even buying yogurt.  The French auto companies are in trouble.  I think gold is going much higher.  I am buying energy stocks because I want to own something real.  Preserving capital is my focus now, not making money, but I like IBM and Apple.  Also some Swiss multi-nationals.  If Obama wins in November the market will go down.  A Romney victory will create a rally, but once he gets into office he will find there is not much he can do to make things better.


I left The Smartest Man’s office somewhat dazed.  My optimism was clearly diminished by what he had to say, but I still believe that somehow disaster has a way of usually not happening.  It seems clear that world leaders are going to do everything possible to avert a financial catastrophe and I think they have the resources to accomplish that goal.  It does seem, however, that the developed world has to resign itself to a prolonged period of slow growth.


*     *     *     *     *

Byron Wien, Vice Chairman, Blackstone Advisory Partners.

Investlogic Strategy Update as of July 1, 2012

Global Growth Outlook Weakens

Financial Review as of July 1, 2012

Little was expected from the EU summit, but quite a lot was actually delivered, although some follow-through will still be required if investors are to retain their newly found appetite for risk.

Analysts have generally argued that the euro’s survival depends on further integration of the eurozone economy, emphasizing the need for a banking union, a fiscal union and a political union. There was clear progress on the first and some on the second. And while there was no direct mention of the third, that becomes much easier once the first two are evolving satisfactorily. There was also a “nod” to growth. The main provisions were:

• A single bank supervisor for euro area (EA) banks headed by the ECB will be established by end 2012.  Following establishment of that single supervisor, the ESM can recapitalize EA banks directly—not via the sovereign—and impose only light conditionality.
• Financial assistance to Spanish banks will come from the EFSF until the ESM is established. Support from the ESM will not enjoy seniority status.
• Support to the Irish banks will be re-examined, presumably with an eye to placing it under the same framework as Spain, and other cases will be treated similarly.
• The leaders re-affirmed that the EFSF/ESM will be used to stabilize markets for member states through primary and secondary bond market purchases, but they did not agree to ECB funding for the ESM.
• The President of the European Council (Herman Van Rompuy) was tasked to develop a timed roadmap to further fiscal integration over the medium term. A first report should be published in October.
• A growth pact was agreed, comprised of more capital for the European Investment Bank, allocation of unused structural funds from the EU budget and project bonds for infrastructure development.

Equities: Everything changed on Friday. Equities traded choppily with a generally offered tone over the first four sessions of the week, then exploded to the upside in the last session. Italy and Spain soared 6.6% and 5.6%, respectively, on the day.

Bonds: The opposite was true for bonds. They traded choppily with a generally bid tone until giving up ground on Friday. Of course, there were a couple of exceptions. Italian and Spanish bonds rallied along with their equities.

Currencies: EUR/USD was offered through Thursday, but rallied over two big figures on Friday. 

Commodities: Gold and oil rallied sharply on Friday as concerns about Europe faded.

Investment Strategy 

The political and financial cost of an incoherent exit of the euro would be simply too high, and for Greece, and for other members of the euro area. If the politicians agree in understanding that they dispose of enough funding to keep Greece within the euro, they are as conscious that these funds wouldn't cover all the economic and political repercussions for the zone, hence the agreement to support it by new non-conventional measures of monetary policy by the European Central Bank and the new born European Stabilization Mecanism. Out of the euro area, it becomes visible that total economic recovery weakens. American growth weakened, but shouldn't slow down as noticed in 2011.

In emerging countries, after a recovery of equity markets since the lows of October, 2011, fed by a renew appetite for the risk of the investors, the rebound of the expected profits should carry the next movement of increase. From this perspective, it is the Chinese economy which remains decisive. The weaker growth of former quarters reflects the deep monetary tightening operated the last year to decelerate the activity of credit - quickly overturned when negative effets on small and medium sized enterprises became visible.

If Chinese economy continues however decelerating, a combination of measures of monetary expansion  and of a recovery stimuli plan including investments in infrastructures would lead to a recovery, supporting other emerging markets.

Equities Markets - include from now on the impact of a slowing or no growth seems to have reached a floor on the short term.. The risk premium is indeed at levels which would correspond to an stagnation of profits. Besides, the perspective of an expected coordinated  action by the central banks to lower  tensions on markets should constitute  a floor for actions, even if the timing of an intervention remains uncertain. In the States we are still in an election year which would also provides some supportive measures. The perspectives of the American economy growth, the robustness of the company profits  and the strength  of the dollar US should give some support to the US stock market. Conditions remain also positive for the emerging markets. 

On the Bond side, Corporate and High Yield always introduces welcome diversification and potential higher returns (see below). However,as long as it remains high uncertainties on the European crisis  and in the timing of a global  economic recovery, we are encouraged to protect us of turbulences by overweighting of German governmental bonds and some long-term US T-Bonds, as well as of course as an large part  gold.

Let's go Corporate 

Specifically, Grant is bearish on one of the very “safest” of safe things: highly rated government bonds. “The times may be troubled (they often are),” he says, “and people may be desperate (someone usually is), but that doesn’t mean that low-yielding sovereign debt is the last word in safety and soundness.”

Grant does not assert that top-tier government bonds are necessarily unsafe, merely that they are undesirable…and potentially unsafe. At current yields, many government bonds offer what Grant has termed, “return-free risk.”

As the nearby chart clearly shows, the yields provided by the marquee AAA government bonds of the US, Germany, Switzerland and the UK have been in a freefall for several years. As recently as four years ago, a 5-year bond from the Swiss government yielded about 3%. Today, the 5-year yield is negative! That’s right; an investor must pay the Swiss government for the privilege of lending it money.

The 5-year yields provided by the other AAA issuers in this chart are at least positive, but just barely. All of them yield less than one percent per year. Longer-term yields from these AAA-rated governments are similarly underwhelming.

Therefore, Grant suggests, rather than buying the 10-year German bund that yields a whopping 1.75%, why not buy the common stock of the German chemical giant, BASF, which is currently yielding about 4.3%?

“By the same token,” Grant continues, “we favor Wal-Mart over the 10-year Treasury, and Nestlé over the 10-year Swiss government note. Wal-Mart, which yields 2.4%, and Nestlé, which fetches 3.5%, have shown the ability to grow and adapt in economies both good and indifferent.”

Clearly, the shares out of BASF, Wal-Mart and Nestlé are not “safe” in the sense of providing a certain, government-guaranteed return. They are safe only in the sense of offering a potential return over time that greatly exceeds that of today’s ultra-low yielding sovereign bonds.

Furthermore, equities deliver returns that derive from real-world commerce, rather than from the increasingly dubious promise of a heavily indebted national treasury.

Emergent Markets: internal demand gives a relay for a more permanent growth

If in 2012 emergent equities overperformed, in some respects, of about 3 % the equities in developed countries, the last published figures mention one flat performance since the beginning of the year versus one light advantage to for the developed markets. However as in 2011, this visible under-performance comes out again mainly from a comparison with the American market. Due to the disappointing performances of the most part of Europe and to the weakness of the Japanese rally, the emerging markets continue nevertheless outperform the developed economies, except the United States, of about 3 %. 

As long as questions will persist if Greece is going  to stay in the euro area, risky assets should continue to underperform. This period of uncertainty should be of relatively short term and it could be wise to reinforce the exposure  on the emerging markets later in year. On the basis of the expected multiples (ratio lesson / benefit), equities stay on the whole attractive, but the  stronger growth in benefits within the emerging markets companies should be translated by the higher performances. 

The dynamics which drives the performance of the emerging markets however evolved. Two major topics focalized attention in the course of last decade: 1) the exports of raw materials towards China, 2) exports of consumer goods towards the developed world. The slowing down of the growth of China should weigh on the overall demand of raw materials from this country. Current debate does not limit itself to determine if China faces up a soft landing of its economy or in harder landing scénario. There remains that China still has  huge needs in infrastructures and even the assumption of a more modest growth rate - between 7 and 7,5 % - guarantees a strong demand for a lot of raw materials, particularly industrial metals. Countries and traditionally profitable firms of Chinese demand are going to continue to profit from it, but probably to a lesser extent.  

The accent should be put from now on more on the internal growth of the emerging markets rather than on the demand of of the developed world consumers, which should remain apathetic during several years. On the other side, many emerging countries achieved a level of development such as their internal demand is becoming a factor more and more contributing to  the growth of their GDP. If many investors are already aware of attraction that the Western luxury products have on these consumers, it concerns only a marginal part of the population. True opportunities will be in the consumer goods of lower range. This potential can be noticed in the over performance in equities of consumption goods sector which was 2,3 times superior to that the broad emerging market index since March, 2009, as well as in the performance of small capitalisations, more exposed to internal demand. The sector MSCI Small Cap advanced of 91 % over 3 years against 61 % for indication Broad Cap.

INVESTLOGIC : UPDATE MARCH 2012

If short-term economic rebound seemed to have begun in the United States, electoral year obliges, it is only hoped at the moment in Europe. The decline recorded in last quarter of year 2011 will be undoubtedly confirmed during the first quarter 2012, what technically at least will confirm the recession for the Old Continent. But the hope of a stabilisation of economic activity for the second half is allowed thanks to the action of the monetary authorities.

The European central bank decided since the beginning of the year to join the supporters of "Expansionists". It so injected liquid assets in great numbers to stimulate growth, and especially, to contain systemic risks and to lower the effects of austerity.

Markets have already marked their enthusiasm on this orgy of liquidity, all the more as the valuation are still attractive. Side benefits, firms succeeded in supporting their margins at high levels by playing on the job flexibility.

It is therefore mainly the interest rates at their lower levels which support the tactical rebound of stock markets.

Aggressive monetary policies of central banks could however draw away eventually a loss of value of the fiat currencies.  The only asset which allow to preserve the intrinsic value of the capital in the course of time remain gold. We think that current correction is a period of accumulation for the precious metal even if we forecast that gold shouldn't record a strong bullish movement in 2012.

On emergent markets, recorded disappointment the last year could make room for a renew interest in 2012. We support our overexposure on EM, deducing that their predominance with medium to long terms (3-5 years) should increase.

On the forehead of currencies first, the loss of confidence contrary to the main paper currencies (USD, EURO) and the ineluctable evolution of balances of economic powers  favors emerging currencies in the medium term. In this context, Asian currencies appear to us be attractive positions.

Let's note that the management of the public finances is of better quality than that the one recorded by the developed countries, a an improvement of deficit of current accounts, a strengthening of the local capital markets and the needs of financing of the emerging companies support the regional public and private debts. We recommend to keep a total bond allocation in Emerging countries on horizon of 24 months.

This good health will reverberate on the economic dévelopement and will reinforce the weight of these countries in worldwide economy, after the last period of higher risk aversion. Nonwithstanding the volatile character which shouldn't be ignored, an exposure in emerging  equities seems justified.

Si la reprise conjoncturelle semble amorcée aux Etats-Unis, année électorale oblige, elle n’est pour l’instant qu’espérée en  Europe. Le déclin enregistré au dernier trimeste de l’année 2011 sera sans doute réitéré durant le premier trimestre 2012, ce qui techniquement du moins confirmera l’entrée en récession du Vieux Continent. Mais l’espoir d’une stabilisation de l’activité économique pour le second semestre est permis grâce à l’action des autorités monétaires.

La banque centrale européenne s’est décidée depuis le début de l’année à rejoindre le cano des “expansionistes”. Elle a ainsi massivement injecté des liquidités pour relancer la croissance mais,et surtout, pour contenir les risques systémiques et amortir les effets de l’austérité.

Les marchés actions ont déjà marqué leur enthousiasme à cette fête de la liquidité, d’autant que bien des valorisation sont encore attrayantes. Côté bénéfices, les entreprises ont réussi à maintenir leur marges à des niveaux élevés en jouant sur la fléxibilité du travail.

C’est donc prinicpalement le maintien des taux d’intérêt à leur faibles niveaux qui soutien le rebond tactique des marchés boursiers.

Les politiques monétaires aggressives des banques centrales pourraient cependant entraîner à terme une perte de valeur de la monnaie fiduciaire. DAns ce cadre, le seul actif qui permette de préserver la valeur intrinsèque du capital au fil du temps reste l’or. Nous estimons que la correction actuelle est une période d’accumulation du métal précieux même si nous pronostiquons que l’or ne devrait pas enregistrer un fort mouvement haussier en 2012, alors que le US dollar retrouve ne certaine fermeté dans le rebond conjoncturel.

Sur les marchés émergents, la déception enregistrée l’année passée pourrait faire place à un nouvel engouement en 2012. Nous maintenons notre sur-exposition sur les EM, arguant que leur prédominance à moyen-long terme (3-5 ans) devrait s’accroître.

Sur le front des devises d’abord, la perte de confiance à l’encontre des principales devises papier (USD,EUR) et l’ineluctable évolution des rapports de forces économiqes militenten faveur d’une revaloraisation des devises émergents à moyen terme. Dans ce contexte, globalement les devises asiatiques nous apparaissent être des psostions raisonnables.

Notons que la maîtrise des finances publiques de meilleure qualité que celle affichée par les pays développés, une fragilité réduite sur le front des déficits des comptes courants, un renforcement de la profondeur des marchés de capitaux locaux et les besoins de financement des sociétés émergentes constiruent autant de soutiens pour les dettes publiques et privées régionales. Nous  recommmandons de maintenir une allocation obligataire globale dans les émergnets à horizon de 24 mois.

Cette bonne santé se répercutera sur le dévelopement économique et renforcera le poids de ces pays dans l’économie mondiale, après une période d’aversion plus sévère au risque. Nonobstant le caractère volatil qui ne doit pas être ignorer, une exposition en actions émergentes semble justifiée.