BY ROB EDEL, CFA
HIGHLIGHTS THIS MONTH
- WHAT IS OUR NEXT PLAY WHEN NAVIGATING THESE VOLATILE MARKETS?
- MONETARY POLICY: MIXED PERSPECTIVES FROM THE STRATEGIC INVESTMENT CONFERENCE
- RECOVERY VS. INFLATION
- GRADUALLY, THEN SUDDENLY: A TALE OF INTEREST RATES
- CHINA: THIS ECONOMIC GIANT MAY HAVE TRIPPED BUT SHOWS PROMISE OF REGAINING BALANCE
- STRATEGISTS VOICE VARIED SENTIMENT TOWARDS EUROPEAN MARKETS
- THE JURY IS STILL OUT ON WHAT’S TO COME FOR OIL PRICES
Rather than follow our usual monthly format, this month we thought we would provide an economic update on how we see the economy and capital markets.
While we are continuously monitoring the markets and listening to the views of many economists and strategists, for the past several years, we have also attended the annual Strategic Investment Conference, jointly organized by Altegris and John Mauldin.
This year’s event was held in early May, and as always, the excellent lineup of speakers provided a valuable source of information in helping organize our views and thoughts.
While we won’t review all of the presentations, we will try and touch on as many as possible as we discuss the current state of the global economy and appropriate investment strategy.
No Safe Assets.
Our bottom line view is the U.S. economy continues to slowly recover, and should drag the rest of the world with it.
The U.S. is creating jobs, the housing market is gaining strength, and the consumer is starting to spend again as their personal balance sheets are repaired. The recovery has been unusually slow and uneven, however.
Because of this, interest rates have remained at historic lows, and will likely remain at these levels for the foreseeable future. Slow, but steady, growth and low interest rates are actually a favourable investment environment for many asset classes, especially stocks.
As such, we continue to allocate investment dollars to equities, both private and public, and especially favour companies with exposure to the United States. While we don’t expect interest rates to move meaningfully higher in the short term, we do expect them to rise at some point and thus do not find the risk/return tradeoff attractive in longer duration assets.
Rather than extending the maturity of an investment in order to pick up extra yield, we would rather accept greater credit and liquidity risk.
Corporate bonds and mortgages are examples of products that provide varying degrees of both. It’s not to say that these products have less risk – they don’t – though we believe they have attractive risk-adjusted returns.
There are no safe assets right now. This is what happens when central banks cut short term interest to zero and one of the reasons a diversified portfolio is essential in the investment environment.
What Do The Presenters At The Strategic Investment Conference Think?
In general, they tend to be a pessimistic bunch. Long time bear, David Rosenberg, Chief Economist and money manager at Gluskin Sheff, was probably the most optimistic, with a view generally in line with our thinking that a stronger economy and low interest rates are good for investment returns.
He believes lower oil prices and the strong U.S. dollar should be net positives for the economy, and rising interest rates won’t be an issue until later in the tightening cycle. As for longer-term risks, he thinks inflation might be an issue, but not at the moment.
Ex-PIMCO economist Paul McCulley, was also more glass half full, believing central banks are on the right path. Mr. McCulley, a self-confessed Keynesian, believes, however, monetary policy wasn’t the right policy, arguing that fiscal policy would have been more effective.
Monetary policy and lower interest rates helps reflate asset prices, thus making leverage ratios more manageable, but it doesn’t create demand. The notion that central banks are using the wrong policy was a common theme expressed by a number of speakers.
Bill White, Chairman of the Economic and Development Review Committee of the OECD, and for what it’s worth, a Canadian, was probably one of the most bearish speakers to present.
He believes central banks should tighten monetary policy, but he doesn’t think they will. Because of this, the end game is very uncertain and could result in more monetary policy, financial repression, and even hyper-inflation for countries with too much debt.
Mr. White believes the odds of a bad outcome outnumber the odds of a good outcome. Agreeing with Mr. McCulley, White believes monetary policy was important in maintaining financial stability after the financial crisis, but is not effective in creating economic growth.
Monetary policy takes future consumption and attempts to bring it forward. There is a limit to how much of this can happen, and monetary policy is not effective if people don’t want to borrow money.
Fixed income researcher, Jim Bianco, suggested monetary easing could actually be holding the economy back, because the uncertainty around when and how much the Federal Reserve might raise rates is causing investors and consumers to delay purchasing and investing.
The big problem with the aggressive use of monetary policy is, how do you wind it down? A number of speakers, including Bill White, expressed this concern, but perhaps the darkest was Stephanie Pomboy, who runs a research firm called MacroMavens.
She feels the recent decline in consumer spending could be a game changer and we could be seeing a secular change in consumer behavior. Low interest rates compound the problem by requiring consumers to increase savings even more.
While she doesn’t believe monetary policy is the right solution, she also thinks more quantitative easing could be in the cards if economic growth disappoints. Pomboy is worried about the dollar and fiat currencies in general.
Like a few of the speakers, she doesn’t know how central banks are going to unwind the quantitative easing bubble they have created.
Lacy Hunt, an economist at Hoisington Investment Management, believes the world is still stuck in a deleveraging cycle and thus the economy will not be able to achieve sustainable growth.
Hunt’s firm has been going long on 30-year U.S. Treasuries for a number of years, and shows no signs of selling. His overall view is similar to economist Gary Shilling (author of “The Age of Deleveraging”) who didn’t present at the conference, but joined Lacy on stage after his presentation to facilitate a Q&A session.
The deleveraging theme is something we have talked about in the past and is one of the reasons we think the economic recovery has been slow, and will likely remain so in the immediate future.
Where we may differ is the trajectory of the recovery. Are things slowly getting better, or continuing to deteriorate? We have the same question in regards to Mr. White and Ms. Pomboy’s views. If the global economy is not recovering, but in fact starting to deteriorate again, more monetary easing is in our future.
In this scenario, Mr. Hunt will be well served with his long interest rate risk strategy.
Jeff Grundlach, head of fixed income manager Doubleline and dubbed by Barron’s as the new “King of Bonds,” generally shares our view that while growth will be slow, it is moving in the right direction.
Mr. Grundlach has also been a long Treasury bull the past several years, but turned negative earlier in the year, believing interest rates have seen their lows.
He doesn’t, however, feel the Federal Reserve will raise rates this year, a prediction that he reiterated in mid-August. Grundlach, in fact, doesn’t believe bonds will do much this year either way, and when the Fed does raise rates, it will do so in a slow and deliberate way.
He also points out higher short-term rates don’t necessarily mean long term rates will spike higher. In fact, during previous Fed tightening cycles the yield curve flattened, not steepened.
If he is wrong and rates do move higher, Grundlach believes the high yield bond market could be in trouble given it has never experienced a secular rise in interest rates as the asset class didn’t exist the last time the U.S. Federal Reserve was tightening, in the early eighties.
He likes high yield right now, but worries about what will happen when they mature and need to be rolled over, especially if rates are also rising.
A character in the novel was asked how he went bankrupt, to which he replied, “two ways: gradually, then suddenly.” Grundlach believes the same could happen for interest rates. They could go up slowly, then very quickly.
Given the impact higher inflation would also have on interest rates, Rosenberg and Grundlach appear to be on the same page with regards to the future path of interest rates. The timing and magnitude are, of course, key.
While Fortress Investment Group’s Peter Briger didn’t expressly mention inflation or abruptly higher rates as a concern, he did highlight that central bank manipulation was the “elephant in the room” and didn’t know how the liquidity being created will impact markets in the longer term.
Like those concerned with excessive monetary policy, Mr. Briger believes politicians only worry about the short-term impact on the economy, not the longer-term fallout. Fortress invests in the distressed fixed income market and, like Grundlach, believes the market could be under pressure in a few years. He views this as an opportunity, however; valuations are not currently attractive and they are finding it hard to allocate funds.
China was also a subject that more than one speaker tackled.
China is attempting to change its relationship with the rest of the world with sights on becoming a reserve currency and part of the MSCI Emerging Market Index. Once this happens, portfolio managers will be forced to buy, given the relative size of the Chinese economy, and stocks will go up even more.
He also believes Chinese capital will help industrialize the emerging market. Gave is quite a China bull and highlighted some of the cost advantages Asia/China has over the U.S. in regards to litigation and regulation.
Ian Bremmer, founder of Eurasia Group, also endorsed China for being the only country with a coherent foreign policy and compared China’s recent announcement of an Asian Infrastructure Investment Bank to the U.S’s Marshall Plan after World War II. He believes the Bank could challenge the U.S. dominated IMF and help Chinese companies strategically align with governments in the Asian-Pacific region.
Michael Pettis, a professor at Peking University, also spoke at length about China, but was more measured in his outlook. He feels credit growth is on an unsustainable path and China only has three to four years of debt service capacity left.
Pettis laid out the challenge faced by the current government in trying to rebalance the economy towards being more consumption-based and less reliant on investment. It’s largely a political problem, as the elite and politically connected have benefited from the export and investment-led growth and now must accept a smaller share of a slowing economy. In order to be successful, China has to consolidate power, which is evident in the current anti-corruption campaign.
The comments of all three are very topical for what is currently happening in China. Of course, we all know that the MSCI has subsequently decided not to include China in its emerging market index and the IMF has chosen not make the Yuan a reserve currency.
Also, Chinese equities have come under considerable pressure and foreign investors have headed for the exits. China has implemented a number of measures to try and stabilize the market, and more importantly, the economy, which appears to be slowing at an alarming pace.
China’s potential is indisputable and Gave and Bremmer may eventually prove correct in their optimism, but in the short term Pettis appears the superior prognosticator as China delays economic and market reforms in favour of old style investment and export-led growth. According to Pettis, the time limit on this strategy is running out.
Freidman warned against investing in Germany given exports comprise 50% of GDP, with half going to the Euro-zone and another 25% to emerging market economies. We would point out China represents a big chunk of the emerging market exports, with nearly 7% of total merchandise exports, or 2.6% of GDP, going to the Middle Kingdom.
David Zervos, on the other hand, doesn’t like the Euro, but does like Europe as an investment, especially Germany. He thinks U.S. stocks are expensive and doesn’t see how the Federal Reserve can increase interest rates without the dollar going up even more.
He looks at the impact QE had on the U.S. asset prices and is using that as a roadmap for what is likely to happen in the Euro-zone. In the U.S., QE created liquidity, but rather than going to assets that needed it most, the liquidity flowed to the strongest and safest assets. If the same happens in the Euro-zone, German assets will be bid up.
Finally, oil was mentioned by a number of the presenters, particularly Jim Bianco, with the common belief being crude prices would need to go lower before normalizing.
With the consensus belief being supply/demand dynamics will eventually drive crude prices back to the $70-80 range, there is too much capital eager to be deployed into the market. Of course, this is exactly what has happened and oil prices have indeed moved lower, with some now believing $30 a barrel is possible in the near future.
It’s a tough market to call. Lower prices will inevitably drive demand higher, but a weakening global economy, especially China, makes this harder to time. On the supply side, producers are hurting, but no one appears to folding their hands.
It reminds us of the card game Hearts. If you have the queen of spades in your hand, are short-suited spades, and one of your opponents keeps leading with spades, you better be trying to get control because eventually you will need to lay down the queen.
It’s a very uncomfortable feeling and we suspect there are a few oil-producing countries out there that are more than a little nervous. Saudi Arabia, by continuing to produce more oil, keeps leading with spades. Most thought U.S. producers were their target, but we suspect Russia, Venezuela, Iraq, and Iran are also short-suited.
One of them has the queen of spades and will eventually be forced to play it.
Overall, some positive, but also a lot of negative forecasts and commentary.
Agree or disagree, what we like is the non-conventional thinking the Strategic Investment Conference encourages. Consensus thinking can be very dangerous, especially in today’s uncertain investment environment.
Mark Twain once said “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.” So what do we (or the market) know for sure right now that ain’t so? According to many of the presenters at the conference it is that central bankers know what they are doing.
Another might be inflation. Though only David Rosenberg commented on future inflation being an issue, because the impact on investment returns would be so significant, we think it is something that needs to be continuously scrutinized.
Most economists, like Lacy Hunt, worry about deflation, but in their fight to avoid deflation, central bankers end up creating an undesirable level of inflation, the impact on investment returns will be equally negative.
What did you think of August’s economic activity? Let us know in the comments below!This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.
China becomes important in this scenario because nearly half of the World’s recent GDP growth was made in China. Losing it could push a slowing global economy back into recession. Recent market volatility is derived from this fear, namely that global economic growth is slowing, again. China’s lack of transparency just adds a layer of uncertainty on global capital markets.
In these days of volatility, we learn from the high-profile economists but be careful of what they “know for sure.”