2013 Q2 letter: Tapering off the rocket-fuel
We hope you are enjoying the summer thus far.
In the financial markets, things seem to be heating up as temperatures rise across the northern hemisphere. The events of the last few weeks of June seem to have triggered a wake-up call for many investors who may have been lulled into a false sense of security by a market that rose steadily throughout the winter. Many long term trends are starting to reverse course and risks we have been tracking for several quarters are beginning to materialize.
In a large part, the moves are being driven by two major players: the central banks of the US and China. In the US, various Fed board members have been travelling the country recently in an effort to warn investors that the enormous amount of bond purchases being undertaken monthly by the Fed will begin to “taper” off. In many ways, it is an attempt by the Fed to let all the party-goers know that the punch-bowl is about to be taken away. They aren’t saying it’s midnight and the party is over, but they have made it clear they are watching asset bubbles, have taken into account the improvement in housing and employment, and will be moving away from crisis tools. In other words, it’s Last Call.
The market has been discounting the probability of this happening for some time, but these recent public pronouncements have forced a rapid adjustment of expectations. The 10 year treasury rate has moved about 1% in a couple of months, wreaking havoc in any leveraged rate portfolio. The last time rates moved this rapidly was about 20 years ago. While this may be the beginning of a larger move that we believe will be spread over many months, the larger picture should be clear: the 30 year bull market in bonds is over. Bond investors should be prepared for potentially a five to six year period of rising yields and falling prices.
Meanwhile, on the other side of the world, China has executed a rather smooth transition of power, but the cost in terms of economic imbalances has been large. Like the US, the Chinese authorities have maintained an easy money policy since the onset of the global credit crisis. Along with looser credit, they have delivered large fiscal stimulus, by spending on investments, largely on infrastructure and other construction activity. Much of this spending has been financed with credit, and the borrowers are primarily local municipalities and governments. In many cases, projects are initiated and built to satisfy bureaucratic ambition, rather than commercial ends. Many of these projects will be unable to recoup their costs. In some ways, the outlook for Chinese regional governments is worse than it ever was for US municipal debt. The central Chinese authorities have begun to rein in excessive credit growth after voicing concerns over rising levels of indebtedness in late 2012 and early 2013. Overnight lending rates were raised unexpectedly in June, and this shocked Chinese banks and lenders. The local stock market promptly fell over 20%. We expect the re-adjustment in China to generate more pain for investors, and this will impact resource driven economies like Australia and Canada who have been relatively immune to the malaise in the US and Europe, In our view, these recent monetary policy adjustments by the US and China will most adversely impact the future prospects of multinational banks. Banks that have positioned themselves for the move will benefit as the Fed withdraws from purchasing long-dated bonds. As the yield-curve steepens (long-term rates rise faster than short-period rates), the core lending franchise of most banks should become more profitable. While long-term rates rise faster than short-term rates, banks will profit since they generally borrow or take on deposits paying short-term rates and receive long-term rates on loans made. The problem is that in the aftermath of the financial crisis banks shrank the volume of general lending they were doing and began to load up on long-dated bonds of government and quasi-government entities instead in their search of low-risk investments. As rates rise, these bonds will drop in value, leading to painful losses which impact balance sheets and bank income statements. We see few banks/financials that have adequately prepared for the inevitable rise in interest rates, and we believe most financials will underperform over the next two years.
Another noticeable theme this year has been a steady profit-taking in various speculative momentum assets that have enjoyed outsized gains over the past few years. From Apple and Emerging Market stocks, to Gold ETFs, high-dividend stocks and High Yield Bonds, the speculative investments of choice have sold off over the past few months with breakneck speed. To us, this signals a loss of confidence in the late stages of a rally and is not a positive sign for equities (neither are rising interest rates). That said, the dramatic drops in certain stocks have created select opportunities for value investors like ourselves.
We have been re-positioning client portfolios to take advantage of some of these long anticipated moves. Most client bond portfolios have been heavily weighted towards short-term, low duration, and floating rate bonds and funds. We have continued this positioning and have attempted to reduce long term bond exposure. For more tactical portfolios, we have added a short-position on long-dated bonds (an investment which gains from drops in the value of long-dated bonds). We believe this leaves us well placed to take advantage of a rising yield environment. Where appropriate, we have been adding stock to client portfolios, generally high-quality, income-generating issues (rising dividends). We also added Japan exposure to many client portfolios late last year and very early this year. We think selected Japanese equities are a good, long-term holding and there is another opportunity to acquire them after the recent sell-off.
We have also been adding alternative energy exposure to client portfolios where appropriate. Alternative energy stocks sold off dramatically as the solar sector went through growing pains over the past few years. We believe the adjustments in the sector brought on by large-scale Chinese capacity build-out and the expiration of certain tax credits are largely complete and the industry is now poised for growth and value creation.
We expect markets to continue to be volatile this summer, and we aim to stay in touch with all clients, please feel free to call us if you have any questions.
Regards,
Louis Berger Subir Grewal