Category: Economics
Market update: Measures to stall Coronavirus’ spread begin to impact global economic activity

Market update: Measures to stall Coronavirus’ spread begin to impact global economic activity

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This week has seen two precipitous declines in US stock markets. The volatility has been attributed to fears of the Coronavirus strain named COVID-19. This infectious disease has now spread to several countries and caused over 2700 deaths. The reports of confirmed cases have almost certainly been under-counted as numerous developing countries with weaker health systems lack the resources to identify and respond to such outbreaks. To keep things in context, the annual flu causes more deaths in the US alone.

The market drop on Monday was driven by fears about the impact of COVID-19 on global trade. On Tuesday, federal officials warned that COVID-19 would almost certainly spread in the United States. They indicated that health professionals, hospitals, communities, businesses and schools should begin making preparations. This would include “social distancing measures,” like smaller groups in classes, canceling meetings or conferences and making arrangements to work from home. Dr. Nancy Messonnier, director of the National Center for Immunization and Respiratory Diseases, said in a news briefing that “it’s not so much of a question of if this will happen anymore but rather more of a question of exactly when this will happen.”

While we can’t speculate about the disease itself, or its spread, as this is far outside our area of expertise (we would urge readers to follow guidance from public health and safety officials), what we can do is evaluate the economic impact of the CDC’s recommended containment measures. We know that measures taken in China to prevent the spread of COVID-19 have been very disruptive. Most commercial flights within China have been cancelled. Almost all international airlines have suspended flights into and out of China. Supply chains for numerous industries have been reduced to a standstill and economic activity measured by power has slowed markedly. Oil demand in China has fallen 20%. In Europe, sports events have been cancelled, the hospitality industry in affected areas has seen cancellations and schools have sent students who recently visited northern Italy home. A major bank issued a warning that Switzerland may enter a recession due to the COVID-19 outbreak.

If the measures discussed by the CDC were to be implemented in the US, there would be a significant impact on economic activity and by extension corporate earnings. Millions of Americans can telecommute to work and it is reasonable to expect they could continue to work through such a potential crisis. However, a large segment of the US manufacturing and service sectors would be hobbled. This includes most entertainment, food service, travel, manufacturing and retail. It is difficult to estimate the precise impact on earnings, but the fact that we were recently at all-time highs and at the end of a maturing business cycle suggests any drop in expected earnings would have a significant impact on markets.

We are also concerned about the current administration’s preparedness for such a crisis. In 2018, part of the pandemic response infrastructure put in place after the Ebola outbreak was dismantled, without an adequate replacement put in place. This gap may lead to less than optimal coordination between federal agencies. The current crisis also reminds us of Michael Lewis’ 2018 book, The Fifth Risk. Lewis interviewed senior staff and ex-staff across numerous government agencies after the current administration took office amid reports of a haphazard transition with qualified personnel were leaving without being replaced. One of Lewis’ observations is that the Federal government is partly in the business of risk management. It evaluates and contains risks that are too big for any other US organization to handle. Funding cuts and the loss of experienced personnel severely undermines this mission.

Our healthcare system also has idiosyncratic vulnerabilities when dealing with such public health crises. Unlike other developed countries, most Americans face out of pocket expenses for healthcare. There are reports that individuals asking to be tested for COVID-19 received large medical bills. We know that the fear of unexpected bills often prevents people in the US from seeking timely care, necessitating expensive, late-stage interventions. The lack of timely diagnosis and treatment could exacerbate the spread of COVID-19 and have widespread public health impacts. 

Even prior to the COVID-19 outbreak, we believed high equity valuations merited caution. Containment measures in China have already begun to impact the global economy, we expect the rising number of cases in Europe will have similar effects. If containment measures are required in the US, they are likely to have a significant impact on corporate earnings.

We reiterate our recommendation that investors maintain a defensive position in equities and other risk assets. We recommend caution as this situation continues to develop.
2019 Investment Themes: Bear Market Blues

2019 Investment Themes: Bear Market Blues

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Dear Friends,

We hope you’ve had a restful holiday season with family and a pleasant start to the New Year.

The fourth quarter of 2018 saw steep declines in US stocks, with certain indices entering bear markets (20% below their highs). Amid these moves, the Federal Reserve followed through on broadly held expectations and raised its benchmark Fed Funds rate to 2.5%. Taking a longer view, it’s clear the post 2000 era has been unusual. From 1962 to 2000, the Federal Reserve had never lowered rates below 2.5%. Since 2000, rates have remained below 2.5% for 15 of the last 18 years. Extremely low interest rates were made feasible by the near disappearance of inflationary pressure in the US. Prices for most manufactured goods have been kept low for over two decades as manufacturing was outsourced and large Asian populations were integrated into global industrial production. This multi-decade trend has allowed US and European central banks keep interest rates at historic lows without triggering inflation. Absent a dramatic reversal in global trade policy, we do believe this long-term trend will continue. In the near term, the Fed chairman has signaled two more interest rate hikes are expected in 2019 which would take the benchmark rate to 3%. We believe the Fed is more likely than not to follow through on these hikes, for two reasons:

1. Q4 saw unprecedented pressure from the White House on the Federal Reserve to avoid a rate hike. This included rumors that the president had sought to dismiss chairman Powell in an attempt to influence interest policy. The White House does not have the authority to dismiss the chairman except for cause, and we believe the Fed will be keen to demonstrate its independence by following through on its previously broadcast intentions.
2. Fed governors are well aware that recessionary risks are high in 2019. If the Fed Funds peaked at 3%, the Fed would have more room to respond to a downturn using rate cuts alone. We believe Fed governors would prefer to use interest rates to respond to the next recession, rather than a revival of the unprecedented Quantitative Easing (QE) program put in place in 2008.

Normalized rates, trade disputes, a faltering Chinese economy, and concerns about asset valuations in a long-running US bull market combined to deliver a very volatile stock market in December. Stepping back to get a wider perspective, we are nearly ten years into an exceptionally long bull market. Several risks to economic growth materialized over 2018. Central banks globally have pulled back from the exceptional liquidity programs adopted after the financial crisis. These factors combine to create a less forgiving investment environment and makes a so-called soft-landing less likely. In our view, the underlying risks to the US and global economy advocate for continued caution on the part of investors. As always, long-term opportunities will present themselves in choppy markets and we intend to capitalize on them when they do.

We have enclosed our 2019 investment themes as well as a review of our 2018 themes. We hope to have an opportunity to discuss them with you in the near future.

Regards,

Subir Grewal, CFA, CFP                                                Louis Berger

2019 Economic Themes: Return of the Bear

  1. Bear Market Comes out of Hibernation.  2018 saw a major speed bump in the nearly 10 year global bull market run in stocks. We contend this reversal gains steam this year as stocks globally will finish 2019 in firmly negative territory.  Trade wars, rising interest rates, inflated asset valuations, and a general slowdown in economic activity will contribute to  a “risk-off” environment where investors prefer protection over speculation.
  2. Peak Interest Rates.  In December of 2015, after seven years of 0% interest rate policy, the Federal Reserve shifted course and slowly began to raise interest rates in 0.25% increments. At the start of 2019, the effective target rate stands at 2.25%-2.50%. While the Fed has signaled a continuation of rate hikes this year and into 2020, we think rates will peak in 2019 and the Fed will pause before potentially cutting rates if/when a recession materializes.  We do not think the Fed will raise past 3% in this year.
  3. Unemployment Rises.  2018 saw the US unemployment rate reach a 49-year low of 3.7%. The US economy has come a long way since unemployment peaked at 10% in October 2009.  That said, this expansion cycle looks due for a reversal and we expect the unemployment rate will climb back over 4% in 2019.
  4. Investors Want Value.  Since 2009, US growth stocks have outperformed US value stocks in seven of those ten years (including three of the last four). We believe value will outperform growth this year as economic expansion slows and investors shift investment capital into more defensive sectors.
  1. The Unwinnable War.  Despite rhetoric from president Trump that trade wars are “easy to win” and a March 1 deadline to resolve the US/China trade dispute, we see no quick and easy resolution to this fiasco. We see 2019 ending with some measure of tariffs still in place, continued global hostility towards the Trump administration and ongoing damage to the US reputation and economy.
  2. Real Estate Reckoning.   2018 saw residential real estate prices finally eclipse the peak reached before the credit crisis. The S&P/Case-Shiller 20 City Composite Home Price index peaked in April 2006 and didn’t reach a bottom until March 2012.  Since then, it has seen a nearly 7 year uninterrupted run-up of higher prices.  We think this streak comes to an end in 2019 and the index will finish the year lower.
  3. Oil Prices Flounder.  After peaking at $86.07 on 10/4/18, Brent Crude oil prices tanked in Q4, finishing the year at $51.49 per barrel. While there may be a short term bounce in prices to start the year, we believe Brent Crude will dip below $50 per barrel and finish the year under that level as global trade slows and energy consumption slackens.
  4. High Times for the Cannabis Industry. In recent years, marijuana has made a steady push into the mainstream as several US states and a few countries have passed legislation to legalize recreational consumption.  A nascent industry has emerged to service this growing demand.  Many of these companies are small, regional operators, but recently, larger and better-financed corporations have entered the space with many becoming publicly traded entities.  While the road has been rocky and the sector has seen large price swings, we think this is an industry poised for long term growth.  We expect 2019 will bring more legislation to expand the recreational market and more investments from multinational conglomerates (2018 saw Altria and Constellation Brands invest in the space).  We expect publicly traded marijuana stocks will outperform consumer discretionary stocks in 2019.
  5. China Stumbles. Over the course of 2018, we saw several worrying signs that the Chinese economy is slowing. Property prices, which have propped up all other assets for years have slowed, and there are numerous reports that several non-bank lenders have halted redemptions. The trade war with the US has also been a major drag on the economy.  2018 was a terrible year for Chinese stocks — the S&P China Composite index returned -27.82% — and while some investors expect a bounce-back year, we  believe 2019 will continue to be a flat to negative market for Chinese equities. The Shanghai Composite remains around 2,500. This is less than half the 5,178 level reached in 2015, which was lower than its all time high of 5,800 in 2007.
  6. Battery Power.  A long-term trend we are highlighting in our thinking for 2019 is the growth of plug-in electric vehicles. Roughly 2 million four wheel electric vehicles were sold in 2018. US sales of EVs represented over 1% of total vehicle sales. In California, the largest passenger vehicle market, EV were 4% of all vehicles sold spurred by tax incentives and emissions targets. When we include plug-in hybrid electric vehicles, EV sales account for over 7% of all vehicle sales in California. These figures portend a long-term shift in the transportation industry, of the same degree as driverless cars. 10 years from now, we expect 25% of the world’s vehicle fleet to be battery powered. Over the long-term, this implies a very difficult environment for the oil and gas industry. We expect EV sales to continue to grow in 2019, and global liquid fuels growth to be below 1.3%.
Review of 2018 Investment Themes

Review of 2018 Investment Themes

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2018 was an uneven year for our market predictions.   We were right on six calls and wrong on four calls.  While we were right about the general market direction, a few of our sector specific calls were off the mark.

  1. Slow But Steady Rate Rise: We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% range.  The Fed started 2018 with a target interest rate of 1.25%-1.50%, raised rates four times by 0.25% to finish the year with a target rate of 2.25%-2.50%.  This was precisely in the range we expected.
  2. Year of the Donkey: We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal government.  The 2018 midterm elections resulted in a sharp rebuke to the Republican agenda.  Democrats won the House popular vote by a whopping 8.6% and had a net gain of 40 House seats, taking back control of the House of Representatives.  They also had a net gain of seven governorships and six state legislative chambers.
  3. The Bull Runs Out of Steam: We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two years.  After a fast start in January, 2018 turned into a down year globally for stocks.  In the US, large caps fared best as the S&P 500 index finished the year at -4.38%.  Mid caps were hit harder as the S&P MidCap 400 index returned -11.08%.  Small Cap value stocks brought up the rear in the US as the S&P 600 Value index returned -12.64%.  International stocks lagged the US as the FTSE All World (Ex-US) index returned -14.13%.
  4. Rise of the Machines: As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.  While we strongly believe Artificial Intelligence and Automation companies will be integral to the global economy in years to come, 2018 saw stocks in this sector hit a speed bump as investors sold off more speculative technology names.  The Global Robotics and Automation index finished the year at -20.92% while the S&P Global Consumer Discretionary index returned -6.24%.
  5. International Beats Domestic: We expect international stocks, especially European markets, to outperform the US in 2018.  We were flat out wrong on this call.  International stocks fared worse than US stocks in 2018, with European stocks performing particularly poorly.  The S&P 500 index posted a return of -4.38%,  the FTSE All World (Ex-US) index returned -14.13% while the MSCI EMU index returned -16.90%.
  6. Bitcoin Bust: Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018. Bitcoin’s meteroic rise in 2017 saw a sharp reversal in 2018 as speculators fled en masse.  Bitcoin opened 2018 at $13,444.88 per coin, but finished the year at $3,880.15 per coin, a drop of 73.70%.
  7. Renewables Redux:  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities.  We expect this trend to continue through 2018.  While we strongly believe in the long term prospects of renewable power, YieldCo stocks trailed conventional utilities for a variety of reasons: energy prices fell (because of higher up-front costs, YieldCos tend to be more attractive when energy prices are high) and a flight to safety from investors (conventional utilities are a popular safe haven in times of market volatility).  The INDXX Global YieldCo index finished the year -4.98% while the S&P Global 1200 Utilities Sector index was up 1.69%.
  8. Organics Go Mainstream: We think organic food stocks will outperform conventional food stocks this year.  2018 was a tough year for packaged food stocks across the board.  That said, organic companies performed notably worse than conventional food companies.  The MSCI World Food Products index returned -12.99% while the Solactive Organic Food index returned -26.61%.
  9. New Dawn of Space Race: 2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission.   2018 saw several space related milestones. The highest profile was a successful test launch for SpaceX’s Falcon Heavy rocket, which placed a car in a helio-centric orbit that takes it past Mars. Virgin Galactic completed testing a craft designed for sub-orbital space tourism flights. The most interesting project is the Japanese Hayabusa2 mission. Hayabusa2 successfully rendezvoused with the asteroid Ryugu and placed multiple rovers on the surface. The spacecraft will return a sample from the asteroid to Earth. This mission provides a viable template for future space based mining endeavors. These technological advances will take a decade or more to reach industrial scale, but once they do we believe they will significantly alter the nature of the mining industry.
  10. Net Neutrality Fallout:  Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.  2018 did see a backlash against the major telecom companies and the net neutrality ruling certainly didn’t help to reverse the cord-cutting trend.  Telecoms underperformed the broader market in 2018 as the S&P 500 Telecom Services Index returned -7.20% while the S&P 500 index returned -4.38%.
The signal among the noise

The signal among the noise

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Friends,

As we approach the end of an eventful 2018, there continues to be a steady torrent of major news stories dropping daily. From CEOs tweeting about taking their companies private, to escalating global trade wars, to bitter battles on Capitol Hill, the financial markets have had a lot to digest. Though the news can seem overwhelming at times, we believe investors should remain focused on the issues that matter for their investment portfolios: valuations, interest rates, economic conditions, and global trade. Each of these factors are at levels that indicate a richly valued stock market in the final stages of a historically long expansion with potential for major risk ahead. Let’s walk through each of them one-by-one.

Interest Rates. As expected, the Federal Reserve raised interest rates in the third quarter and the Fed Funds rate now stands at 2.25%. The 10 Yr Treasury rate is almost at 3.25%, which is the highest it’s been since 2010. It’s likely the Fed will raise rates again by 0.25% in December and continue to raise rates at a similar pace (quarterly) in 2019. While rates remain on the lower end historically, rising rates will continue to take a chunk out of corporate profits as companies raising funds for projects in the debt markets are now paying higher rates than they have in years. The tax cut passed by Congress last year has provided a bit of a tailwind for corporate profits, but this boon will likely be offset by the costs associated with higher interest rates, especially for sectors that depend on high levels of debt.

Global Trade. Despite a major change in trade policy (tariffs), trade levels remain high. That said, there are several looming disputes (US-China, US-Europe) that may cause continued dislocation. We are beginning to see American companies modify their supply chains in response to tariffs. Though, in the long run, this will lead to the growth of manufacturing in new markets and new sources for intermediate and finished goods, in the shorter run this is likely to lead to some dislocation. History shows us that tariffs are almost always a net negative on economic output (as open trade is closed off) and we see no reason why the current tariff war will result in anything other than economic slowdown. If the results of the “new NAFTA” is any indication, the tariff wars will not bring increased economic prosperity to the US, but rather, hurt industries dependent on foreign trade while damaging relations with our trade partners/allies and eroding their trust.

Valuations. Stock valuations remain at cyclical highs. The S&P 500 is trading at 25 times historical earnings, which is about 50% higher than the historic average. When we look at cyclically adjusted measures of earnings, these are at even higher levels. Yale professor Robert Shiller’s Cyclically Adjusted PE ratio (which uses the past ten years of earnings as a denominator to account for the business cycle) is currently over 33. The only other time it has been higher than 30 was in 1929, on the eve of the great depression, and in 1999-2001 during the tech boom. This measure has been above 30 for most of 2017 and 2018. Can this continue? It certainly can, but if we use history as a guide, economic expansion can end quickly, rendering current valuations as especially lofty in hindsight.

Economic Conditions. Despite the concerns mentioned above, economic conditions in the US continue to be quite strong, with consumer confidence levels high and the unemployment rate low. Inflation is relatively tame and average hourly wages are finally rising. However, debt levels — corporate, government and consumer — are all at precariously high levels. If interest rates rise, trade wars persist and valuations remain elevated, we could see these conditions deteriorate.

In addition to these factors, there is a potential major market-moving event on the horizon: the mid-term elections on November 6th. Mid-term elections tend to be a referendum on the White House and ruling party in Congress. Given the president’s low approval ratings, we believe Democrats are likely to re-take the House. We think they have an outside chance at winning back the Senate. This is far less likely because there are fewer Republican seats up for election, and because small, low-population inland states get as many senators as large coastal ones. We think a House controlled by Democrats will lead to meaningful investigations of political corruption in the Trump administration. All indicators suggest this is a target-rich environment for such investigations. If the White House decides to work with Democrats, as they indicated they might in 2017, we could see a curtailment of tariffs and a wide-ranging infrastructure bill. Given the highly partisan political environment, however, compromise seems less likely and gridlock the norm.

How will markets respond? It’s difficult to predict, but if we see a Democrat controlled house, the Congressional agenda of the past two years (deregulation, protectionist trade policy, tax breaks and loosening of environmental regulations) will likely end. Investors in sectors like conventional energy and materials/mining will see this as a negative. Sectors like renewable energy and industries dependent on trade, like technology, are likely to view it as a positive development.

We continue to recommend balanced investment portfolios and a reduction of exposure to risk assets that may be vulnerable in a market correction.

Regards, 

Subir Grewal, CFA, CFP    Louis Berger

Keeping an eye on what matters for the economy, Trade.

Keeping an eye on what matters for the economy, Trade.

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Dear Friends,

Over the past year and a half, trying to absorb news has felt a bit like drinking water from a fire hose. Like many of you, we have steadily become more concerned and simultaneously more accustomed to the chaos being created by the current US administration. While the actions of our government have deviated from the values of the American people in the past, this disconnect is especially evident today. The government’s high disapproval ratings reinforce the fact that its actions represent a minority of American society. A large majority of Americans are not beguiled by the administration’s base appeals to fear.

Amid all the animosity directed at weaker members of our society, the administration has also undertaken ill-considered actions on trade that we believe will impact investors.

In many industrial fields, US protections for workers and the environment outpace those in developing parts of the world. This, coupled with our relative wealth, creates a situation where set-up costs tend to be higher in the US than they are in less wealthy nations. The international trade norms which have been adopted by much of the world over the past several decades acknowledge this fact. They establish basic labor and environmental protection standards which most nations adhere to. The expectation is that as industries in other countries mature, they face natural pressures to improve labor and environment practices. We can see this dynamic in effect in China, India and much of the developing world as a more assertive labor force organizes itself and citizens demand safer, cleaner, healthier environments. Previous US administrations have largely stuck with this bargain and helped cement it. This administration’s response is markedly different. It has worked relentlessly to demolish protections for workers and the environment, engaging in a race to the bottom. Such an effort will have a long-term impact on our human and ecological capital.

US workers, citizens and enterprises have legitimate concerns about our trade policies. Much of what our country exports is ethereal: movies, software, music, designs and technology are simple to reproduce if the original source is available. American technology companies fend off numerous attempts each day to steal valuable designs or content. Some of these attempts are successful. In several cases, the perpetrators and beneficiaries of such thefts are politically connected businesses.

Prior administrations have worked to slow down and deter such anti-competitive trade practices, opting for targeted action that sought to limit the impact on other industries. The current administration has repeatedly shown a penchant for using a sledgehammer when a scalpel is more appropriate, and this matter is no different. It has embarked on a series of wide-ranging punitive tariffs on a range of goods, from a number of different countries, including China and close allies like the EU and Canada. These countries have begun to respond, slapping tariffs on American exports.

As the cycle of tit-for-tat increases in import duties gathers steam, markets have begun to wobble. Global trade and supply chains rely on orders placed months ahead of time. For the system to function, some degree of price stability has to exist. When prices, or in this case, duties are changing rapidly, traders are apt to overcompensate, not knowing whether the worst of the increases are baked in. An increase in duties can force companies to modify supply chains, moving production to different areas in an effort to avoid tariffs. Newer centers of production take time to ramp up and build expertise. When enough of this happens, supplies become constrained, prices rise, and quality suffers. None of these are good outcomes for enterprise or consumers.

As the administration’s trade war intensifies, driven by a president whose instinct is to always double down, we are not complacent about the risks.

A decline in trade levels will impact a wide swath of American industry, which is deeply interwoven into a global network of production. When trade levels fall, we will see this ripple through corporate expectations and outlook, eventually reducing valuations, earnings and prices.

Based on this outlook, we recommend investors maintain caution and adopt defensive positions. Reducing risk assets and holding a portion of portfolios in low risk securities such as short-term government bonds, fixed deposits or cash remains our priority.

 

Regards,

 

Subir Grewal, CFA, CFP                                                                     Louis Berger

2018 Q1 letter: Why the roller-coaster market is back.

2018 Q1 letter: Why the roller-coaster market is back.

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As we noted in our 2017 year-end review, we expect 2018 to be a tough year for the domestic stock market. Rising interest rates and valuation concerns are going to be the major story for investors this year. Stock market valuations remain elevated, with the S&P 500 currently priced at 24 times last year’s earnings. This is far higher than the post-war average of 17 times earnings.

The primary justification for high P/E ratios is the extremely low interest rate environment we’ve experienced in this century. For much of the 80s and 90s, interest rates remained above 5% (see chart below). In contrast, since April 2001, US interest rates have kept well below 5%, apart from 13 months spread between 2006-07.

This unusually low interest-rate environment has support stock prices throughout the 21st century. Low interest rates spur higher stock prices for a variety of reasons:

  • Income oriented investors are driven to the stock market since bonds and bank deposits offer very little return.

  • Future corporate earnings are valued more highly since the discount rate is lower.

  • Consumers and companies take advantage of low interest rates to finance projects and purchases cheaply. This spurs sales.

  • Leverage becomes cheap for speculators, amplifying the amount of money invested the market.

When rates begin to rise, all these supportive factors are reversed, acting as a head-wind for stocks. The Fed has signaled that it intends to continue raising interest rates since unemployment is low and the overall health of the economy remains strong. In our view, rate hikes are the crucial factor driving the recent stock market drops, and we believe this volatility will continue.

There’s no denying the market has been more volatile since January. Over the past three years, the S&P 500 has seen 20 days when it was down more than 2%. Seven of those days have occurred in 2018 (and we’re only in early April). As of this writing, the S&P 500 is now 10% below the peak reached on January 26th. Technology stocks, which had seemed relatively immune to the downturn have also begun to sell-off. Over the long-term, we continue to believe technology will become a larger part of consumer’s lives and our economy. However, just as with every industry, business models can change and seemingly unassailable companies can falter. The current, sky-high valuations for many technology companies leave little room for error.

In our view, conditions remain challenging for the stock market, and investors should adopt or maintain defensive positions. This can be accomplished in multiple ways: holding short-term and floating rate bonds, reducing overall allocations to stocks and shifting into more stable stock-market sectors (such as consumer staples).

As we do on a continuing basis, we have been evaluating client allocations and adjusting investments as warranted. Please let us know if you have questions about your portfolio or holdings.

PS. If there is a friend or relative you believe would benefit from a conversation with us, as always, we would appreciate the introduction.

Regards,

 

 

Subir Grewal, CFA, CFP Louis Berger

Review of 2017 Themes: The Doldrums

Review of 2017 Themes: The Doldrums

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2017 was an uneven year for our market predictions. We were right on five calls, half right on one call and wrong on four calls. Continued bullishness and investor support for the Trump administration (despite abysmal poll numbers) torpedoed three of our calls.

  1. ? Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017. The Fed started 2017 with a target interest rate of 0.50%-0.75% and finished the year with a target rate of 1.25%-1.50%. While the Fed raised rates, they met but did not exceed 1.50%, so we’re giving ourselves half a point on this one.
  2. × Equities Caution: We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year. We were dead wrong on this call as US equities continued their bull market run through year eight.
  3. ? Artificial Intelligence: We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call. Artificial Intelligence-related companies had a very strong 2017 as the Global Robotics and Artificial Intelligence Index was up 57.62%. Comparatively, the S&P 600 Consumer Discretionary Index was up 17.13%.
  4. ? Continental shifts: Over the next several years, we expect Indian markets to outperform those in China and the developed world. We were right on year one of this call. The S&P BMI India Index was up 29.56% in 2017. This compares to 26.67% return for the S&P Greater China Index and 21.83% return for the S&P 500 Index.
  5. × European upheavals: We believe European stocks to be more attractively priced than US equities…we expect European stocks to outperform US equities. While European stocks performed in-line with our expectations — S&P 350 Europe Index was up 10.75% on the year — the unexpectedly strong performance of US stocks (21.83% return for the S&P 500 Index) easily outperformed this total.
  6. × Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. Despite rising interest rates, the USD weakened against a basket of international currencies in 2017.
  7. ? Drones are going to be delivering much more than bombs: We expect companies building these technologies to outperform the freight and shipping transportation companies. While we view this as a long term trend, 2017 saw drone-related companies outperform. The Solactive Robotics and Drones Index was up 38.7% while the S&P 500 Transportation Index was up 23.52%.
  8. ? Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. YieldCos saw a strong rebound in 2017 and handily outperformed traditional utilities. The Global YieldCo Index saw returns of 22.87% while the S&P 1500 Utilities Index returned 12.16%.
  9. ? Retail Real-Estate: We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments. This prediction came to fruition as brick and mortar stores, and particularly malls, continued to see a decline in foot traffic and a loss of market share to online shopping in 2017. The FTSE NAREIT Regional Malls Index was -2.68% and the FTSE NAREIT Shopping Centers Index was -11.37%. Meanwhile, the FTSE NAREIT Composite was up 9.29%.
  10. × Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises. As we expected, President Trump has been unable to follow through on his campaign promises, and his approval ratings are among the lowest ever recorded for a first year presidency. However, a strong economy, robust corporate profits and the prospect of a tax cut allowed investors to shrug off his policy failures, chaotic management style and a criminal investigation to send equity markets to all-time highs.
Powering down the Fed’s bond buying engine.

Powering down the Fed’s bond buying engine.

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We trust you’ve had a restful and enjoyable summer.

This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.

This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.

Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.

The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.

Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.

The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.

Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.

 

Regards,

 

Subir Grewal, CFA, CFP                           Louis Berger

2017 Q2 letter: A threat to human civilization

2017 Q2 letter: A threat to human civilization

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Dear Friends,

The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.

The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.

Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.

From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the  five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.

Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.

As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.

Data source: Robert Shiller – Yale University

We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.

For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.

Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.

At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.

Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.

Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.

As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.

There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.

Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.

The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.

It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.

All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.

Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.

 

 

 

Regards,

 

 

Subir Grewal, CFA, CFP                                                                                              Louis Berger

2017 Themes: The Doldrums

2017 Themes: The Doldrums

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  1. Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017.
  1. Equities Caution: We continue to be cautious on US equities, as we have been for the past several years. S&P 500 is priced at over 25 times last-year’s earnings. Even if we use projections that forecast a recovery in energy sector prices, P/E ratios are over 20. Rising rates erode support for outsized price-earnings ratios. We are also in the eighth year of a long bull market with a number of credit related issues in markets across the world. We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year.
  1. Artificial Intelligence: Technology continues to come at us hard and fast, but the groundwork has been around for decades. We recall using voice-recognition software to dictate texts almost 20 years ago. It was slow and cumbersome. Modern voice recognition is vastly improved by faster hardware and refined software. When coupled with the ability to search for information and issue instructions to connected devices, this technology can seem very much like science fiction, evoking both fears and dreams. Yet, asking Alexa to lower your blinds is in essence no different than using “the clapper” to turn on the lights. We expect this to be the year that voice activated instructions come to various devices, including cars and household appliances. Companies with effective voice activated solutions will find themselves partnering with manufacturers of all sorts of devices, not simply computer and phone makers. The revenue and earnings implications are less clear. Licensing fees may not amount to much and a large part of the value for technology companies may derive from sales of media and in Amazon’s case, all sorts of goods. We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call.
  1. Continental shifts: For much of human history Asia has been the center of the global economy. That changed in the centuries following the European industrial revolution and colonial expansion. Over the past thirty years, rapid growth in China has brought gross East/South Asian annual GDP (ex-Russia) to roughly 25 Trillion USD. This exceeds both that of North America and Europe/Central Asia, both around 20 Trillion USD. The big laggard in Asia has been India, where per capita GDP is 20% that of China. We expect India’s growth rate to exceed that of China’s for the next several years, with the relative difference in per capita GDP falling. Despite the numerous hurdles to doing business in India, we expect investors will begin to pay more attention to companies with exposure to India and an India related strategy. Over the next several years, we expect Indian markets to outperform those in China and the developed world.
  1. European upheavals: This will be a busy year of European politics, there are major elections in France and Germany. Looming over it all is last year’s British decision to exit the Europe zone. Any or all of these have the capacity to inject more policy uncertainty and create market upheavals. Though we believe European stocks to be more attractively priced than US equities, these concerns give us pause. Nevertheless, we expect European stocks to outperform US equities.
  1. Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. This impacts the returns dollar-based investors can expect to realize from foreign investments.
  1. Drones are going to be delivering much more than bombs: Many of us have been concerned about the impact of automated weapons on conflicts across the world. This technology raises numerous difficult ethical questions, alongside legal dilemmas. Less attention has been paid to the revolution soon to overtake transport and delivery services of every form. Remote operations and autonomous guiding systems are approaching the point where not just driverless cars, but pilot-less planes, captain-less ships and person-less food delivery are about to become a reality. These technologies are going to create immense disruptions for various work-forces across the aviation, shipping and transport sectors. As with so many other technologies, the armaments industry has led the way. But the long-term impacts on our economy, politics and lives will be driven by the commercial applications of these technologies. We expect companies building these technologies to outperform the freight and shipping transportation companies.
  1. Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. Despite a high likelihood of loosening EPA standards, we think YieldCos benefit from a newer fleet of power plants and stock prices that haven’t recovered much from the energy crash of 2014/15.
  1. Retail Real-Estate: We believe the retail real estate sector will come under pressure from rising interest rates and a secular shift towards online purchases. We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments.
  1. Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises.
What should investors expect if Trump wins?

What should investors expect if Trump wins?

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First, we think a Trump victory is quite unlikely. That said, the probability is not zero, it’s likely to be around 15-25%. We routinely analyze even less likely events and their impact on markets, so we have considered the reaction of markets if Mr. Trump were to win the general election.

There will be almost no place to hide from the initial volatility after an unexpected Trump victory. We expect significant turmoil in the financial markets and we believe that in the short-term (days/weeks) there will be few safe havens. Mr. Trump’s economic policies are so unconventional, and his temperament so mercurial, that we expect almost all sectors and asset classes to be somewhat affected by negative uncertainty. Precious metals may be the only asset that benefits from a flight to safety.

Bonds have traditionally served as a safe haven in times of turmoil. We believe bond investors should not remain sanguine if Mr. Trump does win the presidency. As a leveraged developer, Mr. Trump has had a colorful and combative history with lenders. His natural bluster has been intermittently aimed at bond markets during this campaign and the prospect of a Trump administration in control of the US Treasury is bound to spook bond investors. He has suggested he would unilaterally default on US sovereign debt (arguably not a novel position since the Republican congress toyed with a similar position in 2011) and seek to renegotiate principal amounts.

Mr. Trump has made combative comments about the Federal Reserve and its current policies. He has also expressed dissatisfaction with the current low interest rate regime. Taken together, these sharp, unusual policy views create immense uncertainty about how Mr. Trump would manage the credit and repayment of US debt, the government’s relationship with the Fed, and other issues of concern to the broader credit markets. We expect FX markets to exhibit a flight to perceived safety which historically has benefited the Swiss Franc and Japanese Yen. Uncertainty about bonds and rates will also hit real assets heavily dependent on credit markets. We do not expect real-estate to do well.

When it comes to stocks, we expect broad declines in the short term, but some sectors will be harder hit than others. The banking and financial sector is likely to see a steep decline in market sentiment and levels. Mr. Trump has made several negative statements about banks and their business models. Banks are also naturally leveraged and very sensitive to market sentiment. None of this augurs well for the banking or financial sectors.

Given Mr. Trump’s combative stance on trade and trade agreements, we would expect sectors dependent on imports/exports in their global supply chain to be battered. This includes consumer discretionary, technology, heavy industry, materials, and depending on precise global footprint, energy companies. In contrast, consumer staples should play their standard defensive role.

The immediate sentiment towards the defense industry is somewhat more uncertain. Mr. Trump has, at times, advocated a combative posture on national security and war matters. In almost direct contradiction, he has also proclaimed he would reduce the defense budget and the number of military bases overseas in line with his “America First” pledge. Defense contractors dependent on Pentagon contracts for services to troops overseas are likely to see sentiment and stock prices decline. Large defense manufacturers should decline as well since Mr. Trump has expressed skepticism about some expensive weapons programs (the F-35 in particular). The foreign policy and defense team Mr. Trump puts in place will determine how this plays out in the longer-term.

Beyond the initial few weeks and months, we expect much will depend on the composition of Mr. Trump’s administration and his demeanor during the transition. A prospective Trump administration caught up in balancing spending, debt, legislative priorities and political considerations would normally be constrained. However, Mr. Trump is likely to have a compliant Congress, with Republican legislative majorities and both Senators and Representatives eager to please the new force in American politics. It is impossible to make longer-range forecasts of what a Trump administration’s policies would look like, simply because we do not know his true priorities. We would advise investors to be extremely cautious about bargain-shopping in the immediate aftermath of a Trump victory.

Mr. Trump is unlikely to win the election, but in the event he did, we believe markets will react very poorly, at least initially. He is in many ways, the opposite of a traditional conservative politician, disdaining societal norms and conventional politics. Mr. Trump’s election would engender policy uncertainty on a scale not seen for decades, upending long-range business plans and reducing risk-appetites across the board. We would advise investors to exercise caution in the event Mr. Trump wins.

2016 Q1 letter: Negative interest rates cap a rocky quarter

2016 Q1 letter: Negative interest rates cap a rocky quarter

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Friends,

The first quarter of 2016 saw market gyrations far rockier than many prognosticators had expected. A sharp drop in commodities prices and oil in particular sparked fears of a global slow-down and impacted all asset classes. Increased oil production in North America and the prospect of renewed imports from Iran led to expectations of a supply glut. Slowing economies in China, Brazil and Russia along with concern about potential slumps in the EU and US drove demand expectations down. Together, they combined to drive oil below $30 a barrel, causing great distress among the highest cost operators. Producers relying on deep sea projects (Brazil) and hydraulic fracturing (or fracking, in North America) have been among the most severely affected. Many small to mid-sized servicers and production companies are facing possible bankruptcy and have been liquidating assets. This has impacted the high-yield bond market (where many of these companies raised capital) and led to job losses in states where fracking had created small oil booms.

The commodity decline also caused steep retrenchment in various equity markets and drove the Federal Reserve to signal a pause in its plan to raise interest rates to 1% this year. The S&P 500 dropped as much 13% during the quarter and the MSCI Global stock index fell 11%. The S&P 500 has since recovered for the year, along with oil prices. In our view, the concerns that drove the asset market declines have not abated. Global growth continues to be weak and numerous markets are showing the signs of a waning seven year bull market. We would continue to urge caution when investing in risk assets across most markets.

Policy makers in several countries seem to have reached the end of their imagination when it comes to additional market stimulus. About 25% of the global economy now has negative interest rates. That includes the Euro-zone, Japan, Switzerland and Sweden. Banks are now being charged to maintain balances at the central bank. In a number of cases, banks have begun to pass these negative rates on to customers. This is bound to create great consternation. Depositors are not accustomed to being charged interest to maintain deposits. They may be used to seeing fees deducted from checking accounts, but most will be shocked to see savings accounts charged interest. In an environment where banks are already suspect in the eyes of many, this will lead to even more discontent.

From anecdotal evidence, customers have already begun to protest negative rates. We believe there is little sense in keeping rates negative for extended periods of time. In theory, it sounds reasonable to say there should be no zero-bound for rates. But humans are not theoretical creatures. We find being charged to keep our money in a bank rather strange, and customers will develop all sorts of behaviors to avoid this. These include keeping large sums of cash at home and purchasing safe haven non-financial assets (real-estate, precious metals etc.). Such behavior undermines the stated aims of negative rates, i.e. increasing the level of bank lending. The longer we maintain negative rates, the more distortions we introduce into the savings/money markets. In our view, this is not a policy that regulators should maintain for any period of time. It would be far more effective to apply fiscal stimulus in the form of government spending.

While markets have seemingly stabilized after a very volatile start to the year, we expect 2016 will see continued ups and downs with high risk assets remaining vulnerable to a price correction. We think this will present buying opportunities and we will continue to look for good entry points to buy equities we see as undervalued. We expect the market for bonds to remain very challenging for investors since rates are extremely low and corporate credit is deteriorating alongside the dip in global growth.

Regards,

Subir Grewal                                                                                                 Louis Berger

2015 year-end review of themes

2015 year-end review of themes

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Overall, we did well on our call for 2015. We were right on six, half right on three others and had one wrong. In general, the year lived up to our expectations of a low return environment with the anticipated Fed rate hike being the biggest influence.

 

  1. ~ If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. We were right on this call, but the Fed chose to wait till December to raise rates to 0.50%.Though the Fed has signaled rates will be raised to 1.25-1.50%, we are calling this one half-right.

 

  1. ~ No one rings a bell at the top of the market: […] we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory. We were mostly right here, two out of the three indices ended down. The S&P500 ended 2014 at 2,059 and 2015 at 2,044; the Dow Jones dropped from 17,823 to 17,425; but the Nasdaq rose from 4,736 to 5,007.

 

  1. + Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. […] We expect emerging market stocks and bonds to underperform developed markets this year. The MSCI Emerging Markets Index ended the year down 17%. The Chinese markets ended the year down over 10%, Brazil was down almost 16%, Russia down over 6%, and India down over 2%.

 

  1. + Commodities weighed down: […] We see commodities finishing the year flat to negative. The Goldman-Sachs Commodities Index ended 2015 down over 30%.

 

  1. +  The trouble with oil: We do not expect oil prices to substantially recover in 2015. […] We expect brent crude prices to remain under $60 by year’s end. Brent crude started the year around $57 and ended 2015 around $37.

 

  1. + Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view. We were half right on this call as healthcare outperformed the S&P 500 Index in 2015 (S&P Healthcare Index +5.8%) while utilities lagged (S&P Utilities Index -7.9%).

 

  1. + Euro Crisis, back to the future: […] Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro. Over the course of the year, we saw another round of concerns about Greece that led to weeks of tense negotiation. The Euro ended the year down about 10% against USD (from 1.20 to 1.07) partly s a result of continued concern about the longer-term prospects for the Euro-zone. Though economic issues have faded from view as a continuing refugee crisis absorbs headlines, we do not believe the Euro-zones strategic challenges have been dealt with.

 

  1. + Junk bonds get kicked to the curb. […] With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.  We were correct on this call as high yield bonds suffered their first down year since 2008.  The Barclays High Yield Bond Index was -6.77% for 2015.

 

  1. × Growth in Renewables: […] With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors. We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.  We believe we’re a bit early on this call, but for year-end list-scoring purposes we were wrong.  Renewable energy stocks had a negative return for 2015 impacted by falling prices for conventional energy. Renewables did however, outperform traditional fossil fuel energy stocks.  The Nasdaq Clean Edge Green Energy Index was -6.21% while the S&P 500 Energy Index finished -21.12%.

 

  1. + The Russian question: […] We are bearish on Russia and expect the Russian market to underperform in 2015. The Russian market ended the year down 6%.

 

Chinese police haul in investment managers to probe “market volatility”

Chinese police haul in investment managers to probe “market volatility”

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Over the course of this week, every move in global markets has been ascribed to “fear about China”. But it’s pretty clear that most of the media does not really understand what is happening in Chinese “markets” and the Chinese economy.

Markets are closed in China today and tomorrow, while Hong Kong will be open on Friday. On Wednesday, Chinese markets were down more than 4%, but came back to close about flat. Many observers assumed this was because state entities had been told to buy ahead of the big military parade to mark the 70th anniversary of V-J day (15-20 million Chinese people were killed in WW-II).

The biggest financial issues in China are related to local government debt (think municipal debt) and its rapid growth. Local governments have been on a debt issuing spree for years, which is necessary since they have limited taxing authority. Their revenues come from borrowing and selling land to real-estate developers. Those sales are complete with kickbacks and evictions of long-time residents. The problem is, real-estate development has dropped off a cliff so they aren’t buying land anymore. And this week, the Chinese authorities announced they would limit how much local governments can borrow this year (they’ve been talking about limits for three years and set some last year). That means local government revenues and spending are about to fall off a cliff as well.

The best commentary on Chinese credit markets comes from Michael Pettis. His latest post is: If we don’t understand both sides of China’s balance sheet, we understand neither.

But the stock market is what interests most people. So, here’s a scary fact about Chinese stocks. A number of Chinese companies trade on both the Shanghai stock exchange (on-shore A shares) and in Hong Kong (off-shore H shares). Their prices in Shanghai are, on average, 115% higher than the prices in Hong Kong. The shares represent the exact same economic interest in the exact same enterprise. Part of the reason is that so many Chinese stocks have suspended trading. Part of it is that China banned stock sales by major shareholders and executives for six months (through 2015). At one point in July, stock brokerage firms in China were instructed by the authorities not to accept any sell orders.

Whatever the Shanghai stock exchange is, it is definitely not a “market” in the sense that buyers and sellers meet and freely trade there. Hong Kong is much closer to a free market, which means if you believe HK prices are correct, Shanghai should another 50%. There are some “free-market” types who (mistakenly) think the H-share discount represents a “bargain” rather than reality. Or it may mean Rmb has a lot further to fall.

Yesterday, there were reports that Chinese regulators have called in numerous heads of investment management companies in an attempt to probe “market volatility”. Rumors are flying around about forcible detentions, in particular there are numerous stories about the Chinese head of the world’s largest fund of hedge funds, Man Group.

Li’s mobile phone was turned off when called on Monday. Chaoyong Wang, Li’s husband, said in a telephone interview that she is in a meeting with “relevant industry authorities” and he doesn’t know who they are. He said he spoke to her by telephone yesterday and today, expects her back home soon but does not know when.

Someone, somewhere is probably thinking, “I wish they were arresting hedge fund types here”. Remember, this is China. One senior manager told a colleague “If I don’t come back, look after my wife” as he left the office in response to a summons from the authorities.

It’s been an open secret that Chinese economic data, on unemployment, GDP and industrial activity is, shall we say heavily massaged. Lots of market participants have joked about this amongst themselves, but the implications are now being debated more seriously. I’ll let Chris Balding cover some of the more egregious issues:

No less than the second in command of China, the Premier Li Keqiang, has stated that Chinese GDP data is unreliable and “man-made”.  To put this in perspective, thecurrent Premier of China, second in command for the entire country, leading economic policy formulation, a Phd in economics, having spent essentially all his career inside public administration in various posts throughout China advises you not to trust GDP figures…

For more than a decade, Chinese unemployment spent most of its time bouncing between 4-4.2%.  Chinese economists became skeptical of the number and conducted a study estimating urban unemployment during their sample period reached 10.9%.

China has undoubtedly grown significantly over the long run and this is unquestionably good for China and the world. However, that is not the question.  The question is how reliable are Chinese GDP figures.  I believe as a baseline case from my own research alone, real Chinese GDP would need to revised downward by a minimum of 10% or approximately $1 trillion USD.  Add in other known problems and I believe the number could go as high as a downward revision of 30% of real GDP.  Think of it using a simple scenario, let’s assume every year since 2000 China has overstated GDP by 1%.  In other words, 10% is in reality 9%.  That would imply that today, China needs to revise current real GDP downwards by approximately 16%.  This would still mean that China has grown significantly but also, as a mountain of clear evidence indicates, Chinese GDP growth has been overstated. Finally, it is important to note that lots of little numbers are clearly off but all these little numbers add up to big changes especially when added up over time.

Compound interest can work against you folks.

A number of people are saying: All eyes on Chinese markets on Monday.

The real risk is China, not Greece – 2015 Q2 Letter

The real risk is China, not Greece – 2015 Q2 Letter

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Two inflection points long in the making appear to have arrived simultaneously over the past few weeks. In Europe, negotiations between Greece and Euro-zone countries that have lent to Greece appear to have broken down; and in China, the stock market has taken a remarkable tumble. In itself, the Shanghai market’s steep fall is not surprising or remarkable (this was a market which had risen 150% over the previous year), but it is interesting in terms of what it portends for other markets and factors in China.

The various actors in the Greek/Euro crisis have indulged in brinksmanship for a number of years. The ECB, Euro-zone countries and the Greek government have stumbled from one crisis to the next, taking action only when forced to do so. And when they have acted, the result is to defer rather than reach resolution. It is clear to us that no final resolution of Greece’s sovereign debts can be made without some debt relief. The Greek economy has shrunk enormously under the weight of uncertainty and austerity policies. None of the modeled targets for growth have been met and Greece’s debts are now a larger multiple of Greek GDP (180%) than ever before, largely because of the sharp decline in GDP. A sudden growth spurt may solve that, but given high unemployment, it is difficult to see that materializing without some level of debt relief to lower the amount of the outstanding loans and interest payments. In reality, the only thing that has been achieved thus far is that Greek loans have been moved from the balance sheets of European banks to the balance sheets of European nations. European (and international) banks that lent to Greece, knowing the risks, were bailed out. There has been no such deliverance for Greece itself, and, despite frantic 11th hour negotiations, we do not expect one in the coming days.

A crucial factor that has made the crisis much worse for ordinary individuals in Greece is the absence of a pan-European deposit guarantee scheme. Bank customers in the US have enjoyed a federal guarantee for their deposits since the 1930s. This guarantee currently applies to the first $250,000 on deposit at an FDIC covered institution and has been the primary reason the US has avoided widespread bank runs by retail customers for the past 80 years. In contrast, deposit guarantees and guarantee funds in Europe are run at the member state level. So Greece guarantees the deposits in its banks up to 100,000 Euros. Of course, Greece (unlike the US federal government) has no ability to actually print Euros on demand. That means most bank customers treat its deposit insurance with justified skepticism. Greek banks too cannot count on the European Central Bank to lend to them freely in a crisis. There is an emergency lending facility, but it works through the member state central banks and let’s just say relations between Greece and the ECB are not exactly amicable at the moment.

These two factors taken together explain the phenomenon of Greek pensioners queuing for hours to withdraw the maximum amount permitted from their bank accounts each day (60 Euros). They do not trust the funds will be covered by deposit guarantees and Greek banks are limiting withdrawals, afraid they will run out of Euros.

As a study in contrasts, we have Puerto Rico, which is facing a similar government debt crisis, largely brought on by similar factors (mismanagement, misstatement of financial data, etc.). Yet, the impact is limited to the government’s ability to issue more debt and the value of its bonds. Puerto Rico’s bank will face no runs and will continue to function even if the government runs out of money. They are regulated and insured at the federal level. So, though Puerto Rico’s debt crisis is very serious, and will likely require some level of write downs, its banking system continues to hum along and is not at risk. If the European Union had a similar bank deposit guarantee system, we believe the Greek crisis would not have been as severe.

Lastly, what makes the Greek case significant and holds the market’s attention is not the size of Greece’s debts, which at around 300Bn are large, but not enormous. A 30% write-down of those debts would be 100Bn, some individual banks took write-downs in the 30-70Bn range during the financial crisis. Clearly Greek creditors (EU countries for the most part) could survive a 30% write-down.

What concerns the markets is that the Greek crisis lays bare an uncomfortable truth. The European Union is both unable, and unwilling to act decisively or with coordination in a crisis. The reasons are myriad, but to us, it has been particularly striking to hear World War I and II era rivalries and events repeatedly invoked by some commentators and even senior politicians. A skeptical observer might say that the institutions created to avoid the recurrence of war on the European continent seem to be hell-bent on re-living them. In contrast, though, we in the United States have had the traumatic experience of reliving civil war-era animosities over the past few weeks, those fervently invoking a North/South divide are firmly in the fringe and have been for at least a century. The same cannot be said of Europe.

We have been wary of asset prices and debt burdens within China for a number of years. Some of those concerns have bubbled to the surface in the last few weeks as the Chinese domestic market has endured a series of dramatic losses with many stocks hitting their down limits and several have halted trading entirely. Companies can also ask to suspend their own shares and many have. Most observers have expected such a crash since the on-shore Shanghai market has risen over 75% this year. What was underappreciated is how much of this rise has been driven by large numbers of first-time retail investors, many of them buying stock on margin (borrowed money). The conditions appear to resemble the state of the US market on the eve of the 1929 and 2000 stock market crashes. In certain ways, there are broader parallels with 1929. China is at roughly the same stage of relative development with the US that the US was to the UK in 1929. China has also seen massive investment in capital infrastructure with declining returns, not unlike the US investment in railroads in the 20s. Lastly, there are large quantities of questionable loans on the books at Chinese banks. Taken together, this story is much bigger and could have much wider repercussions than that just a few down days in a large emerging market.

The final consideration is political. Though there is a lot of tittering at the prospect of the Communist party attempting to support the stock market, this is driven by legitimate fears of political unrest if a severe downturn were to materialize. Coupled with factionalism within the party, such a downturn could make for a very volatile period in China, politically speaking. The impact is likely to be felt across commodity sectors (where China remains a major consumer), and a risk of contagion to other markets. In the short term, we expect the US markets will be seen as a relative safe haven. Though clearly, as one of the three largest economies in the world, any Chinese downturn will affect global market values.

On balance, we view the bursting of the Chinese equity bubble and antecedent effects as more significant than the Greek debt crisis. In terms of wealth impact, they certainly are — the Chinese stock market has lost over $3Tn over the past few weeks. That is ten times the amount of outstanding Greek debt. Margin balances owed by Chinese investors are larger than Greek debt. The real concern, though, is that the stock market bubble in its rise and fall, may lead to a bigger reckoning of Chinese financial institutions which are holding real-estate and provincial debt. As the real-estate sector has slowed, demand for land, which constituted a crucial source of funding for Chinese provinces, has dried up. Both real-estate developers and Chinese provincial government debts are looking very weak and they are widely held by Chinese banks and investors.

In general, we recommend appropriate caution for investors. Though the US markets may appear to be isolated from events in Europe and China, and might even benefit from some short-term “flight to safety”, they will eventually be impacted, and current valuations stateside do not bode well for that reckoning.

We continue to believe that investors will be well served to reduce exposure to risk assets in their portfolios and move some money into short term bonds and cash while awaiting a better buying opportunity.

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