2010 MID YEAR REVIEW OF MARKETS: FUNNY MONEY
"Not only is such a union unprecedented in history, we can declare it a resounding success. Within the space of a decade, it has clearly become the second most important currency in the world; it has brought economic stability; it has promoted economic and financial integration, and generated trade and growth among its members; and its framework for sound and sustainable public finances helps ensure that future generations can continue to benefit from the social systems that Europe is justly famous for."
European Commission Report on the EU Currency Union, May 2008
"The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, having already used it(s) spare tire."
Mohamed El-Erian, Co-CEO, PIMCO, commenting in "Secular Outlook", May 2010
The first half of 2010 ended on a very weak note, as concerns mounted over the strength of a perceived global recovery. Debt problems in the Eurozone came to the fore and stocks returned to a posture of underperformance:
All returns are cumulative, not annualized
Bonds and gold have proven their mettle during these difficult times. Despite their recent dip, emerging markets offer an encouraging longer term picture. Stocks and, more recently, commodities have struggled, and inflation is flattish. The returns above demonstrate that long held investment beliefs (like "buy stocks for the long run") are being challenged, and investors who pursue non-traditional strategies (like buying gold) may be onto something. We suspect that long term return assumptions will look quite different going forward, and the impact of volatility will play an important role in shaping investor perceptions of risk.
In this review, we will touch on macroeconomic themes, bond and stock market developments, and the big picture. We believe the most important overlay for investors is to understand that deflationary forces are gaining strength as fiscal (government spending) policies are being ratcheted down globally. To pick up the slack, private demand must be revived, yet tax and regulatory burdens are rising, creating disincentives to invest. While the risk of inflation is always present, we believe the environment has changed meaningfully since our last review, and suggests a prolonged period of weak demand ahead. Investors should favor cash, bonds, gold and other assets that benefit at the deflationary end of a deflation/inflation "barbell" strategy.
US GDP growth fell slightly after recovering from a steep decline in 2008-09, to settle at a 2.7% annual rate:
Most economists question whether growth can resume without a pickup in new orders leading to inventory re-stocking, which largely drove the surge in 2009, and whether federal stimulus money can be replaced.
Recent indicators suggest that a "double dip" is appearing. A pronounced rollover in the ECRI Index of Leading Economic Indicators is of great concern to many:
This is among the most accurate recession forecaster of all leading economic indicators. The Purchasing Managers Index (PMI), which notes future purchasing decisions, has also notably wilted of late. These all point to a deceleration in growth occurring ahead.
On the inflation front, it is becoming clear that a deflationary trend is taking hold--Bernanke's worst nightmare. The PPI declined in June by -.5%, for the third consecutive month. Crude goods prices, at the beginning of the production chain, are off -7.5% since February. The broad-based CPI is off -.3% since February.
The "trimmed mean PCE inflation rate" is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA), and is highlighted frequently by David Rosenberg, one of the best macro thinkers in the business. It is the "cleanest" read on consumer prices from his perspective, and it clearly shows the recent drop towards deflation:
The dictionary defines deflation as "a general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression." The broad supply of money in the US economy is now declining:
The graph above can be thought of as the "economic blood supply". All of the Fed's actions since the credit crisis of 2007-08 began have been intended to prevent deflation. However, monetary actions alone cannot reverse the primary trend of a debt-induced deflation, which produce lower asset prices and aggregate demand as income is impaired. The "spare tire" of lowering short term rates that is referenced in our opening quote from Mohammed El-Erian has been used, to little effect. The only tool left in the Fed's monetary policy arsenal is to print more money to attempt to stimulate growth. By some accounts, the Fed's balance sheet could double over the next twelve months as the QE II (Quantitative Easing II) is pulled out of dry-dock to sail on its deflationary rescue mission. Deflationary episodes in the past have demonstrated that printing presses cannot substitute for private sector investment and growth, the key missing ingredient to a sustained recovery. However, as in 2009, asset prices may temporarily levitate on the perception of another transfusion.
Finally, the employment picture remains a significant impediment to growth. The "unofficial" unemployment rate as calculated by ace economist John Williams at shadowstats.com is north of 22% (not 9.5%, which is the sanitized and manipulated Official Rate of Unemployment). Williams and others are most concerned with the length of unemployment, where more than 60% have been unemployed for 15 weeks or longer (thus the current legislative push to extend unemployment benefits). Williams states blatantly that "the current circumstance is the worst ever seen in the history of the data, (and is) without modern precedent." This atypical downturn is a symptom of the wage vacuum occurring globally, where excess labor cannot command higher compensation, thus contributing significantly to deflation as "income impairment" becomes permanent for many. This discouraging state of affairs will amplify and support the anti-free market forces which are sure to gather steam in the increasingly confrontational socio-political environment that lies ahead.
Short term interest rates remained near zero during the first half of 2010, but longer term rates declined, mirroring the fall in inflation:
There is much disagreement among market observers about the trend for interest rates. The blogosphere is rife with warnings about imminent inflation and hyper-inflation, which would cause bond prices to plummet, especially the more sensitive long maturity varieties. A recent Barron's cover story warned: "Beware Bond Funds-When Interest Rates Finally Rise, Bond Fund Holders Will Get Slammed".
The just released minutes of the FOMC meeting provide a fitting rebuttal to the Barron's headline. The Fed sees weaker conditions ahead, as they lowered GDP and inflation forecasts, and pointed to continued high rates of unemployment for the next several years. This is the astonishing language used in the Minutes: "Participants generally anticipated that it would take some time for the economy to converge fully to its long run path...most expected the convergence process to take no more than five or six years." That is an extraordinary admission of impotence, and indicates that more Fed actions are coming. This should be a beneficial environment for bonds, as yield curves generally flatten when economic growth slows. While most investors find it hard to find "value" in bonds, they may be one of the best places to position portfolios for a slowdown, as bond prices will rise if long term rates decline further. (It is also worth noting that the FOMC forecast makes it difficult to build a case for rising short term interest rates. The Fed is on hold, perhaps for a long time to come.)
Corporate bonds have remained surprisingly resilient in the face of deteriorating macroeconomic data, which normally causes their yields to increase. In a yield-starved world, it may be as simple as a stubborn unwillingness to let go of higher income streams, even as conditions for distress/default become more favorable. In any event, the credit implosion of 2008 has demonstrated that "risk" assets like corporate bonds are subject to wide valuation adjustments, and any unfavorable economic developments should produce higher yields/spreads:
Source: Bank of America Merrill Lynch Capital Markets
The phenomenon of income impairment is being felt acutely at the state and local government level, as tax revenues decline due to falling asset values and usage, thus heightening concern about the health of the municipal bond market. Unaccustomed to prolonged contraction, city and county managers are being demonized for "draconian cuts", when in fact they are reconciling long bloated and unsustainable budgets with the new austerity paradigm that many are realizing is here to stay.
Some entities will need to start over. In early June, for instance, the Town of Central Falls Rhode Island appointed a receiver to reorganize the town's dire finances. Like 22 other states, RI does not permit bankruptcy filings under Chapter 9. Instead, a receiver steps in to assume control of all assets and to rework union contracts, cut pension benefits, adjust tax rates, etc. As an indication of its problems, the Central Falls pension fund has $4 million in assets, but has promised $35 million in benefits (liabilities). Basic math apparently eludes elected officials or their pension consultants who are supposed to act with a fiduciary obligation. The courts will weigh in as all these solutions will be challenged. More importantly, it is a microcosm of significant fiscal imbalances which have to be rectified.
Pension mismatches are especially rife throughout the public sector, and there are significant behind the scenes efforts underway to have the federal Pension Benefit Guaranty Corp. (PBGC) assume some of these deficits. It will be an important test of whether the bailouts are ending or continuing, and we feel it is one of the most under-reported developments of the evolving dilemma for state and local governments. A cave-in by the PBGC will open the floodgates for all fiscal miscreants to enter.
Unlike the Directors of publicly traded companies, mayors, councilpersons, and governors can threaten bankruptcy without being sued, so expect to hear a lot more of these "dire warnings" going forward. Over time, however, it is more likely that a slow and steady series of credit downgrades/bond ratings will occur, rather than pervasive defaults. The ratings agencies are more proactive on this front, having been caught flat-footed during the sub-prime mortgage debacle, and, with the loss of many municipal bond insurance guarantees, they are keen to demonstrate sound and timely ongoing credit review practices.
Lastly, investors should begin to think about the introduction by the Fed of long term interest rate targeting to aid a flailing economy. Ben Bernanke explicitly stated in his famous 2002 "helicopter" speech ("Deflation: Making Sure It Doesn't Happen Here") that the Fed could buy bonds to prevent yields from rising above a certain level if monetary stimulus (printing money, lowering short term rates) failed to revive the economy: "A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields." This rare policy tool has been used before, but not in the modern era. The bond vigilantes who think that they can influence market rates may be in for a shock as the vast levers of the Fed (and perhaps other central banks) prevent interest rates (and bond prices) from finding their natural levels. This is the one outcome that the "hyper-inflationists" need to explain, and it may come as a shock to the rest of the market as well that there may be a "lid" on future interest rate increases. This scenario becomes more plausible as the gargantuan cost of carrying the US debt is magnified by unwelcome increases in interest rates.
Stocks declined in the first half of 2010, as fears about a global slowdown gained traction during the second quarter, reversing a positive first quarter. Defensive, consumer oriented names held up best, while cyclical shares underperformed:
Source: Dow Jones Industry Groups
There is a great debate among market observers currently about whether stocks are "cheap" or "expensive". Current year operating earnings for the S&P 500 reside around $78, with next year pegged towards $90. At a level of 1050, that produces PE metrics of 14X and 11.6X for trailing and forward estimates. S&P notes that earnings surged 43% year over year from the bottom in Q2 2009 (with a large contribution from the propped-up finance sector), but the recent quarter was up just 1.9%: "Bottom line is earnings may hold up, but sales growth is slow and companies aren't going to invest their record cash holdings until it improves." We think the operating environment will support only modest earnings increases for the next several quarters, and therefore a lower than normal equity weight is called for. We also favor the longer term view that U.S. equities are in a secular bear market, and that a base for broad based revival of shares should occur at valuations lower than here--perhaps 6-8X current earnings levels.
On May 6th, U.S. equity markets experienced a brief but severe drop in prices, as indexes plunged over 5% within minutes, and some individual stocks traded down 90%. Now labeled the "flash crash", this was in our view perhaps the most significant market event this year. It remains unexplained by regulators. Many hypotheses center around the sudden evaporation of buyers as trading patterns detected by computer driven, algorithmically programmed machines were disrupted. Short term "high frequency trading" by computers (in some cases milliseconds), aided by algorithmic intelligence, now accounts for over 70% of volume in the US by most accounts. While "circuit breaker" rules were re-imposed after May 6 (a temporary halt in trading upon any short term decline), this phenomenon has the capacity to derail equity markets. It contributes significantly to the risk profile of equities, and can make fundamental valuation metrics irrelevant. In the end, market confidence will be most detrimentally affected should future "trap doors" appear, and investors should monitor developments around this activity closely.
Globally, equity investors are grappling with the prospects for Chinese growth, for which much of the bullish outlook has been built. Chinese share prices have corrected by some 20% from their recent highs, and GDP growth is rolling back to the high single digits from double digit increases of late. The real concern is whether a housing crash is imminent, as pessimists point to mushrooming bank loans (up by a third in 2009 alone) and huge over-supply. Jim Chanos, a famed US short seller, is highly convicted that the Chinese "bubble" will burst, and has aggressively positioned to benefit from falling asset prices there. Just as in 2008, our view is that the Communist Party will do whatever it takes to prevent widespread social unrest that a collapse would bring. Their massive trade surplus gives them the luxury of deciding when and how to combat any deleterious trends, and we would not bet against this behemoth.
Closer to home, the disastrous Deepwater Horizon oil pipeline rupture in the Gulf of Mexico has recast the entire energy debate going forward. Despite the healthy untapped resources lying offshore, our view is that the "cost" of a future accident will now be deemed unacceptable. Onshore deposits that are in politically "safe" areas and which have low extraction risk will be the "go to" projects. That means Canadian oil sands, also known as tar sands.
Canada has 178 billion barrels of proven oil reserves, virtually all in oil sands, exceeded only by Saudi Arabia. Mostly lying in the Province of Alberta, whose government recently rescinded a poorly conceived royalty tax increase, these deposits are virtually "risk free" in their processing, which involves scooping up vast quantities of tar-like soil (bitumen) and "melting" out the oil (through steam-assisted gravity drainage, or SAGD, among other processes). The heat required is fired by nearby natural gas fields, whose price languishes at very low rates (i.e. input costs are very affordable). The stars are now aligned so that these operators are going to enjoy healthy increases in demand and profits. Already, the chessboard pieces are in motion, as China Investment Corp. (CIC) has agreed to a Joint Venture with Penn West Energy to meaningfully increase output, and a 9% position in Syncrude was purchased by Sinopec (China's largest oil refiner) recently.
Furthermore, Canadian oil sands are expected to become America's top source of imported oil this year, surpassing conventional Canadian oil imports and roughly equaling the combined imports from Saudi Arabia and Kuwait, according to IHS Cambridge Energy Research Associates, a consulting firm. In a new report, it projects that oil sands production could make up as much as 36 percent of United States oil imports by 2030. "The uncertainty and the slowdown in drilling permits in the Gulf really underscores the growing importance of Canadian oil sands, which over the last decade have gone from being a fringe energy source to being one of strategic importance," said Daniel Yergin, an oil historian and chairman of IHS CERA. "Looking ahead, its importance is only going to get bigger." Put another way by David L. Goldwyn, coordinator for international energy affairs at the State Department: "It is undeniable that having a large supply of crude oil available by pipeline from a friendly neighbor is extremely valuable to the energy security of the United States."
Lastly, we note that the Paris based International Energy Agency proclaimed that China surpassed the U.S. in 2009 to become the world's biggest energy consumer, five years ahead of experts' forecasts. Calling it a "new age in the history of energy", the U.S. relinquished the top spot held since the early 1900's. The tectonic plates are truly shifting.
The Bigger Picture and Outlook
The primary near term challenge for global markets is the outlook for the Euro and the Eurozone debt. The European Commission report quote that began our review was premature, as the vaunted "framework" for the Euro came crashing down in May amid Greek wailing and nashing of teeth. The European Central Bank (ECB), taking a page from the US Fed's playbook, began its own version of Quantitative Easing in May, as it stepped in to buy badly wounded Greek bonds to support prices. This was a week after Jean Claude-Trichet, the ECB head, declared "there is no way we will intervene". Confidence in the ECB has been wounded by these actions.
Yields on "Club Med" bonds (Greece, Italy, Spain, etc.) continue to gyrate as sentiment remains in flux. Short term loans are virtually unavailable. In the private banking sector, the ECB announced in mid-June that it would re-institute a program of short term loans to banks "on an unlimited basis" through the summer at favorable rates, but also gave no indication that the program would end soon. The reason for these lifelines is that many European banks cannot fund themselves by selling short term commercial paper or CD's. They are frozen out of the market because investors are (rightly) suspicious of what lies buried in their financial statements. These are the same conditions that held in the summer of 2008 in the U.S. when confidence in the health of the banking system began a steep decline.
In another twist, it turns out that US money market funds hold some $60 billion in short term investments in European banks. There is speculation that the US Fed recently re-opened US dollar swap lines with the ECB to provide liquidity to the European banking system, which will need these dollars to pay off maturing commercial paper that will not be reinvested. This is another indication of global co-dependency that causes a move in one market to reverberate in many others.
Closer to home, and seemingly lost amongst all the daily perturbations about stock prices, interest rates, and currency moves, is the worsening state of the US housing market. U.S. home foreclosures reached a record for the second consecutive month in May 2010, with increases in every state, as lenders stepped up property seizures, according to Realty Trac Inc. Bank repossessions climbed 44% since last May, and foreclosure filings are rising. A recent Bloomberg story quoted Rick Sharga, Realty Trac's senior vice president for marketing: "We're nowhere near out of the woods...we're likely to set a quarterly record for home seizures if June is anything like May." Lenders are completing the 'inevitable progression' of taking properties from homeowners who stopped paying, Sharga said. He predicted last month that another 5 million delinquent mortgages will end in foreclosure, in addition to properties that had already been repossessed. "The second quarter won't be the peak...I'm not even sure 2010 will be."
The financial regulatory reform bill in the U.S. will serve to dampen bank profitability, as new taxes and compliance burdens will constrain and raise the cost of loans. The so-called Dodd-Frank bill is already being pilloried for imposing the most complex regulatory burden since the post-Crash reform of the 1930's. The Wall Street Journal estimates that at least 243 new federal rule-makings will be needed, running from hundreds to thousands of pages in the Federal Register. It does not address the most urgent matter in the entire U.S. financial system, which is the disposition of Fannie Mae and Freddie Mac and their impaired assets and the continuing federal guarantees for housing loans.
In Europe, a mandatory tax/levy on banks will go forward to create a "superfund" as a solution to the "bad loan" problem. This will be overseen by governments who were absent at the regulatory switch in the first place (just as in the U.S.), and who have already capitulated to saving these mega-banks by saddling the public sector with the bailout. They are "saving the system" by creating more debt funded by more taxes.
(We introduced our readers last year to Simon Johnson, the former chief economist of the IMF, who warned that the financial oligarchy (i.e. big banks) which control many of the world's governments (and thus the financial system itself) must be broken up before it is too late. A re-read of "The Quiet Coup" is recommended):
In another twist, European central banks loaned vast quantities of gold to the Bank for International Settlements (BIS) in June to raise cash for their own lending activities, the first such action in decades. One astute observer thinks that this manoeuvre reflects a paradigm shift in central banks' evaluation of gold. Heretofore seen as a non-interest bearing dusty relic, gold may now be viewed as a valuable asset to help attain policy goals going forward.
These actions collectively are producing heightened uncertainty for business which will retard spending and investment going forward. Historically, the economic pendulum has swung from favourable conditions in the private sector to less favourable, and investors should adapt their views to account for this downshift now occurring.
The primary long term challenge for global markets is how fiscal reform will proceed. It appears to us that some sort of tipping point was reached with the recent G-20 meeting, as the "Austerity vs. Stimulus" contest was unveiled. The Eurozone committed to reducing government expenditures, agreeing to halve their collective budget deficits within 3 years. The US did not support this position, arguing for continuing expenditures to avoid another downturn. Tony Crescenzi of PIMCO (the world's largest bond manager) has labelled this a "Keynesian endpoint", as exhausted balance sheets of developed nations leave policy makers with few options to bolster economic growth. "Time, devaluations, and debt restructurings might be the only way out for many nations," Crescenzi wrote in a recent e-mail to investors note titled "Keynesian Endpoint". Debt-fueled spending programs aimed at combating the global financial crisis of 2008 are among policy tools now "being seen as a magic elixir that has morphed into poison". A long and uncomfortable period of adjustment lies ahead regardless of the path chosen.
The continued ability to borrow and spend has practical limitations, and it is well illustrated by the following graph, which includes not only "official" debt (bonds issued and outstanding), but also unfunded liabilities (promises to pay future benefits):
In the U.S., Fed Chairman Bernanke has been beating the drum steadily for a return to fiscal responsibility. Appearing before the U.S. House on June 9 he said: "...history makes clear that failure to achieve fiscal sustainability will, over time, sap the nation's economic vitality, reduce our living standards, and greatly increase the risk of economic and financial instability...in the absence of further policy actions, the federal budget appears to be on an unsustainable path...unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth ".
Perhaps the idea of throttling back is finally gaining traction. A recent front page New York Times story read: "Calls for Stimulus Yield to Deficit Concerns: At a moment when many economists warn that the American economic recovery is likely to be imperiled by prolonged high unemployment and slow growth, President Obama is discovering that the tools available to him last year - a big economic stimulus and action by the Federal Reserve - are both now politically untenable. The mood in both parties of Congress has turned decidedly anti-deficit, meaning that the job-creation programs once favored by the White House and Democratic leaders in Congress have been cut back, then cut again." The approaching mid-term elections will make it difficult to vote for more spending, regardless of the parting of ways at the G20.
In our view, the catalyst for resolution will be for electorates to cast out profligate governments (hopefully by peaceful means) and re-alter the path to fiscal serfdom that is the inevitable outcome of current actions. This may happen quicker than markets expect. In April, the far right Fidesz populist party won a landslide victory in Hungary, and promptly challenged the commitment to pay off Hungary's debts. Party leaders backtracked quickly when the markets punished their currency (the Hungarian forint is not part of the EU), but this is merely an opening salvo in the coming fiscal wars. In May, Conservatives in the UK regained power preaching fiscal austerity and a dramatic shrinking of the State. It took the help of a third party to boot the Labour party out, and a "coalition government" now rules. In Germany, the party of Chancellor Angela Merkel, the CDU, suffered its worst election defeat since 1945 in the State of North Rhine/Westphalia, as voters spoke loudly and forcefully against the bailout of Greece and the EU. In June, in the Slovak Republic, a group of right leaning political parties dedicated to shrinking state spending won enough votes to be part of the next coalition government. The same thing happened in the Czech Republic. In the Netherlands, a far right party preaching fiscal conservatism has also won a place in a coalition government. Most recently, the ruling party in Japan lost their parliamentary majority as the upstart Your Party took seats on a platform of smaller, limited government. Change is coming, and the socio-political ramifications have yet to be fully extrapolated by markets. The political risks attending portfolio management will become paramount in the period ahead.
For all these reasons, we see gold and precious metals being a core holding in all portfolios. The level of debts now in the system can only be repaid through rapid and deliberate inflation, or a "haircut" (restructuring to reduce the value owed to bondholders). All of the bailouts and austerity measures announced to date are band-aids that buy time and prolong the inevitable. In spite of short term setbacks, we expect a powerful gold buying frenzy to develop at some point as investors realize that global currency and credit systems must be dramatically reformed before they can heal. As shown below, long periods of out-performance by gold (the "valleys") follow the rise and fall of stock prices (the "mountains"):
Investors have been whip-sawed by violent market actions these past several years, and subjected to a relentless litany of bad news. This is all part and parcel of an historic global change underway, which will see economic and political power migrate towards younger nation-states. Realistically evaluating and implementing a long term plan to benefit from this paradigm shift will mitigate the inevitable ups and downs of sentiment-driven markets.
Working through the debt problems faced by advanced economies will take quite some time, and will result in lower rates of growth than in the past, especially now that the "austerity vs. stimulus" battles have begun. Markets will continue to ponder whether the un-backed currencies of over-indebted countries are "funny money", or actually have a viable future. Real wealth in the ground, whether precious metals, energy, or agriculture, will have a greater role to play, especially as emerging middle classes globally increase their consumption.
Despite today's challenges, investors have never had a broader global investment opportunity set. The continuing evolvement of the mutual fund and exchange-traded fund marketplace has been nothing short of revolutionary. Small and large investors alike have before them a plethora of wealth preserving and enhancing vehicles, which are not all centered around bearing equity market risk and volatility. Our focus and commitment remains on prudently deploying portfolio assets across a wide array of assets and markets to grow wealth through changing and unpredictable environments.
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