“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”
~ Ernest Hemingway
Before diving into to this Mountain Vision Update, I want to wish all of our American readers a Happy Thanksgiving!
A few weeks back, BFI Wealth Management released its latest outlook report, the BFI InSights Q4 2015; we published it here on Mountain Vision on November 12th.
In the report, Dirk Steinhoff, BFI’s Chief Investment Officer, focused on outlining the considerations and benefits of restructuring your investment portfolio in preparation of what lies ahead. In particular, he explained the measures being taken in adjusting our client portfolios with an increased allocation in best-in-class and so-called market-neutral hedge funds, funds with long and solid track records even going back to the market periods encountered in 2008 or 2011.
We are fast approaching a crossroads in financial markets which deserves prompt attention and action. Dirk Steinhoff, in the report’s section titled ‘Beyond the obvious: The times are changing!’ touched on the influence of central banks over the past years and questioned their “omnipotence”. In essence, more and more central bank-induced liquidity will only get you so far.
After decades of decreasing interest rates and the past 7 years of extensive, and at this point global, monetary expansion and currency depreciation games, it is only a matter of time until this house of cards comes tumbling down, with potentially a very loud bang. It is not a question of ‘if’, but ‘when’.
At this point, several indicators and factors warn us that we may be fast approaching the end of the paper-lifeline. The implications will be significant, and not just for bond markets. Equity markets will be impacted, too.
Today, I’d like to summarize some of our concerns and point out the signals and indicators that, quite imminently, concern us. The most important one first: INFLATION!
Yes, I know, like a mantra, we have been told for several years now that deflation was the (only) enemy. And, in general, that has been true. However, as mentioned in several of our Updates in the past, price stability is a fickle monster. In the coming months, inflation will be on the rise.
So far, financial markets have largely ignored this fact. Nevertheless, with rising inflation, we stand before one of the starkest challenges we’ve encountered since 2008 or 2012, when Mr. Draghi, the president of the ECB, avoided more damage and potentially detrimental speculations in the midst of the European debt crisis by promising to “do whatever it takes”. He kept his promise. Since then, as we all know, the ECB jumped on the bandwagon of speed printing.
Since the beginning of the financial crisis in 2008, base money supply in the Euro zone has increased by 130%. In the US, it increased by 460%. In Switzerland, in its own battle to fight the upward pressure on the Swiss franc while the Euro came tumbling down, base money supply increased by 500%! Similar numbers can be seen in Japan and other large economies.
The issue we see today: we stand before a “wall of inflation”. The challenge we face is the fact that inflation rates will rise in industrial nations in the coming months, because the dampening effects of the retracting oil price we witnessed in the winter of 2014 / 2015 has been largely used up.
According to the Monthly Perspectives of October 2015, published by Wellershoff & Partners, a leading economic research firm in Switzerland, official inflation rates will rise from 0% to 2% in the US. Meanwhile, in the Euro zone, inflation will rise from 0% to 1%. This might not sound all too dramatic. Inflation of 2% and 1% appear quite reasonable and potentially healthy, right? These kinds of swings in the inflation rate, as a result of energy or food price fluctuations, are quite normal…not a big deal. This will surely not impact financial markets.
Well, we dare to disagree. Even more important than these inflation estimates are the inflation expectations of market participants. The reactions of market participants to inflation changes are generally not rational.
The challenge, and our concern related to financial markets, will be for the market not to overreact in terms of its inflation expectations. We have our doubts. The current mix of indicators tells us that global financial markets will not easily digest the revived specter of inflation, particularly when it rises most prominently in the US.
Rising inflation = rising interest rates
Inflation will lead to rising interest rates. In the current context of a zero-interest rate world, and after years of radically expansive monetary policies, even a nominally moderate increase of 1 or 2 percent in US interest rates will have a well-noticed ripple effect across all financial markets and asset classes, stocks included.
Please note, this inflation-induced increase in interest rates is not to be confused with the US Fed Funds Rate increase expected for next month’s meeting of December 15th and 16th. The Fed is expected to proceed with the rate hike, after keeping at close to zero for the past 7 years. In fact, we are concerned that the Fed has fallen behind the curve. Maybe they did so intentionally. One of the declared measures to solve America’s debt problems has been inflation.
The Fed’s rate hike would hardly have much of an impact on markets. To some degree, market participants might consider it as a positive sign, one that confirms hopes for further economic recovery. The inflation-induced rise in interest rates, however, is very different in nature and will not be interpreted in a positive light.
Are rising rates bad for stock markets?
This is a good and important question. Rising interest rates, as we all know, will have a negative impact on bonds. But, what about stocks? Historically, rising inflation and interest rates have been a companion of economic growth and prosperity, a scenario that will obviously favor stocks.
But our current situation, unfortunately, does not support that scenario. Yes, growth numbers in most developed economies are in a positive zone. In the US, estimates come to about 2.5 percent annualized growth for the next two quarters. In Great Britain, Japan and Switzerland too, growth rates are expected to remain in positive territory. And in the Euro zone, expectations are now at 2 percent, and therefore on a positive tangent indeed.
Why then are expectations in stock markets generally so subdued? Several factors need to be considered that do not bode well for stocks, particularly when inflation and interest rates start rising as discussed above.
A bull market running out of steam
Since 2008, we have witnessed a rapid sequence of central bank interventions in monetary markets. The US Federal Reserve took the lead in 2008 with its QE programs. Wall Street took the blessings of the Fed in full stride. A 6-year bull market followed. At this point, the bull market is rapidly running out of steam.
Disappointing company earnings
The spree of Quantitative Easing (QE) in the US, while having certainly super-charged the financial markets, did not benefit real median income of US households nearly as much. The following figure (Figure 1) compares the rise of the S&P 500 Index (green line) versus the real median income in the US. The divergence is striking. A sad picture for Main Street indeed.
Figure 1: Wall Street versus Main Street
Source: Carmignac Research
Figure 1 highlights the fact that, since the end of 2013, company earnings are no longer benefitting from QE. After-tax earnings are falling. Wall Street just concluded its worst reporting season since the financial crisis. And, based on consensus expectations, there is little hope for improvement anytime soon. For Q4, analysts expect shrinking profits for the largest US corporations. One reason for this weakish outlook is due to the strong dollar. Further uncertainties arise from the expected Fed Funds Rate hike. The red line in Figure 1 depicts the now rapidly growing gap between the stock market and company earnings. This gap will not hold for long.
During the first phase of QE, starting in December 2008, company earnings rose rapidly, with stock markets. QE helped companies to employ cheap money to achieve high returns in financial markets. Meanwhile, a lot less money flowed into investments for operational purposes.
Buyback “Bonanza” is over
QE-induced cheap money was also heavily used for corporate buy-back programs. Today, that is over.
A lot less money is flowing into buyback programs now. Figure 2 below paints the picture of a clear trend in that regard. A study by Goldman Sachs points out the drawbacks of the buyback frenzy. Their calculations show that net debt levels, relative to company EBITDA, have reached its highest level since 2008. This too cannot go on much longer, particularly in site of rising interest rates.
In other words, the vogue of buybacks is over. That means that an important driver of the bull market is stepping out of the picture.
Figure 2: Buyback Bonanza – Contribution to S&P EPS growth coming to an end
Source: Deutsche Bank
Market breadth in decline
A typical alert sign for a bull market running out of steam is decreasing market breadth. Imagine a bull market carried by fewer and fewer stocks. Toward the end of a bull market cycle, investors become increasingly selective.
This phenomenon is particularly visible in US stock markets. While it can be measured in a variety of ways, one example is by counting the number of stocks or indices that lie above their 200-day moving average. The higher the number, the more robust and sustainable the bull market is. Vice versa: a lower number can imply the end of the cycle. In the case of the US market, today only 27% of stocks listed on the New York Stock Exchange are above the 200-day moving average. Any number below 50% is considered bad news.
Reduced gross exposure of hedge funds
An early indicator I find very interesting and regularly consult is the equity exposure of hedge funds. A number of large hedge funds such as Atlas, a multi-strategy fund managed by Balyasny Asset Management, regularly report their net and gross exposure.
In the case of Atlas, a large portion of their portfolio is made up of long-short equity strategies. The net exposure measures the proportionate allocation of long versus short positions. Generally, long positions are over-weighted, resulting in positive net exposure. In down-markets, the net exposure tends to rapidly turn negative. The gross exposure measures the overall allocation of the fund in equity markets, including long and short positions.
At this point, the hedge funds we’ve qualified for our own investments at BFI (see the BFI Alternatives Composite mentioned earlier) have been lowering their gross exposure drastically over the past few months. I consider this a very noteworthy negative early indicator.
Figure 3: Copper Price, futures New York, $/lb
A host of uncertainties and warning signals
Emerging markets have, over the past years, been an important driver for international stock markets. How will they react to rising rates in the US? At this point, capital flows out of emerging markets are weakening those economies that have, over the past years, most depended on them. Economies like Brazil boomed on the back of cheap money, high commodity prices and capital flowing into the economy. At this point, the tide has turned.
Copper has just reached a new low (Figure 3). It too is widely considered an important early indicator. Copper is a cyclical metal. Demand increases and decreases according to economic activity. The price of copper is strongly influenced by the buying behavior of the Chinese; approximately 40% of the global demand for copper comes from China. When China’s building and industrial activities drop, the price of copper is rapidly suppressed. The cooling off of China’s economy is therefore largely mirrored in a falling copper price. It also has a considerable influence on the global economy.
The PMI, or the US Purchasing Manager Index, a measure of economic expectations by “members of the real economy”, has been in rapid decline. It is currently just slightly above 50. A PMI dropping below 50 is seen as an early indicator for recessions.
Geo-political tensions are growing. So far, the market has proven immune to the recent horrible terrorist attacks in Paris, or the Ukraine crisis. What impact will Turkey’s shooting down a Russian warplane have? Such political developments are difficult to factor in and generally will not impact short-term economic fundamentals. However, geo-politics and the global economy are intertwined. In the longer-term, you can expect a further continuation and aggravation of events to have an impact on economic growth and prosperity.
I will stop here; the list of warning signals has become quite long…and long enough. I hope I’ve been able to alert you to the fact that it is a good time to consider the implications and possible adjustments in your wealth planning.
How to protect yourself
There are two dimensions to effectively protecting and growing your wealth: one regards structure, the other investing. It is important that you consider both.
The structure you set up should ideally afford a solid combination of asset protection, institutional and jurisdictional safety, tax efficiency and global investment flexibility.
Your investment strategy, in consideration of the above, will need to find a good balance of risk management and risk taking. In the current context, when return expectations are highly questionable for most asset classes, and certainly for bonds, the traditional and somewhat automatic allocation toward stocks and bonds will hardly cut it. I recommend you consider a very selective and diligent allocation toward alternatives.
We are calling on our clients to make these adjustments in the coming weeks. Let me know if you’d like some guidance and support. We are here to help, as best as we can.
Frank R. Suess