Asset Prices And Risk Levels Rising – Market Commentary by Narrow Road Capital
- Both risk assets and “safe haven” assets rose in July with negative interest rates and quantitative easing helping to drive gains
- “Safe haven” assets are becoming crowded and the widely held belief in lower for longer interest rates creates a risk for almost all asset classes
- Economic data points to sluggish US and global growth
- Sections on banks, regulators, monetary and fiscal policy, China, emerging markets and politics
Asset Prices and Risk Levels Rising
Almost all risk assets rose in July, with strong gains in equities and debt. US equities are back to record highs finishing the month up 3.6% with strong gains in Japan (6.4%), Australia (6.3%), Europe (4.4%) and China (1.6%). Investment grade and high yield recorded very strong gains in the US and Australia. Commodities were a mixed bag with US oil down 14.0% and iron ore up 6.7%. Gold (2.2%), Copper (0.7%) and US natural gas (-1.4%) had smaller moves.
The big question for the month was the dichotomy created by both risk assets and “safe haven” assets rising. When risk assets perform well that usually indicates a strong economy. When bond prices rise (yields fall) that usually indicates a weaker economic outlook and potentially a recession ahead. With both occurring at the same time which one is right? There’s a slew of different answers, but the simplest one is that negative interest rates and quantitative easing are the tide that lifts all boats.
Central banks buy government bonds with the aim of pushing down yields. When investors sell their bonds to a central bank they can either put the money in a bank or go and buy other assets. When cash rates are near zero or negative, cash rates look so bad some say that there is no alternative but to buy riskier assets. We can see this in US investment grade corporate bonds where corporates are struggling to issue enough to meet demand and the new issue premium has collapsed to almost nothing. In markets like this you start to see people arguing about relative overvaluations, for example junk bonds are overpriced but are not as bad as equities and are emerging markets a trap?
I use the term “safe haven” carefully now as supposedly safe assets are becoming crowded and aren’t necessarily safe anymore. The idea that interest rates could increase is almost heresy. The consensus view is that the world is awash with cash and interest rates are going to be lower for longer. Investors are responding by going all in on long bonds. The belief in lower for longer interest rates also underpins gains in equities, property and infrastructure investments in recent years. If the consensus is wrong asset prices could change quickly and dramatically. The reigning bond king Jeffrey Gundlach called it a “ world of uber complacency” and recommended investors sell everything.
The three main concerns for US equities are the high P/E ratios, a poor outlook for earnings growth and the quality of earnings issue. The run up in indices this month was primarily P/E expansion as quarterly earnings are showing only 1% year on year growth. Bank of America has 14 out 20 indicators saying that equities are overpriced and energy P/E ratios are literally off the chart. The earnings quality issue continues to grow with 94% of S&P 500 companies now reporting two types of earnings.
Perhaps the only investment sector that fell hard during the month was UK property. At least nine unlisted property funds with total assets of more than £15 billion halted redemptions. There’s been a range of responses, some funds have slashed asset values and then re-opened, whilst one sold a property at a 15% discount to the book value. I wrote about these issues last month so I won’t repeat it all, but this is a warning as what can happen to illiquid assets in open ended funds. US high yield debt is probably the sector that has the biggest risk of this type.
In long term economic indicators there’s five ugly data points this month. Second quarter GDP for the US came in at a measly 1.2%, following on from 0.8% in the first quarter. US consumers are spending up, but businesses ran down bloated inventory levels and pulled back on investments. US restaurant sales are flat year on year, which could be a pre-recession indicator. McDonalds is hoping to grow by stealing market share from competitors, so that will pretty much guarantee margin compression on top of no revenue growth. The US Cass Freight index and global trade levels are both saying economies are stagnant. Lastly, online job ads in the US have plunged this year.
The decline of the oil price this month is troubling for many highly indebted companies and countries. Standard and Poor’s has seen 100 defaults in the first six months of 2016, which is on pace to beat the record number of defaults in 2009. Many of the defaults are from energy companies. Supply is increasing as Canada and Nigeria are coming back on line after recent disruptions. Demand growth is flat as global economic growth is sluggish. Oil and associated products in storage in the US, China, Europe and at sea are at record levels.
The Italian government is scrambling to put together two programs to support its banks. The banks need help as the pile of non-performing loans is bigger than the bank’s tangible equity and provisions set aside for losses. Following on from the Atlas fund another solvency program is being proposed. This one involves the government using €10 billion of taxpayer money to buy €50 billion of non-performing loans from the banks. A separate liquidity facility would provide up to €150 billion of senior debt if depositors and international lenders rush for the exits.
The most troublesome of the Italian Banks is Monte Dei Paschi. It was the only bank to outright fail the Europe bank “stress” test, which is so weak it should be called a tickle test. A bailout is obviously required and is being patched together. Part one involves dumping €50 billion of non-performing loans onto the Atlas bailout fund. Atlas is expected to receive another €15 billion in order to be able to swallow those loans. Part two is a €5 billion capital raising to be underwritten by eight banks. On face value the numbers for all of this don’t work and a lot more capital will be needed. It’s also not clear who be willing to throw good money after bad in the Atlas fund or Monte Dei Paschi, a taxpayer funded bailout seems the most likely option. An updated business plan is due to be released in September.