RGA Investment Advisor 2Q20 Commentary: The Tale of Two Markets
RGA Investment Advisor commentary for the second quarter ended July 2020, titled, "The Tale of Two Markets." Q2 2020 hedge fund letters, conferences and more In our Q1 2019 commentary we expressed how “COVID-19 will kick off one of the most profound reshaping of our world any of us will see in our lifetime,” accompanied Read More
“Forecasts tell you little about the future but a lot about the forecaster” Warren Buffett
- Global Recession
- DM Equities Down at least 10% for the Year
- ECB Rate Cuts
- Income Worship
- Australia Loses it’s Shine – AUD plummets
- Value of Liquidity Increases
- USD up 10%
- Real Estate Prices Fall 5%
- More Fallen Giants
- Obama Loses Election
- Pension Problems
In hindsight, making my 2011 predictions was relatively easy because I thought that there was a fairly high likelihood of a bunch of non-consensus events happening which would surprise market participants and make me look quite clever. Because of this, I predicted the seemingly contradictory moves to 2% on the 10 Yr Yield and a Silver price spike to above $40 per ounce (and got out before the crash, with thanks to Cullen Roche at PragCap!).
This year I feel that it’s much harder to be contrarian, the world is distinctly gloomier and furthermore, I am finding it hard to even get a handle on “where consensus is?” I think these predictions are probably more aboutdegree of difference from what many market participants are saying.
In caution, I refer to Bob Farrell’s Market Rule #9 – “When all the experts and forecasts agree — something else is going to happen”
1. Global Recession
The US Economy continues to substantially outperform UK and Europe’s austerity based misery; but it still enters recession barring substantial fiscal policy change. In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, re-regulation and deglobalization would actt as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite.
My template is that this is just an extension of the 2008 recession, the return to the spotlight of the ongoing Balance Sheet Recession we have been mired in for 3 years. As Niall Ferguson terms it, we are in a “Slight Depression”. The great worry is that we are very light on policy tools to engender a 2009 style cyclical recovery.
“I think there’s a larger camp that says we’re going to muddle through; we’re going to get slow growth. I would point out that that’s never happened. We never muddle through. A market economy does not want to have a static state. It either accelerates or it decelerates, and these forward looking indicators say decelerate.”Lakshman Achuthan
Achuthan makes a very interesting point here given that “muddle through” has become a very common “go to explanation” for many market commentators. If what he says is correct, and it usually is, then there is great concern to be taken from the pronounced deceleration in most economic activity indicators globally.
HSBC Flash PMI Index
2. Developed Market Equities Negative for the Year
The Street consensus is, as it always is, for a good year in equities with around an 11% increase on the S&P 500 to 1360 (this is exactly the number they had for Year End 2011 too!). In recessions equities get whacked by at least 20%. I say this as fact until someone proves me wrong. I do not care for strategists telling me that recessions are priced in; I strongly suspect that this is absolute nonsense. Markets are incredibly good at whistling idly by until the evidence smacks them in the face.
“When the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, Citigroup CEO as of 2007
I think we are probably in a renewed cyclical bear within an ongoing secular bear market.
Andrew Smithers recently updated his CAPE and Q Ratio data to include Q3 earnings reports, at that date the S&P 500 was at 1131 and the market was overvalued by 26.5% according to the Q Ratio, and was overvalued by 37.5% according to CAPE. Historically these valuations are getting close to extremely elevated.
Operating Margins are at near all time highs too leaving much to go wrong, although this partly due to operating efficiencies and productivity gains.
There is the possibility that we have a horrendous trifecta of falling margins, contracting P/E multiples and cyclically enhanced earnings tailing off as the economy rolls over. As I have noted elsewhere, European valuations are considerably less stretched – perhaps with good reason!
However, I believe Mr Market’s way is to attempt to cause the most pain to the most people – in this regard – I postulate if perhaps the most painful trade for the majority of market participants is actually up?
3. European Crisis
The Great Denouement – I don’t believe the can gets kicked into 2013. Austerity leads to slower activity, which requires more austerity, which forces further slowdowns. We are in a death spiral. Every day that the cost of funding is above the GDP growth rate, and this is the case for every single Euro economy as of today, their debt dynamics get worse.
Whichever metrics you look at – absolute bond yields, spreads over Bunds, the TED Spread, financial sector equity and bonds prices, investor sentiment, European PMI numbers etc we can see that the situation is getting out of control. I think markets will force a resolution.
Fate would dictate that the PIIGS have a massive amount of debt rollover in 2012 – more than 300bn Euros from Italy and 100bn from Spain, much of it focused in Q1.
It is also a big year for bank debt rollover, commercial property refinancing and probably financial equity issuance too. Where does all the money come from and at what cost?
The ECB steps up to plate taking rates down further to 0.5%, but only after making politicians sweat for as long as possible forcing bank recaps via nationalisation or rights issues.
I quite like the idea of owning German assets like Bunds for the possibility that in a Euro End-Game scenario they would be converted into Deutsche Marks and therefore receive a substantial appreciation relative to other currencies on that redenomination.
4. Income Worship
There were two main trends playing out in 2011, Risk ON/Risk OFF and the outperformance of dividend stocks. Many investors and professionals embarrassed themselves with doing little more than whipsawing themselves from bullish to bearish based on the most recent press release from the most recent emergency Euro Summit. The market ended flat after months of persistent, record volatility and now investors are watching as many dividend-paying stocks break out to new multi-year highs, regardless of political turmoil here and abroad.
A portfolio of unsexy but high-yielding utilities trounced the market and investors are now paying attention. GMO demonstrated that over the course of 3 years or longer, the dividend stream becomes a larger and larger part of the investor’s total return on an investment. The lesson investors will take away from 2011 is that you can buy and hold, but only if you are being paid handsomely to wait.
Focus on the sustainability of dividends and a requirement of “strong balance sheets” was starting to bore me by Q3 2011 but I strongly suspect it’s only going to get more and more prevalent as the buy on every dip cyclicals disappoint investors. There will be a global dash for finite yield.
I think we’ll see companies forced to give back some of the large cash reserves on their balance sheets as the year progresses. “Use it or lose it!” I expect Tech companies like Cisco, Dell, Microsoft and maybe even Apple to start paying more shareholder friendly dividends.
The only things that don’t work in this space are financial credits and EM bonds. EM bonds in particular strike me as a risky trade because so many big institutional players own around 30% of these relatively immature and shallow markets. Big Boys all trying to fit out through a small fire exit leads to losses for everyone. EM Bonds have also seen a lot of hot money flows from the carry trade and retail investors. Who am I to call out Bill Gross but I don’t think this is a “safe spread”.
5. Australia Loses its Shine
This is a holdover from my 2011 predictions. I think it offers potential as a nice asymmetric trade going into this year. Australia loses its shine as its own consumer debt/housing bubble finally comes to light. House prices as a multiple of income are way too high and given the lack of constraints on land – they are setting themselves up for a fall. Sentiment is resolutely bullish, everyone believes the banks are in great shape, they are perceived to be insulated from the problems in the rest of the developed world. There is a lot of carry trade money that could potentially have to unwind.
To me, they are incredibly sensitive to, and resolutely unprepared for, a slowdown in Chinese growth. I think the housing bubble pops, the Aussie Dollar suffers, rates plummet, the banks hit hard times and the infatuation ends. Their 2012 is our 2008.
Jeremy Grantham is one of the most prescient investors alive today and is arguably the world’s most pre-eminent “bubble spotter”, in 2010 he said
“Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend. Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”
(Charts below from Chris Pavese @ Broyhill)
6. Value of Liquidity Increases
“IF you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting……
Yours is the Earth and everything that’s in it,
And – which is more – you’ll be a Man, my son!”
Rudyard Kipling “IF”
You do not make money going into the crisis, you make money in the aftermath picking the flesh from those who were less well prepared. In a crisis, people have to sell positions into illiquid markets for non-economic reasons forcing distressed prices – in this event the purchasing power of your liquidity vastly increases.
7. USD Strength
When all assets are correlated – Cash is King. It’s a safe haven and it’ll be the currency of one of the world’s best performing economies. That alone should be enough to take DXY well into the 80’s or higher. This could be negative for Gold and for other commodities.
I also believe that there is likely a global shortage of USD. Yes, I said it – a shortage of dollars. The total value of Global Credit increased from $40 trillion to $200 trillion over the last decade. That extra $160tn has to either be repaid/retired or defaulted upon. My contention would be that the assets the credit was created to buy are probably underwater. If you borrow $200k to buy a house, you are now forced to liquidate it at $150k; you are short $50k. There is a shortage of $50k that is owed, but is not readily available to the borrower to give back. The “printing” of $2 trillion since 2008 barely scratches the surface of the vast amount of credit dollars created and subsequently vaporised in asset price declines. They should print more and spend it better.
How much further can the global reserve currency of the global economic and military superpower fall when it’s the means of exchange for all major transactions and the unit of account for the world’s best public companies? USD – accepted everywhere.
8. Real Estate Prices fall 5%
House prices are interesting because price discovery is so slow to happen.
If people can’t get what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on your property, there is also no volatility which makes property owners feel much more secure than they should.
For each person be that moves back into their parent’s house, or each elderly person that moves in with their children another unit of excess inventory is created. Despite current record low mortgage rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices.
Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, makes people question if home ownership is worth the hassle – rent or stay with your parents instead.
A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.
Banks are looking to offload their commercial and residential inventory slowly in the hope they don’t flood the market and collapse prices, however they are a huge weight of supply which will cap prices for years to come.
We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend; however, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.
To meet the Tier 1 Capital Ratios required by mid 2012, Morgan Stanley estimates total bank deleveraging required over the next 18 months to be somewhere between 1.5-2.5 trillion Euros or alternatively they will need to raise equity in excess of 100bn Euros. The first option could be catastrophic for house prices through asset sales and will prevent all but the safest lending. But it might be the only option because who wants to supply equity to this earnings trend….
9. More Fallen Giants
The Global Financial Crisis and its aftermath saw the embarrassment and the retirement of several investing legends for reasons ranging from exhaustion, poor performance and a loss of fighting spirit. Stan Druckenmiller, Michael Burry and Bill Miller are three of the most prominent.
I predict that 2012 and all the market and macro volatility it will bring will lead to the dethroning of a few more legends. Just look at how John Paulson has fallen from grace in 2011, with his main funds down 30% plus. Top of my “most likely to retire” list are Bruce Berkowitz or Anthony Bolton who are tarnishing their stellar reputations more and more as each day goes by. An extra prediction – Bob Doll of Blackrock, the world’s largest long only equity manager, will be bullish. Thomas Lee of JP Morgan gets fired for being offensively bullish. Crispin Odey, a man I admire very much, runs a risk of decimating his wonderful track record if my predictions are correct. It irks for me to be betting against my heroes.
10. Presidential Election
Who could comment on 2012 without trying to forecast something about the US Election? I would be much, much more interested in this if Chris Christie had been convinced to run for the Republicans. It seems that voters could be faced with a polarized, superficial, simplistic and sound-bite-based choice between President Obama’s pledge to ‘tax millionaires and billionaires’ and protect entitlements, on the one hand, and a fiscally conservative, “big government is bad, entrepreneurs are good” Republican nominee, on the other. According to Betfair, Mitt Romney seems like the most likely opponent for Obama. One would hope that this black or white positioning would encourage the emergence of a credible independent candidate, adding further uncertainty to the election outcome, but it probably won’t.
I predict Obama loses the election, despite currently being priced to win, because economic deterioration, pervasive unemployment and struggling pension/home values leaves voters demoralised.
Things do not seem to be getting better for Joe Six Pack as the Occupy Protests demonstrate. Voter resentment piques at the realization that the Obama Administration promises of “Hope” and “Change” were one of the slickest marketing campaigns in history, but they failed to deliver. Social Cohesion, Income Inequality and Class Warfare continue to be huge issues.
11. Pension Problems & Savings Rates
One of the great unmentionables (we’ll deal with that later) is how vastly underfunded our pensions are – both private and public sector pensions are billions in the red. I think renewed recession and lower asset values make people finally take notice of this sword of Damocles. To make matters worse we are facing lower asset returns going forward across all asset classes and an industry of “expert consultants” are guiding pension trustees towards lower returning, “uncorrelated” asset classes like hedge funds, EM bonds and commodities.
This chart encapsulates the problem…
A balanced, mixed asset portfolio today yields around 3% which is about half of what it did 20 years ago.
Most discount rates I have seen on pension funds are around 8%, the more conservative are around 6% – these are based on backward looking data which use historical returns to forecast future returns. Hello!? It’s not gonna happen!
If you own 10 Year Bonds today you’re getting paid 2%, that means the other 60% of your 60/40 portfolio needs to compound at 14% (after fees, trading costs and taxes) just for you to hit your discount rate – that doesn’t even remotely address the initial underfunding.
Any “Financial Repression” that changes laws to make pension funds and banks hold more Treasuries/Gilts will only exacerbate this return shortfall problem, and on a long enough horizon, probably guarantee some capital losses too.
This is one of the most pernicious consequences of a zero interest rate policy, savers and pensions get killed to bail out people who took too much risk or bought things they couldn’t afford.
I think the long term savings rate has to gravitate back towards 10% and this will be a drag on what percentage of income can be afforded in mortgage payments/consumer spending.
The fact that savings rates started to tick back down again by mid 2009 shows me that the DM consumer doesn’t quite “get it” yet and still believes in a seemingly endless entitlement to both credit and consumption. Perhaps much of the household pain is still to be felt?
I think 2012 will provide massive opportunities for savvy investors to pick amongst “risks worth taking” and will be another year where passive management just doesn’t get it done.