Randall Abramson, CFA – Trapeze Asset management 2014 letter to investors
Trapeze Asset Management – The Big Picture
As consummate value investors we are continuously seeking individual stocks and bonds that are trading at mispriced undervaluations. At 80%, or less, of our estimated values for big cap stocks and, say, 50% for small caps. Looking up and down for value.
However, these days we need to look up more intently to the macro picture, which is complex, historically unusual, and volatile, and which has helped some big cap stocks, the so-called safe dependables (for their low volatility and yield), while hurting others, the cyclicals and commodity resource producers, and small caps generally.
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The big picture, the global economic condition, is characterized by record high debt levels, an unusually slow recovery from the ’08 Great Recession, ultra-low interest rates from stimulative measures taken to combat deflation, competitive currency devaluations, and deflation concerns in most regions.
The International Monetary Fund has cut its forecast for 2015 global growth, indeed, for every major economy, including Canada, except for the U.S. whose growth forecast it raised to 3.6%. And high debt levels are a major issue. Even though many governments, including the U.S., are not expanding their fiscal deficits, U.S. debt is still equal to its GDP. Thankfully better than Greece, whose debt is 175% of its GDP. Total global debt is up $57 trillion since ’07 to $199 trillion, the biggest increase coming from government debt, with China accounting for more than one-third of the increase. Whenever interest rates begin to normalize, the cost of servicing the excessively high debt levels could become overly burdensome.
The big picture also needs to account for the economic impacts from the turmoil of radical Islamic terrorism in the Middle East and North Africa, the Syrian war, the sanctions against Russia from its aggression against Ukraine and the potential departure of Greece from the European Union with the risk that others such as Portugal, Spain and Italy might follow.
Trapeze Asset Management – Pedal To The Metal
Central banks everywhere are on the case, pushing hard for growth and to combat deflation by debasing their currencies through ultra-low interest rates. The ECB just implemented Quantitative Easing saying it was ready to buy over $1.1 trillion of sovereign and asset backed bonds between March 2015 and September 2016. Pedal to the metal. Sweden, Switzerland, Denmark and the European Central Bank now even have negative interest rates on bonds with maturities up to 6 years. The 10-year German bond yields 0.3%, France 0.6%, Japan 0.3% and Canada 1.3% after it lowered its key interest rate in January to 0.75%. Deflation is an economic negative in that it discourages consumers from spending currently believing that prices will be lower in the future.
Japan was the poster child for that phenomenon as it experienced a lengthy recession and deflationary period, with consumers, after years, suffering mortgages higher than the value of their properties. Now Europe is emulating Japan. A lower Euro (down over 20% against the U.S. dollar since last May) will help exporters and keep deflation in check from higher import prices.
This period has also recently witnessed low commodity prices, whether the effect of slower economic demand or, in the case of oil, more likely from U.S. shale-led excess supply and from political motivations of OPEC. Imagine, oil prices dropping more than 50% since June. And oil equities, of which we had our fair share, suffered big time, though recently there seems to be a reversal at hand. Our work suggests that the oil price has likely bottomed and should improve. And the price of gold too. Especially since both commodities trade below their average global cost of production. The beaten up producers, especially those with stronger balance sheets, should recover smartly.
Trapeze Asset Management – Proceed With Caution
The U.S. economy has been the global standout, though GDP growth for Q4’14 declined from Q3 to 2.6%. Unemployment is now at an improved 5.7%, though wage rate growth is still lagging. And January consumer confidence is higher at 98.2 although, paradoxically, retail sales slumped in January, even with savings at the gas pump and improved household savings. The extreme winter weather is obviously impacting too.
With low interest rates from low inflation, the U.S. 10-year treasury yields only 2%. U.S. stocks are at record highs. The U.S. dollar continues to rise, lowering inflation. And recently, a rarity, the dividend yield on the S&P was higher than the 10-year Treasury bond. The Fed continues to defer the date it will raise rates. It wants to spur inflation and does not want an even stronger currency which is deflationary and hurts exporters. Witness the recent negative impact from the stronger dollar on the earnings of Procter & Gamble, Microsoft and Pfizer. Understandably, the trade deficit is growing and should restrain GDP growth.
With that background where does an investor go? We think bonds are risky. And that the U.S. dollar index is at a ceiling and that other currencies, including the Yen, the Euro and our Canadian dollar are at floors, although, it is possible that a continuing global deflationary slowdown could result in an even higher U.S. dollar.
We also think U.S. stocks are generally fully valued, with the S&P 500 at 18x forward earnings, half of them with P/E multiples over 20x, and with earnings growth slowing. Profit margins are abnormally high and share buy backs have held up per share earnings. Analysts’ consensus estimates show no sales growth for the S&P 500 in 2015. It is getting harder to find stocks that meet our value criteria. And if the Fed raises rates it could lead to lower price-to-earnings ratios.
With central banks generally pushing to keep rates low, depressing their currencies and stimulating economies, global economic recovery might accelerate. Q4 saw a modest increase in GDP for the Eurozone, with Germany and Spain recovering somewhat, although Italy and France were still languishing. China, the second largest economy, is slowing too, to the lowest growth since 1990, and is stimulating with easier monetary policy. Russia is in recession. Japan is just starting to recover from its recession. The UK economy is doing better but the Bank of England is also concerned about low inflation.
Trapeze Asset management full letter below.