HITCH - January 2008
The HITCH Update -- (The HAHN Intellectual Tap-dancing & Chicken Heroics Update)
Quarterly Strategy Comments & Updates - January 2, 2007
Key Considerations & Decision Points: See page 2.
Major Current Investment Themes
- A Stagflation Jungle is here ... perhaps moving to a Survival of the Fleetest Wealth" Era.
- Global Economic Slowdown: Consumer Retrenchment in North America
- Monetary Bedlam: Combative Policy Reponses to #2, #5, #7.
- USD: Anticipate a Bottoming Now.
- Liquidity Hoarding Continues (Objective: Safety and Credit Risk).
- Yield and Non-correlated Asset Focus.
- Global real-economy impact of liquidity crisis and insolvencies. Economic slowdown
- Major global re-inflationary boom: Will it work?
- US Supply-Side Boomlet Revived? 10. Special buying opportunities.
Significant Event (SE) Watch
Significant Events currently being monitored, that are anticipated to either support or trigger future strategy shifts.
- Tentatively ... a US dollar bottom in sight.
- US households further moving into recession mode.
- Housing downturn (Still ongoing).
- Major credit event watch. (Ongoing and still heightening!)
- Reverse Bond Conundrum in Force (But, temporarily overwhelmed by liquidity flight.)
- Fed Reaction to 2, 3 & 4 above (Capitulation ... multiple rate cuts ahead!)
- "Liquidity & Insolvency Watch"
Pending and New:
- US Economy: Recession? (January 2008?)
- US Financial and Economic Coupling with ROW. (Europe next to slow.)
- BRIC Slowdown in 2007
- Counter responses of Euro, Yen and Yuan central banks to USD policy.
- Geopolitical Developments: Russia, China, Iran, Iraq Pull-out Strategy.
- A Wealth Preservation "Velocity Inflation" ahead?
Investment Stance - Key Distinctions
- Cautious: Still Above-average cash levels. Buy quality income.
- Emphasis upon big cap equities.
- Tilting towards a "Stagflation Jungle" scenario.
- High reliance upon non-correlated and quality yield assets.
- Asian currency bloc - fixed-income.
Risk Assessment: (Overall Financial Markets) Remains Above average.
7-Year Return Outlook: Slightly raised but still modest (from CAD base). Between 4% and 7% per annum (average of balanced portfolios).
Other Strategy Resources: Global Strategy Chart Panorama -- Stagflationary Jungle
Key Considerations & Decision Points:
Summary: Anticipated Opportunities and Decision Points (1 to 3 year view).
• Bond Trap: Unprecedented drops in interest rates (US government) have occurred. 10-year yields have fallen from 5.30% to under 4.00% in little more than 4 months. (A decline of approx. 25%.) Interest rates are now back down to the low levels of mid-2005 at the height of the USD carry trade. Normally, such a move would be highly supportive of stock market valuations. This recent decline however is more a reflection of "flight to quality" concerns. However, now that inflation is rising, the liquidity flight towards bonds will likely end up being a value trap.
• The US dollar has probably bottomed. The euro has already well-exceeded our longrunning minimum upside target of 142.50 against the USD. We expect a global rebalancing to take place which would likely last for at least a year. While there remains the possibility that the US dollar could yet face another emotional downspike this probability is diminishing. After all, USD has fallen some 50% from its top against the euro. A decisive turn in the dollar could trigger a rush of portfolio capital back to the US.
• The biggest conundrum for long-time experienced money managers at the present time is determining the "zeitgeist" of global monetary affairs. Given the many monetary excesses, grotesque global imbalances and economic deformations, the classicist would argue that a traditional-style purging (an old fashioned recession) is long overdue. At the same time, the pork barrelling politician and pragmatist policymaker cannot risk such an outcome. We argue that a new era of the Wealth Transmission Model could evolve into what we call a Stagflationary Jungle -- an environment where the prevailing challenge is "Survival of the Fleetest Wealth." (See page 9.)
• Why have stock markets not yet succumbed to the overwhelmingly negative economic news? To date, stock markets in North America remain only 5-6% below highs. This may already be a symptom of the "Survival of the Fleetest Wealth" scenario. For reasons we explain, financial capital has stratified and increasingly become delinked from the real economy. For instance, while real economies and many households are under strain, art markets (the domain of the well-heeled) and stagflation hedges such as big cap stocks (primarily bought by institutionalized capital) remain near highs.
• A "credit revulsion" continues. If so, this dynamic will be the key determinant of market environments from here forward and could mean that money velocity declines. We consider 4 scenarios.
• The US economy may already have slipped into a recession. At least a mild recession is likely in the first two quarters of 2008. However, the jury is still out as to whether it will be a deep slowdown. There are several reasons why the recession could be mild: 1. Protracted and unconventional economic and monetary intervention is likely. 2. The US financial system will likely be refinanced more quickly than originally thought, thanks to foreign investors and SWFs. 3. While realestate- related hardships are real and are the worst in many decades, it is only a small minority of households that will lose their homes. Most of these didn't have much equity to lose in the first place. The major financial impact will fall upon banks and non-bank institutions. In the end, a portion of the global reserves of the surplus countries may be exchanged for significant ownership of the US and European wealth management and banking sector.
• A global recoupling is now highly likely. We expect that a US slowdown will soon be joined by Europe at large. Already, Spain, Ireland and the UK are experiencing downshifts. Given that 60% of the world economy will face headwinds, a major impact will fall upon emerging markets, particularly the BRIC group. Also, we do not expect China to escape the chillier winds. As a result, emerging market equities are vulnerable at the present time.
• The US consumer sector is under barrage. This will continue to drive up household savings rates and continue to narrow the US current account deficit. US retail sales fell 2.7 percent last week (December 12th) from a year earlier. Sales were pressured by a 12 percent decline in shopper visits to stores, according to ShopperTrak RCT Corp. Six-month LIBOR determines the reset rates for an estimated 99% of subprime ARMS and 38% of Alt A ARMs and LIBOR rates remain high at this time. (A further 1% of subprime and 22% of Alt A ARMs will be reset based upon 1-year LIBOR rates.) Also, energy prices remain high. Piscataqua Research Inc. (Consumer Crush- December 2007 Update) recently reports that its Consumer Cash Flow model now has fallen to an 18.5 day reserve and is still declining. By comparison, at the worst levels in the 1990-1991 recession, this cash reserve level was at 50 days.
• The next quarters appear to be pivotal. A number of pending and/or new SEs of a major nature that are expected are listed below. All of these will have a material impact upon our investment strategies.
- US Economy: Recession or "Soft Landing"?
- US Dollar Bottom
- China: Will a further monetary/graft crack-down work?
- Counter responses of Euro, Yen and Yuan central banks to USD policy.
- Geopolitical Developments: Russia, China, Iran, Iraq Pull-out Strategy.
- Financial Deflation/Unwinding vs. Inflationary Scenario?
- Contagion Watch: Economic decoupling with rest-of-world (ROW).
• Despite our expectation that a slowing economic trend around the world will take the pressure off industrial commodities for a duration, long-term secular trends continue to augur for rising commodity prices in general. Particularly, if world-wide monetary actions become highly stimulative and the motive of wealth preservation moves to the forefront, hard assets will be favored.
• An SE that we instituted in March of 2006 remains in force. The US housing downturn has longer to run. Supply/demand factors, affordability conditions and a tougher financing environment continue to underline this conclusion. We therefore continue to monitor real estate trends closely.
• It has been at least refreshing to see a declining US monthly trade deficit over the past several quarters. However, for now, this development has a negative lining as it is imports that are falling while exports stay flat. Such conditions imply a slowing economy ... and, significantly, also indicate a slowing influence upon the rest of the world.
• Corporate earnings growth is deteriorating, though still remaining at very high levels. A theoretical approach that we employ suggests slowing corporate earnings growth over the next few years. Currently, cyclically-adjusted earnings are at near recordhigh valuations. This in turn implies that equity returns will also be generally modest over this same period.
• The Canadian dollar remains highly overvalued. Should the US dollar begin to rally against the euro, we anticipate that the CAD will fall further. Ultimately, the CAD should be expected to settle back to the 0.85 to 0.88 USD range. During this period, global diversification will be attractive to Canadians.
• Gold has vindicated itself as an inflation hedge ... at least for the time being. We continue to hold a core holding for "insurance" purposes." Given the material probability of an inflationary "wealth velocity inflation" we must continue to hold an exposure to this asset.
• We have anticipated a move to "supply-side" of North American economy, preferring to establish these positions during an expected economic downturn. Instead, a mini "supply side boomlet" (SSB) has already occurred, as stock markets have not reacted to economic slowing signals. Actually, cyclical sectors have spurted over the past year and more. We will keep this theme in reserve, as it will likely re-emerge as the strongest performing once an economic recovery is again underway.
• We have modestly lowered cash levels in favor of US large cap stocks. Yet, cash levels in portfolios remain above average, awaiting further buying opportunities. Again, we suggest that Canadians should continue to consider USD cash deposits ... especially given that the CAD has risen further against the USD. Rotation towards "big cap" stocks, favoring a higher US equity weight in global portfolios. We continue to emphasize large "caps" in portfolios.
• Asian currencies have performed admirably in recent weeks. Many Asian currencies have nowhere to go but up, we still think. We continue to hold a significant position in Asian bond markets. Market trends this year have broadly supported our thesis that equity markets overall and high-yielding deficit currencies are much more vulnerable than those fixed income and currencies of the Asian surplus countries.
We expect that the next quarter will be pivotal. If it proves true that the bulk of the bad news relating to the global credit crises peaks; that banks are quickly recapitalized; and that financial markets and economies witness unprecedented intervention on the part of policymakers, a highly inflationary or monetarily debasing environment will ensue. At the very minimum, it will be a stagflationary environment, in which equities will fare best.
Headed Into a New Era?
History is being made.
Firstly, we may be finally discovering the "geo-political" strategies behind the foreign currency reserve and Sovereign Wealth Fund (SWF) hordes ... namely, to buy into Western/Anglo Saxon financial and economic systems. The emergent "surplus countries" have turned the tables and are now taking their pound of flesh. The world's economic power balance continues to shift to Asia (inclusive of the Middle East).
Secondly, never before, have central banks coordinated their resuscitative activities as in the previous few weeks. Current initiatives on the part of central banks around the world far exceed the measures instituted during the Asian crisis period of 1997 to 1998. On December 18th, for example, the European Central bank injected $348.6 billion euros (roughly one-half trillion CAD!) into its short-term lending facilities to member banks. Strong actions were also initiated by the US, British and Canadian central banks. (While these are large actions, the actual underlying monetary mechanisms are actually more complex than the headlines reveal.)
The current actions and positioning on the part of financial institutions and policy makers are exactly as we have anticipated. Dire times for the world's monetary and credit systems mandate desperate measures as the only acceptable outcome on the part of domestic and international policymakers.
However, the actions of the SWFs represent a new actor on the world stage. This, we believe, holds implications for world economic power distribution as well as equity market trends. All in all, recent credit crises point to a very confusing environment ahead. It stands to be a tug of war between unwinding asset bubbles, credit deflation and the efforts of central banks and governments to forestall their negative effects. This will become ever more clear over the next few months.
As mentioned, we should expect extraordinary measures on the part of policymakers. The potential crises in financial systems remains serious at the present time. The next US election is less than a year away and the pork-barreling will be in full swing. Already, actions of the past weeks herald the arrival of this environment. Measures to prop up the banking system ... both through the front door and the back door such as the FHLB (US Federal Home Loans Bank) extending billions in loans to bank and mortgage providers ... and direct intervention in the housing markets have already been announced.
What will happen next? Let's follow the interests of vested money to find out. Firstly, what about the actions Western policymakers? Lawrence Summers (Former US Treasury Secretary) makes some poignant observations in an op-ed column in the Financial Times (November 28, 2007). In view of the unfolding crises he prescribed three necessary steps. To do otherwise, he says, would be negligence on the part of US policymakers.
What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognize - as the market already has - that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as longrun deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens. (Ed. Translation: Keep slashing interest rates and don't worry about budget deficits.)
Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. Very likely this will involve measures that are non-traditional, given how much of the problem lies outside bank balance sheets. The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust - the so-called "super conduit", in which banks co-operate to take on the assets of troubled investment vehicles - has never been publicly explained in any detail by the US Treasury. On the information available, the "super conduit" has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made. (Ed. Translation: Get creative in filling in the black holes on the balance sheets of both banks and non-banks.)
Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually. (Ed. Translation: Get creative in providing support to the falling housing market.)
Mr. Summer's reflects the practical view that policymakers can simply not stand by and watch households, financial institutions and real estate markets sink into the ether and trigger a deep recession. They must at least try to avert such negative outcomes. And so they will.
Therefore, investors should expect heavy market and economic intervention in the year ahead. By nature, these interventions must be considered both inflationary and monetarily debasing. Given the structures and constructs driving the behavior of financial wealth today, it is very possible that global financial markets will transition into a new era ... a period we will call a Stagflationary Jungle. It may even lead to a "Survival of the Fleetest Wealth" scenario in which frightened capital will shift to tangible assets and "monetary debasement" safe investments. This would be a form of "velocity inflation."
Whichever of the above scenarios play out, we do believe that the current market environment is unprecedented and will require some adaptive thinking.
Uppermost Conclusions - Stagflationary Environment Dead Ahead
It is a new day ... a new environment. Investors must quickly acclimatize themselves to the reality of a stagnationary environment -- modest to slow economic growth with persistently high inflation. Uppermost, then, two major bellwethers must be kept in mind as we review the current investment outlook.
1. The world economy (still centered by the US) has entered an inflationary environment. At the very minimum, a stagflationary environment has begun. This has major implications for investment policy. We will review the various scenarios that could yet play out and assign probabilities. Until only recently, general world consumer price conditions remained disinflation in tone (though credit and monetary policies were strongly inflationary). Secular developments such as an emerging Asian manufacturing colossus, rapidly expanding world trade, outsourcing, and temporarily-successful currency manipulation have together acted to suppress or offset inflationary conditions in most countries (Please refer to the Global Spin of November 2007 for a further explanation of this unique conditions.)
2. Secondly, the structure of fungible world wealth (financial assets) today is markedly different than at previous global economic inflection points. A greater proportion of the world's wealth in is in the form of securities and mobile capital. This is an extension and byproduct of the large role of non-bank financial sectors today. We have pointed out in the past that the traditional banking sector today probably represents less that 30% of the credit creation apparatus. Next, in this context, it is crucial to understand that this greater amount of fungible capital is managed and commandeered by a smaller circle of people. Not only is global wealth distribution more skewed today than probably the entirely of human history, more wealth is managed in some type of institutional form ... i.e. pension or mutual funds, sovereign wealth funds (SWFs) or, burgeoning currency reserves funds.
These conditions give rise to a fecund environment for "velocity inflations" in asset markets as well as stagflationary economic conditions (if not virulent inflation).
With respect to the latter, such outcomes already appear to be unfolding. Consumer and commodity price inflation is spurting around the world as of late.
Producer price inflation (finished goods) in the US spiked to a 7.2% rate year-over-year in November 2007. Consumer price inflation levels both in the US and Europe are currently well in excess of 3%. China's domestic inflation levels recently have been reported to be in excess of 6.2%. Similar trends are being witnessed elsewhere. Yet, though inflation levels may be at the highest levels of the last 5 to 10 years, many monetary authorities find themselves in the situation where they must stimulate economies. Assuming that an outright credit system meltdown does not ensue, inflationary pressures and wellsprings will continue to percolate.
Let's turn our attention next to what we call asset "velocity inflation." What do we mean and just how do such conditions come about? To begin, we first review the various credit scenarios, then explore new investment environment scenarios with a view to anticipating some crucial investment trends ... some of which may prove surprising.
Possible Financial-system Scenarios Ahead: The Major Minsky
In early September 2007, we published a Global Spin that outlined four possible unfolding scenarios with respect to the ongoing credit crunch at that time. We called them, Minsky, Mini, Minor or More. The probabilities of each of these are shown in Table 1 on this page.
At the time, we received some worried feedback. Some respondents thought we were being too apocalyptic. We had placed a 40% probability on the unfolding credit inflation at that time to result in a "Mini liquidation." (A full description of each of these four scenarios can be found in the September Global Spin. Please visit our website - www. hahninvest.com.)
We are not always correct in our prognostications. However, we are students of past credit cycles and understand the capriciousness of what is called "liquidity." Liquidity is only widely available when few want it and fair-weather optimists see no reason for any insurance nor can contemplate any accidents. When everyone wants liquidity at the same time -- like the one toy that has grabbed the attention of a room full of nursery school kids -- few can have it. There can be no liquidity if everyone wants it at the same time. That's why central banks want to step in and make it available when liquidity crises occur. Of course, all of this becomes much more complicated and intractable when insolvency issues are involved.
Back to the Major Minsky. Events since July of 2007 to the end of 2007 actually have proven our previous forecasts somewhat optimistic. The credit system as we know it has indeed hit extremely rough shoals. At this time we are teetering between scenarios 2A and 2B, as shown in Table 1. Without a doubt, a Mini Minsky has been playing out to date. Will it yet turn out to a full Minsky? The jury is out.
What we can conclude with a high degree of certainty, given the graveness of the unfolding financial problems, is that interventionist policies in the global financial and economic systems will attain new heights (as already discussed). A 2B scenario must be avoided by policymakers, if at all possible.
This could lead to an unstable "velocity inflation" ... an outcome that will result in highly inflationary stock markets (in other words, soaring equity markets). Let's next consider the likelihood of just such a scenario.
Shifting Investment Environments -- The New Era Wealth Transmission Model
We outline four investment environment regimes in the table on the next page, along with our probability estimates. Whereas investment markets of the last 10 to 15 years would have been classified under the Post-Modern model, we now believe that the balance of probabilities has moved fully to the New Era Wealth Transmission model. Given the specter of recent events (as we have already described) for the first time we think that the Manic Preservation scenario (See #4 ... what we also call the Survival of the Fleetest Wealth scenario) is calling for a meaningful probability. We wager to estimate that this scenario -- the asset "velocity scenario" to which we have already alluded -- has at least a 20% chance. That is significant. As such, it behooves us to start hedging against such a scenario ... even if only partially. Our strategy shifts this quarter already take into account the rising probability of this scenario.
There are several reasons why we think that such an outcome is becoming ever more plausible.
Viewing the possible scenarios ahead, it is very likely that investment market trends will appear to be non-intuitive and surprising. To an extent, this is already happening. By that we mean that market movements -- particularly equity markets -- could stand to stump historical theories. Despite negative credit developments and seemingly gloomy economic news, certain sectors of the equity market will prosper ... seemingly against all odds. We will explain this perspective more fully.
It begins with these observations: Significant monetary destruction is occurring and financial systems are being taxed under both liquidity and insolvency pressures as perhaps never before. And, world money systems are integrated and coordinated as never before. There are at least 8 channels through which this occurs. As such, it is key to realize that the world is facing a global crisis at present, one that requires a global response. This will be clear soon enough as economic weakness spreads abroad.
World policy makers will not stand by while Rome burns. The clear and apparent gravity of current credit crises will drive rapid responses. In one way or another, money and inflation will be manufactured through monetarism to sufficiently fill in any black "financial" holes.
Additionally, (and this a new development to which we have already alluded) a major part of the solution to the past financial follies will be the opportunism of foreign SWFs.
These extraordinary scenarios will prompt extraordinary responses both on the part of policymakers and those with capital (or those that manage capital). The result is that we are entering a post, post-modern world. Financial markets firmly move into the realm of relativism -- of the "Survival of the Fleetest Wealth." It now becomes all about relative wealth preservation, a volatile era of capital flight and refugee wealth which is trying to stay one better than the mode of the masses. Absolute valuation plays less of a role. Rather, capital and wealth in motion could create conditions of "velocity inflation." This is nothing more than money in motion fleeing depreciating currencies and money, seeking safe haven and relative wealth preservation, and thereby driving up the relative value of some assets, while collapsing others. A simple way to think of the effects of "velocity inflation" is the actions of a large crowd of passengers on a small boat. If they all rush to one side of the boat, one side will rise, the other will fall. The number of people has not changed, however, their collected and accelerated actions create motion.
Structurally, the world of money and securitized assets has a larger role in the lives of people on this earth than ever before in human history. Secondly, wealth today is more unevenly distributed than possibly ever before in the history of mankind. We have quoted supporting research on this condition in past updates. Just recently, the International Monetary Fund (IMF) published a report on this topic, entitled Globalization and Inequality, observing that "inequality has risen in all but the low-income country aggregates over the past two decades." What this signifies is that there is vastly more idle wealth today, in a form that is mobile.
A third fact to recognize is that the control of money and wealth is more centralized than ever before also for structural reasons. The emergence of funded pension systems, the rapid growth of wealth management services and government, (and an assortment of other developments) have placed the fate of world monetary and financial affairs in the hands of a very small cadre of people.
It is crucial to understand that the actions of the super-wealthy and the elite money managers are likely to be very different from that of the individual. Why? While the average household strives to pay bills and debts, people with significant capital are more concerned about relative wealth and its preservation.
What additional evidence is there that this could happen? Crucially, stock markets are seeming to already respond to this outcome. For example, stock markets to this point are refusing to succumb to steep declines. Despite "high profile" and well recognized news and statistics -- economic, monetary, geopolitical, systemic and otherwise -- that historically would have signified a death knell of equity markets, equity markets remain near highs. Why?
We theorize that one reason may be because equities as a class are the best vehicle to survive an inflationary spiral ... excepting gold and other rare commodities, of course.
Of the major three asset classes, equities -- the ownership securities underlying companies -- are well suited to passing on inflationary pressures. While higher inflation normally has a negative valuation effect upon stock markets (price-earnings multiples decline) this may be over-ridden if a capital flight to equities takes place ... at least for a time.
Financial history provides a strong precedent for this outcome. Whenever owners of capital are faced with inflationary spirals, they will seek to escape to assets that will experience the least loss of relative wealth. A recent example of this can be seen in Zimbabwe. While inflation rages at plus-1000 percent per month, the local equity market soars at a pace that effectively neutralizes loss of wealth. Could this effect play out on a global scale?
Indeed, we do not expect that inflation will rise to double or triple digit rates. All the same, we do expect the world's major currencies will continue to lose their purchasing value and that stagflationary condition will prevail. Already, shorter-term maturities in bond markets -- a significant asset class representing upwards of $80 trillion worldwide -- and short-term paper are yielding negative real rates. While cash provides the safety of liquidity, at this time it offers no sinecure from the ravages of inflation and depreciating currencies. Where will the preponderance of the world's managed capital seek relative wealth preservation?
Besides hard assets such as gold and other non-perishable commodities, equities are the logical target. Moreover, this asset category is large enough to absorb much capital.
Large capitalization equities -- global multi-nationals, particularly -- are the most attractive vehicles in this regard. They have geopolitical clout and access to capital markets. Such companies can circumvent "blocked" and "constipated" banking systems. They can issue debt directly to non-bank buyers such as pension funds. Additionally, they have global mobility and many have world-wide recognition and brands. In an inflationary world of unstable currencies and tenuous economic conditions, such companies will engender greater trust than governments and sovereign fixed-income securities.
Again, all the above gives rise to an investment strategy, that in the face of currently negative financial news, will seem counter intuitive -- to raise equity weightings at the expense of cash and bonds even in the face of above-average valuations and an earnings downturn. This makes sense against government bonds, particularly, as these have soared lately as liquidity and transparency have been in demand. As such, bond markets now are likely a trap in view of the fact that inflation has risen markedly and the real returns are low to negative. They are overvalued relative to the expected monetary malfeasance, economic interventionism and price inflation trends that are now beginning to unfold.
Here are some other factors that may play a role in the determining stock market trends. Some are supportive, others possibly exerting negative influences.
Factors That Are Likely Discounted in Equity Market Levels
The American household has not been a committed buyer of equities this past 18 months. As such, there may be no "weak hands" that will be selling and forming a deep bottom for the current down phase. Typically, retail investors are large buyers at late stages of an equity bull market. Not so to this point.
Government fixed-income markets have experienced an upside crash. This appears to have been more the result of a liquidity and transparency panic, rather than a discounting of recessionary conditions ahead. Whichever the case, normally such a drop in interest rates would be supportive of equity market valuations. While interest rates for non-government sectors have not declined as much (indeed, some rates have actually risen) this interest-rate effect is already priced into stock markets.
Equity markets to date have absorbed a lot of bad news. Overwhelmingly, economic news reports and been quite negative. Yet, stock markets have not entered a traditional bear market period. Could this mean that most of the downside is completed? Or, does it infer that stock markets have yet to align with the economic and financial outlook?
The impact of a weak US dollar upon foreign buyers. Foreign buying of US equities (and other assets) is impacted by a chronically weak dollar. This may no longer be negative if the US dollar indeed does begin to rally.
Private equity, LBOs, share buybacks and takeover activities have caused outstanding equities to decline in recent years. This would have caused an upward influence upon stock markets. Currently, due to the credit crisis, takeover and private equity demand has collapsed (a negative influence).
Markets already anticipate an earnings decline.
New Changing Factors Yet to be Realized
Sovereign Wealth Funds have emerged as buyers of assets other than AAA bonds and fixed income instruments. Recently, the Abu Dhabi Investment Board injected $7.5 billion into Citibank. Could this support US equity prices? Yes. However, this source of demand in reality could not avert a US bear market. There is approximately $2 trillion SWFs today. Perhaps, only 25% (certainly not more) could be mobilized if there were a fire sale on US assets. This would amount to around 1% or so of current US equity market value. The deep pockets of SWFs and surplus nations are coming to play a role in refinancing the lost capital of the US (an other) financial sector. As such, this opportunistic capital could serve to truncate downside risks for the US equity market.
Currencies and stock market trends are normally inversely correlated. (Impact upon earnings translations, exports, lower import competition ... etc.) A rising US dollar in this respect would undermine US equity markets.
Should the US dollar stop falling, foreign buyers will likely perceive value (certainly so in relation to other assets in other countries) and begin buying. This would be a positive and sizable force on the US stock market.
There are reasons to suggest that a monetary inflation will further exacerbate the currently-wide wealth skew in America and elsewhere. As such, this inflationary/monetary boom (whatever its form) will more likely find a channel into financial assets than into consumption. As the world of elite investors runs away from depreciating currencies, assets such as commodities and equities of MNCs will prosper, though hardly seeming to be reasonable value. However, this latter point would miss the point. These assets will rise in value simply because there are no other viable alternatives.
The Current Credit Imbroglio - Destruction and High Credit Growth
For the time being, we see that a strange phenomenon is unfolding in the financial world. Credit and debt growth is booming and inflation is flaring upward. Total credit growth (both financial and non-financial) accelerated to 11.1% in the 3Q of 2007 from a pace of 8.6% the previous quarter. (Federal Reserve, Flow of Funds Report, Z1)
What indeed makes this strange is that supposedly there is an ongoing credit crunch at this time. Credit supply, primarily for new mortgages, is crimping households who wish to either renew or refinance their mortgages. The interbank lending market -- witness the high LIBOR rates, even as administered rates have fallen to new lows -- also signals tight credit markets. Then why is credit still growing? Shouldn't credit growth be slowing down at a time like this? Certainly outstanding asset-backed paper (ABCP) is collapsing. Given all of these extenuating conditions, wouldn't deflation eventually rear its head?
Yes ... and no. To begin, we are witnessing some short-term effects. In effect, we now are experiencing a time of credit destruction ... in other words, real destruction of capital on the liability side of the bank and non-bank financial system (financial balance sheets). For the time being this is not being reflected in financial reporting. Impaired capital has yet to be totally realized or written off. Instead, for the time being, what is happening is that many financial institutions are taking onto their balance sheets the assets of some of their defunct non-bank subsidiaries ... namely SIVs (Special Investment Vehicles, bailouts of funds holding assetbacked paper, perhaps high-yield money-market funds that have "broken the buck" or taking back bad mortgages for which they are the servicer. The effect of these desperate measures is the expansion of the respective banks's balance sheet.
For example, recently, Citigroup Inc. decided to consolidate $49 billion in off-balance sheet vehicles (including SIVs) and in the process will be assuming $59 billion of new debt. Other major banks have decided to move similar assets onto their balance sheets. Why? They had the option of closing down the fund and liquidating the assets, or bailing out the SIV. It needed to do this as its assets were under water and the short-term funding obligations were coming due. Which of these options is the better choice? Liquidating the assets would have caused fire-sale conditions as there are no bids for many of the SIV's holdings. At worst, such fire-sale activities would have depressed asset prices further, in turn triggering larger losses and in the process causing it to "mark to market" other assets of a similar type that it might have held. This would be disastrous, most certainly wiping out all of its tangible equity capital and having knockon effects for other financial institutions that are holding the same types of assets.
The SIV funding problems are not over. Another salvo will occur when medium-term notes (MTN) issued to fund SIV holdings come due. Desdner Kleinwort analysts recently estimated that some $180 billion of such funding comes due by October 2008, which currently represent approximately 65% of funding.
The net outcome is that credit growth will likely remain high at least into the middle of the next year, as both banks and non-banks refinance losses and reposition their portfolios.
The Bottom for the US Dollar: Another Significant Event?
Currencies trends are notoriously difficult to predict over the near-term. Nevertheless, we think that it is very likely that the US dollar may have seen its bottom. We postulate a number of factors that at least could lead to a bounce in the USD ... if not a rally lasting as much as 1 to 2 years. What will contribute to this turnaround?
Firstly, negativism on the US dollar could not be more black. Expectations for the US dollar, a discredited and much maligned currency recently, are universally low. How black can sentiment yet become?
The US dollar has already fallen some 50% and more (top to bottom) against the euro. Would it be reasonable to expect it to fall another 10 % ... 20%? As it is, Europe has been experiencing a double-whammy. Not only has the euro fallen against the US dollar, but also against many Asian currencies, notably the Chinese Yuan.
In the meantime, relative conditions are beginning to shift for the US dollar. In due time, it will soon become more obvious as to why the dollar should again be rising against the euro. Significantly, US imports are now declining ... in fact, possibly even faster than the (ex ante) capital account. This argues that the major world imbalance represented by the large trade and current account deficits of the US could begin to contract ... albeit slowly. The major influence on the US trade deficit currently is high energy volumes and prices. Already, the US current account deficit has begun to shrink relative to US GDP.
It is important to grasp the significant leverage of such a shift. Currently, the US trade deficit approximates 6.5% of US GDP. US GDP represents 26-27% of world GDP. As such, US excess demand is stimulating Rest of World GDP by 2-3% per year, not to mention the sizable impact upon currency reserve accumulation in surplus countries. Therefore, should the US deficit contract (and also, considering all of the multiplier effects that are involved) the slowing effect upon world growth is potentially very large. Even China would be impacted at the margin.
Also, as a credit crunch worsens, demand for USD dollars could rise. Another factor that will cause the US dollar to again move upward is a concerted repatriation of foreign portfolio investments back into the US. In recent years, US investors have moved heavily into foreign investments, including emerging markets. Once the dollar again begins to rise, and slowing economic conditions spread to the rest of the world, stalling stock markets abroad will prompt capital to move back. As such, a self-reinforcing process could be in play for a time. The same would apply to US fixed-income investments. Presently, they have become increasingly unattractive to global investors (whether sovereign nations or private investors) as the USD has fallen sharply. The exact inverse will occur when the dollar again moves upwards.
According to the Investment Company Institute, American investors directed 10 times the money to foreign equity funds than US domestic stock funds over the pastq8 months. And, for 2006 as a whole, this ratio was 13 times in favor of foreign equities. In recent years, institutional investors have also raised allocations to foreign investments.
A declining US dollar is also reinforced by private investors. A good asymmetric bet is never to be overlooked and unappreciated. In time, such a situation invariably becomes the material of self-fulfilling action. A declining dollar boosts returns on overseas investments (thanks again to currency translation effects) therefore attracting more investment and contributing to a lower US dollar. It becomes a macro momentum trade. The vulnerability in this situation lies in the fact that "private money" is fickle and pro-cyclical, not counter to the market trend. In the case of the US dollar, private investment outflows have been a juggernaut in recent years ... calculated to be over $1.5 trillion last year alone. This sets up the possibility of short-term vulnerability. While it may be difficult at this point to outline a scenario arguing for a robust US dollar for the next decade, it does leave open the possibility that the US dollar could soar ... and rapidly ... and very dangerously.
Finally, the current credit crunch is a global affair and appears to be much more acute in Europe than in America. An economic slowdown is likely in Europe and already seems to be in tow in Britain, Spain and Ireland. Overall, this expectation does not yet appear to be reflected in currency markets. All in all, we suspect that the US dollar has seen its low.
This supports our shift away from Europe (and Canada) back into a overweighted position in US equities.
Updated Expected Returns: Our expected return forecasts for our portfolios have been revised this quarter. While market returns may have been ameliorated due to developing economic recession perhaps being on the horizon. On the other hand, given the rising Canadian dollar, future foreign investment returns have improved. Return expectations remain modest for the next 7 years.
All long-term return projections for all portfolio mandates are based upon 7-year real and nominal returns. (For further information, please see the corresponding exhibits at the back of this report.)
(Forecast revised as of December 3, 2007)
Long-term Investment Strategy Summary - Changes
For specific portfolio strategy details, please see internal minutes or contact HAHN Investment.)