An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2” policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.
margindebt0214

Declining U.S. Dollar Liquidity Coming Home to Roost for Emerging Markets

Emerging Markets’ finance ministers today surely feel the pain of their European counterparts in the early 1970s. Shortly after President Nixon removed all U.S. dollar convertibility to gold, European finance ministers complained of the global inflationary pressures of such a move, driven by Nixon’s “guns and butter” policy and a deteriorating current account deficit. In just a generation, the United States transformed from the world’s largest creditor to the largest debtor country. Nonetheless, the superiority of the U.S. Dollar as the world’s reserve currency was never really challenged. Surely, Charles de Gaulle–who tried to tip our hand by trading France’s dollar reserves for gold in 1963–must have been spinning in his grave.

Responding to his European counterparts, U.S. Treasury Secretary John Connally famously said “The dollar is our currency, but your problem.” All of which is true. Sure, I lived in Texas for 12 years. Many of the buildings at my alma mater, Rice University, were funded by the wealth of the oil barons–including that of Sid Richardson, whose ventures helped Connally become a successful businessman in the 1950s. This is typical Texan culture–John Connally was merely being blunt–this has been the official if unspoken policy of the United States since Alexander Hamilton helped establish the First Bank of the United States in 1791.

The QE policies created by outgoing Fed Chairman Ben Bernanke simply continues this tradition of “America first; the rest of the world second.” Even the misguided Fed policies of the early 1930s was no exception. As all former and future Federal Reserve Chairs recognize, Fed policy must be targeted for the good of the U.S. economy and U.S. labor–not fine-tuned to satisfy the whims of finance ministers of foreign countries.  Making policy for the good of the U.S. economy–and the U.S. economy only–is the only way to ensure the superiority of the U.S. Dollar as the world’s reserve currency.

Seen in this light, the current plight of EM countries (e.g. Turkey, South Africa, Brazil, and Russia) is not really a problem for U.S. policymakers, even though U.S. “hot money inflows” have overly inflated EM currencies and assets in recent years. But make no mistake: U.S. Fed tapering, as well as a shrinking U.S. current account deficit  (an expanding U.S. current account deficit acts as a global liquidity provider, as most of world trade is still denominated in US$), will continue to be a drag on EM countries for much of 2014. The fact that recent rate hikes by Turkey, South Africa, Brazil, and Russia failed to stem fund outflows is highly problematic (in Russia’s case, it is especially troubling as Brent Crude is still over $100 a barrel). Cumulative EM net fund flows since January 2013 turned negative last August (below chart courtesy the Bank of England), and we believe fund outflows from EM countries will accelerate as the Fed continues to taper. Other global liquidity providers that are strong enough to arrest this decline–i.e. China and the U.S. consumer–will simply not come to the aid of EM countries. The only possible candidate is ECB easing, but we do not anticipate the ECB to ease aggressively enough to stem the decline in global liquidity.

Chart 1: 2013 Cumulative Net Fund Flows into EM Countries Turned Negative Earlier Last Summer

EMvsDMfundflows

More important, the state of EM finances has been declining precipitously over the last several years. Studies from the BIS and the Bank of England show that over the last several years, large foreign inflows into EM countries have enabled EM credit levels to rise sharply. As such, credit-to-GDP gaps in most EM economies have risen to levels not seen since the 1997 Asian Crisis, as shown below. With EM outflows now accelerating–and with the Chinese and other EM economies experiencing dramatic slowdowns–I expect EM assets to underperform for at least the next several months. Furthermore, recent corruption scandals in Turkey are reminding investors that political risks in these countries is still quite high. There may be a buying opportunity in EM equities during Q2 or Q3 2014, but for now, stay away.

Chart 2: Credit-to-GDP Gap in EM Economies – Higher than that During the 1997 Asian Crisis

credit-to-GDP-gaps-EM

Fed Refuses to Taper – Yes, it’s a Big Deal

No major firm anticipated this, but by staying on course with its $85 billion-a-month purchases in Agency MBS and Treasury securities, the Fed has sent a strong signal to global financial markets: We will stay fully committed to QE3 until inflationary expectations become well-anchored at the 2% level and until U.S. hiring begins to accelerate. These are tangible benchmarks (the former garnered from TIPS prices, and the latter from U.S. weekly jobless claims) that are disclosed and digested by investors at least on a weekly basis. In other words, investors no longer need to guess–global liquidity will continue to stay elevated until the U.S. employment picture definitively improves and inflation hits and stays at 2%.

The U.S. economy is still far away from hitting these benchmarks. U.S. inflation in August was lower-than-expected, with year-over-year CPI growth at 1.5%. According to the Cleveland Fed, ten-year inflationary expectations as garnered from TIPS prices are still near a record low, while the ECRI U.S. Future Inflation Gauge (a leading indicator for U.S. inflation) just hit a 19-month low (in the Euro Zone’s case, this indicator just hit a 40-month low).  Geopolitical events notwithstanding, certainly the U.S. economy is at no significant risk of higher inflation anytime soon.

In essence, the Fed has: 1) sent a strong signal that global liquidity will stay elevated, and more important, 2) prior to any tightening, investors would get strong signals from both market indicators and the Fed–i.e. there will be no surprises. It is thus not surprising to see India and Indonesia–two countries with strong recent outflows–spiking up immediately after the publication of the Fed’s FOMC statement. As we are writing this, India is up more than 3%, while Indonesia is up by more than 8%. Keep in mind that both markets were down earlier this morning. Asia is going to go gangbusters tonight. More important, the Fed has eliminated any potential systemic risk in Asia (prior to today’s announcement, we believed India and Vietnam were the two countries most at risk to Fed tapering). U.S. home buyers, as well as gold and oil speculators, can also celebrate.

The Bank of Japan Surprises: Profound Implications for Global Risk Assets

Since the Japanese stock market and real estate bubbles popped in 1990, one of the surest ways for a portfolio manager to get fired is to go long Japanese stocks or real estate. ROEs on Japanese companies are among the lowest in the world; while Japanese real estate prices had been mired by a 23-year secular decline. There were massive policy failures–including building “bridges to nowhere” and the infamous consumption tax hike from 3% to 5% in 1997–just as SE Asia sank into a depression. While Japan’s policy rate was eventually brought down to zero, it came too little, too late. High-ranking BOJ officials eventually stopped attending the annual Jackson Hole Economic Policy Symposiums simply because they did not want to be ridiculed by other central bankers.

All this changed tonight. The Bank of Japan just announced it will double its monetary base over the next two years, as well as embark on a massive quantitative easing policy with an annual goal of 50 trillion Yen (US$538 billion) in JGB purchases. Consensus going into the meeting was in the order of an annual 15 to 20 trillion Yen in JGB purchases. A US$538 billion QE policy is massive, as Japan’s economy is less than 40% the size of the U.S. economy. Essentially, the BOJ will be purchasing JGBs at the rate of over 9% of its GDP every year. An equivalent QE policy in the U.S. would be in the realm of nearly US$1.4 trillion in Treasury purchases on an annual basis.

The policy implications are massive. For one, no living portfolio manager had ever been surprised by the BOJ in such a manner. Surprises have been many, but those have all been disappointing. The Yen is down by 1.1% as I am writing this article. We expect more competitive currency devaluations and supressions by other Asian central banks in 2013 and 2014. Such a move will no doubt generate a massive rise in global liquidity–which will drive up the prices of risky assets around the world.

For two, we know that Japanese households have continued to hold massive amounts of cash and deposits due to ongoing deflationary fears and general aversion to risk-taking. According to the BOJ’s Flow of Funds, Japanese households held nearly 800 trillion Yen in cash and deposits as of June 2012, or nearly US$8.6 trillion (see below chart). With a yield of 0%–and with the BOJ now hell-bent on a 2% inflation target–many Japanese households will no doubt start deploying their capital back into higher-yielding or riskier assets. A mere 10% shift out of cash into riskier assets would mean a wall of liquidity totaling nearly $900 billion. Keep in mind that this amount is equivalent to the sum total of ALL U.S. equity/hybrid/bond mutual fund inflows (totaling $913 billion according to ICI) during the peak tech bubble years from 1997 to 2000! We thus expect global risk assets–especially U.S. stocks and U.S. commercial real estate–to be driven significantly higher by Japanese inflows over the next few years (to be compounded by Chinese inflows as the Chinese capital account is liberalized). All corrections from hereon should be bought.

japanassets

The Superclass: A Rational (Investor’s) Perspective

It’s that time of the election cycle again. Many frequent musings I overhear include:

“This is one of the most important Presidential elections.”

“The market is going to sink by 30% and the U.S. is entering a recession.”

“The Fed shouldn’t be doing this or that, and the Fed should be abolished.”

This is all random noise, and ultimately a waste of time. It doesn’t matter what you or I think. It only matters what Fed Chairman Bernanke, the ECB, IMF, Angela Merkel, and the new Chinese government think. Unless you are Bill Gross or Larry Fink and have a direct line to Treasury, I won’t care about what you have to say unless you are better at getting inside their heads–as well as the heads of large institutional investors–than I am. If you failed to time the last two major peaks of the global stock market (i.e. early 2000 and late 2007), then you have failed your clients–and should get and stay out of the investment industry.

To quote French dramatist, Jean Anouilh:

“God is on everyone’s side … and in the last analysis, he is on the side with plenty of money and large armies.”

To gauge the sentiment of global policy makers and large financial institutions, you need to at least read Bernanke’s two major publications (“Inflation Targeting” and “Essays on the Great Depression”) and to get inside his head regarding what the Fed will do today. If you had read both books before the late 2007 to early 2009 crisis (which we did), you’d have had a much better idea on Bernanke’s next steps on a real-time basis during and after the financial crisis. It is unacceptable to be learning and reading about things after the fact.

It is also unacceptable to write a long commentary when one could be brief. So here goes.

Today, we know that:

1) US Treasury rates remain at historic lows; therefore, the US government will not cut Federal spending
2) Using the same logic, neither would they increase US taxes
3) And yes, the Fed will inflate–the Fed is already doing this through QE3 with $40 billion of MBS purchases on a monthly basis

A currency regime is only sustainable if the underlying currency is allowed to be debased on a small and consistent basis. It is laughable to hear young Americans advocating for the return of the Gold Standard, when these same Americans (especially the so-called Jeffersonian “yeomen farmers”) were advocating for a bimetallic standard and rallying behind William Jennings Bryan’s “Cross of Gold” speech in 1896. It also did not occur to these same individuals that a true gold standard never existed in the United States. Chaos reigned after President Andrew Jackson killed the Second Bank of the United States. Banks issued their own bank notes and inflated the economy through the normal credit cycle, in spite of the so-called gold standard. The “gold standard” subsequently became a strait jacket on credit creation once the down cycle hits–thus accentuating the busts. For example, at the peak of the Panic of 1873, the NYSE closed for 10 days, and 36% of all corporate bonds defaulted from 1873 to 1876. The latest financial crisis pales in comparison.

With regards to U.S. interest/Treasury rates, we also know that there exists a shortage of global risk-free assets. According to numerous studies, there will at least be a shortage of $9 trillion worth of risk-free assets in the next five years due to the destruction of risk-free assets during the European sovereign debt crisis; as well as the implementation of Base III requiring higher capital standards of global banks.

That means there will be a rush to purchase more US Treasuries, no matter where US domestic inflation lies. By the way, there is no hard rule that nominal interest rates have to track inflation; nor any hard rule that nominal interest rates have to be positive. In fact, my base case scenario is for the U.S. Treasury Bill rate to decline below 0% sometime in the next several years.

Besides, we also know that inflation is nowhere near as “sticky” as it was in the last inflationary cycle during the late 1970s (culiminating in the peak of the gold price at $850 in January 1980). A comparison to the late 1970s to 1980 is thus erroneous. Inflation was very sticky in the 1970s given the rigidity of wage increases due to the power of unions and the fact that US labor was mostly domestic in nature. Today, unions no longer hold any power; and US labor wages are tied to global wages due to outsourcing.

So in a nutshell, yes, the Fed will continue to ease. And no, the government will not spend less; nor will it increase taxes. And yes, interest rates will remain low until at least the next Presidential election. And yes, what you say does not really concern me, unless you happened to be in a “Top 50 list” of global policymakers or a fund manager with >$100 billion in AUM. And at the end of the day, it doesn’t matter whether you agree or disagree with these global policies. As an investor, my concern is only about making money for my clients. And outside of that, my time could be better spent with family and friends rather than discussing the questionable virtues of a “sound currency” or “sound policy”–whatever that means.

The Multi-Dimensional Impact of QE3

There. The Federal Reserve implemented an open-ended quantitative easing policy (QE3) last Thursday with a promise to: 1) extend ZIRP to at least mid-2015; and 2) purchase a monthly average of $40 billion worth of agency MBS for the foreseeable future.

By the end of the week, the U.S. stock market sat at a post-financial crisis high, while gold prices flirted with $1,800 an ounce. WTI spot hit $99 a barrel, and copper prices rose to a five-month high of $3.80 a pound. The Euro also rose to $1.31, its highest level since late April.

QE3 will directly benefit the U.S. housing market through lower mortgage rates–all the more so given the recent tailwind in U.S. housing prices. Those with negative housing equity–at least those still making their mortgage payments–will eventually be made whole. The spending habits of a household with a positive balance sheet are considerably more generous than those of a household with a balance sheet in the red. From the end of WWII to 2008, U.S. housing activity has been one of the best U.S. economic leading indicators. With U.S. housing sales and prices normalizing, the U.S. economy should perform relatively well in 2013, as we have previously mentioned.

As evident on Thursday, QE3 will also benefit stock prices and prices of other risky assets, such as junk bonds. This is not surprising. As the Federal Reserve’s MBS purchases squeeze out more investors through lower MBS yields, these same investors will purchase more risky assets (e.g. junk bonds, emerging market bonds, and even stocks) to garner the necessary returns. At the same time, such money-printing should also result in higher gold prices, inflation expectations, and a lower US$.

As stock ownership is skewed towards wealthy households, the majority of U.S. households don’t benefit much from QE3. Worse yet, the U.S. poor and lower middle class will suffer from higher gasoline and food prices–as gasoline and food spending represent a higher portion of their budgets. Unless there is some kind of “trickle down effect” (higher housing prices leading to increased retail spending and hiring), QE3 does not benefit the U.S. from a social standpoint.

As mentioned in prior commentaries, we like U.S. housing, gold, commodities, and U.S. economic prospects in 2013. We now add to that the commodity currencies, such as the Australian Dollar and the Canadian Dollar. The Euro is still structurally flawed. However, we like the Swiss Franc. We understand that the Swiss National Bank stands by its 1.20 per Euro cap–and to that end, has accumulated foreign reserves equal to 71% of its GDP. As such, the Swiss Franc remains a solid currency, especially with Bernanke’s promise to create $40 billion worth of U.S. currency every month on an indefinite basis.