Global trade has stagnated since 2011.

Why has trade stagnated?

In the wake of the global financial crisis of 2008/9 countries realized that their consumers were weakened, their businesses were discouraged, and their governments had used much financial reserves to bailout their banking systems. The only feasible driver of output was trade. All countries therefore attempted to increase net exports.

A state of Cold Trade War has persisted since then. Initial battles were fought in foreign exchange where each country in turn attempted competitive devaluation. Subsequent gambits included reshoring of manufacturing and protection of intellectual property to protect domestic businesses. It is impossible that all trading nations are net exporters. Currencies are quoted one in terms of the other. There is no successful resolution to trade wards, cold or hot.

 

What are the consequences of a Trade Depression?

In a trade war, exporters suffer, as currency volatility, protectionism and mercantilism weigh on business conditions.

Manufacturing is more export exposed than services. Manufacturing suffers relative to non-manufacturing. This has been supported by empirical data.

A general favoring of non-manufacturing over manufacturing explains the weakness in the Chinese economy as the larger part of its economy slows and the smaller services part of the economy takes over. It means, however, that the rebalancing is not a voluntary action by the Chinese but a reality imposed by circumstances.

A reduction in trade negatively impacts productive efficiency and lowers global productivity growth. Post 2008/9, productivity has been volatile and weak and this is set to continue.

Slower productivity growth implies lower efficiency and a smaller output gap. So far it has been assumed that central banks have much latitude to operate expansionary policy, however, a tighter output gap could challenge this assumption and introduce more uncertainty around interest rate assumptions across term structures via inflation expectations.

The uncertainty created around central bank policy and around the trajectory of rates and the shape of term structures will have significant impact on asset valuations.

IMF World Trade, Exports:

 

The Euro Stoxx is down 12% year to date as I write this, Nikkei down 15.85% and China down 16-20% depending on the exchange and S&P500 down 9%. A barrel of oil (-20% YTD) is now cheaper than a barrel of fried chicken at a fast food restaurant.

I read in the newspapers that the collapsing oil price, WTI now trading below 29, is one of the factors for the rout in global equity markets, and I find this a bit strange. I understand that weak oil prices are not so good if you are in the middle or the periphery of the oil industry but for consumers, this is not such a bad thing. One argument goes that weak oil demand is an indication of a weak global economy yet we are increasingly seeing data favoring services over manufacturing almost across the globe, which could weaken that particular argument.

I also read that the slowing economy in China is responsible for the weakness in global equity markets. Yet China and the US have simultaneously turned away from one another, the US reshoring manufacturing and China turning to domestic consumption. I understand that this bodes ill for economies and industries supplying old economy China, heavy industry and somnambulistic state owned enterprises. But China world trade stagnated in 2011 and has not recovered. The world is less global from a trade perspective than it used to be. China’s ability to export deflation is contained.

Emerging markets have been cited as a source of risk. Capital flows on the back of QE(N) supported unsustainable business models and propped up currencies and assets which are now retreating as capital flows reverse. Some emerging markets have again funded themselves in USD, but where credit creation has been greatest, China, debt has been raised mostly in local currency, and the Chinese government still has sufficient capacity to support its markets and economy, if it is smart about it. Even the biggest cache of ammunition is quickly depleted by a loss of confidence.

If there is a real problem that threatens to plunge us into the next crisis, it’s unlikely to be one of these. The oil price has been declining for 18 months and China has been slowing since 2012. Emerging markets do not suffer from a balance sheet problem but a business model and cash flow problem, not insignificant, but known and therefore unlikely to be a blindsiding impact. For that we have to look elsewhere.

But since the markets are looking a bit seasick, perhaps we should try to find some positives to sooth ourselves.

One, regulators have not been complacent. The banking sector is safer now than it was before. Banks have been forced to raise more capital, to deleverage and to be more prudent in lending practices. Not all regulators have been as successful and not all banks as cooperative, but by and large the system has been fortified.

Two, central banks have not been complacent, but they may have been one dimensional. Efforts to boost output through QE have been widespread and determined. The US has ended its QE activities but they have not reversed them. Plans to reverse them have, in fact, been placed on the back burner. Whether this is a good thing is another matter. The ECB has been slower to act and then less robust, but circumstances will likely pressure them to do more. The BoJ is already at the limits of credulity in its efforts and is attempting more subtle adjustments instead of outright increasing the expansion. The PBOC has the most complex problem and the most complex policies, but is supplying liquidity wherever and whenever it is required.

In the absence of cataclysmic risks it would seem rational to seek investments which offered good value. Chinese equities listed in Hong Kong are pretty cheap, so is Korea, Taiwan, Vietnam, the US auto, transportation and tech sectors, Brazil, Argentina, Russia, Turkey and just about any MENA stock market. Some of those markets are cheap for overwhelmingly compelling reasons, recession, stagflation, sovereign insolvency, broken business models, but not all of them are and value can be found. The same variation of valuations can be found in credit markets, with the same variation of credit and legal jurisdiction quality and economic strength. Generally, credit is cheap compared with benchmark sovereign and swap curves.

So, should we all go out and buy emerging, frontier and submerging market equities, leveraged loans, junk bonds, and structured credit junior tranches? It depends on your time frame. Too short, and you have volatility, too long and an unpalatable truth might emerge.

Since 2008 we have been playing a game of chicken with the central banks. The system broke, the central banks and governments stepped in to prop things up and reassure us that everything was alright, and we in turn knew that this was not the case but that the governments would have to keep the pretense up until everything was in fact alright. We always knew that one day, either everything was alright and our initially artificially elevated asset values were justified, or that things were not alright and the game was estimating when the wheels would come off the government QE machine and asset values would head lower in pretty short order.

When central banks are the determinants of asset prices, volatility is not a reflection of the risk in an asset but the risk of execution of central bank policy. A significant part of the volatility is likely due to the recent uncertainty in central bank policy. The Fed increased uncertainty when it failed to raise interest rates in September as it said it would resulting in speculation that the economy was in worse shape than suspected. At the same time, the BoJ failed to increase its asset purchases, as weak Japanese data suggested it would have to do, disappointing the market and leading to the unwinding of large consensus shorts in JPY. The ECB failed to increase its QE efforts enough, announcing a halfhearted extension to the asset purchase program from September 2016 to March 2017. The PBOC’s and CSRC’s multiple miscommunications and missteps led to a severe loss of confidence in the Chinese equity markets. So used have the markets become that they cannot make up their own minds about economic and commercial prospects they need central banks to show them the way. And when central banks themselves falter, investors understandably panic. This is unhealthy, but some change is coming, at least from the US.

The US Federal Reserve has a useful modus operandi. When it wants to do something, it telegraphs it well in advance, gets the market to price it in and then moves to align policy to the new market reality which it created, thus avoiding nasty surprises. This was not always the case, especially under Greenspan whose deliberate obfuscation may have hid bona fide confusion. From Bernanke onwards we are being fed information to manage us, to co-opt us into the deployment of policy. The Fed will now wean us off scrutinizing its actions as determinants of market behavior by itself becoming more data dependent in policy. With time, it is hoped, the market will try to gain an edge over the Fed by looking at the data.

We are in a period of adjustment, whether central banks still command markets or not, away from watching and front running central banks. It has been an easy 7 years, although many investors made it hard for themselves, relying on fundamentals instead of central banks in those early years after the crisis. Investors are as always slow to adjust. But the central banks are either losing their way, in part because there is no longer a clear and present danger, which is good, in part because policy has reached its limits, or recognizing that it is unhealthy to forever lead the market with a helping hand. Their messages are less clear and they seem less certain, even in Europe and Japan. The adjustment from policy focus to fundamental focus is a turbulent one with elevated volatility through the process.

The question then is, what will the fundamentals tell us? What valuations will we accept, under the assumption that central banks no longer drive asset prices. History is a guide but adjustments will need to be made to account for a loss of efficacy and certainty of central bank policy, a weaker credit transmission mechanism due to greater bank regulation, slower trend growth, slower global trade as countries seek greater self-sufficiency, the evolution of economies under innovation – the dominance o
f services over manufacturing, et al. Estimates for uncertainty around growth estimates will also need to be updated to take into account greater financial stability within the banking sector, the gradual withdrawal of central bank influence, income inequality and the risks of social unrest, increased geopolitical risk as countries become more insular, et al.

In the long run, growth will likely be lower, the loss of specialization by trade is an important factor as is credit creation which has run well ahead of itself and needs to be allowed or encouraged to mean revert, and asset markets will need to reflect this, likely with lower long run equilibrium valuations both in equities and credit. From the early 1980s we rerated in volatile fashion with booms and busts until we peaked in 2000. From there, valuations have fallen, again in volatile fashion. This long cycle derating is likely to continue, and again in volatile fashion.

In the medium term, an investor working with long term valuation assumptions will need patience and loss tolerance. The market will continue to adapt to the slowly changing reality of policy’s role in asset pricing, and in so doing will regularly overshoot in both directions providing good entry points and exit points to the lucky or smart investor. I’m happy to be either, I’m not fussy.

Disclaimer: All information and data on this blog site is for informational purposes only. I make no representations as to accuracy, completeness, suitability, or validity, of any information. I will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.

Because the information on this blog are based on my personal opinion and experience, it should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. My thoughts and opinions will also change from time to time as I learn and accumulate more knowledge and as general conditions evolve.

 

 

Following from our Investment Outlook for 2016 we formulate an investment strategy. A number of high level principles or themes will animate this strategy.

The strategic allocation is actually quite risk averse. The reason for this is that the global economy remains fragile and the performance enhancing drugs or policies prescribed by the world’s central banks are losing marginal effect, even if they have worked to a limited degree. The central banks of the world have no leeway or capacity to deal with a recession or other crisis, if such should happen in the next 12 months. Even the Fed has only just begun raising interest rates.

Equity markets have fared quite well in the last 5 years, the S&P 500 index for example, returning over 10% per annum. Global equities (MSCI World) has returned an annualized 5.3% in the same period. US high yield has returned 4.2% and the Barclays Aggregate 2.6% in the same period which on a risk adjusted basis, this is quite respectable. Corporate performance, however, has not kept up and companies have spent the money they raised paying dividends, buying back stock or each other instead of investing in productive assets. Valuations have therefore risen and are highly sensitive to interest rates.

The US Federal Reserve has just raised interest rates and signaled 4 further rate hikes in 2016 and the market is pricing in just 2 rate hikes. The fixed income market is not robust against a hawkish surprise by the Fed and the USD term structure is too important in the valuation of all assets from corporate credit to equities to real estate.

Global trade peaked in 2011 and has been trending sideways. When trade lags output growth productive and allocative efficiency suffer and the risk of inflation rises. That inflation hasn’t risen in the last 5 years is evidence of deficient demand. This is corroborated by the weak impact of successive rounds of quantitative easing on real output growth even as it inflates asset prices.

Geopolitical risks have been rising. The energy independence of the US has played an important part in the increased turbulence in the Middle East. The Arab Spring has been unsuccessful and ISIS is seeking the establishment of an Islamic State across Syria and Iraq. The rise of China economically has also led to increased ambitions abroad if not at least to secure its own interests. Europe’s unity has been tested in the bond markets and latterly by the election of anti-austerity and Euroskeptic parties in Greece, Portugal and Spain. Right wing nationalist parties have gained traction in core Europe as well. In the UK, an in out referendum on Britain’s membership in the European Union is scheduled to take place before the end of 2017. While geopolitical risks are always with us, the last 5 years have experienced an escalation.

Since markets were not driven by fundamentals in the post 2008 era of QE and the central bank, can we assume that fundamentals will return to drive markets in a post QE era? Are we even close to a post QE era?

With this much uncertainty in the markets it is likely that markets will be fickle and sentiment driven, at least in the next 12 months. A guerrilla trading approach may be necessary if one is to manage volatility. Long term investing is laudable but long term investing can and must also include short term risk management and trading. If we challenge established wisdom we will come to conclusion any part of an optimal investment strategy must be itself optimal, we find theoretical support for lower latency strategies. We are not talking about high frequency trading but of adjusting the optimal portfolio to suit the evolution of market prices and information.

Strategy:

Maintain an underweight in US equities. Valuations are expensive, growth is tepid, and the Fed is not expanding its balance sheet. US equities cannot rely on higher earnings multiples with the Fed in neutral and so have to rely on earnings growth, the prospects of which are not looking very attractive.

Restore overweight in European equities. We were underweight risk assets on the whole coming into 2016 simply because the macro environment just looked risky. We are restoring our position in European equities to overweight. European growth is still in recovery mode, earnings are recovering in sympathy, the ECB is still buying assets and thankfully didn’t overdo it in December when it disappointed the market with less than expected monetary stimulus. There is potential for the ECB to do more and this could propel European equities. That said, we are taking our time to restore the allocation to overweight and events may derail this deployment.

Underweight Japan. Japan appears to be pushing the limits of policy. The latest macro data is not encouraging and yet the BoJ has stopped short of increasing QE although it has tweaked the current program slightly. Japan has relied on a weak JPY to invigorate the stock market and it looks like the JPY has reached a trough.

We began the year with an underweight in China. Since then the market has fallen 15%. It may yet overshoot and lose more, but it is time to revisit the underweight call, since it has worked. China’s regulators have mismanaged the market policies and exacerbated if not precipitated the equity market sell off. The underlying economy, while slowing, is not in crisis. We think the time is right to begin seeking value in Chinese companies.

US duration is very tricky and although model weights are circa 10% for investment grade, we are err on the side of caution. The market disagrees with the Fed on the path of interest rates and is therefore vulnerable. Arguing for duration is the fact that inflation is weak and 30 year USTs are likely to outperform. The mid section of the curve is particularly vulnerable to rate hikes.

US high yield is facing a divergence between sentiment and value. We intend to raise US high yield exposure from circa 4% to circa 10% with a preference for leveraged loans. The bond market has too much energy exposure and exposure to the vulnerable belly of the USD curve.

For our European credit exposure, the ECB’s position on QE is helpful and we are happy to own peripheral duration as well as corporate credit. That Europe has yet to get over the deleveraging phase is helpful to credit and we are balanced between owning high yield and sovereign duration. A sub strategy within European credit is bank ca
pital where the implementation of TLAC has extended a trade which began in the 2011 LTRO and the 2014 asset quality review.

We like the USD on the strength of the US economy, short term cyclical slowdowns notwithstanding. With the ECB maintaining QE and indeed having not done enough, threatening to do more, we see the EUR remaining weak. The JPY is different. While fundamentally the Japanese economy continues to languish, it appears that the BoJ and the government have reached the limits of accommodation and as a result the JPY may have found a temporary base. It may not weaken as quickly as fundamentals would suggest. CNH, however, wants to weaken, and the current weakness masks PBOC efforts to support the currency.

Cash. In turbulent times we like cash, not so much as a dampener of volatility but because there may be assets to buy. We maintain high cash levels, model weight 10%, actual weight probably 20%, in anticipation of buying opportunities in the first quarter. But we are in no hurry. We have a shopping list and we are cashed up but the cheap sale continues and the markdowns continue. Its not a bad thing to be patient.

Market pundits did say that 2016 would be a difficult year for investing. However, they did say the same thing in 2015, 2014, 2013, not to mention 2010, 2011 and 2012. One can only conclude that it is always a difficult year for investing. 2009 was easy. You either couldn’t or wouldn’t exit in which case you made some money in the recovery but lost all your clients, or you could exit, did, missed the recovery, and lost all your clients. All the investors who experienced 1997, 1998, 2001, and said they were waiting for a crisis to invest, all fled, and missed the boat. These same investors are awaiting a market crash sometime in the near future when they say they will pile in, but will probably flee again when push comes to shove.

The two most important things in investing are courage and luck. Fundamentals and analysis are excellent at shoring up courage and providing very general direction. Too much a focus on fundamentals and your profit and loss will be volatile. Focus on profit and loss, and you will lose faith in your analysis. Markets are moved by the average marginal buyer or seller, and therefore by the average interpretation of the facts. The average person is by definition smarter than 50% of the population and dumber than 50% of the population, and has therefore a 50% chance of being right. Markets are therefore a coin toss. A series of coin tosses is a drunken walk (random walk is a technical term and I cannot afford precision here). To successfully trade a drunken walk, one needs courage or one will never act, and luck, or one will never win. The only other thing is discipline and risk management to ensure that one is able to replicate one’s good or bad luck day in day out. As long as you can stay in the game, you are successful. Don’t be overambitious or delusional.

In markets, perception drives reality. It’s has a parallel in quantum mechanics.

Once in a while, an obvious trade comes along. If it is obvious to many, it will become crowded and volatile and risky. Before it becomes obvious to too many, you will not be able to convince your boss, the risk manager, the client, the prime broker, the investment committee, or indeed your wife. Often you will need market counterparties to trade with without alerting them to the opportunity. Hired guns or investment banks, can help to run interference. The instruments available to capture the trade will often not be available, or you won’t be set up operationally to trade it, your risk systems cannot capture it or measure it, your back office will have no idea to settle it. If you are Supreme Commander, you might be able to surmount these obstacles, by which time, half of the opportunity has been realized by price discovery and the trade is becoming crowded.

Markets are prone to changing direction when the majority agree. If a market is going up and all agree that it will continue, it is likely to reverse. If the consensus is that the market will fall, it is likely to fall. If, there is disagreement and uncertainty, markets may be volatile but are likely to hold the current trend. When there is a strong consensus, either there is no longer incremental capital to maintain the trend, or there is sufficient incremental capital to reverse it.

China is having a spot of bother controlling the volatility in its stock markets. For one, the circuit breakers are not functioning as intended. Trading is temporarily halted if the market moves by more than 5% and halter for the day if it moves by more than 7%. The quickest way to empty a room is to threaten to lock the doors. Also, large investors, that is investors with more than 5% holdings in a company will only be able to sell 1% over 3 months, and then only with 15 days notice to the regulator. This means that these investors are subject to hedge fund liquidity. In the jargon, its quarterly liquidity, account level gate, 15 days notice. But in a hedge fund this applies equally to all investors, whereas in these markets, such notice gives smaller investors a chance to run for the hills. Good work CSRC. Nothing cures falling prices better than low prices. Closing the gates only makes people run for them. And banning selling only de facto bans buying.