Economic outlook

Growth is slowing. After ten years of expansion, it is to be expected that the global economy should slow down. The slowdown is very tangible in Europe, is evident in China and rest of Asia, and in the US is showing early but significant signs.

The Trade War is a drag on growth. 10 years ago, trade between China and the US began to decline as a share of the economy. This was a) a conscious effort by China to reduce its dependence on exports, and b) a reversal of US trade policy to outsource production. In 2018, President Trump escalated this trade war using tariffs, which are very blunt instruments and are paid by the aggressor nation’s people.

Central banks are in expansion mode. Balancing these growth reducing factors is a U-turn in Fed policy. Until October 2018, the Fed was raising interest rates and shrinking its balance sheet. Since then it has paused and there is talk of rate cuts. Two years ago the ECB signaled raising rates in the summer of 2019. Given the weakness in the European economy, it is doubtful if the ECB can raise rates at all and will more likely have to start QE again (via the LTRO). The Chinese central bank, the PBOC is also loosening to try to boost growth.

Credit spreads are tight. Contrary to popular opinion, the corporate sector has not increased its leverage or borrowings out of hand. The bulk of the credit creation has been in the government sector. While corporate indebtedness has risen in the past decade, they remain below pre 2007 crisis levels. In particular the banking system has reduced its leverage and maintains healthy balance sheets. Credit quality, despite some deterioration in the past few years, remains good. It is valuations that are the issue.

Market Outlook

Equity markets are rising because central banks are cutting rates, not because earnings are accelerating. If earnings slow and markets remain high it means equities are getting more expensive. In the past decade, earnings have been supported by cost cutting and rationalization. Growth cannot be sustained by making less investment and businesses smaller. Be cautious investing in equities.

Bond markets have been supported by the same loose central bank policy. Tactically, buying duration may seem attractive. However, duration (sovereign bonds) is volatile and central banks have used all their tools to support the market.

Within the bond market, corporate bonds offer the least value and the most volatility as they are most easily bought and sold by retail investors. This is especially true of the investment grade market, and to a lesser extent the high yield market.

Amid the noise of central bank policy, the mortgage bond market is interesting and more rationally priced. On a relative basis, commercial mortgages are more expensive than residential mortgages. Also, household balance sheets look healthier than corporate balance sheets which also favours residential over commercial mortgages.

Loans are the senior most debt issued by companies and because their coupons are floating, they also have no interest rate risk. Central bank policy has shifted investors’ interest away from loans to bonds and as a result there is good value in the loan market. Leveraged loans yield on average 3 month LIBOR + 4.5% and have a default rate of about 1.3%.

Bank perpetuals are attractive, especially in Europe. This may seem to be a niche market but banks are one of the largest and most important sectors in the economy. Up until 2008, banks were lightly regulated leading to all sorts of problems. Since then, banks have been tightly regulated, required to raise more capital and make their balance sheets safer. The logical strategy therefore is to buy the riskiest securities ranking just above equity in safety (since capital raising leads to equity dilution).

FX is the most difficult asset class to call. Whereas once FX was driven quite loosely by two competing theories (higher interest rates = stronger currency versus higher interest rates = weaker currency), today FX is driven by politics and central bank policy. Yet FX has important implications for investing. Emerging markets like a weak USD. If you think the USD will be strong, you cannot simultaneously favour emerging markets. In this era of FX inflexion, a good policy is to be hedged all the time. Putting the fundamentals of the economy aside, since they seem to have weak predictive power over FX, the psychology of investors is a reasonable guide. Europe faces much political instability and an inefficient single currency system. Only Europeans would keep EUR and they might keep other currencies as diversifiers. JPY has negative rates and a huge national debt. JPY can look like a haven currency and negatively correlate with markets because it is a funding currency but it is not a haven. That leaves USD. Americans will keep USD but so will Europeans and Asians. What about CNY (CNH)? This could be the reserve currency of the future if China keeps opening up its economy and builds bridges instead of walls, like America. CNY is weak today due to a slowing economy but if China opens it capital account, it will one day reflect the economic fundamentals of the Chinese economy, which are strong.

Strategy:

I am cautious because

a) it has been 10 years of growth and the business cycle is at a turning point,

b) sovereign balance sheets are not very strong anywhere in the world,

c) central bank policy is mostly fully deployed (except for the Fed) and there is not much room for further QE, and;

d) most assets are expensive, especially large liquid markets but also private markets like private credit and private equity.

• Cash is one solution but it is a poor one as inflation risk is rising as countries turn to fiscal policy. Market timing is also a losing game over time. It is better to be fully invested but to choose the risk exposures more carefully and to be LESS diversified. If general conditions are not so good, being more diversified means you guarantee you will earn the average just when the average is poor.
• Loans are attractive as they are the senior most corporate claim, and are often first if not second lien. They are also zero duration assets and are insensitive to interest rates rising or falling.
• Bank perpetuals are good value but market prices are volatile. We will take advantage of that volatility to buy them and as we are long term investors, tolerate the volatility when we hold them.
• US mortgages are stable as despite the slowdown, jobs are growing and wages are stable. Mortgages are getting expensive in some areas so we have to be selective.
• The Euro yield curve is still relatively steep and buying duration on a FX hedged basis is attractive. The Euro investment grade term structure is also steep and buying long maturity investment grade is attractive.
• The USD yield curve is flat but there is a steepening trade in the 5 and 30 year sector. In USD corporate bonds there is no value and low exposure is warranted.
• Equities are expensive globally and we would be underweight generally unless we had a real reason to be invested.
• Banks are cheap and growth is stable, however, the market is not recognizing the value. A slow accumulation at lower levels across US and European banks is recommended.
• Healthcare has underperformed this year and is good value. The longevity theme is a long term one and we will use this period of underperformance to accumulate exposure.
• Luxury brands is a niche market but an attractive one. The issue here is that brand leadership rotates and active management is important.
• Tech has been the best performing sector in the last 10 years. Banks outperformed from 2000 – 2008 when they were lightly regulated and underperformed from 2008 to 2019 as they were heavily regulated. The fate of tech lies in regulation. It has begun in Europe. If the US also begins to regulate tech, the sector could begin a multi-year underperformance.
• Private equity, credit and real estate: The liquidity premium has shrunk across illiquid markets as too much money has gone in search of a home. We would reduce the pace of investing in anything illiquid for now. The time for illiquid investments is just during (if you are brave) or just after, a recession. We haven’t had a recession in 10 years. There are pockets of opportunity or potential we see:
  • Tokyo real estate, specifically office and hotels.
  • London is not yet an opportunity but if there is a Hard Brexit, a London prime office asset could become a bargain.
  • SME lending in frontier markets struggling with Basel banking regulations. This has impact implications for employment and development.
  • Non-performing loans in China. The PBOC and CBIRC are cleaning house and banks have begun selling NPLs. The usual approach of sweeping the NPLs under the AMC carpet is longer acceptable to the regulators.
  • India’s 2017 bankruptcy code (which is liquidation and not reorganization) creates a gap for a private reorganization solution.
  • Financial inclusion. This is related to banking regulation. Banking regulation while making banks stronger is choking the provision of credit to small and medium businesses. Trade finance and other small scale commercial lending activities can become attractive as banks exit from the business.

The history of our planet is replete with extinctions. As our planet’s environment and conditions evolve, and as the various species which live upon it evolve, speciation and extinctions occur. At the point of writing there are an estimated 8.7 million different types of life forms of which animals number between 1 to 2 million and plants just below 400,000. These are rough estimates of course, given the difficulty of discovering and numbering the vast number of living things in the world. There is a natural rate of extinctions in a dynamic system such as our planet, and a natural rate of mutations resulting in new species. Most species do not alter their habitat significantly or significantly quickly to alter the balance of creation and destruction. One species defines itself by its ingenuity, ability to use tools, ability to organize itself to achieve macro sized impact, and ability to intentionally change its environment to suit its own purpose. Humans. Humans do not set out to systematically cause mass extinctions within or across species. They may do so out of neglect or inability to foresee the collateral consequences of their actions. One of the most damaging impacts of humans is that their actions, by reason of their macro influence, correlate the extinction phases of multiple species. They also interfere with the duration of speciation and extinction. This loss of temporal diversification is damaging. In addition, human’s colonization of greater areas of the planet also reduce geographical separation and impedes speciation. The result is a net reduction in bio diversity as speciation is slowed relative to extinction. The actions humans take to encourage bio diversity have unpredictable results. Any systematic approach to encourage bio diversity could introduce systematic biases which miss the point of temporal diversification and balance between speciation and extinction.

Following a pretty bad final quarter in 2018, markets had a good first quarter 2019. The reasons for the rebound included a) the fact that markets overreacted in 2018 to growth fears and the US Fed sending too hawkish a signal, and  b) the US Fed retracting its hawkish message and aligning with the Chinese and European central banks in accommodative policy. The global economy continues to cool as trade tensions maintain a damper on growth, loose monetary policy faces diminishing returns and loses some of its impact, and the natural fatigue of a long period of growth sets in.

Many factors can drive markets but only one or two do at any one time. Earnings growth may be slowing and valuations may have recovered but the U turn of the Fed in signalling policy from hawkish to dovish, and the ECB finally caving to evidence of weak Eurozone growth, together with the PBOC making large scale liquidity infusions to address slowing growth in China, all together represent significantly expansionary liquidity conditions. These have driven and will continue to drive markets higher. That growth and earnings will moderate mean that valuations will get richer and there may be more caution in the markets as it heads higher. This is no bad thing in the short term.

Since the driver of equity returns has been looser monetary policy, bonds have rallied in unison. Also, since the momentum behind returns has also been due to a rebound from an overreaction to bad news, we can explain the relative performance of certain markets. The most liquid and retail investor populated markets suffered the most volatility, fell most against their valuations and rebounded most. Chinese equities were priced for recession in 2018 when reality was a moderate slowdown. The actions of the PBOC to supply liquidity and cut funding costs have buoyed the Chinese equity market and are likely to continue to drive that market up. European equity markets have also done well as the ECB has back tracked on its intentions to raise rates. In fact it has replaced QE with repo operations that represent quasi QE. The Indian market, which did well last year, has fared less well this year as political risks loom with the elections already underway.

Liquid credit did very poorly in Q4 2019 and subsequently rebounded strongly. The initial sell off was triggered by fears of tighter policy and slowing growth hitting both duration and credit spread simultaneously. The sensitivity of credit to liquidity exacerbated the impact. Both the ECB and the Fed backtracked on normalization. The ECB had been too optimistic on Eurozone growth and had to replace QE with a similar policy while the Fed signalled a pause in rate hikes and balance sheet normalization. The rebound was equally as sharp as the declines the past quarter and occurred in both duration and credit. As a result, floating coupons underperformed fixed coupons. The liquidity impact was also reversed. Basically, CLOs and loans suffered smaller losses and experienced smaller rebounds  compared with the bond market which fell harder and bounced higher.

What does the rest of the year hold for markets?

The expectations for slower growth are well founded and telegraphed. This will validate looser monetary policy which will continue to support asset markets. However, as slower growth becomes more evident, the strength of the rally should fade. On a net basis, liquidity should beat slower growth and markets should trend upwards albeit at a slower pace. In equities, this favours more levered companies. In debt markets, this favours duration over credit. Given the extent of weakness in Europe, this theme will be more pronounced in EUR and Eurozone issuers than in USD or US issuers. Already there has been rotation from loans and CLOs to bonds and this should continue further into the year.

A word about oil. The collapse in the oil price in 2014 was due to the Saudi’s flooding the market in reaction to increased US shale production. The collapse in the oil price in 2018 was due to the Saudi’s over producing beyond their quotas in reaction to the recovery in US shale production. The market is highly manipulated or managed if you are more diplomatic and strong short to medium trends can result from these interventions. In the longer run, that’s 3 to 5 years, the industry hasn’t invested in sufficient capacity and shortages will result. In the longer term, the rotation to cleaner energy sources will limit the demand growth for oil.

At some point the markets will turn and fall but there will be specific triggers for this. I cannot, of course, see what these triggers are, but can guess at the conditions necessary for this to happen.

Interest rates head higher. This could be because of inflation, which is unlikely, causing central banks to reassess their policy. Central banks might reassess their policy because of a rebound in growth prospects as well but this is equally unlikely. Rates could head higher if fiscal positions weaken and sovereign issuance rises relative to demand. This is more likely.

Politics could be a trigger and is always unpredictable. Europe has elections, India is in the midst of them, the US will be preparing for them. Inequality continues to sustain populism, no bad thing unless that populism takes on a lazy, cynical and later aggressive posture. Politics would have direct impact on risk assets as well as sovereign rates. The list of potential political dislocations is long and deserves separate comment.

A crisis in a specific market such as Chinese debt, US loans, corporate bonds, is unlikely. We are more likely to face a whole host of smaller problems, although they might coincide in terms of timing. The banking system has always been the coordinating factor in financial crises and the reform and regulation of the past decade have made banks safer and less of a systemic threat to the economy.

The level of debt in the global economy is high and rising and a problem but it is a latent one. It requires a catalyst without which it is likely to grow quietly in the background. We have found various innovative solutions to funding this growing debt and avoiding a disruptive repricing. Anything that threatens the debt service, which is most sensitive to interest rates, will catalyse the repricing. So while the level of debt is a problem, it is already too big for us to worry about, we should focus on the level and path of interest rates. Given the structure and organization of the economy, society and politics, it is unlikely that the debt level will be significantly addressed or reduced for some time to come.

It is clear that the global economy is slowing, most acutely in Europe, but also in China and even in the US. This much is quite obvious from slower moving economic data. Yet for the first quarter, risk assets from equities to high yield credit have done well. This has mostly if not entirely been down to central bank policy, real or perceived. We know the ECB had been ignoring weak data to its peril and had to retract its optimistic appraisal, we know that the PBOC had been tight last year before loosening in the final quarter 2018 and following through this last quarter. The Fed, which miscommunicated in Sep 2018 has since made a radical turn and signalled loose policy.

I think there is a serious weakness in the global economy and financial system, which is excessive debt. Its not a forgone conclusion and there are serious arguments why chronic and high debt may be sustainable. I just don’t think it is, and if you agree with me, then there is a day of reckoning somewhere in the future. Predicting this day is difficult given the efforts of central banks to defer, hopefully indefinitely, this event.

However, if I’m right, then a crisis must coincide with a sharp rise in interest rates, and FX volatility, which we do not see at this point or indeed in the near future. The volatility in the last week, is therefore most likely to be a short term phenomenon without much depth. It could signal a cap on market levels or it could see further declines, but not a bear market, and not a crisis. Such dips are tradable. It may even be possible, in less volatile asset markets, to sell with a view to re-buying in 3 to 6 months time. In fast moving markets like equities, its not so easy. I don’t even think we are in a Q4 2018 magnitude correction.

China is important. Its population and its fast paced growth, even as it slows, is a significant factor in global demand. China’s situation is not so bad. It certainly has over-leveraged corporate and local government sectors but household debt and central government debt remain well contained. The slowdown is also engineered and self inflicted, most importantly, it is a controlled demolition. The CBIRC and the PBOC are trying to regulate the non bank sector and to do it they need to first divert credit away from it into the regulated banks. This will take the burden off the non bank sector which they can then begin to regulate before allowing credit back into the newly regulated channel. 2018 saw a wobble as the regulators struggled to manage the deleveraging of one sector and the leveraging up of another. Deflating a more highly leveraged structure while inflating a less leveraged one led to net deleveraging at a faster rate than they expected. This has been corrected and the capitalisation and liquidity provision to the banking system has increased significantly.

India is in the midst of crucial elections which could determine its long term trajectory. India’s growth spurt in the last 5 years has been down to having a simple majority in the Lok Sabha for the first time in over 30 years, under a business friendly Prime Minister. If Modi’s management ceases, the risks to India are substantial. At 2.2 trillion USD nominal value, India is a significant player in the global economy, but its linkages are nowhere as ubiquitous and influential as China’s and poses less of a threat, or boost, to global growth. India is a domestic risk and opportunity.

The US has been the only country able to normalise monetary policy for any length of time in the last decade. The recent pause by the Fed is unfortunate, as it signals a Fed beholden to the President, investors, and asset owners, to the subordination of longer term stability and prudence. I do not deny that a slowdown looms but a recession is still a small risk. To back track on normalization because of a slowdown which appears to be a cyclical slowdown, one which should be expected in the normal cycle, is disappointing and could store up risks for the future. Moral hazard is the first and biggest risk, but the lack of latitude in policy is the other big one. The Fed should take the opportunity to normalize so that it can cut more effectively when the depth of recession necessitates it.

And finally, Europe. This is possibly the weakest link, not for Brexit and Italian debt but for the latent political tensions and dynamics that are likely to break cover at this year’s European Parliamentary elections. The Far Right is gaining foothold across Europe, German leadership is in flux, Italy is beginning to sway rather too easily to the League and Spain’s upcoming elections (end April) could easily see another hung parliament. In the meantime, the ECB has been too sanguine and too late and is also about to see a change of Chair. The focus on fiscal and monetary policy has distracted from balancing the economy away from exports, a position which is precarious in the wake of a Chinese US trade war.

So, some serious concerns on the horizon, but the markets should refocus on liquidity for the rest of the year while fretting about growth occasionally. A range bound market at worst, or at best, depending on your point of view.

Capitalism and democracy are fundamentally bound. So it is with some trepidation that we witness the evolution of capitalism post the financial crisis of 2008. Without Communism as a nemesis and a guide it was also a risk that capitalism would make unexpected detours. The reaction to the crisis and its pragmatic prescriptions were done perhaps without considering the deeper ideological implications. Bailouts of particular institutions, industries and of whole economies are not capitalist concepts but the acuteness of the situation at the time called for extraordinary measures and a temporary suspension of principles. Unfortunately, such is human behaviour that a palliative once discovered is difficult to wean off. So it would be a good 7 years before QE would be tapered and then only in the US. No sooner had the rest of the world signalled a return to normalcy that economic growth has begun to slow and policy makers appeared to relapse into accommodation.

The emergency economic measures involved as a side effect the transfer of wealth from labour to asset owners. This will later prove to be a dangerous side effect with far ranging social and political consequences.

The development of capitalism and a welfare state was a deliberate solution to the Marxist threat. The West, recognizing that Marx was possibly right in his observation that capitalism leads to inequality and to the roots of its own demise, rightly pre-emptively addressed this by establishing social safety nets. The cynic may call this appeasement or worse, a capitalist narcotic, but it is prudent risk management.

With the downfall of Communism, Capitalism lost an important part of its raison d’être. Capitalism, communism, are ideologies governing how the organization of society and how it can harness resources to improve its welfare. One important pillar is the avoidance of war. Democratic societies are less likely to seek war, since the masses pay the price, the rule of the masses are likelier to avoid it. Dictatorships are more likely to wage war since the price is not paid by the ruling class who declare war.

The flavour of democracy and capitalism that evolved to meet the communist challenge was always one of balance, against communism and the forces that give rise to it and sustain it. Capitalism post 1990 was designed to check itself, lest its unfettered progress gave rise to the conditions ripe for revolution. For capitalism to persist, the threat of communism was necessary. Without communism, there is no superior economic and social model to challenge it. Without capitalism, there is no inequality to address. You could say capitalism and communism were one and the same, the two faces of Janus.

The world that Marx envisaged and the polarization of the post war years saw clear borders between these two worlds, Russia and China on the one side and the West on the other. The situation today is more complicated. We are still two worlds, but no longer are they geographically distinct. They are among us. Whomever they may be.

However, the deprivation of opportunity is as powerful a force for change as hunger and physical deprivation. The rise of the European Far Right, of populists, of strongmen, are symptomatic of this disaffection for the status quo. It threatens to escalate.

One mitigating factor is the ageing population. Discontinuous and turbulent change tend to be precipitated by the young. The old have invested too much in the status quo to seriously challenge it; they have too much to lose, not a long horizon left to accrue the benefits of that change, less energy and less aggression.

Still, the current type of capitalism persists. It encourages inequality of wealth and income, it often transfers wealth from poor to rich, it fails to address the underlying causes of slow growth, it fails to address fundamental weaknesses in the economic system, and it is increasingly seen as unfair and unjust. In Europe, and elsewhere, it is beginning to incite incipient constitutionally compliant revolt. The democratically sanctioned rise of populists is an example.