Sentinel News

Market Insights: February 2012


So here are the Top 10 from Sentinel for 2012
  1. US unemployment drops to low 8% mark
  2. ECB manages new round of easing but...
  3. Euro/USD weakens to €1.15
  4. One or more EU states do not ratify compact
  5. Greek default
  6. China slows and no RMB* revaluation
  7. US bond yields remain below inflation
  8. S&P dividend growth accelerates
  9. Lower US stock market volatility
  10. Casey Stoner wins MotoGP world championship

One Citadel at a Time

Moderates Need not Apply

In the last few years, we saw entrenched arguments between the "expel indebtedness" and "spend to resuscitate" camps of economic management. Like many polarized debates, we tend to hear extreme views. How many times have we heard that the Fed is pressing the liquidity solution to the detriment of price stability? Or that German policy will run the peripheral European economies into depression? Throw in China's dilemma of growing consumption while dealing with overinvestment and it all becomes overwhelming. Nuanced discussion is tough to find.

The good news is that i) the US is emerging stronger from this recovery than any other major economy ii) Europe's woes are temporarily eased and iii) China is past the worst of its inflation scares. If that sounds muted, it is. The damage done to the economies through irresponsible lending and uncontrolled asset price inflation (the US) or unencumbered vendor financing and overvalued exchange rates (EU) was immense. Both meant huge banking messes. And households are the only ones who clean up banking messes. In time. Slowly. And that's where the world stands. Stephen Spender put it well, albeit in another context:

"The war had knocked the ball-room floor from under the middle class...People resembled dancers suspended in mid-air yet miraculously able to pretend that they were still dancing."

For investors, this means that any investment strategy must assume disequilibrium. There will be pockets of opportunity but very little in the way of trends. Storm one citadel at a time. And if you hear any talk of sustainability or grades of normal, run.

Things Not to Worry About

1. Monetary Easing: The Fed has been entirely consistent in following a playbook written over ten years ago. Bernanke has played a deft hand. He drives decisions on the assumption that monetary policy influences prices and yields but that velocity and savings propensities change. In a near zero rate environment, he has recently executed three strategies: i) assuring investors that rates will stay lower for longer than they expect ii) changing the composition of the Fed's balance sheet and iii) increasing the size of the balance sheet to expand the quantity of reserves. Recently he stepped up communication to include FOMC[1] participants' forecasts of what should happen to rates. So far so good. He is pragmatic enough to realize that these take time to feed into the real economy and until they do, inflation remains a chimera.

2. Fiscal Debt: Much of the complaints focus on the absolute level of debt ("trillions of dollars wasted...irresponsible government growth," etc.). But US debt is declining as shown here.

Source: Federal Reserve Bank of St. Louis, Economic Research

What is going on is that households and corporations are delevering and government, the only remaining player in the GDP equation, is withdrawing fiscal stimulus. Quite what our heirs will make of the run up in the 2000s is embarrassing to contemplate. But we are now reducing borrowing and repairing balance sheets. The government has a lot of borrowing capacity. Federal interest payments have rarely been lower and the average coupon on the debt is less than 1%. Here are interest payments as a proportion of GDP. It's back to levels seen in the 1950s and 1960s..


Source: Federal Reserve Bank of St. Louis, Economic Research

Government expenditures in GDP declined every quarter in 2011. This was mostly inertia rather than policy. And there's probably more to come what with the expiry of the payroll tax credits, sequestration cuts, defense spending and lower unemployment benefits. So we can worry about fiscal withdrawal but not about the level or fragility of debt in the economy.

3. Inflation: They say generals always fight the last war. So it is with inflation. It is broadly held that monetary growth leads to imminent inflation, that every twitch in commodities foretells of broader price increases or that Federal Reserve balances and reserves must feed through to consumers. But we see no wage push, no demand pull and plenty of spare capacity as measured by utilization, the U-6 [2] rate, and deviation from pre-recession growth. And above all no change in the inflation metric that matters (PCE [3] deflator). More inflation would be good. It would at least indicate broader growth.


Source: Federal Reserve Bank of St. Louis, Economic Research

And Things to Worry About

1. Europe: The effort of countries to lessen their debt burden increases it. This is the Fisher paradox, which states that the more debtors pay, the more they owe. In the case of Greece, the easiest to understand, retrenchment and austerity have lowered the ability of the economy to service the debt. So more and more resources are used to liquidate the debt and, without an inflation option, the value of each debt payment increases. Real incomes are reduced and under production accelerates. Or, in Fisher's wonderful analogy, the more the boat tips, the more it tends to tip. Until it capsizes.

The additional problem with Greece is that some creditors (European banks, ECB [4]) want to extend payment, take a haircut and reorganize, and others want a default (CDS [5] holders). It's rare that creditors are polarized. In most cases, there is a shared interest in resuscitating the borrower and keeping the enterprise afloat. The CDS holders, in contrast, are like frigid beneficiaries of a life insurance policy. They have every incentive to accelerate death.

For now, the LTRO [6] facility is keeping banks liquid and restoring confidence. It also helps a liquidity driven rally. But borrowing costs remain high for some vey delicately balanced economies. And the fiscal compact requires a delegation of sovereignty that may take years to ratify. Meanwhile the political stakes increase. The cycle of euro summits (identify a problem, meet, declare there is a problem, resolve to address it, repeat) ended five governments in 2011. So a Eurozone break up remains a central scenario for 2012.

2. China: The rebalancing of China away from a centrally planned investment infrastructure and export model to domestic consumption was always going to be fraught with problems. Much of the infrastructure investments of the last five years have been at diminishing utility. Projects were approved by the central government with very little regulation and oversight. It's one thing to build and hope they will come. It is quite another to assume that every airport, housing project, road and rail network and incentives will be efficiently used by the next wave of consumers. We have already seen friction in housing policies with sky-high real estate prices and official comments about trying to provide a soft landing. It's not a good mix.

So the government will try to encourage consumer spending. They did this in 2009 with credits for autos and white goods. But this time, any policy has to compete with the challenge that exports and the current account are lower and very sensitive to the European downturn. For the consumer to buy more, interest rates and inflation have to be lower and personal incomes must grow while maintaining a low exchange rate and export competitiveness. It's a tough circle to square. And the authorities know it. Recent decisions to increase quotas for foreign stock market investment look desperate. If there is not enough local demand, it rarely works to expect foreigners to fill the void. It's a policy best done at market tops not bottoms.

A final point on China. Official policy states that growth has replaced inflation as the top concern in 2012. It is fine to declare policy adamantly but quite another to pull all the levers to change from one growth model to another and appoint a new premier and president. So a lot has to go right in China this year. The best hope is controlled slowdown. Not much to look forward to.

And For Capital Markets

Bonds
The run into the below 2% level for 10-year bonds was a reaction to lower growth, low inflation, a quest for safe assets and the policy of keeping real interest rates negative. None of these will change. The January FOMC statement was unambiguously dovish and we have a commitment to "exceptionally low" rates for at least two more years. This confirms our view of range bound rates for the future, i.e. 1.75% to 2.25% on the 10-year note. With that:

1. Trade the GTs: which is what we have been doing for most of the last six months. The duration of the two benchmark bonds (the 10-year and 30-year) are 9 and 19 respectively. So the risk/reward of (roughly) a 1% change in rates leading to a 10% and 20% price change is very unbalanced. Daily price movement can swamp coupon returns. So we like to trade these and measure our holding periods in days, not months.

2. MBS [7]: We are not concerned about refis and loan modification programs. Despite record low mortgages, higher underwriting standards and impaired LTVs make it unlikely that MBS will experience much prepayment. We also continue to like the monthly income and relative price stability of MBS.

3. Corporates: Demand for new corporate issues remains high, mostly because institutions like pension funds and insurance companies are eager to match liabilities. The New Issue Market volume may not reach last year's, which means supply is probably shrinking. We like good names and intermediate to long-term paper and expect spreads to remain stable.

Equities
Many equities traded as a "risk on" block last year. This meant individual securities and fundamental analysis took a back seat to some aggressive trading and narrower correlations. This year is off to a different mark with some laggards like financials and materials well ahead of the SPX [8]. One broad metric that we like is the earnings yield of around 7%. Compared to bonds at 2% this represents a nominal risk premium of nearly 5%. Take off 2% for inflation and this should produce real returns well in excess of bonds. If that sounds too tidy, then let's look at some other drivers:

1. EPS growth: should be 10% this year with some big changes coming from financials. With that we should see dividend growth. As we've mentioned here before, dividends account for nearly 40% of equity returns and we especially like companies that demonstrate growth of payouts. We tend not to like pure high dividend stocks; they act like bonds and have weaker returns.

2. And speaking of financials: last year's earnings had ephemeral factors working for them: i) asset quality improved so loss reserves could be released and ii) debt valuation adjustment, which allowed widening spreads on their own debt to be taken as income. This time around, we see expense controls, asset and deposit growth (European banks' contraction helps here) and better capital formation. We have avoided financials for years. But they're beginning to look more attractive now.

3. What to Look For: We tend to stick to what we know best. That is high ROE, long-term management, low debt, dividend growth and earnings growth. That usually steers us away from pure cyclical plays and tends to work over time.

4. Small and Mid Caps: We don't like to time either asset class. We find sticking to the management, margins, profitability and low debt profiles helps. If large cap companies are looking for growth, they tend to come looking for M&A in both spaces.

So put all this together:

  1. Macro concerns will remain high especially in Europe.
  2. The ECB will be more pragmatic than last year but deflation and austerity are heavy problems.
  3. China's economy is facing real challenges.
  4. Monetary policy will remain loose and predictable.
  5. No inflation pressures.
  6. Broad economic growth in the US will remain steady if unspectacular.

Sources: Federal Reserve; Federal Reserve Bank of St. Louis; Michael Pettis; Bureau of Labor Statistics; Irving Fisher, "The Debt-Deflation Theory of Great Depressions"; Bloomberg; Sentinel Asset Management, Inc.

[1] Federal Open Market Committee
[2] Total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force
[3] personal consumption expenditures
[4] European Central Bank
[5] credit default swaps
[6] Long-Term Refinancing Operation
[7] mortgage-backed securities
[8] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
* renminbi

 

 

 


 
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