Is China Likely to Leapfrog the American Economy?
Dear Valued Clients and Friends,
We actually feel guilty about how much we have discussed the Fed in recent weeks and how much we do so this week, as it essentially makes us an accomplice in the media’s hype machine which we believe to be highly counter-productive to investors and most civilized human beings. With that said, if we do not talk about it, it won’t stop readers (and most importantly, our beloved clients) from getting their “information” from other sources – and we would rather the well not be poisoned by the hype machine of others whose agenda is certainly not a fiduciary duty to protect and guide you. This week we saw the most hyped Fed meeting in history come and go, and the result was – absolutely nothing. Nothing. More perspective and information can be found throughout this week’s commentary, so we will spare you in this introductory paragraph. Our hope is that this commentary and each weekly edition thereof be a source of information, perspective, and point-ofview, motivated by a desire (a duty) to create positive financial impacts for our clients. (Click here to see David’s interview last night discussing the Fed inaction.)
The Fed did not raise rates, again. And we have a lot to say about it throughout the commentary. Expect uncertainty and volatility to continue through the end of the year (or longer?). Read on for a history lesson on the Fed, a perspective on the relative strength of the U.S. economy, China’s real situation (a key take on the difference between the structural and cyclical issues they face), contrarian plays in emerging markets, and more MLP “stuff…”
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First and foremost, what did the Fed do last week?
They did not raise the Federal Funds rate off of the 0% level it has been for seven years now. Chairwoman Yellen said in the post-meeting press conference that they want to see greater progress towards their 2% inflation target, and that they remain very effected by the global conditions we have all been watching over the last few weeks. What she said exactly was, “the exact timing of the first move is not very important; we will be highly accommodative for quite some time.” There are few precedents in history of a central bank going to the zero-bound and getting off it quickly or easily. We believe we will be in a low rate environment for years and years, and that the actual tightening which will have to take place will be first token, and then forced upon them by economic conditions. We don’t believe there is any chance data will change things by the time of the October meeting, and if consensus is 60-70% chance that they raise in December, we would be 6070% that they don’t. Now, that is not a 0% chance, but we still would not be surprised to see a 2016 lift-off from 0%. And we remind you all – 2016 is then an election year.
How did markets react?
They didn’t move at all, and then they went up a bit, and then they went down a bit. A yawner, quite frankly.
Was your confidence that the Fed was not going to raise rates driven by your ideology or by history?
Our ideology only deals with what we believe should be the case; it does not deal with what ought to be the case. It is true that we favor a rules-based approach to monetary policy and disagree with the idea of using manipulation to effect an economic behavior. However, our forecasts on what WILL happen have more to do with our studies of their ideology, not of ours. Ideologically, this Fed (or at least the majority of its governors) are highly supportive of the idea that the Fed can and should intervene more heavily in the asset based markets. Historically, we have seen a certain trend and pattern of behavior that strikes us as rather undeniable. The Fed raised rates in 1986, saw the impact in 1987, and cut dramatically from there. They raised in the mid-90’s, saw the impact (think emerging markets 1997; Long Term Capital Mgmt; etc.), and cut again. Plans to raise have often been thwarted by their fears of what impact a raise will have on capital markets, and yet the delay in raising has always, and we mean always, led to simply delaying the inevitable pain, only amplifying it in the future. The Fed is in a pickle. And this week we saw a tremendous value in knowing history. The Fed is worried about having to go back and undo tightening in a distressed economy, so they are afraid to act at all. And yet, in not acting, they don’t give themselves the room to act next time there is material distress. Again, it is a pickle.
But don’t you agree that with all of the problems in the economy, the last thing we need is a Fed rate hike?
We agree that there are a lot of problems in the world, and a lot of problems in the U.S., but we certainly do not believe that the cost of capital is one of them. A natural cost of money is in line with a healthy economy; no sane person believes a 0% cost of money is natural (and therefore healthy). We acknowledge the “excuses” that exist for delaying steps towards a normalization of monetary policy – China, commodities, emerging markets, wage growth, etc. – but fundamentally we do not believe our 0% Fed Funds rate will be the source of remedy for any of those things. Rather, we believe the sooner markets normalize, the better. The volatility that has to happen until these things do normalize is the necessary consequence of seven years of unprecedented easy monetary policy. The more beverages the individual consumes, the worse the hangover will be. Detox can be a glorious thing.
How much has the U.S. declined in world economic significance over the last decade?
Tell us if this chart does much to refute the premise in that question. China has leapfrogged the UK, Germany, and Japan in terms of global GDP contribution but the United States remains right near 25% of the world’s total economic output.
How does the U.S. rank right now in terms of economic strength, not just contribution to GDP?
One of the reasons we believe the “TINA” trade (“there is no alternative” – the thesis that U.S. equities are the beneficiary of global capital not being attracted to much else) is still on is that even the United States’ tepid growth still trumps much of what else is out there …
Does China’s selling of U.S treasuries serve as a form of “tightening” monetary policy itself?
Yes and no. But more than no than yes. Look, China’s buying of treasuries does nothing to add dollars to the money supply, and China’s selling of treasuries does nothing to subtract dollars from the money supply. In that sense it is a non-event as far as tightening goes. However, in theory, enough selling does put downward pressure on prices (things being sold excessively get cheaper), and cheaper Treasury bond prices does mean rising rates. We believe that in the midst of this flight to safety over the last month Treasuries would have gone much higher and therefore yields dropped much lower had China not been selling. They have largely stopped selling now, so what happens next in the rate market will be of interest. But should their actions push the long bond rates up higher, that is a form of tightening monetary policy.
Your assessment of the overall economic situation in China right now and its impact on the world economy?
We were greatly impressed by a strategy report we took in last week on the subject from our friends at Cornerstone Macro Research (one of the substantial sources of macro perspective we now have access to here in our new independent home, and one from which we read ten reports per week). The answer to the question probably strikes readers as something that should be obvious – “we think the economy in China is a disaster” – fair enough. But nothing in the investment world is ever quite as obvious as it may seem. Here is the first reason we want to be diligent in how we approach China:
The significance here is that if that percentage of folks were complacent two years ago, we may very well see too high of a paranoia now. Sentiment is like that – too extreme on one side, and then too extreme on the other when the tides shift (like Martin Luther’s analogy of the drunken peasant, who gets up on one side of the horse just to fall off on the other). Fundamentally, though, we know deep problems persist in China of a fundamental and even structural nature, so we never want to dismiss a perspective merely because a lot of people hold to it. Contrarianism is not intended to defy laws of logic or common sense. The reality is that manufacturing and industrial production in China have turned south in recent months, significantly so:
But truthfully, “cyclical” problems like these do not scratch the surface of the real depth of their problems… The structural challenges are the focus of our attention: 46% of their GDP is related to investments, vs. 19% in the rest of the developed world. This is highly unsustainable. Consumption is far too insignificant in their economy, and even exports are cyclical and not reliable. That high of a reliance on investments has forced them into significant excess capacity, and now that has to be absorbed. In the meantime, their growth is shackled. Too much auto inventory; too much vacant real estate; too many empty factories; etc. We remain structural bears on China, believing the re-calibration of their economy and transition to greater consumption is not going to happen easily. We also believe their financial system is in disarray, and will end up requiring highly creative assistance from their central bank as their shadow banking system is forced to de-lever and write down toxic assets. These two things we have just said are a big deal, and acknowledge more pain and volatility ahead for China and likely for surrounding forces via contagion effects. However, cyclically, China is highly likely to see much pickup in exports as they navigate through this, a pick-up that has the potential for really disrupting the outlook for the perma-bears. The actionable advice is to avoid direct exposure, but not be positioned as if China will bring down the rest of the world. We dispute the thesis that all is well in China and we dispute the thesis that China is going to bring Armageddon.
Your assessment of the lay of the land with MLP’s last week? The Barclays CEO conference was a wonderful source of sentiment and information about the entire energy sector. The big takeaway to us having digested every research summary we could get our hands on last week was that counterparties matter. The upstream space (which we are not invested in at The Bahnsen Group) is in a bad way; the midstream space is in a much healthier position and the names in the midstream space whose counterparties have better drilling economics (vs. the ones with very leveraged and weak exposure) are in an even better place. The main space we fear is the commodity-linked names which, again, we have no exposure to the largest fear in the midstream space is that contracts which guarantee certain fee levels will have to be renegotiated. Once again, there is a Darwinian comfort here if one is properly positioned – the companies with the best balance sheets and best counterparties have the most flexibility and opportunity here. The most bearish analysts we follow still believe this fear is extremely overblown. All in all the space is in a really interesting period historically, has had profound implications on our portfolios, and is an area we believe we are managing well despite significant adversity in the space.
What is your feeling right now on the lifting of our ban on crude oil exports?
The fact that the House has put it up for a vote tells us that Boehner and Republican leadership know they have the votes to pass it. The Senate is more of a mystery, because while the Senate GOP would vote yes, we are not sure if all nine of the Senate Democrats who voted for Keystone would vote for this or not. Either way, ultimately it goes to the President’s desk and this week the White House announced their criticism of the measure. We suspect there are some in the Senate and perhaps the White House who may be open to lifting the ban or more likely “easing restrictions” if there is some sort of quid pro quo involved (commitments around wind and solar investment, etc.). The play from an investment standpoint is to assume nothing will happen through 2016, but to be positioned for what could very well happen after the Presidential election. The exporting of liquefied natural gas might have a more friendly response between now and the election. We expect this will be a bigger election issue than many realize. (The environmentalist side who oppose increased production and therefore exporting crude are not going to vote for GOP candidates anyways, giving the GOP a limited downside to campaign hard on the economic benefits of such a measure.) Stay tuned…
With all of this shake-up in the markets in the last few months, where do you see equity valuations now – cheap, expensive, or in between? Not cheap, though some are cheaper than others. But we did an extensive re-visit of our historical valuation metrics last week and the best thing to say is that stocks are trading cheaper than they have as measured by price-tooperating earnings over the last twenty years, but more expensive than they have over the last fifty years. “Fair value” is a better term, and with bond yields so low, and taxation on dividends and capital gains so much lower than they have been historically, we think a P/E ratio above some of its historical measures makes sense… but just slightly – not dramatically. By the way, the Price-to-Free Cash Flow in the S&P 500 is currently 30% below its 20-year average, and 70% below where it was in the famous March of 2000 bubble.
What do you see as the most likely move in your asset allocations as we continue through the rate increase cycle of the next year or two or whatever it ends up being?
The reason to hold stocks and bonds in a portfolio is because of their non-correlation to one another – and often reverse correlation. This is Modern Portfolio Theory 101 – the blend of the two together increases return while decreasing volatility in a portfolio when optimally mixed. However, the efficacy of blending stocks and bonds is limited when they correlate highly to one another, and one thing we know about interest rate increases is that they push correlations UP. Look at this stunning chart our partners at Invesco sent us last week:
We have a need in our bond portfolio to bring correlations to equity markets down, but we also believe that the constantly-decried alternative investment universe is in severe need of achieving dramatic portfolio allocation increase… This is a huge priority in our pending New York trip, it is quite challenging around our income-generative portfolio strategies (clients withdrawing cash flow), and it puts the pressure on our due diligence of human talent and process as opposed to mere asset classes… But if we were to guess what most significant changes lie ahead going into the next 12-24 months, it is the need to increase allocations to alternative investments (those with low correlations to equity and bond markets). We anticipate doing this both with LP versions of alternatives (actual hedge funds) and liquid versions (mutual funds).
David and Brian, we like your contrarian “against the crowd” kind of philosophy, and we know how you feel about energy infrastructure and MLP’s. Where else do you see excessive anxiety which may mean “buying opportunity”?
Presupposing the timelines and appetite for volatility are there, the emerging markets equity space is where we believe the most oversold conditions lie. We anticipate significant opportunity there, and believe the record 34% of portfolio managers who are underweight to their benchmark in emerging markets stocks (a record) according to latest BOAML Monthly Fund Manager’s Survey backs this thesis up.
What are your closing thoughts on the Fed inaction last week?
At the end of the day, our economic society puts far, far too much credence in what central banks say and do. We leave you with the perspective of one of their own governors.
Quote of the Week
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections that has been lost in corrections themselves.”
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We tweeted out before the market opened last Thursday that there was no action the Fed could take or not take which should represent anything close to a substantive impairment to an investor’s actual real-life financial goals. A particular day can create a rally (we’ve had plenty of those lately) and a selloff (we’ve had plenty of those too), but for a properly structured and allocated portfolio, daily events from the Fed to the White House to the boardroom are inconsequential to the material results a goal-oriented investor pursues. We were rather hopeful that the Fed would raise last Friday, believing the zero-bound range was excessively reckless in terms of the poor decision-making it facilitated in the marketplace. The results were exactly what we expected ad exactly what we did not want – no action, more uncertainty.
But what we never questioned was the fact that our clients have portfolios which meet their goals, which are suitable for their situations, and which will deliver the results we are after in the appropriate timeline. To that end, we work. And with that said, Fight On, Trojans. Enjoy your weeks…