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The Gavekal Monthly
Enter Ursus Magnus?
February 2016
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The Gavekal Monthly – February 2016
Overview
Charles’s Take We’re In A Bear Market! Charles Gave 3
Anatole’s Take No, We’re Not In A Bear Market! Anatole Kaletsky 6
Louis’s Take Portfolio Strategy For An Uncertain World Louis-Vincent Gave 9
Key Calls
US Equities Buybacks Are Not The Savior Tan Kai Xian / Will Denyer 14
European Equities Playing The Recovery Right François-Xavier Chauchat 18
UK Economy Chill Winds From The Labor Market Nick Andrews 22
Dashboard
Our Views in Brief Economies, Markets, Themes 26
Indicators Darkening Growth Outlook 29
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This is probably an Ursus Magnus• The only question is whether this bear market is a “cub” or what I call an Ursus
Magnus. The cub variety involves a minimum -15% top-to-bottom drawdown over a 12-18 month period. The daddy bear, by contrast, leaves investors nurturing losses four years or more after the declines started.
• An Ursus Magnus always follows a period of extensive capital misallocation caused by central banks keeping interest rates below the “natural rate” for a lengthy period of time (see Of Wicksell And Fed Fallacies).
• The chart overleaf shows that market conditions meet this “Wicksellian” test. I defy anyone to argue that we have not seen profound capital misallocation.
• The collapse of the commodity boom, stress in overly indebted emerging economies and ructions in China are symptoms of a problem whose origin lies with the economy at the center of the global system—the United States.
• Reasons given for a collapse in prices in the early stages of a bear market sell-off almost always turn out to be wrong (see Anatomy Of The Bear).
• Blaming China for the current collapse is a classic rookie mistake.
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Green shaded areas in the chart show periods when central bankers kept real short rates in negative territory.
Ursus Magnus has never materialized during periods when short rates were positive, but always after (or during) periods when short rates were negative for a considerable time.
The easy money policies of the Federal Reserve under Arthur Burns in the 1970s, Greenspan after the 1998 Russian crisis and Bernanke after the acute phase of 2008-09 all satisfy these conditions.
Sadly an Ursus Magnus is now unavoidable.
The cause is always faulty US monetary policy settings
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Another correction in a deeply unloved bull market• I agree with Charles’s bear market definitions, but reach the opposite
conclusion. We are experiencing a “cub” like correction and the risk of Ursus Magnus is small.
• The bull market that began in March 2009 has been deeply distrusted, resulting in many significant corrections: triggers included fears of US deficits, a threatened Treasury default, the euro crisis, Federal Reserve tapering, geopolitical problems in the Middle East and Ukraine and last summer’s China devaluation. Each sell-off proved to be a buying opportunity.
• Today the market is worried about a China bust, the oil collapse and fears of a US recession. China is a legitimate concern; the latter two factors are not.
• The disruptive phase of the oil panic seems to be drawing to a close.• Outside of the commodity and closely related capital goods sectors, there is
no serious evidence of economic weakening in the US and Europe.• Now may not be the moment to catch a falling knife, but the bull market that
began in 2009 can probably keep going.
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The idea that falling oil prices are a leading indicator of shrinking economic activity has no historical precedent.
Every global recession since 1970 has been preceded by a big rise in oil prices, while each decline of more than -30% has been followed by accelerating economic growth.
Plunging oil prices are disruptive to markets, causing credit spreads to widen and stress for leveraged players, but the oil market seems to have reached a clearing point (see The Oil Market Confusion).
Taking the wrong message from the oil market bust
The key question for 2016, and three scenarios
Will 2016 show as narrow a
leadership as 2015?
YES
NOMarkets will
collapse
Buy dollarsBuy US growth stocksSell US multinationalsBuy exporters in Asia, EU Buy investment grade US$ debt
More hedge fund closuresMisery for money managersEarly retirementsGrumpy managements and spouses…
NOMarkets will broaden out
Buy 30 year treasuriesBuy JPY yield (JGB, REITs)Buy volatilityBuy gold and gold miners
Buy value in EM, EU, JapanBuy yield in CAD, EM Buy MLPsUnderweight US$, US growth
This is a bet on aUS recession, a Fed mistake, a return to EMU crisis, or a serious meltdown in China
Essentially, this is a bet that growth in Europe and Asia makes up for US and China slowdowns
Scenario 1: Consensus opinion at the end of 2015
Scenario 2: Market direction in early 2016
Scenario 3: The hopeful/bullish case
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With the tough 2016 start, global equities are now in a bear market
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Scenario 1 is out: Even in the US, we have reached full liquidation mode
We recommend a bar-bell portfolio
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Less perceived risk & volatility
More perceived risk & volatility
UST 30 years, JGBsUS$ cash, Gold,negative Fed rates
US tech, global healthcare, global staples, US mortgage debt, US corporate debt. Stay away!
Higher risk: Oil, MLPs, CAD, Brazil, China, HY debt, EM debt
Lower risk: EMU equities, Japan equities, Korean equities
Consensus today: Global growth muddles through
SCENARIO 2: Global growth/markets get worse
Scenario 3: Growth/markets improve
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US Equities Buybacks Are Not The SaviorWhat’s happening What it means
Sovereign wealth funds of oil producing countries are selling assets to raise cash
• One more investor group turns net liquidator of US equities.• Generally speaking, the very strong dollar makes US equities unfavorable for foreign investors.• On top of these factors, aging baby boomers are shifting away from equities to bonds. • So who will now buy equities? One possibility is corporate share buybacks. But we think buybacks have peaked, and may fall.
S&P 500 buyback activitypeaked in 1Q14 at US$159.3bn
• Shares repurchased by S&P 500 companies have since slowed gradually to US$150.6bn in 3Q15.• This is yet another negative factor for equity prices.
US corporate credit spreads widened again in January, to the highest level since the 2011-12 euro crisis
• Spreads widened due to falling oil prices, renewed renminbi depreciation and the China equity rout. Spreads will stay wide thanks to weakening corporate profitability (see What To Make Of Wider Credit Spreads). • Moreover, stabilizing inflation and rising short rates could soon push up risk-free rates as well. • This translates into a higher cost of funding for debt-fueled buyback activity.
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Conventional wisdom says share repurchases are a waste of capital and a shameless way to boost equity prices.
In contrast, we think buybacks are often part of a rational decision by corporate managers. They enable debt-reliant capital structures, exploiting a tax structure that has been in place since the 1980s that favors debt over equity (see Will The Buyback Craze Ever End?).
This explains the pro-cyclical nature of buybacks. During the good years, as profits roll in and the book value of equity rises, managers issue debt and buy back equity to maintain the targeted capital structure. When profits and balance sheets quit growing, buyback activity slows.
Today, the strong dollar, rising wage pressures and an inventory overhang have caused profits to flatline, or even decline. Buybacks should do the same.
US Equities Buybacks Are Not The Savior
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In addition to the diminishing need to repurchase shares, corporate managers’ ability to borrow to fund their buyback activity is weakening, at least at the margin.
US bank lending standards for commercial and industrial loans have become tighter in recent quarters, according to the Fed’s Senior Loan Officer survey. Corporates were already borrowing relatively little from banks, but this isn’t helping.
Most funding comes from the bond market. This remains an option for most high-quality issuers. Yields are still low compared to historical levels, current rates of ROIC, and equity earnings yields.
But rising spreads make debt issuance marginally less attractive for high-quality issuers, and impossible for low-quality ones. All in all, we expect share buyback activity to stay flat or even decline in 2016.
US Equities Buybacks Are Not The Savior
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European Equities Playing The Recovery RightWhat’s happening What it means
Interest rates in all major eurozone economies have converged
• After six years in which the high-low spread among corporate lending rates in Germany, France, Italy and Spain ranged from 100-150bp, rates in all four countries have now converged at around 2.5%.• This marks the end of “financial fragmentation” in the Eurozone, which was the core macro policy problem.
European economic sentiment is steadily improving
• The composite eurozone survey of economic sentiment was basically flat in April-September 2015 but rose sharply in 4Q.• This essentially reflects the success of the ECB’s quantitative easing program in improving liquidity and boosting economic activity.
European large-cap equity prices are down about -9% since late November and -16% since their April 2015 peak
• The fall in large-cap equity prices seems mysterious in the context of lower funding rates and stronger economic growth. • However, European small-caps have substantially outperformed large-caps since September.• This reflects the fact that large-caps are dominated by exporters to emerging markets and sluggish quasi-SOEs. Small-caps benefit more from the intra-EU recovery.• The divergence reveals the importance of playing the European recovery through equity allocation rather than through indexes.
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Economic activity in the eurozone has steadily picked up since Mario Draghi’s announcement of QE in early 2015.
However, since August European equities have not fared so well. So far, the ECB’s QE program has been more beneficial for economic growth, and corporate earnings, than it has for stock prices.
It is also worth noting, however, that a big performance gap has opened up in favor of small/mid-cap stocks.
One reason for the weak performance of equities is that many large-cap European exporters have large exposures to emerging markets, where demand has been battered by the economic slowdown triggered by falling commodity prices. EM exposure is much more negative for European than for US equities.
Hence a successful European equity strategy must focus on finding domestic reflation plays.
European Equities Playing The Recovery Right
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Since QE by the ECB became imminent in late 2014, international investors have tried to play Europe as if it was Japan in 2013-14, by shorting the euro and buying the most liquid and export-exposed indices (Euro 50, DAX 30).
This was misguided. Unlike Japan, Europe’s recovery has been led domestically, not by exports. And the large-cap indices are dominated by EM-exposed exporters and dinosaur “national victim” utilities.
A better way to play European reflation was to identify the stocks exposed to European demand, or US-oriented exporters (left chart). The small/mid-cap universe is much more concentrated in these segments than are the large-cap indexes.
This theme has not fully played out: the scope for catch-up in European small/mid-cap EPS—and hence for relative outperformance—is still large (right chart).
European Equities Playing The Recovery Right
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UK Economy Chill Winds From The Labor Market
What’s happening What it means
The UK unemployment ratefell to 5.1% , the lowest level since 2005
• The labor market data is sending mixed signals. Unemployment is now down to its non-accelerating inflation floor, but wage growth is now decelerating after peaking in May last year.• Three key influences stand out: high levels of foreign workers, increasing numbers of self-employed and relatively high numbers of part-time workers.
UK services PMI fell to 55.5, from 55.9, still above long run trend level
• Still relatively solid but trending lower. More worryingly, PMI business expectations in the services sector fell to a 34-month low and the Bank of England Agents’ summary of business conditions shows businesses have the lowest demand for labor in two years.
GBP/USD fell to 1.4183, the lowest closing level since 2009
• Sterling is vulnerable due to the weaker economy as revealed in the soft labor market data.• Other negative factors for sterling include: general global risk aversion, wide current account deficit, and the approaching Brexit referendum.
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UK unemployment has fallen to the lowest level since 2005 and is now at the Bank of England’s estimate for the non-accelerating inflationary rate. However, nominal wage growth has fallen since peaking in May last year.
The Bank of England admits its unemployment model is subject to a margin of error and that there may be more slack in the labor market than their figures show.
Two factors suggest a softer labor market:
1) 326,000 out of the 448,000 new workers in the 12 months to September were foreign workers (50% from eastern Europe) willing to work for lower wages.
2) Self-employment has also risen significantly since 2008. Self-employment is associated with lower productivity and slower wage growth.
UK Economy Chill Winds From The Labor Market
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A third negative factor:
3) The ratio between full-time and part-time employees is still lower than before the financial crisis. Part-time work tends to be less productive than full-time work. If self-employed workers are included the ratio is even lower.
The bottom line is that wage growth is sluggish and likely to remain so. Only a major increase in productivity (similar to that seen in the 1980s and early 1990s) can change the picture.
This implies that interest rate expectations will remain low, creating further vulnerability for sterling.
UK Economy Chill Winds From The Labor Market
GavekalResearch 26
Our Views In Brief Economies
Region Analyst View Read more
US Will Denyer
The start of the interest rate tightening cycle will not threaten growth, as the cost of capital is well below the return on capital
A New Look At Capital: Reassessing Cost And Return; The Fed’s Opportunity For Liftoff
China Andrew BatsonGrowth slows further in 2016 to 6-6.5% as industry stays weak and services soften
Breaking Down The Services Cycle
Eurozone François-Xavier ChauchatRising intra-EZ financial flows are creating a sustained recovery
Animal Spirits And The Revival Of European Finance; A British-Style Recovery For France?
Emerging Asia Joyce PoonGrowth is constrained by high leverage and limits on monetary easing due to weaker currencies
Emerging Asia’s Leverage Problem; China And North Asia’s Deflation Syndrome
US corporate profit margins
Will Denyer/Tan Kai XianExpect a contraction in US profit margins due to rising wage pressures and/or a strong dollar
On Profits: There Will Be No Revolution; High Profit Margins Are Here To Stay; Brace For Lower US Margins
GavekalResearch 27
Our Views In Brief MarketsMarket Analyst View Read more
Japan equities Joyce PoonGood earnings and improved corporate governance will keep the bull market going
The Next Phase Of Japan’s Bull Market; Japan’s ROE Revolution
US equities Will Denyer
As we are more than half way through the cycle, investors should hold a balanced portfolio of tomorrow's winners and cash
Keep Calm And Rebalance Into Equities; Portfolio Construction Towards The End Of The Cycle
Europe equities François-Xavier ChauchatEuropean stocks set to rise on EPS expansion; balance with peripheral European bonds
Europe’s Equity Bet; Tantrum II And European Portfolios
China fixedincome
Chen LongShort-term government bonds will benefit most from further monetary policy loosening
Justifying The Bond Bull Market
US corporatespreads
Tan Kai Xian/Will Denyer
US corporate spreads are likely to remain wide as US corporate profitability weakens due to a strong dollar and rising wages
High Yield Worries; What ToMake Of Wider Credit Spreads; The Shudder In US Credit
Equities Louis-Vincent GaveThe top of the US$ and the end of the China panic signal a “pain trade” favoring cyclicals and EMs
Is The Bull Market Over? (II); The Birth Of A Pain Trade
GavekalResearch 28
Our Views In Brief ThemesTopic Analyst View Read more
Oil: lower for longer Anatole Kaletsky Abundant supply means US$50 is a ceiling not a floor
Oil: Lower For Longer; Oil At Its Ceiling, Not Its Floor
The low-rate fallacy Charles GaveZero rates are destroyingproductivity and leading to a deflationary recession
Poverty Still Matters For Capitalists; The Myth Of Secular Stagnation
China policy uncertainty
Andrew Batson Nationalist politics make policy choices less predictable
Expect The Unexpected;The Nationalist Style Of Economic Reform
Europe’s Thatcherite Keynesianism
François-Xavier ChauchatCombination of monetary support and supply-side reforms strengthens eurozone
Europe’s Thatcherite Keynesianism; Greece, Europe & The Equity Market
US long-run growth Will Denyer
US structural growth to slow to 2-2.5% as demographic factors that boosted growth in the last century have abated
New Century, New Structural Growth Rates
Renminbiinternationalization
Louis-Vincent GaveBeijing’s drive to globalize its currency to continue despite market turmoil
The Crocodile Mouth About To Close; The New Way To Think About China
GavekalResearch 29
Our main indicator for economic activity remains decidedly negative.
Granted, this indicator is geared towards industrial activity in the developed world (which is in a structural decline), but recent service PMI and consumer confidence data seem to suggest of a broader slowdown.
In the US, as corporate spreads have widened, the cost of capital for companies has risen. Thus, we are now perilously close to a negative reading on our Wicksellian spread (see Four Quadrants: A Wicksellian Analysis).
This is somewhat concerning, especially at a time when the Fed is trying to raise short-term borrowing costs.
Indicators The growth outlook is darkening
GavekalResearch 30
In many ways, January 2016 represented the worst start of any year in modern history for risk assets. The world MSCI lost more than -6% and the commodity complex continued its seemingly unending downward spiral.
China was again blamed for the sell-off, but we worry that there could be something more nefarious behind the sharp drop in risk appetite.
On a more postive note, our short-term spread indicators (which had started to blow out in December), have now come back down.
The big question from now is whether risk assets can escape being positively correlated to commodities and the price of oil.
Indicators Still a risk-off world, but short-term spreads improved
GavekalResearch 31
Indicators Inflation still very much missing in action
GavekalResearch 32
Indicators Can the central banks come to the rescue again?
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