A few lifetimes ago, in early August, the editor asked me to write about optimal portfolio composition ahead of the then expected US rate hike in September. I scribbled up a note on how global growth remains sub-par, under threat, and how a rate hike might just result in the surprising outcome of lower bond yields as more and more global money would flock towards the mighty dollar. I then took a week off to enjoy what we laughingly call an English Summer…
While I was out, the China Syndrome finally exploded.
Global markets were a sea of red. Expectations of a Fed Hike in the face of such global dislocation evaporated. But, the following day, as Asia continued to nosedive, the Occidental markets stabilised. There are definitely bargains out there in equities!
But, where does the bursting China Bubble leave us? To answer the question what happens tomorrow, it’s important to understand what happened yesterday, so here goes…
Seven years after the Global Financial Crisis exploded with the collapse of Lehman Brothers in 2008, global markets remain perverse and difficult to call. The current threat list includes obvious ones like the ongoing China crisis, the oil and commodities collapse, Greece Elections, and emerging markets struggling to cope with the strong dollar.
Policy responses have been disappointing. For all the talk of co-ordinated G7 action to stimulate global growth, what we’ve seen is competitive devaluations and protectionism. Central banks have pumped money into the system through QE, but zero interest rates, cheap energy, minimal inflation and low wage pressure have done nothing to stimulate real global growth.
For the last seven years we’ve seen global growth fail to meet expectations, fizzle out and disappoint. Market sages have been talking about “new normal” low growth and low interest rates going on forever. I call it Null Entropy. The end of the commodities “super-cycle” and low oil prices are proving long-term fixtures rather than short-term featurettes.
Any portfolio strategy has to address the realities of low growth, low inflation and potential long term stagnation. Some economies – notably the US, the UK and even some European states – are seeing some signs of real growth, but it’s still sub-par. Other economies remain in crisis. And should that surprise us? The countries in the recovery room are those with the most market based economies.
Prior to the China bubble exploding, the consensus was that the US Fed would announce its first rate hike since 2007 as early as September. When it comes it will be a modest 0.25% rise. What will it entail for growth, stocks, commodities, foreign exchange and bond prices, and how should these assets figure in a portfolio mix?
As I write this note, the market is discounting a Fed hike. Many banks say it won’t now come till 2016. However, I suspect it may still come this year. In normal markets, rate hikes produce fairly predictable and uniform outcomes – fear and panic in bond markets (as higher rates infer lower bond prices), countered by optimism in stocks (on the back of rising growth prospects), and strengthening currencies (as money follows higher rates). In such perfect markets, choosing an optimised portfolio is fairly simple – buy stocks for growth, rising rate currencies, and sell bonds. And since dollar rates are rising, be long the dollar.
However, this time it’s different.
First, there are the markets: Seven years of central bank financial repression and the unintended consequences of quantitative easing have distorted asset prices across the financial markets, creating a host of knock-on effects in the relative values between asset classes. Ultra-low yields forced “yield-tourists” to go hunting for returns in less familiar markets. As a result we’ve seen stronger bond sectors and stock markets than the metrics justify – fuelling the suspicion current asset prices are bubbles in the wake of QE distortions.
The fact bond yields remain so low is causing less concern than it should. The foundations of the global collapse of 2007 were firmly rooted in overly easy monetary policy – it was too easy for banks to lend money, building up the debt crisis and US housing ructions that toppled money markets leading to the drying up of bank funding. The ending of easy money precipitated a funding crisis for Northern Rock and sank half-a-dozen structured bond investment funds, before escalating out of control and into the near total rolling collapse of the banking sector in 2008. Only the swift action of central banks, led by the Fed, kept the financial system open and afloat.
These were brutal days as the surviving US banks underwent forced recapitalisation. It worked – the US banks have repaid their bailout cash and are functional again. The situation in Europe is far less clear – banks and sovereign debt remain intimately linked in mutual co-dependency under the ECB. European banks show disturbingly few signs of ever being fixed.
Second, there is the global economy. It remains critically vulnerable to recession. The fact banks haven’t been lending hasn’t helped. They have been constrained by draconian new capital regulations and requirements, and by over $200 billion of fines stemming from their crisis inducing behaviours. As the investment banks have been forced to give up market making across security markets, many investors fear being trapped by illiquidity if markets turn – hence market reactions are likely to be exacerbated.
Fears that flooding markets with QE cash would create inflation have proved utterly wrong. There is almost zero inflationary pressure in the global economy. Commodity prices have crashed. Oil prices have tumbled. Low rates, low commodities and low energy prices have not created perfect lift-off conditions for economies – instead we’ve seen stagnation. Deflation rather than inflation has become the market’s fear.
Attempts to drive global growth through trade agreements and growth initiatives have become mired in political treacle with a strong protectionist theme emerging. Abenomics – credited with perhaps rescuing Japan after 25 years of decline – is basically devaluation by any other name.
Global investors haven’t felt pushed to invest in risk/reward assets. While interest rates have languished at millennial lows, the expectation had been a glut of entrepreneurial growth. Instead, investors have preferred to park cash in safe places rather than risk investing in high risk/low reward projects. What we’ve proved is that ultra-low rates act as a disincentive to risk-taking and funding risk ventures. When container rates from Asia are at record lows because of limited demand, when global steel capacity usage is only 68%, and global commodities grind lower every day, why take the risk of building new factories?
As global business risks rise in the wake of the commodities crisis and crashing Asian demand, that raises increased risks for corporate debt and stocks.
Low rates have distorted and damage economies.
Ultra-low bond rates have caused corporates to borrow billions from the bond market. But rather than invest that cash in new factories or other forms of job creation, the cash has been used to shore up pension schemes or to buy back stocks, pushing up (and further distorting) stock prices. The only beneficiaries have been CEOs seeing their bonuses rise on higher stock prices. Increased income inequality is just one effect! Weaker corporate credits and leveraged balance sheets are another.
Let’s look at the underlying asset markets themselves:
- Stocks: In recent months we’ve seen a distinct softening in global stock markets reflecting a lack of confidence in future growth and doubts about current valuations, culminating in August’s Black Monday. The biggest loser has been China, but that was patently a bubble that has now conclusively burst. More worrying are the travails of strong firms like Apple highlighting how tired markets are. Apple produces and sells lots of high value goods, yet when it only beat estimates by a small amount, the stock crashed by 16% as negative concerns such as declining China sales and the lack of new product pipeline came to the fore. Some folk think Apple’s time as a top stock is past, but I rather see it as a Canary-in-the-coal-mine for stock markets. If it’s in trouble, then so is everything else.
- Bonds: When bond yields spiked higher in the US, Asia and Europe in March, many called the end of the bond bull market. The corrections told us a new bear market had arrived with bond prices likely to see further significant losses as the global economy recovered and bond buyers priced in central bank rate hikes. However, the bond sell-off has stalled.
- Currencies: Most major nations have been playing a game of competitive devaluations to make exports more attractive. China tried to address its deepening dismal economic woes through devaluation. The effect has been to favour the dollar – which will clearly continue if the US is the only economy to hike rates – which begs the question: does the US actually need to hike? And a strong dollar simply creates greater stress in emerging markets!
If I were pushed to recommend portfolio approaches for September and the “we-might-get-a-US-rate-hike” scenario I’d go with the following:
Bonds are likely to rally on ongoing weakness and demand as global investors pile into the US Dollar and treasuries in particular. This is counter-intuitive as bonds should slide on a hike, but this time is different.
Stocks are likely to weaken on the threat of higher rates, but clearly some are good defensive long term plays.
Bonds – defensive corporate bonds and secured debt.
Currency – dollars, dollars and more dollars.
I go for the old adage that “Americans usually do the right thing after first exhausting every other possibility.” On that basis, buy US stocks on weakness and sell bonds into strength!
Bill Blain is Head of Capital Markets and Senior Strategist at Mint Partners.