Roundup 14/09/11
“No man needs a vacation so much as the person who has just had one.” - Elbert Hubbard
I hope you have all had a safe and enjoyable summer break. You may be wondering where I disappeared for the past few months. Part of my time away was spent on vacation in Spain and in Singapore. The rest of my time has been spent scrambling to follow what is going on in this painfully volatile market. It has been hard to form cohesive thoughts that feel relevant beyond a few days of market developments. I know I feel like I need another vacation already!
It felt good to know that I made the right call earlier this year for a significant correction in Q2 or Q3. Additionally my call that gold may come to be viewed as a hedge to the currencies of the ugly G3 stepsisters also materialised. At the same time, it has been painful to see the wealth destruction and psychological stress that has accompanied this market correction. It is not easy for investors to move into cash or short aggressively during a period of market volatility. The majority of big moves happen over very few trading days, while the rest of the time is spent on a roller coaster ride, accompanied for many with indigestion, nausea and headaches.
A few big points are worth mentioning. One is that the markets are still highly correlated, which suggests that liquidity remains the key concern for most market participants, as the events of 2008-2009 are still fresh in their minds. Do not let your banker fool you, diversification does not work in these kinds of markets! Secondly, you cannot decisively argue either way that US or European stocks are in a long term bull or bear market. I would say we are still in a bear market but a bottom has been found. A bull market is not far away. But I do not have strong justification for my view, it is based more on instinct or perhaps even naïve optimism. The way I look at it, the longer the market fails to make new highs, assuming the world economy continues to chug along, the cheaper stocks get. It may be a lower growth world with lower leverage, but there will be growth nonetheless.
Many of the headline risks affecting financial markets today are very hard to quantify in the short term. You cannot decisively model what impact European sovereign debt problems or the failure to reduce the US deficit will have on stock markets. To some extent what markets collectively decide will be the outcome will determine how positively or negatively the outcome will resolve itself, as the market determines financing costs and access to liquidity. And given most managers have had a difficult year to date, I’d think many will jump back on to any market rally to try and make back some of their losses for the year.
I want to focus a little on the European sovereign financing problems. There appear to be two main problems with pushing through the current Greek restructuring plan which was agreed by European ministers on July 21st and due to be implemented by October 15th.
The first problem is getting the required 90% majority of private Greek bondholders to take around a 20% haircut and extend debt maturities further into the future. Despite this proposal being far more generous than I’d have expected, the plan has thus far not got the required support from bondholders to make it happen. Either the Greek government will have to find a way to force through this plan (by revising the law to require a lower participation rate), or abandon the proposal and default.
The second problem is getting all the Eurozone members to agree to this revised Greek bailout plan. Europeans politicians seem to enjoy playing the game of chicken with financial markets. In terms of the key players, France has approved the plan but German politicians are having a harder time pushing it through. Other smaller nations are playing hardball and refusing to approve the plan without further conditions, like Finland and Slovakia. Following what must feel like a lifetime of relative anonymity in the world media, leaders from these small European nations have got to be loving the attention they are getting nowadays. We have even had one ECB board member resign recently, reportedly in protest at the recent ECB purchases of Italian and Spanish debt.
When push comes to shove, I doubt European politicians would risk holding up the approval of any plan that could destroy the European project. As yet, I haven’t heard about any mainstream political parties calling for their countries to exit the Euro. This suggests that despite all their reservations about Greece, most Eurozone countries want the Euro and the monetary union to continue to exist. It would be far more difficult to politically recover from being responsible for causing a disruptive breakup of the Eurozone, than it would be to approve a plan that was unpopular but kept the Eurozone project in place.
If the Greek plan is to fail, it is more likely to happen because the Greeks unilaterally choose to abandon the European project. Alternatively, it is possible that in a few years Greece could be forced to leave the Eurozone, if it fails to achieve the required fiscal cuts and assets sales that have been stipulated as preconditions for the bailout funds. But I don’t think they will be pushed out in the very near future. An orderly Greek exit from the Eurozone does not have to spell the end of the Eurozone project. On the other hand, a disorderly default and restructuring will be a big problem for global financial markets. This is because financial markets do not like to be taken by surprise.
The current level of the Euro, while lower than it was a few weeks ago, does not reflect the possibility of a disorderly debt default by European peripheral nations. A disorderly default could take the Euro down below parity with the dollar. This would cause significant inflationary pressure and pressure the growth outlook, making a bad debt situation much worse and felt around the continent. This is one key reason the Europeans will want to come up with a solution sooner rather than later.
Still, it could be a messy 1-2 years but eventually some kind of fiscal union will come out from this. European nations will be forced to unconditionally support their banks, like the US did in 2008-2009. Once they manage to inspire confidence in their collective political will to keep the Eurozone project going, markets will self-correct and possibly create a virtuous cycle of declining credit spreads and improving financing conditions. The painful deflation and erosion of wealth that the citizens of peripheral Eurozone countries are experiencing will setup the base for renewed prosperity in the future, especially in my view in Ireland and perhaps Portugal.
In general, if you look at a snapshot of most equity markets today and don’t read the headlines, it would be hard to argue that stocks are overvalued. The main risk to stocks comes from profit margin erosion and weaker economic growth. But when you see how things are progressing in most emerging markets it feels like there is reason to be optimistic about the prospects for the world economy. US exports are actually not doing too badly, especially because of the weak dollar. I don’t think many companies are making significant investments into new capacity just yet, so capacity utilisation may improve in the coming year. A lot of innovation is going into reducing commodity consumption and becoming more energy efficient, which offsets some of the margin erosion taking place.
If any asset class is relatively overvalued, it has to be high grade bonds. Interest rates are abnormally low, which is supporting very low levels of absolute yields, even if credit spreads are not at their tightest levels.
Additionally in some markets real estate may be heading into bubble like territory. On my recent holiday in Singapore, I did some research into investment in residential properties. I cold-called a few Singaporean banks, and the customer service representatives (who knew donkey about me) basically said that with (1) a copy of my passport and (2) a 20-25% deposit, I would be able to get a 75-80% loan for 40 years, at an average total 1% rate for the next three years (based on the current variable benchmark rate). On this basis a potential investor can make (excluding capital repayments) over a 10% return on equity based on current rental values. This encourages speculative investment in a country where you sometimes have to pay to park your money in a bank. Local buyers are able to get loans that are around 10x their income, which compares to about 3-5x income in the UK, due to the extremely low interest rates.
When you factor in capital repayments on a 40 year loan, your ROE on this hypothetical property purchase falls to 2%. It will only take a slight increase in interest rates or lower rental values for you to start having to pay out to support your large property loan. As of right now higher rates or lower rental values seem a distant prospect for most investors and real estate agents in Singapore. They continue to buy properties despite government tightening measures, driving the market there to levels never seen before. The same thing is happening in Australian, where yield seeking investors have provided wholesale funding for domestic banks to fuel a debt driven real estate asset bubble.
In comparison, following the recent correction, you can buy some prominent Singapore stocks that yield (without stock margin) a net dividend return of 3-4%, or REITS yielding 6-7%. In fact around the world I think you will find most company balance sheets are improving because of the difficulty accessing debt and the low confidence in expanding new capacity at a time when economic prospects are uncertain. This is not a bad time to start researching which areas could be the leaders of the next bull market, and if you have any ideas what these could be, I’d be happy to chat about them with you.
Hussain Premjee
I hope you have all had a safe and enjoyable summer break. You may be wondering where I disappeared for the past few months. Part of my time away was spent on vacation in Spain and in Singapore. The rest of my time has been spent scrambling to follow what is going on in this painfully volatile market. It has been hard to form cohesive thoughts that feel relevant beyond a few days of market developments. I know I feel like I need another vacation already!
It felt good to know that I made the right call earlier this year for a significant correction in Q2 or Q3. Additionally my call that gold may come to be viewed as a hedge to the currencies of the ugly G3 stepsisters also materialised. At the same time, it has been painful to see the wealth destruction and psychological stress that has accompanied this market correction. It is not easy for investors to move into cash or short aggressively during a period of market volatility. The majority of big moves happen over very few trading days, while the rest of the time is spent on a roller coaster ride, accompanied for many with indigestion, nausea and headaches.
A few big points are worth mentioning. One is that the markets are still highly correlated, which suggests that liquidity remains the key concern for most market participants, as the events of 2008-2009 are still fresh in their minds. Do not let your banker fool you, diversification does not work in these kinds of markets! Secondly, you cannot decisively argue either way that US or European stocks are in a long term bull or bear market. I would say we are still in a bear market but a bottom has been found. A bull market is not far away. But I do not have strong justification for my view, it is based more on instinct or perhaps even naïve optimism. The way I look at it, the longer the market fails to make new highs, assuming the world economy continues to chug along, the cheaper stocks get. It may be a lower growth world with lower leverage, but there will be growth nonetheless.
Many of the headline risks affecting financial markets today are very hard to quantify in the short term. You cannot decisively model what impact European sovereign debt problems or the failure to reduce the US deficit will have on stock markets. To some extent what markets collectively decide will be the outcome will determine how positively or negatively the outcome will resolve itself, as the market determines financing costs and access to liquidity. And given most managers have had a difficult year to date, I’d think many will jump back on to any market rally to try and make back some of their losses for the year.
I want to focus a little on the European sovereign financing problems. There appear to be two main problems with pushing through the current Greek restructuring plan which was agreed by European ministers on July 21st and due to be implemented by October 15th.
The first problem is getting the required 90% majority of private Greek bondholders to take around a 20% haircut and extend debt maturities further into the future. Despite this proposal being far more generous than I’d have expected, the plan has thus far not got the required support from bondholders to make it happen. Either the Greek government will have to find a way to force through this plan (by revising the law to require a lower participation rate), or abandon the proposal and default.
The second problem is getting all the Eurozone members to agree to this revised Greek bailout plan. Europeans politicians seem to enjoy playing the game of chicken with financial markets. In terms of the key players, France has approved the plan but German politicians are having a harder time pushing it through. Other smaller nations are playing hardball and refusing to approve the plan without further conditions, like Finland and Slovakia. Following what must feel like a lifetime of relative anonymity in the world media, leaders from these small European nations have got to be loving the attention they are getting nowadays. We have even had one ECB board member resign recently, reportedly in protest at the recent ECB purchases of Italian and Spanish debt.
When push comes to shove, I doubt European politicians would risk holding up the approval of any plan that could destroy the European project. As yet, I haven’t heard about any mainstream political parties calling for their countries to exit the Euro. This suggests that despite all their reservations about Greece, most Eurozone countries want the Euro and the monetary union to continue to exist. It would be far more difficult to politically recover from being responsible for causing a disruptive breakup of the Eurozone, than it would be to approve a plan that was unpopular but kept the Eurozone project in place.
If the Greek plan is to fail, it is more likely to happen because the Greeks unilaterally choose to abandon the European project. Alternatively, it is possible that in a few years Greece could be forced to leave the Eurozone, if it fails to achieve the required fiscal cuts and assets sales that have been stipulated as preconditions for the bailout funds. But I don’t think they will be pushed out in the very near future. An orderly Greek exit from the Eurozone does not have to spell the end of the Eurozone project. On the other hand, a disorderly default and restructuring will be a big problem for global financial markets. This is because financial markets do not like to be taken by surprise.
The current level of the Euro, while lower than it was a few weeks ago, does not reflect the possibility of a disorderly debt default by European peripheral nations. A disorderly default could take the Euro down below parity with the dollar. This would cause significant inflationary pressure and pressure the growth outlook, making a bad debt situation much worse and felt around the continent. This is one key reason the Europeans will want to come up with a solution sooner rather than later.
Still, it could be a messy 1-2 years but eventually some kind of fiscal union will come out from this. European nations will be forced to unconditionally support their banks, like the US did in 2008-2009. Once they manage to inspire confidence in their collective political will to keep the Eurozone project going, markets will self-correct and possibly create a virtuous cycle of declining credit spreads and improving financing conditions. The painful deflation and erosion of wealth that the citizens of peripheral Eurozone countries are experiencing will setup the base for renewed prosperity in the future, especially in my view in Ireland and perhaps Portugal.
In general, if you look at a snapshot of most equity markets today and don’t read the headlines, it would be hard to argue that stocks are overvalued. The main risk to stocks comes from profit margin erosion and weaker economic growth. But when you see how things are progressing in most emerging markets it feels like there is reason to be optimistic about the prospects for the world economy. US exports are actually not doing too badly, especially because of the weak dollar. I don’t think many companies are making significant investments into new capacity just yet, so capacity utilisation may improve in the coming year. A lot of innovation is going into reducing commodity consumption and becoming more energy efficient, which offsets some of the margin erosion taking place.
If any asset class is relatively overvalued, it has to be high grade bonds. Interest rates are abnormally low, which is supporting very low levels of absolute yields, even if credit spreads are not at their tightest levels.
Additionally in some markets real estate may be heading into bubble like territory. On my recent holiday in Singapore, I did some research into investment in residential properties. I cold-called a few Singaporean banks, and the customer service representatives (who knew donkey about me) basically said that with (1) a copy of my passport and (2) a 20-25% deposit, I would be able to get a 75-80% loan for 40 years, at an average total 1% rate for the next three years (based on the current variable benchmark rate). On this basis a potential investor can make (excluding capital repayments) over a 10% return on equity based on current rental values. This encourages speculative investment in a country where you sometimes have to pay to park your money in a bank. Local buyers are able to get loans that are around 10x their income, which compares to about 3-5x income in the UK, due to the extremely low interest rates.
When you factor in capital repayments on a 40 year loan, your ROE on this hypothetical property purchase falls to 2%. It will only take a slight increase in interest rates or lower rental values for you to start having to pay out to support your large property loan. As of right now higher rates or lower rental values seem a distant prospect for most investors and real estate agents in Singapore. They continue to buy properties despite government tightening measures, driving the market there to levels never seen before. The same thing is happening in Australian, where yield seeking investors have provided wholesale funding for domestic banks to fuel a debt driven real estate asset bubble.
In comparison, following the recent correction, you can buy some prominent Singapore stocks that yield (without stock margin) a net dividend return of 3-4%, or REITS yielding 6-7%. In fact around the world I think you will find most company balance sheets are improving because of the difficulty accessing debt and the low confidence in expanding new capacity at a time when economic prospects are uncertain. This is not a bad time to start researching which areas could be the leaders of the next bull market, and if you have any ideas what these could be, I’d be happy to chat about them with you.
Hussain Premjee