Market Outlook March 2013

“Risk”, according to Elroy Dimson of the London Business School, means “more things can happen than will happen”. This sums up why markets in 2012 surprised on the upside. Things that might have gone wrong didn’t. The dangers of the Euro imploding, a Chinese slowdown or the US teetering off its fiscal cliff were averted (or at least postponed). The absence of awful news diverted attention from the permanence of the same old bad news in forging investor psychology. Crisis fatigue set in and, tired of earning nothing on cash, investors embraced risk assets.

While unorthodox monetary stimuli managed to prod the financial markets awake, they have, so far, failed to revive Western economies. The Eurozone, the United Kingdom and United States all saw their economies shrink in the fourth quarter of 2012, while corporate profit growth also disappointed.  According to Citigroup, UK corporate earnings were, in late 2011, forecast to grow by +9.7% in 2012. A year on, the outcome looks more like -7.1%, an implied downgrade of -15.3%, yet UK stocks rose by +12% as investors accepted higher levels of risk in a desperate gamble for returns ― any returns. This disconnect between corporate profits and share prices may continue, but it cannot do so indefinitely.

We are almost four years into the current cyclical bull phase for stock markets. The rally began on the solid foundations of valuation and corporate earnings growth but those supports have long since been kicked away. More risk is being taken than investors acknowledge, and complacency is a major danger. In recent months anecdotal evidence of investor capitulation has been building. There is a whiff of panic to invest cash at any price. Investor surveys point to the highest level of bullishness since 2007. Stock market volatility, as defined by the VIX (or Fear) Index that reflects how much investors will pay to insure against volatile equity prices, is at its lowest since 2007. Sceptics of the rally have thrown in the towel and started to join in. ‘High Yield’ has become an oxymoron. Junk bonds are now not only yielding less than in 2007 but are also offering the lowest returns ever. Record issuance and record low spreads (compared to equivalent government bond yields) are evidence of the next great capital misallocation. Emerging Market bonds are also an investor favourite. Bolivia can borrow for 10 years at a mere 4.75% and Indonesia at 3.3%. The credit supply conveyor belts of the City and Wall Street will run 24/7 to ensure the income-starved are fed, but we have seen recently how food can be adulterated. Who is to say that Bolivian bonds will not prove the credit markets’ equivalent of horsemeat?

With bond yields having collapsed, equities are the final game in town for those scrabbling feverishly around for income. Yet bond investors make very nervous equity investors as they are not used to big losses. Since 1970, the most that global equity investors have lost in a year is 48%, while the most that bond investors have lost is 16%. In the topsy-turvy markets of today, the most cautious, with the most to lose, are taking ever more risk. We appear to have entered a bizarre phase of reluctant speculation in which tomorrow’s income is being converted into today’s (perhaps temporary) capital gain.

Has the yield bubble shifted to equity markets? Certainly the demand for UK and global income funds has been strong in recent years. Investment Management Association data confirm that, of the £3.4bn of net UK fund sales in 2012, £2.3bn was directed into the two income sectors. The yield on the FTSE All Share Index currently is 3.3%. This yield has been lower in the past but it is near the bottom quartile of its long term range of between 5% and 3%. Another 10% rise in the stock market would diminish the yield to 3% and alarm bells would then start ringing. This level would, by coincidence, be the old high on the FTSE 100 Index of 6950 and in a world where a 3% yield looks mouth-watering (at least compared to bonds) the overvaluation could always stretch even further.

Whatever has happened to interest rates? We miss them, not least because without them we lose sight of a vital investment truth: money has its correct price. Untethered from a monetary anchor, today’s optimists follow Irving Fisher by suggesting there is no downside risk. The wish being, as usual, father to the thought, justifications are being dreamt up for ever-rising prices. Some bullish on stock market prospects argue equities are cheap because cash trades at 200x earnings and ten year gilts at 50x (the inverse of the yields of 0.5% and 2% respectively).

Such frameworks of valuation have lost touch with reality. While cash is no longer a nil risk asset, it remains low risk and we have decided that taking the certain real loss (after inflation) of holding cash is preferable to the uncertain risk of a material loss to capital through the purchase of overpriced equities and most bonds. High levels of cash will be a temporary shelter until fairer-priced equities can become a more permanent home. Other recent grounds for confidence include the theory of the ‘The Great Rotation’ – the hope that pension funds will switch their assets from bonds into equities. We find this implausible. The cult of the equity has been replaced by a bond cult. The stock market weightings of Defined Benefit Pension Funds in the UK have been falling for 14 years from their peak of 71% in 1999 to 43% last year. Many of these funds are now closed to new members and are effectively winding down as they shift towards paying pensions to beneficiaries. For regulatory as well as liability matching reasons, such funds are unlikely to allocate greater amounts to equities in a hurry. And in a world with too much debt, somebody has to own these bonds and pension funds and will be asked to share this heavy burden. Pension fund trustees are still selling into rising stock markets. While in the longer term such funds may be buyers of equities again, the ‘Great Rotation’ will this time be at a glacial pace.

We must get used to this new period of uncertainty which has replaced the ‘Great Moderation’. Financial repression in the form of negative real interest rates is likely to stay for years to come. Even if interest rates were to be increased in nominal terms, they are likely to lag rising levels of inflation as central banks choose to stay behind the curve. Remember, unexpected inflation is dreadful for financial assets - bonds and equities. Optimists overlook the inconvenient truth that bubbles do not burst on tighter monetary policy; they pop when the surety of the income is questioned.

Central bankers are guilty of style drift by shifting their stance from ‘inflation targets’ to ‘targeting inflation’. They have, so far, failed to generate economic growth and frustration may lead them to ever more radical rigging of markets. Currency crises may not be far away as the race to debase currencies heats up. The trap of zero interest rates is harder to exit the longer they last. In his General Theory, Keynes aptly described financial repression as ’the euthanasia of the rentier’ - it is making savers buy assets they would not otherwise buy, at prices they would not otherwise wish to pay.

With central banks in the Eurozone and Britain drawing closer to having to decide whether their weakening economies need yet another round of monetary stimulus, they can be forgiven for casting an envious eye towards China. The US is also in a similar situation due to a deadlock in budget talks which has caused mandatory federal spending cuts to be implemented in stages. This will slow a recovery as growth in jobs reports is already sluggish.

China, the biggest contributor to global growth in recent years, has plenty of headaches of its own, of course. Over reliance on investment in heavy industry, a financial system rigged in favour of the state, and a failure to integrate some 140 million rural migrant workers into urban life top the list of structural problems.

Louis Kuijs, an economist with Royal Bank of Scotland in Hong Kong, added rising inflation, a renewed climb in house prices and a rapid expansion in “shadow banking” to the government’s to-do list for 2013.

But Kuijs and other economists expect outgoing Premier Wen Jiabao to reaffirm a growth target of 7.5% for this year when he delivers his last “state of the nation” report to the annual meeting of parliament that opens on today.

China entered 2013 with solid growth momentum thanks to measured policy stimulus in the second half of last year. That impetus is now fading somewhat after a strong fourth quarter, as figures for January and February will probably suggest.

So, just as the West is looking to China to boost global demand, China is counting on a pickup in the West as 2013 unfolds to help exports and revive corporate investment. Looking at trade and industrial production indicators, we are all expecting a strengthening global picture, coming especially from the United States and Europe, but it’s still a forecast: it’s not showing up yet in the hard data.

Indeed, the European Commission is projecting that the Eurozone economy will shrink in 2013 for the second straight year. And February’s survey of purchasing managers was downright weak. This increases the chances of a rate cut, but it’s still not our baseline assumption. The ECB has done all it can at this stage.

There are no guarantees of an immediate reversal in the price of stocks but the margin of safety is becoming perilously thin again. Back in March 2009, in the days when cash was king, Jeremy Grantham of GMO wrote a prescient note called ‘Reinvesting When Terrified’. His message was that you can never time the market bottom, but you can time when to begin to increase your exposure to equities in a methodical way. He called the bottom within days.

Today we seem to be almost at the opposite extreme. In the same way that you will never catch the low, you will not catch the high either. Rather than reinvesting when terrified, it is also appropriate to disinvest when fearless. Markets have a tendency to climb the stairs and go down in the lift. We are not market timers but we are value investors. If and when we cannot find value, we will bide our time. This may be a long and nerve-wracking process, but at least we aim to protect your capital.


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