Author: hfoelsing

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Geld Zug: HELLENIC HADES APPROACHES

As we approach the June Solstice in the northern hemisphere, we would do well to remember that in Greece and North America at this time of year it is known as the longest day of the year. The Latin from which the name is derived is “Solstitium” which means nothing less than “sun-stopping”. So, as we approach the final chapter in a farcical end game between Greece and the IMF/EU/ECB/EFSM/EC/European-taxpayers/(insert acronym beginning with “E”), we truly are about to finally watch the sun stop shining on Greece’s financial credibility. Again.

 

Angela Merkel, the Chancellor of Germany, now finds herself pulled into political discourse due to her to date unbridled support of expending all possible efforts to extend to Greece the means to avoid default. The way political parties have to share power to govern in Germany is in fact quite similar to in Greece. Merkel’s Christian Democratic Union party (centre-right) could not hold power in its own right. Neither can Tsipras’ communist-principled party, Syriza. Merkel shares, indeed owes, her power with the Christian Social Union party (centre-left). In this party coalition, Wolfgang Schauble ranks second only to Merkel and in return for his allegiance and willingness to work with a coalition, holds the post of Minister for Finance in “Merkel’s” government. In recent weeks there have been noticeable fractures between both Merkel and Schauble, with Merkel wanting to be more lenient towards Greece in order to reach a deal, and Schauble wanting Greece to pay what owes or leave the EU. In Greece, the other parties Syriza shares power with in order to govern have approached Tsipras’ tin ear, begging him to not risk Greece’s inclusion in the EU and the Euro currency.

 

Tsipras’ own political judgement is observably sub-optimal. This is a man who joined the Stalinist Greek Communist Party in 1991. That year, he would have received his membership card just in time to watch the Soviet Union finally come to the conclusion that after around 50 years of communism, it didn’t really seem to be working for the people. The government’s fiscal affairs were poorly run and essentially broke, so they discarded the communist model and became the Russian Federation. At Tsipras’ right hand as Finance Minister sits another self-avowed communist who, despite being an academic and having authored a book on game-theory, doesn’t seem to have made the transition to the big leagues known as “the real world” particularly well at all.

 

The IMF will come calling by June 30 for EUR1.5 billion. Then, in a mere matter of weeks, the total bill owed to creditors will reach EUR7.2 billion. Should Greece even miss the EUR1.5 billion payment to the IMF (which they will) then they will find themselves in the esteemed “ZZZ” rated class of Zaire, Zambia and Zimbabwe. You couldn’t make this stuff up even if you tried to. No “developed” country has ever before in history missed a repayment to the IMF. This of course speaks to the heart of the matter. Why was Greece ever allowed to rank as AAA rated (their debt was as good as German debt) when they, now proven to be fraudulently, entered the EU? As Wolfgang Schauble said in 2012, when the Europeans were asked to provide another EUR130 billion, “Why do they deserve another 130 when 100 two years earlier [sic.] had proved insufficient”. Wolfgang’s comments embody the argument that you simply cannot have a political union without fiscal union within the European Union.

 

So what happens next globally after Greek defaults? Do we get to see a repeat of 2011 when other nations in the periphery fall under the same spell of sovereign contagion as Greece’s debt markets? Do we get a return to the blowout in sovereign spreads for Spain, Italy and Portugal in the region of 640 bps over German Bunds? Bunds have, at certain maturities, only just re-entered positive yield territory again in the past 4 weeks.

 

Materially speaking, Greece is of course immaterial. This is applicable to both the operations of the EU should Greece depart and also global financial markets. Apologies to those of Hellenic descent, but Greece’s USD$241 billion GDP contribution per annum to EU’s USD$17.3 Trillion GDP is only 1.3%, which therefore represents 0.047% of the USD$509 Trillion of global GDP. To put this in perspective though, as the World Bank tells us, Greece’s economy is still larger than Kazakhstan, Azerbiajan or Uzbekistan. The Greece FTSE Large Cap index has lost 50.8% in the last 12 months since June 2014. The FTSE/AThex Large Cap index had a combined value at time of writing of USD$38.1 billion as at 19 June 2015. To put this in perspective, the single stock Australian and New Zealand Bank has a market cap of (in comparable USD terms) of USD$70.2 billion.

 

Greece will, as sure the sun sets, default on its debt. This will hardly be a trailblazing event when it comes to Greek financial history. The current Greek administration needs to cease and desist pursuing academic games and embrace mathematical reality. The question that Tsipras and his comrades should start devoting their time and attention to is whether, once the default occurs, do they choose to remain in the EU, and if so, on which currency. After they have made this decision (if they stay, they should no longer expect any sweetheart funding subsidy deals from the Germans, Scandinavian states or any other member state of the EU whose population pay taxes) then they need to decide if they stay on the Euro currency, or revert to the Drachma. Again.

 

The smart play here would be to promptly default, put global financial markets out of their misery and beg humbly to stay in the European Union, whilst exiting the European Area (countries in the EU that trade on the Euro) and revert to the Drachma.

 

The summer solstice marks the start of summer. This may bring short-lived joy because only a few months later this means that winter will follow. With the European grand project called the “EU”, we are concerned that a “successful” resolution to a Greek default may disprove the old notion that it is darkest before the dawn.

 

The largest stock by market cap on the Greek exchange is “Coca-Cola” and its weighting constitutes 54% of the entire index (ref. Athens Exchange Group). The sixth largest stock by market cap is the “Greek Organisation of Football Prognostics”. Syriza’s leader, Alex Tsipras rides a motorbike with a symbol that shares the colours of the Greek flag, but is made by a Motor Works company in Bavaria. This is and always has been (since 2011) an issue of political ideology vs material impact. Everyone wants the finer things in life, but if you buy them with borrowed money, one day you must pay the piper.

 

References:

The Athex Exchange Group

Factset

The Financial Times

The World Bank

 

Marcel von Pfyffer

Q.E.D.

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Geld Zug: CAPTAIN AMERICA AND THE WINTER GDP

Winter has come. A bitter winter can bring with it devastating effects and not just for Al Gore. Winter will kill crops, defeat armies and in some countries where snow falls, it will hide the green grass under a blanket of white for an entire season. Only when the season changes and the snow melts away will the grass appear greener than ever to those who look upon it.

 

Winter in the US this year (2015) has affected US first quarter GDP numbers in a very similar fashion as to what they did to first quarter GDP numbers last year (2014). Alongside this, we see many market participants voice continued concern over the level of valuation for US equities. Another distraction coming to market is that some market participants are questioning whether the equities market’s ascent is due to earnings growth or simply share buy backs. There is a veritable buffet of reasons, were one that way inclined, to believe that US equities have hit their peak.

 

The first quarter GDP numbers in 2014 painted a dismal picture for calendar 2014 in the US. Remember that in 2013, the US economy delivered a below trend annual GDP rate of 2.2%, so the Fed expectations going into 2014 were markedly higher, given the expected uplift that the pledged continuation of QE was supposed to contribute. The winter of Christmas 2013 going into January 2014 was particularly bitter across the US leading to an advanced estimate of first quarter GDP being a barely positive +0.1% (% change from 1st quarter 2013 to 1st quarter 2014). This “advanced estimate” which is allegedly seasonally adjusted was revised further downwards on May 29th 2014 to -1.0%. By the year’s end however, US annual GDP was found to have grown +2.4% through calendar 2014.

 

Come Christmas 2014 and going into January 2015, the US was again beset by yet another bitter winter and on top of this was forced to endure severe labour market “action”, which saw many East Coast ports shut down due to strike action. As the data would show, this would eventually blow the trade deficit out by a massive 8% change at the end of the first quarter. In regards to GDP, clearly when ports are shut down if not by winter, by strikes, then it is quite difficult to export goods which would have otherwise contributed to GDP numbers. Hence, when presented with 2015’s 1st quarter GDP number being +0.2% (a very similar number to 2014’s) some market participants are concerned that this will herald a slower 2015 than the US Federal Reserve forward projections would otherwise have us believe.

 

The problem here with the inaccuracy of the 1st quarter GDP numbers’ bearing on actual economic activity for the other 3 quarters of the year have been cause of much debate. “Seasonal adjustment” of the numbers is supposed to remove noise or volatility from the data due to holidays, weather and lost productivity often associated with Christmas and the winter period. However, 1st quarter GDP has been shown to average 1.6% lower than other quarters across the last 20 years. If this can be observed with regular effect, then theoretically seasonal adjustment should be “taking care of” what the human eye can do to a column of quarterly spreadsheet data.

 

The US Federal Reserve Bank of San Francisco by its own admission states that, “Of course, seasonal adjustment is an imprecise and uncertain statistical exercise”. This should make hedge fund managers throw their toys out of the sandpit in pure exasperation when they are using such data to attempt to make multi-billion dollar investment decisions based on the direction that the nation’s statistical body, the Bureau of Economic Analysis, is leading them.

 

 

Why is all of this so important? Without a clear read on “proper” US GDP, the market will not be able to accurately forecast (yes, an oxymoron!) what Dr Janet Yellen’s decision may be regarding the timing of a rate rise. The market has moved earlier this year from an almost unanimous decision that the Fed would raise rates in June 2015 to a possible rate rise by the end of 2015. Despite continual performance of US corporate debt markets (or perhaps because of them), investors are even more so concerned about the timing and pace of US interest rate rises. If the economy is not recovering, then the Fed will not raise rates quickly or possibly at all. If it does raise rates, what effect will that have on the wider economy? If the wider economy suffers due to an interest burden imposed by an impatient (or overly patient) Fed, then will there be any corporate profits to distribute?

 

People suggesting that relying on revised US GDP estimates this time round (2015) to be different may want to take a look at the data set. Although it is almost taken as gospel that the most amazing growth period the US ever experienced was through the Great Moderation of the last 30 years, this is simply not the case. Since 1930, average annual US GDP has been 3.4% (all data presented here is in chained 2009 dollars). Since 1964, the average annual GDP number in the US has been 3.0%. In the Great Moderation of the last 30 years, it has been 2.8%. This gives pause to the thought that the US economy may not be able to deal with an environment of rising interest rates. To be sure, a heightened interest rate environment will affect some industries and companies within the US economy, but if their business is only sustainable in a near-zero interest rate environment, then the question must be asked, was their business model ever really sustainable?

 

During the tenure of Paul Volcker at the Head of the US Federal Reserve (1979-1987) and across the Regan administration which saw off stagflation, US GDP annually averaged…wait for it…3.0%. This was at a time when Volcker raised the US Federal Funds rate from low double digits (!!) in the late 1970s to a monthly peak of 19.1% in June 1981 (US Federal Reserve FRB_H15).

 

Mark Twain once said that “History does not repeat itself, but it does rhyme”. Well, during Volcker’s reign from 1979 to 1987, the stock market only had 2 years where it finished in negative territory. Clearly 1987 was one of those two years. So, a return of 147% in US equities across 9 years implies an average annual (but not compounded) return of 16.3%. Not bad for a period where interest rates averaged double digits. However, for the stock market to be firing, so too must the broader economy.

 

By the end of May (29th), time – or the Bureau of Economic Analysis – will have told.

Marcel von Pfyffer

Q.E.D.

 

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Geld Zug: UNDERWEIGHTING THE POOR WHITE TRASH

UNDERWEIGHTING THE POOR WHITE TRASH

The death of Lee Kuan Yew brought to mind his warning in 1980 that Australians were in danger of becoming the “poor white trash of Asia”. As things turned out, we didn’t: in terms of the World Bank’s inflation adjusted data, Australia’s GDP per head rose from USD 10,187 in 1980 to USD 67,458 in 2013, a six-fold increase. That’s pretty good compared to the US, which only managed a four-fold increase in the same period, to USD 53,042 in 2013. But let’s not get too cocky – over this period, Singapore’s GDP rose eleven-fold from USD 5,003 to USD 55,182. In short, Singapore has overtaken the US and is hard on our heels.

Real GDP per capita 1980 2013 multiple
Australia 10,187 67,458 6.6x
Singapore 5,003 55,182 11.0x
USA 12,597 53,042 4.2x

Source: World Bank GDP per capita in current USD

The point of these figures is to show that, although Australia has been a pretty good place to invest, there are other places which have been a lot better. In particular, we think that for the next five years Australian investors will do better outside Australia.

Many commentators have pointed out that the Australian share market has underperformed the US share market since the GFC. This has nothing to do with the innate genius of Americans or the laziness of Australians. It is the inevitable consequence of the end of the resources boom. From 2002 to 2012 rapid economic growth in many countries (especially China) pushed up commodity prices to record levels; but these high prices eventually encouraged producers to build new mines, and now the over-supply is pushing commodity prices down. The last decade favored resource-producing countries like Australia, Brazil and Canada, but the next decade is going to favor resource-consuming countries, particularly the US, Europe and Singapore.

Australia has enjoyed the benefits of rapid Chinese growth since 1990, and now its export dependence on China is causing the Australian economy to slow as the Chinese economy slows. China’s 2014 GDP growth rate of 7.4% was the lowest since 1990, and 2015 is forecast to reduce to around 7.0%. The long term factors behind slower growth include:

  • An ageing population and a shrinking workforce.
  • Rising real wages, as regional and sectoral labour shortages enhance employees’ bargaining power.
  • Over-capacity in many industries, as a long term consequence of policies that have favoured investment ahead of consumption.
  • Visible pollution of air, water, soil, food: resistance from consumers and residents increases, and pollution control will mean higher costs for many companies.

What should the Australian investor do? In order to minimize the effect of the fall in the AUD and the coming recession in Australia, investors should look at ways to reduce exposure to AUD-denominated assets and increase exposure to resource-consuming economies which will benefit from lower commodity prices. The cheapest methods are ETFs based on a US, European or Singaporean index, or ASX listed companies with substantial US or European operations.

 

Neill Colledge

Q.E.D.

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Geld Zug: INVESTMENT ARITHMETIC FOR 2015: 2 + 2 = 4

INVESTMENT ARITHMETIC FOR 2015: 2 + 2 = 4

In 2014 my Australian Equities mandate returned 15.1%, but the S&P/ASX200 Index managed only 5.6%. Share prices in the mining sector dropped as iron ore and coal prices fell to levels not seen since 2009. Repeated downgrades to Chinese GDP growth forecasts added to the negative sentiment. In the second half of the year oil prices halved, causing share prices in the energy sector to join the miners in their slide. Things were worse in Australia than overseas: the US S&P 500 index returned 13.6% in CY14, and although European share markets had a mid-year attack of nerves, they have risen by 20% since mid-October.

In the wake of such experiences, many investors are now gun-shy, if not shell-shocked, and fearing more of the same in 2015. We believe that outlook can be summarized very simply:

  • the two big trends of last year – low oil prices and a high US dollar – will continue to operate in 2015.
  • the two long-term macro events which we write about almost every month – slowing GDP growth in China, and the eventual normalization of US interest rates – are still in place, and they will drive bond and equity returns over the next three years.
  • these two sets of two factors just mentioned will trigger four sources of risk in 2015 – junk bond defaults in the US energy sector, defaults in US dollar bonds issued by non-US corporations, defaults in low-quality sovereign debt, and “covert defaults” by second-rank Chinese companies.

So that’s how we get 2 +2 = 4. The four sources of risk originate in the credit markets, but their effects will spill over to the equity markets. There’s nothing like a default in the portfolio next door to incentivize a fund manager to re-evaluate the risk in his own portfolio. Before we jump to investment conclusions, let’s look at all eight items in detail.

The halving of oil prices is a spectacular positive for oil importing countries, not only because it improves their balance of payments, but also because it reduces petrol costs for the average consumer, increasing their ability to spend on other things. (The impact of low oil prices was discussed in detail in our 19 December 2014 Commentary.) The US is a good illustration of the point. As its high-cost oil producers will go out of business over the next two years, states like Texas and North Dakota will suffer economic damage, but the effect on the US as a whole is positive because of the widespread benefits of lower petrol prices for consumers and lower input costs for downstream users of petroleum products. Petrol is a big expenditure in the budgets of US consumers because 86% of US commuters travel to and from work by car every day (according to Commuting in America 2013, from the American Association of State Highway and Transportation Officials). Because of the lags in oil supply, we expect oil prices to remain low for the next five years.

The rise of the US dollar against most other currencies reflects the resurgent economic strength of the US and in particular the fact that its growth rates are speeding up while other countries are decelerating (e.g. China) or stalled (e.g. much of Europe). The primary cause of this divergence is the end of the resources boom. From 2003 to 2012 resource producing countries such as Australia, Brazil and Canada prospered because resource consuming countries like the US had to pay higher prices for resources. Over the next decade, however, as commodity prices decline or stagnate, the resource consuming countries will prosper. Hence we do not expect that the rise of the US dollar will reverse in the near term, although it will undoubtedly have fluctuations and retracements. Students of history will recall the relentless rise of the US dollar in the early 1980s, which was halted only by the combined efforts of five central banks (the Plaza Accord of 22 September 1985). The rise of the US dollar is similar to the rise of the Chinese renminbi, which is now 51% above its real effective value in mid-2005 when it was unpegged from the US dollar: its appreciation against the rest of the world reflects the faster growth rate of its economy in the long term, despite the persistence of capital flight as Chinese elites smuggled their money off to safer jurisdictions. (That said, the Chinese renminbi is expected to depreciate in CY15.)

The big macro trend of China’s slowing growth is now part of the conventional wisdom. CY14 GDP growth was 7.4%, the lowest level since 1990. The slowdown is partly driven by tighter monetary policy and partly by structural change in the economy, so we expect that CY15 and CY16 will be slower again. The emerging economies which have profited from supplying resources to China are already suffering the pain of lower prices and lower volumes. For Australia, the China slowdown is an ongoing negative influence because a third of our exports go to China.

The eventual normalization of US interest rates seems likely to begin this year, if recent comments from the US Federal Reserve are any guide. The process of restoring cash rates from zero to their historic averages of 3% to 4% will take a year or two, and its speed will depend on how healthy the US economy is over this period. Higher cash rates will tend to push up term spreads and credit spreads in US bond markets, with flow-on effects to business financing and mortgage affordability. The key point here is the Fed is only concerned with the health of the US economy. The impact on the rest of the world economies doesn’t matter, because the rest of the world doesn’t vote in US elections. Because the Fed has been talking up the rate rise for some months now, it is likely that the first 0.50% of the rise is already priced into US credit markets.

The two big trends of 2014 interact with the two long-term macro events to produce our four sources of negative events for 2015.

The first source of risk – a rash of junk bond defaults in the US energy sector – is the inevitable outcome of lower oil prices. For high-cost producers, lower prices mean that operating costs can’t be covered and interest obligations can’t be met, i.e. they default. The financial consequences of these defaults will fall on bond portfolios and bank loan books. It is likely that many banks in the energy states will fail without Federal assistance. (Connoisseurs of banking crises may like to read Mark Singer’s Funny Money, which chronicles how oil-exposed banks collapsed in the 1980s.) The real-world consequences include insolvencies, unemployment and a slump in oil sector capex. Although these events will attract media attention (just as they did in the 1980s), the damage will be localized to the energy states.

The second source of risk – defaults in US dollar bonds issued by non-US corporations – is the result of the appreciation of the US dollar, reinforced by slowing Chinese growth and the normalization of US interest rates. Companies which do not have the natural hedges of USD assets and revenues will find themselves exposed to higher interest and principal obligations in their home currencies, and some of them will be pushed into default by high gearing or other misfortunes. This source of negative events will be more widespread than energy sector defaults and harder to predict.

The third source of risk – defaults in low-quality sovereign debt – is what happens when countries get into the sort of difficulties which force companies into insolvency. A country can’t go bankrupt, but it can certainly stop paying its creditors, and there are many examples over the last three decades. The usual solution is some form of “restructuring”, which means extension of maturity, partial forgiveness of principal, reduction of interest rate, etc. The main effect of sovereign defaults is on the bond portfolios which were foolish enough to own these securities, but they also provoke a re-evaluation of risks and a lot of media noise.

The fourth source of risk – “covert defaults” by second-rank Chinese companies – is a subset of the second source, but it needs to be considered separately because it has different consequences. Chinese companies are by no means immune from over-borrowing, but important Chinese companies enjoy the benefit of an implicit government guarantee. In the handful of near-defaults by Chinese companies over recent months, some arm of government has usually managed to arrange a last-minute rescue so that actual default does not occur. It is conceivable that these heroic interventions spring from the Chinese Communist Party’s deep concern for the welfare of investors. It is more likely that some level of government has a more direct motivation for averting an outright insolvency, such as the potentially disastrous impact on the local economy. In short, the only Chinese companies which will be allowed to go bust are the unimportant ones.

What do the four sources of risk mean for Australian investors? The sovereign and corporate defaults will have little direct impact on Australian bond or equity markets, but their impact overseas will increase the volatility of global capital markets. In this context, it is important to remember that, because Australia is small compared to the US, our capital markets function like a derivative of US capital markets. Or, to put it more bluntly, when the US sneezes, we catch cold.

The collapse of US energy companies will not be paralleled in Australia, because 160 years of resource booms have taught most Australian banks and investors not to lend money to mining and oil companies. Over the next two years, the listed mining and oil sector will shrink sharply.

The “covert defaults” by Chinese companies will reinforce the negative impact of slowing Chinese growth. A company which has just been rescued goes into work-out mode, not expansion mode, so it will not be importing more raw materials from Australia. This phase will be how the Chinese central government deals with the over-capacity which has been built up in many industries as a result of low interest rates and other investment incentives. Factories and plants will quietly shut down, and modest pensions will be paid to the laid-off workers, following the precedents set when the government shrank superfluous state-owned enterprises in the 1990s.

The net effect of our 2+2=4 is to bring the Australian and US share markets closer to their next correction. Because we expect higher volatility in 2015, we suggest that, from March onward, investors should either take out derivative protection against downside risk, or reduce their exposure to equities.

Neill Colledge

Q.E.D.

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