What markets are thinking, where they might be wrong, and what might be prudent to do about it
0There is presently a good deal of optimism on the outlooks for the US, and especially corporate cash flow and consumer confidence, the prospects for Japan with Mr Abe and Mr Kuroda, improvements in Europe for both Germany (more inflation) and the periphery (economic prospects and stability), developments in Asia and in China in particular, and in world trade. Against this backcloth markets have surged ahead. But these perceived improvements are by no means in the bag, so market riskiness, or the chance of a correction, must be rising.
Looking through the issues in turn, it is generally perceived that the recent high level of US corporate profits and indeed corporate cash balances have resulted from cost cutting and staff retrenchment, but whilst wage cost reductions can improve profits and profitability of individual companies, in aggregate it can involve a fall in household sector incomes and consumer expenditure, unless households opt to reduce savings rates. Keynes referred to this as the ‘Paradox of Thrift’ and arguably the high level of US profits at present (and their recent weakening) really reflect shifts in the budget deficit, which is now of course shrinking.
Joining the dots, if the budget deficit contracts further, so too will US profit margins, with consumption expenditure and wage receipts converging. A stronger housing market does generate some perception of higher wealth and some extra jobs and extra growth and in the mid 2000s, US households were borrowing around $900bn per annum in mortgage credit but only spending $600bn on housing with the balance used to support consumption. In 2013 in contrast, far from reducing home equity, households are investing $300bn in the housing market and repaying around $200bn of outstanding mortgages, therefore devoting $500bn of cash flow to rebuilding housing equity, and hence taking cash flow from consumption and this can only depress personal consumption expenditure growth.
A connected issue behind high US corporate profits is the all time record level of corporate bond issuance in the US at present, chiefly it seems to fund equity buy-ins and similar and although companies are being rewarded for ‘returning cash’, there are longer term issues for real investment trends, economic growth and corporate sustainability.
On the Euroland front, in aggregate German real household disposable incomes are falling and credit growth in the German household sector remains resolutely negative in real terms. Realistically, Germany will only inflate if the Euro falls heavily but that might just yield stagflation with domestic real incomes and household spending facing higher import prices. Meanwhile, it would seem that heavy public sector debt monetisation by the commercial banking system (that has now halted) and strong inflows of investor capital from the US and Japan did help the peripheral economies, but these trends have not delivered self-sustaining growth.
The third leg of the global recovery story has been Asia. As part of this, markets have focused on Bank of Japan (BoJ) statements of intent, but it’s interesting that whilst the BoJ has been expanding its balance sheet aggressively for six months, this balance sheet expansion has not lifted macro liquidity in the economy. This is because in effect all that the BoJ has done is to provide liquidity for those investors (including the commercial banks) that want to sell JGBs, following Mr Abe’s promises to raise inflation and the level of public sector debt, both of which are profoundly negative for JGBs in the longer term.
For Japan to prosper, there needs to be an easing of domestic planning controls and domestic regulations, modernisation of the banking sector and the bankruptcy code and companies need to change. With no plans to force the pace on these issues, there is a real risk that Japan’s economic ‘revival’ is modest and short lived.
More broadly for Asia, the consensus view is that consumption trends are strong and Asia will support global growth this year, but the data suggest that Asian domestic demand and export shipments are currently weak, with Asian production growth trends subdued, and a sharp accumulation of inventories, probably reflecting the appreciation of real exchange rates over recent years.
Asian economies may now seek weaker exchange rates (as Japan, India and Indonesia have already done) and while a limited depreciation of Asian currencies that allowed domestic wages to rise might be useful, currency depreciations risk global deflation which would upset global risk markets.
As a related development, China’s been easing, but this may reflect the problems of the local governments and the need to offset the recent sharp deterioration in Chinese corporate cash flow (itself a result of the squeeze implied by rising wages and falling export prices) and the affect of the easing may have been on prices and inflation rather than output. With China having experienced three inflationary cycles in the last ten years, it may well be that China is now stuck in stagflationary stop-go, as experienced by the West in the 1970s – and in the near term, we may see policy move towards another ‘stop’.
With so many moving parts, we can get a composite picture from world trade and there is a common assumption that global trade has revived, indicative of a cyclical recovery in the global economy – yet ‘hard’ shipping and air freight data suggest that this isn’t so.
Meanwhile investors are now selling bonds to buy risky assets, but whereas with Japan during the 1990s and 2000s, ‘risk on’ rallies were frequently brought to an end by rising JGB yields, now bonds are under-written by central banks, thereby support the relative valuations of risk assets. But whilst central banks have created a very powerful force for higher risk asset prices, this rally in risk assets is having little or no impact on real economies – hence the current lack of cyclical recovery.
So what may happen from here?
Optimistically, equity markets could continue firm and the realities required to sustain current valuations could catch up to justify such progress if central banks can keep optimism going and this then feeds the real economy. But whilst central banks can keep asset prices moving higher there’s the real risks of a jolt, perhaps from Euroland, perhaps from Asian currency moves, and as Richard Williams, CBF Trustee and manager at BlueCrest has long noted, central bankers have a poor record at demonstrating that they can manage economies.
From our viewpoint, the key problem for the global economy remains a lack of real value added growth. This is a supply side problem that governments seem unable or unwilling to tackle.
So we face the prospect of continued negative real rates of return on government bonds, both as a reflection of central bank policy and economic reality, and investors seeking high and rising real returns typically continue to need to take some additional ‘risk’ relative to their ‘normal’ neutral asset allocation, when ‘risk’ is defined by reference to volatility and near term return uncertainty.
Yet investors need to be very discriminating in thinking about the scale and nature of the risks they run and are prepared to take. Riskier risk assets, especially opportunities dependent on high operational or financial leverage, look very risky. Such opportunities can pay off handsomely, but for now the evidence just isn’t there for such bets to be construed to be rational investments rather than speculative forays.
In contrast, if we define risk as the possible permanent impairment of real value, high quality opportunities with genuine sustainability and growth characteristics, can be construed to be low risk. Indeed, for multi asset mandates, the avoidance of government bonds, and underweighting of cyclical and risky risk assets, with firm focus on sustainable growth may offer the best of both worlds: participation in upturns and protection in downturns. Such a strategy would be expected to be left behind in speculative runs, but for now that seems a risk well worth taking, given that if there’s a correction, many of the more frothy movers will be sold off hard and may then offer little prospect of affording investors the comfort of an ‘earn out’.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccl
