Opportunity knocks for equity buyers
For the first five months of the year the global portfolio enjoyed a net gain of 21.0%, 350 basis points better than the index, edging ahead further in May. Recent smoke signals from the Federal Reserve Bank implying - subject to a wide range of get-out clauses – that less money might be put into the system, have caused market hysterics. Bond investors have rightly been stampeding out, ending a 32-year old bull market. Its longevity had caused dangerous complacency and overexposure, especially to illiquid and expensive emerging market debt through open-ended vehicles. Some of these will have to close to redemptions. For bond investors, the great inflexion point has arrived.
Not so for equities, because the financial punch bowl will not be much diluted. Central banks are notoriously bad at meeting targets – witness the inflation records for the Banks of England and Japan - and they always fail if there is more than one target. The Fed‟s often contradictory remits are higher inflation (to reduce the real cost of servicing US government debt) and lower unemployment, which has become its prime focus. The result is the Fed has been ignoring increasing signs of deflation. One cause of this is Japan‟s dramatic policy changes. These are enjoying some success, such as stunning first quarter GDP growth at a 4.1% annualised rate (the highest in G7 economies) and the sputtering back into life of household spending and private residential investment. Yet the weakening yen/dollar exchange rate means Japan is happily exporting deflation. Despite some signs of recovery in America, consumption fell in the first quarter, real disposable income was flat and the improving labour market was largely the result of temporary hiring. US inflation looks set to fall through its 1% floor. Real interest rates have moved from -0.5% in the third quarter of 2012 to +2.1%: potentially deflationary. Real rates are a government nightmare because either the economy is taxed into stagnation, or eventually debt has to be “restructured”. Mr. Bernanke is no fool; doubtless he believed that his announcement of a diminution of pump priming was anticipated. Cleary not. Yet the trillion plus dollars already pumped into the economy will not be withdrawn as was once widely expected. These vast sums will continue to slosh around the system looking for a new home. Until recently, this has been in developed and emerging market bonds. Now, if only because of decent, liquid alternatives, the main beneficiary is equities.
How this soap opera plays out depends not on central bankers but their political masters. Electorates are hard wired to expect economic growth. President Obama, PMs Cameron and Abe, and Chancellor Merkel all know this. They do not want to be remembered for creating a depression. Given a choice between piling on debt, or policies to „benefit future generations‟, debt will always win. The risk is austerity by accident. Already, higher interest rates have damaged financial companies, thus credit creation; the financial companies and pension funds in most major countries have their highest ratio of bond holdings in history. The ripple effects are rapid: Italy is expected to beg the European Central Bank for emergency funding before the end of 2013, complicated by the government caught cooking its books, again. Government structural balances have been contracting since 2010; higher rates will make this worse. If Mr. Bernanke and other central bankers do turn off the taps, they will not be allowed to do so for long.
Whilst bond markets in developed countries have swooned at the possibility of a mild policy change, those in emerging markets have been hammered , especially countries – such as Turkey, South Africa and India - enjoying large foreign inflows into their capital markets, which had become seriously mispriced. Moreover, many EMs will continue to suffer from repeated external shocks (exacerbated by their failure to reform in the good times such as by ending fuel subsidies). These shocks include: that demand in the EU - key export market - will remain flat; much heralded US growth will not lead to higher imports; Japan‟s currency devaluation is hurting competitors such as South Korea and simultaneously squeezing import volumes and margins into Japan.
There is an irate elephant in the room: China. Managing a switch from high growth fuelled by gigantic credit expansion to investment-led growth with lower credit is always a difficult balancing act. China‟s problems are simple to analyse, hard to fix. These include chronic overinvestment in the wrong areas. On a production basis China looks impressive – ever more steel and ships; on a profit basis, horrible. Many industries are bleeding from overcapacity and bad investment decisions; only subsidies are preventing a tidal wave of bankruptcies. The enormous grey market banking system is in crisis, with many loans secured by the official major banks. The currency remains too strong; wage increases trucking along at 15% p.a. are crushing profit margins. A banking/property crisis looms. The jury is out on whether the government has the will, knowledge or tools to address these problems. China is now only a weak engine for world growth. Those countries over-dependent on the China miracle - commodity exporters such as Australia, Brazil or Canada - or those locked into China‟s manufacturing supply chain in South East Asia are under a darkening cloud.
Equity markets will settle soon enough. The signs of distress, from municipal bond ETFs trading at a discount (sold to investors as „impossible‟) to China‟s roller coaster interbank market, are enough to make politicians force their central bankers to respond. Historically, in the early phases of rising bond yields, equity markets have tended to rise. There is no reason why this time should be different. Moreover, flows from bonds into equities will accelerate; valuations have readjusted from mildly expensive to mildly cheap. The end of the 32-year-old bond bull market is an equity buying opportunity.
© Bedlam Asset Management
