Follow the money
For the first half of the year, the 17.7% gain by the portfolio was 390 basis points better than the index; during June, market panic over potential changes in Fed policy resulted in a 3.0% fall in the index, with the portfolio down by a similar amount. US bond funds suffered a record $58 billion outflow during the month, 2%of their assets. During a similar interest rate scare in 1994, the outflow was 14%, suggesting more will flee. In contrast, US equity funds enjoyed a net inflow of $2 billion. Foreign equity buying continued in Japan, but emerging market funds suffered a $20 billion outflow, approximately one third of the net $66 billion invested there since QE3. Institutional weightings in bonds relative to equities remain a mere 2% off the 30-year high (and over twice the 1981 low). These changes in the pattern of fund flows, from bonds and to a lesser extent emerging markets into developed markets equities (especially the US and Japan) are expected to continue, and indices to respond accordingly.
Financial volatility is hardly new news. Nor should anyone be surprised by a stagnant global economy given that reducing national debt mountains and budget deficits will take time. Only three factors really matter: that the 32-year old bond bull market has cracked; that recent changes in fund flows are the start of a long term trend; and that June's market panic showed which countries, sectors and stocks should be owned, or avoided. Japan remains the most obvious national "winner", hence the portfolio's 17% weighting. Its huge monetary experiment is working, for now: higher inflation, 4.1% GDP growth annualised and stronger housing data. In contrast, weak capital investment and falling profitability make the industrial mining sector supremely unattractive because riotous capital expenditure since 2005 has ensured rampant oversupply (yet full marks to CEOs of major mining companies for saying so - investors refuse to listen). The recovery in property prices in North America and other property-obsessed countries looks largely done, so too for those industries dependent on strong credit growth and demand such as autos and financials (with some country exceptions - financials in Japan).
However, apart from these perhaps obvious areas, earnings pershare on the rest of the world index should rise. Balance sheet restructuring and takeovers continue. Higher interest rates are no concern to those many companies which have refinanced their debt cheaply. They would be welcome to those holding large cash balances. Pressure on profit margins is ebbing given weaker commodity prices and wages and there is still reasonable growthin the emerging economies. The major investment problem is that “safe bonds” and “cheap” index funds are unlikely to preserve or increase real wealth. This must come from specific stock or sector selection.
The market consensus is for an accelerating global economy over the rest of this year, demonstrating humankind's attractive but naive optimism. Most of the main data is fading, or worse. The global Purchasing Manager Index for June was flat at 50.6 (low historically) and trending down. The two notable stand-outs were China at 48.2 – implicitly manufacturing is contracting – and Japan with its highest reading in 28 months. Much other data points towards a slowdown. World money supply in dollars has been stagnant since September 2012. If themuch feared tapering commences, money supply will fall, a potential concern for all asset prices. Even in Japan, despite enormous pump priming, money supply is down in dollar terms because of weakness in the yen. Between 2006 and 2012, world money supply increased by $32 trillion, between $3 and $6 trillion p.a. A contraction this year of $1 - $3 trillion if governments reduce their monetary stimulus would therefore be significant. Global economic growth would suffer badly. The absence of expansion without continued government stimuli resulted in falls since January in G4 private sector growth, and worryingly weak credit demand in the G7 countries.
There is much optimism that the US consumer will return as "the engine of world growth". Such descriptions are often the economic kiss of death, appearing at cyclical peaks - China was sodescribed in 2011. US median earnings are down 5.4% since 2009, the savings rate has halved to 3.2% in the last 18 months and credit demand has dwindled. It is more probable that the US consumer becomes cautious. Yet 70% of the US economy is consumption. Where there is growth, it is almost entirely confined to the private sector in service industries. Expansion here is unlikely to result in an improvement in world trade or commodity prices.
To this litany of evidence of a dull outlook should be added the re-emergence of potential banking crises both in China (as discussed in last month's issue), and in Europe. Deposits are still pouring out of the peripheral and weaker countries into larger banks in stronger economies. Hence from September 2008 to end March 2013, foreign deposits in Portugal have fallen by 46%, in Spain 32% and in Italy (the world's third largest bond issuer) 36%. Their banking systems remain in a parlous condition. Even theIMF, always late to the party and recently bullish for GDP expansion in emerging countries, cut its forecasts to one of slower EM growth for the third year running, and for developed economies down to 1.2%.
Why the Federal Reserve and other central banks believe that reducing their support will not be damaging remains inexplicable. A recession and tottering banks would be the most probable consequence. Hence we repeat our guess that central banks will blink first in response to the growth concerns of their political masters; thus we will still be discussing the timing of tapering formany years. Note that already several Fed Board members, the Bank of England and the ECB have been backtracking.
© Bedlam Asset Management
