Market Comments
MARCH 2010 - A WORLD OF TWO TALES
An uninspiring quarter in terms of perfomances for the main indexes, but a most significant quarter in terms of fundamental trend changes.
In local currency terms, Q1 2010 was a good quarter overall with Sweden, Japan and the Nasdaq leading the pack, while China, Spain and Europe in General around - 5 % altogether.
BOND INDEXES
For Bonds, Q1 2010 was a slow quarter for OECD Government Bonds, relatively negative for the US and Australia New Zealand, relatively positive for Europe and a general tightening of spreads in emerging markets.
MACRO ECONOMIC ANALYSIS
As we have advocated for several years now, In 2000, the world entered a stage of transition between the old super power, the USA and the new superpower, China.
The 2008 financial crisis and the election of Barak OBAMA in the US mark the turning point, the beginning of the economic and geo political descent of the USA and the rise of a credible China as the geopolitical superpower and the economic mega-giant of the next century. The process may take two decades before the world - and especially the US, remember the UK before WWII - accepts it as a fact, but the momentum is there and its impact in terms of asset allocation is fundamental.
In 2008, the financial world experienced a shock of tectonic proportions, a shaking of its foundations that sunk many decade or century old companies, that changed fundamentally the way Governments look at the financial system, that changed the nature of Corporate Governance, that is questioning the role of banks that have forgotten that their primary role was to intermediate between savings and investments to become huge market punting machines, using their access to unlimited funds and the assurance that they are too big to fail or explicit Government guarantees to allow 30 years-old traders to bet on whether the elevator is going up or down, and that is questioning the role of houses like Goldman Sachs that have used their might to influence policies and events for the benefit of a happy few - remember the House of Rothschild in 1910 -.
The 2008 shock amounted to a general, sudden and massive liquidation of assets as banks and hedge funds were rushing to de-leverage their books. It had ripple effects all over the world through the contagion effects and the transmission mechanism of global financial markets and a global banking system.
The GOOD NEWS is that the shock HAS TAKEN PLACE and IS NOT ABOUT TO HAPPEN AGAIN.
For next two to three years, the world has entered a phase where long term trends are in place and where Governments, economic agents and market forces are adjusting to these trends and these trends are so structural and powerful that there is not much they can do to alter their course.
In other words, after the awe and panic of 2008, the world is probably MORE PREDICTABLE and LESS DANGEROUS now than it has been for years.
The world is also clearly divided into two camps, one that has to deal with structural debt-deleveraging and its deflationary consequences and one that has to deal with structural growth and its inflationary dangers.
USA - Economic DEFLATION and Asset INFLATION
The 2008 shock is not cyclical neither is it a simple bump on the road as some -ever-optimistic- commentators in the US would like to present it. The 2008 shake-out marks the topping out of the US DEBT SUPER-CYCLE, a cycle that started in the 1950's, when the USA finally asserted itself as the superpower of the century, and accelerated in the 1990's when the fall of communism made the US system the unquestionable winner amongst all.
The combination of the longest era of peace for centuries, the sentiment of belonging to the safest and most powerful nation on earth, uninterrupted economic expansion for the whole span of two generations, and continuous asset price appreciation, particularly since the 1982 Volcker era, led US households to lose any sense of prudence and sound management of their financial affairs, and induced them to consume to the point where spending MORE than they earned - savings ratios into NEGATIVE - and where borrowing money against ever-appreciating assets - real estate and stocks - to cover the shortfall was lauded as constructive economic behavior.
Banks were happily accommodating consumers, constantly finding new ways to entertain higher levels of borrowings, lower and lower credit standards and lower quality of collateral with less and less liquidity.
Between 1982 and 2007, US households total debt increased threefold, savings ratios fell from + 10 % to -1 % and the corresponding mushrooming of the banking system balance sheet was accompanied by a sharp decrease in lending standards and credit quality.
The whole phenomenon was encouraged by rating agencies that had a vested interest in facilitating the lending binge and by bank CEOs whose compensations were geared towards risk taking and leveraging instead rather than towards prudent management and safeguarding..
The extraordinary might and weight in the economy attained by the financial sector over the last 30 years and its influence in the political circles made it difficult for the traditional counterbalancing forces to play their role and contain the excesses.
The debt accumulation binge was also greatly favored by the ill-conceived policies of Mr. Greenspan who kept NEGATIVE REAL INTEREST RATES for almost three years, favoring an uninterrupted rally in asset prices from 2003 to 2007.
When asset prices turned, as they ALWAYS do, the financial markets went into freefall and liquidity disappeared, creating a massive banking crisis as banks suddenly discovered that their high levels of leverage and the low quality of their assets condemned them when the all too predictable turn around took place.
A very interesting feature is that the 2008 crisis was not triggered by some kind of unexpected financial nuclear device, terrorist attack, hurricane or earthquake. The crisis was all too-predictable and happened simply by the forces of supply and demand in a world of excess optimism and leverage.
It obviously helps every bank CEO to have Nassim Nicholas Taleb, who happens to be classmate of mine, describe the fall of Lehmann Bros. as a Black Swan event when the chain of event that led to their demise was fully described, anticipated and warned about by numerous economists, including ourselves, as early as Q4 2006 and Q1 2007.
The only "Black Swan" feature of the crisis is how the immense majority of financial, leaders, actors and commentators could be so out of touch with reality as to believe that asset prices would never turn. In terms of market psychology, this is a true Black Swan occurrence.
It also has to be said that the demise of Bear Sterns and of Lehmann Bros, and the carnage that ensued in the financial markets and the real economy between Q4 2008 and Q1 2009 could have been avoided if some banks and hedge funds had been prevented from shorting massively their stock and provoking their demise by altering confidence through market rumors.
The Greek debt panic in February 2010 is not dissimilar, but this time round the Governments and financial supervisors have started to act, and it would probably be healthy for the world economy and the financial markets if some traders and some CEOs were sent to prison for a few decades.
But was is done is done, and after the destruction of more than 10 million jobs in the US and more than 30 million in the OECD, after 25 % of US homeowners having lost their homes and their savings, after global wealth having lost about 20 % of its value, after having caused most pension funds around the world being technically unable to meet their obligations and after countries like Iceland, Ireland, Ukraine, Greece, being on the verge of bankruptcy, the world is still ticking along, economic growth has stabilized and asset markets did recover sharply in 2009.
Faced with a banking crisis of worldwide proportions, Central Banks and Governments, SARKOZY, BROWN and later on OBAMA reacted forcefully and injected massive amounts of cash to keep the banking system afloat. They also extended wide Government guarantees to avoid cascading bankruptcies and a total collapse of the banking system and of the real estate market.
Such a collapse would have had dramatic repercussions on the real economies, causing a profound and lasting recession, of proportions probably larger than the 1929 great recession.
The FED lowered rates to ZERO %, guaranteed interbank activities, quasi-nationalized FANNIE MAE and FREDIE MAC to stabilize the real estate market and resorted to quantitative easing to re-ignite growth and entice banks to keep on lending to the real economy.
Since then, a number of economic indicators have rebounded sharply, although from an extremely low base. US growth was + 5.9 % in Q4 2009, leading indicators have recovered, confidence has improved, job destructions have almost stopped while real estate prices have stabilized.
Stock markets have rebounded and the US Dollar has turned.
As can be seen from the chart below, the MSCI WORLD EQUITIES INDEX rose by + 71 % between March 2009 and November 2008 but is still trading 30 % below its 2007 peak.
More importantly form a structural standpoint, US households have started saving again and the US current account deficit has reversed its deadly plunge into negative territory.
Today, a very large part of the market actors is convinced that 2008 was simply an unexpected bump on the road - the Black Swan Theory - and that the US economy is on its way to a strong recovery.
It is true that the ever Optimistic American investor seem to find it difficult to accept that the US system is not immune and that the USA, as a country may have problems, let alone structural problems.
The investment implications of such a thesis is that stocks should rise to much higher levels as earnings recover, that commodities should rise on the back of worldwide demand, that inflation is around the corner and that US Government bonds should tank under the weight of over-issuance and roaring inflation.
Unfortunately, the above thesis is more akin to wishful thinking than to anything else and does not resist the examination of hard facts and long time proven economic mechanisms.
It takes an amazing twisting of the reality of facts to describe the 2008 crisis as a temporary cyclical bump in the road, considering the amount of job destruction, the percentage of homeowners in negative net equity, the collapse in final demand and production and the first ever and extremely sharp decline in Total US PRIVATE DEBT. All these phenomena are structural by nature and their magnitudes have no equivalent in the last 70 years of economic history.
The 2008 crisis marks fundamental changes in Structural trends and structural conditions of the US economy.
The US has entered a MULTI -YEAR phase of de-leveraging of its Debt super cycle after having reached astounding levels of accumulated debt on the CONSUMER and on BANKING SYSTEM balance sheets.
TOTAL DEBT in the USA more than doubled in the last 20 years to reach USD 54 Trillion in 2007, or 3.8 times GDP. Over the same period, Households Saving ratios plunged into NEGATIVE for the first time ever, and the US current account deficit reached - 6 % of GDP.
2008 also marks a fundamental turn in US consumer's psychology. They have realized the hard way that borrowing ever more to consume ever more was not a recipe for success, far from it. On the contrary, it has led 25 % of the population to lose the entirety of their savings and 10 % of the population to lose their jobs.
Wall Street should not underestimate the political backlash induced by the real economy hardship, and having a bumper year in 2009 in the financial sector will only make the resentment worse.
US Households have now been forced to realize they need to reduce their level of debt, that consumption needs to be limited to the necessary, that they needed to save more to provide for rainy days and that economic growth and jobs easy to find may not be a given at all times.
This sea-change in attitude will be a lasting phenomenon as it is a whole generation of economic agents that have been affected and who learned the lesson the hard way, and it will take a new generation to forget and indulge again in over- consumption and over-reliance on credit.
Working out balance sheet excesses will take years as banks and households can reduce their loans and increase their savings by a maximum of 10 % per annum, and it is usually more like 5 % that is achievable. A 20 % reduction in global debt levels at the rate of 5 % per annum will take at least 4 years to be completed, and we can assume that we only started the process.
In the coming 2 to 3 years, low levels of consumption and restoring the health of the banking system balance sheet will imply LOW economic activity. US Consumers represents 73 % of GDP.
It is therefore more than likely that the US economy will experience SUB-PAR GROWTH, if not even outright recession, for at least another three years before seeing light at the end of the tunnel.
Some commentators argue that the US recovery will be fueled by a strong recovery in corporate earnings ahead, inducing a virtuous circle of investments, personnel hiring and ultimately a resumption of households' consumption.
Corporate profits have indeed recovered strongly in 2009, as US corporations went into the crisis rather mean and lean, with no excess leverage, with cash on their books and the ability to lay off part workers swiftly, the explanation to why US unemployment shot up dramatically in a matter of months only.
When economic growth recovered in Q2, Q3 and Q4 2009, corporations saw their profits sky-rocket in percentage terms. In absolute terms, however, they still stand 20 to 25 % lower than their 2007 peak.
The key issue looking ahead is whether the recovery in demand will be sustained, leading to the hoped for virtuous circle of profits, investments, job creation, consumption, profits, etc...
The latest indicators of retail sales, disposable income and employment seem to indicate that the sharp rebound of 2009 form an extremely low base could be petering out. If this happens in economic terms it will affect corporate profits a quarter or two later.
Moreover, recovery in demand always benefits the lowest cost producer FIRST. It remains to be seen if any extra demand at the current levels will generate strong employment in the US and therefore further demand, or whether it will mainly benefit foreign producers, leaving US workers on the side of the road to recovery. In this regard, the sharp increase of Chinese exports into the US in H2 2009 is a bad omen and explains the virulent political demands to force China to revalue its currency.
The world is characterized by a global glut of labor force and production capacity and it has lived for more than two decades with extremely unfavorable imbalances in the relative cost of Labor between China and the West. It is perfectly conceivable that a global recovery will benefit Chinese workers rather than their western counterparts for as long as their cost ratio still hovers at 1 to 10.
the US equity market has risen 100 % from its March 2009 low, but it is still trading 30 % lower than its 2007 High. The rally was fueled by zero nominal interest rates, inducing investors to flee zero return cash and invest in more promising equity returns. This "Asset Inflation" is welcomed by the FED and the Government as it helps shoring up the balance sheets of banks and households and restoring consumer confidence.
However, and as was seen in Japan at the beginning of the 1990s, if the anticipatory rally is not met by lasting economic growth and corporate earnings, investors will get disappointed and equities could prove to be an expensive and volatile bet.
The key to the outcome will be watching the US leading indicators. If they peak out and start pointing down again, something we could see happening by the end of April or May 2010, the markets could be in for serious volatility.
The proponents of a quick recovery also believe that Inflation is around the corner.
EQUITY INDEXES