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Tuesday, August 12, 2014
Director, Capital Markets Strategy
Director, US Rate Sales
Out There Beyond the Wall
Germany, France, J apan and the Eurozone are expected to follow Italy with flat or negative Q2
GDP when the data is released this week. Italy’s economy grew at -0.2% in Q2 and has not
grown in over 10 years. J apan’s Q2 number tonight is expected to show an annualized decline
worse than 7% (maybe <10%). These four countries collectively account for 18% of global GDP.
In a globalized world with vast inter-connected supply chains, protectionism poses the most
dangerous risk to economic growth. Sanctions against Russia combined with significant
counter-measures have spanned and impacted international trade between dozens of countries.
In India, newly-elected Modi’s government doubled the minimum price of exporting onions, and
doubled tariffs on imported sugar to buoy the local industry. Sovereign actions to improve
competitiveness are often taken to weaken a countries currency, but imposing tariffs and
imposing protectionist laws have similar results but with far quicker and more targeted results.
China’s powerful National Development and Reform Commission has gone after many multi-
national foreign firms, hiding behind allegations of anti-monopoly practices (for WTO reasons).
There have been several heavily-publicized raids where Chinese officials have interrogated
corporate executives and confiscated computers. Some believe the motivation behind the raids is
to incite nationalism to give a boost to less-competitive domestic products. Some of the firms
involved include: Apple, Google, Walmart, Starbucks, McDonalds, Microsoft, Qualcomm,
Symantec, and Chrysler. Executives fear the next step is seizure of property.
The global monetary system is diverging and fraying. Central bank post-crisis quasi-
coordination has broken down. Initially, foreign central banks unhappily followed the Fed in
cutting rates toward zero; or else risked an appreciating currency affecting competitiveness. As
domestic challenges developed and the Fed initiated ‘tapering’, many central banks pushed rates
back up. Developed world economies have grown from around 30% of global GDP 20 years ago
to 50% today. This improvement has helped motivate the unfolding of a new international
economic order between developed and developing world economies.
Geo-political tensions seem to inch ever-higher with each passing day. Protectionist actions are
on the rise. Relationships amongst global trading partners are being altered. Supply chains are
being disrupted. Shifting Fed policies are unsettling current imbalances (Note: The J ackson Hole
forum begins Aug 21). Too many investors remain exposed to too many financial securities
where, simply put, they are not being adequately compensated for the risk.
o Portfolios need to adjust to the changing landscape. Cash is king. Holding outsized
allocations of cash has high optionality and low opportunity costs. The most liquid
securities should command a liquidity premium. On-the-run Treasuries and high-quality
corporates are preferred to most securities down the capital structure. The curve will
continue to flatten over time. A liquidity-compromised over-shoot in risk assets is highly
probable in the next few months.
Investors should refrain, as much as possible, from being lulled into complacency by low
market volatility or the Fed’s bold promises of providing a “highly accommodative stance” of
monetary policy and a “gradual pace” of normalization. Markets are likely in for a wild ride for
the balance of the year, due foremost by shifting central bank actions, rising geo-political
tensions, and increasing protectionist actions.
For the most part, financial asset prices have performed well over the past 30 years. “Buy dip”
typically worked. The main catalyst has been the Fed’s stair-stepping interest rates from the
‘high-teens’ to zero. However, since official rates have now (5 years ago) reached the end of the
line (i.e. zero or ZIRP), and since the Fed balance sheet has reached its practical limit ($4.5
trillion or 40% of the market), shouldn’t risk assets have a negatively skewed risk/reward profile
because the main upside catalyst has been exhausted?
o After all, prices can no longer be powered much further by interest rates. At some point
equity valuations get ahead of themselves and can only be justified by above average
economic growth (but the US is more likely to be trapped in the ‘new normal’).
Paying higher asset price levels today lowers expected and actual returns tomorrow (that’s the
simple math). Earning ever-lower returns creates a feedback loop of ever-extending risk
profiles in search of better expected returns. The lower yields fall and the higher prices rise, the
greater the risk. Fed-created moral hazard has cause irrationally low “risk premiums” at the
precise time that there is enormous political and economic uncertainties, and little visibility.
“Hey You! Don’t tell me there’s no hope at all. Together we stand, divided we fall” – Pink Floyd
J ackson Hole Aug 21
RBA Sep 2
ECB Sep 4
BoE Sep 4
BoJ Sep 4
FOMC Sep 17
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