Vigilare Wealth Management Q3 Summary
By Jason@vigilarewealth.com on October 8, 2012 in Investor Lounge
It was the best of times; it was the worst of times. On one hand the global stock markets march forward, while on the other the global economy experiences a synchronous slow-down. This particular story does not need to end with Madame Guillotine (hopefully), but the current tug of war between deteriorating economic realities and market enthusiasm eventually will have to be reconciled. What is the cause of this divergence? Are we missing out on market returns? Should we be more aggressive? Are we getting the big picture? How should we position ourselves going forward?
The global economy is slowing from Beijing to Berlin, from New York to Tokyo, from Sidney to Sao Paulo. Europe is experiencing a severe debt crisis and is on the brink of political and currency disintegration. This is significant because the European Union is a larger economic block than the U.S., so naturally a crisis this large has spread global economic uncertainty. Europe is mired in recession. Unemployment is 11% and rising, and manufacturing has been contracting for over a year. In China, growth has slowed to a multi-decade low. The data in the U.S. has been mixed. On a positive note, car sales have been robust, and we have observed signs of real estate stabilizing, but the negative momentum from Europe and China has taken some of the wind out of our sails. For example, over the last year U.S. GDP has declined from 4% to an anemic 1.3%. Consumer spending has been subdued, savings and income are declining, and business investment in manufacturing has turned sharply negative, mostly in light of the weak global economy, and impending uncertainty over the fiscal cliff and Presidential election.
Having anticipated this global slowdown we have emphatically chosen to focus more on the “protect” part of our mandate. We have invested primarily in U.S. large companies, which in retrospect has been a sweet spot in the stock markets, and U.S. dollar cash (U.S. dollar has outperformed its peers). We have also chosen to underweight bonds because we feel safe bonds yield very little (below inflation) and even a small rise in interest rates would wipe away the income.
Why have the markets recently done so well in spite of the gloomy economic backdrop? In short, there has been an overwhelming amount of monetary stimulus by the world’s central banks. Let’s put this into perspective. The Fed has already expanded its balance sheet to $3 trillion, and with the new QE3 program announced this September (which pledges unlimited amounts of money printing until the economy recovers and beyond – see the last writing for more detail on QE3), there is no telling how large the Fed balance sheet could get. Also, European Central bank (ECB) President Mario Draghi stated in July that the ECB would do “whatever it takes” to preserve the Euro. Taken together, the balance sheets of the major central banks (U.S., ECB, U.K, and Japan), have ballooned to well over $8 trillion. Compare this to the size of the Dow Jones Industrials Stock Index which is valued at about $4 trillion. We wrote a few weeks ago, that the Fed decided to pull out the “bazooka” to provide support for asset prices such as real estate and stocks, and that they felt that the economy (labor market in particular) in its fragile state, was at high risk of stalling. This is a far cry from earlier in the year when it appeared to the Fed and to most pundits (not to us) that additional QE would not be needed or implemented this year. Now, the Fed feels that shocks like the realization of a fiscal cliff and/or further uncertainty in Europe could easily tip the U.S. economy into recession and with inflation (how they measure inflation) benign, a more proactive strategy needed to be employed.
Fed officials have acknowledged that these policies are experimental, and although theoretically sound, they are not sure in practice whether they will work and what the long term effects will be. There are heated debates among economists as to whether these policies lead to inflation and whether the inflation can be controlled. One possibility we have to be prepared for is much higher inflation. A worrisome outcome is that we have an experience similar to the 1970s with high inflation and slow growth (we will write more about this).
A more promising possibility is that, unlike the 70s experience, the Fed succeeds – that is, modest inflation and lots of new jobs. If the Fed is successful it will take help from the economy. Remember, the Fed can only medicate the economy but it cannot cure the economy’s ills (if they could, why not just print $1 million checks for each American household and drop them in the mail). We believe it is possible for the U.S. to recover with the help from the Fed, but this will require many different moving parts to come together favorably. We highlight the following leading data which would help identify this:
1) Bank loan expansion – the consumer represents over 70% of the economy and given weak labor markets and incomes (also savings rate below 4%), the only conceivable catalyst for sustainable growth will come from an increase in credit, e.g. credit cards, mortgages, car loans, etc. The Banks will be leading the recovery.
2) Business Investment – Regulatory and tax uncertainties along with a global slowdown have caused businesses to be defensive and stockpile cash ($2 trillion). Unlike the consumer, a change in sentiment alone could quickly turn companies offensive given their strong fundamentals. This change in sentiment could happen with a resolution of the elections and some clarity in regulation and taxes (a one-year extension is not enough though).
3) China – China is the only country large enough to change the momentum in the global economy. If we see a stimulus follow through from China, this could bring back much needed global demand, especially in the industrial and commodity sectors (e.g. China accounts for over 40% of demand for industrial commodities, over 35% for cotton, and over 10% of crude oil demand). China is transitioning its leadership (done every ten years) next month and they might be saving any new stimulus announcements until after the leadership change.
Our portfolios are currently lagging and for good reason. Central bank money printing presents an irresistible craving to abandon safety for riskier investments, but without conclusive data on an improving economy and/or lower asset prices, it is imprudent (and borderline speculative) to put that much faith in the Fed and other central banks. The “ocean of money”, to borrow the words from Richard Fisher (Dallas Fed President), has created buoyancy in the markets, at least temporarily. This liquidity is fickle and could quickly destabilize wiping months (or even years) of market returns in a short period of time.
If this liquidity however finds its way into the real economy (as the Fed hopes), then we would see a substantial increase in lending, business investment, hiring, and consumption (we are talking 5-7% GDP growth). There would be clear winners and losers. Cyclical stocks (industrials and materials), real-estate investments, bank stocks, growth stocks, and international emerging markets stocks would do extremely well, while bonds, fixed investments, defensive stocks (telecom, utilities, and staples), and the dollar would be big losers. To take advantage we would realign portfolios in this fashion.
When we look at the picture in its entirety, we have not yet observed the necessary inflection points, and think that additional risk taking right now would be premature and could even lead to sharp loses. If everything does come together favorably (as we have highlighted could happen), a recovery of this magnitude would not be temporary. There would be ample opportunity and time to invest more aggressively. And we will. As of today, however, we remain defensive.
Thank you for entrusting us with your wealth.
The Vigilare Management Team