Risk in the global economy and markets are rising towards 2007 levels. The global economy could be nearing the edge of recession. Unprepared investors could stand to lose a substantial amount of money as markets revert to mean.
The Tactical Edge
Before we begin our exploration of global risk, we’d like to take a moment to discuss an investment management approach we use called “tactical asset allocation.” Not only do we manage client money using a tactical asset allocation approach to investing, but ours as well. What is tactical asset allocation?
First and foremost, tactical asset allocation is an investment approach that seeks to manage risk above all else.
At Global View Capital, we manage risk by measuring how different asset classes are performing relative to each other. Measurements are made using price trends, money flow and other quantitative data. We then attempt to avoid what our analysis deems the riskiest sectors and asset classes.
Markets have done well over the past few decades and especially since quantitative easing began in 2009. The combination of failed active investment management and strong index returns has driven many to become “index” investors over the past several years.
There is a problem to index investing though. By definition, if you are an index investor, then you are taking 100% of the risk of the markets you are in. How many of us want that kind of risk?
The idea of tactical investing is usually met with skepticism. It is often wrongly considered “market timing.” The reality is that tactical investors are not timing, they are seeking to measure relative strength. We have shown that by identifying risk factors, we can reduce negative outcomes more than traditional methods of investing.
There are multiple methods of tactical investing. The money managers on what we consider our “all-star” investment platform use various approaches. Some use different forms of value and growth investing. Most use low-cost ETFs (exchange traded funds), but some use stocks, bonds and options. We primarily stick to ETFs and a form of trend following. By blending a few tactical approaches, investors can diversify by methodology and asset class for a tactical edge.
Onto our analysis of risking global risk.
Risk is Rising Rapidly
Over the past few years, the global economy has failed to live up to growth expectations. This is despite massive efforts by central banks and governments to stimulate growth.
With negative megatrends in aging demographics and global debt taking firmer hold of the global economy, we are getting very concerned. Risks have rose despite the loose monetary policy and deficit spending by most governments.
The reason we started this letter by discussing risk management and tactical investing is because risk is close to reaching 2007 levels. Not only are people’s jobs threatened, but financial risk in stocks and bonds are once again at historic levels.
The next several sections of this letter will focus on the rising risks facing the global economy and asset markets. In our last quarterly letter, All the King’s Men , we covered in-depth the megatrends that we are watching. We suggest reading or rereading that letter.
Today, we start overseas in our risk analysis with the 2nd, 3rd and 4th largest economies in the world.
As a bloc, the European Community is the 2nd largest economy in the world after the U.S., at least until Brexit is complete. By sheer virtue of size, if the European economy tumbles back into recession, then that will impact the rest of the world.
In addition to aging demographics and many unemployed new immigrants, slowing global trade is putting Europe at risk. That is a global risk parameter that is not unique to Europe.
The impact of the above has made the European banking system very fragile. We recently discussed the problems at Deutsche Bank. The problems don’t stop there.
Portugal’s debt might be cut to sub-investment grade later this month. If that happens, then their banks would no longer be eligible to access European Central Bank liquidity (ECB). While it is unlikely that step would be taken for political reasons, the reality is that Portugal is another nation drowning in debt.
Italy, has over 360 billion euros of non-performing loans. That is a major drag on their banks. Prime Minister Renzi however points out that they are not subject to much derivatives exposure: “If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred…” Renzi rationalized in July.
That is essentially saying; “Yeah, it’s bad over here, but oh boy, look at them!”
Significant banking issues of course remain in Greece, Spain and several other struggling nations. Earlier this year, ECB Vice President Vitor Consancio wrote a missive describing the European banking sector as “under siege.”
The risks emanate from approximately 5.5% of all loans being non-performing )not being repaid) as identified by the European Banking Authority.
The problem of non-payment can only be alleviated a few ways. First, the economy suddenly and powerfully picks up. For that to happen, there would have to be significant fiscal policies in place to set the stage for a structural bull market.
Next, the economy could continue to muddle along slowly over many years, the loans would gradually be paid down and partially written off with little impact to the economy. This is what central banks hope will happen. The result of such a process is a very frustrating period of slow growth and not much (if any) improvement to the standard of living.
There could also be a wave of defaults and a deep recession that cleanses the system setting up a sustained recovery. This is the route Austrian economists would support, but most would prefer to avoid the suffering.
Finally, we have the path of near economic collapse headed off by more massive monetary intervention. Given how much monetary intervention there has already been, we would likely also see “helicopter money” , printing and distributing money to favored growth ideas.
With some of the other risks we are about to cover, it is easy to see that pushing Europe over the edge is clearly possible, especially given the internal discord over the EU at the moment.
China has been the second growth engine of the global economy after the United States in recent decades. Chinese demand for commodities and a supply of cheap manufactured goods stimulated growth everywhere.
Over the past several years however, problems have risen as fast as buildings. Two things jump out.
First, as the Chinese economy developed, wages have slowly increased. That has gradually reduced the competitive advantage that China has held against other manufacturing nations.
While that is good for other manufacturers, it has been a drag on the Chinese economy. The impact of slower demand growth globally due to aging demographics has also taken a toll. Chinese GDP growth is well under 7% now and the reported numbers are suspiciously high when compared to trade data.
In response to the change in the manufacturing paradigm, the Chinese have attempted to shift to a service based economy. This is a slow and painful process full of economic disruptions from the individual level up to the banks.
That leads us to the second major economic issue in China. The banking system has been very loose on credit for a long time now. According to the Bank of International Settlements, China has a credit to GDP ratio of 30.1%, the highest level of any country since data collection began in 1995.
The high credit to GDP ratio puts China at serious risk for a credit collapse if loans should go bad. As we are seeing recently, bad loans are rising at an accelerating pace. This is reminiscent of what happened to subprime in 2007.
The bad loans have led banks to raise more Tier-1 capital. They have not had an easy time raising money as in the past. This is due to many Chinese investors trying to get money out of China, rather than leaving it in.
Famous investors, including Kyle Bass and Jim Chanos, are warning of a hard economic landing in China.
The Chinese government promises that there is no credit bubble risk and that there is no risk of a recessionary hard landing. We remember when the Fed told us that subprime mortgages would not infect the entire economy.
Japan has been mired with bouts of deflation for two decades. Since 2013, when Shinzo Abe became Prime Minister, Japanese central bankers have taken on extraordinary monetary measures to stimulate the economy. They have failed.
Japan’s second quarter GDP growth this year was .7%. Their inflation rate is stuck near zero. Both measures are far below the 2% that the government is seeking.
Japan’s slow growth and non-existent inflation has occurred during the most prolific example of quantitative easing ever. Their monetary base has swollen to 400 trillion yen. This is roughly equal to the monetary base of the United States, but with an economy one-fourth the size.
Such an increase in money supply would normally create inflation. However, the Yen has remained very strong as investors view it as a relative safe haven, probably mistakenly.
The massive problem that the Bank of Japan faces is that they are running out of assets to buy for their quantitative easing program. At the current pace, the BOJ would own around half of all Japanese debt by next year.
The BOJ recently targeted a zero percent interest rate on debt for the next ten years. This is unprecedented.
The BOJ has also become buyers of Japanese exchange traded funds. This has propped up their stock market and made the BOJ a top five owner of most large publicly traded companies. That is clearly a massive disruption to price discovery.
The imminent risk that Japan faces is they run out of bonds to buy. Should that happen, they would then be faced with buying even more equities or discontinuing quantitative easing. Either case has massive implications for Japan going forward.
With all the money printing and asset buying, it appears that Japan could go from deflation to hyper-inflation. This could happen quickly if foreigners lose faith in the currency.
Due to Japan’s aging population, the oldest among developed economies, there is little hope for increasing aggregate economic demand. Most of the rest of the world is slow too, so there is little help there. With dwindling policy options, Japan could be at risk of an economic collapse could impact the world.
The Main Risk in America
In America, our greatest risk is an unwillingness to think cooperatively and long-term. While the Federal Reserve gets the crux of the criticism lately, we think government at multiple levels and indeed many Americans, need a long session in front of the mirror.
Let’s throw out this notion that we are not a great country. Nowhere else is there a combination of attributes that we have in the United States. The United States has clear and likely permanent advantages to almost all of the rest of the world.
Our geography is undeniably the most advantageous on earth. We have arable land and potable water. We are abundant in most minerals, metals and energy resources.
From a security standpoint, oceans guard two borders and we have only two neighborly relationships to manage. We are safer than most despite our penchant to hurt each other.
Having security and resources are as monumental as rare. Added with the technology we create, a skilled and educated workforce, and a global currency, the United States is and should always be a leader.
We should always lead even if our economy becomes second or third biggest due to just sheer population differences someday. In other words, “so what” if we don’t have the biggest economy in a decade or two. That might even be good.
In the next decade, America will need to start paying for Medicare and Social Security that we have promised to the retiring Baby Boomers. That is a massive amount of money over the next few decades and we cannot neglect that promise.
Ultimately, if we don’t move the bell curve of opportunity and income to the center, then we will be in deep despair someday soon. The frustration of slow economic growth and non-improving standards of living will morph into something much worse.
We need to reach across generations and make sure that the Millennials do well. The “X” Generation will need to play a leadership role in the transition from a Boomer to a Millennial led economy. We need the Boomers to continue to contribute their wisdom and creativity so that we can avoid the mistakes of the past.
The Impact of Cheap Energy
Moving back into the realm of typically discussed economics, one of the headline risks in the past couple years has been the impact of cheap oil and gas. Instinctively and logically, cheap energy is good for the economy. However, oil has been king for so long, it is a massive transition to a different paradigm.
The new energy paradigm will include a shift to renewable energy over the next few decades. With 196 nations approving last year’s Paris Climate Agreement and making it international law recently, there is dwindling opposition to a massive shift to renewable energy.
Nobody knows just how fast the shift to solar, wind and geothermal will occur. It will be very technology dependent, especially within batteries and electrical grid infrastructure. As tactical investors we recognize the huge potential, but are managing for volatility and risk as well.
Due to the fall in oil and gas prices, brought on by OPEC action, we have seen a massive shakeout in the American oil and gas sector. According to S&P Platts and Bloomberg, less than 65 companies have gone bankrupt.
While energy prices remain low, there has been significant damage to the sector. A realignment is occurring away from the highest cost shale to the lowest. We have also seen over a trillion dollars of deep water and oil sands megaprojects cancelled. Soon, western oil supply will flatten for a period and then fall dramatically over the long-term.
Across OPEC, low oil and gas prices have been disrupting their economies. They have allowed that to happen specifically to get megaprojects cancelled. Why? Because OPEC, specifically Saudi Arabia, the Gulf Cooperative Council, Iraq and Iran, know that oil’s days are numbered.
OPEC does not want their low cost oil and gas getting land locked and to miss out on the intermediate term revenue. They have sacrificed short-term. However, OPEC already has captured more market share producing over 33 million barrels per day of oil compared to just 29 million per day a few years ago. We should expect the share to rise a couple million additional barrels as disrupted flows come back online.
The idea of OPEC’s death is greatly exaggerated. They will maintain a price of oil that is as high as possible for them while hanging Damocles sword over potential large competition. Their clear threat is if western producers ramp up production via long-lived megaprojects, OPEC will crush them again.
The large risk with oil and gas prices in the short to intermediate term is that historically, price spikes have led to recessions. OPEC is taking the responsibility to not allow that to happen. That is a massive responsibility, but also comes with a degree of power. The transition to renewable energy can’t happen fast enough.
Rising Geopolitical Risks
At the heart of many geopolitical risks today are populist and nationalist movements. Even where a nationalist movement doesn’t exist, often the fervor supports an autocratic leadership.
In Russia, which has a thieving strongman as its leader, behavior has become more erratic in recent years. Russia invaded Ukraine and has not come to a resolution yet. The conflict still threatens to become more expansive. Russia has also become very active militarily in the Middle East.
In the long-game, the depletion of Russian resources due to low oil prices and expense of military action, could lead to unexpected consequences. What if NATO were to become weaker due to a new U.S. President. Would that invite Russia to be more aggressive? The risk is significant.
China, in a move to secure trade influence and acquire resources has been aggressive in the South China Sea. This is a national ambition, again borne out of autocratic leadership. As an ally to Japan, the U.S. is very active in the region.
In the Middle East, low oil prices have contributed to the destabilization of the region. What is the risk of further conflict? Not low. Saudi Arabia has not only internal conflicts, but serious problems with Iran.
How about the risk of conflict in South America where Venezuela is in a depression and Brazil isn’t far behind? Or more conflict in Africa where Nigeria and Algeria have pirates and warlords?
As we discussed, an oil price spike could cause a recession and that would batter markets.
In Europe, Brexit has already signaled fragmentation and inward looking behavior that is not unique to the U.K.
Monetary Policy and Malinvestment
We have discussed repeatedly in the past quarter, how an accommodating monetary policy has led to poor investment decisions at multiple levels. It’s hard to argue that the first rounds of monetary stimulus were unnecessary. Conversely, it’s easy to argue the latest rounds haven’t been effective.
Central banks have bought about 25 trillion dollar’s worth of financial assets, according to Bank of America’s Michael Hartnett. Those assets include not only government bonds, but corporate debt and in Japan stocks. We also suspect, but there’s been no acknowledgement that China’s central banks financed buying of oil.
According to Allianz’s latest Global Wealth Report, global financial assets of private households grew only 4.9% in 2015, a significant slowdown. That is very likely due to the megatrends we talk most about, aging demographics and expanding global debt including by central banks.
Central banks, and by extension, governments buying financial assets, is a massive distortion to the financial system. Here’s an interesting question: Can they keep it up forever?
Governments need low interest rates to finance their debt and high asset prices to generate taxes. Could they really print money to buy assets forever? The answer is no.
Eventually, there is nothing more to buy. Japan, as we discussed above, is already running into that problem. The implication is that Japan’s stock market will have a massive collapse eventually or that their currency will crater and probably both.
The other problem with all of the quantitative easing is that someday those assets have to be sold back or retired somehow. There is an old trick that governments use to pay back debt. It’s called inflation.
Right now the officially reported inflation numbers look benign, however, standard of living has also stalled. When there is a lack of improvement in standard of living, it is a clear signal of inflation even if it is not reported by official sources or is disguise in the accounting.
The central banks are walking a very fine line. We hope they can pull off smoothing the economy so greater turmoil doesn’t develop, but history is not on their side.
Stretched Stock Valuations
One result of monetary stimulus has been the rise in stock market valuations. Initially, when companies were earning a bit more, valuations were more normal. In the past six quarters, with earnings falling due to low growth and slightly rising earnings, P/E has become high again.
How high? Take a look at these charts from a recent client presentation:
We’ll continue to cover valuations throughout the quarter, however, what we can surmise now is that we are somewhere between the 8th and 10th inning of a baseball game. In other words, late for a significant correction.
So, while equity markets might very well continue to rise, we are walking on thinner and thinner ice. This is why our tactical approach is so important. We can move quickly to safety when the cracks do appear.
The Bond Bubble
Valuation problems are not restricted to the stock market. There is wide belief that we are in a bond market bubble.
Every time the Fed talks about raising rates a fraction of a percent bond prices fall. But, we know that the government needs low-interest rates to afford its debt. Interesting conundrum.
For the bond market bubble to burst, one of two things must happen. Either we see interest rates go up due to inflation, or we could see defaults start to occur in the banking system.
The interconnected nature of the financial markets means that a domino effect could have similar impact as that which occurred in 2008. Why? Take a look at this chart:
As we can see, we are significantly past the amount of global debt we had in 2007. This chart by Bloomberg gives a better visual as to where debt resides.
As we see, emerging markets are adding debt, but especially China and Brazil. We already briefly discussed China’s debt problem. Brazil is a victim of low energy prices and other poor economic policy. Either economy could take on the chin again soon.
If China starts to see rapidly defaulting loans and a drop towards zero economic growth, that would trigger events around the world. Brazil would be significant, but more contained. The BIS just warned China about their mounting debt concerns.
The United States would become an even stronger safe haven, so we don’t believe the bond bubble will burst here soon. That might wait until we see more measurable inflation and our bonds become less attractive.
So, there is a sequence of events likely to play out. However, predicting when these events occurs is virtually impossible. As tactical investors, when something like that begins to happen, we can quickly see we are not married to an asset allocation. Our goal would be to avoid a substantial portion of any losses that others are stuck with and even potentially make money on the waterfall decline that would occur.
A Wall of Worry and the Dollar
As we mentioned above, in a crisis, the U.S. is the safe haven. That shouldn’t be construed to think that asset prices won’t decline at home though. It just means that certain assets will be hit less and others could even rise, such as 10-year U.S. Treasuries which rose in 2008.
The Fed talking about raising interest rates remains an interesting thought exercise in the short-term. Why is the Fed really considering raising rates remains a valid question. While the Fed says they are looking for inflation at or above 2% and their PCE deflator doesn’t indicate that rate as we mentioned recently.
Janet Yellen has cited the transitory impact of low energy prices repeatedly in the past year. If the Fed raises rates, does that mean we could anticipate inflation due to energy prices rising soon? That seems as credible as anything given the economy is stuck in second gear.
Regardless of Fed short-term actions, the global economy remains tepid and intrepid. As long as fear remains, the dollar stays strong and could get stronger. Will is fall someday, probably. But we have to remember that currency is a relative system.
How bad would the U.S. have to get to be worse than Europe, China, Japan or the U.K. which are the other currencies in the IMF Special Drawing Rights (SDR)? Pretty bad indeed. There really just isn’t a credible alternative to the dollar anytime soon.
Now, that doesn’t preclude inflation in the U.S. The entire globe could see an inflationary period at the same time given most of the world is in debt and the governments all have the same goals, stay in power and pay down debt. The “race to the bottom” game could be back on again in spades someday. The hope is that America would let the other guys win so we maintain as much standard of living as possible.
If the dollar rises, then that could destabilize some emerging markets, particularly economies like Brazil or Venezuela which are both largely oil dependent. If emerging markets start to rattle bonds, then the whole asset class tree likely gets rattled, but, if central bankers have any credibility or firepower left, then maybe the tree won’t blow over. If central banks are hamstrung, well then, uh-oh.
Tactical Closing Thoughts
As discussed at the outset to this quarterly letter, we are tactical investors at Global View Capital. While we believe there will be an inevitable correction to markets, we are not predicting when. Those who have attempted to predict the next correction, recession or collapse have been wrong for years now and have missed substantial gains. So, rather than tell the markets when to correct, we simply follow what the markets do.
What we are doing is sticking to our weekly analysis and finding the asset classes that are doing well to participate in. Likewise, we are doing our best to avoid the weak asset classes. This repetitive exercise helps us manage risk in an ongoing way even when we go long time periods without needing to make any trades.
Right now, our models and indicators remain neutral to slightly bullish for the intermediate and longer-term perspectives. We continue to favor the U.S. equities over international equities.
With regard to capitalization and styles, we remain neutral. We are maintaining our low duration bond holdings and are overweight cash.
Like last month, our models’ message is that this isn’t the time to be overly bearish (negative), nor is it the time to be overly aggressive. A more neutral/mildly bullish stance is currently warranted.
We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities. At this point, the competing number of bullish and bearish indicators illustrate that markets remain vulnerable and are likely to continue to meander, or potentially fall, until economic growth can find a more solid foothold.