Commentary: 2013 2nd quarter musing
by Franco Seguso, July 2013

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Portfolio underperformance

 

In the second quarter there were very few places to hide except Japanese, US and German equities. The outflow from emerging markets equities and bonds has been relentless and in some cases ruthless (Brazil -35%), as was the intense selloff in the global bond market following the FED communiqué on scaling down quantitative easing later in the year resulting in the rapid steepening of the yield curve (risk premiums normalization). The BRIC markets, yesterday darlings, were all crushed to multiyear lows while yesteryear most hated market, Japan, has taken the limelight amid surreal volatility.

One of the worst performers has been another yesteryear darling: gold. The yellow metal has been a major drag on our portfolio performance in the second quarter and raises the question of its allocation usefulness. There is an ongoing debate on whether gold is still overpriced, in a secular bear market or simply in a corrective phase. While we will find as many answers as analysts, we will keep the recommended exposure to physical gold unchanged. Gold remains the ultimate hedge against the ongoing financial instability, debt profligacy, monetary debasement, asset inflation and socioeconomic revulsion, all of which may result in a reset of the global monetary system at some later stage.

Physical gold remains thus the cheapest form of private wealth insurance against the extraordinary fiscal and monetary experiments undertaken globally by central bankers and politicians for our own greater good. As long as these experiments in uninterrupted global monetary expansion (QE), zero interest rates (ZIRP) and exponential fiscal commitments remain our operating world, I would strongly recommend maintaining a healthy dose of wealth insurance, as the probabilities of a smooth handover from assisted to organic economic growth are inversely correlated to the size of this experiment.

To put this insurance attribute in perspective, the whole Eurozone official physical gold reserves of 11,000 metric tons are today valued at Euro 330 billion before hypothecation, approximately the outstanding debts of poor bankrupt Greece ... and corresponding to the grand total of 3.5% of the Eurozone government debts or 1% of total debts (public and private).

While the outstanding amount of paper liabilities dwarf the tiny physical gold market, for the time being the price of physical gold remain anchored by the price of the much larger and levered derivative paper-gold market notwithstanding the steady increase in physical demand, especially from the east. Should central banks lose control of assets prices and market confidence, we would expect the physical and paper gold prices to diverge markedly.

 

Deflationary pressures reemerging

Japan elevated the global currency war to a brand new level by devaluing the Yen by a quarter of its value with the explicit aim to export its domestic deflation. Japan competitors, from Korea to Germany, have little choice but to cut their own export prices, intensifying the deflationary impulse across the globe.
This come at a time of EM overcapacity in a whole lot of industries, while the fall in emerging market growth is trimming their trade and current account surpluses with deflationary consequences domestically (monetary contraction) and globally (fall in import demand and in export prices).

We are seeing a multiplication of such deflationary signposts, from commodity prices (down over a fifth in the past few months) to the liquidity crunch in emerging markets, from a string of negative purchasing-price indexes (PPI) to the correction in export driven currencies (AUD, CAD, BRL) and economies (China, Korea, Germany), from the collapse of money velocity (standing at a 6 decade low) to the contraction of the money multiplier (credit).

Gold counterintuitive crash just days after Japan decision to double its monetary base looks like a giant margin call on paper-gold driven by the risk of a deflationary shock to a demand-constrained, over-levered global economy. Such a deflationary shock to a global economy barely growing would risk tipping the world economy into price deflation: we remain a short recession away from outright deflation.

Liquidity driven sales seems affecting both the less liquid parts of the markets (EM equities, currencies and bonds) and the most levered ones (gold, sovereign debts of the G10, investment grade and high yield bonds, and more recently stocks). The relative strength of the US Dollar and the US equity market is another signal of a potential liquidity crunch driven by deflationary pressures.

To taper or not to taper, that’s the question

Since Bernanke uttering the now infamous ‘tapering’ word, Fed-speak for less quantitative easing cool-aid, the markets responded with a general selloff as QE has been powering asset reflation everywhere since 2009; tapering could spell an incremental phase-out of the QE party and thus an increase in risk-premiums, although several mouthpieces of the FED were immediately dispatched to reassert the continuation of the other central bankers’ big party on the dance floor of ZIRP (zero interest rate policy).

With financial markets disconnected from economic reality and reach-for-yield extremes elsewhere, financial stability seem thus to becoming a real concern for the Fed; the challenge remains how to taper ‘QE exuberance’ without triggering a rout in bonds, mortgages and equities while the economy is clearly improving but still quite weak.

The US yield curve steepening of late in spite of an extremely dovish FED could thus be construed as a benign term-premium normalization within the context of a healing economy (the bull case) or a more challenging yield back-up driven by liquidity flows (less EM reserve accumulation and less prospective QE) in the context of the biggest bond bubble in history. Only time will tell if fear rather than optimism is the cause of the bond market selloff. Whatever the outcome, any asset priced off the yield curve (carry) is being re-priced, from high yield at one end to gold at the other.

However, higher nominal interest rates at a time of lower nominal inflation could quickly strain the debt-servicing costs of most developed countries private and public sectors; with an average total debt of well over 300% of GDP (lots of which unproductive), any single percentage increase in the average cost of debt would result in a highly deflationary 3% of GDP annually, a cost that will be considered socially unacceptable in many capitals.

Considering the anemic pace of economic growth in the developed and developing world, the excessive debt-to-GDP ratios, the low nominal growth of the US economy and the falling implied inflation, we doubt that the yield curve steepening will breakout from its well established long-term channel (1%~3.5% on the 10 year Treasury) anytime soon. We will thus add some solid corporate names to the bond portfolio within our preferred 4 year duration.

Japan monetary and fiscal gamble

The other major event of the quarter apart from the gold crash and the bond selloff has been the arrival of Kuroda-san at the Bank of Japan (BoJ) and the implementation of Prime Minister Abe-economics to defeat deflation (and reach a 2% inflation target) through a mix of fiscal and monetary policies (asset reflation) coupled with structural reforms. Japan gamble is three times as bold as the US one in relative terms. So far they have achieved to export deflation through the exchange rate channel by announcing the doubling of their monetary base and the doubling of the JGB (Japanese Government bonds) holdings by the BoJ. Such fiscal-monetary impulse is clearly front-loading GDP growth in the short term: the question remains sustainability.

The mathematics of Japan are daunting, not to say desperate. The decision to monetize JPY 60 to 70 trillion of Government debts in the context of a 50 trillion annual budget deficit leaves the BoJ with a ‘meager’ 10 to 20 trillion to absorb the sales from a private sector logically moving out of a 1% yielding asset when facing a central bank targeting a 2% inflation. A 10 o 20 trillion buffer corresponds to a tiny 1 to 2% of the existing stock of JGB (JPY 1 quadrillion = 1,000 trillion ...).

With a falling current account (only 1% of GDP), a very large deficit of 10% of GDP and an aging demographic to boot, the BoJ may soon need additional QE firepower to absorb the lack of roll-over as well as outright sales (demographic tide) to contain interest rates within sustainable levels as they already absorb a quarter of all government revenues.

The hope is that by reflating asset values, households and corporations will jolt out of their deflationary mindset and start spending again. Whatever the outcome of this regime change, a short JPY looks like the trade of the decade, as well as tactical long Japanese equities and real estate.

Regime changes at major central banks

Like the Fed in 2010 and the ECB in 2012, the BoJ is implementing a regime shift from which it will be extremely difficult to exit gracefully if nominal growth doesn’t outpace interest rates fairly quickly.

From the Fed to the BoE, ECB and now the BoJ, all major central bankers are on a monetary treadmill in search of the so far illusory escape velocity for their economies. Exiting the monetary treadmill was always going to be much more difficult than printing its way-in: the tapering-Fed is discovering this notwithstanding an economy surprising for the better, yet not growing sufficiently to absorb a much higher risk-premium.

The strong beliefs in central bankers omnipotence, from Bernanke’s put to Draghi’s ‘whatever it takes’ and Kuroda 2% inflation target are embedded in today’s asset valuations, as is the faith in their uncanny ability to save the markets from their own excesses through their power to by-pass the legislative and judiciary due process.

History, however, is replete of events spiraling out of control of these gentlemen, most recently the collapse of systemic entities in the US. Today confidence could prove misplaced should these deus-ex-machina lose control of their monetary leviathans. In the meantime, the liquidity party will all but continue as the show must go on.

 

Investing

For a developed world constrained by excessive and growing debts, low potential and nominal growth and at a demographic inflection-point, falling into a deflationary spiral would be the very definition of an investment hell. We expect central bankers to respond aggressively to any hint of deflation with ever-increasing monetary and fiscal doses (through ZIRP accommodation).

In the meantime governments elsewhere are relenting from austerity under mounting hostile public pressures. Without substantial spending cuts or debt write offs, it is hard to foresee how debt to income ratios can be reduced in a structurally low nominal growth environment. Coupled with central banks’ inflationary targets, currency wars and financial repression, the structural factors remain clearly in favor of real and productive assets although a deflationary shock or scare could wreak havoc on valuations in the interim.

The return of heightened volatility, while expected, leave asset markets all-the-more difficult to navigate as poor timing can ruin even the most rational investment decision. The absence of safe haven status in today’s markets is also compounding volatility as market participants jump from one perceived safe heaven to the next (today’s is the dollar, until 3 months ago was the 10 year Treasury and 2 year ago it was gold).

We would like to add exposure to European and EM equities as valuations down to 2008 levels have become less demanding but will wait for the latter part of the year for a favorable seasonal bias. We will also add some exposure to senior corporate bonds within our duration target.
 
Thank you for your patience and enjoy the summer break.

 

Franco

Switzerland, July 9th, 2013