Commentary: 2013 Annual musings
by Franco Seguso, December 2013

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Fundamentals have got taken out

The turn of the year is always the time our annual performance is set out in stone, for all to see and compare. That number will remain on all our statements for the next ten years, testament to our success or failure to achieve absolute performance or at least a relative one. This year will fail remarkably, with negative readings on both counts.
 
Caution and capital preservation have not been a profitable investment strategy in 2011 and 2012, but 2013 will stand out as an outlier in the realm of asset management: quantitative easing and zero interest rates have rendered capital preservation in the short and long run mutually exclusive. Only the brave can sell these risk markets and bunker down as most informed and rational investors have since long being taken out.

Investment discipline is being tested to the limits by such unrelenting market advances, evidenced by some of the smartest bears throwing in the towel, one at a time. Likewise 1998-2000 or 2005-2007, investors are ‘forced’ to dance, that is until the music stops. Equities, small caps, junk bonds in developed markets not only did overcome the traditional wall of worries, of which we had plenty in the last twelve months, but thrived on it. Bad news and FED unorthodoxy have become a substitute of more free money, riskier asset best friends.

Such performance is all the more remarkable as the yield curve steepened abruptly following Bernanke’s taper speech in May, with the 10 year Treasury yield almost doubling to 3 % despite the ongoing one trillion dollar FED monetization intended to stifle the yield curve. You can only imagine where the back-end of the yield curve would be without that trillion annual injection.

Equities raging bull markets are rarely associated with abrupt Treasuries bear markets, but 2013 fits the picture, while 2014 is shaping as another bumpy year for bondholders with two of the major global liquidity spigots squeezed: the Fed attempting to taper its purchase of Treasuries and MBS and China tapering its domestic credit growth.

As Warren Buffet once said, interest rates act on financial valuations the way gravity acts on matter, by pulling downward: the higher the risk-free rate, the greater the downward pull on valuations. Higher interest rates, through the discounting mechanism, lessen mechanically the expected rates of return on all other financial assets, including housing.

Maybe riskier assets will continue to defy such financial gravity in 2014, but I would not bet the farm on it as today valuations don’t bode well for long-term returns.

 

Markets valued for perfection, and then some

From a valuation standpoint, equities are priced for a continuing expansion of record high earnings and margins while bonds (especially riskier ones like junk, PIIGS, subordinated) are priced for an inflation-free world and an infinite period of zero interest rates: that’s a perfect goldilocks scenario of high growth, low rates and no inflation.

In the US, cyclically (10 year) adjusted reported earnings are at a 25x P/E, level historically associated with secular peaks. Corporate profits at 11.2% of GDP are 70% above their historical norm, suggesting a much higher forward P/E normalized for this ratio. The mirror image of record high corporate profits is the record low share of wages which has shrunken to 56% of GDP from 66% a decade ago: shareholder gains have become labor force pains, a schism noticeable in today corrosive income divide and social inequality.

The S&P500 equity price to revenue of 1,6x is today double its pre-bubble historical norm, likewise the total stock-market capitalization to GDP (1,3x vs 0,6x norm). Return on sales are 42% above their historical norm and the price to book ratio of 2,5x is 70% above the norm. The Tobin Q ratio (market value versus its replacement value) is 60% above it historical mean.

If valuations for the S&P500 are not already back to the year 2000 bubble-peak levels, valuations of the median stock have already exceeded that year extremes as epitomized by the Russell 2000 trading at a trailing P/E of 65x. These market metrics are not only flagging a 40 to 60% overvaluation relative to the norm, but are also inconsistent with investor inflated expectations of future returns.

Clearly, such lofty valuations are not driven by fundamentals but by central bankers coercing investment flows into riskier yielding assets in pursuit of a fabled wealth-effect. With ZIRP and QE crowding out risk-free and low-risk alternatives, investors herding behavior has been increasingly directed toward fewer assets, generating powerful trends and self-feeding momentum (margin debt on equity stands at a record high of 2.5% of GDP).

There is also a ‘this time is different’ rationale at play based on the supreme confidence in monetary policy ability to solve whatever problem the future may hold. Such blind faith in the powers of today’s central banks is somewhat reminiscent of the blind faith in yesteryear dot-com metrics or in the perpetual rise of housing prices.

Not only has the massive credit failure of 2008 been absconded from central bankers’ responsibility, but 14 years and counting of constant credit bubbles (two of which popped in the last decade) and persistent monetary interventions to deny markets their inherent creative destruction role are hailed as a paramount success in avoiding debt deflation and economic depression. Note that the 2002-3 deflationary trap was also ‘avoided’ by inflating a huge housing bubble, until it popped; what will be needed to offset the popping of the current monetary bubble?

The combined power of QE, ZIRP, forward guidance, accounting engineering and structural fiscal deficits have so far suspended the secular bear market dynamics that started in 2000 and were revisited in 2008, and demoted any fundamental approach to portfolio management to a widow-making activity.

This whole monetary experiment is unprecedented in scope, size and duration, and no one has a clue on how this liquidity feast is going to end. In a world where price mechanisms have been distorted for so long, the unintended consequences of unwinding the flows of free money could quickly become socially intolerable, quite far from the beautiful deleveraging scenario advertised.  That’s why capital preservation in the long run, embodied by real and productive assets, is mutually exclusive of capital preservation in the short run, embodied by nominal and paper asset inflation.

Structural shift underway

Is the economy in the midst of a structural change? Answering that question is probably the most important step in framing a portfolio for the next 10 years.

The real economy is clearly transiting from a mass-market industrial-service model towards a universal digital model, reshaping the way commerce and services are delivered (think Kodak film versus Instagram or your e-book versus its paperback version). There are going to be whole industries replaced by new ones, with great winners but also big losers (technological creative destruction is still in motion). This digital transition is well underway and is unleashing major breakthrough in efficiencies, in bio and nano technologies, in healthcare, in 3-D printing, in robotics and in a whole lot more industries.

But the structural change I am referring to is rather in the realm of the economy superstructure. Figure out an inverted pyramid with the real economy at its base, the debt superstructure above it (3.5x larger than the economy), a lesser layer of off-balance sheet liabilities and uncollateralized guarantees, then the unfunded entitlements commitment at the next level (3 to 5 time the economy, depending on the discount rate you assume) and the financial derivative hyper-structure above it all (with a nominal value of approximately 12-14x the economy). The balance of this credit edifice depends upon the capacity of the base to deliver sufficient free cash flows to pay for the carry (interest) and sufficient credibility to roll-over the principal at maturity. This inverted pyramid of credit leverage is the ultimate bubble: it’s the one ruling them all.

The whole financial super-structure is mechanically sustained by the cash-flows generated in the productive economy, and the 2008 crisis appears to have been the bang-moment when such cash-flows became insufficient and the debt marginal utility turned negative.  The failure of the FED to kick-start a new cycle of leveraged growth notwithstanding four years of zero rates and over 3 trillion of quantitative easing is testament to the leverage overhang left by this four-decade long debt super cycle. The resulting structural shift from a secular credit expansion to debt monetization will shape the epic interplay between deflationary and inflationary monetary forces in coming years.

The issue of debt is one that just won’t go away

Debt permeates every level of society: never in peace-time history have we observed such a colossal accumulation of promises to pay later, a gigantic liability transfer from current earners to future ones.

Debt has evolved dramatically since its previous peak at the end of WW2. From the early 80s the developed world underwent a structural shift from an age of savings/investment (1945-1982) to an age of credit/consumption (1982-2008). To achieve this transition, the real economy has been gradually financialized through a credit superstructure (also labeled the debt super-cycle) where economic gains were inflated by increasing amounts of leverage. The last forty years of economic growth were artificially revved-up by this inflation of credit compounding three times faster than real GDP at 8% per year. Until 2008.

The crisis of 2008 was inherently financial in the sense that after four decades of levering up, each new extra unit of credit started to have a flat or negative marginal utility on growth. If in the late 50s each dollar of credit would generate an extra dollar of growth, by 2007 that ratio had fallen to almost nil; more and more units of credit were required to generate a single unit of growth.

There is the law of diminishing return at play, but also the fact that credit was increasingly directed toward non-productive consumption (think secondary residences and cruise vacations) and toward asset inflation rather than investment. Debt accumulation and debt derivatives went to such extremes that to save the credit system from collapsing, interest rates had to be suppressed.

Preventing a debt-deflation spiral has thus become policy-makers main objective since Lehman; unable to kick-start a new credit and investment cycle, facing debt-deflation (deleveraging of the private sector) and demographic constrains (graying populations are by definition deflationary), the Fed moved aggressively with zero interest rates first (ZIRP) and then started monetizing the safest assets in the debt superstructure (Treasuries and MBS).

By flooding the system with newly printed money at zero interest rates, and promises to keep it there for several years, policy makers have been funding extraordinary fiscal deficits at no cost, flattening the yield curve to radically enhance the debt superstructure sustainability and reflating assets prices (housing and equities in particular).

The substitution of one liability (Treasuries or MBS) with another (newly printed money) did not however change the correlation between a relatively small real economy at the bottom of the inverted pyramid and its much larger debt superstructure above it, but only its composition. The overall debt load remains, is a very large multiple of the underlying economy and keeps growing and compounding much faster than economic growth. Debt isn’t going away, just morphing in composition.

If monetization didn’t generate inflation in the real economy, it is because so far these liabilities were not cashed-in against goods or services but were either parked as excess reserves in the banking system or went chasing the epic inflation in all things financial. It is only when the demand to exchange increasing amounts of paper liabilities for limited amounts of goods and services available in the real economy that the inflation genie will eventually come out of the bottle, unless the deflationary dragon destroy the paper-liability edifice before.

The bottom line of this credit superstructure review is that we live in a complex economic and financial system where we have accumulated extraordinarily large amounts of liabilities requiring a perpetual inflation of credit and economic growth to be sustained. As no amount of achievable growth by the underlying real economy could possibly pay for these massive liabilities, we face the prospect of a deflationary collapse of the credit edifice (debt insolvency) or of an inflationary escape (debt monetization). Either way, debt won’t go away with a whimper.

It remains my strong conviction that, to restart economic growth, debts will need to be diluted or defaulted at some stage through a mix of debt repudiation, financial repression (negative real interest rates), financial confiscation (negative deposit rates), compounding inflation, currency devaluation and by entitlements modification. In some cases, more aggressive tools like outright public debt monetization, asset confiscation/taxation and bail-ins could be involved, as well as extremes like war and revolution.

Shelving QE: the sequel

The 2014 taper is the 3rd time since 2010 that the Fed attempts to end its quantitative easing programs, having accumulated over 4 trillion in assets on its balance sheet. The progressive phase out of QE3 will add another half trillion in 2014 to the Fed balance sheet in the best case scenario.

The Fed intended to exit QE1 (the backdoor bailout of Wall Street) as early as May 2010 and QE2 in the summer of 2011 (European crisis) but was forced to abort as the markets swooned badly in the months following the termination of both monetization programs. The Fed was eventually forced to start new rounds of QE (Operation Twist end 2011 and QE3 in 2013).

To avoid another aborted termination, the Fed announced that it will proceed with a gradual tapering of the money printing with the objective to suspend it entirely by the end of 2014 depending on incoming economic data. This last tentative to shelve QE altogether (no exit strategy formulated so far) is not because economic growth is reaching an escape velocity (it is not), but because the collateral damages of QE are becoming manifest in capital misallocation and financial instability.

The danger of QE having badly mispriced risk by subsidizing all main asset classes (equities, bond, credit, real estate and commodities) is that there are few ways out of QE without investors taking meaningful losses as the artificial support of the Fed is removed. To mitigate such large market risks, the Fed is not only postponing indefinitely any exit strategy (selling its 3.5 trillion excess assets) but also engineering to swap the phasing-out of QE with more forward guidance on ZIRP to avoid tightening financial conditions.

The endgame of quantitative easing has not been written yet, and we are no near an end of this monetary experiment as the US and the rest of the world will depend on very low yields for a very long time.

The fact remains that the global economy is far more vulnerable to a resumption of the debt crisis that consensus would like us to believe as not only all previous debt imbalances are still there and have become 1/3rd larger since 2008, but new ones have emerged (huge credit bubble in China). Any loss of faith in the capacity to generate and sustain more debt by anyone of these global overleveraged actors could reignite the 2008 crisis with a vengeance and bring us QE4 along the way.

Conclusion

We live through exceptional times. This is the 5th year in a row of zero interest rates and the 4th of massive quantitative easing, the worst economic recovery ever recorded in post war history yet one of the greatest period for equity prices. The disconnect between fundamentals and valuations are at extreme rarely seen outside bubbles.

Finding value these days is a though process and if past historical metrics apply, equity investors in the most developed markets are looking at negative real return for an extended period of time.

The incoming year is fraught with surprises and will be challenging to navigate. In this over levered and very multifaceted system where inter-connections have been replaced by inter-dependences, it’s simply impossible to forecast any chain of events considering the complexities involved.

Tapering could trigger few surprises, from capital repatriation out of emerging markets (EM crisis coming back) to the yield curve shifting upward in the US as large EM foreign reserves are liquidated to defend currencies. Higher interest rates in the US could send equity and bond markets in a tailspin, the dollar up and trigger a new deflationary shock that would force the Fed to un-taper and then some. 

China, having created the equivalent of 100% of GDP of credit in just 5 years, has also some surprise on hold. She no longer amass reserves and could see her balance of payment turn negative in 2014, triggering a surprising Yuan devaluation and a new currency war. Together, China and Japan could trigger a new deflationary wave that will badly impact the US, but even more the Eurozone, with unwelcome price deflation.

Europe remains the epicenter of a sovereign-banking crisis that will not go away without an injection of EUR 2 trillion in new capital that only an outright quantitative easing by the ECB could provide. Any new funding shock, being from Eastern Europe periphery or from the French-Italian duo, will reactivate the European crisis with a vengeance.

Finally we have to take into account policy makers priority in maintaining the debt edifice status quo; their need to financially repress savings is a powerful incentive to stop investors from taking evasive action by channeling funds outside their purview. We now have governments all over the world confiscating their citizens’ assets and pension funds, capital controls creeping back, negative interest rates and currency debasements. Gold or Bitcoins are hardly part of that picture.

 

Portfolio

Portfolios need to maintain substantial protections from the cost and unintended consequences of these monetary experiments with a barbell strategy of real and productive assets (gold, REIT, oil/gas, selective equities, strong franchises, real estate, etc) as opposed to levered paper assets (debt, sovereign bonds, derivatives, paper gold). Free and sustainable cash flows built on solid balance sheet should rule the selection process (but it’s easier said than done).

Going into 2014, the consensus is unanimously tilted toward growth normalization in developed countries and overwhelmingly upbeat on equities and bearish on bond, with the ‘great’ rotation of investments from cash and bonds into equities well established at the end of last year. Stocks are perceived as the only game in town by lack of other choices while Central Banks continue to rule the day.

Moreover, this equity optimism is clearly oriented towards last year big winners, Japanese and US equities. Cash and commodities are expected to underperform, as well as all developing market asset classes. So the template for the next 12 months is eerily similar to the last 12, with a level of overconfidence in equities that is at an all time high since 1987. Consensus will continue to shape trends in 2014, and we need to take notice.

In the equity compartment we will increase our exposure based on bottom-up valuations. Private equities remain our favorite exposure to the compartment, but we will also add European equities where valuations remain acceptable and to Japanese equities where the asset reflation cycle remain in its early phase. We have also added an exposure to greater China equities to capitalize on low historical valuations and the market-oriented reform agenda just approved by the Party plenum.

Our bond ladder centered on the belly of the curve will remain a core holding of the portfolio, with accrued exposure to Asian and Middle-East credits where the recent back-up in yields offer some value to replace maturing papers.

The case for gold bullion as a hedge against the paper-world epic inflation is stronger than ever notwithstanding its 28% fall in 2013: we buy physical gold because we believe in the math of compounding debt. Should central bankers ever lose control on debt markets, gold will be the potential anchor to a new monetary order (reset). Finally, gold bullion remains very under owned and loathed by most investors. For more speculative investors, the long physical gold funded by a short JPY could be rewarding albeit volatile.

Gold smack-down in 2013 has all the fingerprints of a textbook bear-raid brought to us by powerful and deep-pocketed forces. More importantly, the epicenter of the smack-down was in the derivative paper-gold market rather than in the physical one where demand for bullion at lower bidding prices spiked significantly; so, while the West was busy selling paper-gold, the East was busy accumulating physical gold. This migration entails that there is a diminishing pool of physical gold collateral to back-up an increasing amount of paper-gold claims. Likewise sub-prime AAA mortgages that defaulted once the collateral scam was exposed, we may have a substantial amount of uncollateralized paper-gold claims that may turn out to be sub-prime. Keep your physical gold!

 

Thank again for your loyalty and patience, and all our best wishes for 2014

 

Franco

Bangkok, January 14th, 2014