If you focus on the downside risk, the upside return will take care of itself




Monday 29 August 2011

Commodities and currencies

With two weeks of negative results in global stock markets that seem to have been triggered by the downgrading of US debt by S&P, our return to the office was focused on looking at opportunities in commodities and currencies.

We are concerned that the USD has a long decline ahead of it as de leveraging from its consumers and government will imply low real GDP growth. They have an incentive to print money as foriegn debt issuance is also in USD. This will encourage the authorities to increase the money supply to dilute the current debt load and encourage a changing economic structure by weakening the currency to help support exports, and put pressure on exporting countries that have currencies pegged to the USD.

We are looking at opportunities versus the MXN and KRW. Chile and Peru are also economies worth studying.

The problem is USD cash. We can hedge by simply investing the USD cash. Fears of weak real economic growth can be partially covered by put options on the stocks we hold.

But why use that cash in put options when can keep the cash and wait for more opportunities?

But then predicting markets? The cash may depreciate, the stock prices may increase, we may be priced out of the market.

Invest in the put option, it can become bigger if markets do fall so can have more to invest later. Whilst we reduce the net long position of the portfolio.

But perhaps can focus on companies and the management of this portfolio, rather then currencies and commodities and other secondary ideas.

Better securities on companies which have more understanding then filling the portfolio with secondary ideas.

If see mis pricings in commodities and currencies they can play a role. but dont be forced to do it. Keep ideas waiting until the price is ready, whether it is real commodities, stocks, bonds or currencies. But we need a broad understanding and have an approximate valuation in which we are willing to buy.

However, currencies are bought because they behave in a certain way in certain environments, or because they have good companies and may want to buy later when their price has dropped but the currency may be expensive. But can also use forward contracts.


Sunday 21 August 2011

Why are real assets outperforming financial assets?

Certain countries have accumulated large cash reserves in foreign currencies over the last decade

There investment decisions has an affect on global asset prices

If there is a global growth slowdown from DM experiencing weaker GDP growth (which they are very likely to experience)

Then countries like China will have smaller trade surpluses

Hence will accumulate less USD

What will they do with the USD they have?

If they see the USA has a policy of weakening their ccy (they have an incentive to do so as foreign countries buy US debt in USD as it is perceived as the global reserve ccy)

Then they will change their investment habit of buying low yielding US treasuries and buy other USD denominated assets such as commodities or equities (real assets)

Hence we see large capital flows into real assets which previously went into financial assets

This will have the affect of reducing the value of a future cash flow of USD, hence the Shiller P/E ratio will come under pressure to decline (equities prices fall if profits do not increase by more than the multiple on profits decline)

Commodities such as gold benefit

This is a typical cyclical behaviour last experienced in the 1970s when equity multiples decreased but commodity prices increased. When financial assets become too expensive from too much credit, real assets become more valuable until financial assets become too cheap and enough debt has been destroyed

History rhymes

Evolution of the European debt crisis

An economy has a excessive debt burden when the cost of servicing the debt is greater than the increase in the GDP

At this point investors become fearful of that economy and capital flight begins, which makes the matter worse as the cost of borrowing increases

INCENTIVES FOR NEW CAPITAL TO BUILD NEW GROWTH OPPORTUNITIES MUST BE CREATED

As were finally done after a decade of economic crisis in Latin America from 1982 until 1990 when the Brady plan was initiated

No new capital will go into an overly debt laden economy until the debt burden is decreased either via debt restructuring, money printing or re distribution. This is a fact

Authorities are focused on austerity at the moment in Europe. As was the case in the start of the Latin America debt crisis in 1982. Later they discovered that under these conditions a country cannot grow out of its debt.

Next year the Europeans will figure this out for the periphery countries as the problem does not diseappear. Why doesn´t it diseappear. Because what started the problem is still there - too much debt.

Since periphery countries cannot print money and the German influence on the ECB does not make it a feasible solution for the moment, there will be either FISCAL UNION (CAPITAL RE DISTRIBUTION FROM RICHER TO POORER COUNTRIES) OR DEBT RESTRUCTURING to resolve the issue.

To get new capital into a country need to suggest growth opportunities not austerity. New capital goes into an economy or company because there is a possibility to make money, often from growth. Capital does not go to an investment for pity, the market is not a moral decision maker.



Friday 19 August 2011

Pondering how to invest in emerging markets

I often query the EM issue. Higher growth, there currencies are likley to appreciate over the next decade over DM currencies, now all we need is an investment!

Our exposure is via

1 Accumulating REAL ASSETS (consumption will increase if ccy is stronger and will import more)
2 Indirectly via shorting the USD over the long term
3 High quality companies that have increasing sales in these regions

Buying the ccy of these countries and buying their stock is proving to be more difficult. Their ccys are often not freely floating and corruption is rife amongst corporate managers

Macro conclusions

GDP growth will remain weak in developed countries for a number of years, as discussed in more detail in past blogs over the years. Credit growth essentially will be weak as the developed economies are over extended due to excessive credit growth in the recent past. Non leveraged emerging markets do not yet have the financial institutions to take the place of the DM. Hence the world market suffers from a lack of "global aggregate demand". This is de leveraging at work.

Deflation is the natural remedy demanded by over leveraged econmies (i.e. de leveraging. This is the destruction of capital which should not have existed).

Authorities are trying to fight this by applying inflationary policies such as money printing.

Eventually this will lead their currency to drop (seeing this in UK and US where money printing has been most active) and eventually the cost of borrowing in their currency will increase in an attempt to patch up deficits with more foreign capital. In essence, try to attract foreign capital by offering a higher deposit rate or higher bond yield. The latter effect we have not seen yet. We suggested in past blogs that two particular events may trigger this event (European fiscal union or Emerging countries cutting their peg to the USD).

In Europe money printing is not an option for individual countries. They will as a result suffer a classic depression. Recent news on Greek bailouts are irrelevant unless their is a chnage in the structure of Europe and new institutions are created. If fiscal union does not occur the cost of borrowing in the US may continue to be held down for a while longer. If fiscal union does not occur, a classic depression will occur within peripheral EU countries to remove the inefficiencies to compete globally and to attract new foreign capial

Regional banks would suffer if US govt rates increase and FED rate does not

The regional banks rely more on the business of taking in deposits and making loans,” “Right now deposits have little value because rates are so low and the loan demand is very minimal.”

Hence, if market determined US government bond rates were to increase, money would move out of deposits and into money market funds and govt debt. Hence the regional banks would suffer the most from a spread between FED rate and the market interest rate increasing.

Hence, a increasing cost of borrowing for the US government can be negative for banks, especially regional banks.

Less deposits means less money to make loans, hence less credit supply for the American household.

Also banks hold plenty of govt debt, which means more marked to market write downs.

"The Federal Reserve announced last week that it would keep its benchmark interest rate at a record low at least through mid-2013. The persistent low rate is preventing regional banks from turning an increasing deposit base into earnings growth because of flatter yields".

Furthermore, if economic growth is 1 percent or less in the next one to two years, profit estimates for large U.S. lenders including several regional banks may be slashed as much as 30 percent, according to analysts at Deutsche Bank AG.

With lower-than-expected loan growth, regional lenders will continue cutting costs

Total credit-loss provisions among U.S. banks plunged 60 percent in the first quarter this year from the same period in 2010

SOURCE: Bloomberg news.

Currencies do matter

Suppose an American investor was concerned the market was pricing risk assets too agressively relative to his estimate of fair value for the market index. The investor may decide to be 100% in cash and wait for the right moment (when risk assets are priced less than what he believes they are worth).

However, the USD depreciated 20% during the last 2 year. This means his purchasing power globally has declined, though he may say it has not locally (he would be foolish, in America many goods the investor purchases are made abroad, hence his purchasing power has decreased because his costs have increased whilst his capital has generated zero income due to 0% interest rates). Overall, his wealth has decreased by making what seems like a wise decision.

We can say he was wise because he lost less money than if he was invested 100% in the market - at least that seems to be the case for the moment.

However, the reality was he was foolish because he explicitily assumed (without even probably being aware) that the USD was the only currency in the world, hence why he only holds USD.

Making a decision to hold cash may be a good asset allocation decision when compared to bonds or equities and other risk assets - but it might not be the same as having held cash in AUD or SGD during that same time period as the investor was holding USD cash.

Furthermore, often when currencies decrease in value, their assets may increase in value. This typically happens in the US due to the strong faith people have in this currency. Hence when it weakens, many foreign investors buy US assets which seem cheaper relative to foreign currencies. Hence our USD American cash investor is priced out of the market and is forced to continue holding USD cash paying zero income if he keeps his same criteria.

To ignore that financial markets are becoming more globally interconnected and hence one must appreciate the cost of a security and the value of the money the security is priced in, is to be foolish and to ensure certain suffering.




Real assets versus financial assets

We note the ongoing theme of capital flowing to real assets relative to financial assets seems to continue. As a result the USD continues to weaken and the Shiller P/E multiple will continue to decline.

We feel a European alliance on supporting periphery countries can be a critical event in starting the decline of the EUR and the increase of the cost of borrowing for the USD.

The other great event that can start such a large shift is the de pegging of the USD for many emerging countries. This will have the effet of reducing demand for USD and weakening the link between emerging markets (EM) and developed markets (something which is urgently needed due to the inflation this policy is creating in EM).

Support to periphery countries will reduce the spread in the cost of borrowing between such countries and Germany.

We fear the USD can only decline - it is the most important varible (and easiest to change in the current global system) that can reduce the huge imbalances that have built up within the global system.


Main themes


Buy real assets at cheap prices. We prefer timber and oil and are investigating agriculture (we find it hard to invest in this sector at the moment)

Short the USD for the long term

Buy high quality companies

Currency management is becoming more important. The lack of a freely tradable currency in many countries that are accumulating cash makes this difficult and distorts the market (i.e. the need for the Euro and the CHF)

Buy cheap insurance against increasing interest rates (market determined interest rates such as government cost of borrowing or libor rates. The authorities in DM will do all they can to keep interest rates low) in developed markets that have large debt burdens (US, UK, many european countries)

Deep value investments that are considerably less dependent on macro issues. A iliquidity premium may be available here