Another rare macro view

Dear Reader,


Not one for musing on macro issues (the stories sound nice, but they offer a limited ability to select well priced securities with good prospects to make money, with a large possibility of being wrong in your underlying assumptions), but many clients find this arena entertaining and have asked many questions recently. As a result, below please find some of the thoughts that influence my personal macro thinking, and hence the asset allocation we propose.

1 Developed economies issues

As policymakers decide whether we shall suffer inflation or deflation, as fundmanagers decide whether they should be long or short equities and bankers decide whether they should go on holiday in or outside of Europe due to cost cutting, it really is an uncertain world we live in, and market volatility is clearly showing this to us.

Lets start this email with the following observation. When economies are in a low inflation and low interest rate environment, this should be positive for risk assets. Couple that with a loud government voice that seems to be keen to help when too much negative news comes out, we seem to have a strong support that allows risk assets to remain expensive. Indeed, until that government support is muted either by 1. Such action not being found attractive by the public anymore due to its fiscal costs, or 2. Government bond yields shoot up so stimulus becomes harder to fund, it is likely to continue.

However, we may find a second level feedback loop developing. If government funding becomes more difficult, where will capital go? Gold? Equities? A reduction in the markets perception of the quality of government debt is likely to affect the valuation of all risk assets, hence risk assets are also likely to fall in price. Such a scenario could set the conditions for a severe recession to occur unless governments print money to re introduce liquidity into the system, which they probably would. Hence capital would flow to government bonds again, the only creator of money in a system that wants to deflate. Hence government bond yields could stay low for quite some time. Indeed, only until inflation rears its ugly head are government yields likely to rise. Capital is then likely to flow to real assets.

Hence in a low inflation, low interest environment with an embedded government put option, it is a probable scenario that bonds and equities are expensive as yields stay artificially low (hence prices are high). Inflation is likely to be the driver that changes this scenario. Inflation, for the moment, is losing on points to deflation fears due to weak aggregate demand (more on this below).

In such an environment risk assets are likely to stay flat for quite a period of time. They should fall (as we have mentioned in past emails over the last year), but the variables above mentioned offer resistance, and they have little incentive to rise too much because the demand is not there to increase earnings in general for economies (i.e. weak private credit growth). Hence re balancing the portfolio frequently is important to take profits on risk assets as they oscillate up and down, heavily influenced by political and economic news, as well as individual company developments. But, please don't get me wrong, risk assets today are, in general, overvalued. One sector I believe does not seem to be expensive are high quality blue chip companies that have the attributes of low debt, high returns on capital and strong free cash flow generation. This includes companies such as Johnson & Johnson, Wal Mart, Total, Sanofi Aventis etc. The boring companies...

Recent discussion by the authorities to change the game from who can print more money to who can cut their budget the fastest, is, as far as I am concerned, scary. This will reduce the perception of the governments "invisible" put option, which is likely to push risk assets closer to fair value (i.e. they will decline). Furthermore, by shifting the weight of supporting the economy to a weak and credit strapped private sector, one should expect economic growth to be weak, and only a question of time before governments start financing the bill again.

As an aside, it is interesting to note that there is an incrediable statistical data set to show that on the third year of a US presidents reign, equity markets are positive as projects are commenced that are positive for the economy prior to the election. That third year would be next year for Obama's presidency. Such "political muses" may be less relevant than history would suggest due to the large stimulus that has already been launched ove rthe last two years. Nevertheless, an interesting point to keep in the back of our minds.


2 Global market issues

With regards to this issue, I find it worthwhile to quote William H. Gross, who describes this scenario most aptly, and whose view I agree with almost totally.

"What is hard to understand is there are 6.5 billion people in the world and will soon be 1 billion more. Many of them are debt-free and have never used a credit card or assumed a home mortgage. Why can’t lenders lend to them, allowing developing nations to bring their consumption forward, developed nations to supply the goods and services, and the world to resume its “old normal” path toward future profits, prosperity and increasing standard of living? To a certain extent that is what should gradually happen, promoting more rapid growth in the emerging nations and a subdued semblance of it in the G-7 – a “new normal.”

But they – the developing nations – are not growing fast enough, at least internally, to return global growth to its old standards. Their financial systems are immature and reminiscent of a spindly-legged baby giraffe, having lots of upward potential but still striving for balance after a series of missteps, the most recent of which was the Asian crisis over a decade ago. And so they produce for export, not internal consumption, and in the process leave a gaping hole in what is known as global aggregate demand. Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above.

It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem. If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.

Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. "


We look forward to hear from you if you have any questions or queries.



Yours sincerely,

Alessandro Sajwani