Author Archives: Charlie Fell

The catastrophe that beset Cyprus’s ‘too-big-to-bail’ banking sector confirmed that the seemingly never-ending crisis in the eurozone is far from over.  Indeed, investors are already busy searching for the member of the single currency that is likely to be next in the firing lining.

The hunt has exposed the Republic of Slovenia as the most plausible candidate for a future bail-out, and the financial markets have responded accordingly.  The yield on ten-year sovereign bonds jumped from below five per cent mid-March towards seven per cent by the end of the month, while the yield on two-year notes registered an even larger increase.  The resulting inversion of the yield curve confirmed that investors believe the risk of default to be high, as too did the surge in the cost to insure five-year sovereign bonds, which rose by more than twenty per cent following the Cypriot debacle.

But, is investors’ heightened concern justified?

The Republic of Slovenia became the first of the former communist states in Central and Eastern Europe to adopt the euro in 2007.  The relatively small country – with a population of little more than two million and an economy that accounts for less than 0.5 per cent of euro-zone GDP – staged an impressive acceleration in economic growth during the years that immediately preceded its accession to the monetary union.

Indeed, annual growth in real GDP accelerated from four per cent in 2005 to seven per cent in 2007; the rapid growth reflected robust domestic demand driven by increasingly leveraged private-sector balance sheets, and vigorous export growth arising from strong external demand.

However, the economic expansion came to an abrupt end once the global crisis struck, as the evaporation of external finance precipitated a sharp decline in investment expenditures, while weak demand abroad caused export volumes to shrink by close to 25 per cent.  All told, the Central European nation endured a cumulative decline in real GDP of about ten per cent from the peak in the third quarter of 2008 to the trough in the second quarter of 2009.

The Slovenian economy limped through most of 2009, but a recovery was underway by the following year, only for it to be interrupted by an escalation of the eurozone crisis during the second half of 2011.  The resulting double-dip has persisted for six quarters and deepened throughout 2012, as weak external demand weighed on exports, while higher unemployment and lower real wages led to a contraction in household consumption.

Persistent economic weakness has placed considerable stress on the banking sector, with a notable deterioration in asset quality.  Indeed, non-performing loans increased to €7 billion last year or 15 per cent of total assets.  Eighty per cent of the impaired credit or €5.6 billion stems from the non-financial corporate sector – almost one-quarter of all outstanding loans to non-financial firms.

The declining asset quality is even more troubling among the country’s three largest banks.  Non-performing loans exceeded 20 per cent of total assets by the end of 2012, with roughly one-third of all outstanding loans to the non-financial corporate sector turning sour.

The banking sector’s credit woes are unlikely to improve anytime soon, and the non-performing loan ratio is virtually certain to increase further during the current calendar year.  Indeed, the economic outlook is far from encouraging, and a return to growth is unlikely before 2014.

Slovenia’s pre-crisis credit expansion was concentrated primarily in the non-financial sector, with the outstanding debt relative to GDP jumping from below 60 per cent to more than 90 per cent by the time economic recession struck.  The rehabilitation of corporate sector balance sheets has barely begun, and the debt ratio continues to move higher, as the cumulative decline in GDP outpaces the overall reduction in outstanding debt.  The deleveraging process seems certain to intensify in 2013, and as a result, investment spending is sure to decline.

Weak investment spending is likely to be compounded by soft household expenditures, as high unemployment continues to weigh on demand.  Further, the external environment is unlikely to provide much support to exports in the year ahead, while efforts to reduce the public sector deficit below three per cent of GDP will act as an additional impediment to growth.  All told, it is not unreasonable to assume that the economic recession will continue throughout the current calendar year.

The continued contraction will place further strain on the beleaguered banking system.  However, it is important to appreciate that the Slovenian banking sector is nowhere near as outsized as Cyprus, or Ireland for that matter, with assets amounting to 130 per cent of GDP, and recapitalisation needs are estimated to be in the region of €1 billion to €2 billion or three to six per cent of GDP.  These sums appear manageable in the context of a government debt ratio below 50 per cent of GDP, but credible action to stabilise the banking system is required sooner rather than later.

Investors view the Republic of Slovenia as the eurozone member next in line to require external financial assistance, given a poor economic picture that continues to weigh on its distressed banking system.  However, the situation appears manageable – if addressed quickly – but ultimately, the financial markets will determine the country’s fate.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

It is only a matter of weeks since European officials openly congratulated themselves on their seemingly successful efforts to bring the prolonged eurozone crisis to an end.  The backslapping subsequently proved premature, as the botched rescue package – designed to help an ailing Cyprus raise part of its emergency funding needs internally and ultimately secure external support of some €10 billion – put policymakers’ incompetence on show for the entire world to see.

The initial proposals are difficult to fathom, given that policymakers’ had months – and not days – to devise a credible plan.  The lack of time pressure should have allowed decision-makers to get ahead of the crisis, but this advantage counted for nothing, as the proposed plan to recapitalise the banking system was virtually certain to prove ‘dead-on-arrival,’ given that it violated the hierarchy of claims in the capital structure.

The original plan envisaged that senior bonds would be made whole, while uninsured deposits would participate in losses, even though these depositors should rank at least pari passu with senior bondholders.  Further, Cyprus’s leadership – in a desperate attempt to minimise the losses imposed on uninsured foreign deposits, and thus preserve the country’s status as an offshore banking centre – decided to bail-in insured depositors, even though such liabilities should be considered sacrosanct, so as to avoid devastating bank runs.

It came as little surprise that the deeply-flawed plan, which was intended to raise €5.8 billion and fill the hole in bank balance sheets left by bad debts and losses on Greek sovereign debt, was rejected decisively by Cyprus’s parliament, with not one single Member of Parliament voting in favour of the proposals.  Sent back to the drawing board, sanity ultimately prevailed among policymakers, as the revised plan unveiled eight days ago, resembled what one would hope to see in an orderly bank resolution.

The revamped plan scrapped the ill-advised idea to impose a ‘stability levy’ on all depositors, and will “safeguard all deposits below €100,000.”  Instead, the banking system will be restructured – the Laiki or Cyprus Popular Bank, the second largest lender, is to be split into a ‘good’ and ‘bad’ bank, with the former to be backed into the country’s largest lender, the Bank of Cyprus, and the latter to be wound down over time.

Both Laiki’s shareholders and bondholders – junior and senior – will be wiped out under the revised plan, while insured deposits, alongside the €9 billion in liabilities that stems from liquidity support provided by both the European Central Bank (ECB) and the national central bank, will be transferred to the Bank of Cyprus.

Meanwhile, Laiki’s uninsured deposits amounting to €4.2 billion will be placed in the ‘bad’ bank.  These depositors can reasonably expect to recoup very little – if anything – as they will eventually receive a sum that amounts to no more than the distressed value of the ‘bad’ bank’s impaired assets.

The enlarged Bank of Cyprus will face a large restructuring effort to raise its capital ratio to EU-mandated levels of nine per cent by the end of the programme.  Since no bail-out funds are to be used to recapitalise the troubled bank, both shareholders and bondholders are likely to lose all of their investments, while the hit to uninsured depositors – via a deposit-to-equity conversion – could amount to as much as fifty per cent.

The revised plan is a vast improvement on the initial policy blunder, since it respects established credit hierarchy.  However, there are still reasons to believe that the Cypriot banking crisis is far from resolved, while the new blueprint could well have far-reaching consequences across the monetary union that are decidedly negative.

The banks may well have reopened last Thursday – with no sign of a disorderly run on bank deposits – but this was purely a function of the €300 daily limit on withdrawals and curbs on cashing cheques.  These measures – alongside capital controls that prevent virtually any cash from leaving the island – are supposed to be temporary and last just seven days.  However, once lifted, panic is sure to ensue, as depositors scramble to protect their savings.

Cyprus’s banking system has already lost access to normal ECB operations, and is dependent upon emergency liquidity assistance (ELA) from its national central bank.  However, a shortage of unencumbered collateral – alongside the haircuts the national central bank applies – limits the availability of ELA, which may prove insufficient to fill the gap left by deposit flight.  As a result, further losses could well be imposed on uninsured depositors.

This means that measures are likely to prove anything but temporary, and remain in place far longer than currently envisaged.  This should serve as a warning to bank creditors in other eurozone states with ailing and oversized banking systems.  Depositors – both insured and uninsured – are sure to be increasingly nervous, and willing to withdraw their cash at the first hint of trouble, which means that banking crises are likely to develop far more quickly than previously.

Further, bank funding costs are likely to increase permanently for troubled banks.  The decline in margins and the resulting downward pressure on already-beleaguered profitability could well prove to be a key factor behind accelerated deposit flight.

It may be a small island, but the precedent set in Cyprus could have big consequences for many years to come.  Cypriot banking woes are a game-changer.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The Chinese property market is back in the spotlight, following the central government’s decision just days ago, to harden its three-year effort to put house prices in an affordable range for ordinary citizens.  The latest measures include higher down-payments and interest rates for buyers of second homes in cities with excessive price gains, and perhaps more importantly, a twenty per cent capital gains tax on homeowner profits on sale, as against one to two per cent on sales price previously.

The impact of the latest clampdown on property speculation was immediate, as publicly-quoted real estate developers endured a decline of more than nine per cent, the largest one-day decline since the summer of 2008.  The rest of the world barely paused for breath, as the major stock market averages in the US continued their assault on the all-time highs registered more than half a decade ago.  Is the complacency justified, or could the Middle Kingdom’s housing market be the elephant in the room that interrupts investors’ latest bout of exuberance?

It is important to note that household ownership is a relatively new phenomenon in modern China, and did not exist until 1998, when the government gave birth to a market-oriented housing market through the privatisation of the existing urban housing stock to current occupants at heavily discounted prices.  Previously, housing allocation in urban areas was determined by employers, primarily government institutions and state-owned enterprises.

The fledgling housing market was virtually certain to be vulnerable to excessive price rises given the peculiarities of the Middle Kingdom’s chosen growth path.  These include low real interest rates in the presence of high growth, a closed capital account, and an underdeveloped financial system that offers few investment options to a nation of high-savers.

It’s hardly surprising therefore, that central authorities have felt compelled, from time to time, to step in and temper outsized increases in house prices.  For example, the rapid ascent in urban house prices that began in 2003 and continued through 2007 prompted a serious of administrative measures and financial policies, designed to curb speculative demand.

Efforts to cool the property market proved successful, but renewed – and perhaps even dangerous – stimulus followed the outbreak of the ‘global financial crisis.’  The moderation in prices ended, as property development and consumer mortgage loans surged by roughly 40 and 50 per cent respectively in 2009, and year-on-year gains in house prices reached record levels during the first half of 2010.

Talk of a Chinese housing bubble filled the pages of the respected print media in the West, but the Middle Kingdom’ felt compelled to act for domestic reasons, as it became increasingly clear that speculative buying had driven asking prices well beyond the reach of ordinary citizens.

The measures that followed contributed to moderate price declines of about fifteen per cent across major urban areas, before the most recent ascent in values began following the easing of monetary policy – in the face of economic slowdown – last summer.  Most commentators believe that the authorities have averted a housing bust, and in their defence, the month-on-month increases in prices over the last nine months do not seem excessive.  Indeed, the year-on-year gain in the country’s largest cities turned positive only recently, and was still less than three per cent in February.

Further, a top-down perspective paints a similar picture.  It is beyond dispute that house prices look expensive relative to household incomes at roughly seven times, but China’s notorious cash economy means the actual figure could be far lower.  Additionally, rapid income gains have outpaced annual house price appreciation over the past ten years, which would appear to discount bubble concerns.

The final bullish point is leverage.  The average down-payment that Chinese banks require is roughly thirty per cent on a first home, and as much as sixty per cent on a second property.  Also, home equity loans are virtually non-existent.

Unfortunately, a bottom-up view leads to entirely different conclusions.  The substantial number of unused apartments in the major cities is plain for all to see, and the amount of unsold apartments, as measured by floor space, jumped forty per cent over the past eighteen months.

Herein is the true problem in the housing market.  Property developers are focussed primarily on the construction of luxury apartments that are purchased by the wealthy for potential capital appreciation with little consideration afforded to possible rental income.  Meanwhile, the stores of value for the highest-income brackets remain beyond the reach of the ordinary Chinese, who struggle to find appropriate accommodation, given the developers reluctance to build affordable housing.

Is there a bubble in China’s housing market?  The aggregate figures suggest not, but a micro-perspective suggests there are dangerous pockets of overvaluation in high-income segments.  Should the world be worried?  Time will tell.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

It should come as no surprise that the uber-bulls have found their voice, and forced their way back into the media spotlight.  After all, the major stock market averages continue their assault on the all-time nominal highs registered just as the financial crisis gathered momentum during the autumn of 2007.

Caution is now perceived as a dirty word and stock market bears have gone into hibernation, as bullish opinion is in vogue and virtually certain to capture the public’s imagination – and a sizable share of their hard-earned savings.  However, savers need to be aware that the positive commentary is often misguided – and occasionally downright dangerous.

The latest opinion piece to catch the eye was penned by James Glassman, who co-authored the infamous 1999 investment book, ‘Dow 36,000,’ in which he and the economist, Kevin Hassett, argued that the stock market index could reach the headline number within three to five years.

Unfortunately for the authors, the powerful bull market that began almost two decades earlier in the autumn of 1982, came to an end just months after the book’s publication, and the Dow Jones Industrial Average registered a percentage point decline of close to forty per cent over the 33 months that followed the equity index’s secular peak.

Stock prices resumed their upward trajectory over the next five years, but the financial crisis pushed the index down to 6,547 by the spring of 2009 – a level that was more than eighty per cent below the book’s catchy title.

Glassman remains undeterred however, and believes that the original forecast is within reach.  He writes, “From its low of 6,547 on March 9, 2009, the Dow has risen 117 per cent.  Another 117 per cent in four years would put it at 31,022, just 16 percentage points shy of the magic number.”

It is important to remember that Glassman’s original thesis was premised on the belief that, “investors had mistakenly judged the risk in stocks to be greater than it really was.”  The authors argued that the stock market deserved a higher valuation multiple, since the historical data demonstrated that, “over long periods, stocks were no more volatile, or risky than bonds.”

The basic idea is that time washes away all sins, and as a result, stocks are a safe asset for investors with sufficiently long investment horizons.  Known as time diversification, the contention rests on the use of the standard deviation of annualised returns as the appropriate risk measure, which as a matter of basic statistical fact, decreases as the time horizon increases.

The argument is totally misleading however, because it is the terminal portfolio value that matters to investors, and in this regard, it is the standard deviation of total returns that is the appropriate risk measure.  It may well be true that the standard deviation of annualised returns decreases in proportion to the square root of time, but the standard deviation of total returns does the opposite.  In other words, a 25-year investment is five times as risky as a one-year investment – the dispersion of potential terminal portfolio values grows ever larger as the time horizon increases.

The idea that stock market investments are safe in the long-run rests not only upon the standard deviation argument, but also upon the observation that the probability of loss decreases with time.  However, the problem with this line of reasoning is that losses of different magnitudes are treated the same.  Is a thirty per cent loss on a $1 million retirement fund in year-thirty really equivalent to a thirty per cent loss in year-one?

It is important to note that not only does the potential magnitude of losses increase with time, but so too does the risk of catastrophic losses.  For example, incurring a loss of forty per cent is ten times more likely after three years than it is after one year.  It is clear that the risk in stock investing is very real as the time horizon grows.

For those who remain unconvinced, then consider the words of Professor Zvi Bodie, “If it were true that stocks are less risky in the long-run, then the cost of insuring against earning less than the risk-free rate of interest should decline as the length of the investment horizon increases.  But the opposite is true.”

Stocks may still be safe for long-term investors if returns are mean-reverting.  Fortunately, there is substantial evidence to support this case and valuation multiples typically act as the pendulum.  In this regard, the verdict is against the uber-bulls and believers in Dow 36,000, as valuation indicators with statistically significant, predictive ability call for minimal investment in stocks right now.

It is a sign of the times that the champions of time diversification are back in the media spotlight, but investors should be aware that the advice could prove hazardous to their financial health.  The arguments were bogus when Dow 36,000 was published in 1999, and they remain bogus today.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

It is a low-return world, and even the Chairman of the Federal Reserve, Ben Bernanke, recently admitted that he, “takes very seriously…the possibility that very low interest rates” could prompt “portfolio managers dissatisfied with low returns” to “reach for yield.”  Unfortunately, such concern is already reality, as ultra-accommodative monetary policy has helped push the yields available on both ‘risk’ and ‘safe’ assets to levels that virtually assure lacklustre returns for a traditional 60:40 equity/bond policy mix over long horizons of ten years or more.

The less-than-inspiring outlook for long-term investment returns is a matter of simple arithmetic, yet much of the investment community continues to cling to the belief or hope that pension plan assets will ultimately deliver satisfactory outcomes for long-term savers.  There are few who dispute that ‘safe’ assets are likely to deliver sub-optimal returns over long horizons, but many – conditioned by the outsized investment performance of the 1980s and 1990s – continue to argue that the gains on ‘risk’ assets will make up the difference.  The ill-founded arguments are likely to prove wrong.

The fact of the matter is that the rewards generated from traditional asset allocations has been so good for so long that many have come to see high inflation-adjusted returns as some sort of birthright.  Both global equities and bonds have delivered annualised real returns in excess of six per cent over the past thirty years, but current valuations suggest expectations that extrapolate this trend for a traditional 60:40 mix into the future are nothing more than wishful thinking.

Real bond returns have been nothing short of breathtaking over the past three decades, but with twenty-twenty vision, that’s understandable given both the starting point and subsequent fundamentals.  Ten-year Treasuries offered a yield of more than fifteen per cent in the autumn of 1981, but the disinflationary monetary policy conducted by Paul Volcker during his time at the helm of the world’s leading central bank, saw the yield drop below nine per cent by the time he was replaced by Alan Greenspan six years later.

Monetary policy that prioritised opportunistic disinflation continued under Greenspan, and by the end of the 1990s, the yield available on the benchmark Treasury bond hovered around six per cent.  All told, Treasury bond investors earned annualised real returns of close to eight per cent during the 1980s and 1990s – the best two-decade performance in all of American financial history.

More was to follow of course, as the disinflationary trend gave way to deflation fears following the South-East Asian crisis in the late-1990s and the collapse of the stock market bubble at the turn of the New Millennium, but the biggest fillip to the realised returns on ‘safe’ assets came with the crisis in structured finance that stemmed from misguided lending in the sub-prime mortgage space.

Treasury yields continued their long journey downwards, and the inadequate recovery in the post-crisis economy ensured that yields remained close to all-time lows.  That remains true today, with the ten-year benchmark bond yielding less than two per cent, a level that does not compensate for long-term inflation expectations.  This virtually assures that – absent deflation – investors can expect to realise negative real returns in ‘safe’ US assets over the next ten years.

Traditional investors might turn to corporate credit to boost returns, but the story – adjusted for risk – is much the same.  The current spreads for lesser-quality corporate credit imply a real yield of just two per cent, and incorporating likely default rates and recoveries, suggests that investors can expect to earn even less.

The debt markets provide little optimism for high future returns, so all hope rests on the equity market.  Stock returns exceeded all expectations during the 1980s and 1990s, and though equity markets endured a torrid decade during the first ten years of the New Millennium, the major market averages still sport valuations that are well above long-term norms.

Indeed, the stock market’s current dividend yield in combination with long-term real growth suggests that investors should expect no more than three per cent per annum in real terms – less than half the historic average.  Of course, even this sub-optimal outcome does not take account of the well-known tendency for valuation ratios to mean revert, in which case the most likely annualised real return is closer to one or two per cent.

It is a low-return world, and traditional policy mixes are unlikely to deliver annualised real returns of more than one to two per cent over the next ten years.  The plain facts may well encourage return-chasing, but the astute will keep their powder dry – and remember the words of the late investment visionary, Peter Bernstein, “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Equity prices have vaulted to within touching distance of all-time highs, and the upturn in investors’ fortunes has pushed valuation ratios to levels that have preceded protracted periods of poor stock market performance in the past.  The widespread belief that stock market returns mean revert over long horizons means that it could well be possible to use the information contained in high valuation ratios to time the market, and capture the favorable combination of lower risk and higher returns.

An interesting paper authored by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School, and recently published in the ‘Credit Suisse Global Investment Returns Yearbook,’ casts doubt on this view.  The academics assess the predictive ability of a cyclically-adjusted price-dividend ratio – the ratio of the current real index level to the average of the preceding ten years’ real dividends – across a variety of world stock markets, and conclude that, “we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”

The choice of valuation metric appears reasonable, since dividend payments, unlike earnings, cannot be manipulated, and often reflect a company’s own view of its long-term earnings power.  However, there is no theoretical reason as to why a cyclically-adjusted dividend-price ratio should mean-revert, since the higher multiple might simply reflect substantive changes in the percentage of earnings that companies decide to pay to shareholders.

It is important to appreciate that stock market value is made up of both current dividends and expectations for future growth.  The pace at which dividends grow in the future depends on the percentage of earnings that a company distributes to its owners, and the rate at which retained earnings are reinvested in the business.  In other words, a low dividend yield might simply reflect a lower payout ratio, and higher expectations of future growth.

Historical data for the US demonstrates that the corporate sector’s payout ratio has been in secular decline for decades.  The ten-year average payout ratio dropped from a peak of almost ninety per cent in 1940, when expectations for future growth were virtually non-existent, to below forty per cent in 2007, when expectations for uninterrupted growth for the indefinite future held sway.  Long-term differences in payout policy means that it is impossible to identify a mean around which the cyclically-adjusted dividend-price ratio might oscillate.

Financial theory suggests that we should be able to observe a negative relationship between corporations’ payout ratios and subsequent growth rates in earnings and dividends.  In other words, higher growth rates would be expected to follow lower payout ratios and vice versa, but if this expectation is frustrated, then the dividend-price ratio might retain some predictive ability, as disappointing growth outcomes are reflected in lower share values.

The historical evidence in both the UK and the US reveals that low payout ratios have typically been followed by surprisingly low real growth rates over subsequent ten-year periods, and not the high rates of expansion that might have been expected at the outset.  This surprising outcome suggests that the corporate sector is either over-investing, or that  competitive markets quickly erode excess returns, or that low payout ratios reflect management’s intention to signal lower future growth to shareholders.

In light of the above, the dividend-price ratio does retain some predictive ability regarding future real returns, but it is still not possible to say what level is indicative of fair value.  As a result, it would be wise to replace the cyclically-adjusted dividend-price multiple with a valuation metric that rests on sounder theoretical footing.

In this regard, the Q-ratio, developed by the late Nobel laureate James Tobin in 1969, is a natural choice.  This metric measures the market value of equity relative to its replacement cost, and a fundamental relationship should exist between the market value and replacement cost; corporations should be valued at their cost of creation in the long-run, and as a result, the multiple should hover around unity given rational expectations.

The “law of one price” or “build-or-buy” arbitrage should ensure that the relationship holds over long horizons.  A ratio above unity implies that it is cheaper to invest in new capital rather than buy existing capital, while a figure below unity suggests the opposite.  The historical data confirms that the Q-ratio does indeed demonstrate mean-reverting properties, and importantly, the analysis reveals that the adjustment takes place through a change in real share prices rather than changes in the capital stock.  In other words, Tobin’s Q can be used to predict long-term real returns.

Unfortunately for equity investors, the current value of Tobin’s Q is almost forty per cent above its long-term mean – a level that has rarely been exceeded in the past.  The ratio’s elevated level, in tandem with its mean-reverting properties, does not mean a catastrophic decline is imminent, but it does suggest that disappointing real returns are virtually assured over long horizons.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The ‘dash for trash’ is on, as the near-record low yields available on safe assets has prompted investment professionals to move further out the risk spectrum in a desperate bid to earn nominal returns that satisfy client needs.  Cautious optimism persists among buy-side commentators, but actions speak louder than words, and market movements suggests investors are behaving quite differently than their rhetoric, as robust demand continues to outstrip supply and push the yields on lesser-quality bonds ever lower.  The resulting valuations confirm that a substantial part of the market for fixed income securities has entered the speculative phase of the credit market cycle.

It was all so different not so long ago, as the bullish complacency apparent at the height of the credit bubble, turned to all-embracing fear following the collapse of Lehman Bros.  The first tremors of what would soon become the worst financial crisis in seventy years erased the irrational exuberance evident in the prices of risky debt, but the failure of a major investment house proved lethal; the credit markets ceased to function, as forced selling – and the resulting illiquidity – pushed yields to unfathomable levels.

Extreme risk aversion prompted investors to flee the market for corporate credit en masse, which saw investment-grade bonds suffer double-digit losses in a matter of weeks.  The carnage in high-risk segments was far more punishing, as the spike in the yields of junk bonds to more than twenty per cent resulted in losses of some 45 per cent for their unfortunate holders.

All told, the default rates implied by the yields available on even the highest-quality credits moved to levels that were without modern precedent, and savvy investors could bank on equity-like returns with bond-like risk.  Of course, outsized rewards could be expected if, and only if, the Bernanke-led Fed’s unconventional monetary policies could unfreeze the markets, and return risk appetite to more normal levels.

Near-zero interest rates, in tandem with credit-easing policies proved successful, and the spread on lesser-quality credits versus default-free Treasuries dropped from a peak of more than six per cent at the end of 2008 to below three per cent just eight months later, as investors priced out an economic and financial apocalypse.  Fed policy ensured a quick return to ‘business-as-usual’ on Wall Street.

Corporate bond pricing may not seem excessive to many on first glance.  After all, the credit spreads on lesser-quality corporate bonds have made little progress in the past three years, hovering around three per cent for most of that time, while current spreads are more than one percentage point above the lows registered at the height of the credit bubble.  This observation has seen many buy-side commentators argue that the bull market has further to run.

However, vigorous demand for safe assets, in concert with aggressive central bank purchases, has pushed the yield on ten-year Treasury debt deep into negative territory, when adjusted for long-term inflation expectations implied by the yields available on Treasury inflation-protected securities (TIPS).  As a result, current spreads for lesser-quality corporate credit imply a real yield of just two per cent – a level of return that rewards investors for delaying consumption, but provides little to no compensation for default risk.

It is quite clear that risky corporate debt is dangerously overpriced, but identifying a trigger that changes the status quo is always difficult.  Nevertheless, the trigger could well be a peak in corporate profitability, which may not prove sufficient to derail the equity market, so long as aggregate earnings do not come in too far below expectations, but a wide dispersion of profit outcomes across the individual constituents that comprise stock market indices, could punish corporate bond investors.

To appreciate why, it is important to grasp the financial theory that explains the pricing of corporate credit.  The Nobel laureate, Robert Merton, increased our understanding of corporate debt pricing, when he applied contingent-claims analysis way back in 1974.  He argued that owning a corporate debt claim is analogous to owing a risk-free debt claim of the same maturity, and issuing an option to default to the company’s shareholders – an option to put the firm at the value of the risk-free claim.

The value of the put option is determined by total firm volatility – both firm-specific and market-related – unlike equity prices, which only incorporate the latter.  Thus, if firm-specific or idiosyncratic risk increases on the back of a wide dispersion of earnings outcomes among equity index constituents, the value of the put option will increase and benefit shareholders at the expense of bondholders.  In other words, if stock market volatility and firm value remain unchanged, wealth will simply be transferred from the holders of debt claims to the company’s shareholders.

The theory helps explain why the market for corporate debt typically leads the equity market at important turning points.  Indeed, credit spreads bottomed in the spring of 2007, or more than half a year before aggregate stock prices reached their apex.  A similar dynamic could well be in the offing today.

The Federal Reserve’s unconventional monetary policies may well underpin the excesses apparent in the pricing of lesser-quality corporate credit for now, but liquidity is a dubious concept at best, and can disappear in a heartbeat.  Stormy weather may not be far away.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Japanese asset prices have jumped onto investors’ radar screens of late; the return of the Liberal Democratic Party (LDP) to power late last year has sparked hopes that the new leadership might match their pre-election rhetoric with actions that help to bring years of economic stagnation to an end.

The Diet was dissolved last November, and the LDP, under Shinzo Abe, secured a landslide election victory four weeks later, as voters expressed their disillusionment with the Democratic Party of Japan and backed the LDP’s promises to wage a determined battle against deflation through aggressive monetary easing, alongside flexible fiscal management.

Mr Abe harangued the Bank of Japan (BOJ) during the election campaign, arguing that the monetary authority has been far too timid in its efforts to combat long-term deflation.  Further, he threatened to amend the 1998 Bank of Japan Act if the central bank does not soon accede to a two per cent inflation target, and after he assumed the post of Prime Minister, he taunted the monetary policymaker with the words, “There is no future for a country that abandons hope for growth.”

The need for bold action on both fiscal and monetary fronts is not difficult to understand in the context of an economy that has been in relative decline for more than two decades, and recently slipped into its fourth recession since 2000.  Real GDP growth averaged more than four per cent a year from 1974 to 1990, but has averaged barely half a per cent a year ever since, as the economy continues to languish in the aftermath of the bursting of a joint asset and credit bubble more than twenty years ago.

The damage inflicted upon private-sector balance sheets by the implosion of the bubble led to a pronounced and protracted deleveraging that saw private-sector savings surge relative to investment.  The resulting deflationary impulse has seen the GDP deflator drop almost 18 per cent from its 1994 peak, while nominal GDP is almost ten per cent below the peak registered during the fourth quarter of 1997.

The BOJ cut policy rates to near-zero by 1995, and shifted to a zero-interest-rate-policy (ZIRP) in the spring of 1999, which was followed by the adoption of a quantitative easing policy that persisted from 2001 to 2006.  However, the unconventional policy failed to prevent deflation from taking hold and the resulting strong demand for precautionary money balances ensured that the private-sector’s financial surplus persisted at high levels.

High private-sector savings relative to investment contributed to large fiscal deficits that have seen the public-sector debt ratio jump to close to 240 per cent of GDP, a level that is in a class of its own – even compared to the euro-zone’s troubled periphery.  Fortunately, the preference for low-risk assets in a deflationary environment ensured that the growing government debt could be financed by private-sector savings at a low interest cost.

Looking forward however, projections of future fiscal deficits and household savings rates as the population ages, suggests that it is only a matter of time before the Japanese is forced to tap foreign capital markets, which are far less likely to provide funding at today’s historically low rates.

An upturn in borrowing costs would have a large adverse impact on the financial sector’s health.  Indeed, the central bank estimates that a one percentage point increase in yields would wipe out roughly two years of banking sector profits.  Thus, the need to revitalise the Japanese economy is a matter of some urgency.

There is no doubt that the world’s third-largest economy is beset by many structural issues that need to be addressed if nominal economic growth is to be lifted to a level that will put the fiscal position on a more sustainable path.  Constructive government policies are required to raise real growth, but ending deflation is the purview of the central bank, and the time for credible action is now.

Sceptics will argue that increasing the inflation target to two per cent will have little durable impact, since the BOJ has already failed to meet its current target of one per cent.  However, the central bank has all too often been the architect of its own failings, and has snatched defeat from the jaws of victory on more than one occasion.

Indeed, Ben Bernanke, then a professor at Princeton, remarked as far back as 1999 that “Japanese monetary policy seems paralysed, with a paralysis that is largely self-induced.”  He noted “the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”

Little has changed in the intervening years, as the BOJ consistently argues that deflation is not the result of timid monetary policy, but stems from structural issues that have lowered the economy’s potential growth rate.  The central bank’s rhetoric has signalled to economic agents that it cannot defeat deflation alone, which has almost certainly reduced the potency of its unconventional policies.

Central bank credibility may well be restored under a change of leadership orchestrated by Mr Abe, but deflationary expectations are deeply engrained and the battle will not be easily won.  Nevertheless, monetary developments in Japan merit close attention in 2013.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The dawn of a new millennium marked the end of the secular bull market in stocks that began almost two decades earlier in the autumn of 1982.  The magnitude of the subsequent decline in equity prices forced investors – albeit reluctantly – to accept that returns had been more than excessive during the heady days of the dot.com boom.

The verdict that stemmed from investors’ soul-searching soon became clear – the high valuations afforded to stocks meant that they could no longer be depended upon to deliver stellar returns year after year, while the notable increase in correlations among existing classes of risk assets amid the turbulence, confirmed that the diversification benefits of traditional asset allocation models had been eroded.  Not surprisingly, the hunt for non-traditional assets began in earnest.

The search for alternatives coincided with an end to the two-decade long downturn in commodity indices, as supply/demand dynamics converged to push prices higher.  Years of under-investment in the infrastructure of several raw materials combined with the emergence of China as a major source of demand, which led many savvy analysts to conclude that commodities had entered the expansionary phase of a super cycle that could be expected to last for several years, and perhaps, even decades.

The super cycle hypothesis took some time to capture investors’ attention, as two decades of ‘false dawns’ saw investable cash deployed elsewhere, but the game changed following a number of high-profile reports from respected analysts in 2005, including Alan Heap at Citi, not to mention the best-selling book, “Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market,” which was penned by Jim Rogers, co-founder of the Quantum Fund with George Soros in the early-1970s.

Academic papers soon followed, and demonstrated that changes in commodity prices and stock market fluctuations demonstrated a strong negative correlation through time.  Inviting returns alongside the potential for significant diversification benefits proved hard to resist, and the sheer size of the funds that poured into the non-traditional asset class helped underpin the most pervasive commodities boom in modern history.  Indeed, the cyclical upturns of the early-1950s and early-1970s fall well short of the most recent boom in both magnitude and duration.

The global financial crisis and the steep economic downturn that followed brought an end to the seemingly irrepressible rise in commodities, with indices of metal and mineral prices declining by more than thirty per cent from the peak in 2008 to the trough in 2009.  However, the setback proved to be temporary, as the world’s emerging economies soon returned to a high-growth trajectory, and the resource-intensive nature of their growth brought the expansionary phase of the commodity super cycle back to life.

The revived bull market has sputtered of late, and investors are questioning whether the commodities space is still an attractive home for investment funds.  To provide a satisfactory answer to this query, investors need to know whether super cycles actually exist, and, if so, can the supply/demand dynamics be depended upon to justify investment.

More than three decades ago, Walt Whitman Rostow identified a commodity super cycle that is roughly fifty years in length, with expansionary phases extending from 1790 to 1815, 1848 to 1873, and 1896 to 1920.  More recently, John T. Cuddington and Daniel Jerrett employed more sophisticated econometric techniques in two separate papers, and provided evidence that supports the existence of super cycles for both crude oil and metals.

It is clear that commodity super cycles – spanning anywhere from twenty years in length to seventy years – do exist, but that alone, is not sufficient to support the case for investment in basic materials.  Do supply/demand conditions point to a continuation of the expansionary phase, or is it running out of steam?

The demand-side enthusiasts cite the rapid industrialisation and urbanisation of China as reason to remain bullish.  The Middle Kingdom’s economy has doubled in size in just seven years, and the resource-intensive nature of its growth means that it has accounted for more than eighty per cent of the increase in global demand for nearly all energy and metals products over the same period.

However, per capita consumption of energy and most metals is already well above the figures apparent in economies with comparable levels of GDP per capita, while the high investment share of GDP – at more than forty per cent for a decade – calls for a rebalancing of the economy.  Consensus estimates look for economic growth of seven to eight per cent a year in the decade ahead, but simple arithmetic suggests that a successful rebalancing of the economy towards consumption would lead to a growth figure closer to five per cent.

The demand-side case is weakening, but the bulls believe that supply-side constraints will continue to support prices.  It is important to note that two decades of declining prices meant that producers did not commit to new investment projects until they could be sure that the price increases were permanent and not just one more false dawn.  Obviously, after ten years of rising prices, such caution is no longer evident.

The expansionary phase of the commodity super cycle is running out of steam, while investment flows have eroded the diversification benefits.  The motivation for commodity investment is questionable.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Stock prices moved sharply higher during the summer months, as investors speculated that further central bank action might just return the economies of the industrialised world to a more familiar growth-setting in the not too distant future.  The world’s leading monetary policymakers from the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve, duly delivered on cue, but the notion that the latest round of unconventional measures will do anything more than maintain economic growth not too far below trend, is misguided and virtually certain to disappoint.

Investors continue to cling to their misguided beliefs, even though almost four years of ultra-accommodative monetary policies have already failed to deliver anything like a typical economic recovery in the developed world, and the lacklustre activity in the US has prompted the Federal Reserve to commit to a near-zero interest rate policy through mid-2015 – nearly a full seven years after the global financial crisis reached its climax during the latter months of 2008.

Real economic activity remains below its pre-recession peak throughout most of the developed world despite the extraordinary monetary stimulus provided in recent years, and the reason is clear.  Monetary policy loses its potency in the face of a deep and protracted deleveraging; it can do little but soften the blow, and buy time until balance sheets have been repaired, such that credit expansion can proceed anew.

Milton Friedman, the Nobel Prize-winning monetary economist, warned the American Economic Association, in his 1968 Presidential address, not to expect too much of monetary policy.  Investors need to wake-up and appreciate that the late-economist’s words of caution are particularly true of the developed world today, where most economies are caught in a liquidity trap.

A liquidity trap occurs when the implosion of a joint asset and credit bubble severely harms private sector balance sheets, and leads to a pronounced and prolonged deleveraging that renders conventional monetary policy ineffective.  To quote the late American President, Dwight D. Eisenhower, “Pull the string and it will follow you everywhere. Push it, and it will go nowhere at all.”

Central banks may reduce policy rates to zero, attempt to engineer higher inflation expectations that lead to negative real rates, and manipulate asset prices through quantitative easing measures, but the impact on growth will remain muted, so long as the private sector’s borrowing capacity remains impaired.

The inability to stimulate domestic demand may prompt the monetary authority to resort to the last policy tool – the exchange rate – and attempt to engineer a currency depreciation that prompts a sufficient increase in exports vis-à-vis imports that offsets the weakness in domestic demand arising from the desired increase in private-sector savings relative to investment.  However, a competitive devaluation’s ability to replace demand lost to deleveraging depends not only upon the size of an economy’s exports and imports relative to GDP, but also upon the strength of import demand among its trading partners.

The economic reality suggests that the export sector is not sufficiently large across the majority of industrialised countries to make a meaningful difference, while the dependence of many economies upon the consumer means that higher import costs could depress domestic demand even further.  More importantly, most of the developed world is caught in a liquidity trap, which means that ‘beggar-thy-neighbour’ policies are simply not an option.

With no more tools in the central banker’s toolbox, governments have little option but to run large fiscal deficits and fill the demand gap – even though public-sector debt ratios have already climbed to levels that have been shown empirically to retard growth.  In this regard, central banks need to compromise their hard-won independence by allowing monetary policy to become subservient to fiscal policy in an effort to get the industrialised world growing again.

Financial markets have become used to the tactics employed by the most credible central banks in their efforts to dictate fiscal policy and defeat the inflation demon through the 1980s and 1990s.  Indeed, former Fed Chairman, Paul Volcker, forced President Ronald Reagan’s hand by setting real interest rates above the economy’s real growth rate, which put the fiscal position on an unsustainable path.  The battle was won by the central banker, which underlined the Federal Reserve’s independence as we know it today.

Investors need to appreciate however, that changed circumstances call for different rules.  In the presence of a liquidity trap and the resulting deflation risk, central banks need to set interest rates well below the economy’s growth rate in order to keep public-sector debt ratios in check, while governments exploit the favourable borrowing costs and engage in well-planned fiscal stimulus.

Investors continue to look to central banks for solutions to the developed world’s economic travails, but most of the developed world is caught in a liquidity trap, which has rendered monetary policy ineffective.  Premature fiscal austerity will only prolong the economic misery.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.