With so much going on at the moment and so many themes fighting to claim the main market discourse, I am in the mood for some random shots. First of all and to my continuing regret I have never actually got to thank Niels C. Jensen from Absolute Return Partners for the nice coverage I got way back in October 09 when Mr. Jensen discussed my thoughts on demographics and the life cycle.
So, let me repay by pointing towards Jensen’s recent two monthlies which form the basis for this round of random shots. Both are very much worth reading and in some sense they go together to form a common narrative, but especially the second one where Niels is blowing echo bubbles is mandatory reading I think. The themes taken up by Niels are well known and so is the underlying narrative, but this does not mean that it is not worth repeating; I will Niels set the scene;
In last month’s letter I looked at the challenges confronting the world’s baby boomers based on the assumption that we are in a structural equity bear market, which implies below average returns for equity investors for several more years to come. Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.
Please note that this forecast is predicated on a 5-10 year time horizon. Within a structural bear market – which is characterised by falling P/E ratios – it is certainly possible to have cyclical bull markets, so it is by no means one-way traffic. As you can see from chart 1, since the 1982-2000 structural bull market came to and end, we have enjoyed two powerful cyclical bull markets; however, global equity prices remain at 2000-levels.
However, this is not the same as saying that it will always be a losing proposition to invest in equities. Equities can, in fact, do quite well for long periods of time despite the negative undercurrent. This is what the perma-bears do not understand. They assume that structural bear markets equal negative returns and that is not necessarily the case.
Thus and to clarify, what is referred to here as an echo bubble is the rally we have seen since March 2009 and thus evidence that while structurally, deleveraging and low trend growth will be the main driving force, that does not mean that equities cannot and will not perform extraordinarily well for long passages of time. I mean, who wouldn’t wish that they bought with everything they got back in March (I know I myself feel a bit peeved over not piling in).The broader issue of course is that while smart money may very well learn to navigate such an environment the smart dumb money (i.e. those who buy and holds the market) may realize that the reward from such a strategy may turn out to be less than splendid. And since this is basically a proxy for the return on savings, it means that permanent income will fall which means that consumers will need to save relatively more to compensate, and then we get the problem of a lack of consumption and aggregate demand and … on and on we go!
On this, I agree that deflationary v inflationary forces will feature a tug-of-war for many years to come and, like Niels, I tend to favor the former. However, when pointing to Japan as an example of how continuous attempts have failed to spur inflation (and is still failing) I do think it is important to qualify that this goes strictly for domestic inflation. In this sense, what has become known as the Yen carry trade (and recently USD carry trade perhaps?) is merely a proxy for much broader and structural tendency which signifies how central banks have lost control over where the liquidity they provide is applied. This goes in both direction. In Japan, the liquidity create slips through the back door and ends up e.g. in Brazil or New Zealand who, in order to combat domestic inflation, are busy increasing interest rates only to that it sucks in more liquidity (or, if you will, purchasing power).
Clearly, with US rates stuck at near zero this provides a huge push for global liquidity and even though I think that the US (and the UK) will eventually succeed in getting inflation (and quite possibly, a lot of it), the fact that these economies may withdraw liquidity slower rather than faster represents strong sheet anchor for excess global liquidity and thus although we may be in a structural bear market, it is also a market with a high level of volatility.
This leads me to the following three themes I am following at the moment inspired not only by Niels’ thoughts but also by the recent themes laid out in Variant Perceptions monthly (which is sadly not available online).
1. I accept the idea of a structural bear market but interpret it as investment lingo I guess for broader macro reality that we are now in a situation where we need to delever and that will be deflationary in domestic OECD economies (i.e. this is German austerity writ large). This, I would assume, is tightly connected to lower trend growth. In this sense, demographics (which I tend to focus on) and the defacto excess leverage (regardless of underlying capacity) serve as a ball and chain and it represents a structural break both in terms of behaviour by part of economic agents but also in terms economic growth.
2. Higher volatility. Why? Because just as Japan may fail in creating domestic inflation and just as the US/UK may find it hard to create domestic inflation (although at some point they will, for sure!) they may all create inflation and bubbles elsewhere. Please do read this again if you did not have the chance.
I guess it goes back to the premise that while we may in a situation where growth and equity returns (beta!) are sluggish, we will still see bull markets that lasts (well the current one is running on a year now no?) and more importantly; there will be economies who are able to suck up excess liquidity but they are outnumbered by economies with a desire of excess (external savings) and this is what leads to volatility in asset markets and the real economy.
3. Who is running the deficits? This is an old time hobby horse of mine, but still one which is extraordinarily important. In short; where will bubbles form and why? Emerging markets seem certain. But more importantly and using demographics as a yardstick the equilibrium is changing. Thus, we are all ageing, so we are all moving towards the same “preferences” for a high level of desired external savings as well as more and more economies will struggle with domestic deflation. How this ends is still an open question and it is also the straight line my theoretical work draws into the real world.
Lastly, and now moving with some truly random shots, I think Niels has some interesting points on investors and commodities and how these markets are not really suited for the kind of activity they are seeing. This is of course a direct effect of all those who really think that we are heading to hell in an express elevator and that the fiat system is collapsing etc. You all know the story I guess. Yet, after having looked recently at Chile and thus copper, I am sure that here is a metal which looks very, very bubble prone! Finally, Niels touches on China and the fact, as we have talked about, that as China moves into a trade deficit would a freer Yuan actually appreciate? Or would it in fact depreciate? Well, we will see soon enough I guess since it turns out that Niels was right here. Consequently, news has just come in off the wire that China posted its first trade deficit in six years in March as the trade print came in at a $7.24 billion deficit. Q1-10 is still a surplus but is this the first signs of true and real rebalancing? Well, color me (very) skeptical here that China will be pulling the global economy anywhere through a trade deficit that is not based e.g. on stockpiling of base metals and other commodities, but the ball is in my court as a skeptic with these latest numbers I fully accept this.