Blogs from Our Experts | January 27, 2017
We want to start by explaining our central tenet behind the macro view of the world. It rests on determining the net leveraging force. What do we mean by net leveraging force? The world always faces two kinds of force at any point of time i.e. re-leveraging and de-leveraging force. As the name implies re-leveraging force is positive and good for financial assets while de-leveraging force is negative and typically bad for financial assets. Some examples of re-leveraging forces are reduction in interest rates, increase in capital investment, fiscal stimulus and relaxation in credit availability. Conversely, examples of de-leveraging forces are increase in interest rates, unavailability of capital investment, fiscal tightening and reduction in credit availability.
In physics parlance, net leveraging force is determined by the sum of re-leveraging and de-leveraging force. And as we have studied in physics, both the direction and magnitude of the net leveraging force matter. If the net leveraging force is positive, financial assets typically will do better. The magnitude of the force determines how well the assets will do or not. As in physics, where there is force, there is momentum and determining the change in momentum when force changes direction is critical. In our experience, it is easier to determine the direction and magnitude of net leveraging force once it has taken hold but much harder to determine it at inflection points or during periods of slow changes. The difficulty in the process leads to mis-timing of trades and mis-allocation to different asset classes.
When the financial crisis hit in late 2008, almost everybody realized that we had a problem. But unfortunately, most people including the experts did not understand the magnitude and hence the crash. Only when an overwhelming amount of re-leveraging force was unleashed by the Federal Reserve in form of QE, did the direction of leveraging force change to positive. As asset prices started to recover and culpability of banks started to set in, the Western governments along with various banking authorities also unleashed a de-leveraging force by requiring the banks to increase capital requirements and adhere to punitive regulations. The net leveraging force from the QE and banking reset was still overwhelmingly positive and asset prices recovered by end of 2012. In 2013, with the first whiff of monetary tightening when Bernanke hinted at stoppage of QE and normalization of interest rates, it took very little time for the net leveraging force to turn negative. The resulting financial market tantrum was quickly forgotten as both Europe and Japan stepped in with a combined QE larger than that done by the Federal Reserve. Along with the Federal Reserve, the magnitude of re-leveraging force after 2013 as it turns out to be double of what was employed right after the financial crisis leading to a phenomenal return in most assets. Anytime we prognosticated that the net leveraging force was about to change, we were proven wrong by the central banks who doubled down on their willingness to do more. And therein lies the problem.
But something is afoot now. Despite weak economic numbers, even the staunchest of the Federal Reserve doves have started to raise the specter of raising interest rates. They have ruled out negative interest rates as being useful. The ECB in its press conference last week refused to say anything about their willingness to continue QE after early 2017. Negative rates have brought the European banks to their knees. Japan has given up any pretense of even knowing what they are up against in their homeland. The negative interest rate that was introduced with such fanfare has resulted in Yen giving up all the QE inspired depreciation in last 3 years. Not to mention that both Europe and Japan have no bonds left to buy and in case of Japan, Kuroda has resorted to buying stocks in large amount. Even the central banks on the periphery such as Swiss are seen buying stocks all over the world as a result of their currency intervention.
So what are we saying? The magnitude of re-leveraging force is about to drop drastically if the central banks are going to stick to the script for once. This is definitely going to stop the ascent of financial assets turning into a full-fledged risk event. The damage is going to depend on the drop in magnitude of the re-leveraging force. If it drops a lot, it will turn net leveraging force negative and all hell will break lose for financial assets. Anecdotally, there are few other red flags. We are also about to enter the time of the year most associated with financial crashes. 2015 was the year of peak M&A activity and the previous peaks were seen in 1999 and 2007, just a year before things started to unravel. Japanese government bond market (in USD terms) has returned close to 40% before this year which is unheard of for any government bond. Even in India, microcap funds have provided stellar return in dollar terms over the last 3 years by buying "super speculative microcap" and price insensitive buyers such as Swiss Central Bank have pumped the stock market by routinely buying large cap stocks.
What can prevent this from happening? As the saying goes, once bitten twice shy. It might happen that the 40 odd unelected and unaccountable officials of the central banks of US, Europe and Japan may not keep their word. They can turn on a dime and we can find ourselves facing an even larger QE. Also, there is a reasonable probability that the western governments will employ some form of fiscal stimulus especially if the sentiment and markets deteriorate a lot by the end of the year. The effects of such stimulus will definitely be positive for the beaten down commodity plays but the effect on other asset classes are less clear. Another reason to think about stock markets such as S&P500 is that a dominant 65% of market capitalization is in technology, consumer and health care stocks. These have been the driver of markets in recent times. So in essence a drop in markets will be meaningful only if something happens for investors to lose confidence in these 3 sectors.
Given below is the various asset returns over last 3 years adjusted in dollars. There are a few interesting observations and our broad recommendation for different asset classes:
India is the best performing asset in the last 3 years. Modi can take heart. We believe that short term headwinds notwithstanding, India will continue to outperform if Modi continues to snuff out the parallel economy. A portion of the parallel economy will move into mainstream and buoy the economic numbers. This will maintain foreign investor interest.
It is hard to beat a good broad stock market index. Using S&P500 as an example, over last 3 years, only 3 sectors – technology, pharmaceuticals and utilities – have beaten S&P500. Every other sector has lagged. It is also not worthwhile to be in fancy corners of stock market such as growth, value, small cap, large cap etc. The returns are simply not there to justify higher fees. Consumer stock has been the bedrock of stable returns as globalization benefits have accrued to them in large measure. Our recommendation would be to exercise caution on equities for the remainder of the year. If central banks back off, then come back.
Exposure to fixed income must be shortened in duration as longer bonds may suffer in two scenarios. If central banks stop QE, yield grab will end and the incessant buying pressure on long end will cease. If central banks raise rates, contrary to historical moves, the yield curve may steepen. This can happen as lack of bank leverage will ensure that historical bets such as selling higher notional quantities of front end against long end will be unavailable as it has been in prior times. Capital losses due to duration in long end will be amplified, as a result leading to selling of long end.
Fixed income is in a very precarious state, especially in developed countries. Yields are non-existent. By these standards, India stands as an exception in nominal terms but not in real terms. If you are a rupee bull, it still makes sense to be long fixed income.
We recommend buying into commodities, especially if there is a meaningful correction. Even though commodities may undergo some pain, they are fortunately in a sweet spot. Commodities have not been the beneficiaries of easy money as the China commodities super cycle bust forced them to face fierce de-leveraging force over the last 3 years. Commodity producers as a result, are already well underway in reducing supply, digging deeper into the cost curve and tackling debt. Additionally, they will be the biggest beneficiaries of any fiscal stimulus that may be employed by the western world.
Commodities offer the best risk option in our mind. However, one should buy a well-diversified portfolio of such assets. Zinc has been the best performing commodity. One reason for this is the fact that zinc is still not a dominant asset for major miners as it is not widely available in the natural resource capitals of the world. Major metals such as copper and iron ore have taken a beating and are fairly priced now. Energy has also taken a beating and will continue to get battered as the world conjures new forms of energy. The best way to be long energy is via energy producers as they are masters of productivity gains with cost per barrel of oil falling below $10 for majors. The drop in grain prices has been quite astounding. The carnage is due to abundant supply from better-than-expected crop yields. We would expect it to recover over time.
In currencies, Rupee has done well in last 3 years but its performance has to be put in context of last decade. If one accounts for interest rate differential and capital appreciation, Rupee is on par with the US Dollar. And so are a lot of other currencies. If there is any outflow from Indian markets over next few months as a result of FII rebalancing or maturing of excess FCNR deposits made during the Rupee devaluation, the currency may come under pressure. But again, one should be a buyer in longer term.