Two Views on the New Year from Across the Pond
John Mauldin
In today’s Outside the Box we’ll continue with our traditional New Year’s forecasting theme, but we’ll look to a couple of European voices – or I guess, especially considering the Brexit vote, I should just call them English voices.
Ambrose Evans-Pritchard, writing in the London Telegraph, see a rather less optimistic 2017 than the one I’m hoping for, but we have to acknowledge that he may be correct. His title pretty much says it all: “Trump, interest rates and Chinese panic: Why euphoria could turn to a credit crunch in 2017”; and his view back across the pond at us has him seriously squinting:
Donald Trump's reflation rally will short-circuit. Rising borrowing costs will blow fuses across the world before fiscal stimulus arrives, if it in fact arrives.
By the end of 2017 it will be clear that nothing has changed for the better. Powerful deflationary forces retain an invisible grip over the global economy. Bond yields will ratchet up further and then come clattering down again – ultimately driving 10-year US yields below zero before the decade is over.
There are few ‘shovel ready’ projects for Trump’s infrastructure blitz. The headline figures are imaginary. His plan will be whittled down by Congress.
And he goes on. Without attempting to issue any sort of a corrective to his pessimism about our chances this year – we are, after all trying hard to stay outside the box in this letter – I’ll just move on to introduce you (and to re-introduce most of you) to our second… Continental voice, my good friend Niels Jensen of Absolute Return Partners in London. (Note: Niels was born in Denmark but has been in London in the money business for 25 years and is one of the most astute observers of markets that I know.)
Niels isn’t particularly sanguine about 2017, either – you’d have to be a pretty foolish investor to be comfortable with the coming year – but he does lead off with what he variously terms “a flicker of good news,” “a glimmer of hope,” and “a twinkle of optimism.” Take your pick. What it amounts to is that it appears the post-Great Recession collapse of “discorrelation” among risk assets that has so plagued us all is finally appearing to reverse! He points as evidence to a precipitous fall over the past six months in the correlation between the S&P Index and S&P sectors. Here, let me pluck a chart out of his piece and show you:
Nice, huh? And now back to the future bad news. You’ll find quite a bit of overlap between Ambrose’s and Niels’s worries for 2017, but also some intriguing differences. So now, let me get out of their way and let them give the New Year their best shot. And I remain convinced that, however things develop in our political and economic spheres, we can all achieve some personal bests in 2017.
You have a great week, and in a few days I’ll send my own 2017 forecast.
Your hopeful but watchful analyst,
John Mauldin, Editor
Outside the Box
Trump, Interest Rates and Chinese Panic: Why Euphoria Could Turn to a Credit Crunch in 2017
By Ambrose Evans-Pritchard
The Trump effect is to accelerate capital outflows
from China, increasing the risk of a painful reckoning this year.
Donald Trump's reflation rally will short-circuit.
Rising borrowing costs will blow fuses across the world before fiscal stimulus
arrives, if it in fact arrives.
By the end of 2017 it will be clear that nothing
has changed for the better. Powerful deflationary forces retain an invisible
grip over the global economy. Bond yields will ratchet up further and then come
clattering down again – ultimately driving 10-year US yields below zero
before the decade is over.
There are few ‘shovel ready’ projects for Trump’s
infrastructure blitz. The headline figures are imaginary. His plan will be
whittled down by Congress.
The House will pass tax cuts for the rich but
these are regressive, with a low fiscal multiplier. The choice of an
anti-deficit Ayatollah to head the budget office implies swingeing cuts to
federal spending. These will hit the poor, with a high multiplier.
This Gatsby mix is mostly self-defeating in
economic terms. To the extent that there is any extra juice, it will be
countered by the Fed at this late stage of the cycle. Tight money will push the
dollar higher.
Once markets accept that Trump is not bluffing –
that he really does intend to smash globalism – euphoria will give way to
alarm. For now Wall Street remains drunk on wishful thinking. The
longer the delusion lasts, the stronger the dollar, and the greater the trouble
in Asia and Latin America.
The broad dollar index threatens to reach all
time-highs in 2017, hammering vulnerable regions of the world. Credit: St Louis
Federal Reserve
Such is the currency paradox. As the Fed’s
broad dollar index pushes towards an all-time high of 130, the mechanical
effects will expose the Achilles Heel of an international system that has never
been more dollarized – and never been more sensitive to US interest rates since
the end of the Bretton Woods era.
King dollar will tighten the noose on emerging
market debtors with $3.5 trillion of liabilities in US currency. It will force
banks in Europe – through complex hedging contracts – to curtail offshore
lending to the Pacific Rim, Turkey, Russia, Brazil, and South Africa. It
will lead to a credit crunch in the developing world.
China moves to a different rhythm but it cannot
hide from higher US rates. The imported squeeze will come just as the
latest 18-month boomlet rolls over, a form of pro-cyclical tightening on a Chinese
economy that has already reached credit exhaustion.
It is whispered – and always denied – that the US
agreed last February in Shanghai to delay rate rises, buying time for the
People's Bank to calm the yuan panic. The Fed retreat worked like a charm.
Markets did indeed stop worrying about China. Global bourses rebounded.
Next time – and it is coming soon – there will be
no such accord. The Trumpians want China to blow up, thinking they can handle
the blow-back. They can't.
Draconian controls by the People's Bank will not
be enough to stem capital flight.
Nor will reserve losses blowing
past $100bn a month in January. The nuclear risk through 2017 is that
Beijing's ‘weak yuan’ mandarins will prevail. If they let the exchange rate go
completely, the Asian currency storm that must inevitably follow will unleash a
deflationary tsunami through the world. I think China will hold the line, but
don't bet on it.
China's slowdown will kill the commodity rally
stone dead. Saudi Arabia and Russia will find that output cuts agreed in Vienna
are not enough to clear the oil glut this year, pushing off the
desperately-awaited rebalancing into the distant future. Neither country can
handle the implications of this. Riyadh will buckle before Moscow.
My New Year’s piece last year spoke of sunlit
uplands: “The economic sweet spot of 2016 before the reflation
storm." I hoped the treacherous moment could be deferred until 2017.
Unfortunately we are now almost there.
The tailwinds of global recovery are fading
whatever equities purport to tell us. JP Morgan's 'Nowcast' measure of world
growth was been slipping quietly for the last six weeks and is now down to an
anemic 2.6pc, even before the China's credit curbs kick in and the Asian
slowdown becomes obvious.
We have already enjoyed the $2 trillion consumer
windfall of cheaper oil. Europe has already enjoyed austerity relief. The
European Central Bank has already played its cards. On a flow basis the ECB
will soon be tapering, and therefore tightening.
Yields on Italian debt will climb well above the
growth rate of nominal GDP – the fatal threshold – as markets anticipate the
loss of the ECB shield. This means attrition on €400bn of sovereign paper held
by banks, eroding capital buffers. Rome’s €20bn fund for bank rescues will run
dry within months, and the political costs of a second bail-out will be much
higher.
It will become clear again that Euroland has
resolved nothing. The fatal pathologies – lack of fiscal union, lack of a
banking union beyond the name, the one-side adjustment imposed on the South,
Germany’s unpunished current account surplus – have merely been veiled by
QE and the Draghi Put.
None of the elections in Holland, France, or Italy
will bring an anti-euro government to power, but they will come close enough to
rattle nerves and drive the euro below dollar parity.
The parliamentary balance of power will shift,
greatly weakening the ideological lockhold of the Maastricht elites and free
movement purists. Alternative fur Deutschland will make it into the Bundestag. The
centre-Right will harden everywhere to stop leakage to the populist fronts.
Brexit Britain will no longer stick out in quite
the same way. It may even start to look like a liberal haven set against
Europe’s unanswered rage, and this will change the narrative. The threads will
become confused, the pieties of Remain less certain, the Scottish temptation a
little less alluring.
The UK economy will not perform any better than
the eurozone in 2017, but it will not do any worse either, and those who talk
of ‘punishing’ Britain in EU capitals will discover the asymmetry of political
risk. The British can perhaps fall back on the Dunkirk spirit. Brussels can
fall back on nothing.
The next global downturn will come before the G4
central banks have been able to replenish their ammunition, while the bar
on New Deals or budgetary largesse is dauntingly high. World debt ratios
are already 35 percentage points of GDP higher today than they were at the top
of the last cycle in 2008. Emerging markets cannot come to the rescue as the
did after the Lehman crash. They too are now mortgaged, and psychologically
battered.
As polities fray, those nation states with an
organic cultural unity and strong allegiance to sovereign institutions will
fare best. Utopian constructions and brittle dictatorships have less margin.
Will we make it through 2017 before the reckoning
hits? Probably, by the skin of our teeth.
Happy New Year.
Hiccup of the Year?
By Niels Jensen,
“What the New Year brings to you will depend a
great deal on what you bring to the New Year.”
– Vern McLellan
The most outrageous predictions of 2017
Saxo Bank of Denmark (a bank I hold no grudges
against, so don’t assume I am on a mission here) have in recent years been high
on entertainment value when publishing their now (in)famous list of Outrageous Predictions for the
year to come, some of which are highly controversial. The 2017 list, which you
can find here, contains the usual mix of more plausible predictions
combined with some truly outrageous ones. Amongst their 2017 predictions, I
find the following particularly thought-provoking:
1. The high yield default
rate exceeds 25%.
2. Brexit never happens as
the UK Bremains.
3. Italian banks are the
best performing equity asset.
I am not
into making outrageous predictions myself but, if I were, and given
the fact that I have a rather wicked sense of humour, my outrageous prediction
# 1 for 2017 would probably be for either David Cameron or Hilary Clinton to
participate in the 2017 edition of BBC’s flagship entertainment show Strictly Come Dancing.
As Ed
Balls just learned, that particular show provides an excellent platform to
resurrect a fading political career (he probably got more votes for his dancing
skills than he did in the last parliamentary elections, but that is an
altogether different story). Having said that, only last month did I promise
not to make fun of politicians anymore, so let’s drop the ball right there.
Even if 2017 is not likely to be particularly high
on entertainment value, it could certainly be high on drama, which makes this
Absolute Return Letter particularly challenging. As you may recall from
previous years, the January letter is always about the mine field laid out in
front of us. What could cause 2017 to be a year to remember? What could
possibly go horribly wrong? At this point in time, I see many potential
problems. I have some concerns about the US. I see dark clouds gathering over
Europe, and I see very slippery conditions in many emerging markets (‘EM’). In
other words, lots of markets around the world appear to be accident prone but
for very different reasons, which I shall get back to in a momento.
A flicker of good news
However, before I go there, let me share with you
a glimmer of hope; a twinkle of optimism that you don’t find too often in the
Absolute Return Letter. Not that I am a born pessimist – actually far from it.
I just learned many moons ago that, when it comes to investing, good news is
the last thing you should spend your energy and resources on. The secret to
being a good investor is to focus on risk management and to be well prepared
for bad news.
Long term readers of the Absolute Return Letter
will know that I have always been of the opinion that we have never properly
exited the global financial crisis (the ‘GFC’) of 2007-08. One of the
conditions I have used to make my point is the high correlation between risk
assets, and how life as an investment manager has become complicated as a
result of that.
Prior to the GFC, you could fairly safely assume
that diversification across a number of risk assets would dramatically reduce
the overall volatility risk, but not anymore. The GFC changed how risk assets
correlate with each other (chart 1), and when the correlation between risk
assets approaches one, diversification does little to reduce the overall
volatility risk.
Now the good news – it looks as if the correlation
between risk assets – or at least between different types of equity risk – is
finally coming down (chart 2). As you can see, the correlation between the
S&P 500 and the average equity sector has fallen quite dramatically over
the last six months. This is not the only dynamic that needs to change for me
to become more optimistic, but it is an important one.
Expect me to dig deeper
on this topic at some point in 2017.
Growing nationalism
As we enter 2017, what should we worry most about?
One factor appears to be standing out head and shoulders above everything else,
and that is what is usually classified as growing nationalism. It forced the UK
out of the EU, and it got Trump elected in the US, but I am not even convinced
that the true driver is just growing nationalism.
As you may recall, national income is ultimately
shared between capital and labour, and I think capital has belittled labour for
too long by taking an ever larger share of national income. Frustrated by the
stagnation in living standards, the man on the street wants something to change. The
decision to vote for Brexit (or Trump) was a plea for change, as much as it was
a sign of growing nationalism. When your own living standards are under
pressure, the last thing you want is an army of immigrants to come in and put
you under even more pressure.
Stagnating economic growth and low – or even
negative – real wage growth has created a deep level of dissatisfaction that
the electorate chose to use politically, and the Brexiters (and Trump) took
advantage in spades.
For the first time in 150 years, the average Brit
is now facing falling real wages (chart 3). That the low or negative growth in
wages is driven by entirely different factors and have nothing whatsoever to do
with Brussels is being conveniently ignored.
Meanwhile, the political leadership in the UK is
facing a very tricky year, with the real opposition to the ruling Conservative
Party coming not from the Labour Party but from inside its own ranks. The
Brexiters want Theresa May to act now,
even if all logic would suggest that the country may be better off counting to
10 before any moves are made.
As 2017 progresses, we face important elections in
the Netherlands, Germany and France. The Dutch will kick it all off on the 15th
March with the extreme right-wing leader of the Freedom Party, Geert Wilders,
currently in pole position. On the 23rd April, the French will be asked to
choose their next president. If no outright winner is found in the first round,
a run-off between the top two will be held on the 7th May. German general
elections will follow in the autumn. The date hasn’t been set yet, but German
law prescribes the 2017 elections to take place in either September or October.
Radical forces in all three countries are on the
roll and, given what happened in the UK and the US last year, and what happened
in Berlin just before Christmas, nothing should be taken for granted.
As far as nationalism is concerned, we are also
about to learn whether Trump walks like he talks, and we are saddled with a
certain Mr. Putin in Russia, who clearly knows how to take advantage of rising
nationalistic sentiment. All in all, 2017 could shape up to be a most
interesting year.
The (over)valuation of US equities
That said, growing nationalism and the
implications of negative real wage growth are by no means the only things we
should worry about as we enter 2017. In the US, equities are very expensive irrespective of
how they are valued (charts 4 a-b). Investors have ignored fundamentals in
recent years and instead focused on the liquidity provided by the Fed through
QE and other means of monetary policy.
This has created equity valuations in the US that
almost certainly will come back and bite investors in the derriere at some
point. The only question is whether it is going to happen this year or ...?
Take chart 4a (price/EBITDA). When acquisitions
are made, most companies are acquired at valuations well below 10x EBITDA. If
the average company in the S&P 500 now trades at 11x EBITDA, interesting
M&A deals are likely to be few and far between. Companies on the
acquisition trail simply cannot justify to pay 12x, 13x or even 14x EBITDA for
their acquisition target, removing an important pillar for higher equity
prices.
Chart 4a also confirms a point I have made in
previous Absolute Return Letters, i.e. that US equities are very expensive on a cash
earnings (EBITDA) basis. Many US companies ‘mislead’ investors by reporting
solid EPS numbers (by buying back their own shares), but chart 4a tells a very
different story.
Europe’s colourful menu of challenges
Let’s return to Europe for a minute or two, as
there is an entire menu of potential problems to choose from. The
constitutional crisis in the EU could worsen dramatically if either the
Netherlands, France or Germany were to choose the ‘wrong’ leader later this
year. Putin, who is clearly on a roll at present, could quite possibly upset
the cards even further – in particular if the new leadership is relatively
inexperienced.
In Italy, the banking crisis is an accident
waiting to happen. Most Italian banks are seriously undercapitalised and will
need many billions of euros of new equity capital. However, under European law,
equity investors must take the first hit before the government steps in, but
how that will all unfold in Italy, only time can tell.
Given the size of the Italian economy compared to
the Greek one, you shouldn’t be overly surprised if the Italian banking crisis
were to create bigger problems for the Eurozone than Greece ever did. My alter
ego (the more sinister side) would even assign a meaningful probability to the
entire euro currency system collapsing, with the member countries forced to
re-introduce their original currencies. This would require for the Italian
banking crisis to escalate further, and for either the Netherlands, France or
Germany to exit the Eurozone. It is certainly not my core scenario, but it is
not as far-fetched as some investors believe it is.
Brexit could also cause considerable damage to the
European economy in 2017. Cocky British newspaper editors have left people with
the impression that Brexit means nothing; it was all a storm in a teacup, they
say, conveniently ignoring the fact that the ramifications of Brexit are yet to
be felt. A hard Brexit will certainly be bad for the British economy, but
little will change until people begin to lose their jobs.
That said, a hard Brexit is likely to be even
worse for the rest of the EU than it will be for the UK (as the EU is a net
exporter of goods and services to the UK). I am not entirely convinced, though,
that the full impact will be felt in 2017. These negotiations could take a long time – certainly longer
than the couple of years that appears to be the consensus.
Rising leverage across emerging markets
My next worry is the rising indebtedness across
emerging markets combined with weak EM currencies. Overall debt levels, in developed
market (‘DM’) countries as well as in EM countries, are much higher today than
they were when the GFC nearly took us all down in 2007-08 (chart 5). Although I
am also worried about debt levels in DM countries, I think the risks associated
with excessive debt are higher in EM countries than they are in DM countries,
and that has to do with the implications of FX movements.
EM non-financial corporates have continued to
accumulate debt as if there is no tomorrow (chart 6). As DM interest rates
continued to fall, those corporates increasingly switched to borrowing in US
dollars. Given the recent strength of the US dollar – in particular when
measured against EM currencies – that decision has been a spectacular own goal.
What appeared to be very cheap borrowing costs turned out to be anything but.
USD 890 billion of EM bonds and syndicated loans (an all-time high) are coming
due in 2017 with almost 30% of that denominated in US dollars.
Weakening EM currencies vs. USD has been akin to a
significant rise in interest rates for EM borrowers, and the possibility of a
high profile accident or two should not be disregarded. I am not close enough
to the EM corporate sector to tell you exactly how bad it is, but I am told it
is pretty bad out there.
The high price of low interest rates
I have written extensively already about the
consequences of very low interest rates for insurance companies, pension funds,
local authorities, and therefore ultimately governments and shall not repeat
myself. Suffice to say that, should rates stay this low, it is only a question
of time before somebody noteworthy blows up right in front of us.
So far, all these very exposed entities have been
able to extend and pretend, but it won’t last. As long-term readers of the
Absolute Return Letter will know, I expect interest rates to stay low for a very long time to come –
particularly in Europe. It is possible that US interest rates will go through a
cyclical upswing over the next year or two, but the longer term (structural)
trend is still down – unless our political leaders take drastic action (see
what could be done in the December Absolute Return Letter here).
Consequently, somebody will almost certainly
default. It is only a question of who and when. Obviously there are the
explicit defaults, and there are the implicit ones. Increasing the retirement
age meaningfully, and implementing a mandatory conversion from defined benefit plans
to defined contribution plans with a built-in haircut would translate into an
implicit default, but before the unions bark too loudly, they’d better realise
what the alternative is.
Local authorities in the US are at the very front
of the bankruptcy queue. Take the state of Illinois with over $200 billion of
pension liabilities, much of which is unfunded. I am not saying that the state
of Illinois will go
bankrupt. If I went through the books of every single US state, I am sure I
could find a few that are in an even worse condition. That said, the 1% rise in
municipal bond yields since July (chart 7) could turn out to be not the buying
opportunity that many argue it is, but still a great shorting opportunity
despite the recent rise in yields, should the situation be as bad as I suspect
it is.
Other possible hiccups
I think I will stop here. I could list quite a few
other candidates for hiccup of the year 2017, but those that I have mentioned
above are the ones I believe are most likely to do meaningful damage in the
year to come, should they unfold.
I haven’t mentioned the fact that the current
economic cycle is getting very long
in the tooth. The last recession ended in early 2009 and the next one will
undoubtedly commence not too long from now. Could it possibly happen in 2017? I
don’t know, and I don’t think anybody else does either, despite the fact that
about 1⁄2 million commentators claim they do.
GDP growth projections for 2017 follow an almost
perfect normal distribution, suggesting to me that few economists have a very
clear idea what sort of conditions 2017 is likely to bring (chart 8). If I were
a betting man I would bet against a recession in 2017, though, as almost
everyone does in chart 8. There seems to be a great deal of momentum in both
the US and the EU economy at present, and I see nothing to change that in the
short term.
However, the Fed could quite possibly ignite the
next recession, should it be necessary to tighten more in 2017 than they have
already indicated. Based solely on US domestic data, they should probably have
tightened a great deal more than they actually did in 2016, but weak data elsewhere
kept them sitting on their hands – most likely because they didn’t want the US
dollar to appreciate too much. That could potentially force them to tighten
more than they would like in 2017. An increasingly capacity-constrained US
economy could lead to rising inflationary pressures, but that is more likely to
be an issue for 2018 than for 2017, I suspect.
Neither have I mentioned China at all, but China
could certainly blow up. After all, the credit bubble appears to be bigger in
China than anywhere else. How that will all pan out I don’t know, but I have
learned over the years that normal rules do not apply in China. Despite what
the rulers want us all to believe, it is most definitely not a proper market economy;
hence applying normal logic doesn’t work as far as China is concerned.
Investing in China is about knowing the right people and little else. In our
part of the world you would most likely go to jail if you applied that
investment technique, but not in China – at least not so far.
Summing it all up
The combination of Brexit and Trump has generated
significant momentum for nationalistic forces worldwide, and one would be
foolish to conclude that the worst is over. I certainly expect at least one of the forthcoming
elections in Europe to deliver an outcome that will create further problems for
project EU, but don’t assume that I am bearish on the euro for that reason.
Yes, low economic growth across the EU will almost
certainly lead to further USD appreciation vs. EUR, but a complete collapse of
the euro currency system – or at least a reconfiguration (the latter of which I
think is the more likely outcome) – will not necessarily cause the euro to
weaken. It will all depend on how the crisis is handled.
The timing of the forthcoming weakening of US equities
(which I consider a given) will to a substantial degree depend on when the US
economy goes into reverse and, as I said earlier, that is more likely to
materialise in 2018, but it could certainly happen as early as 2017.
Some sort of emerging market crisis driven by a
combination of high USD- denominated debt and weak EM currencies is my prime
candidate for hiccup of the year, but it is not entirely clear what the
implications will be for developed markets – sort of depends on where it
happens and to what degree DM banks are implicated. Generally speaking, though,
DM banks are only modestly involved in emerging markets these days; hence an EM
crisis doesn’t necessarily imply that we all get sucked in.
What to do in practice
You would be forgiven for thinking that, from an
investment point-of-view, the not insignificant risks laid out in front of us
makes it virtually impossible to construct a portfolio that is likely to
generate an attractive return in 2017, but nothing could be further from the
truth.
Firstly, remember what I said earlier. I usually
focus on the negative aspects when investing; hence my writing also has a
negative bias. That is not the same as saying that I am always bearish, and I
am most definitely not particularly
bearish going into 2017.
Secondly, given the risk factors mentioned above,
I would emphasise alpha risk over beta risk at this (late) point in the
economic cycle. There are indeed many ways that can be accomplished, and that
is precisely what next month’s Absolute Return Letter will be about. This
month’s letter is already too long, so all I will do for now is to wish you a
very successful 2017.
Niels C. Jensen
3 January 2017
3 January 2017
0 comments:
Publicar un comentario