Is this a long weekend or not? ‘Cause this is a long weekender. I hope you learn from it if you don’t enjoy all of it.
Did you miss?
- GOOD READ: HOWARD MARKS’ WISDOM
- GOOD READ: MORE HOWARD MARKS’ WISDOM (Actually a must read) (Sorry for the bad link yesterday)
More good stuff for your weekend. David Kotok’s piece explains the current fears from low oil prices (especially). From my Dec. 21 post YIELDING TO HIGH YIELD:
The commodity rout is so violent following a decade of rising prices and leverage that the final episodes could be pretty nasty with many potential known and unknown unknowns. Who can confidently predict when and where oil prices will bottom? And China? In such leveraged environments, groundhogs can surface anywhere, anytime. The year 2016 could well become groundhog year.
We have yet to see one pop up, but many are smelling a groundhog whiff and rushing to the sidelines.
Contagion Risk, Big Banks, Junk Funds (David Kotok)
“When Currencies Collapse” is the title of a Peterson Institute essay by Simeon Djankov (December 30, 2015). Djankov discusses the drivers of recent currency devaluations in Azerbaijan, Georgia, and Russia, along with the fallout that lies ahead. In addition, there are violent currency adjustments visible in Asian currencies including China.
Our observations follow, with an eye toward the potential risk of contagion.
In order to dampen that risk, we have taken the financial sector to underweight and specifically lowered the large banks. Some bullets follow.
1. We remember 1997, when the very first currency in crisis was the Thai baht. Markets dismissed the baht’s collapse as an aberration. But by 1998 a major hedge fund had failed; the big banks were in retreat; and the Fed was intervening to avert a meltdown. Many currencies and their related debt were in trouble. What began as a seemingly isolated incident morphed into a contagion. The players in the Asian crisis of 1997-8 hadn’t learned from the Mexico crisis of 1994 or the European Monetary System crisis of 1992.
2. The Djankov essay names several currencies in trouble. Since that essay, China has made headlines with its problems and its use of reserves to defend its currency. Many of these currencies have or had managed links to the US dollar. Those links are now broken or are breaking. So debtors owe in dollars and attempt to earn in the local currency. When the link breaks, all hell can break loose. It may be doing so now.
3. History shows many examples of broken links and resulting shocks. (…)The list of broken currency links in history is long. An attempt to peg exchange rates inevitably fails once the pressures to maintain them grow too costly. And the outcomes are never pretty.
4. The sequence of a meltdown in a contagion is unpredictable. Someone owes and cannot pay. But who is owed and how much is leveraged is not visible until the situation blows up. That is what the high-yield fund scandal is all about. So which sector of junk suffers first is not the issue. (…)
5. Gating by a fund is a tendency to induce contagion. We only learn of a gating when it is announced. The day before a gating there is no public information to help the investor front run a gating. We do not know who is considering gating, but we do know that fund investors do not place money in a fund with a plan to leave it there when adverse circumstances arise. Mutual fund investors expect to be able to redeem if and when they want or need cash. When the gate closes, it is the investors who suffer and may have to resort to some other action. It is those follow-on actions that start a contagion snowballing. Each action is followed by a reaction and a new action. The sequence is unpredictable … until it becomes visible. (…)
6. The contagion risk in the world seems to be rising. And the rating agencies are seeing it and acting prospectively, so we see fast action by raters, and warnings. One of the legacies of the financial crisis is that rating agencies now move faster. This is true for larger agencies like Moody’s or Standard & Poor’s or Fitch, and it is true for a specialized rater like Kroll. Credit rating changes are to be heeded in this post-crisis and newly regulated environment.
7. A. Gary Shilling’s INSIGHT dated January, 2016 makes two important observations. He notes that “as of last September 30, the Focused Credit Fund had 28.4% of its assets in its top holding of illiquid junk bonds.” Focused Credit Fund experienced large withdrawals in the fourth quarter of last year. Shilling reports that “in an unprecedented step, the fund suspended redemptions without SEC approval and fired David Barse, the fund‘s manager, after stating that it couldn’t meet redemptions. Instead, it transferred all of its investments to a liquidating trust.”
Gary shilling and his superb research team note that this is not only a mutual fund problem. He wrote that while “junk mutual fund assets reached a high of $305 billion in May 2014, triple their 2009 level, insurance companies joined the throng. Allstate more than doubled its portfolio of junk securities from 2008 to a level of $8.4 billion. That equals 11% of total investments and 41% of shareholder equity. AIG had 35% of its shareholder equity in junk as of last September 30.”
8. In December of last year (2015), Standard & Poor’s downgraded the credit ratings of the non-operating holding companies (NOHC) of all eight US global systemically important banks: Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corp., The Goldman Sachs Group, and Wells Fargo & Co. Of note is that S&P divided those eight into two categories depending on the structure of the operating components in each company. S&P stated, “We are keeping our ratings on the core and highly strategic operating subsidiaries of Bank of America Corp., Citigroup Inc., Morgan Stanley, and The Goldman Sachs Group on CreditWatch with positive implications….” Readers may note that the other 4 are BNY-Mellon, JPMorgan Chase, State Street & Wells Fargo. (…)
Let’s sum this up. (1) There is a developing credit concern focused on energy debt, emerging-market debt, and the conduit form of mutual fund investments. Such mutual funds have blended US high-yield with currency-hedged emerging-market debt. (2) A contagion is possible at any time. Whether we are heading for a contagion in 2016 is unknown. It will not be known until it is visible. If it happens, it is likely to develop without warning. (…)
We believe that the recent troubling stock market behavior reflects activity in the Asian markets (China) and geopolitical risk premiums (Iran-Saudi) and political uncertainty in the US. Weakness is exhibited strongly in the energy sector and in financials. We are underweight financials but are positioning in the energy sector for a strategic and positive recovery. Oil and gas are now cheap. They may become even cheaper for a temporary period but they have reached levels that are discounting wholesale bankruptcies and failing business entities. The selloff of energy related ETFs is becoming extreme, in our view. (…)
Also an important read:
Nevsky Capital is no ordinary hedge fund and Martin Taylor no ordinary manager:
“We have come regretfully to the conclusion that the current algorithmically driven market environment is one which is increasingly incompatible with our fundamental, research orientated, investment process,” Martin Taylor, the firm’s chief investment officer, said in a statement. “The bear market in emerging market equities, which began in 2011, may eventually engulf developed markets too.”
In their final letter, Taylor and Barnes explain further (via Zerohedge):
Over our twenty-one year investment career we have always invested using a broadly unchanged process. This process marries the top down forecasting of key macro-economic variables with the bottom up forecasting of company earnings; initially just in Eastern Europe, then across the Emerging World and finally on a global basis from 2003 onwards.
For this process to work we have consistently needed the following criteria to be met:
- Access to transparent and truthfully compiled data at both a macro and a company specific level, which is made available on a timely basis to all market participants. This allows us to construct and maintain detailed top down economic forecasts and bottom up company models.
- Logical decision making by macro-economic policy makers.
- An ability to achieve a clear understanding of the positioning of other investors in the market so as to be able to come to a view as to what is ‘in the price’ and what is ‘fair value’.
- A reasonable level of divergence in equity prices between different geographies and sectors and the existence of constantly evolving, but logical, inter-relationships between these different asset classes.
- Manageable ‘fat tail risk’
- A reasonable spread of uncorrelated potential investments across time zones.
Unfortunately, global trends over the past couple of years have begun to militate against these pre-conditions for successful fundamental investing. Namely:
Data quality has deteriorated
- Data releases have become much less transparent and truthful at both a macro and a micro level. At a macro level the key issue is the ever increasing importance of China and India. China is the world’s second largest economy, but already much larger than the US in a broad swathe of sectors. India will be the world’s third largest economy within a decade. Unfortunately their rise is increasing the global cost of capital because an ever growing share of the most important data they produce is simply not credible. Currently stated Chinese real GDP growth is 7.1% and India’s is 7.4%. Both are substantially over stated. This obfuscation and distortion of data, whether deliberate or inadvertent, makes it increasingly difficult to forecast macro and hence micro as well, for an ever growing share of our investment universe.
- At a micro level corporates have also responded to greater market scrutiny since the GFC to disclose less not more, on the basis that the less they reveal the less often they can be proved wrong by regulators, investors or law courts. This means the cost of capital relating to holding large company specific exposures has risen as the ‘headline’ risk of being proved wrong with regard our earnings projections is now commensurately higher.
The transparency of decision making has also declined
Assuming we can obtain trustworthy data we then apply logic to produce our forecasts. The validity of this process becomes questionable if economic policy makers do not themselves apply economic logic and in a transparent manner. Obviously we accept politics can trump economics and political analysis has always been a very big part of our process, but surely never has so much of the world been governed by leaders where the logic of that peculiarly parochial yet multi headed beast – nationalism – trumps all (China, India, Russia, Turkey, South Africa, Malaysia etc. etc.). Almost by definition the path of logic within nationalism is difficult for ‘outsiders’ to follow with any confidence, leading to highly unpredictable and potentially dysfunctional modelling outcomes.
- At the start of our careers we spent much time being forced to try and decipher the indecipherable – the moods and subsequent decisions of Boris Yeltsin. This ‘Kremlinology’ was truly the definition of banging your head against a proverbial brick wall. Fortunately this and similar masochistic macro-analytical tasks then gave way to the logical joy of the Washington Consensus which was adopted almost without exception across the Emerging World following the multiple devaluation crises in the mid-1990’s. Unfortunately though the Washington Consensus, having been severely wounded by the GFC is now stone dead. Kremlinology, with an additional nationalist twist, is back – and it is now the norm, not the exception, for most countries in the Emerging World. We are not convinced that knowingly continuing to bang our heads against these newly erected brick walls would be a sensible decision.
- Equity markets are also less transparent
- The unintended consequences of those new regulations introduced as a result of the GFC, which have largely removed the market making role of investment banks from global equity markets, has coincided with the recent massive increase in market share of both ‘dumb’ index funds and ‘black box’ algorithmic funds to create a situation where equity market volumes have fallen sharply and individual stock volatility has risen dramatically. An initially badly executed order can now inadvertently create a price trend (because there is no longer the cushion to price moves which was in the past provided by market maker inventories) that, as algorithmic funds feast on it, can create a market event even if the initial order was a simple innocent error. Truly – to mix metaphors – butterflies flapping their wings now regularly create hurricanes that stop out fundamentally driven investors who cannot remain solvent longer than the market can remain irrational.
- In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical. More butterflies.
- Index and algorithmic fund manoeuvrings also make it very hard to ascertain what the markets ‘clean’ positioning is at any given time. All of which pushes up the cost of capital.
Fat tail risk has also increased
- Less disclosure means more event risk, while thin volumes coupled with trend seeking algorithmic trading mean the markets responses to such events have become much more violent. Instant downside risk on both longs and shorts has become immeasurably larger as a result.
Asia is becoming an increasingly dominant time zone
- If this wasn’t enough, the growing dominance of Asia, because of the growth of China and India and (happily) the resuscitation of Japan as a viable investment destination by Abenomics, also makes operating our all inclusive global equity process ever more difficult from a time management perspective. With the world ever more interlinked economically, gone are the days when one time zone (of Asia/Europe/the US) could be neglected at any given time to the benefit of the others. This has forced us, over the past two years, to resume the brutal hours we stepped back from in 2010, but which we now think are both unavoidable going forward and unsustainable.
In summary, all of the above factors now mean that it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables. This pushes up our cost of capital and substantially increases the risk of us suffering substantial capital loss on individual positions either because of a forecast error or simply because we could be caught up in an erroneous market trend, which could then persist for far longer than we could take the pain. This has made what we enjoy most – the thrill of analysing economic data releases and company accounts – no longer enjoyable. It is therefore time to accept that what we have done has worked brilliantly for twenty years but does not work anymore and move on. We are confident our process will eventually work again – for the laws of economics will never be repealed – but for now they are suspended and may be for some time; an indefinite period involving indeterminate levels of risk during which we think it would be wrong for us to be the stewards of your money.
The final reason we have decided to cease managing the Fund is our increasing concern with regard the health of the global economic cycle, which we describe in detail in section 3. This view is relevant because, in our experience, periods of economic pressure and high market volatility will tend to make the issues that are already making it more difficult for our process to work (which we have discussed above) such as poor disclosure, the triumph of nationalism over economic logic, low market liquidity and heightened event risk, worse not better, thus potentially leading to a further deterioration in our risk adjusted returns.
When I retired from full time professional management in the early 2000s, I was also frustrated by some of the “problems” mentioned by Taylor. It was also evident then that necessary marketing and servicing obligations were making it more and more difficult to find enough quality time to try to comprehend this increasingly complicated world (!). Taylor and Barnes mentioned these back in 2011 when they decided to cut the size of the fund and limit marketing time.
I have stayed away from China and other emerging markets essentially because of the imbalance of risk these markets entail. North America and, to a lesser extent Europe, offer sufficient investment opportunities for ordinary investors. While certainly not perfect and also subject to algo moods, North American markets and companies are a good place to be, most of the times…
Nevsky also offers its assessment of the global investment outlook. Please read it (section 3 in the letter). It is likely you have never read such a good, thorough analysis. Taylor’s views may not be totally right but he superbly covers the numerous risks out there.
By A. Gary Shilling via John Mauldin’s Outside the Box
(…) Chinese leaders want to shift to a domestic-led economy driven by consumer spending and services, but whenever overall growth flags, they resort to the same old, same old infrastructure spending. So the result is even more excess capacity and more political and economic power for the inefficient State-Owned Enterprises. And officials merge them rather than allow them to fail. At the same time, private firms are starved for capital.
These actions not only reveal Beijing’s distrust of free markets but also its reluctance to address the trade-off between heavy industry pollution generation and economic growth. Meanwhile, consumer spending in China is almost off the chart compared to G-7 and even BRIC economies. It’s 34% of GDP in China vs. 59% in India, 60% in Italy and 68% in the U.S. (Chart 6). (…)
Notice (Chart 9) that since 2005, that the yuan has risen 26% vs. the dollar, but 40% against the trade weighted basket of currencies. This leaves China at a 14% currency disadvantage compared with her trading partners. (…)
(…) “A lot of things will change,” said Hathut, 30, who plans to supplement his income as a business-administration teacher at a Riyadh university with private training sessions. “But many youths are still in a state of shock. They haven’t processed the news and what to do.” (…)
Those aged 15 to 34, who make up more than 40 percent of the 21 million Saudis, are at the forefront of the upheaval. No longer can they take for granted free health care, gasoline at 20 cents a liter and routine pay increases. (…)
“Saudi youth won’t be content with what the previous generations were content with,” said Nuseibeh. “Whatever the state is going to take away from them because of dwindling financial resources they would expect to receive it by some other means.” (…)
In an interview with the Economist published last week, Prince Mohammed said the country is looking into selling all or parts of oil behemoth Saudi Aramco. He also said it’s vital to create employment as he steers the kingdom away from an oil-based economy, including the possibility of putting Saudis into jobs occupied by foreigners who typically work longer hours for less money.
“We have great opportunities to create jobs in the private sector,” he said, according to a transcript published by the magazine. “At the same time I have reserves now, 10 million jobs that are being occupied by non-Saudi employees that I can resort to at any time of my choosing.” (…)
A diamond is forever?
(…) Controlling for a number of demographic and relationship characteristics, we find evidence that marriage duration is inversely associated with spending on the engagement ring and wedding ceremony. (…)
According to a national survey conducted annually by the top wedding website TheKnot.com, the average wedding cost was $29,858 in 2013 (TheKnot, 2014). (…)
In 1959, Bride’s recommended that couples set aside 2 months to prepare for their wedding and published a checklist with 22 tasks for them to complete. By the 1990s, the magazine recommended 12 months of wedding preparation and published a checklist with 44 tasks to complete (Otnes and Pleck, 2003).