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‘The
greatest threat at present is deflation and hence we are now
witness to the “Mother of all stimuli” as policy makers engage in
unprecedented monetary and fiscal stimulation.’
The
Pain Report
From
the desk of HFA Asset Management’s Jonathan Pain
HFA is
a Pentad Group preferred fund manager
The
Mother of all Stimulations
First
of all, an apology is in order as my last two Pain reports
suggested there was a tradeable rally in equity markets. In the
Pain report, “Go Fishing”, published on October 11 and then in “Yes
we can....Buy”, published on October 18th we highlighted the view
that we could see a significant rally. My line in the sand was the
October 10th low on the S&P 500 at 838. We did rally very hard
for the next two days, up about 15%, however, on November 19th we
crashed through the October 10th low and subsequently fell beneath
the October 2002 low. At the time of writing, on November 22nd, the
S&P500 closed the week at 800.03.
Other
equity markets have fared even worse and hence an apology is in
order.
History
shows us that even the most brutal bear markets have significant
rallies, but this one is very special and has already entered the
record books as the worst since the 1929-1932 crash.
So
perhaps I should get back to basics and do my best to think about
the key macro drivers of the global economy and leave the “market
timing” to all of you.
As
stated in many Pain reports we have entered a period of credit
contraction after an era of unprecedented credit expansion. Please
see chart one which is one of my “all time scariest charts” and
joins Robert Shiller’s chart of U.S house prices from 1890 to
2005.
Chart
1- Total U.S Debt as a % of GDP
Source:
Ned Davis Research Inc. Quarterly data 31/12/1922 -
31/3/2008
So the
age of “No deposit, no worries” is now behind us and hopefully the
age of shameful and predatory lending is behind us too.
We now
face a more frugal era and this reality is now dawning upon
citizens from Washington to Wellington. The adjustment phase is
going to be very painful, particularly for those with lots of debt,
and whilst we navigate towards this inevitable destination private
sector balance sheets will shrink and by default public sector
balance sheets will expand. In this regard Governments have much
further fiscal work to do and central banks around the world are
now in a fascinating race to zero.
The
greatest threat at present is deflation and hence we are now
witness to the “Mother of all stimuli” as policy makers engage in
unprecedented monetary and fiscal stimulation.
As we
have been saying for some time now, the whole developed world faces
recession and the next few quarters are going to be positively
“ghastly”.
And
yes, even developing countries in Asia are feeling the pain and
growth is slowing significantly. At the start of the year we
forecast 8% growth in China and the latest data from the third
quarter saw growth of 9% and I sense we are likely to see numbers
nearer 6- 7% next year. In global terms this will be commendable
and there is no doubt that China will continue to be the global
growth locomotive in 2009, having been the undisputed leader in
2007 and 2008, with their contribution to the growth in the global
economy exceeding that of America. Alas, in an age of globalisation
no nation can be viewed in isolation and even countries such as
Vietnam are now suffering the consequences of the born-in-the-USA
virus.
I
travelled to India and Hong Kong in late October and there was
overwhelming anecdotal evidence that the stock market crash of
October 2008 had indeed had a massive impact upon consumer and
business confidence. The Wall Street crisis had finally arrived in
Main Street Asia.
No one,
and I meanno one,
has everseen
anything likethis
before.
In
earlier Pain reports we discussed the nasty reality of “negative
feedback loops” and how the credit multiplier was now working in
reverse. Now the global consumer has just entered a lengthy
hibernation and this coupled with banks cutting back on lending and
companies reducing staff will simply further exaggerate and amplify
the economic downturn. In such an environment governments and
central banks need to take up the slack and expand their balance
sheets as the private sector shrinks their own. We are all
Keynesians now and hopefully every policy maker is up to speed with
what needs to be done.
In
1911 Irving Fisher formulated the quantity theory of money and it
is, in essence, a simple “identity” where MV= PT. M is the quantity
of money, V is the velocity or turnover rate of money, P is the
price level and T the volume of transactions.
Given
that we are witnessing an unprecedented injection of liquidity
(money) into the financial system why are neither P or T rising?
Look no further than U.S Treasury bills which this week reached a
level of one basis point, I repeat one basis point, and in fact
Treasury bond yields across the “curve” reached historic lows. The
fact is that investors are more concerned with the return of
capital rather than the return on capital and have hence sought
safe haven in Government securities and as a consequence the
velocity of money has collapsed. There are very few episodes in
history when this has occurred. The most recent being Japan and
they of course experienced a full blown Keynesian “liquidity trap”.
Until such time as the velocity of money recovers we shall not see
traction between money supply and either P or T.
In
this fundamental regard Governments must come to the rescue and
restore V through massive fiscal spending and restore some
semblance of “animal spirits” to the global economy.
In
addition, central banks must do their part too and drop interest
rates as quickly as possible and as far as possible. The risks are
entirely “assymetric” in nature as the risk of deflation at a time
of record debt is fatal, whilst inflation eases the pain of debt
and can be cured in time. It is important to once again stress that
we are seeing an unprecedented period of asset deflation with house
prices, stock prices and commodity price declines now amounting,
according to some estimates, to an astonishing 30 trillion U.S
dollars.
No
one, and I mean no one, has ever seen anything like this
before.
Now,
regarding some of the rays of light in this remarkably dark tunnel
is that we appear to have avoided a “systemic” banking collapse and
similarly, due to the unprecedented nature of the crisis, we
clearly have unprecedented monetary and fiscal measures being
adopted by every country in the world. And yes, in time these will
work and as we discussed earlier, once the velocity of money
increases we shall see monetary policy gain some
traction.
In the
interim, more banks will be nationalised and at the close today
there was “chatter” in the markets that Citigroup will be taken
over by the government having seen a 61% decline in their share
price in just the last week. It is interesting to note that they
have assets of approximately U.S $2 trillion which is larger than
the whole hedge fund industry. Citi is definitely in the too big to
fail category and the American authorities will not allow another
Lehman event to happen.
Sorry,
I was meant to be talking about rays of light, but in reality the
very fact that governments now understand the nature of the crisis,
having been in denial for so long, at least now we should be able
to say that “systemic” risk has been removed. In addition, as I
mentioned previously, house prices in some regions in America, such
as Florida and California have fallen nearly 50% and hence we are
close to the bottom and on a nationwide basis we might be only 10 %
away from some kind of stabilisation.
In
countries like Britain there is much more housing pain to come and
here in Australia we are seeing widespread evidence of sharp
declines in prices and my forecast of a decline of 25%, made at the
beginning of the year, will prove to be very
conservative.
Corporate
earnings forecasts still need to come down, but at least with stock
prices now down 50% the market is better pricing economic
reality.
In the
months ahead we shall see further cuts in interest rates and may I
make a special plea to the Reserve Bank of Australia to get rates
to 3% as quickly as possible, this means a minimum of a 1% cut in
early December and then another 1% in early 2009. Then again, if we
know rates need to be at 3%, and soon, why doesn’t the RBA simply
take us there immediately. Some suggest this will lead to a
collapse in the currency, but in reality a dramatic cut could boost
consumer and business confidence and therefore serve to support the
currency.
Similarly,
I believe one of the reasons (obviously the worsening expectations
in global growth and the commensurate collapse in commodity prices
was the primary reason )why the A$ fell so sharply is that the
Glenn Stevens “Alice in Wonderland” approach to monetary policy
earlier this year, fully supported by the chief economists of the
major banks here even up until July THIS YEAR, that we needed
HIGHER rates, led to massive selling by foreign investors who could
not comprehend the “head in the sand” policy stance. Maintaining
interest rates at 7.25% in the face of the mother of all credit
contractions - which began in June 2007 - all the way until early
September 2008 can now be seen as a grave error in judgement. The
RBA now has a chance to make amends.
So we
are now witness to the Mother of all Stimuli and at some point in
time, possibly the second half of 2009, we shall see some recovery
in the global economy, led by Asia.
I
obviously don’t know how low we can go in terms of stock
markets.
I do
know that this is not the time for a set and forget approach to
managing money and this is definitely the time for an active
absolute approach.
If
your fund manager is chained to a fully invested equity benchmark
and their stock selection is largely pre-determined by the relative
weightings in that benchmark then you will be pretty much fully
invested through every gut wrenching gyration and more often than
not own stocks that even the fund manager, responsible for your
money, would not personally own. Does that make sense?
This
is not a sensible way to manage money.
In the
years ahead we shall finally see the great portfolio debate
resolved and there will be active and passive managers. There is
absolutely no conceptual case for an approach that is neither
active nor passive and that masquerades as active whilst hugging an
index and hiding behind tracking error as a measure of portfolio
risk.
Not
all absolute return funds are good, not all absolute return funds
are bad, it is simply a way of managing money, and certainly is not
an asset class.
Some
research houses understand this, some don’t, and the media is
largely silent on this important debate.
For
some curious reason the absolute return approach is classified as
“alternative” and the relative return approach is called
“mainstream”.
Moving
forward can we please use the terms active and passive and then
finally we can make some headway and illuminate the reality that a
fund that derives approximately 95% of its performance from the
market can surely not be described as active.
In
closing, it’s been a really shocking year and the contrarian in me,
as the markets plummet and valuations improve, makes me feel more
positive as markets now fully price a very severe recession. There
is no doubt that the macro economic data is going to be absolutely
ghastly over the next six months, but equity markets are down 50%
plus and government bonds are insanely expensive and arguably now
price outright depression.
In
fact, the TIPS (Treasury Inflation Protected Securities) market is
now pricing outright deflation in America over the next five years,
with the 10-year TIPS pricing nearly zero inflation. Given the
unprecedented degree of monetary stimulation, I would not put money
on inflation being zero over the next 10 years. I agree we are in
for a sharp decline in inflation over the next few years, but that
is already in the price. Similarly I would argue that in some parts
of the credit markets that we are now pricing in outright
depression with the implied default rate on high-yield bonds now
higher than the actual defaults during the Great
Depression.
Similarly,
the CMBS (Commercial Mortgage Backed Securities) market is now
trading at ridiculously cheap levels which led one analyst to
recently remark: “The default levels implied by where these bonds
are trading mean we will all be living in boxes “.
I know
things are really bad and they are going to be really horrible for
some time and I know that the Anglo Saxon world has to adjust to a
new world of spending less and saving more and perhaps I am
becoming more bullish because I am just plain bored of being so
depressing and bearish.
But I
do think that there is hope on the horizon and yes, I do believe
that Obama is part of a new beginning and you can call me naive if
you wish.
Whilst
I was in India last month, I was overwhelmed by not just the sheer
mass of humanity and the terrible poverty but also very conscious
of the extraordinary desire of India and every Indian to continue
its remarkable rise.
The
obstacles are enormous and with more than half the nation living on
less than $2 a day, they have a real challenge on their hands.
Infrastructure is shocking, bureaucracy is suffocating and
pollution is dreadful BUT, bit by bit, they are moving ahead and in
a decade from now and in the decades ahead they will be a major
economic power and incomes will rise, spending will increase and
heaven forbid there are many more cars on the road.
This
year and into next India will suffer, in economic terms, but it
remains an extraordinary possibility full of remarkable
opportunity.
You
see this desire to move forward all across the developing nations
in Asia and we must understand that over 3 billion Asians have
embarked upon the path of economic development and the centre of
economic gravity continues to shift inexorably towards
them.
I know
I have frightened many of you with my views on America over the
last several years, but it is an economic basket case and it is now
plain to all that it is one big debt bubble that has just burst,
but at least now we all know it we can do something about
it.
The
world has just changed very dramatically and I know I have said
this before but I think the world will be a better place in the
years to come.
This
may be my last Pain report for 2008 and, if it is (which I hope it
is!!), then I would like to wish you all a very happy New Year and
it has been a pleasure, once again, to have had the opportunity of
speaking to many of you through the course of the year.
All
the best,
Jonathan
Pain
Disclaimer: HFA
Asset Management ABN 25 082 852 364 (HFA) AFS Licence 246747 does
not guarantee/warrant, the accuracy/correctness of the information
in this document. This
document is not financial product advice. Neither HFA, its
employees and/or agents shall be liable for any claim resulting
from any person relying on such information. Professional
advice should be obtained in respect of your own particular
circumstances. Past Performance and asset allocation is not a
reliable indicator of future performance.
25th
November 2008 Back
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