Eye on the Market, November 29, 2010 [the attached PDF is easier to read]

Topics: 2010 year-end wrap-up, with a look at portfolios, and what’s happening in the US, China, and Europe

In our year-end wrap-up this week, we discuss where things stand in markets and in our portfolios, and take a look at China, the US and Europe.  In the first week of January, we will send out our 2011 Outlook.

With some exceptions, the year shaped up as outlined in our 2010 Outlook.  As shown below, US equity markets were up this year, and settled in the range we anticipated in the spring, with strong earnings growth but restrained P/E multiples.  Emerging markets equities outperformed the US this year, while European equities have done worse, both of which we positioned for.  We expected positive returns on credit, and on gold, copper and oil, which were up this year (some more than others).  Our long emerging Asian currency positions performed as expected, but we missed the inflection points on the swings in the Euro/$, and overestimated the ability/willingness of the Bank of Japan to push down the value of the Yen. 

The biggest trend we missed: the rally in long-duration government bonds.  QE2 and the continued accumulation of foreign exchange reserves by emerging economy central banks ($1.7 trillion in 2009 and 2010) helped government bond markets, since those dollars and Euros have to be invested someplace.  Silver lining: US and Asian central bank Treasury purchases helped create demand for corporate and municipal bonds, which were large allocations in our portfolios.

Hedge funds generally provided positive returns, with contributions from Macro, Event-Driven and Credit.  The continued weakness in Statistical Arbitrage was a drag on hedge fund performance.  As shown below, the market-neutral hedge fund industry (of which Stat Arb is part) does not appear to have adapted to the market conditions which have prevailed since 2007, and has barely kept pace with T-bills at a time when T-bills earn close to nothing.

This is what our Balanced and Growth model portfolio allocations look like.  [We also manage portfolios according to Capital Preservation and Endowment/Foundation styles; the point here is to provide some sense for how we have been positioned].  As things stand right now, we feel that we have enough risk in these portfolios.  A decision to add more risk would depend on how we believe the global recovery will progress in the three dominant regions described below.  Our regional equity allocations are highly skewed to the US and Asia, with smaller equity allocations to non-Asia EM, Europe and Japan.

The United States and China: Rattle and Hum

The US and China are showing signs of growth, after some bumps and rattles in the road during the summer.   In both countries, manufacturing surveys are humming above the “50” level which denotes expansion, and new orders have picked up.

In the US, many leading indicators are either improving, or no longer falling.  I am in China this week, and am using the schematic below to convey this.  While some are improving off a low base, they are generally moving in the right direction, even with this week’s very poor labor report.  They will need to keep improving to offset the decline in fiscal stimulus and inventory growth, both of which look to be ending. The rise in labor incomes, even with high unemployment, is supporting a rebound in consumer spending.  We believe 2.5% is a reasonable estimate for 2011 US GDP growth, which is a weak recovery when taking into account the severity of the prior decline.  Consistent growth of 4% is needed for the budget deficit to reach 3% by 2015; if not, austerity measures will be needed to get it there.

As for China, the government is trying a variety of schemes (see table) to control inflation.  Asia appears to be undergoing a classic business cycle in which policymakers are forced into exchange rate appreciation and/or higher interest rates to cool things off.  After these adjustments play out, we expect Asia to continue leading the world in terms of growth (Asia’s share of global GDP is now double that of the US), with increased contributions from consumption.  In China, urban and rural incomes are increasing by 7%-9% ; Singapore may be the world’s fastest growing country at 15%; Taiwan grew by 9% in Q3; and even Thailand grew by 6%, a sign that in Asia, growth can co-exist with fractious politics.  In stark contrast with the West, Asia’s fiscal accounts are in good enough shape to respond to another round of global weakness.    We expect Asian GDP and equity markets to remain volatile, but are willing to live with the volatility the region brings to portfolios.

Europe: Achtung, Buba [a]

Germany is booming, and in last week’s note, we highlighted German manufacturing and retail surveys at their highest levels since reunification.  But Germany better be in good shape, since there may be a large bill coming to the Bundesministerium der Finanzen in Berlin.  Even more rapidly than we thought, Germany may soon have to accept a comprehensive solution to the peripheral country (GISP) problems, if a sovereign default and losses to German (and French) banks is to be avoided.  There are a lot of proposals floating around, each with its own pitfalls, costs and hurdles:

** Much larger ECB purchases of GISP bonds, possibly as much as $500 bn to 1 trillion.  This would entail credit risk for the ECB that could no longer be described as simple monetary policy operations.  They have bought EUR 60-70 bn so far.

** New loans from Germany to Spain, or an increase in the existing IMF-EU aid package.  After rating agency haircuts and required cash reserves, the IMF-EU package might only represent 405 bn in loans rather than the announced 750 bn

** An entity to issue EU bonds, guaranteed jointly and severally by all EU countries.  Such an entity would presumably need powers of taxation to fund itself and not be hostage to annual parliamentary approvals.  Luxembourg Prime Minister Juncker and Italian Finance Minister Tremonti outlined their thinking on “E-bonds” in today’s Financial Times.  German Prime Minister Schauble promptly rejected the idea, saying it would require significant changes to European treaties, and that the Euro’s survival was not E-bonds, but fiscal discipline.  Watching this slow-motion, publicly aired discord month after month….is it just me, or is this starting to resemble Bergman’s “Scenes from a Marriage”?

** A one-time transfer of EUR 350 bn of GISP bonds, assumed by the Core countries, as outlined by JPMSI economist David Mackie in his November 17 research note.  Such a move could reduce GISP debt/GDP to a manageable 60%, and only increase Core debt/GDP by 5%.   (Can we also shift US mortgages to the 30% of US homes unencumbered by debt?)

** A European version of TARP that would focus on bank recapitalization across the entire region.  It could allow for underwater assets to be written off and for bondholder haircuts, if it were large enough to reduce the risk of a wholesale or retail bank deposit run.    The logic for this option was nicely laid out recently by Gavekal Research in Hong Kong.

Each of these might be difficult to sell to the German population, and to its Constitutional Court, which had strict conditions on Germany joining the EMU.  For good measure, Schauble warned private bondholders that if they did not bear some of the risk of their investments, it could destroy the legitimacy of the market economy and of Europe’s political order [b].

As the European debate continues, I am reminded of similar discussions in the 1980s; Mexico’s inflation was not as bad as Brazil’s, whose inflation was not as bad as Argentina’s.  It didn’t matter in the end; they were all effectively insolvent.  Asia, circa 1997: Thailand started the crisis, since it had the largest current account deficit and bank lending/GDP.  However, even countries with smaller deficits and bank lending booms got sucked into the void.   The biggest difference vs Europe today: neither region had big brother countries more than twice their size in a financial position to bail them out.

If Germany is going to save these countries, they may need to do it sooner rather than later.  Saddling Ireland with 135% debt/GDP by 2013 was not a good start.  GISP unemployment is rising, and unlike in the rest of the world, is showing no signs of declining.  Countries can survive temporary spikes in unemployment, but there may be breaking points in terms of its duration and level.  As shown in the chart on the right, Germany’s democracy remained intact in the 1920s, despite reparations payments and 10%-15% unemployment.  But when until unemployment hit 15% in 1930 and stayed there, National Socialists gained more seats in the Reichstag than the 2 liberal parties combined, and the rest, as they say, is history.

The irony is that within Germany, fiscal federalism plays a huge role in smoothing out regional inequalities across its 16 states.  Germany has a constitutional mandate to secure equal living conditions for all its citizens, and its redistribution policies reduce regional disposable income differences by 40%, and state tax revenue differences by 70% [c].  Will Germany effectively accept extending this kind of mandate to the EMU as a whole?   Some senior executives at our firm believe that Germany will ultimately decide to pay/guarantee whatever is necessary to preserve the Euro as it is now constituted.  I have my doubts, but if they’re right, it would remove one of the largest risk factors facing financial markets.

Conclusions: opportunity, risk and return

As we head into another year of opportunity and uncertainty, I wanted to highlight a table that we often show clients.  It looks at the returns on different asset classes, and how the best time to invest is well before “the coast is clear” regarding its related fundamentals.  Case in point: note the substantial US equity returns that occur before the unemployment rate peaks (or starts declining).  This happened in 1975, 1982 and again this time.  Another example: high yield bond spreads tightened substantially well before corporate default rates peaked in 1993, 2004 and 2009, and bank stocks rose sharply well before bank failures crested.

We have a lot of misgivings about the world’s imbalances that we talk about in these notes.   China’s symbiotic financing of US budget deficits would be first among them.  But we feel better armed to make portfolio allocation decisions by looking at the worst of all possible worlds, rather than the best.  The portfolios shown on the first page represent our best thinking about how to navigate the world we live in.

Michael Cembalest

Chief Investment Officer

Notes

[a] Achtung means “Look Out”, and Buba is the shorthand version of Germany’s Bundesbank.  “Achtung, Baby” was a pretty good 1991 U2 album.   “Rattle and Hum”, the header from the prior section, was also a U2 album (1988), probably their best one.

[b] As reported in the aptly titled Financial Times article, “Financial markets ‘do not understand the Euro’”, December 5, 2010.

[c] “Fiscal Federalism in Germany: Stabilization and Redistribution Before and After Unification”, Ralf Hepp and Jürgen von Hagen, August 30, 2010.

GISP = Greece, Ireland, Spain and Portugal

DJIA = Average of the prices of 30 well-known, predominantly blue-chip and industrial stocks

S&P 500 = Free-float capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the US

MSCI Europe = Free-float capitalization-weighted index of 16 developed European country market indices

S&P 500 Banks Index = Free-float capitalization index of US high-capitalization stocks representing the banking sector

JPMS Global High Yield Index = Unmanaged index comprised of over 1400 USD global high yield corporate debt entities

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