By John Brynjolfsson, Armored Wolf
The Armored Wolf investment team held its Secular Forum in late March. This is an annual opportunity to step back and discuss major themes in the upcoming investment environment. This was an effort to identify the dominant underlying forces likely to drive asset prices .
Thorough discussion and analysis led us to the view that what best describes foreseeable market forces is the term “countervailing.”
We see the backdrop of the global economy and markets dominated by:
• Developed countries entangled in the aftermath of a massive credit boom and the lower growth that likely ensues;
• The maturing industrialization and modernization of some very highly populated countries, and the continued development of the rest of “emerging markets;” and
• The potential increased scarcity and cost of extraction of commodities.
The pertinent related issues to this include:
• Reactionary, reflationary policies of developed country government and monetary officials;
• A one-way contest of currency devaluation;
• A test of the acceptance of a fiat money system and social welfare model; and
• A potential, but not confirmed, inflection point in valuations and risk premiums of some asset classes.
The most dominant conflict occurring in developed markets continues to be between forces of deleveraging from burst credit, housing and government borrowing cycles, and the expansionary monetary forces of central banks and the now seemingly restricted largesse of government spending. There are identifiable forces that could lead to an extreme outcome of either deflation or inflation.
In the US, many measures of private sector deleveraging have reverted to trend, or close to trend. There is no reason these could not undershoot, however, and housing statistics such as inventory and delinquencies arguably have further to correct. This private sector deleveraging has been fully offset, however, by public leveraging and overall debt continues to be bloated.
A similar situation has occurred in Europe, with some different nuances. The primary embracers of the private sector debt have been the central banks, which have quite aggressively expanded their balance sheets. It seems monetary authorities are quite willing to play a game of chicken with markets, and specifically bond holders to buy time as the solution to the deleveraging challenge. It would seem their chosen course of action is to “reasonably” nominally inflate away debt over time, with a little bit of austerity and default mixed into the cocktail. Whether this mix produces a hangover or not remains to be seen, however, based on market pricing and levels of inflation, the markets seem to be “so far so good.”
Another scenario is that deleveraging could lead to deflation from, perhaps, another dry heave in European debt or even a pullback from overdone China construction. While this is possible and should be respected, this deflation still seems unlikely at the current time. On the flip side, intended or accidental hyperinflation also seem unlikely, or if even a reasonable possibility, at least still some way off. What seems probable, however, is further career justification by central bankers to continue to act, and more strongly, if economies or markets are to worsen. This resolve has been consistent and we expect it to continue.
In the Fed’s case, further increase of the balance sheet will likely have some inflationary impact, particularly with the steadfastness that Bernanke has shown so far. Some degree of multiplier seems to be necessary, however, so a watchful eye should be kept there. Nominal inflation would certainly be nice for debt holders, and, at last check, the largest US debt holder was the Fed, who just happens to have some influence on inflation. So at Armored Wolf, we will lean towards inflation in this debate, which leads us, at the margin, to expect higher long end interest rates globally. We also assign some credibility to the Bank of Japan’s renewed inflation push, so part of our inflation leaning will also be towards a weaker Yen.
Related to inflation and official reflation, it seems most countries are engaging in a policy of currency devaluation to help their external balances, or for those fairly healthy, at least pushing against currency appreciation. The funny thing in currency markets, however, is that relationships are relative and thus not everyone can devalue. So another leaning at Armored Wolf is toward emerging market currencies in the long term due to superior growth and balance sheet fundamentals. The long term Sharpe ratio of simply holding those currencies or sitting on carry trades is poor, at least until they display decoupling from developed markets and volatility, thus calling for a well thought out tactical approach instead. The other offshoot to unanimously desired weak currencies is that, regardless of which currency crosses trade stronger, an all-out push to devaluation creates a demand for something other than paper fiat currencies. That something is gold. The precious metal is currently undergoing a position unwind that may have quite a bit further to go, but in the long run, we will stay biased to the long side.
What neither the currency devaluation race, nor the deleveraging vs. reflation forces, are doing much of is helping to correct the major problem of global imbalances in trade, consumption, and investment manifested in current accounts. Depending on your belief, this is either a cause or symptom of recent problems and an ever present threat to any real return to global economic health. This needs to be on everyone’s radar at all times, as its effects play out differently at different times. We believe this stands as a central risk factor.
The second major force discussed at the forum crosses global growth, imbalances and inflation. The commodity super cycle is certainly underway. It is difficult to say at what stage, but that to us is also somewhat irrelevant. The scarcity and increased cost of extraction or production is real and will stay generally elevated. Diminishing returns from investment in terms of crop yield and the increased cost of energy extraction represent quantifiable, unlikely temporary, phenomena. Volatility in commodities, however, probably remains above average price returns, even in a super cycle. This situation, as above with respect to EM currencies, requires a tactical approach rather than a long term investment one when operating in an absolute return strategy. But make no mistake – the leaning at Armored Wolf will be toward strength in commodities.
Both a dominant force in terms of resource demand and growth, as well as a manifestation of global issues in terms of asset markets, the emerging markets garnered quite a bit of discussion. We thought it worthwhile to explore the widely held assumption that emerging markets will continue to outperform developed markets. In terms of growth, we agree that the emerging markets will continue to be a primary driver of global growth, though it may be a bit less pronounced in the current decade that the past. In terms of asset prices, however, we do not necessarily agree.
Growth fundamentals should lead to higher company earnings. The most attractive opportunity from this realization is likely a potential re-rating of emerging market corporate bonds when investors acknowledge the superior emerging market sovereign and corporate balance sheets. However, capital markets are still under-developed , and “crapitalism” (crony-
Secular Forum – Q2 2012
capitalism— a term coined by our EM bond manager, Doug Metcalf) persists, so yet again, skilled tacticians should benefit above buy-and-hold investors in this market.
Emerging market equities, however, present a different picture. While growth will probably be higher, it is likely to be investment-heavy growth which, in such an expansion, typically does not lead to higher price/earnings multiples. In fact, equity prices are negatively correlated (-.4) to GDP growth in emerging markets (from 1900-2002, according to Jay Ritter at the University of Florida). So, in this regard, Armored Wolf will lean towards bonds over equities, and approach equities even more tactically.
So we are in a world of countervailing forces and leanings. Having identified likely long-term trends and risks, we still believe that making bold market calls is not a prudent investment strategy. Instead, embracing uncertainty is a better path for macro managers. Aiming to identify medium-term macro trends, trading uncertainties and probabilities, and flexibly and tactically producing alpha is the goal, and more of a focus in the current environment than ever. The recent drop in correlations supports this strategy.
- Armored Wolf will lean towards inflation, but not necessarily an extreme case anytime soon. A real tail risk exists in bond markets, but there is no need to predict it;
- Upward pressure on commodities is real, but the Sharpe ratio of a pure bull commodity play does not belong in an absolute return strategy;
- We favor emerging markets over developed markets, We are, looking for a potential re-rating of bonds but will not get caught pining for higher equities to go with better growth;
- We are aware of tails in markets but believe some have been taken off the table for the time being;
- Tracking how the world deals with a change in credit is a must, as growth usually requires an expansion of credit, while authorities are merely trying to maintain high levels; and
- Potential changes in US capital gains tax treatment is one issue that is not off the table.