Down the road
Volatility is a source of both risk and opportunity. Volatility is typically heightened at, or coincides with, turning points. Even substantial losses can accrue for investors who are ultimately proven right but are simply early. Last week the Japanese stock market index, the Nikkei, fell 11 per cent. Then on Monday of this week it rallied over seven per cent. That’s volatility.
If volatility increases at turning points, could we be at an important turning point? For turning points to indeed turn, there needs however to be an underlying secular or fundamental shift. And that might just be quantitative easing reaching its used-by date. There is no doubt that liquidity is evaporating and that capital is looking for safe havens but finding few. Therefore, fear and uncertainty are generating volatility.
At recent talks and presentations to financial planning groups we have been discussing the increasing impotence of QE, especially as it emerges towards the end of what Ray Dalio describes as the end of a long-term debt cycle.
As an aside, it is interesting that Ray Dalio comes to mind in the context of turning points. If recent reports are correct than even the epochal hedge fund manager is not immune to the volatility associated with turning points. According to some, Bridgewater’s Alpha Fund has lost 10 per cent or $8bn in the two months to the middle of February.
A great article in The Australian this week noted that, (paraphrasing) “according to McKinseys, between the GFC and Mid 2014, global debt had increased by $US57 trillion to 286 per cent of GDP – 17 percent higher than before the GFC. The devaluation of emerging market and developing market economy currencies, including China’s and the dramatic collapse in commodity prices are now amplifying the problem by increasing local currency interest costs and principal repayments [right when growth and foreign capital inflows are slowing or drying up!]. Foreign Banks have lent about US$3.6 Trillion to companies in emerging markets according to the Institute of Institutional Finance. Rating agencies have said default rates in emerging markets last year reached their highest level since 2004 and a lot of the build up in debt has been funded by the Eurozone banking system which has more than $US1Trillion of non-performing loans. Within the $US1.4trillion junk bond market in the US, the energy sector has about $US200 billion of debt securities trading below par and analyst reckon more than $US70bn of investment grade energy related securities could be reclassified as junk over the next few months. High yield energy related bond default rates are rising and will increase when hedges roll off and/or when debt refinancing rolls around. Several hundred billion of debt is at risk if oil prices don’t rise.”
Remember this was the intention of the Saudis all along.
According to another article in The Australian by Bob Gottliebsen, “After the global financial crisis curbed big American Bank lending in high risk situations, the US developed a complex array of hedge funds, private equity partnerships and internet lenders to fund energy stocks(sic). These loans have been unsold in a similar fashion to the schemes that led to the GFC. The US learned nothing. No one knows exactly how much money is involved except that it is massive, but nowhere near the sums involved in the GFC debacle. While the big US banks are not the main players, they still face losses, so the share of many have been slashed around 20 per cent so far this year. At some point US oil production will fall sharply and there will be carnage in the finance markets.”
The former chief economist of the Bank of International Settlements and chairman of the OECD’s Economic Development and Review Committee, William White told London’s Telegraph newspaper that the “global financial system was dangerously unstable and facing an avalanche of bankruptcies” adding, “things are so bad there is no right answer. If they raise rates it will be nasty. If they don’t raise rates it just makes matters worse”.
And with respect to the relationship between China’s slowdown and Australia’s economy, keep in mind between 2008 and 2014 China was responsible for 80 per cent of export growth and it accounts now for about a third of our merchandise exports. And, by way of interest only, George Soros has said a hard landing in China is now unavoidable.
Citi’s chief economist Willem Buiter (a bear mind you who believes the world is on the brink of a global recession) has warned that a financial crisis in China may result in large scale sales of foreign assets owned by Chinese companies. China’s state owned and private companies are significant investors in Australia’s energy, mining, infrastructure and ag assets and has a total estimated external asset portfolio of $US6.5 trillion. “A financial crunch or crisis in China would not just result in a possibly large depreciation of the renminbi but it would also trigger the sudden large scale sale of some of the tense external assets.”
Note ANZ built a large presence in Asia under former CEO Mike Smith. Yesterday new CEO Shayne Elliott warned that credit conditions are deteriorating in Asia.
And this is where a nice piece of prose ought to be included; Fernando del Pino in his essay, The Five Experiments, describes how central banks have tried to eliminate economic cycles, kicking the can down the road;
“Subject to a false sense of security which is nothing but an illusion of control, central bankers have tried to eliminate economic cycles, which naturally occur at least since the times of the Bible, with the seven fat years followed by the seven lean years. However, cycles are indispensable, rewarding vision, intelligence and rightful behavior (and luck, to be sure) and punishing recklessness, excessive greed, shortsightedness (sic) or stupidity. Cycles bring pain, and pain brings necessary change. That’s how human nature works: because of man’s fallen nature, incentives are essential for righting the wrong in the long term. The financial repression of centrally planned zero interest rate policies (ZIRP) will be viewed in the future with dismay and judged as yet another example of human hubris. The price mechanism has been destroyed, asset values distorted; we have run away from reality and created a fantasy where mistakes are not corrected, addictions are not healed and problems are not solved. On the contrary, problems are extended and amplified. The innocent victims of ZIRP have so far been ignored by public opinion: retirees, insurance companies, pension funds, endowments, etc. All these have been forced to climb the ladder of risk desperately trying to grab the yield leftovers.”
We have long warned yield-chasing investors that they have joined a fad that could end badly. According to several reports, a growing group of influential thinkers and investors are arguing that QE has hit its limits. If that is the source of the volatility, this time yield hungry investors may not find it a great source of opportunity.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Tristan Harrison
:
People not learning lessons will make history rhyme it seems.
I’ve sometimes thought about what the world would look like if debt wasn’t allowed (except perhaps for mortgages and a starting-the-business loan).
I hope it isn’t another decade before interest rates are returned to normal.
Thank you for sharing your thoughts Roger.
Michael Shapiro
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Great article Roger.
On QE htting it’s limits, in my opinion QE has diminishing returns, but I am not sure that it reached its limits yet. One way to interpret falling asset prices is a lack of liquidity caused by QE ending over a year ago, and then subsequent hiking of interest rates by the Fed. I bet if they drop the interest rates and restart the QE, asset prices will start rising again quick smart.
Alas, such is a human nature that mistakes are not easily admitted and reversed. So we can look forward to months of sell offs until enough time will pass for the fed to finally admit that it was wrong and reverse course.