Macro, Markets, and Malarkey

Stocks and Bonds
It feels like forever ago, but back in February, the S&P 500 hit its lowest level since 2014 as global growth fears spooked investors, leading to liquidations and deleveraging—most notably for sovereign wealth funds.

Fast forward to now…as of the end of July 2016, the S&P 500 closed at 2,173.60—up 7.5% from the beginning of the year. And, 10-year treasury yields started the year at 2.24%; as of the end of July 2016, rates were at 1.46%—a 35% decline in yield from the beginning of the year. These are big movements in both domestic stock and bond markets which investors shouldn’t take lightly.

Fig1_S&P+10yrTreasury

Also, more than $11 trillion in negative yielding bonds are outstanding, largely in Europe and Japan. The Financial Times wrote a great piece recently highlighting the post-Brexit surge in investor bond purchases.[1]

Fig2_GlobalNegYieldSovDebt

This means that if an investor holds one of these bonds until maturity, they actually lose money. They are also paying the issuer for the right to own these bonds, versus receiving some sort of payment in return—as Finance 101 teaches us should be the case. Governments with massive stimulus policies (ECB, Bank of Japan, and now the Bank of England) are buying up bonds, bidding up the price of these bonds and thus sending yields negative. Accelerating the decline in yields is the fact that the supply of such bonds is not ample enough to meet this demand. Negative yields are supposed to entice investors to invest in other assets, since they clearly lose money by investing in such bonds. This hasn’t happened. And yes, this is completely backwards and deflationary.

Currencies and Commodities
Currency markets have not been immune to this storyline; as Europe and Japan use monetary policy to help grow their economies, foreign investments flow to the US for its higher yields. Since May, foreign buying coupled with more hawkish Fed speak has strengthened the US dollar versus other currencies.

Fig3_USDollarIndex

If the US dollar continues to strengthen or simply stays strong on a relative basis, this has the potential effect of placing a lid on US inflation. The stronger the US economy gets versus its global counterparts, the stronger the dollar looks versus other currencies.

A strong dollar is usually a negative for commodities. And in fact, the strong dollar has kept commodity markets mostly in check since early May, as we wrote about in Commodities at a Crossroads. Of note, crude oil fell to under $30 a barrel earlier this year, sliding alongside the S&P 500, touching its lowest levels since May of 2002. It then spiked to above $50, and now hovers just north of $40 due to dollar related price pressure—nearly 20% below its peak in June of $50.11.

The US Economy and Election
That’s not all. We’ve barely discussed the domestic economy. Here at home, despite anemic GDP growth of 1.2% for Q2, economic growth is indeed expanding as evidenced by the latest payroll and hiring figures. Non-farm payrolls increased by 255,000 in July on a seasonally-adjusted basis, with the unemployment rate at a very healthy 4.9%. Wage growth and labor market improvements here in the US makes a strong case for the Fed to raise rates. Our view is they should raise rates in September, ahead of the election. Whether they will or not remains another question.

Lastly, and as an homage to Vice President Biden’s favorite saying, “malarkey,” rhetoric around the US election has truly captured the American public, including ourselves. We are seeing raw democracy at work here and elsewhere. People are voting against the establishment; it’s a small segment of the human race, but it affects us all. In the meantime, it may become clearer that at extremes, when enough of the populace is truly feeling disadvantaged, capitalism has to make some changes. Otherwise capitalism and democracy are not going to work when the rule of law favors a few as opposed to the many. While this line of thinking may be too philosophical for a financial markets blog, it merits consideration because it does affect one’s view on investing.

Thus far financial markets have not reacted to the election news melee, but investors should pay attention. Should the Republicans lose their majority in the House and Senate, and Hillary Clinton is elected, this could have a dramatic impact on GDP as government spending will very likely increase…then again, it will also increase if Trump builds his wall.

What Should Investors Do?
Stocks can be at record highs throughout the year. The reality is that it doesn’t take much of a move to set a new record high when you have just made one. Odds are we will see low growth for the rest of the year, maybe the rest of the decade. One should expect dispersion by country and company with thoughtful, well analyzed decisions to make on what to own. This is going to take real professionals who are either doing real fundamental analysis or machine learning or can take advantage of the volatility and the anomalies. It’s going to be a different market. We all know that global and country growth comes from demographics and technology (of which productivity is a subset if you can measure it). But, there is a payback when the easy money goes away, causing slower growth than the demographics and technology would suggest.

In light of this, our view is that investors should have two areas of their portfolio well covered. First, there are downside risks to the market right now. Ignoring this fact would potentially leave one’s portfolio without a buffer, and we believe every portfolio needs uncorrelated assets. While it is self-serving to advocate for managed futures, Altegris has a focus on managed futures because time and time again they have performed during some of the worst periods for traditional equity markets.
Fig4_PR_ManagedFuturesPerfDuringEquityMarketStress_1288-NLD-882016

Equity markets could continue to push for new highs, but we believe they are also susceptible to periods of steep losses. Managed futures performance has historically been uncorrelated to the performance of the broad stock market, and we strongly believe all investors with risk capital should consider this diversifying return stream, given the current macro picture.

The second bookend to investors’ portfolios, given the market environment, is private equity. Private equity was one of the few areas that didn’t sell off when investors panicked earlier this year, and whose returns can be orthogonal to the returns of traditional markets. Now, private equity is not a liquid investment option, so investors must be thoughtful in terms of just how much they allocate. But it is the forgoing of frequent liquidity that makes private equity attractive in our opinion. This is what is commonly referred to as the illiquidity premium, which is essentially the potential reward of enhanced returns—over time. This potential for enhanced returns may be particularly attractive for investors given the uncertainty in traditional equities at present.

The bottom line is that investors should aim to diversify portfolios. Look for ways to grow and preserve capital in your portfolio and seek returns in areas where investment managers have a real edge and understanding of the underlying investments. Pay attention, and invest for the future of your portfolios.

 

Data sourced from Bloomberg unless otherwise specified.

[1] Financial Times, June 29, 2016: http://www.ft.com/fastft/2016/06/29/negative-yielding-sovereign-debt-rises-to-11-7tn-globally/

A Flat Market Year-to-date

If one was fortunate enough to avoid the noise of the first three months of the year, one could point to a flat equity market for the year-to-date (YTD) with the 10-year treasury yield declining from 2.24% to 1.91% as the yield curve flattened. Most were not fortunate enough to avoid the noise and the liquidity trap that led to some selling at the wrong time and not much buying. The poor macro guys were making all kinds of bets, while the hedge funds tried to make the most of the dispersion amongst individual securities.

We have written about greater volatility and greater dispersion as a characteristic of a slow growth economy, which produces increased differentiation of earnings performance and a generally slower growth in overall equity performance. We believe this condition will be with us for some time to come as the global economy works its way through industrial overcapacity and the recession produced in the global industrial sector. In the meantime, service sectors around the world and disruptive information technology have been the primary source of jobs. Ultimately, IT will change the mix of talent needed. That is already showing up in the JOLTS reports with quits and job openings at high levels. While one can see the dispersion in individual stocks, we also see dispersion in the pace and the drivers of economic growth in both developed and developing markets. It is worth looking at the dispersion by industry within the US, and we have included a table showing what has happened YTD in the energy sector featuring the 10 best and worst performers year-to-date.

Fig1_TBL_Blog_S&P-Dispersion-by-Sector+EnergyDetail_032916

The US is, in our view, rightfully, on a path back toward normality led by Fed action without much fiscal help. Odds are if the economy continues to produce job growth and, ultimately, wage increases, we will see additional increases in the Fed funds rate this year (See Altegris Perspectives, “What to Expect in 2016 (And Beyond)” for some specific forecasts made as the year began on Fed rate hikes, oil prices, the markets, and a few other variables).

There are two variables at work, which would appear to be affecting the timing and magnitude of the Fed funds rate increases. One of them is bogus in my view, but the other one is a bit more troubling. The bogus element is the excuse of what is happening outside the US as a reason to both delay and reduce the likely Fed funds rate increases for this year. The second variable, which has not been made explicit, but, in my view, is a driver of the move away from being data-driven, has to do with the elections in November. The noise coming from both major parties—to the extent we still have two major parties—has, as a part of their message, been looking to what has really gone on at the Fed with finger-pointing blame for the rate of growth perceived to be lower than it should have been; and making sure that the next president makes it “right.”

There has always been a political consideration that the Fed has been required to acknowledge, even in Paul Volcker’s day. However, with the rhetoric coming from the candidates, I believe the Fed is taking a very cautious approach with a willingness to err on the side of not doing anything that could, in hindsight, be viewed as disrupting the growth path we are on. This likely means fewer increases than were originally anticipated this year and later in the year, unless the employment data forces the Fed’s hand. Our expectation as expressed in our Perspectives piece was for two increases this year. That is now appearing to be the general view (which likely means it’s wrong). If the general view proves to be wrong, I would think we would see more than two increases as opposed to a reduction. As I said in the Perspectives piece, the second half of the year may be very different from the first half—and that’s without the Cushing quake.

As long as we are dealing with unspoken strategies, one could take this even further into the world of strategic interlinkage of actions with an unexpected outcome: The lack of a Fed funds rate increase has had a negative impact on the dollar, and, along with some elements on the supply/demand front, has been a factor in pushing the WTI (Cushing) oil price up from a low of $26.68/barrel on January 20 to around $40/bbl now, while the spread has narrowed with Brent, which hit a low of $28.58/bbl on January 13, and is at the same price as WTI now. The $11/bbl increase in Brent is a huge benefit to Russia, which is pumping out a recent high of over 10.3 million barrels of oil a day. At the same time, the ruble has declined over the last two years relative to the dollar by 50% making every dollar received worth twice as much to the economy and reserves than it might otherwise. The sudden withdrawal of the Russian military’s support of the Syrian government, “mission accomplished” combined with noises about reaching some type of settlement desired by many of the significant Middle East oil producers seems coincident with the interesting move of oil prices off their lows. We will see how long these prices hold, but every day is a huge benefit to Mr. Putin, and some belief or hinted commitment that oil prices may stay a bit higher is reason enough to move toward being a part of a cease-fire and potential settlement. This is not a benefit to the US economy away from the oil and gas industry. It simply reinforces our view that growth will be slow and profit dispersion will be significant, and things happen in this world that are more complex than the pundits think. It continues to require a relook at allocations and a realistic view of what kind of returns one can expect from the traditional liquid markets overall for some time to come.

The dispersion will lead to moments in time when the value proposition is overwhelmingly positive. Those are the most difficult times to make the buy decisions as opposed to selling at the bottom. We have written and “webinared” before about the illiquidity premium that is available and may be necessary to achieve one’s financial goals, as well as the increasing value of pattern recognition as Moore’s Law continues to increase the ability of those who know how to use the technology to the benefit of their clients. We will continue to see these unusual volatile moves as we work our way through this long low return environment. It is a different investing environment.

In the short term, I still believe we need to PAY ATTENTION to the employment reports as a major factor for the Fed, the economy, and, most likely, the elections. We will be getting the March report this coming Friday.

As one can see from the table of historical seasonally-adjusted and not seasonally-adjusted employment numbers, February, March and April typically make up for the actual declines in the employment rolls in January. However, this January’s decline—larger than many of the previous Januaries—along with the numbers of late last year, seem to indicate a changing pattern that is not necessarily being picked up in the seasonally-adjusted numbers. If the make-up actually occurs in February through April, the seasonally-adjusted numbers could be explosive.

Fig2_TBL_Blog_OTM Change_Jan11-Feb16_032816

This will make for interesting media responses. Of more importance will be what is actually happening to wage and weekly payroll increases and what that means for total wages, including additions to the payrolls. This does get pretty technical, and the changing pattern could lead to just the opposite of what I am describing. The wage numbers will be of more importance to the Fed and will likely become the topic that could drive the Fed’s decisions on timing and magnitude of funds rate increases against the backdrop of an adversarial political environment. The confusion that comes with these seasonally-adjusted numbers will add to the volatility and uncertainty about what the Fed will actually do.

To some extent it is noise; to another extent it is a signal, reinforcing the view that we are in a different, slow growth environment that will call for some real decisions on asset allocations and the choices of strategies to meet one’s goals. We can help with some of those solutions. They are not blanket solutions that apply to all investors, but instead do require some real understanding of what an investor or her advisor is trying to achieve over a specific time frame.

A Look at the Year Ahead

Providing some answers to the questions on the media’s minds (and maybe the investors’).

This is the time of year when we get a lot of questions regarding our outlook for next year including a call for point estimates on the usual indices and other variables. It is somewhat pointless to provide point estimates, but we did some of that below. We are in an unusual environment, with many variables that can certainly see some volatility throughout the year with, in my view, greater dispersion in results, similar to this past year. We are working on our annual Altegris Perpectives piece, “What to Expect in 2016 (and Beyond).” I must say, it is a harder year for developing definitive expectations than I have seen in a long time. That says something about the markets and increases the desire to spend time with the micro folks as opposed to the macro types. Historically, when this has been the case, that has paid off.  Paying Attention is still the advice, but I would add the words of my friend and former co-worker many years back, Art Cashin, “…Stay Nimble.”  As many of you who on occasion read the Altegris Blogs, you have seen me write that Past Performance is Not Indicative of Future Results. Given some of the dispersion we did see in 2015, this may be a time when last year’s performance may be more indicative of this coming year’s results.

Below are some of the consistent questions that have come up from those looking for answers.

 

Taking into consideration the rollercoaster some equity investors found themselves on this past year, particularly in August, what are the biggest risks facing investors in the stock market in 2016?

There’s a long list of factors impacting the stock market as we begin the New Year. The global slowdown, a strong dollar and the Federal Reserve’s late-in-the-game rate change, to name a few, all add a degree of uncertainty for investors. I would also stress two other factors that will play into investor returns: another year of profit disappointment driven by wage increases and the end of the oil dividend for many corporations.

 

What will be the biggest surprise for investors over the next 12 to 18 months?

Inflation could pick up a lot faster than widely anticipated. I would encourage investors to keep an eye on wage growth.

 

How are you advising clients looking to allocate assets and potentially reinvigorate their returns entering into the New Year?

We’ll be publishing an in-depth outlook with a few wild cards shortly, but I can provide a quick preview of what we’re seeing in the markets.

To the extent an investor doesn’t need liquidity, the opportunities in the less liquid parts of the markets will likely benefit from a growing illiquidity premium. Just don’t buy a daily liquidity fund that has been buying illiquid securities to juice returns.

Investors experienced no to low equity returns in 2015. We’re predicting more of the same for equities next year. It may prove to be a good year for true equity hedge fund managers. In terms of fixed income, we’re anticipating some credit accidents, but on balance, no major credit meltdowns. The recent moves in the high yield markets may have provided some opportunities if one does very specific credit analysis security by security.  Activist and event-driven managers are likely to experience favorable returns as M&A activity continues to be strong going into 2016. As we have seen this past year, sometimes an activist approach doesn’t work, but I think over time it does. This recent action does open up opportunities for those who have a longer time horizon and are dealing in the less liquid parts of the markets. I recently made a point (which I stole from one of our own, Greg Brucher) “…investors buy and hope, activists buy and influence, and private equity firms buy and fix.”  There will be a lot of situations open for fixing over the next few years.

 

Given Donald Trump’s campaign has been getting a lot of media attention, with speculation that he could actually have a shot at the Republican nomination, what would the election of Donald Trump mean for equities?

Trump’s nomination would most likely be a negative for equities since it would represent some element of disarray in the Republican Party. If he is elected, however, we think it could potentially be positive for the markets. Most of the programs he is calling for would raise debt levels more than any previous administration’s policies. The upside for the economy would be a lot of fiscal stimulus. The downside is that it would inevitably increase rates. This would also bode well for defense stocks. Whoever is elected, I think the odds of more fiscal action is higher than it has been over the last 8 years, even amidst ongoing dysfunction at the Congressional level.

Historically, the President only affects stocks on the margin. But as we’ve seen with Trump’s campaign for the nomination, a Trump presidency would no doubt be a different animal.

 

Who would be the best presidential candidate for the stock market? 

I’m more interested in picking the best candidate for the country. While one could say what’s good for the stock market is good for the country, I tend to think it’s the other way around. Historically, markets have done better under Democratic presidents, but it’s a close call.

 

Looking forward to the next 12 months, on which sectors are you taking a bullish or bearish stance?

We’re bullish on defense stocks, technology and healthcare. In terms of technology, we’re actually favoring old tech over new tech, particularly companies involved with the cloud, cybersecurity and have been spending on R&D.  Moore’s Law continues to be operative.

Consumer staples and most fast food companies are where we’re currently bearish. While staples tend to be a more defensive sector that does relatively well in slow growth environments, changing eating and drinking habits among Americans are going to make it tough for these companies to keep up and generate meaningful returns. Once again, it is company by company, but they won’t all be making the adjustments to new habits in a timely fashion.

 

If you had to give 2016 year-end targets for a handful of major market indicators and indices, what would they be?

Take the point estimates with a grain of salt because on any given day those numbers can and will change. But overall the market may keep pace with nominal GDP results next year in spite of the profit picture looking quite weak.

S&P 500: 2,120 (but with big dispersion)

Dow: 18,100

10-year Treasury yield: 2.65%

Gold: $1150

Crude oil (WTI): $52 (this was my target before this latest downdraft and I’m sticking with it—at the moment)

Fed Funds Rate: 0.75%

An Inflation Wild Card To Watch And…the best disclaimer I have ever read

Inflation

In the blog just posted prior to this one, we pointed out that the Fed’s inflation favorite, the core personal consumption expenditure (PCE) index, was up only 1.3% year-over-year with the last number actually flat month-over-month. I indicated that inflation could remain lower longer thus leading to a slow rate of increase in the Fed Funds’ target rate for some time. I did point out there was a wild card to watch. I still plan on including this as one of the predictions in the “What to Expect in 2016…” Perspectives piece, which will be coming out shortly. However, here is a brief description of what I expect could happen that might surprise the markets and, maybe, the Fed later next year. It does relate to energy. But, you will point out, energy is not included in the core PCE calculation. That is true. However, the impact of a reduction in oil prices and energy in general doesn’t just affect consumers’ transportation and heating costs—putting more money in their pockets. It affects businesses as well, reducing both their energy and transportation costs and, in some businesses, the cost of hydrocarbon-based feedstock as a part of their product. When I hear, anecdotally, that a friend in the paint business is experiencing record profits because of a reduction in cost-of-hydrocarbon-based goods, transportation costs and maybe a bit of a lift in remodeling and new home construction, I can translate that into similar experiences in other industrial and commercial businesses. It does add to corporate profits. While it is difficult to make a precise calculation, the 50% reduction in oil and gas prices over the last year could easily have added $90-$135 billion to the more than $2 trillion in pre-tax corporate profits. That 4%-5% pickup in profits may have reduced the price increases that, otherwise, would have been needed to make up for part of the labor cost increases that were being incurred. While that addition to profits will hold as long as energy prices stay flat, it won’t increase further. Thus, corporations may have to look for price increases to offset the continued more than 2% annual increase in unit labor costs. If energy prices continue to stay around these levels or rise, the direct impact on the core PCE index won’t happen, but the indirect effect of having to absorb the increased labor costs without additional energy offset could start showing up in final price increases. Excess supply in certain industries could mitigate the ability for certain companies to raise prices, but by sometime next year—maybe mid-year—we could start to see more price increases. It will not happen across the board, but specific company and industry analysis could turn up some profit surprises, positive or negative, as the energy transfer of wealth dissipates. Worth paying attention.

My favorite disclaimer

The two topics in this blog have no direct relation to each other. However, I did make a reference to Eric Peters in the last blog. Eric is CEO and CIO of One River Asset Management located in Greenwich, Connecticut. Eric and his team create very interesting theme-oriented bespoke portfolios for several major institutions. His comments on what is going on in the world are shared regularly with a specific qualified list in the form of direct observations, stories and quotes involving several re-occurring characters, his family members and other occasional guests. The observations are always thought-provoking, succinct and very readable. As a financial advisor, Eric always ends his pieces with the appropriate disclaimers and a few additional ones as well. I asked Eric if I could share his disclaimer with our readers. I think he said “yes,” although it could have been someone else. So let’s end this blog with his disclaimer (by the way, I disclaim any claim to his disclaimer…):

The Eric Peters’ Disclaimer:

All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.”

Paris, China, Russia and the Impact on Risk

The tragic events in Paris on Friday have not only raised the global risk levels of further terrorist actions, but will also produce behavioral changes geopolitically and locally. This will affect markets beginning now.

We are already seeing the pulling together of a more coordinated global action against ISIS by the western world. Europe, of course, may bear the brunt of change and would appear to be the most vulnerable to the impact of the increased risk levels on the broad economy, country politics, and societal reaction within the diverse elements of the population. Kim Wallace of RenMac made the observation this past weekend that 3% of the 7.3 billion people in the world are emigrating from developing countries to more developed environs. With the turmoil in the Middle East in particular, but also other closer areas, Europe, with a more open door policy—at least until now—is bearing the brunt of the disruptive emigration on its economies, its existing population and the social issues surrounding the clash of cultures.

In the meantime:

  • Russia is holding back from supporting what is likely to be a western world coordinated effort around ISIS, and will likely be a continued troublemaker relative to its own perceived interests.
  • The IMF staff is recommending the inclusion of the Renminbi in the basket of reserve currencies. The actual adoption or rejection occurs at the end of this month.
  • Commodities, including oil, have taken another downturn.
  • While US employment data looks reasonably strong, it certainly didn’t translate into strength in retailing.
  • The technicians don’t see much cause for recovery in the markets, at least through the data that was available through last Friday.
  • And, the probabilities regarding a Fed hike in December will likely move down.

There is much more that could be said regarding what has happened this past week and certainly opinions that could be expressed. I leave that to the op-ed contributors. It is hard enough trying to make sense about what this means for the markets. Let’s try to address some of the possibilities, starting with the effects on economies.

Almost all of these actions would tend to support a slowdown in activity in the euro region from a combination of the disruption caused by the terrorist action within Europe, the political dysfunction that may occur, and the actual reduction of incoming travel to the region. This is against a backdrop of the possibility that the decline in commodities is an indication of even slower global growth as opposed to simply an oversupply situation caused by the continued production of various hard commodities and oil as long as the operating economics provide cash flow to service debt and cover other costs. I have said this before, but it’s worth reiterating, that energy is a significant input cost to the extraction and refining of most hard commodities, as well as oil itself. As the breakeven drops, production can continue longer than one might expect. We recently discussed this point relative to the Bakken oil fields in North Dakota. We will need to look for other signals to determine whether this is a global growth problem or something more specific. The offset in Europe to the impact of the terrorist activity is the likelihood of continued, and possibly increased, QE or QE-like central banking activity as well as fiscal activity. In addition, the currencies of China and the US are likely to remain stronger than the euro as a result of the IMF action, and some signs of growth stability in China, combined with a possible flight of capital to the two large countries that are somewhat—I say somewhat—more isolated, with lower probability, from the possibility of terrorist action internally. Relatively speaking, these markets may do better for some period as a result of these flows and growth patterns than what we see from Europe. It specifically may hold down rates as money flows into US government securities. Ultimately, the euro currency weakness could begin to mollify that spread in performance.

So what does this say about the likelihood of a Fed move in December? I think that depends a lot on the November employment reports where the Fed will have another set of data before a decision is made. The October numbers were certainly robust as we have pointed out in some of our recent Altegris video and audio broadcasts. If there is actual evidence of a further global slowdown combined with weaker employment data—not our expectation—the Fed could delay. That puts them into next year with all of the uncertainties that entails. If the US numbers are good, combined with no significant deterioration globally, the odds are the Fed will pull the trigger and get started. The markets are to some extent reflecting this, although we will see what the Paris incidents do to the dollar, flows and, ultimately, market rates. As I have said, I don’t think December is a good time to change the rate picture—even modestly—while there are significant end-of-year activities around balance sheets and inventories of securities in the financial markets.

All of this reinforces our view that there will be increased dispersion within and among asset classes, combined with some financial accidents, away from a fluid geopolitical environment. Active management and less-correlated solutions are the likely better performers in the aforementioned economic climate that may be with us for some time to come. I don’t really have to ask, given recent events, for everyone to pay attention.

South America, PE, and the Fed

Watch Friday’s Employment Numbers

Last Friday, July 30th, I was invited back to Bloomberg Market Makers with hosts Matt Miller and Scarlet Fu. Katia Porzecanski, who follows the emerging markets, and Tracy Alloway, executive markets editor, joined the sessions. As usual the producers provide some topics a day or so before the appearances to prime the discussions. The questions were “What are you watching in South America?” “Hedge funds and Private Equity assets—what kind of strategies are you looking at?” and “What’s up with the Fed?” As in the past, below are the notes I sent to the producers in preparation for the segment.

 

South America: I’m watching three countries: Brazil, Argentina, and Mexico.

I don’t think we are close to a turning point on the negative GDP in Brazil. This is important as Brazil is critical to the rest of South America and accidents can happen on the corporate credit side and within the government. They don’t have a lot of levers.

Argentina, may look like a disaster, but is moving closer to an election which will bring in one of a couple of logical, policy oriented candidates, and Argentina will begin its every two decades cycle of recovery. I think the issue on their sovereign debt will get resolved. But, coming out of it may be a change in the covenants of sovereign debt in the future. For example, the ability to hold out from what a majority of creditors agree to on a settlement is likely to vanish.  This makes sovereign debt more expensive but hastens returns to the capital markets for renegers.  In addition, Argentina has phenomenal Shale-based hydrocarbon reserves, which it will be able to exploit once there are adults in the government.  A big part of the shale reserves are in the same area where Argentina’s conventional gas reserves existed. The gathering facilities and movement of the resources are already in place. This could happen quickly and economically.  Unfortunately, in the process, some of the best fishing areas in the Neuquén Province (where I used to fish!) may be destroyed. I hope not. Economically, shale extraction is a big plus. Let’s understand this will add significantly to global energy supply, and put more pressure on prices.

Mexico is, as I said on air, a shining star. The natural growth rate is 2 ½-3%. If Telecom and Energy reform happens, another 1 ½% would be added to the rate. Henry McVey, KKR’s Global Macro Head, discussed this recently on our webinar, “Investing in an Idiosyncratic World.”  Mexico could become one of the faster growing economies in the world with sustainable demographics. Energy reform there would also add to global oil and gas supply. I am pretty optimistic for Mexico.

In general, I like the Americas for opportunities—long and short. Canada is a little problematic right now given the oil patch and commodity producers may have a problem. If global growth picks up at some point, there is a cycle yet to come.

 

Hedge Funds and Private Equity: In general, given the market environment I expect over the next several years, I am in favor of active managers—non-benchmark-huggers, whether that is long-only or hedge funds that can generate alpha on both sides of the market.

Today, the best Private Equity firms have the most active managers among all managers. That’s because these managers can do more analysis and have more companies to choose from (than those operating in the public markets) in making their decisions. In addition, they are typically heavily involved after the investment is made and do not have to worry about specific quarterly earnings. There is truly an illiquidity premium, which could very well be widening.

I am more nervous about the Venture portion of Private Equity. It is reminiscent of the Dotcom Era. (BTW, when I first typed “dotcom,” spellcheck changed it to “sitcom.” In retrospect, that may have been appropriate.) My guess is that, as always, the top quartile performers in that space will remain at the top. One has to make sure they are investing with a top quartile performer.

I think that the five years after 2008 were hardest for hedge funds, in general.  Now we are entering into a period of low global growth but high dispersion.  One can’t count on beta to meet return requirements, and there is risk on the fixed income side—low yields, but principal risk and credit risk if rates rise. I would look for equity hedge fund managers that run a lower net long position most of the time, fixed income absolute return or long/short managers that fundamentally analyze credits. I also think while one can own real estate, I would like to have a hedger there, as well. The macro strategies may start working and uncorrelated strategies like managed futures do belong in a portfolio. I would actually like to create the core of a portfolio around all the alternative strategies and active management strategies that have been on the periphery for the last several years. On the edges, I would play around with passive strategies, hopefully moving in and out at the right time.

 

The Fed: In response to the Fed’s news this week, I think the Fed is saying that they will be data driven, but they really want to start raising rates. I would be surprised if the raise actually takes place before the Fed’s dots and the future’s markets get a little closer to each other. Right now the differences are more than a quarter point apart on where rates will be in December. When will the increase happen? If the employment number surprises on the upside next Friday that may move the dots and the market closer to each other and push the odds up on a September increase.

It could surprise. I would bet it will. Why? July is actually a lay-off month, with plant shutdowns and other changes. Unseasonally adjusted, the employment numbers go down by about a million people; seasonally adjusted ends up as a positive number. The unemployment claims, the job openings numbers, and anecdotal info say that there aren’t as many layoffs taking place. Companies are having trouble finding qualified workers and hanging on to the ones they’ve got and perhaps, they are starting to raise wages on the margin. I can’t make heads or tails of the seasonal adjustment factors, which always seem to be adjusted themselves.  If someone gave me some odds on a bet on the number, I think it could just as easily be 275,000 to 300,000 seasonally adjusted, but certainly above the 218,000 consensus estimate. I’ve never met a seasonally adjusted worker, but this could be a surprising month. If the number doesn’t surprise to the upside, then it’s December. Whatever and whenever it is, it really depends on what happens from there in terms of the size and how often the rates continue to rise. I have even said that maybe the first rise or subsequent increases are at 1/8 of a point instead of ¼.

As an added bonus, as I mentioned, Executive Markets Editor Tracy Alloway joined us in a second segment. At 6:30 am that morning Tracy sent over the three topics of the day that we would be discussing: the emerging markets pain, bad month for commodities, and a good month for Italian bonds. We did cover those topics as well. This link takes one to the Bloomberg clip.

Tracy pointed out that the emerging markets as a group experienced major currency declines in the month and some are actually raising rates. My view was that they should be focusing on growth and raising rates was not the way to do it. It was also a bad month for commodities with many blaming the dollar. There are many causes for low commodity prices—slower global growth and the strength of the dollar don’t help. My view is that lower commodity prices may stay that way because of the oversupply and low prices of oil/energy. Energy is a major input to mining and refining costs. As those costs fall the marginal cost of production may fall enough for extraction and refining to make a contribution to overhead, thus keeping the supply higher than it otherwise might be and prices lower. If mining assets actually change hands at wholesale prices (a coal property was described as selling for a dollar), that also lowers the bar on what the price of the commodity needs to be to produce a return on investment. That will certainly be happening in the energy space, and may occur elsewhere.

I didn’t have much to say about Italian bonds other than QE in Europe is likely to continue pushing yields lower than they otherwise might be. Investors are following the money.

Life may not turn out to be quite that simple. I do believe we will see significant dispersion in economic results, sector results and individual company results over the next few years. Active management will have its day. Pay Attention.