A Different Perspective
Asking the Right Questions
Weekly Market Recap: January 19th 2015
Market Recap
Global equity markets were mixed last week after the shock decision on Thursday by the Swiss National Bank (SNB), to abandon their currency peg with the Euro, reverberated across financial markets. The resulting currency moves seemed to dictate the performance of the local equity markets. The Swiss Franc moved sharply higher but the local SMI equity index lost over 13% of its value last week. Meanwhile, European equity markets shot up on Thursday as the Euro weakened while US dollar strength appeared to weigh on US equity markets. The FTSE Eurofirst 300 equity index gained 4.34% for the week as the Euro moved to an 11-year low against the US dollar.
Amidst the increased volatility, government bonds were in demand as yields continue to move lower. The German 10-Year bond yield dropped to 0.46% while the equivalent yields in the US, UK and Japan closed the week at 1.80%, 1.54% and 0.24%. Domestically, the Irish 10-year yield closed the week at 1.05%, yes 1.05%!! It is hard to believe such a dramatic decline from the 14% yield witnessed in 2011, even as Ireland remains highly indebted. It is evident that the decline is less about fiscal credibility and more about ECB monetary policy, but the Irish government have proved to be an efficient tax collector.
Week Ahead
US markets are closed today for the Martin Luther King holiday. European equity indices are higher despite a mixed session in Asia overnight that saw China’s Shanghai Composite Index decline by a massive 7.7%. The regulator there is clamping down on margin trading as the outstanding margin loans have almost tripled in six months, which has helped fuel a massive rally in the local Chinese equity market. While investors will be hurt by the short term move it should make for a more sustainable equity market longer term.
There is raft of data released from China tomorrow including fourth quarter GDP growth, retail sales and industrial production. The flash PMI surveys from Europe, the US and China will provide some insight into what we can expect in the first quarter from these economies. On the monetary policy front, the European Central Bank (ECB), the Bank of Japan (BOJ) and the Bank of Canada (BOC) will hold monetary policy meetings this week, while the Bank of England (BOE) will release the minutes of their most recent meeting. However it is all about the ECB this week.
Adding a dynamic allocation that can adapt to the changing environment
As I think about the outlook for the global economy and financial markets in the year ahead I can’t help but bring it back to a sporting context, in my case football. In preparation for every football match a manager sets out his team and tactics to win the match, his game plan. As good as that game plan may be no manager can legislate for how the game will actually evolve. One mistimed tackle here or one poor pass there can change the game, just as a poor refereeing decision, what economists might call an ‘exogenous factor’, can put the best laid plans out the window. Still, the best managers set out their team to be able to adapt to anything that comes at them.
It is no different in the financial ecosystem in which we operate. We do not live in a static world, even the most sophisticated economic and financial models have their limitations. We are all part of the very world we try to model and ultimately, as human beings, we are not always rational despite what these models might assume. As investors, while a significant amount of what actually happens is outside our control, there is still a strong case for a well thought-out plan, the foundation of which is realistic expectations of risk and return.
Ultimately, the more robust the investment strategy the more adaptive it can be to the circumstances of the environment that prevails and hence the higher the probability of success. Over the last five years investors have been well served by a long term strategic asset allocation, ignoring short term fluctuations, as equities and bonds moved higher. However, with many of the major equity indices now at record highs and bond yields at or near record lows, there is a strong case for adding a dynamic element to portfolios that can adapt to the changing environment.
The volatility that we have seen over the last few weeks points to a market that is finding it more difficult to appraise the consequences of divergent monetary policy, the oil price collapse, a lower growth environment and, most concerning, the risk of Europe becoming mired in deflation. Whether it is life, football, business or investing it is the ability to adapt to a changing environment that is at the very heart of our survival.
On that note, I’ll leave you with a quote from the self-proclaimed ‘special one’:
“In this moment our team are able to adapt to everything. What the game gives us, we can cope with. We are not the kind of team that play only the same way, think the same things. We can play in a different way and adapt to different situations.” Jose Mourinho, Chelsea FC Manager, October 2014
The Year Ahead: Key Considerations
As I consider the outlook for the year ahead I am certain that once again the predominant theme is central bank policy. The investment world is a dynamic place and each week in my weekly musings I try to touch on the most relevant developments. Therefore, I have outlined briefly below some of the key considerations with respect to the outlook for the economy, monetary policy and various asset classes over the next year:
Global Economy: Overall output is expected to be marginally higher than in 2014; the World Bank forecasts that global GDP growth will rise moderately to 3%. Domestically, the expected growth rate for the Irish economy is closer to 4%, following a strong year in 2014. The domestic outlook is heavily reliant on the actions of the ECB and the reach for yield among investors which has supported the decline in Irish sovereign bond yields to record lows. Given the high level of indebtedness across the economy and the fragile nature of the domestic banks (25% of the value of outstanding loans are non-performing and their funding profile is heavily skewed to the short term), Ireland remains susceptible to an external shock.
Monetary Policy: The BOJ is hoping to slay the deflation ogre that has plagued the economy for over fifteen years while the ECB looks set to pursue more aggressive measures in order to avoid a similar deflationary fate to Japan. Meanwhile, the Fed and the BOE have to balance the need to raise rates for financial stability purposes against the risk of prematurely removing support for what is a relatively fragile recovery. The risk is that with interest rates in the developed world still at emergency levels these central banks will have much less room to manoeuvre if another crisis hits the global economy. The easing party is not limited to the developed countries as we have seen with China and today as I write the Bank of India have cut interest rates for the first time in 20 months.
Cash: High quality cash funds are likely to earn a slightly negative return. Euro area inflation turned negative in December so the real interest rate (nominal less inflation) is flat and could be marginally positive if deflation sets in.
Bonds: Bond yields will continue to be influenced by economic activity, inflation expectations and monetary policy, as well as investor behaviour in general. Today, the 30-year German Government bond yield is 1.19%, pointing to weak GDP growth, low inflation and low short term interest rates in Europe over the long term. Bonds still form an important part of portfolios for diversification purposes but long term bonds are really only suitable for individuals near retirement looking to match the price of an annuity or as part of an LDI strategy for defined benefit schemes.
Equities: Equity valuation is in the eye of the beholder and the concept of ‘fair valuation’ is highly subjective, again a function of the market environment and investor behaviour. At current interest rates, equities do offer better relative value to bonds. Equity markets have been highly responsive to monetary stimulus over the last five years, with China providing the most recent example of how investors have reacted to the prospect of looser monetary policy. In the context of this precedent, European equities should benefit if the ECB finally takes out the big guns and starts buying the sovereign bonds of member states. However, nothing is ever straightforward with the ECB and so there is plenty of room for disappointment.
Property: Domestically, property is en vogue again as both the residential and commercial sectors have enjoyed handsome gains over the last two years. The most recent macro-financial review from the Irish Central Bank noted that initial yields for the commercial property sector have fallen to 6.5%, from almost 10% in early 2012, driven by a buoyant Dublin office market. Against the backdrop of low interest rates, the property recovery has been boosted by the influx of foreign capital, attracted by the higher yields, which could leave the market “vulnerable to a change in investor sentiment”. Investors in property funds have to be wary of the illiquidity risk.
Commodities: The game changer in the oil markets was the decision by OPEC not to cut production and in turn leave it to the free hand of the markets to dictate the price. The market is still finding that price but the futures markets are expecting prices to rise. The macro impact of the oil price decline is debatable but moves of this magnitude over such a short time period in any financial asset can be inherently destabilising; one lesson from the last crisis is that market participants can underestimate the contagion effect from what is perceived as a relatively small part of the market, think sub-prime mortgages! At the start of 2014, equity markets in China and India were among the unloved and they turned out to be star performers; 2015 could be the year gold shines as volatility becomes more normal.
Market Review of 2014: a time for reflection
“Past events will always look less random than they were” Nassim Taleb
Another year behind us and for the most part investors have enjoyed stellar returns, as the influence of the world’s major central banks outweighed the lower than expected global GDP growth, geopolitical tensions and the deflation risk in Europe. There have been a few bumps along the way and not all equity markets performed well in 2014 but investors have been well served by holding globally diversified investments.
Overall though, as I reflect briefly on 2014, what really stands out is the decline in government bond yields across the globe and the collapse in oil prices that took hold in the second half of the year. In Europe, falling inflation, a more subdued outlook for economic growth and more aggressive monetary policy from the European Central Bank (ECB) all served to push the German 10-year yield to a record low of 0.54%, down from 1.94%.
Global Economy yet to turn the corner….
2014 began with a renewed optimism among the consensus that the global economy had reached a turning point; the World Bank forecasted global GDP growth of 3.2%, above the 2.5% recorded in 2013. However, the global recovery was more muted than expected with growth of 2.6% and increased divergence among the world’s major economies. Economic momentum picked up in the US and the UK, while the Eurozone economy continued to languish and Japan was unable to shrug off the consumption tax increase in April. Meanwhile, the slowdown in China gathered pace and growth disappointed in many of the emerging market economies where we have seen domestic policy tightening.
Monetary Policy Divergence….
The theme of monetary policy divergence across the world’s central banks began to gradually take shape in 2014. The US Federal Reserve (Fed) ended their QE3 monthly bond purchases while both they and the Bank of England (BOE) began to take questions on the possible timing of rate hikes as economic activity picked up. Meanwhile, the ECB and the Bank of Japan (BOJ) were forced to loosen monetary policy further. This perceived divergence played out most in the currency markets as both the Euro and the Yen weakened considerably against the US dollar.
Pavlovian response to Monetary Policy is alive and well….
Still, every time we saw a correction in equity markets the world’s major central banks came to the rescue; the Fed and the BOE continued to play the “lower for longer” tune, reassuring investors that they won’t have to go cold turkey if the withdrawal symptoms from easy money prove too much. Even China’s central bank got in on the act, cutting interest rates on November 21st for the first time in two years as the economic outlook deteriorated. Since then China’s Shanghai Composite Index rallied 27%, bringing the annual gain to nearly 50%, the best performing major equity index over the year. This was followed by Indian equities which ended the year up 40%.
Thoughts on Decision Making
“Life is a sum of all your choices” Albert Camus (French Philosopher)
Decision making permeates our lives. At a personal level we make decisions on a daily basis in our social interactions. As well, the decisions of others, translated into their actions, can have irreversible consequences on our lives just as the decisions of those in power shape the very world we live in.
As consultants, decision making is a fundamental part of our business. We make decisions for others, or at least provide the necessary information available to assist in the decision making process. At the same time we are also responsible for making decisions on investment managers, based on our analysis of their decision making.
Since we know that chance can play a big role in the outcome of any individual decision, analysing whether a decision was good or bad based on success or failure does not tell the full picture. This is particularly relevant in the active fund management space where persistent performance is the Holy Grail.
Decisions made on impulse are more likely to lead to regret while paralysis on making decisions induced by fear can be just as fatal. In our personal lives we are more likely to be driven by impulse, and in a way life would be boring if we did not embrace our impulsive side at times.
However, in our role as decision maker for others there has to be a colder analytical approach to our decision making. Therefore, examining the reasoning behind a decision and the wider decision-making process is arguably more important than analysing the outcome, if we are to test the robustness of the decision making in an uncertain and dynamic market environment. (Of course intuition can play a part but this is not to be confused with impulse).
In the end the best decision may not always be the optimal one, that is if ‘optimal’ can even be verified, we can only make use of all of the available information and apply reasonable assumptions to make the most effective decision at that time.
Weekly Market Recap: December 15th 2014
Market Recap
Global quity markets moved sharply lower last week, core government bonds were in demand and volatility jumped. While the slide in the price of oil continues to show little sign of letting up, adding to the unease among investors was the political uncertainty in Greece, weak economic data from China and a lower than expected take-up of cheap funding by European banks under the ECB’s TLTRO programme.
Sharp sell-off in equities: After a volatile week, the sell-off in global equity markets intensified on Friday as the price of oil continued to make new lows, raising concerns about the implications for energy-related shares, high yield bonds and certain economies, like Russia. Some of the major equity indices in the US and Europe suffered their worst weekly losses since 2011. The S&P 500 fell 3.5% for the week while the German DAX Index and the UK’s FTSE 100 Index dropped 4.88% and 6.56%, respectively. These declines paled in comparison to the Greek ASE Index which fell 13% on Tuesday, the biggest one day drop since 1987, and closed the week down 20%.
Bond yields move lower: Meanwhile, government bond prices moved higher last week driving yields in the Eurozone to new record lows. The German 10-Year government bond yield closed the week at 0.64%, while the yields on German bonds with a maturity of four years or less are all in negative territory.
Volatility: The much quoted CBOE Volatility Index (VIX), a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices, jumped 78% last week, the largest weekly increase since 2010. Currently at 21.08, the so-called ‘fear index’ is still some way off the 31.06 reached during the October wobble.
Week Ahead
Key macro data for the week ahead includes reports on inflation, industrial production, retail sales as well as a host of PMI surveys from around the globe that will provide an update on the performance of the major economies in the fourth quarter. In Europe there are reports on the balance of trade, inflation and the latest ZEW Economic survey from Germany. There is a host of data released from the UK including inflation, retail sales and the labour market, as well as the minutes from the Bank of England’s most recent monetary policy meeting. The Bank of Japan will have their final monetary policy meeting of the year with no change expected while the US Federal Reserve’s monetary policy meeting will be centre stage.
Liverpool FC & Tesco Plc: now at rock bottom?
Being a fan of Liverpool FC must be a bit like how Warren Buffett feels with his investment in Tesco Plc. Just when you think things can’t get any worse, they do! After falling from a high of 335.75p in February, the share price fell another 24% last week to 165.75p after the company issued its fourth profit warning in five months (see Tesco stock chart below). As for Liverpool, knock-out from the Champions League followed by defeat to bitter rivals Manchester United has added to a miserable season that began with such hope. Like Buffet I am hoping that we have finally seen the bottom!
US Federal Reserve: One Statement, Two Words!
With recent US data picking up, investors will be gin to once again focus more on the timing of interest rate hikes and the implications for financial markets. While no change to monetary policy is expected investors will eye the wording of the Fed’s statement, most importantly whether they decide to keep “considerable time” to describe the timing of rate hikes. It was first added in December 2012 in an effort to signal to the markets that monetary policy would stay accommodative after the ending of the asset purchase program. For example, the most recent statement in October read: “The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month”.
The Fed have never clarified exactly what “considerable” means in terms of the length of time. In March, Fed Chair Janet Yellen caused the markets to sell off with her off-script remark that it “probably means something on the order of around six months or that type of thing”. While Yellen and the Fed later backed away from this remark it has not been forgotten. Therefore, if “considerable time” is removed it will be the first real signal confirming that the interest rate hike is on the way in the first half of 2015. However, given the sharp sell-off in the price of oil and the worry in financial markets last week it is likely the Fed will avoid adding to concerns.
Environment set for Mario Draghi to get full-blown QE over the line…..
Global equity markets moved sharply lower last week, core government bonds were in demand and volatility jumped. Government bond yields in the Eurozone moved to new record lows. The German 10-Year government bond yield closed the week at 0.64%, while the yields on German bonds with a maturity of four years or less are all in negative territory.
While the slide in the price of oil continues to show little sign of letting up, adding to the unease among investors was the political uncertainty in Greece, weak economic data from China and a lower than expected take-up of cheap funding by European banks under the ECB’s TLTRO programme (4 year loans at 0.15%).
The lower than expected take-up of cheap funding under the ECB’s TLTRO facility and the repayment of existing LTRO loans further strengthens the argument for additional measures from the ECB, if they “intend” to increase their balance sheet by c. €1 trillion. While Draghi has argued for years that Europe is not turning Japanese, in terms of a deflationary spiral, the performance of European government bonds would suggest that the battle is being lost against deflation.
Football, a microcosm of life
The legendary Bill Shankly famously said “Some people believe football is a matter of life and death, I am very disappointed with that attitude. I can assure you it is much, much more important than that”. Judging by my use of football analogies in my commentary one could be forgiven for believing that I too share his fanaticism. While I realise that football and the fortunes of Liverpool FC does not have the same influence over the lives of others as it does mine, these analogies are intended to try and make the subject of economics and finance more accessible to everyone. For me, football is just a microcosm of the economic system and life in general. After all, the macro economy is simply the aggregate output of the behaviour of many individuals, companies and governments (all made up of individuals).
The same principles that provide the foundation for success in sport apply to the world of business and finance. Successful football clubs, leading companies and efficient governments (if they exist, maybe Singapore?) all share common characteristics. Shanks had a simple philosophy of aspiring to being the best at whatever you do; “if everyone thinks along these lines, and does all the small jobs to the best of their ability, that’s honesty. Then the world would be better, then the football world would be better”. As for Liverpool FC, the Kop will be doing their best to inspire a courageous performance tonight in the Champions League!!
