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Reaching Along the Risk Curve

As we break for the MLK holiday, it is a good time to look at where “January Effect” has taken us. In the case of individual stocks, there have been some good performances but the core US indices have largely consolidated the “Fiscal Cliff Deal” gains. We were up just over 4% in the [ppopup id="3860"]S&P 500 index[/ppopup], same as this time last year. Because of [ppopup id="3914"]AAPL[/ppopup], the [ppopup id="3862"]Q’s[/ppopup] are only up 3%, against 6% last year. Earnings season has started and although companies are expected to beat their well whispered numbers on the whole, the overall growth in earnings in not expected to crack much above the 3% mark. So, with unemployment still high, developed market economic growth anemic and most of the problems of the last few years being kicked down the road, it is perhaps not surprising that the markets are pausing at these levels.

But the market looks forward and we should see some New Year optimism in the form of boosted earnings expectations and aspirations. So far, most of the enthusiasm appears to be in the emerging markets with East Asia, led by China, taking point. In last week’s issue, we looked at some of the options available there. [ppopup id="3915"]FXI[/ppopup] and [ppopup id="3916"]HAO[/ppopup] look promising.

This week, we sneak a peek at two reasonable sized funds in the emerging markets that are often overlooked by investors ([ppopup id="3917"]EPI[/ppopup] at $1.3bn in assets and [ppopup id="3918"]TUR[/ppopup] at $900m in assets).

India

India is an emerging market but it can hardly be described as a new one. The BSE (Bombay Stock Exchange) started up in 1875, making it Asia’s first exchange. As a result of the markets relative maturity, [ppopup id="3917"]EPI[/ppopup] is a well balanced fund with only a quarter of its assets in financials and a good spread of Energy (21%), Information Technology (12%), Materials (11%) and Industrials (10%). Although the growth rates have cooled in the past few years, the years of strong growth and economic reform have lifted a huge segment of the population into the middle class. This has led to a huge consumption boom of everything from gold to apartments to laundry powder. India’s politics are messy and its relations with its neighbors are a work in progress, but it would be foolish to overlook the huge population and very favorable demographics (especially vis-à-vis China’s).

Turkey

Turkey is a more typical emerging market when one looks at the make-up of [ppopup id="3918"]TUR[/ppopup]. The fund is heavily weighted (52%) to financials. Industrials (12%), Consumer Staples (11%), Telecoms (8%) and Materials (6%) round out the top five sectors. Turkey is exciting because its geographic and cultural positions look very promising in the medium and longer term. As a secular Islamic state, it is well accepted in the Middle East both diplomatically and commercially. As a NATO ally, it demands a seat at the EU table (although France resists). And culturally, the Turkic people of the oil rich ex-Soviet republics along Russia’s southern border are promising consumers and business partners. Like India, Turkey has a few domestic and diplomatic issues that are far from sorted. The only cautionary note for an investor is the local currency, the Lira. Because the ETF is so heavily weighted towards financials, weakness in the currency can drag performance down.

Stick With Risk

January Effect still looks to be alive and well as developed markets hold onto gains and emerging markets show continued strength. Stay exposed to risk assets for the time being.

The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

The Price of Money

The markets are flopping around aimlessly. Investors are confused. The media is having more and more trouble trying to whip up enthusiasm or maintaining credibility: the latest doozy to float through the market was the Hindenburg Omen (a technical formation which predicts equity crashes 25% of the time).

What is going on? Why are the markets so directionless? Are we staring into the abyss of deflation plus the second part of a double dip recession or will we have to dust off the 1970’s era Misery Index to describe the upcoming years of stagflation? With warning signs of both inflation and deflation in the economy, there is little wonder that professional and individual investors alike are confused by the signals.

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The Rising Dollar

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).
US dollar index and UUP ETF
Source: Bloomberg

Why is the yield curve so steep?

Relative Yield CurvesThe short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.