Europe Archives

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.

Buying Europe?

When FEZ came into the top 3 in my Seeking Alpha portfolio at the end of last week, I have to admit that I felt a little leery. After all, “the market” as defined by the mainstream financial press was still digesting the latest rehash of the slow motion market meltdown in Greek sovereign debt. Surely the system was wrong on this one.

But, when you look at the Euro Stoxx 50 components, the picture is not dire at all. Two-thirds of the index is concentrated in France (37%) and Germany (31%) (see info page here) and looking at the top holdings, these are mostly household names that will benefit from a global recovery. OK, not a hugely compelling story to get the pulse raising at this juncture in the market.

So grudgingly I swapped out of my DBB (Base Metals), which had not performed, and put the proceeds in FEZ (Europe Blue Chips) on Monday because I could not come up with a good reason to fight the system on this change. The result? From Monday close to Friday close, FEZ returned a none too shabby 4.5%.

The result is important for two reasons.

Firstly, the return was split evenly between index and foreign exchange returns. Over the four days, the index gained 2% while the change in the Euro/USD exchange rate accounted for 1.8% of the return. Forex moves are very hard to predict accurately but they are driven by investment flows and Central Bank reactions. And, as you can see in this small example, the result of their actions are reflected in the changing price and can have an important impact on returns. Is the Euro going up or is the US dollar just sinking to new lows? Probably more of the latter than the former as the US Treasury and FED talk about a strong US dollar but act as though they want to bring the value down. Does it matter? Yes, but by the time one has clarity, the market will be preparing for the next move.

Secondly, the move was not foreshadowed by some major research report or market buzz. If there was a table pounding report saying something like “Now is the Time to Buy into Euro Blue Chips”, I certainly missed it. If there was a big “Buy the Euro now” call, it did not make the mainstream financial press. The fact that these companies are soldiering on with the global recovery while their governments and Central Banks attempt to deal with the financial situation as best they can is just not very compelling financial news. It is much more exciting to concentrate on how the Greeks will default and how the True Finn party will manage to throw a wrench into any Europe wide solution.

What does this mean for users of the System?

While certainly not every switch will work out as well as DBB to FEZ did in just a few days, the purpose of the System is to provide an unemotional signal to help you keep your money working in the most promising corners of your investment universe. Sometimes, as in the case of Blue Chip Euro stocks, it is not immediately apparent. But the point of this post is that you need to let the System do its job. Often a move will happen in a market first and the analysis follows later. Waiting for everyone around you to confirm that a particular trade is a winner can be a good way to buy into a crowded trade at a high point. While we want to participate in trades for as long as there is decent momentum, we do not want to have the buy and sell decisions driven by emotions. Our very human need to travel within the safety of the crowd is one of the primary reasons why investors buy at high prices in a bullish euphoria and sell at depressed prices in a bearish funk. The point of investing is to make money…emotions just get in the way.

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.