Decoupling: Markets and Politics

Ben and BarrySince the start of the Global Financial Crisis, markets have taken their cues from government policies, political crises and Central Bank interventions. According to the classic Keynesian thinking, this is to be expected as government steps in to make up for failing private sector demand. But also according to Keynesian logic, we should start looking for the government to withdraw as the private sector picks up the slack in a recovery.

Although equity markets still managed a swoon for the messy outcome of the Italian elections, the relatively quiet passing of the “Sequester” is one of the early signs that market participants are starting to look beyond the Beltway for future earnings. Despite all the dire warnings from the politicians, investors decided that they have seen this movie before.

On the S&P500, as represented here by SPY, the markets have basically been flat for the month.

SPY
Source: Yahoo Finance

Gold, represented here by GLD has been drooping down with only a slight flutter for the Italian election debacle.

GLD
Source: Yahoo Finance

The markets are saying…

To Washington: that they like the idea of some fiscal restraint and can see through the blatant attempts to make the spending cuts as politically painful as possible.

To the Italians and Europeans: that the Italian election is not the worst thing we have seen come out of Europe in the last 5 years. Germany will foot most of the bill for Europe’s financial reconstruction and it will drive the long, slow agenda to put the Euro back on a sustainable course. Nothing to see here, folks, move along…

Meanwhile over at the Federal Reserve…

Although I personally missed the release of the Federal Reserve’s 2012 unaudited annual report, the Mises Institute put out a readable analysis of the changes. Not all is good news (the Fed is loading up on Mortgage Backed Securities), but overall it appears that the tide is changing. The balance sheet actually shrunk slightly year over year and the FED’s holdings of Treasuries has fallen slightly. The author even finds evidence that the banks are starting to lend more to actual customers rather than simply moving electronic pots of money around the various servers at the FED.

Moderately bullish markets call for moderately risky weightings

Wall Street’s top strategists are calling for a tight range on this year’s performance for the S&P500 (-6% to +7%). In general, the big bears are hedging after being wrong last year while the bulls are struggling to come up with the massive earnings growth figures that their models need to support a big run. What most of them are missing is that the decreasing anxiety amongst investors is raising the appetite for risk assets (primarily equities) over safe assets (like Treasuries). The shift will not be dramatic in terms of percentage points of portfolios reallocated but it will be enough to boost stocks into double digit gains for the year. Risk has not gone away but investors are becoming more comfortable with the risks that are in the market and are willing to pay up a bit to capture more potential growth.

The FundLogik portfolios are still leaning towards riskier assets and investors are still climbing a “Wall of Worry,” a healthy sign in a moderately bullish market: Maintain current weightings.

Home Builders Still Strong

The US property bust was ground zero of the Global Financial crisis. Now, five years later, the business cycle is alive and well and property has turned around. Despite the fact that home ownership is still below peak levels and there is still unsold foreclosure inventory hanging over several real estate markets, the companies in two homebuilding ETFs continue to see improved revenues and margins.

KB Homes announcement of earnings is further confirmation that the sector rebound has legs.

XHB vs. ITB

XHB vs. ITB
Source: Yahoo Finance

The biggest difference between the two is the index. XHB’s index is equal weighted and includes more companies in the homebuilding supply chain. ITB is market capitalization weighted and while it also has supply chain companies, it gives greater weight to the actual builders. That weighting difference accounts for most of ITB‘s relative outperformance. XHB, part of State Street’s SPDR range, is slightly larger than ITB, from Blackrocks iShares range, but both have more than $2bn in assets each.

Top 10 Holdings

XHB % of Total
Standard Pacific Corp 3.650%
PulteGroup Inc 3.619%
Mohawk Industries Inc 3.598%
Toll Brothers Inc 3.553%
Ryland Group Inc/The 3.547%
Tempur-Pedic International Inc 3.529%
Owens Corning 3.496%
Select Comfort Corp 3.480%
Lumber Liquidators Holdings Inc 3.477%
DR Horton Inc 3.472%
ITB % of Total
PulteGroup Inc 10.403%
Lennar Corp 10.158%
DR Horton Inc 9.131%
Toll Brothers Inc 8.486%
NVR Inc 7.088%
Home Depot Inc/The 4.176%
Ryland Group Inc/The 3.927%
Lowe’s Cos Inc 3.550%
MDC Holdings Inc 3.443%
KB Home 3.067%

Source: Bloomberg

33:1 – A Landslide for Fixed Income

Now that we have just finished our quadrennial exercise of picking the occupant of the White House for the next four years (at a cost of around $2bn this round), it is time to look at how investors have been voting with their money over the last five years. With the reelection of President Obama, it is tempting to think that circumstances will continue on as they have over the last four years. That may be true of the American political system but the Global Financial Markets are poised for a change.

In a report by Pyramis Global Advisors (you can get the report through this link), the authors note that net investment inflows since the end of 2007 to now have been $1.1trillion into bonds and $33bn into stocks. Lest you think that the bulk of the discrepancy happened during the market meltdown in 2008, a chart on the front page shows that most of the inflows occurred in 2009 and 2010 when equity markets were largely on the mend. The rate of inflows has varied slightly in the last two years as the markets have see-sawed between “risk-on” and “risk-off” trades but the overall direction of money has been solidly towards the fixed income side of the ledger.

That suggests two important concepts that will help us spot any sustained change in the capital flows. First, while the Global Financial Crisis (GFC) certainly raised risk awareness, investors continued to be spooked throughout the “recovery” period. Second, it shows that despite valuation models which show many classes of bonds to be at or near bubble valuations, investors will continue to plow fresh capital into a favored asset class.

Why don’t institutions “Fight the Fed”?

The reason for this outsized charge into bonds over equity can be traced to the hyperactive central banks of the US, EU, UK, Japan and China. At nearly every crisis point, the solution has been to lower interest rates, buy up or lend against toxic assets at above market prices, manipulate the yield curve and generally to loosen monetary policy. Unlike the Greenspan Era, Chairman Bernanke has been crystal clear about his monetary objectives. While economists and other market pundits can bemoan the bubbly prices, national solvency and inflation risks that such policies engender, bond investors and traders have plowed more money into bullish trades to take advantage of the historic circumstances.

What the report suggests

The report leads the reader to the conclusion that valuations will win in the end. And, if one does not worry overly much about time frames, that conclusion is correct. Investing at lower valuation points in the cycle has been demonstrated to increase the odds of superior investment returns in the subsequent decades.

Unfortunately, that does not leave much for those of us looking to invest now.

Will things change?

Yes, despite the best efforts of the Federal Reserve and other central banks around the globe, the economic cycle has only been delayed, not suspended. Once a real recovery is established and well identified, we should see a shift of funds into equities at the expense of fixed income and idle cash. Interest rates and inflation rates will put pressure on the current status quo. And secondly, most financial bubbles tend to pop as soon as they are starved of fresh capital. Even without a robust recovery, a modest shift in capital flows, due to a change in the US current account for example, could tip the balance for fixed income vs. equity capital flows.

How will we know?

The beauty of the FundLogik Application is that it is designed to monitor the shifts in money flows because those money flows have a direct impact on pricing levels. By monitoring a broad range of asset classes and comparing them to each other, it becomes clear which assets are gaining investor favor. One day, we will see a report showing that the flow of money between bonds and stocks has reversed. Unfortunately that report will come out at least six months after the change has occurred. With the FundLogik Application, you can participate in the shift as it happens…and read about it in the financial press later.

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.

Chinese Numbers

The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

China GDP

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Baltic Dry Index

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

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