2012: Fingers of Instability

Our Man recently looked at some of the things that could help the economy and markets in the upcoming year, now for some of the things that offer more concerning thoughts.

- European debt problems (and recession?)

In the absence of major Quantitative Easing from the ECB (see Glimmers), which would reflect a transfer of risk from the individual sovereigns to the Euro-collective, Europe’s debt problems are likely to continue apace in 2012.  However, unlike 2012, the uncertainty may spill over more into the real economy and if European banks retrench (which the ECB’s LTRO’s seem designed to prevent) and we could easily see a Europe-wide recession.  The knock-on effects of this both within Europe and globally, are likely substantially under-appreciated!

- Political (and Social) Instability

History suggests that political instability increases during economic downturns, and Europe is likely to see its fair share be it through more elected governments being replaced by unelected technocrats (see Italy and Greece), or some of these technocratic governments falling from power when it becomes clear their policies are (intentionally?) better for “the European project” than the people they’re supposed to represent.  For Europe, an economic recession (especially one that hits Germany and France) may make QE by the ECB more palatable, but it also increases the prospect of French/German citizens becoming less willing to support further bailouts for the PIIGS.   This of course, doesn’t even consider the further issues we’re likely to see in the Middle East (especially Iran) and Asia (North Korea).

- China (and the rest of the BRICs)

As I’m sure you’re all well aware, Our Mani skeptical of the Chinese growth miracle and believes that while they’ve mastered the art of creating GDP-growth but are failing to create wealth due to the credit-fueled malinvestment that’s driving the GDP-growth creation.  Rather than bore you with more of the same, I’ll point you in the direction of a previous post and leave you with one additional thought; in global recessions (and especially debt-driven depressions), it’s the trade surplus countries that suffer the most, as they’re more reliant on foreign demand and at risk as foreign countries try to support and protect their domestic industrial base (e.g. the UK suffered an 8-10% fall in GDP during the 1930’s depression, whereas the trade-surplus US suffered a GDP fall of 3x this!).

- Global Trade & Protectionism

On a related noted, and especially for those who are historically minded, the steady decline of Global Trade and the rise of protectionism, was one of the noticeable features of the 1930's depression in the US.  With so many countries facing growth headwinds, and attempting to encourage exports, the temptation for domestic politicians will continue to be to blame foreigners and the rhetoric about punishing “cheating” (i.e. trade surplus) countries will remain.  Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Japan

 Japan fascinates Our Man, in part because they were the first country into a debt-deflationary spiral and there’s a reasonable chance that they may be the first country out of it.  What’s intrigues Our Man is that two of the pillars of Japan’s strength, its savings rate and trade surplus, are both fast waning.  The savings rate has been steadily declining from over 15% in the early 1990’s to c2% today, and 2011 saw Japan’s first trade deficit in almost 50yrs.    Though all eyes are focused on Europe at the moment, Our Man’s guess is that it’s Asia (China or Japan) that will prove to be the interesting story of 2012.

- Corporate Margins & Valuation

While all the other ‘fingers of instability’ suggest risks to the global economies, it’s corporate margins and valuations that make the market particularly vulnerable.  While short-term measures (such as trailing P/E or the awful forward Operating P/E) suggest that the market is cheap/fairly valued they require the belief that the current level of margins (near all-time highs) are sustainable ad infinitum.  Perhaps they are, and we’re in a new paradigm but Our Man suspects that reality is that the elevated levels of margins offers more potential for downside surprise than upside opportunity.  While long-term measures of valuation are a terrible guide to any given year’s market performance, they do offer a valuable guide or map for real cheapness or value and they don’t suggest that the broad equity markets offer much in the way of absolute value.

2012: Glimmers of Hope

Traditionally, at the start of each year, Our Man looks at some of the major things that could help or hinder the economy and markets during the upcoming year.  As such, here are this years Glimmers of Hope (see here for an explanation of the thinking behind Fingers of Instability and Glimmers of Hope), which looks at some of the things that could go right in the economy and drive markets higher.

- Monetary Policy and (lack of) Inflation

The largest stimulant to the market in 2012 is once more likely to be the action of central banks and their policies.  Perhaps, I’m just cynical, but it seems to me that the Federal Reserve (since the Greenspan days) is late to every issue and believes that they can all be solved through injecting liquidity.  As such, we’ve seen rates cut (to 0%), promises to keep them there for years, Large Scale Asset Purchases (aka Quantitative Easing 1, 2, Lite, etc) and even recent coordinated central bank actions to help provide liquidity.  With the make-up of the Federal Reserve’s Open Market Committee changing in 2012 to likely become yet more dovish, I’m fully expecting more of the same in 2012; promises to hold rates lower for longer, more asset purchases (QE3…) and probably some new fangled way to try and force longer-term interest rates to stay low (maybe they’re even reckless enough to sell options).  The ‘good’ news is we can probably expect monetary easing from everywhere else of note in the world!  The ECB is already lending to European banks at generous rates (1% p.a. for 3yrs), the Japanese were the first big users of QE, and the Chinese are likely to loosen policy in an attempt to stave off a hard-landing for their economy.  In short; the Central Bankers of the world agree – sell your bonds, and buy risky assets…please!  This plea and its impact on market participants psychology is what most worries Our Man, given his bearishness.

- ‘Constructive’ Government behavior (i.e. can-kicking)

In the US, while the two parties have shown no ability to solve any major problems by working together and with both parties having more incentive to disagree (it’s an election year, after all), it would seem like the possibility for constructive government behaviour is limited.  However, the government behaviour I’m expecting is not the “solving of problems” kind but the “let’s give things a bit of a sugar-high, so the economy is still weak (and thus Obama can lose) but not so bad that we don’t all get kicked out of office (so incumbent Republican congressman can keep their seats)” kind.  This is the type of compromise that leads to terrible long-term decisions, with faux compromises on a small short-term stimulus which will be paid for by some future (probably unspecified) cost cuts.   While these types of deals are not good for the long-term health of the economy, they can help stabilize things in the short-term and also support the equity markets.

In Europe, Our Man expects much more talk of Grand Plans, bazookas, and anything else that can keep sentiment up while only a limited amount of new money is provided (via the EMU countries, or IMF) to deal with budget issues and stave off defaults, Central Banks attempt to provide liquidity, and elected governments are replaced by IMF/EU-approved “technocratic” ones.

In China, with the economy slowing the government will no doubt do its best to try and reignite the credit-fueled boom, be it through encouraging banks to lend (directly or indirectly, through reducing reserve requirements) or other measures.

- Housing Market

It may have taken a while, but the moribund state of the housing market is acknowledged as a major issue problem by both the Administration and the Federal Reserve.  The importance of the issue can be seen in the constant rumors of an Administration plan on housing, as well as a recent speech by William Dudley (President of the NY Fed), which even offered his thoughts on potential solutions.  While there merit and effectiveness of the proposals can certainly be debated, it’s a step in the right direction.  Efforts to help reduce the problems in the housing market, if effective and well-thought out, would unquestionably help both socially and economically.

- Falling Unemployment (and rising incomes)

While there’s many flaws in the data (and its computation), it’s also clear that jobs data in the US is consistently improving, albeit at a slower pace than everyone (I think) would like.   Now perhaps this improvement slows or reverses later in the year and there are seasonal biases benefiting the data currently, but the declining trend in unemployment, positive revisions and increase in hours worked (which will, hopefully, feed through into incomes) is unquestionably good for the economy!  With companies being in a relatively strong position, if demand continues to hold up well, there is potential for this favourable trend to continue.

- China & an Asian soft landing

What if Our Man is wrong?  Just because nobody else has succeeded in controlling their economy, or transitioned from an investment-driven one to a consumer-driven one without going through major pains, it doesn’t mean that the Chinese won’t.  Perhaps they’ve just built a better mouse-trap for managing the economy than the rest of us…

- Valuation
This is a repeat from prior years’ lists..  Our Man continues to mutter that it’s an expensive market (and using longer-term measures it is) but if one only looks at short-term horizons (or uses current year P/E, or mutations of it…such as P/E based on Operating Earnings, or projected forward P/E, etc) then an argument can be made that the market is cheap.

December Review

Portfolio Update
There were only a couple of changes to the portfolio this month, which had no real impact on the portfolio.
- NCAV: The BXG position was sold during the month, following a bid from the majority shareholder (in November) and there were no counter-bids.
- Hedges/Put Options:  The SPY puts expired in December, worthless as they were out of the money.

Performance Review

Unsurprisingly, given the portfolio’s large cash hoard, the portfolio did not show much volatility throughout December ending the month -0.4% (+7.7% YTD).

While markets were broadly up over the course of the month, it was the portfolio’s defensive buckets that helped returns while the equity buckets were largely negative contributors.  The Currencies bucket (+36bps) benefited from the continued uncertainty in Europe (which saw the Euro weaken against the US Dollar), while the uncertainty also helped Treasury Bonds (+15bps) as their remained a strong bid for safety.  The Puts/Hedges book did well (+17bps) despite the rising equity markets and worthless expiration of the SPY Dec-11 puts, as Silver’s weakness during the month offset these losses.  The only broadly defensive books that were negative were China Thesis book (-9bps), largely as a result of burning through premium for the options that expire in Jan-12, and the Bond Funds (-17bps) as a result of their underlying exposures to natural resources stocks and some more esoteric bonds that suffered with the reduced liquidity in December.  The main negative impacts to performance came from the equity books; NCAV (-8bps), Value Equities (-56bps) and Energy Efficiency books (-14bps).  The NCAV and Energy Efficiency books drifted during the month with a number of names suffering from their lack of liquidity.  In the Value Equities book, which was by far the largest detractor over the course of the year, the majority of the loss came as the DRWI position gave up its November gains (which came after the company reached an attractive agreement to buy a business segment from Nokia-Siemens, which will substantially impact revenues) as investors further considered the company’s position and the likely time horizon to sustained profitability.

Portfolio (as at 12/31 - all delta and leverage adjusted, as appropriate)
14.6% - Bond Funds (DLTNX and HSTRX)
5.2% - Value Idea Equities (THRX, and DRWI)
4.9% - Treasury Bonds (TLT)
1.9% - NCAV Equities
1.7% - Energy Efficiency (AXPW, and XIDE)
0.0% - Other Equities (none)

-1.2% - China-Related Thesis (6bps premium in FCX Jan-12 put, and 45bps premium in EWZ Jan-13 puts)
-5.7% - Hedges/Put Options (76bps in IWM Jan-13 puts and 47bps SLV Jan-12 puts)

-10.2% - Currencies (EUO – Short Euro)

65.0% - Cash

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, FCX puts, EWZ puts, IWM puts, SLV puts, and EUO).  He also holds some cash.  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you.