Financial Markets: destination unknown
"Economic activity depends on a degree of trust between strangers. Since money is the agent of exchange, it is the agent of trust. Debasing money therefore implies debasing the trust upon which social cohesion rests. Further debasement of money will cause further debasement of society." (Dylan Grice)
The last two months on the financial markets have been dominated by the European Central Bank’s decision to engage in an ‘unlimited’ programme of buying up short-term Spanish and Italian bonds and by the Federal Reserve’s new round of Quantitative Easing.From the end of July to mid-September, the US and European markets gained an average of about 10%, with a particularly sharp rise for the Spanish and Italian stock market indices and for bank stocks.
It is worth noting that while these measures have prompted a rise in stock prices, they have done nothing to resolve the fundamental problems in industrialised countries and set the economies of these countries on the path to sustainable recovery. On the contrary, by keeping the price of money artificially low, they are preventing the necessary adjustments, leading to a poor allocation of capital, provoking a rise in commodity prices and forcing savers seeking yield to take substantial risks. It is therefore not surprising that the previous rounds of monetary easing failed to generate a sustainable improvement in the economy and there is no reason to think that it will be any different this time. In the absence of such an economic improvement, there cannot be a sustainable increase in company earnings, especially at a time when profit margins are already very high. Without a sustainable increase in earnings, the upturn in share prices is not sustainable. Unless we think that abnormally low interest rates and a massive injection of cash justify a rise in valuation multiples to considerably higher levels. That is the implicit reasoning of people buying equities in anticipation of the measures announced by the Federal Reserve.
Obviously we do not share this reasoning. If there were a positive correlation between exceptionally low interest rates and high share prices, you could be forgiven for wondering why the Japanese market is now nearly 75% below its level at the end of the 1980s. In fact, stock market history shows that the valuation multiples of shares were at their lowest during periods when interest rates were negative in real terms as is currently the case. This seems logical given that negative real interest rates are rarely the reflection of a fundamentally sound economic situation.
In our investment strategy, we do not therefore envisage chasing a rise in share prices which is not justified from a fundamental point of view. The more so since economic indicators and announcements from a number of companies point towards a relatively marked slowdown in economic activity.
The fact is that the economic environment in which we currently find ourselves is exceptional. While economic history can generally give at least a few indications on the developments we could expect, many economic parameters are now at levels unprecedented for the last 200 years. Notable among these parameters are the level of public debt and of budget deficits in the leading industrial countries (and this even BEFORE demographic trends have begun to weigh heavily on public finances), the explosion of the central banks’ balance sheets in these countries (in absolute value and as a percentage of their GDP), and the level of short- and long-term interest rates. Added to this we should add a monetary union in Europe which isn’t working and which is starting to endanger the positive benefits of the European project, a banking scene in a sorry state but having a strong political lobby so it can oppose the reforms that are needed, and a welfare state that most countries can no longer afford to pay for but which is extremely difficult to change in a democratic system, not least because the politicians’ main objective is to get (re-)elected. In this environment, the authorities have chosen to suspend the rules of the market economy and pursue fiscal and monetary policies that will only increase the structural imbalances. By further aggravating the gap between rich and poor, they will also weaken social cohesion all the more. It is difficult to see a favourable outcome to such an environment.
It follows from the above that traditional investment rules – and more specifically the distinction between money market and bond investments as risk-free and equity investments as risky – no longer makes sense. In my blog on 16 May, I wrote that there is no longer any such thing as a risk-free asset class but that the risks differ depending on the type of investment and the investment horizon. For fixed-income investments, the risks are loss of purchasing power (more or less inevitable at present but which the majority of investors seem prepared to accept, at least while the official inflation rate stays relatively low) and the possibility of not getting 100% of your money back if you try to chase higher yields. In the case of equity investments, the risk is loss of capital. However, here it is important to distinguish between a temporary and a permanent loss.
A permanent loss on an equity investment, or at least a loss which cannot be recovered in a reasonable time frame, can result from two factors: buying shares of poor quality companies or buying shares of good (or bad) quality companies at too high a price. However, as the quality of the companies we buy and the valuation multiples we pay for are actually among the few parameters that, as investors, we can control, the risk of a permanent loss can to a large degree be eliminated. This is why in our daily work, it seems to us more logical to focus on an analysis of the quality and valuation of the companies we hold in our portfolio or in which we are thinking of investing, rather than trying to predict the actions of the political and monetary authorities. In so doing, we should be able to reduce as far as possible the risk of a prolonged loss in our equity investments.
On the other hand, the risk of a temporary loss is inherent to investing in stock markets. An investor who is not prepared to run that risk should never invest in shares.
To sum up, our investment strategy is based on the following ten observations:
The last two months on the financial markets have been dominated by the European Central Bank’s decision to engage in an ‘unlimited’ programme of buying up short-term Spanish and Italian bonds and by the Federal Reserve’s new round of Quantitative Easing.From the end of July to mid-September, the US and European markets gained an average of about 10%, with a particularly sharp rise for the Spanish and Italian stock market indices and for bank stocks.
It is worth noting that while these measures have prompted a rise in stock prices, they have done nothing to resolve the fundamental problems in industrialised countries and set the economies of these countries on the path to sustainable recovery. On the contrary, by keeping the price of money artificially low, they are preventing the necessary adjustments, leading to a poor allocation of capital, provoking a rise in commodity prices and forcing savers seeking yield to take substantial risks. It is therefore not surprising that the previous rounds of monetary easing failed to generate a sustainable improvement in the economy and there is no reason to think that it will be any different this time. In the absence of such an economic improvement, there cannot be a sustainable increase in company earnings, especially at a time when profit margins are already very high. Without a sustainable increase in earnings, the upturn in share prices is not sustainable. Unless we think that abnormally low interest rates and a massive injection of cash justify a rise in valuation multiples to considerably higher levels. That is the implicit reasoning of people buying equities in anticipation of the measures announced by the Federal Reserve.
Obviously we do not share this reasoning. If there were a positive correlation between exceptionally low interest rates and high share prices, you could be forgiven for wondering why the Japanese market is now nearly 75% below its level at the end of the 1980s. In fact, stock market history shows that the valuation multiples of shares were at their lowest during periods when interest rates were negative in real terms as is currently the case. This seems logical given that negative real interest rates are rarely the reflection of a fundamentally sound economic situation.
In our investment strategy, we do not therefore envisage chasing a rise in share prices which is not justified from a fundamental point of view. The more so since economic indicators and announcements from a number of companies point towards a relatively marked slowdown in economic activity.
The fact is that the economic environment in which we currently find ourselves is exceptional. While economic history can generally give at least a few indications on the developments we could expect, many economic parameters are now at levels unprecedented for the last 200 years. Notable among these parameters are the level of public debt and of budget deficits in the leading industrial countries (and this even BEFORE demographic trends have begun to weigh heavily on public finances), the explosion of the central banks’ balance sheets in these countries (in absolute value and as a percentage of their GDP), and the level of short- and long-term interest rates. Added to this we should add a monetary union in Europe which isn’t working and which is starting to endanger the positive benefits of the European project, a banking scene in a sorry state but having a strong political lobby so it can oppose the reforms that are needed, and a welfare state that most countries can no longer afford to pay for but which is extremely difficult to change in a democratic system, not least because the politicians’ main objective is to get (re-)elected. In this environment, the authorities have chosen to suspend the rules of the market economy and pursue fiscal and monetary policies that will only increase the structural imbalances. By further aggravating the gap between rich and poor, they will also weaken social cohesion all the more. It is difficult to see a favourable outcome to such an environment.
It follows from the above that traditional investment rules – and more specifically the distinction between money market and bond investments as risk-free and equity investments as risky – no longer makes sense. In my blog on 16 May, I wrote that there is no longer any such thing as a risk-free asset class but that the risks differ depending on the type of investment and the investment horizon. For fixed-income investments, the risks are loss of purchasing power (more or less inevitable at present but which the majority of investors seem prepared to accept, at least while the official inflation rate stays relatively low) and the possibility of not getting 100% of your money back if you try to chase higher yields. In the case of equity investments, the risk is loss of capital. However, here it is important to distinguish between a temporary and a permanent loss.
A permanent loss on an equity investment, or at least a loss which cannot be recovered in a reasonable time frame, can result from two factors: buying shares of poor quality companies or buying shares of good (or bad) quality companies at too high a price. However, as the quality of the companies we buy and the valuation multiples we pay for are actually among the few parameters that, as investors, we can control, the risk of a permanent loss can to a large degree be eliminated. This is why in our daily work, it seems to us more logical to focus on an analysis of the quality and valuation of the companies we hold in our portfolio or in which we are thinking of investing, rather than trying to predict the actions of the political and monetary authorities. In so doing, we should be able to reduce as far as possible the risk of a prolonged loss in our equity investments.
On the other hand, the risk of a temporary loss is inherent to investing in stock markets. An investor who is not prepared to run that risk should never invest in shares.
To sum up, our investment strategy is based on the following ten observations:
- Generally, bond markets are not very attractive. Neither the speculative returns offered by the peripheral eurozone countries nor the low yields offered by the stronger eurozone countries or major global economic powers represent reasonable investment propositions in terms of their risk/return ratio.
- The lack of appeal of fixed-income investments makes equities the default investment. Especially as, unlike money market or bond investments, shares represent real assets.
- The actions of the monetary authorities are likely to lead to increased volatility, with a succession of periods of greater and lesser aversion to risk ('risk-on' / 'risk-off').
- Periods of greater aversion to risk are, for the time being, favourable to the dollar and unfavourable to equities. The US dollar therefore represents something of a hedge against the equity risk.
- On the equity markets, the preference is for shares of good quality companies paying regular dividends.
- The economic situation of developing countries is now much better than that of industrialised countries in many respects, which is an argument in favour of a greater weighting of these countries in a portfolio.
- However, macroeconomic analysis must not be confused with microeconomic analysis. The European crisis should not eclipse the existence of a significant number of high quality European companies that are well positioned to benefit from the emergence of Asia in particular.
- The same applies to American companies.
- The monetary policies currently being conducted could lead to a major problem with inflation in the medium term, which augurs well for gold and gold mining companies. The potential explosion of the supply of euros, dollars, pounds, yen and Swiss francs, and the limited increase in the supply of gold also works in favour of gold’s appreciation against these currencies.
- As regards currency allocation, diversification into the currencies of countries with better fundamentals makes good sense – especially the Singapore dollar, Canadian dollar and the Scandinavian currencies.
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