“Markets are worried about uncertainty of change and we're worried about the market’s reaction to uncertainty of change.” – Andrew Burns, World Bank
Our Monthly Macro is a recurring post that appears on the first Tuesday of every month and recaps the high level macro developments of the previous month. We highlight the global themes that we believe are the most important and discuss why they matter for investors. This month’s piece will focus on the market’s response to Bernanke’s mid-month press conference, the deceleration in several economic data points during the month, and the recent liquidity squeeze in the Chinese banking system.
The most notable event last month was Bernanke’s post-FOMC meeting testimony in which he laid out a hypothetical roadmap for tapering the Fed’s current quantitative easing program (see last week’s Insight for a detailed discussion). Financial assets of all types sold off in response, confirming that there is a level of artificial value priced in across the board. Historically low interest rates incentivize investors to forsake cash in search of yield, and the Fed’s ongoing asset purchases (QE) add liquidity into the market by “removing” treasuries and mortgage-backed securities and replacing them with cash. This additional liquidity has been re-invested into financial assets, putting upward pressure on prices for all types of investments over the past several years. This explains why an incremental “tapering” of QE might cause the type of volatility we’ve seen across the board in capital markets.
WHY IT MATTERS: Coming off a 56% correction during the financial crisis, the global stock market has spent the last four years and change recovering its losses by rallying over 100%. Meanwhile, it has been a difficult period of time for more broadly diversified, macro-oriented investors to keep pace. The recent collapse in precious metals, treasuries and emerging market assets has even tripped up the likes of Ray Dalio of Bridgewater whose $70 billion All-Weather Portfolio is rumored to be down 8% thus far this year. At this point the market is more or less pricing in a likelihood of tapering in late 2013 and an end to QE in 2014. However, if the economy disappoints and these expectations are not met there will likely be a snap back in many of the assets that have performed the worst during the month of June.
As Bernanke made clear, future tapering will be dependent on the economic data and assumes a continual improvement in the housing and jobs market. However, many still doubt this is the trajectory we are on, and in fact the month of June brought a widely ignored downward revision to the first quarter GDP number. Originally reported at 2.4%, the economy is only thought to have grown 1.8% in the first three months of the year. The change was driven by consumer spending (which accounts for roughly two-thirds of our GDP) being lowered to 2.6% from 3.4%. In the World Bank’s semi-annual Global Economic Prospects report lead author Andrew Burns described a state of unconditional anxiety: “We're worried about quantitative easing rising in Japan and we're worried about quantitative easing falling in the U.S. and it almost doesn't matter what happens because what we're worried about is change. Markets are worried about uncertainty of change and we're worried about the market’s reaction to uncertainty of change." Adding to this uncertainty is the fact that interest rates have rocketed upward in response to all the taper talk, driving mortgage rates up by over a full percent in just two months.
WHY IT MATTERS: We’ve highlighted the “second-speed recovery” in our previous monthly macro posts. It’s this very recovery that has led to the shift in rhetoric from Bernanke and the market’s taper tantrum. Thus, any potential weakening of this recovery could lead to speculation that tapering is further off than the market thinks, creating a renewed tailwind for assets such as treasuries and gold. The data shared above is far from conclusive, but it’s worth paying attention to anything that could indicate a departure from consensus in the economic data.
At the end of every day banks compare how much cash they have on the balance sheet relative to the thresholds that are required by regulators. Some banks are slightly short while some banks have a little more than they need. To shore things up, banks make overnight loans to each other (called interbank lending) so that everyone has just the appropriate amount of liquidity to close the books for the night. These loans carry very low interest rates and are backed by collateral such as treasuries or other high grade bonds. During the month of June, the Chinese banking system experienced a temporary liquidity squeeze in which banks stopped lending to each other and overnight rates skyrocketed from around 2% to nearly 14%. This was similar in nature to the credit crisis that bankrupted Lehman Brothers in 2008, so it was obviously very concerning for emerging market investors throughout the month. The media quickly tried to explain what was going on by speculating that there were several Chinese banks on the brink of failure, but a more adequate explanation citing a crackdown on a form of illegal bond trading related to “wealth management products” was subsequently given by JP Morgan and brought to our attention in this Sober Look post. The issue of wealth management products and their role in the Chinese banking system is an interesting one, and probably worth a dedicated Insight at some point in the near future.
WHY IT MATTERS: China has been an important driver of global growth over the past decade. Changes on the margin in Chinese demand impact asset prices of all sorts, but especially those tied to commodities and emerging markets. In addition to a potential property bubble and a languishing manufacturing sector, we are very concerned with the Chinese banking system and its dependence on so-called wealth management products. We believe that what we saw in the month of June could be a look under the hood of what’s on the horizon for the Chinese banking system. See our March 12th post, An Emerging Dichotomy, for a detailed conversation on why we cut our overweight in emerging market equities.
In summary, the month of June revealed how much volatility we can expect around major pivot points in public policy as well as potentially ushering in the initial signs of a banking crisis in China. It will be interesting to see how the next couple of months play out, as we believe markets have overshot in their expectations of a withdrawal of Fed stimulus. Our positions in precious metal-related investments have been problematic thus far this year despite what we feel is a fairly consistent fundamental backdrop for anything that can serve as an alternative to paper money. Sometimes the trend is just not your friend as they say. It’s a trite statement, but there is a lot of truth in it, which is why we are currently working on a trading model for gold that would work similarly to MarketVANE for stocks and commodities. Our hope in developing such a tool would be to empower ourselves to allocate to investments that we feel have a solid fundamental story while knowing there is a mechanism in place for reducing or eliminating exposure if the trends moves strongly against our position. This would be an additional step in the direction of managing risk prudently for the sake of generating superior returns for our clients over time.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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