by Michael Ashley Schulman, CFA,
Managing Director, Senior Portfolio Manager at Hollencrest Capital Management
February 2014

Note: Variants of this paper were first published in Chapman University, Argyros School of Business and Economics, Panther Financial journal, Volume 1, May 2014 http://www.chapman.edu/business/_files/jfc/2014-panther-financial.pdf

 

U.S. money managers may be the most skeptical investors in the world when it comes to the sustainability of 2013’s rise in domestic stocks. It seems that while we see a lot of our own problems clearly, foreign investors, especially Europeans, tend to view America’s political and fiscal problems as almost hackneyed and its promise – particularly when it comes to shale energy and re-shoring of manufacturing – as exciting. They also may believe the late, great investment adviser, Marty Zweig’s admonition to never fight the Fed. The problem now, of course, is that the stock market skeptic isn’t just fighting the Federal Reserve – he’s fighting everybody. All the world’s central bankers appear to have adopted the Fed’s Doctrine: when faced with the stark choice between inflation and deflation, always err on the side of creating too much inflation. Given the fact that financial repression has made it impossible for the saver to achieve positive real rates of return without risk, equities may continue to be driven by the T.I.N.A. factor (There Is No Alternative).

The world’s central banks believe they have done their job by keeping rates low and that it’s time for political leaders to do theirs; returning to stability and prosperity should be a shared responsibility. According to the Bank for International Settlements (BIS), colloquially known as the central bankers’ bank, “cheap and plentiful central bank money” has merely bought time. Investors round the world tend to forget that monetary stimulus is not there to make life easy for financiers; it is there to compensate for the ongoing, violent adjustment still needed in most economies to correct the distortions that gave rise to the financial crisis. According to the BIS, “low interest rates and unconventional monetary policies have made it easy for the private sector to postpone deleveraging.” The most dangerous aspect of the efforts of central banks is that it deludes the private sector from making its own reforms. Although the U.S. has taken most of its lumps and European banks are slowly going through the gut wrenching process, the emerging markets (EM) have yet to take the medicine of financial deleveraging, fiscal reform, and better governance.

There are few positive political developments in the EMs. In the past few months we have seen the parliament in Thailand dissolved, massive protests in Ukraine, hardened demonstrations in Brazil, police force strikes in Argentina, continued strife in Egypt, and even highly unusual rioting in Singapore. Thus, we may see further political risk rotation from developed markets to the EM in 2014. The “Fragile Five” EMs – South Africa, India, Indonesia, Brazil, and Turkey – have high inflation, large current account deficits, challenging capital flow prospects, weak currencies and weak growth. In addition, all the Fragile Five have national elections in 2014, and each election could lead to political upheaval because economic growth has produced a large, politically active and relatively frustrated middle class. In the context of current subdued global growth, this middle class is realizing that the last decade of high EM growth has brought little improvement in their actual quality of life and little in the way of pro-market structural reforms. Watch out for continued unrest in the EM.

EMs are vulnerable to rising global interest rates, lower commodity prices, and political instability. Over the past several years, much analysis has focused on the supposed coming social unrest in Europe and the U.S [remember Occupy Wall Street]. However, these forecasts ignored the facts that developed economies – particularly European ones – have relatively low income inequality, high levels of household wealth, broad safety nets, do not suffer from persistent inflation, and enjoy a much higher quality of governance when compared with most EM economies. Even Europe’s Mediterranean countries – Portugal, Italy, Greece, and Spain – the most politically strained of the developed market economies, have much higher levels of governance than most EM economies. Thus, the first half of 2014 is likely to see a continuation of 2013’s capital outflows from EMs and inflows into developed markets.

Emerging markets have become victims of their own success. Other than Malaysia and Mexico, which is forging ahead with controversial and politically sensitive improvements, most of the EM economies are not making headway in terms of structural reform, especially the deficit EMs which are battling uncomfortably high inflation even as growth continues to moderate well below trend. The pain is likely to get worse with downside risks to domestic demand and overall growth before any competitiveness gains kick in.

Back in the U.S., many investors have developed a fair amount of policy fatigue in the last year. A continuation of the European debt crisis and America’s own political theater and dysfunction, while causing no shortage of financial indigestion, have led many professional investors to ignore the unpredictable risk introduced by global policy makers and seek themes and individual stocks that might actually provide excess returns. Nonetheless, Washington, D.C. holds the key to what can go right or wrong. CEOs are absolutely ready to invest in America. We could see growth like never before if our elected officials can display leadership and provide us with a road map that doesn’t hand us surprises every six months.

A rebound in capital expenditures (capex) is probable and could fill some of the demand void. Indeed, a strong rebound in capex is overdue, but it is too early to tell if a ‘boom’ (such as the 1990s tech cycle) can occur. Long-term capital return expectations have fallen into the low single digits, a phenomenon that may have something to do with the prolonged investment surge around the world over the past twenty to thirty years. This expansion generated enormous growth, especially in the developing world, but it may have also brought about diminishing returns. If so, corporate investment alone will be unable to sustain aggregate demand growth. However, capex adds productive capacity which will eventually enhance the supply curve and growth.

Stock market corrections tend to be triggered by widespread fears of an imminent recession. It’s hard to see a significant correction ahead if the big worry is that better-than-expected economic indicators will cause the Federal Reserve to taper quantitative easing (QE) by $10 billion to $15 billion per month. The beginning of the end of QE is bound to be messy for financial markets. [Personally, I’m rooting for a refreshing pause in stock price appreciation so that the market can consolidate its gains, but it’s not up to me.] Global growth should accelerate in 2014, mainly driven by reduced fiscal austerity in the advanced economies. Expect decent expansion in the US as the housing and labor markets continue their recovery, corporations open their purse strings, and the Eurozone sees its first full year of growth since 2011.

 

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