Market Overview Q116: Out with the Old

Investors raising their weary eyes from tax documents and turning their gaze to investments may be forgiven for questioning what is happening with stocks. The first quarter gave investors a wild ride with stocks plummeting and then recovering, expectations of interest rate increases booming and then crashing, first quarter GDP estimates closing the first quarter at a weakly 0.6%, and gold emerging as one of the best performing assets.

It is always difficult to look at a "snapshot" of the market and come away with much understanding of the underlying trends and interactions. As an increasingly connected global financial system and an aggressively interventionist central banking system reshape the investment landscape, that challenge is becoming even more difficult since these developments subvert many conventional theories and assumptions about how to invest. At very least, for investors to have a fair chance of getting ahead, it makes sense to clear out some space for fresh thinking and new approaches.

A review of some astute market observers and practitioners provides an excellent indication of just how unsettled and schizophrenic the market is. Hugh Hendry, for example, had been extremely bearish through 2013 and then suddenly became bullish. In a recent interview he described the investment environment as being one of "more benign outcomes".

Hendry is the same person who, in that same interview, also noted that, "Everywhere you look, there is a rational fear." Further, in evaluating possible scenarios in an environment dominated by monetary policy, Hendry stated, in no uncertain terms that, "a yuan devaluation would be a catastrophic strategy," and that "the world is over with a 20% devaluation [of the yuan]." So this is bullish?

In addition, Ben Hunt expressed a similar sense of ambivalence about the markets in his recent piece. While he is clear that, "I can't get away from my structurally bearish views about this market," he also claims that, "we're in the early days of a perfectly investable rally, driven by a plausible Narrative of central bank cooperation on currencies."

The point of highlighting such extremely contrasting claims is not to discredit either of these investors; in fact we consider each to be especially insightful. Rather, these contrasts serve to emphasize just how confusing and nuanced the investment landscape is and how careful investors must be in navigating through these conditions.

A good starting point for understanding the confusing and nuanced nature of the landscape is the global economy, and a good window into that is provided by trade. Hunt points out that, "This decline in trade activity ... means that the global growth pie is structurally shrinking." If it feels like global growth just isn't very strong, there is a good reason and it starts with trade. Hunt continues, "Something derailed the global trade locomotive in the second half of 2014, and it doesn't take a genius to figure out that this something was divergent monetary policy, with the Fed embarking on a public quest to tighten, and the rest of the world doubling down on monetary policy easing."

For better and worse, this phenomenon falls into a common blind spot for US investors and management teams alike, which is predicated on the belief/assumption of the US as an economic hegemon. With this assumption, many US investors anchor their views of the world economy based on what is happening in the US in terms of demand, competition, etc. and then adjust their forecasts moderately based on international trends. However, when monetary policy is the cause and the initial impact is felt abroad (in the form of global trade erosion), these investors fail to see the real source of the problem because they aren't looking in the right place. This probably explains why many companies reported "mysterious" and "unusual" declines in demand in the second half of 2015 but are now "confident" that things are "stabilizing". Investors will be better served by watching monetary policy trajectories and global trade figures.

A key theme in Hunt's research is that investors need to re-think what investing even means in this environment, and we heartily agree. While we don't endorse every aspect of Hunt's analysis, he is spot-on with the exercise of challenging old ways of thinking.

One of Hunt's convention-challenging hypotheses is that "we're in a negative carry world." By "negative carry", he is referring to the negative interest rates in many of the developed capital markets. While central bankers have positioned such policies as benign incrementalism, the reality is that non-positive interest rates have huge implications.

As Hunt describes, "The damaging impact of negative interest rates on bank earnings and all that is very true and very real. But far more damaging is the impact of negative interest rates on these basic IDEAS about what it meansto be an investor in public markets."

An important investment implication of negative rates, according to Hunt, is that it makes more sense to think like a short seller, i.e., to be more opportunistic. As he details, "Every position is a rental if you're thinking like a short-seller. Nothing is owned." The logic is simple: if time is not on your side, you don't have the luxury of being anything less than completely efficient with the opportunities that do arise.

Another implication of negative rates is that they will, eventually, take a severe toll on the investment services industry, which depends on returns for fees. Hunt's assessment is stark: "As market participants lose faith in the idea that time is on your side ... the entire financial advisory world is going to burn."

To be clear, this is not any kind of commentary on individual managers or advisers. Rather, it is a clinical assessment of the natural consequences of negative rates. While many investors may not be disappointed to see the population of investment services culled, and to a certain degree it is probably deserved, negative rates do so in a completely indiscriminate way that quite reasonably could diminish access to financial advice, curtail efforts to reform investment services and reduce the efficiency of capital markets. In short, it could get very ugly.

Not surprisingly then, negative rates also affect basic IDEAS about what the future means for investors. With positive rates, people who work hard, save, and invest, can reasonably expect to retire comfortably. This is a common view as well as one that is fundamentally optimistic and worth striving for. Negative rates, however, provide no such clear path to a better economic future for people who work hard, save, and invest. Or, as Bill Gross notes, "Investors cannot make money when money yields nothing." In a "negative carry" world, the future is a not a particularly attractive prospect, at least not in terms of economic or financial security.

A second convention-challenging hypothesis Hunt makes is that "We're in a policy-driven market." Mohamed El-Erian echoed this sentiment in the Financial Times by describing a "... policy world that is grossly over-reliant on central banks."

Hunt claims that "we're farther away than ever [from 'normal' markets driven by fundamentals]. It's a policy-driven market just as far as the eye can see." El-Erian corroborated by expressing, "What should happen - namely a return to fundamental-based investing - is not what is likely to happen any time soon. After all, few investors have the conviction needed to break away from a herd that has done well so far and collectively believes it is still able to influence Fed policy in a self-serving manner."

El-Erian continued, "Market participants have a choice: either break away from a codependency that has served them well but, almost inevitably, exposes them to volatility in the short term and the possibility of major losses over the longer term if economic and corporate fundamentals fail to improve significantly; or continue to ride the rollercoaster powered by signals from a data-dependent Fed that operates in an unusually fluid globally [sic] economy."

Hunt describes the conundrum confronting investment managers in a more personal way: "We want to succeed, and we feel in our gut that we should be trying something new and (maybe) better. But not if it means losing our clients or losing the support of our Board or losing the support of that little voice of convention inside each of our heads." Collectively, these insights illustrate clearly the symbiotic relationship between money managers and central banks.

Insofar as policy driven markets are here to stay, Hunt recommends: "Don't trust the models." He continues, "When I say don't trust the models - and by models I mean pretty much of all mainstream portfolio and investment analysis, basically anything that says "Here's a pattern we observe from some period of time over the last 40 years, and now we're going to extrapolate what the future holds because of that observed pattern." This includes the mainstay of MBA programs and underpins nearly all retail and institutional investment advice.

In our view, the two opposing scenarios of "a policy determined market as far as the eye can see" and an immediate and final "normalization" to a market based on fundamentals presents something of the type of false choice that Hunt derides in his piece. While we don't dispute the likelihood that central banks intend to continue their policy driven efforts, we harbor significant doubts as to their ability to pull them off for much longer.

Importantly, central banks don't exactly have the luxury of time either. The clock is ticking on demographics as the large baby boom year born in 1946 turns 70, the age at which significant disincentives for continuing to work kick in. This suggests strongly that we are at an inflection point of much higher spending on entitlements which will create ever-increasing fiscal deficits. As Bill Gross sums it up: "Central bank policies consisting of QE's and negative/artificially low interest rates must successfully reflate global economies or else. They are running out of time. To me, in the U.S. for instance, that means nominal GDP growth rates of 4-5% by 2017."

Further, the arguments for policy driven markets for "as far as the eye can see" assume that it remains both politically expedient to continue such policies and that a critical mass of investors opt to stay with the herd. Cracks have already appeared in this position. Concerns in the first quarter about the potentially devastating effects of rate increases on China, for example, both shattered confidence in the ability of central bankers to keep markets afloat and revealed how little room they have to maneuver. Further, while a critical mass of money managers has been quiescent with central bank policy so far, their positions are fragile and their investment views are dissonant. What if an important subset of them pulls out of the market? Would the others dutifully support prices or run for the exits?

We propose more of a "third way" of approaching today's investment challenges. In general, this third way recognizes that this is "an unusual economic world in which we live" and as such, investing in it requires greater attention to risk management. We aren't yet willing to ascribe to an "all-or-nothing" position or to concede that this is the "end of the market as we know it". As active managers ourselves, it is easy to lament the incredibly hostile environment that policy driven markets have created, but history and experience suggest a more balanced outlook.

One reason for a more balanced outlook is that central planning doesn't work very well and setting interest rates that are very different from what the market would naturally set is a form of central planning. The core problem is that markets are pretty efficient at setting prices and prices deliver valuable information. With less information and lower quality information, businesses in the economy operate less efficiently and the economy as a whole becomes less productive. Over time, such policies gradually, but persistently strangle an economy. Even in communist China, leaders recognized the weaknesses of central planning in the 1980s and introduced "Special Economic Zones" in order to boost economic growth.

Another reason for a more balanced outlook is that technology is providing ever-greater tools for investment analysis. Just as many new services are reducing the need for big investments in physical assets, so too are new services facilitating high quality investment analysis at much smaller economies of scale. Further, the explosion in data and analytical tools is rapidly increasing the types of analyses that can be done and reducing their costs. Increasingly, the only constraints to benefiting from these developments are knowledge and the willingness to use them.

The fascinating paradox is that in light of central bank "policy" that sets prices almost regardless of what careful analysis reveals, exceptionally few of these technology-driven benefits have been realized by investors. For example, as technology is making many aspects of our lives smarter and better, the market is getting "dumber" about pricing cash flow streams. As technology provides more information and better comparisons for shopping and other activities, large swaths of investors are opting instead to treat stocks as one amorphous mass by switching to passive funds. Finally, as consumers clamor for the lower costs of goods and services delivered through the internet, investors have spurned cheap stocks as evidenced by the persistent underperformance of the value "style" of investing.

If and when cracks appear in the monetary policy narrative, there are likely to be opportunities. If it happens in one major event, there will be an opportunity to significantly increase exposure to risk assets again. If it happens in dribs and drabs, pockets of opportunity will arise that focused active managers will be well placed to exploit.

In conclusion, whether markets continue to be policy driven or whether they revert, at least in part, to being determined by fundamentals, is unknowable and therefore an uncertainty investors must be able to manage. At very least, it makes sense for investors to review their established assumptions and approaches, re-evaluate, and clear out some space for new ideas. If policy continues to drive markets, they will most likely evolve into unreliable utilities. In almost any other scenario, active investing will become a lot more fun - and rewarding!

© Arete Asset Management

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