Pencil in 2019 for the next economic downturn

Our friends at CrossBorder Capital have released end June liquidity data and it shows the same very tight conditions as we have highlighted for three months.  They normally - I hesitate to say always - presage a significant downturn in risk appetite and markets, and then economies.  The overall liquidity index is 17.3 (range 0-100) but that hides a more positive picture for Emerging Markets (58.3) than Developed ones (12.7).  The former appear to be letting their currencies weaken rather than tightening monetary policy in line with the US Federal Reserve. Investors’ appetite for risk also appears to have declined, albeit the confidence collapse is largely within Emerging Markets and specifically China.  This tallies with our anecdotal evidence, where many western investors we speak to remain invested in largely DM risk assets in the short term, despite their worries about the longer term.  Our own view is that there is a lot of complacency around after nearly ten years of rising markets, and we are firmly in the ‘Risk Off’ camp right now across the board. With the liquidity cycle clearly in a downward trend and the risk cycle looking like it has peaked, we would expect the economic cycle to follow and peak quite soon.  We are therefore somewhat sceptical that the train of rate increases envisaged by the US Federal Reserve will all happen.  If they do, we suspect they will prove the exogenous shock needed to precipitate a change in market direction and economies will slow sooner rather than later.  Either way, we now have visibility of how the next economic downturn happens and, increasingly, when.  Pencil in 2019. To purchase the full CrossBorder Capital report with the end June liquidity highlights, please click here.​

Are LGPS funds missing an ESG investment trick? - LGC, July 2018

 The application of ESG risk analysis within fixed income credit was discussed at an LGC roundtable event sponsored by Insight Investment. William was one of the participants.  To read more please visit  

Value investing in Japan will have its day in the sun again

A Nomura report claimed a couple of years ago that ‘Japanese value investors are extinct.’  That is not quite true but, since the Global Financial Crisis, only the most determined investors have kept going.  Relative returns from value stocks actually bottomed out in 2016 but there is little sign of any escape from the value trap which scornful commentators like to refer to.   The cause is not hard to seek: Japan has endured ultra-low interest rates for nearly 30 years and negative nominal economic growth for the first 20 of them.  Investors have responded by putting a huge premium on those stocks who have been able to demonstrate growth and/or a sustainable yield.  The dispersion between growth and value has therefore risen to extreme levels. And yet, and yet… since 2001 Japan Inc. in aggregate has consistently generated positive free cash flow, the economy has generated positive real growth over the past three years and where else in the world can you find thousands of companies on a Price to Book of less than 1.0? One clear message from history is that when relative valuation measures become stretched (for example 2001 and 2008) there are excellent returns for value investors who are prepared to stick to their last.  We believe that will happen again but, as ever, patience will be required to benefit. Our friends at Arcus Invest, one of the Japanese value survivors, have written a further instalment of their regular white papers - Fortune Rota Volvitur (loosely translated as ‘value investing will have its day in the sun again’) - on this subject with much more detail.  Please let us know if you would like to see a copy.​

Hold on to your hats!

We make no apologies for returning to the same theme as two weeks ago, when we commented that the global tide of liquidity was rapidly retreating.  The US 10 year Treasury yield has fallen from above 3% to 2.87%, which in our view is further corroboration that investors are moving back to safe havens.  It is all the more interesting that this is happening while Japan and China have stopped investing in US Treasuries.  The two countries’ combined holding is just under 36%, compared to 40% three years ago and 46% seven years ago.  China is recycling excess cash into its Belt and Road policy, while the driver in Japan is a recognition that China is now its most important trading partner.  The more rapid escalation of trade sanctions driven by Trump is further exacerbation. China’s action over the weekend to cut bank reserve requirement ratios by 0.5% is further evidence of the stresses which are building up.  The PBOC is attempting to deleverage over-exposed parts of its domestic economy, while avoiding too much of an economic slow-down, much as it did in 2016. The signal from global liquidity levels is unambiguously negative, as we commented in our last blog.  We said then that what happens in China would probably determine how quickly the next major economic downturn would hit the world.  The latest action can be seen as a positive in that it is effectively monetary easing, but negative in that it highlights the problems. At Linchpin, against the background of tightening liquidity, we are bracing ourselves for a much more serious market downturn than the one experienced earlier this year, and are firmly Risk Off. Expect US rate rises to be muted, and possibly a bearish inversion of yield curves (ie. where short rates are higher than long term bond yields). Linchpin provides experienced advice from our 35 years of investing including how to invest successfully in market downturns.  Find out more here.

The liquidity tide is going out!​

There is no doubt the liquidity tide is retreating fast.  It has been falling since last August and the series monitored by our friends at CrossBorder Capital shows that the global level has only been this low twice in the last 40 years.  Once was ahead of the Savings and Loans crisis in the late 1980s.  The second was in 2007 – I need say no more.  Worse than that, three measures which are the strongest predictors of a bear market are all at extreme levels: investors’ risk appetite is high, central bank liquidity is low and cross-border flows, particularly those out of the US, are weak. That’s not to say it will happen tomorrow.  There are still some positive signs coming out of China in particular, where in a Trumpian world the People’s Bank is rapidly taking over from the Federal Reserve as the global liquidity provider of last resort.  But if they turn the taps off too, it really will be a case of battening down the hatches. When the tide retreats, who will turn out to be swimming commando?   They will almost certainly be found in the Developed Markets and it probably won’t be the banks this time round.  It’s worth noting that markets lead the economy by at least nine months, and it could just be a good old-fashioned recession in 2020 or 2021, with companies which have extended credit to consumers in the forefront.  Think auto and phone service agreements, store cards, travel companies and anybody else who has extended credit unwisely. Find out more about the end May numbers here.      ​  

Could Asia be different this time?

That the rise of China is leading to shifts in the tectonic plates which link economies together is broadly acknowledged by most.  And yet most presentations I hear about global economics barely, if at all, make mention of Chinese influence. Our friends at CrossBorder have published an interesting strategic paper making the case that the trajectory of Asia will differ significantly from the West over the next economic cycle.  While Asian markets may not be immune to a downturn in markets, they expect them to behave differently and recover much more quickly.  Their first piece of evidence is the rise of a distinct Asian liquidity cycle.  This can be seen statistically in the collapse in the correlation between US and Asian liquidity, and is a result of a clear change in Chinese priorities.  Beijing’s long-term objective is to have the yuan replace the dollar as the major global trading currency.  Today they have switched to spending surplus cash on their Belt and Road project in Asia – effectively their version of the post-war Marshall Plan – rather than investing it into US Treasuries.  This is a factor behind the rise in US yields over the past year and can be seen in the fact that aggregate Chinese holdings of Treasuries have flat-lined over the past 18 months. The Bank of Japan has reacted by switching from its traditional targeting of liquidity to targeting the yen’s currency rates against a basket of currencies including the yuan.  The yen has traditionally been highly volatile against the US$, for example almost halving between 2012 and 2016.  Over the past two years it has traded in a much narrower range.  Tokyo has, like Beijing, stopped purchases of US Treasuries over the last two years.From a market perspective, we think this makes Asia relatively more attractive as a long-term investment, albeit Japan in particular will be more pro-cyclical because it will now be more closely aligned with China.  Lower correlations are also attractive from a diversification perspective, even disregarding potential returns.  On the negative side US Treasuries continue to be vulnerable to further ‘buyers’ strikes’, let alone selling, and the US$ is potentially vulnerable. As background to the interactions between the US, China and Japan, I thoroughly recommend Richard McGregor’s book ‘Asia’s Reckoning’, which gives a sense of the three-way power games these nations have been playing since the last war. Find out more by purchasing the report here (and spot the mis-spelling of linchpin in it!).​

More difficult times ahead (unless you are chinese or british)?

30th April data from our friends at CrossBorder Capital confirms the much bleaker liquidity picture ahead, which we alerted you to a month ago.  While the index at 29.8 overall was slightly higher than March, the composition was worrying.  There is a very high level of risk appetite (ie. investors’ exposure to riskier assets compared to ‘safe’ ones) in Developed Markets, which has historically been a reliable predictor of bear markets.  Central banks, with one exception (below), continue to try to wind down the optimism by tightening monetary policy.  Private sector credit creation remains subdued, especially in the US and Japan.  CrossBorder’s interpretation of this is a high likelihood of a bear market in DM equities within 9-12 months and an economic slowdown to follow. The UK stands out like a sore thumb, however.  Liquidity here is the highest of all the major economies, partly because of ultra-strong cross-border flows.  The explanation may be that the Bank of England is maintaining a looser stance because of political fragility or that overseas investors have more confidence in the UK than we do.  If you believe the data - however unfashionable a view it may be - the UK economy is relatively well placed going forward and sterling should not weaken greatly. The other clear trend, which we have mentioned before, is the growing divide between Emerging Markets, largely driven by China (a mostly positive liquidity background with low investor sentiment), and the major economies and markets (the reverse). If you would like to buy the full report, please click here.​

Decomposing the illiquidity premium

For a generation or so academics have recognised the existence of the illiquidity premium, i.e. investors who are prepared to forego liquidity to receive a higher return.  A recent EPFIF private markets investment forum made me think the picture is more complex than that simple model.  For example, long term infrastructure debt can trade at a zero or even negative premium to much shorter term corporate debt, simply because long duration is valuable to pension funds trying to match their liabilities.  I hasten to add that what follows draws on perspectives from a number of consultants and asset managers, and does not all originate from Linchpin. I would argue that investors in illiquid corporate debt, which I use as an example because it a more homogenous asset class than other illiquids, can benefit from the following premia: credit for taking credit risk; illiquidity for committing for a long period of time; complexity (usually accessed through illiquidity); and an LDI premium, representing the value which predictable returns over a long period can add to solvency calculations. The credit premium can be quantified, but illiquidity and complexity are not easily separated.  I would suggest that illiquidity is the opportunity cost foregone by investing in a long term asset, in other words the opposite of the reinvestment premium.  Some investors, such as pension funds, will place a higher value on predictability and therefore a lower value on this premium, which is one reason why infrastructure debt may trade at a lower yield.  Complexity is probably best thought of as the risk that an investor may not have fully understood a strategy, and should be reflected in a lower entry price. Quantifying these different premia is difficult, partly because of the lack of homogeneity.  At the EPFIF seminar, I believe the general view was that the illiquidity/complexity premium ranged from around 75bps for relatively short term illiquidity to around 200bps for a 20 year lock-up.  The LDI premium was around -155bps for a 20 year relative to a 10 year lock-up.   We will be developing this theme over the next twelve months, and I would welcome any thoughts or insights from readers.  Please contact me on