Central bank liquidity at lowest since early 1980s

At the end of August, central bank liquidity was at its lowest level since the early 1980s, according to the data which our friends at CrossBorder Capital monitor.  The index stands at 13.8 (range 0 to 100) and only the People’s Bank of China is still following a relatively loose policy. We shouldn’t perhaps be surprised by this, coming after nearly ten years of Quantitative Easing (QE).  But an environment of tight money undoubtedly heightens the risk that someone somewhere is unable to pay their bills and the first domino falls. In contrast investors are relatively sanguine and ‘risk-on’ in aggregate.  CrossBorder’s measure of this metric is at +33 on a scale of -50 to +50, which is consistent with what we hear on the street.  Many professional investors are preferring to remain invested for the time being. Although there are pockets of light in the liquidity environment (China and, surprisingly, the UK where corporate cashflow is strong), at Linchpin we would argue strongly for a defensive ‘risk-off’ stance.  The overall levels of liquidity are pointing unambiguously to, at best, soft economic growth and, at worst, a recession if Central Banks tighten further.  Given investors’ positioning, that is unlikely to end well for those exposed to too much risk.To learn more about CrossBorder’s research on liquidity please click here.  

Here we go again... or not? Emerging Markets are a bit different this time

The virus affecting Emerging Markets is spreading this week.  Like most previous occasions (1982, 1997, 2008 et al) the transmission method is currency weakness.  Historically, the causes have been largely to do with economic mismanagement in the EMs.  This time, with a few exceptions such as Turkey and Argentina, the problem appears to be dollar strength.  It is still hurting EMs as much but it may well not lead to the same cathartic volatility in global markets as previously. Why do we say that?  First, we do not believe the Chinese economy, so important to EMs, is about to implode.  The PBoC is still providing plenty of liquidity, and China is embarking on major fiscal initiatives such as its Belt and Road initiative.  Readers may argue about the longer term prospects for a controlled economy but we’d suggest that in the short to medium term there’s no reason to expect it to derail. If you look at EMs excluding China, four key measures of financial health all look robust by historical standards.  These are current account surpluses, net inward Foreign Direct Investment, the level of forex reserves and the volatility of financial inflows.  Data comes from our friends at CrossBorder Capital Ltd and is available from us on request. That’s not to say there may not be further drops in markets, both EM and DM, over the next few weeks and months, but our point is that China is still on track and most other EMs are in reasonable financial health.   We’d argue that there is a buying opportunity coming up in them.

The canary in the coalmine again?

The 2nd quarter US earnings season has produced a 24.6% increase in quarterly earnings, with 79% of companies reporting positive surprises (91% of companies reported, source Factset).  This is close to the strongest result since the Global Financial Crisis, only tempered by a more modest revenue increase of 10%.  We suspect the difference comes from earnings repatriation following the Trump administration’s tax amnesty.  As a result, US valuations are looking less stretched: the forward PE on the S&P is 16.6x, still well ahead of the long-term average but broadly in line with the more recent past.   The bulls see this as evidence that equity markets can cope with recent rate rises, signs of distress in the Emerging Markets, and the opening shots in what looks more and more like a trade war.  At Linchpin we beg to differ.  The liquidity data at the end of July, as provided by our friends at CrossBorder, continues to be at its lowest level since 2007 or 1989, both of which presaged major downturns.  The only major central banks continuing to expand their balance sheets are China, India and the UK, and each of these has their own peculiar problems. The problems – admittedly neither unexpected nor surprising – rearing their heads in Emerging Markets also cause us concern, as they so often turn out to be the ‘canary in the coalmine’.  We see some parallels between the current Turkish situation and Thailand in 1997 in that both followed a major US monetary tightening.  Turkey has exacerbated the situation by printing money to solve its liquidity shortage.  The situation may not be contagious for Emerging Markets, as it was in 1997, but for the time being and despite the US earnings numbers we remain very firmly risk-off on all risk assets. Find out more here.​

Investing in private assets late cycle - is there a case for hedge funds?

At the recent, excellent LAPF LGPS Strategic Investment conference, I was struck that there were eight presentations on investing in ‘alternative’ investment classes of one sort or another, compared to only two on equities and fixed income.  Behind this, of course, lies the make-up of the conference sponsors and behind that are fee trends.  For example, private equity fees are - if anything - rising whereas pooling has resulted in significantly lower fee charges for liquid asset classes.   Overall, as one presenter stated, in 2017 more money was raised for private debt and equity ($2.4tr) than public ($2.1tr).   While the bulk of this has been for mainstream assets, the hunt for returns is leading to considerable fragmentation into increasingly specialist strategies such as structured products, leasing, farmland and specialist property. Again, this should not be a surprise.  The mainstream areas of private credit and particularly private equity are looking crowded, with big money being raised and returns falling.  At this late stage in the cycle, smarter managers are therefore looking for niches with better return/risk characteristics.   Secondaries have been a popular target but at least in the area of private equity managers are having to pay close to, or even above, par to gain access. The same presenter commented on the wide range of outcomes in private markets.  Here there is a crucial difference: when investing in liquid markets, decisions usually have to be made on incomplete information.  The winner is whoever can make best use of the publicly available information in the least time, i.e. before the price has started to react.  In contrast, in many private markets there is full information and no time pressure; the key is normally access to good ‘deals’. In both cases, manager selection is crucial.  If we have to choose between a smart or a well-connected manager, we would therefore prefer the first in public markets and the second in private markets.    This leads us to suggest there is a case for investing in hedge funds, in that they are smart investors investing mainly in liquid markets.  Although they are often lumped in as alternatives, they should probably be considered in this context as investors in public markets.  Hedge fund secondaries are in our view an even more interesting niche at this stage of the cycle.  There is plenty of supply, very limited information and almost no competition.  All you need to find is the right manager, preferably both smart and well connected!  We are happy to make suggestions.

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 LGCplus.com.  

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.