THE BIGGEST QUESTION FOR 2013
The Fed, ECB, BoJ, PBOC, and BoE are all either actively engaged in huge and ongoing stimulus programs or getting ready to do so. History has shown that such aggressive large scale monetary stimulus can temporarily substitute for real wealth creation to prop up risk asset prices.
Are You Still A Believer?
Therefore the biggest question for 2013 is, can stimulus keep working for another year?
Believe In Stimulus Until Evidence Suggests Otherwise - For Now
Until proven otherwise, don't fight the Fed, ECB, or BoJ until we get evidence that the current ultra-accommodative easing game plan isn't working. Admittedly, in the US we're already seeing diminishing returns from it. QE 1 saw the S&P 500 index rise almost 70%, and for QE 2, the index gained 23%. So far, since QE III was announced in September 2012, the S&P had lost 4% as of year-end (though has since erased that loss in the wake of the post fiscal cliff deal rally).
We don't believe ultra low rates and ballooning sovereign debt levels fueled by endless money printing is sustainable, but timing its demise impossible. Currently there is no reason to believe it can't continue through 2013.
As we discuss below, as long as we don't get a solvency crisis in the EU, US, or other major economy, markets remain in a trading range of 10-15% from current levels
What To Do - Focus on S.I.R.P
If you believe stimulus will continue to work through 2013, then you too see markets as likely flat with roughly equal but, as noted above, limited upside/downside, then you're not likely to make money from capital gains or shorting risk assets (unless you're a short term trader). Rather, this scenario suggests that it pays to be in risk assets that produce income like:
- dividend stocks,
- the higher risk/yield investment grade corporate bonds when you believe the market has overestimated risk and thus handed you extra yield
- rental real estate where there is healthy demand and yield
As a rule we're not big on high grade sovereign bonds, which too often represent what Warren Buffet called "reward free risk." They may indeed still have some upside yet as rates edge lower still or in times of great fear, but not enough to tempt us when compared to their downside (unless you're making a short term long trade).
As Gluskin Sheff's David Rosenberg says here, the key is to go for SIRP: safe income at a reasonable price.
We would add two additional criteria.
- Seek SIRP with exposure to healthy currencies or assets exposed to them (and ideally denominated in them).
- Manage Risk: With risk asset markets at decade highs and both the US and EU policies bringing multiple solvency scares per year as they continue to opt for increasingly short term fixes rather than longer term but more painful actual solutions, we buy only on dips and keep stop loss orders in place for at least partial protection against a sharp selloff.
Note Longer Term Ongoing Currency Debasement Risk: Bad In Us, Worse Elsewhere
Major central banks continue to buy their own nations' bonds with printed money at an unprecedented rate for peacetime, meaning that their currencies are due to lose buying power relative to both better managed currencies and hard assets. As radical as the Fed's policy seems, the ECB and PBOC have expanded their balance sheets (bought their nations' bonds with printed money) even more.
Therefore Diversify By Currency Exposure Too
As we remind readers each week (no one else is doing it) the USD, EUR, JPY, and other currencies subject to unprecedented printing are at risk of depreciating versus better managed currencies (and goods/services denominated in them).
Investors should use times of relative strength to pick up income producing assets denominated in or heavily exposed to healthier currencies. Their characteristics include:
- In a flat trading range or (better) in a long term uptrend vs. most other major currencies, especially your local currency
- Not being heavily printed or under central bank in easing mode
- Relatively low debt GDP
- Economy based in hard assets that are in demand by the higher growth emerging markets
Examples include the CAD, NOK and SEK, arguably the AUD and NZD if you believe China will not experience the feared hard landing and will continue to grow at 7% or more per year. It's been said that some of these are overbought on a parity purchase basis.
However, as I discuss in my book The Sensible Guide To Forex, currency trends take a long time to reverse, so these currencies can continue to prosper and be technically overbought for years to come. It's much harder to turn around the underlying fundamentals of an entire country, and thus of its currency, than it is to reverse the fundamentals of a single company and its stock price.
For New Long Positions: Better To Wait For Pullback
Yields for most moderate risk assets don't exceed 6% at best.
With most risk asset barometers like the S&P 500 near decade highs, even a perfectly normal correction of 10-15%, well within the consensus, would negate over a year's worth of gains. Given the bearish fundamentals noted above and risks noted below, we expect markets to test lower in the coming months.
In sum, you're more likely to gain by waiting than to lose, and the opportunity cost from the lost annual 3-6% income yield is not large.
Therefore for income investors seeking to open new long positions, strongly consider building partial positions and buy on only on dips- only via limit orders near what you believe. For example, set a limit order to buy a third of your planned position at near term support that's likely to be hit in the coming months, another order for the next third at deeper support, and so on.
However, accept that easing will reach the limits of its effectiveness and that will likely happen sooner than markets anticipate. For example see here. Therefore have your stop loss orders set in advance to limit your risk. For those in need of guidance on doing setting stop losses, you can read pages 142-150 of my book for free using the "Look Inside" feature on my book's amazon page here.
What are the likely factors that end the trend of higher risk asset prices fueled by borrowed and printed money? Some combination of the above bearish factors, though we believe a renewed EU solvency crisis and contagion threat is the most likely thing to overwhelm stimulus, as we discuss below.
THE BIGGEST 2013 RISK: EU SOVEREIGN DEBT & BANKING INSOLVENCY RISK NOT PRICED IN
As noted above, with markets near decade highs, they are clearly not concerned about insolvency and contagion risk in the EU.
Remember, even Fed Chairman Bernanke said he couldn't stop a recession if the full $500 billion in taxes and spending cuts of the fiscal cliff hit. The fiscal cliff is only a recession threat. The EU crisis is a contagion depression threat on a greater scale of the Lehman Brothers collapse, because the entities involved are bigger, just as interconnected and so more likely to drag each other down. However unlike the US, the EU isn't a single economic entity and can't move nearly as fast or with as much resolve. Meanwhile, as noted above, the full range of GIIPS sovereign and EU banking insolvency threats remain. Even ECB President Draghi admits he's only been able to buy time for the EU. Easy liquidity isn't a solution to wide scale sovereign and banking insolvency.
Even if you believe enough new debt fueled by money printing can save the EU for the coming year, that doesn't mean we can't get some significant scares. Unlike the US, it takes the EU longer to respond, and despite the gridlock in Washington, there is even less consensus about what to do between the ones who pay the bills -funding nations like US republicans who represent interests of the ones who pay most of the taxes- and the ones seeking handouts - debtor nations like democrats who represent the majority who pay only a small percent of overall tax bill
Complicating matters will be elections in both Germany, the main funding nation, and Italy, the largest of the debtor block (ok, maybe that's France, but markets have yet to focus on it). That will limit flexibility of leaders on both sides of the divide as they play to their voters.
Don't confuse current calm with an actual solution. Don't confuse the inevitable but unsustainable additional band aids of more loans to the already insolvent, money printing, 'voluntary' loan forgiveness, etc. Before you get suckered into thinking they've even made progress, check the EU's latest solutions for 2013 against this checklist for what defines real solutions.
The EU crisis remains the big threat to markets, and will likely reclaim the spotlight as soon as there is even temporary closure regarding the US fiscal cliff and debt ceiling, if not sooner.
BEYOND 2013: DELEVERAGING, DEMOGRAPHICS, SLOWING GROWTH MEAN FALLING REAL ASSET PRICES
Looking beyond 2013 the balance of evidence suggests falling asset prices due to:
- Deleveraging: Ongoing debt cutting means spending cuts in both public and private sectors, albeit probably not at the same time. Just as stimulus has helped prop up assets, deleveraging has the opposite effect. The sheer uncertainty about how this process plays out and who suffers most will be an additional drag on markets, as we're seeing with the prolonged negotiations over how to cut debt in both the US and EU.
The current US annual deficit is over $1 trln. The fiscal cliff deal brings in about $62 bln in tax revenues, only about 6% of what's needed. Proposed (not yet settled) spending cuts are about $15 bln, not even 2% of the deficit. The US, like EU, continues to defer the hard choices.
Japan's debt/GDP is even worse than that of the US, and Europe is likely to become worse as well as it continues to fund the GIIPS with more debt.
See the links in Part 1 for more on the coming drag from austerity
- Demographics: Aging populations in the developed world is an additional long term burden on these economies.
- Slow Growth: Even if we assume the US and EU do avoid insolvency or somehow manage its effects without crashing economies, we remain in a longer term secular bear market, partly due to the above burdens of deleveraging and demographics.
- Rising Interest Rates Too? As noted above, for the US every 1% increase in rates on maturing and refinanced debt has the same economic effect as the fiscal cliff. At some point we're due for 2-4 of them just to get rates back to historical norms. As the US continues to grow its deficit and debt load, the cost of each 1% rate hike rises further. Washington wants to defer any serious deficit cutting and rate hikes until some future point when there is a sustainable recovery, and wants to do so gradually, so this is another long term headwind for the US.
We don't know when higher rates will come, although we suspect they aren't coming in the next 12-24 months at least, as leaders in most of the developed world will do all they can to continue keeping them low
In sum, the longer term picture suggests flat to lower real asset prices.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.