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Robbie Morrison
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Investment analyst concentrating on (and working in) non-U.S. markets. Favors bottom-up fundamental analysis but recognizes the necessity to apply a robust macro-overlay given linkages of markets, myriad crises and dynamic global economic environment. Sector concentration has been on those... More
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  • The Allocation: Putting It On The Line 0 comments
    Jul 30, 2013 11:45 AM

    Feedback from recent commentary can largely be boiled down to the following: "We get it. Developed market growth will continue to redefine mediocrity; emerging market leaders cannot decide whether to institute steps to limit hot money inflows or raise interest rates to mitigate the more recent outflows; and financial markets at all points of the compass are distorted thanks to the tidal wave of artificial money seeking marginally respectable returns." These comments are immediately followed by the query: "So what am I to do?" Fair enough. After harping on the aforementioned risks to the global economy and investment portfolios, it is easy to resemble the annoying sports fan at the corner of the bar complaining about every play without offering up a rational alternative. Since there is no Ph.D. in economics hanging on my wall, I'll skip over policy and instead concentrate on how one should deploy capital in such an uncharted environment. So this entry is about asset allocation, the granddaddy of generating investment returns. The concern here is not with market activity this week or this month, but rather how to construct a portfolio able to meet one's financial obligations in the globalized 21st century economy and the eventual unwinding….or unintended consequences…of extraordinary monetary policy, whichever comes first.

    The Landscape

    Although the most expensive words in the English language may be "but this time it's different," this time, it really is. The sources of the recent economic crises have been developed, not developing, countries. There has never been a broader range of financial markets and asset classes in which to invest, not only for sophisticated institutions, but increasingly for the main street crowd. And as alluded to above, it is anyone's guess how the removal of central bank support will affect investor psychology, much less the real economy. If someone comes along pitching the standard portfolio of domestic equities, bonds and cash, don't laugh or slam the door in his face. Just politely take his card and store it on the shelf next to the floppy discs, flip phone and Seattle Supersonics jersey. Instead, rather than being the domain of investors with a high risk tolerance, these new markets and new vehicles should find a place in the portfolios of any judicious market participant as a means to capture returns and diversify risk, in other words: to expand the efficient frontier.

    (click to enlarge)

    So what does this landscape look like? The S&P 500 nailed yet another record high this past week and at 1,691.7 is up 18.6% for the year and 150% since the crisis nadir four years ago. Despite massive Fed purchases, the benchmark 10-Year U.S. Treasury has seen its yield rise 98 basis points since May 2nd. All this must mean the economy is rip-roaring. Not exactly. Over the past five quarters, America's GDP has averaged 1.72%. Immediate prospects are equally grim with yet another sub 2% print for Q2 2013 expected. This has been the same story across developed markets in the post crisis era. As seen in the IMF data below, the U.S. may once again crest the 3% threshold for both 2014 and 2015, with other advanced economies eventually following suit. This number was doubtlessly arrived at by complex economic modeling…and perhaps a coin tossed into a fountain.

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    Continued tepid advanced market growth and a contraction in the pace of emerging market expansion, which carried the global economy on its back during the lean years, have been reflected in other financial market indicators. The MSCI Emerging Market Index is down 11% from its 2013 high and over 20% below its January 2011 level. Similarly, another putatively favored destination for yield-starved investors, commodities, is 6.3% off its 2013 high as measured by the S&P GSCI broad commodities index. Either these asset classes reflect a more cautious view of growth than those imbedded in U.S. equities, or investors are simply jockeying for position in advance of the Fed eventually withdrawing its multi-trillion dollar supportive hand. This talk has become acute of late with the expectation that the bank's current $85 billion monthly purchases may be curtailed towards the end of this year. Frightening thought that markets are jittery, not because the Fed is selling off its gargantuan bond portfolio or planning on raising interest rates, but simply due to the fact that it will be it will be expanding its balance sheet at a slower pace. When markets emit such conflicting signals, especially with the presence of QE distortions, investors must weigh the costs and benefits of major asset classes and adjust his/her allocation accordingly.

    U.S. Equities

    The United States is home to the deepest, most liquid pools of equities anywhere in the world. Stringent reporting requirements ensure transparency and solid corporate governance when compared to other markets, including advanced economies. As a brilliant mind told me years ago when discussing the ascendency of Asia, the U.S. still maintains the competitive advantage of freedom, flexibility and innovation. Also most domestic investors plan on having their retirement funded in dollars, unless they expect to spend their golden years in San Miguel Allende or Mauritius.

    But what of America's recent lousy track record of economic growth? That is offset by yet another differentiating factor for U.S. firms: investors are not only gaining access to U.S. growth, but to global markets as well. As seen below, nearly 50% of sales by S&P 500 member firms are generated abroad. That's a nice hedge to have.

    (click to enlarge)

    Despite record highs being set just this past week, valuations are arguably still within the realm of plausibility. According to S&P, the 12-month trailing P/E ratio is presently 16.99 based on operating earnings, compared to a 25-year average of 17.8. Forward earnings are an even more attractive 15.1. So what is not to like? For one, earnings growth has been woeful of late, averaging under 1% between Q4 2011 and Q1 2013. The expectation is that when all is said and done, Q2 will see a sizeable uptick. Yet is that sufficient to justify recent highs? Hope springs eternal. Just as telling, revenue gains are still stuck in low gear, having averaged low single digits (4%) over the most recent fully-reported six quarters. A troubling characteristic of this…ahem…recovery has been the ability of executive teams to drive EPS growth by streamlining operations rather than expanding the top-line. To borrow a phrase from our friends in the medical profession, one can only cut so much fat until they start hacking into muscle and bone. Also when looked at through another lens, valuations themselves become suspect. When using the Shiller P/E ratio based on 10-years of prior earnings, the S&P 500 is trading at a slight premium (0.7%) to its recent average, compared to the 4.5% discount based on operating earnings.

    (click to enlarge)

    Bulls rationalize current prices by positing that equities are pricing in the release of still-elusive pent-up demand and that the economy will eventually start humming along at a 3%-plus clip. But they have been playing this song during the entire run-up to new market highs. Fool me once.

    The Verdict: Is there a lot to like about exposure to domestic stocks? Absolutely. Just not at 1,691 in a sub 2% growth environment. Long-term exposure is clearly a must for the aforementioned reasons. Adding to that exposure at current valuations is likely an exercise in caveat emptor.

    Bonds

    Much conjecture has been made as to whether the 30-year bull market in bonds has come to an end. How could it not be? The epoch of low interest rates was a consequence of central banks, namely the Fed under Paul Volcker, adhering to strict measures to break the back of persistent inflation during the latter 1970s. That magic formula has sense been thrown out the window as evidenced by advanced market zero-interest-rate-policy (ZIRP) and massive bond purchases (QE). Even the inflation-paranoid Germans have been cajoled by the ECB into going along (kicking and screaming) with loose monetary policy. The Fed has already stated it intends to keep rates at present levels until unemployment dips to 6.5% and that it is willing to tolerate inflation of 2.5%....above its previous comfort zone…in order ensure yet-to-be-seen jobs gains become solidified. This tactic only adds fodder to the camp that believes central banks tend to fall behind the curve when combatting incipient inflation. On top of this concern in the reality that the Fed has become the marginal buyer of Treasuries and mortgage-backed securities (MBS), and once that support is removed, supply and demand must readjust…in perhaps a most unsightly way….to find a new price equilibrium.

    (click to enlarge)

    If one is an adherent to the concept of mean reversion, today's 2.6% yield on the 10-Year will eventually drift back up towards its long-term average of 4%. In doing so, the bond's principle will take a significant hit and with yields at such miniscule levels, only a slight drop in prices will wipe out gains attributed to coupon payments. If inflation does eventually rear its head, the future value of bonds' fixed payments will be whittled away. Here equities, with their nominally-priced dividends, have an advantage over fixed-income instruments as they can be increased to keep up with (or ideally exceed) the pace of price growth. So a little inflation…if it is a consequence of a healthy economy…is potentially a positive for equities markets. Not so for bonds.

    (click to enlarge)As seen above, during the credit bubble, spreads of corporate bonds versus comparable risk-free benchmarks reached laughably low levels. Now that the dust has settled in the crisis aftermath, spreads have stabilized at levels slightly above their long-term average. From an investor's perspective, that may be an improvement over 2007, but in absolute terms…with Treasuries at 2.5%, it pays very little to have exposure to quality (or junk) corporate debt. And once again, once rates begin to rise and new issuance offers juicier yields (if there is any firm left that has yet to refinance at current low rates), securities already present in portfolios will take a punch to the teeth.

    The Verdict on Bonds: Run. Run very fast and far away. Unless one is a manager of a fund with mandated exposure to the fixed income space. In that case, harass Washington about the generational theft that is occurring via its policy of financial repression.

    Commodities

    The so-called commodities supercycle has been on investors' radar screens for nearly a decade. Rather than a fringe component of a portfolio, included to diversify risk, commodities came to be attractive as a source of returns. The reasons for this were twofold: the supply of many key inputs were becoming more scarce, and demand, namely from emerging markets was surging. Historically, an uptick in demand could be easily met by the Saudis drilling another well or multinational miners dynamiting the lid off of a previously pristine mountain. In a wicked twist of fate, the rapid industrialization of the developing world has coincided with the depletion of many of the most easily accessible (i.e. cheapest) sources of raw materials. The result? Elevated prices. Increased investor speculation…partly attributable by the low-interest rate regime of the early 2000s…only fueled the price gains.

    As seen in the top chart, 2013 has not been kind to the commodities space. So much so that many have called an end to the supercycle. It is true that as in the past, industry has ramped up extraction activity to meet increased demand, with the North American hydrocarbons revolution (see below) being a prime example. But these new supplies generally require advanced engineering techniques that had been avoidable during periods of flush supply. The result is increased marginal costs. The next barrel of oil out of Canada or ton of copper only make economic sense at the current elevated prices. Should those fall, then firms simply curtail production, something already occurring in the shale gas space. The end result is the same: prices across the commodities space are not returning to their historically low levels…at least for any sustained period.

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    (click to enlarge)

    On the demand side, despite the much publicized slowdown in Chinese growth to the (gasp!) 7.5% neighborhood, the appetite for raw materials…namely from the emerging world…will continue to grow. And while the transfer of global manufacturing to Asia has largely run its course, and the more recent frenzy in construction spending has begun to cool, we are likely on the cusp of a third iteration of emerging market commodities demand, this time from consumers seeking energy-sucking creature comforts such as cars, and improved diets, which will tax the global food supply chain. More on this in the following section.

    The Verdict on Commodities: this asset class should continue to be included in a globally diversified portfolio seeking to capitalize on secular…that is long-term….investment themes. Ironically, the potential exit of Fed support from financial markets may chase away yield-seeking speculative money and cause a reemergence of the historical attraction of commodities as an investment: lack of correlation with other asset classes and a viable hedge against inflation. Now that the supercycle has entered into a more mature phase, industrial inputs (metals and energy) may become more attuned to the peaks and valleys of the global business cycle, but consumer-specific resources such as food stuffs will continue to benefit from elevated global demand.

    Emerging Markets

    Very much related to commodities are themes surrounding the ascendency of emerging markets. And as with commodities, 2013 has been less than kind with regard to investment returns. Talk about an opportunity. If one believes markets got overheated on excess liquidity, and he is a champion of the secular EM themes such as rising consumer demand, then the upcoming post QE/stimulus shake-out period could be rife with chances to gain cheap exposure to these rapidly growing regions. When identifying tailwinds, favorable demographics are hard to beat. And by-and-large population dispersion and urbanization trends greatly favor emerging countries.

    (click to enlarge)

    While these themes are attractive, investment opportunities remain suspect. Unlike with the U.S., liquidity can be wanting, transparency into numbers and corporate governance can be a sham, and securities movements can be at the whim of macro-policy such as those governing interest rates and currency regimes. That said, big-time investors yearn for exposure and local EM business and government leaders yearn for these investors' dollars. This should….key word….eventually lead to more sophisticated and higher quality financial market regulations.

    (click to enlarge)

    The Verdict on Emerging Markets: Buy cheap access on the dips, utilizing the most liquid and transparent vehicles possible. In some instances this may be U.S. domiciled multinationals. In other cases it will be locally-denominated government or corporate debt. This theme is not disappearing any time soon. Yet remember that not all emerging countries are the same. Some are making great inroads in developing the infrastructure and systems of an advance economy, while others slip back into the historical pitfalls of corruption, cronyism and the excessive meddling of state-driven industrial policy.

    Wrapping it up:

    It may be cliché and simplistic to wrap this up by advising one to avoid asset classes facing significant hurdles (bonds), and buy on the dips in areas tied into robust secular themes (emerging markets and internationally-exposed U.S. equities). But these are the blocking and tackling….i.e. the fundamentals…of investing. Unique to the current environment is the eventual unwinding of exceptionally loose advanced market monetary policy. With growth this lousy, it is hard to believe inflation will be a problem through the mid-term. But then again, there are about three trillion good reasons why it may be. Should it rear its ugly head, real assets…things you can touch… such as commodities and real estate (not mentioned here)….may be attractive defensive positions. It may be antithetical to say this with U.S. equity volatility such low levels, but market riskiness can only go up. The purpose of developing a thorough asset allocation is to plan for the long haul. But as advanced market growth continues to convulse and with financial markets possibly losing the supportive hand of the Fed, tactical adjustments to portfolios will likely need to be made with greater frequency to account for future developments. Such possible undulations also create shorter-term trading possibilities for investors of that ilk. And with yields so hard to come by, those are strategies many investors may plausibly come to consider.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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