It was another fascinating week that was highly predictable, for the most part.
Unless you have a global perspective and understand the relationship among all the markets as well as understand their economic and financial data and actions, it is impossible to manage assets of any kind. Herein lies our strength as we consider ourselves master chess players, not only thinking hard about the next move but planning several moves down the board. Sounds similar to George Soros' Theory of Reflexivity. Clearly, I benefited from the years working by his side as CIO/Partner of the Quantum Fund.
You also need to have what I keep referring to as "core beliefs" to measure what is happening day to day to see if adjustments are needed to your capital allocation and holdings. And finally, you need to control risk against the unknown by maintaining excess liquidity at all times so that you are never frozen and can take advantage of out-size market moves when others are panicking.
The economy is a system. Like any system, there are interdependent parts. The best way to discuss this is by example. Let's use the Fed actions as the tipping point to a chain reaction of events. I will try to keep this fairly basic, as it is really far more complicated than what I write here, but you will get the essence of where I am going and the implications for successful investing.
The Fed declared victory and raised the Fed funds rate on Wednesday by a quarter of a percentage point. By the way, this was the first increase in the benchmark rate in 7, yes that is 7, years. I will discuss later what else the Fed said but it emphasized that future rates will be gradual as the Fed "tests" the reactions of various financial markets and economies to this move.
The U.S. stock market rose by over 300 points on Wednesday as the Fed "was out of the way" so life could go on as "it" was finally over, the sky did not fall and the market gave back the gains later in the week for reasons we will discuss later. Needless to say that we see opportunities out there as others are confused and there is year-end tax selling as most funds have had a dismal year and redemptions are high. Our core beliefs remain intact!
Let's look next to see what happened to currencies. Current interest rates and monetary policy may vary by region, so the comparison or impact of the Fed decision varies by region, too. By the way, it goes for all the variables we analyze. The key regions we monitor include the United States, the Eurozone, China, Japan, India, OPEC and the major Emerging Markets.
For instance, the yield differential widened significantly with the Eurozone as anticipated, so the dollar appreciated significantly following the Fed decision. Remember the ECB recently reaffirmed and extended its QE program while QE is clearly over in the U.S. even though monetary policy remains easy by most definitions. U.S. short-term rates rose reflecting the Fed decision, the prime rate was lifted by most banks and interestingly, the yield curve began to flatten out rather than steepen. That is why financials initially rose but fell back later in the week. We will come back to that later as we still like the financials and it remains one of the major sectors in our portfolio. Strong capital flows into the U.S. suppress rates from what they otherwise would be which remains one of our core beliefs. Remember, that the average yield on our portfolio is currently over 3.3% and we are projecting that these dividends will continue to increase in future years. Not a bad alternative to cash, even now, and one way to mitigate market risk.
A weaker Euro (widening interest rate differential with U.S. rates) is good for most European economies as it stimulates exports, employment and growth. So after the Fed decision, European financial markets rallied Thursday and Friday.
As you know most commodities are dollar denominated, so a strengthening dollar normally results in pressure on commodity prices. That may be an overly simplistic comment but basically true. We do an analysis of the supply/demand and capital spending trends in each major commodity from oil to industrial commodities to food groups as it impacts current inflation, future inflationary expectations, interest rates, the slope of the curve, currencies, commodities, etc. Get it? So Fed policy, which moves the dollar, also moves commodity prices.
We create a matrix to analyze and compare by region economic data, monetary policies (easing or tightening), financial policies (like Graham Dodd or Basel III), regulatory policies (taxes, etc.), interest rates (0-10 years), and stock market multiples to get relative analysis. Each market impacts the other. Remember that we are a dollar-denominated fund group; so even though we may favor an offshore market, we may lose some or all of the performance if its currency weakens against the dollar appreciably. And currency moves impacts operating performance of multinationals so it is a key matrix.
I tried to keep this labyrinth of data points simple, but it goes far deeper and is far more complex. Now you can appreciate why Paix et Prospérité continues to significantly outperform the averages, our peer groups and other asset classes. I've been doing this for over 35 years as CIO at Century Capital, the Quantum Fund, EGS and now at Paix et Prospérité Funds. I combine a top-down global perspective with bottoms-up in-depth analysis. Risk is controlled at all times. Today our funds are internally hedged, less than 94% net long and only with highly liquid investments yielding well above 10 year treasuries.
A fair question is "Why would anyone build a dynamic program to look at historical relationships as a basis for creating a portfolio and outperforming?" Many statisticians did just that and succeeded for years but not recently. Why? The simple answer is that we are living in a rapidly changing landscape at all levels. Behavioral patterns are changing! Therefore, historic ratios and charts are not relevant. The Internet has disrupted many industries for the better and as a result our behavioral patterns are changing.
Didn't we expect a real boost to consumer spending from the $100 fall in energy prices? Yes, it has boosted consumer demand but nowhere near where we all expected. Ask the retailers how sales have been this year. I have talked about this topic many times before as we are in a new environment and unless you recognize and adapt to it, you will stagnate at best and most likely fail. A conservative bias remains a core belief and will end up causing lower highs and higher lows in economic activity. This explains a rising savings rate and corporations not investing as much to sustain and maximize free cash flow.
The Fed and Janet Yellen took center stage last week, so let's begin with the Fed decision on Wednesday and Yellen's comments in her press conference. The Fed raised its target rate from a range of 0 percent to 0.25 percent to 0.25 percent and 0.50%, which led to an immediate increase in the prime-lending rate to 3.5%. Fed officials also raised its forecast for growth next year by 0.1% to 2.4% while maintaining its forecast for 2017 at 2.2%. I found it most interesting that the Fed is projecting longer-term growth for our economy at only 2.0%, which is in line with my core beliefs. Inflation forecasts were maintained at 1.6% for next year and 1.7% for 2017 still below the Fed longer-term target of 2.0%, which the Fed believes won't be reached until 2018. So is low inflation really transitory based on their own numbers? Unemployment will keep falling and reach 4.7% by the end of next year, which translates into more jobs, higher income and more consumer spending. Not bad at all.
The Fed emphasized that monetary policy remains accommodative and future increases will be gradual. The vote was unanimous. Janet Yellen went out of her way in the press conference to declare victory and stated that the U.S. economy was on sound economic and financial footing so it was time to move towards normalization. I particularly liked her comment that economic expansions do not die of old age. Naturally she also discussed the strength of the dollar, weakness in exports, production and investment.
Other data points last week included flat consumer prices in November with the core rate up 0.2%; housing starts and permits both rose by 10.5% and 11% respectively; and the consumer comfort index rose just a little but remains at the weakest level since 2014.
Another key event was Congress passing a $1.8 trillion spending and tax bill that lifted the oil export ban while extending wind and solar credits. Congress approved breaking previous budget constraints representing a major shift in DC. While it will add to the deficit by some $65 billion per year, it will contribute to domestic growth. Energy independence must be an objective of our government, and we certainly need a better overall tax policy, too.
Let's quickly comment on events in other regions: Eurozone industrial production increased 1.9% in October from the previous year after contracting in September; Eurozone companies are hiring at the fastest rate in 4 years with the PMI hitting 54 in December; China's retail sales are forecasted to rise 10.7% in 2015; China's industrial production accelerated to a gain of 6.2% in November; China is loosening its ties to the dollar and letting it fall to remain competitive and to offset the impact of a higher Fed funds rate strengthening the dollar; China's housing prices continue to recover; the BOJ maintained its aggressive QE program at $650 billion in annual purchases but lengthened its average maturity of bond purchases and included buying ETF's tied to the Japanese markets and the government promised a tax package to stimulate consumer spending; and finally India lowered its forecast for the fiscal year ending in March between 7 and 7.5%, similar to the prior year.
Oil prices continue under pressure as inventories rise to record levels during a period when inventories normally fall. Clearly the increase is due in part to a very warm season in most of the country reducing the demand for heating oil. Imports have risen to 8.3 million barrels per day, a level not seen since September 2013 and due to a decline in domestic production. Natural gas prices have fallen to a 14-year low, which is weather, related too. There is no reduction in global oil production in sight, which was driven home once again by the comments of Russian Energy Minister Alexander Novak who reaffirmed that Russia has its own agenda and will not align with OPEC.
On the other hand last week, there were some increases in industrial commodity prices despite a rising dollar. Current production and future capital spending plans continue to be cut and the vast majority of producers are losing money at these price levels. I continue to believe that industrial commodity prices are in a bottoming phase, therefore averaging into the financially strong companies yielding over 6% currently.
Before I wrap this up, let's return to a review of our core beliefs: monetary policy globally is accommodative which is positive for financial assets; interest rates will stay lower than generally viewed as low inflation is not transitory; the yield curve will not steepen as much as one would anticipate due to huge capital inflows; M & A will remain intense; conservatism permeates at all levels leading to lower highs and higher lows in economic activity; corporate profits, excluding energy and commodity companies, will surprise on the upside; and change is in the air.
The bear case appears to be built on either rising interest rates lowering the stock market multiple with sluggish earnings or a global recession as was mentioned as a possibility in this week's Barron's magazine. If you believe that the market multiple is based off the 10 year interest rate, it actually declined last week as the yield curve flattened. If you believe in a potential global recession, let's look for the reasons why? The article mentions weakness in the emerging markets. We concentrate on the large industrialized regions, which comprise over 90% of the global economy. The U.S. should grow 2 to 2.5%; the Eurozone 0.5 to 1.5%; same in Japan: China should expand 6% and India by 7%. You have to believe that energy prices even remaining at these levels are simulative to consumer demand and corporate operating margins.
We view this market weakness as an opportunity as we see no real changes in any of our core beliefs. A brief mention about financials: even though the prime rate was boosted, banks did not increase their deposit rates. Also banks are not nearly dependent on a rising yield curve to make money due a dramatic change in their earnings mix since Dodd-Frank. And if you believe in a global slowdown, wouldn't you want to own stocks with a yield over 3% like the large drug stocks? And finally there are the special situations like GE. Big change is everywhere and with that comes great opportunities, but as an investor, not a trader. Even Carl Icahn's average holding period is over 7 years!
So remember to review all the facts, step back and reflect, think of the inter-relationship of the variables, do in-depth independent research and have a happy holiday week.