1 GLOBAL INVESTMENT INSIGHT July 7, 2015 Forget Greece... Worry About China Rick Golod Chief Global Strategist Greece is a distraction with little economic impact on the Eurozone. If the equity bubble continues to deflate in China, does the real estate bubble follow suit? Overview Building wealth-owning U.S. equity index funds with a buy-it-and-forget-it investment approach will be broadly disappointing in the years ahead. QE in Japan and Europe will likely provide a liquidity tailwind that will move stock prices higher, leading to outperformance over U.S. equities. The deleveraging cycle in emerging markets could lead to weaker currencies, capital outflows, higher rates and equity market underperformance. The Fed will probably move the Fed funds rate (FFR) to neutral, or 2 percent, by the end of Once that process begins, all traditional fixed-income securities will likely trade down. A 2 percent FFR means a 3 percent-yielding 10-year Treasury, give or take, and a 30-year yield of 4 percent, fluctuating in a narrow range for an extended period. Last year, investors worried about: ebola, ISIS, Crimea/Ukraine and the decline in Brent crude. Despite those concerns and the end of QE, the S&P 500 index did quite well, appreciating 11.4 percent. This year, the focus is on Greece, when the real risk to global equities is China. Greece is a distraction with little economic impact on the Eurozone. If the equity bubble continues to deflate in China, does the real estate bubble follow suit? With equities in many markets fully valued, there is always the risk that investors overreact, exaggerating the directional moves. Equity and bond markets do not like uncertainty, especially when equities appear fully priced. In many cases, disruptions to the markets present an investment opportunity. I believe investor s recent reaction over Greece presents one of those opportunities to add to European positions. Both sides know that Greece can never repay their debt. That s a given. Europe Overweight At the time of this writing, 61 percent of Greek voters just decided to vote No to the referendum to accept terms set by creditors in return for financial aid, including curbs on early retirement (50 yrs. old) and sales tax increases. Greece has about 330 billion in debt ( 313 billion in sovereign debt and 16 billion government guaranteed). The largest creditor is the European Union via the European Financial Stability Facility (EFSF) at 141 billion, followed by the ECB at 27 billion. Some investors are concerned that if Greek debt becomes a total loss, it would wipe out ECB bank capital. However, central banks can operate with 1 of capital; they are not commercial banks. If the value of Greek debt fell to zero, it would boost Eurozone debt ratios by just 3 percent. Both sides know that Greece can never repay their debt. That s a given. So, the issue is about debt forgiveness on the part of the creditors, and contrition and sacrifice on the part of Greece. It s a matter of degree for both sides and that will require negotiations. The rest is noise and posturing. From an investment perspective, Greece s economy contributes about 1.3 percent of the Eurozone s total GDP. The Eurozone can survive without Greece, but not the other way around. As one Greek voter said before the referendum, the vote will decide whether Greece becomes a Balkan wasteland or a chance for a better future. So why should the Eurozone continue to lend to a country that cannot repay, that has not implemented the necessary austerity measures (in their opinion) to put the country on a more solid financial footing? Greece s one bargaining chip may be its location in the Mediterranean. As a member of NATO, Greece is an important staging ground for NATO forces. The risk of losing this important launch point and/or opening the door for a Chinese or Russian presence is not lost on the region s political leaders. A Greek default is likely to have a greater impact on the debt markets. European equities are suffering from an increase in the risk premium, not a downward adjustment to earnings. Already, investors are Page 1
2 Page 2 European polls show that both Greeks and Europeans want Greece to remain in the Eurozone. The S&P Homebuilders index looks like a great opportunity to generate better than market returns. seeing a weakening of the euro, which is net positive for corporate earnings. This is a case of bad news is good news. The worse things get, the more accommodative monetary policy becomes in an effort to offset or reduce contagion risk. The ECB has stated that if they need to do more to calm the financial markets, they will do more and their ability to act should not be doubted. ECB actions are likely to follow additional QE in the United States. Additional liquidity injections tend to be positive for equity prices. Equity risk premiums rise during this period of uncertainty putting downward pressure on stock prices. As negotiations turn into resolutions, the equity risk premium declines, driving stock prices higher. European companies are likely to continue to restructure their balance sheets, improving profit margins, regardless of how Greece s financial problems are resolved. Share buybacks and dividend increases will also continue, rewarding shareholders. Investors should continue to use this period of uncertainty to add to European positions, maintaining an overweight allocation. European polls show that both Greeks and Europeans want Greece to remain in the Eurozone. Tspiras didn t run his political campaign on a mandate to leave the Eurozone, just end the level of austerity. An agreement will be reached for no other reason than both sides need to know where Greece goes from here. The proverbial ball is in their court. My message to Tspiras: Apologize and ask for forgiveness. Before investors get too caught up in the rhetoric, let s remember this too shall pass. Focus on what s important: earnings, valuations, risk premiums, interest rates. United States Neutral The LEI index portends better economic growth heading into the second half of the year. The 5.7 percent y/y increase is consistent with 3 4 percent GDP growth. The ISM manufacturing index confirms that likelihood. The economy has plenty of momentum to accelerate into the back half of the year. Jobs, auto sales, and housing are all trending higher. The National Association of Home Builders index just hit a 10-year high. The NAHB index is consistent with a 50 percent bounce in housing starts and an almost doubling in new home sales. It will be interesting to see if student loan debt keeps new home sales from returning to trend levels. That said, there is an 81 percent correlation between the NAHB index and S&P Homebuilders index. The NAHB Index and S&P Homebuilder Index is 81% correlated National Association of Home Builders Housing Market Index United States 4M Lead of S&P Home Builders SEL IND (RH Scale) Correlation = SOURCE: Thompson Reuters Datastream Over the past five years, the S&P 500 has averaged 15%, while earnings have only grown at 5%. S&P Homebuilders index looks like a great opportunity to generate better than market returns. Stronger economic growth is not likely to overcome heady valuations and, something we all know but sometimes forget, reversion to the mean. Over the past five years, the S&P 500 has averaged 15 percent while earnings have only grown at 5 percent. Since October 2011, the S&P 500 is up 93 percent, but the average return would have only driven the market 36 percent higher. The median stock in the S&P 500 index is trading in the 99th percentile. On a price to sales basis, the median stock trades above the 2000 highs. Post 1960, the S&P 500 is trading: 75 percent above on a price to sales basis 40 percent above on a price to book basis 6 percent above on a market cap to GDP
3 Page 3 34 percent above on a Shiller P/E basis A rising earnings outlook and investor sentiment at 2-year lows could take the equity market higher in the short term. That said, S&P 500 earnings revisions seemed to be trending higher with three consecutive months of more upgrades than downgrades. The implied equity risk premium has returned closer to long-run averages. A rising earnings outlook and investor sentiment at 2-year lows could take the equity market higher in the short term. Asset allocation could improve the return outcome. Overweighting growth and underweighting value, and mega caps over small caps is likely to deliver better than market returns going forward. Large growth tends to outperform large value when: Nasdaq outperforms the DJIA Oil prices decline The trade weighted dollar rises Global PMI is weak Growth Tends to Outperform Value When NASDAQ Outperforms DJIA S&P 500 Growth/S&P 500 Value NASDAQ Composite/Dow Jones Industrials Share Price Index (EP) United States (RH Scale) Correlation = SOURCE: Thompson Reuters Datastream Growth Tends to Outperform Value when TWD Appreciates S&P 500 Growth/S&P 500 Value Trade-Weighted Value of U.S. Dollar Against Major Currencies United States (RH Scale) 85 Correlation = SOURCE: Thompson Reuters Datastream Current oil supplies and production relative to global demand suggest further weakening in oil prices into the fourth quarter. Investors should continue to overweight Japanese equities Current oil supplies and production relative to global demand suggest further weakening in oil prices into the fourth quarter. At the sector level: overweight the financial, technology and homebuilder sectors; should also increase the probability of outperforming the S&P 500 index. Investors can only do so much, reversion to the mean would suggest stocks (S&P 500 index) are likely to underperform their long-run average of 7 percent. Japan Overweight Investors should continue to overweight Japanese equities. QE in Japan is $660 billion per year, which should continue to put downward pressure on the dollar/yen exchange rate, driving Japanese equity prices higher. As a result of QE, 1Q GDP has been revised higher to 4 percent, and household spending spiked
4 Page 4 One economy that epitomizes the challenges in [emerging markets] is China. Since mid-june, the Shanghai Composite Index has tumbled 29 percent, erasing $3.2 trillion of paper profits. percent in May on a y/y basis. Currently, Japanese GDP, corporate earnings growth and valuations are stronger than the U.S. Emerging Markets Underweight Emerging markets are struggling under the weight of deleveraging. Weak growth reflects sagging productivity and outsized debt burdens. As a result, corporate profits are declining. One economy that epitomizes the challenges in emerging markets is China. The Chinese economy suffers from excess capacity, which is deflating producer prices. Lowering interest rates and reserve requirements and reducing margin requirements are some of the reasons liquidity found its way into the equity market despite a slowing economy. Despite slower growth and declining earnings, the Shanghai stock market increased one hundred and fifty percent over the past year, mostly on the backs of investors on margin, egged on by official state media. Margin debt increased five-fold over the past year. As of early June, the median stock in China traded at 101X reported earnings. Bloomberg showed the average Chinese stock trading at 25X earnings because of the low bank valuations that dominate the index. Since mid-june, the Shanghai Composite Index has tumbled 29 percent, erasing $3.2 trillion of paper profits. As a result, the Chinese government has intervened; new listings have been temporarily suspended, state brokerage firms have pledged to buy shares, state owned companies have been ordered not to cut holdings in their listed companies and the central bank has promised liquidity support. Investors with holdings exceeding 5 percent and corporate directors and executives are prohibited from selling their shares for six months. These sanctions are likely to create more fear and turbulence. It makes investors wonder how much farther the market would have declined without intervention. Wall Street firms are mixed on their outlook on China, with Goldman Sachs remaining bullish. Investors should work closely with their advisors identifying important technical levels to determine a course of action. Although I don t know how this ends, take a look at the following chart. By the way, the Chinese equity markets are still not that cheap. History may not repeat, but it often times rhymes. Chinese Stocks Appear to be Following the NASDAQ Bubble NASDAQ Composite from March 01, 1999 to January 30, 2002 Shanghai SE A Share from June 01, 2014 to July 7, SOURCE: Thompson Reuters Datastream The answer to China s problems is not easing credit conditions. After three strong years in the corporate high yield bond markets some warning signs are beginning to emerge D54 D237 D498 D696 The answer to China s problems is not easing credit conditions. Easing credit conditions will likely boost excess capacity by keeping zombie companies in business by spurring even more excess capacity. As stated in previous commentaries, investors should underweight this asset class, but consider investing in India for dedicated capital. Recent data shows India s output expanded at a 7.5 percent rate last quarter, outpacing China in terms of growth. Fixed Income Underweight Fixed income investors should use recent concerns over Puerto Rico s solvency to add to high yield municipal bond positions with fund companies with little to no exposure to the country. In the past, potential defaults (Detroit) have created great buying opportunities in an asset class with low default rates and attractive taxable equivalent yields for investors in most tax brackets. After three strong years in the corporate high yield bond markets, some warning signs are beginning to emerge. Speculative grade downgrades to upgrades are running at a 2 to 1 ratio, the worst ratio since Corporate high yield companies have also gone two consecutive quarters without earnings growth for the first time since 2009 and debt to earnings is at an all-time high. I can t help but think high yield corporate bond investors are running on borrowed time. A couple of factors could delay the inevitable. One, the 1000
5 Page 5 In the week ending June 17, investment grade bonds had $2.1 billion in outflows. The higher the Sharpe ratio (return/standard deviation), the better the risk-adjusted return. odds of a Fed rate hike this year is declining according to the consensus outlook. Secondly, 64 percent of outstanding debt in the high yield corporate space doesn t come due until 2019, which should buy the asset class some time. Investors should strongly consider reducing exposure to this asset class ahead of the herd. Investors are beginning to see the adversity of fixed income. Ten-year Treasuries challenged the 2.5 percent rate (inflection point) twice in June. The Barclays Ag is down 195 basis points over the last three months and investors are running to equities. In the week ending June 17, investment grade bonds had $2.1 billion in outflows. This was the first negative week in 78 weeks. High yield corporate bonds had $4 billion in outflows, which was the worst week of outflows in Strategic Allocations Overweight Investors should strongly consider overweighting strategic opportunities. Equity and fixed income markets appear fully valued in most regions around the world. As such, these markets are vulnerable to exaggerated corrections at the first signs of uncertainties. Some investors may think ample global liquidity will reduce the risk of a major correction. Margin levels and low cash positions would argue the risk of an outsized correction has actually increased. My position is somewhere in the middle. I would be opportunistic in the case of Europe and measured on adding new positions to the equity market. However, if we are making decisions based on risk/reward there are a number of investment strategies that remain attractive that are not trading at all-time highs, where sentiment isn t euphoric. In last month s commentary, a chart showed a number of investment strategies that have outperformed the U.S., Japan and Europe s equity markets over the past 14 years on a risk and return basis. What worked in the past doesn t always work in the future. That said, some of the better performing risk/adjusted investment strategies over the past twelve months are: Managed Futures: 1.29 An alternative investment strategy in which professional portfolio managers use futures contracts as part of their overall investment strategy. Managed futures provide portfolio diversification among various types of investment styles and asset classes to help mitigate portfolio risk in a way that is not possible in direct equity investments. Multi-alternative: 0.68 Multi-alternative funds will use a combination of alternative strategies such as taking long and short positions in equity and debt, trading futures, or using convertible arbitrage, among others. Funds in this category have a majority of their assets exposed to alternative strategies and include both funds with static allocations to alternative strategies and funds tactically allocating among alternative strategies and asset classes. Long/Short Equity: 0.55 An investment strategy of taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure, while profiting from stock gains in the long positions and price declines in the short positions. The higher the Sharpe ratio (return/standard deviation), the better the risk-adjusted return. For reference, compare these to the S&P 500 Index at Final Thoughts Central bank liquidity around the world appears poised to quickly extinguish any flash fires that may emerge. Margin debt and low cash levels create the wind speed where flash fires could spread very quickly. Fixed income and equity valuations suggest traditional asset classes are vulnerable to exaggerated moves to the downside at some point, probably not in the short-run. Investors should be judicious in adding to equity and fixed income positions, perhaps broadening their asset class and investment strategy choices in their attempt to build wealth or protect principal.
6 Page 6 The opinions referenced are those of the author and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Behringer professionals, nor any of its affiliates and personnel. The comments are not recommendations but illustrations of broad global market conditions. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, assumptions and potential conflicts of interest. Actual results may differ materially from those expressed in these forward-looking statements and you should not place undue reliance on any such statements. A number of important factors could cause actual results to differ materially from the forward-looking statements contained in this presentation. Forward-looking statements in this presentation speak only as of the date on which such statements were made, and we undertake no obligation to update any such statements that may become untrue because of subsequent events. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. Behringer and/or its affiliates may sponsor, co-sponsor, and/or distribute securities in investment sectors reviewed in this material. Published 7/ Behringer