Patrick de Villiers has more than 20 years of trading financial markets experience and while he says he avoids the folly of making predictions and counting on the markets making sense, he says: “History doesn’t repeat itself exactly but it does rhyme often”. In the piece below de Villiers takes a look at portfolio construction and ways to be resilient during turbulence and advantageous when markets are buoyant. This as he prepares for the oncoming financial storm. – Stuart Lowman
by Patrick de Villiers*
The Seawise Giant, (also named the Jahre Viking), is still the largest self-propelled ship ever built measuring 485 metres in length. Many of the world’s channels were not accessible because of the amount of water she displaced. At her maximum cruising speed her momentum was so great it would require 8km of sea before she came to rest. Her turning circle in calm seas was approximately 3 km in diameter and in shallower waters she was manoeuvred solely by tugboats.
Passive investors often feel like they are at the helm of a massive ship when faced with a potential crisis in financial markets. Their portfolios and in particular their behavioural approach has inertia just like the ship described above and it is extremely difficult for them to change direction of the portfolio or reduce exposure for two reasons:
1) Behavioural patterns of non-professional investors typically lock them into the same patterns or mistakes that the crowd is making. Often dinner table consensus forms the basis of many investment decisions instead of rational objectivity.
2) Their typical investment products (funds, ETF’s etc.) usually have expensive transaction costs associated with redemptions and trading. People generally don’t like incurring expenses and they struggle to lock in an existing loss for future gain.
What most investors fail to recognise is that how your money is managed in times of financial crisis is what distinguishes you from the pack. Benchmarking your portfolio against other friends and associates during an equity market collapse only soothes you emotionally – it does nothing for your wealth. There are alternatives (no pun intended) which I will discuss at the end of this article that can assist in weathering impending storms.
With equity markets rising smoothly since 2009 and numerous property booms throughout the world currently you may ask why this article refers to an impending storm. After 20 years of trading financial markets I avoid the folly of making predictions and especially counting on the financial markets making sense too. Nonetheless as the saying goes history doesn’t repeat itself exactly but it does rhyme often. Before we get into why I believe the foghorn should be sounding it’s worthwhile to refresh our memory of how the world’s financial leaders intervened in global markets over the past 15 years.
In March 2000 the Dotcom stock rally came to an abrupt end with a spectacular 78% crash in the NASDAQ index. The Federal Reserve lead by Alan Greenspan at the time feared significant downward pressure on the American economy which was still reeling from the 1998 Asian Crisis and the collapse of one of the world’s largest hedge funds (LTCM). The Fed Governor promptly responded by instituting an accommodative monetary policy, slashing short terms rates almost monthly beginning in January 2000. This cheaper cost of money had the necessary effect on inflation and by mid-2004 the Fed reversed course and rates started increasing. However they were effectively chasing a galloping horse as the second bout of “irrational exuberance” started to appear in the housing market. Wall Street jumped on the bandwagon and created a myriad of cleverly packaged financial products to leverage up on the massive gains that global assets were enjoying.
As with all asset bubbles cracks started to appear long before the avalanche of selling began. In mid-2007 defaults in poorer quality mortgages started increasing and the warning signs were evident. However investors married to their positions merely argued that this was a natural mechanism of tiered credit buckets. Unfortunately the majority of global investors under-estimated the extent of the leverage in the market as well as the fact that the underlying assumptions were based on misaligned credit agencies’ ratings that were statistically flawed. The house of cards came cascading down, carrying with it Lehman Brothers which was to be the largest bankruptcy in financial history. Once again the Central Banks led by the Fed had to intervene to restore money markets and inject liquidity into the financial system.
Central banks in 2008 expanded their role as monetary policy supervisors and became portfolio managers on an unprecedented scale exchanging stock in insolvent firms for liquidity. Across the globe monetary easing was implemented in the form of short-term interest rate cuts and liquidity injections. The marketing departments of the various finance ministries introduced investors to terms like Quantitative Easing (QE), Operation Twist, Zero Interest Rate Policy (ZIRP) and their best idea to date Negative Interest Rate Policy (NIRP). All euphemisms for the printing of money, creating money in a deflationary spiral with the hope that spending future revenues now will kick-start the global economy.
With this short refresher we find ourselves in the second half of 2015, seven years after the Financial or Debt Crisis of 2008 and analyse what has been achieved by financial leaders when they decided to intervene in markets and alter the natural outcome of a capitalist system. The goal of de-leveraging or reduction of debt globally has failed miserably. In fact, according to a report published by McKinsey & Company, global debt has increased by $57 trillion since 2008 (1) government balance sheets that have expanded exponentially with all the elixir they have been pumping into a faltering economy. More worrisome however is the fact that household debt is reaching new peaks again in the Far East and many advanced economies. Corporate debt had surged by almost $4.5 trillion. Cheap borrowing costs create scenarios whereby capital is not allocated correctly for R&D, increasing efficiencies etc. but rather directed towards more speculative activities such as financing marginal projects and share buybacks.
The most spectacular increase in debt levels has been in China where this number has quadrupled over the past seven years. Up until 2014 most of this debt was linked to a rampant housing and development boom. Another vast proportion is composed of debt created by the “shadow banking” system, a term which describes any form of leverage or credit granted outside of the regulated banking activities. The Chinese stock markets have been beneficiaries of a large amount of this debt over the past 18 months to the extent where rural people have been attracted to the cities to leverage their earnings in equity investments. The recent sell-off in their stock markets has once again prompted the Chinese Central Bank to play portfolio manager by meddling in the markets and spending huge sums of money trying to catch a falling knife.
With an official growth rate still around 7% annually should we be worried about a collapse in the Chinese economy? Most definitely, for two reasons:
1) The official statistical data published by the Chinese authorities has long been suspect and there is sufficient economic evidence to confirm this
2) The Chinese growth machine is no longer an isolated engine only exporting goods to the West but is completely immersed in international trade – importing raw materials and high quality finished product for a burgeoning middle class and aspiring elite. The Chinese economy is larger than the combined economies of Germany, Japan and the United Kingdom and a severe recession there would reverberate throughout financial markets.
The Bloomberg Commodity Index (2) has been falling since mid-2011 and recently accelerated its decline to levels last seen in 2002. The fall in the oil price is a barometer of global growth and as the US used cheap borrowing costs to increase shale production and drilling it was met with falling global demand resulting in an undeniable glut. The Chinese economic growth machine was a strong driver of commodity demand but has displayed very clear signs of under-performing spectacularly. The downturn in commodity prices doesn’t correlate with the official strong growth figures published by the Chinese. Further empirical evidence is the comments made by Glencore’s Glasenburg (3) that said the company was wrong-footed by the sharp slowdown in China. The world’s largest commodity trading house and mining company has seen its share price tumble 70% since its IPO in 2011. China’s inevitable downturn will affect countries that produce raw materials and in many cases these same countries have high debt to GDP ratios which will accelerate deflation.
The Asian Tiger is “long-in-the-tooth” as clearly visible in the index of Asian currencies versus the US Dollar. The growth story is no longer evident there. Emerging market currencies are suffering as the USD carry trade begins to unwind.(4)
Readers will notice the rhyming evidence that is starting to appear in financial markets of 2015. Central banks were omnipotent in 2008, implementing Keynesian style monetary policy that once again inflated asset prices and did very little to reduce global unemployment or reduce debt and leverage. They have exhausted their munitions and with interest rates in developed countries heading negative their impact on monetary policy becomes sterile and inconsequential. Central banks have effectively become impotent.
“Fortune Favours the Prepared Mind” Louis Pasteur
Throughout history periods of excessive speculation in lofty asset prices are met with a sharp reset where the financial system transfers money from highly speculative investments to more defensive strategies. Investors must at all times be prepared to deal with an economic “reboot” that can suppress asset prices for significant periods. (The NASDAQ took 15 years to reach its former peak again) I want to mention a few strategies that investors often fail to consider:
1) Cash – this is the most obvious and defensive route possible as long as investors consider the credit risk of the deposit taking institution. In the current environment many people are loathe to liquidate to cash because of the negligible interest earned. However when financial markets are under stress the return “of” money is more important than the return “on” money. Also crises provide cheap investment opportunities and liquidity is paramount.
2) A counter-intuitive approach is to add strategically to the portfolio. This can be in the form of financial insurance products (Puts & Calls on the outcome of particular events) or Alternative Investments that are non-correlated to the current portfolio.
3) Managed Futures which is an investment class more suited to passive investors. Managed Futures fall into the broad spectrum of Alternative Investments and there is significant research documenting the benefits of a Managed Futures program in an investor’s portfolio. In particular, Managed Futures strategies from August 2007 through December 2008 capitalized on the market dislocations and rewarded investors with returns of +17.69 % as measured by the Barclay BTOP50 Index.5 It is also one of the very few alternative investment strategies that provides excellent liquidity without lock-ups.
Investing successfully doesn’t come without risk it is therefore essential that you navigate the difficult waters with a properly constructed portfolio that can take advantage of buoyant markets but be resilient in the inevitable turbulence that you will face.
“It is not the ship so much as the skilful sailing that assures the prosperous voyage.” George William Curtis
Footnotes
1) McKinsey Global Institute, Debt and (not much) deleveraging, February 2015, Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva
2) Bloomberg Commodity Index BCOM:IND – The index is made up of 22 exchange-traded futures on physical commodities. The index currently represents 20 commodities, which are weighted to account for economic significance and market liquidity.
3) Bloomberg – http://www.bloomberg.com/news/articles/2015-08-19/glencore-s-first-half-profit-tumbles-56-on-commodity-price-rout
4) A currency carry trade is a speculative investment whereby an investor borrows funds at a lower rate in a primary currency and then converts that currency to another higher yielding secondary currency. The interest rate earned in the secondary currency can be significantly higher and the differential is what investor targets. It must be noted that there is substantial risk in the trade if the secondary currency depreciates against the primary currency by more than the interest rate differential. In the context of current market conditions, investors were borrowing in USD and converting to a range of Emerging Market currencies (including the Chinese Yuan). With the rapid devaluation of these secondary currencies, investors are now scrambling to exit these trades.
5) CME Group, A Quantitative Analysis of Managed Futures Strategies, June 2014, Ryan Abrams, Ranjan Bhaduri & Elizabeth Flores
