Market View - December 2012

The US fiscal cliff and the global recovery myth continue to dominate financial markets as we head into the festive season!

Economically there is little to make merry about as GDP figures in the US remain anaemic at 2.1%, while in the UK, 2012 will return negative growth of -0.2%! Following the British Chancellor’s autumn statement in which he admitted the UK’s fiscal outlook had become a lot bleaker, it is little wonder that the rating agencies are considering stripping Britain of its triple A credit rating.

Arguably Britain should have lost its AAA rating a long time ago on the basis that its total combined non-financial (i.e. government, corporate and private) debt exceeds 300% of GDP! The UK is not alone as Italy, France, Canada, the Netherlands, Spain, Portugal and Belgium also share this dubious distinction; while both Ireland and Japan’s total non-financial debt is approaching 500% of GDP!

The United States non-financial debt would appear less of a problem as it is not quite 300% of GDP ($15 trillion), but in addition its combined traditional and shadow banking liabilities are almost $30 trillion according to a recent article on The opaque and little known (outside of Wall Street and The City) world of shadow banking which includes all sorts of non-traditional banking activities such as securitised mortgages and loans, asset backed securities, funding corporations and money market funds, began to take off in the eighties and by December 1995 total liabilities in this deposit free section of the banking world had overtaken those of the traditional side.

By the first quarter of 2008, the liabilities of the US shadow banking world had mushroomed to $21 trillion while those of traditional banking stood at around $12 trillion but the collapse of Lehman Brothers (one of the major players from the Shadow Banking world in the subprime debt scandal) changed all that. Since then shadow banking liabilities have been imploding (now down to $15 trillion) and while the traditional banking side (aided by taxpayer bailouts) has been able to accommodate some of this massive deleveraging, the Federal Reserve System (Fed) has also had to pull out all the stops to try and ensure the resulting deflationary impact does not destroy both the US and global economy.

Despite the Fed’s various quantitative easing (QE), and zero interest rate policies (ZIRP) post Lehman to counteract the collapse of the shadow banking sector, sources such as the zero hedge suggest that a $3.7 trillion deficit on a consolidated financial credit basis has appeared on the US banking balance sheet. Consequently were the Fed to now stop its indefinite QE (currently $85 billion a month), global equity markets would almost certainly crash!

With regards to resolving the US fiscal cliff, bestselling author (The End Game: The End of the Debt Supercycle and How It Changes Everything) and financial commentator John Mauldin in a recent commentary explained why getting two parties with opposing political ideologies to compromise on issues like tax increases and cost cutting can be nigh on impossible due to the inability of most people to put aside their prejudices and be objective. Mauldin cites a recent report from the University of California, Irvine that claims this failing is pervasive across a wide range of human situations, and claims that where our moral judgements come into conflict with evidence, we look for ways to dismiss and minimise the evidence!

The report says “While individuals can and do appeal to principle in some cases to support their moral positions, we argue that this is a difficult stance psychologically because it conflicts with well-rehearsed economic intuitions urging that the most rational course of action is the one that produces the most favourable cost-benefit ratio. Our research suggests that people resolve such dilemmas by bringing cost benefit beliefs into line with moral evaluations, such that the right course of action morally becomes the right course of action practically as well”.

“The studies further show that this effect is stronger in well informed, politically engaged individuals. The more information we have, the higher our propensity to cheat with it. I’ve been talking to a lot of people on both sides of the election, and the thing I’m often struck by is an inability to find any validity in the opposing side’s arguments. By blocking our ability to have meaningful conversations, this effect is actually harming discourse”.

During November global equities as measured by the MSCI World index in US$ terms rose a little over 1% and are up 11.24% since January 1st 2012, while the JP Morgan Global Bond Index fell slightly but it is up 2.35% since the start of the year. The slight fall in the JPM global bond index can be attributed to developed Western government debt where fears of a bubble continue to worry investors after a multi decade bull market that has taken yields down to historic lows, whereas Emerging Market bonds continue to offer good potential value as evidenced by the rise in the JP Morgan Emerging Market Global Bond index which is up 17.44% during 2012.

Most regional equity indices provided positive returns during November with the S&P 500 in the US up 0.28% (up 12.61% year to date), the FTSE 100 rising 1.45% (and is up 5.29% YTD), as did the FTSE Eurotop up 1.81% (up 9.20% YTD), the Nikkei 225 in Japan climbed 5.80% (up 11.72% YTD), the Hang Seng in Hong Kong climbed 1.80 % (up 19.51 YTD), and MSCI India rose 5.53% (and is up an incredible 27% YTD), while the Shanghai Composite in China bucked the upward trend and fell 4.29% (and is down almost 10% YTD)!

While 2012 now looks certain to have well rewarded risk, with both global equities (with one or two exceptions like China), and emerging market bonds providing decent returns, the economic background as referred to earlier, remains difficult weighed down in particular by excess debt built up over several decades. Adding to these concerns are the complexity and sheer scale of the global derivatives market which reputedly stands at around $650 trillion (the global economy totals just $70 trillion), and where four of Wall Street’s big banks (JP Morgan, Goldman Sachs, Bank of America and Citigroup) also have significant exposure to these contracts.

It is a timely reminder that many (both known and unknown black swan) unknowns potentially lie in wait in the New Year, but as always a properly diversified risk adjusted portfolio will provide investors with the best means of wealth protection!

From all of us at Ash-Ridge Asset Management we'd like to take this opportunity to wish you and your loved ones a very Merry Christmas!