Evidence of Graham’s observation in markets is all too evident historically as sentiment invariably driven by either greed or fear oscillates back and forth, quite often swinging excessively too far one way before regressing towards its mean, and over time being driven too far the other way by the opposite emotion. Arguably the biggest challenge for the astute investor when trying to identify the weight of value Graham refers to within various asset classes and individual stocks (or collective funds), is “market noise”.
In his famous 1985 paper titled “Noise”, Fischer Black succinctly summed up the beauty and conundrum combined of market noise thus “Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be. Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies.”
It could be argued that market noise both economically, and in terms of financial market valuations has rarely been more challenging as we enter the fourth quarter of 2014 with conflicting signals from the US and UK (where annual GDP, and employment numbers continue to accelerate) and the rest of the world, where GDP growth is slowing, dramatically in some parts! Evidence of the latter is borne out by the decline in the prices of most commodities recently with crude oil especially having fallen substantially as a result of weak demand.
The potential impact of this on many emerging markets in particular was recently highlighted in an article in The Economist newspaper aptly enough titled “Oil and Trouble”, which reminds us that sadly governments seldom think of rainy days and typically plough all the revenues they get from their resources during the good times when prices are high into various costly infrastructure investments and projects, leaving them vulnerable when prices drop. Many commentators see a soft landing in China, the world’s second biggest economy as being key to avoiding a protracted global slowdown as the Middle Kingdom’s insatiable appetite for raw materials driven by its industrial revolution of the past two decades, slows.
China’s annual GDP growth has slowed from consistently double digits to around 7% currently as it tries to transition from an export led giant to a more consumer driven market while also trying to manage the excessive housing and other debts that its shadow banking industry has built up almost exclusively since the Lehman collapse and which it now appears the Beijing government turned a blind eye to while it suited them for the economy to continue expanding through housing and other infrastructure projects.
The news economically from Europe during the third quarter was disappointing with S&P warning Greece could once again be in default within fifteen months, and the Euro Zone growing by just 0.1% annualized in the third quarter, and expected to record 0.9% for 2014 according to data from The Economist. European Central Bank (ECB) President Mario Draghi continued to resort to extraordinary measures to try and prevent the Euro Zone from experiencing a triple dip, and initiatives to reflate the ailing trading zone included extending the negative interest rate policy (NIRP) by a further 10 basis points from -0.10% (which first occurred in June 2014) to -0.20% to try and dissuade banks from leaving their cash on deposit, and instead lending it to European businesses to try and stimulate growth.
In September, the ECB disappointed markets by announcing that the allocation of 4 year liquidity to Euro area banks under its first Targeted Long Term Refinancing Operation (TLTRO) was just €82.6 billion, whereas the consensus expectation had been for European banks to take anywhere between €100 and €300 billion in nearly zero-cost credit from the ECB (at 0.15%). Next up from Draghi’s monetary locker will be the recently announced 2 year program to buy asset backed securities (ABS) and a broad portfolio of euro denominated covered bonds.
The economic backdrop in Japan for rather different reasons appears just as challenging despite Abenomics having now been in overdrive for some time. According to data from The Economist, Japanese GDP fell at an annualised -7.1% during the third quarter and is expected to increase by just 1.3% during 2014.
One of the key objectives of Abenomics (effectively printing Yen on an unprecedented level in order to stimulate the slumping economy) involves driving the Yen down against other currencies in order to encourage exports, and inflation which in turn might encourage the population to abandon their deflationary expectations (which have more or less prevailed for two decades) and go out and consume, thereby boosting the economy.
Consumers in Japan make up 60% of GDP so it is easy to see why Abenomics revolves around getting them to spend, but so far it is not going exactly as planned with supermarket sales in August down for a straight fifth month (not helped by the consumption tax rising from 5% to 8% in April) and real wages (adjusted for inflation) falling for the 14th straight month!
Even the Japanese stock market (Nikkei 225) which during the past two years had soared on the back of Abenomics expectations (23% in 2012 and 57% in 2013) appears to have lost its enthusiasm and is flat thus far in 2014. So much for monetary theory and many would argue therein lies the fundamental problem with Keynesian Economics which seems to suggest monetary policy can actually defy the laws of physics and permit individuals, corporations and governments to continue accumulating debt indefinitely!
Be wary of raising interest rates prematurely seems to be the underlying message in 16th Geneva Report On The World Economy from The International Center For Monetary And Banking Studies, which titled “Deleveraging? What Deleveraging?” outlines the enormous risks now facing the Federal Reserve and other central banks if their monetary experiment should fail. The report warns that “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.
“At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.“
The news economically in the US where official unemployment continues to fall while inflation data remains subdued, is positive with the latest quarterly annualized GDP figure at 4.6% and forecast to be 2% for 2014 based again upon data from The Economist while in the UK, the annualized third quarter GDP was 3.7% and forecast figure for this calendar year 3.2%. Consequently as might be expected the US Dollar has soared partly on expectations that the five-year old Zero Interest Rate Policy (ZIRP) is soon to end!
Against this mixed economic background, the S&P 500 at end September closed at 1972.29, barely changed on the quarter but up almost 6.5% for the year to date, while the FTSE 100 in the UK closed the month at 6557.52, down almost 3% for the quarter and since the beginning of 2014. In other markets, the German Dax index closed June at 9382.03, down almost 4.5% for the quarter and down more than 1% for 2014, while the French CAC 40 closed at 4365.27, down 2.6% for the quarter and also down around 0.5% for the year to date.
Over the quarter, the Nikkei 225 in Japan closed up 7.5%, at 16310.50,but flat for 2014, while the Hang Seng in Hong Kong closed September at 22932.98, down around 1% for both the quarter and the year to date. On the Chinese mainland, the Shanghai Composite closed at 2363.87, up 9% for the quarter and around 6% for 2014, while the Indian BSE Sensex index at 26630.51 is up almost 5% for the three months, and more than 24% this year so far!
The yield on the benchmark US 10 Year Treasury at end September at 2.54%, was broadly the same as it was three months ago, but lower than the 3.0% it began the year, and many pundits believe the continuing global deflationary forces may mean the secular low in yields (which of course means higher prices) for the three decade long government bond bull market may yet to have been reached, although the end of tapering is almost certain to push yields higher in the short term. In the UK the yield on the 10 Year Gilt at end September was 2.47% compared to 2.64% at the end of the second quarter and 3.06% at the start of 2014.
While selective opportunities undoubtedly exist in both government and corporate bonds going forward, the risks are asymmetric, and in our opinion the better opportunities continue in equities both on a relative and value basis (particularly in some of the higher yielding sectors) in some regional equities, including the Euro Zone where the cyclically adjusted price earnings (CAPE) ratio at 14.7 compares favourably to the US at 26.3. Additionally parts of the UK commercial property market look attractive in terms of the yield available and the likely duration of the business cycle, which has only fairly recently begun to properly recover from under-valuations after UK banks had massively over geared and over indulged in the several years leading up to the Lehman collapse.
While we remain concerned about the signs of slowing or faltering growth in certain key economies such as China, Japan and the Euro Zone, we are cautiously confident that the long term recovery story is intact, and accordingly selective opportunities will continue to present themselves in markets!