Market Thinking - A view from the equity market

• Stronger dollar across the board as the markets look through to higher rates has tended to push equities higher as currencies weaken, returning to the old relationship. Currencies remain the main trading game.

• While investors wait for clarity on US politics, a revisit to our balance sheet approach to economics shows that data on US household wealth and income growth undermines the widespread ‘Great Recession’ meme. US household wealth is up 37% since 2010 and disposable income growth is up 4%.

• Holdings of equities and bonds are down but cash is up three times since 2010. Saying active managers underperform the benchmark assumes that they are targeting the same level of risk. Most are aiming for less risk so will deliver less return. In Asia meanwhile, the benchmarks are sufficiently imperfect that the majority of active management continues to outperform.

Last week in Hong Kong was disrupted with some particularly unusual typhoons. Unusual both in that there were two in one week, and in the fact that they were very late. There was also an unprecedentedly late Black Rain warning and flash floods. October is supposed to be the dry season with an average 41mm of rain for the month, the Black Rain warning, the highest level, is hoisted to warn of 70mm in one hour! Since the system was introduced in the 1990s, there has never been a Black Rain warning later than the beginning of September. This is what happens when El Nino switches straight to La Nina. Coming in a week which also saw the last US Presidential debate it was yet another excuse to sit tight and do very little.

With investors sat on the side-lines, the main activity continues to concentrate in the currency markets and on the major crosses. Two weeks ago, I noted that while sterling struggled to hang onto any technical indicators other than the recent 1.21 low, the euro was hovering around support at $1.10 and looking vulnerable to the downside, adding that the next support was around $1.08, then the previous low of $1.05. The concern here may well be the aftermath of the European referendum, but equally it could be the perception that the European version of quantitative easing will ‘taper’.

With the dollar generally stronger across the board over the last week or so, all the above support levels look vulnerable. Interesting that generally speaking, modestly weaker currencies have translated to modestly stronger domestic stock markets, effectively returning to the pattern of currency weakness offsetting stock market strength to leave dollar based investors largely flat. Oil and gold both traded broadly flat to slightly up. The offshore renminbi (RMB) has been weak against the dollar pretty much since the RMB went into the special drawing rights (SDR) basket at the beginning of the month, with its latest fix at around 6.77. This is gathering some excitement as ‘a six year low’, but while some analysts may get a little breathless at the prospect that the RMB has weakened by “over 1.5% this month alone” against the dollar, the fact that the yen, euro and sterling have dropped between 3% and 5% this month gives some perspective. In fact as a result, the RMB as measured against the SDR basket has started to appreciate. Market commentators maintain that positioning in offshore RMB is neutral and that most if not all of the short term speculators and momentum traders have been forced out by the authorities (something we discussed early this year in the wake of the Davos panic and tales of 40% depreciation). As discussed in recent weeks, while it is encouraging that the markets are not yet revisiting their China panic of Q1 2016, they may still do so. There is probably something of a political dimension here as well, with both candidates talking about China ‘dumping’ products, especially steel, it is probably best to get the depreciation over before the US Election. Afterwards, there is a reasonable prospect that the short term traders might connect a weak RMB with some capital outflows and revisit their ‘China is falling’ narrative. It will be interesting in that sense how they play the iron and steel data. According to the China Iron and Steel Association, crude steel output of its members fell just over 2.4% this year as capacity was taken out. This normalising of supply and demand has helped steel prices jump. According to the Association, steel prices in October were up 30% on the start of the year and accordingly the industry is returning to profit in a classic cyclical supply/demand pattern. A similar reduction in supply has helped coal prices and the Chinese government has suggested that 80% of their capacity reduction targets have been met for this year in these two areas. While not our preferred style, such moves and restructuring illustrate the opportunities for cyclicals and value investing in restructuring China especially when consensus can be so heavily against the sector at times.

Another aspect of this narrative of course is the issue of Chinese debt. While I am relatively relaxed about the total levels of debt, mainly because so little of it is in foreign currency (and thus dependent on someone else’s monetary policy) there is no doubt that parts of the economy are struggling due to past excess and restructuring is necessary.  Last week there was some discussion about debt for equity swaps in China, with the predictable levels of concern expressed about anything to do with a) China or b) debt. However, equally predictably, there are positives as well as negatives to be taken from these developments. First, and perhaps most important, guidelines released this month highlight that the banks will not be allowed to simply swap existing debt for equity and hold onto the ‘loans’ in a different form. They will have to be sold to third party approved agencies. These would include asset managers, insurers and specialised units with in banks as well as some of the state owned enterprises (SOEs). This is positive for a number of reasons, first that it will actually help clean up the balance sheet of the banks in question, second, that it further encourages the development of capital markets in China and third that it reduces (but doesn’t of course eliminate) the issue of zombie companies continuing to trade. The role of vested interests remains a legitimate concern in China, and certainly previous attempts at restructuring, particularly in the state owned sector tended to be less than satisfactory in particular where local governments could see a way of removing the debt from a partially or largely state owned company and leave it with the bank. Some are demanding a tough and quick approach to dealing with this, but realistically I would expect slow and steady pragmatism.

It is telling that for all the ‘advice’ from the west, the Chinese economy is arguably the one performing most ‘normally’ with respect to monetary policy. In my view this is not that surprising since China is one of the few countries where private sector balance sheets are expanding. As noted on previous occasions, if balance sheets are contracting, it doesn’t matter how much cheaper you make it to borrow money, a shrinking balance sheet will not suddenly expand again. This simple fact has in my opinion explained much of the ‘failure’ of monetary policy in the west and in Japan. Over the years I have tended to use what I refer to as The Balance Sheet Framework to help make sense of the impact of monetary and fiscal policy on spending. Essentially, each country has four economic agents, the household sector, the government sector, the corporate sector and the financial sector and that expansion and contraction of their balance sheets can and does have an impact on the cash flows between the sectors that may not be picked up by traditional flow accounting. Thus, for example, a household sector expanding its balance sheet (such as the US in the 1990s/2000s) may consume more than might be inferred from traditional measures of wages and salaries. This could be reflected in more borrowing, or lower savings. Assumptions about mean reversion on savings ratios – a big theme in the 1990s – may prove wrong for a long time. Equally, governments expanding their balance sheets can appear to boost GDP for a period, corporates can boost earnings and so on.

The US tends to have some of the best data and amidst all the noise over the last few months, unfortunately some rather interesting information slipped by largely unnoticed, both on incomes and on balance sheets for the US household sector from the Federal Reserve. Some brief headlines include, total assets of households and non-profit organisations were $103.8tn in Q2 2016. This is a 37% increase since 2010. Cash holdings are at $1.34trn, almost three times their 2010 level, which is now more than their holdings in mutual funds, which at $989bn are actually down from $ 1.13bn in 2010. The fact that total returns on the S&P 500 are around 20% implies disinvestment here, while fixed income assets, at $4.2trn are also down around 15% over the period when a long term bond index (like the iShares ETF has had a total return of 66%). This all suggests a shift out of financial assets into real assets and cash. Home mortgages, at $9.5tn are essentially flat over the period, while equity in real estate has doubled, from $6.2trn to $12.8trn, taking it from 38% housing equity to housing asset up to 57%.

Meanwhile, over this period, disposable personal income as measured by the Federal Reserve rose from $11.2trn to $13.95trn, an increase of 24%. This maps across to the disposable income data from the Bureau of Economic Analysis (BEA) collected here which did get some moderate attention on the last release date because it reported disposable income as rising, while the savings ratio, at 5.7% (personal saving as a % of disposable income) has risen from 2% in 2005. Personal consumers’ expenditure is up around 4.3% year on year, most of which is coming from wages and salaries. One overlooked aspect of income growth of course is that the line “personal interest income’ is basically flat for the last four years and is still lower than it was in 2007. Noting the point above on balance sheets – US households have moved their assets away from equities and bonds and into cash, where they are getting almost no return and this is a major contributor to historically flat incomes. Thus for all the noise about “the Great Recession” touted by economists from Janet Yellen downwards, as far as the US consumer is concerned there has frankly been nothing of the sort. Wages and salaries have grown, household balance sheet wealth has expanded. Personal consumption indices have barely missed a beat. After the one off inventory shock of 2008/9 growth has been running at around 4%.

As discussed recently, the balance sheet of the Saudi economy is under some serious strain. The government is seeing revenues falling with lower oil prices and expenditure rising with military and other expenditure running much higher than expected. Accordingly they have been cutting salaries – hitting households and banks that had enabled them to expand their household balance sheets that now need to extend further loans. For their own balance sheet the Saudi Arabian government has just finalised its bond road show looking to raise $17.5bn at a spread of around 150bps over Treasuries – raising more than expected at a tighter spread. Judged as an emerging market bond and thus good value, it traded well. What remains clear however is that the Saudi exchequer is very stretched at the moment.

One rather interesting fact (picked up by Zerohedge) is that on October 1st, the Saudis  moved from a lunar based Hirji calendar to the western Gregorian calendar which has a useful budgetary advantage of being 10.9 days longer and thus in effect means the annual wage bill drops by 3% unless they adjust wages to compensate. Given we know they are cutting salaries (as discussed in past weeks with reference to Philippine remittances and Saudi bank loans) this is obviously not going to be the case. An interesting discussion on different calendar options (yes really) is found here. They are also upping the charge for religious pilgrimages.

Last week, we discussed how the Philippines is actually an ‘oil economy’ given the number of its population that work in the Middle East and send back remittances. Approximately 40% are in Saudi Arabia and have doubtless seen incomes falling as wages are cut and workers are laid off. This of course presents problems for indebted household balance sheets and of course of those that lent them money.  Undoubtedly this pressure will be at least in part in the mind of President Duterte as he continues his trip around Asia. While much has been made of the split from the US he announced last week, it is interesting that he has gone from China to Japan. One phenomenon that was brought to my attention a few years back by the team at UBS was what they refer to as ‘Patronomics’ – the technique of various ASEAN countries to play Japan and China off against one another in terms of trying to lure Foreign Direct Investment (FDI). It looks rather like President Duterte is following that well-worn trail. Japan is the largest source of FDI in the Philippines and in the light of the spat with the US there will undoubtedly be pressure on Japan to try and keep the Philippines ‘onside’.

Interesting to see at the stock level that some parts of the US corporate sector continue to leverage their balance sheet as we see with the announcement that AT&T was bidding for Time Warner content, a move that brought on a brief sense of déjà vu – the AOL Time Warner deal signalled the peak of the dot com boom, but unlike back then, this mega deal comes at a time of relative rarity. Interesting also that tobacco giant BAT has also just bid for Reynolds tobacco, the cash cow at the heart of the (in)famous RJR Nabisco leveraged buyout that marked the pinnacle of that particular market cycle in 1988.

On the other side of the corporate coin, this week saw the launch of Kyushu Railways, a $4bn IPO in Japan sold by the Japanese government which attracted considerable retail and institutional interest, not least because in a world starved of yield JR Kyushu as it is better known is offering a yield of close to three per cent. The stock priced at the top of the range and foreign investors over-subscribed by 5 times according to Reuters. The railway serves the island of Kyushu, the southern-most of Japan’s four main islands which it connects by tunnel to the main island of Honshu. Apparently there are lots of perks such as discounted train tickets that make the stock attractive to small shareholders which will doubtless suit a government wishing to encourage individual shareholders in Japan.

Finally, on the active versus passive debate. Once again the press are full of stories declaring that 99% of active US funds under-performed the S&P 500 index over the last 10 years. While this is on the one hand valid (the statistics don’t lie) I nevertheless believe that we should be a little more circumspect before jumping to the conclusion that passive investing is the future. First and foremost we need to ask the question “what were these funds trying to achieve?” Was it simply to replicate the S&P 500 Index? Or were there other requirements? This is not an idle question, for while most funds use a benchmark, it is rarely an actual target, and for good reason. If we take the underlying premise that the return on a portfolio is a function of the risks taken in that portfolio, then it stands to reason that if our risk profile differs from that of the benchmark, then so should our return profile. It is not unreasonable to think that the end investor may for example require a lower downside risk than the market, in which case they would need to pay away some of the upside. This is perfectly understood in the context of a hedging strategy, so why not to the proponents of index funds? If I were to look at some of the larger US funds using the Bloomberg PORT function then we can look at how the last 10 years affected their performance and portfolio statistics compared to the S&P 500 index.

First and perhaps most important we need to qualify this ‘failure’ with the return that you did actually get over the last 10 years – 93.6% in the case of the S&P 500. To make out that the customer has somehow been cheated by a fund that, say, underperformed by 5% over that period is to highlight that it grew at an annualised 50bps less than the index, but (and here is the second key point) what if it had a smaller maximum drawdown, or lower volatility? All true for one large US Equity Income Fund that I looked at, which as the name implied focussed on equity income. Over 10 years, volatility was lower than the index, as was downside risk, skewness (less negative) and a lower Value at Risk measure. The fund is 97.8% correlated with the S&P 500 but has an annualised tracking error of 4.44%. Is it worth giving up 50bps of total return each year to have this lower risk profile? I would think so, but the purists clearly disagree.  On the other side of the equation, a large US fund manager with a large cap growth strategy (with $2bn) has 10 year numbers where the correlation with the S&P 500 is still high, but the standard deviation and downside risk are higher, there is more negative skew, VaR is higher, and the tracking error is nearer 7.3%. This fund returned 117% over the last ten years – the risk was higher but so was the return. I picked that fund largely at random, but I can’t believe it’s the only one with those sort of numbers. The bottom line is not that 99% underperformed, but that 99% of funds were not taking the same risks as the benchmark and that over the last - risk averse- decade it is likely that most funds were trying to obtain something similar to the benchmark by way of returns, but wished to take less risk. If you believe that you can consistently take less risk but achieve higher return, then either you aren’t measuring risk properly or I have a bridge I can sell you.

Of course here in Asia this is not the case – according to an article in the Wall Street Journal (here) active stock pickers can still win against a benchmark, mainly because the benchmark tends to be dominated by large, often state owned, enterprises. In fact over 2/3 of active fund managers do beat the benchmarks out here. On the one hand I want to say long may it last, but of course as markets deepen and broaden, we will shift to a similar issue to the US – although to be fair in many European markets the index is still often a third or fourth quartile performer (another way of measuring the same thing). But the real point is that we need to be consistent; if we are to criticise equities for being too ‘risky’ because they are volatile, and if by extension we require our active fund managers to take less risk than the benchmark, then we cannot (and should not) criticise them for achieving lower returns.

There is one more, much bigger, issue at stake here. As I pointed out earlier, if we look at the balance sheet of US households since 2010, they have reduced their exposure to equities and bonds, a period over which both would have given them returns many multiples of what they received from cash. The asset allocation decision was far, far more significant in terms of affecting household wealth than the relative performance of active managers. Moreover, while it might then be easy to say that advisors should merely have bought index funds, the very fact that households were building up cash suggests that they were not prepared to tolerate the level of volatility or drawdown risk on offer from the index (20% annualised volatility 15% downside risk for a 13% annual return). As such most active managers would have been offering some lower risk profile and thus not competing with the index.

To conclude then. Since the GFC the US household has reduced its exposure to both equities and fixed income, but tripled its holdings in cash, suggesting a high level of risk aversion. In doing so it missed out some meaningful returns, but its exposure to unlisted businesses and housing means that US household assets exceed $100trn and are up 37% since 2010. Latest data shows disposable income is also growing at more than 4% per annum, giving lie (in my humble opinion) to the widespread notion of ‘A Great Recession’. There hasn’t been one. Not in the US at least. Missing out on the twin bull markets means the US household is less wealthy than it would have been, but also should focus us a little on the widespread notion that the biggest problem for savers is that active managers underperform passive by a few basis points. I would argue that most active managers are trying to some extent to lower risk compared to a benchmark while still achieving a positive real return.