Wednesday, July 25th, 2012
July 24, 2012
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
- Some investors shy away from international investing believing it’s too risky or complicated.
- We’ll show you how it can lower your overall risk while potentially boosting your returns.
- ETFs and mutual funds can make international investing convenient.
A young, educated workforce in Singapore. Rising household income in Brazil. Export growth in China. Natural resources in Canada, Australia, Brazil and Norway.
These are some of the factors driving global growth. And if you’re only investing in US companies, they represent opportunities you may be missing. In fact, investing solely in the United States amounts to excluding three-fourths of the global economy1 and over half of the world’s stock market value.2
We believe that allocating between 5% (conservative) to 25% (aggressive) of your total portfolio to international stocks can be a smart move for a number of reasons:
- Potential for higher rates of growth abroad.
- International stocks are becoming a larger share of the investment universe.
- Potential to lower overall risk in your portfolio.
- Multiple currencies can provide an added layer of diversification.
Let’s look closer at each of these.
High rates of growth abroad
International markets can offer growth opportunities that may not be available in the United States due to differences in household income, younger populations, availability of natural resources, export strength, and movement toward free-market economic policies. Many Asian countries, for example, benefit from exports to the Chinese economy.
Exposure to these unique growth areas, as well as emerging markets, can boost return potential. Emerging market countries typically have lower household incomes and lower debt levels relative to developed markets, giving them the ability to grow faster.
Economic growth in the United States is expected to be subdued in the near term. The International Monetary Fund (IMF) is forecasting growth in the United States to be below world growth over the next several years.3
Emerging-market economies in particular are expected to have high growth rates which the IMF estimates are two to three times faster than developed-market economies.4 Corporate revenues have the potential to grow faster when economic growth is higher. However, bottom-line profits depend on how expenses grow. For example, wages in China have continued to rise this year, despite the slowdown in revenue growth.
United States becoming a smaller share of the pie
In addition, while the United States boasts the world’s largest economy and stock market, the country’s importance and share of the world economy has been declining, particularly as emerging markets have grown in size. Remember, investing solely in US stocks means excluding nearly three-fourths of the global economy and over half of the world’s stock market value.
While it’s true that US companies can have international operations, investing in companies located overseas provides the potential to benefit from currency diversification (more below).
Potential to lower overall risk in your portfolio
Investors can potentially reduce portfolio risk by diversifying their investments across various asset classes—categories of investments—each tending to respond differently to various market cycles and events. International stocks are one of the five main asset classes, along with large-cap stocks, small-cap stocks, bonds and cash investments. While international investing has higher stand-alone risk, the power of diversification across asset classes can potentially lower your overall portfolio risk.
Put simply, by investing abroad you gain exposure to companies operating in other countries—with potentially unique products and customer sets—that may weather market downturns and upturns differently.
See the table below, which shows how performance in the United States has stacked up versus other developed markets in recent years.
The Best And Worst Performing Markets
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Based on developed markets as designated by MSCI® as of 12/31/2011. Each market, except the U.S., is represented by annual total returns of the MSCI country index and is net of taxes. The S&P 500® Index represents the U.S. market’s annual total returns. Returns assume reinvestment of dividends and interest. All returns are in U.S. dollars. International investing may involve greater risk than U.S. investments due to currency fluctuations, unforeseen political and economic events, and legal and regulatory structures in foreign countries. Such circumstances can potentially result in a loss of principal. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Also, take a look at the graph below. It shows how a hypothetical portfolio of 75% domestic stocks and 25% international stocks delivered a higher return with lower risk than an investment in either market alone from 1971-2011.
International Investing Adds Diversification, Potentially Improving Overall Return and Risk
Source: Schwab Center for Financial Research with data from Morningstar Inc. United States represented by Dow Jones U.S. Total Stock Market Index. International represented by MSCI EAFE Index net of taxes. The 75/25 hypothetical portfolio is rebalanced monthly with dividends and capital gains reinvested, excluding transaction costs. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. MSCI EAFE is the measure of the equity market performance of the developed markets of Europe, Australasia, and Far East. Time period is from January 1971 to December 2011. Risk is measured by the annualized standard deviation of monthly returns.
Currency: An added layer of diversification
An important benefit of international investing is exposure to currencies other than the US dollar, another way investors can diversify their portfolios.
One of the key factors affecting returns is how currencies behave in relation to other countries. And because currencies tend to move in different directions, when the US dollar is declining, investments in international companies can help boost returns. Of course, the reverse is also true—when the dollar goes up, international investments tend to underperform.
These relative currency moves are a significant reason the best-performing market varies from country to country each year (see table above).
Know the risks of international investing
Investing internationally also brings increased risks. However, the good news is that many of these risks are reduced if you hold a diversified (by country, sector and company) portfolio of international stocks, such as many international mutual funds and ETFs provide.
What to keep in mind:
- Political and regulatory risk. Foreign governments can be less stable and they can have restrictions on how freely businesses operate as well as their ability to earn profits. Also, a country’s financial condition can undercut growth prospects. For example, if a country is running large deficits, it may need to raise taxes and reduce spending, which could shrink corporate profits.
- Information risk. Finding timely and accurate information about your investments may be more difficult, and there can be differences in accounting standards. This can make comparisons to US companies challenging. An additional consideration is that news about international companies can occur at nearly anytime, impacting price movements during times that are inconvenient for US-based investors.
- Currency risk. There’s the possibility that the currency of your investment will fall relative to the US dollar, lowering the return after it’s translated back into dollars.
- Transaction risk. Some countries impose currency controls that restrict or delay currency conversion, prolonging the time until you are able to access your funds. Reporting, clearing and settlement of trades also may take longer.
- Higher volatility of returns. International markets can be more volatile and trading can be less liquid (fewer shares changing hands). Dollar-cost averaging—investing a fixed dollar amount at regular intervals—can be a good tactic to spread out risk and lower the average cost per share.
- Higher costs. Investing directly on foreign exchanges can bring additional fees, including higher commission costs, exchange fees, stamp duties, transaction levies and foreign currency fees. These fees are the reason most international mutual funds and ETFs cost investors a bit more (via higher expense ratios) than their domestic counterparts.
International markets are gaining in importance, and by investing solely in the United States, you may be passing over growth opportunities. While there are higher risks involved with international investing, by adding it to your other investments, your overall portfolio risk could decrease while experiencing potentially higher returns—making it well worth your time to add some international flavor to your portfolio.
1. The International Monetary Fund, December 2011.
2. S&P Global Broad Market Index, May 2012.
3. International Monetary Fund, April 2012.
4. International Monetary Fund, April 2012.
For funds, investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Some specialized funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Diversification strategies and dollar-cost averaging strategies do not assure a profit and do not protect against losses in declining markets.
Past performance is no guarantee of future results.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Tags: Asian Countries, Brazil Export, Canada Australia, Chinese Economy, Debt Levels, Economic Policies, Emerging Market Countries, Global Economy, Global Growth, Growth Areas, Growth Opportunities, Half Of The World, Household Income, Household Incomes, International Markets, International Stocks, Investment Universe, Natural Resources In Canada, Smart Move, Stock Market Value
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Wednesday, July 18th, 2012
by Curtis Mewbourne, PIMCO
- Asset classes are likely to be affected by the situation in Europe and, more broadly, by high debt levels in developed countries. The related political debate about austerity vs. growth is also critical.
- Fixed income investors should note whether countries control their own currencies and can monetize their debts. Those that can may be greater inflation risks. Those that cannot may be greater credit risks.
- These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes.
- We encourage investors to broaden their opportunity sets, for example, looking more closely at emerging market government bonds. They also may consider assets such as real estate and commodities, which may partially replace traditional domestic equities.
Navigating the global landscape these days is tough. Macro risks range from uncertainty about the future of Europe to mixed messages about the U.S. economy – not to mention a host of concerns about indebtedness, policy and politics.
In the following interview, portfolio manager Curtis Mewbourne discusses how investors can approach asset allocation in such an environment and over the longer term.
Q: What are the most critical factors likely to affect asset classes over the next three to five years?
Mewbourne: Investors need to monitor the situation in Europe, whether they are directly invested there or not, because of the systemic implications of a potential shock to Europe’s banking system or sovereign debt. The eurozone has the second largest economy and the largest banking system in the world, and the slowdown that we are already seeing in emerging market growth is partially driven by slower demand for goods and services from Europe.
More broadly, asset classes are likely to be affected by high debt levels in Japan, the U.S. and other developed countries as well as the related political debate about the trade-off between austerity and growth. Unemployment levels remain elevated in many countries, partly as a result of austerity measures.
These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes. For example, European equity markets in some cases are at the lowest levels in years, and, as a result, investors may be questioning the notion that European equities provide reasonable returns above inflation – a key point for pension-fund managers and other investors.
Similarly, the low policy interest rates that central banks are implementing around the globe contribute to government bonds in several countries trading at very low levels. These low yields create an asymmetric return profile: There is not much room for further price appreciation, while concerns about possible future inflation could lead to significant volatility and price declines. For fixed income investors, it is critical to understand whether bonds have credit risk, inflation risk or both. Countries with their own currencies have more flexibility to print money and monetize their debts, and hence typically have more inflation risk and less credit risk. Countries that do not have the ability to print their own currencies have the opposite. This largely explains the divergence between Europe and the U.S./U.K./Japan in terms of government bond yields and knock-on effects on risk premium valuations.
Put simply, nominal government bonds and traditional equity investments, at least in the case of Europe, have not performed in the way that investors have expected and likely may not perform according to textbook expectations going forward.
Q: Will we see more convergence – or divergence – in the behavior of asset classes?
Mewbourne: It depends on which asset classes we are talking about, but there are a few high level themes that are relevant to understanding how asset classes may behave. Very high global debt levels and unconventional monetary policies mean that balance sheets are more levered and the global economy is more vulnerable to policy changes. Under such conditions it is likely that certain macro factors, such as policy changes, will affect many asset classes in roughly the same way at the same time. Over the past few years, we have seen periods of heightened correlations between regional markets as well as between previously uncorrelated asset classes.
This is not set in stone. In some cases capital will move from one area to another, or fundamental economic differences will lead to divergence of asset classes. We have seen that recently in currency markets where there has been a large shift away from emerging market currencies and into the U.S. dollar.
Q: PIMCO has talked about the emergence of credit risk in the sovereign market. How will this affect portfolio construction?
Mewbourne: As I was saying before, fixed income is an asset class that has become quite different from textbook explanations. For example, five to seven years ago it was a reasonable decision for a European citizen saving for her child’s education to invest in government bonds, counting on a low probability of principal loss, little volatility and a modest return. Fast forward to today, and government bonds in many European countries have behaved quite differently than expected. The clearest example is the loss of principal on the restructuring of Greek bonds; but also prices of other European sovereign bonds suggest higher probabilities of potential losses. In all, the expected volatility, risk and returns on such bonds have changed, and therefore they likely play a different role in investors’ portfolios.
This shift is a challenge for certain institutional investors, such as insurance companies and some banks, whose business models or regulatory requirements require high-quality bonds with low probability of principal loss and low volatility.
Q: Staying with the topic of risk, what are some other risk factors investors should be managing, and how should they go about doing so?
Mewbourne: Investors need to think about the potential loss of principal on bonds of overly leveraged countries and companies. They also need to think about the loss of purchasing power from inflation as a result of central banks pursuing very low interest rates. When interest rates are lower than inflation, the resulting negative real yields eat away at investors’ purchasing power.
Given the issues that we have discussed, the time they need to spend thinking about and focusing on political risks has increased significantly, and they need to increase significantly their efforts in understanding and factoring such risks into their investment decisions.
Q: Let’s talk about opportunities: Are there new or emerging opportunities that investors should be thinking about? And can you offer some insights into alternative ways for investors to capture these opportunities?
Mewbourne: Markets are still healing from the major financial dislocation of 2008 and 2009 and, in a sense, the recovery creates opportunities in many areas for investors to identify and take advantage of attractive risk-adjusted returns. This requires a very active focus, as those opportunities can be in sectors that have become more credit sensitive and require more resources to review.
For example, in the non-agency mortgage market in the U.S., investors need to understand the underlying loans, a process that can take considerable time and knowledge but also lead to some very good opportunities.
Another example is the U.S. municipal bond market. That asset class has become much more credit sensitive and requires much more credit focus, but investors can really benefit from rolling up their sleeves and doing their credit research.
Also, the heightened market volatility that we expect in the years ahead can lead to greater risks but also opportunities during periods in which investors look to exit the same strategies at the same time. Given the geopolitical landscape, we expect overshoots in currency and commodity markets to result in buying opportunities.
Q: Ultimately, what are the key things investors should be thinking about or doing in their portfolios, considering PIMCO’s secular outlook?
Mewbourne: As risk and return characteristics transform, our view is that investors need to transform the way they think about using asset classes. We encourage them to broaden to the greatest degree possible their opportunity sets, for example, looking at emerging market government bonds as a replacement for some more traditional developed market government bonds.
Developed market government bonds have become riskier in some respects, and emerging market bonds are becoming less risky, and in cases where they pay a higher rate than inflation, they may be less risky both in terms of credit risk and the risk of purchasing power erosion.
We also encourage investors to broaden the type of financial instruments they consider. While they need to appreciate the risks of different instruments, they may benefit from investments in areas such as real estate and commodities as part of overall portfolio construction, and those areas can replace some of the roles that traditional domestic equities have played in the past both in terms of expected returns and volatility.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Tags: Asset Allocation, Asset Classes, Austerity, Banking System, Critical Factors, Debt Levels, Domestic Equities, Emerging Market, Eurozone, Global Landscape, Government Bonds, Indebtedness, Inflation Risks, Investor Expectations, Market Volatility, Mixed Messages, Other Developed Countries, PIMCO, Political Debate, Portfolio Manager, Sovereign Debt
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Friday, May 25th, 2012
Why Invest in Asian Credit?
by Showbhik Kalra, PIMCO
- Asian sovereign and corporate credit offer more attractive yields than a number of other global fixed income sectors as investors take on additional risk.
- Given Asian markets’ diversity and the global macroeconomic environment, investors may wish to consider investment managers with a strong global macro process coupled with strong relationships with local stakeholders and experience in local portfolio management and markets.
- PIMCO believes in the resilience of emerging Asian countries and that leads us to be open to adding exposure in sovereign credit and high quality corporate credits as attractive opportunities arise.
In the current environment, growth in Asia is one of the most talked about macroeconomic trends. After all, the region is expected to contribute around half of global GDP growth and makes up a significant and growing share of global GDP output. Asian central banks collectively hold around half of the world’s foreign exchange reserves and a number of these countries hold a record amount of reserves. In contrast to the developed economies, which have increasing government debt-to-GDP ratios, strong initial conditions and a rapid return to strong growth have facilitated stability in debt levels (with much lower absolute levels) across the major Asian economies. Over the last few years these fundamental improvements have been well recognized and sovereign ratings upgrades have outpaced downgrades consistently since 1999.
How do we take advantage of the growth in Asia?
Unfortunately, investment managers cannot invest directly in a country’s GDP growth or its expected level of foreign exchange reserves. Instead, one can invest in sovereign debt and corporate credit in Asia as a way to take advantage of the region’s growth. Corporate issuers in the emerging Asia markets are either serving the increasingly affluent and growing local consumer base or exporting goods overseas and, as a result, becoming regional and in some cases global powerhouses. Asian currencies are also attractive as many are undervalued by numerous purchasing power metrics. Authorities are also more open to letting their currencies appreciate as a way to deal with inflation and to rebalance their economies to be more consumption driven, rather than investment driven as in the past few years.
The first pan-Asia credit benchmark was created following the Asian financial crisis in the late ‘90s, marking the first step toward establishing Asian credit as an asset class. The Asian U.S. dollar denominated bond market today, as measured by the market capitalization of the JP Morgan Asia Credit Index (JACI), has grown from $50 billion dollars around a decade ago to over $300 billion dollars in June 2011. This index includes sovereign, quasi-sovereign (entities majority-owned by the state) and corporate credit (see Figure 1 for recent issuance). In recent years, the asset class has expanded progressively to cover 14 fast growing countries in Asia with sovereign ratings from S&P ranging from AAA to B-, as countries and corporates across the region looked to broaden their sources of financing. The typical size of investment grade issuances has increased over time, to average deal sizes of $1 billion currently. These larger issues contribute to the overall asset class as they tend to help boost secondary market liquidity.
Investing in growth
A notable development in the Asian credit space is the advent of high yield corporate issuers. The high yield corporate sector is dominated by China and Indonesia, but also includes issuers in Korea, the Philippines and Singapore. The high yield portion of the index has also grown substantially over the years from 30% of the index at the end of 2006 to 40% at the end of 2011. However, following recent upgrades to Indonesia, the high yield portion of the index has moved back down to 30% of the index.
For example, take a deeper look at Indonesia. Robust commodity demand from China and India has been a boon for the resource-rich country, particularly its coal producers. Sustaining industrial production in Indonesia also requires significant capacity expansion in basic infrastructure. Because Indonesia is the world’s fourth most populous country but still has a low penetration rate for wireless connection, cell phone demand will likely remain robust in the medium term. Indonesia’s rate of electrification is about 65% which means around 90 million people still do not have access to electricity. Not surprisingly, commodity, utility and telecommunication companies have dominated Indonesia’s high yield corporate issuance. Compared to the developed world, companies in these sectors across the region are still experiencing strong growth (Figures 2 and 3 illustrate growing demand for the telecommunications and utilities sectors). Note that particularly across emerging Asia there is a trend towards using multi-SIM cellular phones and mobile cellular subscriptions understate the true growth potential.
Attractive yields and greater stability
Asian sovereign and corporate credit is also attractive from a yield perspective. They offer significantly more attractive yields than a number of other global fixed income sectors (Figure 4) as investors take on additional emerging market sovereign and credit risk. What about the relative value comparison between Asian corporate bonds and developed country corporate bonds? A look at the historical credit spreads (over comparable maturity U.S. swaps) of Asian corporate credit compared to those of BBB rated U.S. corporates provides a strong argument. Figure 5 shows that spreads on Asian corporate bonds have consistently been higher than comparably rated U.S. corporate bonds during the past five years. The gap widened to as much as 134 basis points during the post-Lehman Brothers crisis, and recently was 87 basis points as at the end of March 2012 (the gap was close to zero prior to the Lehman crisis). A big reason for this gap is likely higher sovereign spreads embedded in Asian corporate bond spreads. We expect this gap to narrow as markets continue to revalue Asian sovereign risk to reflect stronger balance sheets and economic growth prospects.
In addition to indicating financial health, debt ratios can help uncover value in corporate bonds. One way involves looking at the ratio between debt and one-year earnings before interest, taxes, depreciation and amortization (EBITDA). A one-to-one ratio between debt and EBITDA can be thought of as a single “turn of leverage”. Figure 6 shows corporate bonds from Asia tend to have higher spreads (over comparable maturity U.S. swaps) per turn of net leverage on compared to corporate bonds from the U.S. By this metric, the yield from Asian corporates is potentially more attractive.
Despite a challenging year for risk assets in 2011, including the downgrade of the U.S. and trouble brewing in the eurozone, the JACI index stayed in positive territory and returned 4.12%. The investment grade rated portion (61% of the index) returned 4.92% and the sub-investment grade rated portion (39% of the index) returned 2.85%. The index has returned 7% on an annualized based in the five years from 2007 to 2011. Figure 7 shows how some different liquid Asian assets performed over the last five years and in 2011.
We must be mindful that Asia is not a homogeneous region and countries across Asia cannot be painted with the same brushstroke. India has fiscal challenges to deal with, China is going through a political transition and Vietnam is struggling to sustain growth while containing high inflation. Countries must make further progress on improving the quality of institutional frameworks, regulatory bodies and bankruptcy regimes. Given this backdrop and the global macroeconomic environment, investors may wish to consider investment managers that have a solid global macro investment process, strong relationships with local stakeholders and experience in local markets. PIMCO believes in the resilience of emerging Asian countries and that leads us to be open to adding exposure in sovereign credit and high quality corporate credits across portfolios as attractive opportunities arise.
Past performance is not a guarantee or a reliable indicator of future results.
Investing in the bond market issubject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury. The Barclays U.S. Fixed Rate Mortgage-Backed Securities Index is composed of all fixed-rate securitized mortgage pools by GNMA, FNMA, and the FHLMC, including GNMA Graduated Payment Mortgages. Barclays Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities The Barclays Global Aggregate Credit Index is the credit component of the Barclays Aggregate Index. The Barclays Aggregate Index is a subset of the Global Aggregate Index, and contains investment grade credit securities from the U.S. Aggregate, Pan-European Aggregate, Asian-Pacific Aggregate, Eurodollar, 144A and Euro-Yen indices. The HSBC Asian Local Bond Index (ALBI) tracks the total return of local currency denominated, high quality, and liquid bond in Asia ex-Japan. The index returns for each country-based sub-index are calculated in the respective local currencies and the return for the overall ALBI index is measured in US dollars. The J.P. Morgan Asia Credit Index (JACI) tracks total return performance of the Asia fixed-rate dollar bond market. JACI is a market cap-weighted index comprising sovereign, quasi-sovereign and corporate bonds and it is partitioned by country, sector and credit rating. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC.
Copyright © 2012, PIMCO.
Tags: Absolute Levels, Asia Markets, Asian Central Banks, Asian Economies, Attractive Opportunities, Corporate Issuers, Debt Levels, Emerging Asia, Exporting Goods, Foreign Exchange Reserves, Fundamental Improvements, GDP Growth, Gdp Output, Global Gdp, Global Macro, Investment Managers, Kalra, Macroeconomic Environment, Macroeconomic Trends, Rapid Return, Sovereign Ratings
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Wednesday, May 2nd, 2012
by Peter Tchir, TF Market Advisors
Economic data in Europe brought us back to our typical reality. The economic conditions are getting worse, unemployment is breaking records, and the stocks and banks of the periphery are in trouble again. The main support for the market is complete faith that Draghi and ECB will unveil some new plan that will make everything better.
LTRO was done on February 29th. Just 2 months after the ECB flooded European banks with money and encouraged them to buy sovereign debt we are back in the midst of a crisis. How could LTRO fail so quickly? The better question is how could LTRO not fail? The premise that banks, already heavily exposed to their own sovereign’s debt would buy more, book the carry, and live happily ever after was flawed from the start. Carry takes a long time to work. Carry is a slow, dull, process, but mark to market and fear of default is fast and painful. Now banks are massively overexposed to the risk of their country’s debt, fund themselves through a variety of “non-traditional” methods, and face real risk of big losses as restructuring becomes the obvious conclusion.
There has been so much talk about growth versus austerity lately, that the true goal was lost in the shuffle – sustainable debt levels. The debt burden is too high both in terms of repayment, but just as importantly the cost of servicing it. Any legitimate plan to resurrect the economies of Spain and Italy will need targeted long term cuts, focused short term growth/productivity oriented projects, debt restructuring, and possibly a new currency. When every path leads to the same logical conclusion, it is time to accept the conclusion, and implement it now. As Greece clearly demonstrated, clinging to some false notion that default is “doomsday” and delaying true restructuring to appease foreign creditors (including the Troika) leads to a much worse collapse. Greece needs another round of restructuring already because it didn’t truly embrace default the first time. Default /Restructuring is a process. It needs to be planned for and carefully implemented, but it is now inevitable that it will be a part of the European “solution” and banks will bear the brunt of the cost.
In the meantime, the question for investors is how likely Draghi unleashes some new money and gives the market another brief relief rally? I’m not sure he is able to do anything meaningful and right now I believe the market will fade over the course of the day as realization sets in that not much can be done. I’m not quite ready to put this trade on, but am looking closely at going long Spanish stocks versus short German stocks. The belief that Germany will be fine while Spain is a disaster seems too common and priced in. I’m not quite there on that trade, but it is only that am looking at very closely.
While European PMI was a “clear” indicator of how deep the recession is in Europe, the Chinese PMI data seems to tell a different story? Chinese Manufacturing PMI was below 50 for the 6th straight month. China is largely a manufacturing based economy, yet GDP growth is still in excess of 8%. Somehow this reminds me of high school physics when you are supposed to understand that sometimes light is a wave, and sometimes it is a particle, but never both at the same time. That was basically as far as I got in physics, as I just had a lot of difficulty comprehending that phenomenon. Similarly, I can see how PMI can continue to show slowdown, but GDP can be really high, but it is getting harder.
Copyright © TF Market Advisors
Tags: Austerity, Breaking Records, Debt Burden, Debt Fund, Debt Levels, Debt Restructuring, Doomsday, Draghi, Economic Conditions, Economic Data, European Banks, False Notion, Logical Conclusion, Obvious Conclusion, Oriented Projects, Periphery, Sovereign Debt, Sustainable Debt, Troika, True Goal
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Tuesday, May 1st, 2012
by Peter Tchir, TF Market Advisors
A dull morning with the Euro markets shut down. Stock futures have meandered throughout the overnight session, trading up and down, but in a narrow range. We get the ISM data and vehicles sales today. It would be surprising if ISM didn’t disappoint, which means the market has already priced in a print lower than the expectations of 53 calculated by Bloomberg. Vehicle sales will be more interesting. They have been helpful for the markets, but weather, and some evidence of channel stuffing, could make for a disappointing report this time around. Any upside surprise in this number will be a welcome relief for the bulls.
In spite of the holiday in Europe, it is still one of the biggest issues in the market. I am not sure how the debate has turned into austerity versus growth? Growth, or at least sustainable debt levels is the goal. Austerity and Spending are ways of achieving that sustainable debt level.
Growth is one way of achieving a sustainable debt level. A bigger economy would more easily support the existing debt. The key here is not creating more debt than the growth can cover. That has been one of the big problems in recent years the spending hasn’t resulted in enough economic growth to cover the cost of that growth. If finding an investment that could easily pay for itself was that easy, the earnings of the S&P 500 would be much higher. Projects that can create more than enough growth to cover their cost should be pursued. It has to be a mix of near term projects and longer term projects. Longer term projects may offer the best possible return, but they have more risk, and the market may be too impatient if the spending outpaces the growth potential for too long before the project comes on line. So yes, spending to create growth has to be an option on the table, but assuming it is easy, is wrong. The tendency to fund fancy projects, like Green Energy, rather than dull things like highway expansion, is bad, because the dull project may add a lot more value.
Reducing debt and reducing expenses is another way of achieving a sustainable debt level. It is depressing and a bit scary that governments have promised far more than they can deliver. We all know that the social security and medical care that has been promised will be very difficult, if not impossible to deliver. Demographics, life expectancy, low interest rates, advancement in medicine, etc., all have played a role in making these promises so difficult to fulfill. Cutting these now is realistic and actually lets people prepare and adapt. Cutting these programs has limited impact today, but is key to creating a sustainable future, and as bad as it is to take away promised benefits, it is better for people to have a realistic expectation of the future and be able to prepare for it. This may be very difficult to achieve from a political perspective, but has the least impact on the current situation while creating a future bond investors can trust in.
Then there is all the existing spending that has limited value. Just like new spending should be examined in terms of what can generate growth, existing plans need to be reviewed. Obama never got around to the line item review of all expenses (at least not that I know of), but that might be required. While embarking on new spending programs, let’s figure out what programs should be cut. Clearly they aren’t achieving the goal of a sustainable debt goal. Some things may have to be cut back. This also won’t be easy, but can probably create some immediate benefits without disrupting the economy much. Yet, for politicians, this is also hard. Spending new money is easy, taking money away from someone is hard, yet that is what needs to be done.
So new spending that creates more growth than it costs should be pursued. It won’t be easy to find that many obvious projects, but at least politicians have an easy time spending more money. Cuts, both in the near term and to future promises are also required to create sustainable debt levels. These are easier to find, but more difficult for politicians to implement.
Then there is the pink elephant in the room, or in this case, the black market. Spain has an official unemployment rate of 24%. They project it to be 22% in 2015. This is structural. I cannot imagine the U.S. surviving with that level of unemployment. The unemployed would have taken to the streets long before it hit that level to demand change. In fact, I find it difficult to imagine any country surviving on that level of unemployment, unless it is structurally encouraged. Are the benefits too good? Is it too easy to avoid working? The longer that unemployment insurance lasts, the more likely people are to use it. The closer the unemployment benefits come to covering your working wage, the more likely you are to stay on it. Then if you can supplement your unemployment benefits with a thriving black market and some under the table jobs, why not? The U.S. may have too small of a safety net and that creates its own tensions, but it seems likely that other countries have too comfy of a safety net, especially when combined with an underground economy. If a country like Spain is paying huge amounts of money to the unemployed, and that is causing a spike in debt to unsustainable levels, then something needs to be done. Maybe the benefits can be tied to work or doing some of the projects deemed necessary for growth? This is a touchy subject for everyone, and I certainly don’t have the answer, but it is time to stop ignoring the pink elephant in the room as these economies and countries try to revive themselves.
Anyways, back to a dull and quiet morning in the markets.
Copyright © TF Market Advisors
Tags: Amp, Austerity, Bulls, Debt Level, Debt Levels, Earnings, Economic Growth, Euro Markets, Green Energy, Ism, Overnight Session, Spite, Stock Futures, Sustainable Debt, Tendency, Term Projects, Tf, Upside Surprise, Weather, Welcome Relief
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Monday, April 23rd, 2012
There are plenty of ways to get ahead. The first is so basic I’m almost embarrassed to say it: spend less than you earn. – Paul Clitheroe
I am drafting this letter from a park in Paris. It is early on a Wednesday afternoon, and the park is full of families. Nearby, men gather to play boule, have a smoke, and enjoy a drink with friends. It is glorious. It’s a scene that is repeated throughout France and Western Europe (OK, replace the boules with something else depending on your country). It’s much less common in the United States. It is exceedingly rare in Asia.
According to a Credit Suisse study, in 1980 Europe accounted for as much as 35% of global GDP growth per year. This year it will be 12%. Yes, some of this is due to the advent of economic development in countries like South Korea, Brazil, and China, but the share of world GDP attributable to the U.S. has held much more stable. And keep in mind that at the same time, the debt levels of many European countries have soared, as has unemployment. This debt has purchased lots of things, but it has not been sufficient to keep Europe up to speed with the rest of the world in economic development. And generally speaking, debt must eventually be repaid, a process that removes economic capital from a system. That process is currently underway. In France in 2011, more than 10,000 businesses declared bankruptcy, while fewer than 600 were formed.
All your bras are belong to us
It’s not getting better, either. France has long been associated with sophisticated lingerie, but news that a bra factory in Yssingeaux, a small town in south-central France, will close in favor of outsourcing production to Tunisia has made women’s underwear both a symbol of everything wrong with the French economy and a touch point of the ongoing French election campaign. As one journalist put it bluntly: If France can no longer make bras and lace knickers, what can it make?
None of this is to dismiss the attractiveness of the European way of life. Let’s face it — if living is in itself a pursuit, then the Europeans are better at it than anyone. (Take a deep breath, Californians — it’s not even close.) Their cities are pleasant, their infrastructures mighty, their social structures extremely robust, their vivre full of joie. If I could figure out how to live in Europe but work in America, I’d do it. In a heartbeat.
But traveling back and forth between Europe, Asia, and the U.S. (which I’ve had the pleasure to do, all in the past month), I find the spectrum of the striving nature of Asian commercial activity to the languid attitude Europeans have toward hard work to be nothing short of amazing. Greece offers state employees a thirteenth month of pay. Paid maternity leave in Sweden can be as much as two years. A full work week in France is 36 hours.
Meanwhile in Korea, children attend intense cram schools, both after class and on weekends, preparing to take the standardized tests that determine how prestigious a college they can attend. Chinese workers endure long hours doing, in some cases, backbreaking work. Best of all, in country after country in Asia, systems are being put into place to help bring economic development to a wide portion of the populace. In Europe, they’re simply trying to minimize failure. A noble pursuit, indeed, but not particularly effective as a strategy to remain competitive.
The end of the story here is that the rapid growth of Asia and the stagnation of Europe seem to me to be outcomes of broader policy. It is not a sure thing that a society predicated on hard work will outperform one that has perfected the art of leisure, but that’s probably the best way to bet.
So where is America in all of this?
Both in Asia and in Europe I heard the same thing (which makes it so strange that I heard the opposite when I was in North Dakota): America is viewed by much of the world as having a nearly absurd amount of creative spirit, something that neither Europe nor Asia have been able to match.
And if you think about this, just focusing on three vectors — entertainment, technology, and brands — evidence suggests this is true. America has 5% of the world’s population, but an entrepreneurial capacity that is many times higher. In the past I’ve argued that American schools are much more effective than statistics would suggest, so I won’t rehash that here. But suffice it to say that America’s educational system does a really good job of educating high achievers. Now no politician could ever say such a thing without being accused of ignoring the needs of all American children. But the world is not looking to South Korea — the country with the highest average scores in math and science aptitude tests – for the next great creators of economic wealth; it’s looking to America. Ability at the mean to perform well on a standardized test and encouragement of entrepreneurial creativity are two very different educational pursuits. The scoreboard suggests we do the latter very, very well.
Over the past month the market has continued to soar higher as economic growth in the U.S. and a reduction of fears in Europe have convinced many investors that the water is indeed OK for risk assets. Where these people were several months ago when the stock markets were much weaker is beyond me, but there you go. The problem, of course, is that the absence of fear of risk is far different than the absence of risk. European politicians seem to believe that things are improving (and they are), and that they have done all that they can (they have not) to solve the myriad problems Europe faces. In the last week of March, we began to see some of the results of European complacency as the Spanish government’s bond auction went absolutely horribly, sending markets back into a tailspin.
Lest you wonder if we’ve seen this pattern before, rest assured that we have. Politicians have very little capacity to solve problems before they become crises, for the simple fact that they tend to not act with great courage until all other avenues have been exhausted. This isn’t a slap at politicians (not a direct one, at least), but a recognition that no politician has ever gotten credit for averting a crisis that is unseen by the general populace, and even then there are entrenched interests in maintaining the status quo as the plane flies into the ground. It’s a simple bedrock principle of the “economics of politics.” So while Europe remains in a state of relative calm, little will get done.
So why do we have money in Europe?
If we see so little vitality from Europe, why do we invest there? First of all, the fact that Europe has been in crisis is obvious, which means that investors everywhere — including in Europe — have been looking for other places to put their money. When this happens, investors tend not to differentiate between the great and the not-great. And second, even if Europe were toast (which it isn’t), that doesn’t mean that every company in Europe is equally hosed. Many of the world’s great brands are European, and many of them generate much, if not most of their revenues in other markets around the world. I was shocked by the low level of GDP growth that Europe accounts for, because Europe accounts for so much mindshare everywhere in the world.
Last month we met with managers from several Chinese sports apparel companies, and left the meetings thinking, “Adidas is going to crush these guys.” (As an aside, meeting with competitors of one of our portfolio companies is often more informative than meeting with the company itself.) European companies have not forgotten how to make money, and European managers have not forgotten how to run these companies well. This is meaningful, and as long as the world’s investors view Europe as a basket case, we believe there will be opportunity for those who focus on individual companies rather than on broad-based markets.
Consider, for example, Italian leather goods maker Tod’s SpA, which happens to not only be our largest holding in the Epic Voyage Fund, but also our best-performing holding during the month. Although the Italian market continues to get (rightfully) shellacked, Tod’s continues to outperform sales expectations in emerging markets and throw off cash at a magnitude that should be the envy of most other Italian and/or luxury consumer goods companies.
It was a good month for domestic stocks and a weak one internationally. Our funds followed those results, with excellent returns domestically (Great America Fund), decent results globally (Independence Fund), and flat results internationally (Epic Voyage Fund). All three funds outperformed their benchmarks by varying degrees, reversing results from February when all three underperformed.
For the month, the Independence Fund gained 1.38% vs. 1.34% for the benchmark MSCI World. Little changed in the portfolio, and some of the usual suspects in our Top 11 holdings were among the biggest contributors to a good month, such as Yum! Brands (on general enthusiasm for the consumer sector) and a big comeback from WellPoint on speculation that the Supreme Court would overturn the Patient Protection and Affordable Care Act. Recent addition Crucialtec joined Posco in having a poor month, largely on the back of weakness in the Korean market. As we’ve noted in the past, South Korea is the largest component of the MSCI Emerging Market Index. As such, when thematic investors “reduce exposure” to emerging markets, companies in the Korean market tend to be hit disproportionately hard. Add in the prospect of a North Korean missile test, and you have the makings of a tough market environment.
The Great America Fund increased in value by 2.44% vs. a 2.24% performance for its benchmark. Little changed in the portfolio. We liked what we owned, though by the end of the month, given the increase in prices across the market, it was becoming harder to find things we were especially interested in adding.
Despite turbulence in international markets, it was a fairly quiet month for the Epic Voyage Fund, which was a dead flat 0.00% in March versus a 1.36% decline for its benchmark, the Russell Global ex-US. Our only transaction of note was to sell our shares of Canadian yoga apparel maker Lululemon. You may remember that when we talked about Lululemon during our January shareholder conference call (and compared it to craft beer), it was already quite an expensive stock. And while we endeavor to be long-term owners of great businesses, it’s also true that our stocks are on sale every day — and we believe we received a price that more than compensated us for the value of Lululemon’s brand and growing store franchise. We would love to own this company again at the right price, but we think that the shares are currently valued for absolutely extraordinary future results.
As always, the entire portfolio team joins me in thanking you for entrusting your money with us.
Tags: Bill Mann, Boules, Central France, Credit Suisse, Debt Levels, Economic Capital, Election Campaign, European Countries, French Economy, French Election, GDP Growth, Global Gdp, Knickers, Park In Paris, Paul Clitheroe, Sophisticated Lingerie, South Korea, Wednesday Afternoon, Western Europe, World Gdp
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Thursday, March 22nd, 2012
This article originally appeared on The Daily Capitalist.
I’ve been working on an article about the state of economic recovery and have been studying deleveraging, debt levels, bank balance sheets, foreclosures, and the like. So I was very pleased to find a long research piece put out by Bridgewater’s Ray Dalio on that topic. As readers may know, I am a fan of Dalio and I appreciate his often unique and out-of-the-box view of the markets and the economy. Bridgewater also agrees with my belief that the economy is heading for stagnation and decline this year.
Dalio’s piece was very disappointing because it was an incorrect look at how business cycles work and the role of deleveraging and the liquidation of malinvestment. It may actually lead one to make bad investment decisions. Because Bridgewater’s macro economic forecast came to conclusions similar to mine, I had assumed that perhaps they had done a somewhat “Austrian” analysis, but now I question that. Again, as I mentioned in the above article, you don’t have to be “Austrian” reach similar conclusions, but they would have to look at indicators an “Austrian” would look at and interpret them in the same way.
Dalio’s article, “An In-Depth Look at Deleveragings” is apparently authored by him. It concludes that the best way to “deleverage” is a “proper” combination of debt reduction (defaults and restructurings) and debt monetization (monetary inflation). This is what he considers to be a “beautiful” deleveraging whereas deleveraging by debt reduction and austerity are “ugly.” The ugly ones cause recessions/depressions and deflation which is bad. Beautiful deleveragings minimize debt reduction and revive economies with monetary stimulation.
Unfortunately this is a very conventional view and it is wrong.
I’m not going to get into the entire 31 page article, but he examines six historical events that supposedly exemplify “beautiful” and “ugly” deleveragings. They are the U.S. Great Depression (1930-1932), Japan (1990 to present), Spain (9/2008 to present), UK (1947-1969), and U.S. 9/2008 to 2/2009 (pre-QE). At the end he tackles an analysis of the Weimar hyperinflation.
I’m not as familiar with the UK and Spain, but I am familiar with both U.S. events and the Weimar hyperinflation. Dalio unfortunately accepts the conventional wisdom of contemporary neo/Keynesian-Classical-Monetarist econometric analysis of these events and fails to understand most of the real causes underlying these crises. To save you the suspense, he believes that the current boom-bust cycle is an example of a “beautiful” deleveraging.
Dalio defines a beautiful deleveraging as one “in which enough ‘printing’ occurred to balance the deflationary forces of debt reduction and austerity in a manner in which there is positive growth, a falling debt/income ratio and nominal GDP growth above nominal interest rates.”
Thus far, this deleveraging would win our award of the most beautiful deleveraging on record. The key going forward will be for the policy makers to maintain balance so that the debt/income ratio keeps declining in an orderly way.
What he is saying is that the Fed’s policy of ZIRP, debt guarantees, and QE avoided a disaster, prevented a collapse of the credit markets, and has allowed deleveraging to occur on a more or less orderly basis, and has promoted growth. He notes that the credit markets are “largely healed” and that “private section credit growth is improving.”
This is the Conventional View of the Crisis and he, like most people holding this view, are engaging in a wishful thinking analysis of how things occurred. One could believe that a chariot pulled the sun across the heavens every day, and because the sun came up every day, this analysis is correct. We understand that there are other forces at work. But he is not alone in his conclusions.
He uses a monetarist view which says that tinkering with money supply can prevent the worst from happening. He sees the problem as one in which there was a shortage of money which caused the bust, rather than it being the result of “money printing”. If the Fed could have prevented the worst from happening by printing money, then all of our problems would be solved. Unfortunately for the monetarists at the Fed, including Mr. Bernanke, they have yet to achieve their goal.
Dalio also takes a classical view of the economy as one big aggregate machine which can be properly measured by GDP. His main measure of the problem is the amount of debt to GDP, a measure which really doesn’t tell us much. All GDP can tell us is how much money was spent at any given time. At best it is a rough measure; at worst it is a misleading measure because the data is not revealing of what really happened in an economy where millions of individual decisions are made every day. The amount of debt versus GDP tells us nothing about the role of debt, the value of underlying assets, the ability of pay debt, whether the debt was built on monetary steroids or real economic activity, or really anything. “Economies” don’t incur debt, people do.
Further he measures everything in nominal terms which makes any conclusion misleading without at least trying to apply a deflator to the measure. Then one has to choose the right deflator to determine if the measured activity was really positive or negative. It is many Austrians’ belief that price inflation is actually much higher than officially stated and that there are a number of ways to game the data to make it look better. I have written many times about this and my conclusion is that what we are seeing as “growth” is actually a data fiction because it fails to properly measure the impact of price inflation. In fact what we are seeing as “growth” now is really a further destruction of capital by investors and businesses.
He then uses a neo-Keynesian econometric methodology to interpret and analyze the results. That is, tinkering with the big machine called “the economy” can more or less solve our problems if it is done just right. And we all know that the tinkerers have done a great job of “running” the economy. In fact the current policies proposed and implemented by mainstream economists have been failures and have resulted in an increasingly unstable and fragile economy.
Thus faith in all that tinkering, especially by the Fed, caused the boom-bust credit cycle, and further tinkering with QE and ZIRP, plus the Fed’s and the federal government’s role in preventing a liquidation of malinvestment has only caused the economic pain to be stretched out much longer than it otherwise would have had the government had not interfered. Further, these policies have only served to create further future instability and economic risk. Other than that his analysis is fine.
What he calls “ugly”, an austerity and debt reduction, is actually “beautiful”. While it is painful, it is painful for a much shorter period of time and enables the “economy”, i.e., people, to go bankrupt, repair their finances, start saving again, create new capital, and then create new economic growth and jobs. By preventing or delaying this process the policy makers only doom us to economic stagnation, inflation, and permanent high unemployment. And I fear that is exactly where we are headed.
Tags: Austerity, Bank Balance, Business Cycles, Conventional View, Debt Levels, Debt Reduction, Deflation, Depressions, Economic Forecast, Economic Recovery, Historical Events, Investment Decisions, Monetary Inflation, Page Article, Proper Combination, Ray Dalio, Recessions, Restructurings, S Ray, Stagnation
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Tuesday, March 13th, 2012
While Greece is now cleared to receive a second bailout and Spain and Italy are facing lower borrowing costs, Europe is not yet out of the woods. Greece, for instance, still has unsustainably high debt levels, and Portugal’s rising yields are becoming increasingly worrisome.
Given these lingering issues, I recently advocated that investors avoid Spain and Italy, markets that are cheap for a reason. Now, I’m adding another country to the list of European markets to consider underweighting: the United Kingdom, a market that has its own issues separate from those of the euro zone.
Currently, equities in the United Kingdom appear overvalued, especially when you consider the numerous signs that the country is teetering on the brink of another recession. As of this writing, UK stocks are trading at a relatively rich valuation of 1.7x book value, higher than the 1.5x book value average for developed countries.
At the same time, economic conditions in the United Kingdom are deteriorating. Expectations for UK growth have decreased over the last six months, and UK corporate sector profitability has dropped since the end of last year. In addition, UK mortgage rates have increased and unemployment remains at a 17-year high, headwinds for an economy where household spending accounts for roughly 2/3 of gross domestic product.
While UK inflation is declining, it’s still elevated at 3.6%, a level well above both the Bank of England’s target rate and UK wage growth. Thanks to the United Kingdom’s relatively high inflation, it appears unlikely that the Bank of England will provide further quantitative easing in the near term, meaning the UK economy will have less growth support. Finally, the United Kingdom may be trying to reign in its deficit too quickly by raising taxes and cutting spending, potentially raising the risk of another recession.
So where should investors consider investing in Europe? I continue to believe that much of Northern Europe represents a good value for long-term investors and I particularly like Germany, the Netherlands and Norway (potential iShares solutions: NYSEARCA: EWG, NYSEARCA: EWN, NYSEAMEX: ENOR).
Tags: 7x, Bailout, Bank Of England, Brink, Corporate Sector, Debt Levels, Developed Countries, Economic Conditions, Euro Zone, European Markets, Gross Domestic Product, Headwinds, Household Spending, Profitability, Recession, Target Rate, Uk Economy, Uk Inflation, Uk Mortgage Rates, Uk Stocks
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Friday, March 2nd, 2012
Dirt Demographics: Demographics Matter!
by Shane Shepherd, Research Affiliates LLC
My maternal grandparents grew up on Midwestern farms. As was typical in those days, they came from large families with seven children each. I like to think that my great-grandparents were motivated by a hard-earned grasp of “Dirt Economics”: knowing the benefits of cheap (and even free!) farm labor, they chose to have large families to help work the farm. And, given the economic realities facing a poor South Dakotan farming community, they certainly weren’t relying on their tiny savings to provide a comfortable retirement. Just as they had done for their parents, my great-grandparents hoped their children would run the family farm, put food on the table, and pay the doctor and the dry goods store bills once they were too old to work the land.
My great-grandparents intuitively understood the concept of support ratios: having just one or two children wouldn’t guarantee the retirement security they needed. Despite the economic devastation wrought by the Great Depression and the Dust Bowl of the 1930s, the underlying economic potential for their generation remained quite strong, especially following the Second World War. A growing workforce promised increasing demands for goods and services, and the production capacity to meet that demand. But a problem was forming on the horizon: Americans—my grandparents among them—stopped having so many kids, with long-term implications for the economy and investments. In this issue, we will examine how demographic changes affect portfolios in different economic environments.
The Demographic Bust
If only we found ourselves in such a fortunate situation today as prior generations did. Soaring deficits, massive debt, and worsening demographics—our frequently mentioned “3-D Hurricane”1—leave my generation in a far more dire situation than my grandparents faced. Exceedingly high debt levels and growing deficits across the developed world have attracted much attention, and rightfully so. Deficit spending is by nature a transfer of future consumption to the present. Particularly when built up across generations, excessive deficits can powerfully reduce future economic growth when those bills come due. The economic prosperity of Generation X will certainly be reduced by the need to pay back the heavy borrowing of the Baby Boomers.
Even if we could clean up our current fiscal mess with a wave of Ben Bernanke’s magic wand, our future prosperity still would decline for an even more powerful and fundamental reason. Simply put, I don’t have enough siblings. In addition to running large deficits and spending my generation’s income ahead of time, my parents’ generation forgot about Dirt Economics—they didn’t have enough children to support them in their retirement. As we moved from a predominantly single family support system to a national system anchored on Social Security, the incentives to directly replace one’s labor value vanished; instead, we shifted the burden to society as a whole. Therefore, if the Boomers begin to retire as anticipated, we won’t be able to produce enough goods and services to meet their demand! The core problem faced by the developed world today is not just the disastrous fiscal situation we see headlining the newspapers every day, but—lurking beneath the surface—our impending demographic bust.
Examining the deteriorating support ratios for the developed world puts the magnitude of this problem in context. In 1970, there were five working adults for every retiree. Today, that ratio is 3.5:1 and if the retirement age remains constant, that ratio is projected to drop below 2:1 by 2050.2 The demographics trends in Figure 1 show that, in the early 2000s, there were 10 new entrants into the workforce for every retiree; by 2020, that ratio will invert and show one new worker for every 10 retirees.
Continue reading below – Fullscreen for the better read, or download, options available at the bottom of the pane.
Tags: Debt Levels, Demographic Changes, Dry Goods Store, Dust Bowl, Economic Devastation, Economic Environments, Economic Realities, Farming Community, Food On The Table, Fortunate Situation, Great Depression, Large Families, Massive Debt, Maternal Grandparents, Matter Research, Midwestern Farms, Research Affiliates, Retirement Security, Second World War, Shane Shepherd
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Sunday, January 15th, 2012
Five Global Risks to Monitor in 2012
Bill Hester, CFA, Hussman Funds
As we’re all a bit forecast weary by this point in the year, here’s a list – not of prognostications – but rather of potential risks that may come into even greater focus this year. These risks – whether they intensify or pass – will likely play an important role in driving the performance of global stock markets in 2012.
1) The Persistence of Wide Spreads Among European Debt – Even if Bond Holders are ‘Rescued’
There are two components of the European credit crisis – debt levels and economic growth prospects. While the conversations to this point have leaned mostly toward reducing debt levels, economic growth prospects and the overall viability of a common currency will likely get a closer look this year, especially as Europe heads for recession.
During this two-year crisis investors have continually called on the ECB and euro area leaders to ‘fix’ the debt issue: by wiping out half of Greece’s debt, by protecting Italy’s access to debt markets through bond purchases, or by suggesting a levered EFSF, the euro area’s rescue vehicle.
But even if the ECB does bend to the will of the bond markets this year, and begins to buy sovereign debt directly, the single currency is left with all of the same weaknesses that existed prior to the crisis: the inability to tailor interest rate policy for each individual economy, the lack of foreign currency adjustment needed to offset differences in competitiveness, and growth-limiting trade dynamics throughout the area.
Martin Feldstein, a long-time euro skeptic, in this month’s Foreign Affairs magazine made the point this way: “During the past year, Germany had a trade surplus of nearly $200 billion, whereas the other members of the eurozone had trade deficits totaling $200 billion. A more comprehensive measure that factors in net investment income reveals that Germany has a current account surplus of nearly five percent of GDP, whereas Greece has a current account deficit of nearly ten percent of GDP. Put another way, Germany can invest in the rest of the world an amount equal to five percent of its GDP, whereas Greece must borrow an amount equal to nearly ten percent of its GDP to pay for its current level of imports”.
One of the strongest benefits at the introduction of the common currency was that investors priced government debt similarly across the euro area. During this period investors thought of the euro area as a group of countries that would not only share a currency, but also share economic performance and long-term outcomes. Smaller countries and those of southern Europe experienced the greatest amount of benefit from converging yields. Yield on Greek debt fell by more than half in less than 10 years. Even stock market valuation ratios converged. The spread between the countries with the highest and lowest PE ratios dropped by more than half during the period.
While this period could have been used to improve some of the issues surrounding productivity, competitiveness, and trade dynamics among countries, what occurred instead was that governments took on larger amounts of liabilities, and as interest rates fell, housing bubbles formed. With that period passed, it’s difficult to imagine that investors will soon return to the mindset that Portugal, Ireland, or even Italy, will soon again converge materially – in either economic performance or level of credit risk – with Germany.
I highlighted this risk and the graph below early in the European credit crisis ( The Great Divergence ). At that point the sovereign debt of Portugal was priced at 200 basis points above German bunds, compared with 1100 basis points today. Here is an updated graph.
There is a long history prior to the period of the shared currency where spreads among countries and with Germany were dramatically and persistently wider than even today. This was because expected economic growth rates, inflation expectations, and the real rates required by investors differed. Now that investors have been reminded of the structural weaknesses of a common currency – even outside of the discussion of high debt loads – persistently high spreads may be here to stay. Those spreads will surely play a role in the potential long-term growth rates of economies and euro area stock market valuations.
2) Sovereign Debt Rollover Risks
When the history of the European Credit Crisis is written, it’ll likely be in two parts. The first part will cover the debt crisis of the smaller European countries – mainly the woes of Greece, Portugal, and Ireland. It will cover Greece’s admission that its accounting didn’t add up. And how Ireland’s bad bank debt was turned into sovereign debt – which tripled its debt to GDP ratio in just three years. It will also cover the trajectory of peripheral sovereign bond yields in the face of investor uncertainty, where yields were first pushed above seven percent, and then eventually to much higher levels, forcing a rescue program.
The second part of the story will be about Italy and Spain, and potentially France, and how they were either pulled into the fiscal debt maelstrom or whether the ECB and euro area leaders were able to ring-fence them from the more troubled smaller euro countries. It will cover whether investors pushed these core countries from liquidity concerns to solvency concerns. While these chapters are still being written, the outcome may very well be available to historians (and investors) much sooner than many are expecting. One reason is because of the vast amount of sovereign and bank debt that is due to mature this year, all of which will needed to be rolled over because of existing budget deficits. The two countries that pose the greatest risks for rolling over this debt are Italy and Spain.
The chart below gives some sense of the relative importance of Italy – and to a slightly lesser degree Spain – in meeting its rollover demands this year versus the smaller euro area countries. The graph shows the cumulative amount of debt that will mature this year in the countries listed. (These totals count all government debt coming due – including shorter term notes – and are therefore larger than estimates of only long-term debt.) The graph shows the limited bond market needs (and therefore rescue funds needed) of Greece, Portugal, and Ireland, relative to those of Italy. Also, notice how steep the line is for Italy’s maturing debt during the first four months of the year – when almost half of this year’s total debt will mature.
It will be important to watch bond auction demand in Italy and Spain in the beginning of the year. The recent bid to cover ratio – a measure of the eagerness of bond investor to participate in an auction – for Italy’s 10-year notes has mostly been in line with results from early last year. Of course, the level of yield will also matter. The chart below shows the weighted coupon of the existing debt outstanding for each country (in blue) versus the current yield (using the weighted maturity of existing debt) of its bonds (in red). For many years during the Euro’s first decade, borrowing costs continued to fall versus the average cost of the existing debt of these countries. This trend has now changed for most of Europe, except Germany and France. This will likely continue to further widen economic divergences among countries.
This is one more benefit Germany is deriving from the crisis. In addition to a weaker euro, which helps fuel its export-oriented economy, the cost of financing its sovereign debt relative to its existing debt continues to fall while the smaller countries struggle with rising financing costs.
3) The Depth of Italy’s Recession
It would be difficult to overemphasize the importance of Italy retaining access to the bond markets, and mitigating further losses in its sovereign bonds. According to the Bank for International Settlements, foreign claims on Italian debt total $936 Billion – that’s larger than the combined foreign claims on the debt of Portugal, Ireland, and Greece. And core Europe is long a mountain of Italian debt. French banks, for example, hold 45 percent of Italy’s liabilities. Much more is at stake than France losing its Triple-A rating if Italy moves from a liquidity concern to a solvency concern.
What eventually would force that shift is if investors come to believe that the country’s ability to handle its debt load over the long term is compromised. Those concerns can be partly alleviated if Italian Prime Minister Mario Monti delivers a balanced budget by 2013, which he promised this week. Unfortunately, near-term economic risks could make these goals difficult to meet in practice.
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