Excerpts from a monthly investment outlook by Financial Alliance (FA) sent to its clients recently.
In November 2008, Financial Alliance (www.fa.com.sg) became the first and only Financial Adviser Firm in Singapore to achieve both the Singapore Quality Class and the People Developer status.
Key points:
The weeks ahead may prove to be challenging as more data continue to point to a global slowdown and thus weaker corporate earnings, and the impending fiscal cliff situation in the United States remain unresolved.
It would be very interesting to see how the market pans out in the next couple of weeks given the “October curse”, when many truly memorable crashes, from the Great Crash of October 28, 1929, to the Black Monday of October 19, 1987, have occurred in that fateful month.
• Despite continued news to suggest that the global economy is slowing rapidly, we have long argued that the markets - the credit, equity and economy - all move in different time lags.
At this juncture, we have already seen evidence that the credit market could have bottomed. We are now awaiting the bottom in equities, while that of the economy will come much later.
• With the fresh influx of liquidity into the global system, and especially with the tap left opened in the U.S. and Europe, it will only be a matter of time before risky assets become recipients of such flows. However, we hesitate to be aggressive and bring forth our planned installments as the recent rally in equities may face some headwinds.
In this respect, we are comfortable to keep to our present strategy of accumulating equities via a dollar cost averaging (“DCA”) program.
Q. What could be the catalyst for markets to retreat in the weeks ahead?
FA: On one hand, it could be a simple case of profittaking after the sharp rally in the prior weeks. On the other hand, we could also see the European crisis flare up again.
For example, while the ECB has indicated it will provide “whatever it takes” to assist countries in need, a formal request for a bail-out from the ECB will come with the requirement for fiscal austerity which is considered politically intolerable and economically self–defeating at this juncture.
Notably there is also an increasing threat that markets will be derailed by a strike by Israel on Iran’s nuclear sites and in retaliation, a counter-attack which would almost certainly include attempts to close off the Strait of Hormuz.
Just how important is this particular Strait? Well, the U.S. Energy Information Administration identifies the Strait of Hormuz as one of the world’s “oil chokepoints”, defining these as “narrow channels along widely used global sea routes, some so narrow that restrictions are placed on the size of the vessel that can navigate through them. They are a critical part of global energy security due to the high volume of oil traded through their narrow strait.”
And in the case of the Strait of Hormuz, it is estimated that almost a fifth of the world’s petroleum passes through the Strait, making it the major oil chokepoint. No one can be absolutely sure of the timing of such a strike. Some believe it will only take place after the U.S. Presidential Election later this year, and others doubting if it will ever take place.
However, developments in the Middle East, where the Daily Telegraph recently reported an armada of international naval power assembling in the Gulf, gives the impression that such a strike may come sooner rather than later.
In recent months, both Saudi Arabia and the United Arab Emirates have also reportedly opened new pipelines bypassing the Strait of Hormuz, in an attempt to ensure world oil supplies are not severely disrupted in the event a conflict arises in the Strait.
These pipelines carry 6.5m barrels a day, or about 40 per cent of the 17m barrels a day that passes through Hormuz. Nonetheless, any military conflict in the Strait of Hormuz will still have an impact on oil prices. Energy analysts, quoted in a NY Times report, say that even a partial blockage of the Strait of Hormuz could raise the world price of oil within days by $50 a barrel or more.
And history teaches us that such spikes are extremely harmful to economic activity as nearly all modern recessions have been preceded by a sharp run up in energy costs – and with the world economy in the state it is, a spike in oil prices may be the catalyst that seals a global relapse into a recession.
Q. Wow, if this is the case, shouldn’t we sell off everything and hide in a cave until the dust settles?
FA: If we had done so for every piece of anticipated bad news – from the threat of Greece leaving the Euro zone to signs that the global economy is decelerating at a much faster pace than expected to this Iranian situation now – we would have been in and out of caves quite frequently.
Given the sharp declines, and in some cases outright crashes, in equity markets over the past few years, one cannot blame investors for being risk averse whenever they come across news that heightens the risks of a pull-back in markets.
In our case, we believe that our call for clients to move back into the markets gradually from July via a DCA strategy is designed exactly for this type of situation.
Thus, Financial Alliance investors should just continue to stay the course. Markets are now generally near the top end of their multiyear ranges. If this Iranian situation escalates, we believe markets could retreat to the lower end of these mentioned ranges.
This in itself may represent a 10-15% decline. For example, the Straits Times Index might fall from the present 3050 to around 2600.
However, any such decline does not negate our view that equity markets remain range bound but with the breakout eventually being to the upside. In other words, we continue to see markets range bound within these multi-year ranges even after taking into account an escalation in the Iranian situation.
And we are happy to say that our DCA strategy has been adopted for this very reason - to smoothen out the volatility in the market.
Q. But what if the world falls back into recession? Even in Singapore, the latest manufacturing data lean to the downside and analysts are now forecasting the possibility of a technical recession.
FA: We have long argued (and explained in previous reports based on our Tri-Cycle Model) that the markets - the credit, equity and economy - all move in different time lags.
At this juncture, we have already seen evidence that the credit market has likely bottomed (For example, inflows into bond funds hit their highest one-month level for more than 10 years recently).
We are now awaiting the bottom in equities, while that of the economy will come much later.
What this means is that we do not believe equity markets are poised to head significantly lower, or crash for that matter, due to the possibility that we are going in a recession. To the contrary, history has proved that buying equities in a recession has proven to be an investor’s best trade.
For example, anyone who had bought equities in 2009, 2003 and 1998, would vouch strongly to this fact. Even in the Great Depression of the 1930s, the U.S. stock market actually bottomed out in 1932 . That was the very year it contracted by an astonishing 13%, the largest decline in GDP during that crisis.
If an investor had waited until the economy had started to grow again and sentiment had turned positive again, he would only have entered the market in 1934, when the economy grew at almost 11%. However, by then, the market would have been 100% higher from where it was 2 years earlier.
Q. The Federal Reserve had announced a third round of Quantitative Easing. Wouldn’t this help markets?
FA: We believe it will. Liquidity, after all, makes the world go around. The Fed’s announcement is also unique in that it involves an unlimited purchase of mortgage-backed securities and promises to keep it going until the labour market improves.
These two aspects are radically different from previous QEs and the latter virtually “leaves the liquidity tap open indefinitely”. This historical shift in policy also means that the Fed will be virtually pumping in liquidity even after the recovery picks up speed, as the labour market typically lags that of the economy – something which can only lead to higher inflation and higher asset prices, in our view.
According to a report we read, combined with its purchases of long-dated Treasuries under “Operation Twist”, this will see the Fed buying a total of $85bn in assets a month for the rest of the year, which is similar to the QE2 programme in 2010 (although less than the $100bn in QE1). Note too that the Bank of Japan has embarked in another round to buy Y10tn ($128bn) of government bonds, thus expanding its asset-purchasing programme to Y80tn.
The European Central Bank has earlier said it would buy as many bonds as needed from euro zone states. The QE itself is not free from problems. Ironically, the Federal Reserve Bank of Philadelphia President Charles Plosser recently said that the new bond buying announced by the Fed this month probably will not boost growth or hiring, and in fact, it may jeopardize the central bank’s credibility.
Separately, the U.S. has come under strong criticism from Brazil, which accuses it of re-igniting another round of “currency wars” causing liquidity to flow out of the U.S. into Emerging Markets, leading to an unwanted strengthening of their currencies and raising asset prices.
Q. So it’s the status quo in terms of FA’s strategy?
FA: Yes. Most of what we have expected is unfolding. For example, we are seeing a radically slower global growth environment and equity markets which continue to be range bound (albeit on the up-leg now but are reaching the top of those ranges).
For those who have followed some of our arguments, we have also previously said that liquidity will be driven into Emerging Markets because pension funds in the west, especially the U.S. and Europe, have and will continue to deploy funds in a more aggressive manner as they need to recoup losses made over the past few years, given the mountain of pension payments that will materialise in the coming years.
There is really no place other than Emerging Markets where these funds can recover their losses. To this effect, two pension plans in San Jose, California, are poised to make their initial foray into investing in hedge funds by deploying $730 million to improve returns.
The City of San Jose’s Police and Fire Department Retirement Plan and the Federated City Employees’ Retirement System seek to invest in 15 to 20 hedge funds in the next six to 12 months.
At this point, much of the liquidity coming into Emerging Markets targets unlisted private equity where the returns are many times higher (albeit with higher risks). This results in an influx of liquidity in Emerging Markets. Eventually we will see a spillover into the listed companies arena.
With the fresh influx of liquidity into the global system, and especially with the tap left opened in the U.S. and Europe, it will only be a matter of time before risky assets become recipients of such flows. However, we hesitate to be aggressive and bring forth our planned installments as the recent rally in equities may face some headwinds as mentioned in earlier paragraphs.
In this respect we are comfortable to keep to our strategy of DCA until April next year (or longer for those who did not start the DCA program exactly in July this year). This round of coordinated (and unlimited) liquidity injection helps to strengthen our view that markets will be higher in 2014 and one should at present start to accumulate equities while the majority in the market remain skeptical amid a worsening economic scenario and stay sidelined.
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