Excerpted from the Adrian Day Asset Management Second Quarter Portfolio Review
The primary factor influencing global economies (as well as markets) in coming months will continue to be, as in recent months, expectations of, and the reality of, central bank stimulus. In recent months, since the mini-euphoria at the end of February, when global stock markets peaked following months of improving economic news, central banks have failed to impress markets with additional easing.
In fact, since then, following massive expansion of central bank balance sheets around the world last year, central bank assets have actually been shrinking, albeit modestly and, I’ll warrant, only temporarily. Such shrinkage should not be confused with any grand “exit” from stimulus; the decline in bank balance sheets (in China, Japan and Switzerland, as well as the US) represents only minor pullbacks from last year’s excessive expansion.
But the results of this pullback by global central banks can readily be seen, both in economic slowdown and market declines. Now, banks are getting nervous again about the decline in economic activity, and are beginning to ease again. So far the steps are mostly tentative: the Fed’s renewal of “Operation Twist” (which doesn’t actually add to its balance sheet at all); China’s cuts in interest rates; the ECB’s pledge of €100 billion directly to Spanish banks; and Britain’s stepped-up asset-purchase program.
These measures so far lack the punch of the massive QE programs, but the acceleration of such moves around the world is clear indication of the concern felt among central bankers, as well as the direction they will take.
More Money Ahead
Clearly, the banks of Spain and other nations, including Italy, after being encouraged to purchase additional sovereign debt onto their balance sheets, will require additional bailouts; Greece too will be back at the trough within a year. In the US, a string of weak economic reports, across the board, suggest that the economic recovery is faltering. Employment, housing, consumer spending, consumer confidence, and manufacturing: all have turned down.
FedHead Bernanke seems to want to postpone additional major stimulus – he can hardly look at the evidence and feel it was money well spent. But he has also clearly nailed his colors to the mast by stating that the Fed is ready to act again if unemployment does not improve.
With major export markets in Europe and the US soft, China’s manufacturing sector is likely to weaken further, providing the impetus for China to ease further; lower inflation numbers will allow it to do so without fear of sparking an inflationary spike. Similarly, Britain, which has just officially slipped into recession again, also has seen lower inflation numbers.
In short, it is almost inconceivable to imagine any significant and sustained tightening any time soon. On the contrary, it is only a matter of time before an acceleration in the stimulus measures. This may not have any sustained impact on global economies; after all, monetary stimulus is like a drug injection for the addict – ever greater injections are required to achieve the same temporary high.
But offsetting any beneficial effects of stimulus – and, to be clear, I am not suggesting any long-term economic benefits – is a new trend towards raising taxes, in Japan, in France and the US, among others. Raising taxes, particularly from more productive wealth creators (as in France and the US), is clearly detrimental to any economic recovery.
Easier Money Helps Markets
But additional monetary stimulus will support both global equity markets and commodities, particularly gold. Markets have been focused on the prospects for stimulus measures, rallying on expectations ahead of Fed meetings and European summits, only to fall back on the reality of what actually transpired. But given the repeated disappointments, markets are a little less enthusiastic on rumors and, thus, better positioned to rally on real news.
Two major potential negatives, particularly for the US stock markets, however, loom. First, the upcoming corporate earnings seasons may prove more crucial than most. Much of the improvement in earnings in recent quarters has been the result of cost cutting. With that running its natural course at the same time as the insipient recovery (including consumer spending) is faltering, it is difficult to see where significant earnings growth for much of corporate America is going to come from this quarter.
In fact, there have already been several earnings warnings issued, and they from companies across the board, but especially from companies that are particularly sensitive to the economy (such as Federal Express). Warnings have been 3.5 negative to one positive, the weakest since 2001, after the 9/11 attacks.
Moreover, companies are not in as strong a financial position as the financial media portrays. A telling study by perennially bearish (realistic?) Smithers & Co. in London shows that debt levels for US nonfinancial companies are close to all-time highs, relative to assets. As a share of GDP, around 80%, it is also near all-time highs. Cash levels have risen, but debt levels have hardly declined.
Of course, as an economy declines, a static debt level becomes a larger share of GDP. But also, as interest rates rise, then the share of cash flow going to debt service also rises.
The Election Campaign Can Hardly Help
After that, focus will start to turn to the election, as the campaign ratchets into high gear. This cannot be a positive for the markets. At the risk of over simplification, neither Obama’s promised tax increases nor the spending cuts envisioned by the Republicans will get people excited about economic growth in the near term. (Of course, government spending has to be cut and, combined with lower taxes, could have a strong and positive impact on the economy within a relatively short period of time. But discussion of spending cuts while the economy is showing signs of slowing will not instill confidence in the economy nor make investors pour into stocks in the near term.) In particular, the impending Obama hike in capital gains taxes will likely lead – as such increases always do – to investors bringing forward sales of assets with long-term gains.
On balance, then, we cannot be too optimistic about a strong, sustained market rally. The single major factor on the positive side of the ledger – further stimulus – has problems: larger stimulus is required to have any effect; the effects are temporary; and we don’t like relying on government action for an investment thesis. At the same time, the negatives, at least for the US stock market – the economy, corporate earnings and the upcoming election and possible higher taxes – are all real. Moreover, there is an underlying sense of unease about the direction of the country. So on balance, we are cautious about buying, and want to increase liquidity.
There Are Strong Companies Around
Nonetheless, many companies, having survived (and learned from) the post-credit crisis years, are in stronger positions than they have been for years, while valuations remain reasonable. The business development companies, for example, despite recent rallies are selling at yields of 8% to 11% (covered by net income) and selling at up to 20% discounts to NAV. These are compelling valuations in any environment. Similarly, internationally we are finding gems trading at single-digit price-to-earnings multiples, with growing earnings, and yields in the high single digits.
Global markets remain, generally, better value than the US, with lower P/E multiples and higher yields, and the growth prospects for many look better as well.
So we see the possibility of a strong rally sparked by global stimulus, while, particularly in the US, the risk of declining markets exists for later in the year. And while we will use rallies to exit fully valued or risky stocks, we will also be adding to a narrower group of companies on market weakness.
Global Slowdown Hurts Commodities
Commodities have responded to the slowing global economy, as well as a stronger dollar, with the broad index down nearly 4%. But with many of the soft commodities up year to date – some by large amounts (wheat, 25%, soybeans 26% and so on) – energy and metals have fallen. The exceptions: gold, platinum and, after a strong rebound, copper (all showing only rather meager gains.)
Oil has been the biggest loser, falling from over $100 to just over $85, as concerns increased about the global economic recovery, and Iran – until very recently at any rate – retreated from the headlines. At the current price, there is very little geopolitical premium, so the potential for a rally on any increase in tension exists.
The metals have also pulled back on economic concerns, particularly declines in China’s manufacturing. Copper is the exception, interestingly since it is very sensitive to the economy and China in particular. But, as we discussed last time, the supply side of the equation is worrying, while the de-stocking of China’s inventories, which exaggerated price declines in the spring, has come to an end.
So absent a further sharp decline in global economic activity, we remain bullish on oil and copper. In general, commodity prices reflect the economic reality without any risk premium for unexpected supply interruptions. In the case of many industrial metals, prices are near marginal production costs.
Gold Poised to Rally When the Money Spigot Opens
Gold remains in positive territory for the year, albeit marginally, but the stocks continue to fall, on top of last year’s declines. The senior companies are down 13% year to date (pace the XAU), while the juniors are down over 20%.
More than stocks and other assets, gold is a clear beneficiary of monetary easing, and the market has been particularly keen in responding to hints of additional stimuli (and retreating at disappointment in lack thereof). But as we discussed earlier, it seems that large liquidity injections are only a matter of time in Europe, while the banking sector totters; in the US, while economic reports (especially employment numbers) continue to show the recovery stumbling; and in China, where manufacturing is vulnerable to weaker export markets.
There are hurdles. In Europe, Germany (and one or two others) resist massive stimulus measures. In the US, Bernanke has wanted to delay additional stimulus to allow the recovery time. Basically, since early March, monetary policy has been on hold, even as global economic growth weakened, but the direction of the next major move is clear. And gold has demonstrated clearly what its response to any major new stimulus would be.
At the same time, central banks in many parts of the world – recently, as diverse as Russia, Mexico and Uzbekistan – have added to gold holdings, and leant support to gold on the downside. At the current price level, the risk/reward is quite attractive.
Gold Stocks Are Oversold
Gold stocks are trading at long-term valuations lows, even as margins improve and the companies become more attractive. Gold miners are selling at the lowest absolute valuations (p/e, p/cf etc.) of this bull market. The Toronto gold index is selling at lows relative to bullion not seen in 35 years. And the XAU has been selling at lower multiples than the S&P; I can’t recall the last time that was true.
While the high gold premium that used to pertain to gold miners may be a thing of the past – with the gold ETFs, they are no longer the only game in town – the valuation declines are now overdone.
As margins improve, so too the companies are increasingly becoming more fiscally responsible, increasing dividends (now over 2%) and eschewing high-priced acquisitions made for the sake of getting bigger. The sentiment on gold stocks is very depressed and generalist funds are underweight. Though we want to be selective in both the seniors and juniors, we are buying the sector, focusing on those with good balance sheets (low downside) as well as strong long-term potential.
In sum, while further monetary stimulus may spark a rally in global stock markets, it is unlikely to be sustained, given the fragile monetary and economic environment, as well as the real negatives weighing on stocks. We are therefore increasingly looking to raise cash, focusing on fewer but stronger names, and will step up selling on any meaningful rally. Stimulus would boost gold, however, and we are adding to gold positions, though again on a narrower group with defensive characteristics (such as the royalty companies) or strong balance sheets. We are anticipating rallies between now and the end of the year which we will use to our advantage.