Investment Outlook

Alphabetti spaghetti

Originally published in the April 2008 issue

Two centuries ago, the Governor of the Bank of England set monetary policy by the weathervane that stands atop its elegant headquarters. A benign Easterly breeze that allowed more trading ships to sail up the Thames to dock and so excite London business would also push up the demand for funds. Markets, like the calendar, have seasons, and using this simple tool the Bank accommodated both.

We use a similar approach, today, because a successful asset allocation demands an understanding of which season financial markets are in. We define four seasons, or so-called risk regimes – Calm, Rebound, Speculation and Turbulence. Each regime has well-defined risk characteristics, and each is determined by our position in the global liquidity cycle. Briefly put, equity markets generally enjoy Calm. Steepening yield curves and, initially, strong bond markets occur most often in Rebound. Turbulence tends to be best for real assets and cash, whereas Speculation is typically where the budding Warren Buffet, value-style manager out-performs. Although liquidity tends to move in regular 4-5 year cycles, there is also clear evidence of longer-term secular cycles, often lasting decades, but moving through the same four contiguous phases.

Where are we today? If you take a look at the recent huge liquidity injections by Central Banks, we figure that markets are in their Rebound phase. However, measured by their longer-term or secular cycle, we venture that the regime is definitely not Calm, and it most likely is Speculation or Turbulence. This observation is important because few prevailing investment strategies are set up to cope with this possibility. The bottom line is that, looking ahead over the next one to two decades, equities are probably not the best asset to hold, or at least not the main asset to rely on to meet future liabilities. Here’s why.

Go forth and diversify

The current cycle looks, to us, much like earlier liquidity crises: only the names of the failures differ, but the path otherwise is remarkably similar, at least measured in terms of equity, bond and yield curve performance. However, two things are very different. First, investors’ portfolio exposure to emerging markets is something like two standard deviations above ‘normal’, whereas their exposure to developed stockmarkets, and notably to Wall Street, stands two standard deviations below ‘normal’. This is a whopping bet to make on economic decoupling if we genuinely live in a global world that does not always just rely on the American consumer. Second, and more worryingly, world bond markets are barely yielding 1% in real terms.

Our concern here is that the real yield on bond markets derives from the marginal return on capital in the broad economy. For comparison, the real yield in equity markets typically corresponds to the average return on capital. Ultimately marginal and average returns must, by definition, converge, and any gap between the two will more likely be closed by a movement, ie. a fall, in average profitability. In other words, bonds have set out their stall, so equities had better watch out?

But how sure are we this time that world bond markets are right and equity markets wrong? For example, many economic pundits, echoing similarly assertions from bankers, tell us that bond markets are distorted by ‘forced buying’ by savings-rich Asian governments. Hence, low real yields tell us nothing about future profitability and inverted yield curves no longer give a prescient vision of coming recession. Really? Given the continued faultless track record of the yield curve in predicting booms and busts, you will be reassured to know that US$1/2 trillion of surplus Asian savings are merely a drop in the US$90 trillion bond and credit market bucket. Thus, Asian savers do not drive world bond markets; rather Asian producers do. Asia’s problem is not over-savings; it’s over-production! What’s more, this problem is structural because of the region’s pursuit of mercantilist export policy, and it’s getting bigger because if tiny Singapore and Thailand were blips on the world economy’s radar screen, mighty China threatens power-failure.

History shows time-and-again that investors are always too easily seduced by growth and forget profitability. Remember the Japanese stock market and the US technology bubbles? Growth opportunities were plentiful, but profitability proved scarce. The investment and economic consequences of this are significant. At the margin, profitability and, hence, real interest rates will remain structurally low. The attractions of investment in the rich developed economies will diminish, and so capital spending and rates of employment will either permanently shrink or else become overly-dependent on rising consumer spending. And, it’s hard to ensure rising consumer spending without forcing households deeper-and-deeper into debt, as the American economy is now realising. Reinforcing the fear of fewer American, British and European jobs, existing capital must be restructured to pare down costs. If average profit rates are under threat, the only scope is to bolster productivity and/or ship capital abroad into the increasingly narrow range of industries and economies where marginal returns remain high. Where are these havens?

Structurally low real interest rates, by lowering carry-costs, boost the investment attractions of low yielding assets like gold and physical commodities. On top, assuming that China can garner the credit she needs to plough into still more new capacity, her demand for raw materials will continue to spiral higher. Therefore, it seems likely that the decades-long depression in commodity prices must reverse. However, the still bloated real estate sectors are less likely to benefit.

Global fixed income markets may prove the worst possible investment. Apart from real yields at historically low levels, there must be a risk of Western governments trying to bail-out their economies if a Chinese spanner cripples the domestic jobs machine in the way we fear. Structurally rising unemployment and likely growing social tensions between the ‘haves’ and ‘have nots’ will surely encourage reckless policies of faster inflation. Actually, equities and not only bonds will suffer, too. Equities offer some defence because their earnings will be indexed to the higher prices, but as we argued earlier their underlying rates of profitability will be under long-term downward pressure. Emerging markets offer some way out. But again as we noted earlier, they are still largely dependent on continued healthy export markets, which we doubt, and they already discount a lot of future good news.

Getting the right mix

Yet all is not bleak. We know that markets never travel in straight lines, down or up. The future will likely prove more volatile than recently, but as we counsel there is ‘good’ volatility and ‘bad’ volatility. The ideal product mix looking ahead a decade or two ought to comprise investments that (a) maintain capital; (b) embody a global view; (c) exploit genuine market inefficiencies to capture alpha, and, perhaps most importantly, (d) manage beta, or market exposure. This is the vital ingredient missing from most existing asset management strategies. In the 1980s and 1990s managers largely delivered beta; from the Millennium the focus has been on searching out alpha and eliminating beta. But alpha is finite and beta is both abundant and cheap. Our focus in the future must be not on eliminating beta but taming it. It’s fun when markets are rising, but a disaster when they fall. Successful beta management is our aim.

About CrossBorder Capital

CrossBorder Capital is a London-based implementer of asset allocation strategies. Founded in 1996, it is independently-owned and advises both its own-brand funds and external asset managers and private wealth offices. CrossBorder Capital’s stable of funds focus variously on high alpha; management of beta and uncorrelated returns. The firm believes strongly in absolute returns and capital preservation.