Jittery January

Jittery January

6 Feb 2014

“The bond markets are suggesting that we are looking at a fairly gentle, low inflation recovery.”

The dangerously alluring feeling of comfort that I wrote about in my Q4 report did not last long. Major stock markets have fallen this year: FTSE -4%, Dow Jones -6%, Nikkei -13%. Many financial commentators are saying that this is the result of weakness in emerging markets which are in danger of being starved of investment dollars as the Federal Reserve continues its tapering policy. Even writing that makes me feel slightly ridiculous. It is typical of the confusing non-explanations offered by the financial services industry, helping only to encourage ordinary punters in the belief that all this is far too hard for them to understand.

“Emerging markets” is an inherently biased way of referring to exotic countries in need of investment.  The term seems to have been invented in the 1980s. According to Wikipedia, prior to that the label Less Developed Countries (LDCs) was used.

In 2012, the IMF identified 25 emerging markets.

For the record:

Argentina;  Brazil; Bulgaria; Chile; China; Colombia; Estonia; Hungary; India; Indonesia; Latvia; Lithuania; Malaysia; Mexico; Pakistan; Peru; Philippines; Poland; Romania; Russia; South Africa; Thailand; Turkey; Ukraine; Venezuela

Note, sadly, that that the only African country is RSA. Looking again at the list, if you are particularly attached to democracy, private ownership rights or tolerance of homosexuality, you might find the thought of investing in some of these countries hard to digest.

You might also ask how many countries have succeeded in emerging since the 1980s. The answer to that would appear to be zero. Foreign investment in emerging markets tends to be tidal: it flows in and it flows out again (if it can).

Why then should this concern the risk-averse investor? There are two reasons, one specific and one general. The specific reason is that businesses in which we might be invested could be hit by diving emerging market economies. Global companies that sell consumer products are especially prone to this. Last week, Diageo the drinks company reported weakness in China and Nigeria. The general reason is that nervousness is infectious (especially in the banking industry).

Undoubtedly, we have both these concerns at present. Diageo shares, normally seen as dull but reliable, are -11% this year. And the stock markets tell of general jitters.

It is invariably helpful to check out on what bond markets are doing. Bond markets have a good track record of telling us what informed money is really thinking about.

Bond markets are not panicking. This is reassuring. When bonds and equities sell off energetically at the same time it is usually time to worry. This happened for much of 2008, a year of real panic. In Q4 2008, buyers started to move aggressively into reliable government bonds and this gradually allowed equities to find their lows (in March 2009 in the case of the UK).

In January 2014, first world government bond yields have headed noticeably lower. 10 year US treasury yields have fallen from nearly 3.0% to just above 2.6%. It is a similar story in the UK and Germany. Even in Japan, the most expensive and ostensibly worst value bond market on the planet, 10 year yields have dived from 73 basis points to 60.

All else being equal, equities, competing assets to government bonds in all these countries, have just got cheaper and more attractive. The price of perceived low risk (government bonds) has risen and assets assumed to be higher risk (e.g. equities) are lower. As ever, it is a question of valuing probability.

It is worth thinking more closely about the new popularity of bonds and the willingness of investors to accept lower yields. Sometimes, investors in long-term bonds foretell developments in the economy. In theory, lower yields suggest low inflation and low economic growth. Every time that there is a wave of buying of government bonds, it is helpful to ask whether this is a simple search for counterparty safety or heightened fear of economic slowdown or both.

I remember 2008 very well. Government bonds did badly in the first half of the year. There was no flight to safety. The US sub-prime mortgage market had collapsed in 2007 and Northern Rock had gone bust in the UK. The Fed was cutting rates to aid the real estate market and the government was starting to provide subsidies for home owners. Bear Stearns was rescued in March 2008. At this time, the consensus appears to have been that governments would throw money at the crisis in order to contain it. At the time, it must have seemed rational to expect that governments were going to become less attractive counterparties – consequently, risk-averse money moved away from government bonds.

This turned out to be a dreadful mistake when it became apparent that, relative to everything else, governments were the safest haven around (unless you were a follower of the gold cult).

Around the middle of 2008, government bonds began to rally sharply. In retrospect, it is obvious that this move was the harbinger of a cartoon cliff-top fall for the global economy. I was an analyst following the shares of the German software company SAP at the time. Here is the key text from SAP’s profit warning from 6 October:

“The market developments of the past several weeks have been dramatic and worrying to many businesses. These concerns triggered a very sudden and unexpected drop in business activity at the end of the quarter,” said Henning Kagermann, Co-CEO of SAP. “Throughout the third quarter we felt quite positive about our ability to meet our expectations. Unfortunately, SAP was not immune from the economic and financial crisis that has enveloped the markets in the second half of September, causing us to report numbers below our expectations.”

Lehman had collapsed in September and it quickly became the ubiquitous excuse for every piece of bad economic or corporate news. There is no doubt that Lehman was a short-term shock but it was hardly a complete surprise, given that its demise had been publicly predicted since the collapse of Bear Stearns in March. The economy did not dive because of Lehman Brothers. In July and August, the bond markets had seen enough bad economic news coming to overcome their worries about government finances.

The reason I disinter this living memory is to remind myself to ask whether there is a chance that January’s bond markets could be warning us of an economic slowdown that is certainly not widely predicted. There have certainly been some reports of rather deflationary economic statistics, particularly concerning the Eurozone countries but also the UK and the US where inflation is below the target of 2%. There is even a website devoted to deflation.

As ever, it is a question of judging probability and how it is priced. It is easy to understand that companies generally find it hard to raise prices and are often selling to consumers who routinely expect prices to fall. In turn, they protect their margins by squeezing costs and this frequently involves substituting technology for employees. The bargaining power of employees is poor everywhere (investment bank superstars allegedly excepted) and wage increases that struggle even to match subdued inflation lead in turn to more expectations of lower consumer prices. If you want to make this argument, a deflationary spiral is easy to imagination.

Many of the world’s central banks think that they are countering this by lowering the cost of money to the point where saving becomes unrewarding and consumption deferred struggles to compete with consumption now. In the US the personal savings rate has dropped from 8% during the recent crisis years to 3.9%. Something similar seems to have happened in the UK. What is surely happening in the UK is that the retired generation is working its way through its savings with many reports of parents and grandparents providing deposits for the first property purchases of younger generations. I am watching closely for signs of a wave of property downsizing by those who can see that the alleged value of the family house offers a heavily wedged-up retirement with oodles left over for the grieving beneficiaries of their estate. In the first six weeks of this year, three houses within 300 metres of my own have come onto the market with asking prices of £1.7 million plus. Yikes.

Although the prospect of “ice-age” deflation (as one doomster on deflation.com calls it) is probably remote, the subject gets plenty of airtime. Last month, Christine Lagrade, the head of the IMF said that “with inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.” Today, Mario Draghi, the ECB president said “we have to dispense with this idea of deflation. The question is – is there deflation? The answer is no.” So that’s clear.

Given that deflation is such a major topic, it is reasonable to conclude that the risk is quite widely regarded and consequently, to some extent, already influencing asset prices. The perceived reluctance of companies to invest and their preference to rebuild their balance sheets is surely an indication of widespread underlying caution.

I own government bonds to accommodate, up to a point, the risk that economic growth is going to be disappointing. But I am not inclined to make dramatic decisions. I haven’t even put my house up for sale yet.

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