Originally published by Narrow Road Capital
February brought more gains for risk assets and safe haven assets. Equities rose in all major jurisdictions including the US (3.7%), Europe (2.8%), China (1.9%), Australia (1.6%) and Japan (0.4%). Credit made gains across high yield, emerging markets and investment grade. Commodities were mixed with iron ore (9.6%), gold (3.1%) and US oil (2.2%) up whilst copper (-0.3%) and US natural gas (-11.8%) fell.
Market Sentiment
Economic data has generally been pretty good, giving markets extra impetus to push risk assets to all-time records and multi-year highs. The Eurozone PMI at 56 indicates that Europe might finally get some economic sunshine. The tone in the US is similarly upbeat with the deregulation and tax cutting agenda of the Trump administration widely seen as good news. Not all indicators are rosy, a handful of US data points have the economy at or near recession.
With US stock indices regularly hitting record highs there’s substantial debate about whether this rally is based on solid foundations. The most basic indicator, the trailing price/earnings ratio for the S&P 500 using the accountants view of earnings is at 24.8, well above 15-17 range which is generally seen as fair value. Taking the most optimist view, the forward price/earnings ratio using analyst forecasts of management’s numbers is at 17.7, slightly above fair value. This basic ratio analysis hides a lot of detail though, as mega caps are inflating the index with 40% of US listed companies loss making.
If you want reasons to say that stocks aren’t overpriced, the earnings yield over treasuries says that there’s more gains to come. There’s also views that a price/earnings ratio of 20 is reasonable in the current environment or that the Dow can hit 30,000 during Trump’s four year term. There’s also the treacherous argument that this time is different, at least for long term price/earnings ratios.
The evidence that investors are becoming euphoric seems much stronger. When celebrities are headline speakers at investment conferences and Warren Buffet is buying airline stocks it’s not looking good. Goldman Sachs (NYSE:GS) sees stocks at peak optimism, the global complacency index is at record highs, investor optimism is at six year highs and the boom-bust barometer is flashing a warning. Bears have been slaughtered with some asking are there any bears left? With realised volatility at 21 year lows investors are giving up betting that volatility will spike in the near term. It’s hard not to respond by saying that we’ve seen this movie before and the ending isn’t pretty.
High yield debt is overpriced as well, SocGen has European high yield as expensive as it has ever been. Asian high yield deals are seeing an average oversubscription of 6.5 times. January was a huge month for US high yield issuance with 60% of that carrying the very junky CCC band ratings. 73% of leveraged loans are trading above par, giving borrowers the opportunity to beat lenders into accepting low margins and weak covenants. It’s fair to ask the question: stocks or high yield, which do you like least?
No discussion of sentiment would be complete without mentioning the impact of quantitative easing (QE) on asset prices. With Japan and Europe printing money and hoovering up assets, there’s been an enormous amount of unnatural demand. Most of the central bank buying has been of low risk assets, but that only serves to cascade demand into neighbouring asset classes. For instance, government bond buyers become corporate bond buyers, which then spills over into high yield, followed by equities and property. If this build-up of central bank balance sheets has driven markets higher, it seems logical to assume that the party stops when QE stops. Can central banks ever unwind this false demand without creating a downward spiral for asset prices?
Two charts help sum up what the impact of higher than average prices mean for future portfolio performance. Firstly, Hussman Funds shows the historical upside and downside over a four-year period using the market capitalisation divided by gross value added. Whilst the measure used is a variation from a straight price/earnings ratio this chart is helpful in illustrating the skew in the potential upside and downside over the medium term.
The chart below from Real Investment Advice does use the price/earnings ratio but looks out over a thirty-year period. This is particularly helpful for people under 60 considering what returns might be over their lifetime and for pension funds planning to a 25-40 year outlook. The “you are currently here box” indicates returns of 2-7% on US equities should be expected, way below what most pension funds and individuals expect.
Banking
Whilst the possibility of a trade war has received plenty of airtime, the possibility of a bank war is barely mentioned but fast becoming a possibility. Following the failure of Basel 4 negotiations, the US and Europe are starting to take sides and make threats. The Europeans are threatening to lock US banks out of Europe if Americans roll bank regulation. It wouldn’t be much of a step for the US to respond by locking out European banks that have lower levels of capital than their US peers. Each would argue that the other’s banks are unnecessarily risky. The evidence clearly points to European banks being in far worse shape.
The Italian Government has approved a €20 billion bailout fund for its banks. Monte Dei Paschi is the first to ask for taxpayer money but there’s a cue forming for others that need help. Italian banks are writing down their “investments” in the Atlas bailout funds. These funds were a mechanism for transferring capital from strong banks to their weaker peers, punishing the more prudently run banks and increasing the odds that the relatively better run banks will also require bailouts. There’s been suggestions that a pan-European bailout fund should be created, but as usual there’s no proposal on who will donate the money needed to recapitalise weak banks.
Deutsche Bank (DE:DBKGn) continues to struggle along, most employees received no bonus with the bonus pool down 80%. Management has said that this will be a one-off, but with no clear plan to meaningfully lift Deutsche’s capital levels more of the same is likely. No surprise it is struggling to retain and motivate staff with another round of staff cuts looming. The prospect of a small profit in 2017 provides some hope but who knows how much more in regulatory penalties are lurking. There’s also the risk that losses on loans could eat away potential profits, particularly on shipping loans where German banks have $100 billion of exposure.
US bank shares have enjoyed an enormous run up since Trump was elected with an agenda that includes bank deregulation. What’s been forgotten in all of this is that the agenda also includes banks raising capital levels. The current proposal includes a “regulatory off-ramp” for banks with high levels of capital. The Minneapolis Fed President thinks 20% capital is the right level, way beyond current levels. Banks might make greater profits if deregulated, but if they have to hold more capital the return on equity could be the same or lower. It seems that the market is assuming the positive and ignoring the negative.
In a development that looks an awful lot like pre-crisis stupidity, banks have been lending to hedge funds to help them juice returns on synthetic CDOs. The synthetic CDOs are supposed to reduce the credit risk of banks by transferring the risk to another party. Hedge funds are willing buyers of the assets, but the unlevered return doesn’t meet their targets. Banks are allowing them to borrow some of the purchase price, effectively negating the risk transfer benefits.
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