PORTFOLIO POINT: A European deal that will provide funding to Italy and Spain, and the roll-out of QE3 in the US, are likely to happen soon. But don’t expect a sustained market rally.
I came away from the ADC Leadership Retreat on Hayman Island on Sunday with two messages that are so important they can’t be left until my usual email on Saturday. Actually, make that three.
- The Europeans will announce a deal to recapitalise Italy and Spain and keep the euro intact, perhaps in September but October at the latest.
- The Federal Reserve Board will announce QE3, possibly at the annual Jackson Hole symposium on August 30, or after the next Fed meeting on September 13.
- Those two things, if they happen, will extend and inflame the rally that’s now two months old, but it doesn’t necessarily mean the structural bear market is over.
Point number one was made by Christopher Selth, chief investment officer of Five Oceans Asset Management, one of Australia’s most successful and thoughtful fund managers specialising in offshore equities.
I interviewed Chris on video, and both the recording and the transcript of the interview are published today on Eureka Report.
His key point is that the dynamic in Europe has changed because the focus has shifted to Italy. That’s because Italy is not “peripheral” – Northern Italy is a key part of the European industrial project, as he puts it, and it can leave the euro.
That fact enormously increases Italy’s bargaining power, because an Italian exchange rate devaluation would increase its competitiveness against Germany.
Before the introduction of the euro, Italy’s industrial production was growing and Germany’s was shrinking because of Italy’s persistent devaluations; that reversed in 1999 when the lira was effectively pegged against the D-mark with the introduction of the euro, and Germany benefitted enormously from what was, in effect, a devaluation of its own currency.
Selth’s point is that Italian Prime Minister, Mario Monti, and the Italian head of the European Central bank, Mario Draghi, have sidelined the German Bundesbank, which is focused on inflation and dealing directly with the Merkel Government.
That’s what led recently to Draghi saying he would do whatever it takes to keep the euro together, which is code for keeping Italy in. That means buying its bonds as well as providing a bailout for Spain plus more monetary easing.
In anticipation of all this, the euro has been rallying and so have Italian and Spanish bonds. On top of that, Italy successfully sold €8 billion worth of 12-month bonds this week at a yield of 2.767%.
Europeans are all on holidays at the moment, so nothing is happening. When they get back next week, negotiations will start in earnest. Selth believes that there will, finally, be a deal that works because there are now two more or less equal sides to the negotiation, and because “the alternative is apocalypse”.
On its own that would be likely to produce a powerful rally, since fund managers are underinvested in European equities on the grounds that the euro is doomed.
QE3 on top of it would be a sort of perfect storm. James Rickards, head of a New York hedge fund called JAC Capital Advisors, told me in an interview on Hayman he believes the Fed will definitely have at least one more round of quantitative easing because “the US is out to trash its currency by at least 30-40%”.
How does he know? Because President Obama has declared that his policy is to double exports in five years. The only way to do that is through devaluation.
A big increase in exports is needed because the other components of GDP – consumption, investment and government spending – are not moving; net exports is the only thing left to try.
What’s more, the Fed is focusing on nominal GDP, not real GDP. Says Rickards: “You can get 5% nominal GDP growth through 1% output growth and 4% inflation, or 4% output growth and 1% inflation. The Fed would obviously prefer the latter, but that’s not going to happen, so it will accept the former and go for inflation.”
Thus QE3 will be implemented, no later than the Federal Open Market Committee (FOMC) meeting in mid-September.
If these two things happen – a deal between Italy and Germany, and QE3 – there will almost certainly be a powerful stockmarket rally, of which there have been several since the bear market began, including around this time in 2010 and 2011 (for similar reasons).
The thing to remember, however, is that in 2012 it would take place in the context of recession or low growth everywhere.
Europe’s GDP, according to data released last night, shrank 0.2% in the June quarter. Whether or not this turns into an official recession, there isn’t much growth in the Eurozone and there won’t be for a long time.
Likewise in the US. Forecasts for 2013 growth are now around 1.5%, and that assumes they don’t drive over the fiscal cliff in January when a series of automatic tax increases are due to start.
Japan’s growth is down 1.4%, according to this week’s data, while trade and industrial production figures out of China suggest its economy is also going to be weaker than expected.
We are in a low-growth, deleveraging world and will be for some time. And even if that state ends, it’s likely to be because all the money printing leads to a sharp rise in inflation.
Although I can see why there would be a rally this year on the back of QE3 and a euro deal, I can’t yet see the end of low global growth, lower commodity prices, weak credit growth and weak consumption.
Those things do not point to a new bull market, in my view.
Below is the edited transcript of the interview with Chris Selth, chief investment officer of Five Oceans Asset Management, at the Australian Davos Connection conference on Hayman Island recorded last week.
Alan Kohler: Joining me now is Chris Selth, who is the chief investment officer of Five Oceans Asset Management, an Australian global fund manager.
Chris Selth: A pleasure.
AK: Now, there have been plenty of different views about Europe at this conference.
AK: Some people are saying that it’s a buy that the euro’s going to go up. Other people are saying it’s stuffed, basically. Are you, in your portfolios, a buyer of Europe yet?
CS: We’ve started increasing our weightings in Europe.
AK: And when you say that, whereabouts in Europe? Are you looking for Pan European stocks, or are you focusing on particular countries?
CS: There are some good European companies that are global, and it’s relatively easy to own those companies without making a play on Europe. The fact that Europe is so depressed means that European companies generally are relatively cheap, and so you can buy cheap global exposure in Europe and not worry as much about what is happening in the domestic European economy.
AK: And do you think that the euro will stay together? I mean, what’s your view politically about the European Union?
CS: Europe is clearly at a turning point right now, but intriguingly it’s not that dissimilar to many other parts of the world including Australia. So Australians will, you know, hear a lot of hysteria, understandable under the circumstances, about what’s happening in Europe. But if you look at the European system, it’s a bit like Australia, a hung parliament. America is a government which can’t get anything through; Japan has a hung parliament; China is going through major leadership changes.
AK: Hung parliaments everywhere really.
CS: Everywhere. And, in Europe you basically have a loose federated kind of system dealing with deep structural problems, so it’s not that dissimilar to basically the rest of the world. And you’ve got government through crisis. So, in every part of the world – Australia is the same – the different constituencies use crisis to drive change. The Germans want to drive labour market reform, a number of reforms in southern Europe, before they accede in some way to a new deal.
AK: But the southern European countries seem to be beginning to accept the need for labour market reform.
CS: Beginning. I mean the critical player in Europe right now is Italy, and the difference between Italy and all the other southern nations is Italy is not peripheral. Northern Italy is part of the core European industrial project. There is no question of that. And anybody who knows anything about how one negotiates, the key rule in negotiation is unless you can walk away you have no power. Italy can walk away. Italy can leave Europe, leave the euro in ways that Spain and Greece could not, because if Italy leaves the euro they get a devalued currency, but they have a big industrial base which will be more competitive against the Germans. The other point is that they have a primary budget surplus, which means that they can fund their own public service, social welfare without calling on borrowings from anyone else.
AK: Well, in fact Italy’s industrial base was competitive against Germany before the euro.
CS: Exactly. So Monti [Italian Prime Minister, Mario Monti], and Draghi [Mario Draghi], who’s the head of the ECB [European Central Bank] are now saying to the Germans, “you know what guys, we can walk away, so now let’s deal”, you know.
AK: And is that why the European, the German politicians are coming onside, and it looks like the Bundesbank is being isolated, in a deal between the ECB and the German politicians?
CS: Exactly. The negotiations have entered into an entirely new phase because the Spaniards, the Greeks, the Portuguese, the Irish did not have power. The Italians can walk away. Monti and Draghi both know that. The Germans know that. If Italy walks away, their currency devalues, their industrial base regains competitiveness, all foreign debts held by Italians in local currency must get devalued, and Italian assets offshore go up in value. So, Italy just has to manage the transition. They win. And Germany knows that Italy wins, and the Italians are saying stop.
AK: See, the reason there has been a kind of a bubble in defensive stocks over the past 12 months is concern about Europe mainly.
AK: And cyclicals, as you have been saying, are on the nose. Does all this lead you to think that that will be reversed in the months ahead?
CS: I’d say that it’s clear that cyclicals are probably oversold, so on long-term historical metrics, most of the economically sensitive stocks, particularly European ones, are trading at historic lows, you know, GFC lows.
AK: Would you include Australian resources in that?
CS: Australian resources is a more complex thing, because it’s also to do with the fact that China is changing gear. The issue is Europe on one side, and if you could listen to the politicians they’ll say it’s all about Europe. It’s not just about Europe for Australia. It’s about the fact that Chinese growth is changing its character right now. So, you’ve got Europe plus China moving to a consumption-driven rather than a fixed investment-driven economy, and so the Australian resource story is affected by Europe, but it’s not just Europe. But globally cyclicals are screamingly cheap in long-term valuation terms. In the next 12 months Europe is contracting, and earnings revisions will be negative. So we have a negative momentum situation with global cyclicals, but they are screamingly cheap for the long term.
AK: And is the contrary true, that the defensives are overbought and expensive?
CS: I would say that they are definitely overbought. They are at higher valuation ranges. They’re not yet expensive. I mean they’re not expensive because bond rates are so low. If bond rates were at normal levels, defensives would be expensive, but because they’re not, they’re not expensive. So, we’ve got two issues here. In the very short term, the cyclicals are oversold, defensives are overbought. Europe, everyone thinks, is doomed. The Italians, now everyone gets there’s a deal. The Germans and the Italians will negotiate a deal. There’s always a risk it will fall apart, but the truth of the matter is people have got the game now that both sides now have something to lose, whereas that wasn’t the case before. Before Monti and Draghi stepped in and said there’s a new negotiation tactic in place, people had no idea what was happening in Europe. Now, there are two sides.
AK: That’s a very important change, isn’t it?
CS: It’s profound. And as a result, that’s why [there’s been] the rally that we’ve had in the last two weeks. So, the oversold cyclical stocks have rallied. But the truth is the next 12 months economically will be tough in Europe and … so once we move from the oversold level people will start saying “what are earnings going to be?” and we’ll move to an ambiguous phase. So, defensives and high yield may still be attractive for a while, but clearly the elastic band went too far. It’s pulled back in. Now, we’re going to say, what’s going to happen post the deal? We haven’t seen the deal yet, but one thing you know is it’s a bit like Margaret Thatcher said years ago, there is no alternative. Europe must deal now. You know the next three months, there will be a change. Most utterances recently have just been over the summer break. They’re all on holidays in Europe. So, that’s why I say two to three months. In September they come back, they’re going to sit down, they’ll negotiate. The markets know there must be a deal, because your alternative is the apocalypse. Now, once we get through the apocalypse, one way or the other, we’ll be through by October is the likely outcome. More of the same is not sustainable. And so, once we’re through, you know, the valuation of the cyclicals is so cheap, they’re bouncing.
AK: That would imply that if they come up with a deal in October or whatever, there’s likely to be a roaring rally.
CS: It’s quite possible. A lot of the technicians globally think the market ... because people are so high on cash, so underinvested in equities and one of the telling signs … Bill Gross, the head of PIMCO, God of bonds, has decreed equities dead, and there’s been a tendency every time he’s decreed equities that’s when the rally starts. PIMCO’s made a lot of money, but you know bonds can’t sit at 1% forever, you know. The difference is, in Japan that happened because Japan had very negative demographics. The United States and Asia, the demographics are not the same. Technology is driving through structural changes regardless of what credit availability is. Corporates’ balance sheets are very strong. And fund managers are underinvested. They’re chasing this market right now. They’re terrified. Fifteen per cent of fund managers are outperforming. Most are underperforming, thinking this shouldn’t happen. They’re buying equity now.
AK: Chris, it’s been great talking to you. Thanks very much.
CS: A pleasure.