A detailed report on what’s going on in the markets
Analyst: Kristian Camenzuli
The markets have rallied in the last couple of weeks on optimism that the situation in the world will improve. But what’s worrying about all this is that is the 10-year bund is still trading at very low levels and yielding only 1.462%. This is telling you that despite all the money that is being pumped into the world economies, investors are not convinced that it will circulate and generate growth and inflation. This is one of the main reasons why we are seeing a sell-off in the markets at this point in time.
The US economy is growing at a rate of close to 2% per quarter which is below its long term average. However this is not bad number considering the negative economic scenario we are witnessing in Europe. There are two main problems in the US. The high level of debt the country has built over the years and the high unemployment rate of close to 8% due to negative equity caused by the burst of the property bubble. Do you know that 20% of first time buyers in the US have negative equity and in total are losing more than $700bln on their property! This negative equity is not letting people move around and find new jobs keeping the unemployment rate at a high level. Bernanke had said that in order for this unemployment rate to come down, the Fed has to intervene.
The Fed did surprise the markets towards the end of September when it announced QE3. This time QE3 will be different from QE1 and QE2 because the Fed will be buying mortgage backed securities rather than treasuries. The Fed also added that it will continue purchasing up to $40bln worth of MBS each month until the unemployment rate starts coming down! This means that if the unemployment rate had to come down to 6% in a year’s time, the Fed would have injected $500bln into the US economy! That’s a lot of money for a country which has debt problems!
Regarding the debt problem, the US had a similar problem in the late 1930s and it took around a decade for the US to get the debt/GDP ratio down from over 300% to 150%. So all this talk of the fiscal cliff in the US will not solve itself overnight. It is a burden which the new President will have to tackle and it will take time before the US gets its books in order. The debt problem in the US is serious though they’ve been there before and its useless pointing the finger at the US when the situation in Europe is much worse.
I always liked US companies because they are cash rich and have strong balance sheets. However, valuations are not as interesting in the US as they were in 2008. In 2008, US equities were trading at a discount of 40% to their long term Price-Earnings-Ratio. Today, US equities are trading at a discount of just 9%. If an investor plays his cards right, he could squeeze this 9% by taking advantage of the rally after the Fed announced QE3 and get out at fair value. In hindsight, equities fall in value once central banks stop pumping money into the economy.
Though there are a lot of positives for the US when compared to the rest of the world and this is why it is only trading at a 9% discount to its longer term average. What’s interesting about the US is that although the US economy is growing at just 2%, the forecasted earnings of US corporates are expected to increase. It’s not that US companies are not great companies. On the contrary they are the strongest companies you could be holding. The only reason for the recommendation to start looking at Europe and Emerging markets is the potential alpha which these other economies could contribute to the return on a portfolio.
Draghi also came up with a plan to inject money into the economy and buy sovereign paper with the hope of keeping yields of European countries down. Draghi told the market that the ECB will buy unlimited amounts of Italian and Sovereign paper. Just focusing on that statement one would think that this is a positive for the market. But there is more to it than that. The first thing is that the ECB will only be buying 2 and 3 year paper, not long dated paper. Also, in order for the ECB to start buying these bonds, Spain and Italy must go and register with the ESM. Basically they will file a report saying they know they were in breach and will rectify their position with the help of the ECB. But the problem is that the ESM has not yet been set up! To add to this, the Troika will visit both Spain and Italy every 3 months to see if they are keeping in line with what they told the ESM they will do and the Troika will give the go ahead to the ECB to buy the bonds. So it’s not as clear cut and plain sailing as it is with QE in the US.
To add to all the complications, the Germans want that the ESM is set up after the banking union is up and running. The problem is that the French and Germans are not agreeing on how the banking union should be set up and the longer it takes the more uncertainty there will be in Europe and the greater the volatility in the markets. When and if the ECB will be buying Italian and Spanish bonds is still a question mark!
The problem with Europe is that it is more concerned with inflation than it is on growth. And if the ECB injects money into the economy, it takes the money back out by issuing the same amount in bonds. So in reality, no new money is being circulated in the economy. What Draghi is trying to do is inject more money into the banks in order to start lending out money to businesses. European banks are still on high alert and will not issue loans to companies if they are worried about not receiving the money back. The ECB is aiming at increasing credit growth which will in turn increase economic growth.
JP Morgan doesn’t believe that Greece will exit the Eurozone (Despite Citi placing a probability of a 90% change Greece will exit the Eurozone in a year’s time). JP Morgan are also cautiously optimistic on Europe. The ECB is doing all it can to keep rates on Italian and Spain debt at low levels. This hopefully will allow the countries to refinance their redemption with lower coupon debt and investors would not worry that these countries will default on their payments. Another positive for Europe is that although forecasted earnings are at all time lows, they are not expected to continue falling in the foreseeable future.
Whereas US stocks are trading at a 9% discount, German stocks are trading at a 30% discount to their fair value and Italian debt are trading at a 40% discount to fair value.
However, the problems in Europe are far from being solved and it could take years before we start to see the European economies start to generate growth. The problem in Europe started when the Germans exported to peripheral Europe who bought the goods but couldn’t pay them back. The gap between the surplus of the Germans and the deficits of peripheral Europe is decreasing, however, this means that Germany is exporting less to Europe.
Another problem is the yield on the bund. Although we are seeing a rally in the markets, and although the yield on the bund has come up, it is still very low compared to its long term average. And this is telling you that investors are not confident that the situation in Europe is improving. If the situation was much better we would expect the yield on the 10-year bund to be much higher than it is at the moment.
The UK had a problem with inflation before the recession started. Now it has a much bigger problem. The UK was admired for the way it pumped money into the economy. However, this has worsened the inflation problem in the UK and once the economy starts to recover, the UK government would have a big problem trying to withdraw all that liquidity.
It shouldn’t come as a surprise if we see the Euro continue to strengthen against the Dollar. The only reason why it is strengthening against the USD is because the Fed came up with QE3. And although Draghi came also came up with a form of easing, he is withdrawing that money out of the economy by issuing bonds for the equivalent value. Selling out of the USD at this point in time would not be a bad move in these markets.
The Euro is weakening if you compare it to other currencies such as the Swiss Franc.
Investors are worried about China because of the slowdown in growth. However, the situation in China is better than it seems. The way the Chinese calculate the increase/decrease in exports and imports in not the same way the developed markets calculate it. If it had to be calculated on an equivalent basis, the figures would be roughly flat not lower quarter-on-quarter. And the most important fact about China is that the government has all the tools at his disposition to stimulate the economy in any way it likes.
JP Morgan are optimistic about emerging markets because they offer much higher upside than the US corporates and on the other hand do not have the uncertainties which European companies have. JP Morgan are also confident that emerging markets will not witness another crisis like they have in the past.
The problems which caused a crisis in the past are as follows:
- Currencies which are pegged rather than float against other currencies;
- Highly indebted.
Most emerging markets have a currency which floats freely against other currencies and the level of debt of these countries is no longer one of major concern.
Gold is not a wise investment to be holding at this point in time for two main reasons. The first is that JP Morgan are not expecting a break-up of the Eurozone and the second reason is that investors buy gold as an inflation hedge. Just because the ECB is pumping money into the economy, it is withdrawing it by issuing bonds and hence inflation is not a problem in Europe and should not be a reason why one should be exposed to gold. Warren Buffett is also bearing on gold.
Very interesting valuation in Japan but unfortunately investors cannot make money from these markets as stocks keep trading on low valuations. A lot of investors blame the strength of the Yen for the inefficiency of the Japanese markets. But this is not a correct assessment. The Yen is not overvalued because the strength in the Yen is offset with the deflationary environment in Japan meaning that the Yen is fairly priced. It is more the inefficiency of the Japanese government in adopting the correct policies that results in an inefficient Japanese market.
Emerging markets is the next best alternative to US corporates. US companies are trading close to fair value and it is time that portfolios start shifting to other economies to generate alpha. Emerging markets offer a good risk-reward ratio and exposure to these economies could be obtain via an ETF. Please contact your advisor in order discuss which ETF fits best in your portfolio. Getting exposure to strong European companies would be a wise thing to do considering they offer a much larger discount than their American peers. Always make sure that there is visibility into the future accounts of the companies before buying a stock.
Ask your advisor or call our offices to get our equity recommendation list.