Protecting wealth in a world of recurring crisis
Happy Wednesday. I know the news is ‘less good’ today than it was when I last wrote you but writing these weeklies always puts me in a more positive frame of mind. Nevertheless, today’s topic is about downside risk. My hope is to frame the economic scenario globally and then to offer some strategies of mitigating what I believe is significant downside investment risk.
I am going to go through the risks one by one, building on some of the themes from last week. I see the eight principal risks in order as:
- Europe: banking and sovereign debt crisis combined with contractionary policy support
- China: housing, land and property bubble collapsing and financial sector weakness
- United States: policy support will be neutral to contractionary
- India: Economic hard landing
- Brazil: Economic hard landing
- Oil: Iranian oil embargo or war with Iran
- Australia: housing bubble collapse
- Canada: housing bubble collapse
I may have forgotten a few, but that’s a lot of ground to cover before i get to protecting against it. So I will stick with those eight. The thought you should have in the back of your head though is that these are the known unknowns, but that there are unknown unknowns which create so-called Knightean Uncertainty and make this a dangerous investing climate.
Here is where the real danger lies. Frankly, the Europeans don’t get it. Their economic policy is extremely deflationary and risks a catastrophic Credit Anstalt bank run that creates a Greater Depression. Now clearly, this is all about ideology – the ideology of being against government deficits and money-printing. As I explained yesterday, you have people like Hans-Werner Sinn saying "Germany will pay no matter how you slice it" but claiming the money printing way out is the worst of all possible worlds. That (largely unfounded) fear of hyperinflation is that which could cause debt deflation and Depression.
Bottom line: almost every single country in the euro zone is already in recession including Germany and France. And it will get worse. Now the real problem is the banks. They are insolvent right across the euro zone: Belgium, France, Germany, Austria, Italy, Spain, Ireland, you name it – all of these banking systems are insolvent. So the game is extend and pretend. However, the uncertainty of whether governments will allow sovereign debtors to default has created a credit crisis with the whole of Europe’s inter-bank lending falling onto the ECB’s balance sheet. This is exactly what we saw in 2008 with the Fed. The record deposits at the ECB, the negative interest rates in Germany and the sky-high sovereign bond yields are all due to this turn of events.
What should Europe do then? Europe should set up a framework for both banks and sovereigns to determine who is insolvent. Insolvent sovereign debtors should be run through a credible resolution regime that writes down principle and interest. This means Greek default and likely one in Portugal. Spain, Italy and Ireland would then require backstops to prevent default. Irish and Spanish banks would default as well and the Spanish banks would need to be resolved like the Irish ones. European bank creditors would then take substantially more credit write-downs and recapitalize or be resolved. That is the only real solution.
The Europeans are not going to do this. They believe that the euphemistic private sector involvement (PSI) is deadly and creates contagion risk when its the inevitability of default and uncertainty of the policy response that has done so. In any event, it is clear to no one what the Europeans will do when yields spike again, when the periphery misses targets or when the Greeks need to default. The crucial factor: Germany and the Netherlands will be in recession with the rest of Europe and will care more about their sovereign rating and domestic economies; so all bets will be off.
Trade: Avoid peripheral sovereign debt, avoid France, Belgium and Austria. Swap euro debt for Norwegian. Avoid banks. Overweight low volatility, low beta, high dividend, stocks and high quality corporate bonds of internationally diversified companies.
My view is that China presents a major source of risk, perhaps greater than the US. Recently I started a poll on whether China can avoid a hard landing for its economy and the response so far doesn’t tilt dramatically either way as it did in the previous poll for the euro zone. I think this means there is greater potential for an unexpected response from China. Obviously, there is upside potential here as well as downside But I am focused on protecting wealth in this post. Most of the people who think a hard landing is coming are well positioned for that event. Those who do not may be exposed.
Moreover, most pundits say policy easing will be aggressive. For example, Win Thin wrote PBOC Easing To Continue In 2012 in the past week. Even the more bearish Michael Pettis thinks easing will continue and even posits the potential for currency depreciation being bandied about by Chinese policy makers. It makes sense since the Chinese trade surplus is shrinking extremely fast and the worry is that it could disappear altogether. Moreover, the technicals for the Shanghai Composite are bearish.
So, even though people like Byron Wien predict a Monster year in China you have to see this situation as fraught with risk. what if easing is not enough — what then? That’s the right question to ask.
Trade: Here, you want to avoid building products, industrial cyclicals and commodity producers as any downside in China will collapse those sectors.
The United States
In the US, the near-term problem is policy support. I don’t know how President Obama has finessed this issue but somehow he has avoided cuts that will hurt the economy and ruin his re-election bid. He has even managed to put through bailouts for the financial sector on the sly. And the US continues to prop up the mortgage sector artificially via Fannie and Freddie.
My thinking had been that Republicans would be able to thwart these efforts by the Obama Administration and that fiscal policy support would ease enough to create a double dip sometime in 2012. This may yet occur because of headwinds from abroad but the dip will not necessarily be as a result of federal spending cuts. Meanwhile, the Fed has turned to a form of interest rate caps to continue policy easing but I expect no more from them than that really.
My analysis says that the US is better shape to withstand exogenous economic shocks than Europe but that the principal transmission mechanism for crisis will be via the financial sector.
Trade: low volatility, low beta, high dividend, stocks and high quality bonds. Avoid banks, non-luxury retail, consumer cyclicals and industrial cyclicals.
India is in a more limited position than China due to its trade deficit, plunging currency and current account deficit. The weaker Rupee will certainly help the current account and easing has begun. Nevertheless, the macro fundamentals in India are weaker than they are in China and i expect growth there to slow more than in China. Pundits like Christopher Wood are paring back their previously bullish stance as a result.
Trade: Neutral to underweight India.
Brazil is also slowing. According to the FT, GDP contracted 0.04% in Q3 2011 as weakness in manufacturing spread to consumers. The FT also points to consumer debt distress in 2011 as a sign to watch going forward into 2012. They talk aloud about a credit bubble popping. Again, the risk is to the downside.
Trade: Sell Brazilian Real.
I think the oil market is a tailwind. The demand-destruction inducing price volatility is behind us in my view. Unless demand picks up, there is little reason to believe that oil prices will rise. Ah, but the fly in the ointment is Iran. Warren Mosler thinks "oil prices could double near term if Iran cuts production faster than the Saudis can replace it". And I don’t believe the Saudis actually have enough spare capacity to deal with an Iranian shortfall. Moreover, any spare capacity they do have is likely to be heavier, more sour crude and that is most bullish for downstream oil outfits heavily exposed to sweet-sour and light/heavy differentials like Valero (VLO), ConocoPhillips (COP) and Tesoro (TSO).
Trade: Overweight downstream, underweight independent upstream.
The housing bubble there is well advanced. Last month, Moody’s downgraded Australian mortgage insurers because of ‘tail’ risk in the Australian housing market. As I said then
"These so-called tail scenarios are very tied to China. A booming Chinese housing, infrastructure and property construction market is great for Australian commodity exports. A bust in those markets is bearish for commodities and therefore bearish for Australia and its over-valued housing market."
If the Chinese government policy response is not as aggressive as pundits think, I would expect Australia to really get hit by this. So it’s the Chinese government that matters most to Australia. And Australia has not had a recession in a very, very long time. That is not normal. When the recession comes, it will have a devastating effect on the demand for credit due to deleveraging.
Trade: Avoid, mortgage insurers, banks and housing. Also underweight commodities sector. Sell Australian dollar.
The tale is much the same here but more muted. Canada also has a housing bubble to contend with. The caveats here are that the bubble is not as inflated, Canada did suffer some contagion in 2008 and it is tied to the US and not China. I believe these three factors make Canada a lesser risk than Australia
Trade: Sell Canadian dollar. Underweight big banks. Low volatility, low beta, high dividend, stocks and high quality bonds. Overweight consumer staples.
I have already integrated the protection strategies I think are best here for each individual scenario. Clearly, all data and information provided on this site is for informational purposes only. Creditwritedowns.com is not a financial advisor. You have to decide how these strategies fit with your own.
But let me make some overarching comments before I hit the send button.
- Avoid risk: John Paulson got killed last year because he took risk. And that has upside as well as downside. Simple math, however, tells you that higher volatility is commensurate with lower returns. For example, say I have one investor who regularly gains and loses 20% versus one who gains and loses 5%. After 10 years, the volatility causes the one investor to lose 19.5% because a 20% loss is equivalent to a 25% gain. You need more to return to zero. the guy who has less volatility actually only loses 1.3% after 10 years because his volatility is less. Obviously you want to make gains. But the first rule in bear markets is to avoid losses and the best way to avoid losses is to reduce risk. That means lower beta, lower risk asset classes, less leverage.
- Increased fixed return: This is a variation of the first theme. Rather than take your investment income in the form of variable capital gains (or losses), why not try to lock in a fixed annuity? That is the orphans and widows strategy and means going overweight higher dividend, higher quality bond plays. Bank certificates of deposits are out since central banks are trashing cash. When I look at the equity world, I see a lot of plays that have higher yields like utilities. You can’t strip all of the equity volatility away as this chart of Con Edison shows. But you can get a larger percentage of anticipated upside in fixed income form. Naturally, this caps your upside as well as lowering your downside. I would caution American investors against going overweight munis though. I know Bill Gross is piling in. I think that trade was a 2011 trade. There are budget problems. So the situation is very pro-cyclical – meaning you have a high degree of operating leverage on municipal and state income statements. Leverage works to magnify cyclical ups and downs.
- Take out black swan protection: We are living in a world of unknown unknowns. Who knows what exogenous shock could tip us into a debt deflation. In normal times, exogenous shocks are handled deftly but now we are in a crisis and the global economy is flying at stall speed. Any medium sized shock could precipitate economic Armageddon. So even if you’re relatively bullish you need protection via something like out of the money puts. It’s a bit like homeowner’s insurance. if you have a theft and lose $500 in merchandise, the deductible in your plan says you are out of pocket. But if you lose $200,000 in a fire, the insurance plan kicks in and makes you mostly whole. That’s what Black swan protection is about. It should be inexpensive, out of the money and only limited in size.
- Paired trades/hedges: One way to get sector exposure is to buy a name you like and sell a name you don’t in the same space, a so-called relative value play. This makes your position more market neutral but also gives you upside potential based on your stock picking ability. And clearly, if you’re right about relative performance, you could actually make gains in a down market based on this strategy.
That’s it for this week. All the best investing.