Review: How My Ten Surprises for 2013 Fared

Today’s commentary

I am going to my annual review a bit earlier this go around, hoping that I can do a new top ten surprises list earlier and more comprehensively next year. In 2012, I started the subscriber newsletter out with Ten Surprises for 2012. The goal was to give Credit Writedowns Pro subscribers a list of things that investors only assigned one in three odds of occurring that I believed had a fifty percent or better chance of occurring. So if I was right, then I should get 5 out of ten predictions correct, while 3 to 4 out of ten should have been expected by investors. Last year, I graded myself at 7-3. Let’s see how I did this year.

2013 was a good year

Before I dive into the grading, I want to make a few general comments though.

First, the three market predictions I assigned myself – Greek sovereign bonds and Japanese equities outperforming and Apple falling – all turned out to be wildly right. In fact, Greece and Japan were the two big monster macro calls in global markets for the past year. So I am very happy that I got those calls right. By contrast, in 2012, in terms of market calls, I said the gold bull would end and that European equities would outperform. Those predictions were OK. Gold did eventually enter a huge bear market – but in 2013, one year too late for me to be right last year. And Europe did outperform… marginally. So I am happy out the big outperformance this year.

My second thought goes to the impossibility of the task. To get these outlier calls right a full year in advance is a tough task. I am trying to make calls that are not mainstream that will actual happen, one year in advance. The very nature of the task tells you that many of these calls are going to be wrong. So, last year’s 7-3 was miraculous. Having eyeballed, this year’s calls I know that I was too pessimistic about both the US and the eurozone at the start of the year. I was saying policy makers would induce recession because of the fiscal cliff in the US and that Ireland and Spain would need an OMT backstop to exit their bailout plans. By March, I had already backtracked on the US prediction. And by June, I had fully backtracked on my downbeat European view. That leads me to my final thought.

My final thing to note is that I am more optimistic at the end of this year than I was at the beginning of the year. Having done a quick scan of the predictions, I can tell that is going to affect my scores negatively. What it says is that 2013 was a better year than the tone of my surprises said it would be. When I did my quick scan of predictions, that’s what stood out for me. And I think from an economic forecasting perspective this is an important point. The global economy is more resilient than we often think it is. Things look bleak sometimes and ask yourself how they could possibly turn around. Miraculously things do turn around – to our collective surprise. That’s how it worked in 2013, and frankly that’s how it always seems to work. The Great Depression is an anomaly. Usually, policy makers step back from the brink and make the right political decisions that give the economy just enough breathing space.

I hope my optimism at the end of 2013 remains when we look back at the end of 2014 at the predictions I will make next month.

Grades

Surprise #1. US markets have a major correction i.e. down 15% from the high. See “Predicting major correction in 2013 as contrary indicators are mostly bearish“

0-1: This was dead wrong. The US equities market has gone from strength to strength on the back of a big expansion in earnings multiples. That’s all fine and good but a strong market has setbacks and this market has not had a correction of 10% or more since December 2011. I don’t see this as healthy. On the contrary, it worries me. Yes, I believe the outlook for 2014 s positive for the economy. Therefore, the market should continue to rise. But it will not be a cheap market. It will be an expensive market, something that makes the market more susceptible to a violent pullback.

Would I make the same call this year that I did last year? After all, negative guidance has been outpacing positive guidance by as much as 10-1 this earnings season. The honest answer is I don’t know. Probably not though because it’s not really a useful market call since you can’t take a position based on it. But the contrarian in me says that peak GDP growth, negative guidance, and a long stretch without a correction means even more market vulnerability than 2013. I am more positively biased now than I was when I made my 2013 predictions though.

Surprise #2. Ireland’s government bonds do not outperform again. Greece outperforms this year. See: “Greece records its first primary budget surplus excluding interest in 2012“

1-1: This was the big outperform in bond markets. Bets on Greek bonds paid off big for fund managers. And even Greek stocks were amazing, the world’s best performers at one point, until Iran overtook it. What does this tell us? I think it says a lot about investing. Let’s remember that Greece is a country still in crisis. It has gone through six years of recession and the economy is still contracting. More than one quarter of the population is unemployed. House prices have fallen nearly 40%. And record deflation has set in. It seems a bit perverse that bonds and stocks would rise against that backdrop. But I think the worst is over, which is why I said Greece would outperform at the beginning of the year. And the reason I made a direct comparison to Ireland is that the upside in Ireland was past. Ireland was the sure thing bet in the periphery. Greece provided the most attractive potential return.

What’s interesting about Greece now though is that the Prime Minister is out saying that Greece will somehow exit its bailout program free and clear like Ireland and Spain.

Greek PM claims this chart allows Greece to exit bailout free and clear in 2014. Seriously https://t.co/E9GsbQ3qHH pic.twitter.com/B9Wb4q8Ral

— Edward Harrison (@edwardnh) December 30, 2013

I find this claim hard to believe. I don’t even think Portugal will necessarily pull this off. The interesting bit, however is that Greece is close enough to running a true primary surplus that makes the country self-financing, meaning that Greece can fund itself without having to issue more debt. That’s a big deal. What it means is that Greece has a lot more leverage in negotiations with the Troika. And so, regarding Samaras’ comments we need to keep this in mind. SYRIZA are a wild card here. If they were to govern – they are leading in polling – with Greece having a primary deficit, they would use their trump card and probably get another debt writedown. This is something to think about in terms of risks and rewards in 2014. The Greek debt rescheduling will be big news I expect.

Surprise #3. Germany avoids recession.  See: “On Germany’s avoiding recession” and “Comments on the German model as German GDP contracts“

2-1: Right now, this seems like an easy call. But when I made it at the beginning of 2013, the German economy had just contracted and the periphery was in a tailspin. It looked like the whole of the eurozone was headed down. But while I thought there would be turbulence, I didn’t believe Germany would fall into outright recession. Now, as we look forward, the worry in Germany seems to be more about overheating housing and stock markets. The German press have had a lot of stories in that vein given the easy money policy by the ECB. So I think the macro story in Germany is upbeat for 2014.

Surprise #4. Ireland goes to OMT. See “Ireland to liquidate Anglo Irish to cut government debt“, “On Ireland’s superior economic performance” and recent articles tagged “Ireland” and “OMT“

2-2. Wrong. I don’t have too much to say about this because I was already bullish on Ireland when the year began. The question was how they were going to exit the Troika bailout program. And I believed that the Irish would need a backstop a la OMT. The fact that Ireland left its program free and clear is testament to how much the Eurozone crisis receded in 2013. There was debate as to whether Ireland should get a backstop and I think some Irish policy makers are still wary of venturing out without a backstop. But ultimately, this is only a positive development. It says that Ireland has left the periphery and rejoined the core.

Surprise #5. Spain goes to OMT. See “On the need for Spain to formally apply for an OMT-style bailout“,  ”What’s happening in Spain?” and recent articles tagged “Spain” and “OMT“

2-3. Surprise #5 leads directly from #4. So it’s no surprise this is wrong too. What does it tell us? As with Ireland it tells us that the European situation has panned out better than expected. But more than that, I think the Spanish departure from the Troika program without a backstop is testament to the effectiveness of the Cyprus bailout and policy turn. In the beginning of the year, Europe looked awful and when Cyprus collapsed the situation got decidedly worse. There was a legitimate fear that the eurozone could break up. I think people have forgotten this already. Cyprus was initially looking like a botched rescue when the deposit grab was concocted. But eventually, the Cyprus deposit grab changed the tide. It was a foregone conclusion for me that Portugal would need an OMT program. Spain was on the borderline. But post-Cyprus, sovereign yields in Europe plummeted and now even Greece is talking about leaving bailout programs without a safety net.

In May I wrote that, “I think the big takeaway here then is that Cyprus worked in the sense that it has indeed brought sovereign – bank decoupling to the European bond markets. What the Italian chart most clearly shows of all the charts above is that post-Cyprus, sovereign bond risk has diminished because the sovereigns are no longer seen as at risk for the contingent liabilities of their banking sectors.” This is the big takeaway from 2013 in Europe. The risk of bank default is now borne by bank creditors and shareholders.

Surprise #6. The US has a recession. See “The US fiscal standoff should mean recession in Q2“

2-4. Not even close. I spilled a lot of ink on this early on after the sequester passed so that I don’t have to repeat my thinking here. The bottom line, however, is that the housing-led recovery has touched off a whole host of positive cyclical agents which have kept recovery going. I question the quality of the recovery, yes. But it is most definitely a recovery. What I believe the US situation highlights is the degree to which avoiding major policy errors means upside potential for the economy. If the full brunt of the fiscal cliff and sequester came down on the US economy, we would have had a recession. But the US did just enough to avoid that outcome. Recently, the US even past its first budget in a divided Congress on time for the first time since 1986.

Te lesson should be that partisan bickering doesn’t work. Will that lesson stick though? I am not sure. There is always the chance that partisanship wins out. But I believe in the US, Republican leadership now sees that it cannot allow partisanship to win out or it will lose votes. I expect more conciliation in 2014 on big fiscal issues.

Surprise #7. Japan outperforms all other developed economies. See “On Germany’s record trade surplus and increasing trade deficits in Japan“

3-4: Yes. This was the second big market call.  Japan’s Nikkei rose 57% in 2013. That’s the best yearly performance since 1972 and far and away the best performance in developed markets. Now, if you look at the scenarios I laid out when Abenomics started, we have seen the upside scenario play out:

“As an investor, what we should be looking for is what happens on the fiscal front. I am not concerned about Japan imploding like Kyle Bass because I realise that to the degree foreigners lose faith in the yen as a safe haven currency due to the consolidation of monetary and fiscal policy, this will not result in higher interest rates but rather currency depreciation. A bullish scenario for Japan would be currency depreciation down to 100 or 110 yen to the US dollar, moderate real GDP growth and inflation above 0%. This would be a scenario that would be bullish for stocks and moderately bearish for long-dated JGBs due to rising inflation and interest rate expectations. The only policy response that could produce this outcome is one of yet more deficit spending. And remember, this is the (medium-term) bullish scenario.”

Isn’t this what we have seen? That’s been bullish and that’s why the Japanese market has outperformed. Here’s the thing though? I am not bullish on Japan anymore. I see the Japanese economy under-performing now. See my thoughts on Japan, Abenomics, the consolidated balance sheet and nationalism. This sums up where I am on Japan now. Abenomics can still succeed. But we are in the heavy lifting period. The easy, stimulus-induced gains are behind us. And nothing I see says Abe is serious about tackling structural issues or about leaving stimulus in place until Japan reaches full employment. Instead I am seeing stories about homeless Japanese men being recruited – illegally – for toxic waste cleanup jobs at Fukushima. At least Abe is pushing for wage increases that can buoy consumer spending as the consumption tax comes online. I think we will get them.

Surprise #8. Yen falls below 100 yen to the dollar. See “How the Japanese can get their exchange rate down” and other recent articles tagged “Japan“

4-4: Yes. This is a clear outgrowth of the last call. When Abenomics started, the Japanese tried to act as if they weren’t actively attempting to push the yen down to avoid the currency manipulator label. But of course they were. This was an integral part of the reflation story.

Let’s look at the big picture though. When Abenomics started I wrote it up this way:

“The best case scenario here is the UK post-World War 2 scenario that I like to use as the model case for countries trying to inflate away systemic debt supercycle problems. See here on UK National debt since 1922. The UK was able to work down its government debt burden through currency depreciation and inflation. The result was not benign; we saw a crumbling infrastructure and the British falling behind countries like Germany and Switzerland and even France and Italy on a per capita GDP level. Only through financialization of the economy has Britain been able to make up some of the lost ground. This is a best case scenario. So there are no good answers here. When debt builds up like this, the result is economic malaise.”

That should tell you that Japan has a long road ahead. If it doesn’t find a way back to full employment, it will be tough sledding.

Surprise #9. Canada’s housing market bubble begins to pop. See “Problems in global housing markets” and “Full text: Moody’s downgrades Canadian banks“

4-5: This was my worst call. I recanted on the US recession prediction early and the eurozone problems as well. So that doesn’t bother me. This does bother me because Canadian banks have outperformed. As John Shmuel put it last week in the National Post, “the S&P/TSX Capped Financials index is up 21.7% year to date after a year of record profits, numerous dividend hikes and a couple of stock splits.” That’s crushing! The overall Canadian market was only up 9.2% over the same time span.

What’s the lesson? It may be something about being early. I have written about this before. But if you had anticipated the Canadian housing falling and taken bets on this by underweighting or even shorting financials, you would have underperformed. Jeremy Grantham talks about being early and how he would rather be early than late. But it is a conundrum because I still believe Canadian housing is overvalued. Every single valuation model you look at says so. But how do you make money or keep from losing money based on this belief? In May I wrote down some thoughts on Canada’s housing market and the big takeaway was that there were no “Big Short”-style trades in Canada. The only way to get exposure to a housing downturn is to underweight housing-related stocks. But again, underweighting the banks meant underperformance in 2013. Being early sucks. But if you make the right calls, you will be rewarded in time. Think Washington Mutual, Wachovia or Countrywide Financial for example.

Surprise #10.  France’s housing market cracks. See “Problems in global housing markets” and “Negative credit accelerator from the fall in France’s housing market” and recent articles tagged “France“

5-5: Right. But this hasn’t been a really interesting call. As of late November, French house prices were down 1.4% year-on-year (link in French). I put this in the links, noting that house price falls are a hidden drag on the economy in France that is not really discussed in the English-language press. France was one of the few markets (with Canada and Australia) that had risen a lot before the crisis which has not had a significant housing downturn. That makes France vulnerable. And of course, France’s economy is going the wrong way now.

As I look forward into 2014 I have to speculate whether the incipient French housing downturn is partly responsible for France’s economic malaise and whether this dynamic will continue. It could be a big surprise if that’s what we see in 2014, France’s housing market busting and France underperforming. It is something to consider.

Surprise #11. Apple earnings contract. See “Why earnings contractions are coming for Apple in 2013“

6-5: Very good call. I haven’t posted as much on tech in the latter half of the year but I did note in October that Apple’s earnings were still contracting. Here’s the thing, though. We have already seen the correction in shares. Apple’s shares bottomed at just below $400 in April and have rebounded strongly. The last I wrote about Apple I said I expected iPhone sales volume to decline by the end of 2014. But that is a long way off and the recent China Mobile announcement should be a positive for sales growth. So I would consider myself neutral on Apple at this price. A month from now, we will know better how Apple fared in the holiday season. That should be helpful, especially on tablets where I expect to see some market share erosion.

Concluding Thoughts

There was no discernible world view represented by my calls for 2013. For example, a recession in the US is definitely at odds with reflation in Japan and bullishness on Greece. That is both positive and negative in terms of correctness because all of these events tend to be interrelated. 2013 was a good year and most all of the good outcomes panned out. Even with Apple, a bearish call, the stock bottomed and has risen almost 40% since then. Europe was good, the US was good, Japan was good, sovereign bonds were good and equities were good. The only bearish call that made sense in that context was an underweight US treasury position. Or the short duration play that Bill Gross is using worked too.

I am left thinking that a discernible world view can help get more of these calls right then. Six right and five wrong was not bad. But, it’s certainly lower than 7-3 from 2012. On the other hand, if I had been downright bearish, I would have been killed. 2013 was not the year to be bearish!

As we head into 2014, I am trying to figure out how much of my optimism is a recency effect and how much is truly based on data that will see us through to the end of the year. Right now my sense is that there are no major hiccups that are apparent which necessitate a bearish bias. I could be wrong but for now I am upbeat about 2014 both in terms of the economy and financial markets.