Gambling on a Hard Landing
The DJIA has recently broken through an all-time high amidst talk of a soft landing in the economy. Meanwhile, the statistics keep rolling in showing a dramatic slowdown that the bond market might be interpreting as something a little harder. Finally, the U.S. has banned Internet gambling, largely dominated by non-U.S. entities in what can only be further evidence of rising protectionism. The counter-trend of increasing nationalism within the long-term trend of globalization may well help limit the euphoria surrounding this symbolic milestone.
The Dow Jones Industrial Average (DJIA) has recently broken through its all time high. This event is significant from a technical point of view in as much as the resistance from the tech bubble bursting in early 2000 is now gone. We are in blue-sky territory. This event has not been confirmed by NASDAQ or S&P 500, which are still substantially below their respective all time highs set during the bubble era. The lead taken by the DJIA may signal a soft landing for the U.S. economy and positive developments for the laggard indices like NASDAQ. This milestone does not seem to be celebrated by the U.S. bond market, which with the inverted yield curve, is implying a harder landing. In the short term it appears that these signals are incongruent. Normally, I think the bond market is more accurate as it is much larger and tends to be less volatile. Perhaps the inverted yield curve is a temporary phenomenon and will normalize shortly as the FED starts reducing rates. More likely, stock market volatility will increase again as the market begins to worry about an earnings slow down. For now, the stock markets have the upper hand and are supported by declining commodity prices, prospects of declining interest rates (short) and low investment yields (long), while corporate profits still seem strong and supply/demand factors for equities in general are strong. Once again, market participants envisage the Goldilocks scenario.
I have been in the bear camp for 6 months, largely from a macro perspective and concern over some rather large, dark clouds. I saw four major risks to the capital markets in the form of War, Plague, Deflation and Nationalism, which I collectively referred to, as The Four Horsemen of The Capital Markets. For a while it appeared as though all four risks were rising and not fully appreciated by the markets. This concern reached a zenith during the invasion of Lebanon this summer. Since then, a state of calm seems to have permeated the markets. We managed to get through the invasion of Lebanon, a thwarted terrorist attack, a commodity bubble collapse, rising interest rates, fears of stagflation, the largest hedge fund loss in history, sabre rattling from North Korea and a stand-off with Iran over their alleged nuclear ambitions. Was I wrong to be so pessimistic? On the evidence to date it looks more and more likely that a soft landing for the U.S. economy is in store. However, I have not yet capitulated and joined the happy crowd. I’m close though. But I am still concerned about some of those risks.
Has the risk of war really abated or is it just lingering in the background? The Anglo-American alliance seems to have lost their appetite for conflict and the quagmire in Iraq has gone a long way to that end. North Korea and Iran, not to mention China and Russia, have been emboldened by this situation. The growing influence of regional players like China and Iran complicate the geopolitical picture. Defence budgets are rising around the world and a new global arms race, led by China appears to be unfolding. It would be difficult for the market to quantify such risks and the best barometer of late has been oil futures, which seem to encapsulate risk to supply primarily from the Middle-East region. Another proxy for geopolitical risk might be the TED spread which is basically the yield differential between Eurodollar deposits against U.S. T-Bills of the same duration. Both proxies are indicating low geopolitical risk at the moment. However, risk perceptions can change quickly and the longer-term backdrop is worrying.
The risk of a global flu pandemic is not factored into capital market thinking at all. It is also hard to quantify but it could be quite significant. Like war, this risk would likely be priced in all at once, following some catalyst. No one can deny that this risk has risen substantially in recent years. So-called bird flu invades the media every flu season and then disappears with the arrival of summer. However, each season the news gets worse as the H5N1 virus continues to spread and mutate. The virus has successfully jumped the species barrier on several occasions and earlier this year, it had mutated to a form that was transmittable between humans. Experts say it is only a matter of time before another pandemic hits. The question then becomes will we have an effective treatment or preventative measures in place to avoid mass casualties. For the capital markets, the question is academic and when a flu pandemic hits it will negatively impact the markets for the simple reason that human economic activity will be drastically reduced, even if mass casualties can be avoided.
Deflation seems to be a growing risk as the market begins to focus on reduced inflation fears and signs of an economic slowdown reveal themselves. The collapse of the U.S. housing bubble is of monumental proportions and continues to unfold. The massive collapse in commodity prices may also be signalling the evolution of a deflationary trend. There has been a significant reduction in liquidity, particularly in the U.S. and Japan and this contributes to deflationary pressures. A slowing Chinese economy, with excess capacity, is another potential contributor to this. On the positive side, there are some signs of global imbalances being addressed. The European consumer seems to be picking up the slack a little and evidence suggests the U.S. consumer is still holding up reasonably well despite concerns of a negative wealth-effect from a decline in house prices. Once again, it is still too early to tell if these trends will continue. Business investment, a hopeful candidate to take the place of a potential retrenchment of the U.S. consumer, is falling. Also, a key indicator of the health of the U.S. economy recently showed a dramatic drop suggesting a recession may be looming. The services economy in the U.S., which is a significantly larger component of the economy than manufacturing, as measured by The Institute for Supply Management’s (ISM) of non-manufacturing businesses index fell to 52.9 from 57 in August. A reading below 50 indicates a contraction. In addition, the same group’s measure of prices showed the biggest drop since the survey began. All of this, only months after the FED was expressing concerns about core inflation that was creeping up above 2%.
Nationalism and protectionism are long-term trends that move in slow motion, almost imperceptible to the markets, over long periods of time until the markets final notice the risk and react to attention-grabbing headlines. We have been in a slow motion move towards an increased risk of protectionism despite or maybe because of globalization. The invasion of Iraq, collapse of the Doha round of trade talks at the WTO, and recent ban on Internet gambling are all evidence of this counter-trend. If this trend continues to develop then it poses a material risk to the capital markets and it might only take one attention-grabbing headline to create a reaction. In my opinion, this is the biggest of the four major risks facing the capital markets as it has implications for the other risks with the exception of Plague. If globalization was good for capital market activity, the reverse is also true.
In conclusion, I think it is too early to declare a soft-landing victory. The stock market has already opened the bottles of champagne and is celebrating. The bond market is taking a more salubrious approach. The stock market anticipates a mid-90’s FED induced soft-landing but this is not the mid-90’s and soft landings are rarely achieved. Furthermore, there are many more imbalances and risks now than there were in the mid-90’s. The U.S. markets are still important leading indicators and will have an influence on global capital market activity. In the short run, the DJIA has collectively decided that a soft-landing is a likely scenario and this should have positive implications for most markets. I still think one should maintain a holding in defensive stocks like tobacco, health care, telecoms etc. They should still do well if the FED begins to lower rates and there is still some uncertainty over economic growth. The consumer cyclicals look to be good value if the soft-landing scenario holds but could reverse quickly if evidence of a hard landing appear. I would play the consumer cyclicals but I would be very alert to the signs of a hard landing and be prepared to move quickly to close positions. The commodity cyclicals will continue to be very volatile in my opinion and as I have predicted earlier this year. I still like NYMEX gas and after the big sell-off it has recovered 50%. Oil is still trying to find a bottom and should achieve this around the $50 /bl level. Demand erosion, primarily brought on by a slowdown in economic growth will trump supply concerns over geopolitical risks in the short run. However, the supply/demand factors that helped propel energy prices over the past few years will continue and oil will test $100 /bl. during the next cycle.
Based on this top-down approach and taking into consideration our investment universe I would recommend the following strategy:
- Stay over-weight the large cap Pharmaceuticals like Novartis (NVS) and Roche (ROCM). They will benefit from their defensive nature, the growing risks of a pandemic, strong pipelines and demographics.
- Stay over-weight defence stocks like Ultra-Electronics and Cobham, which will continue to benefit from the global arms race and will provide a hedge in the event of a rise in geopolitical tensions.
- Continue to trade around core positions in the solar stocks like SolarWorld (SRWRF.PK) and Conergy (CEYHF.PK). These are leaders in a true growth sector. While energy prices are likely to remain volatile in the short run we are still in a secular bull market, which could last 20 years. Furthermore, global warming issues are unlikely to abate and governments around the world will continue to support alternative energy programs.
- Consumer discretionary stocks are and will continue to benefit in the short run on hopes of a soft-landing. However, it is worth considering the liquid names with good fundamentals. In this space I prefer Puma (PMMAY.PK) and Geox (GXSBF.PK). Puma will be more vulnerable to cyclical factors while Geox is well positioned for growth.
- It may be time to short or sell companies that are prime beneficiaries of globalization. Perhaps the easiest way to do this is through the banking sector. HSBC could be vulnerable to de-globalization trends as it is one of the biggest beneficiaries of globalization. This strategy is of course risky. For this strategy to work it would require a severe global slowdown amidst an extension of the counter-trend of globalization. This strategy is therefore a contrarian strategy.