On Target Newsletter
2019.03.23

In this issue: 

  • Shares outlook 
  • Europe’s problems
  • Buying property
  • Buybacks
  • Zweig’s checklist
  • China
  • Waste recycling
  • EU and US

Forecasting Markets for Now… and Beyond

Jeremy Grantham, the highly-respected American investment commentator, has been sticking his neck out again with an unconventional forecast.

He says Wall Street’s longest bull market is over — but its transition into a bear market won’t be made brutally apparent by a massive drop. Instead the market is going to drift down, fluctuating between peaks and troughs: “Three steps down, two steps back… Not a typical experience.”

Back at the end of 2017 Grantham correctly predicted (as I reported at the time) that the bull market still under way was entering its final phase. It would probably end “within the next six months to two years,” he said. Nine months later it did, in September last.

Of course, we can’t say for sure that the bull died when the market peaked, as Graham thinks. It could be no more than the start of a major correction. The market plunged nearly a fifth by Christmas Eve, then bounced back strongly this year. But so far it hasn’t regained its September high.

The fall over the final months of last year was clearly due to investors’ prevalent gloom about the prospects for 2019 — sharply lower corporate profits compared to those of a tax-cut-inflated year; the Fed’s commitment to tough balance-sheet “normalization”; the escalating trade war; the expected slowdown in China; the unexpected weakness in Europe; worldwide automotive industry problems.

The market rebound this year can be attributed to the surprise switch in the Fed’s posturing, suggesting there won’t be any interest-rate increases this year; growing confidence that Trump and Xi will reach a deal on US-China relations; and increasing evidence that, even without a deal, Beijing will continue doing enough with successive moderate stimuli to keep China’s economy growing more than 6 per cent this year.

Investors’ pessimism has abated “because of improving short-term impulses from Chinese stimulus, lower global bond yields and sharply lower energy prices,” says BCA Research’s Dhaval Joshi. He reckons this tailwind will continue blowing for a few months longer, extending the outperformance of emerging markets, along with classical cyclical sectors such as financials, basic resources and industrials.

Data showing that Germany narrowly avoided a recession in the final half of last year, the recent sharp drop in government bond yields, and accommodative

signals from central banks, “are, for now, helping to give the impression that the seeds have been planted for a second half recovery,” says the FT’s Michael Mackenzie. However, analysts aren’t flagging a profits bounce. “The recovery trade in global equities needs a weaker dollar, and Chinese stimulus big enough, to actually shift the needle for US corporate profits.”

Grantham may be right, that America’s in the early stages of a bear market. But I don’t think either the charts or the fundamentals offer enough confirming evidence.

More likely, I think, that troubled politics (Brexit, populism in Europe, anti-Trump developments), and perhaps some deflated hopes over international trade and/or economic growth, may bring weak markets for a few months. To be followed by recovered strength towards the end of the year.

Longer-term? Grantham says that at his fund management group GMO, well known for its long-range-predictions, the view is that over the next 20 years or so US equities won’t deliver average annual returns in real terms better than 2 to 3 per cent, compared to the 6 per cent achieved over the past century.

“If you stay away from the US – which I absolutely would – in emerging markets I think investors can do better than 6 per cent”… even 8 per cent in a portfolio tilted towards value stocks.

Grantham is especially bullish on China, whose shares have been growing strongly this year. “They have the people, and the faster growth, and increasingly they direct their efforts in a very intelligent way.”

China is boosting the proportion of university students studying engineering and hard sciences. It’s already “massively outproducing the US in the number of engineers and scientists. As that goes on, it makes it difficult for them not to take the lead in one area and another in science.”

Europe Struggles to Contain Mounting Problems

The European Central Bank wants to soften its extreme easy-money policy of ultra-low interest rates and bond buying, but finds it very difficult to do so because of the risk of damaging the region’s struggling economy. This month the bank slashed its forecasts — in December it expected economic growth of 1.7 per cent this year; now it’s predicting just 1.1 per cent.

This worsening outlook forces the ECB to continue with easy-money policies. Interest-rates guidance indicates that there won’t be any hike this year; its deposit facility will remain at a negative 0.4 per cent; maturing bonds will continue to be reinvested.

A third round of “targeted longer-term refinancing operations” has been announced, but on slightly less favourable terms than before. The TLTRO system offers cheap loans to banks linked to their lending policies. Major beneficiaries are the dodgy Italian banks.

The Eurozone is impacted by “terrible domestic demographics,” (ageing populations), says investment commentator Eoin Treacy, plus “a high debt load, high unemployment and an export sector that is highly leveraged to the outlook for the global economy.”

In addition, there’s the “significant threat to one of the continent’s stalwart industries” – the automotive sector – from the huge costs of transition away from diesel fuel and into electric transmission.

Also, the fiscal austerity imposed in response to the sovereign debt crisis has spurred the emergence and growth of revolutionary political movements all over Europe.

Consequently, it’s “difficult to imagine how the euro can rally” from its current weak levels.

A fundamental problem of the Eurozone for which there seems to be no sign of a solution is that of the so-called Target-2 balances, the huge build-up of liabilities as investors in Europe’s South, mistrustful of their countries’ banks and governments, shift their capital to financial institutions in Northern countries.

Italy’s liabilities within the euro system have now reached almost €500 billion.        

Commerzbank says there are two opposing view about Target-2 liabilities:

►Appeasers say there’s no fundamental problem. It’s up to governments to reduce investors’ mistrust of Southern states and their banks. To that end they should complete European banking union with a common deposit guarantee scheme.

►Critics oppose such a joint liabilities system. Other ways must be found to make “Club Med” economies and banks more stable, discouraging customers from keeping high deposits in the North of the monetary union.

At present banks are able to get virtually unlimited credit from the European Central Bank, even at zero interest interest costs. “It is of secondary importance for them when investors withdraw credit from them and transfer it to the North.” There aren’t enough incentives to induce them to reduce their bad loans “or the much too high holdings of government bonds. And thus make themselves attractive to investors.”

The Eurozone bureaucracy continues to favour ignoring the build-up of Target-2 liabilities and push for greater cohesion… more union, more power for Brussels over national banks.

 

How to Buy Property for Less

Securing big discounts on property purchases is not just for the super-rich looking for a bargain in a troubled market, Hugo Cox writes in the FT. Here’s how those looking for a home can talk down the asking price…

Be prepared. If you are able to show you can deliver the cash quickly, there is more chance of your offer being accepted. The biggest mistake buyers make is waiting until they have found their dream home to organize their finances.

Before you start your search you should have taken appropriate legal and tax advice, established how you will buy the property, who will provide the mortgage, and how long that will it take.

Research the seller. In a troubled market, like as not the seller will have a problem. Find out what it is. The agent may be reluctant to tell you what it is. So be prepared to grill him or her. Favour closed over open questions. Don’t ask why the sellers are selling. Instead ask whether they’re getting divorced!

The devil is in the detail. Is there any evidence lying around of straitened financial circumstances? Go to the master bedroom and open the cupboards to see if his clothes are still hanging there. Are there two toothbrushes in the bathroom?

Keep your ear to the ground. The best-value properties may never even come to market, with agents often handing them to favoured clients. So do your best to befriend agents, and pester them with contact once you have.

Those agents not showing you a house may be a more useful source of information than those who are. For every house on the market there will be two or more agents who tried to get the business and failed. They could provide an insight. Perhaps their offer to represent the seller was spurned because they priced the house too low (suggesting the current asking price is inflated).

The best source of sale leads is the parents’ network. If you are lucky enough to have a child at a local school, or know someone who does, leverage that. As one British agent says: “There is no better place to gather the information you need that at the school gates.”

What’s missing? The biggest bargains at London’s top end of the market can be found on homes that are in a great location but which are missing something. For example, a Mayfair house without a garden, or a third-floor Kensington apartment without a lift.

Interrogate previous offers. If the agent says a previous offer was rejected, check how firm it was. Was it in cash? Was the finance in place? Did the buyer have another home to sell first?

Know which price information to ignore, too. When an agent starts talking to you about per square foot or metre, you know you have him on the run. Such metrics are likely to be months out-of-date. Besides, how do you price the view from the kitchen window, or the fact that the house is close to your in-laws?

As one agent puts it: “There are no absolute values: everyone is selling for a reason.”

 

Stock Purchases Come Under Attack

Buybacks are likely to be targeted by American politicians – and not just those on the Left.

The vast scale of these in recent years – roughly $4½ trillion worth for the US’s 500 biggest listed companies – has enraged those who see them as in-your-face proof that most of the benefits of economic growth go to the wealthiest of the elite, leaving little for the rest of us.

One of the important arguments for buybacks is that they distribute profits in a way that is tax-efficient for shareholders. They reduce the quantity of a company’s stock at issue, which improves earnings per share, which raises market value, which shareholders can realize by selling some shares… which is usually taxed at a lower rate than if the equivalent benefit were distributed as dividend.

However, that isn’t true.

Researcher Ed Yardeni says that over the past ten years, despite the enormous quantity of buybacks, the total number of shares, allowing for some adjustments, actually fell by only 2 per cent, compared to the 29 per cent that would be expected.

“The best explanation for this surprising development is that the S&P 500 companies are mostly buying back their shares to offset the dilution of their shares resulting from compensation paid in the form of stocks that vest over time (not just for top executives, but also for many other employees).”

Since 2005 American companies have been forced to take into account as expenses, the costs of share option grants, even though they aren’t a cash outlay.

Stephen Gandel of Bloomberg says buybacks that are really repurchases of stock issued in the past as a result of options are really just a way of squaring the accounting. Without them, “shareholders would effectively be paying for stock compensation twice – once when they are expenses, and a second time from the dilution of additional shares. Executives get the options either way. And indeed the growth of buybacks in the past decade-and-a-half correlates pretty closely with the 2005 accounting change for options.”

The well-known Leftist senators Chuck Schumer and Bernie Sanders have started to attack buybacks on the grounds that they and the other important way of distributing profits to shareholders – dividends — are excessive. Companies should be investing more to strengthen their businesses or boost the productivity of their workers.

They plan to impose limits on buybacks with a bill that will prohibit firms from doing them unless they first provide a minimum wage of $15 an hour and a basic package of employee benefits… details to come.

 

A Checklist for Investors

Here’s what well-known commentator Jason Zweig advises…

Before buying a stock, do:

► Diversify, spreading your money across a wide range of domestic and international equities, and some in bonds.

► Be sure you can afford to lose 100 per cent of your money if you are wrong about the particular stock.

► Appraise your ability to understand the business the company is in.

► Ask who this company’s main competitors are, and whether they are becoming weaker or stronger.

► Think about whether the company’s customers would take their business elsewhere if it raised its prices.

► Look back at the company’s annual report from its most profitable year and read the chairman’s letter to shareholders. Did the CEO brag about the company’s brilliant decisions and its infinite potential for growth, or did he warn not to count on such ideal conditions in the future?

► Imagine that the stock market closed down for five years. If you had no way of selling this stock to someone else, would you still be willing to own it?

► Go to your supplier of company financial information and download at least three years’ worth of accounts. Read them from back to front. Pay special attention to the footnotes, which is where companies usually bury their secrets.

► Look at the people who run the company. Are options awarded as the stock goes up, or must managers exceed sensible performance targets? Look for “transactions with affiliated parties” which can warn you of unfair perks and conflicts of interest.

► Remember that the stock must go up more than 14 per cent just for US investors to break even after 2 per cent commissions and capital gain taxes. On short-term trades, they need more than 50 per cent.

► Write down three reasons – having nothing to do with the stock price – why you want to be the owner of this business.

► Remember that you cannot buy a stock unless someone else is selling. What do you know that this other person may have overlooked?

Don’t:

► Buy a stock just because its price has been going up.

► Rationalize your investment with any reason that begins with the words “Everybody knows that…” or “It’s obvious that.”

► Invest on a “tip” from a friend, a recommendation on TV, “technical analysis,” or rumours about mergers or takeovers.

► Put more than 10 per cent of your money in one company (including the one you work for).

 

China Moves to a Better Class of Capitalism

China’s economic growth over the last few decades since opening up “has been supported by protectionism” and “outright support for domestic industry,” Eoin Treacy writes in FullerTreacyMoney.

“That manifested itself in free land for factories, generous open-ended credit availability through the banks, zero to low taxation, lax or no regulation, ignoring environmental standards and creation of markets for the products produced. That resulted in rampant credit growth and, with clear government support, there were very low credit standards, provided it served the national interest of industrialization and full employment.”

That has started to change. Regulators in Beijing now recognize that allowing credit to be based on risk rather than government policy considerations could make investment more efficient. The central bank says a certain amount of defaults can be healthy. The big three global credit rating agencies have been allowed to open wholly-owned units in China – S&P has hired at least 30 analysts for the office it’s opening in Beijing.

Eoin says the decision to start allowing defaults “was not taken lightly – but was necessary in the aftermath of the record stimulus unleashed in response to the global credit crisis. “To avoid a bursting bubble, the Chinese administration embarked on substantial credit market reform.”

The introduction of Western credit agencies, allowing it to be admitted that some loans are bad and should default, and introducing foreign investors to the corporate bond market, are all parts of “the broad strategy to de-risk the credit markets.”

One sign that international fund managers are increasingly recognizing the attractions of this changing environment is that foreign ownership of Chinese government bonds increased from 4 per cent of the total at issue in mid-2017 to 8 per cent at the end of January. Last year China was the world’s best-performing major government bond market.

Beijing is increasingly using fiscal policy such as the recent $300 billion in tax cuts to stimulate economic growth, rather than easy-money, as it discovered after its credit-boosting measures in response to the global financial crisis how those encouraged bad lending practices.

Another aspect of how China is changing is that employers are facing increasing labour problems as the work force is ageing and wages are rising. Workers are less keen to do boring jobs, and less keen to take employment in coastal cities far from their family homes in rural areas. “We increased salaries about 20 per cent this year, but it’s still hard to find a qualified worker,” says the general manager of a Dongguan-based electronic equipment firm.

 

Another Fallacy from the Politically Correct

‘The next time some Birkenstock-wearing, tree-hugging do-gooder tells you to recycle that yoghurt cup, sit down and patiently tell them that they are wrong – the way to a better planet is to consume more plastic and frack more wells,” argues Energy & Capital’s Christian DeHaemer.

It isn’t cost-effective to recycle plastic, most of which is dumped in landfill.

The biggest growth in greenhouse gas emissions is in emerging economies such as India and China. The best way to reduce emissions would be to turn such economies into developed ones. ‘The more you consume, the more wealthy and educated they will become,” passing from “low-level industrial production to higher-level, cleaner, service industries.”

Ten years ago, environmentalists in America were screaming about the evils of fracking. “There were movies with flames coming out of kitchen sinks and big stories on earthquakes and fracking poisoning the water table.” Today fracking produces so much low-cost, clean-burning natural gas, replacing coal in power stations, that greenhouse gas emissions in the US have actually been declining.

Another example of the unintended consequences of energy reform comes from Germany, where the shortfall produced by scrapping “clean” nuclear power had to be filled by using more coal. In 2016 seven of the ten worst-polluting facilities in Europe were German plants consuming brown coal.

Much more power does come from renewables, but at enormous cost – a tax on energy of more than $20 billion a year and subsidies of $800 billion. Electricity is among the most expensive in Europe – DeHaemer says Germans pay 33 cents a kilowatt/hour whereas he pays less than eight in Maryland – yet emissions haven’t fallen by much.

 

Europe and the US: an Alliance Falling Apart

Donald Trump is angry with Europe and threatening to get nasty, for example imposing high tariffs on imports of German luxury cars.

There are at least seven reasons, Mike Shedlock reports…

► Trump wants a trade deal that includes agriculture. The European Union ruled that out.

► The US president wants Germany to increase military spending. According to Eurointelligence, its current plans provide for what will effectively be a cut in such spending.

► The White House wants Germany to scrap Nord Stream 2, a planned gas pipeline between Russia and the EU under the Baltic Sea. The EU has sided with Germany on this issue.

► Trump wants the EU to buy liquefied natural gas from the US, but the EU will instead buy from Russia as it’s cheaper. (This is part of the Nord Stream 2 issue).

► He wants the EU to abide by his sanctions on Iran. Instead, the EU has created a mechanism by which European companies can trade with Iran in euros rather than dollars as a means to get around US sanctions. The mechanism is little used, if at all, but the idea infuriates Trump.

► EU tariffs on US cars are higher than US tariffs on EU cars. (However, US tariffs on EU SUVs and trucks are way higher than EU tariffs on such vehicles. That doesn’t seem to matter).

► Trump does not want Germany to use 5G telecom technology from China’s Huawei. Germany says it will do so. It’s almost forced to, as Germany’s existing 4G technology is made by Huawei. There is compatibility between 4G and 5G if both come from the same manufacturer.

“One of the reasons Trump is anxious to close a deal with China is so he can blast the EU with a massive dose of tariffs.” He doesn’t want two trade wars simultaneously. 

 

A Classical Approach to Investing Disappoints

Over the past decade value strategies have been useless, Ben Hunt says in his Epsilon Theory newsletter.

He compares the performance of high-quality companies versus low-quality ones over the past decade. “Quality” is based on quantifiable factors such as return on equity, return on invested capital and accounting accruals, as defined by Deutsche Bank for the 1,000 global large-cap companies selected for its Quality Index.

If equal amounts were invested long in the top fifth of the measured firms – that is the top quality ones – with those in the bottom fifth (the poorest) being shorted, then over the past decade your investment in the stocks selected for best quality would have given you a return of not quite 8 per cent. Not per year, but for the decade. Over that time your investment made simply in US stocks as a whole, as measured by the S&P 500 index, would have almost tripled.

“For the past ten years, quality has been absolutely useless as an investment strategy,” Hunt concludes.

 

Central Bankers Abandon Fear of Ballooning Debt

Fiscal deficits are becoming increasingly scary in America under Trump, particularly as an economy that is buoyant doesn’t need extra stimulus from public spending. The Congressional Budget Office expects the fiscal deficit to grow from $779 billion or 3.8 per cent of GDP in the last financial year to $1.13 trillion (4.7 per cent) in 2022.

As foreigners are unlikely to keep funding the deficits by buying Treasury bonds on the scale they have in the past, Americans will increasingly have to do so out of their own savings. Or resort to “printing.”

The Federal Reserve has greater capacity to handle the problem than other major central banks as its balance sheet is only equivalent to 19 per cent of GDP (annual economic output). That compares to 29 per cent for the Bank of England, 41 per cent for the European Central Bank and 102 per cent for the Bank of Japan. (In Tokyo the central bank has now bought up almost half government bonds issued. That’s really “printing” on a massive scale).

 

Investing in Asia: Looking Good

There could be ”very attractive returns for limited downside risk” in Asian stockmarkets this year, says Kenneth Ng of the small-cap fund management group NTAsset.

Of the four factors that had major influence on markets last year – US interest-rate hikes, high oil prices, the US-China trade war and China deleveraging – the first two have reversed for the time being, while the third remains uncertain but with an outlook becoming more positive. As far as the fourth factor is concerned, the Chinese government have clearly shown that while they could continue tightening, they’re also willing to loosen if the economy starts to look fragile.

Most of these factors are now priced in or are well known. Yet the outlook for NTAsset’s two funds is for earnings-per-share growth of 17 to 18 per cent this year.

 

Falling Values in Australian Property

The slump in Australian housing prices appears to be gathering momentum as Chinese investors are no longer buying. Michael Heath reports for Bloomberg that “shifting money abroad from China is tougher these days as authorities are strictly enforcing rules aimed at curbing capital outflows.”

Local investment is also weaker as would-be buyers find it harder to raise mortgage loans. Banks are more cautious following an official inquiry that exposed widespread misconduct and are facing the prospect of a hostile new government expected to result from an election later this year.

The remaining downside risk is considerable, as prices are coming off bloated valuations. Relative to incomes, they’re among the world’s highest. Australians like to invest heavily in property and they’ve borrowed heavily to do so – the ratio of their private-sector debt to GDP is above 200 per cent.

 

Tailpieces

Demographics: In terms of the average age of its population, Japan is the world’s oldest country. And because of a low birthrate and an anti-immigration culture and policies, it’s also ageing fast. Its population shrank by a million between 2012 and 2017. It’s forecast to contract by a quarter over the next 40 years.

Europe is moving in the same direction. Its working-age population started to shrink in 2009. That’s expected to continue, with immigration increasingly restrained.

Germany: No risk of its starting another war. Government defence spending is so tight that Bundeswehr staff are not allowed to do any repair work on a third of its main weapons systems.

Wise words: 

Nothing sedates rationality like large doses of effortless money

Warren Buffett.

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