Assessing August Angst (September)

Sterling’s
September 2007
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WorldReport
Assessing August Angst
For some reason, tumultuous events seem to happen in August: Russian revolutions,
European exchange rate crises, Middle East wars, etc. This time around, it is turmoil
in global debt and equity markets related to the U.S. mortgage crisis.
Depending on whom you talk to, the turmoil represents
either the start of a major financial crisis, or another great
buying opportunity.
Cost of Corporate Debt Rises Sharply –
But Remains Moderate by Historical Standards
KDP High Yield Bond Index (% Yield)
14
Our bias at the time of writing in mid-August is to believe
that the current volatility represents a correction in an
ongoing bull market. Our reasons are quite simple:
(1) equity valuations remain attractive and (2) the odds of a
global recession seem quite low. Major bear markets tend to
come about when equity valuations reflect euphoria and
when central banks tighten monetary policy so aggressively
that major recessions ensue.
That said, we acknowledge that the negative dynamics in
the financial system are currently severe enough that this
correction could well cut deeper and last longer than the
other (mainly negligible) corrections we have experienced
since the current bull market started in early 2003. We do
not believe that most investors, ourselves included, will be
smart enough to pick the bottom of the correction with any
great accuracy. So we are not responding to current
volatility by making any major asset allocation calls.
Instead, we are focusing on stock picking to take advantage
of excess volatility in the share prices of companies covered
by our research team.
Here is our perspective on a number of questions we think are
on many investors’ minds:
Q. Will tightening liquidity conditions lead to a
synchronized global slowdown and prolonged
slump in equity markets?
A. That’s a reasonable question since credit market pressures
have now spread widely beyond the sub-prime mortgage
12
10
8
6
4
2
0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
(Aug.)
Source: Bloomberg and KDP Investment Advisors
Chart 1: The yield on so-called “junk bonds” has risen from 7.2%
earlier this year to as high as 8.8% recently. That represents a
significant rise in borrowing costs for many companies.
area that had been the focus of concern earlier this year.
Virtually all sectors of the corporate debt market have
been pressured in an across-the-board “flight to quality.”
For example, so-called “junk bond” yields have risen from
about 7.2% earlier this year to as high as 8.8% recently
(See Chart 1). That has occurred despite steady Federal
Reserve policy and no major change in U.S. government
bond yields since the beginning of the year. Similar
changes can be seen in corporate debt markets elsewhere
in the world. Effectively, global monetary conditions have
tightened significantly even though the Fed has remained
on the sidelines for many months.
The good news is that corporate balance sheets remain
quite healthy. For example, the ratio of total assets to total
liabilities for non-financial U.S. corporations is at the
• SEPTEMBER 2007 •
soften in coming quarters. Therefore, to the extent that
“markets make their own economic forecasts,” risks to the
global business cycle have indeed increased and one can
expect many forecasters to begin marking down their
estimates for global growth.
U.S. Corporate Balance Sheets are Robust
1.2
1.1
Corporate assets /
liabilities are at record highs!
1.0
0.9
0.8
0.7
0.6
1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
Total Assets / Total Liabilities of Non Financial Corporations
Source: ISI and Federal Reserve Board
Chart 2: One reason corporate debt costs have been abnormally
low is that corporations have not needed to borrow much thanks
to very strong internal cash flow.
highest level in 40 years (See Chart 2). Thanks to strong
internally generated cash flow, corporations have not
needed to borrow much to fund current operations. That
is one reason that corporate bond yields were abnormally
low. And it suggests that the recent rise in corporate
borrowing costs is not likely to have a major economic
impact – at least on Main Street.
The impact on Wall Street is a different matter. Corporate
debt issuance was a significant force behind the surge in
leveraged buyouts that helped push up share prices.
However, we doubt that the normalization of credit costs
will totally derail corporate mergers and acquisitions.
There remains ample fuel for further M&A activity since
cash on the balance sheet of U.S. companies has grown at
a faster pace than share prices in recent years (See Chart
3). That is a marked contrast to the late 1990s.
That said, economic momentum in most economies
outside of the U.S. remains quite robust and risks of a
global synchronized slowdown still appear, in our
judgment, to be quite low. Accordingly, in coming months
foreign central banks like the Bank of Japan, Bank of
China, and European Central Bank will probably remain
biased toward tighter monetary policy, regardless of their
willingness to provide short-term liquidity injections to
address current market jitters. Broad money growth in
Europe and China remains well into the double-digits,
which makes their central bankers quite nervous.
Real global economic growth has been running at close
to a 5% annual pace for several years. A boom of that
magnitude means that worldwide demand for goods and
services may now be outstripping growth in productive
capacity. It’s a recipe for accelerating inflation that
central bankers clearly wish to avoid. If anything, it
means that they will privately welcome some moderate
slowing in business activity – and so much the better if
much of the slowdown happens in the U.S. rather than
on their home turf.
With the U.S. housing market at the centre of the current
credit storm, surely the near-term risk to the U.S. business
cycle is greater than in almost any other major economic
region. However, given the fact that the U.S. real growth
rate on a year-on-year basis has already slowed to what
many economists consider a “stall speed” of 2%, the Fed
is certainly closer to entering an easing mode than any
other major central bank in the world at this point.
Q. But haven’t the risks to the global expansion increased?
A. Rising credit spreads are – along with yield curves –
among the best forward-looking business cycle indicators.
When spreads widen, indicating investor nervousness
about possible credit defaults, business conditions often
• SEPTEMBER 2007 •
To be sure, the Fed’s rhetoric has been designed to
discourage expectations of an early move toward easier
policy. But it is worth remembering that the Fed has a dual
mandate of trying to maintain price stability and full
employment. That means that U.S. monetary authorities
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WorldReport
will eventually respond with lower interest rates if they
believe that financial turmoil risks creating a serious
recession. Since real short-term interest rates are currently
around 3%, the Fed has plenty of ammunition to support
the economy if the outlook should deteriorate sharply.
Futures markets are now discounting nearly 50 basis
points of rate cuts by the end of the year and we suspect
that the Fed may end up cutting rates by 100 to 150 basis
points over the next two to three quarters to support the
economy.
Q. Given the reasonably benign economic outlook, why
might the current correction cut deeper and run longer
than previous corrections?
A. Despite our belief that the Fed will eventually move to
support the economy, there is reason to suspect that
Chairman Ben Bernanke’s reaction to market turmoil
may be less prompt and more restrained than was the case
in the Alan Greenspan years. Consider the type of
criticisms the Fed has received recently from a respected
monetary policy expert like William Buiter, a professor at
the London School of Economics. Professor Buiter, who
has served as an external member of Monetary Policy
Committee of the Bank of England, recently made the
following trenchant observations on his own Internet site
(www.maverecon.blogspot.com):
“…by not cutting the Federal Funds rate, the Fed would
avoid the over-liquification of the economy that it
engineered and failed to reverse following the stock
market crash of 1987, the Asian crisis of 1997 and the
Russian crisis of 1998 and the stock market collapse of late
2001. The Fed has, with the help of the Bank of Japan and
to a lesser extent of the ECB, created the chronically lax
credit conditions that have resulted in the asset booms and
financial market excesses of the past couple of decades.
Under my proposal, there would be no ‘Bernanke put’ to
follow the ‘Greenspan put’. It’s always good not to solve
the immediate crisis by laying the foundations for the next
one. The Fed has done this too often in the past. It’s time
to get serious.”
If they are at all sympathetic to such logic, Mr. Bernanke
and his colleagues may well decide to delay “coming to
the rescue” of financial markets until they are absolutely
convinced that Main Street – not Wall Street – will be
facing serious and protracted economic weakness. How
much additional market turbulence that will require is
currently anyone’s guess.
Some longtime Fed watchers, like Tom Gallagher at ISI,
have pointed out that one of the Fed’s favoured measures of
financial strain has barely budged so far. That happens to be
the yield spread between actively traded U.S. Treasury
bonds and so-called “off-the-run” Treasuries that have slightly different maturities than the major trading vehicles.
The last time there were major liquidity strains by that
measure was during the Russian debt/Long-Term Capital
Management crises in 1998, which eventually did prompt
the Fed to ease. This time around, that measure does not
yet indicate that the financial markets are facing strains as
severe as those of 1998. So it may well take more hedge
fund and banking woes before the tipping point in Fed
policy is reached – which could conceivably come about
quite quickly.
Corporate Liquidity Remains Ample
18%
16
14
12
10
8
6
4
2
1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
Total Liquid Assets / Stock Market Cap
Source: ISI and Federal Reserve Board
Chart 3: U.S. companies’ cash balances have risen more rapidly
than share prices in recent years, suggesting that there is still
ample liquidity to support share buybacks.
• SEPTEMBER 2007 •
Sterling’s
WorldReport
One final point to keep in mind about the market
environment is that equity valuations around the world
remain quite attractive relative to government bonds. On
current prices, world stocks trade at 13.8 times estimated
earnings for the next 12 months, with Japan and Asia exJapan at the high end at 16.7 and 15.5, respectively, and
continental Europe and the U.K. at the low end at
12.1 and 12.6, respectively. The U.S. trades at a reasonable
14.5 times forward earnings. With 10-year government
bond yields around the world averaging below 4.5%,
stocks appear close to 40% undervalued relative to
government bonds.
Cumulative Return Chart: US$ 10,000
01/2007 to 07/2007
12500.00
12000.00
MSCI USA - Net Return
MSCI EMF (Emerging Markets ) - Net Return
MSCI EAFE - Net Return
+23.8%
11500.00
11000.00
+9.1%
10500.00
+3.6%
10000.00
Q. How are your portfolios currently positioned?
Source: MSCI
Chart 4: Global equity markets have moved together during the recent
downturn but emerging markets have outperformed developed markets
for the year-to-date, highlighting the value of diversification.
Q. Given business cycle differences, will non-U.S. markets
be able to decouple from the U.S.?
A. In the short run, global equity markets have become
highly correlated, so there are few places to hide during a
correction. However, in the longer term, markets do tend
to reflect differing economic fundamentals and the logic
of diversification should be upheld. Consider that since
mid-July, most international markets have corrected more
or less in tandem. But since the beginning of the year, the
U.S. market is up only 3.6%, while the MSCI EAFE and
MSCI Emerging Markets indexes are up 9.1% and 23.8%,
respectively (in U.S. dollar terms). Therefore, a significant
amount of decoupling has occurred (See Chart 4).
A. In CI International Balanced Fund, we continue to favour
equities relative to fixed income and maintain targets of
60% equities/40% fixed income. Our global equity
portfolios continue to be broadly diversified across both
regions and sectors, with about 46% of our exposure in
North America, 27% in Europe, 13% in Japan, 6% each
in the emerging markets and in the developed markets of
Asia-Pacific excluding Japan. In terms of sectors, our
largest weights are in information technology and
financials, at about 18% each, followed by consumer
discretionary, industrials and health care with weights in
the 12% to 14% range.
William Sterling
Chief Investment Officer
Trilogy Global Advisors, LLC
A more interesting question to consider is whether U.S.
stocks may be in a position to catch up to foreign stocks
once the Fed begins to ease, especially if foreign central
banks remain biased toward tighter policy. We have
modestly raised our weighting toward the U.S. in recent
weeks and will be alert for opportunities to take advantage
of excess volatility in some of the sectors that have suffered
most in recent months, like financials.
• SEPTEMBER 2007 •
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