Wednesday, 11 March 2015

Chronic Dissonance: Boom or Bust?

From Wikipedia, the free encyclopedia:
In psychology, cognitive dissonance is the mental stress or discomfort experienced by an individual who holds two or more contradictory beliefs, ideas, or values at the same time, or is confronted by new information that conflicts with existing beliefs, ideas, or values. 
Leon Festinger's theory of cognitive dissonance focuses on how humans strive for internal consistency. When inconsistency (dissonance) is experienced, individuals tend to become psychologically uncomfortable and they are motivated to attempt to reduce this dissonance, as well as actively avoiding situations and information which are likely to increase it.
I admit to experiencing chronic dissonance these days. My views on global markets are influenced by two contradictory beliefs. I am trying not to actively avoid information which is likely to increase the dissonance and my discomfort. The dissonance makes investment decisions difficult because one set of beliefs tells me to add to my risky investments in equities and high yield credit, while the other tells me to reduce risk.

I read a lot of macro research and strategy produced by some of the brightest people in the investment industry. I like to follow analysts who are challenging and engaging. I enjoy differing points of view, which are always out there and also what makes a market.

What has struck me recently, however, is how divergent the views of some of my favourite analysts have become. The divergence in their views and investment recommendations, I believe, stems from their differing analytical frameworks.

Two Frameworks 

One framework emphasizes high frequency data watching combined with momentum investing (or, for short, the HFMI approach). This approach closely follows developments in macroeconomic data to track the business cycle, inflation trends and central bank policy guidance to assess the likely direction of interest rates, exchange rates, equity prices, commodity prices and credit spreads.

Leading practitioners of this framework are presently focused on the recent strength of the US economy (especially the US labor market), the increasing likelihood of Fed tightening this summer, and the stimulative economic effects of both the oil price decline and easing by non-US central banks. Strategists who employ this framework tend to be quite bullish, favouring the "growth trade", characterized by overweight positions in equities, select commodities and credit and underweight positions in government bonds, especially long duration bonds.

Another framework emphasizes balance sheet analysis combined with capital preservation (or the BSCP approach). This approach follows less-watched data on capital flows, national and sectoral balance sheets, debt levels, credit spreads and market liquidity. It interprets high-frequency economic data against the backdrop of balance sheets and valuation levels. 

Strategists who employ this framework tend to be much more cautious about the economic and investment outlook. They tend to emphasize the continued rise in global debt ratios, the overbuilt or bubble conditions that exist in some key economies and sectors, and the persistence of deflationary pressures. They worry about the impact of rapid decline in crude oil prices and the rapid rise in the value of the US dollar and their potential impact on financial stability.

When I worked for a large institutional pension fund, I had the privilege of meeting Ray Dalio and several other fine analysts and
strategists at Bridgewater Associates. Dalio has posted a 30-minute video on YouTube on "How the Economic Machine Works" that every investor should take the time to watch. Within the first minute of the presentation, Dalio outlines the three main drivers of the the economy:

  • Productivity growth;
  • the short-term debt cycle (or the business cycle); and
  • the long term debt cycle.
The interaction of these three drivers determines the path of economic growth and inflation. Productivity growth, the key element of longer-term economic prosperity, does not draw much attention from investors who tend to focus on shorter-term factors that influence the ups and downs of the economy. 

The short-term debt cycle, or the business cycle, is the focus of practitioners of the first framework that I mentioned above, the HFMI approach. The long-term debt cycle is the focus of practitioners of the second framework, the BSCP approach.

The advantage of the HFMI approach is that, most of the time, short-term business cycles determine the ups and downs of the economy and markets. The main disadvantage of the HFMI approach is that it tends to miss (and be surprised by) turning points in long-term debt cycles, as occurred in 2008-09 when the US housing bubble burst, triggering rapid deleveraging, a disastrous tightening of liquidity and a meltdown of a wide range of asset prices.

The advantage of the BSCP approach is that it actively tracks the long-term debt cycle and, if astute, can prepare for the large downturns in economic activity and drawdowns in investment returns that occur when bubbles burst. The main disadvantage of the BSCP approach is that the triggers for the bursting of bubbles are quite unpredictable. It can be true that a dangerous bubble has developed, but without a trigger the bubble can persist for a long time. The over-cautious BSCP investor can miss out on much of the benefit of persistent market rallies in bubble periods.

The current situation

A pickup in US growth in 2H14, a dramatic halving in the price of crude oil as supply grew faster than demand, and renewed monetary easing by the BoJ and the ECB have made practitioners of the HFMI approach more optimistic about global growth. Some HFMI strategists have gone all in for the growth trade.

But, here is the current concern from the BSCP approach. In the period since the Great Financial Crisis (GFC), government policies have aimed to support growth and fight deflationary tendencies. These policy measures have been taken to extraordinary lengths. The US and China supplied very large scale fiscal stimulus in the depths of the crisis. Central banks in the large DM economies took their policy interest rates down to close to zero and have held them there for six years. The Fed, the BoE, the BoJ and the ECB have all undertaken quantitative easing, dramatically expanding the size of their balance sheets. In some countries, including the UK, Canada, Australia and Hong Kong, low interest rates and easy credit availability led to large increases in housing prices and household debt ratios.

Since the GFC, China's central bank, the PBoC, has encouraged the fastest credit growth in memory. For a while, this supported high levels of economic growth in China and other emerging market economies. In the process, China became the world's largest economy (according to new measures of purchasing power parity from the IMF). However, it became apparent that a byproduct of the Chinese credit binge was that housing, infrastructure and industrial capacity all became seriously overbuilt. However, the Chinese economy is now slowing more than expected (and probably much more than indicated by official GDP figures). Other large EM economies, some with large trade ties to China such as Brazil, and others for geopolitical reasons, such as Russia and Turkey, have also slowed sharply. Overhanging this situation is China's housing bubble, the magnitude of which is quite comparable to that of the US housing bubble prior to the GFC. 

What is unknown is whether the Chinese authorities will be able to let the air out of the bubble without the crash witnessed in the US. The Chinese government began to adopt more restrictive housing policies some time ago. Now, with the the housing sector contracting and the economy slowing sharply, the PBoC has begun to ease, cutting the policy rate and lowering banks' required reserve ratio.

With the PBoC easing and the US Fed expected to begin tightening soon, the Chinese yuan's loose peg to the US dollar has come under pressure. With the USD surging in recent months and the CNY still maintaining a loose peg, the Chinese currency has appreciated dramatically against the Japanese Yen and currencies of other Asian competitors. The PBoC has recently permitted the trading band of the CNY to weaken against the dollar. A devaluation of CNY could become necessary (or unavoidable) if the Chinese economy cools too fast. That would lower the prices of a wide array of consumer goods imported from China by the US and other DM economies, adding to global deflationary pressures.

Countries like Canada and Australia have high stakes in how China's overcapacity problem is managed. Already these two commodity-exporting economies have been hit with sharp deteriorations in their terms of trade, a big negative shock to their gross domestic incomes and corporate profits, which has led their central banks to cut their policy rates. The CAD and AUD have weakened sharply. Housing markets are cooling in resource producing regions of these countries and this is likely to spread over time as commodity prices seem likely to remain depressed for some time.

Could the Fed's expected rate hike be unfortunately timed to coincide with a deepening slowdown in China and a new global deflationary shock? This is the dissonance that I am experiencing. How about you? Is it boom or is it bust? Is it go all in for the growth trade or should we focus on capital preservation after US bond and equity prices have reached all-time highs? As a Canadian investor, I remain in a cautious portfolio, with 45% equities, 25% bonds and 30% cash with a high exposure to US dollar denominated assets. When the dissonance diminishes, I should be able to deploy the cash at more attractive valuations for equities, bonds or both. 


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