Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.

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Monday, October 10, 2011

Huddle and muddle

(Apologies for the long gap in posting.  I've been too busy restructuring portfolios to write much.)

Recent massive market instability has reflected substantial uncertainty about policy (and therefore outcomes) in major countries. 

In the United States, the political paralysis in Washington has prevented sensible policy initiatives which would have helped support growth.  Despite President Obama's "Jobs Package", this hasn’t changed, since Congress won't do anything.  At least, though, the Federal Reserve Bank retains the freedom of action to increase monetary stimulus if fiscal policy (taxes and government spending) is tightened too much.

In Europe, the situation is much more serious.  If Europe were a true single entity for fiscal and monetary purposes, then we’d be much more confident of a solution to her pressing problems.  Ostensibly, it is such an entity.  But in fact it is not, because only a very small percentage of EU-wide revenue is raised by the EU itself.  It’s as if, in Australia, the Federal government received handouts from the states instead of the other way round.  And although there is again supposedly a single monetary area because of the single currency, the Euro, in fact the ECB (European Central Bank) is dominated by Germany (its head office is in Frankfurt where the German Bundesbank’s offices are), and its councils are divided against themselves.

In a genuine single currency/single fiscal entity, bank and sovereign debt problems can ultimately be resolved by printing money.  In the US, if necessary, this is what the Fed will do (which is why the gold price is so strong).  In a true European Federation, banks would hold government bonds from all the constituent parts of the Federation without worrying about individual national fiscal imbalances, and if question rose about the countries’ ability to repay these debts, the ECB would, as Central Banks do, simply buy up the government paper, as well as extend unlimited support to the banks it oversees, regardless of their domicile.

But in Europe, both the German politicians and the ECB have dragged their feet at each stage of the crisis.  At each stage, too little was done to resolve the issue.  At one point the ECB even refused to buy Greek debt or accept it as collateral for loans to banks.  Understandable perhaps, but not what a Greek central bank would have done (which is why, of course, Greek inflation was always much higher than the European average before it joined the Euro), and not what was required by the situation.    To draw an analogy, it’s as if the Sydney-based RBA were to refuse to support a bank in Perth or Brisbane.

The political compromises inherent in the creation of the Euro have started to unravel.  The essential role of “lender of last resort” undertaken by any central bank worth its salt, has been performed with reluctance and self-defeating caveats by the ECB.  This raises the risks enormously.

What we don’t know is whether this untenable situation will be resolved cleanly or with a great deal of messy “collateral damage”.  Given the ineptitude and paralysis of both the ECB and the EU itself, the chances are high that they will only act after the fact.  By which time, European markets will be substantially lower, and our market with it.  On the other hand, good policy may still happen, and if it does, we will have seen the low point of world share markets.  This wide range of possible outcomes is reflected in the very large day-to-day volatility in financial markets globally.

What this implies for investment decision-making is that neither “value” nor “growth” can be easily determined right now.  With a wide range of possible outcomes, choosing the one in the middle will most definitely not lead to superior investment performance—the gap is too wide.  Until we know what will happen, we must be watchful and prepared to move quickly, reducing or increasing exposures to shares as required.   There is till the possibility of a substantial rally.  But risks are increasing. 
It’s worth repeating that China and also the other BRIC countries (Russia, India, Brazil) will continue to grow, particularly China, where the authorities are redirecting demand internally, and whose finances are sound.  Consumers have high savings rates, houses are bought with 60% or less loan finance, and internal demand is robust.

As an aside, China has enough gold and foreign exchange reserves ($3 trillion) to buy up the entire Republic of Italy’s outstanding government debt ($2.4 trillion).   Or, to put it another way, China has almost enough money—just in its gold and forex reserves, and without having to borrow any funds—to buy the top 20 US companies (total market cap $3.5 trillion). This includes Exxon Mobil, Wal-Mart, Google, IBM, Apple, Johnson & Johnson, Proctor and Gamble, Merck, Pfizer, Chevron and so on and so on.  This is the sort of financial firepower that the US once was able to marshal.

Very difficult times, as hard and as confusing as any I've encountered in my 40 years managing money.

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