“Safe haven” is the term we use to describe the things in our portfolios that help us sleep better at night. The imagery is rich – amidst the violent tempests of unruly seas there are quiet, sheltered harbors that protect us from Poseidon’s ravages. Or so the thinking goes. Here is a cautionary tale about safe havens and not-so-safe havens.
In the summer of 2011 asset markets were aboil with unusually high levels of volatility. The Eurozone was mired in the latest act of its Greek tragedy, and in the US our redoubtable government policymakers were speeding recklessly towards a possible default as they ineptly debated and negotiated what should have been a routine adjustment upwards of the debt ceiling. In this environment two asset classes found particular favor among haven-seeking investors: gold, and the Japanese yen.
The yen reached an all-time high – 76 yen to the dollar – in October of that year (consider that when the yen was first floated after the breakdown of the Bretton Woods agreement in 1971 its value was 360 to the dollar). Gold grazed the $1900 level at the same time – good enough for an all-time nominal high, though short of the real level of $2,470 (in today’s dollars) reached in January 1980. When stocks and non-precious metals commodities plunged, gold and the yen soared. How the mighty have fallen.
For the year 2013 to date the Japanese yen has plunged by 12% against the dollar, largely a function of the radically new easy money policy embarked on by Prime Minister Shinzo Abe and the new guard at the Bank of Japan. The yen is now around 98 to the dollar – it has fallen nearly 30% from that 2011 high point. Meanwhile gold is in freefall. It is down 10% just in the last week and has also given up more than 25% of its value since those “haven” days of 2011.
Herein lies the cautionary tale. A true safe haven is an asset that is hardwired to deliver predictable, stable returns over a decently long period of time. A government or AAA-rated corporate bond can – to the extent that anything can in our new financial order – be deemed a safe haven asset because if you hold it to maturity you will know exactly how much income you will receive, and when you will receive it, in all scenarios except for that of a default. As long as the US government or Procter & Gamble don’t go bankrupt there is no mystery about what these assets will deliver to you as cash flows.
But currencies and precious metals don’t work that way. They are traded in spot markets and futures markets based on the collective views of thousands of currency and commodity traders about the direction of Japanese interest rates, or the rate of new industrial complex developments in China, or the inflation forecast for Brazil. There is no inherent value – no floor below which these assets cannot fall. As the market cycle of the last eighteen months tells us, these fluctuations can be immense. They are not going to help us sleep better at night, and they are very clearly not safe havens. For asset allocation and portfolio selection purposes we should not treat them as such.
Investors as of late have been heartily cheering the rally in US equities that (at least until today’s bad reaction to the latest job numbers) has propelled the Dow Jones Industrial Average and the S&P 500 into all-time record high territory. Now, it often happens that when the animal spirits are let loose to run rampant in the land of blue chip US equities other riskier asset classes – like small caps and emerging markets – do even better. Often, but not always. Given that the S&P 500 has settled above its 200 day moving average for 304 of the last 314 trading days, you might think this would be a terrific environment for a traditionally riskier play like emerging markets. Not this time.
Emerging equities markets seem to be inhabiting some other spacetime realm entirely. The MSCI Emerging Markets index is down by more than 3% for the year to date. That’s right – it’s in absolute negative territory, and on a relative basis that’s more than 13% worse than the performance of the S&P 500 over the same time period. What are we to make of this?
One school of thought leads to still-troubled Europe. Emerging economies have more at stake in selling their goods and services to Europe’s households and businesses. This is less about the Eurozone financial crisis and more about good old fashioned supply and demand. Those GDP growth rates that have been so impressive in recent years among emerging markets are predicated on robust export markets. But demand in Europe – for many EM companies the most important export market – remains soft.
In a broader sense, though, it may be more about winners and losers in the global economy. The “winners” plausibly could be emerging markets households and US businesses. Average household income levels in the emerging world continue to grow briskly, and with that growth naturally comes increased consumer demand. But who supplies that demand? When you look at the financial reports of large US companies you get a glimpse of the answer: a very significant portion of the earnings growth that has been so impressive of late comes from…yes, sales in emerging markets.
So even if economic prospects for the growth engines are still strong, the main beneficiaries may not be the companies that make up their stock indexes. If GE and Cisco Systems and Procter & Gamble are enjoying explosive earnings from their sales in China, India and Brazil, that doesn’t add direct value to the Shanghai Composite or the Bombay Sensex or the Bovespa. It adds direct value to the S&P 500 and the Russell 1000. And for the moment that value gap – in equity market terms – is in the double digits.
And what of the S&P 500? As of this writing the intraday level for the index is down by a bit less than one percent, in the aftermath of a slew of below-expectations job data. Well, the index had gained more than 10% for the year to date, and when that happens some kind of correction is usually to be expected. Whether it turns into anything more than a brief pullback remains to be seen, but at this point the data signals are not flashing emergency red. Patience and discipline are the watchwords.
Cyprus is a tiny country by most measures, with a population of just over 1.1 million. Most Cypriots who have local bank accounts hold well under €100, 000 in those accounts. They are Cyprus’s own 99%.
Russia is a very large country, with a population over 140 million. A tiny – but extremely influential – subset of that population also have bank accounts in Cyprus, most of which are very, very much larger than €100,000. Call them the 1%, who rose to the commanding heights of the statist capitalism that has defined Russia’s economy since the early 2000s. In this system Cyprus is a sort of combined Delaware and Cayman Islands – an address for moneyed Russian businesses to register office addresses and also to deposit large sums of the personal wealth of the individuals who run those businesses.
So if nothing else, this week’s tempest in the Eurozone has given us the rather awkward spectacle of the 1% and the 99% uniting under one banner, venting their wrath against the System. That system being, in this case, the European policymaking troika of the ECB, EU and IMF and their seemingly ham-handed efforts to impose a 9.9% tax on Cypriot bank accounts. These are the modest checking and savings accounts of the 99% and the opaque multimillion dollar holdings of the 1% alike. What have we learned this week – and what should we be worried about going forward?
We’ve learned that Russians tread carefully with a minimum of bluster when faced with the fear of losing lots of their hard earned (or ill-gotten) wealth. It’s hard to overstate the importance of Cyprus’s banking system for just about anyone in Russia with, say, more than $500,000 in personal liquid wealth. After some heated statements earlier in the week Russian Prime Minister Dmitri Medvedev has softpedaled, telling the Cypriot government to figure out their deal with the EU before expecting help from Russia. Putin himself has mostly remained mum. We imagine that a deal will be done – as we write this on Friday afternoon the parties are still locked in talks, with a variety of alternatives percolating up including a structure exempting small accounts, nationalizing the pension system or collateralizing future bond issues. World markets are taking the events in stride – US stocks have resumed their winning ways after a three day retreat earlier in the week. Market reaction is much more muted than in other Euro crises.
The other thing we’ve learned is that people really, really don’t like it when the Man shows up to take a slice out of their own personal (and mostly modest) fortunes. That’s a new tool to come out of the policymaking arsenal, and it looks to be a pretty bad one. What are the 99% thinking about now elsewhere along the Mediterranean coast – in Athens or Naples or Seville? Maybe they’ll come a-tithing for us – 10% here, 10% there – to maintain the sanctity of bank balance sheets and bond ratings. Very little could be more destructive than massive runs on the banking systems of troubled Eurozone economies. However the deal works out in Cyprus, the specter of the bank tax is now firmly and squarely in the policy mix. It’s something that policymakers may yet come to regret.
For several weeks now – really since the torrid pace of the January rally slowed to a more measured gait in February – market observers have spoken of the absence of a catalyst to move things more definitively in one direction or another. This week we got, if not a full-throated catalyst, at least a handful of reasons for investors to back off from recent highs and once again hold the S&P 500 at bay below the 1527 level it had finally surpassed this past Tuesday. The question is whether these past few days are indicative of a near term defensive crouch or whether the market will shortly resume its winning ways.
So what brought about the dour spirits? First of all, the release of the latest Fed minutes on Wednesday revealed a higher than average level of unease among policymakers about the potential ill effects of the QE3 program that has been going on since last fall. This program has been dubbed “QE4ever” by the market wags, and so anything that hints at taking the patient off the IV drip of easy money is bound to create some gloom. To add to the down mood a handful of signals came in showing Europe’s immediate economic prospects looking somewhat grimmer than expected. The latest GDP numbers show the Eurozone as a whole heading towards a 0.3% contraction this year as opposed to the 0.1% growth the European Commission had predicted at the end of 2012.
There’s little doubt that Fed stimulus and stability in Europe are key drivers for continued growth in equity indexes. However this week’s news didn’t seem to pack the kind of punch that could catalyze an extended downturn. After all there was no announcement that the Fed actually plans to curtail QE3 any time soon. The ECB’s “whatever it takes” stance is as much intact today as it was last week. More likely the mini-downturn (and the corresponding spike of nearly 20% in the VIX over Wednesday and Thursday) reflects the kind of tentativeness about which we have spoken in previous posts when indexes flirt with long term resistance levels. The S&P 500 is still well above its 100 and 200 day moving averages and is trading generally higher as the week draws to a close.
One thing to keep an eye on as February draws to a close is whether the latest Kabuki matinee in Washington spills over into market sentiment. The unfortunately named sequestration involving deep spending cuts across vast swaths of the budget appears likely to come into effect shortly. Lawmakers on both sides of the partisan divide appear to be far away from anything remotely resembling a deal. That doesn’t seem to be making much of an impression on the markets, but the fact is that if all the cuts go ahead as planned there will be an economic impact. Presumably investors, having seen this elaborate pantomime play out over and over again, assume that something will take place to prevent – or at least forestall – a worst case outcome. We will see how the sentiment tracks as the hour approaches.
Will there be a party? Probably not – 1527 is not the S&P 500 all time high water mark. But it is a significant milestone for longtime market observers because it was the peak achieved during the technology bubble; to be specific, the closing price of March 24, 2000. Putting that milestone behind us for once and for all would at least merit a glass of Veuve Clicquot, if perhaps not a truckload of cases of that fine eau de Champagne. It is most likely only a matter of time until we reach it, with today’s (2/13) intraday high breaching 1524 before settling back to close just above 1520. But it could be awhile before we wave goodbye forever.
Animal Spirits or Defensive Crouch?
Of course the S&P 500 is only one index, and it doesn’t move in a vacuum. As this broad US equities benchmark has rallied since the beginning of the year how have other asset classes fared? Relative movement patterns between a blue chip index like the S&P 500 and other benchmarks can act as a sort of sentiment gauge. Strong relative gains by asset classes like small caps or emerging markets can act as a market sentiment gauge. When exposures like small caps or emerging markets perform relatively better than the blue chips it can signify an uptick in animal spirits – a willingness to push out the risk frontier. Conversely, when a defensive sector like utilities outperforms it can imply a more cautious, defensive sentiment.
With that in mind what does the data tell us today? Well, something of a mixed bag actually. The Russell 2000, a popular small cap benchmark, has outpaced the S&P 500 by a bit more than 1% since the start of the year, though in the last couple weeks sentiment has been slightly more in favor of the blue chips. On the other hand the MSCI Emerging Markets index has substantially underperformed the S&P 500 over the same period, and is barely in positive territory for the year to date. Developed non-US indexes like the MSCI Euro and MSCI Pacific ex Japan are likewise lagging the S&P 500. Meanwhile the Dow Jones Utility Average, a traditional defensive haven, underperformed the S&P 500 during the torrid January rally but has since been steadily gaining ground in relative terms.
All of which is to say that there is not a compelling case to make for animal spirits run rampant, nor is there solid evidence of an imminent defensive crouch. None of which is unusual when a major market index like the S&P 500 hovers around a macro trend barrier. The high frequency trading platforms that dominate day-to-day volume are programmed to advance and hedge, advance and hedge, not unlike a tactic one might encounter in Carl von Clausewitz’s timeless military strategy classic On War. Directional allocation calls (e.g. on small caps or utilities) are tough to execute when the ground is constantly shifting underfoot. A better approach may be to stay nimble, with one foot further out the risk frontier and one foot closer in, until a yet to be known catalyst moves things more decisively in one direction or the other.