Posts published in February 2014
China’s currency, the renminbi (RMB), has a relatively brief history as an asset that rises and falls according to market supply and demand. Up until 2005, the renminbi’s rate was tightly pegged to the U.S. dollar. China’s economic policymakers then began a series of gradual moves to liberalize the currency, albeit with the heavy hand of the People’s Bank of China (PBoC, the country’s central bank) guiding the pace of change. Since then, the renminbi’s trajectory has been a virtual one-way street, appreciating to record highs (both nominal and real) in January 2014. Investors have poured into the market in droves, seeing little risk in the orderly evolution from backwater currency to legitimate contender for reserve status alongside the U.S. dollar and the Euro.
But those bets have been thrown for a loop in the past two weeks. The renminbi has indeed been a one-way street since then – but in the other direction. The magnitude of the drop since mid-February is more than 1.5%.
Please See Yourselves Out…
On the surface, this chart would appear to be little different from other emerging markets currencies that have been hit hard recently, from the Turkish lira to the South African rand and, more recently, the Ukrainian hryvnia. But in China’s case this is not about fickle foreign investors racing for the exit doors; it’s actually about the PBoC itself trying to push those investors out the exit doors. China’s central bank is by far the largest player in the RMB market, and it is the driving force behind the plunge seen in the above chart. Central bankers are not coy about this: since the New Year, the PBoC has stated openly its intention to make the currency “more volatile” – i.e. as likely to fall as it is to rise – in efforts to cool off the pace of capital flows into the country and rid investors of the one-way street illusion.
Not the BOJ Playbook
Why would China want to drive down the value of its currency? Observers familiar with the dynamics of export-centric Asian economies may point to other regional examples, notably the Bank of Japan. Over the course of the last twelve months, Japanese financial policymakers have moved aggressively to weaken the yen, which has fallen more than 12% over that time period. Using a weaker currency to promote trade is a longstanding practice. It would seem to make sense for an economy like China, which derives over 40% of its GDP from international trade, to do likewise. But the People’s Bank of China is not the Bank of Japan. At no time since it became a global economic power has China explicitly sought to devalue the RMB to gain export share. On the contrary, the official policy for most of the time since the partial liberalization in 2005 has been to guide its value upwards.
Cooling Off The Hot Money
China’s economic policymakers have targeted the country’s overheated financial sector as a major structural challenge. The country’s GDP is heavily lopsided in favor of investments, at the expense of domestic consumption. On a national balance sheet “investments” can mean anything from factories manufacturing iPad components to real estate speculation on shopping malls in Guangdong. Speculative ventures have been in favor as of late, many of them funded by capital inflows from Chinese-owned offshore facilities in Hong Kong. Worries of a credit bubble have been hanging over China for some time now. A more aggressive PBoC position in the currency market may be a sign that the government is making good on the policy changes addressed in last November’s Third Plenum.
Investors will be watching closely over the next several days to see if the sell-off continues. Many will be hoping that the currency stabilizes around current levels. There are hundreds of billions of dollars tied up in complex currency derivatives that could unravel if the rate goes much lower. The PBoC understands this, of course, and most likely does not want the currency’s trajectory to spiral out of control. But the unexpected can happen, even in a highly controlled market like the RMB.
The magnitude, timing and predictability of cash flows are what determine the returns investors expect to receive from any given asset. With that in mind, it is worth considering the language of a Standard & Poor’s credit report issued today regarding Ukraine’s credit rating, which it dropped from CCC+ to CCC: “We now believe it is likely that Ukraine will default in the absence of significantly favorable changes in circumstances, which we do not anticipate” (italics ours). On a related, unsurprising note, Ukraine pulled a $2bn Eurobond that was to have been issued today.
A Geopolitical Crisis
For most people Ukraine is a faraway place, a country about the size of France with a population of 45 million. The current crisis is largely geopolitical in nature: it stems from the government’s decision last year to abandon talks aimed at bringing Ukraine closer to the European Union, and opting instead to tie itself more closely to Vladimir Putin’s Russia. The population itself is split, with pro-Russian eastern regions supporting the government and the Europe-friendly western areas (including Kiev, the capital) demanding the ouster of President Viktor Yanukovich.
No Isolated X-Factors
Is this country important enough to have a real impact on world markets? In this day and age the answer is yes. Not because of the economic punch that Ukraine packs on the world stage, but because in our tightly interwoven, linked-in day and age there is really no such thing as an isolated geopolitical X-factor. The issue is not how big a country is, or what percentage of the world’s outstanding debt issuance is from Ukraine (very little). The issue is collateral damage – what impact would a default have on systemically critical institutions with an unhealthy exposure to Ukrainian debt? What other dominoes might fall, not just in Ukraine but farther afield?
Remember the CDO…
The domino effect is unpredictable. In 2007, credit markets remained sanguine after the collapse of two Bear Stearns hedge funds with overexposure to nonperforming subprime loans. Here again, subprime loans were themselves a tiny fraction of the total global bond market. Subprime loans didn’t bring down the house in 2008 – it was the CDOs (collateralized debt obligations) and CDSs (credit default swaps) that Wall Street used to engineer astronomically leveraged exposures to subprime debt. The credit rating agencies never issued anything as dire-sounding as today’s Ukraine downgrade language to suggest problems lurking behind the sterling ratings of those alphabet-soup derivatives. Yet the scenario few expected was the one that played out.
Think back as well to 1998, when Ukraine’s neighbor to the north defaulted on its debt. Russia’s default sent its currency spiraling overnight from 6 roubles to the dollar to 25 to the dollar. That might not have been much more than a local problem, except for the fact that Long Term Capital Management, a systemically critical hedge fund, was overexposed to Russia and collapsed. A larger financial contagion was averted only after a massive bailout engineered by the U.S. Fed, Treasury Department and Wall Street’s bulge-bracket banks.
The National Bank of Ukraine has spent about $1.7 billion in the past few days to shore up its currency. Today the government and protesters are trying to find a mutually acceptable compromise that would defuse the crisis. Asset markets are mostly calm. We believe this to be more likely a brief tempest than a gathering storm. But no X-factor lives alone. We must constantly monitor not just the surface, but what lies beneath the surface.
There is a problem in the world of small business. This problem is the absence of good internal administrative processes and owner/executive attention and emphasis for retirement plans.
We are singling out small businesses because larger corporations typically have a dedicated human resources director, whose primary responsibility is the oversight of all HR functions, including employee benefit plans. Small businesses commonly delegate the HR responsibilities to a staff member, usually a CFO or an office manager. This makeshift (non-dedicated) HR director (employee benefit plan administrator) can either be stretched too thin, lack the proper training, resources, and/or time to properly handle and pay adequate attention to the plan, or is simply not the best person to handle the internal administration of the company’s retirement plan. As an owner/executive, it is your responsibility to determine whether the employee who is responsible for these duties is diligently managing the plan. Otherwise, this presents a potential problem: as the plan’s sponsor, you are a fiduciary and are therefore personally liable for any plan non-compliance.
Your internal plan administrator should have a grasp of the details regarding your plan. This includes plan features, administrative timelines, and plan processes. As a plan sponsor, you should also be aware of these details. An assumption exists that plan information and data can be readily retrieved from the plan administrator through the plan’s third party service providers; however, in today’s world, this information requires more digging than one may expect.
Regulations have been created in an attempt to make information from service providers more transparent, but in our experience, a certain level of murkiness still exists. More often than not, one has to do some extensive legwork in order to get to the heart of the information. How much of this work has your internal plan administrator done? For a sponsor to fulfill his/her fiduciary responsibility and ensure that the plan is operating with reasonable fees your administrator should be able to answer the following questions fully and with confidence:
Who are the plan’s service providers?
What services are they providing?
Are they acting as a fiduciary?
How much are they getting paid?
What is the total cost of running the plan?
It is critical that a sponsor ensure that efficient information channels exist, not only with the internal plan administrator, but also with the service providers of the plan. By asking these questions, making certain that key information is understood by all responsible parties and that communication is frequent between these parties, a sponsor can both keep track of the administrator’s handle on the plan, as well as ensure that fiduciary risk is being mitigated.
So, how does a plan sponsor effectively manage this HR Gap? Ultimately, as the firm’s leader, the prioritization and importance you place on your plan is critical. Make it known that you expect your internal administrator to be vigilant and thorough and that you want to have a successful plan that will help your employees retire as comfortably as they can. Set regular meetings with your administrator, review costs and important plan metrics (utilization, investment performance and employee participation) and benchmark those statistics with others in your industry/peer group. Ensure your administrator is in contact with your third party service providers (investment advisers, TPAs, etc.) and emphasize that they provide you with up to date information that helps you and your administrator better keep track of how your plan is faring. These new practices should not prove overly time consuming and/or expensive. If they do, this is a responsibility your internal plan administrator should seek to correct by working with the plan service providers. Set the expectation, trust and verify, and protect yourself while offering your employees the best plan you can.
Asset markets have settled into a gentler pattern in recent days, erasing a sizable portion of the losses suffered during the first five or so weeks of the year. The rising tide has extended to that most battered of asset classes: emerging markets. This asset class has been the big underperformer among equities for more than a year now, ending 2013 with a loss even as the S&P 500 gained more than 30%.
With relative valuations so low, many market participants see a potentially attractive buying opportunity in the works. Our views are a bit more tempered: while we would not necessarily be surprised by a spurt of outperformance in the near term, we think the fundamentals argue for proceeding with caution.
For the better part of the 21st century emerging markets have been the global economy’s growth engines; in many years enjoying double-digit real GDP growth. Millions of Brazilians, Chinese, Indonesians and Indians ascended into a rapidly expanding middle class, bringing prosperity not only to local businesses but to S&P 500 titans as well. Many of the largest U.S. companies earn more than half their revenues and profits from their overseas activities. But recently, the growth trend has markedly slowed down. Brazil’s real GDP growth in 2013 was a paltry 2.2%. Turkey, which as recently as 2011 was growing at a double digit clip, is looking at potentially sub-1% real growth this year. Even India, one of the strongest emerging markets, is languishing in mid-single digits.
Flight of the Creditors
Debt was always lurking under the surface during the heady growth years. Foreign creditors were more than happy to lend to emerging markets businesses and consumers, much of which was in hard currencies. As external debt rose on emerging corporate balance sheets, other troubling data points like inflation and swelling trade deficits appeared as well. In sharp contrast to the sub-2% inflation rates seen in most developed economies, price index gains are currently more than 6% in Brazil, Russia and India. A more extreme case is Turkey, where an inflation rate of 11% helped spark a credit market exodus that spread to South Africa, Russia, India and Brazil. As creditors fled, local currency rates plunged, making those debt-laden balance sheets even more onerous.
The China Question
Looming over the whole emerging markets debate is China. The world’s second largest economy continues to grow: its 2013 GDP rate of 7.7% was the largest among the 42 major developed and emerging markets tracked weekly by the Economist Intelligence Unit. What concerns investors, though, is where most of the growth is coming from. China’s leaders have committed to rebalancing the economy away from investment (much of which is speculative rather than productive in nature) in favor of more domestic consumption. Consumer spending accounts for just 35% of China’s GDP, as compared to 70% in the U.S. But that rebalancing will be tricky, involving a cooling off of the country’s overheated financial system as well as unpopular political decisions.
These are some of the key issues giving us pause in regard to emerging markets. We remain underweight in the asset class, and will remain so until we have more evidence of the case for growth. That evidence will need to include some indication that Xi Jinping and his economic policy team are successfully maneuvering their way through the China rebalancing challenge.
On February 3rd the S&P 500 experienced its most severe pullback since the period from May 21 – June 24, 2012. Oddly, the magnitude of the pullback was exactly the same to within two decimal points: -5.76% in each case. Here at MVCM we use 5% as a marker for a pullback worth recording in our records of peak-to-trough movements going back to 1951. If the S&P 500 rallies by 5% or more without falling below the 2/4 close, then these Bobbsey Twins pullbacks will each merit a small, slightly amusing shout-out in the time-honored annals of Wall Street weirdness.
U.S. equities indexes may indeed bounce back for another rally, but we will not be surprised to see a return to more pullbacks, with greater magnitudes, than has been the case in recent years. The return of the periodic 10% correction, something we have not seen since 2011, is likelier to happen if something else comes back to the market that has been AWOL for a while: volatility.
Been Away For So Long
The above chart is something we have shared before with our Market Flash community: the volatility gap that has persisted almost without pause for the past two years. The CBOE VIX index, fondly referred to as the “fear gauge” by Street pros, had an average closing price of 14.2 in 2013 versus the long term average of 20.2 going back to the index’s inception in 1990 (a higher VIX price means more volatility). Even 2012, a relatively tame year with no 10%-plus corrections, had an average VIX level of 17.8. Those spectacular returns of 2013 came with relatively little risk.
In finance, as in other walks of life, what goes down eventually comes back up. Volatility will return; the question is whether that return is imminent or whether U.S. equities still have a couple big rallies left in them. We are increasingly of the opinion that the return will be sooner rather than later.
(Macro) Event Planning
One thing seems evident: we’re in one of those event-driven environments where meta-narratives rise organically out of the swamp of macroeconomic data points, corporate earnings releases and global goings-on in places like China, Turkey and Brazil. The meta-narrative of late has been decidedly negative. Emerging markets currency crises have prolonged the pain for investors with long exposure to what are looking less and less like the “growth engines” of several years ago. That in turn has concentrated attention on the greatest growth engine of all, China. Concerns have bubbled under the surface for several years now about whether the world’s second largest economy can pull off the feat of defusing a potential credit bubble while rebalancing its growth away from increasingly speculative investment towards a healthier level of domestic consumption. The numbers coming out of China always must be taken with a measure of skepticism; nonetheless, a China-centered shock would have the potential to scorch a wide swath of asset class terrain.
Still Not Cheap
Meanwhile, the latest pullback has knocked about a point off the S&P 500’s next twelve months (NTM) P/E ratio, as seen below. But a pullback of a bit less than 6% doesn’t make for a screaming bargain when it comes on the back of a year of 30%-plus gains. At 14.4x, the NTM P/E is still above its 10-year average of 13.9x.
Indeed, the market’s recent success may amplify the negative tone of the prevailing narrative. With few investors expecting equities to deliver anything as spectacular as last year’s gains – especially the record-breaking risk-adjusted returns – and corporate earnings doing little more than to (mostly) beat downward-revised expectations, there may be an enthusiasm gap between the Pollyannas on one side and the Cassandras on the other.
So where does our -5.76% pullback go from here? Well, the S&P 500 closed 1.2% higher on Thursday, its biggest gain for the year to date. What that says about tomorrow, or next week, is anybody’s guess. But whether our scribes record -5.76% in the MVCM Pullback Annals or not, we are prepared for a volatile ride in 2014.