This note was originally published at 8am on August 30, 2013 for Hedgeye subscribers.
“Neither a borrower or a lender be; For loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”
-William Shakespeare, “Hamlet”
Shakespeare taught us many lessons in his writings. But the quote from Hamlet above is very apropos for those of us who are stock market operators. The lesson is simple: be careful with financial leverage.
Financial leverage is like the blue meth sold by Walter White and his colleagues in the acclaimed TV show Breaking Bad. It is both very addictive and hard to get off the streets. It can also make the sellers very rich in a short period of time.
In the last fifteen or so years, we’ve seen innumerable debt fueled bubbles. The Asian debt crisis, the stock market bubble of the early 2000s, the housing bubble, the sovereign debt crisis, and the list goes on. Shakespeare is correct: returns generated from borrowing dull our analytical focus.
In the spirit of another quote from Shakespeare, “brevity is the soul of wit”, let’s get directly to the global macro grind . . .
Next Wednesday, with all of Wall Street well rested and back from the Hamptons, we are going to update our emerging market outflows theme. Like most macro trends, emerging market outflows is unlikely to be a month or quarter long trend. With the dollar and interest rates being key supporting factors, this one also has legs.
In fact, my colleague Darius Dale looked at the last strong dollar period, from 1995 – 2001, and the MSCI Emerging Market Index CAGR’ed at -5.3% versus the SP500 at +15.8%. So, reasonably, if interest rates are just starting to turn, and the dollar is only in the early stages of a long term strengthening, then emerging markets can be expected to underperform for some time.
In the Chart of the Day, we’ve highlighted recent emerging market equity and bond outflows. As the chart shows, the last four months have been staggering for outflows and emerging market asset classes have performed commensurately. As they say, follow the flows (or at least the projected flows).
After the first big correction is when the “value” investors usually start to get interested in a stock or asset class. No doubt that guy from Franklin Templeton who originally cut his teeth marketing Snoopy is licking his chops right now on emerging markets. The problem is that cheap can get a lot cheaper.
Currently, on an EV/EBITDA basis emerging market equities are still trading at slight premium to the long run mean versus the MSCI World Index. In times of crisis, like in the 1998/1999 period, emerging markets trade at a multiple that are closer to the 30% of the rest of the world (versus north of 70% now). When the proverbial brown stuff hits the fan, emerging markets go no bid.
We will be sending out an update of our emerging market chart book later this morning (ping email@example.com if you don’t get it) and will also be hosting a call on Wednesday, September 4th at 11:30am eastern. Even if you aren’t invested in emerging markets, this will be an important call in helping to understand global asset allocation flows. Or as we like to call it: The Flow Show.
Speaking of flows, EPFR Global came out with some date this week that highlighted some of the key fund flows in the year-to-date. No surprise, emerging markets lead in outflows with almost $7.8 billion in outflows. On the positive is the United States, which has seen $83 billion in inflows, but in the category of sneaky positive is Europe, which has $9.4 billion of YTD inflows mostly over the past nine weeks.
Europe may only be bouncing on the bottom in terms of an economic recovery, but the money has to flow somewhere. Even more sneaky has been the improvement of sovereign yields in the European periphery, with both Italy and Spain both solidly at 4.5% or below (some of the best levels in years). If the sovereign debt issues in Europe are truly behind us, the flows into Europe will only continue.
It only helps the investment outlook in Europe to have more sane central bankers like Mark Carney, formerly head of the Bank of Canada, running things. In his first newspaper interview since taking over the Bank of England, Carney directly acknowledged the risks of low interest rates when he said:
“We have the responsibility to assess emerging vulnerabilities in the economy such as housing, make those assessments and recommend action. Interest rates are principally an instrument of monetary policy for achieving the inflation outcome and there are other tools that address risks."
Well said, Mr. Carney. Well said.
Speaking of central bankers, this long weekend will give us all some time to consider what might happen at the Fed next if either of the two front runners, Janet Yellen or Larry Summers, take over. Hawk or Dove? Shakespearean tragedy or comedy? To flow, or not to flow?
All joking aside, policy matters so this choice will be critical in contemplating asset allocation in coming years. As Shakespeare said about vision and strategy:
“See first that the design is wise and just; that ascertained, pursue it resolutely.”
As it relates to the leadership change at the Federal Reserve, we can only hope this is the path that is pursued.
Our immediate-term Macro Risk Ranges are now as follows:
UST 10yr Yield 2.70-2.93%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research