Monetary policy, political risk and the economic outlook represent the three global macro issues for investors to consider. These issues are fairly constant through the years. However, the mix varies from one year to the next. It should be clear that one of these factors is going to define 2013. Which one do you thing is the most important factor right now?
Monetary policy refers to the role of central banks and in the current context the unprecedented and coordinated policy of low interest rates and quantitative easing by central banks around the world is the order of the day.
A couple weeks ago I detailed the situation with the Central Bank of T&T and the record low interest rates, which is a policy designed to match that of the US Federal Reserve, the Bank of England and Japan and the European Central Bank.
Political risk has as the most glaring example the "fiscal cliff" and "debt ceiling" debate in the US. The inability of the US to deal with their budgetary and tax issues is likely to cause some angst among investors in the coming months. In Europe the social compact based on government spending and welfare services is being eroded and Japan and China have their own political issues to address this coming year.
Finally, there is the real and sustainable driver of economic growth and that comes from business and private sector commercial activity. So far earnings reports that have come out for the last quarter of 2012 have been positive with the one caveat being the uncertainty surrounding bank earnings, both in the US and Europe.
Corporations, especially in the US, have a huge cash build and this has been so for some time. How they choose to deploy this cash and at what rate is going to be a key driver of economic activity.
Here at home the challenge is to embolden the local private sector into more risk taking activities but this will only come about when there are adequate and sufficient rewards for risk taking.
Easy money
My pick for the most important factor goes to the role of monetary policy and ultimately the central banks around the world. As I stated before, it was monetary policy that engineered the stock market and, ultimately, the economic recovery in the US. It was monetary policy that averted the collapse of the Euro and offers some measure of hope to Europe.
Monetary policy is also at the heart of current attempts in Japan to weaken the yen and stimulate some form of inflation in order to escape from the multi-decade long deflation. In fact, one can argue that the monetary policy in the US actually saved their economy and quite possibly the global economy from a bout of deflation.
The key issue though is what happens when there is more of the same? Five years ago yields on the ten-year US Treasury was around 3.5 per cent. For reference that was 2008 as the financial crisis was unfolding. In July/August of last year rates fell to 1.4 per cent and as at Friday last currently stand at 1.84 per cent.
A peak into what is possible came at the start of the year. The 10 year bond closed 2012 at around 1.70 per cent. However, with the release of the minutes of the last Federal Reserve meeting at the start of this year the market got spooked into thinking that the Fed will end its easy monetary policy during the course of this year and rates jumped to 1.9 per cent.
For the record I do not expect to see a pick up in economic activity that will be sufficient to push the Fed towards a less accommodative stance through the course of this year. As you would note from the discussion above, central banks are notorious for being reactive rather than proactive.
One may say this is consistent with their mandate of being the lender of last resort in that it has to be established they are the last resort before taking action.
It was well into the financial crisis that rates got to its lowest point and quantitative easing came about only after zero interest rates failed to engineer a turnaround. The point is that even if the economy were to improve the US Federal Reserve would want to see tangible evidence of an improvement before reversing course.
Trigger happy
The market of course moves on a different paradigm. The market is a discounting mechanism that seeks to anticipate a likely outcome and moves towards that outcome in an attempt to profit. This is why the first sign of a less accommodative monetary policy caused bond yields to rise and bond process to fall.
By how much and how aggressively if at all does the market seek to front run the Fed will determine the investment outlook for 2013 and beyond.
Right now the US is in the middle of a debt ceiling debate. If long-term bond yields were to push upwards to the levels at the last debt ceiling fiasco just 18 months ago, then that will represent around a 25 per cent loss in value in a long bond portfolio.
An investor sitting on those types of mark to market adjustments is not going to sit idly. The longer this easing cycle goes on, the more investors will pile into fixed income and the tighter the finger will be on the trigger ready to exit at the slightest hint of a rate reversal.
This makes bonds a fairly risky proposition going forward. I would put forward that given the gains from falling interest rates of the last couple years, there is little or no value in bonds at this time. Is there the opportunity to trade? Of course, there is and we saw that at over the past few weeks where yields pushed higher and then came back down.
These trading opportunities will continue to exist as volatility increases. However, for the average investor seeking to buy low and sell high, there is little value in the bond market at this time.
For emphasis I suggest that at these levels, the bond market is actually in my view more risky than the equity market. However, no market is homogenous and it is important to understand the segments within a market.
The easing policy of central banks was designed to push investors into risky assets. Many, especially from a T&T context, will see this as simply moving from government bonds into stocks. However before getting into stocks there is the corporate bond market and in particular the high yield bond market.
As a result of the aversion to equities following on the 2008 crash, many investors sought out the relative comforts of higher-yielding fixed income investments when the yield on government paper fell to record lows. These so-called high-yield bonds did extremely well over the past couple years and could very well be priced to perfection.
If, for example, the growth story again comes under challenge and economic activity does not provide the cash flows to support the companies (or, in fact, countries) with higher-yielding paper, then there could be a push up in yields because of credit events. Even without that the itchy trigger for bond investors is likely to be most pronounced in the high yield segment of the market, so there is room for greater volatility.
I will elaborate in the coming weeks, but from where I sit, Type II Stagflation is likely to be the order of the day.
In simple English, that means that economic growth will continue to stagnate or, at best, be below trend while the monetary policies of central banks will continue to be kind to risk assets causing their prices to rise.
The asset class that may be best positioned for a move in this context is stocks. While the T&T stock market may be close to the upper end of the valuation spectrum, most global markets are still trading at valuations which offer room for price appreciation.
If companies do start to invest surplus cash or aggressively engage in buybacks, mergers and acquisitions or pay higher dividends, then that can spur on equities in any market including T&T.
Appreciate that central banks are the catalyst rather than fundamental valuations, so one should not get too exuberant. However, for the time being, stocks present an opportunity.
Ian Narine is a broker registered with the Securities and Exchange Commission.
