Llevo 31 años subido al andamio de la industria financiera, los últimos 25 gestionando patrimonios. He vivido en Nueva York y en Londres, donde he tenido la gran suerte de conocer y trabajar con algunos de los mejores inversores de nuestro tiempo. A ellos y a mis socios les estaré siempre agradecido por la formación que he recibido.
Most financial strategists have been out with their market outlooks and surprises for 2021 for a while. There is some consensus around positioning in value stocks and Emerging Markets. Both are seen as superior alternatives to growth stocks and Developed Markets for the upcoming and much-anticipated cyclical recovery. This group of experts shares a dislike for the greenback as well. By definition, this stance translates into a bullish stance on other currencies. We find this puzzling, especially in the case of the euro. Moreover, some among those who have missed the best performing stocks during this twelve-year long bull market are elated. They believe their train is finally coming into the station. The broader advice is to be bullish on equities, especially ESG compliant companies, as there are trillions of dollars in deposits, money market funds, and fixed income funds with close to zero or negative yields to maturity. As a result, this wall of cash is ready to go into the equity market because there really is still no alternative (TRINA?).
This line of reasoning is fine but there is one tiny flaw. Equity markets are zero sum games. Sellers of equities receive cash from buyers of equities. Thus, the cash balances in the banking system do not change when somebody buys shares from another member of the public. The bull argument is that everybody has an incentive to be first in the market as otherwise they will have to pay higher prices later. If everybody with a cash balance decided to buy more equities at once, all they would achieve is temporarily paying higher prices for their equities, and leave other investors with even larger cash balances to worry about, and the cycle of financial repression will go on and on. This is what has been happening in financial markets in some parts of the world for a number of years, so it is hardly a new development, and so far has translated into little economic growth or much desired reflation.
We are reminded often that the current liquidity conditions in the financial system stem from central banks’ massive purchases of Government and Corporate bonds. These open market operations result in growth in monetary aggregates. In 2020, Deposits of Depositary Institutions at the Fed have increased by $1.5 trillion to $3.2 trillion, while the Treasury Balance increased by $1.2 trillion to $1.6 trillion. Currency in circulation increased by $200 billion. This is how the Fed financed the purchase of nearly $2 trillion of additional Securities Held Outright over the period.
The Congressional Budget Office estimates that the US Federal Government deficit for 2020 will reach $3.7 trillion. Since the Fed also purchased securities other than Treasurys, the financing requirements of the US Treasury in 2020 required at least $1 trillion from other funding sources. US Personal Savings and Net Private Savings increased markedly in 2020, as of the 3rd quarter Net Private savings were $1.9 trillion larger year over year.
The reflationary hopes are pinned on that trend reversing as a V-shaped recovery takes shape in 2021 and households satisfy pent up demand and resume discretionary spending as businesses step up investment and hiring. This may well be the case, or rather, this better happen because this is largely what the US equity market is discounting currently in our opinion.
If financial repression in conjunction with fiscal deficits insured reflation and booming stock markets, we should have seen this outcome in Japan. Yet for most of the past three decades, the Topix was the wrong place to look for good returns. A similar picture is developing in the euro zone, where very low long-term rates have backfired. Financial repression has had the unintended consequence of leading to higher savings rates in the creditor countries of the euro zone for most of the period since QE started in 2015.
Interestingly, Central Banks justify these open market operations because they cannot meet their inflation targets. This is hardly a bullish statement or a strong endorsement of the state of the economy. The fiscal policy expansion of the CARES Act and other US income support programs, which allegedly have stoked the Robin Hood and other retail dives into the stock market, may have contributed to the strength of the equity markets since the March lows. We believe, though, that the normalization of the funding of hedge funds and other levered investors once the Fed started buying corporate bonds and high yield ETFs in April is a much bigger contributor to the risk-on rally that anticipates a reflationary period. Yet we have just observed that the growth in the Federal Reserve’s balance sheet may not be large enough to reach the desired outcome because of the massive drain on liquidity demanded by the Treasury’s new financing needs. As was the case in the European Sovereign and Banking crisis, the muted role that banks play in stabilizing markets since the enactment of the Volker rule has resulted in spikes of volatility driven by poor liquidity.
Like most people, we do not like to follow wanton orders in general. In particular, we do not like to be coerced to take on risks we do not want to take. We do not particularly enjoy this “investment by dictate” culture, whereby you are pushed to take on more risk year after year. Whether the additional risk is in the form of lower liquidity or higher leverage, or in the case of private investments, both; these are not decisions that should be made under duress. The biggest pushback to date is of course that for the time being, following these marching orders is working just fine. Eventually, we will reach a new Minsky Moment but before we get there, large fortunes will continue to be made riding this wave. Not everybody will come out well from that experience, and those who are deemed too timid today will be proven right eventually, but as usual in these processes, it may prove a Pyrrhic victory.
There are of course some investments that we find attractive today. They are in many cases not very different from those we found attractive a year ago except that the upside is lower today, as they have performed very strongly. Thus, it may be more useful to discuss those swathes of the market that we find unattractive or even un-investable. Negative yielding bonds are in the latter category, especially long dated bonds with cash prices well above par. In general, credit is not compelling either. Emerging Markets (EM) yield curves are not as attractive as they used to be. We will discuss the value category in more detail later. We still find some interesting quality growth stocks, but we do not share the current enthusiasm for “mystery” stocks. After all, the Total Addressable Market (TAM) for all businesses is not much bigger than global GDP, by definition, and there is no mystery about that figure, it is both well-known and finite.
Conversely, this is not the first time in the past eleven years that we see growing and widespread enthusiasm for beaten down situations while growth and the new-new things continue to shine. Interestingly, Howard Marks, the legendary value investor and founder of Oaktree Capital Management, discusses in his latest Memo to Investors how spending weeks during the lockdown with his son in law who is an investor in technology companies revealed to him the merits of investing in such growth companies. The memo reads like a financial “Zen and the Art of Motorcycle Maintenance: An Inquiry into Values”. The Marks family’s Chautauquas provide the intellectual background, lay bare the points of conflict, and conclude with the conversion of the value guru to his son in law’s point of view.
This is not so much an intellectual tour de force, as the issues are straightforward, but an unusual display of honesty, for few people of Mr Mark’s wealth and stature would publicly admit such revelations at his age. Interestingly, only three years ago in another one of his Memos, Mr Marks expressed his outmost discomfort with valuation in the markets, derided FAANG, crypto currencies, and emerging markets. At least, he got right one out of four. Today, we are almost tempted to see his capitulation as a bad omen for these frothy markets, but we will refrain from doing so as we fear Hubris far more than the Plague. (You may read our cordial rebuke of the 2017 Memo here).
So far, in the current long bull market, many of the periodic resurgences of broad interest in “value” have ended up in tears, while growth and new-new things keep marching up relentlessly. One of these days, this state of affairs may change of course. However “one of these days…” sounds more and more like the very politically incorrect yet empty threat professed by Jackie Gleason in so many Honeymooners’ episodes. The day of reckoning and opportunity may not come until yield curves normalize; even then, many will be surprised by how well growth stocks behave relative to value. Our research concludes that growth companies have outperformed in both tightening and loosening periods for three decades.
This is an outcome of how the widely used Discounted Cash Flow methodology works which Mr Marks addresses tangentially. In addition, financial repression has left very little low hanging fruit that is not rotten at the core. If a business struggles in the current financing environment, it cannot be a very good business (with the exception of those directly hit by Pandemic restrictions, perhaps fatally). In addition, as Mr Marks points out, the Internet has reduced the cost of obtaining information so dramatically that it is increasingly difficult to find cigar butts lying around, at least in liquid developed markets. The Internet has also reduced the cost of obtaining misinformation. Given that those making decisions still suffer from the long list of cognitive biases that distort our ability to evaluate outcomes rationally, we may not be better prepared to identify trouble today than we were twenty years ago.
«If a business struggles in the current financing environment, it cannot be a very good business (with the exception of those directly hit by Pandemic restrictions, perhaps fatally)»
Eventually, it will be a good idea to look for traditional bargains in value stocks, but we are still not sure that we are there yet. For starters, the much-taunted 2021 recovery seems to be anything, but uniform. In fact, many large economies will not regain the activity levels of 2019 for two or three years. By the time they get there, Governments and businesses will have far more debt than in 2019 when debt levels were already a source of some concern. The Congressional Budget Office projects US GDP growth of 4% in 2021 following a decline of 5.8% in 2020. The federal Government will run very large deficits over that period that will push the debt to GDP ratio from 80% to 108% of GDP by year-end 2021. We are not growing out of this pandemic, as much as borrowing from future generations to mitigate the blow of lower activity and higher unemployment. How this increase in government debt is bullish is the stuff of Modern Monetary Policy (MMT). Conversely, it would make David Ricardo turn over in his grave. (By the way, where is Robert Barro on this debate?). In our experience, the monetization of large fiscal deficits inevitably leads to high inflation in some countries as the national currency depreciates. However, it is true that this has not been the case for Japan, the euro area, or the US for now.
The consensus on a weaker US dollar makes it even more difficult to understand the general bullishness on European equities. For decades, we have observed how European stocks tend to do better in periods of US dollar strength. Should one be looking for traditional value investments, few stocks trade at such low Price to Book Values as euro area banks, in spite of their recent rally. Yet, it is impossible to underwrite the cost of risk that banks in the euro zone will suffer in this downturn, especially with a second lock down underway in many countries. Additionally, the tug of war on the issue of resuming dividend payments between management teams encouraged by City analysts on the one hand, and supervisors on the other hand, should make us think twice before jumping in headfirst. Let us not forget that only three banks from developed economies have grown their Book Value per Share over the past thirty years. All other banks buy back stock and pay dividends at one point in the cycle and then issue stock at a different point in the cycle, when not going bust first. That practice does not bode well for shareholder returns.
Current regulation on capital requirements, coupled with negative rates make it highly unlikely that a bank in the euro area may obtain a satisfactory return on equity (ROE) even today when they are hardly providing anything at all for loan losses even as a significant percentage of the loan portfolio is in forbearance. Many banks reported a cost of risk or less than 0.3% of total loans in 2020, when their average annual cost of risk through the cycle is above 1% of total loans. Add to this, the inconvenient truth that many banks are not paying corporate tax as they continue to draw dawn Deferred Tax Assets and Credits. We will not split hairs by asking how will these banks replace this depleting component of their allegedly ample capital base. Incorporate into your calculus the muted demand for good credit. Reflect on the constant attacks to the most profitable businesses lines such as payments or wealth management from Fintech start-ups, and one wonders what is a realistic assumption for a normalized ROE? Furthermore, why would they be paying dividends when there is so much uncertainty?
The health of banks in the euro zone is crucial to underpin the euro. Whereas it is true today, as it has been true since its inception, that the euro area has a current account surplus and a creditor net international position, which mirrors the US’s debtor position, it is no less true, that unlike the US, the euro zone is not a sovereign state. It is just a subset of the European Union. Thus, the devil is in the details. While certainly, some countries such as Germany, The Netherlands, Austria or Finland enjoy that dual surplus, the usual suspects i.e. Italy, Spain, Portugal, and Greece, do have a debtor net International Financial Position. This external debt position in some cases is quite alarming as it is close to 100% of GDP even before the financing requirements of the very large projected fiscal deficits of the next few years.
Were it not for the current state of ECB induced complacency, very few people would buy bonds issued by periphery countries at these prices, and nobody in their right mind would buy these debts at higher yields because the issuers would not be able to service their debt. These considerations are a source of comfort to many investors today who conclude that the ECB cannot allow a sell-off in periphery bonds. We fear that this arrangement is not a source of long-term strength; on the contrary, this is ultimately a source of fragility for the euro arrangement.
Should the health of the banks in these countries suffer again because of deeper and longer recessions they are likely to suffer, we may likely have a replay of the events of 2010. Yet, we will have a different set of rules and mechanisms that may assuage the pain. Optimists believe there is a fiscal union in the workings, they should perhaps re-examine that premise. The Euro Group of finance ministers meets today. They will likely drill the Spanish Economy Minister on her assumptions and plans for a recovery from the largest peacetime drop in GDP. Some of the ministers will insist that a calendar needs to be set to resume the targets of the Stability and Growth Pact, which the hawks consented to shelve, albeit temporarily.
Portuguese, Spanish, and now Italian left wing politicians refuse to tap the soft loans from the EU recovery Funds because they bear conditionality they do not like. Little do they know that as soon as a reasonable number of people are vaccinated or the Pandemic is deemed to be over, these countries will be compelled to do so by their euro area partners with the help of the ECB. In fact, the technocrats in the Spanish Government are working out the details of 170 strings that come attached to this source of financing. In Spain, Podemos is playing opposition to the Government from within the cabinet in order not to become altogether irrelevant. How long can this last? We are afraid it can last for many years, as most of these disagreements are highly choreographed opportunities to pander to their base. Unfortunately, Podemos was decimated in the latest two regional elections. A revolutionary party does not do well as a junior partner in a Government coalition.
Occasionally, PM Sanchez has caved in and ceded on demands that he may deem trivial but that are nevertheless very damaging for confidence and foreign investment into Spain. These include a recently introduced financial transactions tax of 2%of traded value, that as you all know only the uninformed will pay. There is as well as an ecommerce tax, which Europeans call the Google Tax. These, and other self-defeating ideas, such as the Florange Act, that grants long-term shareholders double voting rights so that they can sell down their holdings while retaining control of the company, or preventing takeovers of domestic companies, are all forms of wealth expropriation. However, nobody seems to care for now.
Many of these abuses are literally transposed from existing French laws, and why not, since France is a wold leader in distorting financial markets. Successive centre-right Governments starting with Chirac, following with Sarkozy, and culminating with Macron have done their utmost to upend domestic financial markets while promising structural reforms. Naturally, they had some inestimable help from scooter riding President Hollande. It is interesting to see the French President, like most other world leaders, smugly sharing his concern on the ugly, yet short-lived, occupation of the US Capitol by a mob of Trump supporters on Epiphany Day. This is perhaps par for the course as Trump was quite vocal in his criticism of security in France following several terrorist attacks there. It is also true that the yellow vests’ rampage of Paris lasted months, resulted in 10 fatalities and thousands of injured people, and caused untold billions in damages. In addition, Macroon’s Government caved in to some of the mob’s demands backpedalling on some of the reforms that had just passed.
The ECB has conducted an unprecedented amount of purchases of government and corporate bonds to date which has eliminated the market’s ability to price credit risk. Indeed, since March, the growth in broad money in the euro are has accelerated from the 4 to 5% annual growth rate observed since 2015 to 11%. These actions have largely benefitted the neediest national treasuries to the detriment of savers in the euro zone. This week, we may see a new government coalition crisis in Italy, which pundits tell us to ignore. We shall soon see what emerges. Experts tell us not to worry because over the past 160 years Italy has had 131 Governments as if this instability had actually worked out very well. The last time we checked, the Italian economy has been underperforming its euro partners’ for nearly three decades because of low productivity growth stemming from very low rates of investment. Allegedly, Apple Inc. invests more in R&D annually than Italy Inc. May these low rates of investment be a result of political instability?
As for Emerging Markets, China is the single largest country weight in the MSCI Emerging Markets Index. While its economy seems to be far better off than most, it will not benefit from a rise in commodity prices or subdued global demand for its exports. China as is a net importer of commodities and an exporter of intermediary and finished goods. In fact, the recent parabolic increase in gas (LNG) prices and higher oil prices are not great news. In addition, officials in China are doing everything within their vast powers to remind the rest of the World that China may be a great growth story and a very large economy, but it is still very far from moving towards a more open society politically. Nor is it a great legal environment either. It is not only political dissenters but also entrepreneurs critical of the CCP who cannot avoid persecution or prosecution.
These crackdowns on political dissidents may undermine a possible rapprochement to the US with the new Administration and Democrat Congress majority. Even if President Biden is perhaps more open to resuming constructive trade talks, he may not be inclined to ignore the repression of political dissidents in Hong Kong and in the mainland. Optimists may observe that the Chinese authorities have a new bargaining chip; pessimists may surmise that the Government is enforcing their authority in the year of the first centennial of the CCP. Certainly, the South China Sea or Taiwan sovereignty issues will become flaring points again soon. In addition, China’s labour force as a percentage of the population has peaked already. The Economist summarized this trend some time ago as “China will grow old, before it becomes rich”, for once they could be right. Sanctions may follow mandatory de-listings from US exchanges and bans from investing in certain Chinese companies.
As the rate of economic growth in China decelerates, India is the hope for a third wave of large growth from Asia. Unfortunately, the contribution to global growth that India can produce in the near term is no substitute for China’s lower rate of incremental contribution. As populous as India is, as much as it has grown in the last two decades, India’s nominal GDPs is still relatively small at $2.8 trillion (2019), just 5% larger than the UK’s and 79% smaller than China’s. For commodity exporters to Asia, nominal GDP matters far more than GDP adjusted for Purchasing Power Parity. Many of the commodity producing emerging markets suffered great disruption and activity declined because of the pandemic. While they will recover faster with improved terms of trade, we cannot find too many bargains within the small universe that meets our investment criteria there either.
«As the rate of economic growth in China decelerates, India is the hope for a third wave of large growth from Asia»
Some take comfort in that if 2020 proved anything, this might be that politics do matter to markets. The unrestrained fiscal response to the COVID-19 crisis was instrumental in bailing out many levered companies as well as some levered investors. This is especially true in the case of transportation and leisure companies, and levered credit strategies. We assume that markets currently discount that all necessary support will be forthcoming in order for many companies to avert very dilutive equity offerings; otherwise, it is difficult to understand why so many companies are more valuable today than before COVID as measured by their enterprise value (the sum of all the financial claims on the Assets at market values). In addition, perhaps we should assume that State Aid would be forthcoming for banks as well, beyond the loan guarantee programs that have allowed a significant transfer of risk to national Treasuries already.
We have seen many asset bubbles in our investment career. None as damaging perhaps as the current bubble in Government Bonds and corporate credit in the euro zone, but certainly, the bubble emerging on both sides of the Atlantic in ESG compliant companies is second to none. As we write this piece, Orsted, a Danish Government controlled utility, has come out with a profit warning. This is hardly a shock since the company competes to grow in developing capacity in renewable energy in projects that offer low returns on investment as fast as they can. This is one of those situations where “What I don’t make on the margin, I make up on the volume”. In this industry, investors today pay for current assets, future projects in the backlog, and all other growth opportunities willingly once again. We say “once again” because this was the case fifteen years ago in the Renewables Bubble v 1.0. Some of you may remember how that all ended.
Software is a particularly interesting corner of the market. Everybody loves the business model. Several companies are so hot that they may only be found attractively valued on a Price-to-Price Target basis, a financial metric we last saw in late 1999 or early 2000. While software is obviously driving many innovations from Fintech to managing the chargers of batteries for electric vehicles, we should not forget that software companies’ competitive advantage stems from pricing the product on a value received basis. This strategy may lead sometimes to lower prices per user or licence in the future, while R&D and marketing expense may rise as a percentage of gross margin. Microsoft is the world’s largest software company by revenues today, yet it had a higher operating margin in 1999 on revenues of $19.8 billion at 50%, than in 2020 when revenues hit an all-time high run-rate of $147 billion but the margin had dropped to just 37%.
Most people believe that we will soon allow self-driving cars operating on sensors and software to take over our roads. We have met analysts who believe that human drivers will soon after not be allowed on the roads as they will be seen as too dangerous. This may be the case someday, but that day remains elusive, always just a few years into the future since we first became aware of the concept in the early 1970s watching the Jetsons’ cartoons from the early 1960s. In addition, the Jetsons not only had self-driven vehicles but these could fly to boot! Let us not forget that airlines still employ human pilots, as most people would not fly a self-flying airplane. Let us also remember that computer bugs are still very common or that hackers continue to create huge problems in spite of massive investments in network security and intrusion detection. Whenever, you feel an urge to force everybody to lift their hands from the wheel remember the last time your Word document crashed without having made a back-up as instructed, or the myriad bugs you have confronted trying to make different machines communicate.
From all of the above, we conclude that it is still difficult to make predictions, especially about the future. In 2020, many people who had not already converted to the ease and convenience of online shopping converted during the lock down. This past week, following a very unusual whiteout in Madrid, physical stores and restaurants recovered much faster than Amazon or other home delivery businesses. In any case, these oracles at the beginning of the year are an interesting cultural icon. First, since the January effect has been a well-documented phenomenon for decades, it seems rather odd that large institutions continue to make new allocations at a time of the year when securities’ prices are more likely to be higher. One would think that real money would try to profit from market corrections and not mechanically add more hot air to the periodic formation of bubbles as directed. Second, why do investors continue to follow the advice of people who in the words of Warren Buffett “take the subway to work” even when in many cases their most recent recommendations have been totally off the mark. We need go no further than the over cautious stance taken by some of these famous strategists in March just as most people you know were not just buying the correction, but trying to find the highest beta plays to boot. Was there a securities firm that chose Tesla as their top pick for 2020? Unfortunately, we were not familiar with their prescient analysis.
We would like to be very sanguine and be able to offer a long list of great investment ideas, unfortunately our best ideas worked so well in 2020, that many are close to our best-case scenario price targets. We would surmise that for the first time since 2007, we have pivoted to a bearish stance on the balance. We were right in our assessment then, and perhaps we will be right again now. The problems we face today are different except for one common thread: there is too much debt around.