Download issues to correctly assess the investment climate and its risks.

JANUARY 2016
In Depth ...
Tectonic Plates — Stop! Cover! Hold On!
T
here are “tectonic plates” that must be considered
periodically by investors.
These include
commodity prices, U.S. government tax policy,
geopolitics, central bank policies, currencies,
demographics and trade relations, which move
meaningfully about every 7–10 years, creating massive
disruptions. Successful investors must incorporate “big
picture” issues to correctly assess the investment
climate and its risks.
As a result of these large plates moving, investors
around the globe and across asset classes are adjusting
their investment positions. Over six years of a broad
bull market has invariably resulted in mis-allocated
capital by investors (i.e., bubbles and bad bets) which
is shaken when the plates begin to shift. As usual, the
markets gave us warnings of the impending earthquake.
In the summer of 2014, oil began its descent and
corporate bond valuations peaked.
Successful investors must incorporate
“big picture” issues to correctly assess the
investment climate and its risks.
SHIFTING PLATES
Tectonic Plate #1: Natural Resources/Oil
By now, everyone is aware of the collapsing price of oil
and other natural resource commodities. Many may
not be aware that wheat, corn and soy are also at multiyear lows. This development over the last 18 months
has caught investors (and lenders) off guard, and is
creating major headaches for economies dependent
on natural resources. Moreover, and more importantly,
the debt that underlies these commodities and these
developing economies is enormous. Remembering
that credit markets lend based on cash flow and asset
values, one can rightly assume that lenders around the
world are very nervous as they see commodity prices
collapse by 50–70%. The situation is similar to 2007,
when we knew that housing prices were falling, but
did not know the extent of the debt and the counterparty risks that were associated with it. Today, some
estimate that there is over $2 trillion in debt related to
the shale industry here in the U.S., which far exceeds
earlier expectations.
Other developed countries, particularly the CRABS
(Canada, Russia, Australia, Brazil and South Africa)
are being pummeled because of their high dependency
on natural resources. And commodity demand from
China (by far the CRABS' largest customer) seems to
be evaporating.
The bottom line is that until commodity pricing
stabilizes (which won’t happen until creditors cease
lending to producers), this major tectonic plate won’t
stop moving, creating major instability around the
globe.
Tectonic Plate #2: Currencies
A simple way of figuring out how and why currencies
get stronger or weaker compared to other countries
is to remember this bromide: “money always goes
g
to where it is treated best.” Over the last two years,
money from around the world has been flowing to
the U.S., which explains the dollar's strength against
essentially all other currencies. While our economy is
not smokin’ hot, it is stronger than most others due to
its better balance sheets and stable growth. Because of
its relative strength and safety, U.S. dollar strength is
likely to continue until these plates stop shaking.
The dollar’s strength presents challenges however,
especially to businesses selling products and services
internationally. U.S.-based company sales and earnings
have been severely challenged as they compete with
international companies based in Europe or Japan.
Until last summer, the Chinese currency (yuan)
was pegged to the U.S. dollar, rendering China less
competitive than its Asian neighbors. In August,
the Chinese government changed that policy and is
now allowing its currency to fall, which advantages
China in international trade. This has created massive
disruptions in the economic vitality of its developing
market competitors.
Lastly, oil is sold in U.S. dollars around the world.
This affects currencies inversely; i.e., as the dollar
strengthens, commodities fall. Thus, there is massive
quaking in world markets as these two tectonic plates
move at the same time.
Tectonic Plate #3: U.S. Federal Reserve Policy
At Quest, we are in the camp that believes the Federal
Reserve has responded far too late in raising rates for
this business cycle. It is questionable whether the Fed
should have raised rates sooner. But it is clear that it
should not have raised rates this past December. If the
Fed truly is data dependent (inflation rates, industrial
production, trade, corporate earnings, etc.), it would
know that the U.S. economy has been softening
since the end of 2014. Given the recent data, and
considering what is happening around the world, the
Fed should be loosening, not tightening.
Current policy indicates the Fed will continue
to raise rates and tighten monetary conditions well
into 2016. This is now causing a third tectonic
plate to begin to move in unison with the other two
large plates outlined above. Until this policy error is
recognized, uncertainty will remain.
The Fed's September 2015 Statement in a Word Cloud
Source: Bankrate.com
Conclusion and Game Plan
Quest has been in business since 1985 and has seen
multiple cycles which have included these massive
moving “tectonic plates” affecting the investment
environment. Prudent management indicates that
after the shaking stops (and it will stop), bull markets
resume. Interestingly, and more importantly, new
leadership typically emerges after resolution, requiring
diligence and rigorous analysis. The challenge is to
determine the magnitude of the temblor while we are
in the midst of it. Magnitude 5.0 is far different than
8.0; regardless, the investment terrain will be affected
post shaking.
In our next issue of InDepth, we will outline our
game plan and strategy as we continue into 2016. In
the meantime, stop, cover and hold on!
MUSINGS
Since the 2008 financial crisis, the Federal Reserve has
become a huge player in U.S. government debt markets. Its
balance sheet has increased from roughly $905 billion in
September 2008 to nearly five times that size today ($4.5
trillion). It is now equal to one-fourth of the U.S. economy.
Through its QE program, the Federal Reserve has purchased
over 60% of all Treasuries issued.
Quest Investment Management is an independently-owned investment advisory firm focused on growth investing for institutional clients.
Contact: questinvestment.com 503-221-0158 [email protected] | One SW Columbia Street, Suite 1100, Portland, OR 97258