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Transcript
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