Markets' Return to Normalcy: Real or Mirage?
Oct 31, 2013 @ 12:00 am
How one investment expert is identifying possible oases to protect from the downside.
This week on WealthTrack, why everything is not what it seems. First Eagle's Matt McLennan believes the market's return to normalcy is a mirage, requiring extra care and caution for investors. He tells us where he is finding investment oasis next on Consuelo Mack WealthTrack. I asked McLennan why he calls the recovery in the U.S. economy and markets a Keynesian mirage. -When you're a value investor, you start with the balance sheet and the free cash flows that when you're looking at a company because it gives you big hints as to what might be going on with market position or management character. We started to notice, over the last decade and a half, balance sheet issues around the world, malinvestment in countries with current account surpluses, white elephant project spending, and recurrent credit crisis in current account deficit countries, be the emerging markets of the United States. And we start to ask questions about what's wrong with the structural shape of the financial architecture in the world that produces this? And you know, we had to culminate in a crisis in 2008. But the market never really cleared fully. We had a crisis, but we had unprecedented state intervention, both fiscal easing and monetary easing, that supported demand at the time when corporations were hunkering down. The reason I say Keynesian mirage is that stability of demand that was produced by unprecedented state intervention happened at the time of corporate prudence. So, corporate margins have gone up a lot. -Corporate margins. -Corporate margins. -Right. -Business sentiment has improved quite a lot. There's this feeling that we're back to normal. Spreads have come from a thousand over in the high-yield universe down to 400 over. -Right. These are yield spreads, right? -Absolutely. Measures of risk perceptions such as implied volatility have come from 40 percent down to 14 or 15 percent on the equity markets. The equity market has doubled off the bottom. It feels like we're getting back to normal. But we never actually had a full economic adjustment. Instead, we've obfuscated and amortized the problems. You can't defy gravity. -Would there've just been a complete disaster? Had the markets fully cleared? I mean, is it possible to have stability with the kind of intervention that we've had by central banks and governments? -It would have been-- It actually would have been a disaster. -Why? -But we would have recovered from the ashes with a clean slate. A lot of debt would have been written off. Instead, the debt has been transferred from the private sector to the government's balance sheet. And so, we're at this point in time where we have a generationally low level of aggregate savings-- -Uh-huh. -in the United States, yet we have generationally high corporate profit margins. Those two things shouldn't co-exist over the long term. So, we run the risk now that we start to unwind that monetary ease, now that we start to unwind the fiscal ease, and now that corporations are no longer in hunker-down mode that corporate profit margins come into question at some point in time. -You use the phrase "financial fault lines" and that you're tracking around the globe, but how-- I mean, how dangerous is this current, you know, state that we're in even with the recovery? Is it-- Are you-- How concerned are you and where do you see the most-- you know, the most vulnerabilities looking around the world? -Well, we do worry about the sensitivity of the U.S. economy to this back-up in long-term interest rates-- -Uh-huh. -to high oil prices. The fact is, with 3 percent household savings rate, there's not a lot of resilience against those kind of external pressures. And of course, that could have a negative effect on corporate profit margins. Outside of that borders, we worry in Europe that, while the periphery may have adjusted through having a depression like problem in their labor markets, and therefore, lower labor cost. -So, you're talking about-- -Spain. -the bigger Spain, Portugal, Italy-- -Exactly. Those countries have recovered somewhat,-- -Right. -but to an unstable political position. The countries like France have not adjusted. Their labor costs now stand out like a sore thumb on the context of Europe. If we have an adjustment issue in France, that's a core issue in Europe. It's not a peripheral issue. And if we go to Asia, we've spoken a lot about the transition risk in the Chinese economy from what was an epic investment for them. -Right. -Okay. -Whether investing in infrastructure and real estate and-- -But beyond all measure of reasonables relative to historic measures. And we always worry about the combined effects of investment and credit terms. And China was at the epicenter of global monetary creation and investment in fixed capital and infrastructure, now that transition to less investment-led economies happening at the time where the competitiveness is being undermined by currency debasement outside of China. You've seen in the last handful of months, Japan, India, Indonesia all have their currencies weakened by 20 percent. The Thai Baht, the Malaysian Ringgit pull off 10 percent. So, the Chinese currency which has remained firm versus the U.S. dollar is now exposed versus its neighbors. And so, these, to us, present a little bit of instability in the Asian region. And don't forget, back in 2009, U.S. investors underestimated how important Chinese stimulus would be to the global recovery. -Uh-huh. -If there's an issue in China, U.S. investors may underestimate how sensitive the price of risk is globally to that event. And so, those are some of the things that we're a little bit worried about and we didn't even speak about the Middle East. -How does the Middle East figure in? -It's unknowable. -Right. -It's an incredibly complicated geopolitical realm, you know, rather like the Balkans, you know, in 1913, that's the region of the world that brings all interests together in one focal point. So, we do believe it's an important area to keep our focus on, but we also believe it's fundamentally difficult to predict. You know, at First Eagle, we've always had the belief that our crystal ball is foggy at best, you know, that we can't predict the future with certainty. When we look at all of these macro factors, the key point is that we think it's a time for some degree of caution, not complacency, and markets are priced for a degree of complacency.
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