Fifteen years ago Ben Bernanke had to ask for $700bn to bail out the US Financial system otherwise "We might not have an economy on Monday", but the often overlooked reason why a financial crisis became an economic one was the role of the Money Market Funds which were effectively funding corporate working capital through Commercial Paper markets. When they froze, so did the economy. Fifteen years on, they are once again dominant, but this time crowding out bank deposits rather than bank loans. Let's hope they don't cause a similar, but different liquidity problem this time.
Recency Bias makes us focus on what just happened and ignore even recent history, while the end of history illusion makes us think that there will be less change in the next five years than in the last five. A quick recap on the last 5 Q4 periods reminds us of the dramatic changes we have seen, and while the next 5 years may not be as dramatic, we would see these changes as pressaging further changes on paths now revealed, be it BRICS+ disrupting the financial system, AI and working from home disrupting the service sector globally or just the retsoration of the proper price of money and liquidity through the end of QE.
Two steps forward, one (or two) step(s) back. After a strong July, when markets seemed to broaden out from the narrow concentration on mega cap tech stocks, investors were once again frustrated to see most stocks and markets give everything back in August, leaving many sectors, stocks and themes once again flat for the year. We believe that the proximate cause of the weakness in August was the late July bond sell off from Japan that spilled across to trigger trading stop losses in equity markets at a time when many were closing books for the holidays. Meanwhile, the high returns available on risk free $ cash are helping the dollar while continuing to impose something of a liquidity drought across other markets, including further out on the bond curve and many medium term risk managers are happy to delay the decision on searching for real returns in equities. China has dominated the narrative in August, but the long term investors need to start to think of the implications of the new BRICS 11 grouping, not least on account of the dominance of resource rich nations and the Sovereign Wealth funds they support...and how they are going to spend that money going forward.
With an upcoming Camp David meeting with US 'allies' in Asia and the BRICS meeting in South Africa, the narrative on China was always going to take a more negative tone. Investors need to recognise that while in the short term narrative managers may dominate, in the longer term cash flows count. China's troubles are not new, but nether are they anywhere near as bad as presented; exports are slowing, but still 40% up on pre Covid levels, while GDP growth is still 3x the US and 10x Europe. China offers both opportunities and threats, but what it doesn't offer is the opportunity to ignore it.
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July saw markets broadening as recognition that the second leg of a bear market is unlikely to appear became more widespread and fears of a recession receded. Shorter duration areas such as energy, mining and financials began to catch up with the megacap tech stocks. While retail may be too bullish, institutional investors are heavily short equities and long cash, a position that is not sustainable in the long run. The wobble in bond markets in early August may have more to do with 'the beginning of the end' of yield curve control in Japan than any US fundamentals, but will doubtless keep cash as a crowded trade in bond markets for the time being. Meanwhile, politically inspired narratives against China should not fool investors that they can ignore the impact of China on economies as well as markets; martial threats may be exaggerated, but competitive ones are very real.
This week, the BoJ finally moved on yield curve control. While the details are not exactly clear, in the manner of FX management in the past, the direction of travel is and the last man standing is now normalising rates. While it will be slow, more in the manner of Powell pre rather than post Covid, unwinding the policies of his predecessors will be a delicate task for BoJ Governor Yueda. As Japan is a major provider of global risk capital and liquidity we need to hope that he succeeds without too much disruption.
We were honoured to be invited to speak at the Sohn event in Hong Kong back in May, where I addressed the topic of investing in the new New Normal as part of our short presentation (video featured) of our 'stock pick' for the conference. We chose one of the themes in our new fund (European Banks) and from that one of the favoured stocks from our colleagues at ToscaFund in the UK where they have run a very successful long short financials fund for over 20 years. Two months in an we are pleased to say that our pick is currently third in the 'competition'. Not that we are competitive.....
We remain unconvinced that Central Banks are raising rates in recognition that their previous policy of zero interest rates not only failed but backfired spectacularly. Indeed, we sense that they are simply chasing reported inflation rates higher risking equal and opposite damage and disruption t omarkets and economies. With the latest inflation numbers coming in weaker, expectations of aggressive tightening are thankfully weakening. For countries with highly rate sensitive household sectors as short term fixed rate mortgages roll off, this would be a major blessing.
As we move further to the new New Normal, investors need to embrace the concept of DEI, not Diversity, Equity and Inclusion, but Diversification, Equities and Income. The good news is that Asset classes are going back to their proper purpose, fixed income (and high yield equity) for income and Equity to offer growth and real returns in an era where inflation will be in the 2-4% rather than the 0-2% range. Cash will trend to a zero real rather than a zero nominal rate and regain its role as a risk management tool.
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