Morgan Stanley: Europe Economics

Morgan Stanley's European economists about the economic outlook for 2011 in Europe:

Growth will moderate due to decreasing fiscal stimulus or increasing fiscal tightening (peripheral Europe), but will broaden out in terms of shifting from inventory rebuilding to stronger domestic demand. Sadly, only few jobs will be generated.

 

Although budget deficits decrease, government debts are still on the increase; not only in the periphery!

As you can see, the debt situation is crying for a solution: Debt has exploded in the last four years. MS Analyst believe that the solution will be EU debt (where the Union is guaranteeing) instead of national debt. However, this systemic solution will likely see some political obstacles, particularly from the German electorate (but what is their alternative?).

Inflation and bond yields will rise over the course of the year.

The macro-economic view leads to the following investment strategy:

• Equity: growth will drive Earnings. The preferred sectors are Materials, Insurance, Energy and Telecom.
• Exchange rates: overweight US-Dollar and underweight Euro because of the stronger US economy

2011 decisive for indebted US states

The FT runs article about indebted US states and municipalities.

(click to enhance the graph)

The huge USD 3,000bn municipal bond market is heading for some difficult times this year.
Although the US economy is recovering, the financial situation is likely to worsen because federal assistance will be reduced significantly, revenue from property taxes is shrinking, and interest rates due to their worsening credit standing are increasing.
In General, it is expected that municipalities will cut spending drastically, manage their finances more rigidly  in order to meet their debt obligation and to avoid default. Nevertheless we will see some defaults  probably in Illinois first where the financial situation is most precarious and funding the budget is depending on selling public debt. Bonds of Illinois have already the highest credit spreads.

Goldman Sachs very positive for 2011

On January 7th, they wrote in their Global Opportunity Asset Allocator:

• An improved economic outlook
  Globally we expect 4.7% GDP growth in 2011 and 4.9% in 2012. In the US we recently increased our growth forecast to 3.4% in 2011 and 3.8% in 2012. Policy tightening in China and the sovereign situation in Europe are risks to our positive view and likely to cause volatility, but we believe the strong global growth momentum will continue to dominate asset performance.
  
• Reshuffling risk exposure in the near term (1-3 months) …
  On a 1-3 month horizon, we upgrade our small equity Overweight to a full Overweight, downgrade commodities to Neutral, and investment grade corporate credit to Underweight. We are also Underweight government bonds and, with the strongest conviction, cash. The changes reflect improvement in the global growth outlook, commodity prices which after the strong recent performance are close to our near-term forecasts, and the low yields available in both investment grade credit and government bonds. Within equities, we are Overweight US and Japan and Underweight Europe and Asia ex-Japan on a 1-3 months horizon; we reverse this ranking on a twelve-month horizon.
  
• … and maintaining our strong pro-risk 6 to12-month position
  On a 6-12 month horizon our allocation is unchanged. Our highest conviction Overweight is equities, which we expect to benefit from strong earnings growth and attractive valuations. We are also Overweight commodities, where tightening demand/supply balances should support higher prices at this horizon. We are Neutral on corporate credit where we expect a limited, yet positive return for the year. We are Underweight cash, where the return potential is very low. Our biggest Underweight is government bonds, where we expect zero return over this horizon.

Now, that's much more positive than Morgan Stanley. But the biggest contrast is this "Weekly Market Comment" by John P. Hussman titled "Illusory Prosperity" - Ludwig von Mises on Monetary Policy.

He notes: "the Market Climate for stocks continued to be characterized last week by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been very hostile to stocks."

Gold, the case for your portfolio

Last week, gold came down -3.7%. Business news media (FT) is already pondering about the end of the gold bull market. Could that be true? First of all, I am not focusing too much on daily or weekly movements, since they make me dizzy. I'd rather focus on the medium or long term. So what are the driver of gold price in the long run?

1. Gold is used for jewellery
   Strong long term growth of emerging economies will increase demand for jewellery and will strengthen the gold  further.
   
   
2. Gold is used for wealth preservation
   Let's not forget that gold has been used for this purpose over 5000 years, while our (fiat) currencies are existing for couple of decades, at best for 100 or 200 years. Gold supply is difficult to increase (you have to dig a lot), while currencies can be increased easily.
   The increasing probability that Japan, USA and Europe can escape from the mountains of sovereign debt only by diminishing it through the means of inflation, was driving the gold price for the last few months.

Pricing gold is a little bit difficult, since holding it is not generating any cash flow (usual models depend on cash flows). However, consistent with the statements about inflation, you can actually model gold, using the (negative) correlation between the price of gold and real interest rates (= nominal interest rates - inflation):

As you can see, the model is fitting the reality pretty well. So, when inflation will increase massively, real interest rates will drop as a stone, pushing the gold price up.

Thus, your portfolio should include a sizeable portion of gold, probably around 10%. You also might add some gold mining stocks, also depending on your tax regime (the US is taxing gold heavier than stocks, were as gold has a tax advantage in Germany).

Morgan Stanley: Four economic themes for 2011

Morgan Stanley identifies four economic themes for 2011 to be considered for investments:

1. Solid but unspectacular global growth
   Growth in developed market (DM) is elevated by cyclical forces (i.e. improving business cycal) against structural headwinds/problems. Early business cycle in DM and mid business cycle emerging markets (EM) have different problems, policies — a dynamic to watch
   
   
2. Global rebalancing and inflation
   Continued rebalancing (i.e. shift of growth) between EM and DM, and within countries, reinforces the growth outlook. But EM inflation risk is rising, potentially exacerbated by better DM growth; makes policy response difficult.
   
3. Sovereign risk 2.0
   The sovereign debt crisis has accelerated, but risks may be less systemic as Europe muddles throu. The key is credible plans on bailout support and restructuring mechanisms to stem contagion soon.
   
   
4. Politicization of economic decisions
   Politics is affecting decisions on the sovereign debt crisis, also raising tensions on foreign exchange (FX) and trade. Obviously, the risk of policy error is high when politics are involved.

$14.025 trillion

For the record, not only Europe is heavely indebted so is the U.S Federal and local government (Japan's epic debt should be covered by histroy books by now).

According to The Daily Reckoning the national debt as of December 31st, 2010, amounts to $14.025 trillion or $140,252.00 for every non-government worker. You might have heard of states like Illinois or California (the eighth largest economy of the world) facing sovereign default.
Since default or saving is too painful, the easy way out is inflation, reducing the economic value of debt.
A sizable Position of precious metal such as gold is therefore mandatory for any investment portfolio. But I might leave that for another post.

Western European Default Risk Same as for Eastern Europe

FT runs an article today about European credit default swap (CDS) spreads. A CDS is used to insure against the default of bonds, and its spread is the annual insurance premium measured in basis points (0.01%) of the bond nominal value.

The chart above illustrates how CDS spreads of central and eastern Europe, the Middle East, Africa and western Europe converged. They argue that it is not only a sign of western Europe's debt and economic situation but also a sign of increasing wealth in emerging markets.

The Problem with Fund Selection

Mutual fund selection is very problematic since you are making investment decision based on history.
Moneywatch.com sports a very interesting article about the return investors made in the famous and very succesfull Fidelity Fund Magellan. The now famous fund manager Peter Lynch run the fund from 1977 to 1990. The funds average annual return for that period was 26% and the benchmark S&P500 returned 13%.
Investors picking that fund must have been very smart with their fund selection. Unfortunately, the average investor of the Magellan fund under performed the market. How is that possible?

From 1963 until 1981 the fund was closed. Before the opening the fund was very small and only run to build a successful track record. After the opening the Peter Lynch achieved an annual performance of 13% and the benchmark a performance of 16%. 1990 Peter Lynch retired with 46! From 1990 to mid-2010 the fund returned 7% annually trailing the benchmark.

Most inflow came when Mr. Lynch was already a retiree!

I once read that selecting a fund based on past performance is like driving a car by looking into the rear mirror.

Value investing, why it works!

Investors generally focus too much on recent company results and project them into the future for many years. Those projections serve as justification for their high stock prices relative to their current earnings, cash flows, and book values. Unfortunately, above average results can generally only be maintained for some more quarters until competitors catch up (mean reversion) and can only be upheld in rare cases for longer periods of time. Those glamour stocks will soon underperform their competitors.

I give you following example:
Peters and Watermann published the bestseller "In Search of Excellence: Lessons from Americas Best Run Companies". In this book the authors mined the market for successful companies and subsequently mined the data of these companies for statistically significant factors for success. Unfortunately, the above average results could not be maintained in the future and "unexcellent"companies caught up in the following years, as shown in the graph below (Haugen, The New Finance, p. 46): 

 

"In search for excellence" may be a great book for business management insights, but it is of little value for investing your money.

Underperforming companies will eventually turn around by changing their strategy and management team, or they get taken over by another company. Anyway, the probability is high that earnings and as an extension the low stock price of the underdog will recover in one or two years (mean reversion).

How quickly mean reversion takes place is made visible by the chart below (Haugen, The New Finance, p. 43):

Companies with the lowest PE will have lower earnings next year, but will recover rapidly in the coming years, surprising markets positively. Companies with the highest PE will have higher earnings next year, however their earnings will not grow rapidly in the years thereafter, and hence, surprise investors negatively.

So why do professional money managers not invest in value opportunities? 

Simple human behaviour: Undervalued stocks have a recent history of underperformance, bad results and bad press. In short, stocks that look bad in any portfolio, stocks you'd like to sell in order to get them out of sight of your client or your boss. Overvalued stocks on the other hand look great in your portfolio, so buy some for window dressing. After all, you might want to keep your clients, your job or even be promoted from fund manager to chief investment officer! Very often fund management companies do not want their manager to deviate substantially from their benchmark, as big underperformance causes bigger damage than outperformance is causing benefit. That's why funds usually exhibit a slight underperformance against the benchmark (due to fund expenses).

The critical reader might respond, Philipp, you presented a nice story, a slick theory, and even gave some anecdotal evidence so far, but that does not prove anything. Do you have some hard evidence to present as well? Or is this just another fad?

Luckily, there is tons of ignored evidence out there:

The interested reader might delve into this paper to examine the empirical evidence further.

Value Stocks for 2011

In line with my post on November 16th, 2010 about overwhelming empirical evidence of outperfomance of value stocks presented by Prof. Robert A. Haugen, I would like to present some attractive stock picks:

• USA
  Some tech stocks are highly profitable and reasonably priced. They are no longer growth stocks but rather value stocks although they are more volatile than classic value stocks: HP (HPQ), IBM, Intel (INTC) and Microsoft (MSFT). Oil shares such as Chevron (CVX) as well as ConocoPhillips (COP) are also cheap and moreover less volatile than average stocks.
• Euro zone
  My favorite defensive stock in the Euro area are RoyalDutch (RDSa) and Unilever (UN) with low market risk and low valuation.
• UK
  British American Tobacco (BATS) and BP are low priced stocks with low market risks, although they carry some sector (tobacco) or company specific risks (litigation due to oil spill).
• Switzerland
  The two pharmaceutical giants Novartis (NOVN) and Roche (ROG) can be bought cheaply and exhibit very market risk. BKW (BKWN),a mid cap electric utility company, is also very attractive regarding risk and valuation.

These picks should do well mid to long term in a buy and hold framework. They are all traded at a discount compared to sexy but pricey growth stocks. Soon or later the market will value their quality, just be patient!