Sometimes, upsetting the status quo can be disruptive and disconcerting in the short term, but good for the long term. These types of disruptions are occurring now around the world, at all levels, from countries to companies, and even down to individuals. The financial markets hate instability, real or perceived, during periods of change. Investors would rather move to the sidelines until change is all but complete and the benefits obvious to all. However, a successful investor recognizes change, whether positive or negative, and takes advantage of the volatility that it causes in the marketplace. Now is such a time.
The global financial markets reversed course last week due to newsworthy events in China and Greece. China continues to clamp down on speculation and leverage. The government announced a further reduction on the use of shadow financing for equity purchases while making available a significant new supply of shares to short sellers. The Chinese market reacted downward. The second event dealt with Greece. As expected, the ECB is growing more impatient with the Greek government delivering on its February promises to curtail deficit spending, which are needed in order to unlock additional bailout funds before the country literally runs out of cash. Neither event was a surprise, nor do they alter our positive view towards the financial markets. More about that later.
We wrote three short blogs during the week that I'd like to reflect back to briefly. The last was called "Beyond the Abyss" and dealt with the banks. First quarter reports of several of largest financial institutions like J.P. Morgan, Citi, Goldman and even Bank America showed higher operating earnings despite a narrow yield spread, increased capital and liquidity ratios beyond those mandated by Dodd-Frank, lower charge-offs of bad loans and regulatory settlements and accelerated lending. Since money is the fuel for economic growth, the outlook for the economy is bright. The banks are back in business.
The second was titled "A Rebuttal to Larry Fink," the chairman of BlackRock. He reiterated his view that activists have forced boards and managements of companies to be too shareholder friendly at the expense of spending needed for future growth. I disagree and believe that managements are dealing with capital allocation appropriately and are, in fact, generating significant free cash flow after sufficient capital and research spending in addition to debt reduction, higher dividends and increased share buybacks. Dave Cote, chairman of Honeywell, Jeff Immelt, chairman of GE and Jimmy Dimon, chairman of JP Morgan, addressed this point in their first quarter earnings calls last week and agreed with my rebuttal.
The blog written last Tuesday was titled "Don't Look in the Rearview Mirror" and reiterated what I said earlier: First-quarter earnings will not be representative of full-year results as they were overly penalized by a harsh winter, hurting demand and production, and suffered from a strong dollar hurting exports and translation of foreign earnings and continued economic weakness overseas. Just listening to managements' discuss first-quarter results supported my view, as business trends improved month to month both here and abroad. Don't look in the rearview mirror and use any market weakness to add to positions in companies that you like.
Let's review each region, concluding with an overview of asset allocation, regional emphasis, risk controls and industry/company selection both on the long and short sides of the markets:
• Both the economic news and company reports/conference calls support that economic activity is improving in the United States after a pause in activity over the last few months. The Fed Beige book came out last week and found modest/moderate growth in February and March in eight of its 12 districts and slight growth in the other districts. These results clearly put the Fed on hold raising the Fed funds rate until at least the fall if at all this year. It has become apparently clear that lower energy prices are helping consumer demand (retail sales rose 0.9 percent in March) and consumer confidence hit 95.9, while impeding industrial production, which fell 0.6 percent and posted its first quarterly decline in 3 years. By the way, capacity utilization fell to 78.4 percent putting further downward pressure on pricing and further reducing inflationary expectations. All good for interest rates. Remember that the key to the U.S economy is the consumer so net, net all of this is good for growth and profits.
• Europe and the industrialized world seems to be overly focused on Greece and what would happen if Greece exited the Euro on the European financial system and other countries in similar positions. There really are no surprises here in that the major players may be talking an optimistic game of wanting Greece to remain in the Euro but on the other hand preparing themselves financially in case Greece exits. Personally, I don't believe that the Greek government will make the regulatory reforms to its pension and tax systems to satisfy the ECB and its own citizens. As I have said before, Greek is a very small part of the European economy and a small percentage of its debt is still owned by the banks, corporations and individuals. Clearly the Greek economy will have another leg down if it exits the Euro, money will continue to leave its banks, inflation will rise and its people will suffer. On the other hand, I believe that the Euro will rise after an initial dip if Greece exited the Euro for reasons mentioned before.
The IMF raised its forecast for the Eurozone to 1.5 percent for the year. A decline in energy prices bolstering consumer disposable income and weakness in the Euro over the last nine months boosting exports has all added to growth. ECB President Draghi at last week's news conference committed that the ECB will purchase up to 1 trillion Euros in bonds until September 2016 even at negative yields up to MINUS 0.2 percent. Isn't that amazing? German bunds rose to record highs and the thirty-year bund fell to a yield of 0.5 percent.
All the economic indicators point up for Europe, which was supported by company comments last week, too. Clearly the financial stimulus is working and a stronger foundation is being built as consumer demand is improving, interest rates continue to fall, industrial production is rising, wages are turning up and companies/individuals have a new-found confidence. By the way, the Euro has had its counter-trend rally as we predicted a few weeks ago. But, while Europe has made significant progress on many fronts, I still believe that you need financial and regulatory union too beyond a common currency to really make inroads as a global competitive force.
3. The Chinese market has had one of the best performances of all markets over the last six months. We have been there! It has been our belief that this administration has correctly identified the past excesses throughout the system that supported high economic growth rate with high risk and is making all the necessary changes to build a strong foundation for sustainable future growth, albeit less than in the past. The Chinese market fell hard on Friday, by over 5 percent, after the government announced new restrictions on shadow lending for equity purchases while increasing the supply of shares available to the short sellers. This was a smart decision to reduce speculation in the marketplace.
China's central bank governor Zhou Xiaochuan said on Saturday at the IMF meeting in DC that the country had the latitude to ease its monetary policies to support sustainable growth by reducing the reserve ratio and interest rates further. Guess what happened on Sunday? The governor did exactly what he had indicated the day before and cut the amount of cash lenders had to set aside as reserves and announced that the reserve requirement ratio will be reduced by 1 percentage point effective April 20th. So here again, one hand taketh and the other hand giveth away. I remain confident that China is building a strong foundation for the future even though it may penalize near term prospects. Be patient!
4. OPEC continues with its strategy of maintaining or increasing production to put added pressure on world prices hoping that exploration will be reduced such that OPEC will gain the upper hand on pricing in the foreseeable future. The members are clearly talking their own game hoping others will listen and take actions accordingly. Take notice how the oil rich nations are selling off other assets to support their local budgets. Watch what they do and not what they say.
Let me state once again that the problem with all commodity prices is mostly demand driven. I acknowledge that there has been a sharp decline in U.S. drilling but total production continues to increase. Also there is a move to gas away from oil and new technologies and net metals reduce the energy consumption/demand. Finally, what happens when Iran comes on the market with an additional 2.5 million barrels per day when/if sanctions are lifted? While the price of oil may increase as the global economies recover or if an event occurs, the long-term supply/demand picture for energy is bearish. Don't listen to Boone Pickens? He is playing his own hand too.
Now let’s see if recent events changed any of our investment thinking. A hedge fund manager is paid to be cynical and look for the potential negatives first and foremost, as protection of capital is our first mandate. But I have also stated that there is a time to hold them, a time to reduce them and a time to fold them and go net short. There are no preconditions at this time to the end of this bull run. That does not mean that there won't be corrections along the way which is the reason why we maintain ample liquidity at all times and are never more than 95 percent net long.
We are living in a totally different environment than eight years ago when speculation was rampant and excessive risk was everywhere. Just the reverse is occurring at all levels, as we have stated repeatedly. Let's just begin with the banks which have virtually doubled their capital ratios in the last 8 years or major corporations which have not only reduced net leverage, lengthened maturities, and increased interest coverage, but also refined new winning strategies to succeed in a global competitive landscape. If not for car and education loans, the individual is in the best financial shape in a decade, too. Pretty good!
The same is occurring globally from Europe to the Pacific. Everyone, everywhere is strengthening the foundation for the future.