Oxstones Food for Thought – June 2017 – Winter is Coming


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An eternal optimist, Liu-Yue built two social enterprises to help make the world a better place. Liu-Yue co-founded Oxstones Investment Club a searchable content platform and business tools for knowledge sharing and financial education. Oxstones.com also provides investors with direct access to U.S. commercial real estate opportunities and other alternative investments. In addition, Liu-Yue also co-founded Cute Brands a cause-oriented character brand management and brand licensing company that creates social awareness on global issues and societal challenges through character creations. Prior to his entrepreneurial endeavors, Liu-Yue worked as an Executive Associate at M&T Bank in the Structured Real Estate Finance Group where he worked with senior management on multiple bank-wide risk management projects. He also had a dual role as a commercial banker advising UHNWIs and family offices on investments, credit, and banking needs while focused on residential CRE, infrastructure development, and affordable housing projects. Prior to M&T, he held a number of positions in Latin American equities and bonds investment groups at SBC Warburg Dillon Read (Swiss Bank), OFFITBANK (the wealth management division of Wachovia Bank), and in small cap equities at Steinberg Priest Capital Management (family office). Liu-Yue has an MBA specializing in investment management and strategy from Georgetown University and a Bachelor of Science in Finance and Marketing from Stern School of Business at NYU. He also completed graduate studies in international management at the University of Oxford, Trinity College.

“Winter is Coming” – the motto for House of Stark in the Game of Thrones (HBO series).  The meaning behind these words is one of warning and constant vigilance in preparation for an epic storm.

By Liu-Yue (Louie) Lam, Global Investment Strategist, Oxstones Investment Club

On one of the last days of spring, my family and I were enjoying a walk in the park when my toddler sang ‘What a beautiful day!’ – A cheerful expression from characters in Peppa Pig (his favorite cartoon).  I nod in agreement and did not want to ruin his cheerful spirit by telling him the weather will soon change to heavy rain.  This situation reminds me of the current market – the calm before the storm.

We have experienced multiple years where market volatility continue to decline to historic lows.  Recently the market volatility hit the lowest level in 20 years.  Investors have grown complacent and continue to buy on every dip in the market.  However stability breeds instability.  Just as snow accumulates until it takes one additional snow flake to cause an avalanche I believe the current market is set for a return to a period of epic market volatility.  The question is when and what will trigger the market avalanche?  No one can predict with absolute certainty but there are multiple economic and geopolitical land mines that can be the eventual trigger.

Market Risks and Alternative Opportunities

Many have accepted the discount rates as-is which have led to extreme asset inflation in equity, bond, and real estate markets.  Blind acceptance when there is clear evidence global central bankers have artificially manipulated interest rates is foolhardy especially with current PE only infamously higher during the 1929 and the 2000 market peaks.

It will be difficult for the current market to further expand PE multiples especially with head winds from rising interest rates and QT.  That leaves only earnings growth for further market expansion.  The saving grace may be a weak dollar.  After peaking at a 15 year high the dollar has started to weaken.  A weaker dollar should help companies that receive over 50% of sales overseas benefit from a recovery in Europe and Asia.  However these companies are vulnerable to heightened geopolitical land mines.

The best values are in international stocks especially in emerging markets where valuations are at significant discounts to developed markets (50% discount to U.S. markets).  The weaker dollar should also support commodity prices and the global reflation theme.  Many emerging market companies are commodity producers.  Gold and silver are set to take off not only as a hedge against renew market volatility, but also due to cheap valuations after experiencing a bear market the past five years.

Precious metal miners offer 3-5x leverage.  After years of capex cuts there is now a shortage of supply in the market while there is strong demand from emerging market central banks, investors, and jewelry consumers.  With low energy prices and cheap labor costs due to devalued currencies in many countries where these mines are located; free cash flow at miners are the strongest in years.

Tip Toeing Through Global Land Mines

There are many global land mines in the near future.  Geopolitical uncertainties abound from China’s next currency devaluation and Chinese shadow banking debt issues to EU banking crisis led by insolvent Italian banks to Brexit2.  Proxy wars and the great game played by regional and global powers in Syria and Ukraine can accidentally lead to WWIII.  North Korea is just one missile launch away from causing U.S. to launch a preemptive strike and causing a nuclear incident.  South China Sea is also another accident waiting to happen.  A trigger happy sailor can lead to the point of no return.

Political Gridlock and Market Pricing Perfection

Since November elections, current markets have melted up by pricing in tax reform, tax cuts, fiscal stimulus, and deregulation.  However, with the President’s popularity ratings at a low 40; Republicans do not fear the President as much as they fear self-preservation.  Republicans will act in their own self-interest and listen to their constituents or suffer the consequences in 2018 midterm elections.

In March, U.S. debt ceiling holiday expired and although the U.S. government avoided a shutdown it has only pushed the can down the road to October when the next budget battle begins.  The U.S. economy cannot regain exit velocity from the slow growth of the past decade without much needed structural changes.  The U.S. economy is now similar to the Japanese zombie economy.

Unfortunately the Treasury department will run out of money late summer.  Will Trump allow the U.S. to default under his watch?  I do not think so.  Expect Republicans and Democrats to continue the status quo which means we can expect no significant legislative changes.  Political gridlock is a given. Democrats will now play the role of obstructionists which the Republicans did for the previous 8 years.

Another note, even if Congress and White House end up passing some form of fiscal stimulus this will not help the economy because it will be offset by the Fed unwinding monetary stimulus (QT-quantitative tightening).  QT will offset any fiscal stimulus unless the Fed monetize fiscal stimulus which will then be a net positive without competing against private sector funding.

Maximum Leverage and Cracks in the System

The Fed monetized so much debt it now owns 35% of U.S. Treasury Market.  Over the past eight years the U.S. government added $14T in budget deficits, consumers added $13T in debt, and corporations levered $10T for financial re-engineering.  We have reached maximum debt capacity in all levels of the economy.  Conclusive signs are everywhere – auto sales have declined to the lowest level since 2011 and may decline to 15M from 17.5M peak after years of loose auto credit fuel unsustainable spending that pulled from future sales.  Previous auto sales bottomed even lower at 11M.

It seems every day another retailer announces another bankruptcy filing.  Retailers are going bankrupt at a mind boggling rate and leaving behind a shopping mall wasteland.  This is due not only from disruptive changes in consumer shopping preferences, but also from baby boomer generation now retiring in full force and significantly cutting back spending.  The younger consumer generations are weighed down by $1.4T in student debt and do not have enough discretionary income to spend.  The median income for U.S. middle class households has not changed for the past two decades.

The financial distress in the retail sector will lead to a domino effect as cash flows are negatively impacted at shopping mall owners; leading to debt servicing shortfalls.  Weak cash flows at mall operators along with auto makers and dealers will impact bank earnings as some commercial real estate loans and auto loans will likely be impaired and loan loss reserves will need to be increased.  This also impacts the employment outlook.  About 15M work in the retail sector.  Four million of the forty-four million student loan borrowers are already in default.  Even large state governments are not immune to serious fiscal trouble.  The state of Illinois was downgraded to near junk status and common wealth Puerto Rico is already in bankruptcy.

Magic Bubble Making Machine

Global central bankers have a magic bubble making machine that put Peppa Pig’s ability to blow bubbles to shame.  Historic low interest rates and near universal money printing by central banks around the world have led a debt fuel spending spree that have impacted all areas of the economy including refueling another real estate and auto loan boom thereby robbing from future demand.  The misallocation of capital and delays in creative destruction has caused investors to reach for extra yield without proper compensation.

Unfortunately efforts to inflate the real economy have instead created multiple asset bubbles.  Bubbles are brewing in U.S. Treasuries, global sovereign bonds, municipals, high yield, structured finance, and certain sectors of the equity markets like in technology (FAANGMT), start-up unicorns, and low volatility stocks.  There’s also a bubble in passive index ETFs.  The massive trend towards passive indexing and short term algorithmic robo trading are causing inefficient price discovery in less liquid sectors such as gold, commodities, small caps, and emerging market securities due to a massive drop off in liquidity.

It’s not too late to heed the old Wall Street adage – sell in May and go away this summer might prove wise to do as a summer of geopolitical hotspots and market volatility heats up.

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