Swimming in waters full of black swans

Luc Synaeghel, CIO 2016-05-10

The current investment waters are eerily calm. Early year concerns about a Chinese hard landing, the oil price collapse or a recession in the US have given way to quiet optimism that the world economy will continue to plod along its slow growth path, with the full backing of monetary authorities. Beyond the fact that such a scenario cannot be expected to generate substantial returns, given the generally rich valuation levels that now prevail across the financial market spectrum, we would caution that investors have been lulled into a false sense of safety. Many a black swan inhabit these calm waters. Put differently, much could go wrong in the next weeks or months, triggering a serious financial market correction.

A first black swan would be an escalation of the Syrian conflict, bringing Saudi Arabia and Iran head to head. This could threaten Middle Eastern oil production facilities and cause a spike in the oil price – dealing a serious blow to western economies (more on page 2).
The resurgence of inflation would be another black swan. The common mantra today is that deflation is our arch enemy. But what about the near 3% wage growth currently observed on both sides of the Atlantic? Are there not also flaws in the way that European inflation is measured? And how far behind the inflation curve will the Federal Reserve (Fed) allow itself to fall? This we discuss on page 3, together with the prospect of Donald Trump being elected as US president – another black swan, still largely dismissed but becoming less impossible by the day.
The next three black swans on our radar pertain to Europe: “Brexit”, “Grexit” and the possibility of bank failures, particularly in Italy. Separately or, worse, together, they could put big pressure on the European institutional construct and economy (see page 4).
Our final black swan swims much further East. Ongoing huge monetary stimulus is driving double- digit lending growth in China. In order to avoid a debt bubble, the government is starting to dabble with bank balance sheet cleansing – with the risk that foreign owners of bank shares be diluted by forced capital increases and, perhaps more importantly, that policy errors push the Chinese economy below its targeted growth path (more on page 5).
Mentioned above and detailed in the following pages are the “known unknowns”, to borrow a term coined by former US Secretary of Defence Donald Rumsfeld. To some extent, our portfolios are positioned to deal with these black swans. We own oil and energy companies, as well as inflation-linked bonds, and have bought protection against a US equity correction. As for the downside risk to European and Chinese equities, where we do have exposure, we are carefully monitoring the situation. But as Donald Rumsfeld went on to say: “there are also unknown unknowns – the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” We can only hope that not too many of those black swans are also swimming near us. BLACK SWAN 1:
ESCALATION OF THE SYRIAN CONFLICT The Middle Eastern situation in general, and the Syrian one in particular, are subjects far too complex to be addressed in such a letter – indeed for us even to claim to have expert understanding. We will, however, attempt to describe how an escalation of the Syrian conflict, now that the fragile “cessation of hostilities” agreement appears to be breaking down, could bring about an oil price spike – and set into motion a negative global economic spiral.
Saudi Arabia seems to be on the side of the Syrian rebels, for reasons that are both religious and political. From a religious perspective, with Iraq having been “lost” to the Shia majority, following the withdrawal of US military troops, Saudi Arabia effectively found itself surrounded by Shia-led countries. As such, the Syrian rebellion to oust President Assad and install Sunni leadership certainly does not displease Saudi Arabia. From a political perspective, Saudi Arabia feels that it can no longer count on the protection historically granted by the US (largely because the advent of shale oil has rendered the US energy-independent), meaning that it needs to uphold its position as a regional power.
Saudi Arabia’s push for low oil prices since late 2014, despite the dire consequences for its own public finances (and the consequent urgent need to transform its economy), has thus been a means to hurt not only US shale oil producers, but also President Assad’s major allies, Russia and Iran.
To a certain extent, the Syrian conflict can be viewed as a proxy war between the two current Middle Eastern powers, Saudi Arabia and Iran. So far, this war has been waged mainly through the arming and financing of the opposing factions in Syria and, as just mentioned, the oil market (beyond striving to keep the oil price low, rumour has it that Saudi Arabia has been doing its utmost to stop Iranian production from ramping up, for instance by refusing to store/refine Iranian oil in the facilities that it operates across the globe).
In the coming weeks and months, an escalation of the Syrian conflict could actually bring Saudi Arabia and Iran face to face. Odds would then be that oil production facilities become military targets, making for probable disruptions in the supply of oil and causing a spike in its price.
Such a move in the oil price would well exceed, both in scale and in speed, that assumed by our long-held scenario of a gradual return to fundamental supply-demand equilibrium in the oil market. As such it would put severe pressure on western economies. Their main engine – consumers – would suddenly lose power and stall, while their central banks would see the leeway for accommodative monetary policy afforded by low oil prices rapidly disappear, as headline inflation rates pick up. Odds are that it would not be long before recession again rears its ugly head. BLACK SWANS 2 - 3:
INFLATION AND “TRUMP FOR PRESIDENT” We wrote last month about the Fed having deliberately chosen to defer its next rate hike, despite increasingly visible price and wage pressures. By explicitly voicing concerns about the global economic situation, commodity prices and potential US dollar appreciation, the Fed has indicated that it prefers to err on the side of inflation rather than risk causing a recession. Some now see its acceptable inflation threshold at 4%. Which in our view makes for a lose-lose situation: either the Fed decides to raise rates before that “new” threshold is reached and surprises investors (negatively), or it does let inflation run up to such a level and causes a valuation reset across bond and equity markets. Note that the latter outcome might actually make for a more acute correction.
Less realized – and disputing the widespread belief that Europe is still on the brink of an “deflationary abyss” – is the fact that the wage bill on this side of the Atlantic is also growing at a near 3% pace, an 8-year high and well out of the negative territory experienced in 2009 (source: BCA Research). Yet the European Central Bank continues to communicate about what needs to be done in order to reach its stated 2% inflation target, and to act accordingly and forcefully.
Beyond the housing component included in US consumer price inflation measures, the gap between US and European headline inflation, in spite of similar wage growth, probably has to do with the way in which it is measured. The European methodology is effectively geared to minimize inflation. When the price of a good rises, it assumes that consumers will substitute it with another (similar) good, rice versus potatoes for instance. And when an appliance is replaced by a more expensive one, the methodology may actually view it as cheaper because of the additional functionalities provided by the new appliance – even though the buyer might not have wanted or even needed them! So although many European consumers would argue that they feel inflation in their everyday life, it has yet to show up in official data. We can only say: watch out for the inflation swan.
Now to US politics. Until recently, few expected Donald Trump to be the Republican nominee for the presidential election – a prospect that has just come to be realised. But fear not, the same “optimists” would now argue, his chances of winning the US presidency against (likely) Democratic candidate Hillary Clinton are extremely low. What if he were actually to celebrate a victory on November 8?
“Washington, we have a problem” would be financial markets’ probable response – even if newly elected President Trump were to implement only some of the measures that he has voiced during his campaign. In particular, we would be wary of a downturn in global trade, should duties come to be imposed on US imports from China, and of a NATO “implosion”, should the US go through with the threatened funding cuts. BLACK SWANS 4 - 5 - 6:
“BREXIT”, “GREXIT” AND ITALIAN BANKS Several European black swans roam the investment waters. First, and only weeks away, is the referendum on the United Kingdom (UK) exiting the European Union (UE). Should UK voters decide on a “Brexit”, we would expect European markets to take a hit. Uncertainty would be huge, given the long period of negotiation of exit conditions that would ensue. Trade barriers would probably mount between the UK and Europe, hurting economic growth and corporate earnings. Last but not least, the political “equilibrium” between the major European powers (Germany and France on the left versus the UK on the right) would be shaken.
Would a “Brexit” also create a precedent for other European countries/regions toying with the idea of independence? While possible, this is not evident to the extent that the UK has always been a somewhat “different” EU member, not least because it never joined the monetary union. In this respect, the threat to the EU construct would probably be greater in the event of a “Grexit”
– also an accident (black swan) waiting to happen. Anyhow, even if the UK elects to remain in the EU, all “trouble” may not be over, particularly if the majority is narrow. New negotiations with the EU, to obtain yet more exceptions, would certainly ensue in an attempt to stabilize the political situation in the UK.
Turning to the Italian banks, a recent report by Gladstone Partners (active in alternative investing) summarizes the problem as follows: “four banks are at risk and no one wants to acquire them; two of them are planning capital increases this year but investor interest has waned. None can be put in a resolution procedure without raising the probability of a systemic crisis in the country, and the Government cannot bail them out without breaking European Union rules”. The banks referred to here are the provincial “Popolari” (mutual) banks that have historically funded the (now ailing) small- and mid-sized Italian enterprise sector, that suffer from dysfunctional governance, and that are experiencing a slow motion bank run as depositors move to safer institutions. The numbers provided in the report are daunting. Italian gross non-performing loans amounted to some EUR 200 billion in the third quarter of 2015, up nearly five-fold since 2008. Gross doubtful loans, which include those set to become non-performing, were a staggering EUR 345 billion. Further, the collateral on non-performing loans is carried on banks’ balance sheets at a value exceeding the price for which it can currently be sold. The problem is most acute in the lower quality segment, where Gladstone Partners argues that “the collateral value is near zero”, consisting of “warehouses of defunct industries in abandoned industrial zones”.
The proposed “solution” is a EUR 5 billion fund, named Atlante, backed by healthier Italian banks and insurance companies. It is intended both to recapitalize weak banks and to purchase non- performing loans, helping launch a real market for such loans in Italy. Given the size of the problem, whether this “solution” will be sufficient to safeguard the Italian banking system remains an open question. Ultimately, European funds may need to be called to the rescue – forcing EU member countries to dip into their pockets and only adding to institutional tensions. BLACK SWAN 7:
THE CHINESE DEBT PROBLEM Recent Chinese economic reports have been reassuring, helping to calm financial markets and drive the recovery in commodity prices. Notably, the manufacturing Purchasing Managers’ Index is now back above the 50 level, suggesting that Chinese industrial activity is no longer in contraction.
This improvement in economic data has of course much to do with the huge stimulus measures being implemented by the Chinese authorities, in the form of monetary easing and front-loading of fiscal spending. The monetary measures in particular have led to a surge in credit, into double- digit territory. The associated growing debt burden is increasingly being pointed to as worrisome by analysts/investors.
Our take on Chinese debt is somewhat different. We believe that the problem resides not in the overall amount of debt, but in the potential policy errors that might be made in attempting to deal with non-performing loans.
On the subject of size, remember that Chinese government debt currently amounts to only a third of GDP, well below the levels observed in Western countries. China also boasts a very high savings rate, meaning that it is not dependent on external financing. And the structure of Chinese debt is somewhat “special”, consisting to a large extent of money owed by state-owned enterprises to banks that are also (mainly) state-owned.
That said, state-owned enterprises are currently having trouble honouring their debt obligations. Well aware of these difficulties, Chinese authorities are starting to have some banks recognize these non-performing loans and write them down – with the state participating in the ensuing necessary bank recapitalizations. They have also allowed some corporate bond defaults, particularly when foreign investment was present.
As is usual in China, the process is being tried out first on smaller banks and in a measured way. But the danger (read: black swan) would be that the pace of non-performing loan write-downs increases rapidly. Bank lending may then take a hit, making the official 6.5% economic growth target more difficult to achieve. And the resulting forced bank recapitalizations could impact the Chinese stock market, via the listed portion of the said banks’ capital base. In other words, private bank shareholders, including foreign ones, would be diluted. Perhaps this is why Chinese bank equities are trading at such a discount?