Macro backdrop

Quick comment on each of the major asset classes, and their relative attractiveness vs. cash. I am agnostic about relative allocations and willing to go 100% cash if it is deemed to be the most attractive asset class.

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Stocks have benefited from lower interest rates the last 30 years and the excessive spending effect that comes from increasing debt/GDP. This is not only true for the US and Europe – global interest rates are the lowest they have been in 50 years.

Global interest rates

Assuming constant equity allocations and no increase in the number of shares outstanding, stock market prices cannot grow unless total money supply (money + credit) grows. Credit cannot grow forever as the total debt burden on economic participants becomes too high. The only way to keep up total money supply growth is then increase m0 (currency in circulation + reserves) substantially, either through printing currency in circulation or open market purchases funded by reserves. We have seen quantitative easing, whose effect is short term and not considerable on the money supply. But unless governments start physically printing money on a big scale, it is hard to imagine total supply of financial assets to grow at a very fast pace in advanced economies. Japan has already lived through this for many years – bullish for the currency but bearish on equity price increases.

Global debt

Investor equity allocations are elevated for most markets. They are especially high for developed markets in North America and Europe. Given high equity allocation figures for households in the US, equity prices must be high – especially considering that most bond instruments also look overvalued.

Household equity allocation

Valuation ratios for other countries in terms of market cap/GDP vs. historical levels

Country Total Market/GDP Ratio (%) Historical Min. (%) Historical Max. (%) Years of Data % of Peak
Belgium 229 80 229 4 100%
Mexico 42 12 46 23 91%
USA 123.7 35 149 44 83%
Sweden 125 63 159 13 79%
Canada 139 78 190 24 73%
Switzerland 287 84 431 24 67%
UK 132 47 205 42 64%
Korea 87 36 140 17 62%
Germany 49 22.7509 81.9083 24 60%
Australia 123 94 229 14 54%
India 78 41 165 17 47%
Indonesia 50 19 108 17 46%
Brazil 48 26 108 17 44%
France 78 54 183 24 43%
Netherlands 88 51 251.5 22 35%
Spain 81 50 235 21 34%
Singapore 141 92 418 27 34%
Japan 120 56 366 30 33%
Italy 14 9 45 14 31%
Russia 33 22 142 14 23%
China 44 41 662 24 7%

Peak valuations may never be reached again in some cases (Japan), so one should take the above figures with a grain of salt. Interest rate levels are also different for each country. But on an absolute level, market capitalisation rates in countries such as Italy, Russia and China are very low indeed, maybe for good reasons. Valuation levels are worryingly high for Western European, North American and selected emerging markets, especially for smaller capitalisation stocks.

The frothiness of the US IPO market is indicating a top. In 1999 around 83% of all companies that went public have never had a profit – today that number is 80%. This is a great source for short ideas.


The AAII Sentiment Survey for the US points to neutral view on the market. Most investors are not even aware the equity prices have boomed. And fundamentals look OK for the US. The yield curve (although manipulated by the Fed) does not point to a recession.



Interest rates have reached record lows in many countries, as mentioned below. But supply and demand for bonds speaks in favour for lower yields, which means that we may not see considerably higher rates for a long time.

Why should interest rates increase?

  • Supply: an increase in supply of credit would come from either 1) government 2) companies 3) households 4) foreign central banks. However, debt/GDP levels are very high in most developed countries, which means that the long term supply growth of credit will be limited absent any rise in taxation levels. 
  • Demand: We are seeing aging populations pretty much anywhere in the world except Africa, Middle East and South Asia, which means less spending, a secular trend toward lower inflation and higher demand for safe assets due to retirement needs. Deleveraging in the banking system in Europe and the US increases demand for high quality assets, which all fixed income securities are priced off.
  • Government intervention: manipulation of interbank lending rates or direct lending from central bank balance sheets would compress the whole yield curve if such actions persist. As growth is unlikely to pick up considerably, central banks have political incentives to keep rates low.

Higher risk bonds have rallied substantially in recent years, in line with increased risk taking by investors. Credit spreads are not as low as in 2007, but absolute junk bond yields are incredibly low.

Screen Shot 2014-08-23 at 13.05.20

High yield issuance in developed markets has been high in recent years. This means pressure on junk bond prices when these bonds will need to be refinanced. Developed market junk bonds may be a good source for ideas on the short side. The benefit of bond shorts is that upside-downside quantity ratios and recovery rates are easily quantified, so downside risks can be held at low levels (at a cost of negative carry).

High yield.jpg-large

Global default rates are not increasing yet, so it does not seem likely that the junk bond market will correct meaningfully. Junk bond default rates for US:

Default rates

Even though there is no compelling argument why interest rates should increase, credit spreads are mean reverting in cycles of 5-10 years. Default rates may be low in developed markets, but there are signs of stress in the banking system elsewhere, including in China, Indonesia, Russia, etc. In the US, the high supply of junk bond issuance over the past few years must have led to a deterioration in credit quality at a time when spreads have reached close to record lows.

Emerging market bonds, after last year’s emerging market bond rout are priced OK against US Treasuries. Current long term EMBI spreads are around 350bps, in line with the 10 year average. Currency risk may be underestimated, however.



Currencies represent a claim on the productive abilities of individuals within a country where a currency has a monopoly through legal tender laws. The value of a currency increases with relative population growth and relative productivity improvements. The value of a currency also decreases with the supply of claims of citizens’ productive abilities.

If a currency (i.e. the local wage level in foreign currency terms) is undervalued, this will show by competitiveness of its exports and FDI flows. Competitive currencies thus tend to have current account surpluses and large FDI inflows. They should also have low debt/GDP ratios meaning base money is less over-collateralized.

Countries such as China, India, Brazil, Mexico and Indonesia score highly on long-term attractiveness for FDI flows.

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Countries with current account surpluses to GDP include many commodity producing countries. Major investable Asian countries in red in the chart below. Interesting regions may include Singapore, Vietnam, Korea, Philippines, China and Hong Kong.


Judging future productivity gains is harder, but a good start is looking at savings rate and R&D spending to GDP. China scores highly in this respect, as does Vietnam (relative to the size of its economy per capita) as well as India and South Korea. These are countries that are likely to have secular productivity gains relative to other economies in the next couple of decades.


Money supply growth may be negative for currencies speculators, depending on the shape of the futures curve, or interest rates levels for spot investments. For equities with strong pricing power thanks to strong economic moats, inflation is less of a worry. What I want to see is low money growth historically, but accelerating fast, as this may propel the economy to begin a new business cycle.

M0 worst

Inflation-wise, worst offenders such as South American and African countries are printing money at a fast pace, usually to finance budget deficits. Macao, Vietnam and Indonesia are also experiencing high inflation, making currency holdings at low interest rates less attractive. Best region for currency speculators in terms of low money supply growth include the Eurozone countries where deflation has taken hold.

Investor allocations for currency are usually driven by carry considerations, underestimating currency risk that may occur at turning points. Popular carry trades at the moment are borrowing in Hong Kong Dollar, Japanese Yen, US Dollar or Euro and investing in Chinese Renminbi and the Australian Dollar. Although the AUD and the CNY have started to correct, it seems like there is still a long way to go before these carry trades unwind.

AUD ownership

It is also worth avoiding currencies of commodity producing regions as the correlation between FX rates and commodity prices are high. Such currencies include the Australian Dollar, the Canadian Dollar and the Brazilian Real. Current account deficits are likely to continue falling.

The conclusion is: exposure to equities in countries with current account surpluses is generally a good idea. These include Vietnam, South Korea, China, India, Singapore and Hong Kong. Fixed income positions and spot currency positions are more attractive in low inflation regions such as the Eurozone. Short commodity producing country currencies such as the Australian Dollar, Canadian Dollar and the Brazilian Real. Also short currencies with massive capital inflows the last ten years including the Philippine peso, the Indonesian Rupiah and the Australian Dollar.


More or less the only marginal buyer of commodities the last ten years has been China. The oil price has been driven higher by higher car penetration rates (boosted by car subsidies) and an increase in energy intensity due to construction activity. Still, the demand increase is driven by demand, thanks to oil consumption in volume terms growing more than 10% per year in China. Supply is now catching up, although very slowly. In real terms oil prices are still very high.

Real oil price

But the growth rate of China’s energy consumption is likely to slow down as it has to some extent been driven by a very large debt build up. The current building boom (infrastructure + real estate) started in 2003 and has led to energy consumption going up 2-3x since it started.

China energy consumtion 1990-2010_2_0

The increase in China’s debt/GDP is a scary chart, as very few countries in the past have increased debt at a pace of almost 80%+ in only five years. Spending levels in China has grown the fastest in the world over the last five years. The fact that China represents 45% of the global luxury market despite having only 15% of global GDP indicates the scale over overspending due to this debt feast.

China debt

Record speculative bets have held up the oil price for the last few years, but it is evident that insiders are increasingly bearish given by the amount of hedging activity.


The most important factor to watch in China – real estate prices – are on a downward trend, and have been accelerating their downward trend in recent months.

China real estate

Many other commodities are also trading at very high levels in terms of real prices compared to long-term averages. Iron ore and copper prices have seen increasing inventory levels and prices are in a downward trends.

A few other commodities such as US natural gas and sugar may be priced attractively, but only in relative terms. It is hard to be bullish on physical commodity prices given that the biggest growth driver may be losing steam in the short to medium term.


Property is a function of household income + leverage applied. Falling interest rates have made it easier for buyers to gear up, which in many cases they really have. It has also benefited from favourable rules such as the deductability of interest expense when calculating taxable income for individuals in many countries. But these rules have been in place for a long time.

Best benchmarks include rental yields in absolute terms and vs. coutry opportunity cost as well as affordability ratios. Affordability ratios have at least double in most markets since interest rates started to decrease in most countries. Attractive rental yields vs. current long-term bond yields include Japan, Philippines, Ireland, Germany, Hungary and the United States. Attractive markets from a affordability perspective is again the United States, Germany, Japan, Ireland and Spain. The most expensive property markets in the world are mostly in Asia, including Hong Kong, Macau, China, Singapore and India. Selected markets such as Canada, Scandinavia, Australia are also showing bubble-like symptoms.


  • Stock market valuations are generally high in most developed markets such as the US, Scandianvia and the UK as well as in favourite emerging market such as the Philippines, Indonesia and Mexico. Competition for high quality value stocks is very high. Good hunting grounds for “cheap” stocks are Russia, Vietnam and Hong Kong. The Japanese and South Korean markets may be attractive given high or accelerating money supply growth.
  • IPOs continue to be a great source for short equity ideas
  • Interest rates may continue to stay low for a long while
  • High yield bonds are pricing in very low currency risks and/or default risks. Credit spreads are close to record low levels, making shorting more attractive than it has been in years.
  • As interest rates are unusually low, long dated options (priced off the risk free rate) may be undervalued as well
  • Property is fundamentally a bet on interest rates. As interest rates are unlikely to shoot up in the near term, selected markets with good rental yield vs long rates and low interest rates may be attractive – including Japan, the United States and Ireland.
  • Cash is underowned and underappreciated, particularly US Dollar-denominated short-term instruments
  • Real estate and infrastructure investment levels in China are built on an unsustainable debt-build up, and the inevitable slowing of real estate construction will mean lower energy, metals and agricultural prices. Most commodities are expensive in terms of real prices vs. averages over the last century.
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