Stephen Tierney MBMG International Ltd.

Offshore asset class commentary

Global Cash

While cash is generating near zero returns on a short term basis, and more than likely negative real returns on a ten year view, it is hard to get too excited about this asset class. However, currency allocation is the big driver in this space and with Emerging Market currencies having sold off in the second half of last year and still offering significantly better yield, this is our preferred currency area and cash play, in addition to US Dollars.

Global Bonds

Our core global bond managers are now net short German Government Bunds and UK Government Gilts and holding predominately US dollars. The yields on Western Government bonds are now at a level (around 2%) that will almost certainly produce negative real returns on a ten year view unless further policy mistakes (not unlike those made in Japan) continue to be made in Europe and the US. History has shown us that if you buy government bonds at yields below 2.8%, you are almost certain to make no money and have negative real returns in the ten years ahead.

Most institutional liability matching strategies are currently advocating buying government bonds to match liabilities with yield and completely ignoring the valuation of such bonds. This is utter madness.

We believe that much better value lies in higher yield and emerging market bonds where either credit pickup, recent currency weakness or falling core inflationary pressures are evident and thus these assets offer good return potential.

Global Equity

As we stated in October last year, after twelve years of negative real returns, this asset class is starting to offer much better fundamental value and thus significantly better chances of achieving a 6.5% p.a. real return over the next ten years. Notwithstanding the still relatively high normalised earnings and profit margins, we have subsequently increased all our neutral strategic allocations to global equity as a result.

On a more tactical or annual view, there is no doubt that, after a difficult 2011, most lead indicators for the US and China appear to be positive. Whilst expected growth is not spectacular, avoiding a recession and achieving a soft landing respectively, appear to be the most likely outcomes. Europe on the other hand lurches from the application of one band-aid to another and this is what may end up dragging America and China down into the abyss before they are meant to get there.

Until orderly default terms are agreed for Greece and Portugal (and thus the others), it is difficult to be very bullish. There is no doubt, however, that the US job market is improving. Their housing is stabilising, risk appetite is rising and volatility is falling. Mean reversion from last year is very likely. Things are more certain now than last quarter.

Global Property

The stability of earnings and cash flow are key positives for commercial property in the uncertain economic environment. The negatives are the debt overhand and the banks’ abilities, or willingness, to refinance current debt. This is such an important component of this asset class’s capital structure.

Asian commercial property still offers growth in rentals. Furthermore, fundamentals are solid. Some significant distressed NAV discounts and special situations still exist in the UK and Europe.

Commodities

Ignoring gold bullion’s 10% rise last year along with oil, most base metals were negative in US Dollar terms. Assuming the US avoids recession, Europe avoids total meltdown and China achieves a soft landing, commodities should be a better place to be in 2012. We remain overweight gold but are looking for our exit price target this year. We see agricultural commodities as a better value play on the old new normal.

Alternative Strategies

Hedge funds finished a difficult year with most mainstream indices down 5%. With the exception of the Trading Advisers and Macro Traders, most strategies did not do well. This asset allocation is best based around access to investment talent in a liquid and low correlation manner. Private Equity remains a high leveraged play on global growth and whilst significant discounts to NAV exist in many listed vehicles, we remain uninvested since the middle of last year.

In Conclusion

JK Galbraith once said, “There are two types of forecasters: those who don’t know and those who don’t know they don’t know.”

The last quarter of 2011 was very difficult for global asset allocators as they experienced continued volatility and many multi-asset class funds finished deeply in the red for the year. JK Galbraith succinctly summarises what a fools game forecasting is but unfortunately we need to have a view for the year ahead.

Advisers and institutional clients will have sensed that we are more bullish and upbeat about return expectations on global equities for the longer term and more positive for “risk on” in the short term over the rest of the year. We are but it all depends on the Euro-zone and what happens there. The knock on effect could bring the global economy to its knees if people do not get it right.

Gavekal research is one of our valued global fundamental research sources and their velocity indicator chart has turned bullish for the first time in a while. The indicator remained quagmired deep in negative territory for most of last year. The change was more than likely sparked by better US economic numbers and the ECB’s Christmas gift of €500bn LTRO bank liquidity program (European QE II in sheep’s clothing!). None of this solves the big picture in Europe and disorderly PIGS default cannot be totally discounted, but the solid start for risk assets made in January may well have some more legs yet.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com

 

Storm in a (China) Teacup

One the most debated points in markets today is whether or not China is heading for a hard landing. Our strategic partners at MitonOptimal were fortunate to recently have met Arthur Kroeber, managing director of GK Dragonomics (an Asian research house, based in China). He gave them his expert opinion on what is really going on in China today. His insights were very interesting, the most important of which was the biases that investors have when it comes to analyzing China.

Many investors, base their China hard landing view on comparisons with the US and Japan. In the US case they cite the housing market, arguing that China is going to have a similar housing collapse and that this will lead to a massive slowdown in growth. Arthur countered this by contending that China is, in fact, very different in this regard. They still have a huge shortage of housing, especially at the lower end.

While it is true that there is a bubble at the top end of the market as well as in certain regions, this is not true for the country as a whole. China needs to build ten million new homes a year, just to meet demand and that, until very recently, it was only building seven million a year. As a result, the deficit between supply and demand remains wide. This is a very different dynamic to that of the US which still suffers from an oversupply of houses.

Demand in China has been fueled by the migration of rural workers to the urban areas, with Arthur pointing out that there are currently sixty five million people living in temporary shelter, under bridges and in construction sites. This is greater than the entire population of the United Kingdom! The financing of the housing market is also very different in China, where 60% of housing is bought with cash.
The other comparison that Arthur argues, people often (incorrectly) make is to compare China to Japan. The argument goes that productivity growth cannot continue forever - at some point it will all end in tears. Arthur argues that China is in fact at a very different point in its lifecycle. One should not be comparing China to the Japan of the 1990s, but rather to the Japan of the 1960s. This effectively means China has still many years of productive growth ahead of it. The movement of rural workers to urban areas will ensure this. Currently only 50% of China is urbanized. The western world has urbanization rates of 80% and GK Dragonomics are projecting that even by 2030 China will only be at 70%.

Gordon Orr, a director in McKinsey’s Shanghai office agrees with this. He believes real estate will stagnate. In an effort to further cool prices, the authorities will maintain purchase and credit restrictions that contributed to the deterioration of property markets in the second half of 2011. According to the China Index Academy, local-government revenues fell as a result of declining land sales - by 13 percent in Shanghai, 14 percent in Beijing, and 29 percent in Nanjing from January to November 2011, compared with the same period in 2010. Fear of local-government defaults and a general property rout may induce the central authorities to ease restrictions. Nonetheless, Beijing will continue to prioritize the construction of affordable housing for the poor in an attempt to prevent a hard landing in the construction sector.

Kroeber does concede, however, that China will indeed slowdown from the heady heights of 10/11% real growth rates to date. Consumer prices jumped 4.5 percent last month in China, the world’s second-largest bullion consumer, the government said recently.

“China’s inflation remains elevated and this will keep demand for gold strong,” Cheng Xiaoyong, an analyst at Baocheng Futures Co., said from Zhejiang in China. Some investors buy gold as a hedge against inflation. Holdings in exchange-traded products backed by gold were at 2,385.85 metric tons yesterday, within 0.3 percent of a Dec. 13 record, according to Bloomberg data.

However, broader inflation in consumer prices appears to have peaked, but those of food rose at twice the rate of the consumer price index in the closing months of 2011. Inflation is highest for meats - the price of pork and beef rose by 27 and 14 percent, respectively, over the 12 months ending in November 2011, compared with the same period in 2010. The trend reflects changing consumption patterns among urban consumers and the growing middle class, who eat more meat, thereby increasing demand for cereals to feed animals. The availability of food imports is limited, and the rate of productivity improvement in domestic agriculture remains low. Moreover, price volatility is high, since even minor disruptions can affect supply dramatically.

Given all of this, China will cut back on its investment spending as it is starting to rebalance the economy towards domestic demand. Kroeber is expecting growth rates of 7.5%. This might come as a bit of shock to investors, but what needs to be appreciated is that even at these rates of growth, China will still be contributing massively to world growth given the very high base that China is growing from. To put this into perspective, China added USD5.9 trillion to global GDP in 2003-2011 and for the next 10 years GK Dragonomics are predicting that China adds USD26.5 trillion to global GDP, five times the previous growth numbers, despite real GDP growth rates falling by a third. The base effect really matters here!

So, in summary, we remain sanguine about a hard landing in China, with growth more likely to slow than come to a hard stop. Even with a slowdown expected, China will still contribute massively to world growth.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com

 

Uber Alles? Nein!

One widely held misconception right now is that Germany is carrying a broken Europe on its back. My business partner, Paul Gambles, explained this to all the participants in Wednesday night’s inaugural MBMG ‘Squawk Back’ that the reality is very different - a theme that he had previously outlined to CNBC’s Squawk Box team last month. For those interested, Paul is a regular guest on CNBC and offers an in depth insight on the global economy and how it is expected to perform.

Paul went on to say, “So we have the EFSF rescue fund going to the market with some six-month bonds. I think yields can be manipulated to remain within reasonable levels, but it depends who's actually pulling the trigger and who's doing the buying. One thing that I think is very interesting is that the EFSF is starting to look more and more like a sub-prime CDO these days. In the years running up to 2008, we had all this junk, and you could put BBBs and CCCs together and call them AAA. S&P clearly learnt the lesson from that and they're not going to get caught in the same way again. Sadly, Fitch's and Moody's seem to be a little bit slow to pick up on the same thing, but the EFSF is just starting to look like a sub-prime CDO.”

Paul continued, “I don't think the AAA governments want to put any more into this. I think they've made that very clear. I think again, going back to December 9th, going back to the Euro deal that was done, Germany wants to have absolute control of what goes on in the Eurozone. It wants fiscal control without the fiscal compact. It wants to set all the rules; it wants austerity, but it doesn't want to ultimately carry the liability, so I think the idea that Germany is going to put more into the EFSF is unlikely, but it may, behind the scenes, do much of the buying.”
He then stated, “I think the collective fiscal resolve people talk about is the last thing we need. What that's going to do is to reinforce the fiscal policies of the last ten years of the Euro and what we've got in Europe (and Nouriel Roubini probably explained this better than most) what we've got is a symmetrical problem. Germany is producing all the growth; it's got all the competitiveness; it's where all the wealth is going to. That's being funded by the periphery with all the debt they are having to take on board, so a lot of people have got a mistaken view on Europe. It's the periphery that's been carrying Germany for all these years, not the other way round. We either need a transfer of wealth from Germany to Greece to allow that kind of transfer of competitiveness back to Greece, which isn't going to happen in a million years, or the only other option is to break the system and start all over again, and to us that means the peripheral countries leaving the Euro.”

A few things are happening. One is the ratings downgrade was heavily telegraphed and therefore people were expecting it; it was not a massive shock. And the other thing is this division between the ratings agencies, and the fact that Fitch's came out and said they guarantee that France will be given a AAA rating for 2012. This is nothing short of absolutely bizarre. How any ratings agency can say that I just do not know. What was Bill Gross's comment, that ratings agencies are full of people with MENSA IQs of 160 and common sense IQs of about 60? Unless they have got a crystal ball, how can they say France will be AAA?

The EFSF's AAA guaranteed 271 billion Euros is probably enough to come to the rescue of Greece in the next couple of months. On the face of it, it should also be enough to save most of the periphery over the next couple of months. It is not enough to go beyond that. We have been saying all along, what you need to make Europe solvent is a transfer of about four to five trillion Euros. That is what it takes to recapitalize the banking system so it is capitally adequate. That is what it takes to fix the broken sovereigns so that they get to a level where they are sustainable and they are repayable. We are not seeing permanent capital of four to five trillion. The EFSF was never that. It was only ever a stop-gap measure. The stop-gap has now got a little bit smaller. I do not think there is any way to raise four to five trillion. The question is how long can they keep raising interim money that keeps the game going before the whole thing falls apart?

Germany's worry is about being sucked down by defaults and recessions across the Eurozone. If you take away that source of revenue, that source of exports, you are taking away all the things that have boosted the German economy for the last ten years and then things, all of a sudden, start looking pretty naked.

A muddle through scenario is possible for a while but then in a year or so, we will have got austerity in all these places, and austerity in the periphery is not going to help anyone; we need growth in the periphery or else the periphery falls apart, and if the periphery falls apart, that is what will bring Germany down. If Europe thinks it is suffering now then wait for that to happen. The French will be lucky to get any rating at all.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com

 

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