Saturday, August 15, 2015

Your Weekly Update AND The China crisis that wasn't...

One can't help but develop a thick skin when one has been an investment adviser since the mid-1980s. Experiencing the investing turmoil---the crashes, the recessions, the bear markets and the currency crises---of the past 31 years gives one a perspective that transcends the fear and stress inspired by situations such as the Greece political/debt crisis, the slowing of the Chinese economy, the devaluing of the Chinese currency and, relatively soon I suspect, the beginning of the first Fed tightening cycle in 9 years.

While my experiences give me the confidence that the balanced portfolios of patient investors will survive the inevitable corrections and bear markets to come, I recognize that I must remain sensitive to the attendant fears and stress of the folks who have hired me to manage their portfolios. Remaining sensitive, in my view, is not about placating clients with the worn platitudes that are notorious among your everyday advisers, it's about offering up a perspective and clarity on mucky headlines that, by design, stir up all manner of fear and angst.

This past week was all about China. Last Tuesday saw the Dow down 240 points on news that the currency (the renminbi [RMB], or yuan) of the planet's second largest economy's peg to the U.S. dollar would be expanded by two percentage points. The world, or, I should say, the media---and a whole slew of pundits---saw this as a move that signaled extreme panic on the part of Chinese policymakers. I.e., confirmation that, by devaluing the RMB, they see major trouble in their economy going forward. The stocks of companies whose fortunes are to some degree tied to the buying habits of a billion+ Chinese consumers took the largest hits---as a weaker RMB means Chinese buyers pay up for, say, American and European goods.

So what gives? Did the kneejerk headlines get it right? Is there something dire brewing in the Chinese economy that could bring on extreme global unrest?

Well, there may or may not be a black swan (an unforeseeable event) lurking somewhere within the Chinese economy, but I can tell you with certainty that last week's currency move was not an attempt to circumvent some impending cataclysmic event. While, granted, a cheaper currency may indeed help China's slowing manufacturing sector---which I suspect was one justification for expanding its range---the following statements from the International Monetary Fund (IMF) speak volumes about another key motivation (the IMF is considering a bid to move the RMB closer to becoming a world reserve currency). I also included IMF commentary on China's economy that reiterates what I've been reporting about its move to a more services/consumer-oriented economy and the resulting slower GDP growth---plus, the IMF's view of where China's present vulnerabilities lie:
The changes by China will help it gradually transition from a tightly managed system linked to the U.S. dollar to one that is more open and more flexible and more responsive to market conditions. The currency ought to move to free float within two to three years.

The Chinese government should put in place an effectively floating rate for the yuan before fully liberalizing its capital markets.

Moving to a free float is necessary for allowing the market to play a more decisive role in the economy, rebalancing toward consumption, and maintaining an independent monetary policy as the capital account opens.

China is moving into a phase of slower, yet safer and more sustainable growth.

Gross domestic product will expand 6 percent in 2017 before rebounding modestly. Growth should be allowed to slow to 6 percent to 6.5 percent per year to address vulnerabilities in the economy.

China’s reliance on credit-financed investment as the primary engine of growth since the financial crisis has created large vulnerabilities in the fiscal, real estate, financial and corporate sectors.

Thus, a key challenge is to ensure sufficient progress in reducing vulnerabilities while preventing growth from slowing too much.

Lastly, as the chart (click to enlarge) below illustrates, the RMB peg to the dollar has, over the past decade, resulted in a substantial appreciation that indeed makes China exports less competitive on the global stage (hence, one motivation to back it off a bit)---while on the flip side creating greater purchasing power for the Chinese consumer, which is consistent with its economic reorientation:

The Remnimbi in USD Terms:

Remnimbi in USD terms

Bottom line: While, as the IMF reports, China's economy indeed holds excesses that should not be overlooked, last week's move was in no way a desperate attempt at saving a failing economy from collapse, as so many "experts" might have you believe.

The Stock Market:

Non-US developed markets—even after their recent pummeling—have outperformed the U.S. major averages (save for the NASDAQ Composite Index) year-to-date. Given many foreign markets’ cheaper valuations, early-stage recoveries and, yes, accommodative central banks, I remain constructive on non-U.S.. That said, there are a number of potential international hot buttons (as we've recently experienced) that could easily delay the narrowing of the gap between the valuations of U.S. and non-U.S. securities. That’s why we think long-term and stay diversified!

Here’s a look at the year-to-date price changes (according to CNBC) for the major U.S. indices---and for non-U.S. indices and U.S. sectors---using index ETFs as our non-U.S. and sector proxies:

Dow Jones Industrials:  -1.94%

S&P 500:  +1.59%

NASDAQ Comp:  +6.59%

EFA (Europe, Australia and Far East):  +5.19%

FEZ (Eurozone):  +3.42%

VWO (Emerging Markets):  -8.00%

Sector ETFs:

Here’s a look at the year-to-date results for a number of U.S. sector ETFs:


IYH (HEATHCARE):  +11.37%



XLK (TECH):  +2.59%


XLU (UTILITIES):  -3.49%


XLB (MATERIALS):  -5.89%

IYT (TRANSP):  -8.90%

XLE (ENERGY):  -12.41%

The Bond Market:

As I type, the yield on the 10-year treasury bond sits at 2.20%. Which is 1 basis point higher than where it was when I penned last week's update.  

TLT, an ETF that tracks an index of long-dated U.S. treasury bonds, saw its share decline by 0.31%  over the past 5 trading days (down 1.56% year-to-date).  As I keep repeating, I see bonds in general sporting a risk/return trade-off that makes going out on the yield curve not worth the risk.

On Volatility and Timing:

Each week I share with you the very short-term (year-to-date) results for major indexes and sectors. I do this with a bit of hesitation, as I in no way want to give the impression that you, nor I for that matter, should base our long-term investment decisions on short-term movements in markets or their sectors. It can, however, serve as a reference point for how the markets are, or are not, responding to the data (which is why I, as a professional, track the short-term). While my beginning of the year optimism over non-US (developed markets that is) and the housing sector, and my pessimism over utilities, appears to be justified by recent results, I need to strongly (very strongly!) emphasize that I was not predicting what we’ve experienced thus far in 2015. Plus, while we maintained our healthcare exposure I in no way expected the gains that sector has experienced this year. Same goes for energy and materials, only in the other direction.

My optimism or concerns over a given sector or region are based on factors such as valuations, trends, supply and demand, monetary policy and cyclicality—and my comfort in making allocation recommendations rests on the view that our clients are not short-minded investors (it can take awhile, if at all, for the market to reward what I believe to be good fundamental logic) who mistakenly believe that any human being possesses a capacity for market timing. Some people get lucky from time to time, but without exception, market timers are wrong far more often than they are right. The path to long-term investment success is fraught with bumps and potholes. The ones who successfully make the journey take it slow and never over-compensate when steering through and around the inevitable obstacles along  the way.

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