The Quarterly:
July 2015
“You must be shapeless, formless, like water. When you pour water in a cup, it becomes the cup. When you pour water in the bottle, it becomes the bottle. When you pour water in a teapot, it becomes the teapot. Water can drip and it can crash. Become like water my friend.” – Bruce Lee
The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications. We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
The second quarter of 2015 was categorized by a litany of precarious global economic events, with the primary focus being on the Greek financial situation and the Chinese stock market collapse. For this commentary, we thought it would be useful to outline the current situations, which will include an overview of the current situation, how these events came to be, and the possible severity and impact on both global and Canadian stock markets.
Despite these geo-political events, the major North American markets barely budged over the second quarter. The TSX composite dropped 2.38%, while the S&P 500 fell 1.11%. Both dismal figures, however, not traumatic either. As a whole, major North American markets thus far in 2015 have been somewhat paradoxically volatile and stagnant at the same time, with the bullish and bearish buying power seemingly cancelling each other out and muting drastic market movements to either side of the equation. Certain sectors have suffered so far, such as the Dow Transports which has lost over 11% year-to-date, while Biotech and Healthcare markets continue to perform favourably. The largest Biotech (IBB) and Healthcare ETFs (IHF) have returned 28% and 21% so far this year, respectively.
Chart 1 below, taken from Raymond James’ CIO Jeffrey Saut, shows the year-to-date performance of the key sectors and indices. For context, – since it is not listed below – the TSX has fallen 0.21% year-to-date. Chart 2 summarizes key valuation metrics, relative to the same period last year, of the S&P 500.
Chart 1:
Chart 2:
Greece Frightening:
With an overwhelming sensation of déjà vu, Greece has once again become the main topic of discussion, and more specifically, whether or not they will be forced to leave the Eurozone. If this situation sounds familiar to you, it should; this is the third time Greece has been in a situation where they have been very nearly out of money and have threatened to rattle the extant format of the Eurozone. Sparking fear was the surprise decision of the Greek government to pull negotiators from bailout discussions, stating that they will put the proposal to the Greek people, allowing them to vote on whether or not to accept the most recently proposed bailout terms. In order to insulate against massive outflows of capital from Greek banks, temporary capital controls were put in place which closed bank branches and limited the amount of money citizens could withdraw from ATM machines. The referendum vote resulted in a rejection of the terms, as Greek citizens claimed that 80% of the proposed bailout was earmarked to repay debts to Euro-area banks; they claimed that the bailout package was for the banks, not for the Greek people, and would do nothing but hurt their economy in the medium to long term. The Greek parliament has since negotiated a new deal which will allow them access to a new bailout package, and the vote of acceptance will be on Wednesday, July 15th. The package would require a multitude of austerity measures, including higher taxes, cuts to pension obligations and significant labour reforms. Although such a deal would abate the risk of a ‘Grexit’ in the near term, many believe that the deal represents another iteration of the same approach that has been used over the past 5 or so years, and that it will likely only act as a short-term band aid to the real issues. As such, even in the event that the new deal is accepted, we believe that we will not have heard the last of the ‘Grexit’ fears, and thusly, we believe it useful to provide an overview of how Greece arrived at their current situation, as well as an evaluation of the potential impact on North American markets.
The situation began almost immediately following Greece’s acceptance into the European Union in 1981. During the 1980’s, the Greek economy, on the surface, was booming. The Greek government took out massive amounts of debt, which was used to support exorbitant government salaries and jobs and drastically increase public investment. Under this scenario and high tourism, private sector wages also increased dramatically. The country’s appetite for debt was exacerbated when Greece adopted the Euro in 2001. Previously, each European country paid wildly different bond yields due to the risk of individual currency devaluation, and Greece specifically was saddled with high interest rates due to poor international regard of their government policies. However, with a single currency, the risk of devaluation was significantly lessened, and Greece’s cost of financing plummeted, making it cheaper for them to take out higher amounts of debt. As an aside, many believe that Greece should have never been allowed to join the Euro, as one of the major qualifying requirements is financial stability and unlikelihood of financial distress; as stated previously, Greece had already been taking out large amounts of debt prior to adopting the Euro currency. Opinions vary in regard to how Greece was able to achieve approval on their application, but suffice it to say that their fiscal position was much worse than what it was purported to be at the time. This opaque picture of the country’s fiscal situation remained until a new government was elected in 2009, which, subsequent to being elected to power, announced that the country’s budget deficit was approximately 15% of GDP, which is almost triple what the past government reported, and five times the stated maximum for country’s using the Euro. The cat was out of the bag; borrowing costs for the country skyrocketed, and Greece became effectively insolvent, which led to the first bailout program in 2010.
Through the 2010 bailout program, Greece received massive funds from Eurozone member countries, as well as the International Monetary Fund (IMF), however, these funds carried with them strict austerity measures aimed at cutting spending, tackling corruption, increasing taxes, and cutting benefits. In conjunction with the amount of capital fleeing the country, these austerity measures resulted in Greek GDP contracting 25% from 2009 to the current period, as well as a stated unemployment rate of over 25%.
Due to the heavily damaged economy, lack of government action and strict austerity measures, Greece found itself needing to be bailed out once again in 2012, and this time, with even more austerity measures. Another key component of this bailout was the shuffling of the debt obligations from bond investors to Eurozone bodies and European tax payers. Most of Greece’s debt was shifted to the books of the IMF, the European Central Bank and the European Commission, which all receive funding from individual member states, and thus, by extension, European taxpayers. Although this served to lessen the threat of international contagion, it also shifted the risk-reward scenario to include individual European citizens, who now had a vested interest to publicly denounce debt relief for Greece. At first, this new bailout program showed promise. Deficits narrowed, some reforms were initiated, and the economy appeared to be growing once again. However, unemployment and unrest remained high, which amounted to a powder keg scenario, requiring only a small spark to potentially return the country to crisis. Unfortunately, such an event would occur in late 2014.
In late 2014, emboldened by reduced bond yields and borrowing costs, Greece announced that they would once again return to the public bond market and expel their creditor monitors. This announcement caused borrowing costs to spike once again, and resulting uproar from the Greek population forced the government to hold an early election in January of 2015. With the prevalence of harsh austerity measures and high unemployment, a recently popularized leftist coalition known as the Syriza party managed to win a near-majority government, promising debt and austerity reduction. Syriza told the Greek people what they wanted to hear: that they would deliver the country from austerity and external control, while keeping them within the Eurozone. This was a lofty promise, which many believe to have been an outright lie in order to gain power. The unrealistic nature of Syriza’s promises was visualized by the amount of concessions they had agreed to by June 2015. The leftist coalition had backpedaled on many of the key pillars of their original message, and another deal, similar to the last two, seemed likely. This led to the current situation, where Greek Prime Minister Alex Tsipras elected to leave negotiations and put the vote to the Greek people. As stated previously, this resulted in a rejection of the terms, and a subsequently negotiated new deal which will be put to vote on July 15th.
As it currently stands, it seems that the best case scenario is acceptance of the new deal and the continued membership of Greece in the Euro. The worst case scenario would be a further breakdown of negotiations which would eventually lead to Greece leaving the Euro and returning to the Drachma. As agreeing to the current deal would mean the continuance of harsh austerity measures which have hamstrung the Greek economy, we believe that it is important to gauge the potential impact of a Greek blow-up, regardless of the outcome of these negotiations.
The key to understanding the potential impact of Greece lies in the 2010 bailout package which served to reshuffle the ownership of Greek debt. In 2010, 85% of Greek debt was held by private bond investors. Currently, 80% of the debt is held by European governments and other institutions such as the IMF and the ECB. Both of these large institutions are much better equipped to handle the situation than individual investors. Foreign banks, specifically U.S. banks, are collectively exposed to $46 billion of Greek debt, as opposed to $300 billion of exposure in 2010. Chart 3 below shows a breakdown of who holds Greece’s debt.
Chart 3:
As the chart shows, the debt ownership is now highly contained to Europe, and more specifically, governments and government institutions. The sum of the total exposure from European governments equates to 3.3% of the Eurozone’s GDP. This serves to insulate the ‘contagion’ fear, especially in North America, which would limit the impact of a Greek default on North American markets. Alternatively, this situation has actually spurred increased sales of American bonds and a higher demand for U.S. dollars, which have benefitted both instruments.
Speaking to the idea that the current holders of Greek debt are more equipped to handle the situation is the fact that, in 2010, the Eurozone had no framework to handle a troubled member state. Since the 2010 bailout, they have established an $800 billion bailout fund for emergency loans, with rules as to how countries can access the money. Notionally, French, German, Italian and Spanish governments have been the largest contributors to this fund, which explains why they have the largest exposure of European countries on the chart.
Based on the concentration of Greek debt to European institutions and governments, we do not believe that this situation will have any real or lasting impact to North American markets. Even if they were to exit the Eurozone, we believe that the ECB, IMF and European Council have sufficient resources and tools to insulate Europe as a whole. From a global economic standpoint, we must be cognizant of how tiny the Greek economy really is. As a country, Greece contributes about as much to global GDP as the state of Rhode Island. Because of this, we do not believe that further economic troubles within the country will have a drastic impact on important global exports such as oil or basic materials.
If the recently proposed deal is accepted by the Greek people, we would view such a situation as another kick of the proverbial can down the road. Strict austerity has proven ineffective, and the country is still buried under massive amounts of debt. Chart 4 below illustrates how poor the Greek fiscal situation is in relation to the rest of Europe.
Chart 4:
Structured as it currently is, this new deal would not fix the inherent issues currently present in the Greek economy. However, outside of avoiding any direct investments in Greece or any of its major creditor countries, we do not believe that we should adjust our investment philosophy towards this development.
The Chinese Stock Market: House of Cards
Speaking of exits, the bull has officially left the building for the major Chinese stock markets. The stock market is down a third over the past month, reducing it to levels last seen in March of this year. This correction has wiped out $2.3 trillion of wealth, or $1 billion for every minute the stock markets were open. However, it should be noted that the market is still up 80% in relation to the year prior. This strong performance over the last year has been puzzling to many analysts, given the slowest economic growth since 2009 and corporate profits that are lower than the year prior. Why, then, have the Chinese stock markets done so well over the past year? And why did they suddenly fall?
The strength of the Chinese stock markets over the past year seems to be attributable to an amalgamation of a slowing housing market, lower interest rates, and government encouragement, all of which have led to a surge in consumer participation in the equity markets. The Chinese are avid and prudent savers; for context, total household, business and government savings in 2013 amounted to 51% of GDP in China, compared to 17% of GDP in the U.S. To add to this, China has experienced booming housing market through its modernization, and as such, investing in real estate has been the main form of investment for Chinese citizens and businesses. Now, with a slowing housing market, citizens are turning to stocks as a method of investment, and the government is encouraging their participation. As a modernized stock market is a marquee characteristic of a sophisticated country, the Chinese government has explicitly sought to encourage stock market investment, and through the last year, the people have been taking the bait.
Through the first half of 2015, more than 10 million new stock accounts have been opened, which is more than the amount opened in 2012 and 2013 combined. Adding to this is a surge in margin accounts, which increased 86% in 2014 compared to the prior year. In April alone, 4 million brokerage accounts were opened in a single week. The increase in margin accounts has recently caused margin debt to reach a record level of 8% of total market cap, while an approximated 10% of total stocks have been purchased on margin. In addition, many of these new investors are relatively uneducated, with a China Household Finance Survey stating that 2/3rds of new equity investors left school before the age of 15, with 1/3 leaving before age 12 and 6% being illiterate. This scenario paints the picture of a perfect storm of an uninformed investor frenzy, leading the median earnings multiple for Chinese tech stocks to levels that are twice those experienced by U.S. peer companies during the dot com bubble. On the Shenzhen stock index, before the correction, nearly half of stocks traded had a forward P/E multiple of above 50. The trigger for the sudden decline was less attributable to a single action, and more-so indicative of an awakening of Chinese stock investors, resulting in a mass of panicked selling.
The effect of the Chinese stock market correction, in and of itself, is not so drastically important. As stated previously, the market remains firmly in the black in year-over-year terms. Less than 15% of household financial assets are invested in the stock market, and equity has played a relatively small role in financing the real economic expansion of businesses, UBS says. In terms of the corrections effect on foreign investors, this should also be limited, as Capital economics states that foreigners own only 1.5% of the total Chinese equity market. The primary concern, however, is the government’s reaction to the situation.
In the midst of the collapse, the People’s Bank of China cut its one-year lending and deposit rates, as well as the amount of cash that large banks must keep on reserve. This action would have been fairly regular in isolation; however, they also capped short selling, and encouraged pension funds to step in and buy more stocks, suspended approximately two dozen IPOs, halted trading for ~ 700 companies, and developed a fund comprised of 120 billion yuan, or $19.3 billion U.S. dollars managed by brokerages, which has the goal of supporting the market by purchasing stocks. These actions – outside of the interest rate cuts – are what worries investors, as some believe that the government is much more terrified of an imminent economic collapse than previously thought. The increased possibility of a ‘hard landing’ for Chinese economic growth is the real story out of the situation, rather than the 30% decline in the stock markets. It is important for us to focus primarily on the potential Chinese economic slowdown, rather than the stock market correction, due to the importance of China to the global economy, and especially to export-heavy economies such as Canada. China, as the largest consumer of commodities in the world, is largely seen has the ‘price-setter’ for many key basic materials and energy products. If their growth and demand slows drastically, it would undoubtedly have a significant effect on commodity prices, as well as global GDP growth as a whole. This scenario would be painful for an economy such as Canada, as we are currently still reeling from the effect of the oil collapse and possibly in recession.
In order to prepare ourselves for this situation, we plan on currently monitoring the developing story, as well as our current holdings in all commodity-related stocks. This, however, is a different situation for gold stocks, as the yellow metal may actually benefit from such a scenario. If the Chinese lose faith in the stock market, with a slowing housing market, they may very well turn to gold as their best option for investment. The Chinese people have been strong buyers of physical bullion over the last few years, and an increase demand would be bullish for gold prices, especially considering the fact that gold supply is forecasted to fall in 2016.
Despite the potential impact of a hard landing in China, UBS believes that this is not a ‘Lehman moment’ for China. They state that the banking sector is holding up well, there is no indication of lost faith in the overall economy, and the bank still has policy tools at its disposal. The big banks are all owned by the government, and should hopefully be able to fine tune the economy through bank lending adjustments. The People’s Bank of China has control over its own currency and vast government resources, and therefore, UBS as well as many other analysts believe that China is not headed for economic collapse.
We continue to believe that the current global economic situation and stock market performance warrants a ‘stock picker’s’ mentality in order to out-perform, and strongly believe that the sideways performance and volatility of the markets thus far validate this opinion.
MacNicol & Associates Asset Management Inc.
July 2015
