Crazy, I just cannot bear
I'm living with something that just isn't fair
Mental wounds not healing
Who and what's to blame
I'm goin' off the rails on a crazy train
I'm goin' off the rails on a crazy train
Crazy Train, Ozzy Ozbourne, “Blizzard of Ozz,” 1980
Isn’t the definition of insanity repeating the same behavior and expecting a different outcome? Over the past few years it feels as though policy makers are trapped in this insane cycle of applying ineffective solutions to solve over-indebtedness and stagnant growth. We believe the first half of 2015 provided more of the same tired rhetoric and futile actions from the world’s political and economic leaders. How much longer can we defer meaningful structural changes that may result in short term pain but can catalyze long term sustainable growth? Fortunately, the world economy is resilient and there is still time to embark on a positive path if policymakers can learn from the mistakes that have caused the recent crises and begin taking meaningful corrective action.
A Review: 1H 2015
In the first half of 2015, the investment, geopolitical and macroeconomic landscapes became even more interesting. The highlights or rather, low-lights, have been the extraordinary parabolic move up in Chinese equities and subsequent ~27.86% decline as displayed below by the Shanghai Composite Index chart, and the acknowledgement that after a four- year hiatus "Greece" is yet again the word. While many equity markets either reached or approached new highs, our prognostication at the beginning of the year in welcoming back volatility seems to have been on target, with the only exception being our very own U.S. equity markets. Take a look at the charts below (Source: Bloomberg) and you can see some of the wide swings experienced by a number of exposures during the first half of the year.
The mix of positive and negative returns across asset classes year-to-date clearly indicates that market volatility has indeed returned, as we predicted.
What to Make of the Flags? Is the Bull Market Waving a White Flag?
Let’s keep things relatively simple.
Greece’s economy is in a deeply indebted hole and, in our opinion, is highly unlikely to emerge from this abyss without debt forgiveness, major internal structural changes, including the dreaded "A" word – austerity - and/or a reversion back to the Drachma. Over the past several years since the last major Greek-precipitated crisis, Europe has done a reasonably good job of isolating the financial risk, but as we see it, the authorities can easily lose control of markets and economies if psychology changes. We feel that the current round of the Greek crisis is not a global economic nor financial one given the relatively small size of the Greek economy (a rounding error relative to world GDP) and the fact that most Greek debt is not in private hands but has been absorbed by public entities (e.g. ECB, EC, IMF) that should be well positioned to handle the fallout. The big issue is for a change in sentiment towards risk aversion and the potential for contagion to those highly indebted peripheral countries such as Spain, Portugal and Ireland, each of which may opt to embark on a similar path that would likely cause a systemic shock to world markets. Today, we are not seeing yields on those sovereign bonds nor credit default swaps (insurance on those bonds) spike, which would be a strong indicator of an increase in systemic risk, but we will be watching closely.
A “Grexit” (yet another term that we are all tired of hearing) or Greek departure from the European Union (EU) would not be a singular event (i.e. one event). While the “No” vote from the referendum possibly pushed Greece forward on a path toward exiting the EU, it also is conceivable that this will result in more serious and productive negotiations than the previous round. It might bring a renewed commitment by EU leaders and their constituents to keep the EU together in its entirety, a favorable restructuring of their debt package, and not a Grexit. That scenario, coupled with the ongoing tsunami of monetary stimulus, could catapult European equity markets higher. Recent provocative and inspiring speeches within the EU Parliament may be the first signs of Pan European nationalism leading to closer political union even if Greece ends up leaving.
I can also foresee a scenario that involves an initial sharp market downturn in the face of a likely Greek exit followed by a strong rally as investors buy into the end of the insanity of expecting a different outcome every time an agreement is reached to keep Greece in the EU. While this drama has many ending scenarios, I wonder if the best scenario is one in which European leaders buy some time with the objective of working with Greece stealthily to develop a well-orchestrated and orderly transition out of the EU that sets the Greek economy up for success instead of sleepwalking into a Lehman-like, messy and highly disruptive one. Effectuating that plan would require a modification of the EU’s constitution to define conditions required for exiting that would provide flexibility yet maintain extremely stringent guidelines to minimize the risk of others wanting to do so simply to escape their debt obligations.
While Greece has been making headlines, we cannot lose sight of the other concurrent risks flaring up across the world. In China, a rapid and precipitous decline of more than 30% in the local mainland Chinese equity markets (A and B shares) resulted in nearly $3 trillion in losses over a three week period. When China equity exposures is present, Threshold portfolios typically own H shares in Hong Kong and American Depository Receipts (ADRS) which did not rise or fall nearly as much. This rapid decline prompted the government to enact highly unorthodox measures to buttress those markets, including halting companies from trading on the Shanghai exchange, limiting sales from large investors and ordering brokerage firms and state run funds to buy shares. This monumental government intervention, in our opinion, may unwind more than 25 years of progress toward opening up their capital markets. Closer to home, Puerto Rico announced that its $72 billion in public debt is not payable. This recognition could initiate a move toward some form of bankruptcy or restructuring. We feel that these risks (which, by the way, may be more serious than the Greek situation), coupled with the uncertainty regarding Greece’s status in the EU, could easily cause equity markets to change direction and reverse the gains from earlier this year. While a correction might seem painful, I would argue it is overdue and could actually be beneficial for the endurance of the current bull market as long as these issues do not expose an "unknown unknown" systemic risk within the underbelly of the capital markets.
What does this mean for markets?
Do not let the low volatility of recent times cloud your views regarding the magnitude of the markets’ reaction to the recent headlines. I remember when -1% to -2% down days on bad news was the norm not the exception. We may see more volatility in the coming weeks and possibly months as the Greek, Chinese and Puerto Rican dramas unfold. As I've mentioned in the past, increased volatility, while uncomfortable, presents opportunities for nimble and adaptive strategies and may favor our focus on striking a balance between participating in the upside of markets while minimizing the drawdowns.
How should you be viewing this relative to your portfolio?
We have had the 4 D’s theme (Debts, Deficits, Demographics, and a Dearth of Leadership) in place as a secular theme and back-drop for our risk management strategies. The Greek, Chinese and Puerto Rican issues validate that Debts and a Dearth of Leadership (the latter being exemplified by the European Union’s inability to resolve the Greek situation before the 11th hour) continue to play a role in market dynamics. Our portfolio positioning reflects this context.
We introduced the concept of volatility returning at the beginning of this year in my piece entitled, “Volatility-Welcome Back! We Missed You!” You may want to reread the piece (thresholdgroup.com/blog/volatilitywelcome-back-we-missed-you/). We believe an infusion of a more rational sense of the true risks embedded in world markets and the global economy is a good outcome in light of the obfuscation of value and inefficient pricing that comes with excessive monetary easing. While experiencing losses in portfolios may not feel good, and will play on investor's inherent behavioral finance related biases, in the short term, markets cannot rise inexorably and a re-pricing of risk can help separate good investment strategies from bad ones. We feel we are well positioned for an increase in volatility given our adaptive strategies as well as our managers' focus on quality. Additionally, a sell-off, assuming the authorities can effectively articulate a strategy that limits contagion risk, may be a good buying opportunity, but we will need to assess this as events take place and more information becomes available.
Conversely, a prolonged elevation of risk sensitivity may possibly cause global investors to view the issues in China (China’s local stock market, as represented by the Shanghai composite chart on page one, is in bear market territory defined as a decline greater than 20%) and the potential default and resultant restructuring of Puerto Rican debt in a more negative light, thereby changing the direction of market to the negative.
While the negative headlines have challenged markets to maintain their risk-on momentum, on a positive front, we have been experiencing synchronized global growth (albeit at a low level) and the U.S. economy continues to show mixed signs but leaning more toward the positive than the negative.
Contrary to the policymakers, we continue to innovate ways to address old and new challenges. Let’s end with yet another insight from the “Wizard of Ozz”, who unknowingly may be a great economist: “The media sells it and you live the role.” Don’t let the sensationalist media drive your perspective regarding your portfolios. Overall, we feel our portfolios are well positioned for this increased sensitivity to risk. The benefits of our portfolio positioning should be viewed within the context of market cycles as they may not appear self-evident when reviewed over a day, week, month or even a few quarters. We believe the upside/downside capture game which leverages the power of compounding takes time and outperformance can be achieved in a lumpy (a technical term) non-linear fashion.
©2015 Threshold Group is a Registered Investment Adviser.
Information and recommendations contained in Threshold Group's market commentaries and writings are of a general nature and are provided solely for the use of Threshold Group, its clients and prospective clients. This content is not to be reproduced, copied or made available to others without the expressed written consent of Threshold Group. These materials reflect the opinion of Threshold Group on the date of production and are subject to change at any time without notice. Due to various factors, including changing market conditions or tax laws, the content may no longer be reflective of current opinions or positions. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, Threshold Group does not warrant the accuracy of this information. The information provided herein is for information purposes only and does not constitute financial, investment, tax or legal advice. Investment advice can be provided only after the delivery of Threshold Group's Brochure and Brochure Supplement (Form ADV Part 2A&B) and once a properly executed investment advisory agreement has been entered into by the client and Threshold Group. All investments are subject to risks. Investments in bonds and bond funds are subject to interest rate, credit and inflation risk.
 Source: Bloomberg, bloomberg.com/news/articles/2015-07-09/how-puerto-rico-s-debt-levels-compare-with-those-of-u-s-states