What does the Macro mean for my Portfolio right now?
My investment strategy is to invest in small and often illiquid companies. This is where I have the greatest advantage. I am willing to spend time investigating names that very few others have even heard of. I have my doubts that there are more than a few handfuls of investors in the world that have spent the number of hours I have on Community Bankers Trust (BTC) or Rurban Financial (RBNF).
Investing in micro/nano/nonexistent cap companies gives me the opportunity to take advantage of what can sometimes be large price discrepancies. But it also has its drawbacks. In particular, because the companies are illiquid, I often cannot get out quickly once the tide has turned.
While I try to hedge this risk with due diligence, there is another aspect that cannot be mitigated with company specific research. In particular, when the macro becomes trump, these little stocks can become very difficult to unload.
I am not very good at holding tight through thick and thin. Perhaps I am a child of 2008 where I learned the rather significant lesson that buying and holding because the business is sound is not always a preferable strategy. In addition to the money and time lost by holding on, there is the mental toll that it takes. I hate to use cliches, but the one that fits well here is that it is better to live to fight another day.
I went back and reviewed some of my past posts on the macro-scene. I haven’t written very much about the macro-environment since my post “It’s a bull market“. In that post I outlined that while I remained wary of the long-term conditions in Europe and was concerned that the LTRO was only short-term panacea that would eventually be overcome by a tide of falling economic data, that the bottom-line was liquidity, which was abundant, and as far as stocks go that tends to trump all:
The underlying condition right now is one of liquidity. It is not the intent of this blog to philosophize (too much) on the eventual consequences of such liquidity. There are plenty of folks, like the wonderful Ms. Park, who are already describing those consequences eloquently. The intent here is to try to evaluate those conditions clearly, and to describe how I am acting to capitalize on those conditions.
For the moment anyways, that means that I own stocks.
Making a more general observation, as I perused through my posts over the first half of last year I was surprised by my trepidation. To give an example, in my post “When in doubt: Get Small“, which I wrote during the last week in May:
All I think I can do in a situation like this is to get smaller. Take on less risk, don’t take too many chances, wait for it to play out one way or another before wading in too far. Remember that even after Lehman went bankrupt, it took a few days for the market to recognize the consequences that were about to be felt. I don’t think this was because the market was ignoring those consequences so much as that no one really knew what they were until they started to happen. Same considerations this time around. It could be Y2K all over again. It could be Lehman all over again. We will just have to wait and see.
Its hard to believe that this was written less than a year ago. I mean, I had 60% gains in 2012 right? Everybody seems to have outperformed the market. You would think, looking back, that we must have all been “balls to the wall”.
Its very easy to focus on the end result and forget the path that got you there.
Right now everything seems rosy. The market is rising. Thoughts of collapse in Europe are back on Page 16. And I haven’t written about anything macro in over seven months.
But what has really changed? Has the world gotten that much better over the last seven months? I think you’d be hard pressed to say that we don’t have the same problems now that we had then.
Liquidity just tends to paper over them for a time.
Look, I have been fully invested since the last Tepper moment in mid-December, and have been on margin since December 30th, the day it became clear that the fiscal cliff was going to be a non-issue.
But I remain wary of the underlying conditions. The most positive underlying condition right now is the sheer amount of liquidity being pumped into the economy. While this is a proven mover of markets over the short term, it is a questionable fix over the long term.
So while there might not be a problem as long as the liquidity is a-flowing, I think it is helpful to review what might be coming. I remain fairly convinced that one thing that is coming, is trouble to Japan.
At the moment, things are quite rosy in Japan. Since the election of Shinzo Abe and his declaration that the Bank of Japan should do whatever it takes to meet the 2% inflation target, the Nikkei has been on a tear and the Yen in free fall.
Yet I think that Japan may be planting the seeds of its own destruction. Back when macro mattered, before the flood of liquidity began to lift all boats, I wrote a piece called “The big problem is going to be Italy, No Scratch that: Japan“. In that post I pointed out that the math simply does not work for Japan. To make the point I went straight to the BOJ statistics and ran through the debt and deficit numbers to see what they might look like in an inflationary environment:
Japan’s net government debt is Y988t or USD12.3t at the end of the second quarter. Tax revenues collected by the Japanese government in 2010 were Y37t, or roughly about $500B in 2010. Doing the same math as we did for Italy leaves us with the incredible result that a 1% rise in the borrowing rate for Japan is a bit over $100B, or more than 20% of government tax collection.
To put this in an even starker light consider the following. Below is a table I made that shows the tax revenues collected by the Japanese government and the interest paid by the Japanese government over the last 20 years. Amounts are in millions of Yen.
Right now debt service is more than half of government tax revenues. In terms of the servicing costs of the debt, debt service was about 2% of overall debt in 2010, which as I mentioned above is Y988t.
To extend those two statements to a far more frightening conclusion, a doubling of the average interest rate the Japanese government pays on debt, which would be an increase of 2% across the board, and debt service jumps to well beyond government tax collection revenue.
So with a 2% increase in interest rates, Japan is done.
Kind of puts the 2% inflation target into perspective. Add to it the fact that duration on the existing stock of Japanese debt is only 6 years and I think you have a serious problem if Abe is successful.
One of the things I did this week was review the Kyle Bass presentation from the AmeriCatalyst conference in November. Much of it focused on Japan. The video is not embed-able but a link to the video is here. I think its worth reviewing. Also worthwhile is the third quarter shareholder letter for Bass’s Hayman Capital which discusses much of the same content.
I don’t really see how you get around Bass’s argument. While I don’t know when this finally plays itself out, I am of the mind that eventually he will be proven right.
To get a more balanced assessment I read some of the bull cases on Japan. One of the biggest bulls on Japan is Jesper Koll from JP Morgan. Koll wrote a good article summarizing his case in a piece titled “Welcome Back Optimists“. He makes some fair points arguing why the Japanese economy may be about to pick up, but does little to address the debt issues.
In an interview with Beacon Reports Koll did directly address Bass’s thesis. I don’t think the counter-argument is terribly inspiring. He seems to be saying that the BOJ can always print more money to make up for a lack of private sector demand for JGBs.
Abe wants to get us out of modest deflation towards a positive 2% inflation − a good thing. To accomplish that, he’s employing an aggressive, sizable fiscal expansion plan which is being funded by issuance of JGBs. Since those plans were announced, interest rates have actually fallen. Yields are below where they were before Mr. Abe became prime minister.
Who is buying those bonds? The Bank of Japan (the central bank) is aggressively purchasing them. They are committed to purchasing the entire debt out to a maturity of up to three years. Today, the risk of short-term interest rates on JGBs with maturities up to three years increasing is de facto nil, because the Bank of Japan is the buyer of last resort.
In my personal opinion there is a high probability that, with the new central bank governor coming in, this maturity will be extended from three to five years. The Bank of Japan would then remain the buyer of last resort for JGBs for maturities out to five years. The implication is that yields on JGBs will not be going up.
Somehow this doesn’t seem very reassuring to me. In the Americatalyst talk, Bass took issue with this line of reasoning, saying that the belief that there are two directions you can go when you are over-indebted (print or default) is incorrect and that, in his opinion, one is the cause of the other. Yes, the BOJ can continue to print more money and soak up bonds but eventually the result of that printing will be inflation, which will lead to higher yields and thus higher debt servicing costs for the government. Such a spiral will eventually lead to default.
As for my stocks…
As always the point of this blog is to ask the question what does it mean for my investments? And right now the answer is – not much. I again come back to liquidity. The last number of years have taught us that problems can be delayed out into the future as long as liquidity is abundant. I don’t think this time will be any different. The global economy, because of its over-indebtedness, is truly a giant confidence game. And with Central Banks printing plenty of money, to bet that confidence will falter in the near term seems foolish in my opinion.
Credit Suisse had an excellent piece a few weeks ago that talked about the risk appetite of investors. They make the point that risk appetites are currently very depressed on a historical basis, even after the recent exuberance of the last couple months and that, absent a negative shock, we might expect a good deal more exuberance to bring things back to their historical norm. They think that the credit cycle, long depressed, may be about to turn up.
…we tend to think that our simple leverage proxy suggests that the global credit cycle is starting to shift from a vicious circle process to a more virtuous process which will help support a more complete recovery in the real economy.
Interestingly, they also take a positive outlook on Japan:
In Japan, “Abenomics” has galvanised the equity market, given a big shot in the arm to business confidence and put Japan firmly back on the agenda for global investors. Of course the jury remains out on finally ending Japan’s long deflationary malaise, but Abe has already transformed the likely path for Japanese growth over the next six months. The top political priority is to make certain of an LDP majority in the Upper House elections this summer (giving the government more leverage over the BoJ among other things), and fiscal policy is being managed to that end. There will likely be no consumption tax increase until the economy is in better shape, while government investment is to get a big short-term boost. By late summer we now see the level of Japanese industrial production some 4%-5% higher than in our previous forecast.
I am of the mind that while it is important to be aware of the brewing troubles, they aren’t something to act on right now. This seems to me a bit like housing in 2003 or 2004. Sure there are problems, things are unlikely to end well, but in the mean time what are we to do? It makes me a little ill to be suggesting such short-term-ism, but it seems a reasonable assessment at the moment.
But much as was the case with the US housing bubble, I am pretty certain that the negatives will manifest themselves eventually. I watch the yields on European and Japanese bonds on a daily basis. Those yields have been going down relentlessly. If they begin to rise and especially if it is accompanied by signs that liquidity is being pulled away, that will be the time to pull money back.
As always, I will let the market be my judge. The strategy that works best for me is to sell into a falling market. The more it falls, the more I sell. While this is a tough skill to master, particularly when you own companies that you have some conviction in – it has proven to be a worthwhile one to have. I admit my own fallibility and the inherent complexity of our system that makes it, in my opinion, impossible to predict the timing of events. Given that I have only a weak confidence in the global outlook and that I don’t know when that outlook will turn, if the market begins to give me the sign that it is turning, I will heed that call.