MAY 2013 MARKET AND ECONOMIC CONDITIONS

An effort to make strategic allocation decisions is rooted in a process of evaluating signals provided by markets and the economy that are often in conflict. We have had frequent conversations with investors over the last five years about the importance of separating ‘signal’ from ‘noise’, and are reminded of it again today, as we think about investing in a world governed by bodies that seem to be determined to make sure that conflicting signals remain in place. In its simplest form, the disconnect in today’s world lies between inflationary and deflationary actions and outcomes.

Central banks around the world have passed the baton to one another in an effort to collectively inflate global assets, and ultimately the global economy, by ensuring that the financial system stays awash with more liquidity than it can easily digest. While the liquidity has indeed propelled asset prices higher, particularly those with a growth or income profile that is too hard for an investor backed by way-too-easy-and-cheap leverage to eschew, it has failed to produce a traditional recovery growth profile while creating a credit market that is seemingly as easy as it has ever been. On the deflationary side, commodity prices have wilted and longer bonds have rallied, as the yield on 10-year Treasuries has fallen from 2.06% to 1.74% since mid-March. Not only bonds of corporations with strong balance sheets and cash stockpiles, but those of indebted governments as well, including Slovenia which recently had its credit rating cut below investment grade, yet received $16 billion (equal to nearly one-third of its gross domestic product) in bids for bonds yielding under 5% for five years. It is an environment, as reflected by spreads and a lack of volatility, that feels eerily similar to that of 2007 – leading those that worry about history repeating itself to lament the market’s lack of institutional memory.

The latest participant in the global central bank race to the currency bottom is the Bank of Japan, but as an institution it is making up for lost time. Since the beginning of 2013, monetary stimulus from the BOJ has amounted to 13.7% of GDP, compared to Fed stimulus over the same period of 3.2% of GDP. They have purchased 46.9% of government issuance, for a figure that equates to 134.4% of the country’s deficit. In the U.S., the Fed has purchased 24.2% of Treasury issuance, or 39.5% of the level of our country’s deficit. Japanese investment has been a significant driver of portfolio inflows around the world for quite some time. The recent bout of balance sheet expansion should take that to another level, and could very well be a dynamic that plays out for many years. The shift from tight to loose monetary policy is largely political in nature. Two rules to remember when investing in Japan, are: 1) never underestimate the willingness of the population to share pain, and 2) never underestimate the willingness of Japanese policy makers to apply the first rule. These two rules mean that Japan will act in the country’s overarching national interest and security at all times. In recent years, the primary national interest has centered on the fact that it is a rapidly ageing country with more than half of voters either retired or within five years of retirement. A currency debasement that stirred inflation would not have been popular. Mild deflation and a strong currency are good for retirees.

Recently, the dual threat perceived to emanate from China, on both political and monetary fronts, has caused a 180-degree shift with respect to a structurally weak yen policy. With China holding significant levels of JGBs (Japanese government bonds), and tensions stirring over the Senkaku (as they are known in China)/Diayou (as they are known in Japan) islands, a weak yen is indeed seen as a matter of national security. With a lot of debt and xenophobia, you don’t want to continue to run large current account deficits. This need to boost Japanese exports is why Prime Minister Abe has a 72% approval rating despite declaring a weak yen policy, a concept considered anathema to policy makers until now.

The relationship between Japan and China is based on trust and understanding – but Japan doesn’t trust China and China doesn’t understand Japan. Fallout from the policy will be felt for years to come. With policy rates kept down, yield hungry Japanese investors will turn anywhere and everywhere. Historically, Japanese investors love REITs, commercial real estate, emerging market bonds, high yield bonds and loans, and equities, with a particular fondness for the markets of India and Brazil. On the trade side, Germany and Korea will likely be hurt, as they have very tight export profiles to Japan.

The notion of an investment pivot from China to Japan is not meant to suggest that China’s impact on the world economy will be diminished going forward. In fact, the transition taking place within the Chinese economy is likely to be a huge driver of macroeconomic inputs such as energy and agriculture prices, as well as global trade balances. While the shift from an export driven profile to one of domestic consumption has garnered the majority of critical thought, the real sea change to monitor deals with the allocation of China’s most precious resource, water.

Many people are familiar with the fact that China is the world’s biggest importer of energy. Fewer are familiar with the fact that China has more shale gas resources than any other country, including the U.S. While China’s shale gas is deeper in the ground and harder to recover than ours, the primary reason that they have produced fewer natural gas reserves than the U.S. is their allocation of water as a natural resource. For generations, water in China has gone largely to the farming industry, as the Chinese have insisted on farming things that don’t need to be farmed. Items that can be imported at a spread much more narrow to domestic production when compared to the cost of energy importation. That allocation decision has left an inadequate supply of water for fracking, leaving the vast majority of natural gas sitting underground. With that policy change in the works, the impact of lower energy prices around the world could have dramatic implications on developed and developing economies.

It is this very emphasis on the technology of energy production that has led to what is being called an energy revolution in the U.S., and along with a nascent recovery in housing and the tangential benefits attached to housing as an industry, have kept the U.S. economy growing at a moderate pace. Headline GDP would be higher if not for a retrenchment in public sector spending. Private sector GDP excluding inventories has been running at a 3.5%-4.0% clip for the last several years.

Three years on, however, one of the surprising features of this recovery has been the low level of U.S. business investment despite companies having plenty of cash to spend. At 53% of corporate profits, capital expenditure is well below its long term (dating back to 1951) average of 88% as well as its short-term (dating back to 2002) average of 68%. Corporate earnings are rising but profit growth is all through cost cutting. The post-crisis level of business investment has been uneven. While spending on information technology has grown by an average of 8.8% per quarter, spending on physical structures has grown by only 0.8% per quarter. Economic uncertainty has been a huge impediment to capital spending. When economic policy uncertainty rises, companies become reluctant to make capital outlays which are long-term in nature. Some of this uncertainty has declined since the beginning of the year, as “fiscal cliff” concerns were largely allayed. Also, the perception of tail risk has come down, as evidenced by the reduction in money market spreads in both the U.S. and Eurozone.

This perceived reduction in macro risks, along with the continued cooperation of central bank actions, may continue to provide a tailwind to financial assets as we continue through 2013. In fact, the Fed is gambling on just such an occurrence. The gamble lies in the fact that 75% of global market capitalization sits in fixed income assets, which the Fed is systematically putting at risk and at a disadvantage with its zero interest rate policy. The Fed is counting on the gains generated in the 25% of the global market invested in equities to produce the 5% real rate of return that is likely required to offset fixed income losses. One manifestation of this Fed-induced capital market assumption has been a shift in how yield makes its way into investment portfolios. In 2007, 64.3% of the yield in a portfolio consisting of U.S. stocks and bonds came from the Barclays Aggregate Bond Index, versus 35.7% which came from the S&P 500. In 2012 that figure dipped to 51.6%, and in 2013 the estimated yield from bonds is 49.2%, while over half of the market yield comes from equities.

In the midst of this recalibration with respect to investor behavior, one sector that continues to strengthen is commercial real estate. Recently, the American Institute of Architects came out with a report detailing demand for its services. As a leading economic indicator of construction activity, the Architecture Billings Index reflects the approximate nine to twelve month lag time between architecture billings and construction spending. With multiple components surging, both the billings index for commercial real estate construction (which reported its highest figure in February since July 2007) and the new project inquiry index (highest figure since January 2007) have been on upward trajectories since early-2009, and are now back to pre-recession levels. As leading indicators of future construction activity, it appears that the commercial real estate market is poised to continue to improve going forward in 2013 and 2014.