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Sunday, January 10, 2016
Nevsky’s prospects: China, fat tails and opaque markets
NORMALLY, when hedge funds shut up shop, it is because the results have been poor. But that is not the case with Martin Taylor of Nevsky Capital who is retiring with an average annual return of 18.4%, some 16 percentage points ahead of the hedge fund average. In his final report (courtesy of Zero Hedge), he says the game is not worth playing; like a batsman who has scored a century, he has tucked his bat under his arm and has headed back to the pavilion, to let someone else have a go.
The report is a fascinating read, not just for what he says about markets but for his views on the global economy. The main points are as follows.
1. Investors need good data if they are to make decisions but the rise of China and India has diluted the quality of that data.
Currently stated Chinese real GDP growth is 7.1% and India’s is 7.4%. Both are substantially over stated. This obfuscation and distortion of data, whether deliberate or inadvertent, makes it increasingly difficult to forecast macro and hence micro as well, for an ever growing share of our investment universe.
Companies are also disclosing less information and this increases the specific risk of investing in individual stocks and bonds.
2. Nationalism is increasing which makes decision-making harder to anticipate and increases the risks for foreign investors, who may be the subject of nationalistic decisions. (For more on this, see this week's column)
3. Markets are less transparent, thanks to the retreat of banks from market-making and the rise of index funds and algorithmic traders. Prices can move rapidly (fat tails), perhaps in response to a trading mistake. This too increases risks.
it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables. This pushes up our cost of capital and substantially increases the risk of us suffering substantial capital loss on individual positions either because of a forecast error or simply because we could be caught up in an erroneous market trend, which could then persist for far longer than we could take the pain.
4. The US economy is likely to suffer from a lower trend growth rate, thanks to a fall in the labour force participation rate (as the baby boomers retire). This means the labour market has tightened rapidly. But the US economy could accelerate in the first half of 2016, thanks to the warm winter, which may force the Fed to tighten more quickly.
5. US companies are not prepared for a rise in the cost of capital. Their sales have been flat, they have squeezed costs as far as possible already and their balance sheets are stretched (Mr Taylor dismisses the aggregate numbers, saying that cash holdings are concentrated in a few tech companies). There are 40% more highly-indebted companies than there were in 2007. US equities are not priced to reflect these risks.
6. Emerging markets are not cheap, despite their falls; their debt has been going up and the return on equity has been going down. So why doesn't Mr Taylor simply act as a bear and short equities? That is because of the risk of a seventh factor.
7. China could decide to solve its problems by using quantitative easing to buy up non-performing loans from the banks. If it does, asset prices could soar. As it is impossible to devise a strategy that can deal with the alternatives of a slow-grinding bear market and a sudden bull surge, it is best to stop
It is a fascinating thesis with a lot to commend it. One can quibble with some of the detail; perhaps the labour market participation rate can rise again, particularly if baby boomers find they don't have enough money with which to retire. Another key point is that it is not just Chinese policies that are hard to read. For the last seven years, central banks in the west have given a clear steer to investors that they are interested in pushing prices up. Philosophically, we have moved a long way from the "you can't buck the markets" philosophy of Margaret Thatcher. Central banks have shown that, with an unlimited chequebook, you can buck the markets for a considerable period. Markets have not been "free" in the classical sense. Now that the Fed is changing tack, it is harder for investors like Mr Taylor to assess the situation, not least because it is hard to know where asset prices would be without central bank intervention. The training wheels have been taken off the bike and it is hardly surprising that many investors won't like the resulting wobbles.