Clover Quarterly Forecast 3Q 2013
The fork in the road...
After four years of Quantitative Easing, the Federal Reserve has reached a fork in the road where it will have to address the future of its accommodative program and decide which direction to go forward. The first indications are pointing towards a gradual reduction of the printing press. With Upon Dr. Bernanke press conference on June 19, we saw the 10 Year treasury rate move from 2.2% to 2.6%. This was an increase of more then 18% in less then two weeks. During the same period, the S&P500 corrected by 3.4%. Since then, the situation has somehow normalized, rates are now hovering around 2.5% and the stock market has recuperated more than half of it losses. However, if the chairman’s speech was a test to measure the market reaction to a reduction in central bank intervention, the answer from the market was clear and simple. Don’t mess with QE.
When all correlations turned to one...
Can we expect down the road from the Federal Reserve following the recent market volatility?
Clover sees three possible outcomes:
A) The Fed is true to his words; and we should note that historically Dr. Bernanke has always warned the market before moving. A reduction in Quantitative Easing is announced by the end of 2013 with a clear plan stating how and when the accommodative stance will be reduced and finally ended.
B) The Fed is true to his word but does not lay down a clear plan to withdraw its accommodative stance. The Fed would clearly state that it can reverse course at any moment to stimulate a vagabond economy.
C) Following a series of disappointing national and international economic news, the Federal Reserve changes course and continues or even increases its QE program.
Each of these outcomes will affect asset prices in a different manner. Lets also take into account the global economic and political situation unfolding:
-European recession and political difficulty to implement austerity measures and achieved stability of governments in the Mediterranean region.
-Major slowdown of the Chinese economy affecting commodity prices negatively and other emerging markets.
-Political instability in Egypt and other Middle East countries which can rapidly inflate the price of oil going forward.
Clover can forecast three specific economic scenarios over the next twelve months:
Scenario Analysis
Scenario 1) Deflation
Probability 30%
Under the deflation scenario we see the US Federal Reserve announcing a reduction of its Quantitative Easing program in the coming months and the end of all market interventions somewhere in 2014. This announcement would be followed by a rapid rise in interest rates and a collapse of global equity markets. Such an event would erase the wealth effect experienced by the population over the last few years. Commodities would drop sharply in value as the US dollar rises above all other currencies. Unemployment would become endemic and the world would face a new recession which could be more severe then the one experienced in 2008. The entire situation would be exacerbated by a recession in China and a depression in Europe. We would see the rise of political instability across the globe and increase tensions between countries. The cost of labor would drop and so would the price of most goods. At start, the price of Gold would go south before experiencing a 180 degree turn as the population loses trust in their fiat currencies and finds refuge in precious metals.
Up till recently, Clover had forecast a low probability to such a scenario as we were of the belief that the Chairman of Federal Reserve would be extremely prudent an his approach to avoid any economic collapse. However, considering the situation across the globe at the moment, the will of the Fed to reduce it’s involvement in the market, the probable change of Fed’s Chairman in the coming months and the violent movement experienced over the last few weeks in interest rates, Clover had no other choice but to increase the probability of a deflationary environment to 30%.
Scenario 2) Muddle Through
Probability 50%
This scenario is not much different in its premise than the deflation scenario. It is based on an announcement from the Federal Reserve of a decrease in market intervention in the coming months. However, the dates and approach are not clearly disclosed and the members of the Fed publicly support the market by continuously promoting future intervention if needed. The major difference with the deflationary scenario is that the fixed income market reacts in with ordinate manor and avoids any shocks affecting asset prices going forward. The reality is that the difference between a muddle through scenario and a deflation scenario is within the trust the market has toward its Central Bank.
Under this scenario, we would see interest rates increase slowly to give the economy time to adapt. The stock market would continue to produce positive single digit returns. The fixed income market would start a long and difficult bear market that could last for years. Volatility would increase as the market participant would anticipate increases in rates while the Federal Reserve actively talks the market back up. Under this scenario, Clover would expect the US dollar to continue to appreciate, in particular against the Yen and the Euro.
To paraphrase Bill Gross, the muddle through scenario could also be called “The scenario of new normalization”. Under this scenario, the global economy would grow between 0 to 2% over the course of the next twelve months.
Scenario 3) Inflation
Probability 20%
Clover is decreasing the probability of seeing an emergence of inflation in the coming months as we see the reduced involvement of the Fed in the market as an important inhibitor to inflation. Any increase in interest rates should be supportive of the US dollar and reduce inflationary pressure going forward.
However, a reversal of the employment situation in the US, the turmoil in the Middle East, the worsening political and economical situation in Europe and the important slowdown in the Chinese economy may force the Federal Reserve to review its exit strategy. In this scenario, the Fed would instead return to, or increase it asset purchase program. It wouldn't be impossible to see the Fed in collaboration with the Bank of Japan, the Bank of China and possibly ECB, to embark in a new phase of monetization. A joint effort would have a calming effect on currency volatility and send the stock markets through the roof. We would also see a renewed chase for yield where corporate bonds and junk bonds would be the asset of choice in the fixed income world. It should be noted that Gold would rapidly hit $US 2000 under such a scenario.
Clover believes the inflation scenario to be too early to present a higher probability. We first need to muddle through. However, we continue to believe that an inflation scenario is forming in the horizon. This is a scenario that should emerge in the coming years.
Inflation is losing velocity
Impact of the different scenarios on Asset Classes in local currency
A review of the previous table illustrates the direction of each major asset classes under the different scenarios. In magenta we identified “long” asset classes presenting a probability of success in excess of 50%. Our forecasting exercise predict that:
-In 70% of the scenarios, US equities should appreciates and therefore the equity component of the portfolio should overweight US equities over the remaining of the world.
-In 80% of the scenarios, the Dollar should appreciate, supporting an overweight in all US asset classes.
-In 70% of the scenarios, Japanese equity should appreciate, however, the negative forecast on the currency would remove most of the added value. Therefore, Japanese equities should be hedge back to the US dollar.
Recommended Asset Mix for Q3
-Clover recommends to underweight equities and fixed income in favor of cash in the coming weeks. Clover believes that equities will present a lower entry point in the future following the announcement of a reduced QE. For the more aggressive investors, short equity positions may be considered.
-US assets should be favored over any other geographical regions as Clover continues to expect the dollar to appreciate over the Euro, Sterling and Yen.
-For US equities, it is recommended to overweight Healthcare, Technology, Biotech and Consumer Defensive. Financials, Utilities and Energy should be underweight. However, if the situation in the Middle East deteriorates, the underweight toward energy should be morphed into an overweight. Outside of the US, we recommend an allocation to Japanese equity, hedged back to the dollar.
-All fixed income positions should remain short in duration and quality should be favored over higher yield. If possible, floating instrument in US dollar should be considered.
After the Storm...
A reading of the previous pages may leave you with a sense of confusion, scared to make decision and wondering where to invest your hard earned money. Please remember that the market always offers opportunities. Whit the state of the Global economies, there is some demographic and structural trends that will present growth in the years to come. These trends need to be present in a portfolio to take advantage of the momentum when the security appreciates. Here is a sample of Clover’s long term themes, their Return Driver(s) and a brief description of why everyone should consider investing in them for the long term.
Health Care (Long): As the developed world population is aging, there is no denying that more money will be spent in health care, in particular on the servicing side. Funeral homes and all the sub-sectors addressing the needs of an older population will grow much faster than the overall markets in the years to come. For the same reason and because of the recent advancement in science we also like the Biotech sector. Return Driver: Aging Population.
Agribusiness (Long): The price of oil has tripled since March 2009, however, the price of food commodities only went up by approximatively 40% for the same period. When considering the important reliance of food production on oil and the future growth in demand coming from the BRIC countries, there is no doubt that food inflation will remain high for the foreseeable future. As food prices increase, earnings from food producers and all related industries would follow. Over the short to medium term, demographic trends are indicating a steady increase in the size of the Global Population. Remember that today, for every one person that dies there are two people born. Invest in Food and Food Commodities Producers. Return Driver: Growing World Population, limited land available for production and Increase demand for high calorie food.
Alcohol (Long): Alcohol consumption is a growing part of our lives. When we face difficult times, we drink to forget. When times are good we drink to celebrate. According to the World Health Organization, (WHO) the adult population drank the equivalent of 6.1 liters of pure alcohol per person in 2005. Consumption is increasing globally. Researches indicate that over a five-year period, for every individual who reduced his alcohol consumption,
14.69 people increased it. At Clover, we have a strong conviction that the earnings growth trends will continue for the years to come in the alcohol sector. Return Driver: Growing World Population, Increase consumption of a addictive substance.
Sovereign Bonds (Short): No asset class has as much risk asymmetry then long sovereign bonds. Sovereign fixed income presents a higher probability of loss and the magnitude of those losses are much higher than the probability of gain. Why would somebody buy a 10 years Treasury today with a yield below 2% continues to astound us. We recommend taking a short position on sovereign bonds, in particular for Germany and for Japan. For the income part of your portfolio, increase the corporate allocation and remain short, 3 years or less. Return Driver: The end of the 25 years bond bull market.
Japan (Long stocks) (Short Yen and Bonds): Only one country was ever able to repay its debts after reaching a debt to GDP ratio of 150 (the UK after WW2). Today Japan is facing both a demographic crisis and a debt crisis. Clover is forecasting that the Japanese debt to GDP ratio will exceed 215% for 2012. As Japan’s trade balance is rapidly turning into a deficit and its aging population increases; savings will drop with money gravitating from bonds to health care. Japan will have no other choice but to continue to print more and more of their currency therefore reducing the value of the yen and make their exports more appealing. Return Driver: Unsustainable level of debts, aging population.
