Economic Crisis

The “multiple uncertainties” that are on my mind

Buenos Aires, Argentina

Heavy rainstorms swept through Buenos Aires in the past few days. Lightning flashed, thunder cracked, streets were inundated, social plans were changed.

That said, on the financial side at least, things have calmed down in Argentina…for now. A year ago, one US dollar bought 17.5 pesos. By late September it reached 42 pesos, which is to say the peso lost 58% against the dollar. That’s the very definition of a currency crisis. Now it’s back to 36, meaning the peso has clawed back 17% over the past a month and a half.

All financial markets are prone to periodic storms. Successful investors do their best to position portfolios to weather whatever falls from the sky. In that vein last week I looked at a snapshot of how the main financial asset classes have performed this year. Within that article (full text here), I wrote the following:

“So far at least, 2018 has been the year of the dollar. With hindsight, most investors will have found it hard to beat dollar bank deposits. Note: this is not the same as saying investors should have entered the year holding nothing but cash. Things could have turned out very differently for each asset class (better or worse).

But it does justify a conservative portfolio allocation, in the face of significant, multiple uncertainties (economic, political, financial), and after many years of emergency monetary policy (ultra-low rates and quantitative easing).”

A reader pointed out that there are always “multiple uncertainties”, and that’s something that I completely agree with. But…it’s just that I have this sense that there’s a bit more than usual that could upset the market apple cart. Hence the recommendation for a conservative portfolio allocation.

Today, I thought I’d share some of the main issues that spring to mind. These are things that are relevant to the world of investment, not general concerns. (For example, I’ll be cohabiting with a newly fledged teenager in five weeks time, once my daughter’s birthday comes around…)

Incidentally, there are plenty of positives too. But today I’ll focus on downside risks.

In no particular order, these are:

  1. Various confrontations between the US and:
    1. China (trade) – It’s not good for business when the world’s two biggest economies are butting heads (three biggest if you throw the European Union into the mix)
    2. Russia (nuke treaties / new Cold War) – It’s not good for anything when the world’s two biggest nuclear powers are butting heads. Not that I’m worried about a nuclear war, in terms of investments. We’ll all have much more serious things to worry about in that event (like where the next meal is coming from). Alternatively, all our troubles will have been (literally) vaporised. But the broader point is the geopolitical instability, as two big powers jockey for influence and waste money on an arms race.
    3. Iran (everyone else wants to keep buying Iranian crude, including the EU) – This issue is driving a wedge between the US and its allies. It also provides new incentives to replace the dollar in global trade (the EU is reported to be on the case).
  2. The potential for a no-deal Brexit (short-term shock) – It’s worth remembering that the UK is still the world’s fifth largest economy. A chaotic exit from the EU could create all sorts of problems in financial markets and trade networks. There’s also a substantial risk that the weak Conservative government is dislodged, to be replaced by the currently hard-left Labour party. (Actually, the latter would probably be more damaging for the UK than any Brexit problems.)
  3. Deeper problems within the EU (multiple and substantial challenges to Brussels / the political establishment) – Italy wants to breach the budget rules, countries in the East are getting uppity (Poland, Hungary), Greece is still bankrupt, the political establishment faces challenges from both the hard left and nationalists. (For example, Marine Le Pen’s nationalist party is neck-and-neck with French President Emmanuel Macron’s lot for voting intentions in the May 2019 elections to the European Parliament.)
  4. Italy’s financial difficulties (huge government debts, struggling banks) – Italy is the ninth largest economy in the world. Government debt is 132% of GDP. At $2.4 trillion, Italy’s government bond market is the fourth largest in the world (behind the US, Japan and the UK). Many Italian banks are stuffed with bad loans, and the political scene is run by a combination of nationalists (incompatible with the EU) and comedians (also incompatible with the EU, a bureaucracy not noted for its sense of humour).
  5. The bubble in many (big) US tech / growth stocks, while other sectors are also substantially overpriced (eg some of the big consumer staples stocks) – Although some tech / growth stocks are off their highs, there are still some big bubbles to deflate. Amazon trades with a P/E ratio of 92. Netflix stock is on 105 times earnings. Such situations never end well.
  6. The impact of rising rates on highly leveraged corporates (especially in US, after years of borrowing like crazy) – This concerns the inevitable hit to profits from higher interest costs, and a potential major reduction in debt-funded stock buybacks. That’s two wobbly legs supporting the market stool.
  7. Hit to corporate profits from rising wages – Make that a third leg. Unemployment is low. Upwards wage pressures will follow.
  8. Faster than expected rate rises due to inflation (commodities, tariff taxes, credit expansion now banks are fixed / no longer paying vast fines) – Everyone expects the Fed to keep raising US interest rates. But what happens if inflation rises more than expected, meaning more pressure to hike rates?
  9. Quantitative Tightening (QT) – This is about the Fed progressively withdrawing trillions of dollars from asset markets (especially bonds) – at the same time as the US fiscal deficit increases, meaning a faster rate of new borrowing. Both put upward pressure on bond yields (which means lower bond prices). It also increases the cost of corporate borrowing and things like mortgage rates.
  10. Political upheavals in some big emerging markets (e.g. Mexico, Brazil, South Africa) – Mexico elected a leftist and Brazil elected a rightist. No one knows what happens next. South Africa wants to redistribute farmland. (You may recall that Zimbabwe tried that already, causing a collapse in production of cash crops and catastrophic hyperinflation. I have a worthless 50 trillion Zimbabwean dollar note in my desk as a reminder.)
  11. Multiple real estate bubbles (e.g. UK, Hong Kong, Australia, parts of the US and Canada) – They all burst eventually, especially when mortgage interest rates rise.
  12. The boom in index trackers means indiscriminate selling will be more brutal during the next crash, as funds are pulled – The next crash could be a doozy, although I’m not about to make the mistake of predicting when it will happen. (Nobody knows. And anyone who says they know should be shunned.) The good news: there will be some amazing bargains in the aftermath (remember to keep some cash “ammo” for when it happens).

I’m sure I could come up with other things. But those are the main ones that came to mind.

Do you agree or disagree with me? What else would you add to the list?

Please let me know at the usual email address (see below). It would be great to hear from you.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.