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Lost in Translation
Toronto: March 24, 2014
By John Stephenson

Global equities experienced another week of mixed performances punctuated by higher volatility, with the S&P 500 hitting and then retreating from a new record intraday high. Worries over emerging markets, most notably China and Ukraine, which have rocked markets lately, seemed to come off the boil this past week.  The market seemed to take in stride the overwhelming pro-Russian vote in Crimea and the subsequent actions by Russian authorities to legitimize these results. Concerns over China’s apparent slowing took a backseat to the view that the Fed would ride to the rescue of the global economy.

Janet Yellen held her first press conference this past week as Chairwoman of the Federal Reserve and as expected, she announced a further $10 billion reduction in the Fed’s monthly asset purchases.  But is was the 25 basis points increase in the official median forecast for the Fed funds rate by the end of 2015 that caught the market by surprise.  In response to a question relating to how long the Fed might wait before halting its asset purchases and raising interest rates, Yellen let a very specific “six months” slip out from her otherwise scripted remarks. This was sooner than the market expected and in a matter of seconds, the S&P 500 shed one percent and yields on Treasury securities soared.

Investors globally seem to view the Fed with reverence, believing that the direction of Fed policy is all that matters for investment success.  For the last ten or fifteen years, lower rates have trumped fundamentals in driving returns and this viewpoint has translated into a positive but complacent stance amongst investors toward U.S. equities.  This view has only been exacerbated by the strong returns of the S&P 500, over the past few years.  For many investors, the U.S. is the place to park your investments, but for growth, you need to look to the emerging markets. And the current volatility has left many global investors in a giddy mood, as they anticipate any sign that unbridled growth is returning to the emerging markets.

I couldn’t disagree more.  Emerging market growth is unlikely to repeat the heady growth rates of the early 2000s, because China, the world’s number two economy, is clearly slowing.  More reports and evidence keeps piling up, virtually every day, that China is no longer pursuing growth at any costs.  In 2007, China’s gross domestic product expanded by 14 percent.  Last year, it was 7.7 percent and last week Goldman Sachs lowered its 2014 China GDP forecast to 7.3 percent from 7.6 percent.

Compounding the growth story in China is a credit bubble that has sent China’s public and private debt soaring.  In 2007, overall Chinese debt was about 150 percent of GDP, today it’s about 220 percent.  And to bring down borrowing before it becomes unstable, Chinese regulators will have to clamp down on the vast shadow banking (leasing companies, insurance firms, trust companies etc.) system that has kept the economy booming by pumping in vast quantities of money into the system.

And China’s growth matters a lot to emerging markets.  In 2012, China’s growth accounted for 60 percent of global growth.  As growth in China comes down, the global economy will need to find a new driver of growth, probably a futile process. Slowing Chinese growth translates into falling inflation rates—already the European Central Bank (ECB) is pushing the panic button over falling inflation.  With inflation well below the banks’ two percent target for the euro zone, many are predicting that Fed-style quantitative easing is coming to Europe.

For my money, the best opportunities are in still the U.S. and in particular in the Financial and Technology sectors.  Financials, particularly the big money center banks, are unloved by investors, who see them as slow growth and fraught with regulatory risk. Investors have dismissed out of hand the dividend and consistent growth of large cap technology companies, driving valuations down to ridiculous levels and instead have focused their attention on small cap social media companies. 

American companies are sitting on vast stockpiles of cash that will ultimately be spent on acquisitions and capital expenditures, however, this is a slower moving train than those of previous cycles where infusions of liquidity by the Fed, set markets soaring. A peaceful resolution to the crisis in Crimea is in everyone’s interest, but I for one, will be avoiding emerging market stocks that are just too linked to growth in China and will be focusing instead on the secular bull market in America.

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On a personal note, my wife and I completed our first spin out with the birth of Jackson Stephenson on March 15th.  It’s times like this that I am reminded that the best investment one can make is an investment in family and friends.

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