Of bunny markets and scapegoat economics

Looking back and looking ahead

By Kokkie Kooyman, Portfolio Manager at Denker Capital (previously SIM Global)

The current ‘bunny market’ is characterised by subdued economic growth, scapegoat politics, increased bureaucracy and ineffective policies. However, despite this seemingly bleak outlook, we believe there are still attractive valuations and good opportunities out there. Kokkie Kooyman, Portfolio Manager of Denker Capital (previously SIM Global) unpacks the present, the past and the future for us.

Yesterday (“looking back”)
Fund managers with 20 years plus experience the world over have experienced terrible returns (both globally and in SA)… nothing appears to be working. We’re in what Jim Paulson (Wells Capital Management Inc.) calls a “bunny market” (not a bull or a bear, just a market that hops around a lot).

Why is the confidence gone?

Like us, markets and economies are older (mature)
A long economic growth period has left developed market governments with excessive debt and little growth. In addition, the Chinese economic miracle is over. China’s population is both aging and declining, it is burdened by large, inefficient state-owned (and managed) enterprises, excessive infrastructure and too much debt. Not a good foundation for a 6% or even a 4% growth rate…

Three ingredients help facilitate growth:

• a growing labour force
• improving productivity levels (competitiveness vs outside world)
• increasing debt levels (to improve productive capacity or increase consumption).

The reality is that China and Europe both battle on all three fronts…

Trump vs. Sanders and scapegoat politics
According to Paul Donovan, a social climate which supports “anti-parties” or politicians has negative economic implications (UBS: The Economics of Prejudice Politics; 22 March 2016).

Deteriorating economic circumstances have allowed politicians like Trump and Sanders to gain support. This is because during recessions management focus on profitability at the expense of labour. Every company we visit in developed markets is downsizing and reducing staff.

Which of the two candidates is better for growth?
Trump (anti-free trade but less bureaucracy) will most probably be better for the S&P, while Sanders (anti-capitalism, increased red tape and reducing the wealth gap) will be worse for markets. Investors will withdraw capital on a Sanders win, fearing more protectionism, interference and hence reduced returns. This is what is happening everywhere else in developed markets (in the UK, Osborne is a good exception). No wonder growth is poor. Increased red tape makes businesses less profitable and globally less competitive.

Increased bureaucracy strangles the goose that lays the golden egg
Capital must be controlled and regulated (it is the role of the state to ensure level and honest playing fields). It has been proven many times that increasing minimum wages also increases unemployment. But increasing unemployment in turn can cause a rise in instability. To solve these equations, one needs a government with the infinite wisdom of Solomon, a quality sadly lacking in most ruling governments today.

Today, the problem that investors face is that current policies are curbing company profitability. The world has become a global marketplace. The lowest cost producer wins. You have to be better, quicker, smarter. To create jobs, governments need to increase labour flexibility, ensure the education system produces a competitive labour force, improve education and training, and attract foreign capital.

Doctors are prescribing the wrong medicines
(i) Central banks are trying to keep interest rates low (negative) in the hope that low/negative interest rates induce spending. It hasn’t and won’t.

(ii) Regulators are fighting the lost war by increasingly loading banks and insurers with increased regulatory and capital burdens. A good example is how prescriptive the US Securities and Exchange Commission (SEC) has become. Not only have they increased the work force of banks/insurers by more than 10% simply to meet their information demands, they also play a huge role in capital allocation decision in terms of whether and to what extent banks can pay dividends or buy back shares.

They have almost succeeded in their stated goal of turning banks and insurers into regulated utilities. No wonder markets don’t want to give managements capital (look at the low P/NAV’s) or that managements don’t want to lend or write new business. From January 2018 it will get worse: new rules will ensure banks lend only to the best borrowers, constraining loans to higher-risk borrowers and accelerating bankruptcies world-wide, as banks will not be allowed to use their own internal risk assessment models.

Citigroup recently shared insight into the nightmare environment regulators have created. Banks and insurers are being forced to spend millions on systems that will provide the information required. This is a nightmare for large, complex banks with many legacy systems. The poor regulatory oversight which allowed AIG, Lehman’s, Royal Bank of Scotland, etc to damage the system is now being replaced by a monster machine. The Central Bank’s low interest rate policy is being negated by the regulators.

The fundamental principle of capitalism is that capital is put at risk in creating jobs which produce products (think Henry Ford, Bill Gates of Microsoft, etc). The current environment has made it very unattractive to provide credit or capital. The debt is all sitting on government and central bank balance sheets.

(iii) And so, investment in productive capacity has been replaced by financial engineering – making money from short-term movements.

Tomorrow (“looking ahead”)

Tomorrow will not be the same as yesterday. Yet, there will always be new investment opportunities.

Many companies are generating a consistent (and growing) 4% dividend yield. In yesterday’s terms this may seem low, but bear in mind we live in a low/negative inflation environment. A real 4% return compounded over 10 years is not bad at all.

Well-run companies can successfully grow shareholder wealth and investors are rewarded over time. However, in the financial sector particularly, these good companies are often mispriced relative to their past, but seldom to their poorer quality peers. Significant investor capital has been destroyed seeking “the bottom” of Standard Chartered, Barclays, Deutsche Bank, etc. These are businesses with considerable legacies. There are good companies with excellent track records and no legacy problems trading at historically low multiples. Yes, tomorrow’s return on capital will be lower, but the valuation more than makes up for that.

For example, both FirstRand and US Bancorp seemed expensive in January 2010. Yet an investment in these generated considerable outperformance.

Uganda is not Greece
The principle of what the Ugandan government tried to bring across is correct. There are governments that are following “capital- friendly” (attractive) policies and successfully generate wealth for both workers (growth in GDP/capita) and investors. Another classic case: Indonesia is not Brazil.

Markets often over-react when the herd gets emotional

This creates good investment opportunities.

Being invested in emerging markets (EMs) has been a losing strategy measured in $ terms since 2011. Consistent outflows together with trade deficits of commodity exporting countries have pummeled many EM currencies. But we believe investors have over-reacted and the tide is now turning for EMs and EM bear is nearing its end. Indeed, EMs have outperformed DMs over the long term.

The chart below (ex-Morgan Stanley) gives a rare insight into how two different sets of investors have reacted (US and European). But the bottom-line is that, based on this graph, European investors have withdrawn everything they have invested over the past 15 years.

Graph one: The chart below aptly captures the difference of investor opinion

• European based managers have taken out everything they have put into emerging markets over the last 15 years.
• US domiciled funds still look to hold substantial cumulative flows in emerging markets.

Source: EPFR, Jonathan Garner and the MS emerging markets team

Countries like Indonesia have demonstrated that good policies do make a difference and are now poised to reap the benefits. In India, Prime Minister Modi was over-optimistic about what he could achieve when he inherited the messy Congress-led government in 2013, but is slowly overcoming the corrupt and inept bureaucracy. India is creating 100 000 new jobs per day!

The bottom line
So yes: yesterday was easier. The high-octane environment after US Fed monetary pragmatist, Paul Volcker, launched his attack on inflation in the US in the mid-70’s, causing interest rates to rise to record highs in 1982, is long gone. The high growth environment and long bull market that was created as a result won’t be repeated for a while.

But tomorrow brings new and different opportunities and, as we mentioned in our last article (Market are ruled by fear, but don’t panic), banks and insurers in both DMs and EMs have become extraordinarily cheap and valuations are looking attractive.

In the current low-interest rate environment, these companies are growing shareholder value at 10% per annum. Not as exciting as yesterday, but in today’s negative interest rate environment, that is considered good. There are never guarantees, but four things remain important: valuation, real returns on capital, good management, experience.

As part of our pragmatic value investment philosophy, we’re invested in good companies with attractive valuations generating good, real returns on capital. Our experience has shown us that the returns eventually follow.