The outcome of the Brexit referendum clearly demonstrated the inherent volatility and fragility of global markets. What many people are missing, however, is that the financial impact of this largely political event comes nowhere close to the financial magnitude of events that led up to January 2016, a month we may look back on as a canary in a global economic coal mine.
U.S. equity markets lost over $1 trillion of value in January. In dollar terms it was the worst January in history. In percentage terms it was the eighth worst. What precipitated this violent and historic decline, and does it signal a future event of much greater magnitude?
Recent concerns over global economic growth and credit quality in China certainly played a role in January’s decline. As the second-largest economy in the world, and the fastest growing of the major economies, China has tremendous influence on global economic growth, not to mention the companies whose share values rely on such growth. As investors entered 2016 they became increasingly concerned about China’s declining growth – not just weak GDP growth estimates but also declining electricity usage, steel consumption and commercial railcar movement.
Another layer to this story is the fact no other country in the history of the modern world has accumulated as much debt as fast as China. China’s debt as a percentage of GDP now stands at about 280%, versus 245% for Japan and 108% for the United States. Unlike Japan and the U.S., China accumulated the majority of its debt post-2008. This suggests many loans were given to sub-prime and non-investment grade borrowers.
In other words, China issued debt to create growth at all costs. While non-performing loan rates in Japan and the U.S. typically hover in the 3% range, it has been estimated by CLSA Hong Kong that the non-performing loan rate in China is closer to 19%. If these non-performing loans were to go into default it would be the equivalent of 50% of China’s GDP. This would create a shock throughout the global financial system.
Heading into January 2016 this issue became a major concern for investors, particularly as it became apparent these loans, taken together, are three times larger than the sub-prime loans that caused the 2008 financial crisis.
Another big factor was the sharp decline in the benchmark WTI oil price, which fell to $26 (U.S.) a barrel. The drop – from $40 in December 2015 and more than $100 in 2014—exacerbated solvency concerns in the North American energy sector, which accounts for about 10% of both stock market values and GDP.
Most North American oil producers, on average, require a WTI price of roughly $35 a barrel to break even. The sharp decline in energy prices in January 2016 forced market participants to re-evaluate not only economic and stock market forecasts but the solvency concerns of a key sector. That the WTI price has since moved closer to $50 has assuaged these concerns temporarily. Yet with global growth declining, oil inventory at record levels, and momentum on the side of increasingly cost-competitive renewable energy technologies, there remains a high possibility the energy sector will face another existential crisis in the near future.
Perhaps the most significant influence on the stock market in January was a decision by the U.S. Federal Reserve to hike its federal funds rate on December 16 by a quarter of a percentage point to a range of .25% to .50%, the first hike in nearly a decade. Why so significant? The federal funds rate is critical to global markets. It influences interest rates around the world and affects everything from bond and stock prices to currencies to mortgage and car loans.
A few things stand out about this particular rate change: first, the magnitude of influence that just a quarter percentage-point change had on the stock market; second, the current rate with an upper range of .50% compared to the various long-term averages of about 5%; and third, the rate remains historically low, with only minute incremental changes, despite the relatively good news we continue to read about the economy.
Incidentally, the catalyst that put a halt to the decline in the stock market in January 2016 occurred on January 29 at the World Economic Forum in Davos, Switzerland. That’s when the governor of the Bank of Japan announced a reduction in the country’s benchmark lending rate to -0.1%. Japan’s decision followed the lead of the European Central Bank, which had previously reduced its rate to -0.3%.
The Financial Times recently reported that negative yielding government debt now exceeds $11.7 trillion—approximately 25% of total global government debt. Negative yields are quite rare and the race to negative yields, or low yields in the case of the United States, is traditionally a sign of economic weakening, not strengthening.
What the great investing minds are saying
Do the factors that caused the violent and historic decline in January 2016 suggest we are facing another major market crash as big – or bigger—than 2008? If so, would catastrophic outcomes persist? Or, do the economic positives we hear each day about low interest rates, low unemployment, low inflation, a healthy banking sector, rising real-estate prices, technology improvements, protection of resources, renewable energy and the rise of India—among others—suggest that any downturn or crisis will merely be a short-term market correction, with the kind of economic rebound we saw following the 2008 crisis?
To answer that, it’s worth remembering a quote from the famous golfer Lee Trevino: “I never took a lesson from someone who couldn’t beat me.”
So let’s analyze the thoughts and perspectives of three of the greatest investing minds of all time: Stanley Druckenmiller, Jeremy Grantham and A. Gary Shilling. These men are truly in a class of their own and, incidentally, share some common traits:
- They have tremendous collective experience, with an average age of 73.
- They are experts in synthesizing global economic and political data and profiting from it through various asset classes such as stocks, bonds, commodities and currencies.
- Their investment track records are legendary and they have shown an ability to earn profits in both up and down markets.
- They are environmentally and socially conscious individuals. Shilling is an avid beekeeper and honey producer. Grantham runs one of the largest foundations committed to environmental protection and was once dubbed the “world’s most powerful environmentalist.” Druckenmiller was named “America’s Most Charitable Man of 2009” by the Chronicle of Philanthropy after he and his wife pledged $705 million (U.S.) in support of medical research, education, and the fight against childhood poverty.
Stanley Druckenmiller started his investment fund Duquesne Capital in 1980. For more than 30 years he’s managed to earn an annualized return of 30% and has never had a single losing year. That includes the great recession of 1980 to 1982, the stock market crash of 1987, the Russian Ruble crisis of 1998, the tech bubble of 2000, and the financial crisis of 2008. It’s why many of the top fund managers in the industry consider Druckenmiller to be the greatest investor of all time.
In 2010, Druckenmiller closed his firm to focus on managing his personal fortune. He said at the time it was getting increasingly difficult to manage other people’s money. Just this May, he gave a presentation entitled “The Endgame” at the annual Sohn Investment Conference in New York City, where he warned investors of the need to sell their equity investments and remain in cash and gold. Why suggest such an extreme move? “TINA,” he explained to the audience, reference to a well-known acronym on Wall Street that stands for “There Is No Alternative.”
TINA is used to describe investor behaviour or, specifically, the mass migration of investment capital into the stock market due to the long-term persistence of low interest rates. In other words, because investors cannot generate a sufficient return from low-yielding bonds, they turn to stocks as their only alternative.
Druckenmiller argues the U.S. Federal Reserve has artificially suppressed interest rates and refers to the current situation as the most excessive and drawn out monetary easing policy in the history of the United States. In his opinion, the Federal Reserve funds rate should be closer to 3% rather than the current 0.5%. Today’s rate reflects what has been the longest deviation from historical norms, and as a result, today’s market consumption and demand has been pulled forward by a generation.
Smoothing growth over a cycle “should not be confused with consistently attempting to borrow from the future,” Druckenmiller states. “The Fed has no end game. The Fed’s objective seems to be getting by another six months without a 20% decline in the S&P (stock market) and avoiding a recession over the near term. In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid.”
Corporations have followed a similar path, he argues. Corporate debt-to-cash flow is the highest it’s been since the end of World War II. Low interest rates have encouraged corporations to take on more debt despite the fact their cash flows can’t support such debt loads. Even worse, he argues, debt loads aren’t being taken on for the right reasons. In previous decades debt was used to finance machinery, R&D and labour. Today it’s used for financial engineering purposes, such as stock buybacks, special dividends and support for mergers and acquisitions. Druckenmiller estimates that the ratio of financial engineering to productive spending is three to one. Put another way, excessive debt is propping up stocks and not being re-invested into the economy as it historically has been.
Then there’s China, which Druckenmiller cites as a major issue for asset prices. China spent heavily on infrastructure before the 2008 financial crisis. However, to maintain high GDP figures and create the impression of economic strength post-crisis, China spent more than $4 trillion on a stimulus program. This led to excess infrastructure, empty buildings and what’s shaping up to be a decade-long slowdown in growth. Pre-2008 it took $1.50 of spending to create $1 of GDP in China. It now requires $7. So like the United States, China has borrowed from its future.
Three years ago Druckenmiller was negative about U.S. and Chinese actions, yet he still felt asset prices could be driven higher. That’s not the case today. He figures stimulus measures have run their course and the bull market has finally exhausted itself. As a result, the market could decline a whopping 60% from current levels.
As Druckenmiller says, “we have borrowed more from the future than any time in history, and markets value the future. While policymakers have no end game, markets do.”
Grantham’s Game Plan
There are great investors, and then there are great investors with brilliant minds. Jeremy Grantham falls into the latter category. Born in Hertfordshire, England, and raised by Quaker grandparents, Grantham is co-founder of investment firm GMO (Grantham, May, Van Otterloo), which he helped establish shortly after earning his MBA at Harvard University. GMO manages over $120 billion in capital and is recognized as one of the premier investment management firms in the world. Significantly, Grantham has predicted every single market bubble since 1977 and is widely regarded as one of the world’s most intelligent forecasters because of his ability to predict major events and long-term trends.
He’s not just focused on financial markets, however. It was after family trips to the Amazon and Borneo during the mid-1990s that Grantham began to think more about the interconnection between the environment, financial markets and civilization. He has since poured the majority of his wealth into his Grantham Foundation, which is dedicated to protecting the environment.
The $600-million foundation actively contributes to a group of organizations that includes Sierra Club, Nature Conservancy, Environmental Defense Fund, World Wild Life Fund and Greenpeace. It also funds the Grantham Research Institute on Climate Change and the Environment, which is based out of the London School of Economics, and it supports Imperial College London’s Grantham Institute for Climate Change. It’s important to note that the foundation is also an active investor in companies focused on climate-friendly technologies. No wonder the New York Times, in a 2011 article, dubbed Grantham “the world’s most powerful environmentalist.”
Grantham is concerned about the future. He calculates that the stock market will climb roughly 10% followed by a decline over the long term of about 60%, with the market peaking shortly after the U.S. presidential election and before the end of 2017. When the fall begins, Grantham says pension plans will suffer. It will become virtually impossible for pension plans to meet long-term annual returns of at least 5%. Those that can achieve a 3% annualized long-term return should consider themselves fortunate, he argues. Yet a majority of pension plans in North America require a 6% to 7% return to stay in surplus, and this doesn’t even account for the constraints that will come with an aging demographic.
Grantham believes it’s likely the majority of pension plans will run a long-term deficit, and this will have major policy implications for government. It won’t always be easy to get a clear picture. More pension funds are allocating to private equity and infrastructure, which as subjectively valued investments make it harder to know whether projected returns are overinflated and that the fund is truly performing as claimed. Increasingly, government and relevant public agencies will have to assure the accurate forecasting and reporting of returns as market conditions deteriorate.
The first major correction, however, will likely happen in a housing market fuelled by low interest rates. According to Grantham, the housing market is close to two standard deviations above its historical norm, making the bubble signal clear. Property prices have appreciated far too rapidly over the past two years, and a rapid short-term move on top of an aggressive longer-term move is a strong indication that an asset-class crash is impending. Once housing crashes, the financial markets will follow.
Grantham also has strong views on the oil market, which isn’t surprising for a devoted environmentalist who participated in Keystone pipeline protests and has called for the death of the “tar sands.” He believes the price of oil will climb back to $65 (U.S.) a barrel in the short term and to $100 within the next five years. The world’s “easy oil” has been depleted, Grantham argues, and current high inventory levels will be used up sooner than the market expects—assuming reasonable global GDP growth.
On top of that, he believes Saudi Arabia craves stability and will reduce its production. This will drive prices higher and refuel its government coffers. As a result, the oil industry will return to healthier price levels and oil stocks will do relatively well (albeit with small profit margins even at high prices). For this reason, Grantham’s firm has aggressively purchased and hopes to profit from oil futures contracts.
But keep in mind, that’s his near-term investment strategy. Grantham also believes that within the next five to 10 years there will be “dramatic technological improvements in non-oil based transportation” that will send the oil industry into a sharp—and permanent—decline. This is precisely why his Grantham Foundation has aggressively invested in alternative transportation technologies, such as the lithium-ion battery systems expected to drive mass-market adoption of electric vehicles. Grantham is also bullish on two particular asset classes—farmland and forestry—based on the simple argument that “they don’t make any more of it” and we need land to grow food.
On all of this, climate change weighs heavily on Grantham’s mind. He cites the impacts of the recent El Niño, and describes 2015 as a “monster.” It was by far the warmest year in recent millennia, with 10 of 12 months setting all-time record highs. And 2016 looks to be heading in the same direction, with January, February and March breaking records. “Temperatures are not just increasing, but accelerating…time is truly running out,” says Grantham.
“Sadly, it has become obvious that the recent talk in Paris of limiting warming to 1.5 degrees C is toast, as it were,” Grantham wrote in his quarterly market outlook in May. “If you line up the previous El Niño outlier of 1998 with this March 2016 El Niño (as we might do in lining up bull market highs) it gives an idea of when 2 degrees Celsius might first be broached in a future El Niño effect: just 17 years!” He also warned of an increase in record-breaking, intense rainfall, such as the Houston downpour in April that dropped four months worth of rain in less than 24 hours. That kind of rain accumulation, he wrote, is “unprecedented without a major hurricane.”
Grantham is clearly worried about climate change, and his investment strategy reflects this. As a professional investor he is positioning his clients to profit from what climate change – and our collective response to it—will do to farmland, forestry, infrastructure and oil assets, and to government budgets and bond prices. Yet as an environmentalist, philanthropist and alternative energy investor, he is trying to halt the accelerating affects of climate change and make people understand the connectedness between climate and financial markets.
“Let me just make the point here that those who still think climate problems are off topic and not a major economic and financial issue are dead wrong,” he concludes in his quarterly outlook. “Dealing with the increasing damage from climate extremes and, just as important, the growing economic potential in activities to overcome it will increasingly dominate entrepreneurial efforts in future decades. As investors we should try to be prepared for this.”
The Shilling Shakeout
It’s been said that if economists were doctors they would be up to their necks in malpractice suits. It’s hard to disagree with this sentiment. It is very difficult to find economists who can make gutsy, high-conviction predictions and consistently be correct. Perhaps this explains why the faces of bank economists keep getting younger and younger. If the banks can’t get it right, at least they can save some money on seniority.
Yet there is one economist who has made big and bold predictions for the past five decades with exacting precision, and in doing so, he has shown it’s possible to be a 79-year-old economist and still be in the game. Gary Shilling has been at it for a while. At 29 he became head of the economics department at Merrill Lynch. He ran it for years before launching his own eponymous firm in 1978. Since then, he has won numerous high-profile accolades as the best economic and stock market forecaster in the United States. And to add more buzz to his career, he’s been a beekeeper since the 1990s.
Shilling was the only individual to publicly predict the 1973 to 1975 bear market, which was the first since the 1930 depression. In the late 1970s he was the first to predict a massive wave of inflationary pressures that would lead to record-high interest rates between 1980 and 1982. He predicted the Japanese bubble of the 1980s, the 2000 tech bubble, and the housing market crash of 2006 to 2008. Most recently, while oil was trading at $70 a barrel, he predicted prices would fall below $20. His call looked quite remarkable when oil fell to $26 this past year. Unlike Grantham, Shilling believes that low global growth will continue to keep pressure on the price of oil, especially when Saudi Arabia, the world’s most influential producer, can continue to pump up oil for less than $10 a barrel.
In 2010, Shilling penned The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation, in which he predicted savings levels would increase and debt levels would fall in the lead-up to 2020. This would be the response to a large amount of bad corporate and consumer debt that had accumulated during the financial crisis. The result would mean significantly less spending and borrowing and this, in turn, would lead to lower GDP growth, corporate profit margins and employee wages.
Six years since the book’s publication, Shilling’s prediction has largely proven correct, with two exceptions: corporate profits have risen during this time because of an intense focus on cost cutting; and corporate earnings per share (EPS) have risen due to financial engineering. It echoes Druckenmiller’s argument that cash is not being re-invested into machinery, labour and R&D but is instead being used to buy back company stock and artificially boost share prices.
Also, while consumer debt is falling and corporate debt is not yet at crisis levels, keep in mind that government debt has skyrocketed—ironically, as a response to slow growth in the global economic system.
As for the stock market, Shilling believes company shares are largely overvalued given the current environment of low growth and low inflation. Here, his position is similar to that of Grantham’s. He expects the long-term stock market return to be 3%—not the historical norm of 7% that pension plans continue to lean on.
Shilling does not say when the stock market will crash, or how big such a crash will be, but he does emphasize the importance of shifting wealth into cash at such times—a point he’s been making for much of his career. “It’s profitable to be in stocks during bull markets, but it’s even more profitable to be short stocks, or at least out of the market, during bear markets—even if many of the major bull market months are missed completely,” Shilling has advised since at least 1992.
This is an extremely important point, and contrasts with the position of media pundits and investment advisors who consistently cite other data as a rationale for being in the market at all times. Shilling, a foremost expert in empirical research, and whose 50-year record of success offers credibility, counters this notion. He insists that when the market is clearly in the latter stages of a bull market it better to reduce a position materially and preserve capital. There is no better example of this than the Japanese stock market.
The Japanese stock market (Nikkei Index) peaked in 1989. Since that time it has been on a structural downward trend. Shilling’s point is clear—do not let the post-2008 rebound in the stock market lull you into thinking the market will also rebound quickly after the next crisis occurs. Interest rates are about as low as they can possibly go. Policy options are extremely limited. Economic growth is low. The next crash in North America and what follows decades later could very well look like the previous 30 years on the Japanese Nikkei.
The Overarching Message
So there you have it: three of the world’s greatest investment professionals believe bad days lie ahead. They have decades of experience making money in up and down markets and across all asset classes. They exhibit high levels of intellectual flexibility drawn largely from empirical research and past experience. They also own their firms and this provides the added benefit of not being held to a corporate line. Clearly, based on the views of these three men, there is something very negative approaching the financial markets. Not only that, it’s an event with potential for lasting impact, and policymakers have little – if anything – left in their toolkit to combat it.
Druckenmiller advises that wealth be moved into cash and gold.
Grantham recommends investment in farmland and forestry assets.
Shilling believes capital should flow into U.S. treasury bills and the U.S. dollar, as well as food, other consumer staples, and factory-built housing and rental apartments.
During these times, another quote from golfer Lee Trevino seems fitting: “Pressure is playing $5 a hole with only $2 in your pocket.”
This isn’t a game of golf, mind you, but if we’re to believe Druckenmiller, Grantham and Shilling, the time has come for investors to limit their leverage and lose only what they can afford to lose.
All with an eye to keeping the pressure off.
Jarrett Hasson is a portfolio manager who has worked in the Canadian investment industry for the past 15 years. In 2013, he was part of a two-person team that won the Lipper Award for top alternative fund in Canada for three-year performance.
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