Churchouse Letter
November 2015         by Peter Churchouse

A “Profitable” Force of Habit

Some Simple Ideas on De-Risking Your Portfolio & Expanding our Defensive Allocation

History point me to a simple conclusion: we are likely much, much closer to the next recession than we are to the previous one.
There's no need for panic, but there are simple ways we can keep building up our portfolio defenses whilst giving us participation in the upside.

Botswana is not a country that makes a lot of news. It is generally a quiet and peaceful place, devoid of the horror stories that routinely crop up in many other parts of Africa.

It is home to the Herero tribe, some great diamond mines, and the vast Okavango Delta. The Herero people are some of the most colourful in southern Africa – the women wear the kind of voluminous dresses that are normally associated with Queen Victoria’s Britain, not a landlocked desert nation in Africa.

The Okavango Delta is one of nature’s most interesting formations. It is created by the Okavango River, which flows south from Angola. The river drains not into the ocean, but thanks to a tectonic trough into this massive delta in the northern reaches of the Kalahari desert. At the height of the floods, it approaches 6,000 square miles. As you might imagine, it is a Mecca for African wildlife.

Back in 1974 I drove across the Kalahari desert, from Francistown in eastern Botswana all the way to Maun, a small village on the southern edge of the delta. It was a drive of about 320 miles on dirt tracks. My wife and I and a friend spent a week traveling in the delta, paddling by dugout canoe through its channels and waterways. Our guide carried a loaded World War II rifle – luckily not needed. But we did have a pride of lions roam through our campsite on the edge of the delta one evening. We were safely locked inside our Kombi camper van on that occasion. The guide finally assured us it was all clear – from on top of the van!

The drive back from Maun to Francistown turned into an adventure we had not bargained for.

The road across the desert was a fairly primitive affair. Dusty, and dry, but deeply rutted. The corrugations demanded a choice of driving styles. You could choose to idle along at 10 miles per hour, slow enough to dip in and out of each of the ruts running across the road. Or you could accelerate up to 50 miles per hour, when the van would scoot across the tops of the ruts quite smoothly. Any speed in between, and it felt like the van would shudder apart.

Map of Botswana in Africa

No prizes for guessing which driving mode we preferred. The 320 miles would be painfully long at 10 miles per hour.

But disaster struck.

As we soared over the brow of a small rise at 50 miles per hour, the left-hand front wheel piled into a drift of sand that had blown onto the road. The Kombi slewed to one side, and ended up off the road on its roof, with the three of us trapped inside. The engine was still running, upside down, and we could hear the jerry cans of spare petrol on the roof rack dripping onto a metal surface.

A mad scramble ensued. We switched the engine off, and secured the leaking jerry cans. The three of us were able to roll the vehicle off its roof and on to its side – but that was it.

Peter Churchouse jumps from his rolled VW Kombi in Botswana in 1974

What next?

Well, being partly of British stock, the first reaction was to make a pot of tea. We dragged the cooker out of the Kombi and soon each had a hearty cup of brew.

As we sat quietly on the sand sipping our tea, still very shaken, I saw Dave, our traveling companion, pull out a pack of cigarettes and light up. “Dave, do you mind if I have one of those?” I asked.

And I’ll explain what that led to a little later in this letter… and why it’s an important investment lesson.

Testing Times

In this edition of The Churchouse Letter, I want to share my thoughts on the global economy – and what we need to do about it.

Everywhere I look, I see increasing signs of slowdowns, downturns, deflation, market risk, and financial risk.

We need to think about how we react to these trends to both protect ourselves – and even profit from them.

Just take the International Monetary Fund for starters. Whatever you may think of this organisation, it does have a pretty good handle on the global Big Picture. Last month it produced yet another review of global growth expectations – in which it cut its 2015 forecast once again.

This is the fourth reduction in growth forecasts by the IMF in 12 months. It now expects global growth to come in at 3.1% for 2015.

It also cut its forecast for 2016, to 3.6%. I would be very surprised if this isn’t cut again when the IMF performs its next review.

This is also the fifth straight year in which growth in the emerging world is expected to slow from the previous year.

The IMF's forecasts made three years ago for growth up to 2020 have been cut dramatically – by 6 percentage points for the United States, by 14 percentage points for China, by 10 points for emerging markets and 3 points for Europe.

The IMF also states that global risks to financial stability remain “heightened.”

It identifies market and liquidity risks as increasing, with declining risk appetite in financial markets.

There’s also been much written about the risk in market structures. [If you haven’t read Michael Lewis’ book Flash Boys I highly recommend it for an entertaining read.]

As an example of this structural fragility, just take a look at the behaviour of this ETF in mid-August during the violent pull-back in U.S. equity markets.

Figure 3 shows the intraday ticker for the Vanguard Dividend Appreciation ETF. You can see, early on the 24th of August, the ETF gapped down nearly 40% in a matter of minutes before sanity was restored.

Vanguard Dividend Appreciation ETF gaps down 40% in minutes between 21-22 August 2015

Let’s be clear though, this is not some little illiquid ETF we’re talking about. This is a US$20 billion assets under management (AUM) fund which holds some of the most liquid blue chip stocks money can buy (the largest 3 holdings are Microsoft, Coca-Cola and Johnson & Johnson).

Both growth risk and financial risk are focused on developments in certain emerging markets, particularly oil and commodity producers. (As I said last week, I believe we are approaching some value in emerging markets, and I put a particular lower-risk EM trade onto our radar.)

But, if things turn really nasty in a couple of emerging markets, experience teaches us to expect wide-reaching contagion. No one will be immune. In Asia, we are particularly sensitive to these effects thanks to the 1997 Asian financial crisis.

The fear of such contagion effects is certainly one of the factors keeping the U.S. Federal Reserve on hold in the interest-rate stakes.

The Fed won’t say it outright – but there is mounting concern that a U.S. rate increase could be disastrous for vulnerable economies around the world, particularly certain emerging markets. Just look at how U.S. markets reacted to China’s correction in mid-August!

But the problems aren’t restricted to the parts of the emerging world. Despite years of quantitative easing, low interest rates, and massive money printing, developed economies have still not reached cruising altitude.

The theory was that all this easy money would feed back into the economy, boost growth, elevate consumer demand, and defeat deflation.

Well, it has not panned out that way.

Yes, the emergency surgery did save the world from financial disaster back in 2008 and 2009, but it has not got the patient back to robust good health.

In fact, over the past few months we’ve started to hear the ‘R-word’ cropping up again… recession.

Another Recession on its Way

It was George Bernard Shaw who said “If all the economists were laid end to end, they’d never reach a conclusion.”

And it’s true – economists rarely agree on anything. There are dozens of schools of economic thought, all with wildly different theories about how markets and countries should behave.

But there’s one thing that all these different factions have in common – they all agree that economies move in cycles, even if they argue about why or how.

There are periods of growth, and bouts of recession. How governments and institutions run their institutions and their policies may affect the frequency and magnitude of these cycles, but these cycles will always be with us nonetheless.

There’s another pithy quote worth remembering: History doesn’t necessarily repeat itself, but it rhymes. We hear this one time and again.

But I can categorically state the following with certainty: the U.S. will once again fall into recession.

Now, what I can’t tell you is precisely when.

However, the history of U.S. recessions tells us that they occur more frequently than you might think.

There have been 14 recessions since the great 1929 crisis.

The average time gap between recessions has been just under 5 years.

The average gap between the previous three re-cessions was a little longer, at 7.9 years.

And where are we now? We’ll, we’re just under 6.5 years since coming out of the previous recession.

That is greater than the long-term average and closing in on recent averages.

Notice here I’m not making a “call” for imminent recession in the U.S. – not at all.

Rather I am purely looking at the previous 85 years of economic cycles and stating what I think is an obvious conclusion which is this:

We are closer to the next substantial economic and market correction than the previous one, and history suggests it is closer than I think market participants are factoring in.

Yes, it may be different this time. But the signs are not particularly encouraging.

First of all, readers already know my thoughts on the U.S. equity market. We wrote about it at length in our June edition of The Churchouse LetterInclement Weather Inbound”.

We covered a handful of valuation metrics for the market as a whole and noted that all of them were at or near historical highs, including:

  • The CAPE or Shiller price/earnings ratio
  • Equity market to GDP ratio (Warren Buffett’s favourite)
  • Tobin’s Q (the market value of a stock market divided by the replacement value of its assets)

Three months later, the S&P 500 fell by over 10% in a matter of days.

It has since rebounded, but that provides scant comfort as far as I’m concerned. Global equity markets simply feel fragile to me.

And regarding the broader economic picture in the U.S., I’m not going to bombard you with reams of economic data that support this idea.

Again, I am not telling you recession is imminent but here’s an interesting little chart from our friends at GaveKal.

They have kindly given us permission to share this with our readers.

GaveKal is an independent research outfit who in my humble opinion consistently produce some of the best thinking on markets and economics available anywhere.

Charles Gave, one of the founders recently shared his “recession indicator” with readers.

This index has some 16 different components ranging from high yield bond spreads to lumber prices. As Charles points out, each time his indicator has gone negative and remained there for several months, recession has followed. You can see this in Figure 4.

GaveKal Recession Indicator

In a recent update on his indicator, Charles said the following:

“When the reading is negative a US recession is a possibility. Should the reading fall below minus 5 then it is time to get worried — on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long-dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads minus 5 which points to a contraction in the US, and more generally the OECD.”

Going back to our recession cycles, it’s worth pointing out that the average correction in the Dow Jones Industrial Average 3 months before recession to 3 months prior to the end of the recession is nearly minus 20%.

But bear in mind that the peak-to-trough in the periods around a recession can be much higher… averaging more than minus 50% in the previous 2 corrections for example.

Running Low on Ammo

In a recent piece (“The global economy is in serious danger”, October 7, 2015) Larry Summers, former U.S. treasury secretary, suggested:

“Policymakers badly underestimate the risks of both a return to recession in the West and of a period where global growth is unacceptably slow, a global growth recession.”

I think he’s right.

He goes on to note that “monetary policymakers would lack the tools to respond. There is essentially no room left for easing in the industrial world.”

In 2015, nearly 50 central banks have either cut rates or devalued their currencies, according to centralbanknews.info. Since 2008 there have been over 600 rate cuts worldwide.

The key difference today is that the Fed is out of ammunition. I think it even risks losing credibility.

They have absolutely nowhere to go on the interest-rate front unless they take the very odd step of pushing them into negative territory. And with US$4.5 trillion of assets on their balance sheet, that represents some 25% of total GDP. So you’ve got to think the scope for yet even more quantitative easing must be limited.

Then let’s look at Europe, where in some countries you have to pay the government to accept your money. I cannot recall a consistent period of negative interest rates in my lifetime … but when you look at where the market expects inflation to head, it’s a possibility.

Figure 5 shows the rate of inflation expected for a five-year period, starting five years from now. This is also known as the 5y5y inflation rate and is derived from the inflation swaps market.

As you can see, in both the United States and Europe, inflation expectations remain extraordinarily low despite all the monetary stimulus thrown at them.

5y5y Implied Inflation - U.S. & Europe falling in 2015

The Astute Investment Play

So where does all this leave us as investors?

How do we protect our capital and assets? And how do we make a buck in a risky and challenging environment?

Defensiveness is my first priority. We need to be increasing the portion of our portfolio allocated to defensive investments, either in equities, bonds or other assets. And we need to be holding more cash.

Regular readers will know of my predilection for owning well-located, simple, rent-producing real estate.

The world is going to continue having low interest rates for a while, for sure. Low real interest rates tend to prove positive for real-estate prices in most places. Don't head for the exits with your real-estate assets in the face of slowing growth.

In fact, such an environment often provides opportunities to pick up bargains from distressed sellers.

Our bets on U.K., New Zealand and U.S. real estate have done well as asset prices recovered after the GFC, driven of course by low interest rates.

I won't dwell on that subject. I want to investigate other suitable investment plays.

We are looking for goods and services that are largely immune to slower growth, or even recession.

These are things that people will need to consume or want to consume, pretty much regardless of the state of the economy. Industries, sectors, companies where revenues are still highly likely to be stable or even to rise during a slowdown.

The market may have rebounded quickly from its last correction, but I think this presents an excellent opportunity for those who haven’t already done so to start making the necessary changes to their portfolios.


So how can you prepare your portfolio?

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