Stay informed about the news at BFI and in a world of rapid change

BFI Infinity
April 4, 2016

Outlook: More Headwinds and Volatility Ahead

The outlook for 2016 can be summed up in one word: volatility. In looking at equity markets, there was the deep correction of the first half of Q1. Since then, the markets have rebounded substantially (Figure 1). The recent rebound in equities markets has yet to reach Q4, 2015 levels, indicating further struggles, with market analysts shrugging off market volatility. Oil, along with other raw materials, is in decline. Despite the recent rally, which witnessed prices reaching $40 per barrel and the first additional rig added in the US, we do not expect oil prices to rebound substantially from current levels. China’s demand remains low. Despite China’s dubious official growth forecasts, oil prices will likely remain low for quite some time, even with OPEC intervention.

Equities out of control

The equity markets are so overwrought with volatility that following the market is a sobering experience.The S&P 500 closed for the month of March at 2059.74, slightly above were it stood at end of last year (2043.94). Europe has recovered somewhat since the lows in February, but index levels are still substantially lower than they were at the beginning of the year. Hardest hit are the Asian markets, which are reeling from the decreased demand for export goods and its impact then on growth.

The American high-yield situation is one we are following closely. In looking at the high-yield bond market, less than one-in-ten high-yield bond funds delivered positive returns in 2015, mainly due to sharp declines in oil prices and the outlook for higher US interest rates. This is especially important because the high-yield market is potentially dangerous due to the amount of money poured into it; it has more than $1.8 trillion in outstanding debt. The high level of debt is, of course, a direct result of cheap money.

Central Banks Losing Control

This brings us to central bank omnipotence, which is now being questioned to the point where market analysts are beginning to publicly voice concerns that the loose monetary policies are setting the stage for the next global crisis.

It seems as though we may be close to a tipping point: if the belief in central banks’ ability to manage the economy fades, then we might be on the brink of another global implosion. It is already becoming increasingly clear that the global central banking system is facing a number of stress factors.

The G20 Summit in Shanghai highlighted the lack of control that central bankers actually have on the economy. The great amount of disagreement regarding monetary policy is simply converting in to market volatility. Even within individual central banks, double-talk abounds as central bankers scramble to manage the economy. After raising rates in December, the Fed’s Janet Yellen testified before Congress that negative interest rates were an option that is still on the table despite the expectation that rates will increase in 2016. The new Minneapolis Fed President, Neel Kashkari, has come out and said that the monetary policy adopted so far has been ineffective in reducing “too big to fail” banks.

In Europe, Draghi’s announcement of further reducing rates and expanding quantitative easing was initially met by a market sell-off. It wasn’t until follow-up statements were issued by the ECB that market nerves were calmed, claiming that the market sell-off had more to do with “miscommunication” on Draghi’s part. At the moment, the Eurozone is threatened by deflation, with very low inflation figures, and the most recent expansion of ECB monetary policy is focused on controlling these short-term pressures without considering what will happen when the policy ends. These trends are troubling as they highlight the lack of control thatcentral banks have over the economy, a realization that is unsettling investors.

As you are reading this, outstanding government bonds with negative yields have reached over $6.6 trillion, nominally, and continue to grow. This trend is deeply unnerving, as government debt, which continues to pile up globally, will hold a total repayment amount below what was offered. Essentially, governments are making money off of their debt as long as rates continue to reside in negative territory. So far, this has encouraged and fueled government spending and will continue to do so as capital will keep being misallocated due to monetary policies distorting the cost of debt (see Figure 2, above).

GDP Growth Slowing

GDP growth is the key issue facing the global economy. Although the US revised its Q4 GDP growth upward to 1.0% (versus the estimated 0.4%), the rest of the global economy is not as lucky. G20 GDP growth for Q4,2015 was revised downward to 0.7% from 0.8%. In taking a closer look at the composite of the G20, the signs of recovery are limited, at best. The Japanese economy contracted in Q4 by 0.3%, while China and India were both revised downward. Looking to 2016, OPEC revised its estimates for global GDP growth downwards as well, while maintaining expected demand for oil even though such an action threatens its member states’ projected profitability.

Global GDP growth remains trapped in a downward trend from 2010 levels. Beyond that, all forecasts that have been made to date in regards to global GDP growth have been extremely off-target. Each time new forecasts are made, they are consistently revised to the downside as Figure 3 shows.

China presents a key challenge, since official estimates can hardly be trusted. Chinese officials revised GDP growth down to 6.5% from 7%. Beyond that, most emerging markets are being pummeled in the current economic environment. This is troubling at best and out of touch with the reality on the ground. In looking at the losses hitting raw materials and many commodities, it is clear that the Chinese and commodity-related emerging market economies are slowing down at a much higher rate than officials would have us believe. The recent recovery in commodity prices was a technical reaction to markets that will once again face a renewed downside pressure over the coming months as weak demand reins speculators back in to reality.

Despite being continuously talked down by central bankers, traditional private bankers (including Goldman Sachs) and equity traders, gold has made gains in the first quarter overall riding on the back of market volatility and loose monetary policies. In looking at the improved circumstances for gold, we maintain a “wait and see” approach in order to assess whether or not this is only a short temporary rebound from a large sell-off.

The Road Ahead

Given the double-talk by central banks, the continuing downward revisions of global GDP growth, in combination with a decline in US corporate profits since late 2014 and an increased political uncertainty (Brexit, US election, Russia/Turkey conflicts, European refugee crisis, etc.), we expect to see increased volatility on a global scale in 2016.

So what should sound investors do?

In the past few months, we have allocated a larger portion of our portfolios under management into actively managed hedge funds that have a long, proven track record of success and that follow investment strategies with a low-correlation to the markets. In this high-risk, low-reward investment climate for equities and bonds, we effectively reduce risk and seek positive performance by integrating these actively managed hedge funds in our investment approach.

Stress Test Underway for Brussels

When the EU was founded 22 years ago, cooperation on economic, social issues, and on forming joint migration and asylum policies were the grounds on which it was based. But the present reality of the EU, with crisis after crisis unfolding, shows that the EU’s ambition for high-level integration is far from reality. The dream of a “United States of Europe” seems to be slowly fading. Faced with many pressures, EU countries are now discussing different approaches and strategies to solving persistent problems. Until recently, the solution to all challenges in the EU was increased centralization. However, we are witnessing the rise of fragmenting forces across Europe due to an increased divergence in the interests of the different member states.

The Fragmentation of the EU

The main challenge the EU currently faces has to be the ongoing refugee crisis. With thousands of refugees stranded on the Greek-Macedonian border, the pressures are mounting, literally, at Europe’s borders. Despite strict border control measuresemployed by the Balkan countries, refugees still flood in, seeking a better life away from their war-torn countries. The refugee crisis has become the most pressing issue lately after reaching a tipping point, with over one million crossing the borders into Europe in 2015.

But the EU’s response has been frail and disjointed to say the least, with Germany and Sweden taking in the largest number of refugees among all EU nations, while the numbers received by other countries have been miniscule in comparison. Germany has therefore pushed for a policy that promotes burdensharing with other European nations and for quotas on the distribution of refugees as a part of a permanent and binding scheme, with the power of the EU commission behind it. But 15 out of 28 EU members oppose the plan for a variety of reasons.

The refugee crisis is a multi-faceted issue with far reaching foreign and domestic implications. An open-door policy usually clashes with public opinion in addition to many security concerns. The attacksin the heart of Paris and Brussels only highlighted those concerns. Furthermore, this modern refugee crisis has led to increased ‘Islamophobia’ in Europe. Besides security concerns, there are the financial burdens of receiving and accommodating the unprecedented numbers of refugees.

And last but not least, the suggestion that a European authority, namely Frontex, should monitor the refugees’ influx and admission into Europe through its external borders threatens the sovereignty of many nations. Imagine Canada deciding to protectthe US border to Mexico due to a (theoretical) massive influx of Mexican immigrants into Canada! The countries refusing to accommodate large numbers of refugees justify it with their lack of capacity. However, for most member states, it is not the lack of capacity but rather a lack of willingness to take on refugees due to security concerns as well as concerns regarding the compatibility between the European culture and the cultural background of the refugees.

The other older and more permanent challenge is found in fiscal, monetary and political imbalances across Europe. While the Greek crisis is currently no longer in the headlines, it is likely to resume again soon and the topic of a fiscal union will once againbe on the table. On many occasions, Germany has acted as the glue holding the EU together. As an economic powerhouse, they have been able to play a key role in resolving some of the region’s key issues. However, Germany definitely often over-reacheswhen it comes to suggestions in its attempt to keep Europetogether.Forexample,in2012,itsuggested the appointment of an EU commissioner to oversee Greek government spending. This is a step that would undermine Greece’s sovereignty. However, the logic behind the idea was to control government spending and tax collection in a country where tax evasion is rampant.

Germany has also been the largest contributor to the Greek bailout package, with $56 billion in contributions, to enable the country to mend, or rather to delay, its day of fiscal reckoning. This is a key point of contention within the Union: each of the memberstatesoftheEUhavedifferentGDPoutputs and provide their citizens with entitlement programs that are incompatible with the Eurozone scale but are nonetheless more democratic than any decision made in Brussels. And that is the root of the problem: democratically agreed upon systems are coming into conflict with detached, undemocratic EU policies and debt negotiations. Binding these different fiscal policies under an umbrella currency truly cripples the democratic decisions made within the EU system.

Last but not least, a third force causing the seams of the Union to fetter is the recent prospect of a Brexit. Britons are to vote in a referendum on June 23rd on whether Britain should leave from or stay in the EU. The UK is the second largest economy of the EU and a potential exit would therefore definitely have far reaching implications on the future structure of the EU, in addition to economic consequences. So how are the British likely to vote? Currently, polls indicate that the British are leaning towards staying in the EU, but that could change in the months to come. A disincentive for this decision is that a large share of Britain’s exports flow into the EU, and, in general, there are strong relations to the EU. On the other hand, Britain will likely gain sovereignty outside of the EU and will be able to take their own fate into their own hands. Listening to the arguments ofthoseinfavorofaBrexitmakesonethingclear:they are not, per se, in favor of the exit itself, but they are rather against the EU’s current dysfunctional form.

In essence, the key issue behind all of these “forces” (not to mention the ones we left out) is the issue of sovereignty. The EU, in its current form, aims to govern all aspects of European life centrally from Brussels and practically trespasses on the sovereignty of the individual member states. The member states are increasingly getting weary of this notion and want to take matters into their own hands by reducing the power that Brussels has over them.

The failed framework

In a region which contains many different speeds of economic growth, different tax systems, different indebtedness levels, as well as different languages, identities, cultures and so forth, this quasi-centralization seems to be doing more harm than good. So far, the “solutions” to problems faced by the EU have been intermittent and reactionary, at best. German efforts to keep the EU together, driven by its historic guilt are both costly for Germany and do not address the root cause of the problems facing the EU. The EU is currently up against a real test for its ability to withstand the current geopolitical and economic winds. Without a strategy to adapt and reach better forms of cooperation on key issues, it is vulnerable and will eventually - if not fully, at least partially - fail.

At this stage, a reexamination of the theoretical framework that the EU operates under, and how it holds up in the face of such challenges, is necessary. The centralist approach to EU governance is not efficient and, under these pressures, is showing systemic weaknesses. A one-size-fits-all approach simply cannot work.

The EU is a blend of many countries with different backgrounds and historical contexts, and not all favor a bureaucratic EU that overrides their national interests. And, as the countries within the EU are both ‘western’ and ‘eastern’, they also show different preferences for free market economics and heavy regulation. Furthermore, there are the different tendencies for being overly politically correct (Germany, for example) as opposed to being openly xenophobic (Eastern Europe). All of these forces combined are causing a schism in the body of the EU, exposing its structure to not being as coherent as was thought.

The speed of the expansion of the EU and the Eurozone was also too fast. Only the economic strength of Germany could temporarily manage the effects of the troubled members. But this strength cannot go on forever and German taxpayers will not agree to continue to pay for other countries’ sluggishness. The current state of affairs is not helping Germany, nor is it helping Europe.

There is an urgent need for a redistribution of burdens and responsibilities. The best strategy would be a shift toward a system where responsibilities are decentralized rather than centralized. This way, any member country can carry the responsibility according to its own capacity, without over-stretching countries like Germany or under-stretching countries like Greece. Only a balanced form of distributing responsibilities could lead to the healthy integration that EU members want and need. Single-member countries, as past events show, cannot be expected to carry the whole burden or weight of the EU. The nationalist identity will always prevail over the European identity. An Italian will always be an Italian, not a “European”.

What the EU can learn from Switzerland

We are confident that the only way for the EU to survive in the long-term would be to review their current organizational structure. At the EU level, they need to ensure that people and national governments are involved and have a voice in key decisions, which they hold stakes in. A good example of this would be Switzerland, which has a longstanding history of a confederate democracy. In Switzerland, individual rights are balanced against community and national interests, and people are involved in decisions at national and sub-national levels.

Switzerland consists of over 3000 municipalities, situated in 26 cantons, working in harmony for centuries. The lessons that the EU can learn from Switzerland are plenty, such as the application of true, direct democracy.

The process of decision-making in the EU needs to be based on open communication and ongoing hard discussions due to regular votes on crucial decisions, as is the case in Switzerland. One of the most important aspects of Switzerland is its decentralized government; similarly, the EU needs to rethink its own structure. For a peaceful and prosperous Europe, it is unnecessary that the whole of Europe is uniform. Like Switzerland with its cultural differences, the EU needs to understand that the only unity that is sustainable is one that allows for diversity and is not based on uniformity.

In looking at Switzerland, the tax benefits are well known but exist due to competition within. Furthermore, the decentralized political and financial authority has led to increased accountability within the Swiss system. The direct democracy approach has bolstered the Swiss and prevented the level of estrangement and detachment from the political elite that other democratic systems suffer from. Beyond that, the emphasis on the constitution – similar to the US – sets the framework for individual liberty and respect for property that serves as a beacon of protection in a sea of European socialism mired in debt. The best bet for the EU would be to model itself after Swiss federalism. Oskar Freysinger, a Swiss MP, has similar thoughts. He points out that the EU has deviated from the cradle of constitutional democracy we knew in the past. He advises against following dogmas, which do not allow opposing opinions to rise and to be heard within the society.

The challenges facing Europe are not trivial; the solution for the systemic problems it is facing should be nothing short of a complete reboot of the entire system. Perhaps, after all, a crisis is what Europe needs to do just that!

In  the Limelight: The Calm Before the Storm

We still have vivid memories of the last financial crisis, but just because we recently had one, doesn’t necessarily mean that we are safe from having another. There are a number of hot spots that could flare up and ignite another potential crisis, and here we want to take a closer look at some of them.

Are the central banks omnipotent?

In December, 2015, the Fed raised interest rates for the first time since the financial crisis first happened. Beyond that, the Fed has indicated its intent to raise rates four more times in 2016, which would bring a return to normalcy. This promise was largelyexpected to be kept, despite the trend European and Japanese central banks have taken to maintain low-to-negative rates.

With the market corrections we’ve seen in the first quarter, the Fed has retreated from its overly optimistic outlook for the US economy and the positive impact of quantitative easing in economic recovery to date. As recently as January, Yellen testified in front of Congress and declared that negative interest rates are an option that is on the table to continue the pursuit of an accommodative policy in the hopes that it might still spur growth. In reality, there is no free lunch and the problems facing the global economy cannot be solved be simply printing more money.

The problems associated with money printing have reared their ugly head worldwide: Japan announced negative rates in late January, revealing the limits of Abenomics in combatting deflation and in supporting economic growth. The negative rates held by many European central banks have done little to spur growth and has instead increased the global growth-debt imbalance. Continuing this policy will serve to promote globally greater debt-growth imbalances as cheap money will accommodate theinefficient allocation of capital.

The G20 Summit in Shanghai laid bare the hard truth that we’ve been saying for years: loose monetary policy is not an effective tool to promote balanced growth. Although this statement was largely agreed upon by the member states, there was no consensus on developing a roadmap to balanced growth, nor a retreat from loose monetary policy by any country. It seems that the central banks’ views on the impact of easy money has sobered up quite a bit. But, they still remain hesitant to do what they’re beginning to see is necessary. The markets are not quite as timid as the central banks and have recognized the inaction for what it really is: the global economy is not as healthy as once believed and central bankers’ ability to manage the economy should be questioned. Once the confidence in the power of central banks is seriously questioned by investors, the house of cards (or better the house of QEs) can easily implode.

Is the Banking Sector Safe from Another Collapse?

WiththeimplementationofBaselIIIandDodd-Frank, banks today are far better capitalized than they were during the financial crisis. Since then, the Fed and their counterparts in the ECB and other central banks have increased capital requirements and taken more pessimistic outlooks in stress-testing the banking sector. In 2015, all US banks passed the stress test, though three of the largest - JP Morgan, Morgan Stanley and Goldman Sachs - only passed after tapering dividend payouts and buybacks. All of this implies one of two things: either the banks have, in fact, improved their economic situation, or the overseers are still too optimistic on the banking sector. We’re inclined to believe the latter.

Within the Fed, there is one voice in the leadership that seems to agree with our outlook on the banking sector. New Minneapolis Fed President, Neel Kashkari, says that the largest banks still pose a threat to the financial sector as they still remain too big to fail. His statement marks the first time that the leadership within the Fed has admitted that the course of action in the banking sector taken thus far is not producing the results that were promised. Although Kashkari did not go so far as to criticize the Dodd-Frank Act, he did emphasize that there should be serious consideration about breaking upthe largest banks.

Although Kashkari has rightly highlighted that the banking system in the US is not as prepared as was once thought, the increased regulations are becoming an operational nightmare. The fear of avoiding a crisis through more regulation and quantitative easing has not promoted real growth as much as it has increased leveraging.

Nor does the banking sector in Europe look rock solid. For example, Deutsche Bank, one of the largest European banks, has been facing many problems lately. The newish CEO, John Cryan, has suspended dividend payments for 2015 and 2016 in an attempt to maintain sufficient capital to repay its debt obligations. In looking at the bank’s performance, its investment banking arm is underperforming and facing a number of costs due to restructuring and fines for potential losses on loans to energy companies. The biggest concern is whether or not DB has the ability to repay its convertible debt obligations. This year alone, DB must make interest payments of EUR 350 MM on its convertible bonds. Further complicating the matter, the bank issued these to satisfy increased capital requirements in the aftermath of the financial crisis (as an alternative to diluting shareholder value by either withholding dividend payments or issuing new stock).

Unfortunately, the bank’s profitability outlook remains pessimistic given the overall sluggish state of the economy at large. Even more worrisome, 2015 losses of EUR 6.8 BN, were 74% higher than they were in 2008. To top it all off, the company has set aside EUR 5.2 BN for litigation alone. The question is whether this will be enough to cover all of the potential fines it might have to pay due to the litany of charges of alleged misbehavior. With DB, the concern is that it may prove to be Europe’s LehmanBrothers, with some speculating that should DB collapse, it will take the Euro with it. We do not share this view, as Germany and the ECB would most likely intervene, just as their American counterparts did during the financial crisis. But this intervention must be questioned if the scope of a potential financialcrisis does get “out of control”.

High-yields bonds in US Shale in Distress

As oil prices continue to hover between $30 and $40 per barrel, the US shale oil sector is taking the biggest lumps. The American energy sector, as a whole, has been hit hard, which is especially the case for the cost-heavy shale oil producers. With Russia and OPEC members refusing to cut production, they have made it clear that the only way for prices to rebound is for higher cost-operators to reduce production. It seems as though this is exactly what is happening as the number of total US oil rigs have nearly halved during the past 12months (Figure5). Russia, Saudi Arabia, Qatar and Venezuela agreed to freeze production at January levels, but there are no indications that they will cut production. Although this has led to prices increasing to the high $30s, it has led to more rigs coming back online, meaning likely price declines.

In looking at output from the Bakken region in North Dakota, the industry has maintained its resilience by shifting toward production optimization. So far, this has led to a production decline less dramatic than projected. However, there is only so muchoptimization that can be done. At the end of the day, these price points are not profitable for the US shale oil sector and production optimization will serve to delay the inevitable, especially in light of OPEC and Russia’s refusal to decrease output. Beyond the issue of over-supply, we must look to the root cause of the drop in prices: China’s industrial slowdown. Oil and other raw materials witnessed a significant decline in prices as the world’s leading manufacturer has decreased manufacturing output.

As if it weren’t bad enough that there is an over-supply without an adequate output decrease to account for reduced demand, the US shale sector is also highly leveraged. Even ExxonMobil’s AAA rating is threatened as its profits drop. Smaller exploration and production companies are harder hit, with risk premiums on junk bonds in the sector hitting record highs, even surpassing the level hit during the financial crisis. Continuously low oil prices might prove to be the straw that breaks the camel’s back in the US shale oil junk bond sector. The spillover effects of a US shale oil high-yield bond crisis should not be underestimated and could easily turn into a full blown market crisis.

Is the Threat of High Leverage Spreading?

The shale oil sector isn’t alone in being dangerously leveraged. Moody’s cut China’s credit outlook to negative from stable on March 1st. The biggest concerns are related to China’s state-owned companies and their ability to repay their debt obligations at a time when growth is significantly slowing down. Beyond that, a major concern is China’s debt level exploding if the governmenttook on the state-owned company debt obligations. The consequences, coupled with the economic slowdown, would bring the Chinese economy, and possibly the global economy, to its knees. And with it, another economic crisis.

The current financial stability is fragile: there are many indications that it is merely skin deep and that the next financial crisis is already building up and might even exceed the 2007/08 crisis. And we’ve only highlighted some of the hot spots; there are many more to consider (debt levels beyond any economic rationality, the exponential risk of debt refinancing from a zero rate level, etc.). Although timing the next crisis is almost impossible because of their high probability, investors should start to take action now.

Legal Disclaimer

This report was prepared and published by BFI Wealth Management (International) Ltd., a Swiss wealth management company registered under the U.S. Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC) as aninvestment advisor.

This publication may not be reproduced or circulated without the prior written consent by BFI Wealth Management, who expressly prohibits the distribution and transfer of this document to third parties for any reason. BFI Wealth Management shall not be liable for claims or lawsuits from any third parties arising from the use or distribution of this document. This publication is for distribution only under such circumstances as may be permitted by applicable law. This publication was prepared for information purposes only and should not be construed as an offer, a solicitation or a recommendation to buy, sell or engage in any venture, investment or financial product. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. Although every care has been taken in the preparation of the information included, BFI Wealth Management does not guarantee and cannot be held responsible for the accuracy of any statistic, statement or representation made. The analysis contained herein is based on numerous assumptions. Different assumptions could result inmaterially different results.

All information and opinions indicated are subject to change without notice.

Download PDF Blog Post