Justified Concerns

Over the course of this year, concerns within global financial markets have been forming.  Our past few newsletters have discussed the events resulting in us being conservative throughout the summer.  Those concerns are not receding at this point, even as the equity markets have recovered.  Therefore, we maintain a defensive position, looking for our concerns to pass and investment opportunities to present themselves.

Over the past month, we have witnessed the following events: the collapse of the Portuguese government threatening a timid recovery, the Catalonia region voting to separate from Spain resulting in their debt downgraded to junk status, an oil glut that continues to build excess inventories even with all the disruption in oil producing countries, weakening global trade hurting an already weakening Chinese manufacturing economy, and horrific events that occurred in Paris and Beirut.  We have mentioned many times in the past that bad things happen in the world even in normal investment markets, so why are we more concerned now?

The availability of credit drives the world.  The credit markets serve the purpose of allowing investment to supply anticipated demand.  The low interest rate environment and easy credit increased the chances of bad investments in the form of funding low return, risky projects and financial engineering by means of stock buybacks and dividends.  Recently, credit liquidity and the desire for risk has changed.  But what happens when the costs of debt increase and liquidity for risky projects goes away?  Bad things can happen.

We have been witnessing a modest erosion in investor willingness to pay up for leverage throughout the year.  It first started with the large debt overhang of the marginal U.S. oil producers and the fear that they required oil to be priced at almost double current prices to be economically viable.  It moved to the cutting of credit facilities in the Canadian oil producers.  And, most recently, higher funding costs for market participants outside the energy field.

We have seen the commodity markets, which we suggested as being a weak point within the economy, continuing their downward march.  The industrial complex in the U.S. and emerging economies around the world that benefited from a commodity super cycle are now sitting in a precarious position.  Debt was used to build out capacity based upon pricing at much higher than current levels.  This has caused the discussion to move from return on investment to return of investment.  We see this manifest itself in the underperformance of the Australian, Brazilian, and British markets where commodity-based companies represent a major portion of the investment markets.  To be clear, the debt issues of the emerging markets are different from those experienced in the 1990’s.  At that time, it was the emerging governments taking on large amounts of dollar denominated debt to fund social programs.  This time around, it is the private companies located within the emerging markets that have levered up their balance sheets, taking advantage of low U.S. interest rates.  This is far less dangerous to economies, but likely more destructive to the emerging equity markets as those highly-leveraged assets may need to be restructured in order to pay off their loans.

Certain parts of our data and analysis are very positive.  The robust recovery of the U.S. equity markets stands in contrast to the fears mentioned above.  This suggests the issues we addressed are manageable.  When adjusted for the strong dollar, corporate revenues were up and rising wages indicate that the consumer is seeing a better economic picture.  This year has been a huge year for large company debt issuances, suggesting the risk seen in the smaller and less liquid markets has not pushed its way into the higher quality investments.  Large mergers are still being proposed and funded.

We have painted a conservative picture for a reason.  The U.S. equity markets are sitting just under their highs despite the concerns we have addressed.  This does not necessarily indicate the start of a bear market.  It could work its way out as market forces bring discipline back into global corporate boardrooms.  Time will tell how this plays out but, for now, we take comfort holding some cash and higher quality companies.