So I thought we were going to look at the latest Market Report of Skagen Funds.(pdf!)
What is Skagen Funds? It's a Norwegian stockpicker managing savings in the form of mutual funds. That's not a very unique thing, so why should we listen to these people, who anyway have a vested interest in saying everything will be fine?
Because they are probably the most successful fund company in the world today. For example, their top rated fund, Skagen Global, has beaten its index (MSCI World) every year for the ten years the fund has existed, and returned more than 20 % per year on average. This evens out to more than 700 % and that is actually better than even the best stock exchange in the world in the last 10 years, the Botswana stock exchange which is up about 700 %. This is supposedly impossible according to the efficient market hypothesis, which tells you everything you need to know about the relevance of said theory.
They couldn't be this sucessful if they were completely stupid, could they? Another, if maybe minor, feather in their cap is that when I idly talked about energy issues with some of their representatives, they immediately brought up the subject of Peak oil.
So, what are their arguments for a bright economic future?
THE INTERNATIONAL ECONOMY
Much fear and little substance for the time being
Strong leading indicators are still being reported from the U.S. economy, but the expectations here, as in Europe, are on their way down. Of the key ratios that provide snap indicators of economic health, it is worth mentioning a minor weakening of the U.S. labour market. Earnings reported by business are still positive, pulled up by exporters profiting from the weak U.S. Dollar. However, it is a free-falling property market that is the major drag on the U.S. economy.
In Asia, key economic figures are generally better than expected. China continues to steam ahead, in spite of tightening credit policies. It is worth noticing that even though exports to the U.S. have shown weak growth for several quarters, the trade between the countries in the region is increasing at a record pace. Recently, inflation has been increasing globally, due to strongly increasing prices of food commodities and energy. Global core inflation, however, which does not comprise these items, is moderate, but headline inflation remains high enough for the central banks to maintain a cautions approach.
If the danger of recession is indeed significant, it is not yet visible. We consider it more likely that there will be a short term growth pause in some countries, rather than a global recession. This is partley due to leveraged consumers, but also the fact that increased investments in capacity and infrastructure will not take place due to increased interest rates for borrowers. However, since August, borrowing costs have mainly increased for financial and not industrial borrowers.
As already mentioned, the prices of energy and food commodities increased strongly in October and November. Meanwhile, the prices of industrial raw materials, such as metals and cotton, have fallen. This is probably primarily due to a reversal of previous speculative positions, rather than overproduction. Most inventories are still small, and supply side growth remains modest. The prices of primary commodities, such as iron ore and coal, remain strong, and may be leading indicators for the whole supply chain.
Within shipping, we have seen record rate levels in dry bulk, continued tightening in the container market and an unexpected record jump for tanker rates. None of these are factors that immediately come to mind as indicators of an imminent fall in global economic activity.
Lifted tanker rates on high volume indicate that more oil is on its way to the markets, through higher oil production by OPEC. It is likely though, that the oil price has passed its peak for this year. This is an assumption that is strengthened by the fact that the major investment banks have raised their oil price estimates strongly for both the short and the long term (they generally make the wrong call).
All the skeletons have to fall out of the cupboards
The finance industry has been really alarmed by continually rising interbank rates and risk premiums on other financial players. And financial scandals are not exactly helpful with respect to dousing fires. Perhaps the biggest confidence breaker is the strong underreporting of losses incurred by the financial industry from August up to November. The financial sector is allergic to making provisions for losses, especially after seven good years. Such ugly creatures undermine both bonus and equity, growth and dividend base. However, the process that will make bank managers face reality, has fortunately started.
So far, financial companies have recorded USD 40 billion in losses. More will be recorded in the fourth quarter. Primarily by U.S. financial institutions, but also by some European and a few Asian companies. At the end of the first half of the year, the special financing instruments infected by rotten U.S. subprime
mortgage loans amounted to around USD 1,300 billion. Now the amount is approaching USD 700 billion, and several institutions, such as HSBC, have announced that they will now record them in their own balance sheets. The bailouts of Citibank and E-Trade also demonstrate that there is still determination to make deals in this sector.
The above explains the strong increase in the interbank rates compared to the discount rates of individual countries. At the same time, we see how finance sector earnings have been overblown because the real financing volume has only been reflected on the income side of financial statements (the big losses have been off the balance sheets). However, just as when the technology boom burst after the turn of the millennium, many now believe that the world will come to an end. But, as the period after 2000 has demonstrated, the world continues on and the valuation of assets will continue to follow value creation.
Thus, it is more important than ever that sound fundamental criteria are used to select investments, and not short-term, speculative and emotional arguments. In our assessment, global value creation will continue, but probably at a somewhat slower and less inflation-driving pace. Meanwhile, global imbalances will lessen, with lower consumer spending growth around the North Atlantic.
Risk-free rates of interest now provide very low real returns. U.S. Treasury yields have fallen to a level previously associated with long-term economic decline, or very low economic growth. Corrected for inflation, the current interest rate level corresponds to a 10-year real rate of interest of 1.5 percent, down from closer to 2.5 percent this summer. Some of it can be attributed to the flight to safety, if it is appropriate these days to call fixed income securities denominated in U.S. Dollars, safe. Some of it may also be due to a great supply of central bank liquidity. Nervertheless, this is a poor long-term investment option, unless you expect deflation and depression to be the global perspective going forward.
We also notice that the risk spread versus less liquid sovereign securities has increased. This is due to a desire for liquidity, which might be a good buying opportunity. For more aspects, please see our comments under "The fixed income market and our fixed income funds".
Globally, the equity markets seem to be relatively disconnected from the drama on the fixed income markets. The reason why is that the low interest rate climate we have had since 2002 has only to a very limited extent been translated into company revaluations. In this decade, global corporations have generally enjoyed very good returns on capital in a period of economic expansion. Few analysts have believed that this is a phenomenon that could last. Meanwhile, corporate risk has fallen, due to ever-lower corporate leverage.
This last thing is something I don't think is mentioned very often - the steadily falling levels of corporate indebtness, especially as all eyes are on consumer and mortage debt.
Modest valuation of equities
Consequently, corporate valuations are modest, by the standards of the last 20 years, and this has clearly acted as a buffer this year. Global earnings growth for the fourth quarter and into 2008 has now been heavily cut by analysts, but this is largely due to the problems in the financial sectors, and is directly related to companies in these sectors. Fortunately, the SKAGEN equity funds are heavily underweight in finance. We are still considering the risk in the financial industry to be considerable.
As is the case with the major asset classes, we are now also seeing a decoupling of geographic regions in the equity markets. Shares in Europe and the global emerging markets have behaved well in a market climate that, based on what has historically been "normal", should have led to a flight towards dollar denominated assets. However, in light of the fact that the risk is principally associated with the U.S. financial system, this seems rational enough. The combination of a falling U.S. Dollar and lower U.S. equity market valuations may in the longer term lead to a better climate for stock pickers - even in the U.S.
As the the credit worries is the main big argument for a recession, we'll take an extra look on what Skagen thinks of the credit markets.
The interest rate market and the fixed income funds
Credit markets out of sorts
The strong unrest we experienced in the credit markets in August flared up again in November. The U.S. housing market weakened further during the autumn and the losses on home mortgages and mortgage-linked bonds increased. Losses are spread over banks and financial institutions worldwide, but it is the major U.S. financials that are bearing the brunt. However, there is still great uncertainty regarding the scope of these losses and where they are located.
Sky-high interbank rates
The banks' uncertainty regarding their own balance sheets and scepticism regarding each other have pulled up the interbank rates - the interest rate that banks charge on loans to each other. The 3-month U.S. Dollar interbank rate has increased 26 basis points since the U.S. Federal Reserve (the "Fed") cut the Federal Funds Rate by 25 basis points at the end of October. The swings have been of about the same size in the Euro zone, and even bigger in the U.K. In Norway the 3-month interbank rate is 5.9 percent, a fair bit above the discount rate of 5.0 percent.
The Federal Reserve and the European Central Bank (ECB) have increased the supply of central bank money to the banking system in order to try to keep a lid on the interbank rates. So far this has only contributed to restraining the rise of the interbank rates.
Some of the lift of the interbank rates is a turn of the year effect. However, for these rates to return to a normal level the confidence of banks in each other has to return. How quickly this will happen is dependent on further developments in the housing market, and bank policies regarding the valuation of problem loans.
Pricey safe sovereign securities
In parallel with the ascent of the interbank rates, yields on U.S. treasuries have fallen sharply. The yield on the 10-year U.S. Treasury bonds is now 3.9 percent. That is 0.6 percentage points lower than at the end of October, and 1.4 percentage points lowerthan at the start of June. U.S. Treasury Note yields have also fallen sharply. 3-month yields are currently barely 3 percent.
The sharp decline in U.S. Treasury bond yields is due to investors selling off fixed income securities encumbered by uncertainty and buying what they assume to be the safest of securities. A fear of losing principle means that many are willing to accept low yields and great risk of price declines. Generally the same developments have been seen in many of the other Western countries, the U.K. and the Euro zone in particular.
Further cuts from the Fed
The market expects the Fed to cut the Federal Funds Rate further at the next three meetings of the Open Market Committee, and that it will end up at 3.75 percent by the middle of March next year. Expectations are due to clear signals from the Fed that it is ready to maintain an accommodating monetary policy in order to help the financial market, and to prevent the U.S. economy from slipping into a recession.
Monetary policy has resulted in a devaluation of the Dollar in the currency markets. The risk is that inflation ends up higher than the Fed comfort level. Inflation is 3.5 percent and is expected to increase further in the coming months. Core inflation, however, seems to be under control. It was 1.9 percent in October. This is in the upper range of what seems to be the Fed's implicit inflation target of 1.6 to 1.9 percent.
What are the other central banks doing?
The European Central Bank (ECB) has kept the discount rate at 4.0 percent and until recently, the attitude in Frankfurt was that it was on its way up. However, the credit market unrest and fear of the combination of lower U.S. growth and a weaker Dollar seems to have made the ECB change its mind. The financial markets are discounting an interest rate cut to 3.75 percent by next summer. Also the U.K. market is pricing in a lower discount rate. It is assumed that the Bank of Japan will wait a bit before the discount rate is increased from the current 0.5 percent.
To wrap it all up or if you didn't stand reading all of this rather long text, in the words of Skagen boss Kristoffer Stensrud.
At the start of 2008, the world of capital has segregated into two camps. Some are preaching the end of the world, as a consequence of falling U.S. home prices, possible drop in consumer spending and the possibility of a U.S. recession. They receive support from diving confidence indicators in developed countries. The other camp preaches "a dangerous thought": that it is different this time. Overall, the world economy has never before in history been less dependent on the developed countries. The years 1989- 1993 showed that it was possible for the global emerging markets to have a long period with different equity development than the developed countries. The final result was a quite dramatic overvaluation.
Naturally, the financial sector regards the problems of the financial sector as the key issue. This may perhaps contain an element of overestimation of their own worth, and a small element of putting the cart before the horse. Even the most snooty financial acrobat has to realise that is impossible to defend the finance industry constituting around 25 percent of global equity capitalisation (as it has in recent year), by the mere fact that a corresponding share of global value creation stems from this sector (has fallen recently, as mentioned above).
The most probable scenario for what will happen to the world economy going forward, is somewhere between the two above-mentioned camps. We have not seen the end of the bad news from the financial sector, and we have a heavy fourth quarter reporting season ahead of us. The finance industry has quite a tradition of skeletons falling out of the closets all at the same time. And the closets are still far from empty.
The general experience from the past 30 years is that, unless you are caught by a speculative cycle, it pays to be invested in shares. Now that the financial bubble has been burst, global equities are again relatively free of speculation. Best rewarded will be the equity investors who have put fresh batteries in the calculator they keep on the nightstand.
And as someone is bound to wonder, these are the current main investments of Skagen Global.
For disclosure and stuff, I have investments in Skagen Global.