The first order of business is certainly to wish all our investors a happy, healthy and prosperous 2015.
Writing the year-end review is always an interesting exercise and starts with reading what we wrote a year ago, which is usually a humbling experience.
2014 has been fascinating because in most areas it totally defied predictions; in fact virtually nothing that was meant to happen actually did happen.
What didn’t come to pass?
The most important consensus for 2014 was that.
Interest rates would rise.
We write a lot about interest rates for the simple reason that the return on cash (risk free as there is no theoretical capital downside) the cost of borrowing and the returns above the risk free rate being offered by other asset classes (bonds, property and equities) are the cornerstones of investment analysis.
Against all expectations in 2014 the yields on the majority of sovereign and corporate debt fell.
We highlighted this during the year when the ten year US yields fell below 2%, Germany below 1% and even the troubled countries such as Italy offered a 2% return.
The problem we all face when trying to forecast the future is that one can really only look at historical precedent and extrapolate this forward (economists are really future historians in this sense).
No one in the West has a model for the QE and super low interest rate environment which central banks have created, so they look to the past and say, “when you pump huge amounts of capital into economies this creates inflation, inflation is only reduced by raising interest rates therefore rates must rise, because this is what is happening”.
Now this is all true historically, apart from one crucial new element that is becoming clearer and which changes everything history taught us.
If at the same time households deleverage (pay off debt), companies hoard cash and (most importantly) if banks shrink their balance sheets by not lending as much as is being repaid to them, then it actually doesn’t matter how much extra liquidity is created, inflation doesn’t occur.
An easy way to think about the economy in normal times is as an engine, the fuel for the engine is money and the engine will naturally rev faster if the flow of money increases, it won’t if the flow is static or slows (this is why inflation is combated by draining out money with higher interest rates).
Now the central banks can increase the size of the fuel tank and fill it to the brim with liquidity (this is QE and in normal times this would flow to the engine and speed it up) but as of 2014 it isn’t, it’s staying in the fuel tank (the banks).
This has resulted in slower growth and falling inflation, with Europe in particular being affected.
The homily anomaly
There are many factors to Europe’s problems but a major one is the anomaly of how the banks are now being regulated (hence the homily referenced above of closing the stable door after the horse has bolted).
It’s entirely understandable that regulators want to stop a repeat of the bank induced financial crisis. It’s right that lessons are learned and practices amended BUT ……
The Basel 3 rules which come in to effect in 2019 require (on pain of corporate death) that banks increase their free capital (their own money effectively) significantly. This means that they firstly have to re-engineer their balance sheets to raise capital (reduce lending to certain areas) and make damn sure they won’t miss the targets (so be well above them giving a margin of safety if things turn bad close to 2019).
All very sensible many people say and yes it probably is but, and there’s junk in the trunk (a big but).
Doesn’t this now mean that banks will only lend to the perceived safest of borrowers, won’t they hoard cash, won’t this actually starve the economy of new liquidity negating all the efforts of the ECB (in Europe’s case) to inject more investment capital into the system?
Yes it most certainly does!
It’s true to say that for many years after a disaster people are focused on preventing it happening again when in reality it’s unlikely because the actors involved have no desire to experience a replay. Their sins were mostly not of intentional larceny but of greed and stupidity and they have been humbled for them.
The resultant ferocious regulations however often have profound unintended consequences (as politicians sate their constituency’s cries for retribution), which cause new issues such as the one illustrated above.
Economies are football teams
As a lover of analogies (and football) it’s therefore appealing to compare economies in such a way..
They go into 2015 having won the league in 2014. Their success has been built on Coach Bernanke’s recognition that wholesale change was needed post 2008/9 and the adoption of all-out attack on all fronts.
Banks were purged of bad debt, the housing market allowed to crater and unprecedented funding was pumped into the economy to inflate asset prices, ward off deflation and create confidence.
It was high risk, many decried it as lunacy and today the United are set to dominate for the foreseeable future.
Their new star striker Fracking Gasanoil will be game changing for a decade plus.
Where to begin?
FC Europe continues to perform as a dysfunctional group of individuals unable to agree on a single pattern of play or a common set of rules.
Club Captain, Herman Von Deutschland, who increasingly holds sway on selection and tactics is highly defensive by nature and by dint of being the strongest player with the loudest voice is able to rebuff all other opinions.
The team is riven with discord and disunity and at its core it has an unworkable system.
The physio, Super Mario Draghi is known to favour significant financial massage (QE of sovereign bonds as per the successful US model) but the club captain won’t agree.
It is hard to see anything other than further struggles for FC Europe.
The Red Devils are a mystery wrapped in a conundrum, nobody really knows what’s actually going on or if the results are “juiced”.
They are attempting to mix a free market attack with a command and control defence which no one has tried before.
They have enormous firepower, the biggest supporter base and if they get it right they will be THE powerhouse but only those inside the club really know the reality of the state of play.
Athletico Emerging Markets
They are young, they have running power, they are capable of great dynamism but they are inconsistent and lack in some cases a solid core.
They will either be very good or very bad and the team will increasing bifurcate with the good players moving up and those who do not train on being relegated.
2015 is a big year with a new manager being elected for 5 years.
A steady performance, not bad not good. There are continuing rumours that FC UK may terminate its membership of its current league and go it alone trying to play a series of friendlies, it remains unclear how this will work in practice.
It is also possible that UK will seek to ban foreign players if Nigel Farage is elected to the board.
Russia North End
The crazy gang have been up to their old tricks again, fouling opposition and trying to bully their way to victory.
Captain Raz Putin (the bear with less hair) is the tough talking, opposition hating outcast of the league who seems to be equally as adored by his team as he is loathed by everyone else.
Financially the club are in desperate straits but they don’t seem concerned.
No one loves them, they don’t care.
PSJ (Palace San Japan)
The club is likely in terminal decline with huge debts and an ageing team.
Coach Abe however is determined not to go down without a fight.
He has initiated an offensive strategy (the three arrows) to kick start inflation, boost asset prices and reform the corporate culture.
The Yen has weakened considerably and will likely continue to do so in 15 which is what is needed.
This really is the last big roll of the dice for Japan, a once mighty club who have stagnated and underperformed for several decades.
Can they resurrect themselves? Long term it’s unlikely but they have star performers such as Toyota and Nissan who will make huge profits from their world-wide sales as the Yen falls.
A strong 15 performance is entirely possible, longer term though, major issues remain.
The single prediction is simply this.
Very cheap money and central bank QE will propel markets upwards if bad stuff doesn’t get in the way.
Oil related fall out
Etc etc etc …………..
George has written an excellent analysis of individual markets and the performance of the portfolio holdings this past year so I now hand over to him.
Quarterly Market Update
Looking back twelve months we expected returns to be lower than 2013, and volatility to continue. We also added a caveat that ‘unknown unknowns’ could impact on returns…..read more
Quarterly Portfolio Update
2014 has to be one of choppiest markets I have seen for some time. We saw periods where the market raced away, only for it to fade away the following month….read more
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.