“This is not a crisis, its turbulence.” – Fauzi Ichsan, Head of the Indonesia Deposit Insurance Corp
The time between our last newsletter and today feels like an eternity, yet is only 30 days. In that time, we have witnessed a dramatic increase in market volatility (a swift fall followed by a uneven rebuild in prices), mass emigration from Syria into Europe, the Federal Reserve holding firm on being loose, fringe political parties advance in global elections, and a Brady victory over NFL commissioner, Roger Goodell. It has not been the easiest of paths for summer to come to an end (especially for Mr. Goodell).
In the words of Ron Burgandy “Boy, that escalated quickly.”
In times of such reversals in fortunes, we find ourselves going back and reviewing our prior thoughts. We try to find a foundation to stand upon as we view the current landscape. It took us back to our newsletter from earlier in the year where we reflected on Seth Klarman’s (Baupost Group founder) words of wisdom. Although the entire article (and our past newsletter) should be reread, the following three points seem particularly relevant.
Lesson #5: “Risk is not the same as volatility. Risk results from overpaying or overestimating a company’s prospects. Prices fluctuate more than value. Price volatility can drive opportunity. Sacrifice some upside as necessary to protect on the downside.”
Lesson #6: “Unprecedented events occur with some regularity, so be prepared.”
Lesson #8: “Holding cash in the absence of opportunity makes sense.”
Although we believe the financial and geopolitical stresses around the world will most likely will be resolved over time without absolute crisis, it would be Pollyannaish to ride this current storm without wearing a life preserver. For this reason, we have been moving into a conservative investment stance throughout the summer. Our investment strategies are currently positioned to dampen the volatility expressing itself in the markets. We have used the last several weeks of volatility to continue shrinking our equity exposures as many factors point to a market of increasing volatility. As stated above, risk is not the same as volatility, but when leverage has been built into the global system, risk can come about because of volatility.
The situation reminds us of thoughts by Charles Gave, a prominent economist and investor. He likens economic shocks to dynamite fishing. The sport begins by throwing a stick of dynamite into the water. After the explosion, the small fish quickly rise to the top. However, you need to be patient to see if the larger fish were also caught. When economic stresses express themselves (similar to the dynamite being thrown in the water), the weakest and smallest participant are exposed first. It takes time to see if the stresses have built to the point of bringing down the larger participants.
What has been notable to us is that despite the talk of free money (Japan’s quantitative easing, the European Central Bank infusing cash into the weak EU participants, China pirchasing 10% of their equity market, the U.S. Federal Reserve holding rates at near zero levels), global liquidity appears to be shrinking. We have seen its clearest impact on the commodity sector and the emerging economies. Gold is down 7% from summer highs. Copper and Oil have declined over 20%. We are closely monitoring global illiquidity to see if it spreads to other regions, sectors, or banking systems that may have the most potential for moving turbulence into crisis.
We do not forecast current market volatility to end anytime soon. Although many factors go into that conclusion, we highlight three:
The slowing of China’s economy is causing disruptions in Asian and Latin America. Both of those regions carry high debt levels and true risks of insolvency. These issues are not likely they fix themselves soon.
Given a recent conversation with one of our clients that lives in Jakarta, we have been looking into the financial system of Indonesia. We have concerns that the major banks are under immense stress. The Indonesian Parliament is focusing on rules around providing banking assistance (rarely done when things are okay).
The Federal Reserve of the U.S. has decided to delay the rate normalization process, elongating the period of uncertainty around rate rises.
Although our goal is to produce market leading returns for our clients, we need to remember that in order to do so requires us to dampen volatility in times of uncertainty. We currently believe the best way to achieve our goal is to move to a conservative stance and wait for opportunity.