U.S. Federal Reserve Chair Janet Yellen testifies on the economy before the Joint Economic Committee on Capitol Hill in Washington
CheckRisk This week: Is risk analysis a contrarian approach? Has China hit a cyclical low or is there further to go? The reason Yellen must raise rates in December. And keeping an eye on political risk in Portugal.

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Is risk analysis a contrarian approach?

It is a legitimate question. Is risk analysis a contrarian approach? The answer is no, but risk analysis may appear contrarian at times for good reason. A contrarian approach merely takes the opposite view of consensus opinion. That may occasionally work but most likely will be luck rather than judgement if things turn out well. Just because a stock is cheap does not imply that it will not remain so. In fact one of the major problems with Dividend Discount Models, for example, is that they identify plenty of cheap stocks, but often there is no catalyst to realize that value.

The above being said the key issue with risk is knowing when you are being paid to take the risk and when not. That implies both a macro risk knowledge as well as micro risk understanding at a stock level is required. It is not good enough to just know that a stock is cheap, although that is a significant risk mitigation. It is essential to understand the business of the investment, what the risks to it are and whether the current price reflects that value or not.

Where CheckRisk differs from the Buffett-Munger approach is to add in an understanding of the broader macro risk environment as part of understanding the micro risk of a business. In other words, a buy and hold strategy is not always a good idea, even if the company has a so-called wide moat. Take CocaCola, for example, a classic wide moat stock that is having to deal with the societal change to less sugar consumption. There are metrics available that show how many kilos of sugar CocaCola and other beverage manufacturers use per earnings per share. CocaCola is right at the top of the list.

Risk analysis appears contrarian mostly because of human behavioural factors. Following a stock market correction or crash instinctively investors do not want to approach the fire. A correction or crash is precisely the point at which investors should be finding value and more importantly a lower risk environment. While this may seem obvious, the converse is also true. After a period of rising markets, it is so difficult to say enough is enough. Risk analysis can provide a more quantita- tive approach. An approach that questions our natural aversion and bias. Risk is not a contrarian approach. Risk analysis is the driver of all returns and the starting point of any sound investment approach. At times, it will tell you to do things that feel desperately uncomfortable and against the crowd. However, for the majority of the time risk analysis will just inform investors that things are just fine. And that is why it is much more that a contrarian approach.

China, damn lies and statistics.

Chinese official economic data is questionable at the best of times. That is not to say that the Western world is much better where data is concerned. It is mildly amusing that the Federal Reserve has said that they are reliant on the data, and yet that information is continually revised from month to month. Also, members of the Federal Open Market Committee (FOMC), that set rates, all have a dif- ferent interpretation of the same data. What it boils down to is that the decisions are no more than gut instinct.

China’s social contract is pretty clear. The government will allow the Chinese to become wealthier provided that they give up their right to question politics. In all fairness, that policy has worked pretty well for the Chinese over the past two decades. China has, after all, become the world’s second-largest economy. The point right now though is that an accurate understanding of China’s actual economic growth rate is essential. If China is growing much slower than market expectations, then there will be a lot of turbulence ahead. Private forecasts of China’s GDP growth rate range from 3.3% to 7%, which is the official figure. CheckRisk, for a number of reasons, believes that China is growing at an actual rate of about 4.5% to 5%. The reason we think that GDP growth is well below the government estimate is from anecdotal evidence. Chinese electricity usage, for example, is growing at just over 1% per annum. Freight rates like the Baltic Dry Index and the Shanghai Container Shipping Index are at or close to multi-year lows. So, we are sticking with our view that China is growing more slowly than the official numbers suggest. That is not all bad news, though. It is just that the markets appear to be relying on the false government statistic, and so there is somewhat of a disconnect. There is a very real risk that investors will need to go through a period of adjustment concerning expectations of Chinese economic growth.

While CheckRisk is of the view that Chinese GDP figures are inflated, we also believe that the short- term outlook for China is quite positive. The freight rates we mention in the previous paragraph are close to all-time lows, but they appear to be picking up. Total freight shipments in September jumped to 4.1bn tonnes up from 3.8bn in June. There are also signs that Chinese PMI data has bottomed too. In other words, once investors have adjusted to the reality the growth outlook does not look too bad.

The implications of a slower Chinese economy are a weaker Yuan and a stronger USD. What is clear is that synchronization risk is worse than even we had anticipated. The US is out of sync with the rest of the world. The Federal Reserve is seriously considering raising rates in December at a time when Japan and the EU zone are about to increase QE. It is inevitable too that the Chinese will lower rates further and allow the Yuan to devalue. One of the biggest risks to the US economic recovery is that the USD appreciates another 10% to 15% from here. A strong dollar would kill off the shallow economic growth in the US altogether. It would be bad news for bond markets if the Fed raises rates and then almost immediately has to reduce them. So while Janet Yellen and the members of the FOMC say they are data dependent we would say that there are much stronger forces at play than targeting a 2% inflation rate. It will be interesting to see what steps China, the EU and Japan make between now and year end to stop Yellen raising rates. Another currency devaluation or a strong hint that the ECB will allow the EUR to weaken substantially might be enough to kill the Fed’s chance to raise rates entirely.

China remains a battleground for the bulls and bears. There is a case to be made that both may be right and that their perspective of time only divides them. Our view is that China is growing at a slower rate than market expectations but that the accelerant that China has used in terms of interest rate cuts, and monetary policy mean that it will recover quickly and that we are not, for the moment at least, looking at a country entering a recession.

The risk then is that China is unable to hide the real growth rate from the reported number during this period of consolidation. Hiding such things for any great length of time is hard. In the meantime short-term stimulus appears to be working and therefore, for the moment at least, we believe that the Chinese will not be exposed as peddlers of false data.

The reasons Yellen must raise rates in December.

CheckRisk has put forward the case on numerous occasions that the US Federal Reserve has cornered itself; that they have already missed the opportunity to raise interest rates and are going to be chasing the curve from now on. Our views on that have not changed. However, there are a number of reasons why Yellen must move now.

The Federal Reserve is having to deal with a number of opposing forces. The US economy is growing but not at a rate that would justify an interest rate alone. Had we already been at 3% interest rates we would not be discussing an interest rate rise right now. So there are other forces at work. The Federal Reserve knows that if interest rates remain at zero that they will have no room for manoeuvre when the next natural cyclical downturn occurs.

There is also a more delicate question of credibility. Janet Yellen made a nonsense of the September FOMC meeting. The guidance, on which the Fed prides itself, was unclear. Yellen spoke of foreign events, and inflation and data, but it was clear that she completely missed concerning market reaction. On the data issue, we are particularly concerned. It is somewhat frightening to consider that the FOMC is being led by the data when it is obvious that the data is revised on a constant basis. Further, the different members of the FOMC interpret the data in different ways. Is it possible that the Fed just acts on gut instinct? CheckRisk believes this is precisely how they act. If we are correct, then the chance of small December rate rise is almost 100%, as the Fed cannot afford to lose face.

Assuming that Yellen feels she must assert her authority then we can expect a small 0.25% rate rise in December. It is of course not certain, and it is not justified, but human factors are beginning to persuade us that the chance of a December increase is a distinct possibility.

What could possibly go wrong? Firstly there is a massive synchronization risk. The US is completely out of step with the rest of the world. China is easing, and we are likely to see further Yuan devaluations whether the West likes it or not. Japan will increase the QE on steroids program probably in Q1 2016. Mario Draghi at the ECB will allow Janet Yellen to do all the heavy lifting, and if the Fed fails to raise rates, then the ECB will increase QE. Synchronisation risk, if it occurs, can have only one outcome; a stronger USD. Currency risk is, therefore, becoming a primary concern. If you want to kill off the US recovery the best way to do it is to all the USD to appreciate another ten to twenty percent.

Another reason Janet Yellen must move now is that we could well end up with only one or two moves higher from here. That means interest rates in the US could stall again at or around the 1% level. It is quite possible having pushed rates higher that the Fed will have to start dropping them again. QE4, believe it or not, is still a distinct possibility even if rates increase in December.

The scenario, therefore, is for a short term increase in interest rates at the short end of the bond yield curve. Futures markets are already forecasting this. After that, the Fed must either stick or reverse the position, and that is likely to happen in the 2017 to 2020 timeframe. This is another reason we think that three year period is fraught with risk of another crash.

Will Yellen move at the wrong moment in December? A lot depends on what happens in the next few weeks in currency markets and, in particular, the appreciation of the USD. The Chinese, Japanese, and Europeans do not want to see higher rates in the USA, and they can influence the decision. Merely talking the euro, yuan and yen lower would be sufficient to pile the pressure on Yellen.

As a consequence, all things being equal Yellen is likely to raise rates in December, however, if the Chinese and others decide that they want to keep rates low it is entirely possible that they could make it nigh on impossible for the Fed to move. This line of analysis implies that the Fed is not in control of the process anymore. And that is precisely what CheckRisk believes. Central banks globally have abrogated their responsibilities in the face of immense political pressure. Perhaps Draghi alone has proven to be effective. However, he is dealing with the most fragmented and disorganized union of countries.

Our last point on interest rates and the December FOMC is that equity and bond markets have already discounted a small rate rise. We would not expect anything more than a minor wobble if the Fed move this time around. The risk is that a move occurs after resistance from other major nations. In other words that the Fed ignores the strength of the USD.

The normalization of interest rates is not going to happen in the same manner as it has following other recessions and downturns. The more likely scenario is that central bankers get behind the curve and then have to raise rates quicker than expected. Interest rate shock risk will follow at some stage in the future if central bankers continue to pursue the current strategy.

If Yellen raises rates in December but then is forced to reverse in 2016, the credibility of the FOMC and Federal Reserve would be completely shot. As a result while December may be a tough decision, it will be nothing compared to the difficulty of the decisions that will be made in 2016.

Portugal

There are radical political changes afoot in Portugal that the mainstream media appear to be ignoring. Three left of centre parties say that they have now reached a deal to form a government. As a result, the incumbent centre right part of Prime Minister Pedro Passos Coelho looks increasingly unlikely to be able to hold power. The risk to Europe is both in the immediate future and of an existential nature.

The centre-left parties are deeply anti-austerity. They include the socialists, two smaller left of centre parties, and the Communists. If they can form a government next week, then Portugal will be heading the same way as Greece. If a parliamentary vote of confidence takes place on Tuesday of next week, then we would expect the centre-right government to fall.

Portugal’s constitutional crisis is a major issue for the European democratic process. The centre-right gov- ernment, after all, was only sworn into power two weeks ago. That despite being a minority government. The election of a coalition that includes the communists would send tremors through Europe. While Portugal has exited its bailout program, it must meet stringent debt reduction targets set by the EU and deal with a mountain of public and private debt as well as an anaemic economic growth rate. Anyone who thinks that Europe is out of the woods and that the euro is safe as a currency should think again. We are merely in act three of a five-act play.

Portugal has the ability to be far worse than Greece in terms of a thorn in the side of Merkel and the EU; the threat should not be ignored.

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