Watling: Zombies, Canaries and Cheap Money

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In January, market commentary was almost universally bullish. Ray Dalio, the billionaire US Hedge Fund Manager told the audience at the World Economic Forum in Davos that those holding cash were “going to feel pretty stupid.” One of the few voices urging caution was that of Chris Watling, CEO and Chief Market Strategist at Longview Economics.

A week before Dalio’s comments at Davos, Watling had sent a note to his institutional clients suggesting that they reduce bullish equities positions as the models were now strongly indicating a pullback or consolidation was imminent.

“Given how clear, strong and across the board the signals from the models are, though, it’s also important to respect them and remove overweight tactical positions. Market chatter, as is often the case when our models are on sell, is demonstrably bullish – with much discussion of a ‘melt-up’ phase. This, of course, is often the case when markets are ready to pause/give back some of their gains.” – Chris Watling, 17 January 2018

In Livewire's first CIO Profile of 2018, Watling discusses the issue of ‘zombie companies’ around the world, and the four ‘canaries in the coal mine’ that will warn of the next global recession (hint: one of them is very close to home for Australian investors).

One immediate lesson is, when everyone calls it healthy, it's clearly not finished. You need a bit of fear in there.

Topics discussed:

  • The best places to be investing in the current market
  • Can the resilient Australian Dollar continue to hold its head above water?
  • The four countries that are likely to 'roll over' first to signal the end of the current global expansion
  • ‘Zombie companies’ account for around 10-12% of listed companies in most developed countries. These companies produce insufficient cashflows to pay the interest on their existing debt
  • The $2.4T of new consumer debt issued in China over the last three years
  • Which indicators are effective for understanding the mood of the markets
  • Why short-term rates will rise faster than long-term rates, and why it matters
  • Areas to avoid at this stage of the cycle
  • Lessons from the recent correction

Edited transcript

What prompted your view, set out in your note on the 17th of January, that it was time to move away from equities towards a more cautious stance?

I have a rough roadmap that that every two years within a bull market, you should expect a correction. It’s a rule of thumb, it’s not precise. But as we went through 2017, everything was absolutely wonderful. We barely had any cracks in the market. It was actually pretty uninteresting if one's honest, but great for making money.

Then you get into 2018 and the narrative starts to change. We had all the great investors coming out and talking about the ‘melt-up.’ Jeremy Grantham and Bill Miller. My favourite was Ray Dalio in Davos, telling people they'd feel stupid if they held any cash. That was probably a few days before the top. Not that I don't think he's a great investor, of course he is, but it was a great line.

Then there were our models. Our models measure excessive periods of risk appetite. People always tell you what a sell off was about after the event. Nothing's perfect, but you can still have some good insights before the event by looking for excessive periods of risk appetite.

You typically get the over-excited ‘melt-up’ narrative at the same time you get our models saying, "People are all in, they've overdone it in their enthusiasm for equities." So, we need to washout of positioning. That’s what we're seeing at the moment.

You can have good insights before the event by looking for excessive periods of risk appetite.

You touched on a few of the quotes where people were talking markets up. What were some of the market indicators where you could see that over exuberance? What's some things that people could look at and see in markets?

Well, you have to be careful, because there are a lot of indicators out there you shouldn't look at, that people do look at. Things like sentiment indicators. Sentiment is a terrific way of gauging the ‘sort-of-mood’ of the market. Sentiment can be bullish for long periods of time before you get a selloff. Technical indicators can be over bought for long periods of time before you get a selloff.

We designed our proprietary models that look at risk appetite daily. Across the globe, across three different timezones, across all asset classes, we measure the market's actual appetite for risk every day. That tells us when people are overdoing it. They're buying high risk and selling low risk, and you can see it in the models over sustained periods of time. You've got to have the right kinds of models, but if you have them, you get the right message.

Let's move it forward to where we are today. Was there anything to learn or anything to take out of the washout that we had? Now you've had some time to reflect on it, is there anything more sinister than a bit of a correction and a ‘healthy pullback’ as people have been quoting?

One immediate lesson is when everyone calls it healthy, it's clearly not finished. You need a bit of fear in there to feel you've got proper risk aversion in market prices. I think selloffs sometimes do have some macro factors associated with them.

I wonder, and I wouldn't want to be more precise and more dramatic than that, but I wonder if we're starting this proper withdrawal of liquidity environment, and we see a very different world over the next year or two. This is not our central case, but what worries me is maybe we have seen a top in this bull market, and I think that's something we have to watch for very closely.

Maybe we have seen a top in this bull market

One of the big risks that I keep hearing people talk about as the one to watch is global growth picking up. Interest rates are on the move, central banks are going to be hiking, bond yields are going to be going up. Is that central to your outlook at the moment as well?

Well, part of that is central; central banks are clearly hiking rates. However, when it comes to the idea that the 10-year bond yield is going up forever, I’m not so convinced.

Let's not forget the major themes that we were all talking about a couple years ago. We were in a world that's got more debt, more debt to GDP, more zombies, and a broken economic model. That's not a world where I see 10-year bond yields going that much above three percent.

But I think short rates will go up because central banks want to move them up. They see wage inflation coming, a little bit of cyclical consumer price inflation, so they're responding to that. That is an environment where the yield curve flattens, and then begins to invert. So, I think bonds are looking reasonably interesting here.

Zombie companies are companies that can't afford their own interest payment.

You mentioned the word zombies. What are zombies?

Zombie companies are companies that can't afford their own interest payment. We did a study of zombies across 18 countries last year. In 17 of those countries, about 10 or 12% of their listed corporate base are zombies. They can't cover their own interest payments.

That's the definition of a zombie, is a company that doesn't make enough money to cover its debt?

Exactly, and it's been around for 10 years. We’re not talking about start-ups, we're getting rid of those. This is not banks and financials. This is just plain vanilla companies, can't fund their own interest payments out of their earnings.

Why is that an important group of companies to be focused on?

Well, what that's telling you is there's a weakened corporate base across the Western world that won't respond well to higher interest rates. It's another reason I think yields can't go that high.

Today, there are about 10-12% of the corporate base. If we go back 15 years, before we went into ‘mad cheap money forever’, it was one or two percent. That’s a very big increase.

People talk about productivity, why is productivity so weak? Well, if 12% of your corporate base is barely alive, they're not investing, and they're undermining the natural creative destruction process.

If 12% of your corporate base is barely alive, they're not investing, and they're undermining the natural creative destruction process.

We talked about 10-year bonds, you don't think they can go much higher. At the short end you think they will start to rise. Can you explain what that dynamic means and why it's interesting?

It's really important, because the short end is basically controlled by the central banks. So, one-year bond yields, two-year bond yields, it's basically telling you about what the market expects the central banks to do. It's the central banks' reaction function, how they behave will govern the movement of that.

The 10-year bond yield is determined by the market’s view of the strength of the Western economies, the world economy, and how they'll respond to those interest rate hikes. The two aren't necessarily moving in the same direction all the time. This goes back to Greenspan's bond yield conundrum, back in 2004. You may remember, Bernanke had a savings glut thesis.

My point is, we see the markets tightening, wage inflation trending up, a bit of consumer price inflation coming back into the system. People use that to talk about the 10-year yield rising, but I think that's wrong. It's more important to talk about the way the central banks react, that means they raise rates. So, the 10-year, I think, will come off.

What you’re talking about then is probably one of the best indicators of recession; the inversion of the yield curve. This is when 10-year yields are below two-year yields. At the moment in the US, the difference is about 50-60 basis points, with the 10-year above the two-year. If I'm right, and the 10-year doesn’t go up much more, and we get a few hikes, we'll get that inversion. Maybe later this year, maybe early '19, mid '19, something like that.

That's generally considered about a one-year lead-in indicator to a recession, is that correct?

Yeah. Six months, 12 months, maybe a little bit longer. It gives you a good heads up that a recession is coming. It's been a really good indicator since we've been in the Bretton Woods system in the early 1970s.

Your view seems at odds with the story that we're hearing about the strength of the global synchronised growth right now, corporates doing really well. How do you explain that?

I think that comes back to what I was saying earlier, that the structural drivers rather than the cyclical. That's all the cyclical story.

The actual structure of the world economy is not better than it was 10 years ago. I would argue it's worse. Asset prices are elevated on cheap money. There are all these zombie companies that aren't operating properly. Productivity growth is under pressure. All these structural weaknesses.

You look at the US household savings rate. It tends to be around 5, 6, 7%. It's now down at 2% and change, the lowest it's been in about 40 years. That tells you about the way we've grown economies. More debt, more borrowing, tapping into savings. It's not structurally good, it's structurally poor. That's why I think the 10-year bond yield is probably pegged to around 3%.

The US household savings rate is the lowest it's been in about 40 years.

A lot of this focus here is around the consumer? Is that the weak link in this current cycle?

It's the consumer, it's the zombie companies, and of course the governments are largely trying to entrench. Although, Trump's swinging the other way at the moment. I think the corporate base has weakened, and households are heavily indebted. In some parts of the world, they deleveraged a little bit, and then they're re-leveraging again. There's been no dramatic deleveraging in any major economies. We've had it in Iceland and the Baltic States, and places like Ireland perhaps, but not in any significant economies have they deleveraged, they might have flatlined at best.

Talking of debt, I was just looking at how much US government debt is on the table. 10 years ago, they had six trillion US dollars of government debt in The States. They've now got about 17-18 trillion. In 10 years, they've almost tripled their own debt and off we go with some fiscal stimulus at the same time.

In 10 years, they've almost tripled their own debt and off we go with some fiscal stimulus at the same time.

The backdrop doesn't sound that pretty, but you do need to have a view on how to invest through this part of the cycle. Can you give me your baseline view on places to avoid and the sorts of assets that you're looking at against this backdrop? Maybe put an Australian lens on if you could.

Let me start with the equities versus bonds question, because really 80% of returns are getting that balance right. Then you add little bits by going further down the chain. The first, most important question investors have to think about is, "Are we in a cyclical bull market or not?" We touched on it a bit earlier.

Bull markets are about cheap money, US economy and global economy expanding in an absence of shocks. Money is still cheap. They're starting to withdraw it, but it's still cheap. Our liquidity indicator is suggesting the liquidity is as plentiful as it can get. Money's cheap, the US economy's expanding, it's got a new fiscal stimulus in there, so it's all good. Of course, there are shock risks, there always are, but there's none that are obvious on the counter at the moment, other than the fact we're in a bit of a shock selloff at the moment.

So, I'd be overweight equities, point one. Then, from an Australian point of view, the question is do you want a bias to Aussie equities, or you want a bias to overseas? For me, that's really a question about the currency, and about the Australian economy.

Timing Australia is about timing that Chinese consumer credit boom.

Let's talk about that. Let's maybe start with the currency, because the Australian dollar has been, it's been pretty resilient.

It's been resilient for a couple of years, that's right. Of course, the currency in Australia and the Australian economy is deeply linked. I was pretty bearish two years ago on the Aussie economy. It's deeply linked to the way China behaves as China drives a lot of commodity prices. If you look at Australia today, I don't think many people would disagree, but it's not quality, exciting growth. It seems to have somewhat limped through in the last couple of years.

Sydney and I think Melbourne house prices, have had another good run for a couple of years, and that seems to be topping out. Household cash flow in Australia doesn't look good. We have a model for that and that doesn't seem to look too impressive. The iron ore prices helped, other commodity prices help. The question is, what's really behind those? The answer is China, on a massive fiscal and monetary stimulus from late '15, early '16, that ran all the way through to mid '17 and is now rolling off.

You've got to ask yourself, why is Chinese growth so strong? That's really the Australian question. The answer is that we've flipped into another credit boom on a different balance sheet in China. Timing Australia is about timing that Chinese consumer credit boom, in my opinion.

There's been lots of doubters about the ability for China to maintain the head of steam that it has, and it seems to have defied your claims. When you have your views, do you think about why you could be wrong on some of this stuff?

Yeah, sure. No one's right all the time. We all make mistakes. We're human. The future is difficult to predict. I think where we went wrong on China a couple of years ago was we weren't completely up to speed on the way they were flipping onto a different balance sheet. The Chinese old economy's just now is flatlining, there's not a lot going on there.

Look at imports of iron ore or cement production. In the last couple of months, they're contracting. That part of the economy is slowing. Consumer credit has grown by 2.4 trillion dollars in three years. There's a big debate about what they’re using it for. 2.4 trillion dollars of consumer credit, which is arguably spending power, is equivalent to 20% of Chinese GDP.

UK consumer credit is about 18% of GDP. We've been growing that for 20 years. They did this in three years. This is like South Korea in the late 1990's. Now, I know a lot of consumer credit goes into mortgage borrowing, it's a bit unclear exactly where it goes. Even if you take a third of that number, a third of 20% of GDP over three years is two percentage points of growth per annum. So, instead of six and a half or seven percent growth, it's really four and a half or five percent. There's a big difference.

That's cheap money. So, it depends how the policymakers play out. The bulls will say everything's under control. The Communist Party is pulling the levers. But that's the risk.

It’s well discussed that Eurozone high yield corporate debt yield's roughly 2.8%, the same as US Treasuries. This is supposed to be junk. We forgot it's called junk.

So, to bottle it up, what's your base case for Australia at the moment? If you were to touch on things like the currency and then outlook for equity markets, and you might even want to roll into that what the RBA might be doing.

I think global equities will be higher over the course of this year, and Australia will go with it. It's been underperforming for a couple of years, but I think that'll change.

In terms of the currency, the market's very bullish now. Positioning is quite high in the Aussie dollar. People have changed their view on that, so I think you want to lean against the wind there.

The Chinese economy's rolling over, and I think the Aussie dollar will go with it. The RBA seem to want to be on hold for a while. I think global rates are going up, and Australia might try and chase it a bit, but I don't think the economy can really take it.

I still think Aussie rates are going to zero.

Still a chance?

Yeah. They'll probably go up before they go down, but I think the point is, the debt here is so high. The house prices are high, it's an expensive economy. It's been living on borrowed time from Chinese commodity demand. It's an awful long expansion, all these things are very well known, but I think that level of indebtedness is a problem.

People love to worry. What are some of the things that asset classes and parts of the market where you think investors would do well to tread very carefully?

The first thing you want to tread carefully on is high yield corporate debt. It’s well discussed that Eurozone high yield corporate debt yield's roughly 2.8%, the same as US Treasuries. This is supposed to be junk. We forgot it's called junk.

Of course, that relates to the ECB quantitative easing programmes. US high yield isn't much better, so be careful there.

I think equities can do well, but one has to be slightly careful about valuations. If we're moving into a phase where the US dollar starts to rally, emerging markets maybe have had the best of their times, and maybe we should be a little bit more cautious there.

We have these canaries in the coalmines. Four key economies of the world I think will start to struggle first, in response to global tightening. Australia, the UK, Canada, and China.

When it gets down to the crunch, while you're here in Australia, visiting the investors that you speak to, what's going to be the message? What's going to be the Longview strategy that they hear?

The Longview strategy is there's probably a little bit more to go in this cycle, but we're clearly well advanced, and the liquidity issues are really starting to be a little bit troubling. We have these canaries in the coalmines. Four key economies of the world I think will start to struggle first, in response to global tightening. Australia, the UK, Canada, and China. There's a couple of emerging markets in there, as well.

Going back to those three factors that drive bear markets and shock risks, I think these canaries in the coalmine are things to watch.

When I look at the UK, the UK housing market looks like it might be rolling over, which is a key thing that takes us into an economic slowdown and recession. The world's built on an edifice of cheap money, and we're trying to remove it, so it's pretty troubling times.


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Ron Patrick

Engaging and wide ranging. Quality guest. Very educational. Watched it twice and with probably watch it again. Kudos to James also. Great interviewing! Followed the interesting leads seamlessly.

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Scott Turton

Some fantastic insights - great interview!

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