Awash with money
Is there still a size premium in the BIST, as financial capital remains abundant
In recent years, the world has been awash with money more than ever. After 2001 and even after 2004, when the U.S. Federal Reserve had finally increased the funds rate, dollars were abundant everywhere.
Already in 2010, global capital had swollen to some $600 trillion, tripling over the past two decades. In 2013 total financial assets were nearly 10 times the value of the global output of all goods and services, and that multiple still stands.
Even as the world economy recovers, financial assets are projected to increase to $900 trillion by 2020. Chinese gross domestic product growth is slowing slightly, as expected, and its economy presents risks that span from the banking sector to real estate. Still, primarily on the back of the development of financial sectors in India, China and other emerging markets’ financialization and capital expansion might continue.
The abnormally large growth of the financial sector at the expense of the real sector has accounted for an increasing share of world economic growth for years. Yes, this is also growth, as observers of the Turkish economy have been fully aware of recently. When liquidity is cheap and abundant, even short-lived credit cycles suffice to generate growth for some quarters, and that adds impetus to the normal trend.
The shift began with the end of the Bretton Woods system in the early 1970s – the rules governing trade relations between the United States, Canada, Western Europe, Australia and Japan – and has accelerated since the 1980s with the advent of financial engineering, computing power and regulatory changes that reinvigorated it. The steady, decades-long build-up of financial capital may have masked the fact that real economic growth was slowing even before the global financial crisis of 2008.
Financial capital is still superabundant. The habit grew upon both the banking and shadow banking industries probably not from some foolish freak, but from very rational a basis after the 1973 oil crisis. However, the practice proved easier to attain than to get rid of. Financial assets are in a prime position to thrive and have constant new sources of fuel. As we speak, risk appetite for emerging market assets looks very solid. Will the advent of the Federal Reserve and a possible follow-up by the European Central Bank in shrinking the balance sheet be powerful enough to curtail that development?
As we see from the graphs, the Dow displayed a very clear trend in the last five years, and it rose from 13,730 to 21,173 since June 12, 2012. This is a cumulative 52 percent increase, implying a compound annual growth rate (CAGR) of 9.05 percent. That is a good return given that the Federal Reserve rate was barely 25 basis points on average throughout this period. If we look at the entire period after Black Monday in 1987, we see that the CAGR for 30 years that elapsed since than is 4.79 percent, still good but does not compare to past years.
f we consider the peak in October 2007, which stands at 16,299, the CAGR is 5.87 percent, and at the through of March 2009 it reads only as 2.05 percent. After March 2009, the Dow went up by 12.70 percent per annum depicting an almost uninterrupted rally.
Emerging markets are necessarily attractive in this environment. Not only the world is still liquid and the hunt for yield is on, but also emerging market stocks are like “in the money put” since their current market prices are below their strikes in a sense.
People grasped that as we entered 2017, first as Chinese banks and China’s real estate sector have staged a striking turnaround from a lengthy downturn and secondly, as the MSCI discount for both price-to-earnings and price-to-book ratios was around 30 percent. Not only the Dow and others had performed very well over the years, but also the emerging market discounts relative to them had rendered emerging market stocks quite attractive. One ought to add also that returns on earnings are rather similar for developed and emerging market companies. Especially attractive are small-capitalization stocks in Asia. Information technology has also attracted attention everywhere.
Therein lies a bright future although many a prudent investment house would prefer to remain on the sidelines with Chinese internet stocks and suchlike as well as Chinese real estate stocks on account of their overleveraging. Still, with similar return on equities and deep discounts nobody could have remained neutral for long.
The Federal Reserve, President Donald Trump and political risks are all there on the table, but liquidity and the hunt for yield are much more important and will definite-
ly weigh heavier in decision-making. Risk-loving investors and all alpha-chasers will to take a long view and not be swayed by short-term gyrations that we could continue to see in financial markets. The possibility of volatility is one thing, the presence of strong momentum another. Add to this the juicy dividend yield for the MSCI Emerging Markets Index, which was c. 2.5 percent by the end of last year, and you might concur with the idea that appetite for emerging market stocks will endure.
Turkey’s stock market lived up to its promise in the first half of 2017. The graph is manifest, pointing to a political through in mid-2016. It is based on valuations, but also on money being abundant. Both arguments still hold although a pause is likely, but why? Regarding the “heterogeneity story” (bears vs. bulls etc.), it was found that large-cap and low book-to-market stocks experience negative skewedness more heavily. The turnover relative to previous trend could be a leading indicator of downward volatility on a stock/firm basis in the Borsa Istanbul 100 too. High past returns, both on the aggregate and at the firm level, may also be an indicator of future negative skewedness.
In the near future, we will consecrate a full scale and rather longer than usual analysis to the following questions. Is there still a size premium in the Istanbul Stock Exchange? How important is (was) the book-to-market effect? Do players base their decisions mainly on the recent price/return information? Are there discernible historical path-dependent strategies and do players get locked-up in their positions as a result of such path-dependence? Do strategic players tilt their positions systematically towards, say, value stocks, small stocks, and growth stocks? Should we always hold, say, some glamour stocks – stocks with low book-to-market ratios – in our portfolios? Are alphas and betas sufficient or, in a much weaker sense, necessary statistics, so a variant of the capital asset pricing model is approximately valid? Is this market efficient in some sense? How do the ISE-100 and the ISE-30, or any constructible portfolio from therein, compare to other developed or emerging stock exchanges? Is the Istanbul Stock Exchange extremely volatile in comparison with other markets? Have professional analysts ever constructed portfolios, sorting assets sequentially according to some criteria, and observed their performance in order to base their forecasts on such exercises? What role and weight to assign to discounted cashflow-based fundamental analysis and to technical analysis-like extrapolation methods? Finally, is a “top-to-bottom” research strategy acceptable as the null hypothesis or should our default be “bottom up?”
I am also astonished to read analysts pointing to a (slowly) rising current account deficit. I offer this in return: Any approach that fails to take into account capital gains and losses on the net foreign asset po- sition, i.e., valuation effects, would necessarily be misleading in a world of instantaneous financial capital flows. The currently huge gross cross-holdings of foreign assets and liabilities make sure that asset price movements largely affect highly leveraged country portfolios.
Transfer of wealth
What this implies should be obvious. There is room for large wealth transfers across countries that alter asset price dynamics. The balance of payments reports the current account at a historical cost, and the same consideration applies to the national income accounts. For countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies – China and Japan are good cases in point – it is imperative to take into account valuation effects. Furthermore, the standard intertemporal approach not only overlooks the financial adjustment channel and focuses solely on the traditional trade adjustment channel, it also by the same token downplays the role of risky investments and that of adjustment costs.
Isn’t it obvious? First, it all depends on relative valuation and the implicit asset arbitrage that provide room for wealth transfers across countries. Second, one should also look at the demand for corporate loans under the guarantee mechanism from this viewpoint and should not abstain from considering the role transfer pricing plays in all this.
Enter fixed income. Risks in Mexico and Turkey were largely priced in in the last quarter of 2016. Hence, the emerging market fixed income looked attractive, and any dollar weakness carried a high likelihood of greater returns. Countries with a current account surplus offered the brightest prospects, and Turkey did not stand alone obviously in any respect, but still did fine.
Brazil, Indonesia, Columbia and Argentina were singled out as potential benefactors more than once year-to-date. We have emphasized more than once that Turkish fixed income could perform provided that the Central Bank of Turkey does not vacillate and ease its stance earlier than warranted. Thus far, we did not prove wrong. After all, the emerging market bond has produced a 29 percent cumulative return in the last five years, showcasing around a 5 percent CAGR, of which nearly 3 percent came from yields.
So, emerging market stocks posted around 9 percent and bonds 5 percent over that span, and this is perfectly in line with the equity premium. Both did well, and they will continue to do well unless money dries out all of a sudden. Because addiction is persistent, and because markets are, among other things, “rational herds”, I predict it will. Any correction is only for the better provided that trend goes on for a while, and in this case a while means at last 2017. Troughs and peaks are only relative, and they do not correspond to those of a large business cycle.
Chief Economist Gunduz FINDIKCIOGLU