On the Impact of Tapering on Global Risky Assets, Fibre Intake and Risk of Colon Cancer!

From: Aditya Rana
Date: Sat, Mar 15, 2014 at 12:58 PM
Subject: On the Impact of Tapering on Global Risky Assets, Fibre Intake and Risk of Colon Cancer!

Hi!,

Fears of the Fed’s continued tapering abound in global markets, with markets selling-off on any news which point towards an acceleration of the tapering process, that being a prelude to eventual tightening of Fed policy. It is therefore helpful to look more closely at the impact of rising U.S Treasury yields on various risk assets. Jason Hsu, CIO of Research Affiliates, a research oriented financial advisory and asset management firm which is one of the pioneers of "Fundamental Indexing" and has $166BN in global assets under management based on their strategies, sheds some light on this important topic (http://www.researchaffiliates.com/). To summarise:

-Historically, pro-cyclical assets such as equities, real estate, high yield and emerging market bonds have exhibited a negative correlation with Treasury bonds (i.e. when prices of Treasury bonds move down the prices of these assets move higher-see table below) as rising rates suggest faster economic growth, higher ROIs and a greater demand for investment capital. These factors, in turn, drive better corporate earnings, improving household and corporate balance sheets and growth in export oriented EM economies.

-Monetary intervention through QE artificially lowers nominal interest rates to subsidize government and mortgage financing (i.e. "financial repression" against savers). However, this makes returns on risky assets positively correlated with returns on Treasury bonds (i.e. risky assets now have positive duration).

-Following the Global Financial Crisis, short-term interest rates have been near zero implying negative real yields, thereby forcing financially repressed savers into riskier assets with positive real yield. Investors are also subsidized (through near zero rates) to lever up risky assets and the "carry trade" has flourished. Given the prolonged period of near zero rates, vast amounts of speculative funds have gone into global risky assets, bidding-up their prices in varying degrees (see table below) and exposing them to the risk of future rate increases.

-When U.S. rates begin to normalise, some of these carry trades will begin to be unwound as the return on risky assets become relatively less attractive. This dynamic has already been in force since tapering was announced (see table below) and high yielding stocks which have enjoyed significant outperformance in recent years (due to their income flows) appear to be most at risk.

-However, prices are ultimately based on fundamentals, as Ben Graham’s analogy so aptly illsutrates: "the market is ultimately a weighing machine in spite of its more transient role as a voting machine". Investors who keep an eye on long-term fundamental valuations, and are able to buy (on the market sell-offs) pro-cyclical assets which will benefit from a recovery in the global economy will outperform over time.

-In particular, EM equities appear to be the most attractively prices asset class and trade at a CAPE (Shiller cyclically adjusted PE) of 13.4x versus a 23.6x for the U.S. (see chart below). EM sovereign bonds also offer an attractive spread over developed sovereign bonds of 3%, and are backed by stronger balance sheets and surpluses. High yield bonds at a spread of 5% should also benefit from reflation and higher growth.

-Price declines driven by liquidity flows should be seen as buying opportunities. With the unwind of the carry trade and liquidity flows, the negative correlation of risky assets to Treasuries and the benefits of a globally diversified portfolio should return.

A simple and insightful piece which supports the case for buying into the turmoil which global assets are likely to experience when the Fed’s tapering ends and they signal a potential rate increase. The likely timing for this is the second-half of this year with perhaps a Yellen-led Fed delaying it to year-end to allow for further evidence of sustainable growth. An appropriate strategy in this environment would be to lighten up as markets continue to rally into the summer/autumn period and keep cash ready to buy as and when the price declines occur.

Jason Hsu also writes that it is reassuring to note that the 2013 Nobel Laureates – Robert Shiller and Eugen Fama, while at opposite ends of the market efficiency debate, both agree (and have independently demonstrated) that market valuation ratios (dividend yields and CAPEs) tend to forecast five-year returns with satisfactory accuracy – i.e. high dividend yields and low CAPEs tend to predict above-average market returns and vice-versa low dividend yields and high CAPEs signal below-average returns.

However, this approach requires patience and a longer term perspective (i.e. 5-7 yrs) and annual returns can diverge significantly from valuations based expected returns. For example, at the start of 2013 the U.S. stock market had a CAPE of 25 (against a recent trend of 22 and long-term average of 16.5) while EM equities had a CAPE of 15 (against a recent trend of 20.5 and a long-term average of 16). Despite this valuation gap, U.S. equities were up by almost 30% while EM equities were down 1%. This valuation and return gap is likely to converge in the years ahead.

2013 was also not a great year for diversification, where excluding developed market equities almost all assets had negative returns (as shown in the table below). This discrepancy is also unlikely to be repeated in the years ahead.

In terms of relative country valuations, as the charts below from JPM illustrate: For DMs the U.S. and Japan seem overvalued while France and Germany still seem undervalued.

-While for EMs, India and Mexico seem relatively overvalued while Russia, China and Brazil seem undervalued.

-And, if you do not buy the EM story please peruse the following charts (also from JPM) comparing long-term trends in urbanisation and economic growth, share of global consumption and investment and growth of corporate earnings for EMs versus DMs.

Fibre and Colon cancer:

I have written previously about the importance of fibre in a daily diet and that modern diets are woefully short of fibre. Fibre is present in whole grains, fruits, legumes, nuts and vegetables and is not present in meat. A new study analysing 20 previous studies on this subject (meta analysis) support the link between fibre intake and colon cancer:

PRCM (Physicians Committee for Responsible Medicine) March 14, 2014

-High-fibre diets help reduce your risk of colorectal cancer, according to a review published this month in the Gastroenterology. http://www.ncbi.nlm.nih.gov/pubmed/24216326

-Researchers identified 20 studies which analyzed fiber intake and risk of colorectal polyps, precursors to colorectal cancer. Those who consumed the most fiber had a 28 percent lower likelihood of developing colon polyps, compared with those who consumed the least fibre.

-Additionally, every 10 grams of dietary fibre (i.e. one bowl of cereal) cut the likelihood of having a polyp by 9 percent. This review stresses the importance of knowing risk factors for cancer and the best practices for prevention.

And to graphically illustrate the strong relationship between cancer and modern diets please see the chart below from the Economist which shows the incidence of cancer declining from developed world countries to the developing world by more than a third.

Here’s to incorporating even more whole grains, vegetables, fruits, legumes and nuts in your diet – at the expense of meat, fish and dairy – the supporting evidence continues to accumulate!

Regards,

Aditya

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