Jan 8, 2015

Xeo's Annual Investment Review & Outlook 2015

Tower of Bellum
Lisbon, Portugual

Dear Friends,

2014 has been another difficult year to invest. It is a year full of political surprises, central bank heroics and differentiated growth. The range of global indices returns are also pretty dramatic, with the best performer, China A Shares returning 53%, to the Russian market loss of 48%. From the way things are, the China domestic stock market is like one big casino, with little regard to valuations. How is it possible that the same stock trading in the Shanghai Stock Exchange and the Hong Kong Stock Exchange can have a price differentiate of 30%? The reason for the stock market rally is because of possible government intervention due to a rapidly slowing Chinese Economy. There is almost no logical explanation for the rapid rally, other than that the local Chinese have turned their gambling instinct from property, to red wine, to jade, shadow banking trust products to the current IPO craze. This year also saw the dramatic fall of commodity prices with iron ore and oil leading the fall with a 50% damage. These divergence of fate masks a warning sign of a potential end of the recent 5 years bull market.

I started the 2014 warning of possible crashes and had been defensive for the entire year.  I was holding on to a majority in cash and riding out the entire year's volatility until the major correction in October. However, the 4 corrections we had seen in 2014, had been characterized by sharp rebounds, with the market recovering to its previous highs within days, leaving us with scarce pickings due to the lag in our switching timings. Even though the return hasn't been spectacular, the portfolio has done tremendously well in lowering the volatility.

2015 will probably be a year whereby the markets will turn ugly. With China and Europe slowing down and Russia and Greece on the edge of a sovereign financial  crisis, the back of the bull market might finally be broken this year. Any mismanagement by the leaders of these global powers may tip the world into another possible recession.

Having said that, it is still possible to make a profit for 2015, given anything can happen. I will adopt a similar strategy to that of 2014. Take profit sometime in the 1st quarter of 2015, hold on to cash until there is a major correction/crash and we rush back in to take advantage of the correction.

Happy New Year and have a healthy and wondrous 2015!

Yours Sincerely
Xeo Lye

Economic Themes of 2014

Central Banks To The Rescue!
One of the key themes that continued from 2013 was the continued strong intervention from central banks all over the world. The U.S. Central bank managed to unwind the Quantitative Easing program with little impact on the global economy, effectively tightening money supply. Meanwhile, central banks in Europe, Japan and China either slashed interest rates or initiated new rounds of QE programs. The Russian central bank hiked the country's interest rates to 17% in an attempt to halt the slide in Russian  Rubles. As a result of the numerous interventions by central banks, the global financial markets last year were extremely volatile.

Can Super Draghi save Europe?

Europe In Turmoil
One of the most important geopolitical event of 2014 was the Crimean and Ukraine crisis, whereby the global markets trembled due to the confrontation between Russia, America and the European Union. Failing to anticipate the strong political retaliation from the western allies and the rapid fall of its chief export: Oil, Russia was transformed from an economic powerhouse to a country plague by a deepening recession, hyperinflation, high interest rates and a falling Ruble. Investment assets and loans to Russia became toxic asset almost overnight and major stakeholders became worried that Russia may take steps to protect their capital, leading to a new possible financial crisis.

The re-election of the Greek parliament threw a further geopolitical risk into the already chaotic European financial landscape, as it becomes probable again that Greece may exit the EU leading to a possible default on all Greek debts. 

These 2 developments require close monitoring for 2015.

Just as the sight of recovery was about to appear for the European Union, it was snatched away again thanks to a series of geopolitical crisis. 
A handful of protesters gathered outside an emergency meeting of
European Union foreign ministers in Brussels on Monday to protest
against Russian troops in Ukraine. (Yves Herman / Reuters)

Reforms Across Asia
Thanks to the slow down in America, Europe and China, the traditionally export oriented economies in Asia have to look for a new avenue of growth, mainly by stimulating their country's domestic consumption market. The election of new leaders in India and Indonesia have spurred hopes of possible reforms driving their stock markets up on the back of these positivity. The verdict whether these leaders can really push through their reforms in the chaotic bureaucracy of the world's second and third most populous nation in the world is still remains to be seen, with the Indian government managing to make some progress. The Japanese government has also been trying to jump-start their stagnant economy by artificially stimulating inflation and changing the deeply rooted workplace culture.

Reforms in China have also been gathering steam as the Chinese government prepares the country for the slower growth rates in years to come. They are walking on a tight rope now, trying to selectively stimulate parts of the economy without adding on to the ballooning local debt market or crashing the property market. However, any miscalculation will lead to the Chinese economy into a deep slump.

The Singapore government is also trying to reform the economy and to divert the resources from the bubbly banking and property industry towards technology and innovation. The effort so far has yielded some success as the startup scene in Singapore is becoming much more vibrant as compared to 5 years ago. 

With governments around Asia trying to prepare their economy for the next leg of the economic race, the fate of many Asian nations will depend on the will of the governments and the result of their reforms. Whoever that is successful will dictate the balance of power of Asia for the next decade.
Sensational headlines on the front pages of many Chinese newspapers on July 30
reported the Communist Party of China Central Committee's decision to build a case
against former security chief Zhou Yongkang for alleged graft.

The Collapse of Oil and Commodity Prices

One of the most important development in 2014 is the fall of oil prices from $107 to $50, a 53% fall in prices. Other industrial commodities such as iron ore also fell by 50%. Base on the sharp fall in not only in energy prices, but also in industrial metals, there can be a few plausible outcome.

1) The drivers of the commodity rush during 2003-2007 cycle ccame primarily from India and China. It is a common understanding that data coming from these countries are often "managed" but consumption of imported commodities cannot be masked. The sharp fall in commodity prices may indicate that the situation in China and India may be much worse than indicated on their official data, which is definitely an are of concern for any international investor.

2) There is an over investment in commodity based industries leading to an over supply of oil and industrial metals. Canada, US, Australia, Russia, Malaysia, Brazil and Indonesia are some of the leading players in the oil and mining industry. Oil and mining projects typically have high barriers to entry and requir loans and financing for the projects. As uncompetitive oil and mining companies get shut down, the organization which finance these projects will be the first to be impacted and it remains to be seen if this will lead to a contagion effect similar to that of the collapse of real estate debt in 2007.

3) The sharp fall in oil and ore prices will be a boon to commodity import countries over the long term. EU, India, China, Japan, Korea will be positively affected over the long term. The greatest beneficiary is probably EU. For India and China, the positive impact may remain to be seen, since they are also one of the chief financiers to many of the oil and mining developments around the world. The chain of defaults that may occur may potentially trigger off a chain effect in their debt market, offsetting any savings incurred by the fall in the prices.

In summary, many of the themes and problems which originated from 2014 will remain as a strong influence to the market direction in 2015. The number of risks have also expanded tremendously. Last year, I was only worried about a potential collapse of the Chinese property and debt market. This year, I am worried about The Chinese property market, India debt, Russian debt, Greece & EU debt, oil and mining companies debt. Each of them can potentially trigger off the next crisis. 

Review of 2014 Strategy

The Strategy of 2014 was pretty simple: Take profit from the decent returns we generated from 2013 and hold on to USD until there is a meaningful correction for us to take advantage of. The portfolio made 4 switches during 2014. Let me grade each of the transaction whether they are Gold, Neutral or Dud as what I had done for the past years. We started the year with 100% allocation into equity, with the portfolio weighing heavily on the US market.

February 2014: Took profit and moved 70% of portfolio to USD Money Market and Global Short Duration Bond Fund

At the start of 2014, I was pretty skittish after a fantastic rally in the US and European markets. The valuation was a bit on the high side and I was on a look-out for any potential 10% correction. During January, the market started to correct by 2% and I was worried that this could be the start of a major correct. I readjusted the portfolio and moved most of the assets into safe haven Money Market Funds. The market recovered quickly after that without realizing a more meaningful correction. I took profit too early and missed out on the slow 3% rally from March till October. On Hindsight, I should have moved out later. However, when I asked myself this question: "Is protecting the client's capital in the potentially risky climate of 2014 worth the sacrifice of 3% profit?"  I will say "Yes".  
Verdict: Neutral

August 2014: Moved 10% of cash into Europe Equities

The European markets corrected sharply as the result of the tension between Russia and the Western Allies over the Ukraine incidents. That position has been profitable when the European markets rallied later but the profits got wiped out thanks to the recent Greek political situation. No Win - No Loss.

October 2014: Moved 30% of cash into US and Europe Equities

The October correction took most of the markets down by 7-10%. We moved in right on the bottom. However, due to the speedy recovery of the markets, we did not manage to catch the entire 7% rally back to the previous levels. We only managed to clock in 4-5% of that recovery. Nevertheless, that was something beyond our control and that's when we made most of the profits for 2014.
Verdict: Gold

November 2014: Moved 30% of cash into US Mid/Small Capitalization stock

I decided to commit the rest of the portfolio into US Mid/Small Capitalization stock as I realize that the momentum from the October rally was going to carry the market way above the previous levels. I moved the rest of the cash into work one week after I did the October switch. That was when we made another 2-3% from that position.
Verdict: Gold

Final Verdict: 2 Gold, 2 Neutral

My strategy to hold on to cash until the October correction took place was in my opinion, a pretty sound strategy. Although the timing had been slightly off and we could have generated more returns by taking profits later in March or April, I did not regret making the call as my priority for capital preservation over rode the need for a small capital gain.

The Outlook & Strategy for 2015

I am extremely cautious about the global financial markets in 2015. There are many more variables which will derail the 6 year old bull market as compared to the end of 2013. Let me tick them off:

- Falling energy and commodity prices leading to potential bankruptcies and bond defaults in energy and mining companies around the world.

- Low oil prices might lead to capital control measures in Russia.

- A potential Greek exit from the European Union.

- US Federal Reserves raising interest rates leading to a rise in USD and the pressure on US debts borrowed by foreign corporations will rise.

- The US rates rise will also lead to pressures on the overinflated property markets in Asia.

- Possible mismanagement of  China's reform process, leading to a collapse in Chinese property and debt markets.

- Strong intervention by European Central Bank leading to volatility in the currency markets.

Having said that, with great risks, comes great opportunities. We will have to be holding on to a nice cash horde in order to take advantage of all these opportunities. I will be looking at moving a big chunk of the portfolio into cash sometime in the near term in order to preserve our hard earned profits from 2014 and take an opportunistic stance to buy into any major market corrections as they come along.

With so much blood on the resource market, there bound to be plenty of bargains on the street once the bloodshed is over. The strengthening US economy and USD will continue to be the mainstay of the portfolio strategy as any global crisis triggered by any of the risks above will probably affect US the least. A major money printing exercise will also invigorate the European Markets, leading to a potential rally like what we see in the Japanese stock market. On the Asia front, I will continue to avoid allocating any large percentage into the portfolio and prefer to observe how the rate rise in US will affect the property markets in Asia.

2015 will be a hell of a ride for the global financial markets! Let us enjoy the ride!

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