Blog : Cutting Through the Noise

Don’t Fear the Flats…

Don’t Fear the Flats…

Is a Recession Looming Ahead? Risks and Opportunities of a Flat Yield Curve

  • Is the treasury bond yield curve sending a dangerous signal about the economy?
  • How have stocks historically performed in similar bond market environments?
  • Can the Fed balance growth, inflation and maintain its independence?
  • Should you refinance your mortgage in the present interest rate environment?

Two key issues currently facing the markets are tariffs, and the shape of the treasury bond interest rate curve.  We tackled tariffs and trade last month and dig into the yield curve messaging this month.  

The “yield curve” refers to the difference between the rate of the 10 year treasury minus the 2 year treasury rate.   The yield curve is an important economic indicator.  Why? Because, historically speaking, when the curve inverts to slope downward, (the short-term treasury rate rises above the longer-term rate) a recession is on the horizon.  

This important interest rate indicator bears watching because stocks appear to be fully priced.  Also, the biggest risk that would lead to a decline in stock prices is IF interest rates rise unexpectedly, or we have a recession that hurts earnings growth.  As such, now that the yield curve is nearing flat, a number of prognosticators are beating the doomsday recession drum.

I don’t know about you, but I am moderate skier (on the decline) and have most of my worst falls on the proverbial “last run of the day”…at the flat section at the bottom of the hill.   As such, I have been conditioned to fear the congested flats.

At the risk of stretching this metaphor beyond its useful lesson;  contrary to the mess that can occur at the bottom of the ski hill, the black diamond runs (inverted yield curve) remain most hazardous.  That said, we are clearly entering the flats, and this month we take a good hard look at whether or not that should be cause for alarm.

Do We Need Ski Patrol?

There are many theories as to why the economy dips into a recession once the yield curve inverts.  I will spare you most of the speculation surrounding these linkages. However, the most commonly accepted reason is because banks borrow (pay interest rates to their depositors) at the short interest rate and lend or make loans based on the long interest rate.  Therefore, when the short rates are higher than the long rates, the incentive to make bank loans disappears. Fewer bank lending leads to a slower or shrinking economy. More on this later.

The chart above illustrates how (since 1980) the economy has always gone into a recession (grey vertical bars) within 18 months of the yield curve (blue line) turning negative.  In fact, this relationship has held for the past 9 recessions dating back to the 1950’s. Note that flattening does NOT signal a recession – only inversion does.  

The negative yield curve is represented by the blue line dipping below the solid, horizontal black line at the “zero” mark on the left hand scale.  This was consistently the case in the 1980, 1990, 2001, and 2008 recessions.

The chart above also shows the health of the stock market (red line) relative to the shape of the yield curve.  Notice that the stock market has done quite well with the exception of the periods surrounding recessions.

Since the curve is not yet even flat, there could still be plenty of meat on the equity-returns bone and plenty of time to de-risk.

This is why we believe that while the stock market is fairly/fully priced, it will likely do just fine as long as we do not enter a recession.  Even though the chart is a bit dated, it accounts for all recessions in the past 40 years. In any event, the market has continued to run up ~35% since the end of 2016 as the yield curve has flattened from just over +1% to about +0.25% today.

Speaking of recessions, the Federal Reserve has a forward looking economic indicator that helps them keep an eye on the probability of a recession.  The current reading of this model indicates the odds of a recession occurring in the next 12 months are below 5%.

NOTE: The market has only spent approximately 36 months in recession over the past 40 years.  That equates to approximately 4 weeks per year.

These Runs Are Groomed

Let’s look at how the stock market has done when the yield curve has INVERTED.    

As the table above indicates, the market has done just fine, especially during the past three instances of the yield curve inverting, despite ultimately leading to a recession.  

In fact, those last three observations actually delivered an average return of 32%, after the yield curve inverted.  Since the curve is not yet even flat, there could still be plenty of meat on the equity-returns bone and plenty of time to de-risk.

I would never be caught uttering these infamous four words when talking about markets: “This time is different.”  However, I will say, “perhaps this cycle may not be exactly the same.”

Below is an excerpt by By Dr. Sonu Varghese via Iris.xyz.  The title of the article is “How Monetary Policy Works”…Aug 11, 2018.  

“Typically, a flattening yield curve, and eventually an inverted one, has been driven by rapidly rising short-term interest rates, while long-term interest rates rose at a much slower pace, if at all.  Yet, the mechanism that links yield curve inversions to recessions is not clear and so there is always a question of whether “this time is different” – including by Fed Chair Ben Bernanke after the yield curve inverted in 2006.

In this cycle, a lot of focus has fallen on the fact that global bond markets have been warped by unconventional monetary policy over the past several years.  Bernanke, once again, suggests that the yield curve’s power to signal a recession may have diminished because normal market signals have been distorted by regulatory changes and quantitative easing in other jurisdictions.

On the other hand, as Minneapolis Fed President Neel Kashkari points out, “this time is different” may be the four most dangerous words in economics.  He says that if the Fed continues to raise rates, not only are they risking yield curve inversion, but also contractionary monetary policy that will put the brakes on the economic recovery.  Though the question remains as to how this may happen.”

I would never be caught uttering these infamous four words when talking about markets: “This time is different.”  However, I will say, “perhaps this cycle may not be exactly the same.”

The reason most economic cycles come to an end is because increased economic activity heats up and causes inflation to rear its ugly head.

Although it is indisputable that the shape of the mountain remains the same, the snow conditions can vary greatly.

  1. At the very least, this time is more like the last three recessions (1988, 1998, 2006)  than the first two (1978 and 1980). The first two were fighting high double digit inflation with short interest rates approaching 20%; steep and icy moguls.  In fact, rates are now significantly lower than all other instances. That is a net positive for the stock market.
  2. There is much more private credit lending in the market today, particularly through hedge funds and private equity.  Increased private credit lending offsets reduced bank lending, helping to stave off recession in a flat yield curve environment.  For instance, in the table below, note how the supply of lending amounts in the Middle Market lending market has reversed from banks to private capital being offered from non-banks.  This growth in lending could be the difference in helping to keep the rails of economic growth greased, which could prove to be the difference between recession and continued economic growth.

Source:  S&P LCO

  1. Banks have diversified their operations and are not as dependent on that yield curve as they were in the past.  This is particularly due to the practice of securitizing and selling/hedging their loans.
  2. Most importantly, the FED has expanded its tool box since the Great Financial Crisis of 2008.  We have seen them introduce Quantitative Easing (QE) and remove “mark to market” accounting for banks.   Those new policies, which had not been used prior to 2008, help to favorably manipulate markets during periods of disruption.  Just the threat of returning to QE activities could buoy investor sentiment.

Let’s Hope the Fed Can Ski, Snowboard and Land Their Aerials

Can the Fed keep inflation in check without damaging growth?  That is their dual mandate.  The reason most economic cycles come to an end is because increased economic activity heats up and causes inflation to rear its ugly head.

… for the first time in several decades, a Presidential administration is challenging the independence of the Fed by suggesting that it slow its interest rate hikes.

Rising fears of increasing inflation will often lead to a flattening yield curve.  The yield curve typically flattens because the Fed becomes concerned about inflationary pressures, so they raise short term rates to tame inflation and subsequently slow the economy.  

This is why it will be important to keep an eye on inflation this cycle and see what the market is expecting.  Is the Fed ahead of the curve and keeping inflation expectations within an acceptable range (1.5-2.5%)…OR, do we see expectations growing toward deleterious levels?  

5 Year, 5 Year Forward Inflation Expectation Rate

Source: Federal Reserve Bank of St. Louis

The chart above shows the market’s inflation expectations for the 5 years that follow the next 5 years…specifically, that means years 2023-2028.  This is the inflation expectation chart that investment professionals follow most closely. At present, the Fed is doing a good job in managing their dual mandate of price stability and full employment.

That’s all well and good… except that for the first time in several decades, a Presidential administration is challenging the independence of the Fed by suggesting that it slow its interest rate hikes.  This unusual interference could impact Fed policy and ultimately the perception of their independence, which could erode its credibility.

It will [sic] also be important that inflation remains subdued to keep this economic recovery and bull market going.

Credibility is the currency of a central bank.  It is what keeps democracies from approaching banana republics, e.g. Argentina, where it is currently ski season.  The attached chart shows how the Argentine peso has declined 90% in past 10 years.  Once a central bank loses confidence, it is tough to get it back.  

Think about it, if a central bank is not independent, but rather politically aligned/influenced, what would prevent an administration from goosing the economy every election cycle without fear of inflation?  That lack of trust would lead investors to take less risk, make fewer investments, stick their money under the mattress, and ride the bunny slope.

Here’s the irony – the Fed may be forced to raise interest rates to cool the inflation caused by the double whammy of tariffs and tax cuts this late in the economic cycle.  It is important for the Fed to respond independently to inflationary threats. It will also be important that inflation remains subdued to keep this economic recovery and bull market going.

Conundrum – So, if the Fed alters the expected path of interest rate increases, market participants may suspect the Fed is being unduly influenced by the administration, which will likely damage Fed credibility.

Storm clouds have a habit of gathering quickly, causing the slopes to get icey and dangerous.  This is a time to stick to the blue slopes and not push too hard for more risk; yet it is no time to call it quits and take the gondola back down the hill.

Put on Your Snowshoes and Take a Look at Your Mortgage

The Federal Reserve can only really directly control a short term rate of interest called the Federal Funds Rate. However, the Federal Funds Rate often serves as a benchmark rate for other interest rates like LIBOR, off of which most adjustable rate loans such as ARM’s, credit cards, and bank loans, are priced. Those with ARM’s that have no plans to sell their home in the near future, may want to consider refinancing into a longer term fixed-rate loan.  Here’s why:

While the yield curve can be an excellent predictor of future economic activity, we feel other key early warning indicators need to ignite before the economy finds itself in a recession.

As these ARM’s hit their reset dates, at present the new rates won’t be much lower than those associated with long-term fixed-rate mortgages. If the yield curve actually inverts, those with an ARM could be paying more than those with a long term fixed rate mortgage.  Moreover, should interest rates fall, which we think is highly unlikely in the near to medium term, those with fixed rate mortgages can always choose to refinance lower.

As can be seen in the chart below, a few years ago, when many people took out ARM’s instead of fixed rate mortgages, the spread between the two types of loans made ARM’s more attractive. However, this spread is has been dramatically reduced, and the long term advantage of a fixed rate loan now outweighs the short term benefits of a ARM, FOR THOSE WHO DO NOT INTEND TO SELL THEIR HOMES.

Apres Ski Round-Up

History is against the economy IF the yield curve inverts, which is why this topic along with trade (last edition) are the TWO most important issues currently facing the market.

The financial press has focused on the shape of the Treasury Yield Curve for most of this year.  While the yield curve can be an excellent predictor of future economic activity, we feel other key early warning indicators need to ignite before the economy finds itself in a recession.  Stay tuned for a discussion about these key early warning signals in future reports.

See you in the lodge.

MMMMMM…TRADE PIE

MMMMMM…TRADE PIE

Escalating Trade Tariffs and their Potential Impact on the Global Economic Pie

Meeting Nelson Mandela in June 1995, during the Rugby World Cup in Johannesburg (aka Invictus), was one of the most memorable events of my life.  

As an institutional mutual fund manager, I was on the other side of South Africa’s very first currency/asset swap. This transaction curried just enough favor to get a brief, serendipitous one-on-one meeting with President Nelson Mandela.  

I will never forget when Mr. Mandela said “The ANC (African National Congress) is not trying to get a bigger piece of the economic pie, but rather to grow the pie for everyone”.  His wisdom was comforting in regards to the future of South Africa and still inspires me to this day.

At that time, apartheid had just ended and there were a number of domestic and international investors concerned about the direction of the newly elected, non-white government.  Mandela knew that he had little leverage and needed to unite his country in order to calm investor fears and attract foreign capital. He was successful.

“Increased tariffs drove down global trade 65% and played a role in deepening the depression of the 1930’s.”

Fast forward to today and we see the Trump administration taking a different approach, imposing tariffs as leverage to renegotiate many, if not all, US trade deals and agreements.  This administration’s tactics seem designed to grab a larger slice of the pie for the US, despite the very real risks that such a strategy may actually shrink the size of the pie for everyone.

Trade Recipe – History of Free Trade

Global trade is large and important to the world economy, but it is also complex and has its pluses and minuses.  Global trade does not lend itself to “one off” transactional deals, where one side tries to get the better of the other.  The idea is that both sides can win, when the ingredients are measured and oven conditions are right for the pie to grow.

The conditions for free trade were put in place through US leadership following WWII.  In 1947, GATT (General Agreement on Tariffs and Trade: 1948-1994) was enacted to create a more fair and conducive landscape for global trade.  GATT was seen as an important step toward global free trade following the Great Depression and WWII.  

“Free trade is not a conservative vs. liberal argument.”

Global free trade has not always been so “free”.  The Smoot-Hawley Act (1930) imposed high tariffs and protectionist measures following the stock market crash in 1929. These increased tariffs drove down global trade 65% and played a role in deepening the depression of the 1930’s.  The 1947 GATT agreement was initially signed in Geneva by 23 countries to reverse the damage done by the Smoot-Hawley Act. The member countries grew to 123 during the Uruguay Round Agreement in 1994.

The Uruguay Round ultimately established the WTO (World Trade Organization), which replaced GATT in 1995.  These two consecutive organizations have been successful in decreasing average tariffs from 22% in 1947 to 5% after 1995.  

The WTO now helps to facilitate international trade, and sets the rules for trade and arbitrate infractions.  As such, there is no single agreement or organization that now impacts global trade as much as the WTO.

As we will see below, the US has historically benefitted from most trade deals even though it has occasionally subsidized others. Regardless, it is clear that the US is the strongest economy in the world with trade being a positive contributor to our sustained growth and low inflation.

Is This Pie GOP Cherry Red or Democratic Blueberry?

Importantly, free trade is not a conservative vs. liberal argument.  Republicans have long been supporters of free trade, while the Dems also have their own fingerprints all over free trade agreements from NAFTA (North American Free Trade) to TPP (Trans Pacific Partnership) to the WTO (World Trade Organization).  

The Trump administration’s policies seem to be taking trade back in the direction of “Economic Nationalism”, which we have not seen for the past 70+ years, since free trade became the dominant trade ideology.

In fairness, President Trump’s supporters claim that he is escalating the tariff discussion in an attempt to level the playing field for US producers.  His detractors point out there is already a process in place to make his case through the World Trade Organization (WTO).

Another argument in favor of Trump’s approach is based on national security reasons and the need to have a vibrant manufacturing economy and middle class.  His opponents say these claims are largely political and point to technological innovation as having a greater impact on jobs and wages than outsourcing to cheaper labor markets.

“The relative importance of trade between the US and the rest of the world is likely the argument upon which the Trump administration bases it’s sentiment that the US has leverage to re-negotiate our trade deals.”

The Importance Of Global Trade In Three Pictures – Sorry, No Pie Charts…

Free trade has been a positive factor in growing Global GDP and keeping inflation low.  After stagnant trade values for over 150 years, global trade has been on a steady incline since the end of WWII until the Great Financial Crisis (GFC) of 2008 (see chart 1).  In fact, global trade has grown at almost twice the rate of domestic growth…while helping to keep inflation low. This inflation link demonstrates how imported goods have seen price declines that have helped to contain the inflation rate, while domestic services have generally been lifting inflation.  

Chart 1 – The Value of Global Exports

Source:  Federico & Tena-Junguito (2016)

Chart 2 below shows how important trade has become for the global economy. Unfortunately, trade now appears poised to turn down.  

Global trade represents ~60% of global GDP, which is approximately twice as important as trade is for the US, which derives ~30% of its GDP value through trade.  As such, the US trade chart would look almost identical to the world chart below, but at only half the value. The relative importance of trade between the US and the rest of the world is likely the argument upon which the Trump administration bases it’s sentiment that the US has leverage to re-negotiate our trade deals.

Chart 2 – Trade as a % of GDP

Source: World Bank

The final illustration (Chart 3) shows the relative contribution of specific countries and regions to the US trade deficit. To put those combined levels in context, the US total current account deficit is only 2.4% of our $20T GDP.  Historically, our current account deficit has averaged 2.6% since 1980.

Chart 3 – US Goods Trade Deficit

Source:  Thomson Reuters Datastream

Specific Regions

NAFTA-  Our North American trading partners, Mexico and Canada, combine to form the largest trading partners for the US at ~25% of total trade.  Yet, these countries only represent ~10% of the total deficit. This agreement has arguably been a net positive for all three countries.

China-  In contrast to our North American trade partners, China represents only about ~15% of total trade, but that 15% represents 50% of our total deficit.  This is the one area where the US is on firm ground to push for more balance.  Protecting intellectual property (IP) rights for our high tech sector within China is another area where the US should push, and hard!

EU-  Our deficit with the EU is actually quite small, when considering the relative size of the two trading partners.  This surplus/deficit represent less than 1% of each partners’ total GDP. When considering the EU is comprised of 28 countries, the relative potential gain of imposing tariffs is quite small.

*Germany  The one issue that stands out underneath those headline EU numbers is that over ⅓ of our deficit with the EU is with Germany alone.  As such, any tariff talk involving autos and the EU will primarily target and affect Germany.

Is This A Fair Bake-Off?

Before getting into the big picture issues of trade and the potential impact of tariffs, it is important to state that this topic is very complex.  We will not attempt to dig into all aspects that drive our trade imbalances nor the fairness of each of those imbalances. Suffice it to say that there are numerous cross-currents woven into all US international trade agreements.

Before moving forward, let’s compare weighted average tariff levels for some key countries/regions in this discussion:

US  – Applies tariffs of 1.6% on imports.  This is low, but not the lowest amongst developed nations.  The US experiences tariffs of about 4.9% on average for its exports.  

EU  – Also applies tariffs of 1.6% on imports.  The EU experiences an average tariff of 3.5% on its exports.  

“Protecting intellectual property (IP) rights for our high tech sector within China is another area where the US should push, and hard!”

China – Applies tariffs of 3.5% on imports, which is actually comparatively low for a developing country.  However, the tariff rate on US goods is closer to 10%…that’s a problem that needs to be addressed.   China faces tariffs on its exports that are in line with those of the US, at ~4.9%.

But tariffs are just part of the story and even the numbers cited above can be manipulated to create varying narratives.  Another angle to this story includes counting all the various components of protectionist measures…highlighted below.

Total Protectionist Measures by Country

Source:  Global Trade Alert, Credit Suisse

Once again, I caution that these measures are viewed through a specific, albeit wide-angle lens, but they do show the US is not being obviously disadvantaged in a systematic fashion.

That said, the US and the world are on very stable footing in pursuit of Intellectual Property protections within China.  The US and our allies should have a strong case if they work together through the WTO to make that happen rather than acting out unilaterally.

Keeping the Oven Light On: Trade Issues we are Watching

We will now attempt to handicap the relative importance of the current primary trade issues and the corresponding potential impact on the economy and markets.

The chart below shows graphically the tariffs that have been implemented and/or threatened to date (July 10th, 2018).

Threatened, Announced, & Implemented Tariffs

Source:  USITC, Goldman Sachs Investment Research

Current Playing Field

So far (as of July 17th, 2018), the US has implemented steel and aluminum tariffs (which total ~$50B) along with tariffs targeted to hit Chinese manufacturers of solar products and washing machines, plus another ~$50B of Chinese products.  The net effect of this initial round is miniscule.

In fact, if all the currently discussed tariffs (including China and the EU) are enacted and retaliated at full force, we are still only talking about a total of ~$800B in products going each way.  Goldman Sachs estimates this will only amount to -0.2% decline in US GDP and +0.2% increase in inflation. The risk to the global economy is a bit more substantial.

The markets will respond negatively if the impact appears large enough to nudge a large trading partner into recession and de-sync the global recovery.

Risk of escalating – Moderate.  Risk to economy – Moderate.

Auto Tariffs

If tariffs directed toward the EU extend to autos, that will not sit well.  Germany and others will feel forced to retaliate – hard. This action will most certainly introduce volatility into the market.  

That said, it is very difficult to determine exactly where a car is sourced and manufactured.  It is even less clear how best to track the impact of tariffs throughout this industry. One thing is for certain, the auto industry are not fans of any sort of change that impacts their supply chains.  GM is on record clearly stating that tariffs will lead to higher costs and loss of jobs.  

The economy can handle the tariffs, but the bigger risk is erratic policy and the resulting impact on the market.  

Risk of escalating – Moderate.  Risk to economy – Moderate.

China Policy

China – this one could sting!  I say that because the Trump administration actually has some solid political and business support behind sticking with this issue.  

Newly imposed tariffs on Chinese products are only $50B, which is insignificant for the $14T economy.  However, the table is now set for a retaliatory ‘tit for tat’ environment, which could lead to escalation with no real winners.  Even if the implementation of those tariffs grows to the currently suggested $250B level or even $500B as threatened, we will still experience more bark than bite.

By the numbers, $500B represents all of the exports China sends to the US, while the US only exports about $150B to China.  This is probably why the current administration believes the US has leverage.

“China was a key player in getting North Korea to the negotiating table and they could reset that table at anytime.  No pie for you!”

For now, suffice it to say that total Chinese exports to the US are less than 5% of their GDP.  Any and all US tariffs will almost certainly draw retaliation, while not significantly denting the Chinese economy.  In fact, US automakers represent 6 of the top 8 car brands sold in China. Based on GM’s initial reaction, a soft ban on US autos could turn this into a net positive for Chinese auto manufacturers.  

These tariffs would also put upward price inflation pressure here at home.  The political fallout of applying excessive tariffs on Chinese goods will likely precipitate an extended negative tone to the markets, which could create a buying opportunity.

Risk of escalating – High.  Risk to economy – Moderate.

NAFTA

If the US ultimately dissolves NAFTA, the impact to the economy could be even more substantial.  Canada and Mexico combine to create our largest trading block. Re-negotiating a multilateral agreement into bilateral agreements will lead to higher prices and slower growth on the margin.  

Trade with these two countries account for ~7% of total US GDP.  Without knowing what would replace NAFTA it is difficult to present estimates, but consensus indicates a -0.5% decline or more in US GDP and an increase of +0.2  to 0.4% in inflation. This scenario would probably not trigger a recession, but could provide a buying opportunity in the equity markets, as long as the geo-politics remain civil.  That’s a big IF.

Risk of happening – Moderate.  Risk to economy – Moderate.

The WTO “The Whole Pie”

Lastly, and this is the BIG one – there are rumors that the US may pull out of the WTO.  Treasury Secretary Steve Mnuchin has denied these rumors, but the administration has been known to reverse course on substantive issues without warning, and we can’t ignore this possibility.  It should be noted that this course currently needs congressional approval; however, as the linked article mentions, the administration may be looking for a work around.

“This is the BIG one – there are rumors that the US may pull out of the WTO.

In our opinion, this would be the worst case scenario and ultimately lead to a market reset and asset reallocation.  This action would no doubt introduce maximum uncertainty into the global markets and markets do not like uncertainty.  The impact of the US pulling out of the WTO could ultimately impact diplomatic alliances.

Risk of happening – Moderate.  Risk to economy – HIGH.

We will be watching closely for this potential outcome.  If the US does pull out of the WTO, we will be back to explain why this will not be a repeat of Smoot-Hawley and a global trade war that contributed to the Great Depression of the 1930’s.

Blind Taste Test – Review

In summary, the markets can handle the first four scenarios discussed above with varying degrees of indigestion and opportunity.  Pulling out of NAFTA makes the least sense, while looking to freeze the deficit with China and make progress on IP rights has the most support and makes the most sense.

Our largest risk is a path that leads to the complete dissolution of multiple global trade agreements, starting with the WTO.  A breakdown in global trade patterns would likely impact geo-political alliances and have broad reaching repercussions throughout the global economy.

The Geo-Politics of Trade   

It is difficult to discuss global trade and the potential risks to the preservation of the WTO, without touching on geo-politics.  Relations with many of our allies are strained, as the current administration has already shown a willingness to pull out of multilateral agreements; withdrawing from TPP, the Paris climate accord, the Iran nuclear deal, and most recently, the UN Human Rights Council.  

President Trump recently tweeted that the “UN is as bad as NAFTA”, while stirring up tensions with our allies at the June G-7 meeting in Canada.  In response, after President Trump visited NATO in Brussels on June 12th, EU President Tusk stated “Dear America, appreciate your allies, after all you don’t have that many.”

President Trump also recently lumped Russia, China and the EU in a similar grouping as “foes” that look to take advantage of the US.  That can’t be comforting to our allies, and in fact, following the recent Putin/Trump Helsinki Summit, that comment has elevated concerns throughout Europe.  These diplomatic steps and missteps by both sides provide a sobering backdrop to the ongoing trade discussions.

Staying with Helsinki, many suggest that Russia likely attempted to lay the groundwork for eventual dissolution of NATO and the WTO during the Putin/Trump private conversation at their July 16th Summit.  These outcomes will not come easy, but seem to represent the momentum of the current course.  

“These diplomatic steps and missteps by both sides provide a sobering backdrop to the ongoing trade discussions.”

If the aforementioned mentioned rumors are true, and the US does pull out of the WTO, China will likely follow.  This path is still marginally unlikely, but represents the politics that could spring forth once alliances have frayed and Pandora’s Box has been opened.

On another front and getting back to how China could retaliate, despite having such a lopsided trade surplus…China could counter higher tariffs by banning the sale of Rare Earth Elements to US high tech firms.  China currently mines ~90% of the world’s production of these 15 critical elements, so this could develop into a major issue.

Another potential “behind the scenes” tactic on the political front is that China could (and may already be looking to) scuttle denuclearization negotiations between the US and North Korea.  China was a key player in getting North Korea to the negotiating table and they could reset that table at anytime. No pie for you!

Lastly, for the past two years China has supported their currency (the Yuan) through the use of exchange controls.  If they once again allow capital to flow out of the country, their currency would depreciate, thus making their products more competitive and thereby offsetting the impact of US tariffs.  We haven’t even mentioned how China is the largest foreign owner and purchaser of U.S. Treasury bonds….they buy our debt with their current account surplus, which helps to keep our interest rates low.

I hope these examples highlight how complex these issues can be and how easily we can find ourselves in a lose-lose situation.  

The Secret Ingredients

Before finishing up our trade deficit discussion, I want to touch on some very important issues that many economists believe more directly impact our trade deficit than tariffs or other protectionist measures.  

“The US economy is heavily skewed toward consumption and away from savings.  Our trade deficit will not materially change until that chronic trend reverses.”

It is important to note that the US has historically had a “strong dollar” policy following the Bretton Woods conference in 1944.  Bretton Woods helped move the global monetary system from the gold standard to positioning the US dollar as the premier global reserve currency.  

All things equal, a consistently strong currency leads to a chronic trade deficit, because a strong currency makes our products more expensive to overseas buyers, while making foreign products more of a bargain to us.  This currency effect helps explain our historical and current trade deficit.

Taking that a step further, most economist agree that a trade deficit isn’t even a bad thing, especially for a country that runs budget deficits.  In fact, trade deficits are not particularly tied to trade or competitiveness, but rather other macro economic factors.

Which brings us to what I believe is the most important point on this trade imbalance topic, and I can’t overstate its role… the US economy is heavily skewed toward consumption and away from savings.  Our trade deficit will not materially change until that chronic trend reverses.  

As such, any gains to be made to the trade deficit through tariffs are likely small compared to any potential impact of structural changes to our consumption/savings rates.  Period.

Let me say that againPERIOD!

The Last Slice  

Looking back through history, it is clear that global trade has been a net positive for the domestic and global economy by spurring growth and helping to suppress inflation.  

Those lower inflation rates allow for lower interest rates, which can attract more investment that can lead to higher productivity and subsequently higher growth.  It is indeed a virtuous circle. In fact, some research indicates that the free trade policies of globalization are actually linked to technological innovation.  

We are now in the early stages of considering the impact of the Trump administration’s trade policies on the global economy going forward.  At this point, the expected economic impact from each flavor of potential trade dispute appears challenging on both the growth and inflation fronts.  Yet, most of these outcomes are manageable, albeit unsavory.

Hopefully this is just a negotiating tactic to help the US “get a better deal” and can still be scaled back or reversed.  Much of that will depend on the political calculus heading into the midterm elections. We still suspect this is more bark than bite.

Let’s just hope we don’t end up getting a bigger slice of a smaller, more expensive and less tasty pie.

EXTRA CREDIT: For those of you that are truly curious, here is a link to a paper that explains why “globalizers” grow faster than “non-globalizers”.

How About a BEER?

How About a BEER?

Let’s Tap A BEER To See If Stocks Are Over, Under, Or Fairly Valued

“Interest rates and volatility are on the rise, as are investor jitters, so now is the perfect time to pop open the BEER analysis.”

Lager, ale, IPA, steam, stout, or pilsner?  Nope, that’s not what we’re here to discuss.  This BEER is both non-alcoholic and gluten-free.  I know what you’re thinking:  “That beer sounds terrible!  Why would I want that?”  Because our BEER is going to help us more effectively navigate the stock market.

Our BEER, the Bond Equity E​arnings-yield Ratio, is a simple, interest rate-based, stock market valuation tool, used by the Federal Reserve Bank to determine if stocks are cheap (stein is half full), or expensive (stein is half empty), relative to bonds.

Interest rates and volatility are on the rise, as are investor jitters, so now is the perfect time to pop open the BEER analysis. Interestingly, this edition of “Cutting Through the Noise” provides a glass “half full” example of the stock market’s valuation.  Well, what else would you expect when discussing BEER?  Read on!

The Bond Market as a Predictor of Stock Performance

“Are we in a period where money is likely to continue to flow into the stock market and drive stock prices higher? Or, are we in a period where bonds are attractive enough to prevent that flow of capital from occurring?”

Before we jump into the BEER analysis, recall that last May we evaluated the market through the lens of the CAPE (Cyclically Adjusted Price to Earnings) ratio, which showed the market to be approximately 30-50% expensive vs. historical prices – or glass “half empty”.  

The CAPE analysis would seem to point to an overvalued stock market which we might conclude we should avoid.  However, CAPE is only only one vantage point, and it is important to remain open to a variety of viewpoints when constructing an investment strategy.  We’ll discuss this in greater depth later in this article, after we crack open our BEER.

So, why would you look to interest rates and the bond market in an attempt to predict returns in the stock market?  Good question.

During periods of economic expansion, which has been the case for the last nine years since the Financial Crisis, bonds yields and stock market prices have generally traded inversely as they compete for investor capital. This is because when economic optimism grows, money moves into the stock market as investors seek to profit from economic growth and associated rising stock values.  

Conversely, selling in the stock market generally leads to lower bond yields as money moves out of the stock market and into the bond market, as investors flee to safety.  We presently find ourselves experiencing expanded economic growth, the stock market has done remarkably well for almost a decade, and interest rates are beginning to rise, even though they remain near historical lows.

The key question to ask and answer is thus: Are we in a period where money is likely to continue to flow into the stock market and drive stock prices higher? Or, are we in a period where bonds are attractive enough to prevent that flow of capital from occurring? This is precisely the question which the BEER analysis is designed to answer.  

OK, Let’s Brew

The Bond Equity Earnings-yield Ratio (BEER) is a metric used to evaluate the relationship between bond yields and stock earnings yields.  At its core, the BEER or Fed model evaluates whether investors are appropriately compensated for the price they are paying for riskier cash flows earned from stocks, by comparing them to the expected returns for bonds.  

BEER has two parts – a benchmark bond yield (10-year Treasury), divided by the current earnings yield of a stock benchmark (such as the S&P 500).

BEER =  Bond Yield / Stocks Earnings Yield (E/P)

The key insight from this equation is that the lower the interest rate – the higher the expected stock price.  Taking that further, standard P/E ratios as a predictor of stock market performance do not account for the present interest rate regime.  Adding the interest rate component to the BEER framework provides for a more robust stock market valuation analysis.

Is The Tap Foamy Or Flat?

“At present, the stock market appears undervalued by ~50% relative to interest rates, which leaves plenty of room for more froth (as long as interest rates remain low).”

So, what does BEER tell us about the current and potential future value of the the stock market?

Figure 1 below shows the relationship between the 10 year US Treasury bond and the earnings yield of the S&P 500 based on the next year’s forward earnings.

The Bond Yield in the numerator is the straight-forward yield of the 10yr US Treasury. The (E/P) in the denominator is simply the inversion of the P/E ratio for the S&P 500.  Inverting the P/E ratio into an E/P yield is done to compare “apples to apples” or Bond Yield to Stock Earnings Yield.

Historically, we have seen the yield on stocks and bonds to be about the same, up until 1999-2000.  Around that time, prices of stocks went up disproportionately to their underlying earnings and relative to bond yields.  Stocks were expensive (red line below blue line) relative to bonds in early 2000, and under performed coming out of that period.

Since that time, stocks have been cheap relative to bonds (red line above blue line), largely due to the impact of Central Bank policies that have suppressed interest rates.  It is important to note that stocks outperformed (as predicted by the BEER model) over this past 15 year period – including the market crash of of late 2007 to early 2009.

Figure 2 below illustrates the over/under valuation of the stock market relative to the bond market according to the BEER analysis within a single line by dividing the blue line by the red line in Figure 1 above.  What we see is that, according to BEER, the stock market has not been overvalued since that big spike up around 2000.

At present, the stock market appears undervalued by ~50% relative to interest rates, which leaves plenty of room for more froth (as long as interest rates remain low). Ten-year bond yields have historically equaled Nominal GDP, which would be ~5% today… and yet current yields are only 2.9%, which makes bonds quite expensive.  Historical P/E’s have averaged 15% and are currently at 16.3%.  Considering the present level of interest rates, one could make the case that stocks are actually cheap…as long as we don’t have a recession.

However, note that the Fed model above shows the stock market was actually viewed as inexpensive going into 2008, prior to selling off ~50%.  It is important to understand that, while the market was cheap visavis bonds during that 2008 time period, it may have also been absolutely expensive.  That 2008 period could be somewhat analogous to today’s market prices, but to a much smaller degree. Specifically, stocks are likely somewhat expensive in an absolute sense, but they remain cheap relative to the more expensive bond market.

So What Can We Expect From the Stock Market Going Forward… Light or Dark BEER?  

Occasionally financial market pundits carelessly opine that, “Stocks are undervalued according to BEER or the Fed Model (or interest rates).” Although this might be a true statement, it is careless because it implies that stock prices will necessarily go higher.

The correct interpretation of the above comparison between stock and bond yields, is not that stocks are cheap or expensive, but that stocks are cheap or expensive relative to bonds.  It may be that stocks are both cheap vs bonds and expensive in an absolute sense, which could make stocks priced to deliver returns below their long-term average.  

However, it may also be true that bonds are even more expensive than stocks and priced to deliver returns far below their long-term average and could actually lose principal after factoring in inflation.  Be aware that both stocks and bonds could lose money under the scenario highlighted above.

This should not come as a surprise, since both stocks and bonds have collectively offered record positive returns for the past 35 years, which could set up for a big bout of mean reversion at some point.  Hmmmm…perhaps we need to further diversify beyond just stocks and bonds?

Importantly, the BEER model can help explain why stocks have done so well in the face of many pundit proclamations that the market is expensive.  Additionally, this analysis demonstrates how equities could continue to climb higher, even while they remain expensive by other measures.

Mugs or Steins?

“…BEER (or some similar signal) is likely the measure used by Warren Buffet when he claims the stock market is cheap.”

It’s clear that the strength of the BEER framework is the incorporation of the additional bond yield component, which helps provide richer context to the stock market valuation analysis.  Conversely, the weakness of BEER is that the inclusion of the bond yield creates a relative comparison, which can send a misleading signal if both stocks and bonds are cheap/expensive.  Ultimately this relative analysis could lead to false signals at the wrong time.  

This is in stark contrast to our CAPE analysis, whereby the strength of the CAPE ratio is its objectivity, by averaging valuation levels over an entire market cycle.  The weakness of CAPE is that it does not consider other inputs, such as interest rates or growth rates, which can lead an investor to miss major upswings in the market.

Just as CAPE and standard P/E ratios have imperfections, so does the BEER analysis.  These two vastly different approaches often arrive at two wildly different conclusions, while each methodology independently attempts to answer the same question.  

I liken these different approaches to viewing the same picture through different lenses.  Sometimes the Rx is just right and the viewer is able to sharply see the proper valuation, while other times the picture is fuzzy, making it  difficult to discern over/under valuation.

As a point of reference, BEER (or some similar signal) is likely the measure used by Warren Buffet when he claims the stock market is cheap.  Psssst… just don’t ask Warren why he holds $120B (or 20% of his market value) in cash within Berkshire Hathaway, if the market is so cheap…

Avoiding Confirmation Bias

So why do we spend so much time looking at competing analytical frameworks when determining our investment decisions, when they often arrive at radically different conclusions?

Incorporation and analysis of multiple conflicting viewpoints is critical to avoiding what behavioral finance refers to as “confirmation bias.”  Confirmation bias occurs when an investor exclusively follows analysts or strategies with which they already agree. This can lead investors to take on too much risk at certain points of the cycle, or to miss major upswings, because they fail to adequately take into account alternative opinions and analysis.  

How many of us watch both FOX News and MSNBC – I mean both of them equally?!  Not many.  When investing, it is equally important to be aware of what the “Pollyannas” are professing, as well as the rhetoric of the “Sky is Falling” types – and everything in between.  Think of it as looking both ways when crossing the street.

It is always possible to find some really smart people on both sides of the market providing equally strong arguments toward being a buyer or a seller.  It is up to the prudent investor to determine which argument is correct at any particular time.  

Hence the need to seek multiple quantitative viewpoints like both CAPE and BEER and beyond.   

How’s The Wine?

As we just noted, it is important to consider as many flavors or methodologies as possible.  More information is always better when building your investment mosaic.

This should include making logical adjustments along the way to draw common sense conclusions regarding risk/return assessments for the markets.  It is helpful to know that some relatively straight-forward metrics view the stock market as cheap, while other, equally-sensible measures, view the market as expensive.

BEER and CAPE are simple and straightforward measures, but there are still other more complex and refined models (we’ll call them wine – When Investors Need more Explanation), which can also be very helpful in determining the markets valuation.

In fact, these more detailed models imply that the stock market is neither cheap nor rich at present, but fairly valued.  Let’s leave those more complex examples for another day.

Regardless of the valuation tool, it will be important for earnings to continue to grow faster than the increase in real interest rates for stocks to continue to deliver that refreshing taste of higher returns.

Cheers!

A View of the Economy: Coming and Going

A View of the Economy: Coming and Going

“You Can’t Know Where You Are Going Until You Know Where You’ve Been” ~ Maya Angelou

As an institutional asset manager, I often compared quantitative investment management to driving through the rear-view mirror.  The view looking backward offers clear 20/20 vision that allows investors to update their inputs and dial settings while relying on objective analysis and eliminating emotion.  The problems arise around corners or “inflection points” in the economy… where we tend to “oversteer”.  The quantitative approach has both positive and negative aspects.

On the other hand, fundamental management is akin to driving while looking through the front windshield during a rainstorm with broken wipers and bugs plastered to the glass.  This provides a somewhat blurry vision of what is coming, but at least the view is forward, providing the ability to course correct – typically more subjectively.  Once again, there are positive and negative characteristics associated with this style of investment management.

The “Holy Grail” is to be able to merge these two completely different, time-tested approaches.  Today, we will look backward with perfect hindsight and use what we learn to clean our screen for a clearer view of what lies ahead.

2017 In Rear View – Where We Have Been

Season’s Greetings – The US stock market has already put together 13 consecutive months of positive returns… an all-time record!  

Key Market Indicators and Market Review:

YTD % Return as of 12/21/2017

S&P 500 (Large Cap Core) +22.2

Russell 2000 (Small Cap Core+14.8

Russell 1000 Growth (Large Cap Growth) +30.5

Russell 1000 Value (Large Cap Value) +13.0

MSCI All Country World Index ex-US +25.2

EEM (Emerging Market Equity) +33.5

AGG (Bloomberg IG bond)  +2.9

JNK (High Yield Bond)  +5.5

In 2017, the markets enjoyed strong returns around the globe.  The strongest returns were found in emerging markets equities (EEM), followed by the MSCI All Country World Index ex-US, and then a still strong US Large Cap stock market (S&P 500).  This return pattern was very much a reflection of economic strength relative to expectations… the international economy showed a larger pick-up in growth rates relative to the US.

The bond market earned its coupon as interest rates more or less “marked time”, with 10 year US Treasury bonds yielding 2.1-2.5% throughout the year.  We did see the high yield (JNK) market do better than investment grade bonds (AGG) as credit spreads tightened.  However, we are now very near record tight credit spreads, so the risk/return outlook is unfavorable for High Yield debt from these levels.

Within the US, we saw a return to a strong ‘Growth’ market (Russell LC Growth) over the ‘Value’ sector (Russell LC Value).  This was predominantly a reflection of a weaker US dollar and stronger growth overseas. The large multinational ‘Growth’ companies were best positioned to benefit from strength in overseas economies.  We once again saw Small Cap stocks lag Large Cap stocks. Looking forward, Value and Small Cap (RUY) stocks appear inexpensive relative to Large Cap Growth and could benefit most from potential changes to the tax policy.

Three Market Drivers in 2017-

  • Markets climbing a wall of worry
  • Anticipating tax reform
  • Relatively easy comparables for earnings and GDP vs 2016

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects…

Climbing the Wall of Worry

An old adage says “The stock market climbs a wall of worry”. This simply means that as the stock market rises as a whole there are more and more investors that believe the existing rally will come to an end. But, the higher it goes, the more greed takes over and more and more investors jump on board and continue to invest.  The more this behavior continues, the more prices continue to rise, thus fueling the rally and creating a self-fulfilling prophecy.  

At some point, the rally becomes based more on price movement than fundamental value of the underlying stock.  And as the other saying goes, “the bigger they are, the harder they fall.”  The higher up the worry wall the market climbs, the more precipitous the drop when the market loses its footing.

Right now, there are three primary “worries” that comprise the current wall.  We are paying particularly close attention to Geopolitics, Rising Interest Rates, and Valuation.

Geopolitics/Black Swan Events-

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects that are often included in this category.  

These outcomes are impossible to score. However, it appears clear that our allies are increasingly disillusioned with our role and our enemies are more emboldened and on alert.  The ‘end of the world clock’ has never been closer to midnight (other than 1953, when the US and the Soviet Union were both testing their first Thermonuclear devices…aka H-Bomb).

Optimists will say the US has done quite well since the time that Elvis first hit the stage, thank you.  The pessimist will say that we are on borrowed time.  The realist will say that the risks are real and we never know when the market will decide to price those risks.  All that said, the risks do seem to be rising.

However, somewhat inexplicably, the market continues its climb over each headline risk, as we have enjoyed the longest period of prolonged lack of volatility in the history of the stock market.  

Eventually, volatility will return to the market as the mean reverts, and we believe that could translate into substantial downside risk.  However, in the meantime, the market continues to climb ever higher.  

Rising Interest Rates-

Now that the Fed has begun to raise interest rates and allow the reserves accumulated through their Quantitative Easing program (last month’s blog) to unwind, investors are concerned that rates will normalize back toward 4-5%.  As 10 year US Treasury rates hold steady in the 2.1-2.5% range, investors are living with the risk and climbing over this worry, for now.

economic uncertainty chart

Notice the chart above from the National Bureau of Economic Research that shows the overall risk for a potential Global Economic Policy misstep.  The policy uncertainty index charts uncertainty through news articles, changes in political control, changes in tax policy, monetary policy, and dispersion in economic estimates.  

The chart graphically depicts what is meant by “climbing a wall of worry”.  The actual policy uncertainty is now even higher than that realized during the GFC (Great Financial Crisis).   Indeed, the market has risen in near lock-step fashion with the uncertainty index, which is counterintuitive to what investors would normally expect.  

Valuations-

No matter how we analyze market valuations, the market is at or near record high values, which has been the case for the past year.  That said, valuations alone aren’t a catalyst for a market decline.  However, valuations will determine future rates of returns which makes when you invest almost as important as in what you invest.   

From current price levels, history suggests that investors can expect approximately 2-4% annual real (after inflation) returns over the next 10 years.  

Also, the scale of the ultimate market correction (although there is nothing that states market prices MUST correct) will be impacted by the severity of the over-valuation.  So far, the market is happily rationalizing the record price levels and continues to grind higher.

The truth is that the current actual effective corporate tax rate averages 24% (not 35%)

Anticipation

Waiting for tax reforms reminds me of the iconic Heinz Ketchup commercial in the 1970’s that shows the young boy patiently waiting for his prized ketchup bottle to delicately and deliciously drip mouthwatering, flavor-filled, tomato sauce all over his burger, as Carly Simon melodiously sings “Anticipation” (Ann-ti-ci-Pay-Aay-Shun) in the background…mmmmm?  Well, this is the same scene as investors await their precious, promised tax cuts.

The market has been running on the promise of lower taxes since the election.  The administration has done a great job of selling the merits of a lower corporate tax rate from 35% to 20%.  The truth is that the current actual effective corporate tax rate averages 24% (not 35%).   When considering the level of anticipation in this tax policy, my mind races to the old adage, “buy the rumor, sell the news.”

We will dig further into the specifics of tax policy in a future blog since the final bill has passed and we know what we’re dealing with.  For now, suffice it to say… it will be a net positive for the corporate world (more so than for individuals), but likely much less so than conventional wisdom suggests.

 Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Global Pick-up and Easy Comps    

The US Real (inflation-adjusted) GDP growth rate looks likely to rebound to 2.5+% in 2017 after falling below 2% in 2016. In fact, after growing at an average 2.3% rate from 2013-2015, the US economy actually slowed to 1.8% in 2016.   

The deceleration in 2016 was largely due to a stronger US dollar and lower government spending.  The stronger currency in 2016 hurt competitiveness and compressed revenues and earnings when translated back into US dollars.  The government spending cutbacks in 2016 came from a Republican Congress that was intent on maintaining a deficit hawk image.  That image has since been tossed aside, now that we have a Republican administration.  

The third temporary cause for a 2017 bounce in GDP growth is an accumulation of business inventories, which basically borrows from future growth.  Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Lastly, a more positive and sustainable component of GDP growth was the pick-up in global economies and markets.  This was a far larger contributor of higher US GDP growth than anything the new administration created domestically.  The global economy showed signs of life in 2017, growing at a 3.5%+ rate after habitually slogging along below 3% since the Great Recession.  The stronger global economic growth, coupled with a weaker US dollar, finally helped US trade, on the margin.

Overall, business and personal GDP growth have been steady at about 2.25% over the past 5-7 years, with government spending, net trade deficit, and inventory accumulation providing volatility around that number.  The true test will be if the rate of GDP growth continues up over 3%, or levels-out in the 2-2.5% range that has become the norm since the Great Recession.

This “easy comparable” syndrome, which occurred due to a decent bounce in 2017 GDP growth coming off a subdued 2016, reminds me of what happens during college football bowl games each year.  During college bowl season, we find out which conferences benefitted from easy competition during the regular season.  Those conferences eventually get exposed.  As an alum of the University of Illinois, I was particularly scarred by the 1984 Rose Bowl game.  I witnessed my beloved Illini (then favored by 18 points) get trounced 46-9 by UCLA after leaving the “easy comps or competition” of the Big 10 conference.  

This year’s economy not only feasted on easy 2016 comps, but with the global economy kicking in more aggressively combined with a weak currency and inventory builds, it is as though we got an extra scholarship for a top recruit to aid in our battle this year.  The “comps” are about to get more challenging.

Is it obvious that the snow has not been spectacular here in Tahoe and I have spent too much time watching college football?

2018 Through The Windscreen – Where Are We Going?

Looking ahead to 2018, we see three themes that will shape the contour of the economy and the markets:  

  • Fiscal Policy (taxes and deregulation),
  • Monetary Policy (interest rates and currency)  
  • Productivity (particularly as it relates to wages).

Let’s examine each in turn with an eye towards how they might influence global economies and markets.

 All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

Fiscal Policy – Stepping On The Gas

The role of government within the economic realm in a capitalist society is to 1) Create and maintain a legal framework for fairness, confidence, and incentives to prosper,  2)  Provide infrastructure to help facilitate trade, improvements to health, safety, training, and education, and 3)  Enforce regulations to deter abuses.  

After that, get out of the way.

Keynsian economists actually argue that the government should also strive to stimulate the economy through deficit spending/tax cuts during times of economic weakness, while similarly harnessing growth during times of economic overheating.  This toggling of stimulative and restrictive fiscal policies act as a governor to prevent the economy from careening too far in any one direction.  

The raising and lowering of taxes is one such toggle.  Ideally, taxes are to be raised in times of prosperity to save for a rainy day.  All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

New Tax Policy

Let’s not sugarcoat this.  That tax reform process was sub-optimal and seemed rushed.  Most Senators, including Republicans, weren’t even given enough time to review the new tax law prior to voting on the initial bill.   Senator John McCain made it clear that he did not think it went well.

When President Ronald Reagan’s Republican party reformed tax policy in 1986 there were 33 public hearings with dozens of scorings by the Congressional Budget Office (CBO).  The bill passed 90-10 in the Senate.  

Even still, that program led to an explosion in public debt following a massive shot in the arm to the markets.  Yet the broader economy never benefited in terms of “above trend” economic growth throughout the Reagan/H.W. Bush years.  

Throughout this year’s tax reform process, there were no public hearings and the Senate used “reconciliation” to avoid needing 60 votes.  As such, the bill passed with a straight-up partisan 51-48 vote.  This tax reform bill received scary scorings from the (CBO) for its impact on the deficit.  

The CBO claims the recently approved tax bill will lead to increasing the Federal debt by $1.5T over the next 10 years. This is the case even under rosy, non-recessionary economic growth assumptions.  Think about that.  Even after 9 years of non-recessionary growth (second longest in history), the CBO scored this bill assuming no recession for the next 10 years and it is STILL expected to add to the deficit.  That means that the deficit will surely soar in the likely event that we do have a recession within the next 10 years.

The fiscally conservative Republican Party that once protected against swelling deficits appears to be conspicuously absent from the Congressional floor.

Impact of the New Tax Policy-

The reality is that the effective US corporate tax rate is already 24% (not the 35% quoted by the administration).  This means there will be winners and losers among sectors, as we move to a flat 21% for corporations.  For example, Amazon’s effective rate is currently 38% (winner), while Nvidia only pays an effective 13% rate (loser).

The biggest benefit realized from the proposed tax policy will be the eventual repatriation of US earnings/cash by US-based corporations from overseas accounts.  This should help spur mergers/acquisitions, stock buybacks and increase dividends.  The jury is still out on whether we will see higher wages and increased capital expenditures.

Our view is that any benefit of lowering the corporate tax rates will be offset by higher debt levels down the road.   The new tax bill should provide short-term gains for the stock market at the expense of long-term challenges to our deficit.  Sadly, this appears to be the modus operandi for both sides of the aisle in our modern day Congress.  

Deregulation

Deregulation will help certain industries (domestically oriented financials, retail, energy, and segments of healthcare), while likely hurting others (multi-nationals).  Unfortunately, the short-term gains will not come without potential long-term pain down the road.  

Take for example the subprime credit crisis of 2008-2009.  The subprime crisis was largely a byproduct of deregulation by both political parties that created a system that encouraged moral hazard.  

Moral hazard exists when a person or entity engages in risk-taking behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome.  Think Bank Bailouts!  

All of this was allowed so politicians could curry political favors from industry lobbyists and industry titans.  It certainly feels as though some of the deregulation programs currently getting passed increase the risk of re-visiting some of those horrendous ethical dilemmas that almost took down our capital markets.

Ethics aside, deregulation in the energy sector will help our trade deficit as we move from a net importer to a net exporter of oil.  This large swing in global energy markets will correspondingly put upward pressure on the USD, thus ultimately pressuring earnings of large multinational U.S. domiciled corporations. This policy entanglement exemplifies the potential unexpected impact and unintended consequences in unrelated portions of the economy.  

Another example will be the rollback of Dodd-Frank and the Volker Rule in the Financial industry.  Deregulation in financials will likely ease lending restrictions, which should lead to higher industry profits and potentially place upward pressure on inflation.  An uptick in structural inflation would not be ideal this late in the economic cycle.  Not only that, but deregulation will likely lead to more instability in our nation’s banks.

Our view is that Deregulation may ultimately end up having a larger initial upward impact on future economic growth than the total net impact of tax reform.  We also expect that there will be long-term consequences associated with these short-term gains.

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.

Monetary Policy – Pumping The Brakes

The Federal Reserve Bank (the “Fed”) is the banker’s bank.  It is charged with oversight of the banking industry and maintaining solvency while managing interest rate and liquidity conditions for our economy.  

Similar to fiscal policy, the Fed operates counter-cyclically to economic activity.  Since the Great Recession began in 2008, the Fed has done most of the heavy lifting to keep the economy moving.  It will now be charged with offsetting the net effects of the new tax policy, while also attempting to maximize full employment, stabilizing financial conditions, and maintaining price stability.

Interest Rate Policy

The Fed raised interest rates three times in 2017 from 0.75% to 1.5%.  Looking forward, the market is pricing-in ONE .25% interest rate increase in 2018, while the Fed is expecting THREE more .25% hikes (based on their published “dot plot”).  

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.  The Fed has a number of balls in the air as it tries to stay ahead of potential inflation created by the tax policy from this low level of unemployment, while also making sure the markets don’t get spooked as they begin to wean themselves off their “drug of choice” (cheap money).

Complicating the Fed’s job will be the swearing in of a new Fed Chairman to replace Janet Yellen in February 2018.  My mind races back to 1987 when the markets tested the then-new Fed Chairman, Alan Greenspan, after he replaced Paul Volker.  The markets collapsed in October of that year, eventually leading Greenspan to turn on the monetary hoses, reflating the stock market.  It will be no surprise if the markets test the new Fed Chairman relatively early in their term.

The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting…. that means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

US Dollar

Be careful for what you wish.  More advantageous trade terms aggressively negotiated through a more transactional and less strategic approach will likely lead to less trade and higher prices, despite a stronger USD.  As Charles Plosser, former Philly Fed President and CEO, stated at an event that I attended earlier this year… “higher prices and weaker economic growth are a Central Banker’s nightmare”.  A stronger dollar further complicates the Fed’s ability to fight potential inflation through higher interest rates.

Productivity – Smoother Ride, Same mpg

Artificial Intelligence (AI), Machine Learning (ML), Blockchain, Robotics, and Innovation – those are the buzz-words and themes that will continue to grow in 2018 and beyond.  

Interestingly while all of these concepts are almost universally viewed as positive, ultimately these trends will put downward pressure on wages. The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting.  

That means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

I realize that many readers live in the Silicon Valley and will want to argue with this statement.  So, I promise to dedicate a future article on this topic to flesh out the evidence from an economic perspective.

The consensus opinion is that populism will not fix stagnant wages.  The simple fact is that innovation will continue to put downward pressure on wages for most of the population.  The shareholder class (equity owner) is much more inclined to benefit from today’s trends than the stakeholder class (employee)…regardless of which political party is in power.

Best reason to be bearish is there is no reason to be bearish. ~Michael Hartnett

WILD CARD ALERT:  There is little debate that the economy, and the stock and bond markets have greatly benefited from low inflation and low volatility.  In fact, in addition to the S&P 500 setting records for consecutive monthly gains, the stock market is similarly setting records for low volatility almost daily.  Most market commentators agree that the record low volatility and record high market prices are inexorably intertwined as one grinds lower and the other grinds higher.  

There are many factors that contribute to these idyllic economic underpinnings, which have correspondingly helped create an environment of low-interest rates and high earnings multiples.  Due to overcapacity in the global production markets, it is unlikely we will see a significant unexpected rise in inflation that negatively impacts interest rates, volatility, and stocks prices.  

In fact, the consensus view is for inflation and volatility to drift just a bit higher than current, but still at comfortably low levels.  As Bank of America Merrill Lynch’s strategist, Michael Hartnett, recently put it, the “best reason to be bearish is there is no reason to be bearish.” Contrarian much?  That said, consensus is so strong against a surprise increase in inflation that it could be quite detrimental to all financial assets… if we were to see the “whites of its eyes”.

This is important because passing tax policy this late in the economic cycle coupled with individually negotiated trade “deals,” increases the odds of higher than expected inflation.  As such, we feel it is prudent to consider some form of inflation protection (which is cheap) in addition to allocating to truly diversified alternative asset classes.

Unwrapping our Review and Outlook

The economy and markets have been on cruise control due to artificially suppressed interest rates through Quantitative Easing (QE) policies by the world’s Central Bankers.  The US economy also benefited from easy comparisons coming off a weak 2016 and a bounce back in the global economy.

Looking ahead, we have fiscal policy being applied at a strange time, given the maturity of this economic recovery.  Normally, we would expect a pro-growth tax policy coming out of a recession, not 9 years into a recovery.  This will likely accelerate the world’s Central Banks to move to a more restrictive stance.  All of this will finally introduce a bit more uncertainty into the markets.   

In fact, it is time to let the markets determine winners and losers, rather than use artificially suppressed interest rates to prevent business failures. Not everyone gets a ribbon anymore.  The bottom line suggests that given all of the uncertainties and moving pieces in the global economy, stocks look better positioned than bonds at this juncture, but many alternative investments offer the most favorable risk-return payoff.

My forecasting goggles indicate that an increase in uncertainty in Monetary Policy coupled with growing tensions in the geopolitical landscape will create a negative market-month at some point in 2018; i.e. the record consecutive winning streak for the market will come to an end in 2018.  How’s that for a prediction…too bold?

Happy Holidays,

Financial Alchemy – The Great Experiment

Financial Alchemy – The Great Experiment

Unwinding the Fed’s Quantitative Easing Program

The Great Experiment is unwinding. The U.S. Federal Reserve Central Bank (Fed) is beginning to reverse its Quantitative Easing (QE) program, a 2009 policy created in response to the worsening financial crisis known as the Great Recession.  Since its very conception, QE was considered a controversial, unconventional, and some would say experimental, monetary policy.

QE occurs when a Central Bank purchases a predetermined amount of government bonds or other securities from the market in an attempt to lower interest rates, increase asset prices, and stabilize the economy.

In total, Central Banks across the globe followed the US Fed’s lead and combined to purchase more than $20T in assets under the QE umbrella.  This coordinated effort had a massive effect on asset prices and interest rates across the globe.  

This monetary policy experiment (QE) had no historical precedent and was the financial equivalent of other controversial lab experiments like GMOs (genetically modified organisms), stem cell research, or genome sequencing/editing: praised by some and scorned by others.  Hence, Quantitative Easing became know as “The Great Experiment”.

Proponents of QE credit it with stabilizing the economy and pulling the United States out of the Great Recession.  Critics claim the effects have increased income inequality, inhibited our return to historical economic growth rates and dramatically increased the chances of future policy missteps.

We’ are about to find out if the old adage “don’t fight the Fed”, which was true on the way up, will hold true in reverse. After more than eight years of QE variations, the Fed finally began to move from QE to QT (Quantitative Tightening) just a few weeks ago.

While the Fed actually ended its bond-buying program in early 2015, they never removed the increased reserves created through this activity.  The Fed is now allowing its bonds to mature without reinvesting the proceeds, and thus those reserves will gradually be removed from the monetary system.

In this edition of “Cutting through the Noise” we review some of the more dramatic effects created by QE that are captured in our “Three Favorite Charts” below and discuss how QE, and its present unwinding, is likely to impact both the economy and capital markets.

Tools And Materials For The QE Experiment

How quantitative easing works

The process described in Steps 1, 2 and 3 above is quite straight-forward. In a nutshell, the Fed buys government bonds and mortgages, which pushes up prices of those securities while pushing down interest rates.  

These lower rates inspire economic activity, while simultaneously encouraging investors to take more risk in securities that offer higher returns than the bonds bought by the Fed.  The net effect is that the money created by the Fed to buy bonds is ultimately re-deployed into riskier assets by the investment community.  

If all of this feels more like market manipulation rather than the ‘free market pricing’ of the cost of money or interest rates; Guess what?  It is!  Prior to its own QE implementation, the U.S. openly criticized other governments for similar behaviors through the IMF, World Bank, and World Trade Organization.  

Immunization or Mutation

U.S. hypocrisy aside, The Goal stated in the above chart is unambiguous and the results are irrefutable.  Since this process began on March 9, 2009, the stock market is up almost 400%, mortgage rates declined more than 3%, and spreads on high yield junk bonds compressed by 15-20% to historic lows, making corporate borrowing much more affordable. These very impressive results helped inflate consumer confidence and jumpstart the economy.

Thus far, the QE experiment is a success on many levels and was necessary at the depths of the recession to avoid total economic collapse.  However, we will never know if (once the economy survived the initial free fall with the help of extensive government programs such as QE) it would be in better shape today had the government backed off such aggressive intervention and allowed more businesses to fail, thereby removing more debt through bankruptcies, and bringing about more business investment in the subsequent recovery.

That question will be the topic of white papers for generations.  Managing this unwind will determine whether the Fed can claim ultimate victory with their Great Experiment or if they created a Frankenstein economy.

The Risks highlighted in the chart above are a bit more debatable.  To be sure, the risks were somewhat avoided because other global Central Banks implemented the same policies as the Fed.  This coordinated global liquidity program prevented the U.S. dollar from falling on a relative basis.  A weaker dollar is often considered a precursor to inflation because a weaker currency leads to paying more for imported products or “importing inflation”.

At the end of the day, it is easy to conclude that the “Goal” of QE was accomplished, and to this date, the risks mostly avoided.  That said, it’s likely the task of unwinding this experiment will get a bit more complicated… all the more so with a new Fed Governor set to take the helm from Janet Yellen next February.

Let’s See What Those Central Bankers Created In The Lab!

Now that we have discussed how QE actually works, let’s take a look at the impact of this program on various segments of the capital markets.  

Favorite Chart #1 – The chart below illustrates the direct impact QE had on stock prices.  The blue line represents the assets purchased through global Central Bank QE operations (RHS).  The red line shows how the S&P 500 responded to these excess reserves being pumped into the capital markets.  WOW.  We have seen ETFs (designed to tightly track a specified index) in certain illiquid markets that exhibit a lower correlation.  This is strong evidence that equity investors benefited from QE.

European central bank bank of japan federal reserve vs s&p 500

This does not necessarily mean that the stock market is about to fall or even that it has to fall at all.  It does suggest this may be a great time to take some profits or consider other avenues for excess returns going forward.

Favorite Chart #2 – European High Yield bonds trade at lower interest rates than U.S. Treasuries or the first time EVER!   Shown below is the Euro High Yield non-financial bond index (blue line) vs the U.S. Treasury bond (white line). Not surprisingly, Euro High Yield bonds traded with much higher interest rates through most of the last cycle, because as expected, High Yield bonds carry more risk.  

BOA US treasury vs BOA Euro High Yield

In late 2008 / early 2009 we see that interest rates on riskier bonds increased to historically wide spreads vs U.S. Treasuries during the depths of the Great Recession. Once the QE policies kicked in 2009, credit spreads began to tighten again.   

However, fast forward to 2016 and look what happened in the Euro Junk bond market.  Once the Fed stopped buying bonds in 2015 and the ECB ramped up their QE or bond-buying activities, we saw High Yield bond interest rates in Euro decline to the same level or lower than U.S. Treasury bonds.  This is crazy!  

How can Junk bonds in Euro trade with the same implied risk as U.S. Treasuries??  This single, irrational data point highlights how the effects of QE have simply gone too far and must recede at some point.

That said, the Fed has begun to let some of their bonds roll off (QT), which is their plan to reverse the effects of QE. However, the BOJ and ECB (and possibly China) will continue their QE operations, so some of these relationships could get even crazier.  

Investors need to be aware of how we got here, because some of those principal drivers are about to reverse.  This policy reversal is likely to reverse the price patterns of many securities that benefited from QE on the way up.

What Effect Did QE Have On Passive vs. Active Managers?  

Favorite Chart #3 – Let’s look at a less direct impact of QE as seen in the chart below.  This chart displays the impact of investors indiscriminately buying passive equity investments rather than actively managed investments after the onset of QE.

Active manager vs all assets

Active managers were clearly outperforming across the board until shortly after QE “goosed” the markets in 2009, which led to initial outperformance from passive products coming off the market bottom.  The longer that paradigm persisted, the more and more investment dollars shifted from active to passive.  At this point, active funds have given up all of their previously accrued outperformance and an additional 3+% to passive funds.

This process has a self-fulling effect, whereby active managers that suffer redemptions must sell their “active” positions, thus putting downward pressure on those active exposures.  This money then goes to passive indexes/ETFs, which continue to funnel into the same basket of market cap leaders.  

The effect of driving more and more money into the largest stocks based on market capitalization had a derivative effect of also driving down volatility.  Guess what, lower volatility leads algorithmic asset allocators to also push more money to stocks.  Lather, Rinse, Repeat…and so on.

Just like the crazy relationship described earlier with the Euro Junk bond yields trading below Treasury yields, this passive craze will likely reverse at some point as the buoyancy offered through QE recedes.

We have seen this before, markets are cyclical and the drivers of market performance ebb and flow.  One cycle that we expect to reverse at some point is the consistent outperformance of passive over active investments.  Not only is the main driver of this phenomenon about to reverse, but active management tends to outperform late in the cycle.

As The Globe Continues To Spin, The Fed Begins To Unwind…

Going forward, it will be interesting to dissect the result of the Fed tapering QE while Congress gets busy implementing fiscal stimulus through tax cuts.  This could break in a number of directions…

The Fed suggests that it will be like watching ‘paint dry’; while others speculate this will lead to a de-synchronized global economy resulting in wild currency swings, higher interest rates and a return to a more normal business cycle that ultimately careens off the tracks.  

The truth will no doubt be found somewhere in between.  Let’s remember this is probably the first step in the eventual return to increased uncertainty in our markets and ultimately more volatility.  That is a good thing. Volatility creates opportunity.

Let’s hope global Central Bankers slowly turn down their Bunsen burners and allow the effects of this simmering experiment to slowly subside.  The free markets have a fine record without the need to put the economy on chronic steroids, and it’s now time to wean it off the performance enhancing monetary policies.

Extra Credit:  

While QE was successful in stabilizing the economy during the Great Recession, it was not the single greatest government policy that helped prevent the economy from the slipping into depression in March of 2009.  

The monetary effects of QE were amplified atop the fiscal effects of TARP (Troubled Asset Relief Program).  TARP was QE’s equivalent on the fiscal side, which was implemented by the Bush and Obama Administrations in conjunction with Congress.  These programs included purchases of mortgage-backed securities along with bailouts for the banking and auto industries.

All that said, the single greatest policy change that occurred on that fateful March 9th morning in 2009 was the removal of ‘Mark-to-market’ accounting for the banks.  This policy not only removed the need for banks to value their loans (and underlying collateral) at market value, but actually allowed them to value their loan portfolio at the purchase price.  The ultimate result was that banks no longer needed to sell assets to reduce risk and thus, removed downward pressure across all assets at our darkest hour.

The combination of all three of these policies (QE, TARP, and removal of ‘Mark to market’) undoubtedly kept our economy out of the dustbin of history and allowed us to eventually regain momentum.  Going forward, it is likely that the government will revert to using its full bag of tricks, or create new tricks in the lab, to avoid a similar collapse in the future.  It will be interesting to see to what degree the government allows the economy to return to a ‘free market’ and how much they continue to use policy tools as political weapons.

 

Disclosures

Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and do not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Seeking Magnified Returns via Alternative Investments

Seeking Magnified Returns via Alternative Investments

Where to Find Reliable, Risk-Adjusted Returns on investments…

  • Peer-To-Peer Lending
  • Short-Term Construction Lending
  • Life Settlements
  • Merger Arbitrage

Most of us are familiar with the famous fictional private detective, Sherlock Holmes, created by British author, Sir Arthur Conan Doyle. In the stories, Holmes was known as a “consulting detective”, tactically tapped by his clients (often Scotland Yard) for his proficiency with observation, forensic analysis, and logical reasoning, to help solve tough cases.

One of Sherlock’s famous phrases was “whenever you have eliminated the impossible, whatever remains, however improbable, must be the truth”.  We at Three Bell suggest that while making solid risk-adjusted returns in the public markets is not necessarily impossible, it is becoming more and more improbable. As such we are looking elsewhere for opportunity. Much like Holmes, we apply many of the same principals and skillsets to assist our clients in navigating the changing (and at present, challenging) financial markets.

Last month, we discussed how the public stock and bond markets are fully priced and adding alternative investments to your portfolio can reduce volatility, increase returns, and mitigate downside risk.

In this edition of “Cutting through the Noise”, we examine alternative investments to overvalued public market investments.  Although its anything but, ‘Elementary, my Dear readers’, we believe these alternatives provide clues to where to find higher returns with lower risk. Let’s dive in!

THE BIG PICTURE

Holmes was famous for his use of deductive reasoning to take seemingly disparate facts, and use them to formulate a complete picture of what had actually occurred. Following Holmes’ example, in order to understand where certain alternative investments fit into a well-diversified portfolio, we must first understand where the sum total of all of the world’s investable assets are deployed.

By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

Take a look at the chart below. What we can deduce is that public markets (stocks and bonds) actually represent a comparatively small portion of the overall investable universe…and, as we discussed in our last article are the most overvalued cross-section at that.

Domestic equities and bonds - fraction of investables
Source: Oliver Wyman

The vast majority of the public market investment universe (stocks and bonds) is confined to the first four ‘colored blocks’ above, and represents just $159T out of a total $437T of investable assets. By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

However, almost all of that remaining $300T can be accessed through some form of private offering, typically through a hedge fund framework, that can blend nicely with a public market portfolio. On that note, let’s take a look at some of the specific alternative investment strategies Three Bell is currently leveraging on behalf of our clients to help mitigate the volatility of the broader stock and bond markets, as part of a well-diversified portfolio.

…many new private credit markets [sic] can offer disproportionate returns to those available in the public fixed income market.

TYPES OF ALTERNATIVE INVESTMENTS

Our last edition of “Cutting through the Noise – Think Alternative(ly)” broadly discussed alternatives as an asset class. However, there are a wide variety of investments that fall within that category and generate returns in vastly different ways.

Credit Market Niches’

The financial crisis of 2008-09, which was first and foremost a credit crisis fueled by defaulting subprime mortgages, resulted in many changes to the banking sector. The sum total of these changes was a substantial pullback from banks offering certain types of financial products, and a “back to basics” mandate. The net response to these changes is many new private credit markets that can offer disproportionate returns to those available in the public fixed income market.

Peer-To-Peer Lending Funds

A specific niche type of lending platform that has gained significant traction since the Financial Crisis is peer-to-peer (P2P) lending. This category looks to serve the individual loan market that does not want to borrow through unsecured, revolving credit (eg credit cards).

Lenders (in our case, a hedge fund) extend credit, often at rates similar to credit cards, but allow borrowers to amortize that debt from the outset, enabling borrowers to see the light at the end of the tunnel and thereby dramatically reduce instances of default. These lenders can then pass along high returns to their investors because they operate much more efficiently than the big banks.

One such hedge fund utilizes a complex algorithm that evaluates and weighs over 1200 different unique data points for each loan, then uses a high-speed trading conduit into the lending platforms to purchase the best loans within 40 milliseconds. This pretty much leaves the little guy out of the equation, but does offer an excellent risk-return profile to investors in such funds.

What do we like about this alternative investment?

  • Consistent, high single digit, low double digit returns since inception (currently annualizing at approximately 12% net of fees)
  • Little to no correlation with the stock or bond markets
  • Maximum loan size is $30K and most are 3-year loans, which means a fund investing tens of millions of dollars is going to own a LOT of loans that are paying off in a relatively short period of time
  • Personal loan deficiencies consistently remain lower than other loan types, including auto loans, mortgages, and credit cards. Supporting data illustrates this further.
  • 9% of investors in this market segment have made money in personal lending over the past 10 years.
  • Default rates through the Financial Crisis needed to be 70% more severe before investors would have lost ANY money in this asset class (see chart below)
Source: Federal Reserve via Theorem Marketplace Lending Fund

Short-Term Construction Lending Funds

Traditional banks lost their shorts in the Financial Crisis, partly because they had loaned money to real estate developers who walked away from unfinished projects, forcing the banks to repossess the properties. Worse, global Basel III commercial banking regulations written after the Financial Crisis prohibited the banks from holding the assets until they recovered their value, and banks were thus forced to liquidate in a fire sale, locking in substantial losses.

Due to those regulations, many traditional banks exited the short-term construction lending sphere, which left a void of capital for real estate developers that needed to borrow money to build their properties. Enter private real estate debt funds…

There are many high return business models that lend themselves well to the private, hedge fund format.

Because of the scarcity of capital for real estate projects, hedge funds that effectively analyze and pick high quality, low risk projects, can charge double-digit interest rates on what are typically relatively short term loans (1-3 years), and are then cashed out of the project entirely when the development is complete and the debt is refinanced with a traditional bank and long-term debt.

What do we like about this alternative investment?

  • High annual interest rates of approximately 12% net of fees
  • No property depreciation risk since not buying the asset, just loaning funds
  • Short term loan duration of 1-3 years
  • Senior secured debt gets paid off first in the event of default
  • Maximum 70% LTV established at time of investment
  • Ability to repossess property at a very low cost and hold that property or develop it to maximize investor returns (thus eliminating need for fire sales)
  • Little to no correlation with the larger stock or bond markets

Special Situations

There are many high return business models that lend themselves well to the private, hedge fund format.  These opportunities vary in their reliance on the underlying stock and bond markets, but one variable remains the same… the overall correlation to the public markets is historically very low.

Life Settlement Funds

A life settlement is the transfer of ownership and beneficiary rights of an unwanted or unneeded life insurance policy in exchange for a cash settlement. The seller of the policy no longer has the responsibility of paying future premiums.  In exchange, buyers (investors) profit based on the difference between the face value of the policy (death benefit) and the aggregate of the acquisition price, plus accumulated premium costs.

The typical returns for investors in these policies have been 10-18% per year with very little volatility, as seen in the graph below.

Carlisle Life Settlements IRR
Source: Carlisle Management Company

The life settlements industry, and returns thereon, are expected to continue to grow due to 1) projected increases in the US senior population and a resulting larger pool of policyholders potentially looking to sell, and 2) the large gap between the current size of the life settlement market (under $20B) and the value of the individual policies that lapse or are surrendered each year (over $640B).

Voluntary Life Insurance Terminations and US Population age
Source: Carlisle Management Company

What do we like about this alternative investment?

  • There is little to no correlation to the larger stock and bond markets
  • Returns are well into the high teens every year since inception
  • Returns are very stable and experience very little volatility
  • The underlying policies are with investment grade carriers
  • Returns are almost all long-term capital gains making it very tax efficient

Merger Arbitrage Funds

Merger arbitrage entails investment in event-driven situations such as leveraged buyouts, mergers, and hostile takeovers. Because of the risk that a merger will not close, the target company’s stock will typically sell at a discount to the deal price. This pricing discrepancy or “spread” is a merger arbitrage fund’s potential profit.

There are a variety of reasons why a merger might fail, creating this opportunity, including government antitrust rulings, financing failures, and shareholder rejections. However, with proper position selection, a merger arbitrage fund can largely immunize itself against stock market fluctuations. This is due to the fact that the fund isolates its exposure to the compression of the spread between only two stock prices, the acquiring company and the target company. Thus price movements at the market level become largely irrelevant.

What do we like about this alternative investment?

  • Returns for the fund we utilize have annualized at approximately 28% since inception, net of fees
  • Low-interest rates and a sluggish economy should lead to increased M&A activity
  • At 170 announced deals, there are a lot of potential mergers to address
  • The Dodd-Frank Bill forced many investment banks out of merger arbitrage, lessening competition
  • Arbitrage spreads tend to be positively correlated to overall interest rate levels (profit tends to increase along with interest rates in a rising rate environment)
  • Fund strategy isolates returns from larger stock market fluctuations, reducing correlation and providing true diversification

THE SCIENCE OF DEDUCTION

Based on an extensive examination of all the clues presently available, we deduce that the public markets offer more risk than return. That said, no one can predict the market, and there is always the possibility that it pushes inexorably higher.

In response to this upsidedown risk-return paradigm, we do not suggest investors retreat to the unacceptably low-interest rates available in money funds.  Rather, we can utilize certain alternative investments to continue to produce stable returns by investing in funds whose underlying assets and strategies are not tied to the stock and bond markets.

Through the use of alternative investments, in concert with stock and bonds, our intention is not to predict the market, but rather prepare for all outcomes.

 

Disclosures

Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Think Alternative(ly)… Invest Different

Think Alternative(ly)… Invest Different

By: Bill Martin
Senior Managing Director and Investment Strategist


With both stock and bond markets priced for perfection, it is time to look for asset classes that can provide true diversification to lower risk and increase returns.

Introduction

Apple, Inc. taught us the power and promise available through embracing change, if we only learn to ‘Think Different’.  We believe that has never been more appropriate and applicable than right now for the financial markets.  In an homage to that timeless Apple precept, we encourage investors to look beyond the typical herd mentality for answers and find “alternative” sources of excess returns.  With the bond market offering record low yields and the stock market trading at record high earnings multiple valuations, we try to answer the question… what’s an individual investor to do?

We’ve all heard it our entire investing lives:  diversification is the key to stable, long-term investment returns.  OK, great, but diversification into what exactly?  It’s entirely possible to diversify into a terrible investment and in so doing, do yourself a disservice.  Logically, diversification into just “different” investments, in and of itself, is not going to help investment returns, particularly in the event of a substantial market correction.

Historically, for many investors, diversification has meant spreading assets across different segments of the stock market, with a portion of the allocation going to smaller more nimble growth-oriented companies, some to larger more established value-oriented companies, and then splitting that up across both domestic and international exposure.  The resulting pie chart shows a wonderfully diverse array of colored pie wedges, creating the illusion that we have accomplished our diversification objectives (at least graphically).

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”

However, when markets experience severe declines, the returns of these various sectors tend to homogenize and drop at the same rate.  This is what we refer to as “correlation.”  During the Great Recession, even if you had all of your fixed income allocation in US Treasuries you still experienced a drawdown of -20% or more.  That number was closer to -40-50% if you were 100% in stocks and bonds that did not contain Treasuries… no matter if you were in US or International, investment grade corporates, or high yield bonds.

So, when we think about true diversification, and the benefits we are supposed to realize from that concept, we must find investments that are not correlated to the larger stock and bond markets, and are capable of generating positive returns regardless of any form of precipitous correction, market decline or increase in interest rates.

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”  By using alternative investments, it is possible to design an “all-weather” investment portfolio where each individual component of the allocation is making money in a way which is both divorced from the broader stock and bond markets, and at the same time different from the other investments within the portfolio.

In this edition of Cutting Through the Noise, we investigate how to use alternative investments as a key component to portfolio construction to achieve stable non-correlated, long-term returns, and why it is particularly important to do so now given where we are in the current market cycle.

Low Expected Returns for Stocks and Bonds and the Need for Diversification

In order to understand the importance of incorporating alternatives into your portfolio, we must first understand the current challenges of the two traditional primary asset classes:  stocks and bonds.  As you will see below, neither are poised for outsized gains, and instead both are set to experience significant headwinds.

Bond Market Headwinds

In the fixed income world, we earn the interest income from the bonds we hold, plus or minus any increase or decrease in the underlying value of the bond holdings.  The biggest driver of increases or decreases of bond prices are interest rates, namely, what is the present interest rate vs the rates when the bonds we hold were issued.

As interest rates rise, the price of a bond portfolio tends to depreciate, and vice versa.  This is because in a rising interest rate environment, new bonds are being issued which pay higher coupon rates than those that are held in the current portfolio.  Thus, if those bonds were to be liquidated in that environment, they would need to be discounted to account for the lower coupon payments.

So, where are we in this cycle?  Gradually lower and lower interest rates due to global Central Bank bond buying programs (“Quantitative Easing”) has driven interest rates to levels previously not seen.  From this level (see chart below),

there is more risk than return available in the bond market.

Based on the chart above, we believe that its more likely interest rates will rise from where they are now… versus fall.  If this is in fact accurate, the best case is for bond investors to earn the income associated with the bond coupon and hold those bonds to maturity to eliminate interest rate risk and resulting pricing fluctuations.  This puts returns anywhere between 2-5%, depending on how much credit risk an investor is willing to accept.

Stock Market Headwinds

As a result of these artificially suppressed interest rates, investors have sought higher returns elsewhere and have correspondingly pushed stock prices to near historical high valuation multiples – particularly when considering the low level of economic growth in the underlying economy.

In order to understand where the headwinds exist in the stock market, we need to start with the general understanding that the more an investor pays for earnings, the lower their expected return.  We have a nice chart that illustrates that point below.

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward. 

Time to get outside of the box…

The market is currently trading at earnings multiples that are higher than any other time in our history, except for a few months in 2000.  As such, we believe P/E multiples are unlikely to expand much further and are instead much more likely to contract.

This, coupled with muted GDP (around 2%), means that earnings growth is also likely to be muted which creates overwhelming risks to the downside for the stock market.  Historically, the 10 years after the stock market trades at these levels, the result is a paltry 1% annual growth (see our CAPE blog for more in depth analysis).

Key Takeaway

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward.  Interest rates are more likely to rise than fall dramatically hurting bonds, and earnings multiples are more likely to revert to the mean and compress hurting stocks.

As a result, we believe traditional portfolios that have relied solely on these two asset classes for diversification and returns are, at best, going to suffer mediocre returns for the foreseeable future, and at worst (particularly in the case of the stock market) suffer severe declines in asset values.

Time to get outside of the box…

What are Alternative Investments and What Do They Do?

The intent of considering alternative investments is to maximize the odds of increasing our total investment return profile, while reducing the risks that are stacked against us if we invest only in the public stock and bond markets.

The chart below illustrates some of the high level key differences between alternative and traditional investments:

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities. 

We are all very familiar with the “Traditional” row on the top of the chart – buy stocks and bonds and hope they go UP…that is what is meant by “Market Direction Sensitive” in the last column in the top row above.

In the “Alternatives” row on the lower part of the chart we see options beyond just stocks and bonds which, very generally, include all asset classes other than long stocks, bonds, and cash. Specifically, Alternatives include funds that trade long/short equity, real estate, private equity, life settlements, venture capital, commodities, merger arbitrage, specialized debt, and much, much more.

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities.

The triangle chart below provides a conceptual framework that illustrates the potential benefits of combining various alternative investments.  Specifically, alternative investment portfolios should include an intelligent combination of fund strategies that generate outsized uncorrelated returns, deliver inflation protection, and provide hedged downside protection thru “true diversification.”

…many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.” 

Impact of Alternatives on Portfolio Returns

We wouldn’t be looking at this important asset class if it didn’t deliver demonstrable benefits.  However, we must start with a caveat:  most alternatives are packaged as “hedge funds” and most hedge funds have lagged the broader stock market recently.  As such, many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.”

“… alternatives have shown the ability to both lower risk AND increase return.”

To that we have three comments:

  1. Returns are time period dependent. As such, many hedge funds did their jobs well and looked dominant vs index funds and ETFs leading up to and through the financial crisis.  They “hedged” against negative returns.  That’s what they do.  Now that the market has run to historically high valuations (see above), would you rather stay almost entirely in long only stocks and bonds or consider diversifying to hedge some of the downside?

 

  1. There are many types of hedge funds, ranging from “conservative” to “aggressive” and everything in between, and many of them do not simply “hedge” stock or bond market risk. In fact, some of them are completely off the grid, don’t have anything to do with stocks or bonds, and can perform well regardless of what the broader stock or bond markets do.

 

  1. Keep an open mind as we avoid driving through the rearview mirror. Investing is not easy and the truest long term successful strategy is to be contrarian.  Many alternatives and hedge strategies are built to capitalize on this phenomenon.

We have two very important graphs to examine below.  The key take-away is that alternatives have shown the ability to both lower risk and increase return.  This is despite following a record bull market run facilitated by the world’s central bankers.  History suggests that the risk-return benefits of alternatives will be even higher in the intermediate future.

The first graph shows the risk and return for a typical “balanced” 60% stock and 40% bond portfolio.  The stock portion is invested 2/3 domestically and 1/3 internationally.  The return of that balanced portfolio has been 7.94% with an annualized volatility of 8.81%.  This portfolio is said to have a simplified Sharpe ratio (return/volatility) of .90.

This simplified Sharpe ratio is an efficiency evaluation metric to indicate how much return your portfolio gets per unit of risk.  The benefit of lower volatility is that it will typically help investors from selling at the wrong time.  It is always important to keep that number as low as possible.

The next graph below shows the benefit of allocating 50% of the portfolio to Alternatives, while keeping the remaining 50% in the 60/40 stock bond mix cited above.  The return increases to 9.33%, while risk declines to 7.28.  This configuration delivers a 1.28 Sharpe ratio, or a 42.4% increase in efficiency.  Greater returns, less risk.  Check!

“… investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.  At market peaks, these segments actually add risk rather than reduce risk.  We call this Di-worse-ification.”

These graphs clearly illustrate the benefit of adding alternatives into a portfolio otherwise comprised entirely of stocks and bonds.  The alternative investments into which we are currently deploying capital should have an even more dramatic positive effect, as they have higher expected returns with lower downside risk than the examples used in the above graphs.

Summary: Utilize Alternative Investments to Provide True Portfolio Diversification, NOT Di-worse-ification!

As we began by postulating, most investors seek to diversify their return patterns by going into more and different public market sectors.  While this can be helpful, investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.

At market peaks, these segments actually add risk rather than reduce risk.  We call this phenomenon, “Di-worse-ification”: the act of unknowingly constructing a highly correlated portfolio.  The dangers of diworseification are highest at low levels of interest rates, tight credit spreads and elevated earnings multiples.  Strike 1, 2 and 3.

We want to highlight the benefits of including completely different asset classes with different return drivers, such as some of the broad categories mentioned in the segments above.  The potential benefits and opportunities of including alternative assets have never been greater.

With the stock and bond markets both priced for near perfection, the greatest risk is that stock and bond markets continue to trade together. This means higher interest rates will bring lower bond prices.  Higher rates will also bring commensurately lower earnings multiples and lower stock prices.  In that event, diversification into traditional asset classes will not mitigate risk or stem investment losses.

That said, we see plenty of opportunity to reduce an investor’s risk profile, while increasing potential returns. Investors need to expand their selection universe to include new ‘alternatives’. This month we introduced the benefits of including alternatives in a well-diversified portfolio. Next month we will dig deeper into specific alternative investment opportunities.

 

Let’s Get Ready to Ruummbllllle!

Let’s Get Ready to Ruummbllllle!

By: Bill Martin
Senior Managing Director And Investment Strategist


Active investing is under siege by a proliferation of passive investments. Must there be only one winner in this fight?

In last month’s edition of Cutting Through the Noise, we took a good look under the hood of passive investment vehicles, and concluded that, while they have a number of positive attributes such as low cost, broad based market exposure, and tax efficiency, there are also growing and often unseen potential perils that should not be ignored.

In this month’s blog, we are going to examine some of the positive attributes of active management, and illustrate why continuing to tactically allocate to certain active managers in concert with passive investments, is a sound investment strategy, particularly in light of where the market is currently trading.

Specifically, we are going to cover how:

  1. It still makes sense to use passive investment vehicles for exposure to efficient and liquid markets, such as Large Cap equities, but
  2. There are market segments such as Fixed Income, Small Cap equities, emerging markets and certain style sectors, where boutique active managers tend to outperform passive investments, particularly late in a market cycle, and
  3. Newly emerging “smart-beta” funds are helping to bridge the gap between passive and active management, and merit consideration in the construction of a balanced, all-weather portfolio.

Let’s take the first jab…

Active Vs. Passive Equities:  Judges’ Decision, Not A Knock-Out

Active management has been the undisputed champion of the mutual fund world for decades.  However, that title belt has been challenged in the past few years by the unprecedented asset flows from active to passive funds.  In fact, the estimated asset split in domestic equity funds is expected to weigh in at roughly a 50%/50% split by the end of 2017.  This is setting up as a real heavy weight fight for assets going forward.  Let’s go ringside…

In this corner, wearing the white trunks – When coupled with their recent stretch of out-performance relative to active asset managers, passive funds have taken on an almost mythical, ubiquitous and omnipotent aura – taking money from active managers in all sectors.  However, as we discussed in depth last month, the self-fulfilling nature of money shifting from active to passive investments has led to a massive, momentum-driven bubble building behind the larger index names that are creating crowded trades with the potential to dwarf the necessary price discovery elements of active management.  All of this could ultimately lead to more volatility, less liquidity, and market dislocation.

And in this corner, wearing the dark trunks – Although active managers have taken quite a few punches losing asset flows to passive investment vehicles, don’t count them out just yet.  This month, we look to provide a head to head comparison between active and passive funds within the equity and Fixed Income asset classes separately, with the intention of leaving you with a better understanding of how and where to find the best investment options within each market segment.

Oh My… What do we have here?  It looks like Vanguard, the indexing powerhouse and proselytizer, admits that active investment management deserves to have a dog in this fight.  It appears that Vanguard is getting set to roll out a fund line-up of actively managed ETF funds. Interesting.

A more fitting segue does not exist to compare historical performance of active vs. passive investment choices.

Let’s take an empirical look at how active managers have performed relative to indexes in the core space through time.

The green line represents the performance of active managers against their benchmark index.  The flat yellow line represents the average number of times when the index beat active managers, measured over a 25 year time period.  When the green line dips below the yellow line, active managers are outperforming the index, and vice versa.  Hence, from the perspective of active managers, the higher the solid green line the worse they performed relative to their benchmark.  In general, Small Cap active managers have slightly outperformed their benchmarks throughout time, while active managers in Large Cap space have moderately underperformed over this period, NET of fees.  This has not been the passive fund knock-out of active managers many may have expected.

These charts tell us two very important things:

  1. Active managers outperform their indexes a greater percentage of time in less efficient market segments. This is evidenced by the fact that Large Cap active managers only outperformed their benchmark 45% of the time, whereas Small Cap active managers outperformed by 55%, and
  2. Active managers tend to out-perform late in a cycle and well into a recession. This is indicated by the dark shaded areas on the chart where you see the green line drop precipitously and stay low until the end of the recessionary period, indicating a prolonged period of active management out-performance.

This merits careful consideration, as we believe we could be nearing the point where the market could turn south due to fears of increased interest rates or an outright recession.  If that is indeed where we are in the market cycle, rotating active managers into the allocation makes a lot of sense.

Boutique Managers Punch Above Their Weight Class

“… boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.”

Let’s narrow this discussion from active vs. passive funds and focus more acutely on the active “boutique manager” sub-group.  A boutique firm is one where the portfolio manager (“PM”):

  1. Has a major equity stake in the firm, often with their name on the door
  2. Specializes in a specific type of investment
  3. Does not try to cover all bases and style boxes
  4. Has the freedom to go where the markets dictate in search of value
  5. Isn’t subject to the tyranny of sales incentives that can unduly influence strategy
  6. Doesn’t not get moved off of funds to more profitable funds, after proving themselves
  7. Is heavily invested alongside shareholders, and
  8. Is more interested in raising returns than assets.

With boutique managers, the incentive structure outlined above drives long-term, multi-generational out-performance.  The ownership structure available at many boutique firms encourages an entrepreneurial risk-taking environment built around an investment-centric franchise.  This is key because it keeps good PMs in place and removes the allure for them to leave for greener pastures following short-term underperformance.

The AMG chart below graphically displays some of the benefits/characteristics of the boutique asset management structure.

Of course, all these positive attributes are meaningless if they don’t lead to superior performance.  The “Figure 9: Boutique Excess Returns:” chart below provides evidence that boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.

“When utilizing active managers for the Large Cap space, we lean toward managers that can ‘go anywhere’ and are not confined to a particular ‘style box’ market segment.”

This chart highlights that boutique managers generated out-performance over their stated benchmarks to the tune of 141 bps per year, on average, between 1994-2014.  Indeed, these numbers are even greater when one looks beyond the US Large/Mid Cap market segment.  This is not a surprise.  It has long been contended that Large Cap companies are over-followed by analysts, which creates a very efficient market with less opportunity to outperform due to almost complete information parity.

As such, the richest out-performance opportunities tend to lie near the market sectors with the most dispersion and least correlation.  This leads us to look to areas like Small Cap and international (especially emerging markets) when looking for active managers.

When utilizing active managers for the Large Cap space, we lean toward managers that can “go anywhere” and are not confined to a particular “style box” market segment.  These types of managers can be paired with index funds in the Large Cap space to smooth the ride for one’s investment portfolio, particularly through a down-cycle.  Examples of this type of manager include Peter Lynch, Warren Buffet, Bill Miller, and Sir John Templeton.  They are all managers that may call themselves “value” shoppers, but are bold enough to skate to where the puck is going to be (or which way the jaw is turning), as opposed to where it has been.

The boutique structure (yes, Peter Lynch was early enough at Fidelity that his Magellan fund was treated as an autonomous boutique fund) gives latitude for Buffet to buy Coke as a Value stock in the 1970’s, because he believed the intrinsic value of the brand was not yet appreciated by the market.  He was right.  The same happened for Bill Miller’s AOL play and other tech names in the 1990’s, and Peter Lynch’s financial and consumer stocks in the 1980’s.  Sir John was early to identify rapidly growing emerging markets as great values in the international markets.  Good managers just buy good companies and don’t worry about fitting them into a style box or sales deck narrative.

“Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.”

The next chart shows the enormous payoff that can occur when one is willing to look under the hood to find a good manager and veer away from the risk-averse managers typically found at larger mutual fund complexes.  The 20 year numbers below are telling in the extreme.  The top-decile boutique manager has beaten their benchmark after fees by over 1100 bps per year!  In fact, simply using a top quartile manager led to more than 700 bps of out-performance over the illustrated period.

Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.   This is the market risk we discussed last month, which stems from ever increasing flows into passive strategies that are creating crowded trades, driving asset prices up beyond where they likely should be, and setting the stage for a wicked reversal.

Passive vs. Active Funds: Heavyweight Vs. Middleweight

When we turn our attention from actively managed equity strategies to actively managed Fixed Income strategies, we see marked out-performance by active Fixed Income managers.  This is primarily because passive Fixed Income vehicles:

  1. Allocate a disproportionate amount to the largest debt issuers, which are currently all US Government securities, and they have abysmal yields at present and can lead to a lack of diversification
  2. Increase interest rate sensitivity because of heavy allocation to Treasuries
  3. Are forced to sell high quality performing bonds when changes to the underlying index are made that mean the fund’s holdings no longer meet the index’s inclusion criteria
  4. Usually this type of planned selling results in the worst possible trade execution and pricing on that day as a larger than normal sell volume hammers down bid prices.

Below, we see that the median active Fixed Income manager has out-performed passive investments, such as ETFs and index funds (net of fees) over almost every time period (1, 3, 5 & 7 year returns), as illustrated by 100% of the red dots being above the horizontal line marked 50. While the 10-year red dot appears to the left of the vertical 50, demonstrating under-performance vs. the underlying index, it still appears solidly above the horizontal “peer group” line, indicating better 10-year performance than the ETFs and index funds, net of fees.

“Yes, the passive investments can actually be more expensive than some of their active counterparts.”

This is an important point… ETFs and index funds appearing in many of the higher risk segments of the market (such as high yield), have such high fees and costs that they are uncompetitive with active funds and their underlying indexes.  Let that one sink in for a moment.  Yes, the passive investments can actually be more expensive than some of their active counterparts.

“Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.”

The chart that follows highlights the challenges that occur within the ETF market once providers move outside highly liquid market sectors.  What you see is how certain high yield bond ETFs performed compared to their underlying indexes, after all expenses and fees.  Not that great.  On average, the ETFs under-performed across the spectrum by over -2% per year.

It is important to highlight that the opportunities for out-performance by active managers in the Fixed Income world only increase as an investor steps out of the risk curve or finds a solid, unconstrained, boutique bond manager to handle the bulk of the Fixed Income portion of their portfolio.

Lastly, the two charts below graphically display the challenges that the high yield bond ETF market will face when flows ultimately reverse.  Also, while the liquidity problems are the most pronounced in the high yield bond market, the lack of liquidity impacts all ETF markets (stocks and bonds) globally to some extent, outside of large cap stock and U.S government bond index based funds.

With that caveat out of the way, what the two graphs below display is that while money has poured into the high yield ETF bond market, the counterparties (“dealers”) that actually provide liquidity when someone sells their ETF shares, have backed away. In fact, it appears they are climbing out of the ring.  This results in the systemic erosion of the indispensable function that the active market plays in price discovery and liquidity, which we discussed in last month’s blog.  The chart on the right is the most striking example of how the ETF craze has impacted this very important function. As dealer inventories decline from above 12% to below 1%, trading volume thins considerably. It will be interesting to watch what happens when panic grips the market and everyone wants their money back at approximately the same time.  Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.

There May Be a New Contender Entering the Ring: Smart Beta Funds

In the last few years, a new type of investment vehicle called “Smart Beta” has gained in popularity and aims to blend the best aspects of passive and active management.  Smart Beta funds are ETF’s that passively track an index, but instead of allocating the underlying positions according to market capitalization alone, they are weighted according to various other factors such as a company’s dividends, free cash flow, earnings, or volatility.  Smart Beta is designed to take advantage of the tax and cost efficiencies of passive investments, but select the underlying investments included in the ETF based on a stated qualitative and quantitative characteristics and data points.

In the Bloomberg chart below, we can see a traditional market cap weighted S&P 500 ETF (SPXT), compared to a Smart Beta S&P 500 ETF (SPXQUT) who’s selection criteria is based upon earnings quality, predictability, sustainability, and balance sheet strength.  The results are stunning.  One can’t help but think of Buffet’s claim that he would rather buy a wonderful company at a fair price than a decent company at a cheap price when viewing the performance of SPXQUT.

However, as compelling as Smart Beta funds can be, investors must pay particular attention to each fund’s ranking/weighting methodology.  Most Smart Beta funds, once the qualitative overlay has been applied, still rank asset weights based on market cap weights, thus making these funds more like the underlying S&P 500 index than the characteristic they are trying to exploit.  We prefer a more equal weighting format when considering Smart Beta funds (as displayed by ticker SPXQUT in the Bloomberg slide above), which more acutely focuses on getting the pure Smart Beta characteristics into the portfolio in a targeted fashion.

This is but one example of many different types of Smart Beta portfolios. Baskets of these types of examples can be utilized to shape a portfolio’s contour through an economic cycle. Smart Beta helps achieve exactly this, but in a cost effective, diversified manner.

“It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.”

And Now, The Judge’s Card

Think about this…if we are indeed coming out of a period of orchestrated, Central Bank led, artificially suppressed interest rates, coincident with historically low volatility – do you necessarily want all your money in investments/funds (passive, for the most part) that have most acutely benefitted from those policies. Or, would you prefer to take some of the profits off the table, and prepare for what should prove to be a different environment as the Central Banks look to drain their own swamp of excess reserves?

We may be about to enter a new round in the fight for returns, where the recent past will not be a prologue.  It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.

Bottom line, a good active, boutique manager (top 1/3) will significantly beat an index through a full market cycle, particularly on a risk-adjusted basis in a lesser efficient market sector.  The difficulty lies in finding those good managers.  The answer is not to buy a manager that has only recently out-performed, but rather to pick a manager with a good long-term track record, who may have only recently fallen out of favor, but is very likely to recover and continue along the same successful long term trajectory.

Focus your manager search on the boutique arena, particularly within more illiquid and less efficient market segments, and lean towards active management for the Fixed Income portion of your portfolio.  Doing so will help ensure your investment plan “floats like a butterfly and stings like a bee” through the full market cycle.

 

Better To Be Seen Than Herd:  Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Better To Be Seen Than Herd: Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Learn About Active vs. Passive Investment Vehicles Here.


By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital


Although index and exchange-traded funds (“ETF’s”) have been around for 25+ years, money has absolutely poured into these investment vehicles (and conversely out of actively-managed funds) in the nine years following the 2008 Financial Crisis.

Many investors and investment companies that provide or allocate to these passive ETF’s and index funds, do so with an almost religious fervor, believing wholeheartedly that it is “impossible to beat the market”, so one should just “own the market” and give up on active investment strategies and vehicles entirely.

“…ETF’s are not Olympic-caliber investments. They are participation ribbons.”

The rationale for this mentality is understandably alluring. Passive investment vehicles are typically cheaper to own, highly tax efficient, and post-Financial Crisis, have generally outperformed active investments on the upside net of fees. Not only that, but the proliferation of “roboadvisors” has made it very easy for investors to create and manage their own passive investment allocations without any professional advice or assistance, further lowering costs.

So, if all it takes to be an Olympic-caliber investor is to create a set it and forget it, auto-rebalanced ETF allocation, and just let it ride for all time, why wouldn’t everyone simply do so? Because ETF’s are not Olympic-caliber investments. They are participation ribbons.

In this edition of Cutting Through the Noise, we take a good, hard, honest look at some of the serious and almost universally underappreciated potential pitfalls associated with passive investment vehicles:

  1. Market cap weighting can lead to price anomalies and a lack of price discovery which could inflame an already overvalued market,
  2. Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects, and
  3. ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously.

Let’s dive in…

How Did We Get Here?

In order to appreciate the oft-hidden flaws inherent in passive investment vehicles, you must first understand the history behind how we got here, namely why did passive investment vehicles exponentially proliferate over the last decade?

Following the Financial Crisis, stock index funds and ETFs, with their low fees and unfettered upside exposure, responded immediately and positively when the Fed and US Government brandished double-barreled fiscal and monetary bazookas and more or less forced the stock market higher with a combination of ultra-low interest rates and financial stimulus.

“This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.”

By contrast, during that same time frame, active managers were exercising prudence, still reeling from the recent, dramatic and rapid drop in portfolio values. As a result, they were maintaining higher levels of cash and allocating to higher-quality, fundamentally sound securities.

The net result was that indexes led almost all active fund managers coming off the 2009 market bottom, and actively managed funds, with their comparatively higher fees and more conservative investment strategies, have yet to close the gap. This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.

How quickly we forget that active management had significantly outperformed through the down market, and that sort of critical analysis and resultant positioning is rapidly becoming more and more relevant in this relatively overvalued market.  We will take a deeper look into the historical performance comparing active and passive investing styles next month.

“The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings.”

The chart below illustrates the asset flows with startling clarity, with passive vehicles (index funds and ETFs) taking in about $1.4 trillion, and active funds losing approximately $1.2 trillion over the past 10 years:

Let’s consider an example that illustrates the negative effects this transition can and has had on active managers’ ability to properly value underlying fund investments.

Assume a money manager has to pick between two nearly identical companies within the same industry. One is included in the S&P 500, while the other is not. Active managers will typically buy the cheaper company that is not in the index, because they are getting the same earnings stream with similar management quality, at a cheaper price. The company that is included in the index, however, ends up being priced substantially higher, not because its better, but because it is included in an index to which capital is being allocated.

These valuation premiums continue to expand as money leaves active management in favor of indexing. That’s the self-fulfilling nature of this trade that keeps putting pressure on active managers. The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings. Thereafter, the passive fund ploughs into a stock index that chooses investments based heavily on market capitalization.

As a result, the cheap stocks get cheaper and the rich stocks get richer. The active managers’ performance has a heavy hand of downward pressure, where fund outflows beget selling their favorite stocks, which begets losses in their stocks, which begets further fund outflows. Meanwhile, the Indexers are on the virtuous side of that trade, where fund inflows mean buying more of their favorite stocks, leading to stronger performance and the subsequent fund inflows, and so on. That is, until there’s a tipping point, and the trend reverses.

“Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy.”

Passive Issue #1: Market cap weighting can lead to pricing anomalies and a lack of price discovery which can inflame an already overvalued market

As investment capital has been taken directly from actively analyzed companies and given to those that happen to hold a weight in an index somewhere, there are far fewer investors kicking the tires of companies to ferret out a competitive advantage, and many more investors who’s only job is to mimic the market as a whole.

Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy. Active investment managers seek to fundamentally and technically analyze companies in an effort to determine if that company’s stock is more likely to rise or fall, and then make investment decisions accordingly. Makes sense, right?

The majority of ETF’s and index funds eschew analysis altogether and instead use a “market-cap weighted” method of determining what companies are included in the index or ETF, which is the exact opposite of the traditional actively-managed meritocracy that has historically driven managers’ investment decisions. A computer program is used to ensure that certain parameters (like tracking a particular index) of the fund are observed, and from there the passive investment vehicles just operate according to that protocol.

So the more indexes or ETFs that a company is included in, the more ETF investment inflows will drive the company’s market capitalization higher. As a result, passive investment vehicles invest many times more money in the largest stocks than they do in the smallest stocks. Even many of the “total market” ETFs are in fact a concentrated bet on the behemoths—out of every dollar invested, as much as 90 cents is a bet on the largest stocks, saving just a dime to spread across the thousands of small- and mid-sized stocks.

Because of passive investors’ abiding and often blind faith in the efficient market, they have ploughed money into cap-weighted indexes, which deploy money into companies based upon their market value vs. stock price, competitive advantages, economic factors, or potential for appreciation. Basically, bigger is better with no critical data analytics, investment discipline, or methodology, and that defies the very purpose of markets—allocating capital to useful ideas.

“…investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.”

Passive Issue #2: Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects

Out of the 500 companies that make up the S&P 500, the 50 largest contributors to risk were responsible for just under half of the S&P 500’s risk. That means 10% of the S&P’s companies are responsible for a whopping half of the index’s expected price fluctuations. Their extreme bias toward the largest of the large-cap stocks means that a full 20 cents of every dollar is invested in the 10 largest companies in the S&P 500.

Take a look at the chart below:

So, why should this matter? As long as the stock market keeps going up and to the right, it doesn’t. But investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.

The difficulty for passive-investing devotees is that when markets decide to become narrow-minded, undiversified, and irrational, so too do their investments. During the last two bubbles—dot com and real estate—the S&P 500 bubbled right up with markets, as both the tech and financial sectors grew to nearly a third of the index before crashing down again.

The role that the “market” or “active” participants play is important in finding a fair price for stocks. Indexes use these “fair” market based prices to find levels at which to transact for the passive money that chases index returns and crowds into the same trade.

“…it’s conceivable that ETFs could find themselves in a downward spiral.”

With the current lop-sided state of cap-weighted indexes and with these indexes receiving the lion’s share of investment, it is very difficult for an investor to simultaneously practice the principals of diversification and remain devoted to passive investing. Herding into passive investments displays a deep disregard for the very principles of diversification upon which index investing was built.

Without active managers executing diligence and fairly pricing investments, those who have piled into ETFs in the last couple of years may very well be the same fickle bunch who sold their equity holdings in the 08-09 melt down. These capital destroyers can be exceedingly dangerous, as they often rotate back into the market at a high, and are likely to sell into any potential market declines.

This self-fulfilling phenomenon works in both directions, and it’s conceivable that ETFs could find themselves in a downward spiral if the confidence in overvalued markets cracks. The high valuations and concentrations of market capital in the index holdings will work against indexes, and when the market does in fact correct, the outflow from passive investment vehicles could be much more dramatic and abrupt than anything we have seen before.

Passive Issue #3: ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously

Let us turn first to the father of index investing, Vanguard founder Jack Bogle. Jack, the man who has railed against active managers for decades, recently declared that there will always be a place for active management. He pointed out here that without the role that active management plays in price discovery, passive investing in indexes and ETFs may break down at some point, “chaos” and “catastrophe” would ensue, and “markets would fail”, if passive investing strategies grew too big.

Take a moment and let that sink in. The crusader who went from the Don Quixote of the investment world to become The Don of the Index, is now waving the caution flag as the index world continues to careen out of control with new offerings under the momentum of their own growth.

To be fair, Jack seems to think we are still on relatively safe ground—blindly stuffing our cash into index funds and ETFs—until passive investing comprises approximately 75% of the entire stock market’s value. However, other market experts are less sanguine, placing the threshold closer to 50%.

In any event, as shown in the chart below, the passive world has recently passed over 30% of all financial assets and is growing quickly. At this pace, the 50% mark is easily expected to be reached within 7 years.

However, the passive investing craze has been primarily focused on the U.S. equity market with considerably less emphasis on international equity and fixed-income markets. In fact, when we look at who owns U.S. equities, as in the chart below, we find that index investors make up a very large portion of the total market. In fact, passive investments grew to 40% of all domestic equity holdings as of the end of 2016.

“…passive investing in indexes and ETFs may break down, and ‘chaos’ and ‘catastrophe’ would ensue if passive investing strategies grow too big”

And the research arm of Sanford Bernstein predicts that by next year, passive strategies will be 50% of the entire stock market. Take a look at the chart below and you can clearly see this trajectory.

It doesn’t take a PhD in applied mathematics to see that we are rapidly approaching the 50-75% range that Bogle warned could be the “catastrophic” tipping point. Although, it’s not a certainty Bogle’s threshold will be hit within the next few years, it seems clear that the warning call has evolved from “um, boss, you really might want to pay attention to this risk” to “Houston, we have a problem.”

Conclusions & Key Takeaways

Investing in Indexes like the S&P 500 and ETFs like SPY has proven to be an excellent way for most investors to get exposure to financial markets through low cost and generally tax efficient vehicles. As such, these low-cost solutions should be an important part of most investors’ financial plan.

If an ETF is well-constructed with transparent and understandable low-cost strategies that helps fill a necessary niche in a portfolio, by all means, include it. But separating the wheat from the chaff in the thousands of ETFs has become at least as important as sorting through all of the individual stocks to determine which ones to buy and sell.

However, like all things financial, one must still take care to diversify, not just by asset class, geographic region, style and market cap, but also by the type of investment vehicles and investment strategies.

This month’s blog is a clarion call to diversify beyond just the simple market cap weighted ETFs (like, SPY and AGG). ETFs have had a great run, which adds to their current popularity and future risks. Just because it is easy and appealing to buy an index does not mean they should be considered the end-all, be-all, one-stop investment shop.

Investors must consider getting exposure through active managers within certain market segments, alternative or non-correlated assets and potentially a relatively new option: smart-beta/fundamental factor funds. When money leaves the stock market (and it eventually will), and index investments are in net liquidation (and they eventually will be), the “active” market participants are likely to find better value in non-index names with similar businesses.

Next month, we will look to provide a common sense approach to mitigating some of the risks we’ve discussed in this blog and blending index investing with other sources of return to produce a reasonably cost effective approach to maximizing risk-adjusted returns.


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Navigating the Shifting Economic Winds

Navigating the Shifting Economic Winds

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital


Just as Bob Dylan grappled with life’s great questions in his 1963 hit “Blowin’ in the Wind”, we at Three Bell are asking ourselves some of the market’s big questions. For example, how many times can the prevailing winds shift before the economy will slow? The answer, my friends, is blowin’ in the wind… the answer is blowin’ in the wind.

The winds of change are howling through our political system with blustery gusts creating cross-drafts for the economy. Additionally, the risk of the occasional gale force wind from geopolitics seems to have increased. I am choosing to save all discussion of political discourse for a future blog and will focus solely on economic winds this time. Let’s just agree that there are political winds out there that are probably not fully priced into the market.

At present, the market’s momentum is being driven by short-term tailwinds related to the outlook for the President’s pro-growth policies of lower corporate and individual tax rates, the economic impact of de-regulation, and the potential for better trade deals as opposed to the negative impact of protectionism. At any particular moment, as it is now, the market may focus on the short term (next few hours, days or weeks), while at other times the market may look at long-term issues or solutions (over the next years or decades). I believe that these short-term winds are considerably less powerful than the longer term, secular winds behind the market’s success for the past 1-2 generations.

Putting aside the potential benefits from the short-term policy shifts, the major tailwinds that have driven the market to all-time highs over the last 40 years, and helped grow the economic pie, are slowly but surely turning into headwinds. It is the following three major forces that we investigate in this blog:

  • Slowing/decreasing globalization
  • Peaking/unsustainable debt levels
  • Bottomed out interest rates

This is not about tornadoes or hurricanes suddenly developing from clear skies. If you’re a golfer or a sailor, you know the wind that starts in the morning as a barely perceptible breeze and steadily builds into a stiff wind in the afternoon. Similarly, shifting economic winds will steadily build over the course of years and perhaps decades, eventually resulting in inflection points which have systemic effects on the capital markets and investment portfolios.

I do not intend to sound overly pessimistic. We humans have a great deal of input into our collective destiny, and the generally positive and indomitable human spirit coupled with new technology improvements and ongoing job training, can make adjusting to some of these newly forming headwinds more manageable.

“It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment gripping the globe or more from a lingering post-financial crisis hangover.”

Before diving into each of these developing headwinds individually, my intention is not to present a dissertation on each topic and prove unequivocally where each component has been or where each is going. Instead, I am taking a long look back at what has historically transpired, in order to develop a commonsense framework for looking forward.

With caveats out of the way…let’s erect our economic weathervane and dive into each of these headwinds!

 

Slowing / Decreasing Global Trade

Simply put, the US has benefitted from the effects of global trade and rising global growth. Much of this growth and benefit has accrued through providing goods and services to less developed regions. As we look back at the tail on the slope of the line in the graph below, which depicts the portion of global GDP that comes from trade, one can’t help but wonder if most of those benefits are behind us. It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment (Brexit, NAFTA withdrawal overtures, import tariffs on China, etc…) gripping the globe, or more from a lingering post-financial crisis hangover. The answer to that question will be important as we consider global trade to be more of a head, cross, or tailwind going forward.



 

Peaking / Unsustainable Debt Levels

We have heard about this one for years. The good news is that the US is generally in a better net debt situation than the rest of the world, on the margin. Sorry, that sounded very equivocated. The US government’s debt is in far better shape relative to the other major world economic powers. Japan, can’t buy an interest rate increase (and believe me, they’ve tried), while the Eurozone’s situation is made more precarious by the heavy debt loads of Portugal, Italy, Greece and Spain. Meanwhile, China’s creditworthiness really gets dinged if one looks through to the liabilities caused by SOE’s (State Owned Enterprises).

One also must consider that the US Dollar is still the world’s reserve currency.   Economist agree that our world reserve currency status lowers our borrowing rates because the world is eventually forced to consume in USD.  As such, there appear to be many more canaries that are flying ahead of the U.S. and they are deeper in the coal mine. Perhaps this is why the U.S. has famously earned the moniker of being the cleanest dirty shirt in the laundry or the skinniest horse at the glue factory – my apologies to my Humane Society Silicon Valley colleagues.

“There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth.”

That said, the US is not out of the storm by any means, and the more troubling aspect of our debt situation is shown in the chart below. Paul Volker summarized it quite succinctly when he said… “Our current debt may be manageable at a time of unprecedentedly low interest rates. But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending”. There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth. In part, this may already be limiting options for new fiscal policies to jump-start the economy in future recessions.

Lastly, check out the rate of total debt growth versus total GDP growth in the chart below. Over the past 35 years, the US has seen its total debt obligations grow at an 11% clip after inflation, while the real GDP growth rate is a much more moderate 3%. The net result is that we have not recognized a good return in our GDP growth rate, per dollar of debt. This is sobering as we believe any debt-propelled growth possibility is likely behind us. Going forward, our current high debt levels will reduce our borrowing capacity are therefore much more likely to be a headwind as opposed to a tailwind.



“Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown.”

 

Bottomed Out Interest Rates

As you can see below, even though in the short term the Fed just raised interest rates by .25% last Wednesday, the level of our interest rates is still at or near historical all-time lows. This is not to imply that rates can’t go lower, as they have in Europe and Japan. Also, given the abnormally weak, current economic realities across the globe, interest rates are not likely to skyrocket any time soon. That said, the catalyst for lowering interest rates from their present levels is likely to be bad news, such as recession or anemic growth, which would add to our debt levels at an even faster rate. In such an environment, investors and consumers pull back on spending and projects, increasing the odds of a deflationary spiral. Let’s not even go there.



The main take-away from the chart above is that gradually lower and lower rates over the past 35 years have provided a very strong and consistent tailwind to the market and the economy. At current levels, it seems unlikely that interest rates will remain a tailwind going forward. It is only a matter of time before the level of interest rates turn into a full-on headwind or at the very least, a swirling wind that proves difficult to navigate.

Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown. This is not a doomsday situation, but merely an observation that the greatest benefits of low rates are behind us. Lower rates make it easier for a company to service debt, spend more cash flow on growth related projects, buy back company stock, or pay dividends. It isn’t that those opportunities are gone, but the delta is about to change from clearly positive to neutral with a negative bias.

Lastly, low interest rates generally help stock investments look more competitive, which raises asset values and fuels consumer confidence. The key takeaway here is that much of the benefit of gradually lower interest rates has run its course.

 

Summary

My intention is to provide moderation and common sense to the ebullient fever of the stock market and related expectations for continued outsized gains. After repeatedly setting new record highs, the market’s valuation is now considered to be historically high (as we addressed in our 3-Part CAPE series). We believe that many of the conditions that contributed to that expensive valuation are now slowing, and likely to gradually reverse.

Gains are more difficult to come by when some of the biggest drivers of investment returns: previously increasing global trade, perpetually lower interest rates, and historically increased borrowing; reverse course and start working against the market instead of for it. The time has come for investors to start adjusting their return expectations to better reflect reality. We will continue to keep an eye on the long-term trends and update any major shifts in weather patterns as the headwinds/tailwinds narrative unfolds.

Please be clear, I am not calling for a market crash, or even a pullback necessarily. I am simply pointing out that the stock market is now running against the wind. Bob Dylan told us where to look for answers, my friends, but it’s Bob Segar’s 1980 classic, which best summarizes our view: we are now running… Against the Wind.

Here’s to getting it more right than wrong. Happy Father’s Day.


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