Sunday, April 25, 2010

When the Facts Change?

In my last post, I went over the IMF's latest World Economic Outlook, as well as some comments made by Bank of Israel Governor Stanley Fischer.

Interestingly, more and more experts are saying that the global recovery will be stronger than anticipated, but that once the stimulus measures wear off, and developed nations deal with their fiscal problems, growth will moderate.

There is also unanimous consensus that extraordinary policy intervention has eliminated the risk of a second Great Depression and that advanced economies don't face a deflationary threat.

I'd like to explore the deflationary threat in more detail. Why is this topic so important? Because the long-term trajectory of the global recovery, and the health of the global financial system, crucially hinge on whether inflationary forces swamp deflationary forces.

Those of you who have followed my blog know that I've been bullish on stocks since last year. Record low interests rates have been a boon for banks and hedge funds trading stocks and other risk assets. The liquidity party continues and money managers are once again succumbing to performance anxiety, bidding risk assets even higher.

From a policy perspective, the Fed couldn't be happier. They are promoting the reflation trade hoping that the rise in asset values will recapitalize banks, allowing them to start lending again to small and medium sized businesses. Moreover, the Fed hopes that a sustainable economic recovery will take hold, and that this will reintroduce 'mild' inflation in the economy, effectively killing the deflationary threat they're so desperately trying to avoid.

But this is a dangerous game because if a sustainable recovery doesn't take hold, then all these "extraordinary policy measures" will have failed, deflation will follow, crippling the global recovery and banking system for decades.

In essence, the whole world is "too big to fail", so policymakers are working hard to ensure that the reflation trade continues. This is why I've been telling people to keep buying the dips on stocks because I know at the end of the day, financial oligarchs have a vested interest to keep rising financial markets going. Everyone wants this outcome and that is why everyone continues to be long risk assets.

But will they be successful or are they just prolonging the agony that's to come? That is the key question that every money manager and regular citizen is wondering about. Are we going to finally get out of this mess or are we in for decades of frustratingly low growth or worse, another Great Depression?

I want to bring to your attention two important commentaries that are absolute must reads. The first is from Niels Jensen of Absolute Return Partners. In his April 2010 commentary, When the Facts Change, Mr. Jensen and his team look at the implications of being in a structural bear market and they make five specific recommendations: (1) Beware of echo bubbles; (2) Do not benchmark; (3) Include uncorrelated asset classes in your portfolio; (4) Do not use leverage; (5): Prepare for bond yields to surprise everyone by falling further.

Mr. Jensen adds: "The last one in particular is controversial. The vast majority of investors appear to have resigned themselves to the fact that interest rates will have to go higher. We believe precisely the opposite could happen, at least in those countries where sovereign default is not a significant risk."

Mr. Jensen goes over many interesting topics in his monthly commentary, but let me focus on a few here. In the short-term, Mr. Jensen is more worried about commodities than emerging market bubbles:
As we all know, investor appetite for commodities has been growing rapidly in recent years - just look at the growth of commodity linked ETFs. However, I suspect that many of those investors do not fully understand the complexity of the products they invest in (see here for a brilliant analysis of this problem), and they don’t realise how small many commodity markets actually are. I fear that many investors are setting themselves up for serious problems as ETFs account for a bigger and bigger share of the total commodity pool.
Having assisted a few of these commodity conferences, I couldn't agree more. Investors should be very careful as to how they approach their investments in commodities because many investors underestimate the risks of these commodity linked ETFs. I know the "brains" at Barclays, Goldman and other firms will peddle these products hard, but do your due diligence, and be weary of these products.

As far as recommendations, Mr. Jensen talks up his business and warns on the misuse of leverage:
Ideally, in the current environment, I would allocate 30-40% to uncorrelated asset classes. This is a much higher allocation than most investors give to this space at the moment. Many became disillusioned with absolute return investing, following the horrible experience of 2008-09 where many absolute return vehicles did as poorly as, and in some cases worse than, more directional investment vehicles. Ever since, it has been difficult to attract investors to attract investors back to absolute return products.

What is not so well understood is why so many absolute return vehicles failed to deliver what it says on the tin. As a whole, absolute return strategies actually did much better than more directional strategies, but returns were widely dispersed. And those products/strategies which performed poorly mostly did so, because they underestimated the liquidity mismatch between the asset and the liability side of the balance sheet.

Which brings me to the next point. If we are, as I suspect, in echo bubble territory, there will be at least on more down leg before we can finally declare this crisis to be over. One does not want to be leveraged when that happens - not so much because leverage per se is bad. In fact, I am a believer that leverage, applied intelligently, can significantly enhance returns. However, our banking industry has not yet recovered from the near disaster of 2008-09 and, even worse, is not likely to have fully recovered by the time the next downturn kicks in. This will leave the banking industry on either side of the Atlantic extremely vulnerable and, as we can testify to at Absolute Return Partners, a bank which is under severe stress can virtually obliterate your business if you have leveraged your investments.

Having said that, we are starting to see leverage creeping up again across the hedge fund industry.
I take issue with some claims made here. First, good luck allocating 30-40% in uncorrelated assets. In this environment, this is a pipe dream. Second, pension fund allocations to hedge funds “have returned to pre-crisis levels”, according to Mercer, one of world’s largest investment consultants (never underestimate the stupidity of the pension herd).

But on the issue of leverage, I agree that most hedge funds have cranked up the leverage to meet their return expectations. This is one of the primary factors driving risk assets higher. Most hedge funds are betting that rates will remain low for a long time, so why not crank up leverage? In fact, some pension funds are also leveraging up, trying to get extra yield to meet their pension liabilities.

This is the one thing that worries me the most. With so much leverage in the bond market and the financial system, if rates do start spiraling out of control, the second wave of the financial crisis will be brutal, and many hedge funds and pension funds will get decimated. It will make 2008 look like a walk in the park.

On the outlook for interest rates, however, Mr. Jensen sees things differently and isn't afraid to stick his neck out:
Bond yields could very well fall over the next few years. This is unquestionably my most controversial prediction, and it is admittedly a risky forecast. I have been arguing for a while (see here) that for years to come we will face a tug-of-war between deflationary and inflationary forces, and I continue to stick to my projection that deflationary forces will ultimately prevail. Classic monetary thinking would suggest otherwise. The rapid growth in the monetary base over the past 18 months is hugely inflationary, or so the monetarists amongst us argue. In a cash based economy I would agree, but we are dealing with the biggest credit bubble of all times which must now be shrunk. That is extremely deflationary. Just look at the wider measures of monetary growth. There is none.

Another argument frequently put forward by the inflationary camp is that governments will be forced to inflate their way out. They have no alternative because they cannot afford otherwise. I am not convinced it is that simple. Morgan Stanley published a very interesting research report recently in which they made the observation that nearly half of all US budget outlays are now effectively indexed to inflation. The obvious implication of this simple fact is that it is no longer possible for the US government to inflate its way out of its deep deficit hole, however tempting that may be. We should also learn from the Japanese experience.
Mr. Jensen ends his commentary by stating:
The final point I would like to make with respect to the outlook for interest rates has to do with the sheer supply of bonds waiting around the corner. In the past, I have taken the view that interest rates would probably have to go up, even if there is little or no inflationary pressures; however, after having studied the Japanese case in more detail, my conviction level is weakening day by day.

The reason was pencilled out in last month’s letter and has to do with why governments are running these exorbitant deficits. The deficits are to a large degree necessitated by rising savings rates which translates into lower economic activity. In other words, without the large deficits, we would be facing negative GDP growth in many countries at the order of 5-10% per annum for several more years. Not only would that be politically unacceptable, but don’t forget that, contrary to common belief, much of the money to buy those bonds will be available because of the higher savings rates.

On this note, one needs to pay attention to which government debt one buys. In the UK, for example, the average government debt maturity is about 14 years, whereas in the US it is less than 5 years (see chart 8). Whether by design or sheer luck (I suspect the latter), it does provide the UK with a significant advantage over most other countries which have significantly less room for manoeuvring.

The UK pension funds play a significant role here. There has been, and continues to be, an enormous appetite for long-dated gilts from the pension sector. Although this is not well understood outside the pensions industry here in the UK, many pension schemes have automated investment programmes in place which are triggered when real interest rates hit certain pre-defined trigger points. All other things being equal, this puts a very effective lid on real rates and is one of the key reasons why I am gradually coming around to the realisation that long dated bonds could be one of great surprises of the next few years.

However, the inflation v. deflation war of words is likely to rage for several more years. This implies that none of the above will happen in a straight line so be prepared for a bumpy ride. It also means that volatility could be quite dizzying at times, so make sure you have investments in your portfolio which benefit from high volatility. Unfortunately, these types of strategies are typically unregulated which means that I am not permitted to write about them in a freely available letter like this. Call us instead if you want to learn more about being long volatility or would like some help in positioning your portfolio for what lies ahead.
One way for pension funds to position their portfolio in a volatile environment is to increase their allocation to good old government bonds, and use overlay strategies (both internal and external) to play on the volatility.

This brings me to the second must read commentary from Van Hoisington and Lacy Hunt of Hoisington Investment Management. In their latest Quarterly Review and Outlook, they too argue that long term Treasury yields are heading lower:
While conterintuitive, the deceleration in the money supply measures should not be surprising. As we have discussed previously, Fisher outlined the rationale almost 80 years ago. In extremely overleveraged economies, monetary policy doesn’t work. Potential borrowers do not have the balance sheet capacity to take on more debt.

Currently, borrowers are loaded with excess houses, office buildings, retail space, and plant capacity. No need exists to get even deeper in debt. Moreover, due to rising foreclosures and delinquencies, bank capital has been badly eroded and banks are not in a position to put more risk onto their balance sheets by lending to already over committed borrowers.

Also, to the extent that borrowers and lenders manage to increase leverage further, the benefits to the economy are fleeting, only serving to make the economy more vulnerable to economic deterioration and possibly systemic risk in the future.

Another major development in interest rate theory was the cofounding of behavioral economics in the late 1970s by Richard Thaler and Daniel Kahneman. Kahneman won the Nobel Prize in economics in 2002. In the compelling analysis of behavioral economics, markets are determined over the short-run by a host of psychological and transitory conditions, including but not limited to, heuristics, or various rules of thumb, to guide trading practices. However, in behavioral economics, the fundamentals apply over time to market prices. This confirms the analysis of both Fisher and Friedman, at the end of the day. That is, lower inflation leads to lower interest rates.

With excessive levels of debt and contractionary monetary and fiscal policies in place, inflation will continue to moderate, thereby driving long term treasury yields lower. The path to lower rates will not be smooth as volatility will arise from heavy sales of U.S. government debt and occasional transitory improvements in economic activity. However, patient investors will be significantly rewarded.
My only comment here is that banks are making a killing in their capital markets operations, and they are in a position to lend more, but they obviously prefer making money on liquid assets than getting tied up in illiquid loans.

Below, I leave you with a Bloomberg interview with Hoisington's Lacy Hunt which took place last year. He was wrong on corporate bond spreads, but ultimately Hoisington's call on lower Treasury yields may be right on the money.

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