Wednesday, June 18, 2014

Time to Load Up on Linkers or Risky Stocks?

Peter Levring of Bloomberg reports, Historically Cheap Linkers Draw In CIO at $76 Billion PFA Fund:
Denmark's biggest commercial pension fund is clinging on to its inflation-linked bonds in case markets suddenly turn and prices surge.

“You’ve never paid less for linkers than you do now; the pricing is at historic lows,” Poul Kobberup, head of fixed-income investment at the Copenhagen-based fund, said in a phone interview. “No one knows what the market will look like half a year from now. Linkers may well prove to be the most attractive asset class out there and the best way to guard against sudden rises in rates.”

PFA wants bonds designed to hedge against inflation even amid warnings that much of the developed world is sinking into a disinflationary rut. The fund, which is also trying to build up its real estate portfolio, says it doesn’t want to risk getting caught in a bottleneck should more investors start buying inflation protection once markets turn.

“We continue to have a very traditional allocation,” Kobberup said. The fund wants linkers and real estate assets to make up as much as 20 percent of its total portfolio, he said.

Denmark’s inflation linked bond due 2023 has lost investors 0.5 percent since it was issued in May 2012. Nominal bonds with seven to 10 years left before they mature delivered their owners a 5.1 percent return over the same period, according to data compiled by Bloomberg.
Tackling Lowflation

A report last week showed Danish consumer prices fell 0.1 percent in May from a month earlier, while annual inflation was just 0.5 percent. In the euro area, inflation is less than half the European Central Bank’s target of close to, but below, 2 percent. In neighboring Sweden prices slid an annual 0.2 percent in May.

Since International Monetary Fund Managing Director Christine Lagarde in April coined the term “lowflation,” evidence of disinflation and even deflation has spread through much of the rich world. At the same time, many of the economies dealing with below-target consumer prices are witnessing record-high prices in their housing markets.

The developments prompted some of the Nordic region’s biggest investors, Denmark’s ATP Pension fund, which oversees $125 billion in assets, and PensionDanmark, which manages $28 billion, to reduce their holdings of linkers.

PFA has seen its stash of inflation-linked bonds fall, though only as a consequence of shrinking supply, Kobberup said. It lost 4.7 percent on its linker portfolio last year versus a 0.5 percent loss on its nominal krone bond holdings. The fund held 23.3 billion kroner in debt that tracks consumer prices at the end of 2013, according to its annual report. That’s a 15 percent decline from the beginning of the same year.

“We’ll always have a part of the portfolio in linkers,” Kobberup said.
Levring also reports that Denmark sees no deflation pressure as economy gathers pace:
Denmark’s central bank said it sees no threat from deflation as an accelerating rebound has brought the Scandinavian economy back to pre-crisis levels.

Danmarks Nationalbank raised its forecast for gross domestic product growth to 1.5 percent in 2014, 1.8 percent in 2015 and 2.0 percent in 2016, up 0.1 percentage point in all three years, according to a statement today. Inflation will be 0.6 percent this year and accelerate to 1.8 percent in 2016, the Copenhagen-based bank predicted.

“Although wage increases are modest, the low inflation at present is not a sign of deflationary pressures in the Danish economy,” Governor Lars Rohde said in the statement.

The bank, which uses monetary policy to peg the krone to the euro, this month opted not to follow the European Central Bank back into negative territory. Policy makers raised the deposit rate in April, exiting negative rates after almost two years. The ECB this month cut its deposit rate to below zero for the first time as ECB President Mario Draghi unveiled a round of measures to help fight the threat of deflation.

The Danish bank said that excluding a decline in the extraction of raw materials, GDP is back at pre-crisis levels.

“Overall, private sector demand is expected to grow steadily over the coming years, while public sector demand is assumed to rise at a more subdued pace,” the bank said.

Linker Yield

The bank is monitoring the declining unemployment, which it says is at the same level for some professions as when the economy was “overheating” in 2006.

The yield on Denmark’s inflation linked bond due 2023 rose the most in a week to 0.136, according to data compiled by Bloomberg. Unlike nominal bonds, linkers are designed to protect the value of investors’ fixed income from being eroded by inflation.

“Interest rates are close to zero and the housing market has self-reinforcing mechanisms,” Rohde said “Closer monitoring of developments in the housing and labor markets is therefore required.”
You'll recall Lars Rohde, Governor of Danmarks Nationalbank, was formerly the CIO of ATP, the giant Danish pension fund which is arguably the best hedge fund in the world.

But this comment isn't about hedge funds. It's about my favorite topic, inflation versus deflation. Whenever I read pension funds are loading up on "historically cheap" inflation-linked bonds, I cringe. Why? Because it's a classic value trap. Just like buying cheap stocks, you can get stuck waiting a very long time before you see any significant appreciation in value and worse still, if deflation sets in, their price will keep falling.

A lot of pension funds have gotten clobbered investing in linkers (inflation-linked bonds). OMERS reportedly bought a ton of them at the top of the market in 2013, which is why it gained a mere 6.5% last year, underperforming its benchmark and all its peers. To be fair, OMERS is implementing Bridgewater's all-weather approach to mitigate downside risk in public markets but that experiment might prove difficult to justify if it keeps underperforming its peers.

In my last comment on whiffs of inflation, I wrote the following:
Whiffs of inflation have gotten everyone nervous that the Fed will rein in their bond purchases at a more aggressive rate and even start raising rates in 2015. I say "bullocks!". Stocks are getting slammed hard in what is a clear overreaction to the inflation data.

If you want to know where inflation is really heading as well as short-term rates, just have a look at the 10-year U.S. Treasuries where yields keep falling, even after the strong inflation reports. The 10-year yield now stands at 2.5%, which is a six-month low.

Why is the stock market overreacting to inflation data while the bond market is clearly unimpressed? Because stock market participants are collectively stupid and when it comes to discerning economic trends, the bond market gets it right.

There is no inflation. Nothing has changed since I wrote my outlook 2014. Sure, the big unwind has clobbered every momo playing high beta stocks, but there is still plenty of liquidity in these markets to drive risk assets much higher. In fact, I wouldn't be surprised to see biotechs (IBB and XBI), small caps (IWM) and technology shares (QQQ) rally very hard in the second half of the year.

Folks, there is no inflation. If anything, the biggest risk remains that we're heading toward a protracted period of debt deflation, which will expose many naked swimmers. Look at what is going on in the eurozone where anemic growth is leading to dangerously low inflation. Gold prices and shares will surge higher once the ECB gets cracking on quantitative easing.

But the problem isn't just in Europe. Even in the U.S., where an economic recovery is slowly taking hold, there is a serious threat of deflation. I was talking to a buddy of mine this morning. He told me that "cheap money for hedge funds and pension funds" is starting to be counterproductive. He added: "credit remains very restrictive for the masses which is why inflation will remain subdued for years to come."

I agree, while the 1% are the ones that profit from all the cheap money, the masses are being crushed under piles of debt. There is a private debt crisis and a jobs crisis going on which is why I take all these upticks in inflation with a shaker, not a grain of salt. I do my groceries too and have seen my grocery bills surge over the last year but that is a transient thing, which is why economists typically look at inflation trends ex food & energy.

Bottom line is there is too much debt out there and until you see a significant drop in the long-term unemployment, and a commensurate and sustained rise in wages, you can forget all about inflation. And if there is a crisis in China, you will see lower import prices which will reinforce deflationary headwinds. This is why I think all the talk of Fed tapering is way overdone. In fact, I expect the Fed to step up its bond purchases if an emerging market crisis unfolds.
I wrote that comment a month ago and since then, the yield on the 10-year U.S. bond has crept up to 2.63% as the crisis in Iraq has impacted oil prices and inflation expectations pick up in the U.S..

But what market participants fail to understand is that a significant rise in oil prices because of the crisis in Iraq is ultimately deflationary, not inflationary (strapped out consumers will have less money to spend on goods and services). And despite the modest rise in cost of living in the U.S., deflation remains the biggest threat in the global economy and nowhere is this more pronounced than in Europe.

A Bank of Japan board member recently warned of the risk of Europe slipping into chronic deflation, adding that slower growth in Europe could muddy the prospects for global growth. Sweden’s central bank will cut interest rates again this year as deflation takes hold in the largest Nordic economy.

The ECB keeps stating the euro zone isn't on the brink of deflation but they are falling further behind the curve and probably worrying the Federal Reserve which will likely continue tapering but keep its accommodative stance when they meet later today.

Importantly, investors betting the Fed will raise its benchmark interest rate faster than money-market investors expect are all going to get killed. A number of high profile strategists have come out lately claiming the "Fed is behind the curve," but they are focusing only on the U.S. economy, totally ignoring the strong global deflationary headwinds.

Go back to read the February letter from Absolute Return Partners, Challenging the Consensus, where the authors cite five reasons why interest rates will remain low and there will be no bond bear market in the near future:
  1. The emerging market crisis escalates further;
  2. The Eurozone crisis re-ignites;
  3. The disinflationary trend intensifies and potentially turns into deflation;
  4. The economic recovery currently underway proves unsustainable; and/or
  5. Flow of funds provides more support for bonds than anticipated
What does all this mean for stocks? There is still massive liquidity in the system to drive shares much, much higher which is why I ignore all those, like John Husman, who think we are at a market extreme. As I recently explained, all of you who think a stock market correction is overdue are going to be sorely disappointed.

So, while some asset allocators are loading up on "historically cheap" inflation-indexed bonds, I'm following elite funds and loading up on risky stocks in biotech and technology (symbols I like: IBB, IDRA, BCRX, PGNX, TWTR, QQQ, XBI, XOMA and many other top performing stocks YTD that are not being mentioned on CNBC!).

Below, even with the market soaring to record heights, some investors are afraid of a melt up: a sudden rise in stock prices. After the rise could come a fall and some investors are bracing to exit the market.

It will be volatile but don't be surprised if stocks start melting up this summer. Once more, feel free to comment anonymously below and remember to donate and subscribe to this blog by going to the PayPal buttons at the top right-hand side (or just give me 10% of your P &L!!).