Financial Retraction Ahead?
Stanley Druckenmiller, one of the masters of the investment world, this week announced his retirement saying that he had become frustrated over the past three years with his inability to make outsize returns.
After 30 years running Duquesne Capital Management – while also spending time with George Soros, when he helped make $1bn on Black Wednesday by forcing the pound out of the European exchange rate mechanism – he is due some quality time with his fortune.
He is not, however, alone in his frustration. Fellow managers of “global macro” hedge funds, which bet on currencies, bonds and equity markets, have been having a rough time this year. In theory, the wild swings in the value of the main currencies and dramatic shifts in government bond yields should be the perfect environment for macro managers.
In practice, it turns out that even the smartest investors find these markets hard to navigate. By the end of July this year, the average macro fund had lost 1.2 per cent, after small gains last year, according to Hedge Fund Research. By contrast, global equities are down 5 per cent since January, while US 10-year Treasury bond investors have made about 10 per cent.
Behind the poor returns for the modern masters of the universe lies one of the biggest concerns investors face: uncertainty. Ben Bernanke, chairman of the US Federal Reserve, warned of an “unusually uncertain” economic outlook in July and since then pretty much everyone has come around to the same view. This lack of clarity has further split an already unusually divided investment community.
Think of investors as a flock of sheep, all tending to move in vaguely the same direction, with the flock as a whole moving relatively slowly. There are always a few black sheep in the corner of the field ignoring the rest, and some lambs gambolling away from the flock. But the bulk of investors huddle together for safety, and rush to join the rest if they are left behind.
Today, the field is more spread out. The flock is smaller and there are far more investors heading out on their own. One group has headed off to join the permabears – finally getting airtime for their deflation forecasts – in the corner, while another group, led by big hedge funds, has barbecued the lambs and buried its assets in gold to protect against inflation. The shrunken flock now spends its time rushing from the deflation crowd to the inflation huddle, creating a binary market far more sensitive to economic data than in the past.
The scale of this change can be seen in the inflation options market. Back in January 2008, British investors thought there was less than a 10 per cent chance that in six to seven years we would have either deflation or inflation of more than 5 per cent (measured on retail prices). That combined probability now stands at more than 30 per cent.
In the less-developed US options market, the risk of consumer price deflation in three years is priced at 23.7 per cent, according to Royal Bank of Scotland calculations. Yet there is about an equal chance of inflation of 4 per cent, more than double the Fed’s unofficial target, suggesting investors are even more divided in the US than in the UK.
In statistical speak, the distribution of investors now has fat tails. This has profound implications for investment.
The most significant effect of the uncertainty is the “risk on/risk off” trade. For three years, any given day in the markets could be seen as a day when people wanted risky assets – equities, emerging markets currencies, peripheral European government bonds – or wanted safer assets, such as the yen, US Treasury bonds, British gilts or German Bunds. With more people taking extreme positions, the markets swing further and faster than usual.
With this comes short memories. Markets always look to the future but the impact of any given piece of economic data suggests investors have, to mix the metaphor, developed goldfish memories. The latest news seems to trump less recent data, even if it covers the same period – and much of it is likely to be revised heavily in future.
For now, the bond markets may be right that the global economy is heading downhill rapidly. Economic data from the US have been terrible, with this week’s jobless claims hitting 500,000 again for the first time since November.
It will not take many signs of green shoots, however, to have the sheep rushing back across the field and bond yields jumping, just as they did in 2003; bond investors will need to be nimble to avoid getting left behind if this happens.
Mr Druckenmiller was more likely to run with the wolves than the sheep. If even he cannot make serious money, lesser investors should beware.
It's not just Mr. Druckenmiller. Paolo Pellegrini, the hedge fund manager who was instrumental in John Paulson shorting the subprime mortgage market, reportedly is returning money to outside investors:
He will continue to manage internal money at his hedge fund firm PSQR Management, according to a report in The New York Times.And on Monday, Warren Buffett's semi-secret stock picker, Lou Simpson, announced that he is retiring at the end of the year after a long career at the helm of Geico's investment portfolio.
Although he earned billions for his former boss, John Paulson, by deducing that soaring housing prices in the 2000s were a true bubble, PSQR’s flagship fund was down 11% through July, The Times said.
Meanwhile, Prem Watsa, the "Oracle of the North" who runs Fairfax Financial, is preparing for what he perceives to be the next big risk:
Recently, in its second-quarter results, Fairfax revealed major shifts in its $22.6 billion portfolio. First, the company increased its short positions on the general market to hedge 93% of its equity portfolio. It shifted nearly half a billion dollars into long-term U.S. Treasuries this year.
Most disturbing of all, Fairfax purchased $23 billion worth of protection (notional value) against the threat of deflation in the coming 10 years.
Each move points to a similar prognosis: slow U.S. growth, intermittent deflation, and a generally poor environment for common stocks. It is noteworthy, too, that Fairfax became worried and implemented its short hedge at an average S&P 500 price of 1,063 -- slightly below where it trades today. Seeing such a great investor turn bearish is a disconcerting sign.
Before you liquidate your portfolio, keep in mind that as an insurance company, Fairfax is playing by a different set of rules because they have to manage their assets and liabilities more carefully than most investors.
Moreover, equity and related investments still represent more than 20% of the portfolio, while cash and Treasuries make up a more modest sum. Prior to the financial crisis, Fairfax held more than half its portfolio in Treasuries and cash, and it was much less willing to take on equity risk. Now, its portfolio is only a quarter Treasuries and cash. And while the company has been cutting its exposure in equities, it has maintained its large position in two companies: Johnson & Johnson (NYSE: JNJ), and Kraft (NYSE: KFT). They also do a large percentage of their business abroad.Still, one wonders why are well known managers retiring and others reducing their risk? Economic uncertainty remains the single biggest factor weighing on all investors which is why Raghuram Rajan, the IMF's former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed:
Interest rates near zero risk fanning asset bubbles or propping up inefficient companies, say Rajan and William White, former head of the Bank for International Settlements’ monetary and economic department. After Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start increasing his benchmark rate by as much as 2 percentage points so it’s no longer negative in real terms, Rajan says.
“Low rates are not a free lunch, but people are acting as though they are,” said White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and now chairs the Economic Development and Review Committee at the Paris-based Organization for Economic Cooperation and Development. “There will be pressure on central banks to follow an expansionary monetary policy, and I worry that one can see the benefits, but what people inadequately appreciate are the downsides.”
He and Rajan will have the chance to make their case at the Fed’s annual symposium in Jackson Hole, Wyoming, this week. In 2003, White told attendees central banks might need to raise rates to combat asset-price bubbles. In 2005, Rajan, 47, said risks in the banking system had increased. They were met with skepticism from then-Fed Chairman Alan Greenspan, 84, and Governor Donald Kohn, 67.
I doubt Mr. Rajan and Mr. White will persuade the Fed to raise rates anytime soon. As I've repeatedly stated, the Fed's policy is geared towards big banks, allowing them to borrow at zero to purchase higher-yielding Treasuries (locking in the spread) and to trade risk assets all around the world. Basically, it's reflate and inflate your way out of this mess, which is why we have a wolf market that's scaring small investors out of stocks into bonds.
Will economic uncertainty persist and are bonds really in a bubble? If you listen to David Rosenberg, Chief Economist & Strategist at Gluskin Sheff, financial retraction is ahead (watch interview below). Moreover, there is no shortage of US Depression data.
Nonetheless, there are some positive signs worth mentioning too. In his latest weekly comment, Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada wrote the following comment:
The Q2 real GDP data published this past July 30 came with a major revision of historical data by the Bureau of Economic Analysis (BEA). The economic analysts of the world were slack-jawed by the disappearance of $100 billion from U.S. GDP for 2010Q1. Consumption alone was revised down $134 billion. As a result, instead of being in expansion territory, it turns out consumption is actually only midway up the recovery curve. As the level of resource utilization in the economy as been pegged back, this implicitly modifies the impact of past monetary easing by the Federal Reserve.
On a more positive note, the level of labour productivity in the U.S. seems to have hit a wall in the short term. For the first time since the start of the recession, the composition of GDP growth has been geared towards employment rather than productivity. This said, if the unemployment rate does not begin to trend down, the Fed will have no choice but to step in once again.
Indeed, US productivity fell unexpectedly in the second quarter for the first time since late 2008, suggesting that productivity is reaching its limits. And with temporary employment picking up and leading full-time employment, a turnaround in the US labour market might be materializing (click on chart above).
If job growth doesn't pick up, expect the Fed to step in and do whatever it takes, including outright purchases of stocks, to reflate and inflate out of this mess. And if these policies fail, more people will be forced on a diet of macaroni & cheese. Come to think of it, maybe Kraft is an excellent investment for these uncertain times.