If Memory Serves

As Jason Zweig wrote in the commentary of The Intelligent Investor, “Daniel Khaneman and Amos Tversky have shown when humans estimate the likelihood or frequency of an event, we make that judgement based not on how often the event has actually occurred, but on how vivid the past examples are.”

The Great Recession is moving further back into history every day, and with that, all other past financial events. As each day passes, it seems like recent history is more characterized by low volatility and a slow, yet steady, climb in asset prices than all out panic. Luckily, many analysts keep tabs on the frequencies of recessions and past financial panics. This reality check may help avoid the pitfalls of going with the crowd when euphoria sets in. Now, it would be easy to say most assets classes are overvalued and it is about time we saw some volatility, but it is important to keep in mind that there has been almost 10 years of Monetary Alchemy being practiced- most of which has not been experienced in recorded history.

So as old memories fade and new ones are created, it is important to remember that we are in an reasonably extended cycle and investors are caring less about risk than return. This is evident in spreads on bonds, the lack of protections bond-holders are demanding, and the narrow discount levels at which closed-end funds as a whole (due to their high yield) are trading at.

The economy keeps printing satisfactory reports it is hard to argue that there is any immediate need to divest or protect with alternatives, yet complacency is a characteristic of the calm before the storm. To be frank, the storm could be as gentle as a sprinkle that extends for years, but as we know, the next one always comes. As ‘bearish” as this may come off, prudence and protection of capital are of the utmost importance and while the number of “bearish” newsletters is declining rapidly as a percentage as a whole, it seems fitting to provide a counterargument.

In total, despite the apparent health of the economy, it would be wise to acknowledge that investors, as a whole, are accepting a diminishing margin of safety as each day of this recovery proceeds. This may seem small on a daily basis, but despite economic health, any time risk is put on the back burner for reward, we must be prepared to face the music. So as our memory of financial downside gets boxed up and stored away, and as younger investors enter the field unknowingly, what is important is that we invest with a careful eye toward risk and a margin of safety so that when our memory is refreshed we are prepared.





Rampant Inflation

Inflation is everywhere-in the markets. Stocks keep ticking up to stretched levels accompanied by record low volatility. Bond are being pushed to record low yields as Central Banks expand to over $14 Thousand Billion. Risk asset inflation is the real inflation that central bankers created with their good intentions.

In other words, it has becoming more expensive to be prudent.

This is evident across the pond, where investors are willing to pay corporations to borrow from them, often locking up their money for years. Money intended to boost the prices of goods, services and wages has been put to work in investments. In an effort to combat this misappropriation, fiscal reflation has been the hopeful buzzword of the day. Tax reform talk has boosted Treasury yields over the past few trading days in hopes of real inflation in the future.

fredgraph (8).png

Back to the idea of prudence. When it becomes expensive to be safe, is that a good time to accept more risk? Well, Warren Buffet has said something along the lines of “be fearful when others are greedy, and greedy when others are fearful”, but is that ideology warranted in an environment when everything seems heady? If, for a moment, you consider that stocks and bonds may be more correlated than in past scenarios going forward, we may have to look at the world differently.

If stocks and bonds are capable, and likely, to face stress at the same time, and because they are both in an apparent state of excess valuation, risk may need to be redefined in the context of the portfolio. This may be why gold has been brought up by a few prominent investors lately. Many will argue against it’s merits as an investment or as money, and their case makes sense in many ways, but when it becomes ever more costly to protect capital due to asset-specific inflationary flows, looking for alternative ways to diversify may be an important option.

So, perhaps we should be greedy when others are fearful, fearful when others are greedy yet also creative when in doubt about the penalties of Central Bank sorcery.


3% GDP

Despite it’s length and the exorbitance of asset purchases by quasi-government agencies, this recovery is becoming harder and harder to poke holes into. All of the usual indicators point to health, notwithstanding asset levitation.


As shown above, this is the first time since Q3 of 2014 that real GDP as risen above 3% in two consecutive quarters-on a QOQ basis. Unlike the prior feat, this is not coming off a negative GDP read. On an even brighter note, this GDP number was fueled by personal consumption spending which may mean the average Joe is feeling a bit more confident in their lot.


Supply and Demand According to Treasuries


The Federal Reserve ended QE and has now decided to let select balance sheet residents mature without reinvestment. This essentially means that the demand for treasuries, when they come up for renewal, should be lower. This would indicate a higher yield as there is less pressure bidding up their price. On top of this, the reflation theme that seems to exist in Washington should move these yields even further up. Why?

When a government runs a fiscal deficit, in which it spends more than it pulls in from taxes, they must borrow. If the US government budget deficit stays the same, as the situation above, it will have to borrow to stay in operation. If it decides to borrow more than it currently is, as expected, it will need to issue even more debt. This should mean that the supply of Treasuries will go up.

In a nutshell, the demand will likely be going down in the future due to the lack of interest from our local central bank, while the supply may go up due to egregious spending in the capitol. In short, it seems like daunting days ahead for those expecting returns-as-usual in the US Government bond market. On a side note, this may cause the diversification benefit on these bonds to diminish in a portfolio context. The Central Bank experiments have likely diminished the usefulness classic ideas for the foreseeable future(which, for the record, is a terrible expression).

The cost(?) of easy money

While the Fed may have delayed the severity of the effects from the great recession, one would think that the layover does not come without a cost. For the time being, though, it seems to be an afterthought. At the moment, some corporate eurobonds are trading at negative yields, meaning that you, as a lender, are being fined for lending them your money. Much like the Treasury Bills in the back end of 1932, investors gladly forking over cash for the privelege to have it confiscated.

While the Fed is letting it’s $4.5 Trillion Balance Sheet melt, the European Central Bank is in the process of walking on eggshells-it is now their turn to turn down the heat. With their decision to slow the growth of their similarly sized balance sheet, they could rock the boat in Europe and abroad. Their problem is different as they are running out of bonds to buy. That tells you something interesting. If they are running out of bonds to buy, what happens when they all of a sudden have no interest in riding the bid?

Over in Japan the ETF buying BOJ is leading that pack at over $5T. None of these major countries are experiencing rising prices that would be expected from this flood of capital. The bill has yet to come to the table. While it could be a slow and arduous process, rather than all out mayhem, what is clear is that assets have followed the path upward with central bank assets. What they choose to do when the music stops is another story.

What lower for longer could look like

fredgraph (7).png

From December 1954 to December 1964, the Effective Fed Funds rate moved from just 1.2 to 3.7. Over this ten year period two recessions took place, yet it took over two years of rate increases from our current levels to cause an economic faltering. That means increases of only .67% per year caused the first recession of this period. We are on pace, as estimated by the market, for three quarter point increases per year as we stand. As the economy starts showing signs of strength, the Fed, depending on how dovish the new regime will be, may start making this a reality.

While 2.5 more years of rate hikes seems like ample time to prepare for such an incident, there is more at play. The Fed is now allowing it’s balance sheet to shrink. What this means is there will be less demand for Mortgage-Backed Securities as they retire from the Fed’s mammoth holdings. This could cause their yields to rise faster than anticipated and spreads could, and probably should, widen.

During this time, William Martin was the Chair of the Federal Reserve. He was famous for the oft used “take away the punch bowl” line, and that he did. During recessions though, he gave it right back. While this was a simpler time, with no sizable balance sheet to note, the same may apply going forward, only this time it could take even longer as investors and regulators feel out the impacts of relative tightening from both rates hikes and uneasing.

The problem with low rates and high debt loads

While rates are low in an absolute sense, they will be moving at a relatively fast pace when compared to recent history. A 1% increase on a loan was not so bad in the 1980’s, but today it could prove catastrophic. Adroit corporate financiers have been loading up on cheap money to boost margins, but if we are nearing the beginning of the rising part of the interest rate cycle, a small bump could cause a shock wave.

I first heard of the Copper/Gold ratio from a Barron’s Roundtable article in which Jefferey Gundlach touted the accuracy of predicting treasury yields, as of late.


The chart above estimates that the 10 Yr Treasury yield should be in the ballpark of 260 bps. If this proves valid, an increase in debt service cost could come whenever companies start to roll over vintages due. To boot, the chart below indicates that this has been a pain point before recessions.

int exp.png

Coupled with the lack of Fed Balance Sheet reinvestment, minuscule absolute increases in the cost of money could be a relatively big issue in the coming years.


Sources: WSJ Daily Shot