One Trick Pony: Whipping the GDP Donkey into a Stallion
“ Sometimes the lights all shinin' on me;
Other times I can barely see.
Lately it occurs to me what a long strange trip it’s been
“Truckin, I’m going home. Whoa, whoa baby, back where I belong,
Back home, sit down and patch my bones,
And get back truckin on ”
– The Grateful Dead, "Truckin"
Psychedelic VW vans, tent villages, the Vietnam War, Jerry Garcia, “Deadheads”, protest marches, Watergate, termination of Bretton Woods and the gold-backed US dollar, oil embargoes, gas lines, inflation, and oh what a long strange money-printing trip our economy has been on since the ’70s. Forty-two years of relentless money creation in order to fund one governmental enterprise after another. However, the Federal Reserve’s money-printing expansion since the financial crisis of 2008 has been truly awe-inspiring, if not intimidating. The gargantuan size and scope of the Fed's balance sheet expansion was unprecedented and unanticipated, and yet the reaction from the financial markets has been, "Give me more of that Keynesian cocaine!" The zero-interest-rate, subsidized prices of US stocks and bonds have created a wealth effect that masks potentially negative consequences to the vast majority of US consumers. For all their good intentions, I wonder whether the Federal Reserve can barely see or whether they have been blinded by the light. Surely they clearly see the erosion of purchasing power and declining real wages for most Americans over the last 25 years. And surely they see the limited effects on domestic economic growth in the US that have resulted from QE1, QE2, Operation Twist, and QE3. And while I will give Bernanke credit for fighting deflation and preventing a potential depression during the 2008–09 crisis, the end result of his continued money-printing policies is going to be inflationary pressure at some point. The trip the Fed took us on, from the first bailout of the banks in 1998 with Long Term Capital, was initially a prosperous if precarious one; but the bust of the credit cycle and inevitable deleveraging that occurred in 2008 financial crisis transformed the strange trip into a credit and banking nightmare that we have lived for the past five years.
We are in unknown and truly mind-bending territory with regard to the question of how much influence the central bankers of the world have on our global economy. This past week the Federal Reserve, after months of jawboning the marketplace with "Taper, taper, taper, taper," coughed up the surprising decision not to change their current QE3 position of purchasing $85 billion per month of US mortgage-backed securities and other debt instruments. As I have commented over the last several years, Bernanke is a one-trick pony. His answer to every economic malady is to print money, and if that doesn’t work, then print more money. He is trying to create a 3% domestic GPD growth rate by lashing a donkey economy with a printing-press whip.
However, as I have stated in my last two letters, the problems with our domestic economy are structural, and the solutions for GDP growth and the reduction of unemployment reside in the hands of our President and Congress. Bernanke cannot substitute his incessant Keynesianism for much-needed tax reform, regulatory changes, and fiscal spending resolutions that would restore confidence in both large and small American businesses and promote investment and growth.
If you think the printing press is not out of control, then simply look at the following two graphs:
Since the beginning of the 2008 financial crisis, the Federal Reserve’s balance sheet has expanded from $800,000 to over $3.5 trillion, through June 30, 2013. As you can see from the graph above, most of the increase has been in two areas: (a) QE2 and QE3 purchases of mortgage-backed securities and (b) increased purchases of US Treasury notes and bonds. Warren Buffett recently called the Fed “the world’s largest hedge fund.”
The Federal Reserve, while it can create money, cannot create spending. However, by buying Treasuries the Fed creates money for Congress to spend, and by buying mortgages the Fed repairs bank reserves so that banks can get back to lending. Remember, lending (credit) creates spending, and without spending you have no GDP growth and no job creation. The Federal Reserve’s intent is for Congress to spend and bankers to lend, and thus we all follow the yellow brick road to a rejuvenated economy. The problem is, the wicked witch bankers are not lending, and the government spending is declining with mandated budget sequestering. The result of declining spending is that the velocity of money is now at a 50-year low!
Velocity of M2 Money Stock – 8-29-2013
*Grey areas indicate recessions.
The primary unintended consequence of Bernanke’s willingness to expand the Federal Reserve’s balance sheet is Congressional fiscal irresponsibility: why budget when you have a printing press?
One thing is certain regarding the Fed's intervention in the financial markets with QE3: the investment world is acutely attuned to any action the Federal Reserve plans as it relates to the potential slowing down or speeding up of the printing press. One of Bernanke’s self-imposed mandates is to maintain asset prices, and frankly he has done a great job of propping up stock and bond prices with the combination of his Zero Interest Rate Policy and QE3. However, the price collapse in all asset classes during June at the mere threat of tapering is an indication of just how hypersensitive the investment world is to any indication of money-supply contraction. But recall Bernanke’s May 23rd speech, when he clearly said that any tapering would be conditional upon future economic indicators and that there was no certainty regarding whether or when the Fed would tighten.
Investors should be forewarned: if the markets will sell off on mere mention of a possibility, what could happen should taper policy become more than rhetoric? In my opinion, if the Keynesian cocaine line is ever exhausted, then the investment market’s rehab will look worse than Lindsay Lohan at Betty Ford.
But for now it is “risk on” for financial assets, as US economic growth and unemployment levels remain miles away from the Federal Reserve’s preconditions for tapering. Why did Bernanke not taper? In my opinion the Fed’s decision was shaped by four factors:
- The data. Frankly, the data did not support the conditions needed for Bernanke to taper. August’s anemic employment report, combined with downward revisions of GDP (both actual and projected), would have required some serious explanation to justify tapering.
- Janet Yellen versus Larry Summers. In my opinion this situation is getting ridiculous, and the President needs to go ahead and appoint a new Fed Chairman to replace Bernanke in January. The withdrawal of Larry Summers makes Janet Yellen the odds-on favorite; however, I would not rule out the possibility of Jeremy Stein, given his relationship with the President. Yellen is not yet a shoe-in.
- Congressional ineptness. We have a problem in our country. In a time when we need reforms and changes, nothing is going to happen on Capitol Hill. The polarization is too great, and the grandstanding, name-calling, and spin-mastering of events is defeating us from within. Bernanke correctly recognized that the announced initiation of tapering combined with a showdown on Capitol Hill over the debt ceiling would have been too much for the markets to handle. Therefore, in the name of price manipulation – excuse me, stability – he elected not to taper.
- Unemployment. The chart below says it all.
The investment community is totally confused about the supposed “transparency” of the Fed, given their decision not to taper at the September meeting. Although I am sure it was not orchestrated, on the day following the FOMC committee’s announcement, St. Louis Fed President James Bullard indicated the Fed might well begin tapering at the next meeting, in October. The markets responded to Bullard’s comments by totally wiping out the gains of the prior day's trading. The Fed is beginning to look like a puppet master that has every investment firm in the world dangling from strings. The Fed has got everyone packed into Hotel California, where guests can check in but never leave. Or is it Roach Motel, given the Fed's tremendous expansion of its balance sheet? I fear that reducing the $3.5 trillion on the balance sheet will prove much more difficult than increasing it – so much so that I doubt the Fed can reduce it anytime soon. Bottom line: the Fed is stalling for time. Bernanke & Company are hoping that the economy will improve and the markets will eventually ease off the crisis-management mode they find themselves in today. Or, at a minimum, that the crisis mode will at least ease long enough for Helicopter Ben to fly off to his Princeton Keynesian retreat.
All Quiet on the Eastern Front
“ Nobody in Europe will be abandoned. Nobody in Europe will be excluded. Europe only succeeds if we work together.”
– German Chancellor Angela Merkel
On September 24, 2013, the German people re-elected Angela Merkel to extend her eight-year reign as chancellor for at least another two years. However, the outcome is somewhat bittersweet, with Merkel's former coalition partner, the liberal Free Democrats (FDP Party), suffering a stinging rebuke in Bavaria. The upshot is that Merkel, in order to rule by majority, will have to find a way to work with the Social Democrats (SPD Party). The question is whether the Social Democratic leadership will go along with patriotic support of Merkel, or let the left-wingers in to push for an alternative government. All of which makes me wonder whether Chancellor Merkel really has the support she needs to push the Bundesbank into some form of euro unification.
Sabine Lautenschlager, who is in charge of banking supervision for the Bundesbank board, said last week that the EU treaty and ECB statues lack a mechanism to unify the euro. “For a permanent and consistent solution an appropriate foundation in the primary law is needed,” she stated. In other words, Lautenschlager is calling for some form of central bank. My expectation is that, once internal politics are aligned, Germany is going to begin playing a game of hardball with the French, Italians, Spanish, Greeks, and Portugese for control of the euro. Like it or not, the Bank of Japan has launched a currency war that Europe will be forced to respond to. They cannot do so when a unified vote of 17 countries is needed to shift Eurozone currency policy. I still view the euro as the biggest risk factor affecting the stability of global financial markets.
Mean Reversion and Asset Allocation
What a strange year. Through August 31, 2013, returns by asset class:
- S&P 500 Index +16.1%
- Emerging Markets Equity -10.1%
- US Bonds -2.8%
- Global Bonds -4.2%
- Emerging Market Bonds -9.0%
- Commodities -6.2%
- Gold -17.9%
“ This is the hardest time to be an asset allocator.… Normally, you find that safe-haven assets are expensive and riskier assets are cheap – and vice versa. But today, largely because of the central banks around the world, we’ve got a very distorted opportunity set, such that there is nothing you can buy and hold.”
– James Montier, GMO
Excelsia’s investment process involves a valuation method that is based on mean reversion. Mean reversion is a mathematical concept that identifies trade ranges for an asset class, where deviations in prices are expected to revert back to a longer-term average. I have often used baseball statistics as an example of mean reversion. If a hitter averages .300 during his career, there are times when he hits .150 (aka “a slump”), and there are times when he hits .450 (aka “a hot streak”). In terms of investing, we want to be buying the player's contract when he hits .150 and selling his contract when he hits .450. In finance, Jeremy Siegel of Wharton fame and author of Stocks for the Long Run uses mean reversion to describe a time series in which returns can be very unstable in the short run but very stable in the long run.
We measure short-term volatility in terms of “standard deviations,” which indicate how far a current asset price has deviated from its longer-term average price. In our investment process we look at metrics such as earnings, sales, and profit margins to determine how these valuation measures will impact prices, to see whether an asset class is likely to revert to its historical average over a three-year time horizon and whether that mean reversion will result in higher or lower prices versus where the asset class is priced today.
The difficulty since 2012 has been that if you are not significantly overweight US equities, then your returns are less than stellar. Employing a diversified, risk-averse investment strategy in 2013 has in hindsight been the wrong thing to do, given that every other asset class is negative year-to-date, while US stocks are up double digits. The combination of the Fed's Zero Interest Rate Policy and the artificial bubble in Treasury bonds has forced conservative investors into riskier positions in order to find risk-adjusted returns. One investment area that we have become more attuned to over the last two years is the "alternative" space. The investment opportunities in long/short funds, event-driven funds, mezzanine debt funds, and commodity futures have historically been the domain of large institutions or ultra-high-net-worth individuals. However, the landscape is changing, with a number of hedge fund strategies now becoming available in mutual funds and ETFs. To mitigate risk and replace bond exposure and yield, the alternative mutual funds are becoming more and more attractive. Why?
Think about it: just five years ago the risk-free rate (as defined by a 90-day T-Bill) was 4%. To achieve a 6-8% return you had to earn 1.5 to 2 times the risk-free rate. Today the risk-free rate is 0.15%, and so to achieve a 6-8% return you have to earn 40 to 53 times the risk-free rate, which is an enormous task if, at the same time, you seek capital preservation. And in today’s market you have to do this in the face of Congressional debates on the budget and debt ceilings, potential Federal Reserve tapering, concerns about what the German election means to the euro, Japan’s initiation of a global currency war via the most massive monetary expansion ever, a potentially massive Chinese contraction, atrocities in Syria and other parts of the Middle East, and how the world will respond to them. Meanwhile, we're experiencing peak corporate earnings, a bull market that is 53 months long, and a potential end to the 30-year bull market in bonds due to currently rising interest rates. Other than that, Mrs. Lincoln, how are you liking the play thus far?
Words of Wisdom
I leave you with two recent videos posted on YouTube. The first is Warren Buffet’s conversation with Bill Moynihan, CEO of Bank of America, at Georgetown University on September 19th, in which Buffett calls the Federal Reserve “the world’s greatest hedge fund in history.”
The next is a release by Ray Dalio on “How the Economic Machine Works.” Ray is the founder of the investment firm Bridgewater Associates, which manages $125 billion. This Econ 101 course is well worth the 30 minutes.
Good luck out there.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.