Monday, April 14, 2014


A posting from last autumn was unambiguously titled Bonds, Why Stick Around? The bearish premise was that despite a low-growth environment and negligible inflation….both favorable for fixed income products….the multi-year run up in bonds was largely orchestrated by expansionary monetary policy and that once this distortion was curtailed, there would be a massive move towards the exits as no one wanted to be the last one in the room. Indeed this fear was reflected in the market for U.S. Treasuries last summer when the Fed hinted that tapering its $85 billion in treasury and MBS purchases was in the works.

Little has changed in financial markets or the economy since then…. except the continued dubious expansion of equities valuations, which was in no small part behind last week’s sell-off in shares.  Yet despite the similarity between conditions in November and now, the lack of anticipated improvement causes one to draw a different conclusion and suggest that investors shift exposure back towards bonds for the medium term.  This is not to say one should go overweight, but simply dial exposure up to an allocation suitable for current (and expected) economic conditions, which remain less than ebullient.

Bonds tend to be influenced by macroeconomic conditions slightly more than do equities. And key data still stink. Growth is slow and the Fed is onto something regarding its worries about inflation being too low. Certain jobs figures, which better reflect the true employment situation, continue to show persistent weakness. If GDP growth even hinted at returning to a long-term rate of near 3%, much less exceed that to play catch up from the half-decade long post-recession hangover, then we’d be in a sweet spot for financial markets, especially if interest rates remain in the current unprecedented range. Instead, the low-inflation, low-growth environment….along with overreaching equities valuations…means that relative to the alternatives (cash yields nothing after all), bonds may once again be the best game in town.

Back to bonds…by default.
Last autumn’s red-flag hanging over the fixed-income space was that bonds were the asset class most directly affected by Fed policy and once the extraordinary measures were curtailed, investor sentiment would sour as the marginal buyer (the Fed) disappeared. Furthermore, should growth actually accelerate, the currently dicey rational for investing in higher yielding asset classes like equities would be validated and a bond sell-off would ensue.

But even with the Fed following through on its threat to trim monthly bond purchases by $30 billion, fixed-income products have maintained the lofty levels achieved over the past few years. A popular investment-grade corporate bond ETF from iShares (LQD) has rallied 26% since late 2010. This gain includes the fund recovering from last spring’s pre-tapering jitters, and it now sits only 0.6% below its 2013 peak. Clearly whatever initial concerns investors had regarding the Fed ending the party were quickly dismissed. Similar sentiment is reflected in the iShares speculative bond ETF (HYG), which has risen 35% since late 2010, including a 2.4% gain this year. As seen below, this riskier bucket of the fixed-income space has roughly tracked the rise in equities during this era of QE, though not with the same dramatic trajectory.

Investors’ cautiousness in further abandoning bonds is also reflected in the market for U.S. Treasuries. Over the course of last summer, the Treasury curve experienced a bear-steepening, as longer-dated notes and bonds sold off in expectation of interest rate increases over the next several years. Since then the yield curve has remained relatively stable.

The greatest movement in yields was in the belly of the curve, centered around 3-Year to 7-Year notes. This is the period in which the market expects a return to more traditional monetary policy. Shorter-term notes are tethered to the Fed-Funds rate, which remains in the 0% to 0.25% range. Should the market’s expectation that rates stay the same deep into 2015 come to fruition, it will have been six years of zero interest rate policy.  The fact that highly-educated and well-meaning policy makers believe the economy merits such extraordinary support for such a long period of time can be encapsulated in one word: disastrous.

Steepening can be measured by the degree different sections of the yield curve have risen. Over the past year, the yield on the 2-Year Note has gained 54% to 37 bps while the yield on the 5-Year has more than doubled to 158 bps.  In contrast, the 10-Year has only risen 45% to 263 bps (2.63%). The more muted activity on the long-end of the curve may be explained by Fed purchases as well as the reemergence of investor concerns that a low-growth economic environment may be in store for years to come.

Equities: “Hold on there, big fellah.”
As in life, much of what determines the attractiveness of an asset class is relative. And a key contributor to a more favorable view of bonds is how far out in front of itself the equity market has gotten. Even after last week’s correction, valuations appear suspect, especially given a string of pedestrian earnings and tepid economic growth. The price-earnings (P/E) ratio on 12-month trailing basis is presently 16.6, which is 12% above its recent four-year average of 15. As stocks, by definition, are forward looking, perhaps more important is the P/E ratio based on anticipated earnings. At 15.3, it is 16% above its five-year average of 13.2, according to Factset and 11% higher than its 10-year clip. Given these lofty multiples, there is the distinct chance that the market trades sideways for a few quarters as earnings catch-up to the optimism recently exhibited by investors. Another….more dire…possibility is that the economy may enter a downturn…or a global crisis materialize…..and equities suffer as investors rush to the safety of bonds. The key beneficiaries of such a scenario would be Treasuries and the highest quality corporate issues. Junk bonds, conversely, would likely be toast.

And speaking of the economy...
GDP growth in the United States during Q4 2013 chimed in at 2.6%, slightly better than the 2.2% annualized rate the economy has averaged over the past three years. Stripping away the effects of inventory build-up and exports, one arrives at a figure called final sales to domestic customers. This number more directly measures the appetite of American consumers and businesses to open their checkbooks. The news here exudes even greater mediocrity than do the GDP data. In Q4, final sales grew at a 1.6% annualized pace, a shade under the average registered since 2011.

It is juvenile for some to insist that the standard post-recession bounce will inevitably occur. It won’t. It’s been nearly 20 quarters since this….ahem…recovery has begun. Another suspension of reality is the belief that the business cycle is no longer in effect. Just because growth has been slow, it does not mean the economy is immune to another downturn. True, recessions are often caused by the excess inventory build-up and rising interest rates that accompany an overheating economy, and we certainly are not in that situation; but peaks and valleys in the economy are inevitable. Now, however, they will likely occur on a lower plane. A shallow recession, which sounds tolerable, but that would be the flip side of persistent low-trajectory growth, which does not.

Weak inflation data also reflects the economy’s chronic softness. After all, the purpose of much of the Fed’s extraordinary policy is to catalyze upward price pressure.  Yet despite throwing the kitchen sink, along with $4.2 trillion at the problem, the Fed’s favored inflation gauge, the price index for core personal consumption, registered a paltry 1.1% in February, dramatically lower than the 2.5% rate that it dreams about.

Why has the Fed been unable to light a spark under inflation? The answer lies in the other bucket of the central bank’s duel mandate: employment. In a service-based economy like the United States, wages are a key contributor to inflationary pressure. Compared to developing markets whose price levels are influenced more heavily by raw inputs, the nature of America’s economy…both services and value-added manufacturing….means that the often-volatile price fluctuations of materials, energy products and foodstuffs are muted by the larger bucket of worker pay.

As exhibited in the charts above, much of the employment situation looks like anything but a recovery. While some of the labor force participation rate.... 63.2% and barely above the multi-decade low hit last year….can be attributed to aging demographics, much of it is a consequence of able-bodied younger workers simply leaving labor pool in frustration.  Whether counted in the labor pool or not, the longer a worker remains out of work, the greater his or her skills atrophy and thus the ability to command a wage similar to one earned in earlier, sunnier, times weakens. The difference between that original wage level and the new reality of lower…or no…wages is directly manifested in lost potential GDP and aggregate demand, especially in an economy comprised of 70% personal consumption.

So how can the Fed print so much money and not have it goose the economy? Well that’s the head-scratcher of the century so far. While the answer remains elusive, the evidence is clear. As seen below, M2 monetary supply has expanded by nearly 30% since early 2009. Yet the velocity of money, that is how many times it is circulated in the economy, has slowed considerably. Paradoxically much of these excess funds have been deposited back into the Fed’s vaults earning scant returns. But with economic prospects opaque and the regulatory hurdles for the financial sector ever increasing, banks have little incentive to deploy this bounty of funds into the broader economy.

What’s an investor to do?
While the rationale to favor bonds is relatively simple from 20,000 feet, picking which fixed income instruments one should include in his or her portfolio is substantially more challenging. As referenced earlier, the belly of the Treasury curve has already sold off. Value could be found in those notes, especially if inflation remains muted over the next few years. Longer-dated bonds, with yields at 2.6% for the 10-Year, look slightly less attractive, especially as the Fed has never tested the various plans to sop up the excess money supply. The questions surrounding that inevitable task are what provide fodder for the apocalyptic hyperinflation and gold-bug cults.

Neither investment grade nor speculative bonds offer yields worth writing home about. But with the risk of either an economic downturn or a sell-off in risky assets both plausible, the logic of holding riskier junk bonds for only a marginally better return than those of high-quality issues is questionable at best.

Lastly, an investor can look abroad. Emerging markets have historically offered higher interest rates in order to garner the attention of investors who would otherwise shy away from illiquid, opaque and sometimes dodgy economies. 2013 was brutal for these markets meaning there are pockets of value likely to be had. One should steer clear of economies with weak fundamentals, namely unsustainable budgetary and current accounts deficits or ones experiencing political instability. Major names on this not-so-short list are Russia, Turkey, Thailand, Venezuela and Argentina, although some brave souls have ventured to the bond markets for the latter two, driving up their YTD returns into double-digit territory. Talk about living on the edge.

The attraction of this trade has been the positive carry of borrowing funds in low-interest markets like the U.S. Japan and Europe and purchasing higher-yielding emerging market-denominated instruments. A bonus has been the appreciation of EM currencies vis-à-vis the dollar, which further gooses returns. Even if U.S. GDP growth remains sluggish, the Fed will likely continue its tapering and investors will expect interest rates hikes, no matter how gradual, to ensue shortly thereafter. This will put upward pressure on the dollar. But an appreciating dollar vs. EM currencies will only slightly offset the positive carry of the higher interest rates in these countries’ bonds.

 Just because the pendulum has swung ever so slightly back towards bonds and away from frothy stocks, does not mean the asset class is a gold mine. Yield is still hard to come by in a low-growth world with rampant market distortions putting downward pressure on fixed-income returns. This reality is in part why bond investors, in their search for yield, have expanded the definition of fixed-income and pursued such strategies as unconstrained funds. Desperate times call for desperate measures. We’ll save that discussion for another day.

Monday, March 10, 2014

Lessons From Moscow: How Not to Build a Modern Economy

The cover story in a recent issue of The Economist magazine detailed Argentina’s fall from grace over the past century.  The piece reads like an economist’s version of a horror film. All the gory bits are present: populist policies, ham-fisted state intervention, fiscal irresponsibility and the frittering away of the rule of law…not only with regard to property and business, but eventually across society. While the purpose of the article was to serve as a warning for other countries, one had to ask, is this cautionary tale really necessary? After all most of Argentina’s missteps occurred way back in the 20th century. Since then the virtues of economic liberalization and free markets have been proven time and again. Furthermore, myriad narcissistic populist leaders have had their clothes ripped off, exposing the dangers of concentration of power.

Unfortunately, there are still countries following this disastrous template, including Argentina itself as well as a handful of other Latin American neighbors. The romance of leftist politics and fiery leaders apparently always has a welcoming audience in balmy southern latitudes. But one country in a decidedly frostier climate has also made a pronounced turn towards a potentially ruinous economic path: Russia. Much like the wayward LATAM countries, Russia is sowing the seeds of underperformance despite a nearly unequaled bounty of natural resources. The country also has in its favor a well-educated populace, especially in the realm of science and math, areas where a certain unnamed global superpower is egregiously lacking. At first glance Russia has experienced an economic renaissance since the nadir of the post-Soviet era, yet this is likely to prove ephemeral given the government’s consistent jettisoning of the policies and tools necessary to create durable economic growth.

Russia has commanded its fair share of media coverage of late due to its adventures in Crimea and the unceremonious dumping of its kleptocratic water boy in Kiev. There is plenty of commentary available on the geopolitical chess match occurring in Ukraine, but this posting is not one of them. Instead, true to this page’s mission, the focus is on economics and how it relates to the investment universe; in this case with regard to Russia. It is not a far stretch, however, to draw a connection between the country’s current economic trajectory and its fitful grasps at the fading shadows of imperial grandeur.

The Wild East
At the risk of dating myself, your commentator recalls a description of the Soviet Union by one of his university professors stating, “…it is a third-world economy with a first-world military.” We know how that story ended. The collapse of the command economy gave way to the chaos of the 1990s and its bastardized version of privatization and capitalism. After the fleecing of the country’s commanding heights, countless gangland shootings and a mass exodus of capital towards the anonymous valleys of Switzerland, the country was fatigued and ready for a new beginning. Enter Vladimir Putin. The erstwhile St. Petersburg functionary (among other things) was the beneficiary of not only Russia’s yearning for a strong hand, but also generous presidential powers as defined by the constitution. One-hundred bucks for a barrel of oil did not hurt either.

Even during Soviet times, Russia was an energy juggernaut. After a nearly decade-long swoon in production, the wind was at the country’s back by the early 2000s with hydrocarbons leading the way. Vast sources of industrial metals such as aluminum and nickel further augmented economic prospects.

The rebound in growth was impressive and soon Russia was lumped with China, India and Brazil to form the BRIC club of large countries with rapidly expanding economies. Moscow’s store shelves were stocked with all the creature comforts of an advanced economy and regular flights were scheduled to London, southern France….and of course, Zurich.  But these economic advances came at a price: the gradual curtailment of civil liberties and other tenets of a civil society.  As has been proven time and again, once the media, courts and a viable political opposition have been muzzled, those in power turn into self-serving crooks in  pretty short order.

How Do You Say “One-Dimensional Economy” in Dutch?
In the recent kerfuffle over Crimea, U.S. Secretary of State John Kerry commented that 19th century geopolitical tactics had no place in the 21st century. Russia’s misplaced sense of time is also at play in the economic realm. One could argue that economy of the Soviet Union was more dynamic than modern Russia’s. The USSR at least produced things across an array of industries. Those wares may have been lousy and forced upon a captive consumer base, but at least the factories were humming. Fast-forward to 2014 and the country has come to redefine the concept of Dutch Disease, meaning an overreliance on natural resources exports at the expense of a value-added manufacturing base.

Virtually anything of worth and complexity is imported, a situation that has only been magnified during the decade of high energy prices. As seen above, Russia is reliant upon foreign suppliers for many of the tools necessary to keep a modern economy buzzing along. This includes transport equipment, machinery, office and telecom equipment, not to mention those fancy Gucci bags and Italian fashions adorning Moscow storefronts. The manufacture of cutting-edge goods creates a greater amount of high-skilled jobs than does digging a hole in the ground for a pocket of crude or a hunk of bauxite.

Creating a skilled manufacturing and services base should be especially important for Russia as the deck is stacked against it from the get go. Economic growth is a result of increasing population and enhanced productivity. Russia’s populace is shrinking, and at an alarming rate, having retrenched nearly 5% since 1990.

With regard to labor productivity, the country dramatically lags advanced economies. To be sure, inroads have been made from the Soviet era, but that is the consequence of an incredibly low base. As seen below, GDP per capita in Russia is only 46% of the U.S. level and output per hour worked reaches just 37%, lower than the rates for Chile, South Korea and Turkey.

Red flags abound….and not those adorned with a hammer and sickle
As any investor knows, diversification is a good thing. Russia rode the positive trend in commodities demand to relative prosperity. But as the super-cycle has tapered off along with previously red hot growth in energy-intensive emerging markets, the country’s lack of diversification is coming back to haunt it. GDP growth, along with fellow commodities producer Brazil, has consistently lagged that of the other BRIC countries, China and India.

As a result, national accounts are less vigorous than they were a few short years ago.  The current account, while still positive, has trended down to nearly 2% of GDP (the U.S. should be so lucky). Also the federal budget, built to generously hand out patronage to favored segments of the population, has dipped into the red. Purportedly crude at $100 a barrel is required for the petro-state…and that’s what Russia has become….to balance its books.

Lower energy prices are not the only thing Russian officials need to worry about.  Production growth for both crude and natural gas has slowed from the boom period experienced a decade ago. Crude production between 1996 and 2004 grew at an annual clip of 5.5%. Between 2005 and 2012 it slowed to 1.5%. The drop may be partly explained away by the curtailment of production in light of the global recession, but other data suggest that additional negative factors are at play. Russia’s share of global crude reserves has dipped from 6.1% in 2006 to 5.2% in 2012. Furthermore, growth in proven reserves has all but stalled.

These trends cast a dark shadow as Russia has become overly reliant upon royalties from the energy industry as its main source for hard-currency. While the Central Bank’s foreign currency reserves are still at lofty levels, accumulation has slowed and at some point those funds may be needed to defend the Ruble against deprecation. Since its level of 27.4 to the USD in 2011, the Ruble has lost nearly 25% of its value, with 10.4% of that decline coming since late-December as a consequence of traders freaking out over Putin’s Black Sea adventurism.

Capitalism….with a little “c”
Overdependence on commodities exports is just one hurdle facing Russia’s economy.  The balance of power between the private sector and state has swung towards the latter, with key industries dominated by state-controlled firms. This is illustrated in the constituents of the MICEX equities index, which largely reads like a who’s who of state-owned enterprises, including giants Gazprom, Sberbank and Rosneft. This concentration is aggravated by the practice of corporations maintaining control by floating only a portion of their shares. Of the ten largest listings on the MICEX, representing 73% of total market cap, the average amount of free floating shares is 39%. Just enough to keep a minority shareholder awake at night. With such suspect underpinnings, it does not take much….say the unprovoked armed invasion of a neighboring land…to send equities investors running for the exits. And this is exactly what has occurred with the MICEX plummeting 11% in the past month.

Portfolio investors are not the only ones proceeding with caution. Foreign Direct Investment (FDI) has yet to recover from the global downturn. From 2000 to 2008, FDI…admittedly from a low base…averaged 51% annually. In the ensuing four years the gain averaged only 11%. With foreign investors…especially in the energy and materials space…getting bullied about, is this to anyone’s surprise?

In addition to the heavy hand of the state, petty corruption and regulatory inefficiency continue to be a drag. Needless to say, none of these characteristics are conducive for nurturing an innovative, wealth-generating private sector. In this environment, is it any wonder that while young Czech computer scientists have created global leading cyber-security firms, their Russian counterparts are renowned for being the world’s most menacing hackers? It isn’t like the country’s leaders are moral icons.

Consider yourself warned
As long as we are quoting past professors, another one opined that the best way for an investor to approach Russia was to avoid it. The comment was made in the aftermath of the 1998 Ruble devaluation, so within that context perhaps it was a prudent strategy.  Yet despite many of the advances since then, investors still must approach the country with extreme caution. In a world dependent upon interconnected capital flows, reticence towards Russian assets by foreign money is itself a hindrance to growth. This risk could become even more pronounced should growth in hydrocarbon exports continue to diminish and the Ruble continue its slide, especially given the country’s reliance on Euro and Dollar denominated manufactured imports.

For those investors continuing to go forward, it isn’t like you have not been warned. The country’s elites make little effort to hide their hardball business tactics. As for commercial partners, such as energy hungry Germany, the inability to confront Russia’s geopolitical dalliances is a direct consequence of not diversifying their energy resources (e.g. an alternative to Nord Stream and the unplugging of the nuclear sector).

The Gucci Revolution
Rounding our way back to any linkage between Russia’s Potemkinesque economy and its latest exercise in Machtpolitik, one plausible connection is that the gents in the Kremlin recognize their economy is ill-equipped to raise the living standards of ordinary Russians anymore (without relinquishing plum positions in key industries). So as a diversion, they beat the nationalist war drum. This tactic is especially effective when resuscitating the ever-lurking fascist scourge to the west, which evidently includes every European between the Dnieper and the Atlantic. Or the plutocrats have simply come to believe their own rhetoric on having rightfully returned The Motherland to Tsarist glory.

But this is neither the 19th nor the 20th century. Russians, especially the young, understand how the rule of law and free market principles lead to increased living standards. This is no East vs. West argument. Yes, many were coopted by the relative stability which marked the early years of the Putin regime, but the loss of freedom and opportunity have reached a tipping point where the future prospects of a nation are at stake. With the Internet and frequent travel to western capitals, the genie cannot be put back in the bottle. In keeping with the tradition of giving every popular uprising in the 21st century an easy-to-digest moniker, we can call this one…should it ever occur… The Gucci Revolution.

Despite its volatile and sometimes dubious history, it is hard to discount Russia’s place in the international community. After all this is the country that gave the world the brilliance of Dostoyevsky, Tchaikovsky, Stravinsky and Maria Sharapova. Rather than suppressing these resources…as well as invading former territories…..the Kremlin should instead harness them by casting away the chains holding back a potentially top-tier global economy.

Wednesday, February 5, 2014

A Lousy Investment

The current account balance of a nation is akin to phenomena like trans fats, water-boarding and West Nile Virus in the fact all have entered the popular lexicon, very few people know exactly what they are, but most are pretty sure that experiencing any of them would be quite unpleasant. Despite the well-documented risk of consuming more than one can produce domestically, the United States has chronically rung up a deficit in its current account since the early 1980s. The country has gotten a “pass” on this profligacy from creditors given it is home to the world’s largest economy, its transparent and liquid financial markets, and the dollar’s status as the de-facto global reserve currency. As evidenced by recent events in Turkey, emerging economies are not so fortunate, with financial markets eventually punishing countries that are perpetually in the red. Yet the great economic axiom of there is no free lunch holds true; there is genuine risk should the U.S. fail to address its imbalances.

A Quick and Dirty Lesson in International Economics
A most basic definition of a nation’s current account is that it measures the goods and services a country buys from abroad versus those it exports. A country which buys more than it sells will run a current accounts deficit (yes there are additional buckets that comprise the current account tally, but as to not bludgeon the reader with national account minutia, those will be ignored for now). In the past generation, the U.S. has transitioned from a creditor nation to the world’s largest debtor. One reason for this is the country’s dependence on foreign oil. While the U.S. is still one of the world’s top producers of crude, the energy required to fuel its suburban-living, SUV-driving lifestyle means it has had to import approximately half of its oil needs, although the number is presently on a downward trend thanks to the Greenies’ favorite bugaboo: hydraulic fracturing. Not coincidentally, America’s persistent current-account deficits has roughly coincided with the country becoming a net crude importer.

Another contributing factor has been the relocation of massive amounts of manufacturing capacity to low-wage, namely Asian, countries.  In one of the most blatant ironies in modern economic history, the revenues generated by foreign (and domestic) firms hawking a range of cheaply built products were funneled back into U.S. financial markets for safe keeping, which in turn helped keep interest rates low (high demand and subsequent high bond prices push yields lower), thus spurring additional credit-fueled consumption.

On The Flip Side
Even less known than the nuts and bolts of the current account is that there is a (mostly) offsetting account measuring capital flows into a country. If a country consumes more than it produces, it must borrow the funds from abroad to pay for the difference. This is especially true in the United States, which, when including government accounts, doesn’t bother with anything as trivial as building up savings. Without a national piggy bank to dip into, and with consumption far outpacing domestic production, the U.S. must make up the difference with funds loaned from our buds in Beijing, Tokyo, Riyadh and Dubai.

Fortunately for spendthrift policy makers….and their overindulgent constituents….the U.S. remains atop the list of the most attractive destinations for risk-adjusted investment returns. Despite many shortcomings including sluggish GDP growth, chronic joblessness, an uptick in regulations, lousy coffee and a mediocre national soccer team, the country still has liquid, well-regulated capital markets, the rule of law and the reputation for paying its bills.

“You Spent It on What??”
Just like with consumers and businesses, financing certain purchases at times can be prudent for a country. It all depends upon how the borrowed funds are spent. If they are used for investing in high value-added endeavors such as modernized infrastructure, increased industrial capacity and education, then the return on investment could merit the financing costs. This is a reason why many….not all….emerging markets get a free pass for temporarily running current-account deficits. In order for a country to upgrade from goat herding, strip mining and small-arms manufacturing to a more complex, value-added product based economy, it must first import the capital goods necessary to retool its medieval industrial capacity. That entails running deficits until the high-margin exports start flowing.

So how has the United States invested its bounty of foreign inflows? Clearly not in infrastructure, given the nation’s crowded freeways and crumbling bridges, nor in education as evidenced by the country’s steady slide down global science and math rankings. It is true that the U.S. is home to a number of hyper-efficient, cutting-edge factories, but the manufacturing sector has contracted over the years to the point that it no longer provides the pop to the overall economy when output is buzzing. Nope, instead the country has gone on a binge of buying financial assets and speculative real estate in crappy locales such as  Las Vegas, mosquito-ridden coastal towns and down-market ex-burbs.

During the boom, policy makers and business leaders alike thought they had stumbled upon the perpetual motion machine; cheap credit funds housing expansion, home-buyers demand even more gadgets to cram into their man caves and three-car garages, which in turn fattens the wallets of purveyors of those goods…along with  those of numerous housing-centric service providers…allowing them all to partake in the virtuous circle. But one can only buy so many flat-screen TVs. Once the sugar-buzz of a housing spurt wears off…which it inevitably does…if there is no underlying industry (ideally export-oriented) to pick up the slack, the…pardon the pun….house of cards collapses. As it did. A robust housing market should be the consequence of a strong economy, not the source of one.

The influx of foreign funds also flowed freely into U.S. financial markets. This lowered the cost of capital across the economy thanks to treasury purchases, goosing aggregate demand and driving corporate profits higher.  Some of this foreign money went directly into equities markets, joining domestic investors as they chased indices to record highs.

In theory, robust demand for shares can provide corporate boards with funds necessary to expand capacity and invest in new projects. This concept is one of the underpinnings of the Fed’s multiple iterations of quantitative easing. The only problem is that it hasn’t worked. Instead of building new factories in the borderline Soviet expectation that increased supply will somehow spur demand, firms have squirrelled away these funds and will likely not deploy them on any large scale until there is greater evidence that economic growth finally has hit the afterburners and demand for their products returns.

Capital Stock: The Missing Link
A key contributor to economic growth is increasing productivity. And a sure-fire way to increase productivity is to have glitzy new factories and cutting-edge technologies deployed across society.  While there are certainly such examples in America, over the past four decades investment in nonresidential fixed assets has been on a downward trend. Much of that is attributable to the transition to a service-based economy. One can argue that as the world leader in exporting services, the country does not need levels of investment required during an earlier era. The contrarian view, however, is that a country that makes stuff, value-added stuff and in large quantities, should have a bright future.

As seen in the chart below, the trend for investing in private sector equipment has steadily fallen over the decades. In the meantime, residential real estate went on a tear, far outpacing overall economic growth. As stated earlier, such gains proved ephemeral.  In a tragically fitting irony, yield-hungry investors, spurred by the Fed’s extraordinary monetary policy, made cash-investing in depressed real estate markets a borderline national pastime in the aftermath of the crisis, essentially, doubling down on a sector that does nothing to increase competitiveness.

Giving Trickle-Down Economics A Bad Name
So when it comes to preparing for the future, the U.S. is a lousy investor. What’s worse, rather than squandering its savings (it has none) on dud endeavors like real estate and stock speculation, it is borrowing money from abroad to do so. The safety of the country’s financial markets has been a strong competitive advantage versus even other developed economies. But eventually, if the return on investment is not there, foreign governments, sovereign wealth funds and private investors will find other, higher-yielding destinations.  Should that occur, the country’s ability to get away with consuming more than it produces would be threatened and any attempt to raise interest rates to win back foreign capital would add yet another headwind to this unprecedented era of sputtering growth.

Whether one is a supply-sider or not, it is evident that the concept of trickle-down economics only works when the titans of industry put their wealth to work by investing in factories and office space, hiring workers and increasing productivity.  Yet in the wake of the financial crisis and policy responses it triggered, there has been no wealth effect sending positive shockwaves through the economy as promised….unless one considers Aspen hoteliers, stock brokers and Manhattan real estate agents.  This backdrop of a recovery benefiting only the very few who have large amounts of paper assets makes the recent State of the Union speech, grumbling about income inequality, all the more laughable. This administration’s…and  the Fed’s…. misguided understanding of investment incentives and requirements for durable economic growth have only aggravated the income gap.

Tuesday, January 14, 2014

Hedging 2013

With 2013 firmly in the rearview mirror, investors are using yet another arbitrary point in time as an occasion to reflect upon the market’s recent moves and divine what may be in store for the year ahead. The equities market in 2013 can be characterized as the continuation of the beta trade, meaning all sectors in the S&P 500 rose on the same tide, with some benefitting from the giddiness more than others. The year also saw the luster wear off the post-crisis, Fed-induced, distorted (pick your modifier) rally in fixed income instruments. There are plenty of analyses offering up post-mortems on the year that was, and an even greater number of forecasts for 2014, with most of which falling into the buckets of being simply wrong or borderline absurd. The changing of the calendar also prompts portfolio managers and retail investors alike to adjust their tactical allocations, especially as many a portfolio got out of kilter given the solid……well preposterous…run that equities have experienced in the post-crisis era.

For most investors, including long-only professional managers, tweaking portfolios consists of rebalancing asset classes and sectors relative to the longer-term strategic allocation, changing the strategic allocation itself, or if exceptionally paranoid, shifting into cash. A third possibility is to hedge the portfolio by layering on some simple yet effective derivatives. Despite their reputation as a reckless tool used to hungrily goose performance, instruments such as options and futures contracts, when judiciously employed, can act as an insurance policy protecting past gains, and access exposure to bullish themes in a cost-effective manner. It is true that many of such instruments are the domain of sophisticated, institutional investors with some serious firepower on their balance sheets, but when feasible, other segments of the investing public can employ similar tactics to buttress their portfolio.

There is no hard-and-fast rule determining which part of one’s portfolio is ripe for hedging. This aspect of investing falls under the category of more art than science. Areas which may be fertile, however, include sectors that have euphorically gotten ahead of their fundamentals, securities which have lagged the market for no logical reason, or anything where the intrinsic value does not jibe with underlying economic conditions.  And with the S&P 500 rallying 170% over a five-year period typified by 2% GDP growth and employment in a complete funk, there is plenty of reason to think a correction is more than overdue. With such an uneasy backdrop, one may ask why not simply load the portfolio up with liquid, defensive instruments, taking the unreasonably massive gains of the past few years as a gimme? In normal times, that would be the prudent thing to do. But these are extraordinary times in which we live. Not Armstrong on the moon extraordinary, but an era of a $4 trillion Fed balance sheet and government debt still stuck at 100% of GDP extraordinary. With market rationality tossed aside, an investor may as well adhere to the adage the trend is your friend and keep riding the bull. If choosing that path, however, one will sleep much easier if his portfolio is adequately hedged.

The 2013 leg of the bull market was a story of P/E expansion with the 12-month trailing P/E ratio based on operating earnings rising from 14.7 to 17.2 over the year. This was the major driver behind the S&P’s 29.7% rise, as earnings grew a rather subdued 10.7% over the period, which in fairness, was at least better than annual rates registered in other recent quarters.

Investors’ willingness to pay more per unit of earnings was also reflected in another P/E metric, Robert Shiller’s P/E ratio, based on earnings over the prior 10 years. The beginning of 2013 saw the long-term P/E at 21.2, which is what it has averaged since 1980. By December the premium for owning shares had risen nearly 20% to 25.4. Fund flows echo this transition into equities as several years of outflows from domestic equity funds were finally reversed. It only took shareholders stung by the financial crisis four years to rediscover equities, and stewing that they missed out on much of the ride, they tossed fundamentals aside and demand alone drove the market higher.  And how many times have we heard that a sure sign that a rally is in its final stages is when the broader investing public becomes consumed with chasing stocks?

The Hedge
If one is of the mindset that the rally may be due for a break…if not a correction….the next question is, where to hedge? As seen in the chart below, consumer discretionary, healthcare and industrial names have outperformed the market. Two of those sectors are cyclical, meaning they are susceptible to a dip in the economy, which is entirely plausible. Despite optimistic incantations from Wall Street, chronically slow growth does not preclude the possibility of an eventual recession. The current expansion measures 73 months, and since 1945, the average duration of expansions has clocked in at 58 months. The other hot sector, healthcare, could be in for a bumpy road as consequences of the Affordable Care Act’s roll-out continue to be uncovered.

Investors aware of these realities, yet unwilling to pare back their exposure, could execute a variety of tactics. The highest flying shares could be candidates for a protective put strategy, where the purchase of put options on names already in the portfolio acts as an insurance policy, locking in recent gains should prices fall beyond a specific point. For those more bullish, yet still thinking the pace of the rally may subside, a covered call strategy may be appropriate. Here selling call options on portfolio components can increase yield, but on the flipside, cap the earnings potential should shares go on another tear.

The two clear laggards of 2013 were the historically defensive sectors of utilities (8.8%) and telecommunications (6.5%) as investors preferred more growth-oriented names. If one expects these sectors to either play catch up with the broader market in 2014 or benefit from investors retreating into defensives, buying call options on select names within the sectors could be a tactic with an attractive risk/reward profile. What makes any of these strategies cost-effective ways to modify exposure is the fact that volatility….a key ingredient to options pricing….is at historic lows. As seen below, the VIX index…the so-called fear gauge….is 43% below its 2008-2013 average. Coupling low volatility with relatively deep out of the money strike prices…another contributor to options pricing….enables investors to take advantage of tranquil market conditions to hedge their portfolio against any curveball 2014 may throw their way.

Fixed Income
The clear loser of 2013 was the fixed income space as the U.S. Treasury curve underwent a bear-steepening, meaning longer dated bonds sold off as investors expected the Fed to slowly remove its loving hand from the marketplace. While these pages stick by the expectation that bonds are turkeys in the short run, it is fair to ask whether this sell-off marks the end of the multi-decade secular bull market or authorities will continue on with a strategy of financial repression, which tilts the fixed income market towards government securities and low nominal interest rates. In the case of the latter, the downside of bonds is limited, although the outcome for the nation’s savers…if there are any left… grim.

Current yield levels on Treasuries reflect the expectation that the economy will continue to grow in 2014 and that the Fed will maintain…if not add to….its paltry $10 billion tapering of monthly asset purchases.  Yet if either of those assumptions fails to materialize, a reversal back into the safety of Treasuries could occur. Hedging against a rates reversal is more complicated as interest-rate derivatives are largely the realm of institutional investors.  For those with that capability, however, the chart below illustrates how purchasing futures contracts on 10-Year Treasuries can enable investors who have recently culled their fixed income holdings to still participate in a bond market rally.

As with any futures contract, the shape of the curve in part determines the profitability of the position. Futures prices reflect the expectation that yields will rise (prices will fall) over the course of 2014).  If prices remain at current levels, those who bought discounted futures positions will benefit from a carry yield when they roll over the contract. This is the same dynamic exhibited in several commodities futures curves. If the spot price falls towards the purchase price of the contracts, profitability diminishes.

Emerging Market
Assets associated with emerging markets also endured a brutal 2013. If one is a believer in the strong secular emerging markets theme…as this analyst is….then the sell-off presents an opportunity to gain exposure at discount prices.  While the selling was broad-based, some markets suffered more than others. Many for good reason. As with any emerging market investing, one should pay special attention to transparency, liquidity, commitment to the rule of law and free markets as well as to sound macro-finances. Those alone eliminate about half the emerging markets space, including the entire eastern seaboard of South America. And while Turkey has been an investor darling over the past decade given its pro-market reforms, the current political strife is reason enough to stay away for a while.

Countries whose solid fundamentals are at odds with the lousy performance of 2013 offer up an assortment of securities ripe for the picking.  Accessing these through derivatives is more complicated as the many markets lack the range of products available in developed markets, and when they do, liquidity and volatility come into play. Still call options on unloved ADRs of emerging market listings could be attractive as well as derivatives on currencies whose underlying country has attractive fundamentals.

No discussion of hedging portfolios would be complete without mentioning the default hedge…at least according to those apocalyptic cable-TV commercials: gold. When global central banks unleashed an array of extraordinary measures to stem the financial crises of the past six years, many warned of runaway inflation and the diminishment of the dollar. Dialing up one’s exposure to the yellow metal, was considered an antidote for both scenarios. Indeed, gold prices did broach $2,000 per ounce in 2011. Since then, however it has been a steady slide.

The truth is that despite unprecedentedly loose monetary policy, the problem with inflation is that there is still not yet enough of it, at least in the U.S. and Europe. Consumers have not yet been cajoled into liberally opening up their purse strings. Only the Japanese have been able to exert upward pressure on prices, with headline inflation reaching levels not seen since 2008.  So if one seeks gold for near-term returns, purchasing it denominated in Yen would be the method of choice. This tactic would do nothing however to protect dollar-based investors from inflation, especially as the Yen decreases in value vis-à-vis the greenback.

So while it is not necessary at present for U.S. and European investors to utilize gold as an inflation hedge, it can still act as a defensive component in a diversified portfolio. This is especially true should the recent decline near the marginal cost of production of gold miners and the lower prices spurs activity among a key segment of physical users: Indian jewelry buyers.  Yet buying physical gold incurs costs, namely secure storage. If investors gain exposure via futures, they will get tagged with the costs of rolling over these contracts upon expiry. This negative carry is indicative of futures curves in contango, which is the opposite of the curve exhibited by many commodities (and interest rate futures). Any rise is gold prices would have to be large enough to offset this cost.

Tuesday, December 17, 2013

Recent U.S. Data Indicates 2013 Limping To the Finish Line

Most users of the mainstream media are vaguely aware of the constant stream of economic data reported between crucial updates on the Kardashians and other drivel that currently passes for legitimate news.  With arcane names such as the Purchasing Managers Index and New Orders for Nondefense Capital Goods less Aircraft, it is easy to see why much of these data can cause otherwise inquisitive eyes to dart straight to the sports section. But taken in aggregate, and over an extended period of time to smooth out inherent volatility, such data tell the tale of the condition of the economy, its bright spots and areas of lingering weakness. Recent numbers, at least at first pass, have been encouraging. Yet when applying slightly greater scrutiny, one uncovers wounds that have been difficult to heal.

GDP: Stuck on Low Gear
One recent headline-grabber was the upward revision of Q3 GDP growth to 3.6% annualized. Quite an improvement over the previous five quarters, where growth averaged 1.5%. But before declaring an American wirtschaftswunder, it is necessary to point out that inventory build-up…that is goods produced but have yet to find a home….accounted for one-half of the gain. Filtering out inventory factors, a more pedestrian rate of 1.8% is in line with the roughly 2% growth in which the country has been trapped since 2011.

History indicates that excessive inventory gains tend to suck growth out of ensuing periods as prudent managers whittle down warehouse levels. That adversely impacts everything from worker hours and electricity usage in factories to fuel demand for the nation’s trucking fleet. High inventory levels also can lead to price slashing to move products, which cuts into corporate profit margins.

One way gauge the economy’s heartbeat at its most basic level is the Final Sales to Domestic Purchasers data series (speaking of arcane titles).This scrubs out the effects of both inventory gyrations as well as exports, in order to determine how willing American households and managers are to open up their wallets. As seen below, for five of the past seven quarters, final sales have lagged top-line GDP growth. For Q3, Final Sales growth was 1.8%, which is what it has averaged since the beginning of 2011, compared to slightly higher…but still forgettable…2.1% for the overall economy. For some perspective, Final Sales averaged 2.9% between 2000 and 2006 when the economy was chugging along at a 2.6% clip.

Business Investment: The Real Driver of the Economy
While personal consumption accounts for roughly 70% of the U.S. economy and often is used as a proxy for the overall health of the marketplace, the real engine for durable, long-term gains is business investment. Not only does such investment lead to productivity gains, which in turn leads to a more skilled workforce and higher wages, but also complex manufacturing is one of the sectors in which the U.S. still ranks among the global elite. That along with ever-creative ways to improve the cheeseburger. It is healthy for the country to have sleek, automated factories producing precision-crafted capital goods (often for export) rather than churning out volumes of low value products like t-shirts and rubber duckies. The broadest investment category in GDP data has registered strong gains over the past several quarters, but much of that is due to a rebound in the residential housing sector, which is peculiarly lumped into this bucket. Much of housing’s gains are due to a pronounced base effect after the sector spent years in the dumps. A number which more cleanly captures output of products like capital goods and computers is the business equipment series. After having been a strong contributor to growth in the wake of the recession (again partially due to pathetic 2008 and 2009 base effects), such investment has cooled dramatically over the past year, with Q3 investment being flat.

From 2000 to 2007 investment in business equipment averaged 4.2% annualized. A consistent return to such levels would signify confidence by the nation’s businesses that growth prospects are sufficient to justify ramping up purchases (often on credit) of machinery, computers and logistical equipment. While investment in business equipment has belatedly clawed its way back to its pre-crisis proportion of the broader economy, real estate has not. As seen below, during the bubble years, residential real estate investment rose from 5.2% of GDP to over 6%, eclipsing business equipment investment for much of that period. Since then it has dropped to the 3% range. Given the structure of the U.S. economy, residential investment is joined at the hip with personal consumption, partly due to the need to outfit housing with furniture and neat gadgets like turbocharged espresso machines, and partly due to the nifty financial engineering which enabled homeowners to use their houses as ATMs, thus increasing the magnifier effect of the sector. Those days are long gone….which is not necessarily a bad thing.

Cooling investment in equipment is also reflected in recent orders for durable goods, which is considered a trusted barometer of future economic prospects. The new orders data for core capital goods decreased 0.6% from September to October. More worrisome is the establishment of a trend, which has seen the three-month moving average in negative territory for the past four months.

PMI: A Good Harbinger for 2014?
The aforementioned GDP data for recent quarters, by definition is backward looking. Like the new orders for capital goods data, certain components of the ISM’s Purchasing Manager’s Index are also regarded for their ability to gauge the future path of the economy. This report takes the pulse of managers in the trenches, those actually writing the checks. If they don’t have confidence in future prospects, the checkbook...for payroll, increased production and equipment purchases….likely stays in the desk drawer.

Fortunately, as seen above, recent data have impressed with many key sub-indices of the PMI having greatly accelerated over the latter half of 2013. New orders and production have led the charge, whereas employment, has slightly lagged (but still registered its strongest gain since early 2012). The PMI is a diffusion index where numbers greater than 50 indicate expansion in the manufacturing sector. Not only has the headline PMI number been above 50 since late 2009, it is well above 42, which is the threshold indicating growth in the broader economy. Why does 42 in the manufacturing sector infer growth in the overall economy? The answer is in the changing composition of the workplace. Manufacturing has been in decline for decades so even in expansionary years, the nation’s factories continue to atrophy.

Job Gains: Belated Growth…And In The Wrong Places
The diminishing fortunes of the nation’s manufacturing sector are also on display in the jobs data. Since 1990, manufacturing jobs, as a share of nonfarm payrolls has fallen from 16.3% to 8.8%.  In its place are increases in dubious sounding service sector categories like hospitality and leisure, which have seen their share of total payrolls rise from 8.5% to 10.4%.

Historically, manufacturing jobs have been key drivers of the economy as they offered solid wages and opportunities to build skills. On the contrary, in a service economy, one can froth a latte only so many ways.  Just as important, the sector’s workers, confident in their futures, would enthusiastically partake in the ever so American tradition of rampant personal consumption, thus creating an outsized magnifier effect, benefiting the entire economy. Manufacturing still offers plumb positions, but the landscape is different. The current emphasis is on intelligent manufacturing, which is a euphemism for automation and fewer workers. One guy with a laptop in a control room can do the tasks it took a dozen to complete only a few decades ago. This trend has resulted in the sector losing the critical mass of workers necessary to fuel ancillary segments of the economy. Now only the local Prius salesman and yoga instructor benefit from this more highly skilled….yet much leaner….workforce. Need numbers to back this grim claim? In 2007 the nation’s factories employed 14 million workers. During the recession, it lost 2.5 million of those. In the mother of all jobless recoveries, it has only clawed back 554 thousand of those positions, a paltry 22%.

Aggravating the travails of the nation’s factory workers, is the slow pace of overall jobless growth. As seen above, the nation still has nearly one million fewer jobs than it did at the outset of the recession…and it has taken six (!!) years to reach this point. The composition of the meager job gains does not help matters. Since 2008, workers in part-time positions for economic reasons (i.e. that’s their only option) have risen from 3.1% of nonfarm payrolls to 5.2%.

Such part-time workers, along with the unemployed and those marginally attached to the workforce, are components of the broad U-6 unemployment rate which remains a depressing 13.8%. The chances of this bulging bucket, by historical standards, being strong contributors to personal consumption during the Christmas shopping season (and beyond), in economic terms, is zilch.

A Cold Shower
The take-away from recent data is that the bifurcation of the American economy continues. If one has mad engineering skills or owns a Boulder County yoga studio, things are rolling along. For those ill-prepared for a complex 21st century workplace, prospects simply don’t look good.