Sunday, October 5, 2014

The Bond Rally Is Still Hanging On, But Now Is The Time To Consider Alternatives

Once again, news of the death of the secular bull market in bonds has been greatly exaggerated, especially as the yield on the 10-Year Note dipped below 2.4% on Wednesday. So continues the intellectual gymnastics around the future of fixed-income markets, with key items of contention being, is the multi-decade secular rally over?; how does the Fed go about unwinding a $4 trillion balance sheet?; what happens if monetary policy is behind the curve should incipient inflation rear its ugly head?; and perhaps most vexingly, should an advanced economy really be so dependent upon central bank largesse? The last issue is all the more alarming given that six years of zero-percent-interest-rate policy (ZIRP) and unprecedented financial market intervention has only managed to deliver growth in the neighborhood of 2%.


Given the challenges of a low interest-rate landscape, many a portfolio manager are grappling with novel tactics that enable them to meet client obligations. In doing so, yet another phrase has entered into the already convoluted lexicon of investing: unconstrained fixed-income funds; unconstrained being a euphemism for "where on Earth do I find satisfactorily yielding investments?" In an April note, when the 10-Year Note yielded 2.8%, we turned bullish on bonds, given a lack of viable alternatives… e.g. overheated equities…, an underwhelming recovery in employment, and the expectation that even after the cessation of QE3, the Fed would likely maintain ZIRP deep into 2015. So far we have been proven right. (To continue reading, click here)

Friday, September 5, 2014

The Emperor Has No Clothes: Emerging Market Investing Just Got Simpler

To say that the world is currently rife with geopolitical turmoil and economic uncertainty would be an understatement. Such periods usually mean a rough ride for risky assets as investors shift their capital to safer havens until the storms subside. But these are not normal times. Emerging market securities are often the first to experience a pullback, yet the broad MSCI Emerging Markets Index has gained 8.5% YTD after having spent 2013 in the red.


There are myriad explanations for the rebound in emerging market (EM) indices this year. Some are due to bullish fundamentals in specific countries. Yet one cannot ignore that in a yield-starved environment, investors are clamoring for any security that portends to offer an attractive return. Such demand-driven rallies….we call them bubbles….have a tendency to disregard fundamentals, which obscures truly attractive destinations for one’s capital and enables pretenders to take a seat at the global financial markets table. Ironically, this overly-bullish, top-down approach (which has more-than-once been in favor during the past decade) is occurring at a time when heretofore major emerging economies are running into stiff economic headwinds, backsliding on market-friendly reforms, or in the case of Russia, putting geopolitical arrogance ahead of economic development. To continue reading please click here.

Tuesday, August 12, 2014

The Recent Equities Slide: A Momentary Lapse of Irrationality?

In a January investment note, we expressed caution towards U.S. equities, which at the time had been nearly five years into a bull market. Not that we expected a strong correction, much less a bear market, but it was unlikely that 2013’s 29.6% gain in the S&P 500 would be anywhere near repeated. Through the first eight months of the year, that forecast has played out with the S&P up a more pedestrian 4.5%. We did not, however, expect the index arriving at this point by initially sliding nearly 6% before rallying 14% to a record high of 1,988. While the winter’s dip at first appeared to be an outlier to the smooth upward trend (notice the nearly parallel lines of the moving averages below), the recent 2.8% retreat has again raised the eyebrows of more than a few cautious market participants.

At the time of January’s note, we expressed the commonly held lament that while believing valuations had gotten ahead of themselves, there were few alternatives to maintaining current stock allocations given that cash returned zilch and the Fed was still gorging on Treasuries, keeping yields in unappealingly low territory. With this in mind, we suggested multiple options strategies that would lock in recent gains or take advantage of certain names and sectors that had lagged the broader market in 2013. These tactics (protective puts and purchasing calls) are still on the table. To this, we would add another possibility: trimming one’s equities exposure

(to continue reading click here)

Monday, July 14, 2014

The Dollar: A Canary In The Coalmine?

For much of the current year, the eyes of many in the investment community have been focused upon the continued dubious rally in U.S. equities, which after stumbling out of the gate have gained 13% since early February.  At the same time, the yield on the 10-Year Treasury has not broken much above 2.5%, despite purportedly improving economic data, namely on the jobs front, as well as the Fed’s announcement that the latest iteration of its bond-buying will be wound down by autumn. Overshadowed by these developments has been a steady weakening of the dollar. Over the past two years, the greenback has lost 11.4% of its value against the Euro. And that’s against a currency that many thought might not be around….at least in its present form….today. Granted there may have been a sympathy bounce since the nadir of the Eurozone debt crisis, but at what cost? Growth throughout the currency bloc’s periphery continues to be strangled by austerity, and in the name of doing whatever it takes to exit the crisis, even the Germans have agreed to green-lighting Europe’s own version of quantitative easing should it come to that, shadows of the Weimar Republic be damned.


But it’s not just against the Euro. The broader dollar index (DXY), a basket comprised of six major currencies….albeit weighted towards the Euro…., has slipped 5.4% over the past year. Two years ago, when the dollar was, relatively speaking, riding high, this forum championed a strong dollar policy and the benefits it would bring to an advanced economy such as the United States as well as to its financial markets. Evidently no one was listening. Why would a forum geared mainly towards mainstream investments venture into an esoteric asset class such as foreign exchange? Three simple reasons: the dollar’s level and outlook impacts virtually every other asset class, the same policy distortions that are arguably driving risky assets higher are also sending the greenback lower, and lastly…and even more sinister than the previous point….perhaps the day is drawing nearer that the chronically weak U.S. fiscal position becomes too egregious for markets to ignore, manifesting itself in an enfeebled currency and all the economic headaches that accompany it.


Foreign exchange markets: caveat emptor
The foreign exchange market is massive. How massive? The Bank of International Settlements puts the tally at north of $5 trillion per day, making it the world’s largest financial market. Theoretically…a loaded word in economics….the relative value of a nation’s currency reflects the demand for the nation’s products and services (and thus the local FX to pay providers), the overall growth prospects of the country, its fiscal position, namely its ability to pay its public debt and lastly its monetary policy, ideally administered by an independent central bank not coopted by politics. In reality, the FX market is unlike other broadly traded assets in the fact that the markets are blatantly distorted. Rather than having supply and demand drive price and let the chips fall where they may, currencies are manipulated by policies ranging printing money, which weakens it, buying up excess local currency with foreign reserves to prop it up in shaky times, and the setting of benchmark interest rates to levels which directly impact demand for instruments denominated in a currency. One need not venture far past page two in a financial newspaper to find contemporary examples of each of these phenomena. In Vegas parlance, if you are a currency trader, you are playing against a dealer with a loaded deck.

The dollar occupies a special position in currency markets as it is the dominant unit used in settling international commercial transactions as well as being the de-facto reserve currency for the rest of the world. These result in built-in demand for dollars, which largely has given the country a get-out-of-jail free card for decades when it comes to glaring fiscal imbalances. Given its position as a reserve currency, along with dollar-denominated Treasuries being the global standard for risk-free assets, the greenback performs well in times of economic uncertainty, paradoxically even when the source of said uncertainty is the United States (see the 2008 housing crisis). Normally such domestic tumult would send investors fleeing from the transgressor’s currency. The economist Stephen Jen, formerly of Morgan Stanley coined this concept the dollar smile. When the world is seemingly on fire and flight to safety paramount, the dollar rises. That is one side of the smile. If America’s economy is performing well, relative to other global players, the higher growth rates….accompanied by expectations of increasing interest rates….push the dollar up as well. That’s the other side. In the middle, the dollar tends to underperform when all the world is rosy and investors can pick off extra yield in currencies that tend to have higher interest rates than the U.S. (think emerging markets).


This is what makes the dollar’s current slide so vexing. While not exactly in flames, prospect beyond U.S. shores are hardly impressive. Japan has emptied its economic quiver in hopes of ending two decades of malaise, with nearly all of its monetary and fiscal arrows being Yen negative. The Eurozone at age 15 is going through an adolescent identity crisis, unsure of what it wants to be when it grows up. And many emerging markets have fallen back into old vices including state control (Russia), politicians brow-beating central bankers (Turkey) and an inability to tame inflation through sound policy (nearly anywhere in Latin America). By comparison China looks lovely. But there growth is not what it once was, it has a property bubble to deal with, and the state’s tentacles continue to firmly grip the levers in key industries (e.g. banking), clouding commercial decisions.

Slow progress on the jobs front
Back in the U.S., after a shaky start to 2014….far too conveniently blamed on lousy weather… economic data have improved of late, namely on the jobs front. Skipping the population survey’s headline unemployment rate (currently 6.1%), which is littered with so many arbitrary omissions to render it meaningless, meatier data from the establishment survey have indeed been strengthening. As seen below, the change in nonfarm payrolls has been on a tear with the three-month moving average registering well above 200 thousand in each of the past three months. This amount is sufficient to absorb new entrants into the workforce as well as the legions that continue to remain marginalized…those not counted in the population survey….five years after the recession’s end.




Pandora’s box
The combination of rough seas globally and steady….if not spectacular…improvement at home…should infer that investing in U.S. assets is the only game in town. Looking at the S&P 500, Treasuries and pockets of red-hot real estate prices, this appears to be the case. But the dollar lags. Rather than benefiting from the aforementioned dollar-smile, the trajectory of both the greenback and U.S. stocks can be explained by another phenomenon: recent moves are likely the result of extraordinary monetary policy. The Fed’s dominant role in absorbing less-risky bonds, which has sent investors scrambling for yield in stocks and dodgier loans, has been paid for with the dollar-negative expansion of the Fed’s balance sheet (upwards of $4 trillion at last count) via the printing press.


The Terrible Trifecta
Exacerbating the problem is the fact that the Fed’s indirect assault on the dollar could not have come at a more inopportune time. For years economists have prophesized doom for the U.S. currency (and the economy) should the country not get its fiscal house in order. Yet the supposed benefit of quantitative easing….a return to robust growth…has failed to materialize, and without a boost to government revenues at the same time ever greater pressure is placed upon safety-net outlays, the country’s fiscal position has only worsened. As seen below, the federal government’s deficit is projected to remain above 6% this year. Granted the Fed is stacking the deck in the Treasury department’s favor with artificially low rates, but deficits at this level mean that interest obligations continue to add to the federal debt, which remains over 100% of GDP. 



Paying this down is complicated by the fact that the U.S. is not a nation of savers, as evidenced by chronically negative current accounts balances.  The dollar’s position as the world’s reserve currency has enabled the country to get away with such imbalances, but at some point in the future, the willingness of foreign investors to continue providing credit to such profligate spenders may diminish. The risk is that far-off day may be drawing nearer.


Those who don’t study history are doomed to what?
A stated goal of Fed policy is to drive up inflation expectations in order to cajole consumers to spend before prices increase even more. The merits of such a tactic is questionable being that excess consumption, along with its housing investment cousin, led to the imbalances and credit overloads that drove the economy into deep recession. As we have argued in the past, an economy dominated by personal consumption and housing at the expense of business investment and exports is not equipped to deliver consistent long-term growth.

It is true that headline inflation, as measured by the Fed’s favored gauge has ticked up over recent months, but much of this is attributable to one-off factors, that when stripped away, results in a more subdued 1.5% year on year core inflation rate, well below the Fed’s target of 2% or wink-and-nod limit of 2.5%.


The truth is that in an advanced economy dominated by the service industry, a key driver of inflation is wage growth. Unfortunately….and despite the improving nonfarm payrolls data….wages gains have been miserable, averaging 2% annually since mid-2008 versus 3.3% in the lead up to the crisis.


And What of a Strong Dollar?
Rather than seeking to ignite inflation, which also debases one’s currency, authorities could have taken the strong-dollar route. The U.S. is already a top investment destination both in the form of portfolio investment (financial markets) and stickier foreign direct investment, or FDI.  A large economy, strong legal framework, transparency and liquidity all contribute to this. With the country in dire need of a catalyst to emerge from its 2% growth funk, an injection of foreign capital would be a welcome development. Expectations that the value of the dollar would rise relative to other currencies would only add to the attraction of investing in America. Not only does that translate into new factories, offices, and jobs, which then would spur consumption in a more sustainable manner, but the jockeying for U.S. assets would provide fundamental support to current corporate valuations, which by nearly all accounts, have gotten a bit ahead of themselves. Another related dose of common sense would be to reform the corporate tax code with the aim of reversing the current trend of tax inversion through foreign acquisitions. This exodus of U.S.-domiciled entities is precisely what the economy and government coffers do not need at this juncture.


Weak-dollar apologists argue that a diminished currency aids the country by making exports more competitive and increases the value of foreign profits of American businesses, which account for close to half the earnings pie. But trade is a small slice of the U.S. economy and the country produces sophisticated capital goods that tend to be inelastic to currency fluctuations. In other words, if your military needs a U.S.-made fighter jet or your factory requires precision machinery, movement in the level of the dollar will not likely deter your purchase. And who doesn’t need a shiny new fighter jet? With regard to foreign profits, half of corporate revenue is still derived domestically and the increased purchasing power that accompanies a stronger dollar would stoke demand for foreign products, many of which are produced by U.S. multinationals.

A weak dollar also has the…ahem…added benefit of monetizing the country’s debt, meaning a cheaper currency lessens the burden owed to foreign creditors. This is not the best way to win friends in the international community. Then again, it’s not much worse than tapping the private cell phones of the leaders of major allies.

Dear Washington: be careful what you wish for
One can argue deep into the night whether or not the weakening dollar is an intended or unintended consequence of current monetary policy. If it proves to be an ephemeral distortion caused by recent extraordinary measures, perhaps the situation will right itself as the Fed attempts to successfully exit various initiatives, which is by no means guaranteed. More troubling is the prospect that the weaker dollar is a sign that investors are growing more concerned about U.S. growth prospects, its inability to control its fiscal position and the rapid encroachment of a regulation-happy administration into the private sector. Should these concerns materialize, U.S. investors and consumers will learn an unwelcome lesson on how a weak currency can diminish a country’s investment returns and shackle its growth prospects.


Monday, June 2, 2014

Commodities in 2014: A Place in the Portfolio?

At a conference in 2007, a speaker initiated the proceedings by posing the question “what are the most expensive words in the English language?”  The answer to this was “it’s different this time.” The subject of the event was commodities, namely whether or not the space had developed sufficiently to be considered a viable asset class and a beneficial component of investors’ portfolios. During those heady pre-crisis days, the winds indeed appeared to be at the back of investing in raw materials. So much so that experts filled investment notes and the financial press with talk of a commodities super-cycle, driven by shifting supply/demand dynamics and rising investor appetite, partly fueled by the proliferation of new, accessible products.


During the crisis and its immediate aftermath, the bullish case for commodities remained largely intact. This was the period when emerging markets…a theme related to commodities demand….were the engine that kept the global economy (barely) treading water. Aggressive monetary policy also provided support to the commodities space as investors ventured farther out along the risk spectrum in search of yield. A key attraction to commodities during the roaring 2000s was that they had become a viable source of returns, something that had eluded the asset class for decades.  Since the initial post-crash period, which was marked by the binary risk-on / risk-off trade, with Treasuries encompassing the latter and nearly everything else mindlessly lumped into the former, markets have shown greater differentiation among asset class performance.  And during these past three years commodities have really taken it on the chin.


As seen in the table above, even as equities have sailed along at nearly a 16% annualized clip, total returns for the broad S&P GSCI commodities index have dipped into the red, with the agriculture and industrial metals buckets especially getting pummeled.  Now, with U.S. equity indices hovering near record highs, developed market bond yields at historic lows and trillions of dollars in fiat money lurking in the shadows, an investor must ask if dialing up commodities exposure at this time may at least in part address some of these sources of consternation.

A history lesson
Long considered a niche investment, commodities as an asset class have exhibited characteristics over the decades that were attractive to investors. They lacked correlation to major asset classes like equities and fixed income, meaning they could provide diversification when included in portfolios. Not coincidently, they tended to be positively correlated to the bane of many investments: inflation.  The logic was that rising raw materials prices squeezed corporate margins, thus diminishing the present value of a firm’s future cash flow, which by definition meant a lower stock price. Moderate inflation, driven by increased demand accompanying robust economic growth could allow both input costs (e.g. commodities) and stock prices to rise in lock step, but only up to a certain point before consumers get squeezed and snap shut their wallets. Conversely, inflation caused by an adverse supply shock of key raw materials…so-called cost-push inflation….seldom bodes well for stocks. Similarly, inflation and bonds are akin to oil and water. Any whiff of upward price pressure, regardless of the source, usually sends bond investors fleeing.

The downside to this inflation hedge and lack of correlation has been the volatility inherent in commodities, the difficulty in accessing them (historically available mainly through futures contracts and the physical market), and perhaps most importantly, the absence of any respectable yield. In fact, not only does a hunk of metal or bushel of corn not pay a coupon or a dividend, but investors often incur holding costs such as those for storage or rolling over expiring futures contracts, which were priced lower than farther-dated replacements.  Why were yields historically paltry? A simple answer is supply and demand: For much of the 20th century, there was plenty of easy-to-find oil, copper and arable land. As long as balances favored supply, it was difficult for raw materials prices to go on a sustained tear. Either producers would bring more product to market to meet increased demand or incipient inflation would sour consumers’ appetites in what industry-types call demand-destruction.

 What fractured this status quo was, in a word, China. Over the past three decades much of the world’s manufacturing capacity was relocated this rising giant and to other low-cost countries. The industrial base of these developing nations was less than efficient, meaning for every unit of output, a greater amount of inputs was required vis-à-vis developed markets. This was true for energy consumption, the utilization of metals and an array of other raw materials. The lack of efficiency also applied to nonexistent pollution standards, but no worries, none of that toxic air drifted across the Pacific. Right.

At the same time these countries were updating infrastructure and housing, increasing demand for construction materials such as copper, steel and electricity (city dwellers are more energy intensive than country folk). Not to be left out, demand for agricultural commodities increased as large populations switched to protein-based diets, which paradoxically, require a greater amount of crops like soybeans and corn to fatten up cows and hogs for slaughter.

At the same time…..this was prior to the shale revolution sent from above….cheap sources of raw materials began to peter out. The crude, copper and aluminum were still there, but these harder-to-access materials required additional expenses in R&D, exploration and extraction, thus pushing up marginal costs. It was the confluence of this increased demand inconveniently occurring as supplies were pressured that lent credence to the super-cycle premise. Sensing there was a buck to be made, the investment community funneled cash to commodities firms to develop new resources; they also became active participants in the physical and futures markets. Why a bank needs to own a warehouse full of zinc is beyond me. But they did, resulting in increased demand from financial…or speculative…players, who bought raw materials not to produce anything, but simply to flip them and keep the profit.

The Shakeout
But this increased investor attention led to an increased correlation between commodities and other risky assets such as equities, undercutting one of the primary attractions of commodities in the first place. The measures undertaken in the wake of the financial crisis reinforced this development as yield-starved investors lumped all riskier…thus higher yielding….asset classes into the same bucket. Rock-bottom interest rates also played a role by making it cheaper to finance highly-levered commodities futures. As evidenced in the chart below, beginning in late 2008, the historical lack of correlation between equities and commodities abruptly rose to a range consistently above 0.50.


Since the depths of the financial crisis, it is safe to say that financial markets have returned but the economy hasn’t. This dynamic is represented by commodities, as measured by the S&P GSCI index, having traded sideways since mid-2011. Over the long-term, supply/demand fundamentals (theoretically….a loaded word) determine the prices for raw materials, and without robust growth in major economies, the 2009-2011 rally proved impossible to sustain. The divergence in fortunes between commodities and equities is also a reminder that increased correlation refers only to direction and not magnitude.

Speaking of markets
Another knock against the increase in speculative investors…as opposed to commercial users of physical commodities….is that often their allocation decisions are driven by macroeconomic developments rather than fundamentals. Yes, the participation of a certain amount of financial players increases liquidity, thus market functionality, but when taken too far, it distorts necessary signals from underlying supply/demand dynamics. This was certainly the case in the two years immediately following the crisis when the broad S&P GSCI returned a total of 25% and the energy, industrial metals and agricultural buckets returned 20%, 70% and 32% respectively. Since then, the broad index has returned -6%, with metals and crops getting especially routed.

Certain segments of the commodities universe are more tightly tied to economic growth. It should come as no surprise then that two such sectors, energy and industrial metals, have suffered over the past three years as global growth remains elusive. As seen below, growth since 2010 has been on a downward trajectory for most global regions. Of special concern is the lower rate of expansion in emerging markets, which had been the shining star after the crisis.


With economies stuck in low gear, inflation remains muted. While the Fed’s favored inflation gauge (below) ticked up to 1.6% year-on-year in April, the rolling three-month average is still a minuscule 1.2%, far below the 2.5% that they would happily accept. At the same time, the Eurozone is flirting with deflation. It says a lot when Japan is more effective in stoking upward price pressure than its advanced economy peers. Without any inflationary pressure to hedge, a further rationale for commodities exposure has been reduced.



Falling short of the promise
As it stands, commodities exposure is not delivering what it has historically promised. Correlations with other risky assets are elevated, meaning there are few benefits of portfolio diversification. Even if the eventual curtailment of loose monetary policy chases away a large amount of speculative investors…in turn lowering correlations…other merits of owning commodities in the present environment also ring hollow. Inflation remains muted and with global growth stuck in a rut, commercial demand for industrial inputs will fail to match the rates registered earlier in the millennium. In such a scenario, investors may as well chase asset classes like equities, which despite dubious fundamentals, at least generate juicy returns.



The genie however is out of the bottle and exposure to raw materials should remain on investors’ radar screens, if not in their portfolios at present.  Across the commodities universe, the new sources brought online after the latest round of investment largely have higher marginal costs than the fields, wells and mines of yesteryear. This provides a price floor to many different resources. And if central banks get behind the curve of controlling upward price pressure due to the mountains of money created to combat slow growth, then the need for an inflationary hedge may indeed reappear, especially if economic growth forecasts surprise to the upside…..but let’s not hold our breath for that.

For those itching to for commodities exposure today, one avenue is via the shares of commodities producers. Historically these tend to be more correlated with the overall equities market rather than physical market, but they are naturally levered (thanks to firms’ balance sheets) and they’ve been outperforming the broader market of late. Year to date, the energy sector of the S&P 500 has returned 7.5% (including dividends), outpacing the 5% of the broader index. Materials, meanwhile have returned a respectable 6.8% year-to-date. And there still may be more room to the upside as both sectors lagged well behind the S&P 500 over the past three years, with materials and energy returning 10.3% and 9.1% (annualized) compared to the 15.2% registered by the broader S&P. And as evidenced by certain segments of the physical market having tanked of late, investors may finally be differentiating between slices with favorable and unfavorable fundamentals.  While not a complete return to normalcy, this development means that those who do their homework can be rewarded.  The key is to identify resources with long-term favorable demand dynamics and whose current prices are not too far above the marginal costs of production, which in part may contribute to limiting downside risk.


Friday, May 2, 2014

Connecting the Dots: The Financial Sector and the Economy

The banking sector never seems to stray too far from the headlines of the financial press. And there is good reason for that. Financial companies occupy a unique nook in advanced economies as they serve as the transmission mechanism to allocate capital…in the form of excess savings…to its most effective use, which are investments offering the most attractive risk/return profile. Therefore an undeniable link exists between a healthy financial sector and overall economic well-being. In addition to this broader function, investors shower the sector with attention given that, even after the financial crisis, it remains the second largest bucket of the S&P 500.


Investments are not like the entertainment industry, where any publicity is good publicity. Sector stalwarts continue to get raked over the coals for missteps in the run up to the financial crisis. Recent headlines involving one key player’s (Bank of America) error in reporting capital data are reminders of that. Also the current earnings season, as usual, has been front-loaded with banking announcements, which, while varying among components, collectively hints at challenges to top-line growth, especially in key business segments like fixed income and mortgage origination.

This week it is particularly relevant to examine the banking sector as the Dow Jones hit a record high and Q1 GDP data came in at a comatose 0.1% annualized gain.  Divining the health of banks can shed light on the….ahem….logic underlying the equities rally as well as whether or not we can expect GDP growth, which finally showed signs of life in H2 2013, to rebound after this past winter of discontent.

An inflated market raises all ships….justified or not
Investors love to say that equities rallies need the validation of financial stocks. In the current instance, they’ve got it….for the most part. Over the past year, excluding dividends, the financial sector has gained a shade over 17%, only slightly below the 17.6% registered by the S&P 500.  For 2013, financials actually outpaced the broader market, but have since come back to Earth, being nearly flat year-to-date, while the S&P 500 is up over 1.5%.


Looking further back in time, one can see the same story. Over one-year and three-year periods, on a total return basis, financials have trailed the S&P 20.4% to 19.8% and 13.7% to 12.3% respectively. Over a five-year timeframe, the delta is slightly larger with the S&P’s annualized returns clocking in at 19% and financials, underperforming at 16.9%. Over that length of time, two fewer percentage points makes a hefty difference in total returns.


Of course the five-year returns encompass the aftermath of the financial crisis, which includes the bounce-back year of 2010, making all the numbers appear a bit jazzier than they would otherwise. Since then, the fact that financials have not joined more cyclical sectors like industrials, consumer discretionary and IT in the upper echelon of returns can be attributed to the regulatory constraints placed on the industry in the form of higher capital cushions, the evisceration of their trading business and the disappearance of the securitization cash cow.

Recent earnings reports from leading banks tell this story. JP Morgan (JPM) saw its net income decrease and Bank of America (BAC) recorded a net loss, in part due to litigation expenses stemming from the housing crisis. The environment remains challenging for large banks as every corporate treasurer and homeowner with a lick of common sense has already refinanced, locking in historic low interest rates far out into the future.  So what had been a source of strength in the early stages of the quantitative easing era has become a shortcoming for both fixed-income divisions and mortgage origination. Even Wells Fargo (WFC), which reported an increase in net income of 14%, did so on the back of cost-cutting and not needing as many reserves to cover loans previously considered suspect. Neither of those developments can be relied upon for future growth.


Instead, what will be needed in coming quarters is robust top-line growth and that can only come with an improving economic outlook that entices bankers to lend out their considerable funds at a substantially greater pace. Before jumping into that, we must ask the question whether or not banking shares are attractively priced.

Discounted….perhaps for good reason
As seen below, based on estimated full-year 2014 earnings, the nation’s five largest banks all have P/E ratios at 12.1 or under. These are at a discount to the 13.7 of the broader financial sector (below) and dramatically lower than the 15.6 P/E ratio of the S&P 500. Banks are cheap on a Price to Book Value basis as well. But cheap does not necessarily mean attractive.  While the sector as a whole has been aggressive in cleaning up the bad-debt mess from the financial crisis…as opposed to European banks…one can see that some firms still have lingering hangovers. Restrictions on dividends by authorities have hampered growth of that previously alluring component of financial shares.


Prior to the financial crisis, when financials were metaphorically printing money, unlike the Fed, which literally printed it during multiple iterations of QE, investors were attracted to banking shares, not just for their securitization-fueled growth model, but also because it was the leading generator of dividends. And as we all know, the more quickly a Board can return capital to shareholders, the lower the chance that it goes off and funds some poorly thought-out acquisition (Countrywide comes to mind). Even today, as seen above, the sector still contributes the second greatest amount of dividends within the S&P 500. And this is with a collective dividend yield of 1.8%, firmly in the lower rung of sectors (telco is 5% and utilities are 3.8%). Imagine what financials could return if regulators took their foot off of bankers’ throats?


Spring is here. Are the green shoots?
One cannot lay blame for the sector’s woes entirely on its governmental overseers. After all, banks did take some egregious liberties in their lending practices in the mid-2000s, which has merited greater oversight. The other constraint hampering the sector is the economy itself. Corporate borrowers don’t like uncertainty and will not increase their fixed costs if future business prospects seem foggy at best. Even if the economy gets a mulligan in Q1 due to a wretched winter, GDP growth has still averaged a depressing 2% over the past 13 quarters. Similarly bankers hesitate to lend in such environments for fear of getting stuck with a bunch of dud loans. Ironically the same authorities that are encouraging banks to be less parsimonious with their reserves are the same ones threatening to sue them back to the Stone Age if their lending is deemed inappropriate or predatory…whatever those mean.


With the exception of personal consumption chiming in at 3% in Q1….evidently from brisk hot chocolate sales….the remainder of the data was abysmal. Headline growth was 0.1%, which is one tick from no growth. Nonresidential business investment dipped into negative territory and housing fell off a cliff at -5.7%, following Q4 2013’s wretched -7.9%. Yes some of that can be attributed to the cold, but higher mortgage rates (albeit still low by historical standards), did not help matters.

We have previously argued the need for the U.S. economy to rebalance away from a reliance on consumption, which accounts for two-thirds of GDP. Another favorite mantra is that residential construction should be a consequence of a robust economy, not the source of it, as was the case prior to the crisis. Resolution to those issues are years away however. In the here-and-now, the economy needs robust consumption and a rebound in housing, which sends positive reverberations through a range of other sectors. The problem is that, with a weak jobs market, household formation has slowed to a crawl and in several regions subdued wage gains impede the ability  of potential buyers to move upmarket from starter homes.

There are signs of optimism. As seen in the confusingly squiggly lines below, lending standards for commercial & industrial (C&I), auto, and general consumer loans have gradually loosened over the past two years. Demand has also picked up for these loans to meet this newfound supply. The sole exception has been mortgage demand, which has taken a nosedive as rates have risen and cash investors have satiated themselves after gorging on the market for years.



This thawing of the lending market can be seen in the return to growth of outstanding loans. While C&I loan expansion has been impressive over the past few quarters, growth in consumer and real estate loans remains well below pre-crisis levels. As noted above, these two areas have been major contributors to GDP growth over the past few decades and additional credit flowing into them will be necessary in order to increase the trajectory of what has been a frustratingly tepid recovery. On a brighter note, the growth in C&I loans likely represents credit flowing to small businesses…ones too small to tap the hyperactive bond market….which is important given the role smaller firms play in creating jobs in the United States.


A rightful place in the portfolio? Better than tulips.
So it’s all connected. Optimistic banks, willing to lend, provide a needed catalyst in a highly-levered…euphemism for debt-addicted…advanced economy.  A healthy economy further instills the confidence of bankers and also rewards investors by juicing the profits of financial firms. Somewhere in here there is a story about the wealth effect and virtuous circles but it is 1:00 AM and my double espresso has finally worn off, so we best not go down that path.

Should one own banking shares today? At current valuations, why not? At the very least they help diversify one’s portfolio, are naturally levered investments and many listings are still sources of attractive dividends. Given the new regulatory hurdles of the gargantuan Dodd-Frank law and the tepid pace of economic growth, especially in debt-dependent sectors, there is probably not much room for upside. This is especially true if one is of the belief that the rationale of this extended bull market is tenuous at best.  

Not to go totally macro but much depends upon the interest rate environment and how the Fed shimmies out of its extraordinary monetary policy. If one believes that the Fed will back off any threat to raise the Fed Funds rate thus keeping short-term notes tethered to the sub 1% range, and that excess liquidity (or a return respectable growth) will light the inflation flame causing a sell-off in longer-dated treasuries, the ensuing bear-steepening of the yield curve will be manna from heaven for banking net-interest margins. Conversely, if the Fed indeed raises rates while growth prospects remain muted, the consequent bear flattening would squeeze margins while at the same time discourage lending in the slow growth environment. Two divergent scenarios; a question investors and committees must hypothesize over in coming weeks. 

Monday, April 14, 2014

Reversal

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.