Interest Rates Archives

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

Three FactorsAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

Earnings pop
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

Earnings roll
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.


The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

Carry Trade Ending?

When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

Business Loan Chart
Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

3m Swap
Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

3m Libor
Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.

Presidential Cycles and Australia

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

Living in Interesting Times

Looking back on the first quarter, an impressive amount of the big news has hit the market. The political unrest across Northern Africa and the Middle East has entangled the US Military in its third shooting war, Japan endured the triple disaster of earthquakes, tsunami and partial nuclear meltdown, the European sovereign bailout took political prisoners in German elections and the largest bond fund manager announced that it had cashed out of US Treasuries. In the US, the housing market seems to have sprung some new leaks below the waterline.

What will the next few quarters bring?

One great place to start is ECRI’s Weekly leading index series which shows that the positive momentum is starting to taper off.This does not mean another recession is on the way, just that the current surge in the leading indicators (which correlate highly with the discussion and implementation of QE2) appears to have lost its head of steam.

Source: Economic Cycle Research Institute

What does this mean?

Investors are right to wonder how the markets for risk assets can be bogging down when there is still an estimated one-third of the QE2 campaign to be injected into the system? Part of the reason is that the likelihood of a QE3 has become more remote as even FED governors start to question the need to continue pumping liquidity into the system. Another part of the reason is due to the fact that much of the newly created money was used by big owners of long dated treasuries (Chinese government, PIMCO and others) to purchase other assets. The increase in base money did not have the desired multiplier effect because it was not used as fuel to create new credit in the commercial banking system. In the land of M2 money supply figures where most of us live, QE2 was a fizzle.

Last Spike?

Source: St. Louis Federal Reserve Bank

Pushing on a String?


Just over 4% growth in M2


The other side of the coin

Yield CurveFor the big financial institutions who have access to cheap FED funding (or paying very little on demand deposits), the current state of affairs is still very attractive.But, as the situation remains very fluid, banks have shown a marked preference for Government paper (Treasuries, Agencies and Agency MBS) which can, in theory, be liquidated much more quickly than private mortgages and corporate loans.

But the banks are still burdened with a large backlog of toxic assets. Recent buoyant earnings reports and the cash flows behind them will not last if the whole yield curve gets shifted upwards by inflation or even just stronger economic performance.

Borrowing short and lending long works very well in flat or falling interest rate environments. Although we have seen lower interest rates recently, the FED has spent its political capital as quickly as it has built its balance sheet. Lower interest rates seem very unlikely in the medium term.

Sell in May and Go Away?

SADoes this mean we will reach another “Sell in May and Go Away” moment when QE2 runs its course? The numbers have been slipping from the 20’s to the teens in most of the Systems that we track, which suggests a cautious outlook.

As investments start to fall out of the top rankings and you look around for the new investment opportunities, it might be time to take a bit of money off the table and wait to see what opportunities arise after the next bit of bad news rattles the well priced equity markets.

The commodity sector suggests that not all of the optimism in the market is warranted. Most of the strength in the short term remains in Silver (SLV), which has just hit new multi-decade highs and traditionally serves as a store of value as well as an industrial metal. And despite exclusion from core CPI figures, the energy ETFs like UGA, USO, UHN and DBE are all running stronger than economic growth in the G8 economies might warrant (or appreciate).

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