Archive for November, 2012

Regime Uncertainty – Why We Are Still Waiting

As my eldest daughter approaches her final year of high school, I am constantly reminded (and proud) that she is starting to take in a larger view of the world. Most of the time, this takes the form of the typical issues which energize people her age. We don’t always agree but it is nice to have a civilized debate from time to time. And I like to think that we have both learned from the interaction.

But the other day, she asked me how things were going in the market over the dinner table. When I responded with a short (my wife occasionally makes wild claims that I can go on a bit), pithy response, she crinkled up her nose and declared: “Well, it sounds like nothing much has changed!”

I really couldn’t find fault with her statement. Europe is still becalmed (some people would use a stronger adjective), the US government is still spending several percentage points of GDP more than it is taking in, sovereign debts are piling up and interest rates are being held aggressively low.

The resolution to Europe’s issues will continue to suffer from the lack of a Federal political structure to match the monetary union. Given the history and recent election results, US politicians will raise taxes and make only token cuts to spending, giving us neither a balanced budget nor a pathway to revived economic growth. And, because the FED’s actions are transmitted globally through the US dollar, the artificially low interest rates (for some) will continue to clog up the global economic arteries.

The interest rate issue bothers me in particular because the FED’s well intentioned QE and Twist programs play havoc with the pricing signals that individuals, corporations and governments use to make decisions. Corporations are sitting on piles of cash because their investment yardsticks are sending very conflicting messages about the cost of capital and hurdle rates. Knowing that the interest rate regime could change overnight by bureaucratic fiat does not engender great confidence when planning for a multi-year, multi-billion dollar investment strategy.

Just when I was looking for a way to simplify it down for myself and others, the Mises Institute dropped an article into my email called “Regime Uncertainty”.

The crux of the Mises article is that we are experiencing a slow recovery because net new private investment has stalled. This is the private investment over and above what is required to keep our capital stock in shape (considering depreciation and obsolescence). In past recessions, the drop off in private investment reverses within a year or two of the economic trough. The only two times this has not occurred in the past 100 years: “during the Great Depression and during the past five years.”

The author determines the core problem to be Regime Uncertainty. In the 30’s, the future of property rights did not look bright given the global trends towards Fascism and Communism which were really two different versions of state directed economies. Nowadays, the risk to property rights seems to be more a question of slow erosion through higher taxation, a larger public sector and government regulation rather than outright expropriation of assets.

That explanation goes a long way towards fitting the “fact pattern” that we see playing out in the developed economies today. Corporations are not only facing the usual uncertainties of the marketplace but they have the added uncertainty of the operating regime in these markets. The interest rate manipulation which vexes me can be seen within this framework as just another government encroachment on the normal workings of the private market.

And, if we need more evidence that the markets are being led around by the politicians, look no further than today’s 2% rally on the news that maybe the politicians will get their act together in time to avert the overhyped “Fiscal Cliff.” Given that the Fiscal Cliff is the artificial construct of the same politicians who are now being compelled to solve it, is it really that hard to see why private capital feels reluctant to mobilize?

After all, everything is on the table according to these politicians. If you are the CEO of a major corporation or bank, do you want to place any serious bets before the end of the year? Hmmm…it seems that “Regime Uncertainty” is not such a radical title for an article after all.

33:1 – A Landslide for Fixed Income

Now that we have just finished our quadrennial exercise of picking the occupant of the White House for the next four years (at a cost of around $2bn this round), it is time to look at how investors have been voting with their money over the last five years. With the reelection of President Obama, it is tempting to think that circumstances will continue on as they have over the last four years. That may be true of the American political system but the Global Financial Markets are poised for a change.

In a report by Pyramis Global Advisors (you can get the report through this link), the authors note that net investment inflows since the end of 2007 to now have been $1.1trillion into bonds and $33bn into stocks. Lest you think that the bulk of the discrepancy happened during the market meltdown in 2008, a chart on the front page shows that most of the inflows occurred in 2009 and 2010 when equity markets were largely on the mend. The rate of inflows has varied slightly in the last two years as the markets have see-sawed between “risk-on” and “risk-off” trades but the overall direction of money has been solidly towards the fixed income side of the ledger.

That suggests two important concepts that will help us spot any sustained change in the capital flows. First, while the Global Financial Crisis (GFC) certainly raised risk awareness, investors continued to be spooked throughout the “recovery” period. Second, it shows that despite valuation models which show many classes of bonds to be at or near bubble valuations, investors will continue to plow fresh capital into a favored asset class.

Why don’t institutions “Fight the Fed”?

The reason for this outsized charge into bonds over equity can be traced to the hyperactive central banks of the US, EU, UK, Japan and China. At nearly every crisis point, the solution has been to lower interest rates, buy up or lend against toxic assets at above market prices, manipulate the yield curve and generally to loosen monetary policy. Unlike the Greenspan Era, Chairman Bernanke has been crystal clear about his monetary objectives. While economists and other market pundits can bemoan the bubbly prices, national solvency and inflation risks that such policies engender, bond investors and traders have plowed more money into bullish trades to take advantage of the historic circumstances.

What the report suggests

The report leads the reader to the conclusion that valuations will win in the end. And, if one does not worry overly much about time frames, that conclusion is correct. Investing at lower valuation points in the cycle has been demonstrated to increase the odds of superior investment returns in the subsequent decades.

Unfortunately, that does not leave much for those of us looking to invest now.

Will things change?

Yes, despite the best efforts of the Federal Reserve and other central banks around the globe, the economic cycle has only been delayed, not suspended. Once a real recovery is established and well identified, we should see a shift of funds into equities at the expense of fixed income and idle cash. Interest rates and inflation rates will put pressure on the current status quo. And secondly, most financial bubbles tend to pop as soon as they are starved of fresh capital. Even without a robust recovery, a modest shift in capital flows, due to a change in the US current account for example, could tip the balance for fixed income vs. equity capital flows.

How will we know?

The beauty of the FundLogik Application is that it is designed to monitor the shifts in money flows because those money flows have a direct impact on pricing levels. By monitoring a broad range of asset classes and comparing them to each other, it becomes clear which assets are gaining investor favor. One day, we will see a report showing that the flow of money between bonds and stocks has reversed. Unfortunately that report will come out at least six months after the change has occurred. With the FundLogik Application, you can participate in the shift as it happens…and read about it in the financial press later.