Issue 95 – October 1, 2014
2014 – The Summer of Geopolitics
The summer of 2014 will long be remembered for the remarkable set of diverse geopolitical events that dominated the headlines. From the failed Scottish independence vote, to the shooting down of a commercial airliner over Ukraine, to the outbreak of the Ebola epidemic in western Africa, to the increasing chaos brought about by extremists in Syria and Iraq, to the pro-democracy protests in Hong Kong, market participants had their hands full trying to absorb, analyze, and prioritize potential impacts. Global financial news took a backseat to these many events, but nonetheless presented investors with a wide spectrum of results to consider as well.
Beginning with Europe: slowing economic activity even among the workhorse economies pushed the European Central Bank to consider further stimulative measures. Negative rates on short term bank deposits (you pay the bank to hold your money!) were coupled with 4 year loans priced at 0.15%. This was followed by a September announcement of open market purchases of various corporate bonds. The aim of the ECB is to increase their balance sheet to levels previously seen in 2012, representing an increase of approximately 50% over current levels. The immediate response to these many programs has been somewhat disappointing. However, the ECB still retains the potentially powerful “quantitative easing” arrow in its quiver where they would be purchasing significant amounts of government debt on the open market. Collectively, these programs have already brought interest rates in the euro zone down to levels which are now less than those found in either the US or the UK. This has in turn modestly weakened the euro currency which should provide further positive support to these many programs. The Scottish Independence referendum which took place on September 18th, ultimately did not prevail, but not before it became a much closer call than many would have considered earlier in the year. There are now numerous independence movements throughout the Eurozone coming at a time when a fondness for historical nation states does not help the cause of a unified economic body. The impact of the economic sluggishness and potential political uncertainty does not change the fact that many of Europe’s largest businesses are global participants like their US counterparts, but are trading at much more attractive valuations.
The news out of Asia was another set of complicated facts. China continues to see a certain amount of economic slowing, although just how much is matter of good debate. The activity is certainly diminished relative to say where it was before 2008, but it is important to consider that China is playing for the very long term and with the world’s largest population. Recent protests in Hong Kong in support of pro-democracy measures were met with resistance from Beijing, although nothing along the lines that were employed 25 years ago in Tiananmen Square. Hong Kong’s current influence within China is somewhat diminished relative to what it previously enjoyed back in 1997 as there are now many more windows available into China. Markets will be watching closely to see if these movements spread beyond Hong Kong.
Japan has been employing an unprecedented Quantitative Easing program since April of 2013. Their program is effectively 3 times the size of that which was used in the US when adjusted for GDP. Initial measures of success have more recently given way to more modest forward progress. The Yen is now, just as the euro currency, under pressure given extraordinarily low interest rates. Both Japan and the Eurozone will benefit from a lower currency. We saw this very effect earlier in 2014 as numerous emerging market currencies rapidly adjusted to slower economies. This process has allowed the Emerging Market index to start to perform positively once again. The US Economy now stands apart from much of the rest of the world. This is not to say that our domestic economy is without major challenges. It is simply to say, that our current economic performance is the current envy of the world.
In This Edition
· 2014 – The Summer of Geopolitics
· Smartest Kid in Summer School
· Matters of Influence
· Changes in the Wind
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Smartest Kid in Summer School
This is how David Rosenberg of Gluskin Sheff in Toronto, describes the US economy relative to the rest of the world. While somewhat unflattering, it speaks to the measured unevenness of our current economic performance both on a quarter to quarter basis as well as to marked regional differences. On the matter of measured unevenness, we have questioned for some time the accuracy of many of our traditional economic measures which may be, to put it charitably, “outdated”. We prefer to consider corporate earnings which have rigorous legal and accounting underpinnings and which tell a far more consistently constructive story. On the matter of the relative strength of regions within the US economy, this has always been the case. The fact that North Dakota or south Florida may be outpacing other regions does not come at a cost to those underperforming regions. It is not a zero sum game. David, like all of us, would prefer an economy which is growing steadily and across every geographic region and industry, but we have never seen such an environment. This is the economy we have and since 2008, corporations have made extraordinary improvements in their businesses in order to adapt to the aftermath of the credit crisis. US corporations have certainly benefitted from the steps taken by the Federal Reserve over these intervening years and will once again have to adapt as the committee moves to restore a more balanced policy.
Janet Yellen took the helm of the Federal Reserve in January of 2014 and has delivered on the promise to transparently wind down open market purchases of US Government and Mortgage Backed securities. While the cash flow that is derived from a $4 Trillion dollar balance sheet will continue to be invested after October, the main challenge on tap for the committee will be to establish a path forward to restore interest rates to a level which is consistent with today’s level of economic activity. In their post meeting report of September 17th, the Fed suggested that they would expect a Federal Funds rate of 1.875% at the end of 2015 and 2.875% by the end of 2016. Just to review, the only interest rate that the Federal Reserve can dictate is the Fed Funds rate which is currently set in a range of 0%-0.25%. All other rates are set by market participants and trade relative to this benchmark. Therefore, how we think about what “higher rates” specifically means and how we get there has everything to say about how we should think about the valuations of other risk assets in 2015 and beyond.
For several years now, pundits have called almost in unison for “higher rates” without specifically spelling out what they really expect in terms of absolute levels or the relative relationships of maturities or different types of bonds. For example, in the 30 plus years since the early 1980s, we have witnessed interest rates on the benchmark US Treasury 10 year note range from double digits to now 2.55%. We have also seen episodes when the spread between short term rates and long term rates have been quite modest; even negative from time to time, as well as times when that relative spread has been much greater. There is also the matter of the credit spread between the benchmark US Treasuries and other types of bonds. So, what specifically do pundits expect to happen now that the QE program has been wound down?
Since the onslaught of the financial crisis, the major global central banks have largely worked in unison in their efforts to provide liquidity and stimulative levels of credit. Going forward, at least for some period of time, US policy will diverge from those in the Eurozone and Japan as US short term rates will be raised from their current zero bound. While it is appropriate at this time in our economic recovery and, as several members of the committee have argued, it may well be beneficial to have the discipline of market based rates, the US Federal Reserve does not act in a vacuum. That is a windy way of saying that Janet Yellen will have at least one eye on foreign markets as she plots her rate course. A large or unanticipated increase in short term US rates could be destabilizing for fragile Euro and Japanese markets and currencies which ultimately would have ill effects here at home. “Higher rates” therefore will be a function of domestic economic activity as it has always been as well as being meaningfully influenced by the progress in other major markets. These practical realities are clearly reflected in the Federal Reserve’s preliminary estimates that we were given. So, yes, we will see higher rates in the coming years but it is far from certain that we will return to anything like the levels we saw prior to 2008 where we had Fed Funds at 5.25% and the 10 year US benchmark was 4.50%. There is also the matter of supply and demand for individual securities. Take the Municipal market for instance. Prior to the credit crisis, high quality Municipal issuers traded at 80-85% of the comparable US Treasury. After 2008, Municipals traded at spreads of 150% and higher! As conditions have improved, and buyers have returned to the asset class, spreads have come down to anywhere from 100-120%. It is entirely possible that as we go forward and longer US Treasury rates do rise, the spread on Municipals may continue to compress providing virtually the same level of yield that we are currently seeing today.
Matters of Influence
Since the advent of Quantitative Easing, certain pundits have argued that the primary reason that risk assets have risen in price is due solely to the accommodative policy. If this were true as the thinking goes, the withdrawal of the policy would then have the unpleasant and opposite effect. We have thought that while cheap credit was helpful, it did not come close to explaining the entire equity growth story. Individual businesses were able to infuse technology into their practices with a speed and in ways previously unseen. Blackrock, recently published a piece entitled, “Interpreting Innovation: Impact on Productivity, Inflation, & Investing”. In this piece they explore a number of ways that “technology” has moved from being a simple asset class to something that is now pervasive and truly transformative. Could, therefore, technology be as or potentially more influential to future market valuations than modestly higher interest rates? We think this is an excellent question. It will certainly depend on the company and the industry, but the point that Blackrock is making is that the pace of adoption today far exceeds anything that has come before. Traditional assumptions regarding profitability in a rising rate environment may be exceeded at this time given the positive influences of technology relative to the negative drag of higher rates. It is a consideration that has not been factored into models historically.
The recent rapid pace of change and adoption has also coincided with the period of extraordinary Federal Reserve accommodation making the attribution of influences complicated. However, the pace of technology is unlikely to slow and may well prove to be a far more powerful determinant in future corporate earnings than what a modest increase in rates could offset.
Changes in the Wind
No sooner had we heard the news that one of the country’s largest pension funds, the California Public Employees Retirement Fund (CalPERS), had decided to wind down all hedge fund exposure, did we hear the bombshell report that Bill Gross who is known as the “Bond King” was leaving the firm he founded 43 years ago, PIMCO, to start anew at Janus Funds.
CalPERS cited their relatively modest exposure to the asset class
coupled with high fees and modest returns as their rationale for exiting
hedge funds. While the industry quickly responded by saying that CalPERS just
wasn’t particularly good at picking the managers, the data since the 2011 has
not been good.
We have long argued that for taxable individual investors, hedge funds on an after tax and after fee basis were not in general, compelling. These numbers, as dreadful as they appear, also paint a picture that is more attractive than the facts on the ground as funds which have closed over time, presumably due to poor performance, are dropped from the data. CalPERS’ move will, at a minimum, make for a broad review of the asset class within investment committees around the country.
The news regarding Mr. Gross, which followed on the heels of an SEC announcement of an investigation into pricing of one of PIMCO’s ETFs, was remarkable not so much for the fact that he was leaving, but that he was headed to a competitor. PIMCO has always been known as a challenging place to work, and was in the news for that very reason this past spring when Mohamed El-Erian, the then Co-CEO resigned. It was assumed however, that the root of the challenges was Mr. Gross himself. Given the oversized role that Mr. Gross and PIMCO have played in the bond market, many long term institutional customers will take this as an opportunity to review their relationship with the firm and will provide PIMCO’s many competitors with an opportunity to pitch for new management.
The third quarter performance of 2014 was on balance, a challenging quarter for many financial markets. While the S&P 500 more or less ended the quarter where it began, small cap and international stocks lost ground. The 10 year US Treasury was also virtually unchanged while the overall shape of the yield curve was flatter with short rates incrementally higher and longer rates lower. In municipals, an overall shortage of supply coupled with good demand drove rates lower. The dollar was the big winner of the quarter, strengthening against many major currencies as it responded to lower rates abroad. Commodities, despite potential disruptions in the Middle East, were also off on the quarter as the strong dollar was more influential than geopolitics.
The multitude of events and the evolving position of the Federal Reserve will provide market participants with a lot to consider in the coming months. That being said, the improving fundamentals underpinning corporate balance sheets coupled with modest interest rates continues to provide for a reasonable investing backdrop. We look forward to your comments and to speaking with you in the near future.
Jen & Patsy