Where To Hide?

By: Michael Ashton | Wed, Apr 28, 2010
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The water is getting a little choppy, and perhaps dangerous enough to consider not swimming for a little while. Today the June 10y note gave back 3/5ths of its Tuesday gain (21/32nds, to be exact, with the 10y Treasury at 3.77%) while stocks recovered 0.7%. This retracement came as incrementally more aid was offered to Greece. However, that financial aid is contingent on keeping at least a 'B' average this semester - just kidding, sort of. As usual, the aid was too little and with too many conditions to even be relevant, but even a small sense of taking the kettle off the boil is welcomed. But the kettle won't stay off the boil long; this ball has rolled too far downhill to be pushed back over the summit.

Already, politicians are working on their scapegoats, and since they all golf together they pointed at non-politicians. The European Commission is very ticked at the rating agencies, you see, because the downgrades are helping to stoke the crisis. I think the ratings agencies ought to take a page from Casey Stengel, who famously said that the art of being a manager is "keeping the people who hate me from those who are still undecided."

The Federal Reserve, as expected (considering the European turmoil), remained on hold and reiterated that rates will remain low for an "extended period." Here, the monetary authority actively wants things to boil but the statement read like a classic economist "on the one hand, on the other hand" waffle. In part:

...Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

...Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee's flexibility to begin raising rates modestly.

The fact that they retained the language about being on hold "for an extended period" is not surprising, especially if you think they believe their press about there being no inflationary pressures because of the output gap. While Hoenig is right in principle to object to the open-ended liquidity promise, there is too much downside today to hiking rates or even indicating that a hike is eventually coming, and no matching upside. If and when the fear of those imbalances outweighs the fear of what will happen to the economy when they tighten, they believe, then they'll tighten.

Of course, the real issue is that by the time those imbalances scare them, they may also be scared of taking action to correct the imbalances. The history of the Fed, especially in the Greenspan/Bernanke era, has been to pretend that since they cannot know with absolute certainty that a bubble is forming, it is best to ignore it completely. This strategy, of selling policy options with small upside and big downside, is exactly what they are avoiding today by not making the language more hawkish (I discuss the notion of monetary policy "options" in my book. Greenspan was perennially taking big gambles for small gains). When the bubble - equity, fixed-income, real estate, or whatever - forms, I suspect they will not have the fortitude to take a sure, small loss rather than the wager between a small gain or a big loss.

Maybe that is a reason to bet on stocks. Wager that the Fed will continue to provide costless capital and drive risky assets higher. Perhaps bullish investors are merely turning their sails to the wind. There may be merit in this approach, but it isn't my approach. I am a value investor, and when there is little value then I don't default to riding the most-recent momentum. If you row crew, then you don't hoist a sail just because it looks easier sometimes.

It is interesting that bonds retraced more of their rally than equities did their selloff. Perhaps a "flight to quality" no longer automatically means Treasuries - perhaps they just serve as a liquid stopover for money while it finds a true safe harbor. But what would that be here? If sovereign bonds are iffy, top quality credits are better investments...but if you're really a top quality credit, then you haven't issued many bonds (after 2008, the last thing I would want to do is introduce bonds to my portfolio that depend on the issuer being able to roll its existing debt when it comes due. No matter who it is, if the market shuts down again then levered companies are vulnerable. Equities have problems, the most notable of which at the moment is valuation.

That points mostly to real assets (and folks, I am not saying "gold"). As I have written here before, I don't much care to own commodities directly, since they can't have much more than a 0 real return in the long run, but commodity indices are worthwhile. However, they are volatile, and too dangerous to stick too much of your assets into. I suppose the answer is the answer that is usually right: diversify, diversify, diversify. Deposits in New Zealand, bonds in Canada, real estate, certain hedge funds, inflation bonds in your home currency (I would avoid nominal sovereign bonds), commodity indices, junior bonds or preferred stocks in high-quality firms, some high-dividend stocks of companies that produce real stuff and are not highly levered. Not helpful, I know.

I think one of the reasons to look for inflation protection under every rock right now, especially if you can find a way to source it cheaply, is that the Fed is likely to be (a) slow to respond to price pressures, when they begin, for all the reasons above and (b) they are likely to accelerate much more rapidly than they have in the past...partly because pretty much everything is happening faster these days, and partly because the lower level of private debt lowers the economy's natural resistance to inflation.

Tomorrow, there is a bit more data from the Chicago Fed (Consensus: -0.20 vs -0.64 last) and Initial Claims (Consensus: 445k vs 456k). Again, economists are calling for an improvement in 'Claims to near the best levels of the year. The last time we got such prints, it was apparently due to faulty seasonals, but hope springs eternal (and they'll eventually be right). I will watch with some disinterest - the important stuff is happening in Europe.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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