We have come to the end of another quarterly strategy cycle and yet again we are required to make significant changes to our portfolio strategies. "Long-term investing" has become an oxymoron.
Three topical issues are top of mind at this juncture. For one, we had expected a "Stop/Go/Stop scenario to play out economically (what others call the 'W") before settling into one of the 5 longer-term scenarios that we had been probability-weighting. (Please see our quarterly HITCH Update for a more detailed overview.) Certainly, financial markets fulfilled our expectations and more in this regard. However, we're worried that the predicted "Go" in North America is not yet visible. Or, did we miss it? Could the tripping of the "bond trap" have played a role?
Furthermore, even in China's manufacturing hub, where we were sure that the "bungee cord" effect of a reversing inventory cycle and the "rocket ship" effect of stimulative government spending would be first observed, has still not served up incontrovertible evidence of a broad recovery. Speculative rebuilding of industrial commodity inventories and other factors have padded the statistics. In the meantime, other economic indicators -- i.e. basic power consumption -- have signaled contrary trends.
Recovery? G8 financial heads likely are congratulating themselves much too early on a crisis well averted. Any thought of pulling life-support at this late terminus will not be received well by financials markets.
With respect to our anticipated "Go" stage, are we being dealt a "Go to Jail, Do not Pass Go" card? Given the scale of the global equity market rallies to date, there's not much to be gained remaining overly exposed to "high beta." As such, countertrend to consensus, we've recalibrated our portfolios this quarter to again lower risk.
The second conundrum on our minds is the apparent gross misreading of inflationary conditions. Even Paul Kasriel, a highly-regarded analyst and apparent adherent to the Austrian School, we fear, has terribly misread the tea leaves. But let's be clear before we digress. There currently exists enormous monetary inflation. There is no doubt on this matter as inflation is essentially a monetary phenomenon. With central bank balance sheets doubling and trebling over the past 12 months, there is lots of monetary inflation seeking to work its alchemy. How it will manifest itself is an entirely different question.
Here, we best be on guard for the very deserved reason that inflation is a chameleon. It likes to fool most people all of the time ... even Austrian School devotees. In terms of its popular public conception -- namely the prices of the current output of GDP ... i.e. the CPI or the GDP deflator -- sometimes you see it, sometimes you don't. This is a most unreliable indication of the destructive distortions of inflation, in any case (it being a symptom, not a cause). But what other channels could inflation be impacting now?
First, off, let's reaffirm some ol' time theory. In the classical view, in addition to rising consumer prices, manifestations of inflation include:
1. Asset inflation ... the kind everyone likes, at least until it collapses from an unsustainable bubble and related credit problems ... of existing assets that are not current output of GDP.
2. Gross distortions in the input/output structure of an economy. This is a technical concept involving malinvestment best explained with this example: When U.S. retail store space doubled from 19 to 38 square feet per capita between 1990 and 2005, this was definitely a distortion of the input/output structure of the American economy. (By comparison, most European countries have less than 10 square feet per capita.)
3. Chronic external deficits -- for example a current account deficit -- requiring reliance upon international borrowing to sustain its spending and/or investment.
4. Shifts on the household's balance sheet that lead to a plunge in personal savings rates.
5. Widening income and wealth skews in the general population. This last indicator is not normally considered a text-book manifestation of inflation. Under certain conditions, such as are being experienced today, we make the case that it is. We will explain further.
There is yet one more manifestation that may be missed right now. Monetary inflation has been expressly marshaled to tamper with risk spreads in the credit markets. Most monetary inflation hasn't gone much anywhere else to this point, certainly not in the US. The Fed itself has used its expanded balance sheet (which is monetary inflation) to buy assets other than treasuries. Also, other government programs have been funded to support "troubled assets."
Another factor perhaps ignored is that actual monetary destruction has occurred in the banking system. In other words, assets have been written off as worthless (impaired), thus crimping the banking system's balance sheet. That, technically, can be seen as a monetary event. To the extent that monetary inflation is deployed to fill in "deep black financial holes" by virtue of relative price distortions in credit markets or other means, that is indeed another manifestation of inflation.
All of the above, serves as a lead-up to this assertion: Narrowing yield/risk spreads in credit markets in the aftermath of the GFC, are not necessarily proof that there is actually a growing and natural preference for higher credit risk. As Kasriel concludes: "If the current and increased supply of Treasury debt coming to market were 'crowding out' private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield." Whoa! With huge dollops of monetary inflation specifically directed to messing with natural pricing of credit risk, this conclusion does not necessarily follow.
In the meantime, the US bond market is doing its job of regulating capital supply and "price" inflation fears (i.e. the opposite cousin to asset inflation). Those of us who are rightly worried that "velocity inflations" (a unique distributive variant of asset inflation) may erupt in certain "hard" assets types, are also best reminded that a large, functioning and alert bond market is the best protection against rampant price inflation. Mainly, that is what the sharply rising bond yields are signaling. (Shades of Ed Yardeni's concept of the "bond vigilantes.") This "inflation sentinel" is something that Zimbabwe and the Weimar era did not have. At present, there is way more supply of government bonds than there is appetite and inflationary complacency (and this, despite no hint of any US dollar funding crisis!)
Given the slow traction of economic growth, the slumping bond markets are best read as signaling another economic slowdown later this year. Protesters to this interpretation will argue that the rise in long-term rates has nothing to do with rising demand in the private economy .Therefore, how should it slow what hasn't accelerated much? Well, that's the crowding-out effect. What we are witnessing, alas, is the catch-22 to financial godhood for Geithner and Bernanke. Only through the scares of a deeper economic slump or a phase-2 of GFC, will investors be willing to pile back into longer-term government bonds. And, maybe not then either.
Finally, commenting upon investment performance year-to-date, all we can say is that it's been one of those years that throws a curve ball into the theories of performance measurement consultants. Even managers that have successfully pursued long-term allocation strategies will have some explaining to do. Why? Active managers are bound to have recorded high performance volatility against benchmark this year (unless they whimped out and hugged the benchmarks throughout the steepest stock market decline in a century). Of course, the reason that people hire asset managers in the first place is for "positive" volatility against benchmark ... as much as safely possible. But here now comes to play the catch-22 of the consultants. If you deliver too much "positive volatility," this apparently is taken as evidence that you have subjected portfolios to too much risk. In certain situations -- certainly this year -- such a contention is nonsense. When the entire financial universe is polluted with mispriced risk, who is to say?
Long-term oriented asset managers, of course, had no complicity in the sharp and reversing financial market movements witnessed to date this year. These have been of a scale that have turned long-term strategies into shortterm trades. In other words, decisions that were theoretically based upon longer-term return and risk expectations, were either validated or disproved in a matter of weeks.
The granddaddy of these moves has been the relative performance of stocks versus longer-term bonds. Figure #1 illustrates the sharp and defined diversion between these two asset classes. The rotation we have witnessed this year is simply unprecedented ... either career-making or -breaking. In fact, the relative volatility between these two asset classes today makes the 1987 experience look like a shrinking violet. (See 360 View on the front page.)
Our conclusions? We would dearly like to join the effusive enthusiasm for an imminent economic recovery ... a sustainable, self-replicating kind that has been the usual type of the post-WW II era up until 2000. While we have had to be in the reflation trade since last year, we think there is little to be gained waiting for a economic recovery to appear when long-term yields are soaring to extremely high real levels.
Theory and history argue that the full ramifications of the GFC have not yet fully played out. There are still many repercussions that will leave their legacy over the next few years. The current equity rallies presume a trouble free future and a return to the economic growth rates of the past several decades. This is virtually impossible for the Western parts of the world economy.