The Grand Monetary Experiment
January 14, 2015
“And so the miracle of the debt supercylce meets a logical end when yields, asset prices and in the increasing amount of credit place an unreasonable burden on the balancing scale of risk and return. Too little return for too much risk” – Bill Gross, January 2015
Markets By The Numbers – 2014 In Review
Global stocks ended the year up 4.2%. There was quite a dispersion between U.S. stocks and international stocks as international developed and emerging market stocks recorded losses for the year. Continued concerns regarding slowing growth and a risk of deflation in the Euro-zone impacted international developed stocks. Slowing growth and lower commodity prices hurt emerging market stocks, especially in the last quarter of the year. US stocks were once again the best performers with the S&P 500 rising 13.7% during 2014. For the year, most markets had positive returns with small cap stocks bringing up the rear. Despite a volatile year, the 6-year bull market continued pushing valuations, at least in the US, to higher levels.
Surprising many, the bond market rallied 6% for the year as interest rates dropped. A lack of supply and higher-quality debt helped the municipal bond market rally 9.1% in 2014. High-yield bonds took a break and eked out a 2.5% gain for the year. Global bonds, especially emerging market bonds, posted modest gains impacted by a strong dollar. Amazingly, global government bond yield curves all flattened during 2014 (figure 1). The outlook for government bonds is cloudy as G-7, 10-year sovereign debt on average is yielding a whopping 1% with an average duration of 7.4.
Oil plunged dramatically during the latter half of the year impacting commodity prices with the broad commodity index dropping 17% on the year. A strong dollar certainly didn’t help commodities as the dollar gained 11.4% in 2014.
A balanced portfolio of 60% world stocks and 40% bonds rose 4.9% in 2014. This same portfolio has gained 7.3% annually over the past 5 years and 5.5% annually over the past 10 years.
Figure 1: Global Yield Curve FlatteningSource: DoubleLine
Grand Monetary Experiment
The grand monetary experiment of the past six years rolls along in all its grandeur as the calendar turns to 2015. Last year was unique in that the United States Federal Reserve (Fed) began to shift its policy stance to a more neutral position. The Fed wrapped up its Quantitative Easing (QE) program in October. Quantitative Easing (QE) is central bank purchases of assets, primarily bonds. The Fed has forecasted an increase in interest rates sometime during 2015. Barring a major economic collapse, I expect the Fed to raise rates this year, most likely during the middle of the year. Yet much of the data historically suggests the Fed should not raise rates; inflation is low (figure 2), wage growth is anemic, the number of people unemployed is high, and the capacity utilization rate is below normal. Couple this with a precipitous drop in oil prices (figure 2) and plunging global interest rates are signs of deflation which the Fed would normally attack by lowering interest rates.
Figure 2: US Consumer Price Index and Oil Prices – January 7, 2005 through January 7, 2015Source: DoubleLine
However as Jeffrey Gundlach recently said, “The Fed may raise interest rates just to see what happens.” Predicting when the Fed will start raising rates is not as important as the path to a normal Fed funds policy rate. The policy rate is important as it is a rough proxy for the rate of return on cash. Where the Fed stops in its path to a normal policy rate is the key issue which affects all asset classes and markets.
“That said we suggest not getting too wrapped up in the exact timing of the Fed’s first move. Focus instead on the speed and magnitude of future hikes.” – Tony Crescenzi, December 2014.
With QE in the rearview mirror in the US, it appears it’s the European Central Bank’s (ECB) turn to pick up the QE baton. As seen in figure 3, the ECB has lagged Japan and the US in the size of its balance sheet. This is mostly due to Germany refusing to allow direct purchases of sovereign bonds by the ECB. I expect the Mario Draghi, the head of the ECB, to announce a round of QE this January. The size and magnitude of their program is another question. If the ECB comes across too weak or yielding at all to Germany, the market may react negatively to the announcement. Clearly, now is the time for the ECB to flex its QE muscles.
Figure 3: Central Bank AssetsSource: The Economist
Japan’s Triple Play
Japan has been battling their own deflationary demons for over 20 years now and continue to add monetary stimulus to their economy. In the case of Japan, their QE is two to three times our QE over the past 12-18 months. In October the Bank of Japan surprised the market by increasing its monthly QE to 80 trillion yen ($668 billion USD). Not only this, but they expanded the amount of the QE that will directly be used to buy stocks. The Japanese government pension fund also announced higher limits for its holdings of both domestic and overseas stocks to 25% of its portfolio. Finally, Japan has also eased fiscal policies completing the triple play: monetary easing, fiscal easing and government pension fund-aided QE.
I do think there is a misconception as to why Central Banks engage in Quantitative Easing. The point of QE is not to lower interest rates. As seen below in Figure 4, in general, QE has caused the 10-year treasury rate to increase. The Fed engages in QE primarily to remove the risk-free asset from the market, so risk taking can increase. For example, if the Fed buys $1 trillion in US Treasury Bonds, it gives the seller (or would be buyer) cash which then can be invested in stocks, high-yield bonds, real estate, etc. With the 10-year treasury rate now below 2%, QE 4 in the United States cannot be ruled out. For now, the QE baton is squarely in the hands of the European Central Bank and the Bank of Japan. Both Central Banks are clearly trying to avoid a deflationary spiral to their economies.
Figure 4: 10-Year US Treasury Performance During QESource: DoubleLine
The endgame for this global monetary experience is anyone’s guess. There are certainly arguments on both sides for and against the actions of Central Banks.
“Investors can be opportunistic if they stay mindful of the destination for rates in the U.S. and globally when market sentiment inevitably occasionally sours against assets that are likely to benefit from today’s era of low interest rates.” – Tony Crescenzi, December 2014
Crescenzi argues in the favor of risk assets if the Fed can successfully navigate a policy tightening to a normal, albeit, lower Fed funds policy rate. PIMCO’s view should not be taken as wildly bullish, but also not wildly bearish.
Jay Compson of Absolute Advisers provides a more bearish view on this endgame preaching balance and caution in portfolio allocations.
“We fear that further efforts by policy makers at this point in the cycle may eventually have even larger unintended consequences. Currency wars, unsustainable and artificial asset prices, or increases in interest rates may threaten the global economy and financial system far beyond anyone’s expectations. We also believe that these risks are more evident now than ever. Regardless, asset allocation and diversification efforts need to take into account the historical precedent that money printing and currency wars have never ended well. And such intervention over the past 15 years (20 years for Japan), have yet to prove otherwise. Yet most asset allocators and investor portfolios appear almost entirely leveraged to a positive outcome with no risk of being wrong. How can they possibly be so sure?” – Jay Compson, Absolute Advisers, September 2014
This global monetary experiment engineered by Central Banks the past six years has come on the heels of a secular rise in global leverage and low interest rates. Since around 1980 the world has been awash in debt. I have shown figure 5 below in a past article as it depicts this precipitous rise in global leverage. The Bank Credit Analyst has described the secular cycle as the “debt supercycle.” In Bill Gross’ most recent commentary, he argues we are nearing an end to the “debt supercycle.” Low interest rates, negative yields and QE alone can’t generate enough economic growth. Zero-bound rates encourages risk taking driving stock and bond prices higher, yet economic growth stays low and in some parts of the world, drops. Instead of investing in CAPEX such as machinery, equipment, etc., Gross argues corporate executives have opted for share buybacks and dividends. This too has a deflationary effect.
Finance – instead of functioning as a building block of the real economy – breaks it down. Investment is discouraged rather than encouraged due to declining ROIs and ROEs. In turn, financial economy asset class structures such as money market funds, banking, insurance, pensions, and even household balance sheets malfunction as the historical returns necessary to justify future liabilities become impossible to attain. Yields for savers become too low to meet liabilities. Both the real and the finance-based economies become threatened with the zero-based, nearly free money available for the taking. – Bill Gross, January 2015
While I have argued QE is good for risk assets, the party can’t go on forever. Momentum can carry asset classes higher for longer than most imagine. However, time and again, history shows that asset classes always revert to the mean. The rise in risk assets has created a world in which there are very few asset classes that are bargains. One of the unintended consequences of this global monetary experiment is a highly correlated rise in risk assets. As a value investor at heart, this can be a difficult time to invest. Research Affiliates projects a typical 60% stock/40% bond portfolio to produce an annualized return of only 2.5% for the next 10 years. This is a far cry from the 5-8% over the past 10 years.
Figure 5: Global DebtSource: PIMCO
While expected future returns may be low, an asset allocator should not loose heart!
International stocks appear cheaper relative to US stocks over the long term. A growing using of passive strategies is good for costs, but if markets sour, be prepared to ride the market south. While I advocate index funds as a core holding, don’t give up on active managers. Seek out managers with proven track records, reasonable costs, and portfolios that can withstand difficult markets.
Active management in the bond market is paramount in these times. Seek strategies with a good spread between yield and duration without taking on too much risk.
Alternative strategies have been on the rise recently liquid alternative strategies become more available to the mainstream investor. Seek out strategies that can diversify risk, reduce beta where desired and provide uncorrelated returns to stocks and bonds. Rob Arnott of Research Affiliates advocates for “third pillar assets,” those that can diversify away from mainstream equities and help add greater inflation hedging characteristics. These include long TIPS, real estate, commodities, high yield, EM equities, and local currency EM debt to name a few. I would also argue in favor of alternative strategies. While there is no free lunch, these strategies may provide uncorrelated returns in volatile markets with downside protection.
Investment Outlook – Bill Gross, January, 2015. Available online http://janus.com
Global Central Bank Focus – PIMCO Tony Crescenzi, December 2014. Available online http://pimco.com
Cumberland Advisors Commentary – Japan Equities as the BOJ Puts on a Full-Court Press, October 2014. Available online http://cumber.com
Absolute Strategies Portfolio Commentary – Q314 Commentary, October, 2014. Available online http://absoluteadvisers.com