Quantitative easing appears to be helping the deleveraging American market so far, but investors’ fears could dominate overall sentiment as they are forced towards riskier assets.
Taking the medicine
Nobody wants to hear this story: America is deleveraging after a 30-year credit binge, which means we had better curb our expectations for our investments and living standards.
Citing historical returns, many managers glibly assure American investors of an average 8% return on their equity holdings, while pension funds dangerously factor overly optimistic scenarios into their assumptions. Suppose 2-5% returns were a more realistic outlook?
The hairshirt may cling for a long time. In a March 2011 working paper for the National Bureau of Economic research, academics Carmen Reinhart and Belen Sbrancia have traced periods of sovereign debt restructuring. They write, “following the Napoleonic Wars, the UK’s public debt was a staggering 260 percent of GDP; it took over 40 years to bring it down to about 100 percent … following World War II, the UK’s public debt ratio was reduced by a comparable amount in 20 years”. Today’s American debt ratio, which recently crossed 100%, will hopefully be worked off in fewer than 20 years.
The Federal Reserve is using a set of policies to address its own Waterloo. “It’s flooding the system with liquidity to devalue the currency, so we can export our way out of debt troubles,” says James Shelton, the chief investment officer at Kanaly Trust, the largest independent trust company in Texas. The object, he says, is to “inflate away the debt burden and encourage investors to take more risk, and to generate some type of wealth effect.” The Fed has implemented its expansive monetary policy through low interest rates and quantitative easing (QE), by buying securities from the market for its own balance sheet.
This medicine may work in the long run, but carries heavy baggage. Investing has become exceptionally difficult and unpredictable in unchartered waters. Negative real interest rates operate as a tax on savers; investors fear for the return of their capital; and a flat yield curve discourages investment in the real world economy. Banks would rather safeguard funds at the Fed than commit them to risky ventures. Growth looks sluggish, while American home prices remain mired at cyclical lows. Don Quigley, who co-manages the Artio Total Return Global Bond fund, notes how treacherous it is to navigate the environment. “A lot of successful hedge fund managers have closed up shop now,” he notes. (Stateside continues below)
The fixed income quandary
Managers normally turn to treasuries and other bonds, to buffer volatility and deliver yield. With government rates close to zero, however, prices have little room for appreciation.
Having served as a haven magnet since the crisis, and after 30 years of hefty gains, treasuries have enjoyed their day in the sun.
Shelton describes government bonds as “mathematically unattractive, when 2.0% on the 10-year doesn’t cover inflation.” Bond manager Quigley agrees: “Real rates ultimately have to gallop higher. Moreover, the Fed is holding a lot of assets on its balance sheet that it can start selling. If it dumps them on the market, increasing supply, and depressing prices, the only question is, how fast will that happen?”
With scant upside left in treasuries, investors are being forced toward riskier assets to generate fixed income. Fund flow data from EPFR Global as of mid February shows American high yield bonds up 4.7% for 2012; non-US high yield inflows are 4.1% higher; and emerging market debt has risen 2.4%. And all that buying took place before Valentine’s Day.
Shelton looks at other fixed income classes, such as higher yielding corporate debt. “Spreads are still wide, and default rates low for now, with balance sheets looking healthier.” He also favours non-agency mortgage backed securities, which are priced at discount. As a Houston native, Shelton is familiar with local energy pipeline operations, structured as master limited partnerships. These pay high dividends, thanks to favourable tax treatment.
Horns of a dilemma
It is not unusual for markets to vacillate between inflationary and deflationary views. But now that they are so heavily influenced by policy makers and press conference risk, sentiment has become more schizophrenic than ever. As Pimco’s Bill Gross wrote in his January Investment Outlook, “it’s as if the earth has two moons instead of one”. The new bimodal world comprises two alternative directions, of either continued delevering and contraction – think Japanisation – or higher inflation triggered by the splish-splash of liquidity.
”Having served as a haven magnet since the crisis, and after 30 years of hefty gains, treasuries have enjoyed their day in the sun”
That is where equity and commodity investors have their work cut out. Chris Ciovacco, an independent money manager in Atlanta, predicts an ongoing series of meltups and meltdowns, the lengths of which will get shorter and shorter. Sentiment will “flip on a dime”, he says, so investors must be exceptionally nimble. That means a buy-and-hold strategy is less likely to pan out. Although it is more comfortable to settle into a two-to-three year horizon, two-to-three months will be a more pertinent time frame.
Ciovacco has a prescription for dealing with such volatility. Do not construct a portfolio for either a bull or bear environment, going all in to reflect one scenario. Instead, blend the two approaches by overweighting one side or other, according to the “risk on” or “risk off” flavour of the market.
The key is deciding how fast to migrate, based on the prevalent conditions. For example, new headline developments might justify a faster shift, whereas technical topping patterns would recommend a more gradual move. Adjustable positioning is suitable for psychological reasons. It is emotionally easier for an investor to change a weighting and allocation, than to abandon a prior stance altogether. Ciovacco reminds that, “the highest objective is to protect one’s confidence.”
One school of thought sees handsome returns ahead for equities, assuming the Fed and other central banks continue to deliver doses of liquidity. At least the monetary sugar highs seem to have worked so far, with each influx of QE boosting stock prices. Yet the danger is that fear still prevails as the dominant sentiment. Fear of missing rallies may be eclipsed by the dread of capital erosion, or years of paltry returns may depress animal spirits.