Economics

Rubber Duckies

Imagine a bathtub full of rubber duckies. Most of them are bright yellow and cheerful eyed with permanent Mona Lisa beaks. But perhaps there are a few other colors, shapes, and sizes mixed in. Maybe, if this particular bathtub is anything like the one I remember my kids playing in, there are a few plastic sharks, whales, and maybe a penguin or a platypus thrown in for good measure. My favorite was always the wind-up scuba diver flippering along endlessly intrigued by who-knows-what under the bubbles. Regardless of the particulars of the floating toys, when you turn on the bath water they all float. Water in, duckies up. Water out, duckies down.

Asset prices and money (credit) behave in much the same way. When there is more money around, assets appreciate (expansion) and when there is less money around, assets depreciate (contraction). Money in, prices up, Money out, prices down.

This is obviously a simplification excluding the longer term human factors in the economic process (namely innovation and population growth). However, it serves our purpose as a way to visualize boom and bust market dynamics. An booming market can defined as the value of the stuff (stocks, bonds, real estate, money markets) people own going up relative to the size of the economy (GDP) and a bust defined as the inverse. This ratio (Household Net Worth to GDP) is shown in the following chart well over half a century.

Household Net Worth to US GDP

Household Net Worth to US GDP

During the period of 1945 to the early 1990's the price of assets (measured in units of economic production) remained range bound. Measured this way, asset valuations gradually rose into the early 1960's, fell as inflation became pronounced and eventually peaked in 1980, and then rose again ending entire fifty-year period close to where they began.

However, since the early 1990's the credit and market cycles have been particularly pronounced with asset valuations rising substantially overall with sharp corrections during the recessions following the tech stock boom of the late 1990's and the housing bubble culminating in the Great Recession of 2008- 2009. Over the past 25 years, aggregate asset valuations rose over 40% according to this measure.

Going back to our rubber ducky analogy, the household net worth line in the chart above is similar to the rise and fall of the floating toys (e.g. prices of stocks, bonds, real estate) in the bath. Why do they go up and down? Because of the amount of water (money/credit) in the tub.

A boom is created by a combination of available money (money, debt, credit are fairly interchangeable) and a reason (a narrative or story) to buy. There are almost as many ways to measure amounts of money and credit in our modern economic system as there are economists. Certain types of credit and debt instruments have become much more liquid and increasingly used to buy assets at the macro (Inter-bank) level. We'll use treasury securities, government agency securities (Fannie Mae mortgage securities for example), and Federal Reserve credit. The prevailing narrative depends on the period.

In 1990, there were about $2.5T of Treasury Securities, $1.5T of Agency Securities and $340B of Federal Reserve Credit. These three sources added up to $4.25T, or 71% of GDP. A decade later, at the end of 2000, the total stood at $8.34T or 81% of GDP (Treasury $3.36T, Agency $4.35T, Fed $635B). The narrative of that era was American Technological Dominance. This was the era when the Cold War was one, when America displayed overwhelming military force in Iraq (Operation Desert Storm), when the personal computer became ubiquitous, and the Internet was born. Confidence and optimism abounded. Booming markets fueled by credit growth certainly didn't hurt.

And then the technology bubble burst, resulting in widespread bankruptcies among Internet, telecom, and technology companies. The result ultimately was large stock market losses (particularly the richly-valued technology stocks), and a US Fed determined to rapidly drop interest rates (at the time the prominent Central Bank tool) and "reflate" the markets.

The chart below shows the course of Federal Reserve interest rates over the same time horizon as the net worth chart from before. This shows the Fed's efforts to react to recessions (the grey bars on the chart) by lowing borrowing rates aggressively. A critical aspect of our analysis is that there is no free lunch in economics and no way to "print to prosperity". Deliberate intervention in markets carries a cost even if that cost is not immediately recognized. 

Effective Federal Funds Rate

Effective Federal Funds Rate

In 2002 economist Paul Krugman, Nobel prize winning professor of economics at MIT and Princeton wrote about the difference between typical economic fluctuations and credit boom-bust dynamics. He even specifically called for the Fed to create a housing bubble to replace the Nasdaq bubble! The following is a direct quote from his "Dubya's Double Dip" article written in August 2002 in the New York Times, "The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off." 

The housing bubble was indeed created. As all good replacement bubbles must, it exceeded the previous bubble in scope. Toward the end of the mortgage finance and housing price bubble in 2007, Treasury securities exceeded $6.0T, Agency securities had surged to $7.4T and the Fed's balance sheet chipped nearly another trillion dollars at $950B. The total then stood at $14.4T or 99% of GDP.

The narrative shifted to the American Dream of Home Ownership (also plausibly named "Real Estate Always Goes Up"). With mortgages easy to obtain and rates declining, the lure of gains and fear of missing out combined with widely availability of real estate financing to drive prices upwards. Eventually rising interest rates and declining affordability slowed the boom. A recognizable characteristic of credit booms is that when the growth ends, a bust follows.

We know what happened next. In 2007, the housing bubble popped and credit growth turned sharply negative as one lender after another approached bankruptcy. The Federal Reserve repeated its burst bubble prescription, recently learned in the early 2000's, and turned again to forcing interest rates lower and encouraging credit growth. This time though, lower interest rates and optimistic talk weren't encouraging enough. The FASB accounting standards board changed rules to no longer require banks to value their credit portfolios at market prices and the Fed created a new tool. Called Quantitative Easing (QE), Central Banks led by the US Fed began creating money to purchase bonds and other credit instruments. These efforts stopped the bust in its tracks,and got credit growing again by early 2009. As shown below, heavy Central Bank money creation and asset purchases have been a persistent feature of global financial markets ever since.

Global Quantitative Easing (QE)

Global Quantitative Easing (QE)

What has unfolded in monetary and credit terms since early 2009 is astonishing. As of the end of 2016, Treasury securities had reached $16.0T. Surviving the mortgage bubble bust (Fannie Mae and Freddy Mac insolvency and receivership), and returning to growth, Agency securities stood at 8.52T. The Fed’s balance sheet ended 2016 at $4.43T. Again, the replacement credit boom has exceeded the preceding credit bust. The total of these sources of credit now stands at nearly $29T or 156% of GDP.

Household Net Worth to US GDP

Household Net Worth to US GDP

Today's narrative is Interest Rates Will Stay Low (as will inflation and economic growth). This story points to continued scarcity of yield (earnings, cash-flow, profits, and dividends) and the unfortunately common refrain in today's financial media that There Is No Alternative to investing in common stocks even as richly valued as they admittedly are.

It is futile to try to predict exactly when and how the market's prevailing winds will shift, but history shows us that nothing lasts forever. With recent coordinated efforts by Central Bankers to inch rates up and rein in asset purchases (QE), the initial steps may now be taking place.

(Additional investment specific commentary follows for client subscribers)

References:

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html?scp=4&sq=krugman%20mcculley%20bubble&st=cse

http://creditbubblebulletin.blogspot.com/2017/06/weekly-commentary-washington-finance.html?m=1

https://fred.stlouisfed.org/graph/?g=cvIg

http://www.bloomberg.com

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

The Oil Market Is Back In Balance

The U.S. Energy Information Administration (EIA) recently reported domestic crude oil production declined by another 200,000 barrels per day over the most recent six week reporting period. The same EIA report also showed stocks of crude, gasoline, and distillates all falling during the period. In the simplest possible terms, these developments on the supply side mean that supply and demand are finally starting to come back into balance. 

For years OPEC represented essentially the lone source of incremental oil supply.  In fact, an often-used analogy was Saudi Aramco turning on and off the oil spigot to match oil demand. On the other hand, oil demand is fairly inelastic in the short run. Because of these dynamics, OPEC could achieve a large positive price response in exchange for a small reduction in supply.  In the last decade these monopolistic market tendencies evaporated as a new oil market reality emerged with American shale producers creating a market with multiple marginal suppliers. Today OPEC could make a large production cut, only to see American producers increase supply (and profits) at their expense. This is the dynamic OPEC leadership is referring to when you read of their unwillingness to cut supply due to their focus on “defending market share”.

The US oil supply growth of recent years was primarily driven by additional production from tight shale using horizontal drilling, fracking, injections, and other non-traditional methods. These new technologies unlocked access to large reserves that were known to exist, but were formerly thought to be uneconomical. Shale oil supply differs from traditional oil supply in two important areas. The first is that to drill and produce oil from a shale well costs more and therefore requires a much higher price of oil. Recent studies have put this breakeven price point somewhere around $50-$70 per barrel for a typical shale well, versus $20-$35 for a traditional well (this is an over-simplification for example purposes, actual well break-even levels can vary widely from well to well based on a variety of factors). The second difference is the expected production curve of the well. Traditional wells can produce for decades with little production decline, whereas typical shale oil wells expect substantial production declines within 18-24 months. In other words, shale production can be expected to begin declining less than two years after a sustained and substantial decline in drilling rig activity.

Much energy market analysis has focused on the role of OPEC in energy supply and on the recent reported failures of OPEC to agree to curb supply. However non-OPEC supply reductions (i.e. US shale producers) have continued right on schedule. Shortly after oil prices (thin gray line in the chart above) began their sharp drop in the second half of 2014, drilling activity as measured by the Baker-Hughes rig count (the bright red line in the chart above) declined precipitously by nearly 80% from the 2014 highs.

Given the relationship between drilling and production on a well-by-well basis, we might also expect the relationship to hold between drilling activity and shale production volumes in the aggregate. As shown in the chart below courtesy of Ned Davis Research via SPDR, not only does the relationship clearly hold, but the timing is spot on with what might have been our a priori expectation. 

Returning now to the global oil market picture, and remembering ECON 101, as price declines, we expect to see demand increase. Demand growth has occurred as the price of oil has declined. Much of the demand increase has come from the still rapidly growing emerging market economies. The IEA now expects India to begin overtaking China as the main engine of global demand growth, but expects both countries thirst for oil to remain strong. Therefore, we now have reduced supply combining with increased demand and this has now resulted in market flipping from an oil surplus to an oil deficit. The following chart from Goldman Sachs via Bloomberg illustrates the historical and projected market surplus/deficit (using Goldman’s current forward-looking estimates):

We believe that it is reasonable to assume that the oil price lows were reached in the first quarter of 2016. While prices may certainly decline from current levels between $45 and $50 per barrel, the global supply and demand picture demonstrates that a much lower price level would be unsustainable. 

However, while the physical oil markets are now re-balancing, the structural imbalance in the energy capital markets may be yet to reach such a point. While beyond the scope of this memo, it should be clear that drawing the conclusions we have about the state of the oil market is entirely different than drawing conclusions about the profit potential available to an equity investor in an oil producer. Many energy companies still must cope with large debt loads, much of which was incurred at substantially higher energy prices. While the new oil fundamental picture will continue to be constructive for many areas of the energy markets, capital restructuring adjustments may continue for some time.


SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Lowest Interest Rates in 5000 Years?

Positive interest rates are such an embedded cultural norm that Wimpy’s offer to Popeye, written by E.C. Segar in 1934, that he’d “gladly pay him Tuesday for a hamburger today” was often heard nearly a century later. And it never lost its hilarity and relevance as a wisecrack…until now. With over $7.8 Trillion (and growing!) in negative interest rate loans in the global market place today, it’s as if investors the world over were flocking to Popeye’s restaurant begging to pay right now for a hamburger next week. If we bought hamburgers with $7.8 Trillion and stacked them up, we could eat hamburgers all the way to the moon. It’s an incredible sum paying for the privilege of being lent. “Please take my money, I’ll pay you when you decide to give it back.” You can’t make this stuff up. Milton Friedman would roll over in his grave.

This note focuses on the history of interest rates and the consequences of changes in interest rates levels. There is an effect on both asset prices and portfolio strategy. We first take a (very) long term look at interest rate history and where the current levels are relative to that history. Then, we discuss three important investment implications of very low historical rates and briefly touch on some portfolio strategies we can use. Future notes will focus more directly on strategy.

Interest Rate History

Interest rates are low now and have been falling for thirty-five years. But before that 1981 peak, interest rates rose for thirty-five years. In order to put things in perspective, let’s take a very long look at American 10-year Treasury rates. This is the interest rate paid by the United States government on money borrowed for a period of ten years with a bond issued in exchange for funds. Below is a chart attributed to Bank of America Merrill Lynch’s Michael Hartnett (and the research team at BofA ML).

During this period Hartnett references five different rate change periods 

1790-1902: Erratic yield fluctuations and then a sustained decline in yields to below 3%.

1902-1920: The First Bear Bond Market, yields rise from 3% to 5-6%.

1920-1946: The Great Bull Bond Market, yields decline from 5-6% to below 2%.

1946-1981: The Second Bear Bond Market, yields soar from 2% to above 15% during 1981.

1981-present: The Greatest Bull Bond Market, as yields tumble from 15% to 1.4% in 2012 (and under 1.6% earlier this year).

However, we can “zoom out” even more! Last September Business Insider’s Elena Holodny presented an even longer term chart (this one prepared by Bank of England and Global Financial Data). 

Andy Haldane of the Bank of England provided the following annotated list of key historical episodes and the corresponding interest rate of the time:

3000 BC: Mesopotamia: 20%

1772 BC: Babylon, Code of Hammurabi: codified earlier Sumerian custom of 20%

539 BC: Persian conquest (King Cyrus takes Babylon): rates of 40+%

500 BC: Greece, Temple at Delos: 10%

443 BC: Rome, Twelve Tables: 8.33%

300-200 BC: Athens/Rome, first two Punic Wars:  8%

1 AD: Rome: 4%

300 AD: Rome, under Diocletian:  15% (estimated)

325 AD: Byzantine Empire, under Constantine:  limit 12.5%

528 AD: Byzantine Empire, Code of Justinian: limit 8%

1150:  Italian cities: 20%

1430: Venice: 20%

1490: Venice, (Leonardo da Vinci paints "The Last Supper in Milan): 6.25%

1570: Holland, beginning of the Eighty Years' War: 8.13%

1700-1800: England: 9.92%

1810: US, West Florida annexed by the US: 7.64%

We see that global interest rates are currently at or very close to the lowest interest rates in 5000 years. Certainly the interest rate “ride” of the past 35 years looks like a historical anomaly and unlikely to continue indefinitely. What are we to make of this and what are the implications to us as investors?  

Investment Implications

Think of interest rates as the “price” of borrowed money and also correspondingly as the rate of return on loaned money. More borrowers and less lenders means rates go up. More lenders and fewer borrowers mean rates go down. 

Declining interest rates also mean increasing bond prices. For example, if we were to buy a 10-year US Treasury bond yielding 5% and the 10-year US Treasury interest rate subsequently fell to 3%, the market price of our bond would increase (because in an open and liquid market trading at 3% would mean that the price of each similar bond would adjust up or down until a buyer of any of these similar bonds would earn the same 3% market rate.)

The following example from thismatter.com shows the effect of interest rate changes on bond prices (in this case a bond with a coupon of 6%:

“Bond prices — not including accrued interest — vary inversely to market interest rates: bond prices will decline with rising interest rates, and vice versa. Bonds with longer effective maturities, or durations, are more sensitive to changes in interest rates, as can be seen in the diagram below, showing the price/yield curves per $100 of nominal value, as the market interest rate varies from 1% to 16%, for a bond with 3 years left until maturity and one with 10 years left, both with the same 6% coupon rate and paying interest semi-annually. Note that both curves intersect at $100 when the market yield = coupon rate of 6%.” (thismatter.com)

If you are with me so far, here is first of three important observations for investors:

Over the past 35 years, fixed income (bond) investors have greatly benefited from the general decline in interest rates because they have earned the yield of their investment PLUS the price appreciation of the bond due to falling interest rates.

When we look at a broad measure of the US bond market (in this case the Barclays Aggregate Index), we see historical annual returns on bonds exceeding 8% since 1980. This represents the combined return of both the bond yield and the price appreciation that occurred as interest rates fell. 

The US Federal Reserve (Fed) began the process of inching rates back toward what they consider as long-term normal last November. The Fed estimates short term interest rates in the 2%-3% range (roughly equivalent to the long term inflation rate) to be the longer term steady state level. This roughly corresponds to US Treasury bonds yielding something like 4-6%. Currently the 10 year US Treasury yield at 1.9% is more than 3% below the mid-point of this range. 

If interest rates trend upwards towards this longer term steady-state range, investors could expect to again earn the bond yield plus the price appreciation due to declining rates. But as interest rates rise, this price appreciation is now negative rather than positive. So fixed income investors find themselves between a rock and a hard place. With Treasury bond interest rates below the rate of inflation, the offer little return and with little room for rates to fall further (pushing up prices). If rates simply remain where they are today, meager yield offers very little investor return. If rates rise, this small yield offers little cushion against the accompanying decline in bond prices. At minimum, today’s bond investors have little reason to believe that their forward-looking returns will resemble recent historical returns.

And now the second point. The interest rate impact on asset prices has not been isolated to bonds.

As rates have fallen many other asset prices have also benefited via substitution and financing effects. This means that these other classes of assets (like stocks and real estate) have also had the advantage of an interest rate tail-wind in recent decades.

As an example of the substitution mechanism, imagine a recent retiree faces an investment decision. She can either buy a 5-year Treasury Note paying a 5% yield (as was common just a few short years ago) or invest in the stock market with obvious additional risk in the hopes of achieving additional return. Her choice would depend on her need for income, risk preferences, and overall financial situation, but a reasonable approach would be to own some of each of the options as many actual investors have done for years (i.e. a typical 60/40 stock/bond portfolio). Now what happens when the bond pays close to 2% and our same investor has the same need for return and yield? It gets much more tempting to “reach for yield” and increase the percentage allocated to the stock. 

Extend these types of substitution decisions across the global asset market place, and we can certainly understand how declining yields in one area of the market could affect prices and yield in other areas of the market. Data seems to confirm this effect. Using the same post 1980 time-frame as before, see the following chart of S&P 500 earnings yield and 10-Year Treasury yield over time:

Keep in mind that as stock prices increase for a given level of earnings, the earnings yield will decline since it takes more money to buy the same amount of yield.

We can also derive financial transmission mechanism from lower interest rates to higher asset prices based on borrowing prices. For example, a house is typically purchased with a fixed rate mortgage. Putting 20% down and assuming a 30 year fixed rate mortgage, a $250,000 home could be bought for a monthly payment under $1000 at a 4% mortgage rate. However, if mortgage rates were to rise toward 7%, the same monthly payment would only buy about $180.000 worth of house (assuming other variables stayed constant).  Data upholds this directional relationship as a national home price index rose roughly 400% since 1980 as interest rates fell from over 18% at their peak.

Another example of financial transmission would be an institutional investor (think bank or hedge fund or manufacturing company) with a borrowing cost of 5%. If an investment opportunity yielded an expected return of 8%, the investor could borrow at 5% and earn the spread of 3% (8%-5%) between the investment return and his cost of borrowed funds. If the investor’s borrowing costs fell to 2% due to a general decline in interest rates, the “hurdle” or necessary expected return, falls also. So this investor could now afford to pay more for the same opportunity because even a 5% expected return yields the same 3% expected spread (5%-2%). Thus substantial and sustained changes in interest rates permeate the economy as a whole providing capital gains to current investors and reducing yields (and expected forward-looking returns).

In addition to these return and asset price effects of a prolonged period of declining interest rates, there is also an important portfolio strategy implication. 

During periods of very low interest rates risk reduction is difficult. Volatility often rises while traditional diversification may be both costlier and less effective.

It has been shown that when interest rates are low, asset correlations (statistic measuring how closely the direction of movements are “linked”) and volatility often increase (statistic used to measure risk). Increased correlations mean diversification provides less “bang for the buck” because a portfolio of assets that move independently of each other provide risk reduction, whereas if the asset prices increasingly move together (increasing correlation) the portfolio risk becomes closer to simply the sum of each asset’s risk, reducing the benefits of diversification.

Furthermore, as interest rates decline, the loss of equity risk premium (the additional return historically available to stock holders in excess of the return available to bond holders) becomes proportionally more important. Note that the following table is for mathematical illustration alone and represents neither actual past or expected future returns. If stock and bond returns were separated by a 5% equity risk premium, we can compute the returns of a 50/50 mix of stocks and bonds at various rates returns. Of course this is a complex and non-linear relationship, in real life. However, the point here is that in a low general interest rate environment, alternative sources of return (for example, the equity risk premium in this case) grow increasingly important.

Tacking Into Possible Headwinds

In summary, we can draw a few specific conclusions:

•    The investor experience of the most recent 35+ years since 1980 was relatively unique within a long span of history because of the magnitude and persistence of interest rate declines over that period.

•    Based on historical data, this seems unlikely to continue for much longer. In fact, it appears that this downward trend in rates is likely to at least end and possibly be reversed in the future.

•    If this historical interest rate tailwind subsides, or potentially reverses into a headwind, asset classes that benefited previously from the downtrend in rates will at least have this advantage removed and could potentially face an interest rate disadvantage for some period of time.  

All of this has a somewhat negative tone, and it is important to note that the outlook is not negative at all for the investor willing to think outside the box. Using longer-term mean reversion among asset classes is important. Certain areas of emerging markets and commodities look historically undervalued. The recent trends that have left US stocks and global bonds well above long term averages have been nearly mirrored (in the negative form) in many markets ranging from Copper, to Natural Gas, to Oil, to Brazilian, Indian, Chinese, and Russian stock markets. The headlines in the former asset classes are optimistic, and cheerfully hopeful. The news on emerging markets and commodities are scary and negative. The setup in such unloved assets therefore appears quite attractive to the patient long term investor.

Another way to think outside the box involves looking for ways to purchase “insurance” against the under-performance of a specific group of assets. One of the best assets to hedge against “systemic” risk has always been gold because of its nature as a currency, its portability, and its liquidity. In a negative yield world, the fact that gold is just money and doesn’t pay a yield becomes a positive trait rather than a negative one. Other real assets without associated liabilities can serve a similar role. 

Our forward-looking strategy toolkit includes:
•    Using long term mean reversion concepts to look for unloved and under owned assets.
•    “Store-of-value” type assets with inverse correlations to traditional financial assets.
•    Taking advantage of expected increased volatility by raising cash balances and deploying into market sell-offs.
•    Limiting exposure to relatively overvalued areas of the equity markets.
•    Reducing bond exposure and minimizing the duration of bond holdings.

At some point in the future interest rates will approach a more viable level. Until then, we need to be aware of the headwind potential, nimble, and ready to engage in tacking into the wind. Taking a macro view in the search for undervalued and unloved assets (particularly ones with low correlation to our other holdings) is always good investing strategy. We plan to continue this discipline under all circumstances.

References

BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, 2016

Business Insider, 2015, <http://www.businessinsider.com/chart-5000-years-of-interest-rates-2015-9>

Business Insider, 2015, <http://www.businessinsider.com/10-year-us-treasury-note-yield-since-1790-2015-2>

Haldane, Andrew, “Growing, Fast and Slow” Bank of England 2015

https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/the-expected-real-interest-rate-in-the-long-run-time-series-evidence-with-the-effective-lower-bound-20160209.html

http://www.calculatedriskblog.com/2013/06/house-prices-and-mortgage-rates.html

MULTPL, 2016, <http:// www.multpl.com> (Chart Data)

Bankrate, 2016, <http://www.bankrate.com>


 
SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

  

Clunkers

clunkers

Isn’t war massive economic stimulus and didn’t World War Two finally drag the United States out of the Great Depression? Why not a government to mandate a maximum life on all automobiles? Why doesn’t the government mandate a certain minimum “fair” compensation for workers? Wouldn’t these workers then be able to spend more money? Wouldn’t that be good for them and for the economy? Destroy the old, rebuild with new, raise wages for everyone. Oh the growth, the jobs, the wealth! 

Snarkiness aside, one of those ideas was actually enacted in 2009 as “Cash for Clunkers”, only to see a National Bureau of Economic Research (NBER) working paper published finding “no evidence on employment, house prices, or household default rates” benefits from the $3 Billion program. Another subsequent NBER paper concluded that sixty percent of the subsidies went to households that would have purchased during the period anyway. The remainder did accelerate auto sales by less than eight months. However, this initial acceleration was matched by an equal reduction in sales in subsequent months. The program’s cost in hype, inefficiency, and distraction went unmeasured. 

Economic quackery is often passed out in soundbites that appeal by highlighting obvious benefits of a proposed action, while ignoring sometimes obscure or delayed negative effects. This is particularly effective when the positive benefits are concentrated on a certain economic group (whose members lobby for the action of course), and the negative effects are widely dispersed across a larger population.

"There is a persistent tendency of [people] to see only the immediate effects of a given policy, or its effects only on a [certain] group, and to neglect to inquire what the long-run effects of that policy will be not only on that group, but on all groups. It is the fallacy of overlooking secondary consequences. The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy no merely for one group but for all groups" -Henry Hazlitt

Many of ideas and examples in this piece are borrowed from portions of Henry Hazlitt’s wonderful tome “Economics in One Lesson”. Originally published in 1946 and most recently updated in 1979, it combines cogent readability with biting wit. Hazlitt displays an interesting and often humorous perspective on economics, liberally and pointedly laying all about with his version of Occam’s Razor. 

The Broken Window

One of our favorite examples of secondary effects and their importance is Hazlitt’s example of a broken window, and the economic consequences that follow. Let’s assume a young vandal has just thrown a brick through a grocery store window. The store manager runs our furious but the perpetrator is gone. A crowd gathers and begins to stare at the gaping hole in the window and the shattered glass. 

After a while, the crowd feels the need for philosophic reflection on the act and its consequences, and several people are almost certain to remind the store manager that there is a bright side to the misfortune. After all, it will create some business for a glass maker. How much would such a window cost? Maybe a few thousand dollars? That would mean a decent amount of business for the glass-maker, but the possible benefits wouldn’t stop there. In fact, the glass maker will pay a salary to the installation technician who will then be able to spend money on goods and services. This will in turn bring additional business to those merchants. So the smashed window will go on providing money and employment in ever-widening circles! The conclusion of the crowd is that the destructive act was actually a publicly beneficial one.

The crowd is in fact correct in their initial conclusion that the act of vandalism will mean additional business for the glass manufacturer and another job for the window installer. However, the store manager will be out of the few thousand dollars he planned to spend on a new delivery vehicle (or some other equivalent need). Instead of having a window and a delivery vehicle that day, he just has the new window and no vehicle. If we think about the overall economic community as including the glass maker, the auto dealer, and the grocery store owner, there is no net gain and in fact there is a loss because the resources that would have “produced” the delivery vehicle merely “replaced” the window.

The key here, is that by forgetting about what the store manager could have bought with the money he instead paid to replace the window, the crowd’s calculus only considered roughly half of the economic consequences of the event. This is unfortunately common in economic analysis. It is easy to forget entirely about the negative consequences of actions and transactions that never happens. These obscured economic opportunities that failed to become activities, are what is meant by “secondary consequences”.

The False "Benefit" of Destruction

Having finished with the Broken Window, let’s apply this same line of thinking to destruction, war, and ultimately Cash for Clunkers. The key thought process remains the same, specifically the consideration of the secondary consequences. In the case of the destruction caused by war (or any other physical calamity), and the subsequent increased demand often cited as an economic benefit, it is helpful to think in terms of property and of the exchange of value rather than the more abstract notions of supply, demand, money, and GDP. No one would want to have his own property destroyed by a war. Anything that is harmful to an individual cannot be beneficial to a collection of individuals in net. 

Of course it is true that destruction can move benefits from one pocket to another (from the auto dealer to the glass manufacturer in the Broken Window example). In the case of the World War Two, it was indeed destructive to the global economy overall and Europe specifically, but proved beneficial for some period to the American economy while the United States remained out of harm’s way. However, it is important that this shifting in resources results in a net loss to the “system” (however defined) even while creating relative winner and losers within the “system”. The magnitude of destruction and loss evident in Europe and Asia went far beyond the beneficial economic growth that happened in the United States.

This is exactly what happened with the Cash for Clunkers program, initially pitched as a net economic stimulus. In the short run, it is easy to list the winners. Automakers certainly weren’t hurt. At worst they sold more vehicles now and fewer later. The most obvious beneficiaries on the consumer sider were the fortunate few who were planning on buying a new automobile to replace an aging vehicle anyway. Free money fell in their lap. To a lesser extent, as the NBER research concluded, benefits accrued to those planning to buy a new vehicle in the next eight to ten months. These individuals were able to gain marginally by “pulling forward” their vehicle demand (in exchange for a rebate) by a few months. Of course, this meant that the demand that otherwise would have been there in the future went missing-in-action.

But government cannot create wealth (barring certain special circumstances). What was given to the beneficiaries of the Cash for Clunkers program had to be taken from someone else in the form of taxation. What would these funds have purchased? What investments or consumption would have been improved? No one will ever know for sure, and these secondary consequences may be estimated, but will never be measured.

Now of course, critics of this line of reasoning would point out that the new automobiles are more efficient and therefore our analysis misses the benefit of the upgrade. Similarly, it was sometimes said that post-war Germany and Japan had an advantage over their American industrial rivals because they had newer plants and equipment (due to the need for replacing destroyed factories). But if this were really an advantage, the Americans could have offset it immediately by wrecking their old plants and junking the all of the old equipment. This didn’t happen. Owners of truly worthless Clunkers could have towed their vehicles to junkyards and bought new already, but they hadn’t until they were offered the hefty rebate.

There is an optimum rate of replacement for old plants, equipment, and automobiles. This optimal replacement occurs when new utility is significantly enough improved over old utility to justify the investment (given utilization and interest rates). The only advantage in destruction for a manufacturer would be if she were to have her plants destroyed at exactly the moment of optimal replacement. At any other time, destruction of old plants and equipment is merely destruction of capital. Destruction of capital, however marginal it may be, is never advantageous to the owner of that capital.

Minimum Wages

While we’re at it, let’s wade directly into the emotional and often politicized topic of wage controls (i.e. minimum wage). It seems silly to think that general prosperity could be increased by artificially boosting prices doesn’t it? Similarly, very few would today argue that general government price controls (mandating low prices) lower was doing anything but harm to its economy. To that effect we have the shining example of Soviet Union. But surprisingly many people have a concept that a minimum wage is somehow economically beneficial. If it isn’t true with prices, it can’t be true with wages. In fact, the opposite is true. The more such a law attempts to raise wages, the more harm does. 

To flesh this out a bit, let’s say that government mandated a minimum full-time wage equivalent to $100,000 per year. The first thing that would happen is that no one who is not worth $100,000 per year would be employed at all. You can’t make an employee worth a certain sum by making it illegal to offer him or her anything less. Such a policy simply substitutes unemployment for low wages. Under such a mandate, the former employee capable of $75,000 worth of economic output is now claiming unemployment because no company can afford to take incremental losses for each employee. 

There is an economic concept of equilibrium. Equilibrium wages and prices are those that equalize the production of stuff and services (supply) with the consumption of that same stuff and services (demand). If wages are pushed higher than the equilibrium level set by market forces in the employment market, the effect would simply be to reduce the supply of jobs and therefore increase unemployment. The best level for wages is not the highest level, but rather the level that results in the best possible levels of overall production and employment.

To add two minor disclaimers, there are a (very) few special situations where wages could be held below “market value” and in such specific cases government action may be appropriate. Also, these comments are not political in nature. We certainly aren’t “against” wage earners or high wages. However, we must consistently point out the economic costs of secondary consequences. If improving the lot of a particular set of workers was the policy goal (and a certain level of associated cost considered acceptable) then there are more economically efficient ways to accomplish that goal than falsely justified wage and price controls.

Summary

We began with some questions (with acknowledged sarcasm). But each of those demonstrably incorrect positions, have been taken by various experts and talking heads. These type of fallacious economic thinking do real economic damage to everyone in the economy. Interference in normal market mechanisms no matter how well-intended, has adverse secondary consequences even when those effects are difficult to specifically point to and measure. 

The Broken Window initially appeared to be net positive to the local economy. Destruction wrought by war or natural calamity is often misconstrued as beneficial. A minimum wage sounds like a benevolent policy. Until we trace the full consequences over time, the soundbite quackery can be appealing. But we must account not only for the immediate impact of a given economic action or policy on a particular group, but also the impact on all groups over all time. Secondary consequences (things that don’t happen) are tough to measure and are often overlooked. 

Cash for Clunkers was a real government program that passed Congress with little resistance. The concept sounded good, and the soundbites cheery. What could possibly be wrong with replacing old clunkers with newer more efficient vehicles? But secondary consequences were swept under the rug or ignored altogether. There is simply no free lunch in economics. Benefits and behavioral incentives can be directed to particular groups, but there is always a cost for doing so. In many cases the costs far outweigh the benefits.

References

Hoekstra, Puller, & West, “Cash for Corollas: When Stimulus Reduces Spending”, NBER Working Paper No. 20349, July 2014

Mian & Sufi, “The Effects of Fiscal Stimulus: Evidence from the 2009 ‘Cash for Clunkers’ Program”, NBER Working Paper 16351, September 2010

Hazlitt, Henry, “Economics in One Lesson”, Three Rivers Press, NY, New York, 1979


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