The failure of governance and the uncertainty curve
Tuesday, February 5, 2013 at 03:53PM Phineas Taylor Barnum constructed and marketed his fraudulent Figii Mermaid to the crowds, and his spirit lives on.
"I am a showman by profession...and all the gilding shall make nothing else of me,"[1] .
At least Barnum, setting aside for a minute the notion of authoring two autobiographies, remained sober in his perception of reality.
For stark contrast we would highlight for the attention of our national policy makers that certain corporate issuers of investment grade debt have periodically traded at negative spreads to their US Treasury benchmark, that is at lower rates than the comparable Treasury note. A capital markets redux of The Emperor's New Clothes?
We would be remiss in the interests of showmanship if we did not note that our longstanding bias to short term investment grade product has been well documented on these pages, but the appearance of negative spreads to Treasuries of short investment grade product evidences the more complex, problematic issues (the answers to which appear at the end of this post):
- It shouldn't happen, but it did.
- What is the phenomena telling us?
- What to do going forward?
The risk profile of US fiscal policy and the anticipated trajectory of the government's funded & unfunded liabilities all remain surrounded by uncertainty, and we see no reason for that trend to change. We do recall dimly the old fashioned three "C's" of credit: Character, Capital & Capacity, and soberly note with regret that the US now joins the clown show of most euro sovereigns. We get sell high and in that vein under weighting some investment grade spread product seems like a good trade, but what to buy? Like Scarecrow in the Wizard of Oz, we currently lack conviction in most options, so we shall, like politicians, do nothing and talk about other things.
We have long held that genius is a rising market and need look no further than the recent equity markets of late to claim our proper & visionary status. Below for comparison are price charts for VTI (Vanguard's Total Stock Market ETF) and BND (their Total Bond Market ETF) for the dates specified.
Boom ... a good example of outsized returns clustered in a short period of time, a characteristic of equity markets. It also shows how much the market will pay for just the ever so slightest clarification of policy, let alone clarification of effective policy.
We stipulate that the global corporate 1,000 in the main is well positioned from a cost and systems perspective. There isn't an ounce of fat in the cost structure, supply chains are well managed, and uptick in the top line will create an object lesson in operational leverage, remarkable earnings. Even if margins slide sideways to slightly down, there may adequate cash to support significant share repurchases to juice EPS another few percent for a few years even in face of low or periodically negative growth. The updraft could be real, but at some point you must have support of real sustained economic growth. And we have no clue if that growth will come to pass.
We do know that low growth plus inflation equals stagflation, and the inflation indicator taken as the spread between TIPs and nominal bonds below is not comforting
And money velocity, a proxy for demand, is not encouraging:
So we have the table set with low growth, moderate inflation, escalating pressures on over leveraged governments, social contracts, and economies globally. We've previously talked about the impact of the Treasury bubble and our concern with the impact on asset prices in general, and it manifests itself in a variety of ways.
The Financial Times advised a bit ago that KKR is launching two investment funds to be distributed to retail investors, a signal event of market froth. Let us quote:
The move comes as buyout firms are finding it harder to identify reasonably priced companies to take private and are raising smaller funds than they did at the peak five years ago...One lawyer who heads the private equity practice at a leading New York law firm said: “The game is now to grow assets under management, rather than to grow carried interest,” referring to the 20 per cent cut of profits that private equity companies take when they sell portfolio companies. He added: “It’s all about fees and asset size now" ... co-founder George Roberts will be at the KKR booth at a Charles Schwab sales event next week...”
Hmmm... evidently it's time to stuff retail now that it is harder to find reasonably priced companies, and the source of compensation will be shifted from value-added to volume. We call to mind a conversation we had with a major, if not the major, player globally in timber royalty limited partnerships. He noted that one of the larger properties in Scotland was coming on the market but dryly noted the best real returns he could see coming off the project were about 1/2% p.a. Times are tough all over. KKR's underwriters know that either the product goes or they go.
Shall we now be surprised to learn that Wealth Management Lures Big Banks? And why not? "That's where the money is". Dazed, we call to mind the entirety of the financial crisis & one of the quotes to be found in Our Philosophy made in particular reference to a leading wealth manager:
"It's hard to make a case to someone wealthy that you can manage their money well when you've just lost $37 billion yourself," said Dirk Hoffmann-Becking, an analyst at Bernstein Research (WSJ, April 4, 2008; C1)
And compliance? Stability of rule of law? Bear traps? Dispassionate enforcement? What Great Whale? No worries. We learn from No Individual Charges In Probe of J.P. Morgan that "The top U.S. securities regulator doesn't intend to charge any individuals in its planned enforcement action against J.P. Morgan Chase & Co. for the allegedly fraudulent sale of mortgage bonds, according to people close to the investigation. The largest U.S. bank by assets will pay a significant financial penalty under the proposed deal, which has been approved by Securities and Exchange Commission staff ... said the people close to the probe." One might well ask, do we have fraud or not? If so, why not prosecute it as such? Are not defendants innocent until proven guilty? Or do we have a regulatory who's-your-daddy shakedown? Too Big to Jail? Or the current S&P shakedown? One might think there is an acute public interest in finding out. In either case, Willie Sutton is right again, that's where the money is. And the message is we can end you.
On the macro front our expectation is for real GDP growth for the coming year ranges from .50% to 1%. We leave OMB to its bowl of medicinal cannabis and forecast of 1.4% this 2013 and 3.6% for eternity. We expect it to be choppy and perhaps include a negative number here or there. In general we're in general accord with the Predictions of John Cochrane, particularly,
I have no idea what any of this means either. I do know that hundreds of billions of dollars are at stake, and the involved industries, their lawyers and lobbyists, are furiously "helping" to write all these rules.
This is the real news. It's baked in. Any new regulatory agendas come on top of this. And it will remake the American economy in the next four years.
The point here is not good or bad. I'm just forecasting what is going to happen -- and it seems clear to me that writing, haggling over, implementing, challenging, and repairing all this regulation is going to be the main story about actual economic policy for the next four years.
Our concern is two fold: first, we suspect permanent full time job growth will stay very low as we have seen or perhaps go negative. Our second concern is the paralysis of capital investment. No healthy economy can be sustained without growth in employment or robust capital investment. Low growth is low growth. We're 0 for 2. Why?
We have argued with no end of hot air that the uncertainty, imbecility & instability of major policy issues - tax, monetary, regulatory, energy, health care ... essentially the fundament of our economy - have profoundly impacted economic activity globally. We were pleased to find Measuring Economic Policy Uncertainty in which the authors try to estimate the impact in magnitude and duration of economic uncertainty. We strongly recommend the article from which we borrow the picture below. These are really big numbers and long time frames. They evidence the huge agency cost of poor leadership.
Looks just like a hurricane forecasting map, doesn't it? That's because it is. Our economic Sandy, if you will.
These are large scale numbers with long tailed impact on our national standard of living. In the meantime citizens watch the Administration and Congress manufacture uncertainty and use it to create political leverage and/or monetize it with rent seekers. They defer the budget issues for another quarter as they sort through the mess of the tax code, figure out how they're going to continue to spend more than they have or can get, and issue more debt than is prudent. Look at the re-write of all the regulations in the last 6 years. And by the way would you care to make a contribution while we sort this stuff out? The deferral extends uncertainty which elongates the time frames in the pictures above and likely increases the risk bands. It lowers our standard of living.
Last year the Fed, courtesy of Mr. Bernanke who should pay attention to the chaotic non-linear part of this stuff, purchased, if memory serves, about 80% of the entire term issuance of US Treasury bonds. We now see the emergence of negative spreads on short investment grade product and sustained negative real rates inside of 20 years with dramatically further downward migration over the last year.
We recall the admonition "if you push it hard enough, it will fall over" but perhaps we err? Obama has terminated his Jobs Council. He is brimming with confidence but we can't help but consider the dismal facts below:
Or the happy state of which the WSJ informs us, that Low Rates Force Companies to Pour Cash into Pensions, the very same position of any citizen trying to save for retirement or fund a college education or two. At least the corporations, unlike many states & municipalities, have some cash to do it... at least for now. Or consider the magnitude of increases in health care that are working their way through the private health care system.
How will these issues resolve? Ask Ben? Barry? Who knows?
We shall wait and and watch the uncertainty curve extend. No doubt the pressures will increase as the costs of the current and past deferral of global and domestic fiscal excess trickle out the bottom of the dam.
Now the answers:
- It shouldn't happen, but it did.
When investors pay lower rates for select investment grade issues than the comparable Treasury benchmarks it evidences the erosion of US debt as a safe haven. We may have seen the start of the passing of the baton. Real negative rates shouldn't happen either, but there they are, a function of fear, uncertainty & lack of opportunity.
- What are the phenomena telling us?
All are indicia of systemic stress across the global markets. All the bad assets went somewhere, actual wealth was lost. The Fed and the US Treasury, rather the US taxpayers, ate it, stored it, and since the costs are trickling out. The financial crisis is not solely responsible for our current economic malaise. Government has compounded the cost with bad policies, poor execution, unproductive investment, and counterproductive consumption.
You can't see opportunity cost & kurtosis. Some speculate this is symptomatic of or preparatory to the eventual loss of the US $ as a reserve currency. We're not ready for that tin foil hat ... yet, but we'll see. Our concern about the bond bubble is ongoing & well documented on these pages.
- What to do going forward?
The US economy might go very well or just well enough to enable rising US equity markets in conjunction with slightly rising interest rates. Foreign equity may tag along. Things might be very good or things might be very good until they're not.
Beta, duration, liquidity, credit & counterparty risk are the same everyday matters of basic portfolio management. They also sum to systemic risk. Pay attention. Manage them.
hb
The Fed's Asset Inflation Machine by George Melloan excerpted:
The Fed policy of quantitative easing is designed to rebuild the asset inflation edifice that collapsed in 2008. German banker and economist Kurt Richebächer provided some of the earliest warnings of the dangers. In his April 2005 newsletter, he wrote that "there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output.... Richebächer added that "a credit expansion in the United States of close to $10 trillion—in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000—definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation." ....
The "wealth illusion" of asset inflation is seductive, which is why central banks in charge of a fiat currency and subject to no external disciplines so often drift in that direction. Politicians smile in satisfaction and powerful Washington lobbies cry for more.
But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long."
hb
Where's the Inflation? John Taylor WSJ video
hb
What's holding back the US economy? - Must watch & hear straight from the horses's mouthes. Btw - this video was posted subsequent to our commentary. This discussion is exemplary and informative, and all the participants, including the Booth School of Business, should be commended.
hb
portfolio strategy, systemic risk, uncertainty
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