The price of everything

Sacrificing some sacred cows

“Absurdity, n.: A statement or belief manifestly inconsistent with one’s own opinion.”

- Ambrose Bierce, ‘The Devil’s Dictionary’.

 

Certain combinations of words can be virtually guaranteed to lower the spirits. One thinks of constructions like “Michael Winner”; “diplomatic solution”; “Ricky Martin”; “Big Brother” (the Endemol incarnation, as opposed to George Orwell’s). To which grim list we can now add “academic studies” and “the wisdom of pension funds”. In a letter to the Financial Times, investment manager Evan Salway alludes to the futility of academic studies when contemplating the benefits of active versus passive management. He goes further and cites the debatable wisdom of those pension funds who, having largely ignored the biggest equity bull market in history (1982-2000), finally took the plunge – at the start of 2000 – and cheerfully switched out of bonds and into stocks just in time to a) get hosed by a catastrophic bear market in stocks, and b) miss out on a monster rally in bonds.

 

Mr. Salway points out that while academic studies of active versus passive management may suggest that the average active manager underperforms, such studies can easily be challenged, not least because they tend to focus on long-only investing. But regulators have made it increasingly easy for active managers to sell short as well as trudge along the long-only treadmill. It is difficult (though not, sadly, impossible) to believe that there are investors out there who cling resolutely to the “long-only is best” school of guaranteeing sub-optimal investment returns. He also suggests that with much corporate newsflow pointing to the adoption of passive management by pension funds,

 

“at such an inflection point in capital markets when choosing between active and passive on a historical performance basis, it is [perhaps] just as dangerous as choosing between equities and bonds on that basis in 2000.”

 

To descend to the ‘policy out of the rear-view mirror’ level of pension funds for just one moment, a comparison between the benchmark hedge fund index and the benchmark global equity index makes a striking argument in favour of the former. Between 1994 and 2008, hedge funds – as represented by the CSFB / Tremont hedge index – returned an annualised 10.7%. Stocks – as represented by the MSCI World index – returned an annualised 6.3%. The data haven’t been arbitrarily “fixed”: the Tremont index doesn’t go back beyond 1994. Not only did hedge funds, in aggregate, deliver 68% higher returns per year – after fees – than stocks, but they did so with significantly lower drawdowns. Hedge funds’ worst period historically (July-October 1998) incurred a drawdown of 13.8%. That is shorter in duration and shallower by comparison with the 30-month drawdown of 48.4% suffered by the global stock market between March 2000 and September 2002. In crude terms, with the benefit of hindsight, which market would you rather have owned ?

 

Some caveats may be required. Survivorship bias – which removes failed businesses from the indices – will be present, but in both indices. And it could turn out to be the case that the hedge fund industry, having seen huge capital inflows during the period as it grew toward maturity, has delivered its best returns. But the single biggest caveat is that we are not realistically comparing like with like: equities constitute a discrete asset class; hedge funds comprise an altogether broader school of disparate individuals who putatively represent talent. Whereas the equities asset class is by definition long-only, the hedge fund sector is effectively unrestrained, whether in terms of investible assets (anything), positioning (long or short, or both), or leverage.

 

The fragility of academic study of investment is that, as with economics, it presumes the existence of a closed, scientifically rational system. Not only are there multiple players within the markets with multiple approaches and beliefs and multiple relevant time horizons, not even a majority of that varied crowd can ever realistically be described as entirely rational. And whether or not there is an information gap between the academics who study the markets and the professionals who work within them, there is undoubtedly a wealth gap, the existence of which carries its own conclusions.

 

On the topic of pension funds, Bloomberg’s Caroline Baum (“Pension funds ‘diversify’ into commodity bubble”) quite fairly points out that while other asset classes enjoy metrics that express the degree to which prices have travelled beyond fundamental anchors (earnings, for example, in the case of stocks, and yields in the case of bonds), for commodities “no such quantifiable ratio” (other than the crude measure of the rate of price increases over time) exists. Her implication is that now that pension funds seem to have fully embraced the commodities story, their entry into the market could easily represent a worrisome near-term top. Michael Aronstein of Marketfield Asset Management is cited with the following useful advice:

 

“If you want to be in commodities, buy a process, not a product.. Own a gas company. Or a forest products company. Buy an entity that extracts value. And you get a free option: the product might appreciate.”

 

So although the macro picture darkens daily, there are still pockets of promise within the equities markets, even if those markets in aggregate now seem to be trading on nothing more than the fumes of wishful thinking. And this gets to the heart of the “academic” wrangling over active versus passive investing. Markets and investment products are too complex to be reduced to binary decisions like (higher cost) active versus (lower cost) indexed. Investor expectations, too, are more nuanced than the academics (and consultants ?) might care to admit. In broadly efficient and relatively low-yielding markets like government bonds currently, active managers, with all their attendant costs, will have to perform heroically to outperform low-cost ETFs. In the maelstrom of equity markets, however, investor requirements and objectives are likely to be more varied. While some investors will crave outsized returns, others will have a natural preference for avoidance of loss and the pursuit of absolute returns. Both strategies demand active management. Other investors, particularly with a longer and perhaps more disinterested time horizon, will be largely satisfied with low cost passive management. But passive management comes with its own costs – particularly during a bear market that will doom advocates to tracking that same market lower. No one approach can possibly suit all. To assume otherwise does a grave disservice to those managers expending valuable intellectual capital to preserve and grow client capital in the midst of a treacherous market environment.



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The infantilization of markets

“What are the facts ? Again and again and again – what are the facts ? Shun wishful thinking, ignore divine revelation, forget what “the stars foretell”, avoid opinion, care not what the neighbours think, never mind the unguessable “verdict of history” – what are the facts, and to how many decimal places ? You pilot always into an unknown future; facts are your single clue. Get the facts !”

-  Excerpt from the notebooks of Lazarus Long, from Robert Heinlein’s “Time Enough for Love”.

 

Or instead of “facts”, he could have said “prices”. Clobbered by months of write-offs and profits warnings from distressed banks; nervously peering at the prospect of softer property prices for the foreseeable future; and overshadowed by crude oil trading north of $120 a barrel, stock markets have done the only thing one could reasonably have expected them to do – they have rallied strongly off the lows. No small thanks are due to the interventionist zeal of the US Federal Reserve. Note how US equity markets bottomed this year just before the emergency support lent to ailing (and “too interconnected to fail”) brokerage Bear Stearns.

Are we now being borne up by nothing more substantial than a relief rally ? Quite possibly. Banks and investors now seem exhausted by news of the credit crisis, and understandably want to focus on something new. Be careful what you wish for.. Pretty soon we can all get to worry about the impact of widespread deleveraging on the consumer, on consumer spending, on the services sector that defines most western equity market valuations, and whether rising food and fuel prices will start to dismantle the growth story for Asia. On which note, UBS estimates that China’s foreign currency reserves, which are currently the world’s largest, could be cut in half over coming years if grain prices were to double again from existing levels. Having until recently been a significant grain exporter, the China of 2010 is forecast to be importing the equivalent of 40% of US corn exports. Niels Jensen of Absolute Return Partners mischievously suggests that as the largest wheat exporters today comprise the US, Canada, Russia, the European Union, Kazakhstan and Australia, they might wish to set up between them an OGEC (an Organisation of Grain Exporting Countries) to match the economic clout (and vested self-interest) of OPEC in oil. As Niels indicates,

 

“..investors will increasingly differentiate between the ‘haves’ and ‘have nots’ [in food production]. And the ‘haves’ are those countries which control the world’s resources.. few countries are net exporters of both oil and foods on a large scale. Come to think about it, it is less than a handful. And no Asian country is on the list. (Italics mine.) So who is on it ? In the old world only one – Canada. In the grey zone (emerging economies but not necessarily young and dynamic populations) perhaps two – Russia and Kazakhstan. And amongst full blooded emerging economies ? No-one today, although Brazil has the potential to turn itself into a winner and so does Africa, it if can sort itself out.”

 

There are other reasons to see pockets of opportunity within equity markets. US multi-nationals will have benefited from the weaker dollar even though that trend now seems to be going into reverse; and in the realm of energy services and infrastructure, oil price strength – assuming it continues – may well outweigh the impact of a newly enlivened dollar. The Financial Times reported on Thursday that “senior officials” now have a “united” desire to see a stronger dollar versus the euro. A degree of distress at an uncomfortably high euro is inevitable in the euro zone, given the somewhat baffling monetary policy intransigence (if not liquidity provision) of the ECB. But any supposed feelings from US officials about a stronger dollar should be taken with a pinch of salt. Rhonda Schaffler and John Brinsley for Bloomberg News reported on April 16^th that former Treasury Secretary Paul O’Neill (admittedly perhaps one of the worst in the role in recorded time) had said that the

 

“’strong dollar’ policy that he and every other Treasury chief since 1995 endorsed is a vacuous notion.. It implies in it that somehow we have the ability to manage the relationship between the value of the US dollar and other currencies around the world.. When I was Secretary of the Treasury I was not supposed to say anything but ‘strong dollar, strong dollar’.. The markets actually have control over those relationships. When people say strong dollar, if they don’t mean that ‘we believe intervention can work and we’re prepared to intervene’, then ‘strong dollar’ is ridiculous.”

 

It would be similarly ridiculous to believe anything expressed by unnamed “senior officials”. But even if the sentiments expressed were genuinely felt, as Paul O’Neill points out, it is the markets, and not the central banks, that have the capital to act upon them. And according to the BIS, average daily turnover in the traditional foreign exchange markets runs at roughly $3.2 trillion. No central bank can do anything in that market other than seize onto a change in trend and hang on for grim life. The latest analysis of IMM data points to a reversal in fortunes for both the euro (weaker) and Sterling (weaker) against the dollar. Sterling’s specific exposure to a domestic banking, government finance and property crisis makes it look like a basket case currency against just about anything. Look out below.

The hopeful nature of equity market investors faced with the effects of the credit crisis (largely priced in and behind us) but also with the looming impact of economic slowdown points to the way in which markets have become juvenilized. Few investors have the patience to sit out a slowdown, so the presumption becomes that markets are now looking out to the anticipated recovery perhaps 12 to 18 months down the line. Wishful thinking is no way to manage a portfolio. In some respects, the hedge fund lobby is responsible for this infantilized approach to volatility, peddling the myth that investors can almost without effort secure constant positive monthly returns without incurring risk. But markets aren’t like that. Will the equity rally be sustainable ? The most dangerous presumption would be to presume that you really know. In the absence of such perfect foreknowledge, the argument for asset class diversification – and the avoidance of obvious equity market blackspots – remains as sound as ever.


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Pricing power: signal versus noise

“The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.” – Friedrich Nietzsche.

 

It has become increasingly accepted wisdom that commodities prices now seem to be caught in something of a speculative bubble – that speculators, in other words, have steered commodities markets away from their economic fundamentals, and are in turn triggering the growing impoverishment and in some cases starvation of the peasantry in the developing world. (As Rio Tinto’s chief economist Vivek Tulpule wrote earlier this week, high prices by themselves do not automatically constitute a bubble. It is difficult to argue, however, with Michael Jones of RiverFront Investment Group who suggests that commodities are near-term overbought.)

 

But could it be that commodities prices – those of oil, gold, industrial metals, foodstuffs – whilst evidently reflecting leveraged capital inflows are also, and more profoundly, reflecting a reality of decades of underinvestment now crashing horribly into a historic surge in global demand ?

 

To an extent, debates about the role played by speculators – whether leveraged or not – in the agricultural markets play a subsidiary role to the price action itself given the current and prospective human cost. As RJH Adams is surely right to claim,

 

“..the crux of the matter is that at these price levels the leveraged flows into grain are an imminent source of great harm. Expectations of price volatility or, where rough rice is concerned, straightforward price rises are promoting hoarding, export controls and a vicious cycle of more leveraged buying. Meanwhile, in Port-au-Prince and company, rising food expenditures have been reducing real wages by large, double digit percentage amounts.. For it does not take much of this to cause catastrophe – even though the end result, in due course, will be lower prices. The last grain boom in 1972-5 saw a major famine in Bangladesh triggered by a tripling of rice prices over a three-month period in 1974. A million, on some estimates, died.”

 

At times of volatility and human crisis, morality sits extremely awkwardly with consideration of the market. But if one is to take “speculators” to task – a definition that would have to include unleveraged individuals as well as traditional savings institutions, given the role played by exchange-traded vehicles in introducing commodities to a broader investment constituency – then one should rightly also point a finger of blame at governments themselves. As Jude Webber and Javier Blas wrote in a recent feature article for the Financial Times (“Farmers doomed to pay price for export restrictions”), moves by some countries to ban foreign sales are threatening to extend and even worsen the international food crisis. Countries from Argentina to Vietnam have either stopped farmers from selling their crops abroad or have imposed punitive taxes on agricultural exports. Given that the same farmers are beset by rising input costs (not least for diesel, seed and fertilizers), crop acreages – far from being increased as the natural response to price signals – are, counter-intuitively, being cut. As Tim Murphy wrote in response to the Webber and Blas piece, market intervention, like the proverbial flapping of a butterfly’s wings in chaos theory, leads to unforeseen and sometimes unmanageable consequences in a highly complex system.

 

Keynes famously wrote of the dangers of financial (over)trading. Speculators, he said,

 

“may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.” (‘The General Theory of Employment, Interest and Money’, p.159.)

 

Or in other words: I invest intelligently and pragmatically; you are a momentum-follower; he runs a hedge fund. It is certainly difficult to re-read Keynes’ words above without an involuntary shudder at the activities that have brought the western financial system to such an acute crisis – not exactly from “directing new investment into the most profitable channels” so much as from fooling their customers – and, quite brilliantly, themselves – into believing that mortgage derivatives of the purest lead could be transmogrified into gold.

 

At what point speculative capital starts to outweigh macro-economic fundamentals and becomes the primary fundamental in its own right is a fascinating question. But we are also living in a dysfunctional market environment where multiple price mechanisms seem, for a variety of reasons, to have broken down. That leaves classic free-marketeers in something of a philosophical wilderness. As Deutsche Bank’s Josef Ackermann commented, a little bleakly, in response to the then broadening credit crisis earlier in March,

 

“I no longer believe in the market’s self-healing power.”

 

When sovereign nations throw grit into the wheels of the market to “control” food prices, they at least have the interests of the disenfranchised at heart, even if the consequences are damaging or counter-productive. But when administrations in the developed world intervene in markets and suspend the natural pricing mechanism – most recently for mortgage-backed securities – businesses not privy to state-subsidised support (manufacturers, say, who produce things of tangible value that benefit society at large, rather than a relatively small constituency of highly paid financiers repackaging financial assets) will naturally cry “foul”. The role played by exceptional remuneration in the credit crisis was alluded to by Bank of England governor Mervyn King on Tuesday, in what is likely to be an increasingly polarising debate between City apologists and sceptics. While the Bank evidently has a watching brief to maintain low inflationary financial stability, there is precious little it can or should do to control financial sector pay in a free market. Over the medium term the governor probably need not fret unduly – the City, as a consequence of market forces, is imposing its own price control mechanisms in the form of laying off bucketloads of staff. For as long as property prices and the availability of credit are pressured, animal spirits, and headline grabbing bonuses – at least at the banks – are unlikely to be haunting the Square Mile any time soon.

At a time when the tone of equity markets has been relatively subdued, one of the week’s more prominent stock market stories was news of Mars’ $23 billion acquisition of gum-maker Wrigley. The deal was part-financed by Warren Buffett’s holding company, Berkshire Hathaway. Some commentators seized on the deal as proof of some kind of bottoming process for stocks. Making that leap seems something of a stretch; if the deal carries any significance at all, it relates to the value of Wrigley alone rather than the broader market (and, in the case of Berkshire Hathaway and Warren Buffett, to the merits of having cash on hand). But it also serves as a reminder of an investment approach barely practised in modern times – that of owning businesses outright rather than merely trading stocks. Buffett’s fortune is a testimony to business ownership and long-term stakeholding as opposed to the altogether more wildly popular practice of renting stocks. There is much to be said for owning and controlling an investment in entirety, rather than hitching a ride on the back of a tradeable asset whose momentum is ultimately in the hands of an unruly and somewhat feckless mob. That holds whether the asset is an agricultural commodity, a currency, a government bond or a glamour stock. With hedge funds controlling assets to the tune of $2.5 trillion, and more conventional managers controlling assets many multiples of that number, individual investors would do well to consider just who is truly directing any portfolio that consists heavily of listed, public securities. With some fairly blatant intervention on the part of authorities in the normal price discovery mechanism, investors may come to appreciate that they have managed to fool themselves, twice.


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Some inconvenient truths

“We are born brave, trusting and greedy – and most of us remain greedy.” – Muriel Strode.

 

Just following the investment markets this past year has been a largely thankless task. A Chinese water torture of ongoing black comedy from a now distinctly subprime banking sector has reduced formerly strong individuals – and hitherto credible financial institutions – to gibbering rubble. In the wake of Northern Rock, Bear Stearns and <insert the name of any random bank here>, the financial sector has largely taken its lumps and moved onward - if downward. Banks aren’t necessarily fairly priced yet (water may be an increasingly scarce resource; bank shareholders, however, are still in for further dilution), but the bad news is well and truly in the market. Time for the rest of us to move on.

 

In search of new enthusiasms, one opens the second section of the Financial Times with an almost giddy sense of optimism, only for one’s spirits to sag once again at around page 29 or so – the start of the London Marathon that is the Managed Funds section – lots of entrants, and plenty of them both amateurs and comedians. To view this jammed thoroughfare of third party managed funds in a vaguely positive light, it at least points to the vigour of competition in the asset management market – if not necessarily to the health of the underlying funds.

 

An anniversary that never fails to fire six bullets into one’s joie de vivre as an asset manager is that point in the early 1990s when the number of mutual funds (roughly 4,300) on the New York Stock Exchange amounted to double the number of stocks listed on that same exchange. A particularly fat tail had started to wag a somewhat vulnerable dog. Now a new book by Louis Lowenstein (the title seems to give the game away: “The Investor’s Dilemma: how mutual funds are betraying your trust and what to do about it” – John Wiley & Sons) serves to remind us of one of the financial services industry’s dirtier not so little secrets:

 

“There is a profound conflict of interest built into the industry’s structure, one that grows out of the fact that (mutual fund) management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance.”

 

The figures are startling, and drive a peculiarly large nail into the coffin of efficient market theory, or for that matter plain economic sense. Between 1980 and 2004, the assets of stock funds in the US increased 90-fold, from $45 billion to $4 trillion. Fund managers harvested a lustrous crop of fees irrespective of whether their investments rose or fell in value. (Many of the same managers spend much of their time criticizing their hedge fund rivals for charging too much fee income from the surely more ethically defensible goal of making absolute, rather than relative, returns.) What is almost painful to relate is that while the industry now manages $6 trillion in equity funds, it manages a further $3 trillion in bonds and money market funds. Portfolio theory, and plain common sense, would suggest that while there are limited opportunities to generate value (“alpha”) from inefficiencies in the equity market, there are virtually none in the bond market and certainly not overmany opportunities in the money market once fees are taken into account.

 

Mr. Lowenstein evidently marshals a number of damning arguments in his systematic dismantling of the mutual fund industry. One of the more compelling touches on the alignment of interests between manager and client. From 2003 to 2006, by way of example, the chief investment officer of T. Rowe Price (no relation) amassed ownership of equity in the management company worth over $75 million. His total personal investment in T. Rowe Price’s mutual funds amounted, apparently, to $1 million. Whatever the quality of the cooking, there was precious little eating going on. The contrast between “traditional” funds and hedge funds, in this respect, is explicit. The role played by hedge fund management fees is worthy of a whole separate jeremiad, but the alignment of manager and client interests in the form of equity participation in the underlying funds is worthy of note. Many hedge fund managers – as the failure of Peloton earlier this year revealed – have much of their personal net worth invested in their funds. That obviously betokens no guarantee of ultimate success, but if failure is the outcome, investor misery can at least enjoy some company.

 

As we have noted before, egregious fee extraction is not restricted to so-called hedge funds. Traditional fund groups are perfectly comfortable charging high fees for substandard performance. If future market returns are likely to disappoint by comparison with the now almost mythical 1980-2000 bull market, and they surely may, then the imposition of any fees whatsoever will hinder portfolio returns. As Alistair Blair, writing for Investors Chronicle, wrote last year:

 

“consumers simply cannot grasp the fact that the man sitting in front of them and the people behind him are being paid via a long-term and hugely expensive levy on the returns from their savings.. here’s a suggestion.. Investment products should be required to be sold with a warning comparing the total impact of fees over 20 years with the impact of fees on the least expensive indexed product on the market. I believe this slot is currently occupied by the Fidelity Moneybuilder UK Index Fund, which has an annual management charge of 0.1% and total expenses of 0.3%. The warning would run like this:

 

1) This product aims to deliver you a greater return than you would obtain by buying the Fidelity Moneybuilder Index Fund directly. It will need to do so because our costs are much higher. Very few people understand the effect of fees – even apparently small ones – on investment returns, SO PLEASE READ THE FOLLOWING CAREFULLY.

 

2) If you invest £5,000 in the Fidelity Moneybuilder Index and it achieves 7% growth a year for 20 years, your £5,000 will grow to £18,000. If you invest in our product and it achieves 7% growth for 20 years, the effect of our higher fees will be that you will end up with only £12,000.

 

3) But we aim to do better. In fact, even to match the Fidelity Moneybuilder, we’ll have to outperform the index by an average of 2.4% every year for 20 years.

 

4) In the FSA database of 15,000 funds offered to the public over the past 20 years, only 10 funds have achieved this kind of performance. We aim to be the 11^th.”

 

Of course, not everyone wants index performance, hence the continued rise of the hedge fund sector. But the recent divergence of the asset management industry between low-cost tracker products (now ETFs) and high-cost “market neutral” structures leaves an increasingly awkward-looking no man’s land in the middle of mongrel vehicles of no real underlying merit: funds which at best could track the market but are destined to underperform due to high active management fees. Just as the banking sector is going to see an inevitable compression in returns (if not outright consolidation) as the credit crunch allies with heightened regulation to stifle growth, so the number of managed funds should, if there is any natural justice whatsoever, finally contract as investors become increasingly familiar with both the lower cost exchange-traded proposition and with the higher cost absolute return offering. No man’s land is not a pleasant place to spend any length of time.


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‘Stuff’ versus paper

“Unfortunately, self-regulation stands in relation to regulation the way self-importance stands in relation to importance..”

-  Willem Buiter, in The Financial Times, on the latest laughable attempt by banks to weasel out of any kind of real regulatory oversight.

 

“There was a time when a fool and his money were soon parted, but now it happens to everybody.”

- Adlai Stevenson.

 

Judging from admittedly unscientific anecdotal evidence, investors seem to believe that equity markets have dodged something of a bullet. And while certain sectors (leisure goods and retailers, telecoms, financial and media – the list is not exhaustive) have all slumped since the start of 2008, the FTSE 100 as a whole is holding up pretty well against its European and even North American peers – financial relativism, perhaps, always being the last refuge of the scoundrel. But just as there is more to banking than specious attempts to evade accountability, so there is more to investing than just lobbing one’s savings into the stock market. How have other major investment sectors and asset classes fared ? We can debate subjective fundamentals, after all, until the bulls come home, but the price is where the price is. As Mrs. Thatcher said, you can’t buck the market. (And as Hank Paulson and Ben Bernanke are now discovering, you can’t market the buck.)

 

As at the end of the first quarter, the FTSE 100 index was showing a total return of -10.3%. This compares with -9.4% for the S&P 500, and with an altogether more miserable -15.6% for the FTSEurofirst 300. The Nikkei 225 was showing a total return of -17.5%, the Hang Seng an almost identical -17.4%, and Shanghai a somewhat more striking -34%. Whatever the Chinese economy is doing, in other words, its stock market hasn’t exactly decoupled from the west – more like entered a suicide pact.

 

So much for stocks. If you liked them in January, you have to love them now. As to those certificates of confiscation known as government bonds: UK Gilts, as represented by the FTSE Actuaries UK Gilts All Stocks index, have returned 0.19%. After inflation, of course, that is a loss. Bloomberg’s US Government Bond Index has delivered a total return of 4.49%. Whether that represents a meaningful real return largely depends on whether you trust US inflation data. Euro zone government bonds were almost exactly in the middle, with a return of 2.29%. As we never tire of writing, the optimal risk / reward – if there is any value inherent in government debt – is likely to be in the inflation-linked market.

 

Hedge funds, often erroneously referred to as an asset class (talent class might be more appropriate, only the phrase smacks of leaden irony given 2008’s returns), have disappointed. The CSFB / Tremont Hedge Index, as at end March, was showing year-to-date returns of -2.01% (not bad considering the stock market, but uninspiring given the essential mission to generate absolute returns in all market environments). Whether hedge fund investors are waving or drowning will be almost entirely down to strategy selection. The “traditional” strategies – convertible arbitrage (-7.6%), event driven (-3.3%), equity long/short (-4.1%) – were largely rubbish. A degree of honour was restored by dedicated short bias (+9.8% - every dog has his day), global macro (+6.9%) and managed futures (+10.4%). One does feel obliged to ask, however, whether hedge funds as a whole have just been hit by their quadrans horribilis – as FRM’s John Beech points out,

 

“The worst fear for many in the hedge fund industry has always been a bankruptcy in the prime brokerage community, and.. the threat posed by the run on Bear Stearns intensified the deleveraging process that has been occurring in one shape or form since the summer of 2007. As Bear Stearns was an important counterparty to many Fixed Income Arbitrage hedge funds, the link to losses in this sector is clear.”

 

John Beech attributes most hedge fund losses during the quarter to risk aversion trades: deleveraging, de-risking, and hedging. Hope should obviously play no role in the investment process, but it may not be inappropriate to suspect that if the hedge fund sector can weather the volatility of Q1 2008 largely unscathed, the survivors of the deleveraging cycle may be well placed to benefit from the resumption of slightly more normal market conditions. While hedge funds are supposed to benefit from volatility, you can evidently have too much of a good thing. A final aside: “multi-strategy” delivered -3.9% for the quarter. Fund of funds managers will have to work hard at regaining the trust of investors newly sceptical of their ability to locate alpha as opposed merely to creaming off fees.

 

No surprises to see the asset class winner in the first quarter’s lottery of returns: commodities. The Dow Jones AIG Commodity Index returned 9% to end March 2008. Oil itself (WTI crude for May delivery) returned 7.3%; wheat 4%; natural gas a stunning 32.7%; gold 10%. And perhaps there is more agreement here than in most sectors that commodities prices now seem to be ensnared in an uncontrollable bubble. ‘Bubble’, of course, is also how investors describe rapidly appreciating assets when they’re not themselves already on board.

 

In light of the widespread losses incurred by most asset classes so far this year and the seemingly crowded trade that is pretty much every component within the commodities complex, what are investors to do ?

 

At the risk of stating the blindingly obvious, perhaps the most critical observation is to restate the fundamental counsel: only invest what you can afford to lose. Bound up within this core advice is the requirement to identify an appropriate time horizon for investment. An unrealised loss from a quality equity investment, for example, may be nothing more than a reflection of market noise. But if the capital tied up in that investment is soon required to set against short term liabilities, something has gone awry with the investment process.

 

And while the price chart is the purest form of investment intelligence, the role played by so many ‘shadow banking institutions’, leveraged, deleveraging or otherwise, is likely to keep prices across multiple sectors highly volatile. Given the vulnerability of equity markets to fresh disappointments by ostensibly internationally diversified businesses, and the particular vulnerability of Anglo-Saxon asset markets to a still deteriorating residential property sector, there seems more than usual merit in a) a healthy exposure to cash, and b) a disciplined commitment to dollar cost averaging versus market timing. As to preferred equity market sectors, we have long advanced our preference for energy, natural resources and related support services. As we have now had confirmation from no less a business than Rio Tinto that world quality miners are unable to maintain production even with commodities prices at record highs, that commitment is – US recession or not – highly unlikely to change now.

Wall Street to write off another 300,000,000 staff

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“You don’t have to predict it. We’re in it.”

- Paul Volcker, former US Federal Reserve chairman, responding to a question on whether he still predicted a dollar crisis in coming years.

London, April 2010 – Wall Street firms have just announced their latest results for FY 2009;

300 million staff have been “written down”, leaving just two (Sid and Doris Bonkers) to manage the investment banks’ remaining worldwide debt, equity, merger and advisory, securitisation, syndication and prime brokerage businesses.

 

Marti Peeps, sole analyst at the last remaining research house, Teletext, welcomed the results as “a bold step in the face of ongoing bad debt provisioning,” though conceded that the City’s newly “rightsized” payroll might struggle to take on board the burgeoning supply of new issuance, namely the packet of Walkers Crisps rumoured to be hitting the primary market in late summer 2012.

 

Hopes for a recovery in Wall Street earnings have for several quarters hinged on the prospects for the successful completion of a 40p private placement of a bag of Salt and Vinegar flavour crisps on behalf of the Walkers Crisps Company. Lead underwriters JPCitigroupMerrill, a subsidiary of the US government, and Northern Rock SocGen KFW Nomura, a wholly owned subsidiary of Tesco plc (Neasden branch), are rumoured to have “solid” interest for the underwriting, most notably from Asia, itself a subsidiary of Texas Pacific Group, but declined to go into further detail.

According to a filing at Companies House, recently rehoused atop a kebab shop on Tottenham Court Road, The Walkers Crisps Company plans to use the proceeds from the placement to refinance existing snackfood operations and to fund working capital needs. The above investment banks are “focused on supporting institutional private financings, strategic partnering and the acquisition needs of both growing and mature businesses, and indeed corporate entities not necessarily restricted to those operating in the Salt and Vinegar flavour potato-based derivative snackfood market.”

 

The latest round of layoffs on Wall Street has seen personnel departments resorting to ever-more creative means for dispatching staff. A popular approach is the ‘cluster-fire’ escalating waterfall method, by which senior managers deliver ‘just-in-time’ firings to their own staff, and are then immediately fired themselves by their own line reports, who are then in turn fired by the most senior manager on the premises, at which point that manager is himself made redundant by means of a controlled tactical nuclear burst. This latest word in financial disrecruitment has been praised by Wall Street watchers as hyper-efficient, but there have been complaints that pedestrians in nearby urban centres have been clubbed to death by the falling body parts of newly superfluous brokerage employees.

 

In other popular payroll deleveraging strategies, managers have been pouring gasoline over their workforces and igniting them. This has proven increasingly difficult, however, ever since people started stockpiling oil once it surpassed the psychologically significant $1,000,000 a gallon level. Regulatory observers have also been critical of such ritual staff immolation on ‘carbon footprint’ concerns. Mass stoning, by contrast, has been deemed to be environmentally friendly.

 

Other financial sector commentators suggested that the requirement for firings was less pressing, now that dark, mounted riders in interesting robing were chasing through the streets of New York and London and skewering passers-by with sharpened, flaming spears. Others suggested that this was merely a legacy of past investments in leveraged subprime deals.

 

Marti Peeps, relaxedly smoking one of his last HBOS share certificates, posited that every indicator saw signs of renewed growth, now that there were no more analysts maintaining fatuous predictions of US corporate earnings growing by 15% this year as per the previous four centuries. In late trading, the market for broken pieces of jagged wood was $2.7 – 2.8 trillion per piece (1 Yuan in regular currency). Defra, the UK Government department for the environment, food and rural affairs, issued an upbeat assessment of prospects for the forthcoming flint harvest. Analysts also expected a flurry of transactional activity in the front month grass contract. Leaves were down $1,380,700,000 a bushel. Apples and water did not trade, being bid only. Mr. Peeps apologised that his latest research opinion on banks and brokers had been reported as ‘Sell’. This was a typographical error. He had actually titled his outlook ‘Hell’.

Living beyond our means

“Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we.” – George W. Bush, August 5 2004.


*Please note: there are a number of graphs in this article. Readers are encouraged to download the full, graphically enabled PDF piece, below.*

“What have we done with two decades of prosperity ?” asked Mark Pragnell of the Centre for Economics and Business Research at a recent Citywire seminar. Good question. His rhetorical remark relates specifically to the UK, but many of the conclusions have commonalities in the US economy too. UK citizens have – until recently, at least - enjoyed the lowest cost of living increases on record (the contributing factors are highlighted in yellow):

 

..with monetary conditions (the volatility of Bank of England policy rates, or rather the lack of such volatility) offering unprecedented financial stability; the number of employed has risen to over 25 million; and average earnings have grown with impressive strength, with annual growth in average earnings, according to the Office for National Statistics and the CEBR, oscillating around the +4% level since 1993. Which is where the good news starts to dry up. Other trends have been more ominous; symptomatic, perhaps, of a gathering economic storm. Household spending has been paid for by abandoning savings (US householders will be well acquainted with the principle of using the home as an ATM machine):

 

Manufacturing industry has been hollowed out, with annual growth in investment showing an alarming negative long-term trend:

 

As Mark also points out, the UK has seen a growing number of either “can’t work” or “won’t work” potential employees (the ONS refers to them, more diplomatically, as “working age economically inactive”), from under 7 million in 1972 to just under 8 million in 2007. An awkward statistical companion is that those with jobs have seen recent falls in hours worked. Without foreign migrants, getting plumbing or housework done in recent years might have been impossible. Of the 2.9 million extra “jobs” created in the UK in the ten years from 1996, half have been in the public sector:

 

And note that two thirds of the “jobs” created by the public sector have disappeared from manufacturing. There has been significant growth in red tape and taxation (Mark cites figures from BBC News and LexisNexis: the number of pages in Tolley’s Yellow Tax Handbook has risen from 6,000 in 2001 to almost 10,000 in 2007; the 2007-8 edition required a smaller font size to make it into print). Welcome, says Mark, to the “something for nothing society” where citizens expect or want:

 

• A family and the right to stay at home to bring them up
• Flexible working hours and a shorter working week
• A decently funded National Health Service and state education system
• A decent wage
• A pension and a comfortable retirement
• The state to pay for it all.

 

Mark’s carefully worded conclusion: the long term challenge is making Britain competitive after two decades of living beyond our means.

 

There is a broader problem. The financial sector, including commercial banks and investment banks, and more recently including members of the so-called “shadow banking sector” such as hedge funds and structured investment vehicles, has grown comparably fat, stupid and lazy after decades of access to easy credit and leverage. Instead of adding value, financiers have simply taken to trading financial assets, sprinkling “innovation” (not least, securitisation) upon them, and hawking them around, irrespective of suitability, morality, or “know your client” concerns. Thanks to the implosion of the US residential property market, that game is now up – though not everybody appears to have recognized the fact, judging from some of the recent rallies by stock markets on otherwise terrible news from the banking sector.

 

Here are the inconvenient truths for the bulls:

 

• 70% of US GDP is accounted for by consumer spending
• The US consumer – the “spender of last resort” – will be unable to maintain historic spending levels when the prices of residential housing are falling at their fastest level in at least 40 years: Anglo-Saxon consumers are going to have to rediscover the lost art of saving. For more, anecdotally, on the apparent self-interested desperation of US homeowners, see the Wall Street Journal story from 2^nd April, “Some homeowners leave pets behind in foreclosure”
• Ongoing credit contraction and banking writedowns can and will have only one effect on western economies, and it cannot logically be positive
• Further capital support for the banking system may have to come from the taxpayer, which carries stark implications for already imperilled government finances. Assuming it does not come from existing shareholders, those shareholders remain in danger of being diluted painfully or fatally in the event of longer-lasting widespread deleveraging.

 

As James Ferguson of Pali International points out, the equity market downtrend “has been littered with sharp, double-digit, contra-trend short squeezes”. The chart below shows the recent downtrend of the US S&P 500, but it could just as easily be showing the FTSE 100 or Japan’s Topix (or China).

 

In short, one day’s rally does not a bull market make. Whether the S&P 500 – or other key indices – make technical breakouts from their range, or not (we have to respect the price action, but it may be wholly irrational and therefore unsustainable longer term), the bulls will still have to justify how western economies can withstand widespread weakness in residential property prices, a related slowdown in consumer expenditure, an ongoing liquidity and solvency crisis amongst undercapitalised banks, and more general fears relating to a possible sea change in the macro-economic environment. To return to and paraphrase Mark Pragnell’s earlier thesis, the long term challenge is making banks relevant after two decades of living beyond their means. If the age of easy credit is indeed dead, what might possibly replace it ? For many, though not all, “smart” financiers, hedge fund managers (particularly in leveraged credit strategies), private equity players (again, hitherto using easy leverage as a replacement for more difficult decisions) and associated capital markets flotsam and jetsam long used to the zero sum trading of paper rather than generating real and sustainable economic value, the future may involve having to do some real work for a living. For all investors, a degree of expectations management may be in order. The 1982-2000 period (and the period of ultra-easy interest rates that followed, combined with a huge buildup of imprudent leverage and property-related speculation) looks like being a huge anomaly in market history. Perhaps the rational response to current conditions – it certainly has been for the last twelve months - would be to refocus on capital preservation and worry a little less about what to do with all those wondrous anticipated investment profits.

Download living_beyond_our_means.pdf

After Goldilocks

“Today you can go to a gas station and find the cash register open and the toilets locked. They must think toilet paper is worth more than money.” – Joey Bishop.

The so-called ‘Goldilocks’ economic environment, writes Peter L. Bernstein, was aptly named:

 

“low volatility in capital markets and in the real economy, low inflation, central banks in firm control, a healthy appetite for risk-taking in the business world that led to revolutionary technological change, the transformation of the ‘emerging’ economies into ‘developing’ economies, and the resulting boom in globalization.”

 

Bernstein suggests that after the dotcom bubble messily burst in 2000, the business sector was slow to regain any appetite for risk-taking. For this reason, Goldilocks lasted longer than she might have done. But as stability reigned and the global economic system effortlessly grew, in time-honoured fashion it was the banks that stepped in where more intelligent businesses might have feared to tread, and ratcheted up the dial for risk. In equally time-honoured fashion, the housing market became the focus for renewed risk-taking, aided by two deadly contemporary trends: rapidly rising prices, and financial innovation. Three, if you count leverage. Now, “in the aftermath of the fervour for risk-taking, Wall Street and the mortgage banks have created many deep-seated problems for themselves. As an unhappy side effect, the business sector, a relatively innocent observer, is going to have to absorb much of the pain of curtailed consumer budgets and fewer exports to foreign nations affected by the turmoil in the US.”

 

In a letter (“The Shape of the Future”) republished by John Mauldin in his ‘Outside the Box’ column, Peter L. Bernstein goes on to suggest that far too much time is given over to analysis of the present or the anticipated near term – “the short run always tends to dominate mass thinking in any case, but in an odd way the short run is irrelevant to the current situation.. As Goldilocks shreds, we have to start thinking about what kind of long-term environment is going to replace it. Shifts to new environments are always attenuated. They are also rare across time, which means most of us have limited experience with this phenomenon. New environments often tend to sneak up on us and do not announce themselves with a fanfare. Most of us are unaware of what has happened until enough time passes to provide good perspective.”

 

As one might expect from the author of ‘Against the Gods: the remarkable story of risk’ (one of the finest books written about the risk inherent in investment, and the ways to study it), Bernstein’s letter does plenty to encourage longer term contemplation of the state we’re in. Extrapolating just from the short term, the very nature of the western financial system is likely to change profoundly. A badly bruised credit system will take some time (longer, probably, than many commentators suspect) to recover its health. And it may never regain the lofty heights to which it has recently reached, through a combination of economic retrenchment and more intense regulatory friction. As Bernstein points out,

 

“Without securitization, and without the lively derivatives markets that developed around the securitization process, the entire credit system loses an immense source of capacity, hindering deserving borrowers in search of financing and, as a result, the pace of economic growth.”

 

With trust in financial institutions, primarily banks, in total disarray, rebuilding that trust will also take longer, most probably, than many expect. “The pace of change in that direction, however, will be slow, a matter of years rather than months. An entire structure has crumbled and has to be rebuilt, brick by brick. The impact of unforeseen but inevitable credit problems will loom large, detouring and delaying the pace and patterns of recovery on each occasion.”

 

Bernstein’s central argument is that the cause of recent financial market turbulence, the effective bankruptcy of the western banking sector, of an unsustainable rise in leverage combined with opaque financial engineering, came about not from too much inventory nor overexpansion in industrial capacity, not from a burst of inflation requiring tighter monetary policy, but

 

“The root of today’s problems in the financial markets and in the economy as a whole is the household sector.. the shrinkage in the personal savings rate [in the west, at least] is not the result of consumer profligacy, as other commentators persist in describing it. Rather, the savings rate has been suppressed by a slowdown in the growth of household incomes. The shortfall.. has been met by borrowing, and in particular by borrowing against the family real estate. Now the opportunity to borrow has shrunk dramatically, an outcome that will profoundly change the household’s spending power and spending patterns. But the impact is not just on the household. A slowdown in the growth of consumer spending has ominous implications for the entire global economy – and, along the way, the US [and other western sovereign nations’] federal deficit, soon to be overburdened by spiralling benefit obligations. This predicament is not a short-run matter..”

 

Quite what emerges from the reconstituted rubble of the financial system, in however many months’ or years’ time, is obviously unclear. But it seems a reasonable bet that banks as we know them will play a smaller role in the future, constrained by both regulatory fiat and by lingering recollection of how much damage they have spread among a broader and largely blameless economic community. Much doom-mongering has been deployed over the rise of the so-called shadow banking system. Inasmuch as this relates specifically to hedge funds, while the stupidly overleveraged or just plain stupid will continue to go to the wall, there is no reason why the hedge fund sector (to the extent that it constitutes just one homogenous group) will not continue to attract assets at the expense of older and less relevant investment structures – such as the venal and poorly named mutual fund complex, where conflicts of interest between asset gatherers (or euphemistically, asset managers) and investors continue to reign supreme.

 

On this note, last week’s piece by E.S. Browning for the Wall Street Journal (“US stocks’ lost decade”) will have made many traditional fund investors feel distinctly uneasy. Despite the ongoing refrain from the fund management community about investing for the long run, since 1999 the stock markets of the US and the UK have gone.. nowhere. More precisely, taking the S&P 500 Index as a proxy for the broader US equity market, US stocks are exactly where they were nine years ago. Stocks over that period have been beaten by Treasury bonds (an outperformance that both Gilts and Treasuries will struggle to repeat given the parlous state of government finances and the further deterioration implicit if Bernstein’s thesis is correct). The performance of UK stocks over the same period has been even worse. Whether expressed in the form of the FTSE All-Share or by the FTSE 100 Index, UK equities are now worth less today than they were nine years ago. Given that we have just been through a period of extraordinarily benign global growth, that is some achievement.

 

It is not all bad news. Investors today benefit from products and vehicles that simply didn’t exist in anything like their current form nine years ago: low-cost exchange-traded funds (if you resent your fund manager – do the job yourself !); closed-ended listed hedge funds and funds of hedge funds; exchange-traded commodities and precious metals trackers; capital guaranteed structured products.. Not only are equities no longer the only game in town, even if they were, there are now a myriad ways of slicing and dicing market risk to the appetite of the individual investor. And some of the investible themes are little short of compelling. In a piece for the FT’s Insight column in early March, Barclays’ Tim Bond compared the recapitalisation required by the banking system with the funds required by the global energy complex. While estimates of the banking capital shortfall vary from $300 billion to $1,000 billion, that compares with the prospective capital requirements of the resources markets:

 

“According to the International Energy Agency, the global energy sector alone needs a real $22,000 billion over the next two decades to meet the anticipated rise in primary energy demand.”

 

If that doesn’t look like an investment sector that will repay careful study, it is difficult to know what will.

 

Download after_goldilocks.pdf

Not waving but drowning

“The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn’t want to go bankrupt. People must again learn to work, instead of living on public assistance.”

- Cicero, 55 BC. (Note: Edward Gibbon dated the actual fall of Rome to AD 476, over five centuries later.)

 

If ludicrously overblown press headlines were a definitive contrarian guide, the financial crisis has reached its nadir. Fortune went last week with ‘The end of Wall Street as we know it’. If only. The London Evening Standard billboard, long a source of gaudy amusement to weary commuters, went with ‘BANK CRASH: LONDON PANICS’. (The Standard, of course, has some form here. Previous measured coverage of topical events from the paper that never discovered lower case has included ‘TOXIC CLOUD HITS LONDON TONIGHT’; ‘THAMES FLOODS: PREPARE TO FLEE’; ‘TOOTHPASTE CANCER ALERT’; ‘EXPLODING LAPTOP COMPUTER ALERT’; ‘KILLER FOG TRAVEL CHAOS’; ‘AAAAAARRRRRRRRGGGGGGGGHHHHHHHHHHHHH!’ (this last entry looks suspiciously like a fake – judge for yourself); ‘IPOD HEALTH ALERT’; ‘EUROPE: IT’S WAR WITH FRANCE’; ‘INSIDE HORROR PUPPY FARM – PICTURES’; ‘SUMMER KILLER WASPS ALERT’..) Other coverage was more nuanced. The Financial Times on Tuesday led with a somewhat baffling photo from the Chicago Mercantile Exchange of someone arms akimbo who may just have been ordering a cheeseburger. The Daily Express, admirably meeting its journalistic responsibilities in addressing the biggest markets crisis since World War 2, led with a headline about Princess Diana.

 

With the fifth largest US investment bank having been repackaged and sold at distressed valuations to what is now the largest, and with several UK banks now optically at least yielding over 10%, it would be redundant to say we are living in extraordinary times. But we are, and as Citigroup’s Patrick Perret-Green points out, desperate times require desperate measures:

 

“It is time for Federal involvement no matter how distasteful the issue of moral hazard is. There are times when only the public sector can halt the rot. I believe that this is one of them. GSEs (Government Sponsored Enterprises, namely Fannie Mae and Freddie Mac) and munis need to be guaranteed and the White House needs to exercise its executive muscle. If it means that you have to replace your Treasury Secretary to enact the equivalent of a “surge” then so be it..

 

“Equally significant is that it is time for the other firefighters (central banks) to become much more involved. The fire may be centred in America but the sparks are floating on the wind and too little has been done to prevent it spreading..”

 

From a behavioural perspective, one of the slightly more positive straws - as opposed to sparks - in the wind is, perversely, the very failure of Bear Stearns: traditionally, the collapse of a major institution would have been treated as symptomatic of the low being in, or at least close by. It is a sign of the times that no sooner had Bear entered the welcoming arms of JP Morgan than the market sniper was directing his crosshairs at the likes of Lehman Brothers and MF Global. The difference this time round would seem to be that the crisis, like the financial system and the international economy, is properly global. So there are likely to be more Northern Rocks and Bear Stearns to fail before the worst can be said to have passed. Particularly in Europe, where the monetary authorities have been surprisingly grudging to offer the financial sector anything (other than simple liquidity) by way of meaningful emergency support in comparison with the Fed. One other, significant, observation: if we are entering a realm of much enhanced government (i.e. taxpayer-) funded support for the financial sector, that is occurring at a time when government balance sheets are already a disaster. Government bond yields run the risk of exploding upwards in an environment of further emergency bail-outs for badly run banks or near-banks.

 

But then these are extraordinary times. RJH Adams, conversely, takes a less than charitable view of the Fed’s energetic and creative intervention:

 

“And now the Fed has decided, post Bear Stearns collapse, that even more largesse is required for the troubles at hand – this time including non-banks and allied to terms of greater secrecy.

 

“This latter feature is both a sop to financials wishing to preserve their reputations which, for some curious reason, they collectively appear to believe are currently held in high esteem; and to stave off depositor / client scrutiny and exit.

 

“The secrecy is, viewed in these terms, a deception upon shareholders and a symptom of a weak banking supervision regime. Banks in difficulty are being allowed to hide and roll over their solvency issues (where they can) in the hope that their catastrophic losses on assets held prove transitory with the underlying security at some future point marketable.

 

“So far the opposite is happening and yet this behaviour is likely to continue until the Fed eventually comes up with a package soft enough to persuade the banks (and other financials who, like Bear, will find an indirect way to access Fed support) to take it up anonymously.

 

“Maybe the Fed just did that; but the opacity of the deal destroys confidence more than the fig leaf excuse of protecting banks’ operations merits. Here is the point: it is currently impossible for investors to determine which banks / other financials are solvent. Allowing all and sundry to tap Fed offers can only turn out to be a drag on the broader economy and delay final settlement.. Banks need recapitalization. That requires transparency – and that someone takes losses. Just ask your average shareholders like Mr. (Joe) Lewis (whose Tavistock Group owns 9.4% of Bear Stearns) and Citic (a Chinese brokerage that agreed in October to invest $1 billion into Bear Stearns). Buying time and pretending otherwise is wishful thinking.”

 

Not every debate last week was over the appropriateness of Federal Reserve support for broker-dealers and other members of the so-called shadow banking system. In a timely piece for The Financial Times, investment consultant David Roche wrote of the commodities ‘lifeboat’ being swamped in a rush to safety:

 

“In the current turmoil, there has been a rush into commodities.. the speculative element has grown sharply.. (but) global growth is declining fast. Recession will ensue and no region or asset class will be immune from its ravages..”

 

Roche suggests that as the Chinese authorities tackle domestic inflation (unlike their western counterparts), China’s growth rate could easily fall by, say, 3% to 8% - which “would remove the ex-ante global supply / demand deficit from energy markets and push most industrial metals, including steel and copper, into significant surplus.. we can expect the price for refined oil to fall 30% and industrial metals by 20% to 30%. The big fall is coming.”

 

Since commodities, and more particularly softs, have recently been the only game in town, Roche’s suggested correction leaves investors with something of a quandary. Government bond yields are pricing in hell on earth. Equities and corporate bonds are trapped in a bear market, along with the US dollar and confidence in the international banking system. If commodities join them, where can despairing investors go – either in search of profits, or simply to preserve capital ?

 

One response would be that a commodities correction might be short-lived: limited, perhaps, to the extent that a Chinese slow-down takes some of the heat out of the market. If it turns out to be an altogether longer-lived correction, even that would be nothing that BMO’s impressive global strategist Donald Coxe didn’t foresee as far back as October 2003 (‘Basic Points: A major investment sonata in a miner key’):

 

“Within months, this Movement will probably end. Whether it will come from disappointing economic news.. or simply because stock prices have gotten ahead of themselves, one cannot know..

 

“The Second Movement will mean further development of the [commodities] theme, but will be more stately, and will frequently be in a minor key. At each of those intervals, the miners will rediscover their primal fear: they must not be up dancing when the music stops.”

 

Donald Coxe goes on to explain that the Second, or middle, movement of symphonies was historically a shorter movement that gave the orchestra a chance to cool down; “Since stock prices for the leading mining companies [and the prices of most commodities] will be up so hugely as this movement begins, there will be itchy portfolio manager fingers to take profits as the rest of the stock market encounters downdrafts..”

 

Again, given that Coxe was writing these words in October 2003, he deserves bonus points for prescience. As he then pointed out, in relation to the metals markets (but surely his words have a broader resonance for the entire commodities complex):

 

“..the demography of the market.. includes those too young to have seen a true bull market for mining stocks, and those who remember all too vividly the ghastly bear market of the 1990s, and the ups and downs of the 25 years before then. Within the mining industry, the aged players are battle-hardened and cautious. Youth doesn’t understand, and age doesn’t believe.”

 

David Roche may well be right in the short term in relation to the overvaluation of commodities, but in the longer run his argument is up against some significant headwinds, including: a secular shortage of supply (40 year low inventories in the case of some agricultural softs); a multi-decade bear market before the most recent gains; the new ease of access into the sector, in the form of low-cost exchange-traded funds; the chronic underweightedness of institutional investors (see, for example, our commentary ‘All in the mind’ of 7^th March, which cited a Bloomberg report claiming that the Calpers pension fund, the largest in the US, having made its first investment into commodities in 2007, was considering increasing its investment some 16-fold); the demand shock represented by a newly emergent and newly wealthier Chindia; a US monetary policy regime that seems determined to sacrifice the dollar on the altar of banking system survival. Commodities markets are always going to be volatile, but rarely have there been so many fundamental reasons to be positive about their longer term prospects in an otherwise acutely unstable world.

Download not_waving_but_drowning.pdf

Bernanke Goes Forth

“Edmund: You see, Baldrick, in order to prevent war in Europe, two superblocs developed: us, the French and the Russians on one side, and the Germans and Austro-Hungary on the other. The idea was to have two vast opposing armies, each acting as the other’s deterrent. That way, there could never be a war.

Baldrick: But this is a sort of a war, isn’t it, sir ?

Edmund: Yes, that’s right. You see, there was a tiny flaw in the plan.

George: What was that, sir ?

Edmund: It was bollocks.”

- From ‘Blackadder Goes Forth’ - Richard Curtis and Ben Elton.

So the Federal Reserve has shown it is willing to act as a prime broker (to the tune of another $200 billion) even if the rest of Wall Street is having second thoughts about the role. This week’s immediate response to another historic liquidity injection was an unsurprising relief rally by stock markets, but the longer term reaction will be an equally unsurprising retreat back to the lows. Stock market investors seem to be thinking, “If easy money got us into this mess, surely even more easy money will get us out.” Replace ‘easy money’ with ‘idiocy’ or ‘leverage’ and you can see the essential logical weakness of the proposition. Diapason’s Sean Corrigan was not alone in wondering whether the Fed would be getting value for money from its latest liquidity experiment:

“According to my reckoning.. the Fed’s extra $253 billion in liquidity enhancing measures bought a 1.3% increase in the S&P 500. Since we need a 19.4% rally to regain October’s Sucker’s High at 1476, we might only need another $4.8 trillion in new measures to do the trick ! Neatly, that would equate to the Fed buying out the outstanding total of Agency / GSE-backed mortgage pools, with enough room to nationalize Freddie and Fannie at current market value, into the bargain. Over to you, Ben..”

Unfortunately, there is just one tiny flaw, cf. Blackadder, in Bernanke’s plan. Not least, a crisis of solvency will not be resolved by the provision of any amount of liquidity. As Marcus Ashworth of Mitsubishi UFJ points out, the latest emergency measure “probably only postpones the latest series of fire sales, allowing some to meet margin calls and hang grimly on pro tem, but it does not recapitalise the financial system. In fact, it helps banks to own [impaired debt] for longer,” and it merely delays what must inevitably come – the transfer of toxic waste to safer longer term hands, where it can either be held, or extinguished.

Wolfgang Münchau, writing in this week’s Financial Times, was pretty unequivocal in his commentary, not altogether subtly entitled ‘Central bankers cannot stop this contagion’:

“For as long as this financial crisis persists, interest rates will be determined by toxic market conditions, not central bankers.. We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run.. What spooks investors is the loud and clear signal from central banks that they are not prepared to stabilise inflation in adverse circumstances.

“This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market.. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem. [If there are, we can count on the Bernanke Fed to use them.] I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.” (Emphasis mine.)

As far as credit markets are concerned, we are evidently entering something of a ‘new paradigm’ world, at least as far as securitisation, credit quality assessment and asset-backed lending are concerned. Unfortunately, while the Fed is at least behaving pro-actively to attempt to forestall further dislocation in the US financial sector, central banks like the ECB are still doggedly fighting the last war against inflation. Inflation is unlikely to be a significant issue once the economy falls into the grip of an economic recession. Rises in commodity prices, and specifically the price of oil, will ultimately be self-correcting (though non-replaceable commodities affected by robust global and Asian demand, and which have seen decades of underinvestment in capacity, may have some way further to run). But in any case there is little that central banks can do to address commodities prices, nor should they try: there is enough manipulation of the money supply going on; the price discovery process in credit has already been suspended by the intervention of the monetary authorities (if only all markets had such powerful ‘Get out of jail free’ cards). We do not need intervention in commodities prices when free markets can and ultimately will lead to some form of equilibrium.

If Wolfgang Münchau’s scenario comes to pass (and we have some sympathy with it), the implications for investors are severe. Coming at a time when public finances in the Anglo-Saxon economies are already stretched, the requirement to support major banking institutions with taxpayers’ money would positively murder the government bond markets. It is for this reason that we still see inflation-protected government debt as the ‘least worst’ debt market investment, inasmuch as investors are hedged against the inflationary scenario, but still given high quality credit exposure and a minimum income – even if the ultimate outcome is actually one of disinflation (consistent with a major economic slowdown). As for equity markets, we continue to see merit in being highly selective. This is not an environment conducive to broad market-based exposure, rather one