The price of everything

Dammit, Janet

 

 

According to Einstein, time is affected by gravity. Clocks far from strong gravitational fields run more quickly; those close by run more slowly. We can only assume, then, that Janet Yellen has the density of a neutron star. Under her leadership of the US Federal Reserve, time seems to have stopped altogether.

It is now seven years since the Fed pegged short term interest rates at zero percent. That was in response to the credit crunch that engulfed the world after the collapse of Lehman Brothers. A lot can happen in seven years. The typical newborn, by the age of seven, can talk fluently, has well-developed physical coordination, and can read and write. Evidence of intellectual or kinetic progress at the Fed has been somewhat more limited.

Unlike many central banks, the Federal Reserve is empowered to pursue two specific mandates: stable prices, and maximum employment. The data on jobs looks clear enough: the US unemployment rate stands at just 5.1 percent, or half its level during the height of the financial crisis. (Just ignore the fact that those out of work who are politely called ‘discouraged’ tend to fall out of the statistics after a while, so the true count is some way off.) But the progress on prices – or rather, the lack of it – is even more startling. Despite quadrupling the size of its balance sheet to $4.5 trillion (which incidentally means the Fed is sitting on $4.5 trillion worth of existing bonds), signs of ‘proper’ inflation – in the prices of goods and services, say – are almost invisible.

Given that the experimental policy of Quantitative Easing was always predicated on triggering inflation, the almost complete lack of inflation so far might be regarded as something of a failure.

The neo-Keynesians will no doubt argue that QE has worked, and that Janet and our own Mark Carney simply haven’t done enough of it yet. I have a subtler fear: what if expectations of our central bank policymakers are simply too high ?

The food you eat and the clothes you wear and the house you live in and the petrol you put in your car all have a price. The price of each of those goods was set in a marketplace consisting of buyers and sellers, providers and consumers. You may not like a given price, but you are then free to shop elsewhere and purchase other items instead. But the most important single price in the entire modern economy – the price of money itself – is not set in a market but by people like Janet Yellen. Whatever you may think of her intellectual credentials, she does not have godlike powers of omniscience over the workings of the economy. No central banker does. But we allow them to dictate monetary policy as if they do.

Note also that nowhere in the constitution of the Fed is there provision for China’s economic problems, or its stock market, or the appreciation of the US dollar, but they were all cited, directly or indirectly, by the Yellen Fed as reasons for delaying a rate hike. Another contributory factor was doubtless the chorus of naysayers from Wall Street urging Janet to hold the line (and keep the party going). City folk like to maintain the myth that central banks are independent of the brokerage community, but the reality is somewhat different.

Most Federal Reserve meetings don’t matter, but this one did. As McKinsey pointed out earlier this year, after a financial crisis triggered by the bursting of a colossal bubble in debt, there is now more debt than ever before: $57 trillion more, raising global debt-to-GDP ratios by some 17 percent. If a problem is caused by an oversupply of something, what possible good can come of expanding that supply by way of remedy ?

The great Austrian economist Ludwig von Mises expressed it somewhat more darkly:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Nudging interest rates higher by the order of a quarter percentage point would not have triggered an extinction level event. It would certainly have made life more interesting for bond traders, most of whom have never seen a bear market in their entire careers. But it would have sent a powerful signal from the Fed: we are ahead of events.

But Janet blinked. Which makes any future Fed tightening that much more problematic. It also reinforces the suspicion that our central bankers don’t know what they are doing, but have entirely capitulated to the financial system they are supposed to control.

 

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio. This article was originally published in MoneyWeek.

 

I’ll be joining Bill Bonner, Merryn Somerset Webb and others on the second MoneyWeek Cruise next week, so the commentary will be making its next scheduled outing on Monday 12^th October.

Squashed

 

As a child I was fascinated by the concept of a neutron star. A neutron star is the tiny but immensely dense thing that’s left after a massive star explodes. Imagine something eight times as massive as our sun packed into a 12 mile diameter sphere. Gravity compresses the surviving material so profoundly that its protons and electrons are squashed into neutrons. Just how dense ? A single teaspoon’s worth of a neutron star would weigh a billion tons. That presupposes you could actually get close enough to extract a teaspoon’s worth. In reality, the gravitational pressure would reduce your body to a very thin smear on the surface of the star. Very little escapes the gravitational force of a neutron star.

I never expected to encounter a neutron star but Messrs Bernanke and Yellen at the US Federal Reserve have been kind enough to engineer one for us. Like CERN it’s been something of an international collaboration – Messrs Carney and Draghi have also pitched in to do their bit. The hybrid of Quantative Easing (QE) and Zero Interest Rate Policy (ZIRP), our current monetary neutron star has succeeded in collapsing the yields of just about every financial asset. The tractor beam of ZIRP in particular is difficult to evade. Just ask Janet Yellen. After one of the most widely anticipated FOMC meetings in history, she has boldly decided to do precisely nothing.

Today’s investors are not exactly a lucky generation. Assuming they’ve survived two precipitous declines in stock markets in the course of a decade, they’re now faced with overpriced stocks, overpriced bonds, overpriced everything. The Economist cites a Deutsche Bank study pointing out that for 15 countries going back as far as 1800, the average prices of equities, bonds and residential property stand at an all-time high. In terms of investment yield, very little escapes the monetary policy neutron star.

Assuming prices matter, the implications for future returns are somewhat grave. “This is most obvious,” writes The Economist, “in the case of bonds: a yield of 2% means the nominal return if you hold the bond to maturity will be 2%. The real return may even be negative if inflation rises.” Gilt investors today dream of even 2% nominal returns: 5 year UK government paper struggles to reach a nominal yield of 1.3%. 5 year US Treasuries offer a munificent 1.4%.

“Worse still, there is always the chance that profits or valuations will return to their historical norms. If that happens, Deutsche reckons the average real return from equities over the next ten years will be negative. The same is true for Treasury bonds, European corporate bonds and American residential property.”

Deutsche are not alone – just more honest than most investment banks these days. The asset managers GMO recently published their own 7-year average annual real return asset class forecasts. For US large cap stocks, US small cap stocks, international small cap stocks, US bonds and international bonds, those annual return forecasts are all negative.

But not quite everything in the financial universe has seen its yield obliterated by the monetary policy tractor beam. Not quite all valuations are stratospheric. In a recent piece for the Financial Times (“The going gets tough for value managers”), columnist John Gapper suggests that QE “has lifted all boats in the equity markets”. With all due respect to Mr Gapper, that is simply not true. What is true is that to identify genuine value from today’s listed equity markets, you have to go further afield than most benchmarked and index-relative fund managers are either willing or able to. A case in point: the US accounts for fully 58% of the MSCI World Equity Index. Japan, by way of contrast, accounts for less than 9% of MSCI World. Yet over 40% of the Japanese stock market trades on a price / book ratio of less than one. It is objectively cheap – despite the fact that BoJ Governor Kuroda has himself been no slouch when it comes to stimulative monetary policy. And many Japanese companies remain disgustingly under-researched by a brokerage community still shell-shocked by a grinding, two-decade bear market. Question: would you rather look for bargains in a market recovering from 20 years of underperformance – or in a market that, on the basis of current overvaluation, now faces precisely that prospect ?

Absent some entirely magical economic developments, Janet Yellen looks set to be an unlucky Fed chairman. There is a growing risk that the fabric of the financial system may start to unravel during her tenure. Commenting on last week’s do-nothing FOMC meeting, Marcus Ashworth of Haitong Securities pointed out, fairly, that this is hardly progress in rebuilding market confidence in the Fed’s communications policy: now, after last Thursday,

“We are not just data-dependent but uncontrollable foreign economy-dependent.”

So there are some isolated pockets of value out there in stocks, but none whatsoever discernible to this observer from within the bond market – and doubtless plenty of skirmishes in the currency wars to follow. The Fed has managed to paint itself into an extraordinary corner. It has blown a pivotal opportunity to begin normalising interest rates and made its next attempt – if it ever even bothers – that much more problematic. The next flashpoint may not now be in stock markets themselves but in the international bond markets that dwarf them. Bonds, stocks, property – all in a bubble, and with the Fed having exhausted all its current and indeed feasible ammunition. Let’s not mention those $5 trillion of bonds the Fed happens to hold, the prices of which are only likely to appreciate further in an environment of entrenched deflation that will smash the economy in the process. Hardly a picture of progress on the part of our monetary central planners. Janet Yellen may yet go down in history as the very first person, and Fed governor, to have successfully squashed herself.

 

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.

Rolling boulders uphill

         

 

* The commentary will now be taking its summer holiday. It will be back on 21st September. *                    

As symbols of futility go, that of Sisyphus takes some beating. In Greek mythology, Sisyphus was captured by the gods after having freed humanity from Death. They punished him, of course: he would spend the rest of his days pushing a boulder up to the top of a mountain. Just when he reached the summit, as perpetual torment for his efforts, the boulder would inexorably roll back down again. Sisyphus was condemned to push the boulder uphill for all eternity. His was the original rolling stone.

The American author Henry David Thoreau would go on to echo the essential pointlessness of Sisyphus’ struggle. In his own memorable phrase,

“Most men lead lives of quiet desperation and go to the grave with the song still in them.”

Today’s Sisyphus is China. More particularly, the Chinese authorities. They are determined to roll that boulder uphill.

The path of least resistance for the boulder, however, is downward. Gravity, after all, is a bitch. The Chinese stock market is still comparatively young, and as stable as any toddler overwhelmed by parental expectations.

With their boulder beset by the giant suck of gravity, China’s Sisyphus first cut rates, and trimmed banks’ reserve ratios.

The boulder continued to roll downhill.

So Sisyphus announced plans to slash brokerage costs. But the boulder was not in a mood to listen.

Sisyphus is nothing if not persistent. Next up: a relaxation of rules on margin trading. But the boulder remained impassive, and continued to roll downhill. Sisyphus threatened to look into illegal market manipulation, and to round up the usual suspects. Bothered, replied the boulder as it kept on rolling.

Sisyphus tried to repeal gravitational laws. He banned numerous accounts from selling the market short. But the boulder rolled on down.

So Sisyphus knocked heads together on the exchange, and rustled up a package of 120 billion yuan to help support the boulder. The boulder still fell.

Sisyphus tried to tackle supply. Over two dozen Chinese companies suspended their IPOs. But the boulder remained deaf to these efforts.

Sisyphus strong-armed his friends to put money into the market. The boulder was impassive.

Sisyphus warned of “panic” and “irrational selling”. The irony: Sisyphus warning of irrationality. Still, down she came.

Sisyphus began looking for a new market regulator. Good luck with that, replied the boulder as it resumed its imperious decline.

Sisyphus started moving pension fund money into the market. But the boulder kept falling.

Sisyphus tried to persuade anyone who would still listen that the real problem was not his own currency devaluation but fears over a looming interest rate rise by the US Federal Reserve. The boulder allowed itself a quiet giggle, and resumed its fall.

But Sisyphus will be back tomorrow, with new plans.

Global investors are right to be spooked by the example of Sisyphus. But they are learning the wrong lessons. Sisyphus is alive and well and active in western markets, too. He has been busily trimming interest rates across the developed world. He has been bidding up the price of bonds, with some kind of ‘cargo cult’ belief in a magical, trickle-down economic paradise. He has been distorting, warping, manipulating and destroying all he touches, in a fond belief that the State knows best.

The August 11 devaluation of China’s renminbi was when our collective market boulder lurched decisively downhill. A problem previously contained within China’s borders suddenly spread westwards. The boulder is coming after us, and it’s a boulder called deflation.

Trying to make sense of complex market developments, investors are at risk of confusing the narrative. This is not a reprise of the 1997 Asian financial crisis. It is not a reprise of the 2008 financial crisis, either. Many Asian economies are now in far better shape than their western competitors. They have significantly less debt, more promising demographics, much lower welfare burdens, and demonstrably higher foreign exchange reserves. They still have ammunition to deploy, if required.

This is not quite an emerging markets crisis, either. The very term ‘emerging market’ is, like the term ‘hedge funds’, now so widely used and abused as to be meaningless. Some ‘emerging markets’ are clearly vulnerable, though, especially those exposed to the commodities complex and with substantial dollar borrowings.

In a globalised economy, in which boulders are moved as much by confidence as by capital, all governments will be tempted to act like Sisyphus. As investors collectively brace for that advancing boulder, they should consider just how much they are paying to stay on the mountain. Asian stock markets may have absorbed the brunt of the volatility thus far, but it is largely the western stock markets that trade on expensive valuations, that cannot possibly decouple from that deflationary surge, and which are ripe for further falls.

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.