Until demographics organically improve aggregate demand and the US navigates a minefield of ARM resets, I’m wary of exchange-based assets. There’s an inherent systemic risk incorporated with every exchange-traded security. Characterized by 30-year disinflationary Fed policy, The Great Moderation rendered an oversaturated investment environment. The associated risk mitigation coaxed wild participation (think of the explosive crowding-in to the Private Equity, Venture Capital, and Hedge Fund spaces).
As a result, we’ve seen a commoditization of traditionally non-correlated assets, which was compounded even further by financial innovations like derivatives and the entire shadow financial system that all sought to accommodate the Fed’s force-fed demand. At the height, vehicles like SIVs, ARSs and ETFs brought retail investors access to more and more remote investment options. Think about it, such widespread access aligns co-movements. As assets are lassoed and moved to exchanges, they start moving with the heard. More on this later.
Throughout the Great Moderation, our Fed continually stimulated our mature economy, simulating demand to rear unnatural, artificial growth. Somewhere within 2008’s trough, natural demand levels were touched, but the Fed has since buried the correction beneath a mountain of liquidity.
Because of that “Bernanke put,” America’s unfathomable investment infrastructure (remember Lenny Dykstra ran his own Private Equity-esque operation into the ground?) not only stayed [relatively] in-tact, but also reflated the risk-trade. The liquidity surge had an excess of capital chasing a dearth of quality within this huge American financial landscape; much of which not only had to stay invested, but had to continue to invest. (After all, Money managers, PE, VC, Hedgies, and IBanks aren’t paid to manage cash, particularly in a zero-interest rate environment.) With the flight to quality already en force from the global recession, gratuitous liquidity had nowhere else to go, so it spilled over to risk-based assets, positioning us where we are today. Again, much of the US investment players don’t have the option of cash-under-the-mattress. Unless Hedge Funds wanted to lose money by parking it in negative-yielding Treasuries, they had to invest in some risk or shutter their doors.
The debate du jour focuses on inflation/deflation forecasts. For the more immediate term, deflation is the real threat. Despite the “inflationary” federal stimulus outstanding, banks have worked in concerto with regulators to [finally] gauge the economic climate. By every measure, Americans remain dangerously overburdened by debt loads. The liquidity provided banks by taxpayers was designed to pad solvency ratios, not to leverage toward revenues. Given interest on excess deposits with the Fed, plus zero-interest financing, banks have no incentive to undertake risk by cramming more loans down the throats of gorged consumers. Instead, they’re feeding the insatiable appetite of the US Treasury, who’s merely displacing tapped-out consumer demand with its own leverage. As the global lender of first- and last-resort, the Treasury is groping around in the dark, trying not to bump into a sovereign debt breaking-point. Nevertheless, as long as liquidity remains in bank vaults (rather, not unleashed on the private sector in the form of loans/leverage), there’s no inflation risk until 2012, when our sovereign solvency will come back into question. (It will be comical to watch politicians scramble to keep a healthy bid-to-cover ratio at Treasury auctions over the next 2 years.) As long as the Treasury’s capital is on the line [via the Fed], banks won’t be loaning these funds. As evidence, consider the continued erosion of the broad money supply, as every gob of M1 yields progressively less M2 since 1q09.
Sustained disinflationary policy caught up with the Fed when a secular US Dollar bear started stirring after the tech boom-bust. Then, it roared in 2008 in light of accelerated quantitative easing. After a flight to quality, the global recession provided USD support, so the climate was opportune for the Treasury/Fed to sacrifice the USD in exchange for inflating away domestic debt, repairing battered asset prices (subsequently, battered balance sheets), and theoretically reversing macro-deficits. The repair became a self-fulfilling prophecy and markets melted-up. In ignorance of the non-domestic consequences of currency devaluation, the rallying market makes Americans feel like we are on a mend, but the sputtering economy isn’t as easily fooled.
Bringing my expose full circle, let’s start talking about investment strategy: Look at real estate, left far behind in our 70% rally from March 09’s lows. Although RE has been somewhat commoditized by financial innovation, the alternative space has a huge foothold in it. PE transactions and hedge fund exposure to RE is rarely accessed through exchanges. Although that’s a testament to RE’s low beta, I’m not endorsing RE as an undervalued asset. Rather, I’m doubting the liquidity-driven, exchange-based rally when superimposed over non-exchange-traded investments—like alternatives that are insulated from cyclical frothing because of illiquidity, capital lock-ups, and open/closed ticketing windows.
Then, there’s the 36-year fixed income bull has been stopped in its tracks by zero-bound interest rates. ‘Who in their right mind would own a fixed coupon in a historically low rate environment like this? There’s nowhere for rates to go but up!’ On the other side of the coin, the prevailing call among [non-biased] analysts is for a double-dip recession. So why should a portfolio own stocks and bonds? Although the Fed has never bagged a black swan, it does effectively manage policy to counteract prevailing sentiment:
Policymakers will allow liquidity to slosh around in bank vaults throughout the ARM adjustment wave (ending 2012) and Commercial Real Estate doldrums. With taxpayer capital on the line, they’re helping banks navigate the choppy waters. They’re helping banks frontrun policy too. Given government stakes in banks, there’s a conflict of interest involved, but there’s also no statutory insider information restrictions on the Treasury/Fed as investment entities. Don’t think regulators aren’t helping banks frontrun policy changes. (See 1/7/10 Fed memo to banks, “Advisory on Interest Rate Risk Management.”) Frankly, the game is rigged… in an investor’s favor. The Fed directly controls this liquidity, the monetary base. Wary of hyperinflation, they won’t let banks lend too aggressively. Lending graduates the monetary base to broader classifications: M1, M2, M3. The Fed doesn’t directly control these broader measures, so they can be irrevocable hyperinflationary sparks.
A trillion dollars are printed, but billions are destroyed in defaulted [2006-vintage] loans and levered-up bankruptcies. In my social circles alone, I know four PE proprietors (Boston & NY) that’re out of work. So many investment boutiques crowded into the field at the most inopportune time, top-ticking the market. There were far too many institutions out there and not enough fruitful investment opportunities to go around. The ones without the scale to access government liquidity are weeded out, bankrupted. Their leverage destroys capital, but their assets are reshuffled within the industry like a deck of cards. It’s almost Darwinian.
This “destroyed capital” hardly affects creditors… AKA banks, who have trillions of government granted loan-loss reserves in their vaults. Reserves are earning interest while on deposit with the Fed. In addition, they’re leveraged for only 50 bps at the discount window to buy T-Bills—a strategy that earns 50bps of risk-free interest due to a historically steep yield curve. This is the money effectively “stewing in bank vaults,” and the risk-free return far outpaces loan-losses. True to form, a look a the most recent TIC data reveals that indirect (foreign) bidders for Treasuries have disappeared from the short end of the yield curve since March, moving out on the curve to attain higher yields. The important takeaway from this is that the bid at the front end has been maintained by Primary Dealers, venders to banks looking for these risk-free returns.
Equities, however, have inflated as a result of dollar destruction. Since the Fed knows that it’s “groping around in the dark, trying not to bump into a sovereign debt breaking-point,” it can only milk this for so long. That being said, the USD-funded carry trade ramped-up so quickly, that a perfect window of opportunity has open. The Dollar Index (DXY) is trapped like a pinball between $78 and $73 bumpers. Right now we’re at $77.50 with a long way to ease after sequential data upticks. The unwinding of the USD carry trade will snap DXY back to a precipice, providing another devaluation opportunity—i.e. equity ramp. Thenceforth, asset reflation plus that liquidity stewing in bank vaults will have provided enough balance sheet cushion to weather the ARM reset storm through 2012. From then on, we’ll have to reevaluate, because the next foreseeable boost for the economy comes in 2020, when the demand left void by the baby-boomers is finally filled organically by population growth. We have to fight pension, Social Security & healthcare battles en route, so there are some seriously troubled waters to navigate.
Best case scenario, equities are destined for consolidation within a wide range. Preferred stocks and income stocks can weather such oscillation; if you’ve got a long enough timeframe to gather dividends while waiting for some growth, quality, low-beta names are your top picks. As for fixed income, there’s no hyperinflation unless the US defaults on its debt (i.e. the T-Bill bid disappears) or the excess liquidity reaches the private sector. As I’ve hashed out herein, the Fed seems to have accidentally structured a “sweet spot” in an otherwise impossibly unraveling economy. Banks will continue to buy at the front end to capture risk-free return. Indirect bidders are moving en masse to medium (3-5 year) durations, while the entire domestic banking industry is leveraging up to feast on short-term bills, front-end fixed income will continue to fare quite well. I think that there’s a small window here where bond investors can push out their duration a bit to safely capture some more yield. Again, that’s a small window that’s closing quickly. When it’s shut, the secular bull market in bonds will wrap up with it. Tread lightly.
All that being said, alternative investments have a renewed value in a portfolio. I'm not thinking about the event-driven, momo, PE LBO styles. I'm thinking more about Long/Short or non-correlated stuff that gives investors access to non-exchange traded assets. No ulterior motive here, just trying to protect my clients' portfolios. To reiterate, I’m on this verge because I fear a secular stagnation for all exchange-traded assets; this isn’t a tactical shuffle. Capital invested is capital committed. Although they trade through exchanges, Long-short funds should outperform in a consolidating or leaky market.
Disclosure: Long HTS, SUN, FXP, NWN, and NUAN.
