Sunday, October 10, 2010

Governments Join the Bond Bashers

(Warning: this blog is both argumentative and complex. You may find little that you will accept)

The Preamble

I challenge you to find the single most powerful political drive in the constitution of the US or any other government. Whether democracies, pseudo-democracies, or controlled states, the governing group is leased the franchise by the governed as long as they put bread on the table. The lesson that has crept out of the years of the welfare state and other socialistic approaches is that the central government is not very good at putting bread on all of the tables. Due to inefficiency and corruption, governments are not good engines of employment. Military contracts, road building and other grants as pump primers haven’t worked effectively for at least ten years. What is a politically savvy government to do in this post-industrial state? In many countries unemployment and under-employment is much too high for those in power. Complicating their problem, the current size of aggregate demand is not sufficient to foster hiring.

The Political Solution

Apparently the governing élites believe that the size of the existing demand in units of work is currently fixed. The way to increase the economic power of the existing demand is to raise prices. They believe higher prices will lead to more jobs rather than higher prices will lead to less demand. Raising taxes has little positive effect for employment. However, if prices go up the unsophisticated businessman and many securities analysts will see nominal profits rising. Rising profits will encourage employment and investment, or so the theory goes. The problem for the political powers is how to get prices up with slack demand. The way to do it is to raise costs, which on the surface level can be accomplished by increases in taxes and user fees. Politically there is a risk in this strategy. There is a better way which apparently has less political risk and is not as obvious.

The Better Way

If the governments, not just the US, can import inflation, costs will rise and nominal profits may as well. Inflation is being imported from that very powerful engine of inflation – China, as well as that sometime inflation factor, energy prices. The mercantilist recipe for a nation in economic difficulties was to devalue the stated value of its currency compared with its trading “partners.” (This is a game many Wall Street Partnerships also learned.) With the creation of both “the single currency” (the euro), and the de facto single reserve currency (the dollar), an exchange rate currency war would be difficult to win. However, if a currency’s value is depressed by the recognition that its purchasing power is declining, currency exchange rates will respond. The impact of lower effective rates is that export prices are lowered and import prices rise, which helps the balance of payments. As the US and now the EU are attempting to push the yuan higher with limited success, the US currency is dropping in value against almost all major currencies.

The Talking Heads

One of the age old beliefs in Wall Street is the odd-lotter’s theory that the public investor is always wrong at turning points. Careful statistical analysis of the data does not support a strong conclusion to this effect. Nevertheless, one of the favorite approaches of market commentators is to divide the world of investors between sophisticated investors and the “hoi polloi,” or the common investor. They view the net outflows from equity funds and net inflows into long term bond funds as a classic odd-lot signal to buy stocks and sell bonds. As with most sound bite views, the background analysis is not so one-sided and therefore is open to further interpretation. While there are a fair number of individual active traders, there are a decreasing number of active individual investors trading these days in their own accounts. Many use their salary savings plans (401k, 403b, and 457 plans) for their structural investing. Mutual funds have become the most visible arena of individual investors and this needs to be studied to understand what people are doing with their money.

Reading the Mutual Fund Tea Leaves

The net flow data on the purchases and sales of mutual fund shares do not tell the mis-asset allocation story that the talking heads believe. I believe that there is a decline in the gross sales of equity funds. Many of the funds’ good to great performance records were destroyed coming out of 2008, and for the most part their recoveries have not reached their 2007 peaks. Thus many minds believe there is no immediate incentive to invest in perceived riskier equity assets now. Further, many of those in the their middle ages who are the traditional fund buyers are worried about their jobs. On the redemption side of the equity funds, I believe that most redemptions are, in effect, completion payments for retirements or to a lesser extent, educational expenses. Retirements for many came earlier than expected and there was a need to husband remaining assets when income disappeared. Perhaps more misleading to some was what was happening on the fixed income side of the flow data. Many observers recognized that the $2 to 3 trillion in money market funds was largely cash reserves that used to sit in bank deposit accounts awaiting future expenditures. They focus on all of the rest of the taxable fixed income funds, which currently total more than US$1.9 trillion.

What really happened was that a significant minority of money market fund holders grew tired of earning practically nothing on their reserves and moved some of their money to Short/Intermediate Bond funds of various credit qualities. These funds now represent over $1 trillion on their own or over half the $1.9 trillion in the non-money market taxable mutual funds. Over the last twelve months they have earned 2.64% to 9.43% on average, depending upon credit and interest risk they have assumed. I believe that at least half of these dollars will return to the equity market when there is forward momentum in stocks.

Another disguised equity component in the fixed income mutual fund field is the group that has the most money in long term bond funds. High Yield funds currently have over $176 billion in assets. When setting up the original Lipper Analytical Services Fixed Income Fund Performance Analysis report as a companion piece to the equity report, I was tempted to put High Yield funds in the equity report. At the time, as a student of Graham and Dodd I viewed them as essentially stocks with coupons. If one traces out the performance history of these funds, one will find they move with the stock market. When the stock market is moving up there is a better chance to refinance expiring low to mid quality bonds. Also more “junk bonds” are created in equity-like deals in a bull market. My friends in the distressed securities funds are salivating at the huge number of low quality bonds that are maturing in the next few years. If we remain in a flat economy with some induced inflation, a number of these issuers will not be able to refinance their debt and will become candidates for the distressed securities buyers.

The Evidence of Inflation

Central governments in conjunction with most central banks appear at the moment to be winning the currency wars through inflation. Clearly the rise in the price of gold is attracting more buyers. But compared with the size of the gold market, the size of the market for US Treasuries is much, much larger. One of the measures that I use in determining the expected magnitude of inflation over the next ten years is the break even ratio between 10 year Treasuries and 10 year TIPS (Treasury Inflation Protected Securities). In August, TIPS were yielding 1.51% less than similar treasuries. Currently the spread is about 1.98%. Knowledgeable buyers are paying an increasing insurance premium on inflation.

What to Do?

For those accounts that must carry reserves, we have been shifting money into Ultra Short obligation funds that invest in very high quality paper with average duration less than a year and a maximum maturity of two years. For some accounts we have added Australian and Canadian dollar short term investments and even some foreign currency Certificates of Deposit.

What are you doing?

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