Sunday, July 2, 2017

Janet Yellen Could be Right, If……


Janet Yellen, Chair of the US Federal Reserve Board of Governors, has said she does not expect a 2007-2009 financial crisis in her lifetime. For many reasons we hope that she has a long life. One of the lessons learned from lots of sports, including horse racing, and applied to business, portfolio management, and life in general is to be conscious of what could go wrong. If you will “the known unknowns” as well as making some allowance for “the unknown unknowns.” 

As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.

What Causes Crises?

Major financial crises typically have both preliminary causes and a galvanizing event. The preliminary causes are relatively easily to spot, often by looking in a mirror. The event is often the unintended consequence to an action that forces many to brutally re-examine an intellectual or emotional structure in which we had total faith, that suddenly is found wanting.

Underlying Causes

The first cause is the belief in the inevitability of a pre-determined future. The growing enthusiasm for this belief overrides all past cautions. Because we all believe that we should be richer than we are, we will borrow to multiply our stake in the inevitable “goody.”  Often people and institutions look to borrow from any available source including surreptitiously from others without their notice... embezzlement. Thus, the essential second underlying cause for  crises is leverage. (For my mathematical readers- Enthusiasm in the “inevitable” times expanding use of “cheap” leverage = precursor of crisis.)

Where Are We Today?

Chair Yellen can not identify any major causes for concerns. She is right at the moment. Focusing on my continuing analysis of the global mutual fund business, I see some potential worries.

Are Equities About to Take Off?

One of the reasons that mutual fund performance is so often quoted by media, academics, and even government officials is that the data is quite accurate and rapidly and relatively available. I have been following these numbers for fifty years. This how I start to view the movements in the marketplace. On Friday we finished the first half of 2017. While the data is preliminary and subject to minor modification, it is instructive. There are at least nine investment objective averages producing double digit returns for the first half. (A copy of the list is available by contacting me. The leading investment objective is the Health & Biotechnology average of +18.46%)  Without dividends both the Dow Jones Industrial Average and the S&P500 were up 8% and using the Vanguard S&P 500 Index fund’s total reinvested return was 9.3% as a rough guide to the market.

In terms of our analysis, the key point: if the fund and general market performance produced high single digit gains in the first half, is it a reflection of growing enthusiasm which is relatively higher than the current sales, operating earnings, earnings per share or dividend growth? Remember that most institutions such as pensions and endowments have a targeted goal of between 4 and 9% for the year. The biggest gains were experienced by Growth rather than Value-oriented funds. Growth enthusiasts tend to be more future-oriented than value investors who are basically betting on correcting mis-priced securities. Either the markets are now premature in discounting future growth or will be in the future. Thus, we may begin to exhibit one of the standard precursr to a crisis.

Could Fixed Income be a Trigger?

The thirst for income is a global phenomenon to pay current or future bills. Almost everywhere that has a sizable Mutual Fund marketplace, money is pouring into bond funds at the retail level and into other credit instrument funds at the institutional level. What makes this concerning is the general market perception that interest rates will rise, and if things go wrong the rise could be significant. While Fixed Income investors typically focus on yields on purchase price, they are often shocked when they sell at prices below their initial purchase price. At some point at least the institutional investors will look at their investments on a total return basis incorporating current prices which could be materially lower due to interest rates rising. Future prices could be hurt by various trading entities like hedge funds being forced to meet collateral calls as their Fixed Income holdings are marked down to a declining market. My own suspicion is that the two segments which are most exposed to high leverage is government issued paper and credit instruments.

Archduke Accident Replay

Popular beliefs hold that World War I was begun as an outgrowth of the murder of the popular Archduke Franz Ferdinand of Austria on an automobile route in Sarajevo that had been changed due to security precautions from an incident earlier that day. The change was ordered without telling the chauffer.  The sad event set in motion countries that were already preparing for war and forced their allies to come to their aid. Often the trigger events are caused by an unintended consequence of a well intentioned act, often by some force within the government. Usually the forces that trigger the consequences have a much too narrow of a view of their impact. Allow me to suggest a hypothetical and probably improbable series of events.

Government officials and media pundits look at mutual funds as products with a sole goal of producing a higher return than some other measure. They fail to understand the history of the fund business. Mutual Funds started as a way to mobilize existing savings (usually on deposit) into long-term investing. To convince savers to part with some of their savings was not a simple exercise of giving the reluctant saver enjoying a level of security something to read. The sales process often took a number of sessions. The global fund business was a financial service activity not a financial product producer. Perhaps the key value of these financial services is not just the initial purchase, but subsequent purchases. Probably the greatest value during periods of scary market declines is urging the investor to stay invested. Finally, the process permits and encourages partial withdrawals and perhaps some switching into more appropriately aged investments. All of these services need to be available everyday and often in aggregate, cost more than the pure investment expenses. In recognition of these needs many fund distributors and allocators have styled themselves as wealth managers.

The UK’s Financial Conduct Authority is complaining that UK funds are not competitive enough. They want competition based on a single fee covering all the holder’s costs and performance. (They are not focusing that in many cases the services aspects of the fund business are equally or more important to the holder than fees and performance.) We have in the past seen similar naivety occasionally in the US. Some similar concerns had been expressed in the EU’s MiFid rules.

What Could Go Wrong?

For the moment assume that this type of thinking becomes popular in many countries, sales people and to some degree, service people will leave the fund business and migrate to more expensive products and services like hedge funds, private equity, venture capital, real estate, or “investment art.” There is some chance that the returns will be below mutual funds. Where this could create a large problem for various governments is that the growing retirement capital deficit is expanding and there will be pressure on taxpayers to fill the gap at the expense of other government services. Expanded government services will lead to higher inflation as the government will have to borrow more to pay its bills. Or taxes will rise which can in and of itself cause a financial crisis as taxpayers rapidly change their investing status.

What Are the Odds that Janet Yellen is Correct?

At the track regular horse players understand that in spite of all their considerable handicapping (analyzing) skills there is something called “racing luck.” Things happen that are the providence of the “unknown unknowns.” Ms. Yellen could luck out and there won’t be a financial crisis the rest of her life. 

For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.  

Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.

One may need good advice now more than just faith that there won’t be any crises.        
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A. Michael Lipper, CFA
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