What Inflation and Deflation Risks Mean for Interest Rates
My top points of the week, noted with an asterisk (*).
1) Hyper low inflation yields in Germany, Japan, France, and Canada are the result of global deflationary concerns stemming from inadequate growth and excessive debt. Anything and everything that facilitates real economic growth are the best solutions to fight debt and deflationary pressures.
2) I have never been in favor of excessively accommodative monetary policy. This doesn’t mean my portfolio management will be skewed to reflect what ought to be. My only focus is on what I believe will be.
3) Historically (and tragically), the biggest thing that moves individual investors back in the market is higher prices.
4) “Risk” and “volatility” are not interchangeable terms. Failure of investors to interpret the difference between the two can cause damaging behavioral mistakes. Investors are afraid of risk – the chance of permanent loss of capital. They should not treat volatility – short-term market fluctuations – the same way.
5) Here is The Bahnsen Group philosophy of risk in a nutshell:
(1) Volatility must be controlled to the point where it will not cause an investor to turn temporary declines into permanent losses.
(2) The permanent erosion of capital should be avoided like the plague.
(3) A future loss of PURCHASING POWER caused by the eroding effects of inflation is just as perilous as “principal loss” – no matter how slow and invisible one may be vs. the other.
* Do you fear a global deflation phenomena and what do you think should be done about it?
I certainly do. Current pressures facing Japan, Europe, and many emerging economies are more deflationary than inflationary. I know this because I look at bond yields and bond yields tell us that market actors are more concerned about deflation than anything else. Our own 10-year bond yield is hyper-low at 2.4%, but Japan is less than 1%, Germany is less than 1%, France and Canada are less than 2%, etc. (2).These are simply bizarre realities that testify both to how militant central banks are being about fighting deflation, but also how concerned the bond market is on deflation (vs. its ugly sister, inflation). The deflation fears come from two economic realities: 1) inadequate global growth; and 2) excessive global debt. What I think should be done about it is anything and everything that facilitates real economic growth – productive growth – as nothing decreases debt like growth and nothing fights deflationary pressures like growth.
Does this mean you favor excessively accommodative monetary policy like we are seeing from our Federal Reserve and other central banks around the world?
No, but it does mean I am not surprised by what they are doing and have done, and it does mean that I feel like I have a lens through which to forecast what I see them doing in the future. I am highly skeptical about the efficacy of monetary policy in addressing problems of Growth and problems of Debt. In fact, I believe an excessively accommodative monetary policy distorts asset prices and economic behavior and creates more problems while not doing anything for Growth and Debt.
* How do you apply your perspective on all of this to your portfolio management?
It has been a while since I have addressed this so it bears repeating: I never, ever, ever confuse what I believe OUGHT to be, with what I believe WILL be. A portfolio manager can only be focused on the latter.
What was your takeaway from the Federal Reserve/Janet Yellen comments at this year’s Jackson Hole symposium?
Policymakers and economists have wrapped up their annual August event in Jackson Hole where markets and the media (more the latter than the former) obsess over tidbits that central bankers may offer which give us some inclination as to what the Fed’s next move will be. I have been a “Fed watcher” for a little less than 20 years, and I feel that most attempts to mine Fed speeches for an edge are futile. (After all, don’t we pretty much “know” what they’re going to do anyway?) The takeaways from this year’s event were very much in line with my previously shared convictions …
Can you refresh my memory as to what your previously shared convictions about the Fed are?
As applied to my work in managing money and allocating capital, I see the risk as disproportionately weighted towards the Fed staying “easy” too long vs. the risk of tightening “too quick”. I think that all language, verbiage, speeches, minutes, and notes notwithstanding, the reality IS, is that no posturing changes this: the Fed is more likely to keep rates low too long than anything else. I recognize the risk in being caught off guard by a shocking Fed rate increase earlier than expected. But in gauging the risk/reward of such a notion, I believe I have more to lose in anticipating that coming early. The bottom line is that the Fed is philosophically committed to the idea of using monetary policy as a means of creating “wealth effect” (the idea that if asset prices are higher people will feel richer and spend liberally), and they are philosophically committed to the idea that the Fed’s job is to oxygenate the economy. They preach “data-dependence”, and I believe they obsessively interpret the available data. However, I believe no data lacks an interpretive lens that cannot get you to a predetermined conclusion. I suspect that they are determined to stay highly accommodative until they think they just can’t do it any longer.
So what is the likelihood of an increase in zero-interest-rate-policy?
Consensus is June 2015. Many wonder if it will end up being Q1 2015. I believe Q3 or even Q4 are much more likely. More importantly, I think people will be stunned with the slowness at which they raise rates and unwind some of this accommodation.
What do people mean when they talk about “labor market slack”?
It is essentially a reference to the under-employed or under-utilized employees in the work force. A lot of “slack” (under-utilized employees) means that there is a long process to go before a ton of new jobs will be created (companies would rather better utilize their present employees than hire new ones). “Slack” becomes a measure to use a diminished view of the unemployment rate (i.e., a low unemployment rate with a lot of slack could be more concerning to policymakers than a higher unemployment rate with very little slack).
What is this week’s argument against performance-chasing as an investment methodology?
Last week Friday, the St. Louis Federal Reserve released their findings on a study they commissioned on investors chasing returns – plowing money into funds after they have hit peaks – etc. The conclusion? Performance chasers generated a 3.6% annual return from 2000-2012 (on average), a full 2% per year less than the asset classes themselves (1).
* What is historically the biggest thing that moves individual investors back into the stock market?
Higher prices. And that is a tragedy.
What is your challenge as a contrarian right now?
Conflicting data. Margin debt is very high. High yield bond yields and spreads are very low (though higher than they were two months ago). TED1 spreads are very low. The VIX2 has been (and stayed at) record low levels for quite some time. These are all signs that would normally tell me euphoria is a bit too high. HOWEVER, flows into equities have not been at all concerning and sentiment/psychology remains very apprehensive. There is no way an objective observer would say that investor behavior looks like the typical signs of a euphoric bull market top.
What does it mean when we read there are 4.7 million job openings in the United States (highest in five years) but there are still 10 million people looking for work (3) ?
It’s what economists refer to as a “skill gap”, the gap between the skills a job requires and the skills the unemployed have. We also have millions of people previously not on permanent disability that now are on permanent disability. It is rare to see those numbers change materially once that transition happens. This indicates to me ongoing structural challenges in our labor market.
Why do you believe the Euro is eventually headed lower?
The economics of my thesis speak for themselves: the Euro zone faces a debt crisis that becomes much easier to manage when paying off bills in a depreciated currency. This begs the question, though, for weakening the currency is easier said than done. The issue is how the political and cultural conflicts that are at play will resolve themselves. Let me give you an historical context for Europe’s willingness to depreciate their currency to deal with debt. Between 1973 and 1999 (the year the Euro currency came to be) Spain’s currency depreciated 76% relative to German Mark; Italy 80%; Portugal 92% (4).This same paradigm exists today: The strength in the continent prefers a rigorous strong currency (Germany) while the member countries most plagued by debt and who have the strongest historical record of currency depreciation favor more of the same. The purpose of the Euro was to force member countries to enact policies of structural strength and global competitiveness. However, my projection (shared by many, but yet to come to be) is that the Euro will end up being used as the pre-Euro individual member currencies were used: As a policy tool for dealing with structural challenges.
Is the Euro something that can survive?
The policymakers in Europe have made clear that they intend for it to, and they have aggressively acted upon those stated intentions. I believe a greater focus on their structural challenges should be the higher priority (cost structure, trade imbalances, debt levels, labor markets, etc.), but at this point the arguments for or against a unified continental currency in Europe are largely irrelevant. Remember my earlier adage: I invest based on what is, not what I believe ought to be …
* Why is the difference between risk and volatility such a big deal to you?
It is not that the actual difference is a big deal to me. It is that the two are used so interchangeably that I believe an underlying ambiguity exists which has been quite damaging to investors. Intuitively, I believe we know that the permanent loss of capital (risk) is what we are afraid of as investors. Temporary price fluctuations (volatility) are obviously not the same thing. But when we refer to them using the same term (risk), we end up treating them the same and making behavioral mistakes we ought not make.
* Would you add anything to this discussion of risk?
Here is The Bahnsen Group philosophy of risk in a nutshell:
1) Volatility must be controlled to the point where it will not cause an investor to turn temporary declines into permanent losses.
2) The permanent erosion of capital should be avoided like the plague.
3) A future loss of PURCHASING POWER caused by the eroding effects of inflation is just as perilous as “principal loss” – no matter how slow and invisible one may be vs. the other.
Where do Alternatives fit in when it comes to your overall risk management?
I utilize Alternatives where I can find investments whose source of risk and source of return potential are largely outside of the traditional stock and bond markets. It is intended to reduce volatility so as to make the year-by-year price levels and compounding more palatable for investors. It is also intended to provide solid absolute returns within the portfolio despite the inherent volatility risk all asset classes inevitably have.
Is there a best practice for how to fit Alternatives into a diversified, balanced portfolio?
I know that many portfolios were, for decades, largely allocated in some version of a 60% equity, 40% bond mix, and that Alternatives were initially popularized as a way of diversifying that 60% stock allocation. Today, I see Alternatives as an important diversifier to our BONDS perhaps even more so than to our STOCKS.
Are “Alternatives” an actual asset class like stocks, bonds, and cash?
I refer to them that way as does the entire financial industry, and for simplicity’s sake it is presented that way in your reporting, etc. But no, in reality, Alternatives are more “asset management styles” than entirely new “asset classes”. Maybe the distinction is irrelevant to you but it matters to me. It puts the burden entirely on me to find good managers, for relying on a class of assets will do me nothing.
So if you accept some degree of volatility in your investment management, how do you seek to achieve your desired investment outcome through time?
From a portfolio standpoint, I manage for the magnitude of the positive returns to be greater than the magnitude of the negative returns; we also manage for the frequency of the positive returns to be greater than the negative ones (5).Having a low magnitude negative return during negative periods will, for me, involve lower beta stocks and the inclusion of alternative investments in my portfolio allocations.
The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt (“T-bills”). The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk-free while the rate associated with the interbank loans is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing. When the TED spread is as low as it is now, it can be an indicator of market complacency.
Often known as the “fear index”, it essentially is an index of options (derivatives) that summarizes the expected volatility in the S&P 500 over the next 30-day period. Without getting into the specifics of how it is created, the practical meaning of the term “VIX” is this: a high reading demonstrates an increased level of fear in the marketplace; a low reading communicates the opposite – that the market is forecasting a relatively healthy and low-risk environment.
QUOTE OF THE WEEK
“For our part, we’d rather invest in eternal verities than in the ebb and flow of transient economic information.” – Lowell Miller