Oxstones Investment Club™By Stephen C. Sexauer, Allianz Global Investors,
The Hungarians who fled Budapest in the 1930s have changed the world. This modern diaspora includes the great mathematicians John von Neumann and Paul Erdős (“the man who loved only numbers”); the atomic physicists Leo Szilard, Eugene Wigner, and Edward Teller; the author Arthur Koestler (Darkness at Noon); and the film directors Alexander Korda (The Third Man) and Michael Curtiz (Casablanca). But these were not the only gifted emigrés from that city. A prior group, from the late 1800s, included the great escape artist Harry Houdini (born Erik Weisz). Projecting seemingly supernatural powers, Houdini could escape from any confinement that could be devised.
The markets as Houdini
As investors today, we find that our world has, likewise, been changed by a handful of talented people from a single source—the fellowship of the central bankers. Most of them were trained at MIT, Yale, and a few other PhD programs that focus on the importance and power of central bank intervention.
And, like Houdini, capital markets have escaped serious trouble time after time. From the bottom in 2009, the U.S. equity market is up an astounding 174%—over 22% per year. After one terrible quarter (2Q13), U.S. Treasury bond yields have stabilized near historically low levels, defying central banks’ inflationary policies. Corporate bond spreads are thin, reflecting high profits; and real estate is recovering nicely.
In the markets, almost everything that could go right has gone right. Riskless yields are effectively zero (“financial repression”) and risky-asset valuations are stretched, presenting challenges to both income and return-starved investors. Yet the real economy has not kept pace. GDP growth, which usually booms after a recession, has been painfully slow. Unemployment is stubbornly high and, until recently, labor-force participation has plunged. As Figure 1 shows, U.S. corporate profits are at an all-time high. So are profit margins, at a stunningly large 14.6%. Figure 1 U.S. corporate profits (in trillions of $ and as % of sales)
Looking outside the United States, the central banks have found an escape path each time the markets have appeared to lock up. The European Central Bank (ECB) arguably saved the Euro with ECB president Mario Draghi’s 26 July 2012 statement, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro… believe me, it will be enough.” And, just for emphasis, he told the bond markets and hedge funds that might have bet against him to ‘go ahead, make my day.’
Italian and Spanish ten-year rates have plummeted from over 7% to under 3.5%, a breathtaking drop during a period when rates more generally have gone up. Japan, sensing a path out of a more-than-two-decade deflationary slump, soon followed with a massive quantitative easing (QE) program that amounted to 10% of GDP.
With each escape route pursued by the fellowship of the central bankers, the markets follow and march upward, proving Fed Chairman Bernanke’s September 2012 Open Market Committee [FOMC] press conference statement that Fed policies can affect not only interest rates, but also asset prices. Do they ever!
Figure 2 captures the relation between asset (in this case equity) prices—which have risen well in excess of GDP and earnings—and the size of the Fed’s balance sheet. The drop in yield spreads has marched down the same path.
Figure 2 U.S. Federal Reserve Bank assets compared to the level of the S&P 500
Now what? From a current level of 1854 on the S&P, and with interest rates at zero (short term) to 2.65% (long term), prospective returns look very low. The prospects for further central bank easing to create growth and employment from this point forward are also dim. There is growing debate whether the central banks have overreacted and are both restraining real GDP growth and creating a new round of asset bubbles.
We are now all padlocked in chains, upside down and underwater, in a world we have never seen before—one where negative real rates are eating our capital, fixed-interest bonds face poor prospects, risky assets are at least fully valued everywhere, and central bank balance sheets are vastly expanded.
So, like Houdini, we need to escape one more time. We need the fellowship of the central bankers to provide us with one last great escape from QE and the zero interest-rate policy (ZIRP), so that incomes and productivity can resume their historical upward path, and the supply and demand for risk assets can assume their traditional roles in resource allocation and wealth creation.
Escaping from debt through financial repression
Compared to the catastrophe of a debt-deflation spiral, financial repression—if it’s effective—is a reasonable choice for escaping a debt crisis. It “works” by enabling households, businesses, and governments to rebuild their balance sheets and credit. In addition, it allows governments to borrow at rates below the nominal GDP growth rate, which is the principal driver of tax receipts. If debt grows more slowly than tax receipts, the crisis gradually dissipates.
The most important requirement for escaping from a debt crisis through financial repression is time. It takes time to achieve the vast required transfer of wealth from short-term savers to bank balance sheets, to consumers who purchase durable goods at low interest rates, and to sovereigns who increase borrowing until fiscal deficits resolve. It takes time for balance sheets to be rebuilt, first private and then public. It takes time for a capital expenditure cycle to build, as even a slowly growing economy relentlessly wears out its capital base.
This is not a costless policy. But the costs are diffuse, not always easy to see, and hard to avoid even when you see them. Relative to “normal” interest rates, savers sacrifice almost $100 billion per year in bank and money market account interest—and that’s just the nominal transfer. After inflation, it’s worse. The drive for income pushes up asset prices to levels that only make sense when interest rates are depressed artificially. Low rates spur poor capital allocations. But we are in year six of financial repression, and it is working, so far. The question is: When will it end? Can the fellowship of the central bankers engineer an escape?
We have yet to find out whether the QE and ZIRP policies, once undertaken, can eventually be terminated without major disruption. The challenge is worldwide (in the developed markets), and embraces the Fed, the ECB, the Bank of England, and the Bank of Japan. Can they gradually remove QE and the ZIRP and see if markets normalize, without further carnage in the bond or equity markets?
So far, the results are unclear. Between April and July 2013, the U.S. bond markets tumbled at record or near-record speed (depending on which part of the market), but then almost miraculously stabilized. The ongoing emerging markets turmoil is disturbing, with the MSCI EM index in U.S. dollars down 21% from its 2011 peak, and some key markets down much more (Brazil −49%, Russia −41%) but much of this decline is not obviously related to central-bank action.
We don’t yet know whether the central banks can engineer a smooth escape. But we do know they are not in a hurry. Time is the key ingredient for a strategy of financial repression, and the central bankers know it. So that will be the test for the new Fed Chair, Janet Yellen: Can she lead the Fed in escaping QE and ZIRP without a major market correction or a breakout in inflation or, worse, triggering a recession?
Prospects for investors
We have a few options. None of them are great. We can wait out the central banks’ financial repression strategy, and slowly lose money in real terms. The losses add up over time. At a 2.5% inflation rate, an account earning a zero nominal rate loses 14% of its value after six years.
We can buy risky assets and follow the “Don’t Fight the Fed, ECB, BOE, and BOJ” rule, an approach that relies on further multiple expansion (or at least no contraction) and some earnings growth. We can hunt for still-undervalued assets where we can realize both earnings growth and expansions in valuation. We can look for sustainable and growing dividends.
Patience will benefit the investor. It may be the best investment strategy for year six of financial repression. When spreads are tight, shorter-term real rates are negative, and valuations are full almost everywhere, a slow-but-not-forever small loss of purchasing power is not the worst outcome. And recovering economies have pockets of value and opportunities for growth.
The favored investment themes are, then, short-duration credit risk, high-quality dividends with growth, and the few remaining value opportunities. Carefully building portfolios around these themes, while waiting out the recovery and central bank normalization, should pay off.
This is a global exercise. There will be times of stress and these will be accompanied by sharp sell-offs. Since the evidence is that the economy and equity markets are in a long-term uptrend, these sell-offs, when acute, are the times to buy.
A cavern with multiple passages that lead nowhere
These do not seem like particularly uncertain times. Slow but steady GDP growth, a multi-year bull market, and relatively easy credit have enabled investors to begin to forget the panics and pain of 2008–2009. Moreover, investors tend to extrapolate past returns, which have been very good in both equities and bonds—even long Treasuries are up 29% and long corporates up a resounding 71% from year-end 2008 in total return terms. Thus, some investors feel flush and lucky, while others are now in pursuit of such high returns going forward. It is at such times that risk is greater than it appears.
Looking to the future, however, investing in this environment feels like exploring a cave with many passages that lead nowhere. Wherever you look, opportunity is limited. Houdini himself would be challenged to escape from the cavern, but patience is on the investor’s side. Low returns, slow growth, and limited opportunity will not persist forever.
Stephen Sexauer
Allianz Global Investors U.S. LLC (AllianzGI) (2003–2012)
Mr. Sexauer is a Managing Director and Chief Investment Officer for Multi-Asset US at Allianz Global Investor U.S. LLC (previously the Chief Investment Officer of Allianz Global Investors Solutions U.S. LLC, which merged into Allianz Global Investors U.S. in January 2013). Prior to Allianz Global Investors U.S. LLC, Mr. Sexauer was a portfolio manager at Morgan Stanley Investment Management from July 1989-March 2002. Mr. Sexauer worked at Salomon Brothers from November 1986-June 1989. Mr. Sexauer previously worked in Economic Consulting at Merrill Lynch Economics and at Wharton Econometrics. Mr. Sexauer holds an MBA from the University of Chicago with concentrations in economics and statistics and a BS from the University of Illinois in economics.
Economic data in this presentation are derived from internal research, publicly available statistics published by Bloomberg, the US Federal Reserve, OFHEO, the US Department of Commerce, and the International Monetary Fund.
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