Wednesday, March 13, 2013

Financial Repression: profits today AND tomorrow? [David Zervos]

My 2cents on a piece by Jefferies' David Zervos I received today.
Maybe I understood his words wrongly. Maybe I am biased.

*** PIECE AT END ***

Zervos has been spot-on regarding risk-on and playing the Bernanke-Put. No doubt about that.

And I accept/agree with most topics touched below.

One thing that gets me to scratch-head is that markets are indeed pricing in "higher real risk-free rates of return", but not because the animal spirits are going to get people into investing, or into believing in growth-escape-velocity and subsequent decrease in debt/GDP (in US it's been +45% debt for +11% GDP growth I think, speaking of 'debt-deleveraging...) producing, then, higher nominal cash flows. We're currently borrowing from future growth as proven by the decreasing marginal utility of debt (transformed into growth).


A/ As market-prices rise for financial and hard assets with a
1/// stable stream of Cash Flow (equities, bonds [sovvies or corporate]) and
2/// a discount factor (time + real-yields), you're actually reducing the scope for higher REAL returns. That's simple arithmetic.

B/ risk-free Bond Yields can't move higher... and here is where I think Zervos is wrong.
Ask around what everyone would do, at least temporarily before proven otherwise, if a Bloomberg HOT headline printed "the Fed, the ECB, the BoJ and the BOE decide to end their monetary stimuli".
I am pretty confident that everyone would get the hell out of pretty much most assets they've been holding onto.
And that could make financial asset prices to go lower, likely much lower, and cause... debt-deflation.

With inflation expectations becoming increasingly negative you can, then, be long "risk-free government bonds", and actually have a "higher risk-free real return". Welcome to deflation (like in 2009).

So the conclusion could be that, financial repression pushed people into risky-assets because they have no alternatives. Herd behavior, scarcity of good assets.
While QEs remain in place and until nominal growth disappears, keeping nominal cash flows positive and stable, people will remain long carry, chasing yields.

Here are 2 charts I keep in a drawer nearby to remind me that whatever doesn't have positive carry (read commodities, Ibovespa x CDI are examples) shouldn't be bought, but sold on rallies.

Then you drill down to what are the best risk-adjusted carries in the world.. and the answer is "what has stable, preferably rising, carry and denominated in the currencies that have ongoing powerful QE programs, but with a currency hedge, if hedging has very low carry against it to your desirable currency.

That gets you to:
// USD: US Equities, Treasuries, Corp bonds
// EUR: German is the risk-free here, so German equities and Bonds
// GBP: same…
// JPY: now, after finally reverting the currency-appreciation due to the enormous stock of assets in foreign currency (said to be 55% of GDP) flooding Japan after each shock, so that pension and insurance companies could cover their deficits without selling JGBs, the Nikkei and JGBs are making new highs…
// CHF: the Swiss Market Index and swiss sovvies.

These all posted new near-term and close to all-time or multiple-year highs in local currency.

While the rest of EM/Commodities start taking a tumble starting in 2010/2011/2012, saturated by foreign capital that made real estate prices higher, inflation higher, but now with much higher currencies in real effective terms (terms of trade…) and unable to keep expanding at the rate it did in the past 10-15-20 years now, so multiples used for equities for example, can't be as high either. The SuperCycle, in my opinion, has ended. Time to get some of that BoP surplus back to where it came from.

The first chart is from Bridgewater. Basically the component break-down of Global Equity Returns into a/ growth in cash flows and b/ the reduction in the discount factor of these cash flows. Basically real-yields dropped, causing the net-present-value of these no-growth-cash-flows to soar.

The second chart is from Kyle Bass’s Hayman letter. It shows the marginal utility of debt through time, since the end of WWI.

I might be wrong. But for now this is how I view things.
Thoughts are welcome.

David Zervos - Risky real rates vs risk free real rates
 Ok, I am going to be a bit of a geek today. So no Breaking Bad, Colonel Jessup or Charlie Sheen references. Sorry to disappoint but there are some serious changes under way in market correlation patterns. And these need to be addressed.
 Specifically, the USD is strengthening sharply as seen in the near 4 big figure move in DXY over the last 6 weeks. The last time we saw a dollar move like this was in late spring/early summer of 2012. Back then, spoos dropped 10 percent and the entire global risk asset complex was rinsed. As was typical in post crisis markets, European problems were to blame for this flight to the dollar and away from risk. It was the Greek election and Spanish banks that had everyone corybantic at that time. But just like in all other "flare-ups", Ben and Janet rode to the rescue dragging the ECB along for the ride. 
 I remember writing some fun commentaries at that time  - "Black Swan Down - Viva La Espana", "Germany Loses, Spoos Win", "The Committee to Save the World - Part Deux", "A New Euro/Spoo Correlation Coming"....etc etc. Those surely were good times - there is really nothing more enjoyable for me than writing a solid BTD commentary as markets swoon. Anyway, as the central bank policy measures kicked in and the pressure from Europe dissipated, the DXY dropped and risk assets gained traction. That was the  boiler plate post 2008/2009 crisis market correlation pattern! 
 But as we fast forward to the current situation, EURUSD is dropping towards 1.30, USDJPY is pushing through 96 and the dollar is even beating up on CAD and AUD. At the same time we are printing record highs in the Dow, while Gold is weak and many of the once venerable developing markets (ie BRICs) are struggling. What explains this NEW pattern in global markets? Strong dollar/ strong risk-assets/weak gold/weak EM is not something that associates well with our post-crisis world - in good times or in bad times. Its a pattern from the old days of "new paradigms" and "goldilocks". Has Ben reawakened the ghost of goldilocks or the productivity miracle? 
 To answer these questions let's go back to our basic storyline from the last 3 years. In nearly every commentary I have written since I joined Jefferies, I have argued that global central bank balance sheet expansion would not stop until we achieved a fully fledged GLOBAL reflationary outcome. In turn, I postulated that these actions would lead to rising long term inflation risks, falling risk free real yields, a reduction in the real value of fixed income assets and an increase in the value of real (non-printable) assets. And while it took some time to get all the central banks on board, we have basically arrived at the realization of this view. 
 We now have a world where ALL developed market central banks, led by the Ben, are engaged in balance sheet expansion, reserve creation and money printing. 
Expected risk free real rates are plummeting across developed markets and inflation expectations are rising. These economies are avoiding a dreaded debt deflation spiral and are instead generating domestic reflationary recoveries. 
The monetary policy makers are all in essence relying on the portfolio balance channel to force savers/investors out of financially repressed risk free assets and into the world of risky investing. And while the long term returns to these risky investments remains highly uncertain, the market appears to be turning a corner on the expected gains from this risk taking - at least in the US. It is precisely this "exuberant" expectational shift in US that is driving our new correlation pattern between the DXY, Equities, Gold and EM.
 Let me elaborate - the variable that best explains this NEW correlation patterns is the expected real rate of return for risky investments in the US. A rise in what I will call the "risky" real rate represents a turn in animal spirits, a jump in investing optimism, and the destruction of deflationary forces. And it represents the expectational seeds of a REAL US recovery. 
 Of course it is very important to make sure we do not confuse this expected "risky" real rate with the expected risk free real rate. The latter of course is in complete control of the Fed at least in the short run. They can drive the short term risk free real rate at will given that short term inflation is sticky and they control nominal short rates. In fact, I would argue that they even have quite a lot of control over the expected long run risk free real rate - which is just a weighted average of expected future short term risk free real rates. With the use of forward looking language and the balance sheet, the Fed is actually able to drive both the risk free nominal and real yield curves wherever they like (in the limit they can always buy up all the 10yr notes and 10yr Tips and set both rates). 
 In any case, having the central bank manipulate the risk free term structure of interest rates does NOT ensure that real returns are generated from actual investment in real economic activity. Nor does it ensure that we get real growth. In the old days we used to debate the neutrality of monetary policy aggressively. I was brought up reading Sargent and Wallace, Brunner and Meltzer, and McCallum. Their basic argument was that monetary policy had little long run impact on real variables. Of course that breaks down as the Fed steps in to alter both short run and long run real risk free rates. It is the movements in these variables that enables the effective transmission of policy from the monetary side to the real side. As our central banks drive risk free real rates lower and lower, and force financial repression into the system, they also force risk taking. The central banks change our incentives to invest in the private sector, but importantly, they do not themselves ever directly generate any real investment activity. 
 However, to the extent that there is some market failure, changing these incentives, and forcing us to take risk can lead to a better outcome for real investment returns and hence growth. This is where the long term money neutrality arguments really break down. It's actually a situation akin to the old collective action problems that have been studied for decades by game theorists. If our incentives to take risk are beaten down after a big crisis - and everyone is in hoarding mode - there will be no growth and no incentive for any one person to be entrepreneurial. But if we become incentivised/forced to take risk via financial repression, then we could achieve a higher equilibrium real growth outcome as everyone joins in the risk taking activity. That's the power of collective action and that's the transmission mechanism. Monetary policy stokes the animal spirits that revive real economic growth. Ben and his disciples are simply trying to solve our post crisis collective action problem and thereby get us to a better equilibrium with higher real growth. Their tool is the term structure of risk free real rates - which is being lowered aggressively. By taking that down, and incentivizing risk taking, they are driving long-run expected real returns on risky investments HIGHER. Those higher expected risky real rates then drive the dollar stronger, equities stronger, gold lower and EM weaker. Et voila! I warned you I was going to get geeky today so don't be shocked. And wait there's more!! 
 Going forward we need to be very careful about the delineation between long run risk free real rates and long run risky real rates. After reading Ben's speech in San Francisco from March 1st on why long term (risk free) rates are so low, it is clear that he fails to make this distinction. He is talking about how markets have low expectations for long run real returns to investment. That is patently false! Decomposing a highly manipulated risk free rate term structure into real, inflationary and term premium components is NOT going to give you any information about market participants view of the long run expected real returns to risky investing. Rather, it will tell you what market participants think about the path for expected risk free real rates - or more specifically the Fed policy reaction function since they set them. 
 To repeat, because this is very controversial and very important, the current term structure of Treasury rates tells you virtually NOTHING about market participants view on long term returns to risky investment activity. Why are long term nominal rates so low is Ben's question? Because of him is the answer!
The Fed reaction function, the Bernanke Put, the Greenspan Put, the Yellen put are all drivers of the long run outlook for risk free real and nominal rates.
 Actually, I just dug out a presentation I made in 2006 at a MacroAdvisors conference that tried to make this point in a completely different era. I will send it out shortly, but even 7 years later the arguments are the same. Back then we were all talking about the conundrum and low rates. And today, Ben is still asking why risk free rates are so low. He suggests that market participants have low expectations for real returns on real investment. 
Pulllease - the Dow is at a record high, that is just plain wrong. The current structure of the monetary policy reaction function is the driver of these risk free rate structures. That's what I argued back in 2006, and I stand by that view today. The consistent exercising of the Bernanke Put is the reason why the risk free real and nominal term structures are so low. And the only transmission of these low rates to the real economy comes from the mechanism described above where we have a breakdown in animal spirits and collective action problem that requires a change in private sector incentives. 
 Here is the bottom line - by lowering the term structure of risk free real rates, Ben is INCREASING the term structure of risky real rates. And these higher real rates (the ones that really matter) get us to a world with higher equity valuations, a higher DXY, lower Gold and weaker EM. So in essence - by lowering risk free real rates and forcing risk taking we are moving down the path to a REAL recovery. Incentivizing risk taking solves a traditional post crisis market failure where no one wants to take any risk. The rise in the risky real rate basically represents the portfolio balance channel at work. 
There is of course always a risk that long term inflation expectations come unglued in the future, and that real returns to these risky investments turn sour. We should always keep in mind that these aggressive balance sheet expansion policies are highly experimental - and therefore they create material future risks to price stability. But markets show no sign of such worries now. 
And it will be a long ways down the road before we have to think about the potential for a stagflationary outcome. Today we can celebrate a US market that has crossed the rubicon into strong and POSTIVE risky real rate expectations. 

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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