Second Quarter 2017
Three trends seem to be capturing the attention of the market in the past quarter: equity index investing, low volatility, and monetary policy normalization. Equity indices are widely viewed by many to be the only acceptable way for the retail community to invest in equities currently. The reasoning is sound. Most active managers underperform the index, making index investing, generally through ETFs, even more attractive. In addition to lower fees, index ETFs are more tax efficient than mutual funds. Most active managers in the long only community hug the benchmark, as significantly underperforming their benchmarks usually means losing their jobs, while outperforming provides little upside. Hence, we’ve seen a huge outflow of assets from active managers to index funds. According to the Financial Times, since January 2000, approximately $1.5 trillion in assets have left active US managers and moved to passive strategies. That means about 50% of long only equity investments in the US are controlled by, well, the people who make the index.
Bernstein Analyst Inigo Fraser Jenkins likened this to Marxism, saying “In a Marxist society at least someone is doing the planning of capital allocation, but in a predominantly passive market the capital allocation process is done by a marginal participant.” When someone moves from active to passive, they force the price of all the stocks that are in the index up, to the detriment of carefully selected securities of their former asset managers. This is all fine and dandy as long as the flow continues one way (a trend now 17 years in length). If I buy SPY now and fire my Fidelity manager, I will be pushing my basket of securities up, and active portfolio baskets of securities down. This cycle is repeated every time someone else does the same. The problem occurs when people begin to sell these passive products. As baby boomers enter the later years of retirement, they will become net sellers of equities. The huge savings of sovereign governments in Asia and the Middle East may need to be spent either defending pegged currencies or paying for the benefits of their populations. While new savers will emerge to buy, it would be imprudent to think these flows will happen in a coordinated fashion. Likely, an event will occur, like a toppled regime in the Middle East, a financial crisis in China, or a North Korea shelling of Seoul, which could cause the stock of wealth held in index products to flow out rapidly. In this sort of situation, owning the same stocks as everyone else in the world is a major risk to the careful protection of capital.
Intricately linked with the rapid rise of index investing, in our view, is the recent decline in volatility of US equities. First, the move to passive investing means most money moving into the market is not stock picking. It is just buying a basket of securities in equal proportion to their weighting in the index. Also, passive investors don’t choose energy over technology, they just buy the sectors based on their weights in the index. This would seem to create lower volatility in the market as there isn’t as much shifting of money around between individual stocks. As most indices are market cap weighted, any new money flowing into the market buys the most highly valued companies. Then, quant funds, who often try to capture momentum, buy those same highly valued companies, because they typically buy what is going up and short what is going down (another self-perpetuating positive feedback loop). The lack of economic surprises this year has also dampened volatility. Generally, the world economy is witnessing decreasing unemployment, modest growth, little geopolitical unrest (outside of Washington and North Korea anyway), all in a low rate environment. So, it’s not surprising that volatility appears low. No economic surprises equal little fear.
Why is this important? I think one area to monitor closely is the amount of leveraged money in risk parity funds. These funds use the measures of volatility in bonds and equities to leverage themselves in those markets. So, if S&P volatility is low, risk parity funds can buy more equities, and if bond volatility is low, they can buy more bonds. When both are low, they can increase their leverage without risking a major blowup in performance (at least statistically). But what if that changes? According to the CFA Institute, $400 billion in assets are currently allocated to risk parity strategies. The largest of these managers are Bridgewater and AQR. With equities richly valued, bond yields low, and a whole lot of assets leveraged 3-4x betting that the situation will remain that way, I think you create a recipe for disaster. The common wisdom is that bonds tend to do well when equities do poorly. In other words, their correlation to one another is typically negative. But what if this correlation flipped? An unwinding of the Federal Reserve’s balance sheet, the European Central Bank’s balance sheet, and the Bank of Japan’s balance sheet could create such a correlation flip. We know the Fed is preparing to carry out an unwind. Likely it will be cautious in doing so, but we don’t know how the market will absorb this supply. It could do so with the 10 Year yield at today’s 2.5% or at much higher yields. Either way, increased volatility from either bonds or equities could trigger a negative feedback loop where risk parity funds are forced to sell both bonds and equities at the same time.
First Quarter 2017
The first quarter of 2017 saw a continuation of the post-election price trends. Equities were generally higher, rates were range bound, and spreads on investment grade and high yield bonds continued to tighten to historical lows. Digesting their large gains, bank stocks and small caps, while up, generally underperformed the broader market. In energy markets, Crude Oil was -5.81% lower, as larger increases in US production offset OPEC production cuts, and Natural Gas declined -14.24%, as mild winter weather led to increased stockpiles. Gold rose 8.3% in the quarter, helped by technical positioning (speculators had cut long positions after the election) and increasing geopolitical risk from North Korea and Syria.
In the US, rosy sentiment toward Trump’s economic and political agenda faded as partisan bickering picked up around the attempt to repeal the ACA healthcare law. Trump faced opposition from his own party, as some Republicans were not content with a partial repeal. This led many to question the ability of the Trump administration to push through the aggressive reforms the market expects, particularly corporate tax cuts. Generally, we think the broad idea of cutting corporate tax rates will have support on both sides of the aisle. However, the problems will come from accomplishing this in a revenue neutral way.
We are closely monitoring the debt ceiling debate that will no doubt pop up in the headlines soon. The US has roughly enough cash to last through late summer, at which point the debt ceiling will need to be raised. Our new Treasury Secretary, Steve Mnuchin, has asked House Speaker Paul Ryan to lift the debt ceiling post haste. However, we suspect, as the Republicans did with the Democrats, the Democrats will attempt to use the debt ceiling votes to extract concessions from the Republicans. No doubt, this needless drama could concern markets, as no one likes to see the US flirt with default as if it is a banana republic.
US economic news has been okay. Job growth continues, albeit modestly. US GDP for the 1st quarter is tracking near 0.5%, which is well below most economists’ expectations. The drop is led by very slow growth in consumer spending and equipment investments. In addition, the Federal Reserve is cautiously optimistic on the economy, but is very cautious in normalizing the Fed Fund rates. Given the meager growth numbers, this seems like a very reasonable approach to us at this point, but the Fed is also concerned with asset values. While real growth in the economy remains weak, asset prices continue to benefit from cheap financing rates. In addition, wage growth is outpacing CPI growth, which could trigger margin compression for corporations. Generally, we don’t see the US equity or bond markets as an attractive opportunity currently, as the Federal Reserve is raising rates, wage growth is strong, demand growth is weak, and earnings multiples are high. Ultimately, we think that the repression of interest rates, once over, could trigger large declines in asset values currently supported by cheap financing.
We are also closely monitoring some negative developments in the credit market for short opportunities, specifically in commercial mortgages, subprime auto securitized bonds, and consumer credit. In the commercial mortgage market, we see signs of distress in the retail sector, where malls are hurting from a shrinking market for physical retail stores. E-commerce is rapidly changing the way consumers shop. This fact, coupled with a maturity wall next year of commercial loans issued in 2007, have impacted pricing of mortgage pools with heavy retail exposure. In addition, we see some stress in the performance of subprime auto loans, a market that has grown considerably in the past 5 years. Morgan Stanley recently stated on an industry call that in 2016, 33% of auto loans were to people with credit scores below 550, compared to just 5.5% in 2010. Finally, consumer credit levels (the amount of credit extended to consumers in the US) just matched their 2007 highs and are growing much faster than incomes. We think this will set the stage for consumer lending losses in the future as consumers over borrow due to their perceived confidence in the economy. We are actively searching for ways to profit from these developments.
Outside the US, political uncertainty continues to abound. French elections in April will be a focus for macro investors, as people are concerned that a win by Marie Le Pen could start a Frexit (or potentially a “Frau Revoir” or “adiEU’). In addition, as I write this, the market is digesting the new air strikes carried out by the US upon the Assad regime. Finally, North Korea continues to lob ballistic missiles into the Sea of Japan. Despite geopolitical concerns, economically, growth in Europe, Asia and Latin America look much better than it did two years ago as a modest recovery in growth appeared. Also, inflation in Latin America triggered by the stronger dollar appears to be abating, as many Central Banks hiked rates aggressively, helping their currencies outperform the US dollar this year. Fears of a full-blown trade crisis with Mexico abated as well, and the Mexican peso is about 10% stronger YTD vs the US Dollar. In India, where the market went through a scare due to the demonetization of the cash market, equities have rebounded substantially, with the MSCI India index gaining 17% year to date.
Fourth Quarter 2016
What a wild 4th quarter -- the Federal Reserve finally hiked rates as bond yields raced higher, and the US elected a reality TV star real estate mogul as our next President. Despite the doom and gloom expected, equities broke higher after President-elect Trump’s acceptance speech was broadly conciliatory. Thankfully, none of our managers were selling S&P Futures while they watched the election returns roll in. Following the results, bond yields raced higher on increased growth and inflation expectations. Banks and small cap stocks also jumped as investors hoped that the burdens of eight years of over-regulation would be alleviated.
With the market at all-time highs, we cannot help but focus on what could go wrong. As markets have priced in the upside of Trump tax and regulatory reform, they have also become more fragile: high yield spreads are back to multi-year lows; equity valuations are at multi-year highs; interest rates are still depressed; and even carry trades are back in vogue. According to the AAII US Investor Sentiment Survey, bullish sentiment rebounded to five-year highs after the election. The US Dollar continues to benefit from unbalanced monetary policy, as the US has started raising rates while Japan and Europe continue to push the barriers of dovish policy.
Across the world, emerging market countries continue to suffer from a drop in commodity demand. Trade imbalances in commodity exporters, such as Mexico, South Africa, Russia, and Brazil have triggered varying degrees of currency weakness, which in turn has led to inflation. Despite slow growth, some have hiked rates to protect their currency. China faces a larger problem. Confronted with highly levered banks and slowing lending growth, China is attempting to engineer a smooth devaluation to improve competitiveness and fight deflation. However, China cannot maintain a fixed exchange rate, free movement of capital, and independent monetary policy. For example, while the currency has been largely stable vs a basket of global currencies, the money market rates in China have become very volatile. Imagine the chaos if the fed funds rate in the US moved by more than 1% a day, an event that is now the norm in China.
Looking ahead, 2017 will bring renewed focus on Italian bank bailouts, Greek fiscal reform, Brexit, and other long simmering macro concerns. It is worth noting that the British pound depreciated significantly after the vote, leaving UK citizens to face higher import prices. Also, we worry that the proxy war between Iran and Saudi Arabia could get more direct, fiscal deficits brought on by low oil prices could create nightmares for the pegged currency regimes in the Middle East, and Turkey’s clamp down on political dissent following last year’s coup attempt could create further civil unrest. Increasing instability between the US, China and Russia is becoming the largest possible source of future geopolitical conflict. Finally, in Europe, additional crimes by refugees and terrorist attacks could trigger larger populist backlashes against the European Union.
In the US, we are carefully monitoring changes in US trade, tax and fiscal policy. We doubt there is a magic bullet where cutting taxes will somehow balance the budget but we do think that corporate tax reform and regulatory reform will help growth. We are also watching for any major changes in US trade policy. Trade restrictions brought on by the Smoot-Hawley Tariff Act in 1930 contributed to a 50% drop in US exports and imports, and were partially to blame for making the Great Depression worse. We hope our President surrounds himself with students of history, and targets unfair trade instead of all trade. Starting a trade war is not in the best interest of anyone.
Third Quarter 2016
Equities rebounded strongly in July and stayed in a fairly narrow range throughout August and September. US Treasury yields rose over the quarter as the Fed slowly became more hawkish and long term bonds priced in higher breakeven inflation. Equities and bonds are simultaneously trying to digest increasing noise from the world’s most important central banks and disparate election polls. While both presidential candidates’ policies include major infrastructure spending bills, which could boost both growth and inflation, differing candidate views on global trade, healthcare and taxes have made predicting the economic direction post-election a coin flip.
Investors are starting to realize that US monetary policy may not continue to provide the same tailwind it did in the past. One of the few bright spots (or at least non-dark spots) in the world continues to be the US economy. Although growth has been slow, the US consumer remains resilient and unemployment continues to be fairly low by historical standards. In fact, firms are finding it more difficult to find workers and are thus increasing wages to retain key staff, according to Fed Beige Book surveys. This wage pressure is seeping into the Fed’s outlook for when to raise the rates. With domestic conditions strong, but international conditions weak, the Fed is walking a tightrope. Concurrently, headline consumer prices are forecasted to rise above the Fed’s stated 2% target, as last year’s oil price drop fallsout of the base effect. Breakeven inflation rates in the TIPS market seem to be predicting this, as 10 year breakeven inflation rates have risen from 1.4% in June to 1.64% today. Still, this rate seems too low compared to the Federal Reserve’s target of 2%. It remains to be seen how sternly the Federal Reserve will stick to its target.
We have often written that US regulatory policy continues to dampen economic and job growth. While it is often hard to point to one culprit for slow growth, we think regulation in the financial sector is a great example of the heavy hand of government doing real harm. For example, since the passage of Dodd-Frank and the Volker Rule, regulations have limited credit available to small businesses. Small businesses in the US employ 49% of the population and provide 64% of net new private sector jobs, according to the Small Business Administration. US regulations effectively cut off banks from doing anything but the most vanilla lending to good corporate customers and basic consumer (autos and real estate) lending. These regulations are increasing the cost of running small banks while at the same time low interest rates are shrinking net interest margins, crippling overall bank profitability. The industry’s response has been consolidation. Many small banks are getting gobbled up by their larger regional and national brethren, where it’s easy to consolidate regulatory costs and realize quick synergies. However, this strips the banking system of their local expertise and favors lending to larger customers at the hindrance of smaller local companies.
Consequently, the lack of credit supplied by banks allows the less regulated markets for lending such as peer-to-peer business models, to fill in the gaps. Here, margins are much higher, but these new “Fintech” business models have yet to be tested by a credit cycle. Further, the cost of capital to businesses through these non-bank credit providers is much higher than what banks would normally charge. Large corporations who can issue bonds in financial markets pay very little in terms of interest rates, but small businesses must pay at least 15% or more to private credit providers, such as Ondeck, Lending Club, Fundera, and SoFi, who are backed by both private and public markets. Furthermore, these models don’t have nearly the amount of capital that US banks can provide. Any new administration would do well to tackle this heavy handed regulation of banks to improve the prospects for small business.
Five years after the PIGS threatened Europe, very little has been resolved. The European Central Bank and the Bank of Japan recently became more skeptical of the positive impacts of negative rates in their economies. They too are realizing the pain low net interest margins create for banks. When banks lend money at low interest rates, their ability to withstand a credit hit is lower, as they don’t make enough money on assets to increase their book value. Normally, these profits would serve as a capital cushion against future losses in a full credit cycle. Thus, in light of the higher risk, banks have slowed lending to only the most credit worthy of borrowers. Given that much of the European and Japanese markets are still financed by loans rather than bond markets, this has limited the transmission of capital to the real economy. In addition, concerns of thin capital cushions at Deutsche Bank and Banca Monte Dei Paschi Seina continue to negatively impact investor sentiment. The coming impact of Brexit on credit quality has further reduced banks willingness to lend. This continues to be a major concern for financial markets.
Second Quarter 2016
Winners vs Losers in the recent Hedge Fund Fiasco
Hedge funds are currently unloved by the media and investors. While some of this rearview mirror criticism is deserved, some of it simplifies the issues hedge funds face by lumping them all together. We think good funds need the ability to buy when panic breaks out, as opposed to being forced to sell. Therefore, a good hedge fund should concentrate on hitting singles and doubles, and avoid swinging for the fences unless they are given a perfect pitch. Hedge funds have capital that can walk out the door every quarter, similar to bank deposits. Pardon another sport analogy, but try to think of hedge funds in two categories. One that tries to maximize Slugging Percentage (SP) versus the other that maximizes Batting Average (BA). Those SP guys will come in with big numbers and will be the darlings that everyone is talking about because of how great their latest home run was. Investors will get greedy wanting to be in on the next homer. Unfortunately for many funds, returns tend to be mean reverting and investments made following large right tail returns from concentrated bets (big wins, outside of a normal distribution) often lead to real capital loss, when those managers experience left tail returns (losses). The image problems of many hedge funds come when those Slugging Percentage funds, which can do fantastic when the market is generally unloved and undervalued, take on increasing risks as the market rises and valuations become extended. Eventually, most SP funds will lose and the return distribution will normalize. From our point of view, we like the home run hitters in an environment when there are a lot of fat pitch opportunities. But in a market such as we are experiencing today, full of curve balls, the guys who get on base more often are more valuable. Batting Average guys are not going to risk blowing up their business by swinging for the fences. They are going to try to bunt, hit singles and doubles, get on base, and get some RBIs. They are engineering returns. BA funds are rarely going to come in with sexy track records of major >20% annualized gains and they aren’t going to grab your attention with home run numbers, but late in a market cycle, they should outperform with significantly less volatility.
There is a major incentive problem with hedge funds as well. If you make big money quickly, you attract assets quickly. A fund that makes 30% a year for two years is much more likely to raise a billion dollars than a fund that makes 9%, despite the approach they used to achieve those numbers. Those guys that swing for the fences and get lucky are much more likely to win the fundraising game. For instance, one way to win a stock picking competition is to pick the two most volatile stocks you can find that have some sort of catalyst during the competition. If you get lucky you win. If not, you lose like everyone else. As the world has learned, separating luck from skill is incredibly difficult. Warren Buffett, with his 50+ year track record, is most likely skilled. However, for a hedge fund with only 3 years of performance, there is not enough data to make that determination, particularly if it is a concentrated strategy without many at bats. Over the past 8 years, in the post-recession bull market, it has been very easy to get lucky. Therefore, we currently have a preference for strategies that have been battle tested through a crisis and lived to tell the tale.
For the time being, we will concentrate on engineering returns with base hitters, rather than investing with concentrated managers. There may come a time to use big hitters again, but in a world more poised for calamity, that time is not now. This doesn’t mean our returns will be lower, as we can still accept volatility in our funds, as long as the returns are not correlated with the rest of the portfolio and the strategies are paired with sound risk management. We just want to make sure we are benefitting from the one free lunch in investing, diversification. As luck would have it, hedge funds provide much greater diversification benefits than traditional asset classes. They can trade currencies, commodities, freight agreements, emerging market debt and rates, electricity, and even carbon credits. Most importantly, they don’t have to be long only. We need to make sure we benefit from diversification to fulfill our mission to our investors, which is to protect and grow their capital.
Yeah, but don't you think today's environment is bad for hedge funds?
The structure of the market has changed and some big asset managers now have shorter time horizons than they used too. This is reflected in the SPDR S&P 500 ETF, which trades its market cap in volume every day. Risk parity funds like Bridgewater and AQR now buy and sell billions worth of bonds and equities based on the level of volatility. When volatility rises, they sell. When it falls, they buy. In the past year, this has been detrimental to their returns, as monetary policy has come to the rescue of every major scare in the markets. However, this same strategy, documented by countless academic papers, has shown to outperform over long time periods, because it helps cut off the periods of massive losses. In fact, these are the types of funds who survived 2008 relatively intact. True hedge funds, as we view them, should not be expected to outperform in bull markets. The way they generate better risk adjusted returns is by minimizing the losses suffered in bear markets, allowing them to compound at higher rates of returns overtime. We cannot predict when the next major event will occur that pains equity and bond investors, but we do know the era of market manias and panics is not over. Therefore, a cautious and astute investor should recognize the value of having hedge funds over a long time horizon and ignore the myopia of the financial press. Because something worked in the past year doesn’t mean it will work in the next. In fact, it is probably less likely to work.
Given that, there is much to fear currently. As equities make new highs in the US, rates across the developed world are at lows not seen in five thousand years (see Chart 1 from the Bank of England below).
To us, this situation seems dangerous. The financial market uses these rates to discount cash flows for every type of imaginable investment. If these rates mean revert, as they surely will, so will the value of every major investment category, including real estate, stocks, bonds, rail roads, you name it. Looking at long term measures of equities, we find that US Equities are well above historical valuation ranges based on Robert Shiller’s CAPE ratio (see Chart 2). This bodes poorly for forward looking returns in equities over the next 7 to 10 years.
We believe the time to protect our clients’ capital is now, because most major assets classes are at all-time highs and forward looking return expectations are statistically low. In the meantime, we will continue to find those managers who can protect our capital and get some base hits no matter what pitch is thrown at them.
First Quarter 2016
This past quarter was one we would rather forget as our funds were whipsawed by central bank support. In the first 40 days of the year, the S&P fell more than 10% as fundamentals deteriorated and fears of slower global growth and significant worldwide debt raised risk premiums in equity and credit markets. February’s release of the January Fed minutes drastically eased the Federal Reserve’s tone and lowered Federal Funds rate hike expectations for the year. This caused the market to quickly price in lower rates, leading to a surge in equities that actually made up the losses faster than the previous sell off. In addition, the European Central Bank pledged to buy corporate bonds in huge amounts and other central banks eased monetary policy in reaction to market volatility. This pattern of markets dropping followed by central bank jawboning makes extracting value from the public markets difficult as the cost of hedging becomes more and more expensive versus its short term value.
We know that hedge fund of funds will do well and have a place in investor portfolios once the Federal Reserve returns to normal interest rates and the Government stops attacking businesses through draconian regulation, antitrust abuse and middle of the night tax law changes. The problem is that we do not know when these issues will stop escalating, start to subside and eventually normalize. Our managers are very cognizant of the risk posed by tight credit spreads, blunt regulation by decree, increased global debt levels and slower growth. However, betting these factors will self-correct proves to be increasingly frustrating as low global rates, central bank intervention and mixed inflation measurements push out the ultimate reckoning for these imbalances into the unknowable future.