Altus Insight - March, 2015
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: March 31, 2015
FR: Forrest Jinks
There are so many different market and economic signals saying so many different things right now that it is hard to sift through the noise. This article isn’t what I think, it is what I think I think. I would probably feel more conviction in my opinions if it were not for an increasing amount of prognosticators that are feeling roughly the same way. When it comes to economic and financial predictions once the crowd starts moving a certain direction in mass it is likely that groupthink will soon be exposed as far off base. And yet, even while we may lack conviction about a particular economic/financial component (in this case interest rates), we still have to make decisions surrounding our investments and assumptions have to be made. Without further ado, let’s discuss what was “Interest”ing in March.
As many of you may have read, the Federal Open Market Committee (a misnomer if there ever was one) took the extraordinary step of removing the word ‘patient’ from the statement released after their March meeting (sarcasm intended). The markets exhibited all sorts of volatility leading up to the meeting as each piece of financial or economic data was examined in light of how the Fed might interpret it instead of paying attention to the piece of data itself. This is the bizarro world in which we live, constructed in part by the action of the Fed itself (and other central banks as well).
I wrote a couple months ago that I didn’t think rates were going up any time soon, at least not meaningfully, and despite the FOMC’s groundbreaking removal of the word ‘patient’, I still don’t. While projections are a fool’s errand and frankly, specific projections aren’t needed in our business since we aren’t making direct investments in or against overnight lending rates, the interest rate environment in general is an important component of our business because rates have a direct effect on cash flow. This in turns affects the capitalization rate investors are willing to pay for investment property (cap rates on commercial properties are now back to where they were in 2007, but yields are higher due to better priced financing). I continue to believe that rates aren’t going anywhere fast. I would be exceedingly surprised if rates increased more than ½ of 1% over the next 18 months. These are my reasons why:
Signals by those in the know:
- The yield curve is currently extremely flat. That is to say the extra yield to invest money for a long period of time is only marginally better than investing that money for a short period of time. Conversely, borrowing money for a long period of time is only marginally more expensive than borrowing money for a short period of time. As example, we are currently going through the loan process for an apartment complex we have in contract in Oklahoma. We have been quoted a 10 year fixed rate on a 30 year amortization of 4%. We have also been quoted a 30 year fixed rate on a 30 year amortization at 4.75%. It is mind boggling to think that for an extra 75 basis points I can lock in my interest rate for 3 times as long. The 30 year rate equates to Prime plus 1.5%. Over the past 15 years (let alone 30) the average Prime rate was 5%, or a quarter point higher than the interest rate I can now lock in for the next 30 years, and that is BEFORE the spread between Prime and borrowing rates are taken into account. Also, keep in mind, this is the average of the last 15 years alone. In the 15 years prior to the date range used for our calculation Prime was commonly over 10% and never below 6%. The reason this is relevant is how it relates to the actions of the Treasury Department. One of our trusted advisors, and by his own admission a big fan of the current Fed strategy, rhetorically asked me this past week why wasn’t the Treasury trading out its short term debt for longer dated bonds. Currently interest on federal debt makes up 11% of the budgeted expenditures and over 1/2 of that debt is on bonds with maturity of 3 years or less. With the current debt holdings structure, if interest rates were to increase only 1% the increase annual debt service burden would be catastrophic. And remember, as we saw above, historical rates average far higher than our current interest rate environment, a potential nightmare of increased interest costs. While rolling the short term debt into longer dated bonds would increase governmental borrowing costs in the short term, the long term benefit to the government (and thus taxpayers) would be substantial. Jack Lew, the current Secretary of the Treasury, may not have had any background in finance when he was appointed to the job, but rest assured that the thousands of people that work for the Fed understand this clearly. The Fed and Treasury, while in theory independent bodies, are intertwined at the hip and the Treasury has no doubt been provided with a much more coherent picture of the Fed’s plans than has the general public. Were the Fed to believe it was going to start raising rates as aggressively as in past tightenings, the Treasury Department would already know about it, and the debt terms would be getting stretched. That this isn’t happening (at least that I have seen) implies the Treasury is calculating it can save on interest costs for a while longer by staying with the shorter dated debt.
Fed Don’t Want Tos:
Don’t Want To #1: When the first round of quantitative easing and ZIRP was initiated several years ago the Fed outlined clear economic performance levels that needed to be reached for them to back off of the aggressive monetary policy. Surely you remember the dual mandate of full employment and stable prices? There is nothing in the mandate about growth, but the Fed has taken on that burden as well. How is the economy doing? Well, new jobless claims are well below their 20 year average, the unemployment rate is below the average unemployment since the end of WW2 and the economy in Q3 of last year grew at an rate TWICE the average growth rate since the end of WW2 (hat tip to Grant Williams). With that kind of performance, what justification could there be for NOT aggressively raising rates? Unless maybe there is something they aren’t telling us when they say how well the economy is doing.
Don’t Want To #2: Even though the next major election is still 20 months away, the election process is upon us. Many people assume that an increase in interest rates will curtail economic activity, from a base level that is already a little shaky. There is no way the Fed wants to take the chance of hurting our limited economic recovery due a rate increase going into an election. Even eight years after the freefall into the Great Recession a large percentage of voters still view the economy as the current most important issue. Re-entering a recession would strengthen the hand of any challengers to power and hurt the chances of any incumbents to hold on to their existing power. This normal reticence to impact elections is likely to be magnified by the current party in control of the executive branch being far more ideologically aligned with the current Fed philosophy than any of the current challengers to the throne, several of which have included abolishment or modification of the Fed in their platform.
Can’t #1: Unfortunately, this latest economic cycle has shown that the Fed is more beholden to the stock market than to Main Street and in various public comments has admitted as much. The stock market is conversely locked onto the words and actions of the Fed. The Fed knows this and is trying to wean the stock market from its dependency, but it is trying to do so from a point of stock market instability. Only two times has the stock market gone more trading days without a 10% correction, 1999 and 2007. We know how each of those market runs turned out. Ironically, the stock market has experienced 18% price volatility since former head of the Fed Volker stepped down in August 1987, this is roughly equal to the volatility of the stock market prior to the advent of the Federal Reserve. Yahoo! and the Washington Post provide back up (Yahoo!) and (Washington Post)
Can’t #2: Nobel Prize in economics winner Robert Shiller, and one of the developers of the Case Shiller Index, has been studying bonds a long time, starting with his first published paper in 1973. In that paper he unveiled his research showing that for the preceding 20 years (going back to 1952) long term interest rates were strongly correlated to a certain weighted average the last 18 quarters of short term rates and inflation. He recently redid his study with data from 1971 through the present. He discovered the correlation continued to remain in place into the 1990s, at which point it started to decouple and his theory started to over predict what yields should be. According to his models 30 year treasuries should be yielding even less than the ~2.25% they are currently yielding.
Another economic principal predicts the same thing, and really is just supply and demand applied to investment returns. Stated simply, if returns are achieved in excess of expected returns based on the assumed risk for achieving those returns, additional investment will flow into that investment and increase the price until the returns are in line with the risk adjusted expectations. France is an economic basket case and yet its 30 year bonds are yielding only 1.12%. Japan’s 30 year bonds are yielding .87% and Switzerland’s 30 year debt is yielding a miniscule .4%. An argument could be made that Swiss debt carries less risk than does US debt, but Japan? Probably not. And France? Certainly not. Eventually investment in governmental debt will self-regulate, putting additional downward pressure on US governmental debt.
Who in the world would invest money for 30 years to make a 2% yield, barely keeping up with inflation (in today’s low inflation environment)? Certainly not me, but obviously investors, and very large investors at that, will and do. Those inter border currency flows can greatly impact the borrowing rates within the countries experiencing the flow of the currency, coming or going. It just so happens that the US will likely be the currency into which the investment flows.
Fed Can’t #3: As a follow up on the point discussed above, what if the Fed were to increase its cost of funds rate but the rest of interest rates throughout the economy didn’t follow? This would create a huge credibility issue for the Fed who would then be seen as not having the control over the economy they currently claim and are thought to have. As discussed above, much of the movements in the stock market, the increase in which was hoped to jump start the economy, has been based on the words and actions of the Fed. In reality it is the words more than the actions that has been the dominant paradigm. Institutional investors have thought “The Fed has our back” and with that assurance have aggressively moved into ‘risk on’ investments. If the promise of “Having our back”, even if implicit, turns out to be without merit, all credibility is gone, and the words of the Fed will no longer carry the weight they have carried. This would crush the effectiveness of Fed policy.
One of the key tenets of quantitative easing and ultralow interest rates is that it would spark an increase in asset prices which would make people feel “richer” which would in turn lead them to spend more money which finally would create more jobs. It is the ultimate trickledown theory except that instead of the trickledown being due to people being incentivized to create wealth through effort and business growth it was trickledown through encouraging investment to be moved into riskier and riskier investments. The side effects of this policy could well be an acceleration of the reduction in size of the middle class. This is occurring in at least three different ways.
1.The Assault on Savers: The negative impact of QE and ZIRP on savers is not a new topic of discussion. People who have done the right thing throughout their life and saved money for retirement suddenly were (and are) making nothing on their savings. The power of compounding interest works just as powerfully in reverse as it does in our favor and without interest being applied to the savings they simply aren’t growing or aren’t producing the income necessary for the owners of those savings to be able to maintain the lifestyle they were expecting in retirement or to which they were accustomed. A vast majority of savers were the middle class.
- Robots on the Job: Robotics are all over the news, and rightly so. Robots are now serving food in restaurants, cooking, cleaning, and doing landscaping. The true impact of robotics though occurs out of sight of most of us. The US has the second highest manufacturing output in the world and the third highest per capita manufacturing output. For decades manufacturing and manufacturing support jobs have been filled by the ranks of the middle class. Robotics are changing that, and rapidly. But manufacturing lines and other methods of increased efficiency have been around for years, why the relatively sudden recent burst in more sophisticated machinery? Any time a company reviews its operations the cost of the humans that work there is a key item that is reviewed. Humans are a relatively variable cost and if demand goes down the workforce can be trimmed and if demand increases it can be ramped back up again. If the cost of the workforce gets to high then an investment in cost saving equipment can be justified despite turning the variable workforce cost into a fixed equipment cost. At full capacity output a comparable variable cost is always preferred to a fixed cost. Just like rising employee costs can increase the financial attractiveness of fixed capital investment, decreasing costs of capital investment can likewise increase the attractiveness of that investment. Such investments have historically been financed. With ZIRP, the cost of that financing has dropped to almost nothing, resulting in an overall less expensive move to equipment and away from workforce. Some people may argue that companies are currently paying cash for the equipment so the financing argument doesn’t apply, but a good portion of the reason for the cash on the balance sheet has to do with the same ZIRP policy. Corporate bond yields dropped precipitously, leading to companies refinancing their existing debt and the savings result in higher cash balances. Of note, that same drop in corporate bond yields (and CDs, and muni’s and T-Bill, etc.) is part of the damage being inflicted on the savers.
- WAAAAY Underfunded Pensions: This is far too large of a topic to be included here so I will ask that you take my word for it or simply type ‘underfunded pensions’ in Google and see what pops up. If it is impossible for something to happen, it won’t happen. It is not a stretch to say that it is impossible that all the underfunded pension funds are going to be able to catch up and pay out as promised. One huge reason for the underfunding is that the drops in yields from yield producing investments (as has already been mentioned) has created a return scenario far below what was forecast when the funding requirements were initially defined. We have already seen at least partial pension failures in the Stockton and Vallejo (and United Airlines and San Bernardino County and …). Nearly all those supposed to receive pension benefits are, or were, middle class. Another victim of ZIRP.
‘Interest’ing Aside: In the latter part of last year economic indicators throughout the Eurozone started to turn, indicating improving economic conditions and foretelling of better days ahead. It wasn’t until several months later, in January of this year, that the European Central Bank (ECB) jumped fully into quantitative easing to fight the latest recession. The ECB has access to the same economic statistics as the rest of the world and so would have also known that things were already on the mend. Why would they chose this particular time to unleash the powers of the proverbial printing press? Maybe I am a cynic but the only plausible explanation I can see is the central bankers wanted an easy win. By jumping into the economic recovery relatively early into the recovery cycle they will be able to point backwards in a couple years and tell everyone how great of a job they did. Not only does this benefit those that believe in such policies but it also strengthens the aura surrounding the actions of the central banks and increases the market impact of their words and actions moving forward.
Before wrapping this up I do need to make a counterpoint to the belief that interest rates will stay low until after the election. Bank lending is finally increasing (which was one of the stated goals of QE several years ago). Increased lending should lead to increased velocity of money. We already know there is a massive amount of liquidity in the market so a marked increase in velocity in conjunction with the existing liquidity could quickly turn our current quasi deflationary environment into a heavily inflationary environment, or (shudder) a stagflationary environment. Of course, people have thought this was going to happen since the original QE and interest rate manipulation all those years ago and it has yet to occur, but maybe now is the time since more and more prognosticators (yours truly included) are now believing in an extended period of deflationary pressures.
The quality of an individual investment is still important, but now, maybe more than ever, our investment returns, and the markets in totality, are being driven by the actions of government and central banks.
Altus Equity Group, LP