The US economy is currently in a slowdown. How significant is this?  If we assume that trend growth for GDP is 4%, as was widely believed to be the case pre 2008, then 2.5% GDP growth would have indicated an economy failing to recover fully in its latest cycle, which would be quite negative. If, however, trend growth is 2% as I believe it is in a post 2008 world where the economy is not only no longer fueled by credit creation but also attempting to gradually deleverage itself, then 2.5% growth represents an overshoot, a cyclical high from which the US economy is currently climbing down, and therefore to be expected. It would be indicative of a normal recovery, albeit along a so-called ‘new normal’ equilibrium path of lower growth. 

Caveat: A strong economy does not always imply a strong US stock market. Companies are global these days and need to be appraised individually on their peculiar merits. Many US companies are exporters and derive their income from markets which are slowing down, such as the emerging markets, or in depression, such as large swathes of Europe. Since the recovery from the depths of 2008 the right plays were exporters, today one should be sifting through US domestic businesses for opportunities. One asset type which is particularly domestically driven is residential real estate. US housing is on a steady path of recovery. Non agency mortgage backed securities provide senior claim as well as income together with upside to house prices.

Corporate balance sheets have been significantly repaired since the crisis of 2008. On the other hand, sovereign balance sheets became and remain in poor condition. Most countries have addressed this problem by instituting programs of debt monetization with, as an associated bonus feature, artificially low interest rates across the relevant term structure.

This lowers costs of debt capital for private businesses, if they are able to access credit, and has provided businesses the opportunity to raise debt and of refinance existing debt at lower rates improving margins thus simultaneously improving liquidity, profitability and this solvency. Equity valuations are also enhanced as discount rates are reduced and comparisons of earnings yields to alternative sources of return such as treasury or corporate bond yields are also improved.

While there is real improvement in corporate solvency and profitability, much depends on interest rates. The questions are, can central banks keep rates low, for how long can they keep rates low, and, how robust are balance sheets and profitability to rising interest rates.

How long will central banks maintain low interest rates? For as long as it takes, seems to be the universal answer, which is reassuring. At least mostly. Interest rates represent a hurdle rate when making an investment. Artificially low interest rates can encourage excessive risk taking or simply ill advised investment leading to misallocation of resources. Also, in a market economy, it might be hoped that the price of capital, arguably the most important price in the exhaustive set of prices in the economy, should be determined by the market and not a central planner unilaterally declaring a price. Academic issues are quickly subordinated to more practical concerns in times of crisis, and yet it seems that the practice has predated and survived the crisis. Let us assume, therefore, that low interest rates are good, thereby transforming a thesis into an assumption.

How are central banks achieving low interest rates and why might they fail? Central banks are able to set short rates by declaring their own short term rates at which they will lend or borrow. The banking system transmits this through their deposits at the central bank by pricing loans as a spread over this base. At longer maturities, the central bank may either do the same and provide credit at longer maturities or it can buy government bonds, simultaneously setting a rate and funding the state. There are some limitations to this strategy. Inflation may accelerate. While a little inflation is a good thing, excessive inflation is not, and runaway inflation tends to be the product of a loss of confidence rather than a continuous erosion of purchasing power. With a money base as inflated as most central banks have, one has to question how this money base will be shrunk when the economy recovers. Also, since the velocity of money multiplies the money base in the measurement of nominal output, a small pick up in the velocity of money could lead to a jump in inflation. Also, asset sales by a central bank which has crowded out the sovereign bond market could make for a very unstable term structure. Confidence can also affect the currency which could force a damaging defense involving higher interest rates.

How robust is the economy to higher interest rates? With interest rates at such low levels, interest expense is highly convex to interest rates. Household debt service is therefore quite sensitive to higher interest rates. Households appear to be aware of this as they increase their savings and reduce debt. The same can be said for corporates which have raised significant levels of fixed rate debt to lock in current interest rates. Corporates cash hoard will also probably mitigate some of the impact of higher rates.

PS:

It is a peculiar time for investing. Investors cannot see beyond low interest rates, reasoning perhaps that the implication of higher rates is simply too dire for governments or central banks to bear. Under a regime of low interest rates, now that the yield has been wrung out of bonds of almost all regions and issuers, equities shine as good value. Investors seem to even have forgotten the volatility of equity investing, seeking yield in the form of dividends. (One could say that dividends dampen the volatility of stocks but the other argument is that yields are far too low for an asset of infinite duration.)

As for hedge funds, the mass of them provide some equity correlation, some spread duration but for the most part generate a negative alpha. As one would expect in the opaque world of hedge funds, a small group continue to generate very attractive returns without taking excessive risk, certainly taking less risk than the garden variety long only mutual fund, unfazed by the macro vagaries of the market, engaging in arbitrage or relative value or trading in niche markets where they have an edge. Most investors will not have the access to these managers, or the resources or faculties to make sense of their activities, keeping them relatively compact compared to their long only brethren, keeping them hungry and nimble. As the growth of the size of the pie slows, it is increasingly important to engage managers most able to take a bigger slice of it on one’s behalf.

The first quarter of 2013 has ended with risk assets mostly higher than at the end of 2012. It would seem that the optimism that greeted the new year was well placed. Indeed many of the problems in the world have been solved, patched or postponed.

The big picture remains very much the same as it had been in the past 4 to 5 years. A credit bubble had been inflated with inflated collateral. The bursting of the bubble was precipitated by falling collateral values which led to a nasty feedback loop exacerbated by excessive leverage. So acute was the problem that governments were forced to step in and bail out the bankrupt, meaning mostly the lenders to the borrowers whose collateral was no longer sufficient to cover their debts. Most of this collateral was residential real estate. The impact was a retrenchment in consumption and thus profits and thus investment and thus employment. These were the effects on the private sector. For the public sector, bailouts are not free and as a result fiscal positions were severely impacted. This meant questions about sovereign solvency which were answered by successive rounds of debt monetization, an apparatus quite indistinguishable, and conveniently so, from quantitative easing, a perceived lesser evil.

With the private sector largely bailed out, a real economic recovery has taken place in most places except where structural impediments have confounded efforts by the private sector operating in market economies to heal themselves. No where is this more apparent than Europe, where the Euro suppresses price discovery and coupled with sticky prices in some markets, such as the labour market, result in a failure of such markets to clear. Elsewhere, the healing takes place, at least in the private sector. The public sector, however, languishes in a risky state of uncertainty and personality disorder.

Absent a strong ideological compass, public sector policy has been pragmatic, itself a laudable quality, but lacking conviction, lacking vision and ultimately, lacking firm theoretical basis.

Where government is weak, indecisive, divisive and chaotic, the private sector has moved on. Some reservations remain, which may constrain longer term investment, but by and large, market mechanisms allow the private sector to move on. These economies correlate with poorer fiscal positions and lower growth.

Where government is more pervasive, invasive, authoritarian and has historically been relied upon to lead the private sector, recovery is slower, less firmly entrenched or unbalanced. These governments, correlate with countries with better fiscal positions and higher economic growth.

A caveat over the government finances. If bank balance sheets are hard to read, country balance sheets are mostly indeterminate. Strong accounting standards can mitigate some of this risk but mostly the problem lies not in accounting standards but in risk management. If either the intention or the ability to manage risk is compromised then so is the endeavor.

The desperate throes of the developed markets’ central banks in their efforts to support their sovereigns, revitalize their moribund economies and inflate away the public debt has led to a number of side effects. Most of all, the expected inflation has not surfaced at home, but rather has manifested abroad, where economic growth is less somnolent. In a world with open capital accounts, this was bound to happen.

Globally open capital accounts and having a currency widely used as a reserve asset together make for effective quantitative easing / debt monetization. It affords the central bank good control over the entire yield curve. Relaxing any of the above assumptions endangers this thesis. Widespread recognition of this phenomenon may also trigger vigorous resistance, most likely by a limited restriction of capital mobility, hopefully not much worse.

A global economy also spawns global businesses or global companies. When investing in businesses, whether it be in their equity or debt, sweeping macro considerations are best replaced by the bottom up analysis of the multinational, multiregional nature of these companies.

This does not mean that macro investing is not useful. However, the tools of macro investing are more often than not currencies, interest rates and sovereign bonds. Equities cross too many borders to yield to macro analysis. Real estate, whether its equity or its debt, is also another highly locally driven asset class. But here, the line between macro and micro is nothing more than a factor of magnification.

Very often, what is and what should be do not converge. This is often a source of opportunityy. The Euro is an interesting example. Its use to the investor lies in its inefficiency and inappropriateness. Forcing a single currency upon a region with differing factor productivities and sticky prices must create imbalances which tend to gradually build and then break. This creates trading opportunities for the astute investor with an eye for fundamentals and a sympathy for the rhythm of market psychology.

A more fearful divergence lies in the very model of our economy. Capitalism. Mathematically elegant, it has become diluted and perverted, by the absence of a nemesis, ever since the fall of Communism. Moral hazard taints all capitalism today. The asymmetric treatment of gain and loss invalidates all the mathematical underpinnings of efficiency of production and allocation under a free market. The arbitrary bailouts mounted by central banks and governments have only served to enhance the reputation of interventionism and big government. Government involvement in an economy should only be to provide contingent measures when the free market is unable or unwilling to supply a good or service. Yet current public opinion, and indeed, the opinion of conventional economists, is that governments need to do more. This has serious repercussions in the longer term. Understanding the motivations of economic agents and macro economic behavior will require new models and new insights.

Finally, before I sign off, there is still a vast amount of debt which remains to be repaid, defaulted upon or inflated away. So far, it has just been moved about and refinanced in rather creative ways.

There are some specific strategies that arise from the above:

Overweight companies with intellectual property and brands. These are more easily found in the US and Europe. They will confound their own countries’ macroeconomic ills.

Buy the US housing recovery. This continues to be best expressed through the non agency mortgage backed securities market.

Avoid Chinese financial risk. The Chinese shadow banking industy is not bad for being a shadow banking system but for its opacity and the resultant difficulty of assessing the priority of claim. The risk that any default or run on the system could turn out to be disorderly is high. By extrapolation, one should be cautious of any associated risks in the real economy and its businesses.

Overweight hard duration in developed markets like US, UK and Germany. Inflation created by QE is surfacing in emerging markets where
one should expect yield curves to steepen relative to developed market term structures.

Overweight the USD. The trade position of the US has changed for the better. While the Fed continues to operate QE, so does the BoJ, BoE and the ECB. At the same time, China isn’t exactly tightening monetary policy and is accumulating debt at an alarming pace.

The cool thing about the Euro is that it doesn’t really work, and yet, the politicians in Europe insist on having it. This creates periodic buying opportunities. Here is an indirect Euro ‘we’ll hold it together come hell or high water’ trade.

The uncertainty surrounding the fate of the Italian government is destroying bank stock prices. An interesting ‘lets ransom the European banking system’ trade is to buy a bunch of Italian banks. Ideally, one would choose the smallest banks which are systemically important and whose demise would take the whole lot with them as well. At current prices, one doesn’t have to be too fussy. Any bank too important to fail will do. A basket is convenient. Many of the candidates are insolvent but it won’t matter. The trade here is to stare down the ECB. Banks like Unicredit, Intesa San Paolo, BMPS and Banco Popolare are just as good as any for the trade.

• Unicredit, 3.33
• Intesa SP, 1.142
• BMPS, 0.1875
• BP, 0.9835

The latter two banks are more interesting because they are smaller and weaker and will price bettter on entry and on exit. It brinksmanship to be sure, but Europe doesn’t have the stones to let Italy under, and that means rescuing all her systemically important banks.

Disclaimer: I do not have any position in the above stocks nor do I intend to take any. This post is purely an academic speculation and not a recommendation or solicitation to trade in securities.

• Inflation is an emerging market problem created in the developed markets.
• Equities are being boosted by factors other than fundamentals, which is fine.
• We invest and spend in nominal terms, it pays to stay invested and it costs to not be invested.
• Uncertainty prolongs trends, consensus ends them. Until bullishness reaches an extreme, the trend will continue.
• Its not useful to think of equities or companies along national lines. Most businesses are global.
• Developed markets have an intellectual property advantage. In trade wars, exchange rates are the first salvo. Intellectual property is the next.

Is the rally in risk assets sustainable? Central banks have held nominal rates at close to zero and thus real rates in negative territory and will keep doing so for the foreseeable future. At the short end they are able to unilaterally declare rates and at longer maturities, open market transactions allow central banks to cap rates using printed money. Fundamentally this is irresponsible behavior being highly inflationary. However, in a globalized world with open capital accounts ultra-loose monetary policy creates inflation not domestically in the weaker economies but abroad, in higher growth emerging markets.

To hedge against higher inflation, emerging market investors need to diversify by investing in developed markets risk assets, particularly the ones operating ultra-loose monetary policy.

Another phenomenon, which we have discussed before, is developed markets, particularly the US ability to generate and monetize intellectual property more effectively than most emerging markets. Falling energy costs at home and rising labor costs abroad are encouraging the re-shoring of manufacturing to the US helping strengthen the USD and reverse current account imbalances.

Another phenomenon supporting equities is the appetite for yield and thus bonds, fuelling high volumes of issuance. Companies are on aggregate issuing more debt to finance dividend payments and more importantly, share buybacks, reducing the float significantly. Institutional investors maintain highly stationary or constant bond to equity allocations and therefore reinvest the proceeds of capital repayments into the stock market further supporting equity markets in a virtuous cycle. 

In the US, the housing recovery provides further support to the economy through the wealth effect. House prices are in their 7th month of recovery putting the recovery in its early days as house prices are typically serially correlated with strong momentum factors. The shortest housing bull run has been 6 yrs in duration. Rising house prices are the result of improved employment and wages, higher levels of savings and lower mortgage rates. They also result in improved home equity against which home equity lines of credit can be drawn driving consumption and retail sales.

Is it possible that the world has healed, has latched on to a new growth path, markets have stabilized and are in a new secular bull market? Well, yes and no. Problems remain. Mostly, these problems have to do with debt levels that remain stubbornly high, growth levels which are depressingly low, so much so that any moderate growth looks like a spurt, imbalances have been transferred from one place to another or transformed from one form to another.

Inflation is a problem. But not for the central banks causing it. It hurts those most frugal and it helps those most profligate.

Risk of the shadow banking system in China blowing up is not insubstantial.

The Euro continues to plague us by its existence.

Low interest rates make debt service highly convex and could lead to credit crunches in unexpected faraway lands.

In the meantime, however, we make money in nominal terms, not real terms. With inflation rearing its ugly head, particularly in emerging markets, it pays to invest in risk assets. Just not always those at home. In a globalized world, thinking of assets along national lines is not useful. One has to think as globally as the world.