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Transcript
Keeping It Simple. A Primer on Basic Macro Indicators Matthew Piepenburg, April 2011 Simple is good. Napoleon defeated the many armies of Europe with one (“strike the center, sweep the flanks”) battle strategy, namely: “keep it simple.” The Chanel dress— straight cut, black color, chosen material—remains among the most beautiful (as well as basic) designs among a history of fashion complexity bordering on comedy. One, moreover, can enjoy the complicated menus of Paris, but at the end of the day, even France’s finest contribution to world cuisine appears to be the baguette—that is: a roll of bread. And after a long workout, what quenches thirst better than, well: water? In short: simple works. But then there’s the capital markets… If ever there were a perfect setting for complexity, obfuscation, confusion, data error, data reporting, speculation, statistical dumping, pundit producing, talking-head overload or confusion, it would have to be the universe of investment management. The mind-boggling interaction of interest rates, growth projections, employment statistics, CPI factors, indices swings, ETF mis-pricings, momentum moves, black swans (and boxes), algorithms, supply and demand curves, yield curves, Fed policies, macro to micro shifts etc…make the notion of “Keep it Simple” almost a niave proposition. Add to these economic realities the wondrously nuanced and eye-popping lexicon of the average hedge fund strategies (risk arbitrage, plays on credit spreads, index hedges, swaps, CDS’s, relative value funds, calls, puts, put spreads, strike prices, carries, floats, straddles, barbells, ladders et al) and the complexity and hence apparent mystery of the markets only increases. After-all, Wall Street makes huge salaries because of how “complex” the markets are. They must be. After all, isn’t the Devil in the Details? These paragraphs suggest that even the markets (and the strategies best suited for them) can be as simple to approach as the aforementioned glass of water. Coming out of 2008, the skepticism as well as the concerns over where the markets are going and how to manage them is an ever-increasing subject for debate. How did that happen? What is going to happen next? Are we headed for a double dip recession? Is inflation coming? Are the equity markets solid or shaky, bearish or bullish? Are public equities safer than private equities? Is passive investment better than active management? Are stocks better than bonds? Is America falling? Is Europe? Are the Emerging Markets growing—too fast? Is China a paper tiger or the next “big thing”? Are the BRIC’s a great opportunity or trap? And on and on and on… How does one answer these questions with any confidence, especially given the complexities that lie beneath each topic or the increasing correlations across markets, asset classes and geographies? I will not dive into each subject at length (they are the subject of other thought pieces penned or to be penned), but what I wish to offer here are some simple, basic measuring tools by which to best gauge these subjects on our own. These tools and measurements, when understood at the most basic/simple level, help us to then dive more carefully into the details (i.e. the “Devil”) lying beneath each of these more specific queries. The Macro Indicators. No one can time the markets. No one. But macros do matter, and they point toward the general “climate” of the future even if they can’t guarantee the precise days of sun or rain. As for macros, it’s hard to argue with the basics, that is, the stuff our favorite econ teachers taught us in college. I sometimes feel that as we stick our heads down in the daily tasks and details of working the markets, it’s easy to lose sight of the simple ways to measure the markets—you know: the insights we learned before we went to work. When looking at any economy—ours, the BRICs, the PIIGS, the Emerging Markets etc—in short from the US to Germany, Mexico to Malaysia, the basics have never (and will never) change. And the three undeniably accurate macro indicators for these markets are: 1) Deficits, 2) Interest Rates and 3) Consumer Spending. If any or all of these pillars of an economy are suffering, predicting bears vs. bulls is not so complex or mysterious. Using the US markets as an example, let’s see what these macro indicators have to say about where things are, and where they are likely heading. 1. Deficits When a government, like a family or individual, is in debt, the gravity of the situation is always a matter of degree. Anyone, for example, who buys gasoline or GAP T-shirts with a credit card understands debt. Debt, of course, is not apriori a bad thing. But then again, if we use that same credit card to buy a Ferrari, we better have a pretty strong conviction about our balance sheet or productivity before we swipe the American Express through the machine... Right now, when it comes to debt, the US seems to be spending (and has been spending) more than it can afford. In short, we kind of look like the kid who went a little too crazy with dad’s credit card… Depending on which source you go to, the numbers vary, but in general it’s fairly safe to conclude that our current debt to GDP ratio is 70% to 80%--if not higher. That’s, well, not so good, but we can’t just look at this simple ratio in a vacuum. In the past, for example, we’ve had high debt ratios as well. But in those eras, such as coming out of World War II, we were the world’s leading creditor, manufacturer and exporter. In simplest terms, we could afford to buy the Ferrari, because our productivity and growth outlooks promised a fat enough wallet. Today, unfortunately, we are spending at Ferrari aspirations but producing at lemon-aide stand incomes/growth. We are no longer the world’s leading creditor, but its leading debtor. Manufacturing is wobbling but not flat lined despite some real problems in the rust belt states, and much of our exports continue to sell overseas, but this is greatly due to the fact that our currency has taken an unprecedented (and desperate, policy-induced) nosedive. Indeed, it’s a bad sign when a nation resorts to currency devaluation to pay its debts or compete in manufacturing (Keynes called it a “a crime against capitalism”)—but that’s precisely how the US is limping along (and we are likely to see Europe and Japan make similar/desperate currency choices in the near future). So what is the solution? If you want to buy a Ferrari but work at a lemon aid stand, you have a choice: either buy a cheaper car or produce more money. The government was hoping to see its wallet increase—i.e. to see productivity (GDP) grow. And so we have seen this thing called “AMP”—Aggressive Monetary Policy in the form of the Fed (or FOMC) lowering short term rates (see infra) and expanding the money supply by purchasing US government securities (i.e. the Monetary Policy 101 material we studied in school). In addition to this gas-pedal approach to increasing (or “stimulating) productivity, we saw another headline making attempt to stimulate our lemon aide stand in the form of “Quantitative Easing,” which, without getting too technical, is effectively a policy of printing money. (In actuality, it’s a government increasing the money supply by purchasing assets other than just short duration securities). Japan did it, now we are doing. In both cases, it hasn’t worked. Why? Infusing an economy with money to stimulate growth in productivity only works if the economy actually grows faster than the increase (or “velocity”) of the money supply. Unfortunately, as the $480 Billion stimulus package nears its June 2011 end, it doesn’t appear that productivity has moved at the anticipated pace. As one of my favorite managers recently noted, with a US balance sheet showing trillions in the wrong places, real GDP growth seems almost “incomprehensible.” The fact is, these are truly unprecedented times. The positives? Yes, there’s cash on corporate balance sheets, but those corporations are not hiring, nor are they spending… Thus, when looking at the first leg of the three-leg macro-indicator stool, the facts point to high debt and low GDP growth. Not good. 2. Interest Rates The second macro-indicator of an economy, involves the price of money, and as far as short term rates go, money has never been more cheap. (We can’t get blow 0.00). In many ways, these low short term rates are yet another sign of an economy on a respirator. The USA as a government and Americans as a population are suffering the common symptoms of a hangover from spending/living beyond their means and the policy response has been to keep rates remarkably low and the supply of money remarkably high to stimulate the economy. But again, the numbers aren’t suggesting the plan (which was better than nothing) has in fact posted the results that were hoped for. As Japan’s example shows, rates can stay low for 15 years and still see a sagging economy. Our GDP growth is anemic at 1.8% for Q1, unemployment hovers around 9.2% and then of course, there’s the inflation question. No conversation about rates is complete without a discussion of inflation, deflation or stagflation. Looking at current CPI measurements, the current inflation rate is 2.7%. A government that is concerned about inflation will increase rates (think of Paul Volker in the 70’s); inversely, a government that is worried about deflation (prices falling) in a sluggish demand/economy (think of Bernanke today) will lower rates. This is a very sensitive game, however. If expansionary monetary policies create too much money supply, there is always a risk if inflation. And then the dual headache of a sluggish economy and higher prices (i.e. stagflation). Some pundits argue that the Fed’s objective of keeping interest rates very low is to actually encourage some upward pricing and avoid deflation in what they believe is too low a CPI rate. The entire Inflation/deflation see-saw is made all the more confusing by the uncertainty around the very scale used to measure inflation, namely the CPI. As another one of my favorite managers pointed out in a recent quarterly letter, our CPI, with a high 40% weighting to housing and an increasing de-emphasis on food and energy prices is simply a broken/manipulated measurement tool and thus a poor indicator of inflation. That same manager maintains that if we were to take the same factors used by the Bureau of Labor Statistics for assessing CPI in 1980, our current CPI rate (2.68% as of 3/11) would be an astounding 10.20% (!). Assuming that these numbers are even remotely plausible, it could be argued that actual inflation is higher than the reported “fantasy inflation.” If this were the case, real rates on bonds could be deeper in the negatives than they were in 08, when the inflation-adjusted returns on 10-year treasuries was underwater (a 3.74% coupon with a 4.3% inflation rate). Today’s treasuries are at 2.97 with a dubious inflation rate of 2.68. As for long-term rates, the market, and not the Fed, makes those determinations. In sluggish economies (and ours is indeed that), default risk increases, and thus investors are enticed to purchase bonds only if higher interest rates are offered. (This at least, is the theory of those who understand risk pricing. Amazingly however, the current yield spread between junk bonds and mature treasuries is at historical lows of 6.9%, suggesting that risk has not been priced into these frothy bonds and that no lessons were learned from 08….) Government treasuries as well will see rates rise. That is, once the government stimulus ends (i.e. once our Fed is no longer buying our own treasuries), those same instruments will need to offer higher rates if they are to find any volume buyers outside of the US. Given the current broad measurements (continued low growth in GDP despite low shortterm rates, an uncertain CPI and the inevitability of higher long term rates), this second leg of the macro stool also appears to be weak as well. Regardless of predicting the precise timing of when rates will go higher (good luck), the facts are hard to ignore: when there’s debt, rates go up. We are in debt, rates will go up. Three decades of low rates will come to end in this environment, and it could be sooner than later (but then again, Japan took her time). We are at an inflection point. When fixed income managers like PIMCO and Blackrock are actually building out equity space/expertise and Bill Gross is shorting treasuries, something is happening… It’s just that simple. 3. Consumer Spending Consumer spending makes up 70% of our GDP, so when our consumers are hurting, so too are the outlooks for our national growth. Once again, this macro-indicator is far from comforting. GDP limps along right now at 1.8% at Q1. Why? Many have blamed the recent 08 debacle (and a debacle it was) and our subsequent economic stall on the greed of bankers and the leveraged “weapons of mass destruction” (Buffet) on their balance sheets. There’s no arguing that the banks were way off the reality reservation—and getting well paid for handing us thin air. Sometimes, I can hardly even say the word “bank” without wincing…But whether or not you agree with another one my recent manager visits (and former Goldman partner) that the “greatest tragedy of the last 100 years was supporting the corrupt and inefficient banking system,” (which includes his own alma mater at GS) the ultimate guilt for our current a situation lies more fairly in the hands of the average American and not just our asleep-at-the-wheel banks. As a value manager I admire recently noted, our country is now seeing the results of 20 years of consuming more than it produced. Under every indicator—from home sizes, belt sizes, car purchases to the repeal of Glass-Steagall, we have become “too fat.” We are in debt. That coupled with an 18% decline in US wealth has served to slow consumption. Bulls will say that consumers are ‘reducing debts’—but the fact is consumers are just defaulting on more credit cards for purchases they should never have made. Again, the guy at the lemon aide stand shouldn’t be flipping through Ferrari brochures… High unemployment doesn’t lie either, and those out of work don’t add much juice to GDP growth. The fact, moreover, that 15% of the US work force (19 million people) are employed by States is alarming, as the States aren’t doing so well either, even if you don’t believe everything Meredith Whitney says. The Net/Net? What’s the Net/Net? Well, the numbers point to a pretty poor combination of macroindicators. That is, when looking at the data pertaining to deficits, interest rates and consumer power, all three legs of the financial stool are quantitatively weak. GDP growth, perhaps the simplest and most basic tool for discussion, is not looking good today, nor tomorrow. So what do we do with these assessments? These paragraphs are not meant to simply assess, but to also, and most importantly, look forward. Nor am I interested in suggesting macro/political solutions to our national economic malaise (I can’t help but note, however, that there is a direct historical correlation to high government expenditures leading to less GDP growth and that reduced government spending in fact leads to accelerated GDP growth. In other words, our current administration seems to be paddling up the wrong creek. We need some austerity to follow our stimulus.) Rather, this exercise was designed as a backdrop to the larger questions, which are: How do we invest in these times? What questions should we ask? What strategies make the most sense given our macro views? a) First, we should question the assumptions (supra) that we are in a bearish economy. Are we? If so, for how long? We must also keep forever in mind that economies and markets are NOT the same thing. Markets can rally over and over in bad macro environments—at least for a while. We can also challenge these macro indicators, or accept them. Either way, they create a strong starting point for reaching consensus. American corporations, for example, have exceptional balance sheets and cash reserves (largely from cost cutting). If and when this capital is put back into the real economy, we could see growth and consumer power (two legs of the economic three-legged stool) increase. This will only happen when our government grows up and adults, rather than children, start leading in DC. b) Assuming we are heading into a continued weak growth economy, does that ipso facto suggest a weak equities market? When economies tank, prices eventually tank, and as old investors often say. “wait until there’s blood in the streets, and then start buying.” In other words, weak markets and drastic dips create extraordinary buying opportunities for smart, patient and LONG-TERM THINKING investors. c) Given interest rate and inflation indicators, what does that portend for credit plays, fixed income views and allocations to managers who operate well in these inflection points and the subsequent volatilities? d) What types of mangers and strategies are best suited for a continued yawning economy and the end of the federal stimulus? With these questions presented in the backdrop of the larger macro numbers outlined above, I can make the following observations. 1. Look for managers who know how to short for alpha. The end of the federal stimulus means there will be less purchasing of risk, and thus many of the C+ names that were being purchased like B+ assets will get their day of reckoning and shorts should start to behave more like shorts. The only risk, however, is that periods of volatility can make shorting difficult as fundamentals go down and correlations go up. 2. Find the best stock pickers—those who understand value and free cash flow companies with low debt. They will be unpopular for short-sighted investors, but those who have the character, conviction and intelligence to value and price the right positions, down markets, slow markets, and even scary markets (such as where we are headed) are the greatest markets to make money—in the long run. 3. On the credit side, inquire with managers which strategies are the best suited for the anomalies created by the flood of money coming into credit despite 0% real treasury yields and tight spreads. As Europe heads toward disaster or inevitable US-like central bank printing (i.e short-term “doping”), we may have unprecedented distressed credit opportunities. Managers best positioned to exploit this cycle could be rewarded. 4. If the US economy and markets are looking sluggish long term, what funds offer the best non-correlation plays (i.e. sovereign bond plays in both emerging and developing markets, merchant bank –direct lending--plays taking over where the other banks have gone dark, superior data plays in RMBS etc. 5. Reconsider (i.e. possibly reduce) the weighting/allocations to long-only managers in a slow tape. (Alternative managers tend to perform best in the weak or volatile markets and tend to have relatively poor performance in running bulls, like 99 or 03.) The best long-only plays in a dying market like the current one is to larger cap, dividend paying names. 6. Look at event-driven, special situation funds best positioned to exploit domestic and foreign distressed opportunities where macro indicators (such as those above) are understood in different markets/geographies. 7. Discuss commodity play in these markets, especially given our undervalued currency and inflation predictions. Price inflation is correlated to dollar devaluations. Also, the remarkable link between money supply increases and gold pricing is worth discussing, as the graph for money supply looks more a like a rocket take-off than even a hockey stick. Could gold go to $3000 or more? Yes: because it’s a currency alternative to weakening mainstream currencies. The US and Euro Zone are in debt. They will devalue their currencies. They have no choice. The US already has. Europe will follow. And gold, it is fairly safe to speculate, will go up…Of course with commodities, speculation is the name of the game, and those without the stomach or risk profile for this asset class should simply avoid it, period. The problem with gold at these prices—or any price frankly—is that it’s nearly impossible to value. They play here is thus speculation, and speculation is not the same as investing.