Download “Keep It Simple

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.