Investment in a Time of Dysfunction
Mad Mad World…
In 2012, despite slowing growth, deepening sovereign debt problems and lack lustre earnings, equity markets advanced strongly. In 2012, the MSCI All-Country World Index of equities increased 16.9% in 2012 including dividends.
23 out of 24 benchmark indexes in developed markets increased. The US S&P 500 Index climbed 13%, the highest increase since 2009. European markets rallied with Greece, Germany and Denmark increasing almost 30%. Only Spain’s IBEX 35 fell but only by a modest 5%. Despite its embalmed economy, Japan’s Nikkei 225 Stock Average rose 23% in the largest rally since 2005.
Bonds of all types returned around 5.7% on average. Safe haven buying and demand for yield increased fuelling demand for bonds. Ever lower interest rates and risk margins did nothing to discourage buying.
Despite continued debasement of currencies through central bank quantitative easing, the S&P GSCI Total Return Index of 24 commodities rose 0.1%.
Highlighting the perversity, even debt of beleaguered European nations was in demand. Astute investors doubled their money on Greek bonds, in a surreal bet on an economically dead nation incapable of paying backs its debt. “Tis a mad world, my masters.”
Investors could easily delude themselves into thinking that “happy days” have returned. As smart investors know, investment genius is a long position, leverage and a rising market. A rising tide, as they say, lifts all boats. But that may now be all in past.
There has been a marked shift in the investment climate. The world is also shifting to a much lower growth path. Investment outcomes are now heavily dependent on government and central bank policy decisions. Investors must re-shape investment practices for dysfunctional times.
Decent returns can be still earned during periods of great uncertainty. They just require different investment approaches.
Investment outcomes are now influenced more by government and central bank policy decisions than fundamental factors. The rally in the Euro and European bonds and stocks following the European Central Bank’s announcement that it would purchase unlimited quantities of peripheral country debt demonstrated the risk of mis-reading policy.
Major central banks dominate markets. Their collective balance sheets have increased from around US$6 trillion before the crisis to more than US$18 trillion, an unprecedented 30% of global gross domestic product (“GDP”).
Government and central bank strategy is targeted at growth and creating inflation using non-conventional monetary policies, quantitative easing and specific inflation targets. High nominal growth would make existing debt levels more sustainable. Inflation would help reduce debt in real terms. But the strategy may not work.
While central banks are providing ample liquidity, the effects on credit creation, income, economic activity and inflation are complex and unstable. The velocity of money or the rate of circulation has slowed. Banks are not using the reserves created and money provided to increase lending, reflecting a lack of demand for credit by stretched households and businesses with over capacity. The reduction in velocity offsets the effect of increased money flows and limits the pressure on prices.
Uncertainty about the effectiveness of policy complicates investment choices.
If policy makers succeed in restoring growth with modest inflation, then equities may prove the best investment. If the policies result in high or hyperinflation (such as that experienced in Weimar Germany or Zimbabwe), then real commodities and precious metals such as gold may be the best investment to protect against the erosion of the value of paper money. If the policies prove ineffective, then a period of Japan-like stagnation may result. In such an environment bonds or other fixed income instruments will be the favoured investment.
In recent times on a number of occasions, equities, bonds, commodities and gold have rallied simultaneously reflecting investor confusion.
For investments denominated in foreign currencies, the effect of loose monetary policies on currency values is an increasingly important influence on investment returns.
US Federal Reserve policies are designed to devalue the currency to reduce the value of outstanding US dollar government debt held by foreign investors and also improve export competitiveness. With all developed countries competing to weaken their currencies, the impact of foreign exchange fluctuations on investments -directly or indirectly through their effect on company earnings- is unpredictable.
Bondage & Discipline….
Given the scale of the problems, governments have resorted to “financial repression”. Governments are implementing a range of policies to channel funds to official institutions to liquidate debt.
These include explicit or implicit control of interest rates, which are negative after adjustment for inflation. This helps governments decrease debt servicing costs and reduce the real value of its debt.
There will be increased interference in financial markets, as governments intervene, overriding normal market mechanisms. Prohibitions on short selling, bond purchases and currency intervention are examples.
Investment and borrowing restrictions, to create captive domestic market for government debt, via reserve requirement or explicit investment constraint, may be implemented. Free movement of funds internationally may be restricted via capital controls.
Changes in taxes, a government seek to garner revenue, will also affect returns.
Successful investment now requires recognising and minimising the adverse effects of financial repression.
Investment theory may not provide succour in this environment.
Governments bonds are no longer risk free safe havens. The risk of default or loss of purchasing power either through devaluation of currency or diminution of purchasing power is prominent. As Jim Grant of Grant’s Weekly Interest Rate Observer observed government bonds now offer “return free risk”.
Risk premiums are frequently negative as investors flock to safe assets or the latest bestest investment – US and German bonds, high yield corporate bonds or high dividend stocks.
Diversification to mitigate risk is difficult as correlation between different investment assets has become volatile. The fundamental risk of domestic shares, international shares and property is similar in the current economic environment. Even returns on cash are positively correlated to risky assets as interest rates have fallen in the recession.
Investors have assumed policy measures have reduced tail risk, the chance of large and frequent increases and decreases in prices. In fact, the opposite may be true. Attempts to suppress volatility, without addressing fundamental problems, increases the risk of major market breakdown in the future.
As the global economy resets, the prospects are for lower returns and increased volatility. The US stock market took 25 year to regain its highs after 1929. Japanese stocks (down some 70+% from its peak) and property markets (down between 50-70%) have still not recovered the levels of 1989.
Low growth will affect corporate earnings and equity values. Recent strong corporate earnings were driven by cost cutting, government stimulus and low interest rates. Slow growth will constrain already indifferent revenue levels. Without underlying demand for their products, corporate profits margins and earnings will be under pressure.
Corporate earnings in emerging markets will be affected by the sluggish growth in developed markets and the slowdown in China, India and Brazil, the regional powerhouses.
The Viagra of investment – leverage – which drove high returns in the pre-2007 is unavailable as the global economy reduces debt. Since 1912, as Pimco’s Bill Gross has argued, equities have returned 6.60% per annum in real terms, above real GDP growth 3.5% per annum. The additional return has, in part, been driven by leverage, which is less likely to influence future equity returns.
“Official” interest rates are low but credit margins are high and with inflation low the real cost remains high. The overall supply of credit is likely to fall as European and American banks cut balance sheets size. Risk averse companies and individuals are also more cautious about borrowing, after recent near death experiences.
But low interests which reduce holdings costs and dividend yields which are above bond interest rates have underpinned equity prices. The effect of policy actions on equity markets is difficult to gauge. Based on the Japanese experience, further rounds of central bank buying of risky assets can be expected. The range of assets bought may expand to include equities and corporate bonds which would boost prices.
A Case of Style…
Investment structures compound the investor’s dilemma.
Traditional mutual funds are structured to generate relative returns measured against a benchmark. Unfortunately beating a benchmark by 5% provides cold comfort to investors when the investment manager is down 15% and the market falls by 20%. Only absolute return now counts.
Management fees and fund expenses are a significant drag on returns. Management fees and expenses of 2% are tolerable when the returns are 12% but difficult to bear when the returns are 5% or lower.
In choppy markets, rapid changes in the composition of portfolio including switches between assets and instruments (physical versus derivative; symmetric versus asymmetric exposure) are required. Long periods of staying uninvested, holding cash or other defensive assets, may be necessary. Investment mandates require investment in a single asset class or limit switching, constrain the type of instruments used and force the fund to stay substantially invested at all time. This restricts the ability to generate positive returns.
Traditional investment styles may not work. Value investing, buying stocks based on fundamental analysis when they look cheap, has historically been successful since the days of Benjamin Graham. The hidden value can be released through cash flow, dividends or acquisition in the long run. But since 2008, value investing has performed indifferently. Arbitrage strategies, such as relative vale trading and long-short equity or equity pairs trading, have also performed poorly. The failures reflect uncertainty about correct values, risk-on/ risk-off trading, risk aversion, illiquidity and the lack of convergence to theoretical values.
Investment in the Time of Dysfunction…
Investors may now need to consider comedian Will Rogers’ advice: “I’m more concerned about the return of my money than the return on my money”. Capital preservation will be the key to survival. A large sustained loss of capital is currently the major investment risk. This favours debt over equity or other risky assets, even though the safety of government debt is increasingly in question. It also favours defensive stocks or hard assets, like commodities.
Investment income (dividends or interest) may be the major source of return. Capital gains will be more difficult as the period of consistent stellar rises in price may be less likely in the future.
In bull markets, investment approaches focus on capital gains, income and capital return in that order. The current environment requires re-prioritisation of those objectives.
Investors have increasingly embraced non-traditional investment. There has been strong interest in gold and other precious metals. Gold prices have risen strongly, although remaining below their 1980 peak in real terms.
Hedge funds and private equity funds continue to attract money, despite variable performance. The attraction is a focus on absolute return and greater investment flexibility. Despite well documented problems, structured products, where investors assuming credit risk or fluctuations in interest rates, currencies or equity prices in return for a higher interest rate, are making a comeback, driven by low interest rates.
Disillusioned with financial assets, the ultra rich are focusing on scarcity – farmland, prime real estate in world cities with desirable properties and collectibles (fine arts, rare cars). Even wine has emerged as an asset class, giving a new meaning to the term “liquidity”.
Increasingly investment approaches focus on matching future cash flows, irrespective of whether it is a known future liability or retirement income needs. Products such as annuities targeted at retirees or specific saving plans that provide a guaranteed lump sum are growing in popularity.
A key element is capturing volatility to take advantage of large price fluctuations. This can be done by purchasing out-of-the money options which provide the investor unlimited gains from tail risk for a known fee. Alternatively, volatility can be captured by allocating a portion of investment capital to either stocks which benefits in periods of “irrational exuberance” (typically growth stocks) or “irrational pessimism” (defensive stocks).
High levels of cash allow investors to capture volatility taking advantage of sharp falls in value. Warren Buffett’s Berkshire Hathaway maintained high levels of cash running into the crisis – around US$20 billion. This liquid reserve was expensive to maintain as interest rates were close to zero. But it allowed Buffett to make lucrative and very high yielding strategic investments in Goldman Sachs, GE and (more recently) Bank of America.
In Chinese, “Shi” is the art of understanding matter in flux. To preserve capital and the purchasing power of their money in these dysfunctional times, investors will need to understand the financial flux and negotiate its complicated cross currents.
Imitation may be the best investment strategy. As Bill Gross has repeated frequently during the crisis, Pimco buys whatever the central banks are buying. It is like the scene from When Harry Met Sally when a woman having watched Meg Ryan fake an orgasm in Katz’s Delicatessen tell the waiter: “I’ll have whatever she’s having”.
But predicting policy actions is difficult. Faced with electoral pressures, desperate policy makers and governments are frequently motivated by political and social consideration rather than economic or financial factors.
Success also requires avoiding common pitfalls. Successful investors often succumb to what theologian Reinhold Niebuhr termed the “most grievous temptations to self-adulation”. Success is always 10% skill and 90% luck but it is unwise to try it without the quotient of skill. Hubris has resulted in a greater loss of wealth than market crashes.
Adjusting return expectations to more modest levels is essential. As Samuel Loyd, an Englishman who made his fortune in finance and was considered an authority on money and banking in his time, observed: “No warning can save a people determined to grow suddenly rich.”
© 2013 Satyajit Das