Mixed Messages & Conflicting Indicators
David R. Kotok,
Cumberland, August 18, 2013
To paraphrase Voltaire, this is the worst of all possible worlds. Market agents confront a Fed two-step, Fed double-whammy dilemma. Meanwhile, economic indicators are mixed and outlook is uncertain.
In four days we traveled 7,000 miles and visited 6 cities, spanning 3 time zones. During those travels we interacted with clients, prospects, investors, and bankers. These meetings, gatherings, and four speeches included about 400 people involved in economics and finance at various levels. Collectively they represented somewhere in the neighborhood of $10 billion in financial assets, mostly US-dollar based.
They were all concerned. Most fear rising interest rates. One asked if he should seek safety by buying 10 year CDs at 3%. He noted that cash is yielding zero. I pointed out that the CDs are taxable and that his tax-free bonds yield more than 3%. “Yes” he said, “but interest rates may shoot up and the ten year treasury will yield 5% and all my bonds are falling in price.” “If you believe that” I said “why buy the CD?” The return stare was a face of panic and one that really said “I do not know what to do.”
The bottom-line responses during my travels involved a series of related questions: “Where will interest rates go? When? How will they move? How much volatility is there? What can we expect for the future?” Of course, the demands for answers to such questions are impossible to fulfill. But the apparent concern of this investor class is obvious whether on the East Coast or in the West.
The bottom line of the two-step, double-whammy risk issues boils down to this. The US central bank is the most powerful and important central bank in the world. Perhaps the European Union and the Eurozone would disagree and point to the ECB (European Central Bank), but my suspicion is that, when push comes to shove, they rank number two. The other two important central banks of the world are the Bank of England and the Bank of Japan, which with the former two make up the G4. There is an additional tier of very important countries like China, Brazil, Sweden, New Zealand, Australia, Canada, and a few others. In the end, the most important is the US central bank, the security-observant disciplinarian of the US dollar.
Throughout my visits, interfaces, and conversations over this road trip of four days, two fundamental questions stand out. They were raised many times.
1) What is the Fed’s policy? No one in my audiences can answer that with clarity or precision. Tapering is an ill-defined term. When to taper, how to taper, what to taper, who to taper, how to un-taper, and what the results might be in an economic framework – for the 400 decision-makers I met and their $10 billion in assets, these critical determinations remain unknown. Nearly all agree that there is a mixed message coming from the spokespersons of the US central bank.
2) Who will make the policy? At every step of the way, we had discussions about Larry Summers versus Janet Yellen versus two other mystery candidates that the president has mentioned but has not named. The whole matter of “Who?” is the dominant issue now. We have written about this in the past. We have talked about how Yellen represents a continuation of gradualism, a form of stimulus and a policy that is profoundly focused on redeploying and re-employing 20 million unemployed or underemployed Americans.
We have also discussed the fact that Larry Summers is now very much in play after being on the front page of Sunday’s New York Times. What Summers represents as an alternative to Yellen is unclear. Some think that Summers would immediately stop QE and introduce a whole new structure at the Fed. They surmise that he would be a harsh implementer of regulatory change regardless of the short-term detriment such changes might do to the US and its financial institutions. Meanwhile, others believe that he would be a strong political player with the Obama White House. They suggest that he would interface with the president, whose agenda is advanced and whose legacy is maintained by a continuation of a zero interest rate policy for the remainder of the Obama term. How are we to know what we would get with Summers?
Thus we come to the most important question: in the post-Bernanke era, who is going to make the policy?” That question is now bigger than ”What will the policy be?”
It is no wonder that markets confront a rising risk premium at this time. Tautology: risk premia rise with uncertainty. We have written this over and over again. We are on the heels of a market repricing based on rising risk premia.
Some of the repricing is absurd, for example the pricing of tax-free versus taxable bonds. We have discussed this previously, too. Other repricing has a more solid basis in fundamentals. If the growth rate in the US is going to slow, the inflation rate is low, and debt burdens persist in their present form, it is unlikely we will have economic growth sufficiently robust as to raise earnings growth rates. Is Wal-Mart’s warning a precursor of more to come? Are sentiment indicators telling us trouble lies ahead?
We have taken the cautious position at Cumberland, which is why we have raised cash and ratcheted back on stock market exposure. Fortunately we did this early.
What do we do now? In the two weeks leading to Labor Day weekend, in non-liquid markets (with many people on vacation), and in conditions of low volatility when fluctuations become more dramatic, we have to try to discern trends. The bottom line is that we cannot discern the trends with high confidence. We study them daily but we know that risk is rising and the trends are harder and harder to discern.
We remain observant with regard to activities coming out of the Fed, but we do not know how they are going to play out. The Kansas City Fed’s Jackson Hole meeting will make news and the presentation of research papers may hold the key to changes in policy. We will know that soon enough.
We remain observant with regard to the activities of the White House and the Obama administration, but we do not know how they are going to play out, either. Washington is away and any policy change expectations are for September. Meanwhile, nearly all in my audiences are disgusted with our politicians of both parties. Confidence in government is very low.
We remain observant with regard to the policy directions of the second largest central bank in the world, the ECB, but we do not yet know how those patterns will play out, because we await a German election and constitutional court decision. The euro zone is on hold for another month.
This concatenation of uncertainties piles on risk premia. That said, valuation metrics would suggest that, in certain sectors of bonds like tax-free municipal bonds, there are great bargains to be had. We’ve written enough about that. We are buyers of tax-free Munis at the 5% level.
Otherwise, a caution on the US stock market and the US economy is in order, since we may be confronting potential developing weakness. Valuation assessments would suggest that we are not out of the woods, in this muted recovery, from the financial crisis that has been ongoing for four years and is not over yet.
At this writing, we are positively disposed towards a cash reserve with respect to the stock markets worldwide, including the US market. We continue to be observant and to worry. We will have our final gathering of the season at Leen’s Lodge on Labor Day weekend. A few other worried observers will be present.
David R. Kotok, Chairman and Chief Investment Officer