David R. Kotok
Chairman and Chief Investment Officer
August 22, 2010
Middle East geopolitics raise the fear quotient. The Obama administration’s response to Middle East tension remains a mixed message.
Israel faces another “flotilla” plus the Iranian nuke threat. For Prime Minister Netanyahu, this is a two-front geopolitical war that can threaten the survival of his country. For the United States, this piles on top of Iraq uncertainty, Afghanistan irresolution, and Russian snubbery.
All this is happening in the heat of an election year, with President Obama’s approval ratings so low that some political pundits now forecast a swing of 50 to 80 House seats. This outcome would leave the Democrats a bruised and repudiated minority. Their replacement would be an energized and harshly vindictive Republican majority. Acrimony will remain the dominant emotion on the political stage, even though the cast of characters may change.
In both world and domestic politics, with threats of war markets gravitate to higher-quality or insular sectors. We have seen that underway since the start of July. Examples: Treasuries (flight to quality) have rallied robustly. Big-cap stocks have outperformed small- and mid-cap stocks. Growth has been doing better than value. Defensive areas like utilities and pharma have gained relative strength.
Let’s get to the Federal Reserve. Bernanke’s big speech from Jackson Hole will focus attention on the new Fed paradigm.
In the pre-Lehman days, the old Fed managed interest rates as their primary policy tool. The Fed’s balance sheet approximated $900 billion, mostly Treasury securities, on the asset side. The liability side was essentially the US dollar-denominated currency circulating throughout the world or held by banks as reserves while being parked in ATM machines. That paradigm is dead.
The new Fed paradigm adds over $1 trillion in securities on the asset side. The Fed is trying to transition from GSE-sourced mortgage paper to Treasuries as a substitute. On the liability side, the Fed now holds $1 trillion of excess reserves, parked with the Fed by the large banks. Nobody knows what the appropriate size of the Fed’s balance sheet should be in a climate characterized by trillion-dollar Federal deficits, 10% unemployment, growing regulatory oppression, high political uncertainty, and the rising geopolitical risk outlined above.
Bernanke is the classic “man in the middle”. His policy back is against the wall of the zero boundary in nominal interest rates. He fully understands the rising risk of deflation. He knows he must do whatever it takes to keep the United States from sliding into a Japanese-style lost decade. Markets wonder whether the Fed is running out of “bullets.” Bernanke’s task at Jackson Hole is to make the Fed’s arsenal credible.
We believe the Fed has the arsenal. They have worked on it for nearly a decade. Clues may be observed in earlier Fed speeches by Bernanke, Reinhart, and others. One needs only to read that history.
Juvenile market observers don’t read history these days. Eyestrain from text has been replaced by irritating TV sound bytes and 30-second summaries. In times like this, we take comfort in being among the “old dogs.”
Our bond accounts are fully invested in high-credit-quality spread instruments. There are plenty of opportunistic places for bond investors. Treasuries are rich. Tax-free munis and Build America Bonds are cheap.
Cash earns zero. At Cumberland, our allocation to cash is zero.
Many of the stock markets of the world are cheap. That includes the US, selected countries in Europe, South America, and Asia, and selected currencies, regions, and sectors. We are nearly fully invested in our ETF accounts worldwide.
Lastly, the next eight weeks are the treacherous part of the investment calendar. September in particular is the most dangerous month. During years when the Fed was tightening, the outcomes have included the famous market crashes of 1929 and 1987. We thank Guy Rosa for the reminder.
During years when the Fed was easing, their actions neutralized the seasonality. The Fed has just affirmed maintenance of its balance sheet size. The Fed did not commence shrinkage. Transition from rapidly prepaying mortgages to substitute holdings in Treasuries is not a tightening, it is a lateral transfer of an easing position.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com