Monthly Archives: March 2014

CFA Minnesota Insight Series Notes, “Where to Invest in a Rising Rate Environment”. March 25, 2014

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Ben Emon, PIMCO

  • Zero bound rates are a huge issue and have been a chronic problem for countries like Japan
  • The private sector is still deleveraging
    • It’s still with us, and there is still $11.5 trillion in nominal consumer debt
    • We need to increase leverage to increase growth, so we need to decrease rates
    • Will increased rates increase the risk of deflation?
  • We have full employment, but what kind?
    • There are lots of temporary workers
    • Many have dropped from the labor force
  •  Interest rate outlook: 4% ceiling off of a 0% Fed funds rate
    • 1.0% impact of Fed bond purchasing program and forward guidance
    • 0.8% impact on GDP due to demographics, global debt and political uncertainty
    • 2.2% fair value, fluctuating between 2.5%-3.0% until clearer economic picture evolves
  •  Thinks that there will be a 2.5% to 3.0% spread between the Fed funds rate and nominal interest rates for now, with a probable gradual increase in interest rates over time
  • Fed’s projection of 2.5% policy rate at the end of 2016 contrasts sharply with the past, which has been nominally faster. The tightening cycle was two to perhaps three to four years. The challenge is how to communicate the change and Yellen may have interjected some uncertainty, and the Fed is not clarifying how it will behave.

 

  • Where to invest?
    • Long U.S. duration not a great place to be right now
    • Overweight European duration may be a better place to be
    • Overweight emerging duration may be better than it was last year
    • Some emerging markets look attractive

Panel Discussion, Different Perspectives: moderated by Paul Doane, St. Paul Teachers’ Retirement Fund; Phil Nelson,NEPC; and Greg Zick, Xcel Energy

  • Don’t want to exchange interest rate risk for credit risk
  • Monetary policy in the U.S. is diverging with the rest of the world
    • Possible tightening cycle
    • Lots of uncertainty with timing and other factors
  •  Increasing rates by the Fed will be data dependent, e.g. GDP level
  • Credit spreads are low and credit quality is good, but we are paid on spreads
    • Tail risk with low yielding assets?
    • Many are forced to buy low yielding assets
    • Be wary of bank loans which carry a high yield but people don’t realize they are callable and sometimes sell above par very close to call price so the total return is not great right now
  •  Still a place for durations
    • Risk mitigating tool
    • Need liquid, non-correlating assets, especially with equities
  • Looking at a range bound market
  • Look at total return, be more flexible and nimble and explore variable rate products
  • Adding additional diversification via investments in a broader array of bonds and equities can be beneficial in the overall risk / return of a portfolio as evidence by the actual portfolio returns presented.
  • It took 14 years to break 4% interest rates in the post WWII cycle, will it take that long this time?

 

Thomas Coleman, Wellington Management Company:

  • As he sees it there are four strategies now
  1. Staying the course
  2. Shift form interest rate exposure to credit exposure
  3. There is a high price for liquidity, and how to use it
  4. Being more opportunistic
  • Expect low rates or a low growth world.
  • Staying the Course
    • Legitimate strategy
    • If rates unchanged, a possibility for 8% cumulative return the next five years
    • Rates abruptly rise, perhaps a negative return in the early years then quickly recover
    • Rates gradually rise and slowly drift higher, comes in at 40 bps /year for this scenario
  • Other scenarios
    • Nominal government bonds do well in decreasing growth and inflation
    • Corporate spreads and high yields do well in increasing growth and decreasing inflation
    • Developed market ILBs do well in decreasing growth and increasing inflation
    • Emerging market currencies and ILBs do well in increasing growth and inflation
  •  It’s not until the Fed is done tightening historically do markets determine if the Fed has overshot or not, perhaps as long as one year plus after the fact
  • Duration hedged credit is like a synthetic bank loan, which can help create a floating portfolio.
  • Think like a lender, own what you want to own
  • Diversification works, but less so on a market cap weighted basis, equal weighted offers more diversification

 

Panel Discussion, Investment Advisors: Josh Howard, Advanced Capital Group; Mark Book, Sit Investment Associates; Neil Sheth, NEPC; Justin Henne, Parametric Clifton

  • One of the panelists was exploring European middle market lending
    • 30% of loans are funded by banks in the U.S. compared with 80% in Europe
    • More shadow banking in the U.S.
    • Bigger corporations are in the middle market tier in Europe compared to the U.S.
    • Default rates in Europe are less than the U.S.
    • Recovery rates in Europe are better than the U.S.
    • Therefore active management works well here
  •  One of the panelists was taking an absolute return strategy
    • Earn more while waiting for rates to rise
    • Use this strategy in conjunction with an existing portfolio, which would include the use of futures and options
  • Another used treasury futures most often to remove rate risk and keep credit risk; this can be an advantage in that you don’t have to sell out of the funds you like and incur transaction costs and/or taxes.
  • Use a rules based approach, as rates increase, increase duration for example.
  • One said the key is how to generate income and return as opposed to gauging the Fed and inflation
  • Clients went from caring about mitigating risk to looking for return, with another person mentioning that he’s seen a big shift to that view in the past three to six months.
  • Absolute return strategy doesn’t work well in the short term, it takes time to implement

If you are interested in reviewing the slides from the event you can view them here

Dorothy, Oz and the Fed.

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Like most people on the planet, I enjoy watching the “Wizard of Oz” (featuring Minnesota native Judy Garland). One of my favorite parts of the movie was when Dorothy pulls back the curtain and discovers that the Great and Powerful Oz is just another one of us and has no supernatural powers. Perhaps this is what investors are thinking to themselves after Fed’s press event last week and how the Fed ending more quantitative aspects of its guidance, which could change the whole “Fed Watch” tone of market of the past few years.

Quantitative guidance I believe had a role for a while; especially during the depths of the crisis and early part of the recovery. The liquidity I thought was truly beneficial and on the qualitative side it gave investors at least the veneer that centralized experts could manage the economy and get us out of the mess.  More recently however it seems that instead of analyzing companies, investors were hyper-analyzing Fed statements and playing guessing games on how the Fed might respond to new data—as measured in recently printed dollars. Thus it felt like we were constantly on the “where will the newly minted dollars go, to growth stocks of course” treadmill.

Now it seems as though the Fed is in the same situation as the rest of us; there no longer is a “formula” to drive our actions. Everything is now data dependent. We now as investors need to view new information about the market and the economy objectively and in conjunction with our individual holdings (or potential holdings), not as some vehicle that can quantitatively drive a certain measure of new liquidity and the beneficiaries of that liquidity. Hopefully, this leads to a situation where we all need to not pay as much attention to that man (now woman) behind the curtain and that we can get back to a stock picker’s market.

(Supply) Chains Keep Us Together

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The Ukrainian crisis is still underway, which got us to thinking about event-driven investing. That and yucca, which I was told was traditional Ukrainian drink. It is mixed in a large communal vessel and then passed to each participant. I tried it with friends a while back and it’s worth the effort—if you aren’t going anywhere for a while. As I mentioned in my last post, I am not a big fan of short-term trades. Having said that, my opinion is that there are investable ideas that come from an unexpected change in world events such as the one in the Ukraine; if one is willing to look deeply into the potential effect on input costs and supply chains.

Using the Ukraine as an example it, and former Soviet Union countries in general, is one of the few places outside of North America that has large scale, and long established, mechanized farming; a left-over from the collectivized farms under Communism. This is one reason the Ukraine is one of the most important grain export countries in the world. Unfortunately for the Ukraine it not only might have lost access to Crimean ports via the recent referendum, many ports on the Black Sea that were not affected by the referendum often have a notable Russian ethnic presence. How this might impact future Ukrainian grain supplies and/or exports via the Black Sea is yet to be seen, but it appears that this has had somewhat of an impact on grain prices as of this writing (California’s drought also likely played a role).

Can an investor find short term opportunities in these situations? I think it is very hard not only due to high frequency trading and artificial intelligence, but also due to corporate hedging. Most companies that have high exposures to commodities hedge their exposures, often for several months out. However after a period of time those hedges expire and need to be rolled over and reflect the new, usually higher, commodity prices. It can difficult for an investor to pinpoint when that might have an impact on earnings estimates, but eventually it should occur in the out years if prices are still elevated.

Additionally uncertainty in supply due to unexpected events can cause companies to reassess supply chains and adjust their sources accordingly. The financial impact depends on a number of factors such as existing worldwide commodity stocks, existing inventories at a particular company, logistical concerns, if a substitute can be used in place of that particular commodity, and the like. It can take time to determine if and when any of these factors, combined or in tandem, have an impact on a company’s costs.

Therefore disruptions in supplies and increased commodity costs might not have a visible effect on margins for several quarters, if at all. Using our example of the Ukrainian Crisis, we might not see grain prices impacts (assuming sustained higher prices) on reported earnings numbers of companies that use those grains this year due to hedging and supply chain factors. However there might be an impact in the out-years that may not be reflected in estimates. Taking advantage of that potential discrepancy may take more time, patience, and research than many investors are willing to undertake. Herein lays the opportunity.

In the meantime do your analysis, be patient, mix up a big batch of yucca, and pass it my way.

Dirty Old Town

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The rest of you can celebrate St. Patrick’s Day with your green beer, green bagels, and shiny green plastic hats. I thought it more appropriate to pay brief homage to the Celtic tiger – the economic miracle that visited the country from the mid 1990s until the financial crisis took over in 2008. Popular sentiment holds that the collapse was caused by profligate bankers making poor investments, and lax supervision from regulators which allowed the mal-investment to take place under their very noses. That’s probably true, but the boom that led to the collapse may have been led by Central Bankers more than the lender on the street corner in Dublin, and there may be a lesson there for other problems cropping up around the globe.

Politicians also obviously played a big role. Ireland’s aggressive Foreign Direct Investment policies may have been an important contributor. So successful were the 12.5% corporate tax rate and other development friendly policies that FDI soared to over 26% of GDP. Then capital began to flow out, FDI collapsed, and in 2004-2007, Ireland ran a deficit. At that point, it looks like banks took up the slack, borrowing significantly in wholesale markets, doubling in size – well, you know the rest of the story.

These days, Ireland is on the mend, I guess. It became the first Eurozone country to exit the IMF bailout in December, some degree of economic competitiveness has been restored, and it is at least flirting with growth. I can smell the spring on the smokey wind…

Now we can talk about Credit in the U.S. Supply continued to be heavy, at least at the start of the week. The market saw almost $37 billion in new issue, but over 50% of it came on Monday. By the end of the week, fears over China and the Ukraine finally forced the market to roll over a bit. Spreads were moving wider by the end of the week – in ten-year space we’ll call it +5 or so for the banks, +3-4 for industrials.  Trading in newly issued bonds looks a little sloppy – shorter maturities were trending a little better than long bonds. Overall it looks like the credit curve steepened, but levels were messy.

We’ll see what next week brings – geopolitics has us a little on edge. There’s always something lurking in some dirty old town somewhere…

Bring Back the Vinyl

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Back in the day when we liked a song we would buy things called albums or CDs. This, for an 80’s era teen, was a risk when disks were $9-$14, so we had to determine if we could live with the album to justify the cost. Fast forward to today it costs $0.99 for one song you know you already like, at least at the moment. However, with songs becoming more commoditized due to so many downloadable options, musical trends can change so quickly that your “cheap” purchase could be a waste of money.

This reminds us of the equity market today. With artificial intelligence and high frequency trading becoming such an important part of market volume (approximately 50-70%) and quote activity (perhaps as high as 90%+), it has had a notable downward impact on average holding periods and likely impacting market volatility, an extreme example being the “flash crash”.  This makes me tell myself every day when I enter the office “chances are I am not trading with humans, but with algorithms and I have no idea how those algorithms are structured.”

Therefore, I tend to do far less short-term trades of individual securities than I once did because of investment horizon risk. Because of these algorithms, my belief is that my risk/reward tradeoff may be neutralized by a computer that can establish correlations and execute risk arbitrage strategies more often, more accurately, and much more quickly than I could ever imagine. This in my opinion adds an element of risk that was not there before. Namely the impact of algorithms impacting market moves more than I anticipate during my investment horizon.

But what about valuation, doesn’t it matter even in shorter-term trades? Yes I believe it does, but likely beyond the investment horizon of my trade. By definition a trade is a very short term holding. It is not an investment. By the time the market does adjust itself, the time horizon for my trade may have passed and I could be stuck with negative alpha longer than planned.

Therefore, like me buying a song that I enjoy for the moment but quickly becoming a thing that takes up bytes on my IPod, short term trading in my view is riskier than it once was due to computerized trading algorithms. That’s why I tend to gravitate to names that I can live with longer than a moment—like my Elvis Costello records.