May 13, 2013

Health problems have kept me away from blogging but they have certainly not kept stock and bond markets from reaching new heights (or in the case of bonds, new lows in yields and spreads).  While virtually nobody can point to a reason for the party to end, the absence of bearish arguments is troubling in itself.  After all, reality is never one-sided; markets don’t go straight up or straight down.  At this point, the divergence between bond and stock markets and equity markets and economies are stark enough to call into question investors’ traditional assumptions about virtually everything.  Unprecedented central bank policy has moved the world into uncharted waters and the tools we have relied on in the past may be insufficient to guide us in the future.

There are a few things that are clear.  Investors should not be buying high yield bonds at yields under 5%.  They should not be lending money to the U.S. government for 10 years at under 2% or for 30 years at around 3%.  Those yields guarantee negative real returns.  By way of comparison, it is hard to argue with the proposition that equities paying a 3% dividend offer a much better proposition since they at least offer the prospect of principal growth while bonds offer lenders a paltry yield and a pat-on-the-back but nothing more if things work out.  Over time there is little question that reasonably valued equities are a better bet than low yielding fixed income securities.

We also know this: in the next 3-5 years, the world will be faced with central banks trying to withdraw the largesse they have been bestowing on markets since 2009, at first out of necessity and then out of some ill-placed belief that they could manage the business cycle and take the place of fiscal policy.  That process is unlikely to go smoothly because the world’s economies will be unable to generate sufficient income to service all of the outstanding debts that will have been created.  As a result, those debts will have to be reduced in value by means of inflation, currency devaluation and outright defaults; they can not be repaid in constant currencies.  How the world gets from where it is today to where it needs to go is the challenge facing policy makers and investors.  It is a challenge the world has never faced before and will require novel thinking, bold leadership, moral courage and strong character.

April 7, 2013

I am starting to have serious concerns about the Bank of Japan’s extraordinary monetary stimulus.  While last week’s announcement that the BOJ would be doubling its purchases of Japanese Government Bonds (JGBs) and other financial assets (including foreign securities) did not come as a surprise, the magnitude of its efforts combined with those of the Federal Reserve, the European Central Bank (ECB) and the Bank of China are nothing short of overwhelming.  Japan alone will be doubling (almost – they will be purchasing about $80 billion per month compared to the Fed’s $85 billion per month) the Federal Reserve’ quantitative easing efforts.  But other major central banks are also purchasing enormous amounts of government securities, which force feeds huge amounts of liquidity into the financial system.  The fact that these floods of liquidity are not pushing asset prices up faster than they are should be raising more alarm bells than it is.  Monetary policy is having a minimal effect on real economies while it is rewarding financial market speculators.  It is no accident that there is such a high correlation between the rise in the S&P 500 and the growth in the Federal Reserve’s balance sheet.  Compare that with the lack of correlation between those two and the growth of the U.S. economy, or jobs growth, or other meaningful measures of economic growth.

One of two scenarios is likely to unfold very soon:  the flood of money will just be added to the already massive piles of money sitting on central bank balance sheets and not make it into circulation in the real economy, which will continue to suppress interest rates and feed speculation in financial markets, or it will enter circulation and push up prices fairly suddenly.  The first scenario will simply push further into the future any possible date at which the Federal Reserve can change policy, and the second scenario will lead to a rout in bond markets worldwide.

In the April 5, 2013 issue of his invaluable GREED & fear, Christopher Wood makes the point that the lines between monetary and fiscal policy are eroding, and that central bank policy is becoming increasingly unconventional.  As a result, he writes that “rather than contemplating exiting such [unconventional] policies, the central banks are moving further and further away from the exits.”

In the case of Japan, one could argue that this was a decision of the voters, who placed Prime Minister Abe in office with a clear mandate for the type of change that is now occurring. In the United States, the Federal Reserve is an unelected body and the direct line between it and the voters is far more mediated (although clearly the Obama administration was seen as supportive of easy money).  But we are clearly in uncharted waters and we are likely to experience unforeseen consequences as a result of the unprecedented, coordinated massive quantitative easing policies of the world’s central banks.  The most likely consequence in the near term will be an end to extended period of low volatility that markets have enjoyed since the beginning of the year.

April 1, 2013

The May 2013 issue of The Credit Strategist will be published tomorrow – “Sanctities of Contract.”  If you are not already a subscriber, be sure to subscribe today!