Grillo's Corner: The Great Central Bank Roller Coaster, Part III

My last two "Grillo’s Corner" columns dealt with controversial central bank policy and some observations about their effects. You’d think I could leave it alone — but I'm back one more time to obsess over what I believe is a massive infringement into the capital markets. We revisit this area of finance and economics to shed light on the current campaign many are waging to validate this exercise. In this installment, I’d like to take issue with the chorus of voices in the media and academia seeking to give intellectual and academic cover to the quantitative easing (QE) measures.

Not about traditional inflation

Although critics of QE claim that monetary intervention could spark potential inflation, I don’t see any evidence of this. When looking at the last two decades (a period that encompassed various episodes of loose monetary policy), I am hard-pressed to find evidence of troublesome inflation in the United States.

The chart above depicts a period in which inflation was relatively tame. The core personal consumption expenditures (PCE) indicator, a favorite Federal Reserve measure of inflation, is charted on a year-over-year basis. The targeted federal funds rate (TFF) depicts an important lever of monetary policy for the Fed over this period. The volatility in the TFF indicates that the Fed was open to dramatic policy measures to smooth over economic or inflationary pressures. (Source: Bloomberg, as of March 2013.)

The chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change.

The period depicted above has been described by some economists as the "Great Moderation.” To them, it was a period in which modern policy theories and activity served to smooth out gross domestic product (GDP) fluctuations and dampen market volatility. Fed funds levels were more volatile than inflation, and portrayed a Fed regime that was open to dramatic policy measures to smooth various economic or inflationary pressures. There was no inflation problem, as measured by core personal consumption expenditures over this time period.

Asset price inflation

If one were to study this period, one might find obvious examples of asset price inflation, or asset price bubbles (to borrow a term popularized by the mainstream media). In my opinion, the Fed displayed a willingness to use easy money policies to cure economic ills, and to create a monetary “put” for the owners of riskier capital markets investments. In creating that physiological environment for investors, I believe the Fed emboldened them to take more and more risk and, coincidently, also increase their leverage.

This environment, in my opinion, helped create the technology-stock bubble of the late 1990s (see chart below) and contributed to the housing bubble in the U.S. When short-term rates were increased slowly in the mid-2000s, the Fed accompanied them with its assurances of the therapeutic effects and projections of economic bliss. Unfortunately, its guidance never made allowances for the coming financial crisis and the ensuing chaos in financial markets.

Source: Bloomberg, March 2013

The chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change. The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common stocks listed on the Nasdaq stock exchange. Indices are unmanaged and one cannot invest directly in an index.

Source: Bloomberg (March 2013)

The chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change. The S&P/Case-Shiller Home Price Index: Composite 20 is the leading measure for the United States’ residential housing market, tracking changes in the value of residential real estate in 20 metropolitan regions.

The willingness to adjust monetary policy to accommodate domestic economic activity and the global demand for U.S. dollars seems to have partially fueled international asset bubbles as well. As the U.S. dollar was used as a major international funding currency, the easy access to lending appeared to help to ignite overseas equity and real estate bull markets.

Hedge funds, private equity funds, and other shadow banking entities used U.S. dollar funding to grow balance sheets and invest overseas. The subsequent bursting of real estate bubbles in Spain and Ireland has been a significant drag on euro-zone economics. Countries within the euro-zone bloc have had to borrow money to bail out banks.

Source: Bianco Research LLC, March 2013

Chart is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change.

Volatility in tax revenue streams

We have discussed the creation of asset bubbles as an outgrowth of Fed policy moves that attempted to smooth out economic growth. What hasn't been discussed enough, in my opinion, is that the asset price swings are creating volatility in U.S. tax revenue streams. Jim Bianco, of Jim Bianco Research LLC, is one of the few analysts who have looked at this aspect of the troubling asset price bubble environment. The chart above depicts swings in capital gains revenue that are indicative of a volatile tax base.

This is akin to the financial company model that uses leverage and trading revenue to generate its earnings stream. In this model, the financial company exists as a more volatile franchise, which usually carries higher risk premiums attached to both its equity and its debt financing. So far, we have not had to endure big risk premiums for our country’s debt. However, we have witnessed a recent downgrade to the nation’s debt, perhaps with further negative action to follow.

Outlook for markets

Our final thought is on the near future of the markets. Several central banks have taken cues from the Fed and begun applying QE measures. Many markets have been influenced by this huge medication. At some point (and it may have started already), the cheap financing from this liquidity may lead to increases in economic activity. At that point, the proponents of QE measures — snake oil salesmen and charlatans, in my opinion — could make the same questionable pronouncements they have about past economic surges.

That is, they could declare that such activity is healthy and naturally occurring, and has longevity. Unfortunately, these pronouncements may influence many an investor. Additionally, other investors may have learned a different lesson — that central banks will always bail them out. (See graph below.)

We will monitor leverage indicators carefully in the coming months. If there are signs of further deleveraging, we believe it will make for a sustained and healthier adjustment (but come at a cost to near-term growth, in our opinion). If, however, investors and shadow bankers are emboldened by this ample liquidity and decide to increase leverage, we believe it could potentially lead to another shockwave event in the financial market. If the graph below is any indication, we may have cause for concern.

Investors’ belief that central banks will continue providing bailouts may increase their appetite for leverage.

Source: Zero Hedge, from The CFA Institute, January 2013.

The chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change.

An increase in debt-to-GDP in the U.S. (and other developed countries) could lead to an asset bubble and possibly another shockwave event. (Source: Ned Davis Research, as of October 2012. Latest data available)

The chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.

Information is as of the date indicated and subject to change.

Current positioning

In the current environment, uncertainty surrounding the euro-zone recession, a China slowdown, and politically volatile budget actions, requires a close monitoring of risk, market liquidity, and Treasury interest rate shifts. We have positioned our portfolios as follows:

  • Overweight in investment grade corporate bonds (we believe valuations are fair)
  • Midrange exposure in reasonably valued high yield corporates
  • Continued exposure to low-coupon mortgage-backed securities
  • Small overweights in short asset-backed securities and high-quality commercial mortgage-backed securities
  • Underweight agencies and Treasurys (manage cheapest to deliver Treasurys for price gain potential as a performance hedge during periods of market liquidity strains)
  • Continued intermediate yield-curve exposure
  • Focus on international investments — higher-growth areas in emerging market and developed countries
  • Partial currency exposure hedge

Warm regards,

Paul Grillo

The views expressed represent the investment manager’s assessment of the market environment as of March 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the investment manager’s current views.

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