Statistically speaking, 2013 was a strange year indeed. The US reported very modest consumer price inflation of 1.5%, whereas the European Union and Japan came in even lower, at 0.86% and 0.36%, respectively. But during the same period, a painting by Francis Bacon called “Three Studies of Lucian Freud” sold for $142.4 million, the highest price ever paid for a painting at auction; a 59-carat diamond sold for $83.2 million, the highest price ever paid for a diamond at auction; trophy real estate prices in Manhattan, London, Sydney, and many other places soared past previous records; a limited-edition batch of Kentucky sour mash whiskey sold out at nearly $4,000 per bottle; and, of course, most developed-world equity markets marched in lockstep to new highs. ... The emergence of so many bubble-like niches in an ostensibly low-inflation world is curious. For instance, if the value of such major cur- rencies as the dollar and euro is stable, why were all these assets becoming so much more pricey? That is, after all, the same thing as saying that when valued in fine art or London penthouses, the world’s major currencies were actually plunging. Either those hot asset classes were simply random bits of foam in a vast, otherwise calm, disinflationary sea or the generally accepted definition of inflation is, in some fundamental way, flawed.
As crisis-induced fear fades, companies take on more leverage ... Companies are increasing their borrowing for three main reasons. The most obvious is that interest rates are low, meaning a key cost, borrowed money, can be obtained cheaply. That can result in higher returns to shareholders. Moreover, rates are likely to rise, which is encouraging companies to lock in low rates while they can. ... A second driver is the resurgence of activist investors which, emboldened by a benign economic environment, are pushing firms to return to shareholders cash that had been retained for a rainy day. There are weekly announcements of one hedge fund or another pushing a company to buy back shares, as much for short-term reasons—a large buyer in the market might temporarily push up the price of a stock—as for longer-term ones. ... And then, inevitably, there is tax. Many large companies are quietly following the well-publicised example of Apple by issuing debt to fund dividends or buy-backs rather than repatriating cash held overseas that would trigger large tax payments. Aside from the quirk of holding cash abroad, debt itself offers tax benefits: interest payments are tax-deductible and push down taxable earnings.
Financial repression refers to a set of governmental policies that keep real interest rates low or negative and regulate or manipulate a captive audience into investing in government debt. This results in cheap funding and will be a prime tool used by governments in highly indebted developed market economies to improve their balance sheets over the coming decades. … We should all be familiar with the effects of financial repression by now. If not, compare the declining amount of interest income coming out of your savings account to the rising costs you pay for groceries, gasoline, or (shield your eyes) college tuition. It has been nearly five years since we heard a loud “THUD” as the nominal yield of the short term U.S. Treasury note hit zero percent. The resulting negative real interest rates have become a pervasive feature of our economic landscape, and we expect them to persist for a very long time.
Inside Germany’s profligate (Greek-like!) fiasco called Berlin Brandenburg ... Three years later, Berlin Brandenburg has wrecked careers and joined two other bloated projects—Stuttgart 21, a years-late railway station €2 billion over budget, and an €865 million concert hall in Hamburg—in tarnishing Germany’s reputation for order, efficiency, and engineering mastery. ... At the very moment Merkel and her allies are hectoring the Greeks about their profligacy, the airport’s cost, borne by taxpayers, has tripled to €5.4 billion. Two airport company directors (including Schwarz), three technical chiefs, the architects, and dozens if not hundreds of others have been fired or forced to quit, or have left in disgust. The government spends €16 million per month just to prevent the huge facility from falling into disrepair. According to the most optimistic scenarios, it won’t check in its first passengers until 2017, and sunny pronouncements have long since given way to “catastrophe,” “farce,” and “the building site of horror.” There is a noted German word for the delight some took in the mess, too.
My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about. ... central bank action has had the effect of de-linking equities from the global growth cycle, as equity investors have chosen to blatantly ignore the fall in global trade in favour of more risk-taking at the back of accommodating central banks. Risk-on, risk-off has miraculously turned into risk-on, risk-on. “Don’t fight the Fed”, as they say, and equity investors have obviously chosen not to. ... First and foremost, returns are going to remain subdued because GDP growth will stay low for a long time to come. Demographic factors, productivity factors and mountains of debt in the majority of countries all point in the same direction, and that is towards below average economic growth. ... The most structural of those factors – demographics – will remain a negative for the U.S. economy for another 10-15 years, whilst economic growth in the euro zone and Japan will be negatively affected by demographics until at least 2050. This does not imply that there cannot be extraordinarily good years every now and then, but the average growth rate will almost certainly be low, causing interest rates to stay relatively low for a lot longer than most expect and corporate earnings to disappoint as well.
Combined stock repurchases by U.S. public companies have reached record levels, a Reuters analysis finds, but as the recent history of such iconic businesses as Hewlett-Packard and IBM suggests, showering cash on shareholders may exact a long-term toll. ... A Reuters analysis shows that many companies are barreling down the same road, spending on share repurchases at a far faster pace than they are investing in long-term growth through research and development and other forms of capital spending. ... Almost 60 percent of the 3,297 publicly traded non-financial U.S. companies Reuters examined have bought back their shares since 2010. In fiscal 2014, spending on buybacks and dividends surpassed the companies’ combined net income for the first time outside of a recessionary period, and continued to climb for the 613 companies that have already reported for fiscal 2015. ... In the most recent reporting year, share purchases reached a record $520 billion. Throw in the most recent year’s $365 billion in dividends, and the total amount returned to shareholders reaches $885 billion, more than the companies’ combined net income of $847 billion. ... Among the 1,900 companies that have repurchased their shares since 2010, buybacks and dividends amounted to 113 percent of their capital spending, compared with 60 percent in 2000 and 38 percent in 1990. ... For decades, the computer hardware, software and services company has linked executive pay in part to earnings per share, a metric that can be manipulated by share repurchases.
Future business activity will reflect two economic realities: 1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment. ... The first reality has been widely acknowledged, as developed and developing countries both have debt-to-GDP ratios sufficiently large to argue for a slowing growth outlook. ... The second economic reality is the failure of the Federal Reserve to produce economic progress despite years of wide-ranging efforts. The Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) have been ineffectual, if not a net negative, for the economy’s growth path. ... The evidence speaks for itself: the Fed cannot print money. The Fed does not have the authority or the mechanism to print money. They have not, they are not and they will not print money under present laws.
In our view, successfully divining the trajectory of markets today has a great deal to do with properly separating the bountiful amounts of information and data we have access to into that which is genuinely useful and that which serves to distract. As a case in point, while we have indeed weighed in on this debate ourselves, the endless discussions about the precise timing of Federal Reserve policy rate lift-off receive far too much attention from investors and the media. Indeed, we think less of a focus on transitory issue like this, and more attention paid to longer-term market influences such as demographic trends and technological change can go some distance toward improving an investment process longer-term. To that end, in this edition of our market outlook we briefly examine a set of influences on markets that we think hold meaningful importance longer-term (demographics, technology, policy evolution and risk, liquidity, and valuation), while at the same time dispelling a set of assertions that we believe are either over-emphasized or mistaken. ... The days of a simple risk-on/risk-off dynamic, depending on whether policy stimulus was waxing or waning, are likely behind us. ... the time may finally have come when carry-focused investments may now be priced as attractively as beta (or down-the-capital-stack) instruments, so investors can selectively search for opportunities there. As described above, though, there are some tail risks in markets, so care is still required. And, perhaps most importantly, investors would do well to tune out the endless streams of noise generated by financial market commentators and focus on the secular themes likely to both endure and help create long-term value.
Since we’re in the midst of election season, with promises of cures for our economic woes being thrown around, this seems like a particularly appropriate time to explore what can and can’t be achieved within the laws of economics. Those laws might not work 100% of the time the way physical laws do, but they generally tend to define the range of outcomes. It’s my goal here to point out how some of the things that central banks and governments try to do – and election candidates promise to do – fly in the face of those laws. ... Let’s start with central banks’ attempts to achieve monetary stimulus. When central banks want to help economies grow, they take actions such as reducing the interest rates they charge on loans to banks or, more recently, buying assets (“quantitative easing”). In theory, both of these will add to the funds in circulation and encourage economic activity. The lower rates are, and the more money there is in circulation, the more likely people and businesses will be to borrow, spend and invest. These things will make the economy more vibrant. ... But there’s a catch. Central bankers can’t create economic progress they can only stimulate activity temporarily. ... In the long term, these things are independent of the amount of money in circulation or the rate of interest. The level of economic activity is determined by the nation’s productiveness. ... Much of what central banks do consists of making things happen today that otherwise would happen sometime in the future. ... the truth is, this “tyranny of the majority” is an unhealthy development. First, society does better when able members have strong incentive to contribute. Second, upward aspiration and mobility will be constrained when taxes become confiscatory. Finally, taxpayers aren’t necessarily powerless in the face of rising tax rates.
The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood. ... To re-establish a shared understanding, we will need to reassess both the imperatives that justified the extraordinary actions and the imperatives about monetary policy that were claimed. This will require candidly acknowledging the uncertainty associated with the transmission mechanism and the challenge of decision-making in conditions of uncertainty. ... It appears to me that the Fed and other central banks have avoided being candid about the uncertainty in order to maintain their credibility. I think this is backwards. Central banks cannot and will not regain their credibility unless they are candid about the uncertainty and how they confront that uncertainty.
- Also: Financial Times - US Treasuries: On the cusp of a reversal < 5min
- Also: FiveThirtyEight - The Fed’s Favorite Inflation Predictors Aren’t Very Predictive < 5min
- Also: Absolute Return Partners - A Note on Inflation: Is it here or isn’t it? 5-15min
- Also: Janus - Show Me The Money < 5min
- Also: Financial Times - Three ways the economic and financial cycle could end < 5min