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NOVEMBER 2013 INVESTMENT JOURNAL: LOWER FOR LONGER
  • In surprise move, Europe cuts rates
  • China unveils sweeping social and market reforms
  • JP Morgan slammed with largest fine in US history

 

November was another strong month for stock investors, while bonds were flat and hard assets  declined:      
    
    
       
 U.S. stocks continue to sit atop the return tables over other investment categories:
        
    
    
As the month began, the European Central Bank (ECB) shocked the markets with a surprise interest rate cut on November 7th. Their "overnight" rate target dropped a quarter of one percent, from .50% to .25% (now matching the Fed Funds rate in the U.S.).  No one saw this coming, and it was announced just as Eurozone CPI data showed a meager .7% annual rate of inflation. This deflationary trend in prices runs counter to their "price stability goal", so they are following the same playbook as Japan and the USA by keeping interest rates lower for longer.
  
It is especially important to point out that the ECB has no "dual mandate" of full employment and price stability like the US Federal Reserve. Their sole focus is on price stability. If prices continue to drop, they'll soon have their official rate at 0%, with no cards left in the monetary policy deck. Some observers point to this as the "impotence" of monetary policy when there is so much slack in the work force (unemployment rates in Europe are at post-WW II highs in many countries). What is really needed, they say, is a change in fiscal and regulatory policies to allow for more and better job creation. That's a discussion for another time and place, but, for now, we note how all developed economies are following Japan's lead, marked by ultra-low interest rates and little to no "official" inflation.
  
As if to underscore this point, two new Federal Reserve papers were published this month which suggest a lower unemployment rate of 5.5% before tightening monetary policy, while also tolerating a higher inflation rate of around 2.5%:
   
   
Notably, this research was presented at an International Monetary Fund (IMF) conference, just prior to the departure of Ben Bernanke. The Fed works in subtle ways. Their research is often a precursor to significant policy developments (i.e. Quantitative Easing was first introduced in a paper authored by then Vice Chairman Ben Bernanke in 2002, where he acquired the moniker of "Helicopter Ben" by positing that money could be showered on the economy as if dropped by a helicopter to avoid a deflationary depression.)
  
The current buzz around these papers is that interest rates will stay "lower for longer"- until at least 2017! There's even a new name for it: Optimal Control (you heard it here first)!  It is based on the work of Janet Yellen, who was confirmed by the U.S. Senate Banking Committee this month as the nominee to replace Ben Bernanke as the head of the Federal Reserve. She has outlined in various speeches how the Fed can use a model to calculate the optimal path of short term rates to hit the new unemployment and inflation targets.
  
In short, Yellen is a champion of the "lower for longer" interest rate scenario, and these papers are laying the groundwork for an extended period of zero interest rates. We think this development is seriously underappreciated in the markets. It reinforces the notion that income will be scarce, and investors will seek risk as there are no other options to earn a decent return. It also sets up an extended period of bond buying, inflating the Fed's balance sheet to gargantuan levels. As seen below, "QE" has brought about a quadrupling of assets held at the Fed, soon to pierce $4 trillion. How big can it get without "collateral" damage"? (Maybe we should ask Buzz Lightyear!)
    
Source:  St. Louis FRED               
    
Whether or not investors can tolerate this extended support remains to be seen. The pessimists see more fuel to blow up asset bubbles until they pop, along with sky-rocketing interest rates. Optimists see a managed recovery that allows for repair and healing of banks, credit, and the overall economy. Realists know that all of this is an untested experiment which may or may not succeed. It is by far the most important issue in world markets, and it will be the 900 pound gorilla in the room for quite some time (who probably gets his way). Don't fight the Fed!?
   
Overseas, China made waves by announcing a set of major reforms which emphasize the market, more private investment moving into the state sector, loosening the "one child" policy, and better protection for farmers' rights. Ambrose Evans-Pritchard lays out the hard task ahead in "China pledges free-market blitz but necessary freedom lags" in the UK Telegraph: http://www.telegraph.co.uk/finance/china-business/10453614/China-pledges-free-market-blitz-but-necessary-freedom-lags.html
   
Interestingly, many strategists and fund companies were touting the appeal of Chinese "A' shares at this year's annual Charles Schwab IMPACT conference, which we attended in Washington DC this past month. The idea goes that Chinese "A" shares, which are listed and traded only by and for Chinese domestic investors, are in the in the pipeline for conversion to a partial "free float" (where foreign investors could acquire shares). If the conversion takes place, the discount that currently exists for "A" shares would theoretically close, and the "gap" would produce excess returns for investors. It's something worth keeping an eye on.
    
As the month wound down, JP Morgan and the U.S. Justice Department reached a settlement over civil charges related to the alleged fraud and deception with which the bank undertook to sell mortgage-backed securities during the Panic of 2008. JP Morgan agreed to pony up $9 billion to settle claims and $4 billion in "investor relief", making this the largest fine ever paid by a single U.S. company.
   
Prominent pundits and part-time bloggers alike have had a field day with this one. All we can say is that this is a small amount compared to the damage done to the economy overall, and homeowners especially, by the putrid paper peddled by Wall Street. Congress has done absolutely nothing to address the "too big to fail" risk in having mega-banks like JP Morgan still operating like it's 2006. Dodd Frank is universally reviled for its regulatory burden and over-reach by almost all small to mid-size banks, and some prescient and forward thinking larger financial institutions like our hometown bank BB&T. Almost every leading thinker not associated with the government or central bank has said we need a wholesale restructuring of the banking system to prevent the risk of another systemic failure. Fines like this are only window dressing, and even possible criminal prosecutions of bank executives won't change the colossal incentives still favoring the mega-banks (heads we win, tails we still win 'cause the government/taxpayers will foot the bill)!
  
We can't resist showing this chart, from the Office of the Comptroller of the Currency, which illustrates how the top 4 U.S. banks have all the risk in the system:
   
   
In other words, 93% of all off balance sheet exposure is concentrated in just four banks. And, for kicks, their $214 trillion is backed by less than $9 billion in deposits, for a leverage ratio of 24 to 1. And they are paying virtually nothing for this "collateral"! This is why people are concerned about "systemic risk" in the event of another "margin call", which is essentially what happened when Lehman Brothers went down. 
      

As the month closed, on November 25th Iran announced that it had reached an agreement with world powers, led by France, to halt its program of uranium enrichment.  Israel immediately called it a "historic mistake", but oil markets were relieved and a bit of the risk premium leaked out as oil prices declined on the news. There is likely to be more volatility ahead as developments unfold, especially in world energy markets.
  

December is always a busy time for investors, and markets have generally been favorable into year end. We'll do our best to keep the coal out of Santa's stocking, and make sure there are plenty of presents under the tree. Have a great holiday season, and we'll be back to you in early January!
  

  

 

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