David Jallits, CIO – Market Observations – June 30, 2016

September 16th, 2016

Letter from the CIO

“I am prepared for the worst, but hope for the best.”

Benjamin Disraeli (1804-1881)

At Signature, one of our responsibilities is to consider and plan for possible market outcomes that may never come to pass.  The goal of this continuous exercise is not to eliminate investment mistakes, but rather to eliminate complacency when managing your capital.  While there are always multiple economic events to worry about, the topic of this note is one potential scenario regarding today’s low interest rates. The current interest rate environment is a direct result of government intervention in the global economy since 2008.

Quantitative Easing (QE) on a global scale has been substantial (equating to roughly $12 trillion in central bank purchases of various assets) and has led to the current situation in both Japan and Germany, where the average interest rate across their yield curves is below zero.  In fact, today, there is almost $12 trillion of global government debt yielding less than zero.  Read those last two sentences again very slowly.  At current levels, were interest rates to rise by 1 per cent, losses in the global bond market would exceed $1 trillion dollars.  This situation could prove very destabilizing, resulting in large losses in fixed income holdings and potentially significant declines in equity and commodity markets. Equities and commodities would most likely experience direct selling pressure as both those asset classes adjust to higher discount rates and investors attempted to raise cash in order to mitigate the losses in their portfolios.

Tempering – if only a little – our concern regarding current bond yields is that we find inflation still falling across most of the globe while the “real” inflation adjusted yield on many government bonds remains positive.  This is not simply a geeky academic observation – central banks usually lower nominal policy rates below the inflation rate to force real yields into negative territory and encourage risk-taking and capital spending.  To see nominal yields so low and real yields remaining positive is a problem that vexes policy makers and encourages them to push policy rates even further into negative territory over time.  The resulting damage done to savers like you and me, insurance companies and pension funds has been and will continue to be immense.  Pension funding gaps, already sizable by any measure (total OECD unfunded pension liabilities are estimated to total $78 trillion), are increasing in dramatic fashion as fiduciaries are challenged to generate the investment returns needed to pay retirees without eating into the principal of the fund.

One could cite many reasons we find ourselves in today’s predicament, but most schools of thought lay some blame at the feet of governments.  Generally, we believe that, over time, markets are efficient in how resources are allocated across asset classes and investment opportunities.  In recent years, however, governments have become more involved in determining economic winners and losers. Their low policy rates may have allowed some firms to survive when they shouldn’t have, in ways analogous to Japan’s “zombie” companies.  With some believing governments are now competing with the sorting mechanism of capitalism, Joseph Schumpeter’s “creative destruction”, thereby short-circuiting free market capitalism, distorting growth, competition, demand, and asset prices broadly – but bond yields in particular. In an environment where non-economic players remain center stage and impact, if not directly, economic outcomes and asset prices, what might they do next in this environment they have created, one of sluggish growth, low inflation and rich asset prices?  It’s also an environment in which governments and central banks are increasingly desperate to generate inflation in order to ease their debt burdens but where they want to avoid a dislocation in the bond market that might then damage the real economy. Perhaps they are about to lose control over market prices? Or perhaps they have another card to play?

The United States Government’s debt burden has grown from $10 trillion to $19 trillion over the past eight years and policy interest rates are now at only 0.5%. Judging by this, one might conclude our government has done all it can from a fiscal and monetary policy point of view to “kick-start” the economy.  Some, however, believe the next step may be for the government, regardless of the outcome in November, to accelerate their spending on infrastructure – roads, bridges, sewer systems, power grids, etc.  Most agree this spending should have been done consistently all along.  The question, then, is how might we pay for this additional spending today?

One worrisome option would be for the Federal Reserve to monetize the debt indirectly.  The US Treasury could sell bonds to the public and the Federal Reserve, under the guise of a new round of QE, would buy the bonds from the public.  In the end, one arm of the government will simply owe the money to another arm of the government.  Then, the government – effectively owing money to itself – could forgive the debt.  The logic here is elegant even though monetization of government debt in this way has historically led to strongly rising inflation. The monetization of government debt allows unconstrained spending that is rarely well targeted or grounded in thoughtful cost-benefit analysis.  This would be a real life version of Ben Bernanke’s “helicopter money”, or infinite QE.  The exact end result on financial markets is debatable – but likely to be negative.  If this scenario comes to pass, Signature may look to place inflation sensitive assets, such as real estate, commodities or Treasury Inflation Protected Securities (TIPS), among others, into our clients’ portfolios to lower your exposure to fixed income in order to benefit from the expected increase in inflation and minimize the expected bond market losses cited above.

Given the slow growth in U.S. GDP since 2008, the regulatory burden weighing on business spending, the low interest rates inhibiting savers’ ability to consume, and the fact that monetary policy alone may no longer be impactful, a hand-in-glove approach for monetary and fiscal policy may be the next card played by politicians in order to drive both spending and inflation higher while holding bond yields down.  While the immediate impact may be positive – construction jobs and an improved infrastructure – the hangover could be brutal.  If monetizing debt was a solution that worked, Argentina and Venezuela would be economic powerhouses rather than economic basket cases.  While our acknowledgement of these risks and a thoughtful prospective response are necessary, I do hope in a few years’ time you can tell me we were wrong to be concerned about this scenario.

As always, we remain grateful for your ongoing support and confidence in us and we will continue to work to deserve it.  If you have any questions or concerns, please let us know.