NIRP – a Central Bank Roadblock to Wealth

NIRP – a Central Bank Roadblock to Wealth

You’ve probably heard some references to the idea that the central bank policy of keeping rates artificially low or negative hurts savers and is partially responsible for the widening wealth gap – the rich get richer and the not-so-fortunate face bigger headwinds. There are a few ways in which this policy harms the less-than-uber wealthy, some obvious and some not too obvious. I recently experienced one of the less obvious first-hand, and I’m still pretty peeved thank you very much, Mr. Mario Draghi.

 

The most obvious way is by reducing the level of income that can be generated from relatively safe investments. At the start of 2000, the 10-year Treasury bond yielded over 6.5%. Today it yields all of 2.4% while the High Yield 100 yields just 5.6%. Yep, junk bonds today yield less than the 10-year Treasury did at the start of the millennium.

 

What that means is savers have to take on a lot more risk to generate even less income than was possible 17 years ago. Think about that when you read about the shrinking Middle Class, part of our Rise and Fall of the Middle Class investing theme.

 

Good thing that the largest generation in American history is at or near retirement when they most need to generate income from their savings – argh! What this means is that this generation, which is the key demographic driver behind our Aging of the Population investing theme, is forced to take on way more risk than any prior generation to get a lot less out of their savings. The potential ramifications of this reality when we inevitably get a meaningful pullback in the markets is unnerving given the state of the average retiree’s level of savings and the dire straits of most pension plans. According to Vanguard’s 2016 How America Saves Report, the average 401K balance is $96,288, but for those Baby Boomers that are now turning 70 the average 401(K) balance is $200,358.  Yes, you read that right… no wonder we keep reading the average Baby Boomer is under saved for their golden years.

 

There is another way in which these policies make it more difficult to become rich. One of the paths to wealth has been investing in new and upcoming companies – finding the next up and coming companies set to ride our thematic investing themes much the way Microsoft, Facebook, Qualcomm or Google have. This is often done through private equity/venture capital firms who pool together investors’ money and then put it in a selection of privately held companies.

 

The dynamic between companies looking for funding and those looking to invest involves competition on both sides. Those looking to invest compete to find those that are most likely to succeed to the greatest degree. Those looking for funding look for those that will be most useful to them in terms of developing and building the business as well as those that will give them the highest valuation because a higher valuation means giving away less of the pie.

 

Now we get to what has me steaming.

 

Recently I was involved in a process to invest money into a privately held company in southern Europe. The idea was that the funds would be used to buy up some of the competition, grow the business and then take it public in around 5 years – pretty standard stuff. All parties involved knew that there were multiple firms looking to put money into this company as well, so all were aware that each would have to give the highest valuation possible within required return constraint to the company.

 

After more months’ work than I would like to recall, the offers were submitted. A bit later everyone learned that all the offers received were tightly grouped, except for one that gave a valuation that was more than 25% higher than the second highest!

 

What the hell?

 

Turns out the investing group with the highest valuation was a fund of one of the biggest global banks and doesn’t source the funds it invests from private investors, but is instead able to pull directly from the European Central Bank at a negative interest rate! The returns this fund generates simply goes to the bank’s bottom line. Not to cry foul, but that’s a very different landscape to be playing on.

 

With the yield curve increasingly flat these days, it doesn’t take much to improve a bank’s bottom line. The rest of the investing suitors instead had to price their offerings at levels that would generate attractive enough returns to make it worth their investors’ while to have their money locked up for many years. The bank’s cost of capital may be negative thanks to the European Central Bank’s policies, but have you met anyone who is happy losing money on an investment?

 

ZIRP (Zero Interest Rate Policies) and NIRP (Negative Interest Rate Policies) hurt those trying to build wealth by not only suppressing interest rates, but by giving those who can access central bank provided lending directly, an impossible advantage. Aside from seriously ticking everyone in the aforementioned investing beauty pageant off, this policy also results in highly concentrated assets and wealth. Those closest to the central banks, which means those who are already uber-wealthy and powerful, have access to cheaper capital than the rest of us, giving them a serious advantage.

This problem affects all investors. Most of those who invest in private equity funds have no visibility into just how many investments their fund managers have lost to competitors like this. The story I just told ripples across all types of investments, forcing savers to accept lower returns along with higher risk levels.

 

Now I’m off to spend some quality time with my two favorite men, Ben and Jerry. Perhaps at this point, you’ll want to join me.

Falling Prices

Looking out into the future, markets and economies will driven in large part by falling prices in a few major areas:

  • Falling Oil Prices
  • Crashing Prices and Excess Capacity in Commodities
  • Diverging Monetary Policies and the Strong Dollar

Falling Oil Prices

Last week oil fell to $36/barrel, going below $40 for the first time in six years. Earlier in December OPEC had its final meeting for the year, and at this point I think it is fair to say OPEC has become completely irrelevant.  A cartel that has no ability to control the production of its members is no cartel. OPEC can’t control its members because Saudi Arabia already learned its lesson in the 1980s, when it cut production in response to falling oil prices and ended up mostly just losing market share. Other nations paid attention. On top of that, these countries’ budgets are in dollars, as oil is priced in dollars, and they need to keep up their spending in order to maintain control over their citizen – the perpetual challenge for countries in which the primary source of national income is owned by the State.

So why are oil prices falling? Simply because while demand is growing, it is growing at a slower rate than supply. The high oil prices from years ago combined with the Fed’s ZIRP (Zero Interest Rate Policy) and technological breakthroughs in oil extraction technology, led to an influx of investing in oil production capabilities which was funded in part by a lot of high yield debt. As the price of oil continued to fall, many of the companies have found themselves in violation of debt covenants. This is leading to rising defaults, (although the default rate today in aggregate is not at historically high levels) which then leads to tightening of credit conditions as lenders are forced to rebalance their lending portfolios. This make conditions even more challenging on these distressed firms, as credit is increasingly less available, which will eventually lead to bankruptcies for many of the more highly-levered firms. We saw a similar pattern back in the financial crisis as the real estate investing boom blew up in spectacular fashion when borrowers were unable to refinance on major portions of their real estate portfolios, even on properties that may have had more than 50% equity, resulting in a complete wipeout of their clients’ invested capital in those properties.

The good news for investors is that this is also reminiscent of the heady days of the Dotcom boom when all the rage was broadband infrastructure, with high-fliers such as Global Crossing, which eventually flamed out in headline grabbing bankruptcies that wiped out most debt and equity holders alike. However, that led to the ability for those that survived the carnage to be able to pick up that infrastructure for pennies on the dollar, leading to materially lower broadband pricing, which facilitated the next wave in the Internet evolution. I think oil is likely to experience something similar, with those companies that have healthy balance sheets being able to pick up production capacity at pennies on the dollar, greatly improving their overall margins and providing the economy with lower-cost energy into the future, which will be a much appreciated tailwind.  For now, I think it best to avoid this sector, but at some point in the near-to-mid future it will provide spectacular opportunities.  This lower-price oil will also be a fantastic boon to those emerging economies that are big energy importers, helping their economies grow at a faster pace than was previously possible, providing investors with yet another great opportunity. U.S. lawmakers are also expected to lift the ban on oil exports as part of the current spending bill legislation, which will provide additional support for domestic producers.

For now, the defaults and struggle in oil will be a strain on the overall economy. For those who point out that oil and gas drilling accounts for only around 4.6% – 6.5% of GDP, residential housing makes up around 5% of GDP and we all recall just how much damage excessive investment and use of debt in that sector did.

Crashing Prices and Excess Capacity in Commodities

Commodity prices have been falling for years, with the CRB commodity index down 21% from just its May 2015 highs. An entire book could easily be written on this topic, so I’ll narrow it down to just a few illustrative points in the interest of preserving your sanity! The last major commodity super-cycle began when China was allowed entrance into the World Trade Organization. Thanks to the enormous shift in its population from rural agrarian to industrial manufacturing, it was able to supply the world with cheap labor, which meant cheaper products for exports. The money it took it was funneled into gobbling up commodities to use in its eye-popping infrastructure build out; for example, China accounts for about half of the world’s aluminum consumption.

During and after the financial crisis, the world greatly benefited from China putting its pedal to the metal on its infrastructure build out, effectively creating a floor under commodity prices and protecting commodity producers from what would have been a much more painful fall without China’s purchasing. To put in it context, in 2009, with the markets crashing, oil stood around $100/barrel and steel plate was at $600, today oil has fallen below $40 and steel is at $260.

Today China’s steel production capacity is around 400 million tons a year, which is nearly four times the U.S.’s capacity at 120 tons. With China’s slowing economy, and more importantly rapidly slowing infrastructure build, it has more and more excess capacity.  China’s steel consumption is declining for the first time in two decades, with the nation’s steel sector experiencing layoffs in the tens of thousands.  Year-to-date the one hundred largest steel companies lave lost around $11 billion with 37 steel plants closing so far.

Most of China’s excess capacity cannot be shipped to the U.S. as it is of lower quality and is barred by tariffs, but it can go to Europe where prices are crashing and has caused quite the crisis in the U.K.  European players have been forced to continually lower prices and unlike China, they can export to the U.S.; despite the tariffs, U.S. steal producers cannot be totally insulated.

Many of these steel and oil mid-cap companies have “crossover” bond ratings, which means they are in-between investment grade and junk status, (BBB and BBB-).  All it takes is one little nudge and they will be in junk territory, which means then that the funds that hold them will have to rebalance their portfolios which in turn affects the credit market as a whole. Here too, those producers that maintain healthy balance sheets and do what they can to raise cash, will be able to goggle up bankrupt production capacity at below-cost, lowering their margins and allowing for lower cost steel into the future, which will help not only domestic users, but will be particularly beneficial for those emerging market, commodity importing nations. While I’ve only talked about oil and steel in depth here, similar dynamics have and are occurring in other commodity markets across the globe.

Diverging Monetary Policies and the Strong Dollar

The strong dollar continues to be one of the most common problems cited by companies in their quarterly reports. So what does it mean, why is it happening and is it likely to continue to strengthen?

The dollar began strengthening when the Federal Reserve first pulled back on its quantitative easing programs. This directional shift marked the first step. Then it ceased quantitative easing altogether, whilst other nations continued or even accelerated their programs. Now the Fed has raised interest rates, which further strengthens the dollar against other currencies. As other nations around the world engage in stimulative monetary policies, the dollar will further strengthen against them.

Commodities are globally priced primarily in dollars. I just walked you through falling oil and steel prices and as those prices have fallen, dollars have essentially been disappearing into thin air. By that I mean, imagine you have drilled an oil well or built a steel plant. When you did so, you forecasted a certain productive capacity that would result in a dollar value of sales based on an assumption of price. Falling prices have cut your expected sales enormously, meaning dollars you expected to have in your pocket will never show up. This means that your investors and/or creditors are not in the same position they expected to be – you don’t have the dollars you were expected to have, so no wonder there is an increased demand for dollars.

This brings us to the $9.5 trillion dollar carry trade which I’ve talked about before in the October 2014 issue, where I explained how the carry trade works, and again in August of this year. The higher the dollar goes, the greater the demand for dollars to pay back that dollar denominated debt. If we look at history, there are two main dollar bull markets. The first one was in the 1980s that only ended after the world’s central bankers got together in the Plaza Accord to weaken the dollar after it had risen about 100%. In the late 1990s, we experienced a second bull run which ended in the Asian Crisis after the dollar had appreciated about 50%. During both, the dollar experienced pullbacks, but never of more than 10%, which gives us a potential metric to mark this bull run. Today, we have the largest global carry trade ever seen, which makes the bigger picture look closer to the 1980s. Looking at the data, there is a material probability that the dollar strengthening process could start to accelerate again, which will put more downward pressure on commodity prices. I think being long the dollar and even owning longer-term bonds while either being short or just staying away from the commodity complex would be the wiser move here. (Hat tip to Raoul Pal of Real Vision Television for some of the research on the dollar bull runs.)

As for longer dated bonds, if the Fed continues to raise rates and the economy is in fact slowing and the rate hikes weaken the economy further, then growth expectations will slow which will cause longer-dated bond yields to drop and bond prices to rise. If the Fed continues to raise short-term rates, an inverted yield curve, (in which short-term rates are higher than long-term rates) is possible, which would be very damaging for banks as they borrow short-term and lend long term. If the dollar continues its rally, demand for bonds will rise as well, which will push up bond prices and push down bond yields. Bond prices could however get hit if the Fed hikes, but hikes much more than is expected, which given the reasonably dovish commentary Wednesday, currently seems unlikely.

Bottom Line: We are in unchartered territory in many areas; higher levels of sovereign debt than during the financial crisis, a bigger U.S. dollar carry trade than the world has ever seen, more excess reserves at the federal reserve than ever before, tectonic shifts in global economic power and rising political tensions throughout much of the world coupled with challenging demographic trends, (aging populations) in the U.S., Europe, China and Japan while many emerging economies are blessed with a much lower median age in their populations. Never before in the modern era of high-yield bonds has the Fed hiked rates when the high-yield bond spread was greater than 6.25%; today it is 7%. Over the next decade the “it” places to invest are likely to be economies that were previously not on many investors’ radars. We are likely to face some challenging times, but those inevitably lead to wonderful opportunities. 2016 will probably give us some 

Neil Cavuto: Fed Policy is the Problem

Neil Cavuto: Fed Policy is the Problem

This morning I spoke with Neil Cavuto on Fox Business about the Fed’s decision to not raise rates earlier this week; my view, Fed policy is the problem!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow. 

All the QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) have kept interest rates super low. That forces people to put their money into riskier investments than they’d like. Riskier investments by definition have to generate higher rates of return to compensate for their higher level of risk. High levels of risk are also associated with ideas, that normally wouldn’t get funding, but manage to get it by promising really high rates of return. If investors are pushed into more higher risk/higher potential return investments than they’d normally like, that means more of these potentially bad ideas get funding.

This means the economy experiences a higher failure rate than would normally be the case. That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand and ever great ideas struggle under the burden of trying to jump through all those extra government hoops that just make it that much harder to be successful.

In my discussion with Neil I refer to how we have a record high level of job openings. The chart below is from the Federal Reserve, but can be researched in depth by looking up the JOLTS report from the Bureau of Labor Statistics.

2015-09-18 Cavuto - Job Openings

I also mentioned how the percent of the population actually employed is where it was nearly 40 years ago.  This data is also from the Federal Reserve.

2015-09-18 Cavuto Employment Population

ZIRP and QE are killing the economy

ZIRP and QE are killing the economy

Shocker! The Fed didn’t raise rates today.A Shocked Baby

I’ve been predicting the no-change decision for months!

It was pretty obvious, but that’s because I can see that ZIRP and QE are killing the economy.

The labor market is still relatively weak, regardless of what the seriously misleading unemployment rate statistic tries to tell us. Job openings are at record highs (companies can’t find the right talent) while the percentage of the population employed is at levels last seen nearly 40 years ago. The three-month moving average for retail sales is at a level only seen during the Great Recession. Second quarter revenues for companies in the S&P 500 were down 3.4% year-over-year.  Second quarter earnings were also down year-over-year.

So what does this mean?

Nearly a decade of ZIRP (Zero Interest Rate Policy) and trillions in Quantitative Easing and still, the economy can’t get off what the Fed believes is life support!

Why?  Because while playing in all their models they miss the big picture!

Economists often make understanding the economy unnecessarily complicated. Part of it is reasonable in that this stuff can be complicated and it takes a lot of time and effort to communicate these topics in a way that doesn’t use terminology that only “big brained” economists understand. They’re busy and most just aren’t interested in putting in the time. Part of it is probably job security – we all like to give the impression that what we do is really difficult!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow.  It is that simple.

All this QE and ZIRP have kept interest rates super low. That forces people to put their money into riskier investments than they’d prefer. By definition, riskier investments have to generate higher rates of return to compensate for their greater level of risk. High levels of risk are also associated with ideas that probably shouldn’t get funding, but manage to get it by promising really high rates of return; sometimes really high returns…I’m sure you’ve heard of the hockey stick effect. If investors are pushed into more “higher risk/higher potential return” investments than they’d normally like, that means more of these bad ideas get funding.

In an ideal world only good ideas get funded because when bad ideas get funded, investors lose their money and resources like people, time and raw materials get wasted.  There’s a net loss to society. (I’m simplifying here a bit for the sake of clear communication as some degree of bad ideas is a relative good because they serve as a warning and provide a place of learning what not to do or avoid).

Putting all that together, extra low interest rates mean investors are pushed into investing in more higher risk investments which means more bad ideas get funded than would otherwise be the case, so the economy experiences a higher failure rate than would normally be the case.  That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand. Even great ideas struggle under the burden of trying to jump through all those extra governmental hoops that just make it that much harder to be successful.

Where do we go from here?

With respect to interest rates, there is no easy solution. We need to normalize, but today that is a bit like dreaming of a bright future for a 17-year girl who’s 8 months pregnant, dropped out of school 4 years ago, ran away from home, and has covered her body covered with skeleton tattoos.  It’s possible – but it is going to take a hell of a lot to get from here to there!  That being said, reducing the regulatory, legislative and tax complexity would go along way towards helping all businesses, whether they be a great ideas, so-so, or even marginal be more likely to succeed, which means more jobs and more money available to invest in the next idea.