Marked Up 26th August

Stanley Fischer is connected

Stanley Fischer is the deputy chair of the US Federal Reserve and he recently spoke in Aspen about the expectation for higher rates in the US and productivity in the American economy.

Whenever Fischer speaks on the economy many people take notice, as he is seen as a centrist and closely aligned to Janet Yellan.

Fischer is also closely aligned to many other academics, he taught the following:

• Ben Bernanke, ex Fed chairman (he oversaw his doctoral thesis)
• Lawrence Summers, Treasury secretary, President of Harvard, Chief Economist of the World Bank to name a few
• Christina Romer, Chairman of Economic Advisors under President Obama
• Mario Draghi, the ECB President
• Greg Mankiw, Chairman of Economic Advisors under George W Bush

In other words we think technology is making the world smaller, but in academia it is already very small.

This brings me to Jackson Hole, the annual economic symposium arranged by the US Federal Reserve. The theme for 2016 is “Designing Resilient Monetary Policy Frameworks for the Future”.

The title captures the challenge for a group of academics who in all likelihood will have known each other for many years, possibly decades.

The criticism of central bank policy is that the uncharted territories of negative yields have been ineffective the lower the rates go. Negative rates are causing a dramatic repricing of risk and a collapse in liability management.

The fact that policy makers are looking to design resilient monetary policy suggests it isn’t that zero rates are ineffective, it is just that they are unsustainable.

Focus on the productivity payoff.

The market focused on Stanley’s ruminations about the health of the economy, but there was less focus on his comments about productivity.

Fischer pointed out that from 1949 to 2005 US worker output increased on average 2.5% per annum, since 2006 output has dropped to 1.25% per annum.

Productivity is the key to economic growth. The jobless recovery had pegged towards making workers work harder for less but it isn’t stimulating productivity in the economy.

Many companies have been either using excess cash or increased debt to pay dividends or buyback shares; they have not used the cash to grow their businesses.

If management focus is on shareholder demands, demands driven by zero rate environments, then who is driving the growth strategy?

When Mr Fischer and others meet at Jackson Hole this week they will probably be discussing the positives and negatives of keeping rates at present levels.

As they look at the pros and cons it will be interesting to hear if they discuss the implications of dividend seekers on corporates, because the accepted wisdom had been if you make cash cheap enough companies will borrow.

What hadn’t been accounted for is if they borrowed to pay for dividends, what happens to those dividends as they are spent by retirees?

Mr Fischer is eloquent in his data point, productivity is down and has been since 2006 and if we wait for investors and companies to realign on dividend policies, we may be in for a very long wait.

The onus may eventually be with government. The government may have to use its economic muscle to stimulate productivity; fiscal policy and infrastructure commitments will become the tools necessary to drive economies higher.

Once governments are convinced electors will accept reform, we could see a plethora of new projects.

Everyone is worried about the risk curve

Many commentators are worried that the zero interest rate setting has forced investors up the risk curve.

I think this assumption needs to be challenged by first identifying which investor cohort we are talking about.

Individual Australian investors have historically been heavily skewed between equities, property and cash. I don’t think the global reduction in rates has changed investments; it might have changed the balance but not the underlying asset classes.

The increased allocation in cash has probably been at the cost of investment or even reinvestment at the elevated prices in equities.

Therefore contrary to the espoused wisdom it is possible that self-directed investors are taking less risk that normal. Critics focus on equity exposure and bemoan the lack of diversity. The critics decry the lack of investment in bonds and the minimal investment in non-AUD assets.

I think this misses the point; SMSF’s are becoming more conservative. Should market participants engage with investors to assist in their conservatism?

To date the question has been how advisors get investors to change their mind. Which is code for telling them what to do!

Professional fund managers are a different type of investor. They have to manage in the same environment as everyone else but they have access to different products and tools than those available to SMSF investors.

If professional fund managers are looking for investments from SMSF investors they may need to recognise it isn’t the product or the management tools, it is the trust.

Professional fund managers traditionally sat on platforms or were funded from industry funds, and with the growth in SMSF’s they will need to adapt to pitching to conservative investors.

Some have started: infrastructure funds, offshore infrastructure funds and low volatility hedged equity funds, and the list will continue to grow.

If you are a conservative investor be sure to understand how the various offerings meets your conservative bias’s.

What does it mean for Australian investors?

The greatest challenge for Australian investors could be recognising the possibility that rates may not be going up for years. As everyone moves about their daily life it is hard to take the time to reflect.

The GFC started in 2007 and nearly 10 years later the ramification of the greatest recession since the depression is still impacting daily life. The affects can still be seen in mortgage rates for borrowers or retiree’s struggling with incredibly low rates.

We are also witnessing a lack of investment by corporates, a criticism of central banks and politicians who are fearful of debt and balance sheets as indicators of the ongoing impact of the crisis.

If the GFC is part of the daily grind, then it is possible portfolio construction is the solution. In order to construct a portfolio the questions that investors may need to have addressed are:

1. What returns do I need?
2. What risk can I take?
3. What do I know about the investments?
4. How much engagement can I undertake?

If a client working full time in a non-market related job, has $100 and needs an 8% return but can only afford to risk $10, they may have to consider working longer to compensate for the challenges necessary in achieving a return of 8% in today’s investment world.

Australian investors should possibly price returns of 5%-6% and then decide how close they get to an acceptable retirement outcome.

If 5%-6% is nowhere near your financial destination then start making plans for a longer career.

It will be easier to work longer if you make plans now than it is to conservatively invest and return 8%.

Recognise today’s environment rather than invest like its 1999[i].

It was only a week ago.

Last week I wrote about hedge funds taking out large short positions in GBP as they expected the UK currency to fall against the $USD as Brexit continues to play out in the UK economy.

 

So what happened over the last week?

Looks like it isn’t what the funds wanted. The rising red line reflects a rally in GBP. That isn’t to say the hedge funds are wrong. I have no idea when they started the trade or when they exited the trade. I do know the retail sales number surprised the market. July retail sales (excluding cars) were announced on August 18th at +1.5% versus and expectation of +0.3.

If you compare the price over the year to date between Sterling and the FTSE 100 (100 most highly capitalised companies on the London Stock Exchange) you get an interesting chart.

The black line is the FTSE, the red line is GBP. They trended closely together until the recent vote.

Critics discuss currency wars and opine that central banks want lower currencies.

 A lower currency is expected to boost economic activity.

The above chart suggests that the market has efficiently priced the benefit of the lower currency and the impact on companies..

Markets could be wrong but this chart highlights how markets sometimes react.

The only caveat I would make in regard to the market reaction is that nothing has happened.

The vote was taken but implementation hasn’t even started. The challenge for investors will be to interpret how the legislative changes will impact companies and countries on both sides of the Channel.

Where can I get my alpha?

Alpha, is the active return on an investment, and gauges the performance of an investment against a market index

Some critics are of the view that Alpha equates to excess turnover. Index fund providers believe very few investors can beat the index.

Increased trading potentially creates profits for providers; if you trade a lot of equities, the broker makes money and the exchange makes money.

Some fund managers highlight their lack of alpha as a way of saving you money, and by default emphasising the competitive price they have acquired assets.

If alpha is expensive should it be discounted entirely?

I think alpha should be realigned and redefined. When interest rates are at 1% investors may need to think about rotating their conservative investments.

It isn’t that these assets are very volatile, but they do move in price and sometimes it is a reasonable strategy to compare similar credit and durations.

If these assets decouple it could be an opportunity to take profit and perhaps reinvest the capital gain.

Uninvested capital is lazy capital.

Investors may be on the lookout for new issues as a means of staying invested but also adding a small amount of alpha in the portfolio.

The key to an increased alpha approach is being able to understand credit risk and having a portfolio that is balanced and offers some trading opportunities.

Please read the NAB disclaimer.

Have a good one.

 

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[i] Fed funds rate was 5.00%