"Be cautious and content with low positive returns in 2015. The time for risk taking has passed. "
" The power of additional and cheaper credit to add to economic growth and financial asset bull markets has been underappreciated by investors since 1981."
Full Comment
A January Investment Outlook should normally be filled with recommended “do’s and
don’ts,” “picks and pans” and December 31, 2015, forecasts for interest rates and risk
assets. I shall do all of that as usual when I travel to New York City for the annual Barron’s
Roundtable in a few weeks’ time. That is always an opportunity for me to engage in verbal
jousting with Marc Faber, Mario Gabelli and the usual bearish forecast from the Gnome
of Zurich, Felix Zulauf. So I’ll leave the specific forecasting for a few weeks’ time and
sum it up in a few quick sentences for now: Beware the Ides of March, or the Ides of any
month in 2015 for that matter. When the year is done, there will be minus signs in front of
returns for many asset classes. The good times are over.
Timing the end of an asset bull market is nearly always an impossible task, and that
is one reason why most market observers don’t do it. The other reason is that most
investors are optimists by historical experience or simply human nature, and it never
serves their business interests to forecast a decline in the price of the product that they
sell. Nevertheless, there comes a time when common sense must recognize that the king
has no clothes, or at least that he is down to his Fruit of the Loom briefs, when it
comes to future expectations for asset returns. Now is that time and hopefully the next
12 monthly “Ides” will provide some air cover for me in terms of an inflection point.
2015
Introduced by Janus Capital International Limited2
Manias can outlast any forecaster because they are driven not only by rational inputs,
but by irrational human expressions of fear and greed. Knowing when the “crowd” has
had enough is an often frustrating task, and it behooves an individual with a reputation
at stake to stand clear. As you know, however, moving out of the way has never been my
style so I will stake my claim with as much logic as possible and hope to persuade you
to lower expectations for future returns over the next 12 months.
My investment template shares a lot in common with, and owes credit to, the similar
templates of Martin Barnes of the Bank Credit Analyst and Ray Dalio of Bridgewater
Associates. All three of us share a belief in a finance-driven economic cycle which over
time moves to excess both on the upside and the downside. For the past few decades,
the secular excess has been on the upside with rapid credit growth, lower interest rates
and tighter risk spreads dominating the long-term trend. There have been dramatic
reversals as with the Lehman Brothers collapse, the Asia/dot-com crisis around the turn
of the century, and of course 1987’s one-day crash, but each reversal was met with a
new and increasingly innovative monetary policy initiative on the part of the central banks
that kept the bull market in asset prices alive.
Consistently looser regulatory policies contributed immensely as well. The Bank Credit
Analyst labels this history as the “debt supercycle,” which is as descriptive as it gets.
Each downward spike in the economy and its related financial markets was met with
additional credit expansion generated by lower interest rates, financial innovation and
regulatory easing, or more recently, direct central bank purchasing of assets labeled
“Quantitative Easing.” The power of additional and cheaper credit to add to economic
growth and financial asset bull markets has been underappreciated by investors since
1981. Even with the recognition of the Minsky Moment in 2008 and his commonsensical
reflection that “stability ultimately leads to instability,” investors have continued to
assume that monetary (and at times fiscal) policy could contain the long-term business
cycle and produce continuing prosperity for investors in a multitude of asset classes
both domestically and externally in emerging markets.
There comes a time, however, when zero-based, and in some cases negative yields, fail
to generate sufficient economic growth. While such yields almost automatically result
in higher bond prices and escalating P/E ratios, their effect on real growth diminishes
or in some cases, reverses. Corporate leaders, sensing structural changes in consumer
demand, become willing borrowers, but primarily to reduce their own outstanding
shares as opposed to investing in the real economy. Demographics, technology,
and globalization reversals in turn have promoted a sense of “secular stagnation” as
economist and former Treasury Secretary Larry Summers calls it and the “New Normal”
as I labeled it as early as 2009. The Alice in Wonderland fact of the matter is that at the
zero bound for interest rates, expected Returns on Investment (ROI) and Returns on
Equity (ROE) are capped at increasingly low levels. The private sector becomes less
willing to take a chance with their owners’ money in a real economy that has a lack of
aggregate demand as its dominant theme. Making money by borrowing at no cost for
investment in the real economy sounds like a no-brainer. But, it comes with increasing
risk in an environment of secular stagnation, demand uncertainty, and with the ROI
closer to zero itself than an entrepreneur is willing to bear.
Investment Outlook | January 2015
And so the miracle of the debt supercycle meets a logical end when yields, asset
prices and the increasing amount of credit place an unreasonable burden on the
balancing scale of risk and return. Too little return for too much risk. As the real
economy of developed and developing nations sputter, so too eventually do financial
markets. The timing – as mentioned previously – is never certain but the inevitable
outcome is commonsensically sound. If real growth in most developed and highly
levered economies cannot be normalized with monetary policy at the zero bound,
then investors will ultimately seek alternative havens. Not immediately, but at the
margin, credit and assets are exchanged for figurative and sometimes literal money
in a mattress. As it does, the system delevers, as cash at the core or real assets at
the exterior become the more desirable holding. The secular fertilization of credit
creation and the wonders of the debt supercycle may cease to work as intended
at the zero bound.
Comprehending (or proving) this can be as frustrating as understanding the
differences between Newtonian and quantum physics and the possibility that
the same object can be in two places at the same time. Central banks with their
historical models do not yet comprehend the impotence of credit creation on the
real economy at the zero bound. Increasingly, however, it is becoming obvious that
as yields move closer and closer to zero, credit increasingly behaves like cash and
loses its multiplicative power of monetary expansion for which the fractional reserve
system was designed.
Finance – instead of functioning as a building block of the real economy – breaks
it down. Investment is discouraged rather than encouraged due to declining
ROIs and ROEs. In turn, financial economy asset class structures such as money
market funds, banking, insurance, pensions, and even household balance sheets
malfunction as the historical returns necessary to justify future liabilities become
impossible to attain. Yields for savers become too low to meet liabilities. Both the
real and the finance-based economies become threatened with the zero-based,
nearly free money available for the taking. It’s as if the rules of finance, like the
quantum rules of particles, have reversed or at least negated what we historically
believed to be true.
And so that is why – at some future date – at some future Ides of March or May
or November 2015, asset returns in many categories may turn negative. What to
consider in such a strange new world? High-quality assets with stable cash flows.
Those would include Treasury and high-quality corporate bonds, as well as equities
of lightly levered corporations with attractive dividends and diversified revenues both
operationally and geographically. With moments of liquidity having already been
experienced in recent months, 2015 may see a continuing round of musical chairs
as riskier asset categories become less and less desirable.
Debt supercycles in the process of reversal are not favorable events for future
investment returns. Father Time in 2015 is not the babe with a top hat in our opening
cartoon. He is the grumpy old codger looking forward to his almost inevitable “Ides”
sometime during the next 12 months. Be cautious and content with low positive
returns in 2015. The time for risk taking has passed.
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