Follow the Herd? Or Reason?
How do you diversify when all asset classes are moving in tandem? This was a key question many faced at the height of the financial crisis, when all asset classes were plunging together, but is an issue that remains today. We have long held concerns over the increased tendency for the values of different asset classes to move in the same direction simultaneously, as was the case leading up to the crisis, throughout the crisis, and today. In fact, according to Bloomberg, the correlation coefficient that measures how closely markets rise and fall together has reached the highest level ever.
Despite recent market appreciation, investors may be concerned , in many people’s eyes increased correlations are ok when markets are rising, when everything is going well, as a rising tide floats all boats, and one turns a blind eye to the downside, but what happens when the herd gets it wrong? What happens when the herd suddenly reverses course (look at oil, which peaked at $145 only to fall to $33)? What do you do if markets should crash again? Where do you hide? We have long argued that investors should consider a diversification approach to something as mundane as cash, and it now appears that this approach may be as crucial as ever.
Market dynamics, of course, are playing out: naturally, as vast amounts of money has been pumped into the system, credit slowly thaws and money is beginning to flow again, combined with a reversal of many risk aversion trades (some money that flowed out of markets into the “safe haven” of the U.S. dollar and T-Bills has now found its way back into the markets), asset prices have reflated.
We believe a large part of the catalyst for the reversal of risk aversion trades has been a misinterpretation of economic data as “green shoots” of a recovery, however, when one digs deeper actual “hard” data do not paint such a rosy economic picture. Many economic overhangs remain and we believe we are far from the beginning of a sustainable recovery. Indeed, many in the media are now pondering whether the “green shoots” are now wilting in the summer sun (incidentally, and as a complete digression, despite tremendous market uncertainty and volatility, the old adage of “sell in May and go away” appears to be playing out).
Moreover, we believe the U.S. Administration and Fed are acting irresponsibly, both fiscally and monetarily, and many unintended consequences are likely to come home to roost over the coming months and years. We are concerned about inflation, market inefficiencies, the crowding out effect that so much government debt may have, amongst others. The market, too, has become increasingly nervous about inflation , implied inflation expectations taken from the spread between TIPS and equivalent maturity Treasuries has been rising steadily since the beginning of this year. Not to mention our view that recent market interventions and the expanded role of the Fed, have and will, compromise its independence and effectiveness.
While it is hard to distill all the market developments simply, the way we see it, many dynamics can be illustrated through an adaptation of an old children’s nursery rhyme:
“A lot of money came to the market,
Some money stayed home,
A lot of money flowed to equities, commodities, oil, emerging markets etc,
Some money was hidden under the mattress and bought none,
And some money went “wee, wee, wee” all the way to somewhere with sound monetary policy and a more fiscally responsible home”
Indeed, we are seeing trends within institutional investors who are actively mirroring the last sentence , repositioning their portfolios to hedge against the risk of a falling dollar by investing in international currencies. Combined with reflation trades and the reversal of risk aversion trades, we believe this factor has contributed to the price appreciation of many international currencies since March. We believe it may only be time before this trend proliferates to the mainstream and we see a heightened level of pressure on the U.S. dollar from domestic investors.
What about Treasuries? Can’t we hide there? Sure, but “hide” is a relative term , you’re going to have to endure the enhanced price risk that now prevails: recent market volatility did not spare the Treasuries market, which had the worst first half of the year in over three decades. Optimists point to the prior week’s auctions, which gave some hope that foreigners will continue to have an insatiable demand for U.S. government debt. Bond dealers have decried that the demand for Treasuries remains strong, that market dynamics remain favorable, but this is all predicated on continued foreign demand. Domestic investors aren’t buying any: we aren’t that benevolent. That’s the real problem we have with this view: with so much debt to be funded, at some point foreign demand will dry up too, interest rates will rise and any nascent recovery may be nipped in the bud.
There is a bigger issue here. By implication, the U.S. is now dependant on foreign countries to fund government spending. All of us in the U.S. should be worried about recent developments , as a nation we are becoming increasingly indebted to foreign countries, as a nation we are increasingly dependant on foreign countries, as a nation we will be paying boatloads in interest to foreign countries for years to come , generations will be affected. These are not just economic issues; these are social issues, and why we take such an active stance on them.
These dynamics may put the revered “reserve currency” and “safe haven” status of the U.S. dollar and U.S. government debt increasingly under pressure. We have argued that the U.S. dollar will not lose its status as the world’s reserve currency over the short-term, as, put simply, there may be no legitimate alternative at present. However, we do believe present initiatives are undermining the “safe haven” status of the U.S. dollar and U.S. government debt. Would you loan your neighbor a thousand bucks if you know he owes hundreds of thousands to others? Oh, and by the way, he’s just told you his income will be dropping over the foreseeable future. That’s exactly the position the U.S. government is in right now , income (taxes) is going down while debt is morphing out of control. Both the government’s and Fed’s balanced sheets looked a lot healthier 12 months ago, and they are only likely to deteriorate going forward (the government balance sheet in particular). As such, we believe investors will increasingly question the “safe haven” status of the U.S. should another crisis erupt.
Kieran
Kieran Osborne
Co-Portfolio Manager, Merk Investments
Comments
6 Responses to “Follow the Herd? Or Reason?”Speak Your Mind
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Very good article! What would you say are alternatives to the US$ in terms of safe haven status or as as second reserve currency? Euro, CNY, or SDRs? What are the possible scenarios we see some of these developments in the next 10 years?
I agree with your concern for a weakening dollar and it’s inflationary effect on US consumers, especially since we are so dependent on imports, and not just energy.
However, I am reading increased comments that the vast amounts of money the government is printing will not generate inflation because it is sitting on the balance sheets of banks and other financial institutions instead of in circulation through loans. Do you consider this kind of commentary valid?
Good article but no guidance on alternative cash investments. The fact that the former correlation numbers were all wrong in light of the ‘new’ market [e.g., hedgfunds and other institutions selling the baby with the bath to stay liquid] proves once again that investing is not as much science as it is risk managment and preparing for the worst. I have a novel idea, why not lobby the Government to return to all of the New Deal reforms like giving savers an increntive by a reasonable fixed and guaranteed return of 5% on all passbook savings [we had it for fifty years before the Republican Contract with America (Bank bosses) came in with the repeal of USURY laws that were with us since the Old Testiment. Since they claimed to be such religious puritans, how can they see any morality in taking our savings in at zero percent and lending it back to us on credit cards at 25%? What we need is a concerted effort to indict politicians for fraud. They are the ones who were supposed to be watching the fort.
Even with the printing of money (2 trillion to date) does the destruction of credit offset that if it is occuring at a faster pace than the printing? Either way the dollar will have it’s problems, but does the destruction of credit offset teh printing from an infltionary standpoint?
I keep looking at Brasil -0f course I have a Brasilian Fiancee and have been there many times, also did extremely well on a house lot near the beach which I held four years and only sold because the next-door neighbor literally made me an “offer I couldn’t refuse” – 20% more than nearby lots were selling for.
But, as Bill Clinton pointed out, the majority of cars and trucks run on ethanol mix(gas hovers around $US5.00/gal), so that giant new oil field can represent pure exportable profit. They have about 3700 miles of coastline – from tropical rainforest to desert-like to temperate in the South and, yes, Vern, you can own beachfront property there. With an investment(in almost anything) of $50,000US, you can get a permanent Resident visa. I am invested in Embraer – they have orders for all the planes they can build this year, and Petrobras the government petroleum company, and am looking at building beachfront houses to sell to Americans – or Swiss -or Argentinians. Brasil has always been known as “the U.S. of South America” – and may pass us yet.
In terms of “safe haven” status, outside of gold, we favor the debt of governments that can actually afford any stimulus spending – such as Norway, for instance, or countries whose central bank is following prudent monetary policy – on a relative basis, we prefer the Eurozone over the U.S.: the ECB is following much more prudent monetary policy than the Fed, however the recent covered bond purchase strategy is somewhat worrisome (though the scale of this program remains well below those seen in the U.S.).
That said, the U.S. dollar appears to retain it’s “safe haven” status, at least over the near-term – but we believe the pendulum will increasingly swing away from the U.S. dollar over time, especially if policy makers continue down the present economic road, further deteriorating government finances.
Longer term, currencies such as CNY are likely to become more prominent globally, and pressure the USD’s reserve currency status. China presently doesn’t have sophisticated enough financial markets to facilitate the bulk of global trade, but is working hard to develop its financial markets. It has recently initiated bi-lateral currency swap agreements with a number of Asian and Latin American countries to facilitate settlement of cross border trades without USD, and is encouraging banks to offer CNY settlement. While we don’t have a crystal ball, we envision the USD’s reserve currency status to be put under increasing pressure from the likes of CNY over the coming years…
It is true that much of the money printed is sitting on the balance sheets of banks as excess reserves, rather than being loaned out, though excess reserves have been dropping over recent weeks. However, the most important factor influencing inflation are inflationary expectations – businesses will try to push through price increases and employees will ask for pay raises if both believe inflation is just around the corner – hence why the Fed spends much of its time talking down inflationary pressures and talking up imaginary exit strategies.
Another possible scenario might be if the banks burst (pun intended) and we see a flood of loans into the economy. Don’t forget: banking is a competitive business – once one bank views the lending environment favorably and starts lending, others will likely follow, excess reserves will be drained and we may see a torrent of money come into the economy. If this happens, the Fed will have its hands tied to rein in inflation in our opinion.
Kieran