Kurt Godel, famous mathematician and philosopher.
Month in Review
Broad asset classes such as stocks and bonds traced sideways during the month of April, while inflationary assets such as Oil and Gold took center stage and moved higher. Meanwhile, economic data continues to be mixed, recent jobs data was disappointing while housing data continues to show a robust real estate market. In summary, the fundamentals of the economy continue to appear weak on the surface but the level of debt expansion both domestically and globally seems to be temporarily offsetting the effects of weaker demand.
Traversing the “End Game”
There continues to be a focus by esteemed market experts on the effects of a negative or prolonged zero interest rate environment. Their predictions about what will happen if the Fed continues to keep rates artificially low seem to be predominantly apocalyptic. However, most of these experts also uniformly admit that the timing of such events is difficult if not impossible to predict.
Stanley Druckenmiller, the famous hedge fund manager with a stellar track record went on record at a recent conference to say that (via Zero Hedge): “The myopia of today’s central bankers is leading to reckless behavior at the government and corporate level.” Druckenmiller sees a storm coming that is bigger than in 2008. He goes further on to say “The Fed has no end game. The Fed’s objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term.”
While the presentation by Druckenmiller contained a lot of convincing facts and evidence in support of his predictions, that does not mean that these predictions will materialize in the short-term. In an interview on Bloomberg in March, Druckenmiller admitted that he did not know when this would happen – it could happen in months or even years. He mentioned that he has been early many times in the past, for example he saw similar problems in 2005 but his predictions did not materialize until years later during the Credit Crisis.
Kyle Bass, another famous hedge fund manager that predicted the subprime crisis in 2008, echoes similar sentiments that the outcome of the end game will be negative but that he also does not know when it will happen. Bass was quoted via ZeroHedge to say: ”Economics assumes that everyone is a rational actor, and we all know in this world there aren’t many rational actors.” He goes on further to conclude “the experiment that’s going on we all know will end poorly at some point in time, I just don’t know when that time is.”
The predictions for what will happen in a world with continued zero interest rates do not need to be negative, rather they depend more on what the policy response will be from the government. The “Oracle of Omaha” Warren Buffett sees a wider range of possible outcomes than just the end of the world: “You can read Adam Smith, you can read [John Maynard] Keynes, you can read anybody and you can’t find a word to my knowledge on prolonged zero interest rates – that is a phenomenon nobody dreamed would ever happen. That doesn’t mean I think it’s the end of the world when it ends, but I don’t think anybody knows exactly what the full implications of negative rates will be.” But the most interesting point that he makes is that he calculates that in world where investors knew interest rates would be zero “forever,” stocks would sell at 100 or 200 times earnings because there would be nowhere else to earn a return (source: CNBC). This gives the market plenty of room to run substantially higher depending on the future actions of the central bank and government policymakers.
Too Complicated to Understand?
What will happen as the trend of current global monetary policy regime continues in its final phases is clearly not straightforward. We know that human beings are not rational as the economic textbooks suggest but they are not completely irrational either. The complexity of the financial system has grown so much since 2008 that all but a handful of experts truly understand how everything works. Predicting how people will react to sudden changes is even more complicated.
I read a recent article that gave me serious doubts that the majority of financial experts truly understand the mechanics of the global financial system. Danielle DiMartino Booth – President of Money Strong and Former Advisor to Federal Reserve Bank of Dallas recently wrote that new regulations have essentially eradicated the Fed funds market. The imbalances in the system are reflected by what is going on behind the scenes in the “shadow banking system”. Di Martino Booth mentions that economist Zoltan Pozsar actually diagrammed the global banking system (the picture at the beginning of this commentary) and I would challenge that most portfolio managers and investors have no knowledge or understanding of exactly how it works. Cryptically Pozsar mentions in the conclusion of one of his reports (“Shadow Banking: The Money View: OFR Working Paper, 2014): “From a policy perspective, the fundamental problem at hand is a financial ecosystem that has outgrown the safety net that was put around it many years ago. Today we have a different class of savers (cash PMs versus retail depositors), a different class of borrowers (risk PMs to enhance investment returns via financial leverage versus ultimate borrowers to enhance their ability to spend via loans) and a different class of intermediaries (dealers who do securities financing versus banks that finance the economy directly via loans) to whom discount window access and deposit insurance do not apply.”
When former Fed Chairman Alan Greenspan was asked about whether he is optimistic about the economy going forward he responded via Zero Hedge: “No. I haven’t been for quite a while. And I won’t be until we can resolve the entitlement programs. Nobody wants to touch it. And that is gradually crowding out capital investment, and that’s crowding out productivity, and it’s crowding out the standards of living where do you want me to go from there.” Essentially Greenspan alludes to the fact that the cure to our problems will require fiscal intervention and cannot be solved by monetary policy. Basically we all borrowed too much from the future for the present, and many or most of us will have to take a haircut to make things work. This means that the myopic focus of investors on the Fed to solve our problems may be completely misguided. Ultimately future actions of the government may have a greater impact and we haven’t even finalized who will be the next president.
How To Invest in This Environment
We believe in systematic investing using quantitative rules to take advantage of trends and momentum across global markets. This has been shown to be one of the most time-tested approaches to investing. Michael Covel is an expert on the subject and he says that: “Trend following is the best tonic for uncertainty, but to pull that off you can’t be looking over your shoulder constantly worried about what your neighbor is doing with his or her portfolio. Here’s some insight: most likely your neighbor has no clue.” We would add that it is clear that even the best experts disagree about the end game in today’s macroeconomic environment. They all agree however that the timing of their predictions are subject to substantial uncertainty. If we believe that the world is either heading toward a calamity (or a runaway bull market as suggested by Warren Buffett), we need a systematic and rules-based method to capture either trend. To conclude, we can look at the historical performance as compiled by AQR of trend-following (via time-series momentum) during the worst drawdowns for conventional portfolios over the last 100+ years:
While this is no guarantee of future performance, we can see that momentum and trend-following to protect and preserve capital during many of these unforeseen shocks. What is most interesting is that the strategy relies on adapting only to what is actually happening in the market and has absolutely no built-in knowledge or opinions of what will happen. Yet it manages to adapt successfully. We believe that this is the best way to invest in the current environment to avoid the pitfalls of either being right and being early or being wrong in our fundamental assessments of what will happen in the end game.
The author(s) principally responsible for the preparation of this material are expressing their own opinions and viewpoints, which are subject to change without notice and may differ from the view or opinions of others at BSAM or its affiliates. Any conclusions presented are speculative and are not intended to predict the future of any specific investment strategy. This material is based on publicly available data as of the publication date and largely dependent on third party research and information which we do not independently verify. We make no representation or warranty with respect to the accuracy or completeness of this material. One cannot use any graphs or charts, by themselves, to make an informed investment decision. Estimates of future performance are based on assumptions that may not be realized and actual events may differ from events assumed. BSAM is not acting as a fiduciary in presenting this material. Benchmark indices are presented or discussed for illustrative purposes only and do not account for deduction of fees and expenses incurred by investors. “MRI” is our proprietary Macro Risk Indicator.
The strategies discussed in this material may not be suitable for all investors. We urge you to talk with your investment adviser prior to making any investment decisions.