The View from the Rock

Acton’s Admonition Power corrupts and absolute power corrupts absolutely. We are witness to this truth in so many places. Even when a country has respect for the voters’ will and transitions of power occur without incident, a bad government, duly elected, can create a climate of oppression without the prospect of recall for many years. […]

By Michael Berry CFA

May 10, 2014

Tent Bay, St. Joseph, Barbados. Photo courtesy Andrew Hulsmeier.

Acton’s Admonition

Power corrupts and absolute power corrupts absolutely.

We are witness to this truth in so many places. Even when a country has respect for the voters’ will and transitions of power occur without incident, a bad government, duly elected, can create a climate of oppression without the prospect of recall for many years. And, the more oppressive it manages to become, the less likely a recall at the polls can be effected. Or, a particular government can simply make very bad economic decisions leading to hardship and ruin for the people it is supposed to serve and yet, it can remain ensconced in office, supported by the institutions of state and the panoply of office. Time and again we see this, especially where some, if not all, of the estates of society are weak. Indeed, a sure sign that a democratic government has turned bad is when it attacks the fourth estate, by closing down television stations or taking journalists to court to punish them within a judiciary (third estate) that is itself corrupted by influence. In this cyber age we arguably have a fifth estate, the blogosphere, which is far harder to control yet, we see democratically elected governments trying to turn off the Twitter and Facebook feeds.

From time to time we do see evidence where the people rise up and fight back against a first estate (we will modify Burke and in this day and age deem it to be elected government) as the people of the western part of Ukraine did, unhappy over a decision to more closely integrate their country with Russia. This was a street recall that came with consequences. In Venezuela, a country with extraordinary riches and tremendous inequities, which has been so ludicrously mismanaged into oblivion as to defy comprehension, the people are starting to stir. When the Chavistas’ own yard fowl can no longer be shielded from shortages of basic items, then Maduro is doomed. But that might not happen soon. Maduro can draw solace from Mugabe’s staying power.

It was Churchill who said, in 1947, “…democracy is the worst form of government, except for all those other forms that have been tried from time to time…” If democracy is the least bad choice then, amongst the various iterations, the UK parliamentary system is the least bad form of it. First-past-the-post has its merits as it is more likely to produce a working government. Those systems which tend to slice and dice the first estate into executive and legislative branches (US) seem to run into three-way gridlock. No system is ideal. It was by democratic vote (280 to 220) that Socrates was given a choice between exile and death (he chose death). And, even in parliamentary systems, one can get bogged down with a choice of two tired camps, neither of which understands any longer the actual reason for their existence beyond turning bombast into an art, albeit one that can have its humorous side. In Barbados we call it “pompasetting”.

Vlad the Invader

Ukraine poses a deep challenge for the defenders of democracy. In effect, a street gang from part of the country held the capital hostage and, forced the duly elected President to flee. The mob then installed its own pro-west government, unelected. The West, perhaps gullibly, quickly took up their cause, grinding Moscow where it particularly hurts. Russia sees Ukraine, along with Moldova and Belarus, as a buffer state between itself and the NATO countries. This was part of the post Berlin Wall architecture that kept things stable for some 20 years. As a neutral and compliant neighbor, Ukraine was allowed to host the Russian southern fleet in the Crimea and export its technologically outdated machinery to Russia. The West upset that equation and the consequences are likely to be a partition of Ukraine.

The irony is that Putin, who has worked to progressively undermine democracy in Russia and to amass near absolute power in his own hands, has used the West’s support of an unelected government in Kyiv to push his cause. Through overt subterfuge he invaded Crimea by arranging an invitational plebiscite. He will next force Kyiv into granting autonomous status to the provinces of Luhanska, Donetzka, and perhaps to those portions of Zaporizka and Khersonska which lie east of the Diniprovska reservoir. This will only end one way; the partition of Ukraine and the creation of a more active military border between a remnant, pro-west Ukraine and a Russian state in trans-Diniprovska, Nevo-Rossiya. This new entity will eventually be integrated with Russia. There is a high probability that Putin will push for this outcome before the scheduled May 25th elections in Ukraine.

Should investors care? Probably not. Eastern Ukraine has nothing that is of strategic value to the West. If it comes our way, the re-structuring cost of its Soviet-era manufacturing facilities will be huge. Western Ukraine has an agricultural and services based economy, which can be integrated more easily with Europe. The USA, the UK and Russia guaranteed Ukraine’s territorial integrity back in 1991. But, in backing Kyiv, the USA and Britain have sanctioned Europe’s, and NATO’s, continued expansion east. The third guarantor is demanding his piece of the pie, and we should let him have it. More than the others, Vlad the Invader actually has some real interests in this area. If he gets greedy the West has some other options; Kaliningrad (Konigsberg) is vulnerable and so is the Russian economy.

A lot of Yellen from the Fed

During January, Janet Yellen assumed the chair at the Fed. It is clear that she is pursuing the exit programme for the Quantitative Easing experiment already started by her predecessor. If anything she appears to be speeding it up as much as she can without upsetting the markets. This is based on a growing expectation that the US economy has reached escape velocity, a point at which full employment becomes attainable, wages will begin rising and inflation will move towards the central tendency of 2%.

At year-end 2013 Treasury yields soared on expectations that the Fed would pull out more quickly than previously expected. Managing these expectations in an era when forward guidance is part of the landscape is tricky. Based on recent Fed decisions, it appears that the bond purchases will end sometime between October this year and January 2015. At the last meeting, in mid-March, the purchase amounts were again cut back to US$ 55 billion a month ($30 billion of Treasuries and $25 billion of mortgage bonds).

What surprised many participants was that Fed forecasts showed the Federal Funds rate would likely be 1% by year-end 2015 and over 2.5% by year-end 2016. This led Yellen to say …” pay attention to the statement; don’t look at the dots…” meaning, listen to what I say and don’t get confused by our paper forecasts. The Fed also ditched the 6.5% threshold on unemployment (that was to trigger an end to QE) because, while the rate has fallen to 6.7%, the central bank feels the labour market is still far from returned to normal, citing many drop-outs and high under-employment. And this is one of the important features of this recovery: some cities and regions are experiencing labour shortages already, where others lag with high rates of unemployment and under-employment.

Two main messages emerge from the Fed’s actions. The first is that the QE era of bond purchases is ending and this will be followed by increases in the overnight rate at some point. The second message is that the journey towards a more normal interest rate structure, with an overnight rate of over 3.5%, is some time off, beyond this current Presidency. What remains unknown is what happens to the Fed’s remarkably large balance sheet once it stops buying bonds. Does the Fed hold securities until maturity or do they begin selling? Given the Fed’s guidance that purchases will end and interest rates will rise slowly over time, the implication is they will be left to mature. But, if the economy becomes very overheated in a few years’ time, and inflation exceeds 2%, selling would have definite advantages as a means of draining excess credit.

EBTOY (Elastic Band Theory on Yields)

Investors make much ado of the 30 year bond yield but, as an indicator of the market’s expectations for Fed policy, it isn’t much use. The two-year Treasury yield better captures sentiment and, the yield has been quite volatile in recent months as the markets try to understand Chairperson Yellen and her reduced Board of Governors (there are four vacancies on the Fed Board). Our sense is that in keeping with reduced purchases, this yield will track upwards from its current level of between 35 and 40 bps. Right now the two-thirty yield spread is large: as large as it has been at any major change in interest rate direction. The trouble with wide yield curve spreads is that, although they tell you yields will very likely rise, they don’t tell you when this will happen The Elastic Band Theory On Yields (EBTOY) says that the current spread of over 300 basis points is at a level which suggests yields will rise. In fact, the spread has already narrowed from a historically large 390 basis points last October since two-year yields have risen faster than long end yields. A spread of over 300 basis points has, in each case shown, eventually been dissipated only when the two-year yield started to rise. This occurred in 1994 and again in 1999 / 2000 even as long-term yields remained in a secular downtrend. Typically, the process ends when the two-year bond yield equals or exceeds the yield on the 30 year instrument at which point the curve is said to be flat or inverted, as it was in 2000.

US Treasury bonds, BloombergYield Spread between two-year and thirty year US Treasury bonds (Bloomberg)

This gives rise to the bond market adage that one should always buy the lowest yielding security on the curve. That worked from the 1960’s through to the early 1980’s when interest rates were rising inexorably. Since then, we have witnessed a secular interest rate decline and that strategy may not have worked very well. As one can see from the chart, despite big swings in the two-year yield, the 30 year rate has fallen by over 500 basis points since 1990. Only in 1994 and 1999 would the strategy have made sense for a nimble trader. However, after 30 plus years of declining long-term yields, some argue we may be nearing an inflexion point and a trend reversal.

Fiscal Fixes

Finally, the fiscal mess in the US seems to be righting itself. We don’t hear very much anymore about debt ceilings, sequesters and Congressional showdowns. The reason is that very strong revenue growth, combined with static government expenditures, are causing the deficit to narrow quite quickly. The US economy will grow this year at the fastest pace since 2005, lowering unemployment and swelling revenues. The federal government is expecting a deficit for the year ending this coming September 30th of US$ 516 billion, or just under 3% of GDP, according to the CBO. That compares to a US$ 1.4 trillion deficit in 2009 which was over 10% of GDP. The improvement is due to revenue growth, now at 18% of GDP compared to a low of 14.5% and, a drop in Outlays from a high of 24% of GDP to 21% currently. The shrinking deficit may also be one of the reasons that the Fed is cutting back on its purchases. At an annual purchase rate of US$ 360 billion, it is still buying a big chunk of the expected financings for the coming year.

One can argue that Congressional gridlock has been the budget saviour in the US. Unable to increase spending, it was frozen by agreement in order to procure the necessary increases in the debt ceiling. With recovery in employment (8 million jobs have been added since the recession low in 2009), a strong rebound in manufacturing led by the auto companies and an improved housing market, tax revenues have been strong.

In Issue #1 we highlighted the plight of Barbados where the government is seemingly unable to control spending and has resorted to increasing taxes and levies in an attempt to control a deficit that is still over 10% of GDP. We argued at the time that the only solution was to cap spending at B$ 3 billion for the next 5 years, or until that outlays were equal to no more than 25% of GDP. We were surprised when, in February, the Minister presented Estimates to Parliament with total spending of B$ 3.9 billion even as it was laying off over 3000 public servants. What this says, very simply, is that the government’s measures to rein in spending, and produce the one time cut of B$ 400 million first demanded by the central bank governor last June, are not working. The stark reality is that true spending restraint will be extremely difficult without a new way to manage and finance both health and education costs which together eat up a big piece of the expenditure pie. Just laying off people isn’t enough. We will proffer our advice one more time.

Freeze spending at B$ 3 billion, do not raise taxes anymore and start clearing the outstanding debits and credits between government and the private sector and then implement a programme of long-term reform. 

As Canada mourns the loss of its former Finance Minister, we can reflect on the sagacity of a policy which, in response to the financial crisis in 2008, deliberately stimulated and tolerated a large deficit but, immediately put in place long-term plans to cut government spending. Today, Canada has a balanced budget at the federal level, thanks to Jim Flaherty. For his part in the Mike Harris revolution in Ontario and more recently at the federal level, he leaves a profound legacy. RIP.

Investment Implications 2014 – 2015, as seen from the Rock

  • The period of ultra-low interest rates appears to be ending suggesting that bond yields will rise next year and beyond. Therefore, bonds with terms of less than three years will provide less duration risk and afford a ride down the curve to the front end where yields will remain lower, for longer. Borrowers should consider extending term and locking in rates. Corporate spreads are generally low and will likely rise with interest rates.
  • The environment for equities remains favourable. If the US economy is indeed reaching escape velocity then huge amounts of cash, now sitting on the sidelines, will begin to be invested. Stock indices could go 25% higher over the next two years. Dow 20,000 is possible. Developed markets will fare better than emerging markets, though some of those will recover from recent setbacks.
  • The US dollar will be the preferred and ascendant currency.
  • The Euro-currency economy is still in the very early stages of recovery and is at least two years behind the US. We expect the Euro to weaken to USD 1.30 / Euro. Nonetheless, the PIGS economies (Portugal, Italy, Greece and Spain) present some good opportunities for equity investors.
  • The UK is now in recovery after consolidating its fiscal position. Fiscal drag on the economy will lessen as the coalition government moves towards the next election. Like the US, it will be a good performer. Expect the Pound to rally to USD 1.70 / Sterling and Euro 1.30 / Sterling.
  • Petroleum and commodity dependent economies will not fare as well. Canada will grow by less than the US this year, the interest rate spread will narrow and, the Canadian dollar will tend to weaken, towards CAD$ 1.15 / USD.
  • China’s headline growth rate will continue to soften as that economy transitions to internal demand, but that will be good for high value exporters in the developed countries. It will be not so good for commodity producers.
  • Avoid countries with political issues such as Turkey and Russia. India is a question mark until the elections are finished. Brazil remains a country which cannot achieve its potential.

Michael Berry CFA

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