In recent years, a grand disconnect has opened between economies around the world, which are growing anemically if at all, and the bullishness of investors who only care that central banks are willing to continue shoveling out liquidity.
“Don’t fight the Fed” is the rallying cry, especially among equity bulls. And for 2012, at least the latter part, they were right. Almost every major stock market rose: in the U.S., U.K., Europe -- even Greece -- Japan, China, Australia and Canada.
Financial deleveraging in private sectors around the globe has swamped immense monetary and fiscal stimulus to the extent that economic growth is subdued at best. In desperation, monetary policies have become highly experimental. Huge government deficits are limiting the possibility of additional fiscal stimulus so policy makers are moving toward competitive devaluations. Meanwhile, low interest rates have spawned distortions as well as zeal for yield, regardless of risks.
Last year, the recession in the euro area deepened and the U.K. suffered three consecutive quarters of falling real gross domestic product. Growth rates in China dropped and Japan had two consecutive quarters of declining economic activity, a technical recession. Economic growth in the U.S. remains lackluster after the deepest recession since the 1930s. In sum, the global economy is weak.
Nevertheless, investors are pursuing “risk on” trades. They are long major stock markets, junk bonds and emerging-market debt, and they are short the dollar against the euro and against commodity-based currencies. And because there is no fear of risk, the investments with the highest yields have been the most sought after even though the highest yield reflects the greatest risks. As a result, yields have plummeted to record-low levels as asset prices rose.
Record-low interest rates have created many distortions. With a zero percent federal-funds rate, the Federal Reserve has no room to react to economic weakness. If deflation unfolds, the central bank can’t push real rates negative so as to stimulate borrowing. That’s the problem facing deflationary Japan. Furthermore, the lack of response from lenders and borrowers to near-zero interest rates is what pushed the Fed, the Bank of England and, earlier, the Bank of Japan into the new world of quantitative easing. This and other non-interest-rate actions taken previously have moved the Fed uncomfortably close to fiscal policy, threatening its independence.
The federal government, of course, isn’t the only borrower benefiting from low interest costs and negative real rates. Residential mortgagors, if they can qualify for loans, are getting a break with 30-year rates at 3.37 percent. Home-mortgage refinancing applications are soaring.
Investment-grade companies have been able to issue debt and refinance at low rates. Low interest rates have also encouraged the issuance of below-investment-grade junk bonds, and many companies have, in effect, pre-refunded their debt.
In his August speech at Jackson Hole, Wyoming, Fed Chairman Ben Bernanke emphasized the benefits of low interest rates, and never mentioned the losers. Neither, to my knowledge, have any important administration officials or members of Congress. Yet near-zero interest rates are causing harm to many.
Consider savers who are receiving trivial returns on their bank and money-market accounts that would be negative if fund managers weren’t waiving fees. Furthermore, free checking accounts are disappearing. Banks and thrifts, facing low-interest earnings, have increased the size of the required balance on checking accounts that pay no interest. In addition, many savers earlier deserted money-market funds for the safety of Federal Deposit Insurance Corp.-insured accounts.
Will Americans be discouraged by low interest-rate returns and save less, or will they save more to reach lifetime goals? I predict the latter, which is one more reason why I expect the household saving rate to climb back to more than 10 percent. At the same time, low-interest returns in conjunction with distrust of stocks and previous huge losses on owner-occupied houses are forcing many of the vastly undersaved members of the postwar generation to work well beyond their expected retirements.
So what can savers do now that the Fed plans to maintain short-term interest rates close to zero through 2015, and probably longer as deleveraging keeps the economy subdued and unemployment high? Hope for the arrival of deflation, which will push real interest rates from negative to positive.
Some investors are pursuing the haven of FDIC-insured deposits, now limited to $250,000 per account. Others, unsatisfied with low nominal and negative real returns, are moving out on the risk spectrum. Bernanke acknowledged this possibility in his Jackson Hole speech. “Some observers have raised concerns that, by driving longer-term yields lower, nontraditional policies could induce an imprudent reach for yield by some investors and thereby threaten financial stability.”
Yet he dismissed the threat, saying, “We have seen little evidence thus far of unsafe buildup of risk or leverage.”
I see lots of potentially unsafe buildups. Consider the rush into junk bonds, depressing their yields and spreads versus Treasuries. So much money has poured into below-investment grade debt that it now takes real skill to default. So great is the investor appetite for yield that 46 percent of junk bonds are selling at or above the prices at which they can be called by the issuer. However, a global recession will hype defaults even though many low-rated companies have a cushion of safety from prefunded debt.
Relatively safer U.S. investment-grade corporate-bond funds expanded their holdings to $131 billion, from $75 billion in 2011, as yields dropped to a record low of 2.6 percent. Meanwhile, junk-bond funds bought $30.1 billion, compared with $13.8 billion in 2011. Yields on BB bonds, the middle of the junk pile, fell from 6 percent at the start of 2012 to 4.5 percent at year’s end. Their spread versus 10-year Treasuries fell from four percentage points to 2.7 percentage points.
And those top-quality Treasury notes returned only 2.8 percent last year as 30-year Treasury bonds had a total return of 1.7 percent. Yields even influenced stock selection: Mutual-fund investors put $21 billion into dividend-paying funds and removed $24 billion from U.S. stock funds.
In another questionable maneuver to satisfy the zeal for yield, some managers of mutual bond funds are investing in riskier assets; they then compare their results with their benchmarks, which are composed of safer bonds. This can be dangerous. In 2008, about 40 funds that had big holdings of mortgage-backed securities and derivatives outside their benchmarks lost 10 percent or more, according to Morningstar Inc.
There has also been a rush into emerging-market bonds and stocks, even though almost all of those economies are driven by exports, the vast majority of which are bought by Europe, now clearly in a recession, and the U.S., which may be soon. Just look at sliding Chinese export growth.
Chronic low interest rates leave defined-benefit pension plans, corporate and public, in the U.S. and elsewhere, with tough choices. They need to reduce asset-return targets and discount rates to more realistic levels, but that means more contributions and/or reduced benefits. Cutting pension benefits is always difficult, especially when such decisions are constrained by union contracts.
The only other alternative is to increase returns, so pension plans have joined the zeal-for-yield crowd. And this often involves increased risks that may not be fully understood by those plan sponsors. The list of alternative investment classes includes real estate, private equity, developing-country stocks and bonds, hedge funds and commodities. But returns, especially adjusted for risk, may be disappointing.
The recent rush by normally conservative Norwegians into U.S. real estate may be a sign that the zeal for yield may be coming to an end. It reminds me of the 1980s stampede by Japanese investors into Midwest farmlands, Pebble Beach and Rockefeller Center. This exercise relieved the Japanese of excess savings when they later unloaded those properties at huge losses.
Norway’s Government Pension Fund Global, which is funded by oil and gas revenue, is the world’s largest sovereign-wealth fund, with more than $680 billion in assets. It has a $34.1 billion real-estate allocation, with $11.2 billion earmarked for the U.S. The fund spent the past two years acquiring high-end real estate in Europe, and now is considering high-priced U.S. office and retail space.
Those are properties that are well located, well leased and attractive to U.S. pension funds and foreign investors who prefer safe-and-sound, low-return “core” real estate -- with 4 percent to 5 percent cash-on-cash returns -- rather than riskier, but higher-return, “value-added” properties. Still, the Norwegians’ long-horizon strategy may work. The fund continues to grow, and it prefers to invest in real estate with knowledgeable partners.
As long as the grand disconnect and the zeal for yield persist, “risk on” trades will continue. “Risk on” will turn quickly to “risk off,” however, if a major shock, such as a huge increase in oil prices or a failure by the U.S. to deal with its budget deficit and government debt, occurs and a global recession ensures.
In Part 4 and Part 5, I will detail my “risk on” strategy for now and my “risk off” approach for the aftermath of a substantial shock.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the third in a five-part series. Read Part 1 and Part 2.)
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