Monday, August 8, 2011

A world without a benchmark, End of the road for hedge funds....

A world without a benchmark, End of the road for hedge funds....

Dollar falls on Fed’s pledge to maintain key interest rate at a record low.

No US interest rate rise until 2013.

China's trade surplus jumps 41%
as exports gather pace.

S&P balks at SEC proposal
to reveal rating errors.

The downgrade of the United States' triple-A rating by Standard & Poor's has elicited a bunch of largely predictable reactions. They can be grouped into broadly two categories:

  • The first group of ''patriotic'' Americans who question the validity of the S&P's action on Friday on the basis of either the agency's fuzzy math or its less-than-exemplary history. (See S&P adds its own footnote to the crisis, April 20, 2011).

  • The second group of non-Americans who have either called for the US to rein in its deficits (like China) or expressed alarm at the development (like the Europeans).

    Both groups are somewhat correct in their assessment of the current state of affairs, even if their views appear mutually contradictory. It can also be said that both groups are almost entirely wrong with their assumptions of how this particular fork in the global financial crisis road needs to be navigated.

    Let us start with a few facts that are largely irrefutable:
    1. In the matter of correctly rating the future quality of debt currently on issue, S&P has about as much credibility as an Indian politician calling an anti-corruption drive.
    2. The downgrade from triple-A, the highest rating, to double-A plus is itself immaterial in terms of the actual probability of default over the next 25 years or so.
    3. However, the downgrade does have the effect of removing US debt from the eligibility criteria of many central banks and other cross-border regulators based on current rules. It is a moot point that such rules may be altered to deal with the situation.
    4. The US is no longer an exemplary sovereign in terms of its risk profile, although the question is raised that if the US is no longer triple-A, do any of the other holders of the coveted title have any greater credibility?
    5. China's foreign exchange rate intervention was the single-largest factor behind the mortgage crisis of 2007 - which is not to say that it was either the proximate cause nor indeed the major swing actor.
    6. Europeans have much more to lose from a US downgrade, seeing as it resumes the race to the bottom between the two currencies (euro and dollar).

    Even with all the factors that clearly make the case for ignoring the ratings downgrade, it is important not to be glib about the action itself - as some analysts have been, criticizing the action itself, rather than examine the practical implications of a downgrade more carefully.

    The outlook
    Middle Eastern markets were sharply down on Sunday, the first day of trading anywhere in the world after the US downgrade was announced late on Friday. Asian stocks followed suit, with most indices having wiped out their gains for 2011.

    The most important metric from a risk management perspective is the realization - or the need thereof - that the global financial system has now entered an entirely new phase; one that presents uncharted territory into which market participants are forced to sail without the benefit of an anchor.

    Protests to the contrary notwithstanding, chances are high that international investors will reduce their holdings of US debt as a result of the downgrade. This may not take the shape of a selloff in current holdings, but rather a reduction in future asset allocations.

    If accompanied by denial of the sort seen in Japan since the late-1990s, it is highly possible that US deficits continue to balloon and as with Japan cause a structural reduction in US growth prospects; eventually pushing bond yields down rather than up as US investors continue to purchase treasuries in preference to risk assets.

    This will be exemplified as ''evidence'' of the rating agency action not having an impact on debt costs even if the argument completely misses the point of what eventually occurs.

    My personal expectations of a reduction in US structural deficits is markedly different from that of many analysts. Firstly, I do not repose much faith in the positive demographic story painted by such people (more on that later), and secondly, I do not believe that either of the two major political parties has the ability (let alone the willingness) to aggressively address the issue of structural deficits.

    This situation augurs for a continued fall in the US dollar's purchasing power - either through a renewed commodities bubble or an eventual increase in (retail) inflation as exporters start passing on costs to US consumers even if overall demand continues to decline.

    If S&P and the other agencies apply the same metrics that produced their cautious outlook on US credit ratings, it is likely that many European sovereigns will be downgraded in short order - including the likes of France and Belgium. While it is possible that the United Kingdom and Germany escape a downgrade over the next 12 months, that eventuality isn't cast in stone either. For example, a further weakening of the UK economy - which appears quite likely - would cause an immediate downgrade.

    Even as Europe sinks deeper into the mess of its own making, the outlook for emerging markets is getting cloudier. Far from being the engine of global growth, emerging markets could become a structural drag as central banks attempt to cool down inflationary pressures (like in India) or asset bubble fears (as in China).

    US demographics
    There is significant debate about the demographic profile of the US. Even as its existing population exhibits the same aging profile as the indigenous European population - the object of much criticism among those who base their long-term analysis on the measure - the key differential remains the issue of immigration.

    It is here that I have significant differences of opinion with those calling for a rising US population accompanied by stable demographics - ie a stable base of taxpayers. There are two sources of immigration: firstly the skilled laborers who leave countries like China and India in search of greater opportunity and secondly the base of unskilled and poorer people who seek an entirely new livelihood in the US.

    Ever since the crisis in 2007 and the divergence in growth between developed and developing markets, the first category of immigration has declined anecdotally. Meanwhile, the number of economic migrants has also declined as a result of the significant rise in home ownership-related bankruptcies among Hispanics and Southeast Asians. The current state of the US financial system doesn't bode well for this source of demand.

    Future prospects for US immigration thus depend very much on the negative scenario for emerging markets playing out - in other words, it would take the decline of China and India for immigration to the US to revive. If on the other hand through the mechanism of internal demand these economies continue to create adequate growth, the outlook for US immigration declines proportionately.

    The downgrade of the US doesn't present the application of the old investment axioms relating to ''buy on rumor, sell on fact'' (in this case applied in the reverse due to the negative nature of the news). Instead, there is a greater realization that new rules apply in the markets now.
  • There's something deeply anomalous about a stock market crash at the peak of United States corporate profitability. Nothing like this ever has happened before. Nonetheless, judging from overnight moves in Asian markets, last week's plunge in world stock markets will be repeated in Europe and America on Monday morning - although recent intraday moves have been so extreme that one is loath to guess.

    Standard and Poor's downgrade of American sovereign debt from the highest, triple-A rating may be the silliest pretext for a stock

    market crash in world history. America is the only big industrial country in the world that will have more taxpayers rather than fewer when a newly-issued 30-year bond matures.

    Working-age population by region, assuming constant fertility

    Source: United Nations

    In Asian trading, the US 10-year note lost about a point and a half, a modest response to S&P's action. But the 3% to 4% declines in regional stock markets and a parallel fall in US stock futures, is harder to explain. Stock markets never have undergone this sort of crash when corporate earnings outpaced the alternatives by such an extreme margin. The earnings yield on stocks is a full 5 percentage points higher than the yield on 10-year US Treasuries, something we have not seen for a generation.

    Equity risk premium (S&P 500 earnings yield minus Treasury yield)

    Source: S&P

    The so-called Equity Risk Premium (ERP) - the earnings yield on stocks minus the 10-Year Treasury yield - stands at a generational high. The corporate bond market assigns a low risk to corporate earnings. In a world short of earnings to fund history's largest retirement wave, why is the market selling an S&P earnings yield of 8% to buy 10-year Treasuries at 2.5%?

    Systemic strains exist, first among them the likely restructuring of Italy's enormous government debt, but there is no reason for this to become a global liquidity event. Central banks stand ready to provide unlimited liquidity. There are good reasons to sell European banks. The American economy is weaker than the consensus forecast, and the US consumer may have dug in for the duration. But the link between US GDP and corporate earnings is the weakest in history, and 46% of S&P sales are outside the US.

    If equity earnings are strong - and careful analysis reinforces the impression that they are - then we have observed a liquidity event like 1987 rather than a systemic crisis like 2008. The banking system, whatever its difficulties, is not the source of the liquidity problem, for banks have been reducing their holdings of risk assets for two years. Governments are not the source of the liquidity problem, for government stimulus in the West has been irrelevant to the economy since 2008.

    There is, however, a bubble in the world economy. Anecdotal evidence points to hedge funds as the bubble that has popped. With equity hedge funds down 10.72% year-to-date on the Hedge Fund Research Index as of August 3, investors are demanding their money back. The debt-ceiling cliffhanger in Washington may have provoked the redemption calls, and the S&P downgrade might provoke more.

    But the reason for the downgrades is that hedge funds have crippled out. Hedge funds can't earn the 15%-20% returns they promise investors in a world of 3% bond yields and 2% gross domestic product (GDP) growth. Investors desperate for higher returns, including pension funds, returned to the hedges during 2010 and 2011, and are now suffering spasms of buyers' remorse.
    That prompted an across-the-board liquidation of all assets, including commodities and emerging market equities most favored by the hedges. The nearly $2.6 trillion of hedge fund assets constitute the system's only real bubble: too much money chasing too few returns, with a lot of fingers on the recall button. As of May, equity hedge funds with $1.25 trillion in assets had strongly net bullish positions.

    They are stampeding to get out. Their overwhelmingly bullish bias left them vulnerable to a wave of redemptions, what has happened to the real-money investors who require the income that only the equity market can provide? No-one can fund a retirement on Treasuries yielding 2.4%, or a corporate bond index yielding less than 3.5%.

    There are other investors, to be sure, who need income to fund current and prospective retirements cannot act as quickly as the hedge funds. Pension funds and insurers require months of committee meetings to change their allocations. They shifted massively to bonds after 2008, moreover, and their book yields cannot be replaced in the present market. Tactical asset allocation is out of the question; they can filter funds into the equity market slowly.

    If them that has 'em can't hold 'em, them that wants 'em can't buy 'em. That leaves individual investors to ponder the cheaper valuations on the equity market. The trouble is that the vast majority of American households are deeply in the hole: according to the Federal Reserve's most recent survey of personal wealth, American households' real estate is worth about a third less than it was in 2006, that is, $16.1 trillion compared to $22.7 trillion.

    The problem is that most Americans approaching retirement age in 2007 had most of their net worth in non-financial assets.

    Apart from real estate, the next-largest component of middle class wealth was in the form of equity in small businesses. Small business has had no share in the recovery. A rough gauge of small business income is non-farm proprietors' income as reported in the GDP tables. As the table below indicates, corporate profits have soared to a record, but proprietors' income remains below the pre-recession peak.

    Judging from the surveys published by the National Federation of Independent Business and other organizations, small business remains in a slump. That is not surprising, for reasons spelled out in a recent study by New York Federal Reserve economists. Most small business growth during the past decade followed the housing bubble.

    Stock crashes in the past have followed bouts of what former US Federal Reserve Chairman Alan Greenspan called "irrational exuberance," or external circumstances that made equity unattractive. The chart below sums up a generation of valuation and equity returns.

    Equity risk premium vs S&P 500 price change

    The last three big drops in the S&P are circled on the chart. All of them occurred when the Equity Risk Premium was negative - that is, when Treasuries offered more yield than stocks. When a safe asset yields more than stocks, investors have to clap their hands and say "I believe in earnings" in order to hold stocks. But we have never had stock market crash when stocks earned nearly three times the Treasury bond yield on a current basis.

    The US government won't go bankrupt. China won't sell its Treasuries (who would buy them?). The world's Asian epicenter of economic growth won't roll over and die. Italy's $1.4 trillion debt might be restructured, Europe's banks might go under the auction hammer, and today's Europeans might postpone their retirement for 10 or 15 years - but that won't change the grand scheme of the world economy. If Italy were the problem, we wouldn't see the sharp rise in the euro that occurred in early Asian trading.

    The bubble that has popped here is not American government debt, but the overstretched and overpromised hedge fund industry. It's impossible to tell how long the liquidation will continue. But the stock market today does not run off fumes as in the dot-com days of the 1990s, nor off the phony profits of ultra-levered financial companies as in the 2000s. Corporate America is flush with cash, financially sound, and making better money than ever before.

    For that reason, I consider this a liquidity event like 1987 rather than a true crisis like 2008 (with a $6 trillion shock to household balance sheets and the evaporation of bank equity). It's not the end of the world. It's just the end of the hedge fund industry.


    No comments:

    Post a Comment