A great deal has been said over the last three days about the S&P downgrade of US government debt. Much of this chatter has been wearily familiar as the usual actors who reside in Versailles-on-the-Potomac recite from the predictable scripts of blame and false sanctimony. Let’s get straight to the point: how is the world different today, and how is it not different?
How it’s not different: The US has not ceased to be a safe haven. Look at the evidence – stock markets are plunging while, true to form, yields on US Treasuries are lower than they were last week. Remember – yields fall when prices rise. In fact the 10-year Treasury is right now flirting with a yield of 2.3%, which is a low of historical magnitude. The plain fact is that there is a global glut of savings that has to park itself somewhere. US corporate balance sheets are swelled with over $1 trillion in cash, and at any given time a good chunk of that cash will be invested in some mix of US government debt, downgrade or not.
How it’s partially different: There are other assets performing the safe haven role along with Treasuries: gold is up $40 today, and both the Swiss franc and the Japanese yen have resisted concerted policymakers’ efforts to keep the exchange rate down. As we noted in a recent column (Safe Haven Economics 3.0) the notion of safe haven asset itself is changing with the times. Relatively speaking there is no natural successor to US government debt as the go-to risk free asset. Rather than the idea of one “risk free asset” we should start thinking along the lines of “low risk basket” as a valuation benchmark.
Which brings us to how it is different: The absolute level of risk is higher now. Whether one agrees or disagrees with S&P’s decision (and fans of the rating agency appear to be few and far between) it is meaningful in a long-term sense that the bellwether asset of the last sixty years of global economic history is no longer triple-A. Not because the US can’t pay its bills – it can, simply by printing more money as Alan Greenspan himself blurted out on one of the Sunday talk shows – but because the pillars of the global economy – the US, Western Europe and Japan – are not as solid as they once were.
With the downgrade behind us attention will once again shift back to Europe. “Italy and Spain are the new Bear and Lehman” goes one pessimistic point of view. Actually they are not, for a number of reasons. Italy is not bankrupt – in fact it has a very high rate of domestic savings and its national fiscal budget is in primary surplus (i.e. before including interest obligations). Spain’s debt-to-GDP ratio is just over 60%, a far cry from the 140% ratio of Greece. In 2008 we were looking at the very real possibility that the banking system itself would simply stop working – payroll systems would stop direct depositing wages into checking accounts and ATMs would run out of cash. We are not looking at that specter – not today at any rate. There is a crisis of confidence in European bond markets, and that has long-term implications for the EU and the viability of the Euro. But what we expect to be more likely in the short term is ongoing volatility with a number of variables that could send markets higher or lower on any given day. Trying to guess which variables will show up on which day would be a fool’s errand indeed.
As these words come to page we are six days away from August 2, the supposed drop-dead date for the US government’s running out of money and, for the first time since 1790, being unable to meet all its financial obligations. Right now it is hard to see the entrenched pig-headedness of vested interests giving way to compromise for the common good – but stranger things have happened I suppose. Perhaps there will be an eleventh-hour-and-fifty-ninth-minute solution. Another distinct possibility is that August 2 comes and goes, no deal is on the table but markets and the economy keep hobbling along anyway. If nothing else, we have become remarkably skilled at kicking the can down the road, putting Band-Aids on the ailing patient and foregoing tough choices. I would still be more willing to bet on some patchwork fix that holds the wolves at bay rather than immediate financial Armageddon.
Regardless of how the next six days turn out, however, one thing seems to be fairly evident – we are at the dawn of a new age of Safe Haven Economics. The concept of a “safe haven” investment is probably as old as finance itself – a place to park your hard-earned capital and sleep a bit easier when the storms rage. So why have we chosen to call this version 3.0? We could go back further, but for the purposes of this post it is sufficient to think of the age of the gold standard and the pound sterling – from the late 18th to the early 20th century – as version 1.0. That era hung on life support for a brief time after the First World War and then fell apart as the clouds of the Great Depression gathered. After the dust had settled from the turbulent ‘30s and the Second World War the United States held the undisputed mantle to version 2.0. The US dollar and Treasury bonds would be the dominant safe haven investments for the next sixty years. Even the financial crisis of 2008 – a meltdown largely caused by US financial institutions – failed to dislodge the dollar and the T-bond from their caché as the go-to port in a raging storm.
This time around things are different. I think the writing was on the wall in 2008 that dollar-denominated hegemony was in its waning days, but investors as much as any human genus are creatures of habit, slow to change. Make no mistake – the transition from version 2.0 to 3.0 looks different from the last go-around. There is nothing on the financial stage today to compare to the clear leadership role the US dollar played when the world went off the gold standard. Rather, what we are seeing is the emergence of something like a safe haven basket – a collection of assets that can play the role of “risk off” trades when capital goes a-scurrying. The Swiss franc, the Japanese yen and gold (some things never change) clearly appear to be part of that basket. Arguably certain other currencies such as the Aussie dollar may be included as well. How about other AAA-rated debt? One of the many possible curiosities of the fallout from a downgrade of US government debt is that the safest domestic corporate bonds remain AAA-rated. Why not? After all, the companies that issue those bonds are citizens of the world much more than they are distinctly American.
In finance we have long been used to thinking in terms of the “risk-free asset”. Perhaps it is time to start recasting this as the “risk-free basket”, the defining characteristic of Safe Haven Economics, v3.0.
Over the past several days we have been treated to the spectacle of an unsavory phone hacking scandal that has metastasized into a full-blown politico-media scandal shaking the upper-crust branches of the British governing class, forcing a reluctant humility on the pashas of an arrogant media empire and making threatening growls from the recesses of that empire’s US stomping grounds as well. Now, what Rupert Murdoch, News Corp, UK Prime Minister David Cameron or any other personage or organization are or are not guilty of is not the point of this post. And as far as I can tell there is no obvious connection between this scandal and the other spectacle of the week – the playground theatrics of the US Congress whose members taunt each other with a rhetorical “Are Too! Am Not!” level of sophistication.
But these two stories are simply different faces – each ugly in its own distinctive way – of a larger and seemingly unshakeable presence in our lives today. That is a chronic, all-pervasive mistrust of institutions on the part of just about everybody who is paying even a modicum of attention. Mistrust begets uncertainty, and uncertainty is what investment markets hate more than anything else in the world. In this light it is not surprising that the dominant paradigm in the markets today is a bipolar, trigger-finger “risk on / risk off” pattern of behavior. One day the world is about to fall apart and everybody wants to do nothing other than hoard gold behind fortified ramparts. The next day investors look at the same news, see the glass as half-full or at whatever level is necessary for hope to spring eternal, and rush out to buy primary shares in some technology 2.0 IPO with a dicey revenue model. And so it goes, back and forth, day in and day out.
This is not rational behavior, in the sense that it is far removed from the “Rational Man” theorems that have filled economics and finance textbooks for decades. But in a way it is an understandable response to the world of mistrust that permeates the modern mind-set. We begin to just assume that massive conflicts of interest exist at every nexus of money and power everywhere in the world. We assume that the ones who actually get caught with their hands in the cookie jar are a small percentage of all the double-dealing and clever scams being hatched and executed – and we further assume that in most cases no one will actually pay the price even if they are caught. We hear the accused and their lawyers dissemble about what they did, what they didn’t do, how they managed to thread the needle through the conflicts of interest and the attendant multiple temptations without coming up on the wrong side of the law. We start to believe that words don’t really matter anymore.
Our better angels say no – that is not how people invested with the public trust behave, and they must know that in a capitalist economy public trust is our single most important currency. But our daily experience nags at these better angels, and with every new empirical data point we think, no, this is not the exception, it is the rule. Am I feeling lucky today? Hello, Wingandprayer.com IPO. Had enough? Time to haul those gold bars over the moat and into my cellar. Maybe tomorrow will be different.
Modern Portfolio Theory – the intellectual framework that underlies the methods by which the vast majority of investment managers and advisors execute decisions on behalf of their investing clients – is approaching its 40th anniversary. In a world where anybody with $1000 and an online trading account can buy once-exotic commodities futures, and where US government securities stand not so far from the precipice of a potential downgrade, how well-suited are the assumptions and tools of MPT – fashioned over the last forty years of thought and practice – to the investment challenges of today and tomorrow? MVCM President Masood Vojdani shares his insights gained from thirty years (and counting!) in the investment industry.
I started working in the investment industry in 1981, a year when both inflation and interest rates were stuck in double digits and the conventional wisdom about the equities market was that it was dead. In an age of unappetizing choices for where to put one’s money I learned an early and valuable lesson: portfolio diversification is the smartest way to ensure that when bad things happen in the market you at least have some cushion to limit the downside. Now, diversification may sound like something sensible people have always done since time immemorial, but in fact the building blocks that underlie what today’s professional portfolio managers do for a living were set in place just a handful of decades ago. The cornerstone was a Journal of Finance article called “Portfolio Selection” written by Harry Markowitz in 1952. Markowitz established the basic principles of mean-variance analysis and with that set in motion a fruitful couple decades of advancement in financial theory and practice. This rich period included contributions from William Sharpe (Capital Asset Pricing Model, early 1960s), Eugene Fama and Kenneth French (Fama-French Three Factor Model in the 1970s) and a number of other leading-edge thinkers. The burgeoning discipline that they crafted came to be known as Modern Portfolio Theory.
From Theory to Practice
MPT, as it is known in the trade, had thus already been around in some form for nearly 30 years when I first hung out my shingle as an investment professional. But it seemed to really come into its own as the Great Bull Market of 1982-2000 gathered steam, so to a certain extent I feel like I came of age alongside the movement of MPT from academia’s ivory towers into the cut and thrust of real investment markets. The practical mechanism that effected this movement was asset allocation, which in turn is a somewhat fancy way of saying diversification. Asset allocation is rooted in the two critical measures of Markowitz’s mean-variance analysis: (a) the risk-return characteristics of different types of assets relative to each other, and (b) the level of correlation between different assets in the same portfolio. A whole industry sprang up around the business of making efficient allocation decisions, perhaps best illustrated by the so-called Morningstar “style boxes”. These nine boxes divided the world of stocks into nine flavors from large-cap growth to small-cap value. Pick judiciously among the style boxes for your risk assets, leaven these allocations with whatever percentage of bonds was appropriate for the risk tolerance of a given portfolio style, and you were good to go.
Challenges of the Post-Modern Era
Modern Portfolio Theory has for the most part served the investment industry well; but for two reasons I feel that we may be entering a new – call it “post-modern” – era. The two reasons are: the rapid growth of liquidity-providing financial instruments in an ever-wider spectrum of asset classes; and the increasingly dubious notion that there is a good proxy for a risk-free rate of interest in the market. Let’s look at each of these in turn.
On its face the rise of liquidity-providing instruments would seem like a good thing. Take commodities futures. Back in the 1970s, when MPT was still mostly confined to the halls of academia, it would take a considerable amount of money, sophistication and hard-to-obtain access to a trading platform for an individual to take positions in exotica such as crude oil, soybeans or pork belly futures (remember the movie “Trading Places”, anyone? Randolph and Mortimer Duke were not your typical middle class family with a savings account and retirement plan). Now, for those larger investors (like the Dukes) able to trade in these rarefied markets there were distinct benefits: commodities futures would tend to trade with very low correlation to movements in the stock market. In the late 1970s, for example, equities investors fared quite poorly, while investors in commodities like gold and oil did really well. That changed in the mid-1980s when the stock market rallied strongly while metals and oil prices plummeted. The point is, having the ability to diversify a portfolio across both equities and commodities was a source of value to portfolios of risk assets.
So isn’t it good news that this source of value is now accessible by typical retail investors who live far from the opulent world of Wall Street barons? Yes, to a point. Mutual funds and more recently Exchange Traded Funds (ETFs) have democratized finance. But they have also been at least partly responsible for a noticeable trend in recent years: those low correlation benefits that historical trading patterns produced are disappearing. Commodities futures are now just another so-called risk asset. What markets exhibit now is a tendency to move in and out of risk broadly – not in and out of equities, or in and out of commodities – but in and out of risk. So commodities and equities tend to move in a more correlated pattern than they used to – and the same goes for other risk assets like real estate trusts. This challenges that one important plank of MPT that selecting among different risk asset classes can add value through low correlation.
The Disappearing Risk-Free Rate
While that is concerning enough, I find the second “post-modern” trend even more unsettling. At the heart of practically every valuation technique that has flowed from Modern Portfolio Theory is the notion of the “risk-free” rate of interest. Think of the risk-free rate as a starting point: as you identify and categorize risks that apply to specific assets the investor’s required rate of return moves upwards in increments from the risk-free rate. Investment valuation models usually include some mathematical formula that reflects the idea of “risk-free plus risk market premium”.
For the entire time that MPT has been around the proxy for the risk-free rate has been the US Treasury bond (or note, or bill). The US had established itself as the world’s reigning economy and financial center long before Markowitz’s 1952 paper – that transition really happened when the world went off the Bank of England-centric gold standard in the years following the First World War and never went back. Now US government debt is teetering on the edge of losing its longstanding preeminence, and in the current climate there is even a plausible case to make that the government will at some point in the not too distant future default on certain existing obligations. Whether or not this happens – and I for one believe that ultimately cooler heads will prevail – the fact is fairly indisputable that Treasury debt today substantially lacks the robust “risk-free” nomenclature. It may still be less risky than just about anything else in the market, but that just means that the whole risk curve has shifted upwards and everything in effect is a risk asset. And those time-honored valuation models are rendered much less useful.
Into the Future
At MVCM these problems have been occupying our attention on a constant basis since the market meltdown in 2008. We will by no means claim to have all the answers at our fingertips. But we strongly believe that the investment assets we will be evaluating for portfolio decisions in the months and years to come require different tools than the ones we have become comfortable using over the last thirty years. Post-modern does not have to mean, as it often does in various arts and humanities usages, jarringly chaotic, confusing or depressing. The challenge is to incubate, develop and deploy tools that work within the practical contours of post-modern markets.
In the time-honored Greek myth Pandora, blessed by the gods with abundant beauty and talent but also an overweening curiosity, opens the box and allows all the Ills to pour out into the world. In her despair Pandora quickly shuts the box but by then there is just one thing left inside – Hope.
Hope was in abundant supply today as well as the shares of Internet music company Pandora came streaming into the public securities markets with opening day gains in the neighborhood of 62%. But it is probably going to take more than a wing and a prayer to make it unscathed through the buzzsaw environment of the market these days. Sharing the headlines with Pandora today were the “Zombie Consumers” – a rather stark portrayal by longtime Morgan Stanley economist Stephen Roach of the bleak landscape of US consumer spending in the age of subpar growth, sticky unemployment and debt as far as the eye can see. With the exception of Pandora-mania risk markets today are decisively buying into the Living Dead point of view – the S&P 500 is flirting with its 200 day moving average and testing the 2011 low of 1256 reached on March 16.
Correction territory? Not quite – as of the writing of this sentence the index is trading around 1263, which puts it at 7.2% below the recent high of 1361 attained at the beginning of May. A technical correction requires a downward move of 10% - but that is hardly out of reach given the trading patterns of the past several weeks. “Sell in May and go away” is ringing true as we head into the summer months.
This seems to be the Yogi Berra of summers – “déjà vu all over again”. Greek protesters in the streets of Athens, an internecine war of words between German policymakers and their counterparts elsewhere in the EU, fears of a US double-dip recession consuming bits and bytes of media real estate. No wonder markets got all in a snit last week upon hearing that the Fed has no apparent plans in its head for a quick fix of QE3 to keep the adrenaline rush going. Investors clamoring for more stimulus have a point – if fundamental conditions today are in many important ways little changed from where they were a year ago, then how has the calculus changed away from the need for another round of intervention?
Perhaps it is time for the Fed to take the morphine away and let the natural healing process take effect. Quantitative easing, like any monetary policy, can be at least somewhat effective when applied in measured doses. But it does not make the organic problem go away. The “organic problem” in question here is the fundamentally changed socio-economic conditions of the centers of the developed world economy – the US, the Eurozone and Japan. Each of these centers faces deep-seated challenges to its health unlike any that we have seen since the second half of the 20th century. It is well and good to say that growth engines like China, India and Brazil can pick up the slack and keep global growth humming along, but in reality the fates of the developed and emerging worlds are intertwined. We believe that countries and markets will find their footing – that is the case more often than it is not – but consumer zombies and other unsavory denizens of the night will likely be an ongoing part of the landscape.