Monthly Archives: September 2012

the Fed’s QE3: a “reverse Volcker moment”?

September 21, 2012 By in inflation vs deflation, Strategy Tags: , , , , , , , , , , , Leave a comment

The most recent A-list editorial feature in the Financial Times, written by Pimco marketer Mohamed El-Erian, asks this question and answers it with a carefully hedged “Yes.”

Several aspects of the editorial are interesting:

–it’s not the usual El-Erian turgid statement of the obvious.  Instead, it’s concise, well-written and makes a point.  To me, this underscores the fact that Mr. El-Erian is writing, not as an individual, but as the voice of the collective wisdom of the largest and most successful bond investment management firm in the US.  As such, the opinion expressed should be taken seriously.

–the original “Volcker moment” was Paul Volcker’s decision as newly-appointed Fed chairman to deal with runaway inflation in the US by raising interest rates to extremely high levels for an extended period of time.

The editorial suggests Mr. Bernanke is currently in the process of deliberately trying to manufacture higher levels of inflation, thus reversing the major thrust of Fed policy over the past thirty years.  Calling the move a “reverse Volcker moment” implies that the decision may have equally momentous implications (more about this next week).

–although the editorial doesn’t say this (Pimco markets bond funds, after all), such a Fed policy reversal would likely have negative consequences for all securities markets, but especially unfavorable ones for bonds.

At present, long Treasuries yield about 3%, which we can break out into a 1% real yield and 2% as compensation for benign, stable annual inflation of around 2%.  If the world began to think that inflation in the US could be 3%–and rising–how would bonds be priced?  …at a 5% yield?  …higher?

That’s a big difference, one which would produce significant losses for current Treasury holders.

Japan joins the QE party

September 20, 2012 By in Asian economic development, China, Current Market Thoughts, economics, Japanese development Tags: , , , , , , , , Leave a comment

Japan’s QE

Two days ago, the Bank of Japan announced it is following the lead of the ECB and the Fed in launching a new round of Quantitative Easing (a term invented by an economist apparently obsessed with the Queen Elizabeth line of ships).

the EU starts, the US follows

The rationale for the European Central Bank to act is clear.  It is in effect using funds from the stronger EU economies to prop up the bond markets of debt-laden and uncompetitive Spain and Italy while they restructure their economies.

Why QE3 in the US is somewhat less clear.  The Fed is propping up the domestic mortgage-backed securities market, while simultaneously assuring investors that short-term interest rates will remain low for the next three years.   This will certainly be good for housing prices.  Addressing the looming “fiscal cliff,” or, better still, reforming the tax code would be much more effective confidence-building steps.  But these are the province of the White House and Congress.  QE3 is all the Fed can do.

The Fed’s intent is to create more jobs.  These might come either in direct fashion from a new residential construction boom (which wouldn’t be a good thing, in my view), or indirectly from the “feel-good” factor that stable or rising home values would produce.

The Fed realizes its action may do nothing.  But its attitude seems to be that it’s better to light one more candle than to stand by and watch the labor force erode through chronic unemployment (see my post).

Japan’s motivation

Japan’s motivation is murkier still.  If EU and US money policy become looser, then simply by doing nothing Japan’s becomes relatively tighter.  This change won’t make itself felt through lower nominal interest rates, which are close to zero anyway.  But the new tightness should manifest itself in relative strength for the ¥ versus the € and the $.

So far, however, that hasn’t happened.  The ¥ has weakened against its strongest trading rival, the €, and strengthened only mildly against the $.  Nevertheless, the Bank of Japan appears to have chosen to draw a line in the sand for its currency at the level of $1 =¥78.  It’s doing so to assist domestic export-oriented industry.

Yet, the central bank must know that such currency defenses seldom, if ever, work.  And it must realize that currency strength isn’t the main problem. Rather, the Japan Business Association (Keidanren) is lost is dreams of the glory days of a quarter-century ago.  Ex the big auto manufacturers, Japanese exporters haven’t evolved since then.  In newer areas, they have been surpassed by the US, in older sectors by Korea and China.

the essential differences

The ECB is acting because it sees no other choice if it wants to preserve the Eurozone.

The Fed thinks there’s little downside to its actions, and they may do some good.

Both central banks are seeking to stimulate their domestic economies.

Japan, on the other hand, is trying to defend its trade position.  And it’s “buying time” for adjustment for a sector that hasn’t changed in 25 years.  Not a great way to make a living.

From an investment perspective, even though the motivations of the various central banks may be different, the overall effect is that more money is sloshing around looking for a home.  In the near term at least, that’s good for global stock markets.

Gavyn Davies on Bernanke’s change of heart

September 19, 2012 By in Derivative instruments, economics, employment, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

keeping inflation low

Since the tenure of Paul Volcker began over thirty years ago, the mantra of the Federal Reserve has been to do what is necessary to keep inflation under control.  Over time, this morphed into the narrower target of keeping inflation under 2%, but the intent has always been to drive inflation lower.  Yes, the Fed has a “dual mandate,” both to conduct monetary policy in a way to achieve maximum sustainable GDP growth and to promote employment.  But the former has invariably trumped the latter.

…until now

In the September 12th pronouncement from its Open Market Committee, the Fed unveiled new monetary stimulus measures targeted at reducing unemployment.  For the first time, they are open-ended both in terms of time and of money.

Why?  

…especially when there’s a lively debate, even within the Fed, over whether we are in fact already at full employment.  If so, the new measures won’t create any new jobs.  It will only ignite wage inflation, as companies poach employees from rivals in order to expand.

Personally, I don’t know.  I think that if the Fed decision has any immediate implications for financial markets, they’re positive for stocks and neutral (at best) for bonds.  So arguably as an equity investor, I don’t need to know.

Still, I’m curious.  The best I can do is to fall back on the old saw that inflation is better than deflation, since the world’s central bankers have plenty of experience dealing with the former but have gone 0-for when confronted with the latter.

the Davies answer

Gavyn Davies, former chief economist for Goldman Sachs and now a blogger for the Financial Times, has a better answer in his 9/16 post for the newspaper.  It’s worth reading.

The thrust of the post is that, in Davies’ view, Mr. Bernanke’s QE3 decision implies he believes the US is at a tipping point with the chronically unemployed.

As workers remain out of the workforce, the theory goes, their skills gradually erode–and, with them, their chances of finding new employment.  At the same time, former workers’ enthusiasm for the job search effort also wanes.  Eventually, they drop out of the workforce permanently–becoming unfulfilled as persons, burdens on the rest of society for decades and–crucially–inhibitors of future GDP growth.

Recent surveys by the Labor Department suggest the “dropout” rate in the US is starting to accelerate, putting into motion the downward spiral just described.  In Davies’s view, this is what has changed the balance of risks in the Fed’s mind.

the curious case of Chow Tai Fook Jewellery (HK:1929)–Tiffany (TIF), too

September 18, 2012 By in Casinos, Current Market Thoughts, Entertainment, Industrials, Industry Analysis, Luxury goods, Retail, Stock ideas, Strategy Tags: , , , , , , , , , , , , , Leave a comment

…toss in Wynn Macau (HK: 1128), as well.

Chow Tai Fook

Chow Tai Fook is a Hong Kong-based jeweler that IPOed there last December.  The company’s main business is chuk kam (24 karat) gold objects, the stuff that’s sold by weight, not market up by 100% (or more) over direct costs.  It’s not only decoration, but you can bury it in the back yard if you’re wary of banks.  And you can wear your wealth to work, in case you find out you have to flee the country right away.   (You wouldn’t chuckle if you’d lived through 1940-1960s China.)

The firm has expanded from the SAR into the mainland, and from chuk nam to high-end “fine” jewelry designed to flaunt your wealth, not hide/preserve it.  In recent years, the latter has become an increasing percentage of Chinese jewelry consumption.

a December 2011 IPO

The IPO was anything but a rousing success.  The stock was priced at HK$15, to raise US$ 2 billion.  But it came to market just as Beijing’s efforts to slow down the domestic economy were causing affluent mainlanders to cut back consumption.

The issue closed on day one at $13.80–and headed south from there.  It finally bottomed some months ago at HK$8.40.  Ouch!!

…so, what’s curious?

Here’s the thing.

The economic evidence over the past few months is that China is slowing further, despite signals from Beijing of its change to a more expansive government economic policy.

The EU is a mess.

US industry is slowing down and the “fiscal cliff” is getting closer.  Burberry and Tiffany have revised down earnings, in large part because of disappointing sales in China.  So too have tech companies like Intel.

Nevertheless,

since July 27th,

Chow Tai Fook share are up by 26.5%–vs. the Hang Seng index up 6.9%

BTW, Wynn Macau shares are up by 30.0% over the same time span

TIF began rising a little earlier in the month, but has gained almost 25% from its low–compared with about an 8% rise in the S&P 500.

why this good performance?

It’s a little like the case of Benjamin Button, whose body went through the opposite of what nature usually does.

Possibilities:

–If this were ten or fifteen years ago, I’d say investors are seeing through current weakness and beginning to discount in advance the recovery that the government policy change will likely bring.

But reacting to government cues is not the winning strategy it once was.  That’s partly because the economic problems the world faces today are more structural than cyclical.  Also, the rise of hedge funds has reoriented markets sharply in the direction of short-term trading than they have ever been.

Besides, luxury goods makers like Hermes and LVMH haven’t experienced the same stock price lifts.

–new bets on China?  But, if so, why no response from Hermes, LVMH or Coach?  Also, why would UK-US (lower-end) jeweler Signet be having better stock performance than the other three?

–influence of EU investors?  My impression has been that a lot of the damage to Hong Kong stocks during the middle months of 2012 was due to panicky selling by EU-based investors.  The clear new bullishness emanating from Europe may be resulting in portfolio managers plowing back into Asia.  That might explain why 1929 or 1128 are doing well.  But why TIF?  …or why SIG and not LVMH?

–minimizing exposure to the EU?  For aesthetic reasons, I like this better than “bets on China,” because it’s a more sophisticated wager–one based on avoiding a bad experience rather than necessarily having a good one.  Still, why TIF?

You could build a “synthetic” TIF-ex-the-EU, by combining SIG +1929.  Not a perfect replacement, but if the main idea is to avoid the EU probably an acceptable one.

my take

I’m sure there’s a method to the apparent madness.  At this point, however, I don’t know what it is.

I could say that professional investors are shifting their portfolios toward secular growth areas (as opposed to more cyclical ones) where they see profit growth will be the strongest next year.  Yes, that’s true, but it’s what most managers always do.  So it’s flirting with tautology.  The crucial question is why jewelry and casino gambling?

Is there something special about these two areas?  …or is there something awful about everything else?

One thing I am convinced of is that solving the puzzle correctly can bring investing rewards.

I own 1128 and 1929 but none of the rest of the names I’ve mentioned here.  I have no burning desire to add to any–although if I can figure out what’s going on I might develop one.

If someone were forcing me to buy  one of the names, it would probably be 1929.  The fact that it’s the most speculative of the stocks is not a coincidence.  I should knock off the caffeine instead.

index funds, passive ETFs and operating leverage

September 17, 2012 By in Industry Analysis, Investment firms Tags: , , , , , Leave a comment

Russell leaves the ETF business

Early this month, the financial press carried stories that Russell Investments, the pension consultant turned money manager, has decided to close its ETF business less than two years after entering the field.

What’s going on?

(By the way, Russell’s is the typical pattern in many commodity-like industries, where latecomers are never able to achieve the scale needed to become profitable.  Presumably, Russell knew this before made its move into ETFs.  It concluded that the possible gains justified the initial outlays.  On the other hand, maybe it didn’t.)

the case for passive products

Arguably, given the repeated failure of active managers in the US equity market to outpace the S&P 500, or other standard benchmarks, passive products are better choices.

At the same time, with passive ETFs or index funds, the possibility–however remote–of market-beating performance is eliminated as a selling point.  Every fund targeting the same benchmark index will have (more or less–a comment on this in a minute or two) the same gross return.  As a result, the only real difference among funds is the size of the fees the fund operator charges.  Lowest fee wins.

basic assumptions

Let’s look at the situation as if we’re a newcomer to the passive fund industry.

We’ll have expenses:

–for a bank to keep custody of assets

–for mathematicians to oversee construction of the portfolio and to monitor the trades the fund makes to deal with purchases and redemptions

–for traders to buy and sell the securities in the fund, and to process customer orders

–for overhead, that is, office space, marketers, boards of directors, lawyers. top management…

To make the numbers easy, let’s say all that costs $1 million a fund a year.  (Unless a firm plans on having a ton of funds, $1 million is going to be much too low.)

Let’s also say that once we have all this infrastructure in place, the variable cost of running a given fund is the electricity needed to power the computers that keep the fund humming.  Call that zero.

charging for our services:  the view from below

Now we’re ready to offer our products to customers.  Customarily we charge a percentage of the assets as our fee.  How do we set that percentage?

well, our fund has to be at least reasonably competitive with other offerings in the market.  Let’s say the most prominent fund among our rivals charges a fee of $.20% of assets.  If we match that fee, then we’ll only achieve breakeven when our assets exceed $500 million.  Until we reach that level, we’ll have to subsidize our operating expenses.

Our other choice is to charge a higher fee, at least initially.  But since low price is the major selling point for the product, it’s not clear that this will be successful.

Worse than that, there’s a second issue with passive products–the question of how faithfully a given index fund or ETF mimics the benchmark it intends to duplicate.  This is called tracking error.  Passive portfolios don’t usually buy and sell tiny bits of all the stocks in their benchmark.  They transact in small, more liquid subsets of the index that their statistical analysis says will mirror the overall index closely.

Assurance that tracking error is low comes partly from the fund promoter’s promises, but mostly from seeing the fund deliver on those promises over long periods of time.  A startup fund only has the first.

It’s going to be hard to attract assets away from the market leader who has a low tracking error by charging more.

the view from the top

Look at the market leader.  He’s getting in new money on a regular basis from IRA or 401k clients.  If the relevant index is up, say, 20% over the past year (the S&P is a tiny bit better than that), his assets under management–and therefor his management fee–have gone up by that amount just by not losing net customers.  So the market leader is making at least 20% more money than he was in 2011.

What’s his best strategy?  Cut his management fee percentage, of course!

If the market leader decreases his management fee to .175% of assets, he’s still making more money than before.  His product looks even more attractive.  And he’s forcing the startup to cut management fees, too–raising the startup’s breakeven to $570 million, thus lowering the chances that the startup will ever reach profitability.

more wrinkles

There are a few.  But I’ve made my main point–that unless the market leader gets piggish and creates a pricing umbrella under which the competition can prosper–it’s tough for a latecomer to gain any market traction.  That’s natural market evolution.  And it’s what has happened to Russell.

That’s it for today.