Hoosier Advisor

I Love football. High school. College. NFL.  All of them.  Now, admittedly, there are brief moments where that love gets tested these days, whether that’s a hardnosed kid getting kicked out of a college game for targeting or one of those silly taunting penalties that we’ve all come to hate in the NFL. College has the better product now (especially since the employees of the multi-billion-dollar enterprise are no longer simply paid in education) and no team will match the love I have for my Indiana Hoosiers. But the 2000s were such fun for we Colts fans; watching them go on to become the winningest of any team in a decade – topping the 1980 49ers.  Yes, we wish they had done more than 1-1 in super bowls – but it was a fun ride. 

They had another chance at a good run in the following decade with Andrew Luck, especially the year that was stopped short by the Deflategate game.  I bring that up not to dig it back up or to blame it for us stopping short of the Super Bowl. I watched that game with my own eyes…a few ounces of air in a few footballs did not decide that game. Furthermore, the discussion should have ended the next year when colts had a chance to beat the pats on the field.  They didn’t. I bring it up because it became tiresome to talk about it, much like its opposite problem in economics today: Inflation.  Inflation has dominated discussion for most of the year.  To complement a talk I am giving this fall; I’ll summarize here the collective of these discussions I’ve been having this year.

Inflation Impacts: Investment portfolio vs. Financial Planning

When investors bring up inflation, we separate the issue between two aspects: Financial planning and investment.  For investing, the job is to be repositioning amidst a changing landscape of winners and losers depending on whether we are under an inflationary or deflationary environment.  Under inflationary circumstances, banks, materials and energy stocks and TIPS bonds will normally find themselves amongst the winners.  Under deflationary circumstances bonds and safer noncyclical stocks are among the first to be turned to. Like every other thing with investing – this isn’t something that will be gotten right all the time.  But it is continually part of the allocation dynamics, even in years where inflation isn’t such a hot and pressing topic.

For financial planning purposes, the inflationary impact is about the interaction between our savings, our future spending and what role changing price levels will play in that relationship.  And these changing price levels affect us all differently depending on what our consumption basket looks like.  The more it looks like the national average, the more it will resemble CPI and other well-known broad representations for inflation.  The less it resembles it…the more it will be…well, different.  For the financial planning implications, it’s always a good idea to test financial plans against various inflation scenarios and see what changes, if any, might need to be made. This process can help take an intangible fear and replace those fears with clarity and confidence – even if that means some changes might need to be made if the harsher scenarios do indeed play out.

Sure, as advisors it would be nice to provide a solid forecast for which direction inflation will take.  But those forecasts have severe limits, and you should take them all with a grain of salt from whomever is providing them (especially the media)!

Better Luck Flipping A Coin?

In an industry that is ripe with poor forecasting, inflation predictions come in right there at the bottom.  As simple as inflation is as a concept, we are far from a unified theory of understanding the forces behind it.  Disagreement in the field of economics is wide on the topic and the only consistency is missed forecasts.  Granted that’s a broad brush with which to paint everyone…but it is my experience from both the classroom as a student and as a CFA by profession. I just think it’s important to have this humbling reality at top of mind when providing guides to the future on the topic. With that gigantic disclosure…

Here is my read on where we are

Fears for a return to a 70s style inflation are overblown.  I thoroughly respect that, at best, we can only estimate probabilities and it is certainly possible for very high levels of inflation to kick in.  I just don’t see it as probable. The last several inflation readings have been in the 5% neighborhood – something we haven’t seen for some time. Its also likely overstated for the time being.

One reason for the readings this high is simply the comparisons to the relatively lower prices a year ago in the heat of the pandemic. A better way to look at it is 2-year inflation rates (chart below) to take out some of the noise of year over year comparisons.  We can see that the 5% readings overstate the current rate just a bit .

However, that we are still in the upper part of the inflation range we have seen the past couple of decades.

Supply Chain & Shipping

Let’s start with the supply chain problems that are clearly part of underpinning some of these higher readings. Supply chain problems are stemming from capacity constraints (from both labor shortage & physical capital) as well as international logistical challenges. These challenges are hitting corporate America more than the retail evidenced by the extremely elevated producer price index relative to consumer price index. 

This means price increases (largely due to supply constraints) are hitting manufacturers faster than they can pass them along to consumers. But even though it’s not being passed through in 1 to 1 fashion, they are contributing to higher end user prices. Perhaps this can be seen nowhere as clearly as in shipping backlogs. There just seems to be no end in sight to the challenges with getting stuff shipped to where they need to be and there are no quick fixes. Hopefully the recently announced plans to operate both LA & Long Beach 24/7 will work to improve the bottlenecks.

I am not a practicing economist in the academic or professional forecasting sense of the word so I don’t have any clue or insight as to specific contributions these logistical challenges are to future CPI readings (whether its .2% or 2% and over what time frame).  But I do think it’s important in building out this framework to acknowledge, in my opinion, that a part of these supply issues will be permanent.  That is because of choices made by companies to adjust their sourcing policies.  More importantly, we were already undergoing a de-globalization trend and this likely accelerated a piece of it.  This, at a minimum, is a counterwind to what was a long-term disinflationary trend.  Again, to what degree I don’t know.  But it is a factor.  We can also agree there is also an element that is indeed temporary.  The pandemic appears that it will continue to have its ebbs and flows, but as global vaccination rates continue to tick up and along with natural immunities, COVID’s impact will diminish over time in its disruptions on prices.

Commodities

Another probability working against the prospects of 1970s style inflation is the rarity of commodity super cycles. The chart below from Cuddington et al. shows the past century whereby we often have a commodity or two in a bull cycle but it’s rare for a simultaneous boom in the majority of them.  

Commodities traders have an adage that “high prices cure high prices”.   This means that higher prices curb demand and invite more supply.  We’ve seen that with Lumber and Iron ore.  I can personally speak to the lumber – which was all the rage this spring.  I was fortunate enough to begin a home improvement project last fall.  Based on conversations with my contractor, had I begun in the spring, the rising lumber prices would have exceeded my budget and we wouldn’t have pursued building.  Some who weren’t as fortunate with their timing had to pump the brakes on projects which curbed demand.  The sustained rally in lumber prices also prompted lumber mills to pump up production.  This doesn’t happen overnight, but eventually the incentive is there to ramp up production.

I believe this core microeconomic principle is why it’s rare to have a bulk of commodities booming simultaneously for a sustained period. At any point in time, some commodity or another will be in a bull market, but as the chart shows above recent history only has 3 examples of such “super cycles”.

Monetary Policy and Money Supply

Also, for the 1970s it’s important to note that we had just pulled the plug on the gold standard which set off a chain of events that helped fueled inflation for the decade.  Pulling that plug allowed for easy monetary policy to continue far too long and dovetail a commodity super cycle.  In the end, the Volcker led Fed of the early 1980s created the playbook for successfully stamping out inflation. The present-day Fed certainly will not want to dust this playbook off, but they will if the hand is forced. You see some tealeaves of that here in the September Fed meeting.

No conversation about inflation is complete without a thorough discussion of money supply.  Milton Friedman would otherwise be spinning in his grave. Our most treasured definition of inflation, after all, is too much money chasing too few goods. The challenge, and it’s a big one, is in that definition of “too much money”.  If an economy is 10 people on an island with only a few seashells as currency, then money is easy to define, measure, and observe.  If you go from 10 shells in currency circulation to 50, but fish and coconut production is still 10 each per day, the price in terms of number of shells for each is likely to skyrocket.

The real world and modern-day economy are more complicated than that and the definition of money is ever changing. I feel I could go down a rabbit hole of Fed papers on the topic and not come out any better than I was when I started. For instance, go back and revisit the Great Financial Crisis and the steps that were taken to help put out the economic fires in 2008 and 2009.  These steps were brand new to many of us as we observed the “money printing” by the Fed truly causing our most basic measure of money (called M0 or base money) to skyrocket.  Base money is the hard currency in circulation as well as reserves that banks keep on deposit at the federal reserve. I can still remember a clip of Glen Beck being circulated where he was climbing stairs to illustrate the heightened level of money on a chart.

False Alarm

Upon closer inspection, all that base money was being created it to facilitate asset swaps with the banks.  Banks simply traded in one government obligation they owned (US Treasury Bonds) for another (Federal Reserve Deposits).  Because the banks never really underwent any massive loan growth, we witnessed no explosive inflation in that decade (more on that later).

Today, the most alarming measure to monetarists (those that follow Milton’s monetary theories) is a rapid increase in our broader measure of money M2.  M2 takes base money and adds checking, savings and other highly liquid accounts that can easily be converted to cash (Personally I follow a private market measure called m4 which has shown similar trends). 

The relief efforts from the Pandemic were strong contributors to the M2 money supply shooting up.  We found all sorts of ways to helicopter money into economy. Heck, we even figured out how to get the banks to facilitate loan through the PPP program…by simply having the federal government guarantee the loan to the issuing banks. It remains completely possible that this increase in M2 represents a bona fide increase in money circulating in the economy and will translate into higher prices.  Its also completely possible that this threat is overstated. 

False Alarm Part Deux?

For one, M2 as a percentage of GDP has been rising for a couple of decades now but we have observed nothing but disinflationary trends.  We can thank many factors for these, including technological innovation, globalization, and more.  But in the end, a lot more M2 has not been enough to overwhelm these factors and create inflation. Also keep in mind a that M2 includes time deposits like savings accounts and money markets. How likely is it that this money gets spent and circulating? Time will tell.

For me, it all comes back to our fractional reserve economy.  One person deposits $100.  The bank keeps $10 in reserves but lends out $90 to a borrower.  Voila …..$100 in money supply turned into $190.  Oh, and guess what, when that $90 that was lent out gets deposited at their bank, that bank keeps $9 on reserve but lends out $81 to another borrower.  On the other hand, when a lot of money gets used to pay down debts etc., we might just wind up with reverse money creation. For me, both inputs (up and down) to inflation from M2 are completely possible. But, it’s unlikely to really crank unless bank loan growth takes off.  In a fractional reserve economy, banks create money…or in a deleveraging environment -shrink it.  Right now, we are just seeing modest loan growth at best. 

Shelter Costs – Clearly More Floor Than Roof

Shelter costs are the 800lb gorilla in today’s inflation discussion. Prices for homes have skyrocketed, but it will take time for rising housing costs to filter through the ways we measure inflation.  No doubt about it, current inflation readings are light on housing calculations and this component is headed higher in the months ahead.

Pump The Brakes on What We Think We Know

Once again, I come back to the reminder that we still don’t know that much about inflation – at least relative to how simple as it is conceptually.  Consider this quote from former Fed governor Tarullo:

“The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking”

That’s why I start with what the market is pricing in for inflation. It’s the sum of all fixed income investors expectations and today sits roughly at 2.5%. Again – forecasts are dismal and I find it important to keep myself humbled before trying to think mine will fare much better.  But I look at these factors above and have a hard time choosing sides at this point.  That’s not always the case, most of the past year it was clear to me the market was way offsides on inflation pricing (see here for why in post from 2020)

Invest Agnosticly

Regardless of what our forecasts call for, it’s imperative that on the investment side we stay nimble.  In our system at FEG, we are free to change uniforms from team inflation to team deflation at any time.  I don’t care if I think 5% inflation is coming…..if the trends and data suggest that I am wrong, at least for now, we’ll be buying up the things that perform well when inflation comes in light (staples, bonds, etc).  When trends change, we’ll swap uniforms and sign up with team inflation. We have worn both uniforms on the investment side over the past year.  Right now – consider me a free agent.

Taken collectively, I do not believe that the current levels of 4,5 or 6% (though possible) is sustainable and that we’ll moderate back into something normal like 2-3%. Nothing magical here, after all its just what the market says. 

What data or indicators comes to mind when you hear the words like “economic data”? We certainly have no shortage hitting our daily screens.  Indicators that range from:

• high frequency to low frequency (weekly or quarterly?)
• lagging to contemporaneous to leading (rearview or windshield?)
• collection methods (estimated or “real”)
  => Ultimately, this means they range from the useful to the useless. 

Over the last 20 years, I have boiled down to just a few that I formally incorporate into my process and evaluate on a regular basis.  This small list of indicators got an addition in 2020 with a data set I didn’t even know existed before the crisis.  Perhaps that is because the Fed did not begin releasing it to the public until then. First, a little background.

The biggest of all economic releases is the Gross Domestic Product (GDP) because it is a gigantic aggregation of all factors into the state of our economy. While extremely important as a yard stick of our overall economy – its usefulness to investing is minimal. At best.  After all, we are getting the initial estimate for the prior quarter – 30 days after it ended.  Additionally, it is heavily revised after that.  That doesn’t mean that markets won’t react to GDP releases, but I find it more relevant for Govt statistics and the history books than for making asset allocation decisions.

However, the Federal Reserve’s Weekly Economic Indicator is the new data set I added to my routine and just happens to be GDP based.  The difference is that it is a weekly indicator that is continually updated based on a set incoming data.  Data that has been found to be reasonably indicative of the level and direction of the economy and where the GDP will wind up.   Does the indicator accurately record data for the history books to report our GDP? No, not really.  However, it does give us a real time meter for which way the economy is heading ….and importantly when it may be turning.

For instance, its helpfulness can be seen during the recovery of 2020 as it never really wavered during its recovery.

Looking back, that continued recovery is obvious and set in stone, but at the time, a ton of uncertainty was slowly chipped away. There were fits and starts, but this key indicator just kept chugging along – week after week as our economy (our GDP) healed. Even when the virus entered its harshest winter season, things simply stalled.  The fact that it didn’t decline speaks volumes.

For the most part our FEG investment team maintains a pretty clear distinction between economic direction and stock market direction.  Accordingly, for data like this, we will be extra careful in guarding against the compulsion to translate into a forecast for the S & P 500 going up or going down.  But a solid economic read can be an excellent input for the characterization of the market and which areas should do well.  I would argue this continually strengthening economy meant a ton for broadening out the rally in later 2020 and so far in 2021.  By broadening out, I mean the more stocks going up as opposed to small handful.

Through late last year, the Russell 3000 was up 5% as shown on the chart below.  Yet, taking a broader view revealed that the median stock was still down 15%. 

Since that time frame, that median stock has been on fire.  I believe the economy’s continued recovery helped foster this condition.  And the Fed’s Weekly Economic Indicator was quite helpful in viewing this in real time. Some of our bigger companies can be positioned to do well despite the economic environment, but a large number of smaller ones need a vibrant economy.

While we can see a tremendous separation of stocks and the economy…. there is far less room for nuance in bonds. Stocks have widely variable outcomes, boards of directors and many other factors that can lead them to detach from the economy around them.  Bonds are contained to a more discrete and finite environment.  You know their death date, their income levels, etc.  In reality, the economy is their chairman of the board. So, this continually improving economy, seen in real time through this weekly economic index was invaluable in protecting against the rapidly rising rates they produced.

As with any indicator, we want to be careful about giving it too much weight and recognizing it for what it is; one input.   But it has proven helpful in this widely variable environment. And, unless you were at the right place at the right time, you may not have even heard it is out there.

It struck me as this post came to mind that most of what winds up on here on the “Hoosier Advisor” blog is another (very likely boring) bond dissertation.  That was almost enough to keep me from proceeding with this snoozer, but those reactions were overridden by the need to contribute something to the dialogue of this worst start to a bond year in nearly a decade.  2013 was a doozy for bond owners, and this year is so far on pace to well outdo the “Taper Tantrum’s” damage to bond indices that year.   45 days or so is not enough to build a narrative on, but its enough that it should get our attention.

2020 YTD

2013 same period

Writing so much about bonds means a few things:

1. Click counts will be few
2. Regular readers fewer yet
3. But, for those few remaining, I believe my voice can add value in this space

As the CIO for an RIA firm, my analytical duties are broad in nature: asset allocation, due diligence into alternatives, equity selection and more.  But where those broad duties go deepest for me is in the management of our bond exposures.  With a world so well populated with stock takes, I think I can fill in some gaps to help people out for bonds.  I say that as much out of years of experience from being an early adopter of ETFs for fixed income as I do for anything out of skill. Also, I can rest reasonably assured that a Reddit mania will not come along and render these thoughts null and void. 

Bond are largely mathematical beasts.  Much of that has to do with the nature of simply being legal contracts with an expiration date.  The issuer, or organization responsible for paying up to the terms of the contract carry many questions that are not simply mathematical. But bonds mostly move based on a series of math equations. So, back to the rough start to the year, one thing to understand is that if you are like the overwhelming majority and own your bonds through a fund that tracks the largest bond index – the Barclays Aggregate Bond Index – it is of the utmost importance to understand that your risks are higher than they were just a few short years ago. 

The math can be intimidating, but for most the bigger hurdle is not the math; it is simply getting past the terminology.  A lot of the math is complicated, but much of the big picture is straight forward.  The big term for the risk experience so far this year is duration, which simply measures how sensitive bonds are to changes in interest rates.  All the duration equation tells us is that if we wake up and interest rates are UP by X%…then (absent any other information) our bond would be DOWN by Y%.  For stocks, we can have an idea of what a down market would mean for the stock, but the “absent other information” is often a moot point.  “Additional information” for stocks will often dominate the day.  But, for bonds, the math usually wins the day.

This relationship that sits underneath most days is on display for the chart below.  Duration is measured in the lighter blue line and can be seen to be moving higher (6 on the right panel).  Meanwhile, the darker blue line is measuring interest rates on the index and have been moving ever so lower.  Together, they had been forming a toxic relationship of lower rates but with higher risks!

Take a quick glance at the charts above for AGG’s start to ’21 vs. ’13.  What makes this year a worse start? Well, the math said it would be worse if rates went up.  Rates have gone up a bit more this year, but the drop in prices to the AGG fund (and the universe pegged to it) has been more than double.

Keep in mind, small moves make all the difference for bonds.  They are in the portfolio to provide ballast and security.  So, these drops can be painful, and therefore, helpful if they can be mitigated.

One group in the crosshairs of this dynamic are lifecycle and target date funds.  I believe most of my RIA peers abhor these funds, and for good reason and I mostly agree with those sentiments. But I save some room for the place they play in some 401k plans where participants lack access to an investment advisor (which is still shockingly high).  But these lifecycle funds are loaded up on bonds that are indexed to the Barclays Agg AND have an investor base plowing money into the asset class as they age.  The chart below depicts a range of allocation in the lifecycle fund industry, but across the board they are meant to lower equities and increase bonds as folks age. 

The math was simply stacked against bond investors due to the underlying composition and levels of interest rates themselves.  A recovering economy coupled, with the promise of massive fiscal stimulus lit the fuse to blow up the start for the year.  If you are on your own with investing and have been in these crosshairs; as of the date of this publishing, I do not see any reason to panic or rush to get out of bonds. Bonds still play an important role – even if your access is limited to the big aggregate bond index.  Even though our firm has had fewer bonds over the past several months for some of the reasons mentioned above, I would not make any blanket statement that fewer bonds themselves are in order.  But it will still be time to pay very close attention as to how that exposure is garnered.   

I am writing this post to myself and sharing it with you.  This year has gotten a bad rap and for good reason. And while the inclination is to emphasize the turning of the calendar for a more positive outlook on life, that is a recipe for disaster should the positive outlook take some time to materialize (see Admiral Stockdale’s experience in Vietnam). Keep the faith, but keep it rooted in reality. In the meantime, this year has brought with it some major developments that we should not let get lost in the shuffle or lose sight of. This will not be a deep dive into any of these topics, but rather a list that I found helpful and at the topic of my mind as I was getting moving this morning.  In no particular order:

• Common European Union bond issuance:

The pandemic’s urgency produced a previously unthinkable result – the more formal tying together of European countries financial markets. Less than a decade ago, the prevailing wisdom was that a breakup of the union was eventually likely and perhaps imminent.  Sharing a currency while maintaining fiscal sovereignty proved disastrous (See Greece, et al). And while the US emerged from the 2008/2009 recession into the longest expansion in history, Europe double dipped back into recession early in the 2010s due to these fiscal limitations.  I will not even go as far as saying this was the right move or that every European will love this; but as investors, this is a positive paradigm shift for risky assets.  And it certainly sets them up for more flexibility and a better safety net for dealing with the next crisis.

• Asian trade pact (RCEP)

Most nations in Asia (including China!), as well as Australia and New Zealand, signed a trade deal in November.  The deal is far from perfect, and as with any trade deal – plenty will find themselves on the losing end.  However, the liberalization of trade is unambiguously good for economic growth in the region.  With time and new leadership perhaps the US, and later down the road, India, can sign onto the deal as well and compound this positive development.

• America awakens to lingering social injustices
  
  Again, I am writing this to me and sharing it with you. Taking the time to listen to the plight of others uncovered an alarming level of plight right under my nose. “The New Jim Crowe” by Michelle Alexander returned to the best sellers list and for a period – tough to find in stock on Amazon.  It clearly articulated what I have come to understand as this 4^th leg of social repair needed in the US.  Ending Slavery 1, Slavery 2 (why didn’t they teach us this in history class??), Jim Crow era I would consider the first three major legs with the mass incarceration / war on drugs the next one to soon fall.  

As this 4^th leg of repair begins to unfold, and it will, an increasing number of young black males will be offered more of the same opportunities as white ones to become productive members of society. It will be a long tough slog, but eventually (I have faith) turn into a virtuous cycle.  The virtuous cycle is that as more are allowed productive opportunities, communities will be strengthened, education funding improved and a stronger foundation for the next generation laid.  How great is that?!?  But that will only happen as more and more of us understand the problem.  But for today, let us celebrate at least that more eyes have opened out of the year’s travesties. Not much more than that punchline can be delivered in this brief post– I highly encourage reading “The New Jim Crowe” if you haven’t: https://www.amazon.com/New-Jim-Crow-Incarceration-Colorblindness/dp/1595586431 /

• We have learned to mine enormous amounts of our precious resource, time. No, not everyone that is currently working from home will continue to do so.  Yes, the death of commercial office space is certainly an overdone worry.  But there is no denying that many will reap the benefits from our mass adaption to more efficient communication.  Personally, a week of work from home saves me 5 hours a week.  That’s no small potatoes when each passing year has brought with it intensified competition for those 168 hours available each week.  I will not be keeping all of those going forward as returning to the office will be necessary for many important meetings, but a good chunk of them will.  Around the country, a lot of happy children will have a parent that can save that day of travel or two (at least here and there) for a meeting that they now realize would be just fine held virtually.

While on the topic of travel, odds are quite high that 2019 was the peak year in the world’s consumption of crude oil.  2020 brought a precipitous decline in demand and 2021 will see a rebound.  However, when you combine the miles saved by many fortunate workers (like me) with the persistent increase in alternative energy – its likely that the rebound in crude oil demand will fall short of those 2019 levels. And from there, face cheaper and cheaper alternatives. I am not a climatologist but have to believe this bodes well for our fight for our children’s healthy future.

These are not the only big items worth remembering, they are just the first ones that came to mind (leaving vaccine speed, sanitation habits, appreciation for people we will get to see and places to go when we can return to them, among others, to not lose sight of).  I do wish to remind myself that the lights on this dark winter are only beginning to dim.  But it too will pass, and we will emerge with all these positives right there under our noses.

Based on emails that hit my inbox, structured products (commonly structured notes), have grown in popularity.  In 2018, a study by Greenwich Associates found that sales of such products reached nearly $50B in the US and represent nearly 6% of all financial assets in financially savvy European countries like Germany and Switzerland. So, chances are good that a few of you reading this have or will soon consider structured notes. A little light googling will dig up some nasty things about these products….as well as some more glamourous portrayals.  Like most things, each contain a portion of the truth and can be good or bad depending on the individual circumstances in play. 

Without diving too deeply into the ins and outs (again, google will easily point you to the basic understanding), I’d like to paint the broader context and also explain why our firm has found good use for carefully designed notes in recent months. Briefly though, a structured note may be a fancy term but is simply a bond that is issued by a bank; but instead of a fixed rate of interest and a fixed payment at maturity – the interest and maturity amounts are contingent on market outcomes. These conditional outcomes are made possible by unlocking the power of options and providing investors a nonlinear investment experience.  Linear merely means that your investment results will mirror the overall market: market goes up by 10, you’ll go up by 10; market goes down by 10, you’ll go down by 10.  Options make nonlinear returns possible, where a market being down 20 doesn’t mean you’ll be down 20 (same to the upside). Structured products wrap these option solutions into a nice convenient and easy to understand package.

Structured product offerings hitting our email inbox are nothing new, it’s just accelerated in recent years. One reason why is a good one as it reflects the fact that the financial industry has been shifting towards the independent based advisor vs. the traditional brokerage house sales model.  (Disclosure: I am biased as such an independent fee-based advisor). Stock and investment brokers have their place with a well-informed clientele that need their services of delivering products for a commission.  But, the problem with structured products in a sales setting is twofold.  First, these products only make sense when considered within an overall financial picture.  In a sales setting, the broker is not necessarily considering the entire picture, they are delivering a product to you which YOU have presumably analyzed within your overall financial picture.  The second problem is that the products being sold are often issued by the very banks or institutions these brokers are licensed to represent.

Recent innovation has democratized this industry and adapted to better suit a world dominated by independent advisors – where the client’s overall picture is considered, and no commission is involved to interfere with sales motivation. I.E. an advisor is paid along the way for managing of assets whether those assets are in stocks, bonds, or structured products.  The innovation specifically is technology that connects advisors and their client(s) to networks of banks that can bid on notes custom designed by the advisor for their client (s).  Specifically, for FEG this innovation has been made possible through Halo Investing, Inc, but I must stop short of discussing any specific amounts or formulas embedded in our note designs.

The appeal to us at FEG lately isn’t based on rocket science nor is that much different from what has driven their broad appeal over the last decade or so.  Interest rates on bonds have plummeted and made it likely the total return from that part of the portfolio will be minimal for quite some time.  But that doesn’t mean we can just gun sling by exchanging less stability for higher returns in the stock market. Stability, at the expense of lower returns, has a role regardless of how low interest rates are. But when designed correctly, a structured note can be a nice complement to the core combination highlighting the stability of bonds and total return appeal of stocks.  Low interest rates have pulled down expectation for bonds everywhere.  But I would never argue that bonds have no place.  They still have a role that structured notes can’t play in terms of pure preservation.  To varying, but often large degrees, we must accept that the stability we absolutely need will just come with no return.  However, we are at a time when some creativity can go a long way to ever so slightly improve upon those results.  

At least part of the justification for going off and obtaining a college degree, I remember being told, was that college would help train you how to think and how to learn.  Rather than equipping you with skills that will be directly and immediately applicable to employment, a well-rounded liberal arts education was to prepare you to grow over the long haul.  Of course, college is more than that. The development of social networks, transitioning to life on your own – but with some training wheels that a campus provides – and learning how to be self-accountable for delivering results are all important.  Oh yeah, and the knowledge from course work shouldn’t be left out.  But a lot can be said for college simply preparing you for how to think. I can only speak for myself, but I believe this was all pretty much on point.  It was certainly true in the analytical field of economics (my major of choice).  An economics education instills a mental framework that prepares you for breaking a complex issue down into its various parts and isolating the individual pieces for analysis; something that has come in quite handy for a career in the investment industry.

Thinking correctly and mindset development wasn’t delivered with the diploma; it has been a career long mountain to climb. And I’ve yet to catch a glimpse of the top. This journey has required tons of reading in order to borrow from others who have learned and are sharing perhaps just an angle or two that they have mastered.  Howard Marks’s writing over the years has meant as much as any to me in helping to think better about investing.  Objectively learning lessons from experience – especially from the painful mistakes has been another big factor in chiseling away poor ways of thinking.  For me, long walks alone with my thoughts and creating a stillness of mind have had a positive impact. One simple example of how all those tools for the journey have converged and been necessary in order to correct thinking gone awry can be found in the quip to “buy low, sell high”.

 “Buy low, sell high” is so intuitive that it is easily grasped by all and so pervasive that we’re all but certain to hear it many times a year.  Yet, this tenet in an improper context is detrimental for making investment decisions.  Keep in mind, it has taken me reading from others and learning from mistakes for me to understand that. I still battle this concept in my head many times during a given year and work hard to clear it from the thought processes that lead to investments being made.  Sharing this in public print may seem a bit risky considering my job of allocating client assets. However, I firmly believe it is a good thing, not a bad thing, to be able to identify and admit to blind spots in order to continually improve the investment process.

To be clear, it isn’t that the spirit of buy low, sell high is wrong. I absolutely do want to buy assets that are reasonably priced. If it happens to be “low”, even better.  The problem is that it can interfere when applied too broadly.  For instance, what if we have a reasonably priced asset on our radar and it moves up to a new all-time high in price? If it’s at an all-time high, then it is easy to call it “high” and therefore at a place to sell, not buy.  After all, arithmetically it certainly is higher than it has ever been in price. However, one of the great ironies in investing, and one that makes the “buy low, sell high” mantra problematic is that all-time highs are safer entry points over time than all-time lows.  If this is a new concept for you, you may need to sit down and pause for that to sink in.  It is a shocking revelation when you first learn this truth.

Being at a fresh high is a signal that things are healthy. True, it may mean that you missed out on part of the appreciation, but it’s a clear sign that right now buyers have stronger hands than sellers of the stock.  Perhaps most importantly, at an all-time high – not a single person in the stock can be sitting at a loss.  Our primal instincts are to part ways with investments that are in the red, and no one is at a loss when the stock is at an all-time high.  My colleague Andrew Thrasher says this often and has been instrumental over the years in beating this into my brain that you want stocks that have nothing but blue sky above them.

Its true that at some point in time, sustained appreciation can eventually lead to “high” territory.  And in this way, “high” territory may depart from what has been a reasonable price.  At that point, a re-evaluation may reveal better opportunities elsewhere.  But it is NOT because it is at an all time high.  There are countless other things that involve being in the right mindset when making good investment decisions. This is but just one corner – but for me a very crucial one for making good decisions.

“Don’t let them try to upsell you
There’s a reason they make chocolate and vanilla, too”
~Sturgill Simpson in “Keep it between the lines”

This market has given every single one of us plenty of ways to be “wrong”, courtesy of swift reversals, multiple historical percentage moves and plenty of “we’ve never seen this before” circumstances.  It also has paid wonderful homage to timeless wisdom; accented by the quote from Sturgill Simpson above as a portrayal of the importance of having and sticking to boundaries.  (Musical side note – the entire album is pure gold once you read the excellent backstory on the brilliance which you can read here:https://www.rollingstone.com/music/music-album-reviews/a-sailors-guide-to-earth-205874/ ).

Though there were ample opportunities to be wrong, discipline to investment boundaries once again helped many be “right”.  And I don’t just mean discipline to stay invested at the March lows, I mean it for the discipline to have not gotten stretched too aggressively leading up to the February reversal. That sounds much easier now in retrospect now than it did with a market that was consistently trending higher at the time.  Discipline on both ends paid huge dividends and I am thankful to have our investment philosophy built around these principles.

If left purely to invest based on my own views and inputs, I am certain I would have missed a large chunk of this rally believing that the potential negative outcomes over the coming medium term remain underappreciated and undervalued (and conversely the positive ones being assigned too high of a probability). Here’s the thing; you can get wrong, stay wrong and then lose your confidence. In that case, even if the market works towards your view – you may not ultimately be there to be rewarded. Thankfully, I don’t support any such efforts that would invest around my whims.  Our investments are weighted by the measuring of value and the observations of trends and with teamwork to provide diversification in viewpoints.  (Another aside; I am beyond fortunate to have @AndrewThrasher as my daily partner in crime.  It’s one thing to have teamwork and another to have a player like Andrew on board).

Boundaries lead to natural diversification.  If you limit your bonds, you should own some stocks.  If you limit your stocks, you should own some bonds. I don’t condone just buying a basket of everything to check all the asset class boxes and believe your diversification work is done.  But I am a firm believer that investors must own enough (truly different) things to protect you for the times in which the cards go against you.  It protects you from being over exposed to or overly influenced by any one factor.  Which I whole heartedly believe applies to our country’s demographics as well.   

When thinking through these basic concepts for this article and being grateful for the discipline of diversification, I kept hearing echoes about the importance of these are great for our society as well.  Personally, during these past few weeks I have tried to do my best to be slow to speak and quick to listen.  I admit this is easier said than done on heated issues, but an abundance of listening is crucial for hearing the voices that need heard at this moment in time. I am thankful for all the positive influences around me that have been great leaders by example of this during this pressing time.

As challenging as this has been, I can’t help but to feel so much optimism for our future after seeing so many in our nation come together and fight for righteousness and justice.  A nation more divided than ever? I don’t believe it.  I see a nation finally coming together to stomp out the remnants of fires that have darkly plagued our nation for centuries.  We are finally going to put an end to police brutality and the disproportionate killing of black people.  The time is overdue, but here we are – together and united we stand.

I don’t want to dive too much into my personal background (shocker), but I have seen the ugliness of racism firsthand. (My school had a giant confederate flag painted on the wall until the early 2000s!!!).  Things as simple as a joke about our differences do nothing but perpetuate the divide.   It makes me sick to think what I might have said to whom as a young person.  I share this to say just how important it has been in my life to listen to others, particularly those much different than me.

I can remember vividly just a few years ago the days following Colin Kaepernick’s decision to kneel and protest the anthem.  The very next day I saw an acquaintance at a youth football game who just happened to be wearing the SF #7 jersey.  I went up to him and said “Man, you’re brave”.  He agreed once he knew what I told him what I was talking about with the kneeling.  At the time, I didn’t see the kneeling as a race issue and it did not sit well with me initially to see them kneel during the anthem.  That’s not the way I was raised.  But with a little active listening, I came to embrace and support the protesting players and why they were doing it.  From the comforts of my community, I was taught to stand for the anthem.  Meanwhile their community observations included the disproportionately killing by police. It was never about the flag or an anthem. Not then. Not now.

Boundaries around power and the importance of diversification has been crucial for surviving one of the harshest investment environments imaginable.  The same will be true for our country.  Different races and ethnicity bring strength to our national fabric. They will play an even much stronger role when given truly equal opportunity. You and I all aren’t going to agree on all the solutions, but I hope you will join me in enthusiasm for what lies ahead in our country.

I hate to add to the growing number of articles out there on negative interest rates (which means you pay, not earn interest on your money).  I’m not one usually to delve into popular topics broadly covered elsewhere, but interest rate policy is in my wheelhouse and believe I can add perspective to the topic, so here goes.

The concept of negative interest rates moved from academic theory to practice in various parts of the globe in recent years. Now the debate has heated up (and will continue for some time) in the US.  We have the President calling for them (Presidents always want lower rates), but the Fed chairman has been busy pushing back against the prospects of rate cuts in the US.  Fed futures market – where investors can bet on where rates will be in the future – recently traded at prices that indicate the next move move to be a cut from zero, not a hike.

A quick aside, I find our fascination with zero to be a little peculiar. After all, the difference between 1 and 0 is exactly the same as the difference between 0 and -1. So, on one hand I think it behooves us to remove this artificial and arbitrary focus on ‘0’.   On the other hand, I get the real-world practical limitations of having to pay someone to store your money for you*.  As an individual, you have the option of simply storing it yourself in cold, hard bills in the privacy of your home.

However, it is quite impractical for corporations and institutions to hold their cash in actual bills versus bank deposits to avoid a negative interest rate. Using data from the Federal Reserve and Statista, institutions hold roughly 30% of the nation’s M2 money stock.  But we can extend the storage impracticality to the American wealthy whom hold the lion’s share of cash that is in the hands of private individuals (which has had sad and devastating recent impacts during this crisis as so many have been unable to accumulate even just a minor reserve).  But for those that do have large savings, it’s one thing to store a few hundred or thousand dollars under your mattress, in your freezer or in a safe (all of which are exposed to risks like fire and theft), and quite another when you are talking a few million or billion. 

This isn’t a case for negative interest rates just yet.  Rather, it’s about crafting a more useful way to think about them.  A more useful framework, that, given more time and widespread understanding may make them more of a reality here in the US. The main component necessary to frame the role of negative rates is to shift the focus away from the stated or “nominal” interest rate and towards the real rate, which is adjusted for inflation. Unquestionably, the real rate is the primary focus of the Fed.

The chart demonstrates how persistently the Fed pursued a negative real interest rate policy until late 2018/2019. This shift naturally brought about economic slowdown concerns, long before we ever heard of novel coronavirus (recall the inverted yield curve last year?).  In effort to help stem this crisis, the Fed abruptly shifted back to a negative real rate.  But here is their current challenge: current price trends are deflationary.  Using the current PCE inflation rate of 1.7% (notably as of March 31^st), the Fed has pushed rates back into the negative real territory they occupied through much of the expansion. But that doesn’t tell the complete picture.

Using the core PCE inflation rate means using stale, backward looking data. I find it helpful to incorporate the market’s prevailing forward view on interest rates as well, specifically using 10-year breakeven spreads (a couple of prior posts dive into the explanation of this difference so I won’t repeat here).  This is a crucial view for periods like this one where the market quickly develops a view of the future that looks different than the current view.  For the next 10 years, current treasury markets are baking in roughly a 1% inflation rate.  I also wrote about this in March and avoiding panic reactions based on the extrapolation recent trends (which our brains are wired to do).  The current 1% forecasted inflation rate incorporates this period in the short run that is destined to be a pretty strong deflationary shock and then presumably a period of modest price recovery. When we sub in these 10-year expectations as a proxy for calculating real rates in the chart below (orange), we can see expected real rates are still firmly above the levels seen during most of the 2010’s.  We would need either a) a much stronger pickup in inflation expectations (which will likely take some time) or b) a cut of interest rates firmly into negative territory.

Now, given the Chairman’s continued push back to negative real rates as recently as this week, a cut of overnight rates into negative territory will be a long time coming.   It would likely take a sustained period of such stubborn inflation expectations.  Long before a change in rates, we would very likely see a thawing in not only the Chair, but also other FOMC members’ language as well. Now here is the kicker, before that, as we have seen time and time again the market itself will likely beat them to the punch and be pricing in such a scenario.  These implications would continue to ripple loudly through the bond markets.

*Technical issues for financial institutions also arise but well beyond the scope of this article. 

I was recently asked questions about what the IMF is and what debts do we the US owe to the IMF? I share my reply here:

To explain the International Monetary Fund (IMF), it is helpful to understand its beginnings. The IMF was established, as well as the World Bank, during one of the most important set of meetings in world history: those in Bretton Woods by 44 nations in 1944.  Those two organizations have different functions, but both serve towards the common goals central to those meetings of fostering stability in exchange rates and in the global economy.  Though the framework of currency exchange stemming from Bretton Woods has long since collapsed, these organizations remain with us today.

Coming out of World War II, these 44 powers knew they were in a different world.  A world that was going to be more linked with one another and therefore benefit from greater levels of coordination. Keep in mind the time frame where, in addition to going through a major World War, the nations were also exiting a decade where they learned the devastation that can come from isolation and halting trade from one another.

From a practical perspective, the IMF is funded by member countries (now 189 strong) who contribute to the fund and receive Special Drawing Rights (SDR) – which are a quasi-currency.  As of March 2019, the IMF’s total resources are about SDR 975 (about $1 trillion). The fund is there to assist countries who essentially are in crisis and make low interest loans to the poorest of countries. Besides their role in fostering stability in global exchange, they have the duty of helping to coordinate policy among member nations.  That may sound a bit like herding cats, and it is. But in times of extreme stress like we have seen recently, the $1T of firepower can provide some comfort against thoughts of the worst of the worse outcomes.

So, the US doesn’t owe the IMF money from a debtor’s standpoint, instead we contribute our portion based on quota formulas to keep the fund alive and kicking. If the topic interests you, I highly recommend “The Battle of Bretton Woods” by Benn Steil.  It is a fascinating (to a money nerd) read that pulls heavily on personal narratives of the central characters behind the scenes of the meetings and is crucial to understanding the US & Britain’s respective roles in the world ever since.  

Sources:
IMF.ORG
Brettonwoodsproject.org

Adam Harter, CFA

Earlier this year, I opened up and talked about my personal path and how I got here. A few weeks later I ask just where in the hell “here” is. On one hand, consider me thankful for being four decades ahead of the curve on social distancing and also thankful for living in such a geographically sparse location.  But we are far from excluded from the pandemic, all the associated concerns, and undoubtedly just days away from confirming that state of Indiana is infected with the virus from corner to corner.   

You all know where we are with stocks, so I will skip right over that (this was never intended to be an outlet to keep people posted on financial market status, but rather what is hopefully some helpful context from time to time from my view of the financial world). But, beyond the carnage in the stock markets, I point you to what has transpired in the market for government inflation protected bonds.  This sleepy little corner of the market paints the gloomy picture of what financial market participants have come to project. 

Investors have two choices when purchasing a government bond.  She can buy one that is completely fixed in nature or one that is protected from inflation (but the cost of that protection is a smaller interest rate).  The difference between these two rates provides a pivotal piece of information (called the breakeven spread) for financial market participants, including the Federal Reserve which watches it very closely.

As you can see in the chart, this figure has had a recent tendency to be in the vicinity of 2%, which should make sense, given that actual inflation rates have also been in that territory.  But the recent bloodbath in markets has taken break even spreads to nearly 0.5% at one point.  This suggests that the market has come to forecast an inflation rate of 0.5% for the next 10 years.  A projection that is so startling because it is almost 1% lower than any rolling 10-year period in the post WWII era!  This harsh view gives ample motivation for the Fed to do whatever it takes (including adding zeroes to the stimulus checks coming) to at least restore those expectations. 

It’s a devastating blow to have such a stark mentality. And here is the essence of why: the mentality itself can slow things down.  A large chunk of how we measure inflation is going to be comprised of things that are for the most part stable and consistent risers (cell service, health care, housing, utilities, etc.).  So, for the overall inflation expectation to be so low, it is signaling the belief that more discretionary purchases will be falling rather sharply (cars, electronics, etc.).  What do people do when they believe prices are falling? They wait.  What happens when people wait? A negative feedback loop commences and is difficult to stop. Again, I say, this stunning drop has the Fed’s attention (among the more immediate financial market concerns) and they will wage war.

I mentioned briefly above the words “among other things” that have the Fed’s attention, which it turns out, are no small such things.  Those concerns are the crucial facilities that function as the mission critical pipelines of our financial system (such as the commercial paper market).  I am not going to go into a deep dive into those here but if you are interested and have not yet, I encourage you to further investigate one of the many good write ups on those markets.  I only point them out to mention how crucial the Fed actions were this past Tuesday (3-17-20).

Yes, the big headlines were the big 1.5% drop in Fed controlled interest rates in the two steps taken between their formally scheduled meetings. That caught investors by surprise and their doubters are correct that the Fed can’t save us from a virus or even a recession. However, the Fed knows (knew?) that massive amounts of support are (were?) needed in the financial system from this becoming a crisis. But the rate cuts were only the appetizer. What they did Tuesday was the (five star in my opinion) main course with 2 key entrees (both essentially from precedents set in the great financial crisis).

These two actions were: a) Allowing more securities as collateral (which prevents banks from having to sell riskier stuff to gain funding) and b) By jumping all in as essentially THE bank to keep American corporations liquid and functioning.  In the coming weeks – I believe it quite likely that at least these key markets will become functional. As functional as we’d like? Time will tell, perhaps not. But I see the odds in their favor of thawing the most crucial of markets. Keep in mind this thawing, should it occur, is no guarantee to have an immediate positive impact on stocks, or the economy, but I do have a higher level of confidence that the bond market returns to normal which is needed above all else (in finance) to keep us in the game for a future recovery.

My investing thoughts from here:

1. Don’t try to be perfect. I mean this in a backwards sense as you take stock of where you are.  In most cases, I’m sure you can find some things that went well and some things not so much. Hopefully there is enough positive with which to hang your hat.  If not, don’t beat yourself up. But also don’t lose any golden chances to learn and how to improve going forward.  Now is not the time for any big changes, but it is the time for big lessons.   I also mean not seeking perfection in a forward sense either.  It’s a messy business, so don’t waste energy trying to either to time the bottom or avoid all future losses. Investing takes place between the ears, and that will likely take some grace and wiggle to ourselves.
2. Survival – it’s the core purpose of our lizard brain for a reason.  You must take care of survival first and make sure to have enough cash and resources for the weeks/months ahead.  Hopefully, you have been planning for days like this and stayed maintained that readiness.  Remind yourself of this and the steps you took to survive. If you are behind the 8 ball, again, be kind to yourself but you don’t have a choice – it is never too late to have yourself set up first for making sure you make it through this crisis.
3. Make no mistake about it – this is a great time to invest (not to be misinterpreted as a 0% probability of future loss). I’ll even give you a couple of examples to hang your hat on.  Examples that are in stocks, but plenty have recently emerged on the fixed income side as well. For anyone with excess liquidity, this is one of those rare times where you can make a shiny penny supplying the fixed income market with liquidity (again for brevity sake, sparing the gory details).

Don’t forget steps one and two.  This is a crisis with no precedence.  It has unknowns to all of us. But you also won’t get a “save the date” in the mail letting you know when a bottom is going to occur in financial markets.