Financial Retraction Ahead?
James Mackintosh of the FT reports, Wolf’s frustration bodes ill for investment flock (HT: Pierre):
Druckenmiller, one of the masters of the investment world, this week
announced his retirement saying that he had become frustrated over the
past three years with his inability to make outsize returns.
30 years running Duquesne Capital Management – while also spending
time with George Soros, when he helped make $1bn on Black Wednesday by
forcing the pound out of the European exchange rate mechanism – he is
due some quality time with his fortune.
He is not, however, alone in
his frustration. Fellow managers of “global macro” hedge funds, which
bet on currencies, bonds and equity markets, have been having a rough
time this year. In theory, the wild swings in the value of the main
currencies and dramatic shifts in government bond yields should be the
perfect environment for macro managers.
practice, it turns out that even the smartest investors find these
markets hard to navigate. By the end of July this year, the average
macro fund had lost 1.2 per cent, after small gains last year, according
to Hedge Fund Research. By contrast, global equities are down 5 per
cent since January, while US 10-year Treasury bond investors have made
about 10 per cent.
Behind the poor returns for the modern masters
of the universe lies one of the biggest concerns investors face:
uncertainty. Ben Bernanke, chairman of the US Federal Reserve, warned of
an “unusually uncertain” economic outlook in July and since then
pretty much everyone has come around to the same view. This lack of
clarity has further split an already unusually divided investment
Think of investors as a flock of sheep, all tending to
move in vaguely the same direction, with the flock as a whole moving
relatively slowly. There are always a few black sheep in the corner of
the field ignoring the rest, and some lambs gambolling away from the
flock. But the bulk of investors huddle together for safety, and rush
to join the rest if they are left behind.
Today, the field is
more spread out. The flock is smaller and there are far more investors
heading out on their own. One group has headed off to join the
permabears – finally getting airtime for their deflation forecasts – in
the corner, while another group, led by big hedge funds, has barbecued
the lambs and buried its assets in gold to protect against inflation.
The shrunken flock now spends its time rushing from the deflation crowd
to the inflation huddle, creating a binary market far more sensitive
to economic data than in the past.
The scale of this change can
be seen in the inflation options market. Back in January 2008, British
investors thought there was less than a 10 per cent chance that in six
to seven years we would have either deflation or inflation of more than
5 per cent (measured on retail prices). That combined probability now
stands at more than 30 per cent.
the less-developed US options market, the risk of consumer price
deflation in three years is priced at 23.7 per cent, according to Royal
Bank of Scotland calculations. Yet there is about an equal chance of
inflation of 4 per cent, more than double the Fed’s unofficial target,
suggesting investors are even more divided in the US than in the UK.
In statistical speak, the distribution of investors now has fat tails. This has profound implications for investment.
most significant effect of the uncertainty is the “risk on/risk off”
trade. For three years, any given day in the markets could be seen as a
day when people wanted risky assets – equities, emerging markets
currencies, peripheral European government bonds – or wanted safer
assets, such as the yen, US Treasury bonds, British gilts or German
Bunds. With more people taking extreme positions, the markets swing
further and faster than usual.
With this comes short memories.
Markets always look to the future but the impact of any given piece of
economic data suggests investors have, to mix the metaphor, developed
goldfish memories. The latest news seems to trump less recent data, even
if it covers the same period – and much of it is likely to be revised
heavily in future.
For now, the bond markets may be right that
the global economy is heading downhill rapidly. Economic data from the
US have been terrible, with this week’s jobless claims hitting 500,000
again for the first time since November.
will not take many signs of green shoots, however, to have the sheep
rushing back across the field and bond yields jumping, just as they did
in 2003; bond investors will need to be nimble to avoid getting left
behind if this happens.
Mr Druckenmiller was more likely to run
with the wolves than the sheep. If even he cannot make serious money,
lesser investors should beware.
It's not just
Mr. Druckenmiller. Paolo Pellegrini, the hedge fund manager who was
instrumental in John Paulson shorting the subprime mortgage market, reportedly is returning money to outside investors:
He will continue to manage internal money at his hedge fund firm PSQR Management, according to a report in The New York Times.
he earned billions for his former boss, John Paulson, by deducing that
soaring housing prices in the 2000s were a true bubble, PSQR’s
flagship fund was down 11% through July, The Times said.
And on Monday, Warren Buffett's semi-secret stock picker, Lou Simpson, announced that he is retiring at the end of the year after a long career at the helm of Geico's investment portfolio.
Meanwhile, Prem Watsa, the "Oracle of the North" who runs Fairfax Financial, is preparing for what he perceives to be the next big risk:
in its second-quarter results, Fairfax revealed major shifts in its
$22.6 billion portfolio. First, the company increased its short
positions on the general market to hedge 93% of its equity portfolio.
It shifted nearly half a billion dollars into long-term U.S. Treasuries
Most disturbing of all, Fairfax purchased $23 billion worth of protection (notional value) against the threat of deflation in the coming 10 years.
move points to a similar prognosis: slow U.S. growth, intermittent
deflation, and a generally poor environment for common stocks. It is
noteworthy, too, that Fairfax became worried and implemented its short
hedge at an average S&P 500 price of 1,063 -- slightly below where
it trades today. Seeing such a great investor turn bearish is a
Before you liquidate your portfolio, keep in mind that as an insurance
company, Fairfax is playing by a different set of rules because they
have to manage their assets and liabilities more carefully than most
Moreover, equity and related investments still
represent more than 20% of the portfolio, while cash and Treasuries
make up a more modest sum. Prior to the financial crisis, Fairfax held
more than half its portfolio in Treasuries and cash, and it was much
less willing to take on equity risk. Now, its portfolio is only a
quarter Treasuries and cash. And while the company has been cutting its
exposure in equities, it has maintained its large position in two
companies: Johnson & Johnson (NYSE: JNJ), and Kraft (NYSE: KFT). They also do a large percentage of their business abroad.
one wonders why are well known managers retiring and others reducing
their risk? Economic uncertainty remains the single biggest factor
weighing on all investors which is why Raghuram Rajan, the IMF's former
chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed:
Interest rates near zero
risk fanning asset bubbles or propping up inefficient companies, say
Rajan and William White, former head of the Bank for International
Settlements’ monetary and economic department. After
Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start
increasing his benchmark rate by as much as 2 percentage points so it’s
no longer negative in real terms, Rajan says.
are not a free lunch, but people are acting as though they are,” said
White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and
now chairs the Economic Development and Review Committee at the
Paris-based Organization for Economic Cooperation and Development.
“There will be pressure on central banks to follow an expansionary
monetary policy, and I worry that one can see the benefits, but what
people inadequately appreciate are the downsides.”
Rajan will have the chance to make their case at the Fed’s annual
symposium in Jackson Hole, Wyoming, this week. In 2003, White told
attendees central banks might need to raise rates to combat asset-price
bubbles. In 2005, Rajan, 47, said risks in the banking system had
increased. They were met with skepticism from then-Fed Chairman Alan
Greenspan, 84, and Governor Donald Kohn, 67.
doubt Mr. Rajan and Mr. White will persuade the Fed to raise rates
anytime soon. As I've repeatedly stated, the Fed's policy is geared
towards big banks, allowing them to borrow at zero to purchase
higher-yielding Treasuries (locking in the spread) and to trade risk
assets all around the world. Basically, it's reflate and inflate your
way out of this mess, which is why we have a wolf market that's scaring small investors out of stocks into bonds.
Will economic uncertainty persist and are bonds really in a bubble? If
you listen to David Rosenberg, Chief Economist & Strategist at
Gluskin Sheff, financial retraction is ahead (watch interview below).
Moreover, there is no shortage of US Depression data.
there are some positive signs worth mentioning too. In his latest
weekly comment, Yanick Desnoyers, Assistant Chief Economist at the
National Bank of Canada wrote the following comment:
The On a more positive note, the level of labour productivity in the U.S. seems to have hit a wall in the short term. For
Q2 real GDP data published this past July 30 came with a major
revision of historical data by the Bureau of Economic Analysis (BEA).
The economic analysts of the world were slack-jawed by the
disappearance of $100 billion from U.S. GDP for 2010Q1. Consumption
alone was revised down $134 billion. As a result, instead of being in
expansion territory, it turns out consumption is actually only midway
up the recovery curve. As the level of resource utilization in the
economy as been pegged back, this implicitly modifies the impact of
past monetary easing by the Federal Reserve.
the first time since the start of the recession, the composition of GDP
growth has been geared towards employment rather than productivity. This said, if the unemployment rate does not begin to trend down, the Fed will have no choice but to step in once again.
On a more positive note, the level of labour productivity in the U.S. seems to have hit a wall in the short term. For
Indeed, US productivity fell unexpectedly in the second quarter
for the first time since late 2008, suggesting that productivity is
reaching its limits. And with temporary employment picking up and
leading full-time employment, a turnaround in the US labour market might
be materializing (click on chart above).
If job growth doesn't pick up, expect the Fed to step in and do whatever
it takes, including outright purchases of stocks, to reflate and
inflate out of this mess. And if these policies fail, more people will
be forced on a diet of macaroni & cheese. Come to think of it, maybe
Kraft is an excellent investment for these uncertain times.