James Montier Explores "The Possibility Of No Mean Reversion"
From Jamies Montier of GMO (pdf)
The Purgatory of Low Returns
This might just be the cruelest time to be an asset allocator. Normally we find ourselves in situations in which at least something is cheap; for instance when large swathes of risk assets have been expensive, safe haven assets have generally been cheap, or at least reasonable (and vice versa). This was typified by the opportunity set we witnessed in 2007.
Likewise, during the TMT bubble of the late 1990s, the massive overvaluation of certain sectors was offset by opportunities in “old economy” stocks, emerging market equities, and safe-haven assets.
However, today we see something very different. As Exhibit 2 shows, today we see something very different. As Exhibit 2 shows, today’s opportunity set is characterized by almost everything being expensive. As I noted in “The 13th Labour of Hercules,” this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.
The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009 (bold emphasis added):
A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
Market participants have (at least until the last month) reacted to this situation by “reaching for yield” as witnessed by the more detailed fixed income forecasts in Exhibit . This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices. The bad news is that reaching for yield rarely ends well.
Of course, like all of our published forecasts, the forecasts for government bonds and cash assume mean reversion...
The Possibility of No Mean Reversion!
As regular readers will know, we at GMO are stalwart supporters of the concept of mean reversion in general. However, if ever there was an economic case for a question mark over mean reversion, it is surely with respect to cash rates and bond yields. The simple reason behind this seemingly heretical statement is that rates are (can be) policy instruments. As Keynes noted, “The monetary authorities can have any interest rate they like… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right… Historically the authorities have always determined the rate at their own sweet will.”
We are all used to thinking of central banks as setting the short-term interest rates, but generally the long rate is seen as a market-determined rate (i.e., some combination of market expectations of future short rates, liquidity preference, and risk premiums). However, there is nothing to stop central banks from setting the long rate as well. Indeed, in the past they have done exactly that (e.g., the UK during World War II had a target of 3% for bond yields). So bond yields can be an outright policy instrument too.
The Myth of the Bond Vigilantes
When I’m talking to people about this, it is at this point that someone usually brings up the bond vigilantes: surely these guardians of monetary and fiscal rectitude will step in. However, for a nation that can print its own currency and has a floating exchange rate, bond vigilantes are a myth – an economic bogey man made up to scare recalcitrant governments into “good” behaviour.
Just imagine that I as a foreigner decide to sell my holdings of U.S. government bonds. If the Federal Reserve stands ready to buy at the same yield at which I sell, there will be precisely zero impact on yields, i.e., I sell at, say, 2.5% and the Fed buys those same bonds at 2.5%. The only impact is that the dollar will go down against the pound as I switch from holding a dollar asset to holding sterling.
This, of course, assumes that the central bank targets price (i.e., has a desired bond yield) and doesn’t care about the exchange rate. As an aside (to me, at least), one of the oddities in the process of quantitative easing is that it is “quantitative” rather than price-based. Presumably, the Fed and its brethren think they can do more than simply lower rates by using the “quantitative” approach. I’m just not sure what. To me, a combination of a price/yield target for treasuries and a quantitative easing policy for other assets (such as MBS) would be the easiest and most logical way to move beyond the zero bound on short rates. A price target is certainly easier to exit as you simply raise the yield target to your new desired level. The good news is that policy making is well above my pay grade!
The Myth of the “Natural” Rate
An alternative argument that gets put forward is that the Fed can’t really set any rate that it likes because, ultimately, it must respect the “natural rate of interest.” One should always be suspicious of the word “natural” in the context of economics. It tends to imply some semi-divine concept, yet there are essentially no natural laws in economics.
The concept of the “natural” rate dates back to early monetary theorists but was given maximum exposure in the works of the Swedish economist, Knut Wicksell. However, there are several arguments that I find compelling and believe cast serious doubt on the concept of a “natural” rate of interest. The arguments over the existence of a natural rate of interest are generally what can only be described as “wonkish” and thus I won’t subject the reader to an elongated discussion here. For those (geeks, nerds, and anyone with trouble sleeping) who are interested, I’ve written a wonkish addendum to this piece called “Wicksell’s Red Surströmming.”
Rather than a single, divine “natural” rate, I’d suggest it might be more helpful to think of a range of neutral or consistent rates. (As Keynes put it, “It cannot be maintained that there is a unique policy which, in the long run, the monetary authority is bound to pursue.” For instance, a price stability consistent interest rate might be defined as the rate of interest consistent with stable prices (akin to inflation targeting, the darling of central bankers around the globe), a full employment consistent interest rate would aim to reduce unemployment to levels that were essentially frictional, and one can easily posit a financial stability consistent interest rate that kept financial markets well-behaved.
The chance of these various rates all coinciding is essentially zero. Trying to achieve all three outcomes with a single policy instrument (short-term interest rates) is likely to be an impossible task. Thus, some political guidance as to the relative merits of the various objectives is needed, or more instruments available to be called upon.
This, of course, simplifies away from the problem of actually knowing what these various rates are. What level of rates ensures price stability? What level of rates ensures full employment? And so on. This is certainly well beyond my ken, and I suspect an unknown for the central bankers as well. To really add salt to the wound, these various rates are highly likely to be time-varying as well. Hence, trying to identify any one of these rates is akin to looking for a needle in a haystack, with the added complication that someone keeps moving the entire haystack!
Fixed Income Forecasts in a World without Mean Reversion
The bottom line is that it is perfectly possible that the Fed, et al, could hold rates down (at both the long and short end) for some prolonged period. This is obviously an exceptionally bullish case for bonds (in fact, I’d argue it was the “best” case outcome that could reasonably be expected, absent a strongly deflationary viewpoint).
It is easiest to see how this would play out by thinking about the buy and hold return to owning a 10-year treasury. Currently, such an investment yields around 2.5% p.a. in nominal terms. If we were to hold such a bond for its lifetime, then we would simply end up with a real return equal to the current yield minus the inflation rate (say, 2.3%), i.e., close to a zero real return.
However, as noted above, if we pursue a constant maturity strategy (i.e., when our 10-year bond becomes a 9-year bond, we sell it and reinvest in a new 10-year bond), a rolldown return is created (assuming a normal upward-sloping yield curve). This would translate into a 7-year forecast in an identical fashion to that noted earlier and as represented in Exhibit 7. Effectively, rather than the -0.20 bps forecast we see under the baseline assumption of mean reversion, we would get a forecast of 2.2% p.a.
This might seem like a reasonable rate of return. However, it only holds if and only if the Fed keeps rates unchanged in real terms over the next decade. As I showed in my previous work on equities under financial repression (“The 13th Labour of Hercules”), the way you behave and your estimates of return are driven by your expectation of the duration of financial repression.
However, as I also pointed out in previous musings on financial repression, as far as I can tell, no one has any real idea how long the Fed (and others) will keep rates low. The market’s implied view has certainly changed radically over the last six months as Exhibit 8 shows. In essence, the Fed spoke of “tapering” and Mr. Market heard "tightening."
For what it is worth (and I assure you it isn’t a lot), I think that given that the Fed merely mentioned the possibility of tapering its quantitative easing policies, this seems like a probable over-reaction, especially since the Fed is explicitly following a so-called “Evans Rule” and is committed to keeping policy easy until the unemployment rate reaches 6.5% (currently at 7.5% with low participation rates) or inflation (based on the PCE) exceeds 2.5% (currently at 1%). A tapering of the quantitative easing policies seems like a very different thing than the Fed embarking on an explicit interest rate tightening cycle.
Given the massive uncertainty surrounding the duration of financial repression, it is always worth considering what happens if you are wrong. In owning treasuries under the assumption that the Fed holds real cash rates negative, you get the roll return as above, but this could be described as a “pennies in front of a steamroller” style strategy. It is always possible that the Fed could decide to step away from the market or normalize real rates and you would end up with a return more akin to the baseline mean reversion forecast we presented above. You are effectively running a strategy that potentially has significant tail risk embedded within. One of the most useful things I’ve learnt over the years is to remember that if you don’t know what is going to happen, don’t structure your portfolio as though you do!
The bottom line is that treasuries offer low returns under most scenarios. If the Fed steps away from the market and normalizes, you get a negative return; if the Fed stays in the market, you get a pretty low return. You are pretty much doomed either way. The only scenario under which treasuries do “well” is one with outright deflation! In essence, in the absence of a strong view on deflation, you neither want to be long, nor short, treasuries. You just don’t want to own any.
The Purgatory of Low Returns
Of course, bonds aren’t the only low-returning asset class. As Exhibit 2 showed, the current opportunity set according to our forecasts is generally not compelling. To us, both bonds and equities generally look to be “overvalued.” Those focusing on the “attractive level of the equity risk premium” potentially fail to recognize this situation.
If the opportunity set remains as it currently appears and our forecasts are correct (and I’m using the mean-reversion-based fixed income forecast), then a standard 60% equity/40% fixed income strategy is likely to generate somewhere around a paltry 70 bps real p.a. over the next 7 years!18 Even if we used the non-mean-reversion-based forecast, the 60/40 portfolio looks likely to generate a lowly 1.7% p.a. real. Thus, if the opportunity set remains constant, investors look doomed to a purgatory of low returns.
So what is an investor to do? I believe there are at least four (possibly not mutually exclusive) paths an investor could go down to try to avoid this outcome:
(i) Concentrate. Simply invest in the highest-returning assets. This is obviously risky as you become dependent upon the accuracy of your forecasts, and right now nothing is outstandingly cheap so you are “locking in,” at best, fair returns (assuming you wanted to have a portfolio that was 100% invested and split between, say, European value and emerging market equities). You are, however, giving up the ability to rebalance.
(ii) Seek out alternatives. This meme had been popular until the GFC revealed for all to see that many alternatives were anything but alternatives. True alternatives may be fine, but they are likely to be few and far between.
(iii) Use leverage. This is the answer from the fans of risk parity. Our concerns about risk parity have been well documented. As a solution to a low-return environment, leverage seems like an odd choice. Remember that leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one (by forcing you to sell at just the wrong point in time).
(iv) Be Patient. This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted20 returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.
Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a re-pricing (witness the market moves in the last month). Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”
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