Blondie: "If you shoot me, you won't see a cent of that money."
Angel Eyes: [frowning] "Why?"
Blondie: "I'll tell you why." [He kicks the coffin lid open] "Cause there's nothin' in here!"
A scene from the movie The Good, the Bad and the Ugly released in 1966.
There is so much talk of deflation taking over the world that I thought it a good idea to explore the good, the bad and the ugly of the potential beast and to see just how precarious the situation has become.
First let's look at the good. In certain cases deflation can help an economy particularly when the deflationary pressure comes from either technological advances or temporary pricing shocks. With the oil price decline the relief that the consumer in the United States is feeling is a definite plus and akin to a tax break; it is putting much needed dollars into consumers' pockets and this is starting to have the effect of jollying along the economic recovery. This is good deflation as it allows the Federal Reserve to let it run while reaping the benefits of accelerated economic growth. In the case of the United States as the consumer makes up roughly 70% of the country's GDP more money in their pockets can really help. Now the reason that this kind of deflation is good is because it is temporary. The oil price relief will not last as even if the price remains low for an extended period the benefit will eventually be lost to other inflationary forces such as rising taxes, medical and insurance costs, food expenses and the like. So while the immediate reaction is to fear for deflation, this kind of deflation is just what the United States needs right now.
Next is the bad kind of inflation and this brings me to the quote above. Change the names of the characters from Blondie to Consumer and Angel Eyes to the Federal Reserve and you can see my point. Should the Federal Reserve jump to the conclusion that deflation is here and it needs to be contained then they will raise rates prematurely. This raising of rates will destroy any benefits received from the good deflation effectively killing the Consumer. Once the Consumer is dead spending curtails and the result is that deflation then takes a firm grip. Once it moves from temporary to longer term it has now become a problem and has now moved into bad category.
Finally the ugly part of deflation is that once it turns bad it can be next to impossible to extricate the economy out of its clutches. In the case of Europe and Japan deflation there is ugly. In Europe deflation has been caused by government austerity and requirements imposed by the EU. By not allowing the rules to be bent in the face of adversity the very rules themselves have driven Europe to the brink of deflation without giving it the tools to extract itself. More austerity means worse conditions and an acceleration into deflation's black hole. As I showed last week yields on large swathes of European debt have already turned negative and even this is not helping. Also as we have seen in Japan, once in a deflationary spiral it can take decades to extract oneself and even now, after trillions of Yen have been spent, the results are still miserable. This is the ugly side to deflation, once it takes hold investment and spending shrivels while the mountain of debt remains intact eroding future investment and crimping the economy further.
The key right now is for the Federal Reserve to realize that it holds the global economy in the palm of its hand. The only bright star in the global economy at present is the United States consumer who is benefiting from lower prices at the pump and low interest rates. Raising interest rates too soon (as it is hinting) will kill the consumer pushing the entire world into the deflationary abyss. My hope is that they are smarter than that and even though history has not shown them to make the wisest decisions I still fully expect rates to remain low for the rest of 2015. Even Angel Eyes worked that one out!
Friday, February 27, 2015
Friday, February 20, 2015
Paying to Play (or Losements)
"A nickel ain't worth a dime anymore." - Yogi Berra
In the investment world, paying to play is synonymous with pretty much all investments - you have to put up the money to buy and pay the broker to cross the transaction with the seller. Both of these require you to pay up and then you are playing the game. After that you expect that the investment will produce a return commensurate with the risk - the risk free rate of return plus the risk premium, If you do an exceptional job then the total rate of return exceeds the expected return earning the investor so called Alpha or return in excess of the risk of the investment.
In the world of loans and bonds the investment is relatively simple, lend the borrower money, write down the terms of the investment which include the interest rate, monthly payments of principal and interest (or sometimes interest only) and the date at which the investment matures. During the term of the note, particularly if it is to a high quality borrower, things pretty much go according to plan and at the end of the term the money is freed up to invest in the something new. Nowadays though not only are the bond investors paying to play but they are paying to lend! A nickel sure ain't worth a dime anymore Yogi!
While this phenomena has not yet reached the shores of the United States, in Europe and Japan government bond yields have turned negative. It may be that this is a temporary thing but recently the Swiss 10-year, the German 5-year and the Japanese 3-year bonds were all producing negative yields meaning that if you were to buy these investments that the return at the end of the rainbow would be negative - you would receive back less than what you invested, guaranteed!
Now why would anyone in their right mind make that investment? Why would anyone invest knowing that they are guaranteed to lose money? The first reason is that the security of those notes is considered exceptional so while you will lose some money you are guaranteed to receive the majority of it back which for some offsets the risk of placing it in a bank or beneath your mattress.
Alright, so not many people would make this investment so there must be more to it than that and the next reason is that these countries are struggling with the very real threat of sustained deflation. In this environment with prices falling faster than the losing investment you actually come out ahead. As an example if you invest $100,000 for five years in the German Bund and receive $99,000 back at the end of the term but the BMW that you were considering buying has dropped in price from $100,000 to $90,000 in the same time then you have come out ahead and you effectively earned roughly 10% on the investment. Not bad considering the low risk.
Another reason for buying these investments (it is really hard form me to call them that, maybe I should change them to losements) is that you have an expectation that the yield will drop further making it a profitable trade. As you know as the yield drops the price of the bond rises so by buying them there may be a trade worth making if the rate drops even further. I would think this a risky bet but there are those that will trade anything, which leads me to my final reason; there are many funds that are forced to invest a certain amount of their funds into these assets due to the way that their prospectuses are written. In order not to fall out of compliance they continue to plow money into these losements (that felt better).
At present there is almost $4 trillion in these losements and as the world struggles to keep deflation at bay, more and more of these bonds are coming to market because central bankers continue to print money in an effort to stave off deflation. Looking at these numbers it is pretty easy to see why the 10-year Note in the United States continues to lower yields even as the economy starts to recover and the stock market breaks to all time highs. While it is hard to imagine we in the Unites States may find in a few years time that we are wishing for 1.90% on the 10-year Note just like people are lamenting now about the 3.00% level of a few years ago.
In the investment world, paying to play is synonymous with pretty much all investments - you have to put up the money to buy and pay the broker to cross the transaction with the seller. Both of these require you to pay up and then you are playing the game. After that you expect that the investment will produce a return commensurate with the risk - the risk free rate of return plus the risk premium, If you do an exceptional job then the total rate of return exceeds the expected return earning the investor so called Alpha or return in excess of the risk of the investment.
In the world of loans and bonds the investment is relatively simple, lend the borrower money, write down the terms of the investment which include the interest rate, monthly payments of principal and interest (or sometimes interest only) and the date at which the investment matures. During the term of the note, particularly if it is to a high quality borrower, things pretty much go according to plan and at the end of the term the money is freed up to invest in the something new. Nowadays though not only are the bond investors paying to play but they are paying to lend! A nickel sure ain't worth a dime anymore Yogi!
While this phenomena has not yet reached the shores of the United States, in Europe and Japan government bond yields have turned negative. It may be that this is a temporary thing but recently the Swiss 10-year, the German 5-year and the Japanese 3-year bonds were all producing negative yields meaning that if you were to buy these investments that the return at the end of the rainbow would be negative - you would receive back less than what you invested, guaranteed!
Now why would anyone in their right mind make that investment? Why would anyone invest knowing that they are guaranteed to lose money? The first reason is that the security of those notes is considered exceptional so while you will lose some money you are guaranteed to receive the majority of it back which for some offsets the risk of placing it in a bank or beneath your mattress.
Alright, so not many people would make this investment so there must be more to it than that and the next reason is that these countries are struggling with the very real threat of sustained deflation. In this environment with prices falling faster than the losing investment you actually come out ahead. As an example if you invest $100,000 for five years in the German Bund and receive $99,000 back at the end of the term but the BMW that you were considering buying has dropped in price from $100,000 to $90,000 in the same time then you have come out ahead and you effectively earned roughly 10% on the investment. Not bad considering the low risk.
Another reason for buying these investments (it is really hard form me to call them that, maybe I should change them to losements) is that you have an expectation that the yield will drop further making it a profitable trade. As you know as the yield drops the price of the bond rises so by buying them there may be a trade worth making if the rate drops even further. I would think this a risky bet but there are those that will trade anything, which leads me to my final reason; there are many funds that are forced to invest a certain amount of their funds into these assets due to the way that their prospectuses are written. In order not to fall out of compliance they continue to plow money into these losements (that felt better).
At present there is almost $4 trillion in these losements and as the world struggles to keep deflation at bay, more and more of these bonds are coming to market because central bankers continue to print money in an effort to stave off deflation. Looking at these numbers it is pretty easy to see why the 10-year Note in the United States continues to lower yields even as the economy starts to recover and the stock market breaks to all time highs. While it is hard to imagine we in the Unites States may find in a few years time that we are wishing for 1.90% on the 10-year Note just like people are lamenting now about the 3.00% level of a few years ago.
Friday, February 13, 2015
An Idea for you Future Centenarians
"A centenarian is a person who lives to or beyond 100 years of age. The term is associated with longevity." - Wikipedia
"Mere longevity is a good thing for those who watch life from the sidelines. For those who play the game, an hour may be a year, a single day's work an achievement for eternity." - Helen Hayes
and a follow on to the above quote (one of my favorites so I couldn't resist)
"Life is not a journey to the grave with the intention of arriving safely in a pretty and well preserved body, but rather to skid in broadside, thoroughly used up, totally worn out, and loudly proclaiming - WOW, what a Ride." - Anonymous
Since records began there are only 35 people who have indisputably reached 115. Now that is a great innings but even more amazing is that it is estimated that one third of all babies born in the United Kingdom in 2013 are expected to reach 100. Considering that the UK currently only has 21 out of every 100,000 people reaching 100, well behind Japan, the world leader, with a rate of 43, to think that the estimate expects 33,000 of them to reach 100 seems hard to believe. That said longevity is certainly something that most people want and are starting to expect. People are working and living longer and this is starting to have a prolonged impact on everyone's portfolios.
Making your portfolio last through your retirement is of high importance and few seem to have it adequately taken care of but it may be possible to insulate yourself by looking to the insurance industry. Now I am not an insurance person but I do believe that the industry has a number of products that can alleviate the problems of longevity. Of course this assumes that their actuaries continue to calculate the numbers correctly and the company remains afloat but this is a fair assumption so for the purposes of this blog we will expect that the annuities offered continue to pay out. Now annuities are not my favorite product as they tie up a lot of capital (sometimes all of it) and can remove the ability to access your capital if you ever need to draw on it (think a medical emergency) so I typically steer clear of them but one may be of interest - the Longevity Annuity.
With the longevity annuity you give the insurance company a lump sum today, they invest the proceeds on your behalf and at a pre-selected date many years in the future it starts to pay out an annual stream of cash through the life of the purchaser. Now the downside is if you die prior to the annuity kicking in the value of the annuity is lost so it is a bit of a game of cat and mouse trying to decide when it should be activated but it can be looked on as a sort of a living insurance policy (rather than life insurance which pays out when you die). So should you happen to live far longer than your retirement funds can support you then it kicks in to save the day. Due to the compounding of the returns inherent in the policy the longer that you can delay the activation date the larger the pool that you can draw on and hence the larger the annual payout. As an example if you are 50 today and you put in $100,000 into a longevity annuity that only starts to payout when you get to 90 you would achieve a benefit in the range of 20 times what you would receive today. This amount would grow to more than 35 times if you waited another 5 years but of course it is a risk that you may not even make 80 let alone 95.
However the power of this investment is that for a small fraction of your intended retirement budget you can put into place a net that will actually pay out a significant amount exactly at the time when you need it most. As we have seen above the longer the payments are deferred the larger the policy grows so if you can calculate a date at which your current retirement account will run out then you can purchase a plan that kicks in at that time. So in the event you live longer than expected (a good thing assuming you are in good health) or longer than you can afford (a really awful thought) this could alleviate a lot of the stress associated with retirement. A wonderful solution to a massive problem and one that might mean you actually live longer.
Now a few caveats before you rush out and buy one of these; shop around as you may find better offers from different insurers, make sure you use a tier one insurer as you are relying on them to be around to pay you out in 40 years or more and do not put more than 10% of your retirement funds into this product as you want to make sure you enjoy your retirement (see quotes above). So while I am not going to say this is the best investment ever, it seems to me to make sense for a lot of us to look into as a potential solution to a massive problem. Now where is my paddle, board and board shorts and I better start to watch my calorie intake as I plan to take full advantage of the extra time!!
"Mere longevity is a good thing for those who watch life from the sidelines. For those who play the game, an hour may be a year, a single day's work an achievement for eternity." - Helen Hayes
and a follow on to the above quote (one of my favorites so I couldn't resist)
"Life is not a journey to the grave with the intention of arriving safely in a pretty and well preserved body, but rather to skid in broadside, thoroughly used up, totally worn out, and loudly proclaiming - WOW, what a Ride." - Anonymous
Since records began there are only 35 people who have indisputably reached 115. Now that is a great innings but even more amazing is that it is estimated that one third of all babies born in the United Kingdom in 2013 are expected to reach 100. Considering that the UK currently only has 21 out of every 100,000 people reaching 100, well behind Japan, the world leader, with a rate of 43, to think that the estimate expects 33,000 of them to reach 100 seems hard to believe. That said longevity is certainly something that most people want and are starting to expect. People are working and living longer and this is starting to have a prolonged impact on everyone's portfolios.
Making your portfolio last through your retirement is of high importance and few seem to have it adequately taken care of but it may be possible to insulate yourself by looking to the insurance industry. Now I am not an insurance person but I do believe that the industry has a number of products that can alleviate the problems of longevity. Of course this assumes that their actuaries continue to calculate the numbers correctly and the company remains afloat but this is a fair assumption so for the purposes of this blog we will expect that the annuities offered continue to pay out. Now annuities are not my favorite product as they tie up a lot of capital (sometimes all of it) and can remove the ability to access your capital if you ever need to draw on it (think a medical emergency) so I typically steer clear of them but one may be of interest - the Longevity Annuity.
With the longevity annuity you give the insurance company a lump sum today, they invest the proceeds on your behalf and at a pre-selected date many years in the future it starts to pay out an annual stream of cash through the life of the purchaser. Now the downside is if you die prior to the annuity kicking in the value of the annuity is lost so it is a bit of a game of cat and mouse trying to decide when it should be activated but it can be looked on as a sort of a living insurance policy (rather than life insurance which pays out when you die). So should you happen to live far longer than your retirement funds can support you then it kicks in to save the day. Due to the compounding of the returns inherent in the policy the longer that you can delay the activation date the larger the pool that you can draw on and hence the larger the annual payout. As an example if you are 50 today and you put in $100,000 into a longevity annuity that only starts to payout when you get to 90 you would achieve a benefit in the range of 20 times what you would receive today. This amount would grow to more than 35 times if you waited another 5 years but of course it is a risk that you may not even make 80 let alone 95.
However the power of this investment is that for a small fraction of your intended retirement budget you can put into place a net that will actually pay out a significant amount exactly at the time when you need it most. As we have seen above the longer the payments are deferred the larger the policy grows so if you can calculate a date at which your current retirement account will run out then you can purchase a plan that kicks in at that time. So in the event you live longer than expected (a good thing assuming you are in good health) or longer than you can afford (a really awful thought) this could alleviate a lot of the stress associated with retirement. A wonderful solution to a massive problem and one that might mean you actually live longer.
Now a few caveats before you rush out and buy one of these; shop around as you may find better offers from different insurers, make sure you use a tier one insurer as you are relying on them to be around to pay you out in 40 years or more and do not put more than 10% of your retirement funds into this product as you want to make sure you enjoy your retirement (see quotes above). So while I am not going to say this is the best investment ever, it seems to me to make sense for a lot of us to look into as a potential solution to a massive problem. Now where is my paddle, board and board shorts and I better start to watch my calorie intake as I plan to take full advantage of the extra time!!
Friday, February 6, 2015
To the Laundry
"The US economy may be 'the cleanest dirty shirt' amongst a world of dirty shirts, but we should not forget that it is dirty nonetheless." - Fred Hickey
The jobs report came out today and it was (to me anyway) surprisingly strong. Headlines stated things like, "Strong Employment and Wage Gains in January Show Sluggishness in December Was not a New Trend." Non farm payrolls added 257,000 new jobs in January; on top of this wage growth surged 0.5% leading to an increase in aggregate wages of 0.7%. Economists lauded the report saying that undoubtedly consumer spending will follow and that the economy is now on firm footing. It is interesting then that at the time I am writing this that the stock market is not up hundreds of points, in fact right now it is actually down.
One reason for this might be that the overall unemployment rate edged up to 5.7% from 5.6% but this was due to revisions to seasonally adjusted numbers so I doubt that this has an impact. Another reason could be that the market had baked in a higher number and that the rally of the past week was overdone. To me though the main reason is that the number has not taken into account the recent oil and gas layoffs and that either the market expects a big revision to these numbers or that future numbers will be weak. Oil and gas extraction worker layoffs amounted to only 1,900 in January and I expect that this number will balloon in the future as oil producers have cut capital spending budgets by $24 billion according to the Wall Street journal. Considering that the oil and gas industry employs 216,000 workers, the highest number in nearly 30 years, I would expect a large number of these to reach the unemployment tables in the coming months.
Furthermore with the strengthening of the dollar, exports are slowing and job reductions have been announced by P&G, American Express, JC Penney, US Steel, Caterpillar, IBM, HP, Cisco, EMC, Citrix and eBay among others. In fact according to Challenger, Gray & Christmas US employers job cut announcements soared 63% from December. One reason for this is that the consumer spending numbers were not as robust as expected over the holiday season. It turns out that the consumer is not opening their wallets to spend their gasoline windfall but are rather keeping it for the simple reason that earnings on their savings is so low that a little bit of extra income is being used to offset the loss of returns. In addition the cost to the consumer of insurance, health care, taxes and education is still biting into their meager pay increases and this is more than offsetting the oil bonanza.
Assuming that the oil price remains low (and it looks like it will) for an extended period of time, consumers may start to spend this extra income but that day has not yet arrived. Furthermore until the job participation rate improves from multi-decade lows consumer spending will continue to stagnate particularly as it is the younger worker that has the highest levels of unemployment and they are the engines of consumption.
So while the market reaction seems to be of interest it might be that stock traders are growing wary of the tired drum being beaten by the Federal Reserve and may actually realize that the shirt while clean in comparison to the others is still dirty.
The jobs report came out today and it was (to me anyway) surprisingly strong. Headlines stated things like, "Strong Employment and Wage Gains in January Show Sluggishness in December Was not a New Trend." Non farm payrolls added 257,000 new jobs in January; on top of this wage growth surged 0.5% leading to an increase in aggregate wages of 0.7%. Economists lauded the report saying that undoubtedly consumer spending will follow and that the economy is now on firm footing. It is interesting then that at the time I am writing this that the stock market is not up hundreds of points, in fact right now it is actually down.
One reason for this might be that the overall unemployment rate edged up to 5.7% from 5.6% but this was due to revisions to seasonally adjusted numbers so I doubt that this has an impact. Another reason could be that the market had baked in a higher number and that the rally of the past week was overdone. To me though the main reason is that the number has not taken into account the recent oil and gas layoffs and that either the market expects a big revision to these numbers or that future numbers will be weak. Oil and gas extraction worker layoffs amounted to only 1,900 in January and I expect that this number will balloon in the future as oil producers have cut capital spending budgets by $24 billion according to the Wall Street journal. Considering that the oil and gas industry employs 216,000 workers, the highest number in nearly 30 years, I would expect a large number of these to reach the unemployment tables in the coming months.
Furthermore with the strengthening of the dollar, exports are slowing and job reductions have been announced by P&G, American Express, JC Penney, US Steel, Caterpillar, IBM, HP, Cisco, EMC, Citrix and eBay among others. In fact according to Challenger, Gray & Christmas US employers job cut announcements soared 63% from December. One reason for this is that the consumer spending numbers were not as robust as expected over the holiday season. It turns out that the consumer is not opening their wallets to spend their gasoline windfall but are rather keeping it for the simple reason that earnings on their savings is so low that a little bit of extra income is being used to offset the loss of returns. In addition the cost to the consumer of insurance, health care, taxes and education is still biting into their meager pay increases and this is more than offsetting the oil bonanza.
Assuming that the oil price remains low (and it looks like it will) for an extended period of time, consumers may start to spend this extra income but that day has not yet arrived. Furthermore until the job participation rate improves from multi-decade lows consumer spending will continue to stagnate particularly as it is the younger worker that has the highest levels of unemployment and they are the engines of consumption.
So while the market reaction seems to be of interest it might be that stock traders are growing wary of the tired drum being beaten by the Federal Reserve and may actually realize that the shirt while clean in comparison to the others is still dirty.
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