The domino effect.
It's a Theory
Economics is not my thing, although I did once enjoy a money and banking lecture from a former Bank of England official, who worked at the Bank in 1992 when hedge funds, led by George Soros, attempted to take down the English pound. As the official tells it, the Bank was publicly brave in its statements but privately terrified. Soros had it rattled. With good reason, too--because of hedge funds' selling pressure, the Bank was forced to devalue the pound by removing it from the European Exchange Rate Mechanism.
Martin Wolf of Financial Times, on the other hand, understands economics quite well. Unhappily, he has a disturbing thesis. In "The emerging risks of ticking time bonds," Wolf argues that investment managers have replaced banks as the danger zone of finance. Leaning on research from Princeton economist Hyun Song Shin, Wolf worries that the global investment community has become addicted to emerging-markets bonds. And vice versa--emerging countries have become addicted to readily available foreign capital.
This pattern was not healthy when banks were the main source of money to emerging markets. The money spigot from banks does not flow at a consistent rate. Late in economic cycles, when capital is least needed by borrowers, it is most readily available from banks. Conversely, money tightens, sometimes to the point of unavailability, during recessions, when risk avoidance becomes the prime goal. This of course is when capital is most needed.
Wolf fears that the evolution in financing, from banks offering loans (the previous regime) to investment managers purchasing bonds (the current regime), has not improved matters. The lending pattern remains firmly pro-cyclical. Writes Wolf, "As the Fed is expected to tighten, the dollar will rise, prices of dollar bonds will fall and dollar funding will reverse. As the bonds they issued lose value, [emerging-markets] borrowers will be forced to post more domestic currency as collateral. That will squeeze their cash flows and trigger a downturn in corporate spending." The result will be recessions in emerging countries; a "doom loop" in Wolf's words.
In such an event, the doom loop would surely also swallow the stocks of developing markets. They likely would not decline as far, but emerging markets have become so large and so connected with other economies that there would be few places to hide with a stock portfolio.
This thesis worries me twice over. First, Wolf is not one to cry his name. If James Grant, for example, writes that terrible things are on the horizon, I won't fuss. Grant is by nature a pessimist who constantly foresees a future that is more dismal than the future that actually arrives. Wolf, on the other hand, is parsimonious with his predictions of doom. For example, when Wolf reviewed Nouriel Roubini's early 2008 forecast of a collapse in the housing market rending the financial sector, he concluded that Roubini was "excessively pessimistic."
Second, with the recent economic strengthening and the Federal Reserve pondering how to end its program of quantitative easing (QE), Wolf's trigger point may come sooner rather than later. Yes, ending QE is not the same as raising short-term rates, but it's a step in that direction. The next step from there would be the higher rates that Wolf believes will begin the domino effect.
Those things said, Wolf's theory does require a fair amount of speculation. As Wolf acknowledges, global asset flows are difficult to track. Returns on emerging-markets bonds and stocks, of course, are straightforward to gather. But as asset flows from investment managers are not, it's all a bit of a guess as to the relationship between the two.
Food for thought. The next time that there's noise about the Federal Reserve raising rates, I'll look at how emerging-markets bonds react to see if Wolf's thesis is playing out.
Protecting Against Inflation
It's always nice when two reliable sources arrive at similar conclusions. Therefore, I was delighted to read the summary of inflation hedges in a paper from GMO's James Montier, as it largely matched what Bill Bernstein wrote in his Deep Risk e-booklet earlier this year.
However, I was slightly less delighted when Montier credits Bernstein midway through that section. (Great minds do to tend to think alike when they are each reading the other's work.)
From Montier, six assets in rough order of effectiveness against inflation:
1) Treasury Inflation-Protected Securities
"This is, I believe, the one true inflation hedge," Montier wrote. TIPS won't necessarily accomplish the task if you buy and sell them on the secondary market, as in that case their prices are subject to the vagaries of Mr. Market. For investors who buy on issuance and hold to maturity, though, U.S. TIPS (as well as the inflation-protected bonds sold by other governments) will get the job done.
Cash is less effective than TIPS because central banks can lower interest rates below the level of inflation, in which case cash has a negative real return. Such is the case today, with annual CPI inflation running at 1% to 2% (depending on the period selected) and cash paying almost nothing. Cash generally pays more than inflation, though, making it a reasonable effective hedge for a long time period.
3) Real Estate
Real estate is an imperfect version of TIPS. As with TIPS, real estate hedges long-term inflation well for the buy-and-hold investor, but it is less effective in protecting against short- and medium-term inflation because market prices fluctuate. Unlike with TIPS, though, there's never a pure starting and ending point for real estate. Thus, if real estate is expensive at the time of purchase and is sold many years later when the real estate market is weak, the investor may suffer a poor return over even a long time horizon.
Similar to real estate.
This section Montier takes largely from Bernstein, who found that stocks from a great many countries, over a great many decades, showed a strong resistance to inflation. In the long run, companies are able to pass along their higher costs in the form of higher prices. In the short run, they can suffer from inflation shock. Also, there is the ongoing issue (except for TIPS) of how the market prices the securities, so that the investor seeking to hedge might choose the wrong exit or entry point. Otherwise, though, stocks do surprisingly well as inflation hedges.
Commodities are highly overrated as inflation hedges. Yes, oil and gold prices soared in the 1970s when inflation was severe and on the rise. That gave commodities the appearance of offering protection against inflation. However, oil and gold prices and inflation have shown such positive correlation in only two decades of the past 13. Moreover, other less visible commodities haven't even done that well. Copper and corn prices went nowhere in the 1970s, for example.
One Thing Leads to Another
This week, I had intended to give voice to those who were bullish on stocks, but who have recently become bearish. This came up, then that, and I did not deliver on that promise. Next week for certain. The bears deserve their say.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.