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Is the Fed behind the curve? (Part 2)

Issues to be addressed in this research paper

In part 1 of this research paper I concluded that signs are growing that the Federal Reserve Bank may be forced to tighten a great deal more in 2017 than most investors expect. As of the latest count, the consensus view is that 2 US Fed Funds hikes can be expected this year (25 bps each), but I came to the conclusion in the earlier paper that 3-5 hikes may be more likely. My conclusion was based on the combination of robust growth in US bank lending and relatively high capacity constraints in the US economy overall.

In addition to that, and what I didn’t mention in part 1, is that the incoming Trump administration will almost certainly implement at least two programmes that are inflationary. Firstly, an easing of fiscal policy in an environment of tight labour markets and a virtually non-existent output gap can only increase inflation.

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Exhibit 1: Medical care CPI for all urban consumers
Exhibit 1: Medical care CPI for all urban consumers
Source: The Daily Shot, January 2017

Secondly, the likely repeal of Obamacare – or at least a repeal of significant parts of the programme – is likely to cause the cost of medical care to take off again. Obamacare is largely responsible for the relatively modest increase in medical care costs in recent years. A repeal now will almost certainly alter that trend. Well, you could argue that a new trend has already been established (exhibit 1). With medical services accounting for 19% of the core PCE deflator, the writing is on the wall.

I should point out that what the US is going through is a perfectly normal reflation cycle. An increase in bank lending (and/or other sorts of lending) is always required to get the wheels spinning again after a period of sluggish economic growth, and bank lending has been largely absent in many parts of the global economy following the financial crisis. That said, as I showed in part 1 of this research paper, bank lending is now increasingly robust in the US.

What I didn’t show in part 1, but what I should point out, is that – at least so far – an increase in bank lending is confined to the US. There are indeed early signs that bank lending is finally picking up in the UK as well, whereas the Eurozone is still far behind. Effectively that means that (i) the US is now into stage 3 of the reflation cycle outlined below, (ii) the UK is still in stage 1, and (iii) the Eurozone is not even in stage 1 yet (exhibit 2). Those who argue that inflation pressures are mounting in the UK are technically correct, but it is not from cyclical factors. It is due to the weak pound, following the Brexit referendum.

Exhibit 2: The various stages of the reflation cycle
Exhibit 2: The various stages of the reflation cycle
Source: Absolute Return Partners LLP
Note: I should point out that increased bank lending is just one way to reflate the economy. Various economic policies (tax cuts, etc.) can also do the job.

On that basis, I noted in the earlier paper that the Fed could effectively be kick-starting the next recession (stage 5) later this year, and I concluded that, after a period of rising interest rates, rates should resume their downward trend.

Exhibit 3: US output gap (% of potential GDP)
Exhibit 3: US output gap (% of potential GDP)
Source: BofA Merrill Lynch, December 2016

That leaves investors in a near impossible situation as far as portfolio construction is concerned. Do you construct your portfolio for recession already, or do you seek to take advantage of a short-term (expected) spike in rates and volatility as the Fed makes its moves? That is what this research paper is about.

One could argue that we don’t normally switch through the various stages of the reflation cycle that quickly. Couldn’t one maintain that the US economy is likely to remain in stages 2-3 for a bit longer? I would normally agree, but the US economy has gone into this cyclical upswing with significant workforce capacity constraints and an unusually low output gap (exhibit 3) due to many years of under-investments in the corporate sector.

And if you wonder why stage 4 would necessarily lead to stage 5, I note that economic expansions never die of old age. They die from policy mistakes such as on overly aggressive Fed.

The big picture

My overriding view is – and has always been – to construct portfolios for the medium to long term, which would favour the recession trade. However, this cycle could turn out a little differently, and there are a couple of very good reasons for that. Given the likelihood for the US dollar to rise on the back of a more hostile Fed, and given the overall level of indebtedness in the US (and elsewhere), the Fed may decide to sit on its hands for longer than it would normally do.

How that will affect the Fed’s decisions in the months to come is an unknown at this stage. In 2016 we had ample evidence that the Fed is not always governed by first principles. If it were, we would have had plenty more hikes than we actually did last year.

Adding to that, one could also argue that the Fed actually wants inflation to rise somewhat. Again, that could cause the Fed to be more passive than you would otherwise expect.

On this basis, for 2017-18, I have therefore assumed the following:

  • The Fed will continue to be behind the curve for a while, forcing its hands later this year, where we will see a more aggressive Fed.
  • Short-term interest rates will rise at least 1% as 2017 unfolds in sympathy with a tighter Fed.
  • Long-term US interest rates will also rise but only modestly (less than 1%).
  • In late 2017 / early 2018 tighter monetary policy will manifest itself in a meaningful economic slowdown in the US, possibly even a recession.
  • As a consequence, US interest rates at both the short and long end will resume their downward trend in 2018.

The outline above is my core outlook for the next 18-24 months, and I would assign at least a 50% probability for that to happen. On that basis, and given the fact that few alternative investment strategies (amongst those that are relevant to this scenario) offer redemption terms that are consistent with my short term outlook, here is what I would do.

The intricate world of TIPS

The most widely recognised inflation hedge strategies - at least amongst more traditional investment strategies - would include TIPS, REITS (property), gold and commodities. (Note: Inflation linked bonds in the US are called TIPS. Similar bonds in the UK are called Linkers. In the following, for the sake of simplicity, I call all inflation linked bonds TIPS). As is evident when looking at exhibit 4, TIPS offer the greatest combination of high correlation with inflation and low volatility. TIPS are therefore many investors’ favourite inflation hedge.

Exhibit 4: Relationship between short-term inflation protection and asset volatility
Exhibit 4: Relationship between short-term inflation protection and asset volatility
Source: Vanguard Research, October 2012. Data from January 1970 to July 2012

Before I dig further into the TIPS opportunity, let me explain one or two things about them. TIPS are similar to conventional bonds in that they are associated with interest rate risk. If you are long TIPS, you are long interest rate risk, just as if you had held normal bonds. And TIPS do not offer protection against inflation; they offer protection against unanticipated inflation. In other words, you won’t make a return on your TIPS unless the inflation in question is unexpected.

In effect, returns on TIPS are driven by two factors:

  1. Changes in real interest rates.
  2. Changes in inflation expectations.

The return on TIPS during a period of rising interest rates depends on the interplay of rising real interest rates, which negatively affect returns, and unexpected inflation, which affects returns positively (Source: Nuveen Asset Management). In other words, the total return outlook for TIPS, which is widely considered to be a function of inflation only, is actually a tad more complicated than that.

Outside-the-box idea # 1: TIPS & T-bonds

The first idea I will present to you today is, on a beta adjusted basis, to go long TIPS and short T-bonds, preferably at the short end, as the correlation factor is much higher there (see exhibit 4 again). This trade will only work for as long as the Fed raises rates in reaction to a stronger US economy; hence it could be relatively short-term in nature.

Investors with no interest in the short-term should wait until the market consensus has moved towards a more aggressive Fed. They could then go short TIPS and long T-bonds, again at the short end. The idea originates from Harvard Management Company, who have incorporated the strategy into its new FIFAA programme, which I wrote about in November 2015 (see here).

It would be an option just to use TIPS to express your views, but the long/short strategy carries two important advantages:

  1. It is largely cash flow neutral, allowing investors to put their capital to work elsewhere.
  2. By pursuing the long/short strategy, investor can almost entirely eliminate the interest rate risk, effectively making the structure sensitive to unexpected inflation only.

I should also mention that it would make a great deal of sense for a DB pension fund to incorporate the short TIPS / long T-bonds strategy at a more strategic level. DB plans suffer immensely from low inflation, and the short TIPS / long T-bonds strategy offers a great deal of protection from that.

Outside-the-box idea # 2: Short US banks / Long UK banks

As you can see from exhibit 5, UK banks continue to perform almost as poorly as the average continental European bank despite the growing sense of optimism in the UK, and despite the fact that the UK is without doubt further into the reflation cycle than virtually any other European country is. Having followed US banks almost 1:1 between 2007 and 2013, the difference in performance is now massive.

Exhibit 5: Performance of US, UK & European bank stocks (local currency)
Exhibit 5: Performance of US, UK & European bank stocks (local currency)
Source:The MacroStrategy Partnership LLP, October 2016

This has created a significant valuation gap between US and UK banks (exhibit 6). Banks are usually valued on a price-to-book basis, and UK banks are roughly 1/3 cheaper than their US counterparts on that basis.

Assuming that my logic is correct, i.e. that the US economy is not that far away from its central bank turning more hostile and that the UK economy is somewhere in between a relatively boisterous US economy and a relatively weak Eurozone economy, UK banks should be able to reduce the valuation gap meaningfully over the next 12 months. Hence I think a strategy where you go long UK banks and short US banks is a winner for 2017.

The main risk to this strategy is probably Brexit, and how the upcoming negotiations are going to affect UK equities. That is a bit of a wild card at the moment, but I believe that a more hostile Fed will do more damage to US banks than the Brexit negotiations will do to UK banks.

In that context I should point out that higher short-term rates should lead to higher margins, and hence improved profitability, for US banks. As a consequence, both US and UK banks could possibly do quite well in 2017. Experience has just taught me that being in the early stages of the reflation cycle is likely to have a bigger impact on the stock price. That should lead to UK banks outperforming US banks in 2017.

Exhibit 6: US & UK banks’ price-to-book ratios
Exhibit 6: US & UK banks’ price-to-book ratios
Source:The MacroStrategy Partnership LLP, October 2016

Outside-the-box idea # 3: European SME lending

As the US economy slows, European economic growth is likely to remain relatively soft, and that has to do with compliance with Basel III plus a host of other factors such as punishing demographics, which I shall not discuss in this research paper.

With the possible exception of tier one corporates, European non-financial corporates have found European banks to be largely inaccessible for funding in recent years (exhibit 7). The banking regulator has been all over the banks to reduce the total loan book and, to a very significant degree, it explains why economic growth continues to be so poor across Europe.

Exhibit 7: Lending to non-financial corporates across the Eurozone
Exhibit 7: Lending to non-financial corporates across the Eurozone
Source: BlueBay Asset Management, January 2017

The seemingly anti-business approach by the European regulator is driven by a need to comply with the new post-crisis Basel III which comes into effect in 2019. Much more capital shall be required from a banking sector that is still licking its wounds from the financial crisis (exhibit 8). Hence there is no reason to expect the regulator to soften its stance any time soon.

Exhibit 8: Capital requirements to comply with Basel III
Exhibit 8: Capital requirements to comply with Basel III
Source: BlueBay Asset Management, January 2017

This raises a major opportunity in the alternative lending space. A significant share of non-financial corporate funding in Europe – in particular SME funding - is likely to be facilitated away from commercial backs – at least until 2019 and possibly longer.

This is a trend that began in the US years ago. Today, US commercial banks have only got a 20% market share in the markets for loans to non-financial corporates, whereas banks’ market share in this market in Europe is 85% (exhibit 9).

Nobody knows where it will all end. Once Basel III has been fully implemented in 2019, Basel IV waits around the corner. Officially Basel IV is about implementing the revised version of Basel III in 2019, but there is already plenty of rumours suggesting that it won’t stop there.

Exhibit 9: Dependency on bank lending in Europe vs. the US
Exhibit 9: Dependency on bank lending in Europe vs. the US
Source: BlueBay Asset Management, January 2017

Given the risk of a US recession in the not so distant future, and given the impact such a recession is likely to have on the European economy, my inclination is to focus on senior secured loans. There is absolutely no reason to chase returns at the riskier end of the corporate spectrum as things stand.

However, because banks are so un-cooperative, and because alternative lenders’ penetration of this market opportunity is still so low, loan providers have a substantial ‘menu’ to pick from, which can only improve the risk/return profile of this opportunity.

Outside-the-box idea # 4: US distressed credit

A meaningful increase in interest rates at the short end of the capital structure, leading to an economic slowdown – possibly even a recession – would almost certainly lead to an increase in corporate defaults. That is the logic behind us warming to US distressed opportunities at this stage.

It should be noted, however, that now may be a tad early to get involved in distressed credit. We have only had two Fed rate hikes in this cycle so far, and more shall be needed for the corporate sector to feel the damage. Defaults are only likely to rise meaningfully when the economy turns, and that hasn’t happened yet. That said, given our outlook for 2017-18, I would be surprised if an opportunity doesn’t present itself over the next 12-18 months.

The key questions that we will be asking ourselves in the months to come are the following two:

  1. How significant does the economic downturn have to be to generate a reasonable amount of opportunities?
  2. Which corporate sectors can best weather higher short-term rates?

As far as the second question is concerned, as the FOMC gradually tightens, many non-financial corporates will only see a very gradual rise in interest expenses. This is due to the fact that the debt held by many corporates is often of longer maturity. As of 2015, short-term debt represents only 27% of total debt in non-financial corporates. Due to robust cash levels, these companies have a high ratio of liquid assets to short-term liabilities. As a consequence, one should not assume that rising short-term rates will be universally destructive.

That said, I also note that there is a fairly large group of lowly rated companies in the US with oceans of debt. There has been a significant amount of debt restructurings taking place ever since the US economy came out of the last recession in 2009, and much of this debt is relatively short-term in nature.

Final comments

I will stop for now, but this is obviously a process that will evolve continuously over the next several months and, as I fine-tune my thinking, the conclusions I draw will to a large degree depend on how aggressive the Fed turns out to be, and how severely the economy and financial markets react.

I should emphasise that there is absolutely no reason to expect a bloodbath similar to the financial crisis in 2008. Cyclical downturns happen every now and then; crises like the one in 2008 have only happened twice in the last 100 years.  

Since World War II, we have had 11 full economic cycles in the US with the average recession lasting 10-11 months and the average expansion about 5 years (and a little longer since the great bull market took off in the early 1980s). Those numbers would suggest that the current expansion is getting a bit long in the tooth, which would further support my argument that a US recession may not be far away.

Niels Jensen

20 January 2017

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.