Note to readers: This e-paper contains links to charts from Cumberland’s website incorporated by reference, www.cumber.com. With a total of nine charts and 2700 words, it will take you about 12-15 minutes to read. See links below.
But first: there is big and good news from the employment report today. All last year we stayed with our “no recession, slow recovery” view. Today’s report validates it continues. We remain fully invested in the US stock portfolios. The S&P 500 has reached a “golden cross.” Stocks could potentially “melt up.” They are vastly under owned after enduring a decade of volatile and weak performance. The “Facebook Generation” has not yet become an investing cohort. That lies ahead. Note that Facebook users measure 12% of the world’s population, mostly younger and not extremely poor. The potential is huge.
Now let’s get to the central banks.
Chairman Bernanke clarified the policy outlook by indicating that the majority of the Fed’s Open market committee (FOMC) expects low short-term interest rates into 2014 and possibly longer. Philly Fed President Charles Plosser told Steve Liesman he was one of those who saw a rate rise in 2012. He and other colleagues are in the minority. Clearly Bernanke has the votes. He will have them for at least another year. Thus, Fed policy has become more predictable than in previous decades. For a discussion in more detail see Bob Eisenbeis’ comments on “transparency” (Feb. 1, www.cumber.com) .
For the next several years, the expectation for short-term interest rates is near zero. According to the FOMC announcement, the “out years” will witness a rise back to the 4% level or so. The Federal Open Market Committee has an ultimate level of around 4% for the Federal Funds Rate as their estimated goal once things normalize.
We do not know what normalize means. The term “new normal” has been batted around to the point of cliché and, yet, it remains undefined. That definition is years away from clarity.
Let’s step back from the isolated look at the Federal Reserve and its actions. We want to view the major central banks in a global context. This is essential in order to grasp the implications for the financial markets.
On Cumberland’s website, we have presented a chart pack entitled Total Assets of Major Central Banks: https://www.cumber.com/content/misc/G4_Charts.pdf. We update it regularly and have placed it permanently on the website by popular request. We will refer to the charts and chart numbers in this commentary and suggest to readers they should download the charts for ease in following the text. It is a series of charts that discuss the G4 central banks. Chart 1 is the combined balance sheet of the G4 priced in US dollars. The remaining charts discuss each of the G4 central banks, specifically: the Federal Reserve (Charts 2-3), the European Central Bank (Charts 4-5), the Bank of England (Charts 6-7), and the Bank of Japan (charts 8-9).
We believe it is important to combine the G4 when analyzing central bank policy. By currency, they collectively define the major financial markets of the world. The adjustment process among and between them occurs in the foreign exchange markets, in the fluctuation of currency exchange rates among and between the dollar, pound, euro and yen. We add that most of the rest of the world’s currencies, countries, and economies are linked to one of the G4. For example, the Swiss franc is now managed by the Swiss National Bank at a fixed peg to the euro. Thus, the monetary policy effects of the European Central Bank are felt in Switzerland. The Hong Kong dollar is managed by a currency board and linked to the US dollar. Other countries manage their currencies in “dirty floats” against one of the G4. For example, Chile manages the Chilean peso so that it floats. However, it is concerned about the value of the peso vis à vis the dollar and will alter policy as a way of intervention. China and other major Asian economies, manage their currency exchange rate. They permit the currency to strengthen when they choose.
The G4 defines approximately 85% of the capital markets of the world. We use BIS aggregates to derive this number. It is important to keep this context as we discuss the outlook for markets.
On Chart 1, we have taken the G4 central bank balance sheets and converted the G4 central banks to US dollars. When you observe the chart, you see that the central bank assets of the G4 were approximately $3.5 trillion prior to the Lehman/AIG crisis meltdown. Today, they are approximately $9 trillion.
There is every indication that the number will rise. The United States is committed to a course of balance sheet size of $3 trillion or higher. The United Kingdom is expanding the size of its balance sheet in another round of quantitative easing that is publically announced and underway. The European Central Bank is expanding its balance sheet and did so with a three-year financing at a 1% interest rate. There is every expectation that the ECB will do it again in February or March with another very large and longer-term financing for European banks. The Bank of Japan’s course is clearly leading to larger quantitative easing as the BOJ contends with very difficult governmental financial problems and its balance of trade.
All G4 members are in expansive monetary mode.
Collectively from pre-Lehman times to today, the G4 has created 5.5 trillion US dollar equivalent in money worldwide. An examination in the chart stack will show the liability side of each of those balance sheets and within that context, one can see the excess reserves that are created by, and then re-deposited in, those four central banks. In other words, the central banks created the money (electronically “printed” the money) and purchased government securities or government-backed securities or lent money to banks which posted government securities as collateral for the loans. The results of those purchases were redeposited in those central banks within a matter of hours as excess reserves. Those excess reserve balances continued to be held by the central banks in increasing amounts. The central banks pay interest on those reserves.
That is the condition of the G4 in the beginning of 2012.
In total, there is $9 trillion in G4 central bank balance sheet assets and rising. There is also $9 trillion in G4 central bank liabilities and rising. The bulk of the liabilities are currency in circulation and holdings of government securities or loans to banks which in turn hold government securities. Note that $3.5 trillion has grown to $9 trillion in created monetary expansion in the space of four years. By year-end 2012 this total may approach $10 trillion. It certainly is not going to shrink.
Think back ten years and ask the following question: Had a speaker come to a seminar and presented a forecast that within a decade the G4 central bank balance sheets of the world would triple in size and there would be little inflation, zero interest rates, bond prices at nearly all-time highs, bond interest rates at record lows, stock markets in recovery and slow economic activity worldwide - had someone presented this, do you think the seminar attendants would have believed him or dismissed the speaker to be clearly insane? Not one would have accepted that forecast as credible, let alone probable that the outcome would be anywhere near his forecast. Think deeper: not one central banker in the world would have outlined such a forecast and supported it with serious research in order to offer that outcome as the one to expect in an environment which has occurred only ten years later.
We are in unpredicted and uncharted waters. There is no 100% predictable course or direction. We do not see the shoals and the rocks, and we do not know how the extraction of this stimulus will occur. We don’t know what will happen and what impacts will happen or when or if they will occur. We only know the present course is to take the central bank balance sheet size from $9 trillion to $10 trillion or higher. Note that the Bank of Japan is the only case study where a previous QE was extracted. We have marked the event and the form of extraction on charts 8 and 9. When Japan performed that extraction the interest rate rise was small. The effect was to get the rate above zero and clear the market at a positive interest rate.
We also know that the Federal Reserve has now adopted an inflation-targeting regime. It said that it will accept 2% on the core personal consumption expenditure deflator (PCE) as its inflation target. We know that the Fed also believes the unemployment rate in the United States will stabilize somewhere in the vicinity of 5.5%-6%. And we know that the Fed believes it will take years for that to occur. We now have the two mandated elements of the Federal Reserve now defined: unemployment rate at 6% or lower and core-PCE inflation at 2%.
Our arrival at this condition remains unclear. Outlying influences, such as the federal deficit, the tax code, productivity, interconnectedness and interdependencies among the G4 and rest of world all have a role to play.
Taking all this into consideration, many ask the question: What do investors do in circumstances like these?
This profound question is challenged by separate account money managing firms like Cumberland as we try to offer guidance to a few billion of the trillions of investable funds in the world. It is faced by hedge funds, mutual funds, common funds, bank trust departments, insurance companies, pension systems - you name it, the struggle is the same. How do you navigate an investment portfolio through the next few years, knowing that what is ahead in the foreseeable future is a worldwide period of the short-term interest rate near zero and an intermediate term interest rate somewhere between 1-2%? How do you address such an issue?
At Cumberland, we argue that global diversification of risk is the strongest approach, the soundest method. What that means investors should own some stocks in the United States, some stocks whose exposure and business conditions are outside of the United States, some bonds, some precious metals, some commodity exposure, some managed currency exposure, some real estate, some private equity business interests, and so forth. You name it- if it trades in a security form that is acceptable and passes tests of creditworthiness, liquidity, market transparency and disclosure- then it warrants consideration in a globally diversified portfolio.
At Cumberland, we utilize an approach with exchange-traded funds that we call “Global Multi-Asset Class.” For six years, we have established numerous live accounts and millions in that asset class, and we strategize by diversifying around the world and manage the market exposures to reduce volatility so that risk-adjusted returns are improved over benchmarks.
Other pools of investment funds diversify in a different manner. Some do it in private equity, some do it through hedge funds, and some do it through leveraged transactions.
Not one of these approaches is bad or good. All have a role, depending on the risk tolerances of the particular investor. Our view is: all options are on the table. Consider everything, and then focus and target the investment objectives to suit separate risk tolerances and requirements.
There is a role for stock markets but which ones? How much to take out of the United States? That, too, is a complex question, especially in the context of US dollar liabilities. The reason is that when you invest outside of the United States, you begin to take currency risk in addition to the investment risk specific to the investment itself. If you buy a US stock, as a US investor whose liabilities and payment scheme are in US dollars, you are not taking currency risk. If you buy a stock on an exchange in a foreign currency in a foreign country, you have added to the volatility. It may serve you well by improving your position, giving you a winner on both the currency and in the stock. It could also hurt you because you chose a currency that weakens against the dollar and the stock that does not perform well enough to offset the currency loss.
The same approach takes place with exchange-traded funds. ETFs allow you to diversify in many ways, but they still require the same analysis. Currency risk, geopolitical risk, economic risk idiosyncratic to a specific country or region - all this comes into play.
We are in for a remarkable decade as investors. We face the opening of the post-Lehman/AIG decade. The central banks of the world have committed themselves to enormous infusions of liquidity. The evidence speaks for itself at $5.5 trillion, and we are still counting, the quantity is still rising. The currencies of the world revalue or devalue against each other. There is no anchor for any of these currencies.
Precious metal enthusiasts would say gold is an anchor; they make their arguments based upon the fact that the central banks hold their gold. They do not disgorge it; they maintain it as a core reserve. Furthermore, some central banks are buying additional gold. Others are adding to it from internally-derived sources. Russia is an example of the latter. So, one can argue that gold and precious metals have some role in this investing mix.
Do you put everything in gold? Certainly not. Do you own some precious metal exposure? At Cumberland, we believe the answer is yes. We have a small position in our Global Multi-Asset Class and we maintain it, modify it, raise and lower it depending on other market opportunities and the price of the metals. We think there is a role for some precious metals, albeit a small one, in every portfolio that can tolerate the exposure of an asset class that provides no or negligible income.
What else are we aware of in 2012? We know we are going to be looking at these low interest rates for some time. We know about the commitment of the financial institutions to continue this massive excess liquidity infusion. We know that the lessons of the Lehman failure and meltdown are driving investor sentiment. Investors are more risk averse now than they have been in a very long time. The youthful generation of the investing public only knows the turmoil of the last few years. Anyone who entered stock market investing in the last 10-12 years has had the experience of roller coaster rides. If they are lucky, they have about as much as they had when they started some time ago. If they did not protect themselves with diversification but instead concentrated, they may have done well like a gold owner or they may have had their heads handed to them like those who purchased tech stocks in 1999.
We think investor sentiment has been terribly damaged by these shocks. We see that in the large amount of uninvested cash that is held elsewhere at interest rates near zero. We see that in the fear that seems to motivate the investing public. We also witness it in the discouraged attitudes, comments and discourse that come from younger potential investors who are uncertain and insecure and do not have the experience of investing disciplines.
We think this platform is one where one can be very opportunistic. Therefore, we believe that the one thing that is not going to happen in 2012 is another Lehman/AIG meltdown. Something else might happen. Geopolitical risks are high but the stories of risk in the financial sector are all well-known. Greece has been discussed ad nauseum. It is an insolvent country in a system of seventeen countries that are struggling to stabilize a listing ship. Portugal is a developing candidate for another round of Greece-type restructuring, insolvency, and default. However, the stories of Portugal and Greece and others in Europe are already well-known. They are not a surprise; they have offered years in which investors could make adjustments. The same is true of the evolution of the debt structure in Japan. It is not new news.
Even the geopolitical threats from Iran and nuclear weapons in North Korea are old news. They are serious concerns and must be followed closely, but they are old news. We know about them, and therefore, any action we take, we do at our own risk. If we are right, we succeed. If we are wrong, we fail. However, we are not surprised by the evolution of these events.
2012. We are rewriting textbooks. We are reconfiguring global investment allocation. We are practicing what we preach in the use of broad diversification of risk.
Our Cumberland accounts are fully invested. For bonds we use spread products and not treasuries. For stocks we use exchange-traded funds. In the global portfolios we are worldwide and broadly diversified.
