The Great Bailout of the global financial system in 2008-09 may be comprised of many different parts—some of which are still being withheld from the public in whole or in part—and the specific government interventions taken may vary somewhat by country, but in general they all represent various forms of fiscal and monetary stimulus and also state guarantees for certain financial assets and institutions. In a few cases there have been outright nationalisations of financial institutions, primarily banks, and even non-financial firms, including General Motors, for example.
In those cases where there has been a specific government bailout or explicit guarantee it may appear rather straightforward to determine the impact of such action on the share prices of the firms in question. After all, had firms been allowed to fail, shareholders would have been wiped out. So in these cases, the current market value of the equity represents the apparent value of the bailout for shareholders. But then what of the bondholders? What would the recovery rate have been on the bonds of failed financial firms? It is difficult to make precise estimates, although given the leverage ratios involved, probably low indeed.
Estimating the impact of the Great Bailout on financial asset prices becomes only more difficult as one broadens focus. For example, consider the impact of the US federal guarantee on money-market funds generally. Had the government not stepped in to provide this guarantee, then an incipient run on these funds in November 2008 would most probably have resulted in a failure of the entire financial system. What that would have done to financial asset prices is impossible to know, only that they would be far, far lower than they are today. Equally difficult would be to quantify the impact of the implied bailout for financial institutions that almost certainly remains in place should the financial system find itself facing another such crisis in future. All we can know for certain is that the prices of securities issued by such firms are somewhat higher than they would otherwise be.
The bottom line is that it is a nearly impossible exercise to quantify the overall impact of the Great Bailout on the level of asset prices generally. However, what we can do is look around and locate certain distortions in relative prices which are the direct result of policymakers’ actions. Some of these distortions are large enough to have significant implications for investment strategy and asset allocation.
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Of all the actions that comprise the Great Bailout, none probably have had greater impact on relative asset prices than various measures, both conventional and unconventional, taken by the US Federal Reserve. These include the following:
- A decline in short-term interest rates from around 5% to effectively zero
- An increase in the size of the monetary base from $800bn to over $2tn
- The outright purchase of federal agency (Fannie/Freddie/etc) and non-agency mortgage-backed securities now approaching $1.3tn in total
- The acquisition of a comparatively small amount of highly risky, illiquid assets associated with certain failed financial firms, such as Bear Stearns and AIG
- Various temporary liquidity facilities which have now largely been wound down
The probable effect of these actions has been twofold: First, the level of interest rates generally is lower than it would otherwise be had the Fed not acted as above. Second, yield spreads between US Treasuries and other fixed income assets—primarily mortgage-related—held on the Fed’s balance sheet are tighter than they would otherwise be, given the substantial relative changes in holdings.1
Also important in this regard is that the government decided to outright nationalise the federal mortgage agencies Fannie Mae and Freddie Mac. Had such support not been forthcoming it is quite possible that both agencies would have defaulted on their debt in the face of rising interest costs and declining residential mortgage collateral values. It is hard to estimate what the residual (post-default) value of such paper would be but given that residential property values are down some 40% from their highs, a 60% recovery rate would be a possible estimate. For a 10-year maturity bond, that would imply a fair spread to Treasuries of over 5%, far wider than the current spread of Fannie/Freddie bonds of only about 0.5%. Taken together, the impact on both the level of interest rates and the spread between US Treasuries and agency securities implies that the term structure of interest rates generally is nowhere near where it would have been had the Fed and the Treasury simply sat on the sidelines and allowed nature to take its course. As a result, what we are left with today is, quite clearly, artificial. But if the term structure of interest rates for Treasury and mortgage securities is to some extent artificial, what does this imply about financial asset prices generally?
10y US Treasury yield and Aaa- and Baa-rated corporate bond spreads (%)
Source: Federal Reserve, Moody’s
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The time value of money is to financial asset pricing what the speed of light is to Einstein’s theories of relativity: While not a “constant” in the physical sense, the time value of money, as represented by the term structure of interest rates, is the universal point of reference for discounting the future cash flows on which financial assets represent legal claims. Financial asset valuation models are therefore sensitive to interest rate assumptions, in particular when the cash flows are a) relatively far out in the future; and b) relatively certain. The shorter the time and the more uncertain the cash flows, the less sensitive a financial asset price will be to changes in the term structure of interest rates.
To illustrate this point, consider two financial assets, a long-term government bond and a lottery ticket for tomorrow’s mn draw. As the cash flows accruing to the government bond are known in advance and extend far out into the future, the price of the bond will be highly sensitive to changes in the term structure of interest rates. However, even a large change in interest rates will not have much impact on the value of the lottery ticket. Not only is the cash flow only one day away—not enough time for interest to accrue—it is also unknown. Probability theory can estimate the value of the lottery ticket but, in practice, the payoff is so uncertain—a binary outcome of either zero or mn—that the actual value of the ticket is really just a function of pure uncertainty independent of the term structure of interest rates.
Imagine now that the relative certainties of financial asset cash flows are laid out on a spectrum, from the certain to the highly uncertain. It might look something like this:
CERTAIN ç GBs == IGCs == HYCs == VEs == GEs == VCI è UNCERTAIN
Where GBs = government bonds; ICGs = investment-grade corporate bonds; HYCs = high-yield corporate bonds; VEs = value equities; GEs = growth equities; and VC = venture capital.
As you move from left to right and the uncertainty as to the size of the cash flows becomes ever more uncertain, the present values (prices) of the cash flows become gradually less sensitive to the term structure of interest rates. As such, investments in equities and venture capital might seem to be relatively insensitive to interest rates. However, it is frequently the case that when it comes to investments in growth equities and venture capital, the cash flows that really matter—that determine whether the investment is going to outperform or not—are those at least a few years out in the future, perhaps even a decade or more. Due to the long duration of these cash flows, it would be a mistake to conclude that, just because they are relatively uncertain, these assets should not nevertheless be somewhat sensitive to interest rate assumptions.
Half a century ago, several economists working independently developed the key elements of the Capital Asset Pricing Model (CAPM) which has provided the theoretical basis for risky-asset valuation models up to the present day.2 In its simplest form the CAPM model calculates the expected return of a financial asset according to the following equation:
E(Ri) = Rf + Bi(E(Rm) – Rf)
Where:
E(Ri) is the expected rate of return
Rf is the risk-free interest rate
Bi is the sensitivity (risk) of the asset relative to the market for comparably risky assets
E(Rm) is the expected return of the market for comparably risky assets
While it is obvious that the interest rate Rf plays a role here, notice that, as the measures of risk Bi or E(Rm) approach zero, the expected return on the asset becomes a function entirely of the risk-free interest rate, normally assumed to be that on government bonds. But as Bi and E(Rm) rise, the expected return on the asset becomes less dependent on the risk-free interest rate. If, alternatively, E(Rm) is highly uncertain, the risk-free rate also becomes less relevant. Regardless, note how the model is based entirely on the concept of relative value: Assets are being valued relative to a risk-free asset and relative to the market for comparably risky assets.
Now given that interest rate assumptions are going to have at least a modest impact on relative risky-asset valuations, note that, if the risk-free rate Rf is being held artificially low by the monetary authority, then this will have the effect of increasing the expected returns on risky relative to risk-free assets. In other words, risky assets in general will become fundamentally overvalued. Applied to corporate bonds, this implies that, even absent any explicit or implied government support, spreads to government bonds will become too tight to compensate investors for the fundamental risks they are taking. And risky equities will become overvalued relative to bonds and to low-beta (low risk) equities. This implies that, for any given level of earnings, equity P/E ratios will be higher than they would otherwise be, such that investors end up paying more for shares than they can reasonably expect to get back (someday) in the form of actual, after-tax earnings. By implication, were interest rates allowed to adjust to their natural equilibrium, corporate credit spreads would most likely rise and share P/Es fall.
Leaving the fundamentals aside for the moment, some might argue that stock market investment is not necessarily investment at all but rather a form of speculation and that what stock-market “speculators” are after is short-term capital gains rather than value-based long-term earnings growth. Warren Buffet and other successful value investors would beg to differ. But Warren Buffett would probably be among the first to acknowledge that a substantial portion of stock market transactions represent the whims of speculators rather than the careful, systematic, value-driven determinations of sensible, value-oriented investors. Indeed, it is the actions of the speculators which move prices to levels that are fundamentally unjustified which creates the very opportunities that value investors such as Warren Buffett seek to exploit.
But this leads us to another way in which the actions of the monetary authority can become so detrimental to the economy at large. By making it more difficult to value risky assets properly and by generally inflating the value of such assets beyond what fundamentals can justify, value investors will be less willing to invest in the market generally. Investment flows will become increasingly dominated by those who are really just speculating and chasing trends rather than making reasoned judgements about which companies offer the best potential long-term value. But the stock market does not exist in a vacuum. The valuations placed on stocks represent the abilities of companies to raise capital in the form of new shares or debt issues; to acquire other companies through M&A; to compensate their employees with shares or options thereon; in a word, to grow. If the stock market becomes overvalued, companies are liable to overinvest in their operations. If speculators rather than value investors are the primary force behind stock price trends, then economic resources generally are being allocated in an inefficient, haphazard way which leads to malinvestments. Such malinvestments will, over time, have the effect of reducing the overall economy’s potential growth rate, as they divert resources from other, more productive activities.
Consider the tech bubble for example. Notwithstanding the very real technological advances taking place in the 1990s, by 1997 the stock prices of tech firms began to rise out of line with any reasonable assumptions of economic reality. Value investors began to retreat from the market, leaving it more open to speculators. In the wake of the Asian crisis in 1997, reducing the attractiveness of emerging markets, these speculators moved more aggressively into tech stocks. When the Fed bailed out LTCM in 1998 and also eased monetary conditions briefly going into Y2K, speculators became even more aggressive. As tech stock prices rose and rose, these companies spent more and more on various expansion plans.
Eventually, it all came crashing down and the malinvestments were exposed for what they were. Sure, there were real economic advances that had taken place but valuations, with some help from the Fed, had become so stretched that a bust became inevitable. To compensate for that bust, of course, the Fed eased policy even more aggressively than it had in the wake of the LTCM failure, with the entirely predictable consequence that new bubbles would form elsewhere, this time in residential and commercial real estate and in credit markets generally, leading to even greater malinvestments which have subsequently been exposed as such by a commensurately greater bust. As for where the next bubbles are now forming, we believe that the Fed and economic policymakers generally have spun a vast web of financial market distortions and systemic moral hazard that facilitates asset misallocations just about anywhere. As we have written before, financial history may not repeat but it certainly rhymes.
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For those who are concerned that the dramatic recoveries in risky asset markets over the past year are largely the manifestation of unsustainable, stimulus-fuelled bubbles of varying magnitude, the question then becomes, how does the defensive investor go about investing? Or merely go about preserving wealth? We think there are several investment and wealth preservation strategies worth considering. In general, these strategies require investors to underweight those assets which have the most potential to be distorted in value and to overweight those assets for which valuation metrics have been left reasonably intact. More specifically, these strategies require investors to underweight growth vs. value assets and also to underweight nominal vs. real assets.
Recall that whereas in theory all financial asset valuations are potentially distorted by artificial manipulations of the term structure of interest rates, the greatest distortions are likely to manifest themselves in those assets with relatively long-dated but also relatively certain nominal cash flows. In this regard, investors should be particularly concerned about recent developments in sovereign debt markets and not only in the weaker euro-area members. The growing perception that government bond markets are not necessarily reliable stores of value given exponentially rising sovereign debt burdens is almost certain to weigh on the prices of sovereign obligations generally in the coming years. Essentially all western government bond markets are at risk. Investors should thus be particularly wary of longer dated government bonds but also other high-quality fixed income assets. A problem then arises in that these assets are traditionally regarded as the standard, benchmark long-term stores of value. For those simply looking to protect wealth, rather than to invest or speculate, what are the alternatives?
We would argue that gold and other precious metals are attractive as substitute stores of value. Historically, they have held their value particularly well during periods in which central banks have chosen to follow unconventional policies, such as in the 1930s, and also when there have been major rebalancings of the global economy, such as during the 1970s. While conditions are certainly somewhat different today, there are enough parallels to make gold, silver and other precious metals attractive alternatives as stores of value.3
Not all investors are seeking merely to preserve wealth, however, but are also looking for investment opportunities to grow their capital. Naturally they tend to invest in equities and higher-yielding forms of debt. Here, too, there are reasons to be defensive. Although the cash flows associated with corporate earnings are in most cases relatively uncertain, they are also long-dated and should be underweighted by defensive investors. Valuations of corporations with relatively high dividend yields, by contrast, are less likely to be distorted, as the cash flows are shorter-term on average, even if somewhat more certain.
An equally important observation is that in general nominal asset valuations are more likely to be distorted than those for real assets, such as commodities. This is because nominal assets are claims on cash flows only, whereas commodities have intrinsic value. Cash is only useful to the extent that it can be exchanged for something else. Commodities such as food, for example, need not be exchanged but can be consumed. Even precious metals can be “consumed” in the form of jewellery and, in the case of platinum and palladium, in catalytic converters and certain other industrial applications.4
Are equities again looking too expensive vs. commodities?
Source: Bloomberg
In the case of relatively perishable commodities, such as foodstuffs for example, there are important additional reasons why their valuations are unlikely to be directly impacted by an artificial term structure of interest rates. First, the prices of such commodities are, by their very nature, subject to natural uncertainty such as weather patterns and local supply, demand and storage factors. Second, precisely because they are perishable, they need to be consumed within a reasonable period of time. As such, while their prices may be volatile, this volatility is unlikely to be a function of the term structure of interest rates.
The volatility of commodity prices generally may appear to exclude them from a relatively defensive approach to investing. But consider: If governments and monetary authorities are deliberately trying to create inflation in order to reduce the real debt burden on the economy, and perhaps to support nominal tax revenue, then cash can no longer be considered a reliable store of value, nor can government or other high quality bonds. Moreover, given that there will always be natural demand for food, clothing and shelter, in various forms, what could possibly be more defensive than storing value in the form of food, clothing and shelter? Given that there is a broad range of commodities that comprise much of the basic inputs for the necessities of life, one can construct a diversified portfolio of such commodities with a much lower overall volatility than that of any one component. This enables the defensive investor to realise substantial diversification benefits in excess of those that can normally be achieved through a conventional nominal asset portfolio of stocks, bonds and cash.
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We have discussed how the Great Bailout has almost certainly distorted a broad range of asset prices and that, of the available alternatives, value equities, in particular those with high dividend yields, and commodities are likely less distorted and hence less prone to becoming overvalued. Notwithstanding growing investor and perhaps even some speculative interest, gold is now almost certainly a more reliable store of value than long-dated bonds and cash. Commodities generally, in particular those required by consumers around the world for food, clothing and shelter, are probably also relatively unaffected and, through diversification, can provide a reasonably stable and effective store of value.
There is, however, an important additional reason why we would favour commodities over financial assets in the post-bailout environment. Consider that commodities represent economic “input” rather than “output”. (There are some commodities that are in fact both: Gasoline is a refined product, the output of a series of chemical processes and, of course, human innovation and labour. But for the most part, commodities represent “input”.)
What concerns us here is that the Great Bailout has not been merely a monetary phenomenon affecting the term structure of interest rates; governments have also responded with all manner of intervention in many sectors of the economy. The US government’s implementation of mandatory health insurance or the UK government’s nationalisation of much its financial system are merely high-profile examples of a general trend. Other factors equal, we believe that, as government intervention in the economy increases, whether through tax or regulatory policies, it is going to place new constraints on the growth in corporate profits (although it might benefit pockets of industries that are adept at influencing the tax and regulatory regimes to their benefit, through legal means or otherwise). Corporate profits are, of course, a form of economic “output”, albeit one that is frequently reinvested, enabling sustainable economic growth. But if corporate profit growth is going to be constrained in future, this implies that the market value of economic “output”—that is, corporate assets generally—are going to underperform relative to the price of economic “input”—that is, commodities—which are not going to be affected to the same degree.
Although we believe this to be a fairly straightforward observation, it is also a somewhat depressing one. Economic growth is dependent on productivity growth, which in turn is dependent on growing the capital stock and finding more efficient ways to mix capital and labour to produce the goods and services that consumers want. In a healthy economy, the market value of “output” should be steadily growing relative to the market value of “input”. Corporate profits should be growing more rapidly than commodity prices. However, as is easy to observe, outside the financial sector, US corporate profit growth has lagged behind commodity price growth for many years. And financial sector profitability would look far, far different if not for the escalating series of bubbles and bailouts of recent decades. For those who care to look, the symptoms of economic malaise have been apparent for some time. In our judgement they are likely to become far more acute in the coming years.
The Amphora Liquid Value Index (through April 2010)
Source: Bloomberg
1 It could be argued that, as the Fed has now ended its scheduled programme of purchasing non-US Treasury securities, spreads for such securities now reflect a fair, free-market value. We disagree. Were the Fed to sell back into the market its holdings of some .3tn in these securities, we find it hard to imagine that spreads would remain mostly unchanged. Not only would spreads need to widen to help to absorb the supply; the signal this would send to the market—that the Fed is no longer the “buyer of last resort” for such paper—would force a qualitative reassessment of the Fed’s willingness to provide a liquidity backstop in future. While moral hazard of this sort is difficult if not impossible to quantify, that does not mean that it does not exert a huge influence on financial asset prices, in particular those that the central bank has demonstrated are essential to its “lender of last resort” role.
2 William Sharpe, Henry Markowitz and Merton Miller jointly received the 1990 Nobel Prize in Economics for the CAPM, although several others also did essential work in this area. William Sharpe is also well known for his eponymous measure of risk-adjusted returns. In recent years, CAPM has come under increased scrutiny in part because it assumes that financial market risk is normally distributed. The 2008-09 credit crisis is just the latest example that this is not the case, although it may appear so from time to time.
3 There has been some discussion in the financial press over the past year that perhaps gold, silver and other precious metals are now bubbles themselves, rising in value not because of reckless monetary policies but just because they are in well-established uptrends increasingly reinforced by speculators. We don’t doubt that there are those who might be chasing the rising gold or silver price in the hope of making a quick profit. But consider that the entire point of investing in gold and silver is to avoid the risk of monetary debasement and/or currency devaluation. As such, as long as central banks are fighting asset price deflation with monetary inflation, there is a clear fundamental basis to expect an uptrend in precious metals prices. But it is certainly possible that precious metals prices might now be overvalued relative to other real assets which have not been the subject to the same degree of speculative buying. We plan to address precisely this topic in a future Amphora Report.
4 For those “gold bugs” out there we don’t intend to belittle precious metals’ historic role as stores of value by suggesting that they are primarily intended for “consumption” in the form of jewellery. Whereas in the West many consumers might regard jewellery as such, the attitude in the rest of the world tends to be far different. While beautiful, many peoples regard their jewellery as an important and in some cases the most important store of value. We would not presume to lecture those of such persuasion that a well-diversified portfolio of major-market equities, bonds and cash is somehow superior, especially given that so much history, ancient and recent, strongly suggests otherwise
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