Destination Reformation — The Dawn of a New Era in Central Banking

Combine contraband coffee, paralytic guilt and a gift for translating Greek and you too can change the world. Such was the case with a young, deeply devout Catholic by the name of Martin Luther in the year 1516.

A decade after he traded academia for the priesthood, Luther found himself disturbed by the quid pro quo nature of Catholicism. Sin expunged via penance in increasingly pecuniary form struck Luther as graceless at best. A field trip to Rome only served to dial up his unease as the ornateness on vivid display communicated dishonesty and even vice. That this epiphany coincided with the first trickles of coffee into Germany was fitting given what was to come.

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Jay Powell – A Quiet Leader

The sheer breadth of Powell’s experience is refreshing compared to what we’ve had for the past 30 years. Powell has a deep understanding of the law and politics. He worked in the Treasury Department under Nicholas Brady and was confirmed as Undersecretary of the Treasury under George H.W. Bush. His background in politics and the experience he has had at the Fed thus far have prepared him well for his role as liaison to Congress and the White House.

Powell’s experience as an investment banker was critical in his carrying out the investigation and sanctioning of Salomon Brothers. Understanding the entirely different type of politics that exists in big banks will bode well for his capacity to regulate the banks. This attribute especially will dilute the power traditionally exerted by the NY Fed in recent years, a District that has a long history of conflicts of interest vis-à-vis the banks it regulates. A stronger regulator as Fed chair in the years leading up to the financial crisis would have been able to recognize many of the markers the economists missed.

At the Carlyle Group, Powell founded and ran the Industrial Group within the Buyout Fund. A separate missing characteristic among Fed leaders for the past 30 years has been a woeful lack of understanding as to how Fed policy effects corporations and the decisions CEOs and CFOs make driven by Fed policy, the most obvious of which has been debt-financed share buybacks at the expense of capital expenditures.

Some in the media have questioned Powell’s being the wealthiest individual at the Fed. That is actually a strong suit. In his work between 2010 and 2012 at a bipartisan think tank, Powell worked for a salary of $1 per year to carry out his mission to raise the debt ceiling. His wealth affords him the luxury of having no preset agenda. His history of working for his country exemplifies that he is at the Fed because he truly believes he is doing a greater good in servicing his country.

Powell’s work on Too Big to Fail banks also speaks to his ability to be independent and objective in his approach to regulating big banks with deep-pocketed lobbyists who hold huge sway over politicians. If he is willing to go up against the biggest banks, he will hopefully prove to be a leader cast in the mold of William McChesney Martin, the longest serving Fed Chairman famous for testifying to Congress that it was the Fed’s job to take away the punch bowl just as the party gets going.

His being a member of the Republican party is a sign he will be less apt to encourage further mission creep at the Fed in its fulfillment of its second mandate to maximize employment. Dovish leaning Fed chairs have induced financial instability time and again in their efforts to bring marginal workers off the sidelines. The busts that have followed though have done greater damage to the labor market. His experience in the financial markets suggests he will be less apt to keep rates too low for too long as has been the case with his three predecessors.

Powell was not in favor of the third round of QE, but voted for its nevertheless. This is his biggest black eye and why market participants perceive him to be as dovish as they do. One can only hope that the quiet leader will have the strength to not only act more independently, being faithful to his convictions, but also to encourage dissent on the Board of Governors which has been absent since 1996 save two dissents.

I lean towards the Bloomberg Intelligence Fed Spectrometer which rates Powell as neutral rather than a hawk or a dove. Or as the man I used to call boss, Richard Fisher, would say, Powell is a (wise) owl. The notion that an intelligent man who has studied economics assiduously since joining the Fed is unfit to lead because he is not a PhD in economics is naïve and utterly preposterous. His not being an academic is possibly his best attribute given he will be battling the next recession and the financial markets disruption that is sure to accompany it.

 

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FINDING NEOM, DiMartino booth

Finding Neom: The Future of Black Gold

Sometimes you have to lose nearly everything to focus your attention on what’s most important, even if you’re a clownfish.

But then it’s not every day a barracuda massacres your entire family, save one damaged egg. Lucky for all us moviegoers, it was Nemo who eagerly emerged from that egg, the big screen’s most beloved orange-striped fish, damaged right fin and all. Not surprisingly, such trauma drove Nemo’s father to helicopter parenting, to the extent such proclivities are possible…underwater…on the Great Barrier Reef. On the other hand, anything is conceivable in animated features. Such was the case nearly 15 years ago with Disney’s release of Finding Nemo.

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DiMartino Booth, China, Policy, Economy

Dim Sums: A Fork in the Silk Road

Two centuries before Christ and millennia before truck stops, there was Dim Sum along the Silk Road. What, after all, could possibly best tea houses with nibbles to break the monotony of a 4,000-mile journey from Xi’an to the Mediterranean and back?

The tradition of Dim Sum is rooted in the revelation that drinking tea helps the digestion process, which prompted the introduction of bite-sized dishes to stand as accompaniments. It’s easy enough to envision the warm feeling those beckoning tea house silhouettes over the horizon elicited, the same sensation stimulated by the Golden Arches today.

 

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THREEofTHREE, Danielle DiMartino booth, Money Strong

Pricing in Perfection: Three out of Three?

We know two out of three ain’t bad. Does that render three out of three perfection itself? The history of the number three certainly suggests that to be the case. Little did we know that three is the first number bequeathed ‘all-encompassing’ status.

True Triads come in many familiar forms including the Father, Son and Holy Spirit; the beginning, middle and the end; the heaven, earth and waters; the body, soul and spirit; and last but certainly not least — life, liberty and happiness.

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Danielle DiMartino Booth, Money Strong, Credit Markets

The Credit Markets: Casting Angels from Crowded Celestials

Mammon, Moloch and Mulciber have never had it so good. If your Paradise Lost is lost on you, a quick refresher. All three are former angels who have fallen on hard times, in Hades, that is.

Mammon is known as the “least erected,” as his eyes are always on the ground, faithfully foraging for gold. A pragmatist and capitalist, Mammon would have exploited the wealth of Hell to turn the heat down rather than bother with all that warring with God.

On the opposite end of the homicidal scale, sits Moloch, an idolatrous deity worshipped by some ill-fated Israelites. His penchant for child sacrifice went hand in hand with his council vote, which was all out war with God. And then there was Mulciber, inspired by Hephaestus in Greek mythology. He must have been the right brain among the fallen given he was the chief appointed architect for Pandemonium.

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Economy, Pensions, DiMartino Booth, Danielle DiMartino Booth, Money Strong LLC, Fed Up: An Insider's Guide to why the Federal Reserve is Bad for America,

Retirement in America: The Rise of the Velvet Rope

Before there was the One Percent, there was the velvet rope at Studio 54.

Gaining entry to the divine disco, with its adherence to a strict formula, was just as exclusionary. This from Mark Fleischman, the Manhattan haunt’s second owner in a memoir released to mark the 40th anniversary of the club’s opening:  “A movie star could bring unlimited guests, a prince or princess could invite five or six guests, counts and countesses four, most other VIPs three, and so on.”

Andy Warhol called it the, “dictatorship at the door.” Brigid Berlin, one of Warhol’s Factory workers and guests, once described to Vanity Fair how she, “loved getting out of a cab and seeing those long lines of people who couldn’t get in.” If beauty alone could sway the dandy doorman, famed for flaunting his fur, a different kind of cordon awaited you once you set foot inside the cavernous strobe-lit mecca, that is a screen hung across the dance floor to separate the chosen from the common. The scrim summarily dropped at midnight, but not a minute before, affording elites ample opportunity to make their escape to the VIP floors above.

The annals of the truly desperate include one reckless raver who rappelled into Studio 54’s courtyard, breaking his neck in the process. But at least he eventually walked away. A less fortunate celebrity seeker perished in one of the club’s air vents. Upon discovering his body, there was no surprise he was in black tie. Studio 54’s velvet rope has long since fallen. Unfortunately, in its place, another has risen.

So inescapable are the headlines pronouncing inequality, we’ve all but grown impervious. But what of the stories of Tomorrowland? What will come to pass in the coming years as demographics and valuations collide?

Last month, Deutsche Bank broke Wall Street’s version of The Ten Commandments, all of them at once, in a comprehensive report titled “The Next Financial Crisis.” In case you’ve been on sabbatical or on the buy side so long you’ve forgotten, the First Commandment is, Markets Always Rise. The nine that follow are a variation on why and how to convey to your clients that the music is still playing, even if you’ve long since sat down.

Though there were many condemning graphs related to the increased frequency of booms and busts, government balance sheets and central bankers gone wild, it was the one you see here that was the most incriminatory in its simplicity.

The chart dates back to 1800 and depicts an equal weighted index of 15 developed markets’ government bond and equity markets. Nominal yields relative to history and share prices relative to nominal GDP are used to gauge historic deviations. The 100 percent reading you see means that in the aggregate, using an equally weighted bond/stock portfolio, bond yields have never been this low and equity prices this high.

You could quibble that stocks are not as richly valued as they were in 2000. But that argument runs counter to the fact that thanks to the bond-sale-proceed/share-buyback feedback mechanism, the symbiotic relationship between stocks and bonds has never been so tight. You could also venture that the central-bank, spoon-fed trend higher in earnings of the past decade will remain intact, that this represents, in the Deutsche analysts’ words, “a new paradigm.” But such declarations do tend to come back to haunt. So why go there?

Instead, marry the inescapable reality of the Deutsche graph to the other fact of life, the $400 trillion shortfall in retirement savings that will pile up over the next 30 years. Perhaps it’s easier to get your arms around the figure if you look at it as a multiple of the global economy. By that metric, underfunding will equate to more than five times global GDP.

The recent World Economic Forum (WEF) report attributed the disaster in the works to longer lifespans and disappointing investment returns. But it’s the what’s to come that is more telling. It’s no secret that employers have been shifting away from traditional pensions to 401(k)s, IRAs and the like over the past several generations. It was somewhat startling, though, to learn that these self-directed plans now comprise more than half of all global retirement assets.

Zeroing in on the United States, we are racking up an additional $3 trillion a year in aggregate retirement underfunding. By 2050, the nation’s retiree assets should be under water by $100 trillion.

It’s safe to say I’ve written reams on the societal ramifications of public pension underfunding in the United States. In far too many cases, it will be mathematically impossible for the funding gaps to be rectified before time closes in and cash flows run blood red. The judiciaries will go toe to toe with the governing authorities who will in turn battle the unions. Around and around the interested parties will go, appearing to man the front lines of the retirement crisis. As is so often the case with appearances, these too will deceive.

While the fiscal unraveling of states and municipalities promises to pack punchy headlines, the World Economic Forum report nevertheless shifts the discussion 180 degrees.

As of the middle of this year, total U.S. retirement assets totaled $26.6 trillion. That’s not all good and well, hence the shortfall cited above. Still, it’s the breakdown of those assets that’s critical. As of the end of June, IRAs held $8.4 trillion followed by $7.5 trillion in defined contribution plans, mostly 401(k)s. Public pensions came in at $5.7 trillion while their dying-breed private pension counterparts rounded out at $3.0 trillion. Annuities complete the picture at $2.1 trillion (who knew?)

Though naïve to do so, remove IRAs from the calculus for the moment given the voluntary nature of these accounts and what that implies, albeit superficially. For the sake of argument, focus solely on 401(k)s and public pensions. Now, envision a typical public pensioner and a typical 401(k)-plan worker. You won’t be alone if similar pictures of hard-working folks came to mind.

The question is, how do their fates differ in Tomorrowland, after markets have begun to revert to the mean? (A full reversion to the mean is more than most can stomach, hence the softer suggestion.)

The fact is 401(k) holders suffer double damages vs. public pensioners, at least initially. While both individual investors’ and pensions’ portfolios take a beating, the pensioner won’t feel it due to their income being guaranteed by law. Heck, the pension fund manager won’t lose too much sleep knowing where there’s a loss, there’s a way…to raise taxes, that is.

That’s where 401(k) investors’ second helping of lumps enters the picture in the form of higher state or municipal taxes. Some lucky residents might see everything save their federal taxes rise if they’re fortunate enough to live in windswept areas where spineless politicians were corrupted by even more corrupt interested parties who negotiated pensions that could never be repaid. If push comes to shove and the increased taxes still don’t cover the pension bill, public services can be slashed.

Of course, public pensioners will also feel the brunt of cost of living increases, if they’ve not relocated to a town with faster EMS response times and more frequent trash pickups. But then, in the public sector many are able to retire at young enough ages to secure second careers and with them, supplemental sources of income.

Recall, though, that the retirement assets of the protected pensioners ($5.7T) are a pittance of those of the unprotected, especially if you factor back in those IRA assets to say nothing of at-risk private pensioners, whose benefits are severely cut in the event of bankruptcy ($18.9T).

It’s hard to conceive a blanket acceptance of working men and women bailing out working men and women. But that’s what we’re supposed to believe to be the solution to what is and will continue to ail public pensions, from, by the way, a starting point of record highs in asset prices.

Now might be a good time to add another snippet from that Deutsche Bank report. “Prior to the last decade, the only comparable rise in populism started in the 1920s and culminated in World War II. So although populism has proved unpredictable in recent years, the rise surely increases the risks to the current world order and could set off a financial crisis at some point soon.”

Substitute out ‘populism’ for ‘anger factor’ as it better captures the sensation shared by so many today who believe they’ve been dealt an unfair hand by a dealer on the take. Most who remain among our middle-income earners understand the terms ‘elite’ and ‘establishment.’ As much pride as they still have, they will find a way to revolt at the first whiff of being asked to bank a bailout on their pittance of a living.

The majority of workers may not have the statistics at the ready – that their paltry and at-risk retirement assets are but a third of the country’s financial assets, that the balance sits in the hands of the wealthy. But they do know what it’s like to be frozen out on the other side of society’s velvet rope and they won’t sit back and take it.

In other words, there’s simply no denying that some pensions, especially those of some acutely fiscally enfeebled states, will require federal bailouts in the coming years. As for how that is funded? More taxes yet, of the federal sort, of course. That is the only fathomable answer, which adds a dollop of insult to injury for those whose other taxes had already been rising for years.

Stepping back, you may be asking, why sound the alarm if the worst of the underfunding won’t crest for another three decades? The shortest answer is the sooner pension underfunding is addressed, the lower the probability a financial matter morphs into one that engulfs our society and provides one more reason yet to add parental controls to the evening news.

In the event your capacity for combining nobility, vision and politics is limited, you might deduce that some can-kicking takes place long before any preemptive pension reform is conceived. If you’d like to capitalize on that assurance and at the same time profit from the few states that have put their finances in order, you might want to put in a call to your municipal bond manager (I have several suggestions if you’d prefer).

The directive is simple enough. First, identify the most vulnerable states with the least-funded pensions and the lowest per capita income. The bottom three are Kentucky, Kansas and Mississippi. Next, locate the mirror image, the states with the most funded pensions and the highest per capita income, as in South Dakota, Wisconsin and Washington State. Now, short the weakest and buy the strongest and then sit back and wait for politicians to do their jobs.

As for the here and now, you can toss out any superstitious notions about October being a spooky month for the markets. September is traditionally the nastiest of the year’s bunch and it was a flat-out party in the house. Market history suggests the year will end with a bang.

But it’s much more than pure pattern that should sustain your risk appetite. The past two years, Federal Reserve policymakers have committed to hike in September and delivered in December. What’s followed have been Happy New Years, one after the other. It’s a safe bet most investors will remain in textbook Pavlovian momentum mode and go long into the mid-December Fed meeting.

Besides, fourth-quarter, hurricane-influenced economic data promise to do one thing and only one thing — produce more noise than the punk backlash that followed disco fever. Fundamentals will thus be fuzzy at best.

And finally, corporate bond issuance in the year through September was yet another for the record books, which says something about lenders looking the other way, or better yet, tuning out altogether. Those sales proceeds do tend to find a home and it doesn’t tend to be a bear cave.

So do the hustle, and fight that rational urge to short these irrational markets. Keep on dancing, dancing, dancing in Wall Street circa 2017’s answer to Studio 54 lest you find yourself rejected and subjugated to boogying down at the Crisco Disco.

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Investing Now & Then: A Panoply of Parallels, DiMartino Booth, Money Strong, Fed Up

Investing Now & Then: A Panoply of Parallels

So much for “ghoulies, ghosties and long-leggedy beasties” having a monopoly on “things that go bump in the night.”

No longer is this classification reserved for things that taunt, tantalize and toy with our terrors as that traditional Scottish poem first invaded our minds. Earlier this summer, some avid astronomers, tasked as they are with mapping out the infinitely capacious celestials, literally stumbled upon a distinctly different sort of bump in the night. A mysterious ‘cold spot’ sighted telescopically might actually be a bruise of sorts, “the remnant of a collision between our universe and another ‘bubble’ universe during an earlier inflationary phase.”

Such a discovery would strip the ‘uni’ right out of universe landing us smack dab in a ‘multiverse’ in which all conceivable outcomes are playing out at once in a layered rather than singular reality. In the event this panoply of parallel possibilities has left your brain in a painful pretzel, ponder not another moment. The jury is in and the verdict is parallel universes in quantum mechanics and the cosmos alike are unanimously unproven.

As for other bubbles of a different stripe, but also spotted during other earlier (asset) inflationary phases, a growing chorus of vaunted visionaries has begun to chant that we are at the precipice of colliding with any number of parallels in investing time.

Yours truly recently wrote of the Panic of 1907, a crisis of confidence brought on by an exogenous event – in this case, the 1906 San Francisco earthquake – that caused a six-week run on most New York banks. As was the case in the years that led up to the 2007 crash, 1907 was preceded by a magnificent era, the Gilded Age, and dominated by one J.P. Morgan. Compress time and loosely liken Alan Greenspan, a banker’s ally among allies, to the bigger than real life personality behind the cultural shift to speculation.

How would 2007 have played out had Alan Greenspan remained at the Federal Reserve, the very institution that emerged from the Panic of 1907? We’ll never know though he never did allow an institution to fail on his watch, for better or moral hazard worse. As was the case with Morgan, history will forever remember Ben Bernanke being at the helm and allowing insolvent institutions to fail on his watch just before, that is, rescuing AIG.

Separately, a few brave souls have dared to compare the feverish times that led up to the crash of 1987 to today. Forget for a moment that it is nearly too neat, having something of similar magnitude unfold exactly 30 years on. The Dow had soared by 40 percent at its August 1987 peak; it’s up a pittance of 13 percent thus far this year. And interest rates were appreciably higher than they are today, which is easy enough to imagine.

That said, there are similarities. Stocks are racking up one record after another, seemingly blind to the news flow. Goldman Sachs’ strategists recently noted that the benchmark S&P 500 has nearly broken the record for the longest period of time without suffering a five percent correction; only four other times rival the current stretch. Multiples, meanwhile, are higher today than any other years save 1929 and 2000.

But then, these statistics all but beg to be bested. The truly petrifying parallel is that of investors’ mindset, or better said, lack thereof. If it seems odd that only eight percent of large-company stock funds have outperformed the S&P 500 over the past five years, it’s because it is plain spooky. This is no great defense of active investing, mind you, simply an observation that it’s impossible that every manager has up and lost all of their acumen. It is the ‘auto-drive’ mentality that smacks of the closely held convictions investors had in their Nifty Fifty (TFANG anyone?) being bulletproof. Or worse, today is a hybrid era – investors sleep well at night ensconced in their low-cost index funds’ ‘safety,’ which is nothing more than the combination of a handful of savior stocks wrapped in today’s answer to portfolio insurance – that is, of course, passive investing.

Because so few believe it to be the case, passive investing will not end well. The investing approach not only magnifies the largest market-cap stocks’ influence on blind portfolios, it effectively negates the need to perform fundamental analysis. Though the premise is sound on its face, the outcome of passivity has grown to be a complete unknown given it’s never been in the ring at its current, record weigh-in level. We know one of two critical parameters – the size of the entrance. The size of the exit, however, is a complete TBD, as in to be determined.

It shouldn’t shock you that an increasing number of institutional investors have grown alarmed at the passive investing trend. To mitigate their enigmatic exposure, many have poured into managed futures funds, otherwise known as “commodity trading advisor” hedge funds, or CTAs.

CTAs are automated vehicles that follow market momentum, which is great when everything is awesome as is the case today. The fact that CTAs bet against already-falling markets? That worked well in 2008, when they were less than a third of their $300-billion current asset size, a figure that doesn’t include cheaper copycat ‘simple momentum’ funds. Those who’ve adopted CTA strategies now include a much wider swath of investors in stark contrast to CTAs’ traditional users, pensions and other sophisticated investors.

Consider these words from a recent Financial Times interview with David Harding, head of Winton Capital and one of the largest players in the CTA: “When an institution allocates to a momentum strategy in the hope of cushioning itself from stock market downdrafts, it really is commissioning someone to sell stocks on its behalf in a falling market; no different to the failed portfolio insurance that was implicated in the 1987 crash.”

For a closer proximity potential parallel, look back no farther than 2007. The accelerant back then came down to one word: leverage. In the spirit of more is more, in the interim decade central banks have piled on $20 trillion or so in fresh debt while corporations have gorged themselves on record borrowing.

As for households, U.S.-based consumers have re-levered back to prior highs, albeit with appreciably less mortgage debt. In other countries, such as Australia and Canada, nosebleed debt-to-income levels have made for many petrified policymakers as they contemplate the economic implications of household deleveraging. Surely it won’t be as nasty as what was witnessed in the U.S. and U.K? Surely not.

And then there’s China, the ‘it’ girl, the standout among leverage gone wild in a post financial crisis world. Given they play by a different set of rules, how China’s policymakers address their homegrown debt bubble is anyone’s guess. If you figure that one out, please let me know.

In all, global debt sits at $220 trillion and counting, about $70 trillion higher than it was ten years ago. How leverage, and more importantly deleveraging, play into the next market reset is as good a mystery as any given the different form it’s taken on in this cycle and the unaddressed situation, shall we say, of that black box we refer to as ‘derivatives.’

For all of the parallels that can be drawn, though, it is that of 1937 that should give investors most pause. None other than Ray Dalio, who has masterfully managed his hedge fund Bridgewater’s assets to $160 billion, raised the alarm in a recent CNBC interview.

Dalio’s case is unnerving in its simplicity. The years leading up to both 1929 and 2008 were marked by a huge debt build, which policymakers answered identically – by lowering interest rates to zero. In both instances, these extreme exertions succeeded in reflating the stock market. Fair enough.

But it’s the cultural comparisons that resonate most. Nationalism was rampant and spreading against a backdrop of rising inequality worldwide. And antitrust was gaining in acceptance as a counter to the deepening sense of societal injustice.

Dalio makes his case stronger yet by drawing the Fed into the fray. You may not recall, nor should you, but 1937 was all about the Fed overtightening the economy right back into a contraction, which in turn put the ‘Great’ into the Great Depression.

Will something similar play out today? With all due deference to most of the those who cover the Fed in the media, Janet Yellen’s speech to the National Association for Business Economics Tuesday was anything but dovish.

In case you missed the consensus conclusion, it started and ended with one Yellen quote: “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.” The takeaway, for most, was that the Fed was set to ease, not tighten.

But then why make such a splash at the last Fed meeting, all but broadcasting a December rate hike was in the offing just to contradict that a few days later? Go back for a moment and focus on one word in that last quote: “Misjudged.” When was the last time you heard a central banker admit fallibility? And therein lies the key. Yellen’s words are on their face highly unusual as they involve something that is completely out of character for her, a mea culpa.

Yellen’s de facto about face was followed by a proposition that, “it would be imprudent to keep monetary policy on hold until inflation is back to two percent.” As for her years of hand-wringing over wages not responding to the low level of unemployment, she countered herself by saying, “inflation may rise more sharply in response to robust labor market conditions than anticipated.” Her conclusion, akin to an admission of guilt: “It would be imprudent to keep monetary policy on hold until inflation is back to two percent.”

In the event you’re not convinced she means business, she added this kicker: “Persistently easy monetary policy might eventually lead to increased leverage.” The added emphasis on eventually is for obvious ironic purposes.

In a few weeks, the Federal Reserve Board will be whittled down to three members. What better time for that other voting member, New York Fed President William Dudley, to exert even more influence than is customary. In the event you missed the news flash, the NY Fed has rolled out a brand spanking new inflation metric called the Underlying Inflation Gauge.

Google it if you’re so intellectually inclined, but you really need only know that this much more holistic take on price pressures clocked in at 2.74 percent over last year in August, up from 2.64 percent the prior month. In FedSpeak, that’s called, “Hitting our two percent inflation target, and then some.”

Add up Yellen’s words and Dudley’s new take on inflation, bearing in mind we’re talking respectively about the Chair and the Vice Chair of the Federal Open Market Committee, and you can safely deduce that the third consecutive December rate hike will be followed by more of the same. This is an entire series of hikes on the launch pad. The Fed will conclude its cycle, at least that’s what they’ve taken great pains in the past few weeks to communicate.

The flip side of this tough talk could well come from across the pond. Mario Draghi was nervous enough about the prospects for a European Central Bank taper that he cancelled his planned remarks on that subject at this past August’s Jackson Hole central bank confab. The German elections have no doubt elevated his anxieties and he could choose to disappoint the hawks once again at the upcoming October ECB meeting.

Does any of this add up to a full reprieve for stretched markets? Well, no, not in the end. But a tightening Fed and an easing rest of the world does suggest variable rate instruments will capitalize on this disconnect in the interim. As the Wall Street Journal detailed, U.S. leveraged loans might not have much more room to run. Volumes this year are on track to outpace the 2007 record of $534 billion; total loan fund assets hit a new all-time high in August.

Europe, however, still has room to run, all things central banking considered. 2017 volumes there are running at less than a quarter of their 2007 record pace. If you are on the nimble side, you might want to have a peek at the Invesco European Senior Loan Fund (IESLGXE:LX, $106.49). If you are downright determined to gain direct exposure, and currency risk is something with which you have a decent comfort level, shoot up a flair. There is a plentitude of precise ways to play the space.

As for our eventual date with destiny, it would help if you could indulge me an etymological detour, and wax Greek for a moment. The word parallel breaks down into two neat parts – para, as in ‘alongside,’ and allelois for ‘one another.’ What if, in fact, we innocents are existing in the investing world’s answer to a parallel multiverse? What if history is aligning on multiple historic counts and we’re living them all at once? A deep thought to be sure and a cautionary tale if there ever was one, or more.

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@dimartinobooth, Danielle DiMartino Booth, Fed Up: An Insider's Guide to why the Federal Reserve is Bad for America, Money Strong LLC, economy, federal reserve, William Safire

Channeling Safire: “If it’s broke, fix it.”

Bert Lance must have left office thinking his legacy was in the soup.

Instead, the wise words of one of the country’s shortest-serving Directors of the Office of Management and Budget would go on to first merit inclusion in Random House’s Dictionary of Popular Proverbs and Sayings and then today, Google status. The expression, “If it ain’t broke, don’t fix it,” achieved such acceptance, conservative legend William Safire would go on to crown Lance’s idiom, “a source of inspiration to all anti-activists.”

For Safire, a gifted word spinner if there ever was one, his acknowledgement of pith perfected in no way implied admiration of the source. Indeed, Safire’s crowning glory as a New Yok Times columnist arrived with his 1978 Pulitzer Prize for “Carter’s Broken Lance.” …

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DiMartino Booth, Big Boys, CRE, Money Strong, Fed Up

The Big Boys of Summer

Do you feel it in the air? Is summer out of reach?

Many of us came of age, or thought we did, the first time we heard Don Henley’s mega-hit The Boys of Summer, released in October 1984. But can a song be reincarnated to mean even more? Can one brush with destiny change everything? This week more than any other, it’s right and true to look back and answer that question in the affirmative.

For those of us in New York 16 years ago, September 12th and 13th stretched on for many more than the 24 hours the clock conveyed. It wasn’t until the early morning hours of the 14th, when Dick Grasso announced the New York Stock Exchange would remain closed through the weekend, that many of us were released, on many levels. Walking the beach that weekend, looking for signs in the sand, Henley’s mournful song stopped me in my tracks. “Those days are gone forever” forever took on new meaning.

An old friend dropped me a line recently. His none-too-subtle message reminded me yet again of Henley’s song, but in yet a different way. It would appear the innocent boys of summer have departed the investing world as well, leaving in their stead conditions in which only “big boys” should engage, his words. Though this market veteran has been around long enough to know most asset classes are vulnerable, the article he shared spoke specifically to tail risks building in ccommercial real estate  (CRE), which we’ll get to in relatively short order.

Longtime readers of these weeklies know the two asset classes I foresee investors will grapple with the most in the next recession are high grade corporate bonds and apartments. The math and logic backing this warning are simple as they most resemble that which supported the explosion of subprime mortgage issuance during its heyday. Accept credit quality as a given, so long as it brandishes an investment grade rating, and green light record levels of issuance at just about any price. No, this will not end well.

But what about other CRE subsectors? After all, rent declines throughout the three most recent recessions were the deepest in office and industrial markets. Multifamily, meanwhile, was the least distressed sector. Retail is a unique case in point:  rent declines were near nonexistent during the 2001 recession, but worse than office and on par with industrials during the Great Recession thanks to pricing pressures accelerating the rise of ecommerce.

Since then, things have gotten mighty interesting in what has, by all accounts, been the lesser manipulated of the two types of domestic real estate markets. Hint: it isn’t housing. The Federal Reserve’s misguided policies and interest rate suppression tactics are manifest in residential real estate, where Morgan Stanley figures prices have recovered 90 percent of their peak-to-trough values (‘Peak’ is defined as 2007-2008 highs, while ‘trough’ reflects 2009-2010 lows).

As for CRE, it’s recouped nearly double that of residential – peak-to-trough prices are up 168 percent. Critically, these are the ‘headline’ figures that catalyze concerns among the superficialists. But it’s the subsectors that serve up the real smokin’ hot spice factor. A quick perusal of the nearby table highlights how haywire things have become in multifamily, which we already know, and about which you should consider yourself amply forewarned.

But look just beneath manic multifamily and you see that in any other world, what’s happened in major market and central business district (CBD) office properties would be garnering plenty of angst if not for apartments hogging the overvaluation limelight. And that’s purely through the prism of price behavior.

Factor in what’s driven those price gains and you really start to get worried. We’re talking the zero interest rate policy that the Fed has facilitated. At the extreme, we’re talking about $60 billion in 2015 CRE sales…in Manhattan alone, a record high and 14 percent above 2007’s prior peak.

Lending standards, of course, played their part and dutifully tanked, hitting their most lenient laxity in mid-2015. Foreign investors, in this cycle more than any predecessor, clocked record transaction volumes, which topped out at 18 percent in late 2015.

This highly favorable dynamic was most visible in capitalization, or cap rates, which is the net operating income of any given property divided by its price. The less in the way of income a buyer is willing to accept for a given price, the lower the cap rate. In 2015, cap rates sank to lower levels than they did at their 2007 lows. Valuations were, in other words, at unprecedented peaks, with the key word being ‘were.’

Since peaking, quarterly transaction volumes have slumped to around $100 billion from late 2015’s briskest pace, when sales hit $160 billion. In the meantime, standards have tightened for eight consecutive quarters and foreign investors’ share of transaction volumes has declined to 13 percent. And finally, as has been broadcast widely, the Fed has been in a tightening mode.

What happens when the favorable dynamic that drove cap rates into the ground reverses? The only answer is rents will have to increase to justify keeping cap rates down.

Some caveats to the caveats. Financial conditions are actually easing as sabre rattling, DC stagnation and Mother Nature collude to suppress interest rates. And while sales volumes are well off their peaks, they did recover somewhat in the second quarter and are down just five percent over 2016 levels.

It should be added that Chinese investors would rather have their cash escape to our fair shores; they just can’t get past the state-imposed controls put in place to staunch capital flight. The Saudis and other crude-export-dependent countries would also prefer to have the resources to keep investing were it not for that sticking point of the lowly price of that sticky fluid they pump out of the ground. In all, Middle Eastern investment is down 73 percent over last year; Saudi investment in particular has crashed by 96 percent.

And so, you have sellers thinking their still- nosebleed prices could be validated and buyers thinking recent trends will deteriorate further and thus refusing to budge. That brings us to where we are today – a virtual standoff.

To bring the extreme back into the picture to prove a point, CRE volumes in Manhattan are expected to end the year at $19.8 billion, matching levels last seen in the dark year of 2008. Not surprisingly, expectations for commercial leasing and the future rental market in New York both hit four year-lows in the second quarter.

The good news is the froth coming out of the market should reintroduce rationale among owners. Let’s just say that’s not exactly how the outcome appears to be evolving, which brings us to that article referenced at the outset, the one that disturbed and inspired at the same time.

The Bloomberg article is easy enough to Google, which you should: “NYC Landlords That Can’t Find Buyers Turn to Borrowing Instead.”

The gist of it speaks to the intersection of easy financial conditions not being reflective of the Fed being in a tightening mode, which actually speaks to the disconnect plaguing many asset classes. As it pertains specifically to CRE, think in terms of how cash-out refinancings increased investor losses in securities backed by subprime mortgages way back when.

Recall it wasn’t until John Thain attached a price tag of 22-cents-on-the-dollar to Mother Merrill’s subprime book that anyone truly knew the Street value of the toxic waste. Though things are certainly not nearly so bad, it is the spirit of owners’ behavior that resonates.

This from Bloomberg, per CBRE: “In a building where building sales are few and far between, it can be challenging to find a comparable transaction to get a reading on prices for an appraisal. There are other ways to calculate a property’s value, but it’s impossible to account for changes on a real-time basis.” (Let their painfully diplomatic wording plant its own seed next time you’re contemplating going long or short CRE on a macro level.)

Pardon the digression. Back to the matter at hand of what exactly entrapped owners should do? Why not seek out buyers for your property and simultaneously take out a mortgage on the property. That way you’re effectively refinancing at an inflated value, what my old friend who’d just as well stay in the private domain for, like, ever, terms the “perfect crime in CRE,” assuming you’ve cordoned said property into its own little LLC.

“If things go well, the property value goes up, no harm, no foul,” he observed. “If the market tanks, you hand the keys to the lender, but you still have the cash from the recapitalization.”

Let’s be clear, we’re not talking traditional lenders here. Indeed, second quarter originations fell two percent for life insurers and a steep 21 percent for commercial banks. The flip side is they rose by 26 percent for government sponsored enterprises and an eye-watering 126 percent for commercial mortgage backed securities.

For the record, retail was the only sector to see a decline in quarterly originations, so that’s something. As for multifamily, Morgan Stanley warns that, “investors are more willing to purchase and lenders more willing to finance, resulting in less deleveraging.” Cue the understatement considering the Bloomberg story referred specifically to apartment landlords though the cash-out contagion is sure to spread to other overvalued sectors by yesterday.

Notably, the Morgan Stanley data did not elaborate on the behavior of the most go-go cowboys in the land of lending, that is, private equity (PE). Disregard for a moment, as difficult as it is, the near trillion-dollar pile of dry powder PE sits atop. Ruminate rather on the quarter of that pile earmarked for real estate, some $255 billion, a record if there ever was one.

The beat looks set to go on and on. According to Canaccord Genuity’s Brian Reynolds, in the five-week period through mid-August, pensions directed an incremental $9 billion into some form of private equity fund. A few tasty offerings illustrate a particular penchant for that hard asset which, by the way, has become one of retirees’ most crowded trades, as you, but not they, can see:

  •   Boca Raton Police and Fire Pension allocated $10 million into distressed real estate fund
  •   Vermont state pension $30 million into value-added real estate fund
  •   Illinois Municipal Pension put $75 million into a value-added real estate fund
  •   Wisconsin state pension sank $395 million into real estate funds
  •   Kansas Public Employees’ Pension allocated $50 million to a real estate fund

And that’s just pensions. All manner of investors continue to herd into the divine diversification on offer with PE funds. As for the founders of PE funds, they’re taking buyouts and getting the heck out, at least according to the Wall Street Journal. Lovely.

“A majority of aggressive CRE recap deals are with real estate funds chasing yield,” my friend further added. “Banks can’t touch their rate and terms, so big boy rules apply.” Lovelier.

In the event you think some egregious omission has taken place, safe assured, the $300 billion in hurricane damages will indeed make a different kind of impact. But no one is sure how prominent that role will be just yet.

What can be said of Houston in particular is nearly a fifth of office space in the city stood vacant as of June while 11 million square feet were free for sublease pre-Harvey, the most since at least 1998. Oh, and the vintage of loans with the greatest exposure? That would be 2015.  For any of you vultures out there, can you please get back to me with a stronger word than ‘emptor’ to put after ‘Caveat ______” before you go off half-cocked?

In the meantime, this chart from Hoya Capital Real Estate highlights office real estate investment trusts (REITs) that have largely been given a pass vis-à-vis their brethren in the battered retail (mall) and massed multifamily spaces. You’ll note one REIT found its niche in low quality properties in Houston.

OFFICE REITS

 

Don Henley’s song reminds us that we can never look back. Perhaps it’s best to then look forward, knowing that time as we know it often compresses and that any summer can come to an abrupt end. With any luck, unforeseen events make us stronger in the end. As investors, the best we can do is be positioned for the likely and unlikely outcomes, those that arrive after even the big boys of summer have gone.

 

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