This past weekend, I highlighted Janet Yellen’s “Optimal Control,” an academic strategy for central bank/monetary policy management. I summarized it like this:
“The new Chairwoman’s econometric model derives an optimized policy path (as opposed to Fed Funds Rate using Taylor Rule) to usher the economy to 2% inflation & 6% unemployment targets, given equal weight to each mandate & as little deviation as possible…
“To offset the negative effects of tapering, FOMC may lower their unemployment target from 6.5 to 6.0% and raise inflation from 2.0 to 2.5% simultaneously with their QE taper–effectively extending ZIRP through 2017 & keeping rates below normal into the early-2020s”…
[In Ms. Yellen’s own words:] “This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the [FOMC’s] 2% objective for several years.”
While it’s unsure whether or not she’ll actually implement this researched approach, my takeaway was as follows:
“Fed policy is starting to react to my demographic assessments [e.g. demographics start aiding organic growth from aggregate demand between 2017-20, when the baby boom echo enters peak consumption]. This has the potential to change my bearish 2014 outlook & form the blasting cap at the end of a generation-long experiment with a disinflationary credit boom; makes me expect curve steepening with sweet spot <5 years–don’t forget that <2y yields actually fell during the summer’s rate rally.”
I wanted expand those thoughts into a more thoughtful list of my investment solutions, which react to the effects of this central bank strategy, were the Yellen Fed to explicitly implement it in the December-February timeframe. In addition, I wanted to discuss my outlook for the resonance of this [continued] policy path.
- Shorten bond maturities ($SHM/$CSJ/$SHY/$SJNK, in that order)- Since Operation Twist, the Fed’s POMOs have essentially vacated the front-end of the yield curve by allowing maturities to roll-off and reinvest in the long-end. Regardless, short rates have remained anchored at low levels because of ZIRP. Relative 1-3y IG credit spreads, however, remain above their normal, 20-year trading range. If ZIRP is explicitly extended through 2017, then maturities between 1-3 years are fair game. This is not a duration issue, for those who understand what modified duration really is. Because the Fed is committed to pinning the front-end of the yield curve and allowing the back to float (i.e. bear steepening), investors in the front-end don’t care about interest rate sensitivity, they only care about ZIRP persisting while they hold-to-maturity.
- Own growth ($IWZ)- Transition equity exposures away from value ($IWW) into growth style for relative outperformance–although not necessarily absolute return. During QE, investors and companies alike were incentivized to own preexisting, cashflowing assets, rather than invest in new projects or assets, as I’ve discussed at length. Conversely, rising rates lowers the present value (PV) of cashflowing assets on the balance sheet (generally owned by value companies), but raises the discounted cash flow (DCF) for prospective investments (generally made by growth companies). As a knock-on effect, I expect this to increase capital expenditures and investments in select capital goods.
- Buy distressed Closed-end bond funds- Not now, but after a selloff, there will be a huge opportunity to buy CEFs holding fixed income assets at >20% discounts to their NAVs. Right now, some of the lowliest funds are at just >10% discounts, but patience [then boldness] will be rewarded.
I still expect euphoria preceding and prompting the taper. In fact, I think we’re in the midsts of it now. I’ve also discussed the probability that the Yellen Fed will pop asset bubbles before they’re full-blown.
On a stock valuation basis, I still can’t conceive multiple expansion (PE) amidst bear steepening of the yield curve. Rising bond yields means rising earnings yields (i.e. multiple compression)–unless sentiment gets terminally exuberant. Since the crisis, SPX has maintained a rare inversion of earnings yield vs. bond yields, in which EP (5.61%) currently exceeds Baa corporate rates (5.46%). A normalization of that relationship is inevitable. In fact, it’s already begun. I still expect bonds yields to rise a lot faster than earnings yields as extraordinary monetary stimulus is withdrawn.
With that in mind, let’s update my hypothetical multiple analysis for 2014 equity valuations¹:
Currently, SPX’s PEs are 17.82x (ttm), 16.02x (FY13e), and 14.5x (FY14e), so given the multiple analysis in the chart above and the aforementioned headwinds against multiple expansion, 2014 may be a slow growth year for US equities–single digit returns. The distribution of potential returns is clearly skewed to the downside.
In addition, the bulls like to cite the fact that 18-20x PE is a fair value for SPX based on historical norms. First off, that normalized range comes with considerable variance about the mean. Second, the PE trend has been secularly falling since its peak in the Tech Bubble, topping at 30 in 2000 and 17.5 in 2007. In my opinion, the PE ratio’s multi-decade slide–lower lows and lower highs–was due to disinflation, which itself was a reaction to unfavorable population demographics’ slowing organic productivity growth. Therefore, not only does a “historical norm” for PE ratios not exist in any manner of significance, but the trend is strongly negative.
Finally, thinking about extreme outcomes, those who say the Fed is not prepared for this unwind haven’t considered the scenarios. Take two examples…
First, the Fed is preparing to preempt runaway inflation with its “fixed rate full allotment overnight reverse repo facility” (currently in beta), which can help rein-in excess liquidity. Because non-financial entities are eligible to participate, this new tool gives the Fed a means of controlling the real economy a lot quicker and more effectively than before, without having to operate through banks as mediums via the Fed Funds Rate. So, if Apple looks at the prospect of rising rates–as described above–and decides to invest in capital (CapEx) or growth initiatives instead of sitting on its cash stockpiles, the Fed can post a deposit rate attractive enough (i.e. opportunity cost) to divert AAPL’s cash from being deployed. The Fed would only do that were it to fear undesirably high inflation from an aggregate glut of liquidity getting deployed.
Second, the Treasury’s new Floating Rate Notes (FRNs) are another preparation for the end of disinflation. FRNs are an idea hatched by TBAC–a Wall Street advisory committee. While FRNs do line the pockets of TBTF primary dealers–who control FRNs’ reference index, the General Collateral market–the floaters also serve a purpose for the government’s management of the real economy. For example, PIMCO observes:
“Issuing Treasury FRNs sends an important signal to the market: It tells creditors that the Treasury intends to extend the maturity of its debt [by taking advantage of generational low interest rates while they last] without punishing purchasers who choose to extend beyond cash equivalents (or T-bills) in a reflationary environment.”
Treasury FRNs also give money markets a new, highly liquid asset to help manage through a rising rate environment. Whether from increasing growth, inflation, or both, MMFs can hold FRNs to access rapidly resetting rates when yields reflate, which diversifies the duration risk of normal, fixed rate paper and the reset-lag in LIBOR-linked floaters. That can keep MMF investors invested in these cash alternatives, as opposed to redeeming to chase a more risk-based investment (i.e. opportunity cost), as described in the Apple hypothetical above.
In such a way, the Treasury and Fed have made their first move toward managing the shadow banking system. That’s in addition to their new powers over the real economy, as aforementioned. Controlling the mix of T-bill/FRN supply at auction not only helps policymakers incentivize or disincentivize investment, but it also helps them assure MMF solvency–avoiding MMFs breaking-the-buck (the equivalent of a bank run on the shadow system).
Since the first ever Treasury FRNs will be issued at auction on January 29th, that’s a clear signal that QE taper won’t arrive until thereafter.² If you need further evidence of the upcoming, rising rate regime, consider today’s FRN analogue to the 1951 Accord, which (coincidentally?) occurred at the last secular trough of 10y Treasury yields ($TNX).
There always exists that black swan–the unknown unknown that you cannot prepare for because you can’t even identify it in advance. In this case, that would be something to break our economic momentum such that GDP actually contracts. In those two examples, the Fed squarely addresses a couple grey swans (i.e. known unknowns like hyperinflation). That’s all we can ask of them.
That said, good luck to corporate America having to roll debt maturities into that new, steeper yield curve. Corporations will have to choose between locking-in shorter financing (with subsequent roll-risk) or suffering marginally higher long term rates (materially increasing their interest expense). Not just High Yield companies, but also some High Grade credits will have to deal with the dilemma and the associated hit to net income.
We so often see a problem arise when most everyone makes the same choice, piling into the same trade, as rational “econs” are apt to do. In this case, either everyone decides to borrow short/invest long (creating a refinancing cliff), or everyone matches asset/liability term structures (stunting near term earnings potential). For every winner, there’s a loser; this time, corporate America might have to take the L, which is why I slapped a “Bearish” tag on this entry despite my growing more constructive on 2014.
- SPX YE13 target = 1775 (+45bps from 11/12 close)
- SPX FY14 consensus EPS estimates = $121.98 (11/7)
- My FY14 forecast EPS = $115.80
- Methodology: ((FY14e EPS/FY13e EPS)-1)*0.5 = ((121.98/109.62)-1)*0.5 = 5.64% EPS growth (y/y) → $115.80 FY14 EPS
²FOMC meeting schedule (2014q1): January 28-29; March 19-20