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Monthly Perspective | September 2019

24 September 2019

Geremy van Arkel, CFA® | Principal

THE NEVER RECESSION EXPERIMENT

Geremy van Arkel, CFA® | Principal

These days, we seem to be operating in a world of firsts. It has become commonplace to utter, “this has never happened before” as a response to many situations. The unprecedented central bank and government stimulus, negative interest rates, high debt levels, and asset prices, and lopsided demographics all seem to leave us in uncharted territory. And then there is the trade war, which, to many, feels completely erratic. It is hard to look back and find a time period in history that is quite like today. But in what way? Because no, the grand fabric of how capital markets operate has not changed. And yes, the rules of investing are still solid. Yet things sure do feel different this time.

Shortly after having gotten started with this text, and right after I had written the above words, I had the honor of speaking with former Senator Alan Simpson (R-WY) at our company’s “Frontier Dude Ranch Experience.”  After mentioning that I was on the company’s investment team, he quickly proclaimed, “Wow, you sure have a lot to analyze in this environment.” To that, I promptly responded that it really does feel like something is different. Yet as soon as those words had escaped my mouth, I remembered one of the oldest rules of capital markets. Wisely, Senator Simpson, too, reminded me of it: that the four most dangerous words of investing are, “It’s different this time.”

I told him to HMB (“hold my beer”) as I ran back to my cabin to continue writing.

My concern is not novel or new. It is really just that same thing we have seen over and over again. Investors always seem to want to over-allocate to risky assets after they perform well, and as expected returns decline, and the probable downside increases. Investors do not become risk-averse in the face of lower expected returns and higher risk – either low interest rates or high asset prices – but instead, they become risk-takers. Uniquely, this time, negative real (after inflation) interest rates may be exasperating the problem, as investors have limited options for savings.

We only need to look to negative interest rate bonds to see that investors are willing to pay a storage fee (negative interest rate) just to store their money in assets that are not risk assets.  The implication of negative interest rates is that there is so much money floating around (or being printed) that your excess savings do not command a yield.  No one seems to need to borrow your savings, nor are they willing to pay you a yield to do that. In fact, having excess savings is a problem: you must store it. You might as well rent a unit at Public Storage.  Just be sure it has a good sprinkler system.

The past decade of negative real interest rates, quantitative easing, and fiscal expansion occurring globally – and relentlessly – has created a sea of money, but not much actual economic growth. Every new dollar printed or borrowed devalues the already existing dollars, which means that it takes more dollars to buy the same asset. This is the classic theory of inflation; more and more money chasing the same limited goods, services, or assets. Yet inflation is not occurring in the real economy: financial assets are experiencing price inflation as a stimulus, and leverage is washing through the economy and into asset prices.

Since 2009, asset prices of stocks, bonds, and real estate have steadily increased year after year and are currently near all-time highs. Investor wealth, in turn, must be near all-time highs as well. With the wealthiest ever generation of baby boomers entering retirement, all the money needs a home. But real interest rates are negative. Gone are the days of the safe 8% municipal bond. Today, in order to achieve a return higher than inflation, investors must enter capital markets with their assets – particularly after consideration for fees and taxes.

Relationship between interest rates and risk assets.

Source = https://voxeu.org/article/new-take-low-interest-rates-and-risk-taking

The above chart depicts the results of a study where thousands of U.S. investors were asked what percentage allocation of risk assets they would hold at different risk-free rates. The expected return of the risk assets was held constant at risk-free +5%. Intuitively, the results make sense: the lower the savings rate, the greater the percentage that investors are willing to commit to risk assets. At a -1% risk-free rate, investors are willing to commit almost 80% of their assets to what were deemed risk assets. After inflation, the real interest rates for high-quality bonds are pretty much negative in every First World country. All of the money that was created – either over an investor’s lifetime or through liquified rising asset prices – needs to be stored in either risk assets that offer the hope of further return, or in safe assets which carry a storage fee (negative real interest rates).

Interestingly, at a 3% risk-free rate – a rate that we were near just a few months ago – investors are willing to hold a more reasonable 58% allocation to risky assets. At the previous 2.5% Fed Funds Rate, short-term bonds could yield over 3%, which, with a 1% inflation, offers safe storage of assets. Yet it seems that neither the Fed, the economy, or the investors are willing to tolerate 3% risk-free interest rates anymore. We were close, though, before the Fed caved at the last meeting. Now the Fed Funds futures imply that there are three more cuts on the horizon.

It seems that there is no length to which central banks and governments won’t go to prop up asset prices. The new standard for “responsible policy” is to not let asset prices fall. In economic terms: it is the “Never Recession Experiment.” China, Japan, the European Central Bank, and now the U.S. again are all back full-throttle on coordinated campaigns to liquefy their economies through continued lower interest rates, and quantitative easing campaigns. As we have learned over the past decade, all this money-printing has to end up somewhere. Since it doesn’t actually result in significant spending growth, much of it simply gets washed into asset prices. The trillion-dollar question, then, is: for how much longer can this go on?

The old economic growth formula (Growth = Population + Productivity + Leverage)

Back to the classic economy. In the old days, the economy was driven by workers becoming employed, earning money, saving money, and spending. When this didn’t work, you could add “leverage” through either monetary policy (low interest rates = consumer and business borrowing) or fiscal policy (tax cuts = government borrowing).  That was it: get workers employed, pay them more, and in times of trouble, apply leverage. Seems like a cute little recipe.

The new economic growth formula (Growth = Demographics + Productivity + Leverage + Asset Prices)

Fast forward to today. Population growth has turned into demographics, like those over the age of 55 control close to 80% of the assets, and as birth rates drift below the replacement rate. Productivity – getting more output out of workers or paying them more – has gone flat and lost much of its power as 10,000 people a day are retiring in the U.S. alone. Leverage seems to be a constant as interest rates around the world are held below inflation rates, and money is an on-demand product that central governments print all day long. This leaves us with a new variable: asset prices or the real wealth effect.

In the classic growth formula, asset prices were of little consequence, because in times past so few people had significant savings or retirement accounts. Today, a house is more than a home: it’s an asset. Almost everyone has a 401(k), maybe an IRA, and many have equity or business ownerships and a personal account.

Employing more workers and paying them more is altruistic, and we all want a happy and employed economy. But the real power of the growth equation lies in asset prices and the real wealth effect. This is because of demographics and the distribution of wealth. Much of the wealth in the current economy is about assets, not earnings power. Consider this example: if I were to give you a $10,000 bonus, how long would that last in your family? Alternatively, what if I could make the stock market and your house price go up by 20%? Which would you prefer? The real wealth effect is real and powerful.  If your investment portfolio, 401(k), and house price all together rise by 20% in a year, you really are richer.

However, asset prices have to stay at those levels or continue to go up. I believe that central banks and governments know all this very well. The new unspoken, unwritten policy is to keep asset prices high because asset prices are the economy. Supporting asset prices drives economic growth, but also vice versa: if the asset prices were to fall, so, too, would the economy.

So, what is the moral hazard; the unintended consequence? What if negative real interest rates really did entice risk-seeking? One thing is for sure: the longer the high asset price policies go on, the more wealth will be at stake. Everyone around the globe is in on this grand “Never Recession Experiment”: central banks and governments, businesses (think: financial engineering), and investors. In a way, at this point, we are all in – with “all in.” Perhaps that’s what’s different this time around.


AUGUST 2019 STRATEGY REVIEW

Gary A. Miller, CFA® | Founding Principal

July might have been boring, but August was anything but. On July 31, the Federal Reserve Board voted to lower the Fed funds rate by ¼%, the first rate cut since the 2008 financial crisis. Stocks, which normally like a Fed rate cut, fell about 5% in a week (as measured by the S&P 500®). Evidently, the cut wasn’t enough.  Although with the unemployment rate at a 50-year low, one does wonder why stock investors think the economy needs more help (read, “we don’t like global trade tensions”). So, while the S&P 500 was falling about five percent, long-term U.S. Treasuries were rising about 5%, so bond investors seem to agree with stock investors that the economy may be in trouble. In fact, the yield curve decidedly inverted no matter how you measure it. The last two times that happened were in 2007 (2008 was not good) and 2000 (2000 through 2002 were not so good either). Stocks did regain their footing and spent the rest of the month getting back some of their losses, but all of the major equity indices that we show in our reports still ended the month down with small US stocks and emerging markets stocks being the biggest losers.

Unusually, Treasury prices did not stall when stocks quit falling and ended the month with a whopping gain of over 10%.  The yield on the 10-year Treasury fell from 2.02% to 1.50% in August.  And that is still a lot higher than other 10-year yields around the world.  Most of Europe and Japan have negative 10-year Government bond yields.  Crazy!  And to show how extraordinary the returns in bonds were last month, the only time in the last twenty years when long-term Treasuries had a better month was November 2008 during the heart of the financial debacle.  And to top it off, the S&P 500 has only had one month with higher returns in the last twenty years: October 2011.  Extraordinary!

Frontier Asset Management’s Globally Diversified strategies had a “relatively” great month relative to their benchmarks, and the more conservative strategies, Capital Preservation through Balanced, actually posted nice “absolute” returns. In Balanced’s case that was particularly good since its benchmark was down nearly 0.6%. Of course, Frontier’s equity dominated strategies have positions in long-term Treasuries which was the main reason for the gap over the benchmarks in August. We will not always have the Treasuries insurance, but with equity prices so high in relation to earnings, the expected returns for stocks are lower than we would like, and the chance for a meaningful decline in equities is higher than we would like. Year-to-date the more aggressive strategies have also outperformed their respective benchmarks; that is somewhat remarkable considering how conservatively we have been invested. In true Frontier fashion, though, while we have generally trailed the benchmarks in the six up months so far this year, we have more than made up for it during the two down months. Longer-term returns continue to be benchmark- beating for all strategies over nearly all time periods.

Frontier Asset Management’s unconstrained Alternative Strategies also had a nicely positive August. Each of the three major strategies was up more than one percent in the month and easily outperformed the broad hedge fund universe. Of course, each strategy was helped tremendously by their allocations to long-term Treasuries. Performance of the alternatives strategies continues to look favorable relative to the hedge fund universe and alternative strategies available in mutual fund formats over longer-term horizons.


Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice.  Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.  References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind.  This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or over compensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts.  Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results reflected, or any corresponding benchmark presented.  In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information. For any investment products mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
It is generally not possible to invest directly in an index*. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
INDEX
INDEX DESCRIPTION
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
Benchmark Composition. The Benchmarks for the Long-Term Growth, Growth & Income, Balanced, Conservative and Capital Preservation strategies are combinations of the Wilshire 5000 Total Market Index, MSCI All Country World ex US Index, Bloomberg Commodity Index, HFRX Global HF Index, Barclays US Aggregate Bond Index and 3-Month T-Bills.
The blends of the indices are currently:
Capital Preservation Bench
Conservative Bench
Balanced Bench
Growth & Income Bench
Long-Term Growth Bench
Wilshire 5000
10%
15%
30%
45%
50%
MSCI AC World ex US
0%
5%
15%
20%
30%
Bloomberg Commodity
15%
15%
10%
10%
10%
HFRX Global HF
25%
25%
20%
15%
10%
Barclays US Agg
40%
40%
25%
10%
0%
3M T-Bills
10%
0%
0%
0%
0%
 
 
Benchmarks for the Global Opportunities, Focused Opportunities, Absolute Return Plus, Absolute Return and Short-Term Reserve strategies are the MSCI World, S&P500®, HFRX Global HF, HFRX Absolute Return and Barclays Capital 1-5 Year US Treasury Indices, respectively. In the case of indices that include foreign securities, index returns are still presented on a total return basis but will be net of foreign taxes on income generated by these securities.
Frontier’s ADV Brochure is available at no charge by request at info@frontierasset.com or 307.673.5675.
092019CST033120

 

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