“FIXING” THE PAYROLL PROBLEM

With the US Fed’s third quantitative easing program since 2009 announced in latter 2012, QE3, we know the Fed is explicitly targeting two key hoped for outcomes. First, Mr. Bernanke has told us he wants to see higher stock prices. So far, so good. The thinking being that if stock prices rise, households will “feel” wealthier and be motivated to increase their consumption – the so-called “wealth effect”. Secondly, Mr. Bernanke tells us that the Fed intends to keep interest rates at zero and will continue to print money (at a current annual rate equal to 6.5% of GDP, well above actual GDP growth) until the US unemployment rate at least reaches 6.5%. But are these two key Federal Reserve endpoint goals actually at odds with each other? I do not see this question being asked, but believe it is very deserving of consideration. Could it really be that the Fed’s own worst enemy in this grand and unprecedented monetary experiment is…the Fed itself? And if indeed the Fed may in part be working against itself, what does that mean for the markets and economy?

Let’s start with some backdrop. In the past I have written about my own perception that in the current environment the “wealth effect” is an academic fallacy. At the heart of the Fed’s wealth effect assumption is that households will have something to spend. Wage growth in the current economic cycle has been tepid, to be charitable, so growth in wages will not be meaningful fuel for additional consumption at the margin. If stock and real estate prices rise, as the Fed wishes, again, what will households spend? Will they sell their stocks and real estate, and use the proceeds for short term consumption?

From the early 1980’s to the middle part of the last decade, the US savings rate dropped from a high of 12% to a low of 1%. Over that period where stock and real estate prices ascended in generational fashion, households spent down their savings – that was the wealth effect in action. Bottom line being, the precursor of a positive wealth effect is a substantial household savings rate. In the current cycle, households have not been able to rebuild their savings due primarily to ongoing deleveraging and lack of wage growth. The character and magnitude of household savings are key not only to the Fed’s desired wealth effect (a primary rationale for QE), but also play an important secondary role in the broad economy that ultimately impacts payroll employment (the latest Fed target rationale for QE3).

If you’ll bear with me for a minute, let’s review the academic definition of GDP. Although perhaps painful, you may remember that in your Econ 101 class of yesteryear, GDP, or output, was defined as the sum of consumption, Government spending and investment (simplistically this definition ignores imports and exports). Whatever is not consumed by households or the Government is available as savings, or investment. It’s in this basic equation that we see the importance of savings as the fuel for future investment in productive economic assets. Now to the potential conundrum in Fed policy of the moment.

One fingerprint character point of the current economic cycle has been the unprecedented weakness in business fixed investment. Very important in that investment in productive capacity (think manufacturing plant and equipment) provides any economy a basis for future growth in trade, and by definition jobs. What could be more important in the increasingly globalized and competitive economy of the present? It’s not wildly surprising in that businesses invest when they foresee expansion in aggregate demand. We know this has been a very slow growth environment.

The top portion of the chart below shows us the history of US business fixed investment as a percentage of GDP. Experience in the current cycle reveals the lowest non-recessionary level on record. And in the current economic cycle, this has been accompanied by some of the lowest historical US savings rate levels ever seen. As your economics teacher would remind you, savings equals investment.

savingsfixedinvest

One more important historical economic data point correlation that ties the importance of business fixed investment to payroll growth. The chart below shows us the year over year change in US business fixed investment alongside the annual change in US payrolls. The key observation is that historically, the year over year change in fixed investment has led the year over year change in US payroll growth in each economic cycle of the last half century. As stated above, fixed investment is the cornerstone of longer term growth in productive capacity and jobs.

             fixedinvestemploy

So back to the original question – is current Fed policy focused on both the wealth effect (the stock market) and lower unemployment competing agendas? IF the Fed is successful in sparking a wealth effect via higher stock prices, already low US savings will be further drawn down for consumption. But as per the very academic definition of GDP, increased savings are crucial for the expansion of business fixed investment. Importantly, we know from the historical chart above that increased US business fixed investment is directly tied to US payroll expansion. Increased savings equals increased investment, which in turn increases job growth.
So for the Fed to see a lower unemployment rate, it makes sense that US savings (and investment) need to rise. But if US savings rise, it will be at the expense of present consumption, negating the supposed positive wealth effect of driving stock prices higher. At least to me, it’s a very confusing Federal Reserve agenda. I have heard Mr. Bernanke give many a speech espousing the benefits of money printing in terms of levitating stock and real estate prices. But I’m still waiting for a speech that has never been given. A speech that directly links the Fed’s money printing and purchasing of US Treasuries and mortgage backed securities to actual job creation. I would think for an academician such as Mr. Bernanke and many of his Federal Reserve cohorts, there must at least be an equation similar to the exercise I walked through above regarding such a linkage between Fed bond buying and jobs, shouldn’t there? I guess for now it’s a secret.
Current business fixed investment remains subdued in terms of growth. That tells us payroll growth will come, but it will be slow. Not surprising within the context of a still relatively slow growth economy compared to historical experience. Near term, Fed money printing will continue to support asset price reflation. In the absence of accelerating fixed investment, corporate cash flows are being used for dividend increases and stock buybacks, likewise acting to underpin stock prices. Given this set of circumstances, we do have an environment where financial assets prices may diverge from underlying macroeconomic fundamentals. It’s into such divergence potential where risk management in the investment process takes on heightened importance.

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The Great Rotation Or “Greater Fuel Theory”?

One of the rationale’s we’ve heard from time to time for market bullishness since we were babes-in-the-wood investors is the “mountain of money” argument. “Cash on the sidelines”, as it’s also known. We’ve heard it at major market peaks and major market troughs. It’s convenient, it sounds good and every once in a while may even be true. But there are so many economic dynamics affecting cash holdings and how invested positions are analyzed, that no one macro argument dominates one way or the other.

A new concept chant for 2013 on Wall Street is what has been called “The Great Rotation”. The argument runs that money is finally leaving the bubble that is bonds and is and will continue to find its way increasingly into equities. Now before venturing even one step further into this discussion, let us be clear. Starting from where we stand today and looking over the truly longer term (say 5-10 years), the mathematics of bonds leave a good deal to be desired. Personally, we think bond “mathematics” border on scary looking over the long term, especially set against ongoing Fed balance sheet and US Federal debt expansion. Alternatively, the mathematics of equities argues more positively for stock investment on a relative basis for anyone with even a modicum of time, patience, and a tolerance for short term price risk. Having said this, we want to look at a few metrics that suggest it may be a bit too early to argue the stampede is on in terms of this so-called “great rotation” from bonds to stocks that has gone mainstream as of late. We’ll get there eventually, and who knows, maybe in the not too distant future. But the starting gun has not gone off yet, despite what you might hear on the “news”.

To set the stage, since 2009 equity mutual funds have been under consistent selling pressure. The common thinking is that the public has been liquidating their equity mutual fund holdings as stock prices have moved higher. In like manner, investment inflows into US bond mutual funds have registered record numbers, giving rise to the thinking that the general public has moved to bond investments en masse after experiencing two gut wrenching 50% stock bear markets in less than a decade’s time from 2000-2009. The reason for the “new new thing” mantra? Well, inflows to US equity funds so far in 2013 have been of a magnitude not seen in years.
Let’s go to the metrics. Investment flows into equity mutual funds so far this year have seen a dramatic turnaround relative to comparable year-to-date inflows from 2012. But what seems left out of the discussion at present is the like period YTD flows into bond funds. The following chart documents YTD flows for both 2013 and 2012 into US equity funds and ETFs (Exchange Traded Funds) on a combined basis as well as collective investment flows to US bond funds and ETFs.

funds

If we consider flows into US equity mutual funds and equity ETFs on a YTD basis, we’re looking at a 135% increase in 2013 numbers relative to last year. Impressive, right? Yet when looking at the combined US bond mutual fund and US bond ETF flows, the year over year increase we’re looking at totals a paltry 2% increase. Put differently, YTD 2013 flows into US bond funds and ETFs are 61% larger than flows into US equity funds and ETFs as of mid-February. So the question becomes clear as per the data – where is the great rotation from bonds to stocks? Yes, equity funds are receiving greater investment inflows year over year in absolute terms, but flows into US bond funds YTD remain larger than into equities, and haven’t subsided. An inconvenient fact left out of a lot of recent “analysis”? It sure appears so.

Again, the current “mathematics” of bond investment doesn’t make a lot sense when looking out over any reasonable time frame. But, we need to remember that in the very near term flows we are seeing into equity mutual funds today are in large part driven by tax anticipation behavior we saw in Q4 of last year and specifically in December. In very interesting behavior, YTD 2013 flows into US equity ETFs are actually down substantially relative to 2012 YTD experience. Odd in that US equity ETFs have been attracting positive flows at the expense of US equity mutual funds for years now. Why would this switch be happening? Again, it may have roots in Q4 2012 and December ‘12 events.

Remember that in Q4 2012 and December specifically we experienced a massive anomaly in accelerated dividend payments by many corporations. From Las Vegas Sands to Costco and well beyond, billions were paid out to equity investors in “special” common stock dividends, and of course a portion of this clearly floated through equity mutual funds winding up as money market fund cash in mutual fund accounts. As we move into 2013, are we simply seeing this money return to its rightful home in equities and equity funds, exactly where it was invested a few months ago? We think so. Combine this with 2012 end of year bonuses, earned income accelerated into 2012 to beat the taxman, early year qualified plan contributions, etc. and all of a sudden the newfound resurgence of money flows to equity funds looks a lot more explainable. Moreover, the very numbers themselves do not show bond fund/ETF liquidations – quite the opposite. So, this great rotation from bonds to stocks may come to be, but it has not started yet.

Tangentially related to current period “analysis” and this great rotation thinking (which we would suggest has been less than thoughtful or thorough), is commentary regarding the positioning of large institutional pools of capital. It was a month back that we saw an article in Barron’s proclaiming large pension funds to be only 34% invested in stocks. We saw a similar number thrown out by a fund manager in Barron’s again just a few weeks ago. Of course the implication is that 65% of institutional pension assets are invested in bonds. Nothing could be further from the truth, but it sounds good in printed media and on TV, right?
Just where are these numbers coming from? Luckily, you can find them quite conveniently in the quarterly Fed Flow of Funds report published on the Fed’s own website. So let’s have a look at the raw data and see if perhaps there are a few “unanswered” questions these analysts have forgotten to include in their commentaries. Below is the current asset class breakdown of US Private (think corporate) Pension Fund investments.

Private Pension Fund Total Assets (billions) $ 6,598.7 % Of Total Assets

Cash (Money Fund) 226.4 3.4 %
Credit Market Instruments 1,166.4 17.7
Equities 2,254.4 34.2
Mutual Funds 2,370.0 35.9
Unallocated Insurance Contracts 491.0 7.4
Other (misc) 90.4 1.4

As you can see, right there is that 34.2% allocation to stocks, exactly as these commentators have described. Private pension fund bond holdings are broken out in detail under “credit market instruments”. The numbers further are broken down explicitly among Treasuries, corporate bonds, Mortgage Backed Securities and Government agency bond holdings. This apparent low allocation to equities actually has been consistent for over a decade now. It did not all of a sudden drop post 2008. The real issue being that the Fed Flow of Funds report does not delineate just what is inside the “mutual funds” categorization. The superficial analysis you have been treated to as of late implies/assumes it’s in bonds, just waiting to “rotate” into stocks.

Let’s remember that private pension funds have been much more aggressive than their public pension fund counterparts over the decades as they shifted allocations to “alternative investments” (e.g. private equity, commercial real estate, venture capital, etc.). Moreover, private pension funds pay well below bond mutual fund fees to have their individual bond allocations managed, so they wouldn’t have a large investment allocation to bond mutual funds. The quoted analysts touting this great rotation thesis have been using selective statistics.

While not broken out, private pension funds have been and continue to be heavily invested in private equity “funds”, hedge “funds”, commodity “funds” and institutional commercial real estate “funds”, among a number of other alternative asset class categories. In large part, is this what we are looking at in this category of pension fund mutual fund holdings? Of course it is. Are these really the type of assets just waiting to “rotate into stocks”? Of course not. In many senses they are already there. So it’s obvious where the superficial analysis of the moment breaks down, despite that “rotation” story and those institutional asset allocation stats appearing in headlines and sound bites. As Steven Colbert would suggest, it’s analytical truthiness. It sounds like the truth. It could be the truth. But…..it’s not the truth.

Before wrapping up, let’s look at Public Pension fund (think States and municipalities) asset allocations. You will not see the aforementioned analysts quoting these numbers. Why? Because they show the Public Pension funds are already 61% invested in equities. That also does not support the great rotation thesis.

Public Pension Fund Assets (billions) $ 3,093.0 % Of Total Assets

Cash (MMF) 59.4 1.9 %
Credit Market Instruments 850.2 27.5
Equities 1,890.3 61.1
Mutual Funds 274.6 8.9
Misc 18.5 0.6

The numbers tell the story. And of course public pension fund assets are also exposed to alternative investments such as private equity, hedge fund, commercial real estate, commodity, etc., just to a lesser extent than their private pension fund brethren. The public and private pension assets in the US “rotated” a long time ago.

So there you have it – just a few facts to contemplate amidst the cacophony of daily “noise” that is often financial market commentary. As always, we have to look under the hood in financial market and economic analysis. In summary, as our President would say, let me be clear. Current bond investment mathematics border on scary if you buy today and look long term. Equities have a relative advantage in a world where central bankers have eliminated the return component from principal safe investments. Central bankers having flooded the global system with unprecedented conjured liquidity that could easily spark an equity “melt up”. We remember an analyst we respect saying a few years back that the public will not come back to equities until they make a new high. We concur. The public always chases the inflating asset….until it stops inflating, of course. Remember the old Wall Street adage – never confuse brains with a bull market. And here’s a new one for you – never confuse asset class rotation stories with central bank asset reflation (one of the Fed’s primary goals of quantitative easing is to get stock and real estate prices higher).
Can we characterize our current circumstances as the “The Greater Fuel Theory”? Time will tell.