On May 21st, Tad Rivelle gave a presentation over lunch at the Chicago Club. The subject “Hey! They’re Raising the Price of the Free Lunch” revolved around on how interest rate increases and deleveraging will affect the economy, capital markets, and the investor class.
Mr. Rivelle is the Chief Investment Officer, Fixed Income for the TCW and MetWest Fund brands.
Tad started his discussion noting that too much thought and weight are given to next word or phrase that is added or eliminated from Fed pronouncements and minutes. Instead, more time and thought should be applied to considering the overall policy and climate that it is applied in. The stage and length of the business and market cycle are also of great importance; “Identify those variables that drive the cycle, as opposed to those variables that are driven by the cycle.”
Tad described a traditional cycle in which business overproduction leads to layoffs and excessive growth rates push inflation higher. Historically central banks have then stepped in to lessen the effect of the cycle by using monetary policy to slow the economy. Tad suggested that this cycle is different as the inventory cycle has largely been eliminated with more efficient supply chain management and the current cycle has been fueled with cheap credit and quantitative easing (QE) programs. These include several rounds of QE initiated by our own central bank, Abenomics in Japan, and now the ECB’s version of QE in Europe. What then will kill the current cycle? Expanding credit past reasonable levels and the resulting debt service hitting a tipping point (usually unseen) will push the current cycle to recession.
One of the problems with all of the recent QE programs is that they are designed to only “fix” one problem, while the capital markets commonly believe that these programs can remedy an assortment of problems; stagnant wages, slow growth, inflation/deflation, and suppress volatility. At its core, a QE program is a credit centric growth model structured to enhance near-term growth at a cost of building up a stock of bad loans and malinvestments (badly allocated business investments, due to artificially low cost of credit and an unsustainable increase in the money supply). These bad loans will end a cycle and the central bank, using the tools at hand, will not be able to stave off a market correction. In simple terms QE was designed to promote cheap credit and the efficient allocation of resources. Substantially QE has changed the allocation of loanable funds. Cheap capital has been pushed to unproductive endeavors while capital is rationed to more productive business oriented endeavors.
The current QE program in Europe is one that promotes inflation and a weaker currency. The ECB will likely succeed by “importing” growth and economic activity. A tangent result will be that as Europe imports growth, they will also “export” deflation to the U.S.
While the intent of QE programs has merit, their effects have been and will continue to be problematic. In the United States, GDP and inflation were both supposed to rise – they haven’t. In Europe and Japan growth prospects are stagnant to recessionary. Mexico and Canada (our largest trading partners) are in an economic slowdown. There is a recession in Brazil, depression in Russia. China’s growth is at a 25-year low, and global disinflation has continued unabated.
Tad provided some conclusions; he expects a flattening yield curve, which foreshadows an economic slowdown. The Fed, with its expanded balance sheet, will not be able to maneuver in an economic decline. If the Fed carries out on its promise to renormalize or raise rates, then risk assets will suffer and marginal borrowers will be crowded out by higher rates.
So then how should one position themselves in the market? Tad recommended playing defense with risk assets, under weighting airline, bank, and utility debt, and strong underweight high yield and bank loans. Overweight; non-agency MBS (ongoing de-leveraging of senior tranches limits downside risk), CMBS / ABS (the capital structure of CMBS are reasonably valued).
Tad concluded the presentation by taking questions. One member of the audience asked Tad to comment on the muni bond market and in particular his view of the Illinois and California public debt problem. Tad’s answer was brief, but perhaps a relief to an audience of Illinois residents as he saw no obvious catalyst to bring the current public debt problem to a head.