Popular Delusions: The bull case for safe havens

John Mauldin

Nov 30, 2012

A month ago in Outside the Box, Dylan Grice made the case for the need for safe havens, due to expansive monetary policy. But what is a safe haven anymore?

In today’s piece, a follow-up to last month’s, Dylan gives us a very good rundown on the historical relationship between equities and government bonds, in order to point out the very atypical current negative correlation between them.

Popular Delusions

The bull case for safe havens

By Dylan Grice, Societe Generale

Government securities are the default safe haven in times of heightened risk aversion. But what happens when Government finances are the cause of the tension? Where are the safe havens then? We offer some thoughts inside… and more!

In a marked softening of the IMF’s former tone, its chief economist Olivier Blanchard, speaking in Tokyo, earnestly pronounced that the prudent policy maker should now be "ready to adjust the [budget] targets" if achieving those targets becomes too painful. Is the bitter medicine of the IMF’s hitherto unshakable orthodoxy, once deemed cathartic to emerging market victims of economic calamity past, too bitter a pill for more sensitive Western palates?

A harrowing BBC report suggests Greece is Balkanising once more. We are reminded that its civil war only ended in 1949 and that harsh austerity is reopening deep social wounds. Yet Spain’s civil war ended only a few years earlier, and a generation ago it was a fascist military dictatorship. Couldn’t it go the same way if subject to the same stress?

Thus Nobel Prize winning clever clogs Paul Krugman says austerity is “fundamentally mad” and all reasonable people agree with his diagnosis, it seems. Spain looks set to finally benefit from the ECB’s printing press with only token conditionality. And poor Greece, close to being cut loose earlier in the year, is once more nestling in the warm bosom of the Teutonic embrace … well … it’s being given more time, at least, to pretend it is able to repay the unrepayable ....

The rest of the watching world has learned the lesson too. BoE governor King, with a nudge and a wink in the direction of the UK chancellor, says missing debt targets is fineso long as there is an excuse". Meanwhile, Ben Bernanke urges Congress to “you know, work together to find a solution” to the loomingfiscal cliff. The grim reaper of fiscal austerity has been banished, it seems. Market relief is palpable.

But is it any different from the relief felt by a chronic alcoholic reaching for the booze once again, convincing himself he’ll give it up tomorrow? The fundamental issue of balance sheet unsustainability has not been addressed. The need to delever remains. Albert and I have always felt that inflation would ultimately prove to be the path of least political resistance, and these events have confirmed that assessment.

Deflationary deleveraging is politically non-viable, leaving inflationary deleveraging as the only remaining option, as far as I can see. Economists the world over seem very confident that such inflation can be generated in a controlled and nondisruptive fashion. There is a first time for everything, I suppose. But I’m very sceptical. I wrote a few weeks ago that I feared a Great Disorder and that I remain bullish on ‘safe havens’. But what exactly are suitable safe havens for such a circumstance?

Generally, and especially over the last decade, government bonds have been the safe haven. Risk-on risk-off’ might be the catchy nomenclature du jour, but the fact is that government bonds have generally benefitted from their safe haven status throughout the past decade. The following chart shows that status reflected in the negative correlation between Treasuries and the S&P500 over this period.

Historically speaking, these last ten years are an outlier. Over time, what’s good for the currency and for government finances (bonds) should be good for the rest of the economy (equities) and vice versa. The correlation should be positive. Indeed, the following chart shows that the correlation generally has been positive, averaging +0.2 between 1875 and 2002, but -0.3 since 2002 (for the whole period, the average was +0.15).

It’s worth pondering this for a few moments. To help, I’ve arbitrarily separated the sample into three periods. The period from 1875 to 1970 saw a number of monetary regimes, each involving a peg to gold in a progressively less robust way. Yet overall inflation expectations were stable during this period. Bonds were reliable safe havens. The correlation would briefly turn negative during recessions or depressions as bond prices rose during stock market declines, but the overriding correlation between them was positive.

Things changed following the collapse of the Bretton Woods regime in 1971 and the embracing of an explicitly unanchored currency. In the 1970s, although the correlation weakened during stock market declines as it had done previously, it didn’t turn negative. In other words, government bond prices no longer rose during stock market declines, they just didn’t fall by as much. Moreover, the overall correlation was positive. What was bad for bonds was bad for equities too.

Government securities consequently lost their safe haven status because they were highly vulnerable to the prominent macro risk of the day, inflation. In the 1980s and 1990s the inflation dynamic was reversed. As ‘order was restored, inflation was brought under control and a spectacular bull market in bonds ensued. What was now very good for bonds was even better for stocks.

Again, therefore, the correlation was strongly positive overall. It would fall during equity market declines but it never went negative because both the bond and equity bull markets were so powerful and the equity drawdowns so shortlived that the three-year correlation never had a chance to go negative (even in the year of the 1987 crash, stocks finished the year higher than they started it). Ultimately, the bond bull market helped to inflate equities to the unprecedented valuation bubble witnessed at the turn of the century. When that bubble burst, the correlation turned negative, and has remained there ever since. This is Albert’sIce Age’.

This little exercise gives us an appreciation of how unusual it is for the bond-equity correlation to be negative for any period of time, i.e. for a macro regime to be good for bonds but bad for equities over any medium to long-run period. It’s interesting to think about what sort of regime that is too. I think one possibility has to do with the unwinding of extreme valuations, which has certainly been the story in equity markets over the past decade. It has also been a huge part of Japan’s story. There, the bond-equity correlation also turned, and stayed, negative following the even more extreme equity overvaluation reached in the late 1980s. There is much food for thought here.

Our second observation is what constitutes the ‘safe haven changes over time. It’s important to remember not only that government bonds aren’t always the market’s safe haven, but that there will always be a safe haven somewhere. For all the headlines about the billions wiped off stock market values during market routs, that money had to go somewhere. It doesn’t just disappear. It will go into whatever the safe haven is, which in normal times will be bonds. But what happens when government bonds themselves fall victim to the primary ills of the day? In the 1970s, bonds were no place to seek refuge from the inflation and so the safe haven mantle passed to gold (see following chart). This is one reason I remain a gold bull.

But the eurozone threw up other interesting examples. Before the crisis, Spanish investors, for example, would normally have considered their sovereign bonds a safe haven on ‘risk-off days. But that stopped working when their sovereigns became the source of risk rather than a shelter from it. Bunds undoubtedly caught some of that safe haven bid, but did the very high quality, zero debt, local-champion-made-good retailer Inditex catch a similar bid too?

A similar picture emerges with the standard quality equity names in countries afflicted by the eurozone sovereign crisis. For example, Hellenic Bottling (Greece), Luxoticca (Italy) and Kerry Group (Ireland) all followed a similar pattern, outperforming their domestic equity indices and performing the safe haven role vacated by their government bonds (see below).

We see the same effect more generally when we look at Quality Income equities through the same lens. The following chart shows how the relative performance of the SG Quality Income Index relative to the MSCI World has moved with confidence in Italy’s government.

So besides gold, another candidate for safe haven status in the event government bonds become unreliable in that department are equity securities in high quality and robust businesses. I therefore remain very bullish of these too.

In recent months, some of you have voiced concern that the time might not be right to buy such names because they have become very overvalued. The following chart suggests otherwise. It compares the forward PE ratios on Quality Income equities (shown here using the SGQI) with those of the overall market. While the overall market is arguably attractively priced (certainly more attractively priced than it has been for some time), the SGQI is priced in line with its historical average.

That implies that expected returns from here should be consistent with its long-run average return, which has been around 6-7%. That’s hardly a once in a lifetime return, but for now, and for a potential safe haven I find it quite attractive because it comes with an embedded robustness.

Suppose I’m all wrong in my fears. Suppose that we go all Japanese and the next decades are low-growth muddlethroughs.

A 6-7% return isn’t a bad prospect at all. But now suppose I am right, and government bonds cease acting as safe havens. Owning such equities implies owning the new safe havens (especially if the rest of the portfolio is made up of cash and gold). So we’re on high ground with this strategy, and have a degree of robustness to the reality that we just don’t know what the future holds. That doesn’t guarantee survival from the worst case scenario, but it gives a better chance.

December 2, 2012 4:25 pm                                                                                                                          
America’s Thelma and Louise moment
Thelma and Louise©Matt Kenyon

“Let’s keep going,” said the Democrat. What do you mean?” replied the Republican. “Go,” the Democrat replied pointing at the precipice. “Are you sure?” asks the second, an insane smile dawning. They clasp hands. The Republican steps on the gas and they zoom over the cliff.

This is Washington’s real-life take on the closing scene of the movie Thelma and Louise. It does not take much to imagine it running on December 31 with a recession instead of the Grand Canyon. Yet whether or not Washington takes the US temporarily over the fiscal cliff is almost beside the point.

Prominent figures in both parties have been flirting with the idea for months as a way of getting concessions. Their leaders are conniving to ensure that the best outcome is if they swerve off-track at the last minute. Either way, the US will head into 2013 with the same nagging question hanging over its future: when will it be governed sensibly again?

The quality of US governance has been deteriorating over many years. Given the poor regard in which the US public now holds its institutions – and Congress in particularany deal to avert the cliff is likely to be drowned out by bipartisan self-congratulation.

It is unlikely to be deserved. The real test will come during the course of 2013. Having averted or temporarily gone over an entirely self-created cliff, Congress will still have to confront America’s long-term outlook – the “fiscal abyss” that lies beyond the cliff.

By this time next year we are likely to have an answer to the nagging governability question. Either Washington will have reached a deal about the size of government and the purpose of the tax system that is helpful to US growth prospects. Or the parties will have hit a stalemate and agreed to postpone the day of reckoning. There are three reasons to suppose they will kick the can down the road.

First, the immediate stakes are lower than many people think. In contrast to the eurozone, which is facing at least another two years of flat growth, the US economy is back on its feet. It may be limping and unlikely to be running soonmost economists, including Ben Bernanke, believe America’s sustainable growth rate has fallen since the Great Recession.

However, even if the US were to dip briefly off the cliff, the economy would probably still grow by between 1 per cent and 2 per cent in 2013. Polls say the public would chiefly blame the Republicans for whatever slowdown ensued. But it is not as though the country would be in depression. And Republicans might bet the damage would have occurred early enough into the new Congress for the electorate to have forgotten it by the 2014 midterm elections. It would be a surprise if they could hammer out a sensible grand fiscal bargain in between.

Second, the gap between the parties – the chief cause of the last bout of brinkmanship in August 2011 – has grown wider. According to voting patterns, the outgoing 112th Congress was the most polarised in modern US history. According to studies of the new intake, the 113th is even more split. It is not just a story of conservative Republicans replacing moderatesthough that has been the chief driver of America’s polarisation. Democrats are also becoming more liberal. The once powerful centrist Democratic Blue Dog coalition has nosedived from 54 members as recently 2008 to just 15 next year.

The term moderate Democrat is becoming almost as rare as its counterpart. Nor is the divergence confined to ideology. The parties also look different. According to Bloomberg, the share of white male Democrats in the 113th Congress is 47 per cent – it fell below half for the first time. Meanwhile, 90 per cent of GOP lawmakers are white male.

Third, the election on November 6 offered only a brief pause in America’s permanent electoral campaigning. With a short break for Thanksgiving, lawmakers on both sides have begun fundraising in earnest for 2014. Moderates need to build up war chests now in order to pre-empt primary challenges. The jockeying for the 2016 Republican nomination has also begun.

Among the big hopefuls is Paul Ryan, Mitt Romney’s former running mate, and the chairman of the House budget committee. Mr Ryan is the current darling of the anti-tax wing of the GOP. If he opposes a tax increase, it is probably dead-on-arrival. If he gives his blessing, he would damage his presidential chances. Mr Ryan could end up being the most pivotal figure in the game of chicken over the coming weeks.

Franklin Roosevelt once said America had nothing to fear but fear itself. Now he might say it has nothing to fear but itself.

Relative to Europe, US short-term growth prospects are good although the measure is much stingier nowadays. Compared to almost everyone, except Canada and Australia, the US energy outlook is rosy. Yet relative to its own standards of governance, the US has rarely been less capacitated.

There is little reason to believe the election results of November 6 have changed anything fundamental. Politics is a bit like stock market investment. It is hard to predict the next gyration – but always safer to trust the longer-term trends. It would be a surprise were Congress to avert the cliff in a sensible manner in the next few weeks. It would be a shock – and a very positive onewere it to follow that up with a year of working productively.

Copyright The Financial Times Limited 2012

Free exchange

Savers’ lament

The complex effects of low interest rates on consumption and investment

Dec 1st 2012


WHEN interest rates hit double digits in the late 1970s, house-builders sent planks of wood to the Federal Reserve in protest. With rates stuck near zero, the protests now come from the opposite direction. The retired complain of a “war on savings”.

The Fed cut rates to current levels at the end of 2008 and has promised to keep them there until 2015. Since 2008, personal interest income has plunged 30%, or $432 billion at an annual rate, more than 4% of disposable income.

David Einhorn, a hedge-fund manager, likens zero rates to an overdose of jam doughnuts: too much of a good thing. Raghuram Rajan, a former chief economist for the International Monetary Fund, describes the Fed’s policy as “expropriating responsible savers in favour of irresponsible banks”, and thinks it should raise rates modestly.

This challenges textbook monetary policy. Typically, lower rates stimulate growth in several ways. They reduce the cost of capital, spurring investment and encouraging households to consume today rather than tomorrow. They also boost stock prices, helping spending through the wealth effect, and reduce the exchange rate, helping exports. Finally, lower rates redistribute income from creditors to debtors, who will presumably spend the windfall. Today’s critics argue that this reasoning no longer applies. Business and households can’t or don’t want to borrow, while the retired and corporate pension sponsors must slash spending to cope with lost interest income.

Are the critics right? Start with redistributive effects. These depend on who are the creditors and who are the debtors. For a net debtor nation like America, lower rates raise national income by reducing the flow of payments to foreign bondholders. (The opposite is true for Japan, a net creditor.) Lower rates may also benefit households and companies at the expense of banks, which cannot lower deposit rates enough to offset the loss of loan income.

In Britain, the Bank of England reckons that between September 2008 and April 2012 lower rates cost households £70 billion of foregone income, but saved them around £100 billion in interest expense. The difference was absorbed by banks.

The actual impact of this redistribution depends crucially on the propensities to consume of debtors and creditors. If the creditors losing income have no choice but to consume less, the hit would indeed be considerable. But reality is more complicated.

In mid-2012 American households held roughly $13 trillion of deposits, bonds and other interest-earning assets, while they owed mortgage and other debts of roughly the same amount. But assets and debts are not evenly distributed. Surveys by the Fed show that while owners of certificates of deposit and bonds were more likely to be older and retired, they are also more likely to be rich (see chart).

Debt, by contrast, is somewhat more egalitarian: 75% of all families carried some, and 47% had a mortgage. For the middle class, interest payments consumed roughly 20% of income compared with 9% for the richest tenth of families.

Although lower rates transfer income from the retired to workers, that effect may be less important than that from rich creditors to middle-class debtors. All else being equal, this probably raises consumption because rich families have a buffer of savings with which to sustain their lifestyle. Middle-income families who lack those buffers must adjust their spending as cashflow changes. The rich are further insulated because lower rates have boosted equities, which are held principally by the wealthy.

Capital punishment

So while low interest rates are a burden on many retired people, this has not been enough to suggest the shift of income from creditors to debtors is bad for growth. But what about the effect on investment and spending? For companies, lower interest rates are not all positive. Some must set aside funds that will generate the pension benefits promised to their workers. As with a bond, the cost of that promise rises as interest rates fall. In Britain, the Pension Corporation estimates that the Bank of England’s quantitative easing (QE), by lowering bond yields, increased pension-plan deficits by £74 billion, even allowing for higher share prices. Since such deficits must be closed over ten years, sponsors may have to divert cash from investment to their pensions.

In America, corporate defined-benefit pension plans had a deficit of $619 billion, in part because of low yields. They could meet just 72% of future obligations, a near-record low, says Mercer, a consultancy.

QE’s boost to business investment may also be less than generally thought. It reduces bond yields in two ways: it signals that the central bank will hold short-term rates low for longer, and it reduces the supply of bonds.

Jeremy Stein, a Fed governor, recently suggested that this second effect, by itself, may not make a company more inclined to undertake capital spending. The company may simply issue a low-cost bond and use the proceeds to pay off short-term debt, or buy treasury bills.

However, Mr Stein said this logic does not apply to households. With fewer financing alternatives than companies, they are more likely to respond to lower mortgage rates by buying houses. But Bill Dudley, president of the Federal Reserve Bank of New York, notes that as consumers age, they spend less on durables such as cars and houses, and thus have less future consumption to pull forward.

Americans have not aged enough in the past decade for this to be a big factor, but it may explain why Japanese consumers have not responded more to zero rates.

A final reason why consumers may not respond is that after a debt-fuelled bust, they do not want to borrow or cannot qualify for a loan. But those restraints appear to be lifting. The number of consumers who plan to buy a new home has jumped 50% since July, according to the Conference Board, a business association.

Ironically, American scepticism about the efficacy of low rates may have peaked just as they start to work. There may be reasons to believe that monetary policy is less effective than it used to be, but it is still doing more good than harm.