Peak Monetary Stimulus

Doug Nolan

October 28 – Bloomberg (Eliza Ronalds-Hannon and Claire Boston): “After all central bankers have done since the financial crisis to prop up bond prices, it didn’t take much for them to send the global debt market reeling. Bonds worldwide have lost 2.9% in October, according to the Bloomberg Barclays Global Aggregate Index, which tracks everything from sovereign obligations to mortgage-backed debt to corporate borrowings. The last time the bond world was dealt such a blow was May 2013, when then-Federal Reserve Chairman Ben S. Bernanke signaled the central bank might slow its unprecedented bond buying.”
German bund yields surged 16 bps this week to 0.16% (high since May), with Bloomberg calling bund performance the “worst month since 2013.” French yields jumped 18 bps this week (to 0.46%), and UK gilt yields rose 17 bps (to 1.26%). Italian yields surged a notable 21 bps to a multi-month high 1.58%.

A cruel October has seen German 10-year yields surge 31bps, with yields up 58 bps in the UK, 31 bps in France, 40 bps in Italy, 33 bps in Spain and 30 bps in the Netherlands. Ten-year yields have surged 43 bps in Australia, 40 bps in New Zealand and 25 bps in South Korea.

Countering global bond markets, Chinese 10-year yields traded Monday at a record low 2.60%. 
There seems to be a robust safe haven dynamic at work. It’s worth noting that China’s one-year swap rate ended the week at an 18-month high 2.73%, with China’s version of the “TED” spread (interest-rate swaps versus government yields) also widening to 18-month highs.

Here at home, 10-year Treasury yields this week jumped 12 bps to 1.85%, the high since May. 
Long-bond yields rose 15 bps to 2.62%, with yields up 30 bps in four weeks.

And while sovereign bond investors are seeing a chunk of their great year disappear into thin air, the jump in yields at this point hasn’t caused significant general angst. During the October sell-off, corporate debt has outperformed sovereign, and there are even U.S. high yield indices that have generated small positive returns for the month. Corporate spreads generally remain narrow – not indicating worries of recession or market illiquidity.

October 27 – Wall Street Journal (Ben Eisen): “By some measures, October is already a record month for mergers and acquisitions. Qualcomm $39 billion deal to buy NXP Semiconductors helped push U.S. announced deal volume this month to $248.9 billion, according to… Dealogic. That tops the previous record of $240.2 billion from last July… It was assisted by last week’s record weekly U.S. volume of $177.4 billion.”
And while bond sales have slowed somewhat in October, global corporate bond issuance has already surpassed $2.0 TN. The Financial Times is calling it “the best year in a decade,” with issuance running 9% ahead of a very strong 2015. According to Bloomberg, this was the third-strongest week of corporate debt issuance this year.

At this point, there’s not a strong consensus view as to the factors behind the backup in yields. Some see rising sovereign yields as an indication of central bank success: with inflation finally having turned the corner, there will be less pressure on central bankers to push aggressive stimulus. Others argue that central bankers are coming to accept that the rising risks of QE infinity and negative rates have overtaken diminishing stimulus benefits.

Importantly, there’s no imminent reduction in the approximately $2.0 TN annual QE that has been underpinning global securities and asset prices. It’s hard to believe it’s been almost three and one-half years since the Bernanke “taper tantrum.” With only one little baby-step rate increase to its Credit, rate normalization couldn’t possibly move at a more glacial pace.

There’s deep complacency in the U.S. regarding vulnerability to reduced monetary stimulus. 
The Fed wound down QE and implemented a rate increase without major market instability. I believe this was only possible because of the extraordinary monetary stimulus measures in play globally. “Whatever it takes” central banking, in particular from the ECB and BOJ, unleashed Trillions of liquidity (and currency devaluation) that certainly underpinned U.S. securities and asset markets. Prices of sovereign debt, including Treasuries, have traded at levels that assume global central banker support will last indefinitely. Markets have begun reassessing this assumption.

October 28 – Reuters (Leika Kihara): “As his term winds down, Bank of Japan Governor Haruhiko Kuroda has retreated from both the radical policies and rhetoric of his early tenure, suggesting there will be no further monetary easing except in response to a big external shock. In a clear departure from his initial ‘shock and awe’ tactics to jolt the nation from its deflationary mindset, he has even taken to flagging what little change lies ahead, trying predictability where surprise has failed. This new approach will be on show next week, when the BOJ is set to keep policy unchanged despite an expected downgrade in forecasts that could show Kuroda won't hit his perpetually postponed 2% inflation target before his five-year term ends in April 2018. ‘The days of trying to radically heighten inflation expectations with shock action are over,’ said a source familiar with the BOJ's thinking. ‘No more regime change.’”
My view that “QE has failed” has seemed extreme – even outrageous to conventional analysts. 
Yet Japan is the epicenter of the Bernanke doctrine of radical experimental inflationism. Unshakable central banker “shock and awe” and “whatever it takes” were supposed to alter inflationary expectations throughout the economy, boosting asset prices, investment, incomes, spending and – importantly – the general price level. Deflation, it was argued, was self-imposed.

It may have worked brilliantly in theory – it’s just not looking so bright in practice. An impervious Japanese CPI has continued to decline, while the central bank has pushed bond prices to ridiculous extremes by purchasing a third of outstanding government debt. Major risks associated with an out-of-control central bank balance sheet and asset Bubbles are not inconspicuous in Japan. There is today heightened pressure in Japanese policy circles to wind down this experiment before it’s too late. It will not go smoothly.

In the category “truth is stranger than fiction”, November 8th can’t arrive soon enough. 
Suddenly, it appears the markets may have some election risk to contemplate. And there will be no rest for the weary. The ECB meets one month later, on December 8th.

October 27 – Bloomberg (Jeff Black and Jill Ward): “European Central Bank officials signaled that they support extending asset buying beyond the earliest end-date of March, arguing that returning to a healthy level of inflation demands maintaining the pace as the economy heals. Speaking in London…, Irish central bank Governor Philip Lane said that the ‘broad narrative’ in the market about the ECB’s strategy on bond purchases is that it will continue until inflation is heading reliably toward the target of just under 2%. His comments echoed remarks by Executive Board member Benoit Coeure… and Spain’s Governor Luis Maria Linde… ‘March was always an intermediate staging post,’ said Lane. ‘The narrative of the euro area is that there’s been this moderate but sustained recovery, by and large driven by domestic factors, especially consumption. But inflation remains low compared to target and essentially that’s the assessment.’”
I’m not so sure Germany and the group of ECB hawks saw March as “always an intermediate staging post.” Draghi purposely avoided commencing the discussion of extending QE past March. What will likely be a heated debate will take place in December.

October 25 – Reuters (Gernot Heller): “There is a growing international consensus that monetary policy has reached the limits of its possibilities, German Finance Wolfgang Schaeuble told a group of government officials in Berlin… Schaeuble also said that he believed that there was an excess of liquidity and excess of indebtedness internationally.”Over recent months, German public opinion has turned even more against QE. ECB President Jens Weidmann has been opposed to QE from day one, and his skepticism has been shared by fellow German (ECB executive board member) Sabine Lautenschläger. A majority of Germans believe QE is hurting Deutsche Bank and the German banking system more generally. And there is growing frustration that the ECB is a mechanism for redistributing German wealth. The stakes for dismissing German concerns are growing.

Draghi has grown accustomed to playing dangerously. Front-running committee deliberations, he has signaled to the markets that QE will run past March. Comments and leaks from within the ECB have encouraged the markets to assume that aggressive stimulus will run uninterrupted for months to come. All this places great pressure on ECB hawks. And this is a group that has seen its concerns repeatedly rejected; a group that has surely become only more troubled by the course of Eurozone and global monetary policymaking. If they have much say in policy come December, markets will tantrum. I can imagine that Draghi’s pressure tactics must by this point be wearing really thin.

Fledgling “risk off” turned more apparent this week. Notably, the broader U.S. equities market came under pressure. Having outperformed over recent months, the now Crowded Trades in the mid- and small-caps saw prices drop 1.8% and 2.5%. In general, the beloved high dividend and low volatility stocks – colossal Crowded Trades – also badly lag the market. The REITS (VNQ) dropped another 3.6% this week, having declined 13% from August highs to trade at the lowest level since April. The homebuilders (XHB) declined to the low since March. It’s worth noting that Ford this week also traded to lows going back to March.

Abnormal has been around so long now we’ve grown accustomed. Fifteen-year mortgage rates at 2.78%. ARMs available at 2.75%. And I’m hearing automobile advertisements even more outrageous than 2007. “Lease Kia two for $222 a month.” How much future demand has been pulled forward by history’s lowest interest rates – and accompanying loose Credit.

QE is not disappearing any day soon. Yet there’s a decent argument that we’re at Peak Monetary Stimulus. The Fed is preparing for a hike in December. The Kuroda BOJ has lost its appetite for surprising markets with added stimulus. And I suspect the ECB is just over a month away from a contentious discussion of how to taper QE starting in March 2017. Market liquidity may not be a pressing concern today, but it will be in the not too distant future.

Private Equity

The barbarian establishment

Private equity has prospered while almost every other approach to business has stumbled. That is both good and disturbing

THIS year Henry Kravis and George Roberts, the second “K” and the “R” of KKR, celebrated their 72nd and 73rd birthdays, respectively. Steve Schwarzman, their equivalent at Blackstone, turned 69; his number two, Hamilton James, 65. In the past few months David Rubenstein, William Conway and Daniel D’Aniello, the trio behind and atop Carlyle, turned 67, 67 and 70. Leon Black, founder and head of Apollo, is just 65.

These men run the world’s four largest private-equity firms. Billionaires all, they are at or well past the age when chief executives of public companies move on, either by choice or force.

Apple, founded the same year as KKR (1976), has had seven bosses; Microsoft, founded the year before, has had three. On average, public companies replace their leaders once or twice a decade. In finance executives begin bowing out in their 40s, flush with wealth and drained by stress. 

The professional longevity of the private equiteers—whose trade is the use of pooled money to buy operating companies in whole or in part for later resale—is thus rather remarkable. But do not expect to see a lot of fuss made about it. Since the uproar over a lavish 60th birthday party for Mr Schwarzman on the eve of the financial crisis (guests were entertained by his contemporary, Rod Stewart), such celebrations have become strictly private affairs. At KKR there has been little fuss over the company’s 40th anniversary—a striking milestone, given the fate of the institutions that previously employed the big four’s founders: Bear Stearns (gone), Lehman Brothers (gone), First National Bank of Chicago (gone) and Drexel Burnham Lambert (gone). The company has announced a programme encouraging civic-minded employees to volunteer for 40 hours.

Out of the private eye
There are good reasons for this low profile. The standard operating procedures of private equity—purchasing businesses, adding debt, minimising taxes, cutting costs (and facilities and employment), extracting large fees—are just the sort of things to aggravate popular anger about finance. Investors in private-equity firms (as opposed to investors in the funds run by those firms) have their own reasons to withhold applause. All of the big four have seen their share prices fall over the past year; Blackstone, Carlyle and KKR are all down more than 20%.

Apollo, Blackstone and Carlyle trade for less than the prices at which their shares initially went public years ago (see chart 1). First-quarter earnings were bleak, though things have picked up a little since.

A chief executive in any other industry with challenging public relations, poor profits and a depressed share price would have a list of worries. There would be a restive board, a corporate raider, and possibly—ironically enough—a polite inquiry from a private-equity firm. Perhaps in the deep corporate waters such concerns are percolating; there may even have been a redundancy or two. But on the surface, things seem placid. There has been nothing like the rending of garments that would be seen if an investment bank were going through a similarly rough patch. The unusual design of private equity makes it resistant to all but the most protracted turbulence; its record redefines resilience.

It is not just that old private-equity firms persist; new ones continue to spring up at a remarkable rate. According to Preqin, a London-based research house, there were 24 private-equity firms in 1980. In 2015 there were 6,628, of which 620 were founded that year (see chart 2). Such expansion looks all the more striking when you consider what has been happening elsewhere in business and finance. In America, for which there are good data, the number of banks peaked in 1984; of mutual funds in 2001; companies in 2008; and hedge funds, probably, in 2015. Venture-capital companies are still multiplying; but they are effectively just private equity for fledglings.

Private equity’s vitality has seen it replace investment banking as the most sought-after job in finance. This is as true for former secretaries of the treasury (Robert Rubin departed the Clinton Administration for Citigroup; Timothy Geithner the Obama Administration for Warburg Pincus) as it is for business-school students. Some investment banks now pitch themselves to prospective hires as gateways to an eventual private-equity job. If banks resent their lessened status, they respond only with the kind of grovelling deference reserved for the most important clients. The funds made deals worth $400 billion in 2015 (see chart 3). The fees they pay each time they buy or sell a company provide a fifth of the global banking system’s revenues from mergers and acquisitions.

The growth of private equity has been so strong it has a bubblish feel. “The existing number of private-equity funds won’t be topped for 20 years, if at all,” predicts Paul Schulte, head of a research firm in Hong Kong that carries his name. His sentiments are shared, if quietly, by many in the industry as well as outside it, and there is good reason for them. But there is also good reason to believe that the expansion will continue, at least for a while, if only because it is very hard for the money already in the funds to get out.

Private-equity investments are sometimes liquidated and investors repaid. Firms can even be wound down. But investors in private-equity funds are called “limited partners” for good reason, and a key limitation is on access to their money. The standard commitment is for a decade. Getting out in the interim means finding another investor who wants to get in, so that no capital is extracted from the fund. That usually comes with off-puttingly large transaction costs.

Billion-dollar roach motels
The contrast with the alternatives is stark. Clients who want to withdraw money from a bank can do it on demand, from a mutual fund overnight, from a hedge fund monthly, quarterly, annually, or in very rare cases, bi-annually. It is because of the speed with which money can flee them that banks receive government deposit insurance; it shields them from market madness. It is because investors can get out that hedge funds suffering a spell of poor performance can find themselves collapsing even though they have investments that might, given time, pay off handsomely.

The stability that their never-check-out structure provides has enabled private-equity firms to assemble enterprises of enormous scale. Look at the companies themselves and this is not immediately apparent. The market capitalisation of the big four is about $50 billion, which would barely break the top 100 of the Fortune 500; between them they employ only about 6,000 people. But the value and economic importance of the businesses held by their funds (which are owned by the limited partners, rather than being company assets) are far greater. The 275 companies in Carlyle’s portfolios employ 725,000 people; KKR’s 115 companies employ 720,000. That makes both of them bigger employers than any listed American company other than Walmart.

The big four have by far the largest portfolios, but others such as TPG, General Atlantic and Mr Geithner’s Warburg Pincus have a long list of familiar businesses that they either used to own or still do. According to Bain, a management consultancy, in 2013 private-equity-backed companies accounted for 23% of America’s midsized companies and 11% of its large companies.

Not long ago most of those companies were owned by armies of individual stockmarket investors—a system seen as both beneficial to business and befitting a capitalist democracy, and as such one that other countries sought to replicate. Private equity’s deployment of chunks of capital from holders of large pools of money has severely dented that model. And this, too, is being replicated abroad. Only half of the world’s private-equity firms, and 56% of their funds’ assets, are American. A quarter of private-equity assets are in Europe. There are funds in Barbados, Botswana, Namibia, Peru, Sierra Leone and Tunisia.

The rise of private equity has always been subject to scepticism. When KKR launched the first big private-equity takeover, of RJR Nabisco in 1988, it and its cohorts were described in a bestselling book as the “Barbarians at the Gate”. Success, adroit public relations and strategic philanthropy have tempered these concerns, and political donations probably haven’t hurt, either. But the industry’s limitations are still apparent, and current conditions are exacerbating them.

Private equity is structured around a small group of selective investors and managers whose efforts are magnified by the heavy use of leverage in the businesses that the funds control. This is an inherently pricey set-up. Investors need higher returns to offset illiquidity; interest costs are high to offset the risk that comes with leverage; managers who have demonstrated the skills needed to design these arrangements and to maintain strong relationships with providers of capital demand high fees.

During the industry’s growth some of these costs were ameliorated by a long-term decline in interest rates, which enabled deals to be periodically refinanced at lower rates. Today rates can hardly go any lower, and should eventually rise. This is one of the reasons Mr Schulte and others see little growth to come.

Political positions
Another change is that banks which are under orders to curtail the risks that they face are reducing the amounts available for highly leveraged deals. That means borrowing will cost more. To see how that could throw a wrench into the system, look at the brief stretch between September 2015 and this February. The average yield on sub-investment grade, or “junk”, bonds jumped from 7% to 10%.

Transactions all but ceased. The value of assets held by private-equity firms with any public stub had to be written down, resulting in those poor first-quarter results. Money was suddenly unavailable for new deals. Carlyle’s purchase of Veritas Technologies, announced just before the crunch, almost failed to close and was saved only after a renegotiation that led to a lower price and lower leverage.

The political environment, too, may be changing. The industry benefits from two perverse aspects of the tax code—the incentive it provides for loading up companies with debt, and the reduced rate of tax the general partners benefit from owing to most of their personal income being taxed at the rate applied to capital gains. There are strong arguments for reform under both heads. In the second of the two cases a change looks quite likely.

There is also a broader political risk, identified in a paper published in January by professors at New York University and the Research Institute of Industrial Economics, a Swedish think-tank, called “Private Equity’s Unintended Dark Side: on the Economic Consequences of Excessive Delistings”.

As companies shift from being owned by public shareholders to private-equity funds, direct individual exposure to corporate profits is lost. The public will become disengaged from the capital component of capitalism, and as a consequence will be ever less likely to support business-friendly government policies.

Another far-reaching question to consider is that sometimes the only truly “private” thing about private equity seems to be the compensation structure. The money within the funds is to a large extent either directly tied to public institutions (sovereign-wealth funds and municipal pensions), or, as a matter of public policy, tax-exempt (private foundations and school endowments). This irks both those who yearn for truly private markets and those dismayed at seeing public policy arranged so as to enrich particular groups of private citizens. The implicit tie between the allocation of funds, investments and the state creates a breeding ground for corruption and crony capitalism.

The madding crowd
The largest threat to the industry, though, comes not from its critics but its success, and those who seek to emulate it. According to Bain, the share of America’s midsized companies controlled by private equity tripled between 2000 and 2013; for large companies it increased more than fivefold (see chart 4). That doesn’t mean private equity is running out of road quite yet; but it does suggest that opportunities will get more scarce.

At the same time other kinds of entities with access to cheap and often state-related capital have entered the buy-out market, including Chinese multinationals (financed by state banks), sovereign-wealth funds and pension funds that want to invest directly, such as the Ontario Teachers’ Pension Plan. That means more competition for new deals. In 2007 private-equity firms were responsible for 28% of the purchases of midsized health-care companies, according to Bain. In 2015 their share was only 8%. The trend has been similar, if not so pronounced, in the acquisition of retailers and companies involved in technology and consumer products. It is “the roughest environment for private equity I’ve ever lived in,” Joshua Harris, a co-founder of Apollo, told attendees at a Milken conference in early May.

This may go some way to explaining the amount of money private-equity firms have on hand—their so-called “dry powder”. Preqin puts the current pile at over $1.3 trillion. Adjust for the leverage applied in private-equity deals (say two-to-one) and that sum by itself would account for roughly 70% of the value of acquisitions carried out in 2015. If fertile fields beckoned, the amount of available cash would be shrinking, not rising. A confirmation of tight conditions comes from the willingness of the largest private-equity firms to look further afield for new opportunities. Blackstone now has larger investments in property, $103 billion, than private equity, $100 billion (plus an additional $112 billion in hedge funds and credit). Less than half of Carlyle and KKR’s invested assets are now in corporate equity, and just one-quarter of Apollo’s.

Competition has had an impact on fees, too. A decade ago the standard formula was a 2% annual management fee and 20% of profits. These are still the terms quoted. In reality, though, management fees have fallen to about 1.2%, according to one large firm—similar to what a plebeian mutual fund charges. The 20% slice of profits remains; but some clients are now allowed to “co-invest”, matching the stake in a company they buy through a fund with a stake bought directly. That reduces the fees on the deal.

All good reasons for doubt. But although that mountain of dry powder may betoken a lack of opportunities, it also shows that there is a lot of money still eager to get in. Whether that is wise is not clear. The lack of daily pricing, used to assess mutual funds and, often, hedge funds, introduces doubt into the discussion of private-equity results. The “internal rate of return” measure that private-equity companies tout can be fudged. This makes academic assessments of performance hard.

This July, in an update of a previous study*, business-school professors at the Universities of Chicago, Oxford and Virginia found that, although in recent years buy-out funds had not done much better than stockmarket averages, those raised between 1984 and 2005 had outperformed the S&P 500, or its equivalent benchmarks in Europe, by three to four percentage points annually after fees.

That is a lot. Ludovic Phalippou, also of Oxford, is more sceptical; he argues that when you control for the size and type of asset the funds invest in, their long-term results have never looked better than market-tracking indices. That said, getting the same size and type of assets by other means is not easy.

The average return, disputed as it may be, does not tell the whole story. Studies find some evidence that private-equity managers who do well with one fund have been able to replicate their success (though again the effect seems to have decreased in the past decade). The biggest inducement to invest may simply be a lack of alternatives. Private equity’s current appeal rests not on whether it can repeat the absolute returns achieved in the past (which for the big firms were often said to be in excess of 20% annually) but on whether it has a plausible chance of doing better than today’s lacklustre alternatives. This is a particular issue for pension funds, which often need to earn 7% or 8% to meet their obligations.

The standard explanation for why private equity might be expected to outperform the market is that it can ignore the dictates of “quarterly capitalism”—meaning impatient investors. This is not particularly convincing. The people who work for private-equity firms are a caffeinated bunch.

During volatile times they often require constant updates on their portfolio companies’ results, and can intervene to quash even the most trivial use of cash.

What does differ, though, is focus. Private-equity funds, the boards they put in place and the top managers who work for them all tend to concentrate on underlying performance to the exclusion of almost everything else. Public companies face a mountain of often incomprehensible or conflicting regulatory demands that are not relevant to performance; that delisting has risen in step with such demands seems unlikely to be a coincidence.

Disclosure requirements, in many ways the most appealing characteristic of the public company for investors, have come to constitute a legal vulnerability. A sharp drop in a company’s share price can prompt litigation based on the idea that investors caught in the downdraft were unaware of a possible risk. So too could any internal discussion of a potentially controversial issue, as reflected by the New York attorney general’s investigation into ExxonMobil’s lack of disclosure on the risks associated with climate change.

Law is not quite the same sport outside America. But the ways that capital markets operate (or fail to) elsewhere provide other opportunities for private equity to outperform. In China, for example, the term structure for bank loans is only one year, and seeking the longer-term funding offered by a public offering means joining a government-controlled queue. Private-equity financing can be arranged in short order, with money coming in, and out, depending on the needs of the business.

A recent working paper published by Harvard Business School** summarises the possible benefits of private-equity ownership: the substitution of debt for equity, thereby reducing taxes and magnifying profits; compensation structures that provide huge incentives to management for increasing benefits; the addition of new expertise; and transactional dexterity. Perhaps the most compelling point is speed. The upper managements and boards of firms the funds acquire are typically replaced within months. Purchases are done at what are perceived to be opportune moments. So too are sales and refinancings. When the public markets are cool, as has recently been the case, private-equity funds resist relisting holdings or taking on new credit, and may choose to repay some loans. When markets become accommodating, the flows reverse.

Public companies could do much of this, too. They tend not to, perhaps because their inner workings are more open to inspection and criticism. Sometimes they bring in private equity to do what they would not. After acquiring Kraft and Heinz in deals that a Brazilian private-equity firm, 3G Capital, also took part in, Warren Buffett of publicly traded Berkshire Hathaway explained things like this in his annual report: “We share with [3G] a passion to buy, build and hold large businesses that satisfy basic needs and desires. We follow different paths, however, in pursuing this goal. Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then—very promptly—to make the moves that will get the job done.” Berkshire, it appears, with its annual meetings featuring happy shareholders applauding a jovial peanut-brittle-munching chief executive, outsourced the hard decisions to a less exposed firm happier to take them.

There are other reasons for public companies and private equity to co-operate. In 2015, when GE undertook a massive reduction in its finance arm, a quarter of the more than 100 transactions that quickly unfolded involved private-equity firms. There were only three public offerings.As well as being speedy, private equity is innovative. When Walgreens Boots, a health-care company, sold a business providing intravenous fluid treatments to Madison Dearborn, a private-equity firm, it was able to retain a significant (if undisclosed) stake. This sort of transaction, which lessens the embarrassment of selling too cheap something which goes on to be a success, is referred to on Wall Street with a pejorative term that can be roughly translated as “sucker insurance”.

They were a kind of solution
Given the flexibility private equity displays, the time may come when there are fewer questions about why a company is held in a private-equity structure rather than a public one. Less taxation, fewer operating constraints and less legal vulnerability are all attractive. There are political risks: structures which skew their benefits to the privileged are always subject to popular backlashes. But that potential vulnerability is also a source of strength. Raise your money from the very wealthy and asset-rich, and from institutions such as the pension funds of state governments and municipal workers, sovereign-wealth funds and universities with large endowments, and you get a certain clout.

In theory, there should be a cost to such privilege. Public markets are inclusive and deep; they should provide capital efficiently (meaning inexpensively and intelligently) and should, as a result, be the best solution for both companies and investors. They should thus outperform the competition. Alas, at the moment it seems that internal and external constraints on public companies are holding that performance in check. The result is that the old lions of private equity, and their many cubs, could be making themselves ever more comfortable for decades to come.

* “How do Private Equity Investments Perform Compared to Public Equity?”, Robert Harris, Tim Jenkinson and Steven Kaplan, Journal of Investment Management, 2016.

** “What Do Private Equity Firms Say They Do?”, Paul Gompers, Steven Kaplan and Vladimir Mukharlyamov, Working paper, Harvard Business School, 2015.

To revive America’s economy, raise interest rates

The longer the low-rate environment lasts, the greater the systemic risk

by: Tony James

The US Federal Reserve delayed raising interest rates again last month. Meanwhile, the American economy is underperforming: gross domestic product is sluggish, productivity growth is down and, though wages are ticking up, incomes have hardly budged.

With fiscal policy locked in permanent austerity mode, the Fed’s easy money policy is not working. Worse, today’s artificially low interest rates are likely to be harming the economy.

Sustained zero rates hurt workers’ pay, the incomes of the elderly and businesses’ funding for long-term liabilities. Low rates destabilise the financial system. If you consider these points in turn, it is easy to see why it is time for the Fed to change course.
First, when interest rates are low for a long time, companies substitute capital for labour to an unnatural degree. Without sufficient demand to absorb this newly displaced labour, cheap capital puts downward pressure on wages and people out of work, damaging aggregate demand and undercutting any monetary stimulus.
Furthermore, businesses will have borrowed all they want, sometimes even more than they need. One result is a huge cash stockpile, another the wave of stock buybacks. Since business credit demand is already satiated and businesses already have enough production capacity, more rate reductions will not stimulate more productive investment.
Second, low rates hurt the elderly and others who depend on income-producing investments.

The yields on these investments are tied to government interest rates. As such, incomes and spending are pinched in a sustained low-rate environment.
Third, low rates hurt households, businesses and institutions that are investing today to fund future spending. A 1 per cent decrease in rates of return can increase savings required to make up the gap by 20 per cent. As a result, people must save more to fund future requirements — and spend less now precisely because rates of return are so low. Whether you consider parents saving for their children’s university education or companies funding pensions, ultra-low rates vastly increase the “present-value” cost of future commitments, creating another vicious cycle of reduced near-term demand and lower growth.
Fourth, low rates hurt the financial system and create systemic risks. Near-zero rates encourage investors to buy esoteric assets as they grasp for higher returns. This diverts resources from more productive investments. Investors dive into risky areas such as emerging markets and derivatives instead, inflating asset prices and creating greater market volatility in the process. The longer the low-rate environment lasts, the greater the danger of asset price bubbles and systemic risk.
In addition, with negative interest rates, banks cannot lend profitably. They need either to take more risks or shrink their balance sheets. But the latter has the opposite of the intended effect as it reduces banks’ ability to ex­tend credit and fuel growth. Finally there is the psychological effect. Negative rates communicate the fear of central banks that the economy is struggling.

That message is counterproductive.
For all these reasons, I believe conventional monetary policy has played itself out. While the immediate damage from artificially low rates may not be large, such rates hold back growth.
There are certainly significant challenges facing policymakers. Populations are ageing and demand from abroad is slowing. Incomes are stagnant and productivity is disappointing. The interplay of globalisation and technology creates challenges across the economy. These are the causes of our economic malaise and they call for real, fiscal solutions. We should not add to our challenges by sustaining ultra-low rates. They are doing more harm than good.
The writer is president and chief executive of Blackstone

Corrections, Patterns, and Positioning

By Sprott U.S. Media

The yellow metal advanced mightily in the first six months of this year and then held those gains for the next three, so it was not a surprise to see it give up some ground in October.
The correction is providing an opportunity to enter stocks that we thought got away. The question is precisely when to make those moves.

That’s both tough and easy. It’s tough – impossible – to know exactly when and how this correction will bottom. It is much easier to look at historic patterns and overlay significant pending events to estimate likely time frames.

Looking ahead from here, there are a couple pertinent patterns.
  • Gold’s strength declines in the final months of the year. September is almost always good and October often is as well, though the tenth month starts with a weeklong holiday in China that creates an opportunity for gold shorters to hammer the price while Chinese traders, who would usually counter such a push, are away. Shorters used that opportunity this year: gold started to fall the first trading days of the month, precisely when China was on vacation. Had Chinese traders been at their desks, I imagine the fall would have been less.

  • The Indian wedding season runs from October through December, after the monsoons are over and before the heat really ramps up. You have undoubtedly heard about the importance of Indian weddings to gold demand, but it’s a topic worth repeating. A large percentage of the money spent on an Indian wedding goes into gold, which adds up to a lot in a nation as populous as India. And the season could be especially good this year because the monsoons were fantastic, which means Indian farmers are not stressing about a third year of drought. Indian farmers make up about a third of the country’s gold demand.
  • Broadly speaking, 2016 has seen two kinds of gold investors: short-term speculators and long term value hunters. The first group moved into gold as it gained and many of them likely ditched in the drop. The second group probably took some money off the table during the year but left core positions intact, guided by the belief that the run is just getting going. As we approach the end of the year, these two groups have different concerns:
·         Short term specs: Want to book gains. If they didn’t sell already, they will sell once the sector strengthens some. That being said, if the public narrative turns pro-gold again this group will buy back in, which is possible if 2017 starts the way 2016 started. 

·         Long term value hunters: Want to position in stocks offering the best leverage to gold and/or exploration opportunity, while also managing capital. On that second point, I expect to see some tax gain selling before the end of the year. I know, after five bad years that concept may seem foregin – but investors booked a lot of tax losses in the bear market and many will look to lock in some gains against which they can apply those losses, especially in jurisdictions where tax losses expire. More generally, why not lock in some tax-free gains and then re-enter on a down day?
The December Fed meeting is very significant for gold. If things continue the way they are now, expect a rate hike. Gold will sell down in advance of and right after that event – but remember, gold’s early 2016 rally got going only a few weeks after the last rate hike.

  • Corrections are rarely V-shaped. Instead, they often look more like a W. The gold price decline we just went through is likely the first low point in the pattern. The forces outlined above could create a small lift over the next few months (Indian buying on the gold side, value hunter buying on the equities side) that leads into a second low (selling by specs who aren’t already out, tax gain selling by long terms players, apprehension around the Fed meeting), all of which sets up for the W to wrap up in a January rally.
Jordan Roy-Byrne of demonstrated this pattern fantastically:

The chart uses the HUI Index as a proxy for gold stocks and compares today with corrections in 2001, 2002, and 2006. Each followed a very strong advance, like we just experienced.

The corrections in 2001 and 2006 show the W pattern, though the 2001 W is pretty flat. In 2002 the correction followed a W pattern until falling for a third time.

History doesn’t repeat, but it does rhyme. The rhyming pattern to note is that corrections don’t have flat bottoms; they oscillate, often twice but potentially thrice (or otherwise). Be aware such oscillations are pending and try to time your buys accordingly.

The durations are also interesting – the 2001 and 2006 corrections lasted 5 months, which takes us from early August (when HUI peaked) through to early January- right on schedule.

Of course when it comes to gold, the metal itself is only part of the equation. Also important are the US dollar and rates.

The dollar was the main culprit behind gold’s October slide. The US Dollar Index gained 2.6% in the first two weeks of the month, a significant move largely because it broke above the highpoint of the band in which the greenback had been trading since the spring.

Why the rise? Largely because the pound has been getting hammered since Theresa May started talking about Brexit realities: timelines for negotiations and her preference for a “hard Brexit” to speed things along. When one currency declines another has to rise, and so it was with the pound and the dollar.

As for rates, US data continues to be middling. The market hoped for some clarity on inflation with the release of the September Consumer Price Index, but the numbers were nonchalant. Headline consumer inflation rose 0.3% month-over-month as expected, but core inflation rose just 0.1%, which was less than expected.

Expectations aside, it is notable that the core rate has now stayed above 2% year-over-year for eleven months. Stronger oil prices should add to headline inflation going forward, so inflation has met the Fed’s target.

Inflation, however, is one of three targets the Fed says need to be met for a rate hike. The other two are unemployment below 5%, which has been essentially the case for some time now, and GDP growth of at least 2%, which is looking less and less likely with each passing day.

I’m not sure the GDP miss matters. What is really on the line right now is Federal Reserve credibility. And if that sounds familiar, it’s because we had this exact conversation around this time last year, leading up to the December meeting where Yellen and Co. did raise rates.

The situation was strikingly similar. The dollar was very strong, having retained its big 2014 move to stay above 93 all through 2015. That greenback strength was all but preventing inflation and hurting US corporations. Raising rates supports the dollar, which had Yellen in a difficult position.  

But after talking about hikes for so long, the Fed had to move.

A year later, the same thing. Dollar strength is hurting earnings for multinational US companies, hampering inflation, and slowing GDP growth, but Yellen has a credibility problem and so a rate hike is likely.

So oscillations until December because of seasonal pressures and rate hike expectations…and then, if historic patterns around W-shaped corrections and gold’s reaction to rate hikes persist, we could be looking at a strong start to 2017.

That means this fall may be the time for patience and using patterns to position your portfolio for gold’s next leg up.  

Don’t Expect Fed to Clarify Its Plan

The Federal Reserve will almost certainly keep interest rates unchanged this week; anyone hoping for a clear signal about December’s meeting probably will be disappointed

By Steven Russolillo

The Federal Reserve building in Washington. The chances of a Fed rate increase by the end of the year are above 80%, based on January’s fed-funds futures contracts. Photo: Bloomberg

The Federal Reserve will keep us in suspense.

No, not about this week’s meeting. The Fed almost certainly will sit on its hands a week before the election. But anyone hoping for a clear signal about December’s meeting probably will be disappointed. Rate setters were far more obliging just over a year ago, before the first rate increase in nearly a decade.

The clues are there, though. Improving economic conditions, including last week’s strong-than-expected reading on growth, suggest the Fed is getting closer to another rate increase. Markets are increasingly betting on a December move. In fact, the signs are stronger than a year ago.

In September 2015, the Fed surprised many by not lifting rates. In the days prior to its meeting in late October of last year, federal-funds futures showed only a 33% chance of a rate increase by that year’s end, according to CME Group. The Fed then specified in October that it might be appropriate to raise rates at its “next meeting.” Odds of a rate increase nearly doubled in the ensuing week. Sure enough, the Fed raised rates in December.

The situation is different today. Traders already are placing odds of a rate increase by the end of the year at more than 80%, based on January’s fed-funds futures contracts. The Fed statement alone probably won’t boost them further. The central bank is likely to keep its options open, particularly at a time when markets could be poised for more volatility.

Sure, the stock market has been relatively calm and trading volumes have been unusually low.

But bond yields have been creeping higher. A market-based measure of inflation expectations just hit a 15-month high. And the Chinese yuan’s steep slide to a six-year low, a move which put markets on edge a year ago, has so far been greeted with a yawn.

Investors may be unwilling to make big bets ahead of the election. Yet, in the background, they aren’t sitting still. The options market is showing insurance against market swings expiring right after the election is higher than index options that expire immediately before it.

December still looks like a good bet for a rate increase, but there is much that can happen between now and then. Just don’t expect the Fed to paint itself into a corner.

 The Boredom Before The Storm

With all the surprising and disturbing things going on – Brexit, China’s soaring debt, US/Russia/China saber rattling, the, um, unique US presidential race, the cyber attack that shut down big parts of the US Internet – you’d think that an unsettled world would be reflected in skittish financial markets.

Instead we’re getting the opposite, with stock price movements becoming more and more placid as the year goes on. The following chart shows the volatility index (VIX) for the S&P 500 which, after some notable action in 2008 and 2011, has become ever-calmer, with recent readings comparable to the (in retrospect delusional) levels of 2006, just before the biggest financial crisis since the Great Depression.


What’s going on?

 First, during credit bubbles volatility normally contracts because enough new money is being created to provide pretty much everything with a bid. In other words, all the new liquidity being created by desperate governments has to go somewhere, so dips get bought before they can become dramatic and traders accept the placid present is the new normal.

Second, we’re in an election year and the people currently in charge badly want their chosen candidates to win. So government spending is rising dramatically. The federal deficit is up 17% so far this year, but jumped 67% in August. This burst of new borrowing has given the economy its current “all is well, stay the course” gloss. A bit more on this from MarketWatch:

U.S. runs $107 billion budget deficit in August, Treasury says

The federal government ran a budget deficit of $107 billion in August, the Treasury Department said Tuesday, $43 billion more than in August 2015. 
The government spent $338 billion last month, up 23% from the same month a year ago. Spending rose notably for veterans’ programs and Medicare, Treasury said.
For the fiscal year so far, the budget deficit is up 17%. The government’s fiscal year runs from October through September. The Congressional Budget Office estimates the shortfall for fiscal 2016 will be $590 billion, or about $152 billion more than last year.

And what does it mean?

 The current financial market insouciance is no more sustainable than that of 2006 because it’s caused by temporary factors that can’t continue without themselves causing turmoil. Debt, for instance, can’t continue to rise relative to GDP forever…


…and equity valuations have only exceeded their current levels thrice in the past century, each time with notable volatility following shortly.


So it’s a safe bet that 2017 will be in many ways a mirror image of 2016. US politics will be decided if not settled, government spending will stop spiking, and equities will return – possibly suddenly – to more historically normal valuations. And rising volatility will once again become the norm – as it should be in a world this dysfunctional.

How to play it? The VXX is an ETF that tracks the VIX – but only for short periods of time. So it’s a trading vehicle only. Shorting high P/E stocks is a longer-term way to bet on the coming mean-reversion of equities to lower valuations. Put options are a medium-term way to make the same bet with leverage. If we’re heading back to the exciting days of 2008 (which we are) then all of the above should provide both thrills and trading profits.

And precious metals, because they attract fearful capital, should benefit from the coming anxiety spike. Last time around – after an initial plunge – gold, silver and the shares of the companies that mine them embarked on a multi-year run that made them the best performing assets of the decade.

Up and Down Wall Street

The Mystery of the Lost American Workers

Janet Yellen believes that her high-pressure economy can drive nonparticipants in the labor market to find jobs. That could be harder than she thinks.

By Randall W. Forsyth

Photo: Pixabay
When all you have is a hammer, it’s said that every problem looks like a nail. So it is with central bankers.

Their tool essentially is money, but it is becoming increasingly apparent that their trillions can’t solve everything.

That doesn’t stop them from trying, however. Federal Reserve Chair Janet Yellen suggests that by creating a “high-pressure economy,” some of the problems of the sluggish expansion might at least be ameliorated. Most notable among them is the unprecedented number of Americans who not only aren’t working, but aren’t in the labor force.

In a speech to a Boston Fed conference the Friday before last, Yellen posited that pushing economic growth could counter the lingering aftereffects of the Great Recession. The unspoken, but obvious, backdrop was the expectation of a second hike in the central bank’s federal-funds interest-rate target, most likely at the Dec. 13-14 meeting of the Federal Open Market Committee, around the first anniversary of the initial increase to the current 0.25%-0.5% target. At last month’s meeting, the decision to stand pat on rates drew three dissents among FOMC members who wanted to raise them. While there’s virtually no chance of a hike at the Nov. 1-2 confab, fed-funds futures put a 68% probability on a December move, according to Bloomberg.

Yellen offered an apologia for going slow on rate boosts to keep the pressure on the economy.
Stronger growth would induce businesses to invest more to expand, especially if they were more confident about the future. That could also spur more productivity-enhancing research and development, as well as faster-growing start-ups.

Most provocatively, the Fed chief suggested that a “tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could lead to more efficient—and, hence, more productive—job matches.”

Leave aside the notion that job-hopping in a hot market leads to more productivity. One could argue the opposite. (Bidding for talent takes away from management time, while workers look for new, more lucrative gigs, instead of doing their jobs. Those boom times are a distant memory now, however.) But Yellen’s more serious suggestion is that a high-pressure economy would induce those out of the labor market to look for jobs. More folks would be working, while employers would have a bigger pool of job seekers—easing one of their main complaints, the lack of qualified applicants.

A high-pressure economy could benefit lower-paid workers, as well as those who have had a tough time finding jobs, write Goldman Sachs economists David Mericle and Avisha Thakkar.

Among the latter are the less educated, some minorities, and those with criminal records, whom they note have had a much tougher time finding employment. Their plight is especially acute given that “the long-term unemployed account for about one-fourth of the total unemployed, a share almost never seen before the last recession.”

If you’re not in the labor market—that is, looking for a job—you’re not officially unemployed.

The increased number not in this market—a decline in the labor-force participation rate, in economists’ parlance—has been striking, especially in recent years. The participation rate stands at just 62.4% of the adult population, the lowest since 1978, before women were fully integrated into the workforce.

In a paper titled “Where Have All the Workers Gone?”, presented at the same Boston Fed conference where Yellen spoke, Princeton University’s Alan Krueger, the former head of President Barack Obama’s Council of Economic Advisers, notes that about four-fifths of the decline since the last recession reflected demographics. Baby boomers are entering retirement, although as noted here last week (“Many in the U.S. Have Zero Retirement Savings,” Oct. 15), the labor-force participation for those over 65 actually is rising, albeit from a lower level.

Krueger finds that there has been little improvement in the labor-force participation rate, even as the headline jobless rate has markedly declined, to 5%, in the most recent reading. In other words, he concludes that this may be as good as it gets. “The idea that many labor force dropouts are returning to the labor force is unsupported by the data,” he writes.

Depressingly, the reasons seem unrelated to economics.

Among younger men ages 21 to 30, the labor-force participation rate fell by 7.6 percentage points, to 82.3% from 89.9%, over the 10 years ended in October 2014, partly because they stayed in school, presumably gaining marketable skills. Time spent on education jumped by 5.3 hours per week, which occupied 38% of their time. But time spent playing videogames rose to 6.7 hours per week, an increase of 3.1 hours, although time watching television dipped by two hours, to a still sizable 21.7 hours per week.

As for prime-age men not in the labor force, Krueger found an astonishingly high number who reported having serious health problems and being on pain medication. Half said their health presents a serious barrier to employment, while nearly half take pain medication daily, two-thirds of which involve prescription meds. Even more distressingly, prime-age men out of the labor force report low levels of emotional well-being and say that they derive little meaning from their daily lives.

As a social scientist, economist Krueger can cite correlations, but actual causality can be open to question. In order to get disability or other benefits, a person has to declare convincingly that he or she has a health problem that precludes work. To justify writing a prescription for pain medication, a medical professional has to determine whether the patient needs it, and measuring pain is highly subjective. At the same time, opioid addiction has become a scourge across the nation.

In his current, much-discussed best-selling book, Hillbilly Elegy: A Memoir of a Family and Culture in Crisis, J.D. Vance writes of his Scots-Irish peers’ “learned helplessness.” As Joshua Rothman’s recent review in the New Yorker points out, if hard work is their tradition, why are so few of Vance’s former peers working? Those cobbling together part-time jobs to make ends meet live alongside those who game the system to become lifetime welfare recipients, according to Vance’s account.

In Middletown, Ohio, whence Vance came (and escaped from, after a life-changing service in the Marines, to Ohio State, Yale Law School, and now a San Francisco investment firm headed by Peter Thiel), the industrial jobs were hollowed out starting in the 1970s—not a new phenomenon related to the Great Recession.

In fact, these are deep-seated problems. Idle young men who spend their hours playing videogames while their older brethren are on disability and taking meds to ease their pain (physical and otherwise) are beset by woes that are not readily solved by a high-pressure economy stoked by ultralow interest rates.

NO NEWS WAS GOOD NEWS for the stock market last week, as the major averages ended on Friday a fraction of a percent higher, which was good enough to break a two-week losing streak. And like a roadside wreck that nobody can keep from slowing down to gawk at, the U.S. elections commanded an outsize portion of the markets’ attention.

Indeed, Dunkin’ Brands (ticker: DNKN) last week blamed the contentious presidential campaign for weaker-than-expected sales of doughnuts and coffee. If that’s the case, look for any number of companies to say they’ve missed their numbers because of the election, which should replace the weather as this season’s version of the all-purpose excuse.

The real problem is tepid global growth, as indicated by General Electric ’s (GE) admission on Friday that revenue, excluding results from acquisitions and divestitures, will be flat to up 2% this year, down from a previous forecast of a 2% to 4% gain. That follows a previous cut in guidance by fellow global industrial giant Honeywell (HON).

Given that, the last thing U.S. multinationals need is a renewed strengthening of the dollar. In the past month, the U.S. Dollar Index was up about 3%, roughly retracing its decline since late January. Back then, it was widely suspected that a secret deal had been worked out to corral the greenback in order to try to bolster plunging emerging market commodities.

The U.S. Dollar Index is heavily weighted to the euro, as well as the yen, an artifact of the currency world of four decades ago. Meanwhile, the Chinese yuan continues to weaken against the greenback; while that’s more important in the 21st century, China’s currency is moving in tandem with its other international counterparts versus the dollar.

That said, the robust buck is an increasingly strong head wind for U.S. companies competing in the rest of the world. Typically, that would be bad news for commodities, such as oil, but U.S. crude remains steadfastly above $50 a barrel.

The depressing effects of the previous collapse in oil prices on inflation measures, such as the consumer-price index, are beginning to wane. Barclays estimates that the year-on-year rise in the CPI will be 2.3% by December, up from the latest, 1.5% reading, just because it will be measured against the low prices of late last year.

Housing and medical costs are further lifting inflation, which the bank said should push the CPI higher through the end of 2017. All of which may make it harder for the Fed to stave off more rate hikes next year, which aren’t being discounted by the bond market. That’s something to ponder after Election Day.