The Three R’s of Investing
By Marc Seidner
December 19, 2011
Volatile and manic movements are becoming commonplace in the financial markets. The pendulum that perpetually swings between optimism and pessimism is changing direction more frequently, driven by extrapolation of the latest economic data point, political rumblings and rumors.
We are aware of the traditional three R’s that constitute the foundation of elementary education: Reading, wRiting and aRithmetic. Investors, however, should increasingly be wary of the three R’s that impact investment outcomes today and in the period ahead: Recession, Repression and Risk.
In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, reregulation and deglobalization that act as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite. The result in many countries is a lack of automatic stabilizers that are so necessary in an increasingly volatile economic environment. Normally, political forces respond to economic and financial market outcomes. In the current environment, political actions (or inactions) drive economic and financial market results. Look no further than the debt ceiling debacle and subsequent complete failure of the super committee in the United States and the inability of European leaders to make necessary progress in resolving the sovereign debt crisis.
Stubbornly high unemployment and underemployment rates, stagnant income levels and growing unrest are the consequence.
In capitalist, or market-based economies, the inability to achieve sustainable levels of economic growth that fuel virtuous cycles of spending, investment and employment growth raises the risk that vicious cycles ensue, resulting in an ever-present risk of recession.
As a result, one hears concerns for an upcoming lost decade in many developed world economies growing louder and louder.
Financial repression is a simple concept with profound implications. Under financial repression, market interest rates are kept very low for a very long time period, starving savers to the benefit of borrowers. The hope goes beyond creditors subsidizing debtors. It is also to stimulate risk-taking, investment activity and economic growth.
The best means of managing mounting public sector debt levels is to generate real economic growth. If real growth is elusive, nominal growth rates fueled by inflation above average borrowing costs will reduce debt-to-GDP ratios. Two simultaneous conditions are necessary: Growth, either real or nominal, and low government borrowing costs.
In August 2011, the Standard & Poor’s rating agency decided to downgrade the rating of United States Treasury debt from the top tier AAA to AA+. What seemed like critically important news was quickly overshadowed the following week when the Federal Reserve announced a shift in communication strategy. In every statement since March 2009, the Fed had stated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Then on August 9, 2011, the language changed to “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”
The message to savers and investors was clear. For savers, there will be no income in bank accounts or money market funds for at least two years and likely longer. For investors, there is no means of achieving a positive real (or nominal for that fact) real rate of return on the presumed risk-free interest rate.
The market impact was immediate. The two-year U.S. Treasury note, which offered an average yield of 0.75% from March 2009 through July 2011, fell to about 0.25%.
The new commitment language is repressive to savers and low duration investors. Operation Twist, the Fed’s subsequent plan to adjust its balance sheet by selling Treasury notes with maturities less than three years and buying T-notes and T-bonds longer than six years, is repressive to all Treasury investors.
The 30-year U.S. Treasury currently yields little more than 3%. That is a fixed, nominal return with no growth potential and is eroded by any prospect of inflation. The reward does not seem compelling, and with price volatility over 20%, neither does the risk.
Risk and Implications
The continuous concern about recession and the increasing role of policymakers and other non-commercial participants in financial markets increases risks dramatically.
PIMCO frames this increasing element of risk in financial market and economic outcomes in the probabilistic context of a normal distribution, one that now has a flatter distribution of potential outcomes with fatter tails.
At PIMCO, we constantly ask questions in order to anticipate the full range of potential developments. Key questions include: What if the concept of a change in the distribution of expected outcomes does not go far enough? What are the implications of an environment characterized by a more pronounced set of outcomes exhibiting markedly distinct and contrasting forms? How should investors respond in an environment where what is considered an average outcome or expectation becomes the least probable event and the rare becomes commonplace?
Uncertainty and volatility can be paralyzing, and understandably so. But rather than become frozen with fear, now is the time to recognize regime change and consider making structural modifications.
The heightened risk of recession increases the importance of a strong balance sheet as volatile economic outcomes will likely have a magnified impact on the success and failure of countries, companies and individuals. In the near term, investment success will largely be defined as avoiding the risk of permanent principal loss by stress testing across meaningful possible tail events. Differentiated outcomes and failure are a near certainty. Capitalizing on distressed situations – most likely first in Europe and then elsewhere – will differentiate investment results over a longer time horizon.
Repression requires a keen focus on income, particularly in a world where aging demographics increase the need for known cash flow when traditional sources such as government bonds do not suffice.
Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices. A significant element in the investment management industry is built on the notion of a normal distribution. If the shape or characteristics of the distribution are questioned, then many related concepts – such as mean reversion and rebalancing – must also be questioned. Price change is not nearly sufficient as a signal for portfolio action. Price analysis accompanied by fundamental outlook is necessary.
Portfolios constructed with a carefully selected and diverse set of return drivers, a focus on income and a forward-looking approach to risk management may be able to avoid the pitfalls of the three R’s and increase the probability of navigating an increasingly uncertain economic and financial market environment.