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Strong Fundamentals Drive Best First Quarter Since 1998


Tuesday, April 10th, 2012

by Douglas Coté, ING Investment

We just wrapped up the best first quarter since 1998, volatility has dropped to almost boring levels, fundamentals are relentlessly marching forward and global risks appear to have returned to a morenormal state.

To the astonishment of the bears, volatility, inflation and global risk are down while profits, employment and manufacturing are up — and markets have been gaining momentum with an aura of sustainability. Could it be that the vicious cycle of the past few years has been broken? Could we have entered into the type of virtuous cycle in which positive data beget more positive data, as has marked prior sustained bull markets?

“Sell in May and go away” and other bear strategies that have worked in prior years will likely be ineffective this year, driven in large part by strong fundamentals and global risks that have been excessively discounted.

Fundamentals Remain the Key to Market Success

Our “ABCDs” of fundamentals are the primary drivers of markets but have been slow to capture investor attention. This oversight has created an investment opportunity given the compelling strength in all of these drivers.

Advancing corporate profits. Fourth quarter earnings season started with a few significant misses and a lot of handwringing in the media before momentum ultimately picked up, driving double-digit year-overyear earnings growth. Sales growth was not too shabby either, with top-line revenue growth of 8.3%. The media may lament the deceleration of earnings growth, but we are, after all, continually setting the bar higher — corporate earnings reached an all-time high in 2011, and we expect a new record in 2012.

Broadening manufacturing. U.S. manufacturing has reemerged as a powerhouse, with the ISM manufacturing index expanding for 31 consecutive months. Who says “made in the U.S.A.” is fairytale of yore? Despite the rise of China and other emerging economies, the U.S. still contributes 20% to the world’s manufacturing pie; if the U.S. manufacturing sector was a country, it would be larger than Canada, India or Russia. The emerging countries have been playing catch-up, but as their wage levels increase and their productivity levels tail off, their advantage markedly decreases. Couple that with the fact that the U.S. is number one in productivity, and we say “game on”.

Manufacturing powers the entire economy

— the Bureau of Economic Analysis calculates that every $1 of manufacturing GDP drives an incremental $1.42 of economic activity in nonmanufacturing sectors.

Consumer strength underestimated. A variety of data points suggest the consumer is emerging as a game-changer. The unemployment rate, at 8.3%, is at its lowest level in three years, and the leading employment indicator, initial unemployment claims, are at 2008 lows. While high gas prices may take a bite out of consumer paychecks, it is more important that consumers are actually receiving paychecks. Personal income and personal consumption expenditures have reached all-time highs. February retail sales again surpassed the $400 billion mark to reach the highest monthly level ever. Even housing has shown signs of life, with the best January/February in five years.

Developing economies are driving global growth. Emerging markets continue to be a key catalyst for U.S. corporate revenue. With signs of a potential hard landing in China, there are concerns that weakness in this important corporate growth catalyst may put the bull market in jeopardy. No way — any slowing in China and other emerging markets will be picked up by the “frontier” or newly emerging markets. Indonesia is a good example. Indonesia, the fourth most populous country in the world, recently made headlines when its sovereign debt was upgraded to investment grade. But other good news abounds for the archipelago.

Indonesia is the largest economy in Southeast Asia and grew by 6.5% in 2011, the fastest pace in 15 years. Although 60% of their GDP is fueled by emerging middle-class consumers, Indonesia is also basking in the light of global trade as a large exporter of oil, natural gas, coal and palm oil, and it is home to the second-largest copper mine in the world.

Global Risks Continue to Wane

Europe’s PIIGS (Portugal, Ireland, Italy, Greece and Spain) remain in the news — the latest speculation is that Spain will need bailout funds to effectively recapitalize its banks. We agree. Spain is no Greece, however, and has taken strong austerity measures to contain its crisis. Spanish Prime Minister Mariano Rajoy recently announced €27 billion in budget cuts in a bid to convince the troika of the European Commission, European Central Bank and International Monetary Fund that Spain has its house in order. Alas, these troubled European countries have tended to underestimate their problems, while the market tends to overestimate their impact on the global economy with excessive worry.

The worry is unjustified. The effective fence around the European debt crisis was further bolstered at the end of March with a €700 billion boost to the permanent €500 billion European Stability Mechanism (ESM). This latest round of funding, while maybe not as ambitious as some would have liked, proves that European leaders are willing to do whatever it takes to stem the tide of contagion. Additionally, as the firewall around Europe gets stronger, it opens the door for the IMF to step in, as other countries have pledged to help contain the crisis if Europe takes those first concrete steps.

Why a Market Rally Is a Risk

There is a bigger risk looming on the horizon, bigger than all of the global and geopolitical risks omnipresent in the media. The biggest risk facing investors is a sustained, pronounced U.S. market rally — while they continue to watch from the sidelines. As equity markets move higher month after month, there remains a cadre of wouldbe investors sidelined by lingering fears of an event — i.e., the 2008 Credit Crisis — that has been over for three full years.

We get it: The credit crisis was the worst market disaster since the Great Depression. But since March 2009, the market’s postcrisis bottom, investors have missed out on double-digit equity and fixed income returns; in fact, the S&P 500 has returned almost 100% since March 2009. Many investors have downgraded themselves to “savers” by cowering in cash — $7.5 trillion to be exact

— as they wait for the dust to settle, missing a golden opportunity to build wealth.

We believe the next phase of the market rally will be driven by savers that are compelled to “capitulate” (or “throw in the towel”) and get back into the market due to a fear of being left behind. This fear is warranted; the S&P 500 is trading at a very compelling priceto- earnings ratio (P/E) of only 13.5, relative to its historical average of 15.0. An expansion of the P/E multiple to the historical average would send the S&P 500 to an all-time record high of 1575 at our earnings target of $105 per share. Compare this to a Treasury bond, which at a yield of 2% is selling at the equivalent of a 46 P/E ratio.

Historically cheap valuations are icing on the cake. Global risks are always looming, but we believe investors need to put fear aside, grab a red cape and jump into the ring with this raging bull.

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This commentary has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.

The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

Past performance is no guarantee of future results.

©2012 ING  – 230 Park Avenue, New York, NY 10169

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Practical …Is Efficient


Thursday, October 7th, 2010

In financial theory, it’s often debated how many stocks are required to be in a portfolio for true diversification. Benjamin Graham, most recognized as the father of value investing, concluded that a portfolio of 15-30 stocks was adequate to eliminate non-systematic risk. Other academic studies have since gone on to contend that to truly eliminate non-market risk, an investor must purchase the entire market. With the development of exchange-traded funds (ETFs), access to low-cost beta (or buying the entire market) became easily achievable. We argue however that owning the market or diversifying with a basket of global equity ETFs is no longer sufficient for even the most aggressive investor. In the chart below, we take a look at the CBOE Implied Correlation Index1. Notice that in times of market weakness and especially during times of financial crises, the correlation among stocks is particularly high. This suggests diversification amongst stocks provides very limited, if any, downside protection. Given the current market, where it’s a tug-of-war between good and bad news or better put “the risk-on, risk-off trade,” we believe the correlation among stocks will likely remain high. The low interest rate policies from several key central banks continues to encourage carry trades1 which will further exacerbate the intra-correlation among stocks.

Although the addition of non-Canadian stocks may provide added returns to a portfolio, when markets contract, equities tend to move in unison. While the theory of decoupling garnered much investor attention during the last bullmarket, it was quickly put to rest after the most recent financial crisis, when we learned that increased globalization has resulted in more correlation amongst international markets, not less. As a result, we believe it’s important for investors to take a holistic view of their portfolios and be diversified across asset classes. As our readers are aware, we remain bullish on gold and gold-related investments, especially with the U.S. Federal Reserve hinting at another bout of quantitative easing3. While fixed income investments may not provide the same yields as they once did, we urge investors not to abandon them. Their non-correlated returns with other asset classes are much needed from the perspective of total portfolio construction and can provide benefits to even the most aggressive investor.

Opportunity:
Heading into 2010, it was expected that the Bank of Canada (BoC) would tighten monetary policy by raising its key interest rates, as the health of the global economy and particularly Canada’s had drastically improved
from early 2009. At that time, reducing a portfolio’s sensitivity to interest rates or lowering the duration of the fixed income portion of a portfolio was a critical tactical allocation call. However, now with the BoC possibly taking a break before raising rates again, we would recommend investors consider venturing further out the yield curve. With no signs of inflation and the economy still weak, we would view more than one rate hike before the end of the year as a surprise. With Mark Carney, the Governor of the BoC, going on record to say that global economic conditions should be considered in addition to Canada’s own, it’s reasonable to conclude that a further succession of rate hikes would come only after the market becomes more confident that sovereign debt concerns are behind us and the global economy stands on more solid footing.

Furthermore, a higher relative interest rate to the U.S. and potentially against China, depending on how quickly China’s currency-peg is loosened, would ultimately cause the Canadian dollar to strengthen. This would come as a risk as the US and Chinese economies are the main destination for Canada’s exports.

For investors wishing to reallocate their fixed income positions further out the yield curve, ETFs are an efficient way to do so. In an environment in which yield and income are tough to come by, we believe extending
duration and adjusting credit quality can be especially important. BMO Exchange-Traded Funds has two ETFs that investors may want to consider to execute this strategy. The first is the BMO Mid Federal Bond Index
ETF (ZFM) which is suitable for more conservative investors concerned about credit quality. This ETF tracks the DEX Mid Term Federal Bond Index, an index made up of fixed income securities issued by the Government of Canada with a credit rating of AAA and a minimum size of $50 million per issue. The yield of the index is currently 2.5% consisting of Government of Canada bonds with an effective term to maturity between five and ten years.

A second ETF investors may want to consider is the BMO Mid Corporate Bond Index ETF (ZCM) which is suitable for those looking for an increased yield since the index is currently yielding 4.0%. This ETF tracks the DEX Mid Term Corporate Bond Index with an effective term to maturity between five and ten years and a credit rating of BBB or higher. It’s worth noting that these bonds are Canadian investment grade corporate bonds and not of the U.S. junk bond quality. At the moment, the yield on the DEX Mid Term Corporate Bond Index is 140 bps higher than that of the S&P/TSX Composite’s 2.6%. Since corporate bonds have higher priority than equities in a bankruptcy, we view this as attractive value, particularly for those investors preferring to avoid the volatility inherent in equities.

While the collective quantitative easing policies enacted by the global central banks to circumvent the collapse of the global financial system was necessary to bring liquidity back to the system, there is a common concern that the increased money supply will lead to inflation. As the amount of money has increased according to the measure of M2 money supply4, the amount of goods available for sale has remained relatively fixed. In that scenario, fixed income investments are disadvantaged because the buying power of a dollar is eroded while invested assets remain relatively fixed. Though inflation could potentially be an issue down the road, the immediate concern is deflation.

The reason the excess money supply has not caused inflation or hyper-inflation is due to the lack of lending at the bank level. With unemployment still high, in the US in particular, and the lack of opportunities in the weak business environment, the need for loans is significantly decreased. This is clearly indicated by the steep decline in the Velocity of Money5 (M2) measure experienced after September of 2008, the same month Lehman Brothers Holding Inc. filed for Chapter 11 bankruptcy and caused a modern day run on the bank.

At this point, business conditions and employment would have to improve to encourage bank loans which would cause the velocity of money to increase. As our readers are aware, we have professed the benefits of holding gold in a portfolio all year long. However, investors should also consider Canadian issued bonds in a portfolio for their downside and deflationary protection. While the previous ETFs mentioned in this report are two that we particularly like at the moment, BMO Exchange-Traded Funds has developed instruments that not only allow investors to fine tune their fixed income maturity profile in their portfolio but also to precisely assign capital based on the credit quality of
the specific issues.

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Footnotes
1 The CBOE Implied Correlation Index is a measure of the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX. The data used in our chart was blended between
two indices with maturities of January 2010 (“ICJ Index”) and January 2011 (“JCJ Index”).
2 A carry trade is a strategy in which an investor borrows money at a low interest rate in order to fund investments in assets that are likely to provide a higher return. As the price of the asset sells off, investors may be forced to liquidate the position causing the correlation of assets to increase during times of market weakness.
3 Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
4 M2 is a category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds
5 Velocity of money is the rate at which money circulates, changes hands, or turns over in an economy in a given period. Higher velocity means the same quantity of money is used for a greater number of transactions and is related to the demand for money. It is measured as the ratio of GNP to the given stock of money.


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James Paulsen: Double-Dip or Soft Patch???


Tuesday, July 20th, 2010

Double-Dip or Soft Patch???
by James Paulsen, Chief Investment Officer, Wells Capital Management.

July 16, 2010

Consecutive monthly disappointments surrounding private job creation, a multi-month stall in the improvement in initial unemployment claims, and a recent litany of “weak” economic reports have focused investor attention on the potential for a double-dip recession. No doubt the contemporary

recovery has hit its first “soft patch.” Although this recovery stall could be signaling something worse, we continue to believe it is a fairly normal slowdown in what will prove to be an ongoing recovery. If this is indeed the case, any current weakness in the stock market should prove a good buying opportunity.

Evidence of Stall is Widespread… But Not Uncommon

Similar to past recoveries, a mid-cycle slowdown has arrived and may extend into the current quarter. We had expected growth of about 4 percent during the balance of this year and now believe it may be marginally softer at about 3.5 percent.

Exhibit 1 illustrates the major economic indicators which have combined to escalate double-dip fears. Real retail sales certainly stalled in the second quarter, consumer confidence measures remain very pessimistic despite a year of recovery growth, both manufacturing and services sector surveys dropped in the latest month, housing activity collapsed last month reflecting a tax credit expiration and finally, persistent improvements since the recovery began in weekly unemployment insurance claims came to a halt since spring.

Real core retail sales did stall last quarter but only after surging at an annualized growth rate of almost 10 percent in the first quarter. Overall, year-to-date, real core retail sales growth remains at a healthy annualized pace of 4.7 percent. Moreover, retail trends commonly run in fits and spurts. Isn’t what has happened to retail sales so far this year very similar to what occurred in the last half of 2003 and the during first half of 2006 or 2007—that is, a major growth spurt followed by a stall? Neither of these previous retail stalls were signs of an impending recession.

What about consumer confidence? It remains severely depressed. We believe many financial market and economic players are suffering from a post-crisis Armageddon hypochondria. Any symptom (report) of a slower economy is instantly extrapolated toward recession or depression rather than a more reasonable interpretation. The good news is measures of household confidence have shown little or no relationship to consumer spending patterns. For example, even though confidence has remained near record lows, real consumer spending has grown by 2.6 percent in the last year.

Do the ISM reports suggest an impending collapse in both our manufacturing and services sectors? As the ISM manufacturing chart shows, at least since 1990, this survey has rarely gone above 60 which was where it was just a month ago. It couldn’t go any higher. U.S. industrial production growth has risen by 8.2 percent in the last year and at the healthy annualized pace of 6.6 percent so far this year. Both the manufacturing and services sector ISM surveys remain at levels normally associated with healthy overall economic growth. Finally, as shown, oscillations in these surveys between 50 and 60 are very common in past ongoing recoveries.

Is housing double-dipping? Far from suggesting a collapse, the chart on housing starts (Exhibit 1) reinforces an impression that a major bottoming process is underway in the housing industry with activity levels in this industry hovering about the same area for the last couple years. True, housing activity collapsed last month, but mostly for the same reason it was rising in previous months—the introduction and then expiration of a tax credit.

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Earning More by Setting Aside Less


Monday, April 19th, 2010

This article is a guest post by John Hussman, Hussman Funds.

As of last week, the stock market remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. The fraud charges brought against Goldman Sachs by the SEC may or may not provide a catalyst for market weakness, but significant risk is already baked into observable market conditions. The present syndrome tends to be followed by large and abrupt losses (though with somewhat unpredictable timing). To the extent that investors tend to attribute market fluctuations to the immediate news surrounding them, the Goldman Sachs issue may become more of a subject of investor attention in the weeks ahead than it deserves. But really, is anybody actually surprised?

With regard to credit concerns, I think the best characterization of recent data is that cross-currents are building between the recovery view adopted by Wall Street, and emerging data suggesting fresh deterioration. Clear evidence of either is still absent.

On the cheerful side, Equifax reported a slight decline the first quarter delinquency rate among the mortgages it tracks, from 6.60% to 6.57%. This almost imperceptible decline was attributed by Equifax to seasonal factors, but it has been enthusiastically reported as evidence that the housing market has turned around.

Also last week, we saw upbeat first quarter earnings reports from J.P. Morgan and Bank of America, with J.P. Morgan reporting net income of $3.3 billion, and Bank of America reporting net income of $3.2 billion. In contradiction to these indications of improvement, last week included several reports like the following:

April 12, 2010: The latest Mortgage Monitor report released by Lender Processing Services, a leading provider of mortgage performance data and analytics, shows that the total number of  delinquent loans was 21.3 percent higher than the same period last year. The nation’s foreclosure inventories reached record highs. February’s foreclosure rate of 3.31 percent represented a 51.1 percent year-over-year increase. The percentage of new problem loans also remains at a five-year high. The total number of non-current first-lien mortgages and REO properties is now more than 7.9 million loans. Furthermore, the percentage of new problem loans is also at its highest level in five years. More than 1.1 million loans that were current at the beginning of January 2010 were already at least 30 days delinquent or in foreclosure by February 2010 month-end.

April 8, 2010: First American CoreLogic reports that distressed home sales – such as short sales and real estate owned (REO) sales – accounted for 29 percent of all sales in the U.S. in January: the highest level since April 2009. After the peak in early 2009, the distressed sale share fell to 23 percent in July, before rising again in late 2009 and continuing into 2010. Distressed sales are non-arms-length transactions such as REO or short sales. Market sales are arms-length transactions between a willing buyer and willing seller and they exclude distressed sales. Distressed sales have a very strong influence on home price trends and are an indicator of a housing market’s health.”

First American CoreLogic observes that when the proportion of distressed sales becomes a significant share of total sales, there is a negative and non-linear price effect. Specifically, “the prices in the two markets (distressed and non-distressed) begin to converge into one large distressed market.”

Meanwhile, it is notable that the “favorable” earnings reported by J.P. Morgan and Bank of America in the first quarter were due to reduced provisions for credit losses – charges that are largely discretionary. In the fourth quarter of 2009, J.P. Morgan charged $8.9 billion against earnings to provide for credit losses, but in the first quarter of 2010, it charged $7.0 billion. Thus $1.9 billion of the $3.3 billion in earnings reported by JPM reflected reduced provision for credit losses. Likewise, the main factor driving Bank of America’s earnings was a reduction in loss reserves. Indeed, the provision for credit losses was $3.6 billion lower than it was a year ago (when delinquency rates and credit losses were running at a fraction of current levels).

The reduced provision for credit losses might be reassuring were it not for the fact that delinquencies, foreclosures, non-performing loans, commercial mortgage strains, and actual charge-offs reported by various sources have been either unchanged or accelerating. Bank of America, for example, reported that 30-day delinquencies on residential mortgages hit a new record of 8.5% in the first quarter (though the surging FHA-insured portion will allow them to pass some of the consequent losses off onto the American public). Moreover, provisions for credit losses are again falling short of net charge-offs, which is what we saw in 2008 before banks got into trouble (see the June 2, 2008 weekly comment: Wall Street Decides to Close Its Ears and Hum). For example, actual net charge-offs at Bank of America were $10.8 billion during the first quarter of this year (versus $6.9 billion a year ago), exceeding the provision of $9.8 billion that was deducted from earnings in the first quarter. In effect, the Bank reduced its reserve for future losses by about $1 billion, which had the effect of boosting reported earnings accordingly. This accounts for the entire improvement in earnings from the fourth quarter of 2009, and then some.

Overall, the current data presents at best a mixed picture of credit conditions. My impression is that investors should not be surprised by a significant second-wave of credit strains. Still, as we’ve anticipated for months, we have now entered the window where those strains would be expected to begin, so I won’t maintain this view if the data don’t increasingly support it. Some evidence is consistent with fresh deterioration, but not nearly to the extent that we would consider decisive. Meanwhile, indications of improvement are also extremely thin. It seems unwise for investors to celebrate variations of a few basis points in delinquency rates. It seems equally unwise to celebrate “favorable” bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting.

Market Climate

As of last week, the Market Climate for stocks remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. The Strategic Growth Fund remains in a tightly defensive stance. On Friday, we benefited both from our avoidance of financial stocks, and from our higher-strike put options (reflecting the “staggered strike” position we’ve been maintaining). The additional time premium required to raise our put option strikes is typically only about 1% of assets, and we do have the potential to lose that time premium if the market moves sideways or continues higher. Also, market declines that put those options “in the money” can result in gains which may be reversed if the market suddenly recovers before we have a good opportunity to reset our strikes. So while our original outlay in the higher strikes may be fairly small, once we establish gains in those higher-strike puts, we can also get a bit more day-to-day volatility depending on how frequently we lower those strikes as the put options move in-the-money

In bonds, the Market Climate remains characterized by relatively neutral yield levels and unfavorable yield pressures. My expectation remains that fresh credit strains would tend to be friendly to Treasury bonds and the U.S. dollar (as relative safe-havens), while being hostile to precious metals, commodities and TIPS (on deflation concerns). Since our long-term inflation outlook is much more hostile than what we expect over the intermediate term, I would expect to gradually accumulate inflation sensitive securities such as TIPS, precious metals and foreign currencies on weakness.

In a long-term inflationary environment, I expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is “less bad.” It’s quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, beginning in the second half of this decade (which is another way of saying that we would expect inflation to be largely a global phenomenon). Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle.

In short, nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. I do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, precious metals and TIPS. As usual, we’ll respond to the data as it emerges, but the foregoing is a reflection of where I would expect the opportunities to emerge.

Copyright (c) Hussman Funds

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Inflation in 2010 and Beyond?


Sunday, March 28th, 2010

by Michael Katz, Ph.D. March 2010, Vice President, michael.katz@aqr.com, and Christopher Palazzolo, CFA, Vice President, christopher.palazzolo@aqr.com
AQR Funds

Inflation in 2010 and Beyond? Practical Considerations For Institutional Asset Allocation

PART I of II

Investors’ Next Concern

While there’s no shortage of topics to analyze as a result of the 2008-2009 global recession, the unprecedented monetary stimulus has justifiably focused investor attention on potential inflation. As an institutional asset manager with strategies incorporating inflation-linked assets, we are frequently asked how best to hedge against inflation.

There is undoubtedly a case to be made for higher future inflation; there are also strong arguments for more moderate levels. Our aim in Part I of this series is not to predict, but rather to outline what we believe are the key issues surrounding the inflation debate, and to clarify some misconceptions about inflation and inflation-linked assets. We also offer some analysis which investors may find helpful in deciding how to position a portfolio for various inflationary environments. In a follow-up paper to this series, Part II will discuss the potential rewards and risks of holding various assets in a portfolio during distinct inflation and economic environments.

What Causes Inflation?

Inflation is caused by an increase in money supply relative to output (i.e. real GDP) and the velocity of money (the speed at which money changes hands). Money supply is a product of the monetary base and the money multiplier (how much banks lend relative to their reserves). In the absence of economic growth, if output and the velocity of money are kept steady while the money supply grows, prices should increase. However, if money supply grows at the same rate as economic activity, prices should remain stable.

It is important to emphasize that inflation rates are a product of the relationship between GDP growth and the overall increase in money supply, not simply the physical monetary base. In the U.S., there has in fact been a dramatic increase in the monetary base as the Fed has pursued monetary stimulus by lowering the Fed Funds and discount window short-term lending rates. It has also pursued “quantitative easing,” the direct purchase of longer-term government and private debt to provide liquidity to the market. However, despite the Fed’s efforts, the overall velocity of money and the money multiplier in the U.S. economy have dramatically declined as banks have been reluctant to extend credit and economic activity has slowed. Put simply, the Fed has “printed” a lot of money, but it isn’t being fully deployed into the economy. Figure 1 below shows the annual percentage change in the U.S. monetary base (MB) and money supply (M2).1 Despite the unprecedented increase in the monetary base, the growth in overall money supply remains in line with historical values.

Why No Inflation in 2009?

Despite the significant growth in the U.S. monetary base, money supply has grown modestly. Furthermore, there is excess capacity in the economy evidenced by an approximate 70% capacity utilization and an “official”2 10% unemployment rate (see Figure 2). As a result, 2009 did not see a significant positive realization of inflation by year-end, though the inflation growth rate changed from negative to positive. Figure 3 displays the annual inflation rate and consumer price index (CPI) since 2005. Inflation rates remain below pre-crisis levels, and the trend in the CPI index is not currently showing signs of a dramatic increase in inflationary pressures.

However, significant questions about inflation remain: Is there a case for a future spike in inflation? If the velocity of money picks up as the economy recovers and banks resume lending, will inflation follow? The Fed is well aware of the need to withdraw liquidity to manage inflation and inflation expectations.3 In recent meeting ‘minutes’ the Fed has expressed the need for a measured end to its emergency monetary policies in order to manage inflation expectations (the often-discussed “Exit Strategy”). In fact, the Fed has broadly outlined the steps it will take to drain liquidity in 2010 and beyond including ending the emergency asset purchase program, among other measures. The Fed’s current unprecedented stimulus posture may not generate abnormal inflation pressures if the Fed can, in an effective and timely manner, withdraw excess liquidity from the economy as money velocity and bank lending begin to increase.

There is another more technical reason that the increased monetary base may not generate the same abnormal inflation pressures it would have generated in the past: the Fed is currently paying interest on bank reserves. If the Fed continues this policy in conjunction with raising the rates it pays on reserves, banks may be willing to hold a higher percentage of their assets in cash. Prior to October 6th 2008, when the Fed began paying interest on cash reserves, the Fed primarily used open market operations – buying and selling of Treasury Bills to manage the monetary base. The Fed’s selling of T-bills reduced the reserves held by banks, thereby lowering the monetary base. By paying interest on bank reserves, the Fed has implicitly made reserves a substitute for T-bills. Banks might therefore be inclined to hold more cash than they would have done in the past. If this holds true, the economy could absorb a larger monetary base without generating abnormal inflation pressure. Figure 4 displays the total amount of reserves held by U.S. banks and other depository institutions, demonstrating a significant increase in cash assets held.

Although the Fed has indicated its desire to keep inflation at bay, investors have expressed concern that it might be slow to reduce the monetary base given its mandate to simultaneously strive for stable prices and full employment.4 The question is whether the Fed will be sufficiently hawkish on inflation to begin raising rates and draining liquidity on the first signs of significant inflation, even if it occurs in a high unemployment environment. This is a valid concern, especially as long as the Fed also perceives a risk of potential deflation (for example, deflation risk might stem from a double dip in the housing market, commercial real estate, or other asset-backed market). Deflation is generally perceived by the Fed as a worse outcome than inflation at similar magnitudes, which might lead the Fed to err toward modest increases in inflation. Perhaps it goes without saying, but the Fed failing to drain liquidity in a timely manner once there are early signs of inflation could result in a cycle of higher inflation expectations and subsequently increasing inflation realizations, a state of the world the Fed has claimed it wishes to avoid.

Will the Fed Inflate Debt Away?

In addition to concern about the Fed’s monetary stimulus, investors are also justifiably focused on dramatic budget deficits and increasing debt levels. They fear these deficits may provide incentive for the government to “inflate its debt away” by lowering the real value of future debt repayments. However, this concern seemingly fails to recognize that the Fed is run as an independent Board of Governors and merely reports to Congress on its policies and procedures (though cynicism about the degree of its independence is one contributor to potentially higher inflation expectations). The importance of having an independent monetary authority is well understood in the U.S. and around the world. As long as the Fed has independence over monetary policy decisions, it will likely try to maintain relative price stability. If there is a concern about monetizing the debt, it should be evaluated based on the probability that the Fed will be stripped of its independence (oddly, the goal of many Fed cynics). Even within the current political environment we believe this is a low-probability outcome.

In summary, while we have experienced an unprecedented monetary stimulus in the U.S. economy, we have not yet seen a significant increase in realized inflation or in money supply, a leading indicator of future inflation levels. And though there is good reason to question whether we may face higher levels of inflation in the future, we do not believe that current economic indicators provide a clear case for a significant increase in the near term.

Is Inflation “Priced In” to Certain Assets?

Many market participants point to the breakeven rate, the difference between the yield of nominal and inflation-linked bonds, as the market expectation of inflation. Although breakeven rates are indeed correlated with inflation expectations, they contain an additional, and often overlooked, cost – the inflation risk premium. In much the same way as a policy holder must pay to insure one’s property,5 the inflation risk premium is the premium a holder of an inflation-protected asset must “pay” (or more accurately forego) for the protection itself6.

The inflation risk premium is only one of the factors that affect the returns from holding inflation sensitive instruments. In the discussion that follows, we describe these factors for nominal and inflation-linked government bonds (TIPS in the U.S.), since these assets are directly comparable and are inversely affected by inflation. The following factors are the primary components which may determine the yield of these government bonds above the risk-free rate (excess yield):

1. “Real” Term Premium – compensation for the risk associated with holding a longer-term bond and taking the risk of real rates moving

2. Inflation Expectation – compensation for expected rise in prices

3. Inflation Risk Premium – compensation for assuming the risk of changing inflation (inflation uncertainty)

4. Liquidity Premium – compensation for holding an asset that is harder to trade during adverse environments

There are essentially two sources of risk that nominal and inflation-linked bonds do not have in common: inflation and liquidity. The inflation risk premium is compensation that nominal bond holders expect to receive since they accept inflation risk relative to holding inflation-linked bonds. However, inflation-linked bonds are generally less liquid than nominal bonds on the secondary market due to the dramatic difference in market depth. As of December 31st 2009, the total amount of outstanding U.S. nominal treasury securities held by the public was $7.3 trillion. In contrast, the size of the TIPS market was only $560 billion (less than 8% of the nominal market size)7. Holders of inflation-linked bonds are exposed to liquidity risk and in general expect to be compensated for taking this risk relative to holding nominal bonds. This liquidity effect puts upward pressure on inflation-linked bond yields (downward pressure on prices) and vice-versa for nominal bonds. Over time, as we expect the size and depth of the TIPS market in the U.S. will continue to increase, the liquidity effects should diminish, resulting in the inflation breakeven rate between nominal bonds and TIPS serving as a more accurate indication of inflation expectations and the inflation risk premium. Figure 5 presents the direction of the risk premia and inflation expectation effects on inflation-linked and nominal government bond yields, as well as the effect on breakeven rates (Nominal – TIPS).

One important clarification is in order. If the inflation rate an investor is concerned with is accurately represented by CPI, inflation-linked bonds held to maturity are effectively the risk-free asset (though a higher real return may be achievable by holding nominal government bonds). However, although the real yield on an inflation-linked bond is known in advance and is not exposed to inflation risk, the bond may still, in practical terms, be “risky” for an investor who may need to sell it prior to maturity. This is due to mark-to-market pricing risk if inflation expectations and/or the magnitude of the real term or liquidity premia have changed.

Before using breakeven rates to infer future expected inflation rates, it is important to note the effect that the inflation and liquidity risk premia have on the breakeven rate. In times of heightened uncertainty, the inflation risk premium can significantly increase as there is heightened demand for inflation protection. This effect increases the relative price of inflation protection but is not actually forecasting higher future inflation. As mentioned above, there is also a positive liquidity premium to holding inflation-linked bonds which tends to decrease breakeven rates. Given high levels of inflation uncertainty – an environment we may currently be in – the inflation risk premium is higher than average, which signals that buying nominal bonds is cheaper than average. It also follows that the opportunity cost of holding inflation-linked bonds versus nominal bonds is higher than average (since investors forego potentially higher yields of nominal bonds). In other words, TIPS may have lower yields than normal versus nominal bonds not because the market is forecasting high inflation, but because the market is willing to pay more than usual to hedge the possibility of higher inflation.

The magnitude of the inflation risk premium effect on assets can be significant over the long term. To illustrate the relative importance of the premium, we compare the hypothetical8 long-term excess return from holding inflation-linked bonds vs. simply holding nominal bonds, each with similar duration to that of 10 year bonds. The average outperformance of nominal bonds vs. inflation-linked bonds can be thought of as the net ex-post “cost” of buying inflation protection. The ex-post cost is a function of both varying risk premia and ex-post inflation realizations which differ from what was priced in. Inflation surprises which exceed priced-in expectations favor inflation-linked bonds (holding other factors constant).

Since inflation-linked bonds were not introduced in the U.S. until the late 1990′s, we can examine United Kingdom inflation-linked bonds (introduced in 1981) to gather the most data points. During this period, the average annual total return was 5.6% on a U.K. nominal bond and 3.5% for a U.K. inflation-linked bond.9 Hence the “cost” of inflation protection net of liquidity concerns was 2.1% in annual returns. This cost was due in part to a surprising decline in inflation during the early 1980′s (a realization lower than priced-in expectations) and in part to the inflation risk premium which favors nominal bonds. Therefore, the effective realized cost of inflation protection for a U.K. investor holding a fixed duration inflation-linked bond portfolio was 60% of its total return. Performing the same analysis in the U.S. from 1997 (when TIPS were first introduced), the cost of inflation protection has been 0.8% per year. Most academic studies seeking to quantify the magnitude of the inflation risk premium estimate it at approximately 0.5% annually for a 10-year nominal bond10. Of course, actual realizations of inflation which differ from market expectations will determine the final cost or benefit from holding inflation-linked versus nominal bonds net of risk premia effects.

Year-end U.S. breakeven rates (including both inflation risk and liquidity risk premia) for U.S. inflation over both the short- and long-term can be seen in Figure 6 and 7. Figure 6 shows the one-year breakeven and economists’ forecasted one-year U.S. inflation rate as reported by Consensus Economics. Of course, both TIPS and nominal bonds are offered at different maturities, implying different breakeven inflation rates at each maturity. Figure 7 shows the term structure of breakeven rates for the U.S., which incorporates longer-term breakeven rates.11

Although Figure 7 suggests moderate inflation expectations even over longer horizons, it is important to note that the breakeven rate is not simply a prediction of future inflation. Rather, as outlined previously in Figure 5, the inflation breakeven rate is also affected by the inflation risk premium (which increases the rate) and the liquidity premium (which decreases the rate). Depending on the market environment, the relative magnitude of each factor will vary and lead to divergence of breakeven rates from expected inflation. Nevertheless, a number of striking facts are observable in Figures 6 and 7. First, despite the discussion about inflation uncertainty (and fear of longer-term inflation), breakeven rates are moderate over most horizons. That can be a result of moderate inflation expectations, a low inflation-risk premium or a high liquidity premium associated with nominal bonds. Second, if we accept the inflation forecasts from Consensus Economics as the expected outcome, one-year TIPS may be attractively priced as of 12/31/09 (meaning that inflation expectations are higher than the breakeven rate). Of course, the Consensus Economics forecast may differ substantially from inflation realizations. Inflation surveys from the Survey of Professional Forecasters12 that provide longer-term forecasts for U.S. inflation show that inflation expectations approximately match the average 2.4% priced into the term structure of breakeven rates reflected in Figure 7, suggesting expected inflation is fully “priced in” over this period.

While the level of future expected inflation priced into the market may be modest, there are indications that the uncertainty around the market’s estimates has increased, which implies greater demand for inflation protection and higher expected returns on nominal bonds relative to TIPS. Figure 8 shows the 10-year inflation forecasts from the Survey of Professional Forecasters with a confidence bound around it and a measure of dispersion in the forecasts. Although there is little evidence of a change in the average 10-year inflation forecast, there is indeed an increase in the dispersion of forecasts which suggests heightened uncertainty. This implies a higher inflation-risk premium today than on average (lowering the expected return from holding inflation-linked bonds).

Inflation Protection in a Portfolio

Although the scope of this paper is only to outline the key considerations related to inflation and inflation-protected assets, it is important to reiterate that what matters most to the performance of various asset classes is not the level of future inflation, but rather the unexpected level of realized inflation. Simply stated, if the market price for goods and services reflects the average or consensus view for potential future inflation, only a deviation from the consensus will lead to value gained – or lost – by holding inflation sensitive assets. In Part II of this series we will build upon these insights and examine the strategic case for inflation-protected assets in portfolio construction and the performance of various asset classes in different inflation and economic environments.

1 Monetary base is currency in circulation and bank reserves deposited with the Fed. Money supply (M2) includes all liquid money including checking and saving accounts, money market accounts and certificate of deposit under $100,000.

2 Unemployment is often said to underestimate the “under-employed” rate – or the rate including those who are working part-time because they cannot find full-time work and those who have given up looking for work. Some economists estimate the under-employed rate at over 17% in the U.S.

3 Inflation expectations are a key factor monitored closely by central banks. Inflation is one of the factors that exhibit “self fulfilling expectations.” For example, if employees expect inflation to be high they are likely to demand wage increases which leads to inflation. Adjusting inflation expectations downward when inflation is high can be very costly as experienced during the Paul Volker years at the Fed. The Fed would want to avoid this cost of bringing inflation expectations down in the future.

4 The fed has two mandates: price stability and full employment. This is the often mentioned “Dual Mandate”.

5 The actual premium that a home owner pays includes an expected loss and an additional premium for passing the risk to the insurer. This additional premium is what we refer to here as the cost of insurance, not the out-of-pocket payment to the insurance company.

6 Another interpretation of the inflation risk premium is that it is the compensation nominal asset holders require to bear inflation risk.

7 Source: U.S. Treasury Department

8 Hypothetical performance is for illustrative purposes only and is not based on an actual portfolio being traded.

9 Source: Barclays Capital. The statistics are calculated over the period April 1982 through December 2009.

10 Source: Barclays Capital, based on a set of rolling bonds over the period March 1997 through December 2009.

11 Consensus Economics surveys multiple professional forecasters including banks’ economists, private and public forecasting services, and large financial institutions. In the U.S. as of the end of 2009, this includes 26 individual institutions.

12 The Survey of Professional Forecasters is the oldest quarterly survey of macroeconomic forecasts in the United States. The survey began in 1968 and was conducted by the American Statistical Association and the National Bureau of Economic Research. The Federal Reserve Bank of Philadelphia took over the survey in 1990.

Disclaimers:

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC its affiliates, or its employees.

The information set forth herein has been obtained or derived from sources believed by author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.

Source: Inflation in 2010 and Beyond, March 2010, http://www.aqrfunds.com/

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