Ben Bernanke’s press conference last week may have been the first of its kind for a Federal Reserve chairman, but the content was hardly history-making—QE2, the $600 billion second stage of the Fed’s bond-purchasing program, will continue, as planned, until June of this year and interest rates will remain low for the foreseeable future.
“There were no surprises,” said John Bailey, CEO of Spruce Private Investors, a Stamford, Conn.-based wealth management advisor with $3 billion AUM. “I think it was well telegraphed to the market that QE2 would end and that interest rates are on hold and will likely be on hold for the next, certainly, nine to 12 months.”
On the other hand, Bob Haber, CEO and CIO of Haber Trilix Advisors, which manages $1.8 billion, believes the market may have been caught off guard by at least one element in Bernanke’s announcement: “I had been watching one-year forward euro-dollar future rates—that’s kind of how the market votes on when the Fed will tighten—and right before the speech they still believed that there would be tightening inside of this coming year.”
For Olivier Garret, CEO of Casey Research, the most interesting part of Wednesday’s announcement is what happens next.
“At this point it’s going to be very interesting to figure out how the Treasury is going to find the $100 billion per month it needs just to finance the deficit forward. This is not counting that they have to roll over an additional $2.5 trillion over the next eight to 10 months just to refinance the debt that is expiring.”
Bernanke said the Fed will continue to reinvest proceeds of maturing mortgage-backed securities for an indefinite period to keep the balance sheet from shrinking. “When we complete the [QE2] program... we are going to continue to reinvest maturing securities, both Treasury and MBS. So the amount of securities that we hold will remain approximately constant.... Put another way, the amount of ease monetary policy easing should essentially remain constant going forward from June.”
But Garret estimates the proceeds from the expiring MBS rollovers at about $30 billion a month, less than one-third of what is actually needed, and he wonders who is going to line up to “start buying Treasuries in excess of the standard rollover, which is a staggering amount on its own?”
“We know Japan, if anything, is likely to repatriate some of its foreign investment, including Treasuries, to finance the reconstruction effort that they have to go through after their earthquake and tsunami,” says Garret. “China is sending a lot of signals that they need to diversify away from the dollar and so has the Middle East. On top of it, I think some of our allies, like the Saudis right now, are not truly enamored with the foreign policy of the U.S..... I anticipate that there is going to be some pressure from the Middle East to diversify away from the dollar. Europe has challenges of its own with the failing of the so-called PIIGs, hence it is also unlikely that we will see sizeable purchases from European investors."
The result, says Garret, is that the Fed is between “a rock and a hard place.”
“On one side, they know they cannot continue to go forward and send the markets the signal that there is unlimited money that will be created to finance the irresponsible policies of the U.S. government; on the other hand, if they stop, they will precipitate the United States and the rest of the world into a recession.”
Bud Conrad, Casey Research’s chief economist, thinks the Fed will continue to support the economy, post-QE2.
“In the big picture, the Fed is a money-printing machine for the powers that be, and they will be back before next year with a new program. The reason the Fed is stopping the QE2 is that it wants to avoid debasing our credit standing further in the financial markets and it is attempting to pressure Congress to be more fiscally responsible.”
Did It Work?
The goal of the Fed’s second round of quantitative easing was, ostensibly, to lower long-term interest rates. How did it do?
“There is little evidence at this point that QE2 has had a material impact on holding down long-term interest rates,” says Bailey. “It’s hard to say whether QE2, from that perspective, was an efficient use of capital, even though we’ve seen a material increase in the Fed’s balance sheet. But if you look at… the long-term U.S. 10-year Treasury premium, you’re not that far out of what you would expect.”
On the other hand, Bailey does see some positives.
“The corporate sector earnings/profits look particularly good; stock market risk assets have appreciated, which helps consumers’ balance sheets—that’s been a primary goal of the Fed, to support the stock market so that people could, if the real estate side of their balance sheet has taken a hit, at least have their retirement and savings programs appreciate. So at this point, there’s a fair amount of positive support for what has occurred.”
Even Garret is willing to acknowledge some benefits to QE2.
“On the equity side… all the liquidity has definitely helped keep the market afloat. In spite of the various stress[es] that have occurred in the last few months—the Japanese earthquake and tsunami as well as the Middle East crisis—the markets have been remarkably resilient.”
However, he points out that “similar programs,” like that in Japan in the ‘90s, also had an immediate positive impact on markets—especially equities—but in the long term, stocks went back to a lower level within a year or two. “We anticipate that will happen in the U.S. just like it happened in Japan.”
Garett also points out that the program has done nothing for other types of assets, like real estate. “I think that the problem of over-supply is such that it hasn’t really [helped] in supporting real estate prices. Real estate is still very, very much in dire straits throughout our country; other than a few specialized markets, the picture has really not improved much.”
What’s An Investor To Do?
Whether QE2 accomplished its goals or not, it has helped create the current market environment, and investors turn to advisors like Haber and Bailey and researchers like Garret to find out where they should be putting their money in this type of environment. So what’s the answer?
“Strategic resources,” says Haber—energy, precious metals and agriculture.
Haber says history is conspiring at the moment to make these resources “the most exciting part of the market.” On the one hand is the U.S. Fed’s historic “adventure in debt monetization.” On the other hand is “this unprecedented surge in demand from the 2.5 or 3 billion people on the planet who are moving at light speed to achieve the lifestyle that we take for granted.”
“Oil, ag and the precious metals—they’re very strategic to the East, which is trying to build up infrastructure, wealth and their standard of living, and they’re obviously incredibly strategic to us here in the developed world because we’ve built our societies around them,” says Haber.
Bailey says that as long as corporate profits and corporate margins remain high, Spruce is telling clients to continue to invest in equities as well as commodities.
“There are three basic areas that we are investing in currently: equities, with an overweight in the U.S.; high-yielding investments, like mortgage debt, gold miners, high-yield corporate bonds... and non-U.S. sovereign debt; and then the third area is commodities. But commodities through long/short positions, not the indexes.”
Bailey’s firm has actually written a white paper explaining why they’re not investing in indices, but the condensed version is first, that the volatility is too great and second, the negative roll yields.
“You have extreme volatility, you have a negative carrying cost, if you will, because of the roll yield for most commodities and, what we find, is that we can eliminate the vast majority of the volatility and we can allocate through particular types of commodity managers that have generated much more attractive returns with a third the risk, a third the volatility to date," he explained.
Finding these commodity managers is the trick, however: Bailey says in four years of searching they’ve found nine who meet their standards.
“We see hundreds and hundreds of commodity managers per year, but most of them, they don’t have any unique supply information or demand information, or they don’t understand how to trade, they just let the fundamental view dictate," he said. "And of course, the worst thing of all, most people tend to fail on the risk side. They’re traders by nature, they take risks, they take a lot of risk but they don’t understand the risk/reward balance. To them it’s an option, it’s like a lottery ticket: ‘Well, I might blow up, but if I’m successful, I’ll make a lot of money.’ That’s great for them, but that’s horrible for our clients.”
Haber’s search for suitable investments has taken him in another direction—north. Having decided that the best way to play the strategic resources space is through “the equities associated with it,” says Haber, you “grow to realize that half of the investible oil reserves in the world are in Canada, half of all of the traded gold and silver equities are in Canada and it’s a very similar position in ag as well as base metals…. So, to…get the tactics right on that strategy, you have to be expert in Canada and we’re expert in Canada.”
Garret is also bullish on commodities, particular agricultural commodities and water, “even thought they very hard to play in terms of investment.”
Bailey agrees that agriculture is both a good investment and a difficult one for a small investor but so, he says, are all commodities. The average investor, he says, is “overwhelmingly investing in the long-only index or they’re investing in commodity equity managers, and the indexes are enormously volatile and have a negative carrying cost, because of the roll yield, and the natural resource equity managers, who are hedge funds, in times of stress, they don’t behave like commodities, they behave like equities."
“So, 2008 was a perfect example—natural resource stocks did not follow the commodities, which actually went up that year, they went down with the stock market," he continued. "People think they have this great inflation protection, they think they have this geopolitical hedge where, if gold goes up and oil goes up, my gold miners will go up and my oil producers will go up, over the long-term that’s true but during times of stress, that’s not true, they behave like stocks, we’ve done the analysis.”
The answer, he says, is to “invest with fundamental managers who invest in the futures and options of the commodities themselves.”
Haber, while admitting there weren’t “as many choices” when investing in agriculture, says he sees some very exciting plays—like Potash Corp., CF Industries, Deere & Co. and AGCO Corp. “There are a lot of small- and mid-cap names. I agree that it’s a little more difficult but it’s well represented, there are important companies, there are good companies so we don’t have a problem.”
Critics of the Fed’s policies say Bernanke is simply feeding inflation. Last week, Bernanke blamed the increase in the consumer price index, which has risen 2.7% over the past year, on higher oil and food prices, pressures he characterized as “transitory.” Subdued inflation trends combined with “low rates of resource utilization,” says the Fed, are likely to warrant holding interest rates at “exceptionally low levels” for “an extended period.”
But Garret isn’t buying it. “While the Fed is denying the reality of inflation and pretending it is a short-term problem that will go away, Mr. Bernanke is as wrong as he was after the collapse of Bear Stearns, when he told us that U.S. financial institutions were sound and that he did not anticipate further problems," he said.
Bob Haber, for his part, is more sanguine: “I’ve always taken Bernanke [at] his word and it’s been very profitable to me to do that—what he said yesterday was they will at some point drop the ‘extended time’ language and when they do that, you’ll know that you are two to three meetings (which implies three to five months) from a raise [in rates] and so, until he drops it I’m not going to worry about it.”
Which is not to say he’s entirely carefree.
“On the issue of rates, I do worry—and it’s always a good idea for a money manager to worry—about Chinese rates," he said. "Obviously, there’s been a lot written on China, I’m not expert on China but I’m making myself expert on the Chinese money market because if the Chinese have to go or by accident go too far in slowing down their banks from lending, that’s a huge factor in all the markets. I see that as a much bigger risk on the rate side than anything we’re doing here, in Canada or in Europe. I mean, these are baby steps here and the issues are so totally different. China seems to be in what we would call a more classic tightening to slow down an incredibly strong economy with inflation. So, that’s where I’m spending my time.”
For Bailey, the bottom line is that, whatever the future brings, commodities, accessed in the right way, will help investors survive it.
“The commodity portion of [our] portfolio has been very important and successful, and if you have an inflationary situation down the road, which you already have in emerging markets, but if the G7 starts seeing inflation down the road, the commodities are going to be a core, critical component to any portfolio. Because equities will take a material hit, as will fixed income, and that makes up 95% of most people’s portfolio…. We think most investors are not set up properly for the coming decade.”