If MCS clients were one large portfolio including their cash, the first quarter 2015 return was 1.35%. Individual client returns ranged between -.25% and 2.49%. The client with the lowest return was negatively impacted by exposure to a large inherited position in Exxon with very low cost bas is. The client with the highest returns had 87% in bonds and 5% in stocks.
Auxier sub-portfolios, on average, gained 1.16%. The Auxier results are included in the total client results above. For comparison purposes, the S&P 500 Total Return Stock index gained 0.95% and the Barclays Aggregate Bond Index gained 1.61% for the period.
Stocks treaded water during the first quarter while bonds benefited from concerns about an economic slow down which implied that interest rates would remain low.
Many money managers, uneasy about high asset prices, are building cash.
An Orange County (Ca.) Register (04/05/15) interview with Mohamed El-Erian, the former co-Chairman of PIMCO, the world’s largest money manager ($1.7 trillion with a “T”), asked:
Q.Where is your money? Stocks? Treasuries? Bonds?
A.It is mostly concentrated in cash. That’s not great, given that it gets eaten up by inflation. But I think most asset prices have been pushed by central banks to very elevated levels.
Q.So we’re nearing a bubble?
A.Go back to central banks. Central banks look at growth, at employment, at wages. They are too low. They don’t have the instruments they need, but they feel obliged to do something. So they artificially lift asset prices by maintaining zero interest rates and by using their balance sheet to buy assets.
A.Why? Because they hope that they will trigger what’s called the wealth effect. That you will open your 401k, see it has gone up in price, and you’ll spend. And those companies will see their shares are going up and they will be more willing to invest. But there is a massive gap right now between asset prices and fundamentals.
While Mr. El-Erian did not use the word ‘Bubble’, there is only one reason that sophisticated investors stay in cash – they believe the odds of making money are stacked against them.
Mr. El Erian is saying that central banks in Europe, US, and Japan are distorting the prices of assets by manipulating interest rates to extreme lows which encourages both borrowing and the buying of all types of assets, resulting in higher asset prices. Here is an inflation adjusted look at borrowing (margin debt) and stock prices. Unfortunately, record margin debt does not give an investor any guidance about when to get out of the market. What is does indicate is a high risk environment in which a negative feedback loop could occur. Margin calls (the lender’s
demand for their money back) beget forced selling of stocks which in turn lowers stock prices and creates more margin selling as more lenders demand their money back.
NYSE Margin Debt and the S&P 500 Real Values
A Bubble can look like this – an extended period of rising prices supported by borrowed money.
The above chart shows the relationship between margin borrowing to buy stocks and stock prices. A steep sloped increase in borrowing and prices is a warning about the future.
NYSE Margin Debt and the S&P 500 Real Growth since 1995
The chart at left shows how rapidly borrowing has grown compared to the growth of stock values after adjusting for inflation.
Two factors cause investments to go up and down in price.
The value of any investment (stocks, bonds, real estate) today, is determined by 1.) the amount of money expected to be received in the future and 2.) the interest rate at which those future payments are discounted.
For example; If an investment will pay you $1,000 one year from now and you can earn 5% (I wish), the present value is $951.80. ($951.80 can be invested at 5% to have $1,000 a year from now). However, if you can earn just 1%, the present value of receiving $1,000 a year from now is $990.10.
Two charts below summarize the general impact of changes in interest rates on investment grade bond and stock prices. As you can see, stock prices have a more complex relationship with interest rate changes because unlike most bonds, stocks’ earnings are more variable.
Influence of Interest Rates on Investment Grade Bond Prices
Influence of Interest Rates and Changes in Expected Earnings on Stock Prices
* Denotes the investment outcome for the past few years
** Denotes possible future outcome of middle class wage increases gain traction.
What would cause interest rates to increase or decrease or stay the same?
The Fed’s goal is to increase demand for goods, services and employment while mildly increasing prices (inflation). The Fed says that sufficient increases in inflation and employment will determine when interest rates rise. Interest rates will be normalized when the economy improves further.
When Mr. El-Erian referred to the Fed’s belief in a wealth-effect, he meant the belief that if your as sets go up in price (especially your house which research shows has a stronger wealth effect than you 401k) you’ll feel richer and spend more. He could have mentioned that the Fed hopes that lower interest rates would encourage companies to borrow and expand and thus increase employment.
What he concludes in justifying his large cash position is: “But there is a massive gap right now between asset prices and fundamentals.” In other words, he doesn’t trust that current prices will stay high. Just as many citizens (for different reasons) don’t trust that the prices of their homes and 401ks are going to stay high after living through a period in which their prices fell precipitously.
Ultra-low interest rates have been enough to keep the economy out of a depression and restart its growth but have not been sufficient to significantly improve the lives and spending of most Americans. Today, financial market participants see low US growth coupled with a near recession in Europe / Japan and slower growth in China as strong support for continuation of ultra low interest rates and elevated asset prices. It’s a very rational conclusion.
What could change this story and shift growth and interest rates higher than expected?
It would take some wage inflation which in turn would cause faster than expected economic growth and higher than expected inflation. Here’s how it could happen.
There is a growing belief that the US economy will not get back to its full potential until the middle class starts making more money. The thinking is that the rich simply do not consume enough relative to their wealth to fuel strong economic growth; a couple worth $5 million does not consume 50x more food, clothing, shelter, etc. than a couple worth $100,000. The need for the middle class to start making more money is supported by many of the income inequality measures.
Income Gains Widely Shared in Early Postwar Decades ‐ But Not Since Then
The chart above shows that the top 5% of income earners have reaped most of the income gains for the past 35 years.
Real wages as a percent of Gross Domestic Product (GDP) (blue) vs. Real Corporate Earnings as a percentage of GDP (red)
The chart at left shows that after adjusting for inflation corporate profits have soared as a percent of Gross Domestic Product while wages have declined as a percentage. This means that workers aren’t sharing in economic growth.
Is there any evidence that wage inflation is occurring?
Yes, but only just recently when benefits like health insurance are considered.
Employer Costs for Employee Compensation
The chart at left shows employee compensation cost increasing quickly in the past 18 months.
No, the income component of compensation hasn’t risen.
Even the Most Educated Workers Have Declining Wages
This chart shows the trend in declining hourly wages by education since the Great recession. No one has been immune.
The chart at right shows that after adjusting for inflation, the economy has grown (blue) but median (middle) household income (red) has trended down overall since 1998.
Maybe, wage inflation is finally reviving. It’s anecdotal but..
Here’s where it gets interesting. The current Federal minimum wage is 7.25 per hour. Many states have rates above this and are considering raising rates further. A recent Huffington post article detailed 13 large US corporations offering higher wages; Wal-Mart, McDonalds, Aetna, IKEA, Gap were among those mentioned. Cities too are getting in on the living wage movement; Seattle is raising its minimum wage to $15/hr over the next few years, in California, Oakland’s minimum wage is $12.25/hr as of March 2, Berkeley will be $12.53 by year end. Finally, the lack of middle class wage growth while corporations enjoy record profit margins is going to be a presidential campaign issue.
Implications for the economy and investments
Central banks all over the world, like the Federal Reserve Bank, are actively trying to raise inflation to around 2.5% by stimulating the economy with low interest rates. It is unlikely to happen until wages in general start to experience above inflation increases.
It may not be Fed’s clunky interest rate manipulation that shifts the economy into a higher gear.
IF these nascent corporate and municipal trends promoting higher wages gain more traction, economic growth could accelerate along with some inflation. Higher interest rates would follow. Remember this is what central banks are trying to do!
‘Disappointing’ news on the economy has been very, very good for stocks, bonds and real estate.
Lower than expected economic growth both in the US and aboard has led to ultra-low interest rates and when combined with record profit margins has resulted in record stock and bond prices. Like a junkie, markets now need a constant dose of near zero rates to maintain the highs. Stocks are tracking sideways in 2015 due to concerns that prices are too high while earnings are projected to grow more slowly due to a global slow down in economic activity and a strong dollar.
Good news on the economy, good for the middle class and bad for investors.
Higher middle class wages would be better for the economy in the long run. Higher interest rates would be better for conservative savers. The problem for investors is that every asset class is selling at prices inflated by low interest rates. Those prices must fall IF stocks are faced with lower profits due to wage inflation which in turns spurs economic activity and thus higher interest rates.
Expectations of a weak global economy and ultra-low interest rates are reflected in today’s high asset prices. The income inequality evidence and demand for higher middle class wages is gaining momentum; large public companies and cities are responding by raising minimum wages which should help lift wages in general.
At the beginning of this report, I introduced Mr. El Erian’s rationale for being in cash; asset prices are too high. Asset prices will drop – sharply should inflation expectations shift from 1.5-2% to 2.5 to 3%. Admittedly, there remains a cohesive story for lackluster global growth, continued low rates /inflation and elevated asset prices. Should the living wage / wage inflation story materialize into stock profit margin pressure and modestly higher inflation, it presents a substantial risk to investors who have bought assets at sky high prices. Heads UP!
Let’s say you are managing the life savings of 80 families and you are faced with the lowest interest (discount rates) in history. What should you do?
The question is not easy to answer. In fact, you could get a variety answers depending on your perspective, circumstances and the perspective of who you ask.
I’m going to selectively raise more cash or maintain high cash levels across client portfolios. I’ll also be looking for special situations that appear relatively insulated from what I’ve described.
1MCS Family Wealth Advisors (MCS) client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. These accounts represented 100% of MCS’s assets under management as of 03/31/2015 and were invested primarily in US stocks and bonds (18% of client assets on 03/31/2015 were invested in tax-exempt municipal bonds). The Auxier sub-portfolio returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. These accounts represented 10% of MCS’s assets under management as of 03/31/2015 and were invested primarily in US and foreign stocks. The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.