“Mr Draghi announced this week that the ECB would not buy bonds yielding less than minus 0.2 percent..”
– Ralph Atkins for the Financial Times, 7th March 2015.
TRADER: “Joe, let’s give this guy a little test ! When interest rates go up, which way do bond prices go ?”
TRADER: “Terrific. You get an ‘A’..”
ME: “Can I help in any way ?”
TRADER: “Get me a burger. With ketchup.”
– Michael Lewis, ‘Liar’s Poker’.
Danish sex therapist Eva Christiansen stands a good chance of becoming the definitive example for future historians of our current interest rate insanity. The New York Times reports that the 36-year-old businesswoman has just been approved for a small business loan at a rate of minus 0.0172 percent. The bank is actually paying her interest on the loan – albeit just over $1 a month. Representing the flip side of this nonsense is the 27-year-old Danish student Ida Mottelson. Her bank just wrote to her advising that it would be charging her 50 basis points (0.5%) to hold her money on deposit. What’s wrong with this picture ?
The French economist Frederic Bastiat created what may be the most powerful – and perhaps most overlooked – metaphor in finance, in his 1850 piece ‘That which is seen, and that which is not seen’. It goes as follows:
A young boy happens to break a shopkeeper’s window. Pretty soon a crowd gathers, which quickly becomes philosophical:
“It is an ill wind,” says the crowd,
“that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken ?”
Bastiat nicely catches the intellectual mood of the mob. Let’s say it costs six francs to repair the window. That is six francs given to the glazier, who can spend it as he will. The six francs will circulate in the wider economy. Perhaps we should break more windows and watch the economic stimulus take hold. The six francs given to the glazier are what is seen.
What is not seen is what the shopkeeper might have done with those six francs had he not been obliged to pay them to the glazier. He would, perhaps, have replaced some old shoes, or bought a book for his library. If he were markedly stupid and easily led, he could perhaps have bought ‘End this depression now !’ by Paul Krugman, or ‘Capital in the twenty-first century’ by Thomas Piketty. But what’s important is that he doesn’t have those six francs any more. Whatever he might have done with the money is now not seen:
“To break, to spoil, to waste, is not to encourage national labour; or, more briefly,
“Destruction is not profit.”
The Austrian economic school has a term for those things that are undertaken foolishly in the economy, perhaps because the pricing mechanism has become hopelessly distorted. It terms them ‘malinvestments’. Do we think malinvestments are more or less likely to happen when people are actually paid to borrow money ? Do we think malinvestments are more or less likely to happen when people are actively penalized for saving ? When there is a punitive cost for holding money on deposit at a bank, are malinvestments more or less likely ? What about money hoarding ? Or ultimately, following the introduction of negative interest rates, a run on banks altogether ? Money destruction is not profit either.
One dreads to think what problems are being stored up for the future by the current monetary policy of our central banks. We have made this point before on innumerable occasions. But an argument is not wrong simply for its being frequently repeated. In this week’s Spectator, Ros Altmann draws attention to the damage being wrought on pension funds by Quantitative Easing:
“During last year, company scheme deficits rose by more than £200 billion, as pension assets increased by around 10 percent but liabilities (which increase when bond yields fall) rose by over 25 percent..
“It is not just company pensions that have been hit. Private pension funds have been damaged too. Annuity rates depend on bond yields – and the lower yields fall, the lower retirees’ annuity pensions will be for the rest of their lives..
“..as gilt prices have driven pension deficits up, pension advisers have increasingly recommended that trustees reduce the risks of their pension schemes. The traditional way to do this has been to buy more bonds and sell shares, so trustees have felt forced into buying bonds, whatever their long-term value.”
Buying assets irrespective of their long-term value is in some contexts referred to as ‘greater fool theory’. That would seem to be the case in the euro zone, where Mario Draghi at the ECB is just about to begin a €1.1 trillion Quantitative Easing programme. Banks and other institutions have already driven down the yields of many sovereign bonds into negative territory (according to ABN Amro, more than a quarter of government bonds in the euro zone now have negative yields), in anticipation that some ‘greater fool’ will take them off their hands. Enter Mario Draghi.
Awkwardly, the ECB’s bond buying programme may prove to be the most ill-timed securities purchase programme in history. That was already the case given that interest rates are now at 5,000-year lows. It looks even more like the case given how bond markets behaved on Friday. “Treasuries in biggest rout since 2009 as job gains spur Fed bets,” reported Bloomberg. Last week the long bond, the 30 year US Treasury, saw its yield rise by 25 basis points to 2.84%. Mr Draghi may be bringing a knife to a gunfight.
Meanwhile, investment consultants will continue to give pension funds the benefit of their advice. That advice, both at a macro and a micro level, may be worth less than nothing; an academic paper has just won the 2015 Commonfund prize for concluding
“we find no evidence that [consultants’] recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.”
So other than being unable to offer any practical advice whatsoever other than to recommend buying government debt at its most expensive levels in world history, perhaps ahead of a grave turning point in the market, and being unable to add any value either in specific fund manager recommendations, pension consultants are clearly well worth the fees they charge to their gullible pension fund clients.
Lest this seem a counsel of despair, for any investor unconstrained by benchmark or regulatory fiat, there is an answer. It lies in the sad passing, just reported, of the lateIrving Kahn, at the age of 109. Kahn was a teaching assistant to Benjamin Graham, the dean of value investing and a man whose influence on and development of the principles of successful investing was second to none.
Now, more than ever, is a time to insist that our investments carry a “margin of safety” – the cushion represented by buying assets (today, most likely to be equity assets, and almost certainly not most sovereign bonds) at a meaningful discount to their inherent value. At a time when few financial prices can really be trusted, courtesy of a tidal wave of QE that is lifting most boats, stocks possessing a “margin of safety” ensure that we run the least risk of consciously overpaying for our investments. Irving Kahn long ago “stopped wasting time on what people claimed a stock was worth and started looking at the numbers”.
Value investing – attempting to buy dollar bills for forty or fifty cents – always makes sense, but it makes a whole lot more sense when risk-taking and asset market reflation are off the charts. The alternative, which has become bizarrely popular among those retail investors flocking into index-tracking ETFs, is simply to gain broad market exposure. That is surely a grisly accident waiting to happen. John Hussman points out that
“the present moment likely represents the best opportunity to reduce exposure to stock market risk that investors are likely to encounter in the coming 8 years.. An environment of compressed risk premiums coupled with increasing risk-aversion is without question the most hostile set of features one can identify in the historical record.”
So the choices seem pretty clear. Track absurdly expensive stock markets higher. Buy government bonds at their most expensive levels in history – even as there are early signs that the interest rate cycle may finally be about to turn. Or take shelter in the sort of value stocks that made Irving Kahn, Ben Graham and Warren Buffett mightily successful long-term investors. Doesn’t seem like a particularly difficult choice to us.