Category Archives: Uncategorized

Fed Balance Sheet unwind

Michael Arone at SPDR Blog has added a bunch of global data to the info I posted previously regarding the Fed’s balance sheet.  He includes some information about current and future levels of required reinvestments (maturity dates) but really doesn’t touch on how equity markets might be impacted.

There are a bunch of cool charts (and one really, really dumb one, click on the link and you figure out which one).

Here’s a couple:

growth_in_global_central_bank_assets_1160x760

us_treasuries_and_china_fx_reserves_1160x687

 

Importantly, he noted that the Chinese sale of treasuries was related to their desire to control the level of the yuan, not some general panic over US Treasuries, as that action is often portrayed.

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Electric cars: Not clear on the concept!

Whenever I see a headline like this:

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Energy

Bloomberg details the current cost of renewables vs. fossil fuels here.  For new installations, solar and wind are now both cheaper than any fossil fuel power plant.  What does that mean?  Well, it means that no one will build new fossil fuel power plants.  However, do not confuse this with “solar is cheaper now so everyone will switch.”

It’s still cheaper to increase production at existing power plants, even if that requires investment to improve environmental impacts.  It’s also cheaper to retrofit existing plants to run other types of fuels, like coal to natural gas, or coal to biomass.  Please note, China claims to be moving away from coal.

What we might hope for is to see the solar industry in the US benefit and grow, supplying emerging economies with energy.  Although China dominates all solar power markets, the US does have significant manufacturing.

What about oil and electric cars?  Bloomberg also posted this video comparing the recent oil glut and price drop to the amount of oil use expected to be eliminated as planned electric vehicle manufacturing gets into high gear.  This is from February 2016, but it’s pretty good:

 

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Fixed Income Dilemma

What are we to do about fixed income?  Current yields are low at all maturities, for all except the riskiest issues.  In addition, investors currently holding bonds or bond funds are looking at interest rates that can seemingly only rise, leading to losses in value.

Let’s start by examining why we hold bonds in the first place, and how they have been performing relative to those reasons.  Bond ETFs will be used as a proxy for bond performance.  Investment grade bonds are represented by AGG, which tracks the Barclays US Aggregate Bond Index (data at morningstar.com and https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf).  High yield bonds are represented by HYG, which tracks the Markit iBoxx USD High Yield Index (data at morningstar.com and https://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf).

  1. Low risk.  A core justification for owning investment grade bonds is that they rarely lose value, and when they do, it’s not much.  3 year standard deviation is 2.64%, compared to 6.01% for HYG, and 10.8% for SPY.
  2. Diversification.  The equity beta for AGG vs. the S&P500 is -.03 as of 9/30/2016.  This tells us that AGG is a very good diversifier to stocks.  From a portfolio construction standpoint, this is not to be taken lightly.  On the other hand, HYG has a beta of .40.  Still a diversifier, but as one would expect, more positively correlated with equities.
  3. Income.  Those who are retired, and many advisors, see bonds or fixed income assets as a way to earn money from savings without touching the money that was saved (spend earnings instead of principal).  Since money is fungible, this is really just a behavioral bias (mental accounting).  However, since all of our clients are humans who exhibit these biases, if it makes a client feel terrible to sell 2% of assets that have appreciated 2%, but feel good to take the income from an asset that has 0% return but 2% yield, then that might be a valid reason to use bonds for income.  AGG has been yielding about 2% YTD, and HYG about 3.5%(!).
  4. Regulations.  This is not a small consideration.  New fiduciary rules impact portfolio management, and portfolio managers will need to document extensive research to back up deviations from “standard” portfolios, which might by default include substantial allocations to fixed income for certain types of clients.

What about going forward?  Will these assumptions still hold, given global negative interest rates (see Eric Robbins’ article in this issue) and the historic bond bull market in US Treasuries?  I’m going to focus just on the first item on the list.

Low risk.  Is it possible for bond values to remain elevated, with depressed yields, for any mid- to long-term time frame?  The driving force behind this dynamic since the great recession has been QE.  According to the Fed’s website, approximately $45B of their $4T balance sheet will mature in the next quarter.  Also from the Fed, new mortgages are being issued at a rate of about $100B per quarter, and according to SIFMA, new US Treasury issues have totaled an average of $165B per quarter.  So in order for the Fed to maintain their current balance sheet, they alone are currently consuming nearly 20% of all new Treasury and mortgage debt issued in the US.  Foreign governments are also engaged in QE.  According to the US Treasury, their holdings of US debt have remained fairly constant over the last year at around $6T.  These holdings also mature, so there is implied demand for new issues from foreign buyers as well.

Jeff Gundlach feels that, based on presidential election political rhetoric, a new round of fiscal stimulus is forthcoming, which will overwhelm these buyers and result, along with Fed interest rate changes, in increasing rates (September 8 presentation, available from DoubleLine).  He recommends moving to lower duration securities and cash, right now.  I would add the observation that government spending comes from Congress, not the White House, so it is the congressional makeup that will determine fiscal policy action, or lack thereof.  Fidelity does not share Gundlach’s view (update from Fidelity website).  Bill Irving believes that “yields will remain at historically low levels for some time.”

Another consideration is that we are, historically, past due for a recession.  This typically results not only in large losses in equities, but a flight to quality, supporting  bond prices.  The bottom line:  Rates are not likely to remain at current lows forever.  However, federally backed debt, which comprises 70% of AGG (including agency and implicit government-backed debt), may continue to hold value in the short or even mid term.  If you look at a graph of the Federal funds rate, you will notice that while interest rates drop in huge increments, they only increase in small increments, over time.  These interest rate changes have previously been implemented slowly enough for the average investor to adjust asset allocation before major impairment to asset values can occur.

Corporate debt, according to both Irving and Gundlach, is now trading at historically normal spreads.  John Hussman provides a lot of data showing that today’s equity market is highly overvalued.  These data points together suggest that corporate debt may not be adequately compensating for credit risk.  Instead, corporate bonds have been bought beyond reasonable levels in the quest for yield (adding credit risk).  That strategy may be a greater risk to overall portfolio value than interest rate risk.  In fact, if high yield bonds have been added to a portfolio including US equity, the risk is now even larger since there is positive correlation between those asset classes.  Gundlach suggests emerging market debt in place of high yield domestic corporate bonds.  Foreign bonds add currency risk, but that can be hedged (for a price).

Another option is to make use of actively traded long/short bond funds or SMAs.  Although the exposure will always be to bonds, this is not an asset class that acts like a bond, but instead is an alternative.

So, what to do?  Assess the timeline of your portfolio, and compare it to basic bond management theory.  Can you match duration to reduce interest rate risk?  Can you use a barbell strategy to reduce interest rate risk and still meet your return requirements?  If this doesn’t work, what kind of risk are you willing to take?  Are you willing to live with interest rate risk, at least in high quality US issues?  Are you willing to take credit risk as well as adding to your overall portfolio risk by adding high yield, preferred stock, or foreign bonds?  Does it make sense to reduce your bond exposure and invest in another asset class?  As you look at these trade offs, be sure to determine your criteria for further review and action.   Set a specific interest rate cutoff (and/or whatever other data points you deem valuable), and determine what actions you will take when it is reached.  Set a specific review date, and determine what data you will review at that time.  And last, but far from least, be sure to record your process for compliance.

Disclosure:  Long AGG, SPY

 

 

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Elon Musk Master Plan, Part Deux

Read the whole thing, here:  https://www.tesla.com/blog/master-plan-part-deux

And here’s the best part:

What really matters to accelerate a sustainable future is being able to scale up production volume as quickly as possible. That is why Tesla engineering has transitioned to focus heavily on designing the machine that makes the machine — turning the factory itself into a product. A first principles physics analysis of automotive production suggests that somewhere between a 5 to 10 fold improvement is achievable by version 3 on a roughly 2 year iteration cycle. The first Model 3 factory machine should be thought of as version 0.5, with version 1.0 probably in 2018.

In addition to consumer vehicles, there are two other types of electric vehicle needed: heavy-duty trucks and high passenger-density urban transport. Both are in the early stages of development at Tesla and should be ready for unveiling next year. We believe the Tesla Semi will deliver a substantial reduction in the cost of cargo transport, while increasing safety and making it really fun to operate.

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Improvements in dental fillings

It’s about time!

From iflscience:

Every year, dentists fill millions of cavities from teeth that have decayed. Ordinarily, this does its job in protecting the inner pulp from harm, but in around 10 percent of cases they fail. This requires the dentist to perform a root canal and completely remove all the infected tissue from the center of the tooth. But what if there was a way in which to encourage the tooth to repair itself?

Well that is exactly what researchers at the University of Nottingham and Harvard University are trying to achieve. They have developed a new biomaterial that they say allows the damaged pulp to regenerate a protective layer of dentin. This should help the tooth prevent infection of the site, and make for more integrated and long-term fillings, causing a significant shift in the way that dental cavities are treated.

Read the whole article for more details.

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video games suck

Wow, just wow.  From Marginal Revolution:

Here is Erik Hurst, from an excellent piece profiling Erik Hurst:

Right now, I’m gathering facts about the possible mechanisms at play, beginning with a hard look at time-use by young men with less than a four-year degree. In the 2000s, employment rates for this group dropped sharply – more than in any other group. We have determined that, in general, they are not going back to school or switching careers, so what are they doing with their time? The hours that they are not working have been replaced almost one for one with leisure time. Seventy-five percent of this new leisure time falls into one category: video games. The average low-skilled, unemployed man in this group plays video games an average of 12, and sometimes upwards of 30 hours per week. This change marks a relatively major shift that makes me question its effect on their attachment to the labor market.

To answer that question, I researched what fraction of these unemployed gamers from 2000 were also idle the previous year. A staggering 22% – almost one quarter – of unemployed young men did not work the previous year either. These individuals are living with parents or relatives, and happiness surveys actually indicate that they quite content compared to their peers, making it hard to argue that some sort of constraint, like they are miserable because they can’t find a job, is causing them to play video games.

This problem, if that is the right word for it, will not be easily solved.

The post What are young men doing? appeared first on Marginal REVOLUTION.

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