Deflation

Monetary Stimulus Bazooka

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Over the past two weeks, we have seen unprecedented, by size and speed, Central Bank action. Here’s just some of what I’ve been able to capture:

· US cuts the Fed Funds rate target range to 0-0.25%, down 1.5% via two emergency cuts between scheduled meetings.

· US cuts the discount rate, the rate that it charges banks for loans from its discount window, to 0.25%, lower than during the great financial crisis.

· US re-launches quantitative easing (QE) of at least $700 billion with no cap on total or monthly purchases. In the past, they’ve always capped both. This includes at least $200 billion in mortgage-backed securities. It is purchasing both at ludicrous speed and on Friday, just five days after announcing the program and publishing a planned schedule, announced plans to accelerate from the planned purchases.

· US opened twice-daily short-term repurchase operations of up to $1 trillion. This basically tells banks “if you need any money at all for any reason, we will provide it.”

· US eliminated the bank reserve requirement, the amount of deposits that need to be on hand at any time (which is fine b/c banks can borrow from the discount window if needed), and encouraged banks to temporarily dip into regulatory and capital buffers if needed.

· US reduced the rate of interest on swap lines with foreign central banks in Canada, England, the Eurozone, Japan, and Switzerland (we give them dollars, they give us foreign currency, we charge them interest… now less interest) to ease any dollar shortages that result from a flight to safety.

· US opened swap lines with Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore, and Sweden.

· US launched the Commercial Paper Funding Facility (CPFF) which allows the Fed to buy commercial paper and for the treasury to cover up to $10 billion of losses. Read this as the Fed is backstopping the short-term corporate lending market.

· US launched the Primary Dealer Credit Facility (PDFC) which effectively provides low-interest loans to primary dealers in return for collateral which now includes corporate debt and municipal bonds.

· US launched the Money Market Mutual Fund Liquidity Facility (MMLF) which provides loans to money market mutual funds in exchange for loans that the funds hold. As individual and businesses liquidate money market funds during the current cash crunch because of the economic pause, this prevents the funds from having to sell illiquid short-term loans in a fire sale. Instead, now they can give them to the Fed for cash to handle fund redemptions and not “break the buck”. Treasury provides $10 billion for any losses.

· In summary, the Fed is either outright purchasing or accepting as collateral: treasuries, mortgages, commercial paper / corporate debt, and municipal bonds (state/local government debt). There are limits on term and quality which can be expanded. There are limits on who can borrow with collateral (banks and primary dealers), which can also be expanded further. As of right now, the Fed cannot purchase preferred stock or common stock under their current powers. I say “current” because powers can be changed by Congress or, in some cases (maybe with legal challenges) by Executive Order in times of emergency.

· Bank of Japan (BOJ) doubled its ETF purchase plans (that’s right, the BOJ actually prints money to buy funds that hold stocks, and they’re buying more!!!) for 2020. They increased their corporate bond buying plan by almost 50% for 2020.

· European Central Bank (ECB) expanded QE, is allowing banks to borrow cash at -0.75% (that’s right, the ECB will pay their banks to borrow money from them). They also launched a 750 billion euro Pandemic Emergency Purchase Programme to purchase the debt of EU countries, as well as lower quality debt. That’s ON TOP OF their existing purchase plans.

· Canada cut rates to 0.75% and launched QE via mortgage purchases.

· UK cut rates to 0.1%, increased existing QE bond purchases, eliminated their bank reserve requirement, and launched a new term funding arrangement that provides up to 100 billion pounds of 4-year loans to banks to provide low interest loans to individuals and companies.

· Australia cut rates to 0.5% opened a fund for lending to banks, and launched QE via purchases of government debt to controlthe 3-year borrowing rate at 0.25%.

This doesn’t even take into account the fiscal response across the world as virtually every government spends money it doesn’t have to help their economy get through this. The buying of government debt by central banks via quantitative easing is what makes that possible. So what’s the end game here? Central banks and national governments have shown their respective hands. In a coordinated manner, they will do everything to not let the global economy spiral into deflation. Deflation causes the price of everything to come down, encouraging anyone who wants to buy or invest to wait until prices fall further, which inevitably makes prices fall further due to lack of demand. It is a chain reaction that can lead to long-lasting depressions. If they print money to afford government spending and cash to individuals as support for this economic pause, they can offset the economic damage the pause would cause. This risks massive inflation in the future since increasing the supply of money and giving everyone their share of it, just increases demand for everything, thereby pushing up prices. In the simplest example, imagine if the government decided to match dollar for dollar, what everyone has in net worth. Everyone would feel richer. Bids for homes would rise immediately. Stock prices would rise due to flood of investment. Commodity prices would rise as global demand for everything increased. Everyone would be spending money at a pace never before seen leading to shortages everywhere from increased demand. The only response will be prices increasing sharply and dramatically until they are about double where they were before the government’s action. Then everything stabilizes (gross oversimplification) right back to where it was before with two times the money available and everything costing twice as much. In a sense, government and central bank action is walking a tightrope of trying to offset reduced demand due to the economic shock without causing too much demand that creates inflation. On which side will they land? Like I said, they tipped their hand already. Expect more from central banks as needed to get through the crisis. At some point, financial markets will realize what lies on the other side… a whole lot of money looking for a place to go.

Note: As I wrote this, the Financial Times announced that the UK plans to buy stock in their airlines and other companies affected by the pandemic. The bazooka keeps getting bigger, from the monetary and fiscal sides.

Monetary Bazooka Fired

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The Federal Reserve Open Market Committee (FOMC) today announced a new program of quantitative easing that goes above and beyond all previous actions they’ve taken to stimulate the economy. For the past several years, the Fed has been buying primarily long-term treasuries with essentially newly printed money, in an attempt to inject liquidity into the economy and keep long-term treasury rates (the rates that long-term loans like mortgages rely on) low. The new program announced today, which goes into effect starting tomorrow, has the Fed buying mortgage-backed securities in the amount of ~$40 billion per month with no fixed end date. The purchase of these securities should directly lower mortgage rates (all else being equal) and allow for another wave of refinances for those who qualify. The purchases themselves were mostly expected by the market given lackluster economic growth and an anemic job market. But, the open-ended nature of the purchase program is the bazooka of monetary weapons.

Ben Bernanke, chairman of the Fed, indicated that the Fed will continue the monthly purchases until economic conditions improve. Read another way, that means the Federal Reserve will continue print money until there is enough money to go around. That money will flow into the economy through lower mortgage and other loan payments for borrowers and through the reduced incentive to hold cash savings since interest rates are virtually zero. If $40 billion per month isn’t enough, they’ll do more. If mortgage-purchases aren’t enough, they’ll print money to purchase other assets too. It’s a commitment that essentially puts a floor under the economy and under asset prices, thereby removing the risk of deflation. Without the risk of deflation (think of housing prices falling), the desire to purchase assets can return (think of people in their early 20’s deciding to buy condos again instead of renting). While the ramifications of the commitment will take a while to filter through the economy, they should result in the following:

· Lower mortgage rates for those with good credit attempting to obtain conforming loans (loans for principal residence that are under the FHA loan limits for the county of residence – typically $417k)

· Another wave of refinancing reducing payments for existing borrowers and freeing up more for discretionary spending

· Reduced risk in house price declines leading to more buyer confidence leading to a bottom to the housing market

· Higher business confidence that the economy will not “double dip” back into recession (the Fed simply won’t let it happen)

· A very gradual improvement in the job market

· A continuing erosion in the value of cash (no interest paid and the cost of living will start to increase more rapidly, especially in volatile food and energy prices)

· Higher inflation (virtually a guaranteed byproduct in eliminating the risk of deflation), higher energy prices, higher food prices.

It’s that higher inflation that will be the next big economic problem in my opinion. How fast it happens is unknown, but when it does, the Fed will have to reverse course and start extracting stimulus or face a 1980s-like bout of hyperinflation. Their forecasts are for that to occur beyond 2015 (they currently promise to keep rates low through 2015 and wouldn’t do that if they didn’t think inflation would be in control through at least that year). I’m not so sure, since I think a promise for an unlimited amount of stimulus could very quickly cause inflation expectations to become unanchored. Either way, taking deflation, double-dip recession, and maybe even depression off the table is certain to be a short-term net positive on the economy in aggregate. It’s also virtually certain to make cash have less and less value over time. So, what should you do to take advantage of today’s changes:

1) Only hold enough cash to serve as an emergency fund and to pay for short-term upcoming lump-sum purchases.

2) Avoid long-term fixed-income commitments (long-term bonds, long-term cd’s, fixed annuities without an inflation rider).

3) If you own a house, look into refinancing or re-re-re-refinancing your mortgage.

4) If you’re renting, you live in an area where house prices are reasonable in relation to rent, and you have enough money for a 20% down-payment, consider buying a house. I’ve been very patient in delivering this message but my confidence is now fairly high that affordability (based on the mortgage payment you’d expect given home price and interest rate) will peak by Spring ’13.

Most of all, stay alert and stay flexible. Today’s announcement is unprecedented and therefore at least partially unpredictable. Bazookas are powerful, but they’re not the most precise weapon and they may have some collateral damage. If we’re using imprecise, extremely powerful, and somewhat unpredictable tools to try to control the economy, the result, well, let’s just say this is probably not the final chapter of this economic cycle.

Market Update 7/5/2012

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*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients just after the start of Q3 2012 as part of that communication effort***

Q2 2012 proved to be yet another roller coaster quarter in the financial markets led mostly by continuing debt problems plaguing European governments & banks, and the economic slowdown driven in part by fear and in part by the austerity measures that are being put in place to try to rectify the debt overhang. After losing much of the Q1 gains through the month of May, markets rallied back in June on hopes of progress in Europe following the latest Greek elections (a win for the party that wants to stay in the Euro), a hint that Germany may be willing to concede to a cross-country banking union of some sort, and the extension of Operation Twist by the U.S. Federal Reserve (thereby also extending hope of more easing in the future). US stocks a whole lost just over 3% for the quarter, with international stocks losing just over 7%. U.S. interest rates continued to fall with short-term rates pinned near zero and long-term rates plunging to historic lows (U.S. 10-year yields just under 1.6% as I type this note). This helped bond funds to perform fairly well in aggregate, up about 2% for the quarter. Commodities fell on global growth concerns, down 4.5% for the quarter with energy components leading the way down. While investments in commodities lost value, the economy as a whole likely felt some relief from declining energy prices which helps consumer confidence and more importantly, consumer budgets. As we noted in our Q1 update, we expect risk assets like stocks and commodities to continue to remain volatile, both up and down, for the short-term, with bonds in aggregate generating fairly constant, albeit low returns. Interestingly, the national average rate on a savings account is now 0.12%. While it doesn’t get much safer than an FDIC-insured savings account, with year over year inflation running close to 2%, that’s a guaranteed loss of almost 2% per year by keeping money in cash.

While much has been blamed on Europe over the last two years, the U.S. faces its own issues heading into 2013. At current pace, we borrow approximately fifty cents of every dollar we spend as a government. This completely unsustainable way of running of the country will take its toll at some point in the future. The good news is that we seem to know that we have a problem. The bad news is that the method by which we fix it is heavily debated by our two political parties, each seeming to move toward a more extreme position as time goes by. It would be difficult to call them deadlines, but at least strong milestones loom in the not too distant future with the major credit ratings agencies noting that if the U.S. doesn’t come up with a credible plan for reducing the deficit by the start of 2013, another rating downgrade will follow. As current law stands, three dramatic changes are scheduled to be implemented in 2013. These have become known in aggregate as “The Fiscal Cliff”. They include the sequestration of defense spending budgets, the repeal of the 2001 & 2003 tax cuts which will increase tax rates on everyone who pays U.S. taxes, and the next steps in the implementation of the new healthcare laws which will institute a new Medicare surtax on certain individuals. If these changes go into effect, they combine spending cuts with tax increases in a slowing economy that is plagued by high unemployment already. This dramatically increases the possibility of another sharp recession. If the changes don’t go into effect and no other credible plan is put into place to balance the budget over time, the credit worthiness of the U.S. will come into question. If/when that happens, borrowing costs will start rise, putting more pressure on the budget (higher interest payments) and that spiral of debt that is all too familiar in southern Europe could attack the U.S. in much the same way. The answer to this problem in our opinion is one that Congress will get to eventually. That is, easing the Fiscal Cliff for the short-term and simultaneously publishing a credible plan for the long-term, likely through an overhaul of the tax system and a review of programs like Social Security and Medicare that are growing to levels we can’t support over the long-term. What’s not clear is whether the will exists to accomplish this before sharp and severe economic realities hit.

Led by the election in November, we believe the issues in the U.S. will come to the forefront over the next few months. It is likely that the stock market will gyrate, perhaps wildly at times, as solutions are brought forward and political power for the next 2-4 years is revealed. Further stimulus by the Federal Reserve, possibly in a coordinated effort with central banks around the world, will become more likely if economic conditions deteriorate. Monetary stimulus would continue to provide a temporary floor to the economy and to asset prices by simply pumping more money into the banking system. If the Fed does this, cash is one of the worst places to be as interest rates will continue to near zero while inflation would likely pick up as more money enters the financial system.

What all of this means is that we’re unfortunately stuck in the middle of a potentially deflationary bout of economic deterioration (where we’d want to hold cash and bonds and avoid stocks and commodities) and a potentially inflationary move by the Federal Reserve and other central banks to offset that economic deterioration (where we’d want to avoid cash and bonds and own stocks and commodities). The market in aggregate continues to do a very good job of pricing the risks to both sides. The current best course of action is to maintain asset allocation targets and continue to take advantage of volatility through portfolio rebalancing. We are monitoring the economic landscape closely and are prepared to take action if risk/reward does come out of balance in the coming months. If the market rally significantly from here on a perception that the world’s problems are solved, we will likely move toward more conservative portfolios by adjusting all models and using hedging positions where appropriate. For now though, we believe the inflation/deflation scenario is well-balanced and that stocks, especially in comparison to other asset classes, remain well-priced.

More on the fiscal cliff, stock valuations, Europe, and a host of investment and other personal finance topics will be presented on the new PWA blog which is officially live as of today (blog.perpetualwealthadvisors.com). In future quarters, rather than sending you emails like this, we’ll be posting shorter, more easily digested ruminations on the blog. You can subscribe to receive emails on new blog posts if you prefer to receive the content in your inbox rather than on the sites. Our Facebook and Twitter pages are also live, though with each still under construction and notably light on content (as is the case for all new pages). We’ll rectify that shortly. Feel free to provide encouragement by “Liking” & “Following” us. You can find links to all the pages via the icons in the signature below. For those of you who have made it this far into reading this email, you’ll be receiving a second notice about the blog, Facebook, and twitter pages in the coming days specifically because I’m guessing only a few of you made it this far (which I find as solid confirmation that a blog will be more useful than long emails each quarter). You have my apologies in advance for the double notice. As a reward however, reply to this message with a suggestion for a future blog post topic and you’ll be entered into a drawing to receive a gift card at the end of the quarter. As always, if you have any questions or comments about this message or anything else, please don’t hesitate to ask. Thanks for reading and enjoy the rest of the summer.