A Tectonic Intermission: World to Turn and Churn: Part II
-- Internal Document: Hahn Investment Stewards & Company Inc. --
Updated Expected Returns: Our expected return forecasts for our portfolios have been revised upwards this quarter. Return expectations are much improved over the next 7 years, our global growth portfolios expected to return in excess of 10% per annum over this period.
All long-term return projections for all portfolio mandates are based upon nominal returns. (For further information, please see the corresponding exhibits at the back of this report.)
|Asset Class||7 Year Averages||Gains Total||Gain Currency||Gain Security||Income Total||Dividends||Interest|
|Cdn Govt. Bonds||-0.31%||3.50%||-0.50%||0.00%||-0.50%||4.00%||4.00%|
|US Govt. Bonds||2.17%||6.07%||1.97%||2.83%||-0.85%||4.10%||4.10%|
|Int. Gov. Bonds||-0.75%||3.04%||-0.96%||-0.81%||-0.15%||4.00%||4.00%|
(Forecast revised as of March 2008)
SECTION IV - LONG-TERM INVESTMENT STRATEGY SUMMARY CHANGES
For specific portfolio strategy details, please see internal minutes or contact HAHN Investment.)
Wilfred J. Hahn, June 2008
Required Policy Prescriptions: What Must be Done?
Today, it is reasonable to presume that policy prescriptions are driven mostly by political imperative, the ballot box, and the financial interests of an over-leveraged Wall Street. Policies therefore must meet the short-term exigencies and needs of the day for all these parties ... and quickly.
As such, an Establishment tactician would surmise that the following strategies must be pursued in the US and other countries that are caught in the same downdraft.
- Boost Spending and Demand (Necessary to minimize the damage of a recession ... or worse.)
- Address the Real Estate Crisis
- Protect and Recapitalize the Financial System
- Boost Household Income and Wealth Relative to Debt Levels (Please see Insert #1 for further background.)
Insert #1: Why an Inflationary Boost of Household Income?
It is urgent that household income and wealth again realign with outstanding debt levels. There are three separate ways of doing this: 1. Reduce consumption and spending in order to pay down debt 2. Reduce debt through default, bankruptcy or write-down by the lender. 3. Cause household incomes to rise faster that outstanding debt.
Of the 3, the most convenient and seemingly painless (subtly dangerous, in other words) is the 3rd approach. High inflation can achieve this outcome, provided that employment levels are maintained. In the early 1970s, Britain pursued this outcome. There, inflation eventually rose to near 20% per annum. In a space of only a few years, its real estate crisis was over. It was a remarkably quick recovery from what appeared to be a total financial meltdown in the early 1970s.
US policymakers should be expected to attempt the same outcome. However, it will be more difficult to achieve than in the early 1970s. This policy points to the necessity of a weaker US dollar (boosting employment through higher exports, lower imports) and rising inflation).
Next, we theorize what policies or initiatives could achieve these goals. The fact that any of these policies may have unfortunate longrun consequences with respect to the US dollar, monetary or moral integrity is not of popular concern at the moment ... nor considered here. We are merely trying to anticipate what the populace and its policy-makers will find necessary and agreeable.
While we clearly recognize the theoretical possibility of a "full Minsky-type" deflationary meltdown -- and certainly placed a much higher probability on this outcome than most others a year ago -- we are not that pessimistic ... at least not yet.
Indeed, the US and global financial system may be in a grim state of disrepair at the moment -- certainly the worst financial crisis since the 1930s -- there yet remain a number of "tricks in the bag" and "innovations" that central bankers can still pull out before the widely feared collapse occurs. As mentioned, we suspect that there is likely at least one more global cycle to play-out -- if not more -- before the theoretical deflationary bust is more likely to occur.
Following is an abbreviated list of the monetary "tricks" that remain in the "magicians" bag on the part of monetary institutions and policymakers. To be sure, these are all deceiving prestidigitations that do not offer a real solution to the basic problems, yet they can probably sustain the "show of smoke and shadows" for a time longer. For now, all the main players have similar vested interests.
Interest Rate Declines. To date, the US Federal Reserve has already passed the point of capitulation ... an anticipated Significant Event (SE) that had been on our list for well over a year. We still expect short-term administered rates to fall further ... to as low as low as 1.00% to 1.50% or lower. Already, on an intraday basis, rates on US 91-day treasury bills have fallen below 1.00%. The most important aspect of short-term rate declines is to create a steep yield curve. And, indeed this has again occurred with a spread of nearly 220 b.p between 91-day and 10-day treasuries. This is essential in order to help banks recapitalize by arbitraging high spreads.
However, here is the key point to keep in mind: Technically, as long as short-term administered interest rates remain above zero and market participants are willing to play the game, there exists an infinite amount of interest-rate stimulus and/or incentive to push the financial system to take on treasury bonds that are rising in price. While we take the position that longer-term bonds are currently overvalued, it is technically possible for bonds to continue rising. Even if rates fall to the ridiculous lows of 5/100ths of one percent, a further reduction to 4/100ths will still produce a huge upward revaluation of existing bonds. And so it could continue, bonds outperforming for quite some time. However, this would only be the case if a deep liquidity trap were underway.
Lending Operations. To date, most of the actions of the Federal Reserve Board and other central banks around the world -- other than interest rate cuts -- have centered on lending operations (the Term Securities Lending Facility -- TSLF and the Term Auction Facility -- TAF). For example, the Fed has lengthened over-night lending operations to as long as 28 days, and has accepted new kinds of collateral, including asset-bank loans. Effectively, the Fed is allowing the swap of US Treasury bonds (which it currently holds and are in high demand by spooked investors) in exchange for lesser desirable paper. Theoretically, the Fed could take corporate bonds or any other security it wished. This may yet happen. However, to this point, the Fed has not technically "printed" any money. (See point #4 below.)
Bail-out Conventions. By design, the Federal Reserve system is enabled to bail-out its member banks should they experience deposit runs or other short-term liquidity problems. Actions to aid other financial institutions -- non-members of the Federal Reserve System, such as Bear Stearns, for example -- are notionally outside this arc. Yet, as witnessed recently, the Federal Reserve stepped in to help engineer this bail out by J.P Morgan. More of these rescues may lie ahead. These are unusual measures.
Outright Printing and Other Such Tricks. As mentioned, to date, the Federal Reserve Board has not printed any money ... at least not technically. It could do so. However, this would require the approval of Congress. Another trick that proved workable was engineered by Germany in the late 1940s. Post-war, it faced a bankrupt financial system. What did it do? It simply issued government bonds and plunked them on the asset side of the bank's balance sheet. Voila! The problem was fixed ... and, it worked. Germany and the rest of the Europe, thanks also to the Marshall Plan, embarked on a post-war boom.
In the case of the US, such a maneuver may also be ultimately necessary, however, it is not as likely to benefit to the same degree it did Europe within a post-World War II boom. There is a cost, after all. Issuing government bonds to prop up the balance sheets of the financial sector will result in higher national debt. How much higher? Some analysts suggest that the financial losses of the entire US financial system may amount to as much as 20% of US GDP. This is quite large comparatively. For example, the US savings and loans crisis of the 1980s ended up costing US taxpayers 3.4% of GDP. On the other hand, government bail-outs of this size are not unprecedented. Consider that Japan's national debt more than tripled during its lost decade (1990s) in the post-bubble period, to as high as 120% of GDP.
Nationalization. It is a dirty word to "free market" disciples and Libertarians alike. However, we believe that a nationalization of some type will occur if mortgage-backed paper is to be resuscitated from the current liquidity pressure affecting even AAA-rated paper. We would not be surprised to see Ginnie Mae and Freddie Mac effectively taken over as a government entity. Also, one or more bond/credit insurers (all referred to as the monoline insurers) may warrant a government sponsored bail-out.
Global Coordination. Already, various central banks around the world have extended credit lines to each other in the past few weeks. More coordination is likely. Specifically, we would not be surprised to see that various reserve funds (i.e. China, Taiwan, Singapore, Saudi Arabia ... etc.) are encourage (or agree to participate, for their own benefit) to buy or swap agency and municipal bonds for US government treasury bonds.
Other Miscellaneous Changes. There are myriad policy changes that can be initiated to support mortgage markets, real estate or other asset segments. For example, recently, the reserve requirement of the big agency mortgage lenders (Ginnie Mae and Freddie Mac) were changed from 30% to 20%. This allows them to buy even more mortgages on an even smaller capital base.
Direct Intervention at the Household Level. Any number of policies are possible in this category of interventions. Some have already been proposed and enacted ... i.e. a special budgetary stimulus offering rebates. Others could include:
Special programs to mandate mortgage relief. This could take the form of new types of mortgages that give upside "house appreciation" options to the funding financial institution in return for writing down the mortgage to a more affordable level. There are a variety of such schemes that could be proposed.
Home Buying Stimulus Programs
Targeted Mortgage Relief Programs
We have only scratched the surface of possible future innovative intervention. To this point we have not considered the "macro" policies that could further serve to realign household incomes with housing prices and outstanding mortgage levels. These would include a chronically depressed US dollar (thus stimulating export growth) and higher inflation with the intent of raising income levels faster than outstanding debt.
Without a doubt, all the above either independently or corporately, will cause overall government debt to rise substantially relative to GDP as well as contribute more inflationary fuel to the global monetary system. Given the many dollar-pegged countries in the world with high exchange reserve balances, large current account surpluses, and already surging inflation, the recent policies of the US truly throw gasoline on these economies.
Reprinted form The HITCH Update - March 2008