Q&A – Answers

Here are the responses to this week’s Q&A:

Q:  Your book says commodities aren’t good investments as a core piece of a portfolio because of their poor real, real returns. But what about MLPs?

CR:  There’s a difference between buying commodities outright and buying commodities for the purpose of investment.  A firm that buys oil in order to innovate is very different from a trader who just buys oil for the purpose of speculation or hedging.  I am not against owning firms who purchase commodities for the purpose of future production.  The thing you have to be aware of with MLPs is that they’re very sensitive to shocks.  We saw this in the recent downturn when MLPs fell over 10% in a matter of days….

Q:  How will you know if we are in a bear market?

CR:  The technical definition of a bear market is a -20% decline in the stock market.   So we’ll all know when that happens.  I don’t think it’s very useful to try to predict every micro move in the markets.  Instead, I focus on the macro picture and construct a framework for being able to ride the big trends while tilting the portfolio in a cyclical manner.  For instance, we know that tail risk events tend to occur inside of recessions.  This makes sense since this is the time when corporate profits falter.  Every 30%+ decline in the S&P in the last 75 years has occurred inside of a recession.  

So, if we can model the macroeconomy in a manner that helps us identify the 10-20% of the time when the economy is in recession (we don’t have to get it perfectly right, we just need to get moderately close) then we can tilt the portfolio in a manner that reduces exposure to big tail risk events. This is in keeping with my view of adaptive asset allocation and the understanding that relative risks of asset classes evolve over the course of the business cycle.  

In essence, the key isn’t identifying when the market will make small shifts.  Rather, it’s much more important to identify the larger trend, take advantage of Mister Market along the way when he makes mistakes (like the recent downturn) and make cyclical adjustments when it looks like the big trends are being disrupted.  The best part is, this can all be done in an extremely low cost and tax efficient manner if you’re mindful of it….

Q:  Where do you see the US dollar in one year – higher, lower or about the same?

CR:  The US dollar index has averaged a -0.5% return for the last 30 years.  The basket just isn’t that volatile in the grand scheme of things.  And since currencies are a zero sum game I don’t know how much sense it makes to try to forecast currencies.  Basically, I wouldn’t expect the USD to do anything spectacular in the next years.  It’s the world’s most stable currency in the world’s strongest economy.  I think the Fed would love to see it decline, but they’re not intervening directly so the better question might be whether China, Japan and Europe can devalue relative to the USD?   The answer to that is probably yes on all fronts….

Q: Asness mentions four market inefficiencies in his work (value, momentum, carry and risk parity). If it is fair for me to ask, what other strategies if any do you see mispriced by market (inefficiencies)?

CR:  I don’t know if I have a specific strategy style that I view as taking advantage of market inefficiencies. Markets are dynamic and inefficient at time.  So it makes no sense to be static and apply Efficient Market Hypothesis type thinking.  I believe an asset allocator should implement a macro adaptive approach not dissimilar to the way William Sharpe has discussed Adaptive Asset Allocation.  That means they should understand the big picture, ride big trends, and understand that the markets are dynamic.  This is somewhat similar to risk parity in that you’re basically allocating assets across broad classes while being mindful of the fact that relative asset class risks are dynamic during the course of the business cycle.  This means your portfolio should at least tilt at times to account for this dynamic landscape.  

The problem with risk parity is that you basically always conclude that fixed income is less risky than equity which I don’t think is necessarily true.  But I take an approach that is very similar to a risk parity approach in that I am using a broad asset allocation approach which is cyclically adjusted to account for changing relative risks in asset classes.  I don’t try to create risk parity as much as I try to tilt away from high risk asset classes during the periods of the business cycle when we know there’s a high probability that they will be risky in relative terms….

Q:  As I understand from the Kalecki equation, if the government cuts back on its spending then the private sector increases its level of debt to maintain growth levels. And since 2008, developed countries have slowed their accumulation of debt (and some have improved their trade deficit as well) whereas emerging have largely increased their debt levels. Does the world observe a global Kalecki equation of sorts influenced by the imports/exports or is each country a stand alone entity and in a closed system. That is, is this increase of emerging market debt the result of the slower debt accumulation in developed market?

CR:  There is no hard and fast law that is derived from Kalecki’s profits equation.  That is, if the government stops spending it doesn’t mean that debt necessarily needs to rise or that private sector profits will decline.  I think a lot of people expected this to happen in recent years as the deficit declined and I tried to explain on several occasions that this wasn’t necessarily going to be the case.  The reason why is because the deficit responds to changes in the private sector.  So, in the last 5 years we’ve seen steady govt spending and huge increases in tax receipts due to the improvement in the private sector.  The govt didn’t really do anything.  But the deficit responded by endogenously improving due to the organic improvement in the private sector.  So I think you have to be careful deriving changes directly from the deficit.  You have to look at what caused the deficit to decrease/increase in the first place.  

Now, one trend we’ve seen over the last 30 years is rising debt levels as inequality has increased.  I think what’s going on is that the middle class is borrowing to maintain a certain living standard.  As incomes have stagnated they’ve borrowed to make up the difference.  I would say that the deficit could be a lot larger in this environment, but I wouldn’t say it’s the cause of the borrowing.

Q: My question concerns the question of QE in the EU. I keep reading articles that suggest that the threat of deflation clearly implies the need for QE on a massive scale (or at least more larger than has been promised to date). Yet another strain of literature questions whether QE has been/can be effective in stimulating faster price inflation in the US and Japan where it has been tried on a large scale. The arguments that imply that QE has not/will not overly stimulate inflation (that it primarily adds to bank reserves that are not being lent out) seem to imply that it simply has not been very effective in doing anything except driving asset prices upwards. Why is it presented as a foregone conclusion that this is a wise strategy (resisted only by the selfishness of Germany) that is necessary to prevent deflation, if it has actually had little impact on inflation at all?

CR:  I don’t expect QE to do much in Europe.  First, we should be clear that banks don’t “lend out” reserves.  Banks lend first and find reserves later if necessary.  The money multiplier is a myth (see here).  So what Europe is basically doing is changing the composition of private sector balance sheets (see my QE primer here) from bonds to deposits/reserves.  I don’t see why this should do anything.  It might alleviate some funding needs at the sovereign needs, but that issue appears to have been solved with the OMT backstop.  So I don’t know why they expect QE to do much.  What Europe really needs is a massive peripheral fiscal program and a reformation of the system via the implementation of a central treasury like the USA has.    QE doesn’t fix the inherent problem in Europe’s monetary system.  

Q:  A question on inflation: What is it that is driving inflation in markets such as Indonesia or Kazakhstan – why is it so much higher than in say Singapore?

CR:  Sorry, but I’d have to learn a lot more about those specific economies before I could express a good opinion.  Sorry.  

Q:  You recently posted 3 macro charts that show a strong US economy. Do you analyse more forward looking indicators? If so, what are they telling you given recent movements in financial markets?

CR:  My general view is that the macro picture in the USA has not changed in recent weeks and that Mister Market was just having an Ebola and Europe scare….

Q:  In a previous Q&A (https://pragcap.com/qa-answers-part-2) you said that the current monetary system has not failed. If the developed world ends up like Japan, unable to escape deflation and implementing perpetual QE, would this constitute failure? If not, what outcome would?

CR:  We’ve been in a period of abnormally high growth for the last 75 years so it’s not surprising that the global economy has slowed some.  But the global economy is still growing at a rate of 4.5% so I don’t think it’s anything to get too worked up over.  And yes, developed economies will continue to lose market share to emerging markets.  That’s just competition at work.  When you’re #1 there’s only one direction to go and that’s lower.  The USA is in relative decline in this regard.   The failure of QE is, in my opinion, totally expected.  It’s not a failure of the monetary system.  It’s a failure of economists and policymakers to understand that fiscal policy is a much more powerful lever than monetary policy.  But we have an establishment of economist who are obsessed with monetary policy and what central banks can do.  So the world suffers.  

Q:  Related to the last question is what can the central bank do to cause real economic activity? Or is monetary policy now impotent?

CR:  Monetary policy isn’t impotent.  It’s just extremely blunt.  Some things they could do: 1)  buy long duration debt; 2) buy non-financial assets; 3) buy muni bonds; 4) buy sovereign bonds.  In the case of the states in the USA or Europe the Central Banks could directly fund govt spending.  In the USA the CB could buy non-financial assets which would be real “money printing”.  Of course, they can’t do this stuff or won’t do it, but it would have a big impact because it is, in essence, fiscal policy.  

Q:  Hypothetical question now: Why can’t an economy have competing private sector Fed-like clearing-houses (similar to the ones used to settle future contracts etc.) instead of one public central bank? Before you answer, just imagine the current global competing currencies but instead of spread out around the world, those currencies were all used within the US with competition eventually leading to the best currency system (essentially introducing FULL market forces to the monetary system). 

CR:  The USA already has a private clearinghouse called CHIPS.  The problem is that a clearinghouse is only as good as the liabilities issued by its members.  So with private clearinghouses you still have private sector solvency issues.  The power of the Central Bank is derived from its relationship with the Treasury whereby it can tax the output of the country.  So reserves are valuable and stable because US output is stable and valuable.  Private clearinghouses will never have this degree of stability or value because they’re inherently fragile entities.  So, in my opinion, Central Banks actually make a lot of sense because they stabilize the payment system that is essential to our economic well-being.  

Q:  How are you currently positioned?

CR:  Seated in an upright position.  Also, long stocks and bonds and Orcam Financial Group.  🙂