by Asset Allocation Committee

We originally published the comments below in our Daily Comment on July 27.  However, we have received a number of questions on the widening of the TED spread and the rise in LIBOR to warrant updating the report for this week’s Asset Allocation Weekly.

There has been some curious behavior in the LIBOR markets recently.  Although expectations of Fed tightening are benign, LIBOR rates have been ticking up.

(Source: Bloomberg)

This chart shows three-month USD LIBOR.  Note that over the past month, the rate has moved up around nearly 20 bps.  Usually, such moves occur for one of the following reasons: (a) the Fed is raising rates, or (b) there is a systematic financial system problem developing, leading investors to flee the LIBOR market for sovereigns.  The second case is one of the reasons for monitoring the TED (T-bills vs. Eurodollar) spreads.

The TED spread has been rising and is near levels seen during the last Eurozone crisis.  Although this increase warrants watching, putting the recent rise in context does suggest that this move, thus far, isn’t a signal of a major problem brewing.

(Source: Bloomberg)

Just compare the above chart to the long-term TED.

(Source: Bloomberg)

Note how LIBOR rates spiked in 2008 and were “spikey” from mid-2007 through 2008.  That is a more classic example of the flight to safety element of the TED spread.  We are not seeing that now.

So, why the rise in rates?  It’s entirely due to regulations on money market funds (MMFs).  On October 14, prime money market funds will see their statutory maximum weighted average maturity fall from 90 to 60 days.  In addition, institutional MMFs will be forced to institute a floating NAV and can put up “gates” to slow withdrawals during crises.  We are already seeing the impact.

Assets in prime MMFs have declined about $500 bn and government funds have risen by about the same amount since December.  Prime MMFs now represent 35% of total MMFs, down from 53% last October.  The total assets in MMFs are about the same but the allocation has shifted from prime to government MMFs, which don’t face the same restrictions.  We expect further shifts as investors begin to realize that a prime MMF isn’t “cash.”

Here are some potential market effects:

The dollar could rise.  The rise in USD LIBOR hasn’t been matched by a similar rise in EUR LIBOR.  All else held equal, the higher yield should support dollar buying.

Commercial paper markets will be adversely affected.  Prime MMFs buy commercial paper.  As funds shift to government funds, the money available to buy commercial paper will decline, boosting funding costs to commercial paper issuers.

A secular change in the TED spread is likely.  In general, investors discount the odds of a problem in the financial markets when they buy LIBOR-based paper.  With the rules on prime MMFs changing, the risk calculation will change, which should permanently shift the spread wider.  It is important for investors to realize that the TED isn’t necessarily signaling a financial system problem during this reset.

The rise in LIBOR and the dollar could be a bearish factor for commodities.  If the regulatory change acts as a de facto monetary policy tightening and isn’t offset by the Fed, we may see some weakness develop in commodities.  The primary driver of this will be the dollar.

Overall, investors will need to consult with their MMF providers and their financial advisors to determine which MMF is appropriate for them.  The issue really is what the function of the MMF is in the portfolio; if it is truly cash, then the government funds might be preferred.  If it is for yield, then one needs to realize that a prime MMF will likely lose its cash-like characteristics during financial crises and one could find that there will be a delay in tapping a prime MMF if financial conditions deteriorate.  Although retail investors in prime MMFs should not “break the buck,” that may not provide much comfort as the potential restrictions on withdrawals remain in place.

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by Asset Allocation Committee

Last week’s GDP data for Q2 came in below expectations, rising 1.2%.  Consumption was robust, accounting for 2.8% of GDP growth, but investment reduced growth by 1.7% and government peeled 0.2% from output.  Net exports added 0.2% to GDP, but we would not be surprised to see the sector revised downward due to the strength of consumption.  The drop in investment was mostly due to falling inventories, accounting for 1.2% of the 1.7% investment report.  Still, investment remains very disappointing.

This chart shows the three-year average of the contribution to GDP from the four major components of the report.  Government and net exports have been mostly a wash.  Consumption is finally improving, although it still remains well below levels seen in previous expansions.  However, the drop in investment is becoming alarming.  As we have shown in the past, businesses are reducing their savings but are spending the funds on mergers, dividends and share buybacks.  New investment has been rare.

Perhaps the most disturbing part of the report is the growing evidence that the economy “has fallen and can’t get up.”

This chart shows the yearly change in annual real GDP averaged over a decade.  The original data begins in 1901.  About 72% of the time, the trend in GDP growth ranges between 2.0% and 4.5%.  The current period of eight consecutive years of sub-2.0% growth is matched in duration only by the Great Depression.  Although the drop in growth in the 1930s was clearly deeper, the rebound was much stronger as well.  Currently, GDP is weak and showing no signs of improvement.

This chart, though simple, makes a strong case that the economy is in a state of secular stagnation.  Thankfully, the economy isn’t suffering from the terrible policy mistakes of the 1930s.  The Federal government’s fiscal stance isn’t nearly as tight and the FOMC has been much more accommodative than in the Depression years.

First, monetary policy has been more accommodative and reacted quicker to the downturn.

This chart shows three-month T-bill rates during the Depression.  Note that interest rates rose sharply in 1931 and 1933.  Even in 1936-37, the Fed allowed for a modest increase in rates that were part of an “echo” recession from the Great Depression.

Second, the path of fiscal policy was significantly different during the 1930s.

The Obama administration’s fiscal package in 2008-10 was larger than the Hoover-Roosevelt budget deficits.  It is widely held that Roosevelt’s decision to balance the fiscal budget after winning reelection in 1936 triggered the 1937-38 recession.  So far, we haven’t seen such dramatic fiscal retrenchment, and, given the tone of the current election campaign, we would not expect austerity in the future.

However, a key difference to the recovery after the Great Depression was the massive fiscal spending related to the war effort.  It is unknown whether the economy would have been able to return to the 2.0% to 4.0% growth range without the war spending.  It may be the case that a major boost in fiscal spending could be the cure for current slow growth.  However, it should also be acknowledged that (a) it is highly unlikely that a peacetime fiscal spending package could be as large as what was seen in the 1940s, and (b) the war, by design, deglobalized world trade.  A massive fiscal expansion in a globalized world would see much of the potential growth siphoned off to imports.  Only if all the G-20 nations agreed to similar packages could that problem be avoided, and that degree of cooperation is unlikely.

Thus, we expect growth to remain slow and policy accommodation to remain in place.  It makes little sense to normalize monetary or fiscal policy in such a slow growth regime.

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by Asset Allocation Committee

In the most recent rebalance of our Asset Allocation portfolios, we maintained an allocation to emerging market equities in the Aggressive Growth portfolio.  As we have noted in the past, there is a positive relationship between the dollar’s exchange rate and the relative performance of developed market equities and emerging market equities.

This chart shows the relative performance of the S&P 500 and the MSCI emerging market index (denominated in dollars).  A rising blue line on the chart signals stronger S&P performance relative to emerging markets and vice versa.  Using the JPM dollar index, we note the dollar bottomed in late 2011.  As the dollar appreciated, the S&P began to consistently outperform emerging markets.

The most important factor boosting the dollar was monetary policy divergence.  The Federal Reserve ended its balance sheet expansion in December 2014.  It raised its policy rate in December 2015.  This tightening occurred while the European Central Bank (ECB) and the Bank of Japan (BOJ) both continued to implement aggressively accommodative policies.  The dollar’s strength clearly accelerated in the 2014-15 period, although the rally has stalled this year.  We believe the stall has occurred because of uncertainty surrounding U.S. monetary policy.  Initially, the FOMC signaled four rate hikes this year.  Currently, fed funds futures are suggesting no rate hikes this year and perhaps only one hike next year.  If this does become the path of policy, the dollar bull market may be coming to a close unless the ECB and BOJ become even more aggressive in policy easing.  If we are reaching the point where further accommodation isn’t possible, a stronger dollar is less likely and thus, emerging market equities become attractive given their recent relative weakness.

However, due to the uncertainty over the direction of policy, as noted above, the asset allocation committee has judged emerging market equities as only appropriate for aggressive investors.  If the FOMC tightens policy sooner or to a greater degree than expected, developed markets could begin to sharply outperform emerging markets again.  Given that market expectations are leaning heavily toward steady Fed policy, there is the potential for a bearish surprise for the emerging equity sector.  Thus, in our judgement, only the most risk tolerant investors should be considering emerging market equities at this time.

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by Asset Allocation Committee

In the most recent rebalance of our Asset Allocation portfolios, we introduced positions in gold.  Although the yellow metal is classified as a commodity, we view it more as a currency, admittedly one that is not backed by liabilities.  National fiat currencies are generally created in the credit process and are backed by the trust imbedded in the nation’s debt.  Currencies have three roles: medium of exchange, unit of account and store of value.  Gold does not act as a medium of exchange in a modern economy.  But, it can be used as a unit of account and it mostly excels as a store of value.

Because it isn’t liability backed, the opportunity cost of holding gold is essentially equivalent to inflation-adjusted interest rates.  If one holds gold in lieu of short-term debt, the lost opportunity is the interest earned after inflation.  History does suggest that there is an inverse correlation between real interest rates and gold.

This chart shows real T-bill rates and the price of gold.  Note that gold prices have increased as real rates have become persistently negative.

The other factor that affects gold is the dollar.  Since gold is priced in dollars, a rising greenback makes gold prices more expensive to foreign buyers.  Since a stronger dollar is often associated with rising U.S. interest rates, a stronger dollar tends to be bearish for gold.

This chart shows gold prices and the JPM real effective dollar index.  Note that since 2000, the dollar’s swings have affected gold prices.  In fact, since 2000, the correlation is -87%.

Since inflation, interest rates and exchange rates affect gold prices, we have created a model of the relationship.

The model uses the EUR/USD exchange rate, inflation adjusted two-year T-note yields and the balance sheets of the European Central Bank (ECB) and the Federal Reserve.  Including the latter two variables generally accounts for investor expectations of future inflation and interest rates.  The current fair value for gold, based on this model, is $1,489.26, suggesting that current prices, though elevated, are not overvalued.

Finally, investors have been putting money into gold through exchange-traded products.

This chart looks at the metric tons of gold held by ETFs, ETNs and grantor trusts compared to the price of gold.  As one would expect, the two are closely linked, correlating at nearly 95%.  Since the beginning of the year, investors have been increasing their exposure to gold through these products.  With the FOMC on hold and additional policy stimulus expected due to Brexit, investors are seeking the safety of gold.

Due to our view that gold is attractively valued and that conditions should favor the yellow metal, as noted above, we added gold to our allocations this quarter.  We expect that conditions should favor gold in the upcoming quarters.

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