Thursday, June 27, 2013

It's The Economy Stupid: Bridgewater on Markets Effects on Economies

This is a really good primer from people who make a really good living figuring out how markets and economies interact.


How good a living?  Well, suffice it to say that Ray Dalio’s net worth is greater than most of the countries on the face of this earth.





June 27th, 2013


To describe the market/economic dynamic that is underway we need to spend a few minutes on



The Mechanics of the Markets and Their Effects on Economies


The Basics:


1) Because all investing is an exchange of a) a lump-sum payment for b) a future cash flow, the price of investment assets is equal to the "present value of the future cash flows". That's a fancy way of valuing those future payments. Money in the future is worth less than money today because money today can earn interest and amount to more money in the future, so the way the "present value" of future payments is determined is by deducting from it that amount of interest. In other words, one "discounts" the value of the future cash flows by using the interest rate. When interest rates decline, present values (i.e., prices) rise because there is less of a discount and when interest rates rise present values fall because the discount is more. In other words, the prices of assets can change without the long-term total returns on the investment changing because the interest rate used to value future payments changes.


2) The amount of the price change is affected by the level of interest rates. That interest rate sensitivity is called the "duration" because it reflects how valuable the later payments are in relation to the sooner payments which is affected by the interest rate. When interest rates are lower the later payments are worth more than they were when the interest rates are higher because the discount is less. For reasons we won't bore you with, the lower the interest rate is, the longer the duration and the more sensitive the present values are to interest rate changes.


3) All investments compete with each other because investors just view them as money making machines - vehicles for converting lump-sum payments now for payments later. When interest rates change that affects the prices of all investment assets in the same way of lowering their present values when interest rates rise and  raising their present values when interest rates fall, all else being equal. However, not all else is always equal. Because the present value depends on both 1) what its estimated future cash flows are and 2) what the interest rate that these cash flows are "discounted" at, sometimes the expected future cash flows change at the same time as the interest rate used to discount them changes, making the relationship less apparent. For example, if prospects for economic growth and earnings pick up, that will cause expected future earnings of equities to rise which might happen at the same time as interest rates rise, so that equities' prices might or might not rise when interest rates rise. In the cases when the future cash flow is known, such as in the case of a Treasury bond, the interest rate-to-price change linkage is clear.


4) The long term returns of investments like bonds and stocks are typically much more known than the short term returns because the prices (Le., the "present values") arising from changes in interest rates cause present values to move around more than changes in the expected future cash flows (Le., the returns over the life of the investment). In other words, increases in prices (Le., the present values) arising from interest rate declines give investors the illusion that they have made more money when they haven't made more money (because they can't make more money by selling their investment because they would get the new, lower returns when they replace that investment). For example, if I buy a 10-year bond that yields 2.5% and it goes up a lot because the interest rate fell a lot, then if I sell the bond to take my profit and reinvest my money at the lower rate, I will still end up with my 2.5% return.  The returns of equities and all other investments that are affected by changes in the discount rate and the prices arising from them behave in the same way.


The headline of this is that expected long term returns are relatively well known, are the most important things for investors to consider, and are paid very little attention to. In other words, for most investors, if their investment does well this year, this month or this day they will be happy even though that return did not give them a better long term return - it just pulled that return forward. Even worse, most investors think a good investment is one that has had a good return rather than thinking that the investment which has had a good return might have become more expensive, so they tend to buy when investments are expensive and sell when they're cheap. If they could only stop looking at short term returns and start looking at prospective long term returns, they would do a lot better.


If you can understand all of that – i.e., that the prices of all investments are affected by changes in the interest rate that is used to discount their future cash flows, and that the lower the interest rate the more sensitive their prices are to interest rate changes - then you can understand the main reason that recent increases in bond yields, which occurred due to the expected tightening of liquidity and without much change in expected growth or inflation, had such a downward price effect on most asset prices.


5) The connection to the economy comes from the fact that price changes of assets have a big effect on what we calculate our "wealth" to be and psychology, which in turn has a big effect on credit growth and economic activity. This also works mechanistically. Think of the financial markets as being like a balloon that expands and contracts with central bank policies which drive the spread between the short term interest rate and the returns of asset classes. When short term interest rates are low and the central bank is "printing money" (Le., adding liquidity to buy financial assets) that puts money into the economy, pushes up prices of financial assets and pushes down prospective returns. In other words when a) the spread between the expected return (especially the yield) of asset prices and the yield on the short term interest rate is large and b) the central bank is adding liquidity to the system, this liquidity and borrowing will be used to buy higher yielding investments, driving their prices higher and their yields lower to be closer to the cash yield. In fact, most financial decisions are made by financial intermediaries trying to grab the spread in investment yields. As a result, the spread between short term interest rate and asset returns is a big driver of the rate at which the balloon is blown up, so it's a big driver of credit growth, asset class returns and economic growth. So, when central bankers want to ease they increase the spread and when they want to tighten they narrow it. On average, in a normal economy, that spread is a couple percent. When it's significantly wider, monetary policy is very easy, whereas when it's negative, a depression occurs. In other words, a depression occurs when a well-diversified portfolio of assets has a lower return than cash, which is when most everyone is losing money, because that produces a negative wealth effect and it hurts psychology, so people are less inclined to borrow and spend.


And because it is the job of central bankers to prevent depressions, they have to make the returns of cash below the returns of a well-diversified portfolio of assets. For a well diversified portfolio like All Weather, the returns reflect that. In other words, a well diversified portfolio of assets will do better than average when the spread between the cost of money and asset yields is wider than normal and will do worse than average when the spread is negative. It will also do worse than normal when a tightening of liquidity causes real interest rates to rise (i.e., the discount rate rises faster than the projected cash flows) causing asset prices to fall at a faster pace than the yield spread contributed to their return.


What Happened and Where We Are Now


As you know from reading our Daily Observations, the decline in Treasury bond yields to essentially a 2% nominal projected return and -0.5% real return occurred because 1) investors piled into bonds and cash to be safe, and 2) the Federal Reserve created cash in order to buy bonds and reverse the deleveraging. Naturally, to the extent that these actions reversed the deleveraging 1) investors holding cash and bonds could be expected to move out of them and into "riskier" assets like stocks, private equity and real estate and 2) the central bank didn't have to create as much cash to buy as many bonds as before, and that, together with bonds offering bad returns, made it likely that bond rates would rise. That began our thinking about what the coming rise in interest rates would mean for the prices of all assets through the discount rate effect.


Before bond yields rose, and when they were lowest, they drove the prices of all investments up because of the discount rate effect. Additionally, money and credit flowed into higher yielding investments as the fears that drove the money into cash and bonds abated and the reaching for return increased. This produced a self-reinforcing spiral because the more these assets rose in price, the more the fears abated and the worse investors felt about holding very low yielding cash and bonds, so the more investors piled into equities, private equity and real estate, which drove down their expected returns, making them, like bonds, less attractive. For example, the projected return for equities fell to only 5-6%.


It was inevitable that liquidity would tighten and interest rates would rise, and that this would hurt all asset prices. While the Fed's policy stance statement contributed to it, the tightening in liquidity would have happened, and that would have raised the discount rate and lowered the prices of other assets anyway. Naturally, as asset prices decline the wealth effect turns negative and borrowing costs rise, particularly in more credit sensitive places like Southern European and emerging countries. In Southern Europe, a rise of interest rates to higher levels in relation to nominal growth rates accompanied by falling asset values will increase the financial squeeze that is already underway. Because this is taking place as economic growth in China is slowing, a number of drivers of growth have turned negative.


While the sell-offs have raised the expected returns a bit to about a 2.5% nominal (and 0.7% real) and about a 5.0% nominal and 3.0% real return for equities, these prospective returns are still poor. By the way, low returns will be true for all asset classes, so it's not like you can escape them by changing your asset mix. Your only question is whether you want your asset mix to be diversified or concentrated. You know our view - that a balanced portfolio of assets like All Weather is optimal.


Since 1) the returns of assets must be kept above the returns of cash or we will have a depression, and since 2) the returns of bonds and stocks will be low unless they continue to sell off which will be bad for the economy, central banks will have to keep short term interest rates low and keep stimulating. That will be especially true in Europe where the ECB will have to find its way of easing (i.e., lowering nominal interest rates relative to nominal growth rates). The more investment asset prices (like stocks and bonds) sell off, the more their prospective returns will rise and the more central banks will move to counter the negative wealth effects by printing money to buy bonds and/or lowering interest rates. For this reason, we continue to expect that the spread between short rates and asset returns will be kept positive and that reversals can be created. In fact, though the Fed just signaled its intention to tighten, it is entirely possible that they will ease first.





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