Thought Bubbles from the Deep

[qldfrog]

Didn't know where else to put this, so thought id post it in this great thread.

Thoughts from the legendary fund manager Ray Dalio, published Aug 25 2015:

theory not wrong;
the central banks have no choice but hyper inflation or country bankrupt
the only way to trigger that is to push the easing to the extreme, so a small tightening in the next week will only be sustainable if the market does handle it well, at the slightest weakness, another QE with limited economic effect
This might end up starting to scare people, and start generating inflation..
interesting

 

[DeepState]

Interesting article from Dalio. I had been trying to secure it through official channels. However, it turns out that there are alternative back channels.

There is too much debt in the world. We have been pulling forward investment and consumption for decades and there is a limit. Who knows where that limit truly is. Dalio's stats (not shown here) compare debt levels and other matters to the Great Depression era. It is hard to say whether that is an appropriate reference point.

In any case, were the point of deleveraging to be here and a secular reduction in real debt burdens is called for the ideal outcome is one where nominal GDP growth exceeds interest costs and inflation remains stable and somewhat positive. This "beautiful deleveraging" (Dalio) has occurred in the last century a few times.

It is quite possible that the Fed's dual mandate of inflation and employment will serve as an adequate guide to achieving these ends. Hence, it is entirely reasonable that the Fed will react to developments in a way which initially tightens (which is what the cyclical components indicate) only to find that this leads to deleveraging, with decreased employment and inflation. This will cause the need to review the tightening bias.

The Fed has previously stated that it intends to keep rates lower than might be usual and for a longer time period even if inflation returns to target and employment levels are towards true full employment levels. It is the dot plots which show Fed expectations with a very hawkish stance. The market does not believe it and has sharply discounted the increased rate path. Yet, the rate path is upwards in contradiction to the Bridgewater view.

I am not convinced that the Fed is fully committed to a tightening path. Under Yellen, it has moved to a data dependent rather than prescriptive method. Further, central banks around the world from Australia, Belarus, Canada, China... have displayed that reversals of courses of action take place as data presents itself. Why should the Fed be any less able to do so? In fact, the Fed is now more dovish with the latest rotation of FOMC voters anyway.

Some observations:
+ Whatever the cause of subsequent economic developments (cyclical upswing or secular deleveraging are in focus), the Fed will react according to the data as it unfolds. It is not on a fixed path;
+ We do not know if the deleveraging point has been reached;
+ There are probably adequate tools in terms of fiscal flexibility, Fed policy flexibility and prudential controls to engineer a beautiful deleveraging....but the margin is tight given the extend of leverage and the way it all cascades;
+ The market is closer to the Bridgewater case than the Fed's case, so the extent of market adjustment which might occur is not as large as might first appear;
+ In the event of an "ugly deleveraging", the best thing to hold is probably cash or bonds with worthy counterparties. Everything else is going to tank it, including commercial and residential property. If it gets really bad, then you are talking Gold, Fine Art, Farmland and weapons to defend them.
+ US mortgages are fixed rate for the most part. Private companies are under levered. The government is being subsidized by the Fed. Systemic risk arising from the US in a direct sense is not so large. Oil shows that there are other issues going on that can impact stuff as well (by the way, the oil price decline is most likely not the result of deleveraging as per Dalio's comments).
+ It is likely the second round impacts might be of greater concern. Capital drain as the carry trade from the US to EM in particular is already resulting in phenomena like the "Suspect Six" (which is the contemporary version of the Fragile Five). Brazil, Mexico etc... are under stress. However, there has been some Bank for International Settlements research recently published which outlines that this debt growth, if in USD denomination (which is the key risk), has been sourced from outside the banking system. Further, there is research which shows that debt borrowed in USD is mostly held in liquid form in the asset side or in USD assets. Each of these reduces the apparent feedback mechanisms from a dislocation.
+ Disorderly inflation financed by cheap money is not what central banks want. This stuff destroys economies. If it were to occur in the kind of world Dalio speaks of, it would be because there was wholesale destruction of productive capacity due to disorderly deleveraging not matched by demand. It would be truly epic to achieve. Interest rates would be kept low to encourage investment and restore production. it is, however, viable that central banks will try to keep inflation higher than normal, but still orderly, to achieve a prolonged period of orderly deleveraging. That's a figure somewhat less than 5% per annum.
+ China is the fulcrum point. Everything rests on what happens here.


Some comments on my positioning:
+ I insure what I cannot hack. I will keep doing so. This has saved a lot of sleep, but not all, from recent runctions.
+ I remain underweight nominal duration and have zero real duration, but would lengthen both at levels below historical levels. This is in recognition of debt burdens being high.
+ I own USD.

 

[tech/a]

So currently very little to no exposure.
More about protection of asset than
Increasing asset.

 

[kid hustlr]

For those who might not have seen it:

https://www.youtube.com/watch?v=PHe0bXAIuk0

 

[DeepState]

So currently very little to no exposure.
More about protection of asset than
Increasing asset.

I see it as increasing the real value of my assets with a survivable pathway along the way. All very easy to punch out stuff like 20% expected rates of return and talk of ultra long term perspectives to ride out 60% falls or step into them. My experience of the actual activity at this time is that this façade disintegrates under such circumstances amongst investors for all but the deepest pockets filled with permanent capital.

The dollar amounts at risk did have me waking up at 4:00am in a sweat for the first time since the GFC. I thought I'd left those days behind. I managed to chill out after checking what the protection had done. Still, I learned a painful and costly lesson in margin management along the way which will lead to a change in trading strategy for indices and FX and all things CFD. So no or little exposure is a concept which does not quite translate to my situation. Position sizes in equities were substantively reduced in early July, which looked stupid for a while when the markets rebounded, and now looks pretty smart. The truth is somewhere in between.

 

[fiftyeight]

For those who might not have seen it:

https://www.youtube.com/watch?v=PHe0bXAIuk0

Awesome, cheers Kid

 

[sinner]

For those who might not have seen it:

https://www.youtube.com/watch?v=PHe0bXAIuk0

I think that while the video was fun to watch, simplifying things into a 30minute edutainment clip makes it impossible to cover the really important points, and it is pretty obvious that Dalio subscribes to the mainstream MMT thinking - which IMHO makes him completely wrong, can't build a good house on poor foundations.

I think FOFOA does a much better job of explaining things, of course you will have to read a lot more words.

http://fofoa.blogspot.com.au/2011/03/reference-point-revolution.html
http://fofoa.blogspot.com.au/2011/11/moneyness.html
http://fofoa.blogspot.com.au/2012/11/moneyness-2-money-is-credit.html

EDIT:
Turns out there is a video, but it's basically just an audio transcription of the a post called "Freegold Foundations"
https://www.youtube.com/watch?v=IKPRJKG9o4w

http://fofoa.blogspot.com.au/2011/01/freegold-foundations.html

 

[DeepState]

Been spending the last few days shifting a few things around. It has been an opportunity to consider prospective investment returns. It may seem obvious, but when I re-do the calculations it is very stark that an after tax return in excess of inflation at current yields is a very tough thing to achieve. (Developed market) Equities, at best, are expected to return something like 7% per annum pre tax. Any tail-winds from a strong AUD with respect to overseas assets are diminished.

It means that, relative to more normal times, the amount of money you can spend in real terms is so much lower than it had been. For example, if you had $1m and inflation was fixed at 2.5%, if you think you would have earned 4.5% per annum after tax in the past, then you can spend about $20k pa in real terms in perpetuity. Today, that figure is perhaps closer to 3.5% per annum (for moderate weights to equities). In other words, you can only sustainably spend $10k pa.

For those whose investment income is the primary source of revenue, how have you adjusted your positions or expenditure to allow for the fact that real returns have come down so much?

 

[tech/a]

Fortunately my own solution in my own circumstances for excess funds is to
buy a heap of new equipment and expand market share----generating higher than the returns you mention.
Pretax average Nett Profit in our industry is 7-12% of which we are achieving above average 15-20%

Return for bulk spare $$s is better handled in my own company.
I cant think of a better Super/Pension plan than a profitable company I don't have to
report to 9 to 5.

For those not in my position it is difficult as you point out.

 

[DeepState]

Fortunately my own solution in my own circumstances for excess funds is to
buy a heap of new equipment and expand market share----generating higher than the returns you mention.
Pretax average Nett Profit in our industry is 7-12% of which we are achieving above average 15-20%

Return for bulk spare $$s is better handled in my own company.
I cant think of a better Super/Pension plan than a profitable company I don't have to
report to 9 to 5.

For those not in my position it is difficult as you point out.

Pre-tax net (assuming you've included a fair salary for effort in that figure in any case rather than tax optimized figures) matters less than the return you are making on capital deployed for this purpose. You can have 50% net and still make terrible returns on capital, for example. Particularly so on capital intensive businesses. What matters, at least in this instance, is the return on capital deployed.

As an investor, I own thousands of companies which are profitable and I don't report to at all. I have to agree, it's pretty sweet. But, right now, the price for that profit is such that you can spend less than might have been possible previously.

 

[tech/a]

Pre-tax net (assuming you've included a fair salary for effort in that figure in any case rather than tax optimized figures) matters less than the return you are making on capital deployed for this purpose.

Yes of course

You can have 50% net and still make terrible returns on capital, for example. Particularly so on capital intensive businesses. What matters, at least in this instance, is the return on capital deployed.

Yes
In this case its 2 more excavators.
Cost / Month in raw terms $400K (initial outlay) operator cost $35/hr.
If We use a 5 yr base for the raw calc Works out at around $16/hr---to re coup the $400K.
They are flat out for 45 hrs a week at $150/hrs. Stick an attachment on it like a pylon rig or rock breaker and that goes to $250/hr.---each

Bulk here----play money in the market for me.
We both draw our wage as directors (Head of finance and myself.) week in week out no matter where we are. Working or not.

As an investor, I own thousands of companies which are profitable and I don't report to at all. I have to agree, it's pretty sweet. But, right now, the price for that profit is such that you can spend less than might have been possible previously.

Thousands! Wow.

 

[kid hustlr]

DS,

I find your comments interesting (and I agree with them) given the context of an ASX200 share market paying circa 4.5% a year (plus franking) in dividends.

I've not got figures on this but my instinct tells me this would be historically quite a high number.

Are companies paying out a higher portion of profits in dividends these days? Do they not have anything better do to with the cash?

 

[shouldaindex]

Just an example of a hypothetical model:

11 ROE
14 PE
66% Payout Ratio
2.5% Inflation
30% Tax Rate

----------
3.5% Capital Gain
4.5% Dividend
2% Franking
10% Total Returns

----------
-2.5% Tax
-2.5% Inflation

----------
5% Post-Tax Real Returns

 

[DeepState]

DS,

I find your comments interesting (and I agree with them) given the context of an ASX200 share market paying circa 4.5% a year (plus franking) in dividends.

I've not got figures on this but my instinct tells me this would be historically quite a high number.

Are companies paying out a higher portion of profits in dividends these days? Do they not have anything better do to with the cash?

Your suspicion appears correct.

Payout ratios have increased despite cashflow per share not doing anything since pre GFC periods. As a result, dividend yields are higher. I suspect that part of this arises due to compositional changes in the market as well (decline of resources in favour of financials).

 

[DeepState]

Thousands! Wow.

Via a handful of very vanilla ETFs....yawn.

 

[tech/a]

EFT's generally invoke ---yawn----yawn

 

[qldfrog]

nice fall in Wall Street, rebound as expected has been quite short, find harder to justify the strength of the AUD vs US
I would have expected an actual worsening, even in front of a falling USD vs Euro etc

 

[sydboy007]

nice fall in Wall Street, rebound as expected has been quite short, find harder to justify the strength of the AUD vs US
I would have expected an actual worsening, even in front of a falling USD vs Euro etc

I was expecting a short term bounce in the AUD if the Fed held.

ont be sad if we get up another cent or so. Top up on the USD ETF for the eventual fall.

Could also be biased as I've got a trip to LOTFAP in a month, but I did buy plenty of $$$ when the AUD was much closer to parity.

 

[sydboy007]

DS,

I find your comments interesting (and I agree with them) given the context of an ASX200 share market paying circa 4.5% a year (plus franking) in dividends.

I've not got figures on this but my instinct tells me this would be historically quite a high number.

Are companies paying out a higher portion of profits in dividends these days? Do they not have anything better do to with the cash?

Definitely churning the cash out instead of investing. Share buybacks have underpinned the higher PEs, not only here but USA especially.

Banks are hitting aroun 70% payout ratio which annoys me. APRA should be forcing them to use the good times to increase their buffers since all the majors are in the bottom half of their global peers when you look at the non weighted leverage ratio. The CET1 ratio will likely be discarded during the next crisis, just as it was durign the GFC. The banks had their risk weighting for home loans as low as 16 but have been forced to move it back towards 25%, though in the past it has been as high as 50%.

Another headwind for the banks will be NSFR (Net Stable Funding Ration) that's still being developed. According to the Reserve Bank of Australia, short-term debt currently comprises about 20 per cent of bank funding, with about 60 per cent of that coming from offshore markets. That is the very type of funding that the financial system inquiry chaired by David Murray said was the most risky, because it could disappear in a crisis. Banks haven't reduced their reliance on this kind of short term funding since the GFC.

It will be interesting to see how the Turnbull Govt handles this issue as the banks will argue they can get 1 year paper at 26 bps + bbsw but 5 year is 90 bps + bbsw and will do their best to scare those in debt they'll face higher interest costs.

I think another issue, which some commentators are ignoring, is that the falls in share prices for some companies, especially in the resource sector, make them look like dividend darlings, but it's quite likely that the ability to continue to pay at current dividend levels will be hampered. The free cash flow for RIO / BHP / STO / ORG etc are becoming very strained, with the likelihood of further falls in most commodities.

 

[shouldaindex]

Good points on all that. My core is in vanilla ETFs as well, so I don't do too much individual company analysis. But looking at the top 14 companies that make up 50% of the All Ords.

Banks - CBA, WBC, NAB, ANZ
Commodities - BHP, RIO, WPL
Supermarkets - WES, WOW
Property - SCG, WFD
Investment - MQG
Telecom - TLS
Health - CSL

You can achieve 5% capital growth through a combination of - Either paying fair value and the companies grow at 5%. Or as may be the case in a low growth environment, pay enough of a discount that getting back to fair value achieves 5% growth in SP. I suspect the medium term will require the latter.