​Wounded Heart

Joseph Schumpeter, the originator of the phrase “creative destruction,” authored a less well-known corollary at some point in the 1930s. “Profit,” he wrote, “is temporary by nature: It will vanish in the subsequent process of competition and adaptation.” And so it has, certainly at the micro level for which his remark was obviously intended. Once proud, seemingly indestructible capitalistic giants have seen their profits fall short of “everlasting” and exhibited a far more ephemeral character. Kodak, Sears, Barnes & Noble, AOL and countless others have been “competed” to near oblivion by advancing technology, more focused management, or evolving business models that had better ideas more “adaptable” to a new age.

Yet capitalism at a macro level must inherently be different than the micro individual businesses which comprise it. Profits in total cannot be temporary or competed away if capitalism as we know it is to survive. Granted, the profit share of annual GDP can increase or decrease over time in its ongoing battle with labor and government for market share. But capitalism without profits is like a beating heart without blood. Not only is it profit’s role to stimulate and rationally distribute new investment (blood) to the economic body, but the profit heart in turn must be fed in order to survive.

And just as profits are critical to the longevity of our capitalistic real economy so too is return or “carry” critical to our financial markets. Without the assumption of “carry,” or return over and above the fixed, if mercurial, yield on an economy’s policy rate (fed funds), then investors would be unwilling to risk financial capital and a capitalistic economy would die for lack of oxygen. The carry or return I speak to is most commonly assumed to be a credit or an equity risk “premium” involving some potential amount of gain or loss to an investor’s principal. Corporate and high yield bonds, stocks, private equity and emerging market investments are financial assets that immediately come to mind. If the “carry” or potential return on these asset classes were no more than the 25 basis points offered by today’s fed funds rate, then who would take the chance? Additionally, however, “carry” on an investor’s bond portfolio can be earned by extending duration and holding longer maturities. It can be collected by selling volatility via an asset’s optionality, or it can be earned by sacrificing liquidity and earning what is known as a liquidity premium. There are numerous ways then to earn “carry,” the combination of which for an entire market of investable assets constitutes a good portion of its “beta” or return relative to the “risk free” rate, all of which may be at risk due to artificial pricing.

This “carry” constitutes the beating heart of our financial markets and ultimately our real economy as well, since profits on paper assets are inextricably linked to profits in the real economy, which are inextricably linked to investment and employment. Without these, the wounded heart dies and shortly thereafter the body. But there comes a point when no matter how much blood is being pumped through the system as it is now, with zero-based policy rates and global quantitative easing programs, that the blood itself may become anemic, oxygen-starved, or even leukemic, with white blood cells destroying more productive red cell counterparts. Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions. Let me shift from the metaphorical to the specific to make my case.

If “carry” is the oxygen that feeds financial assets then it is clear to all – even to central banks with historical models – that there is a lot less of it now than there used to be. In the bond market – interest rates, risk spreads, volatility and liquidity premiums are all significantly less than they were five years ago during the financial crisis and, in many cases, less than they have ever been in history. Before 2009, the U.S. had never had a policy rate so low, and in the U.K. short-term rates at 50 basis points are now nearly 2% lower than they have ever been, which is a long, long time. Throughout periodic depressions, the Bank of England in the 20^th, 19^th and even 18^th century never dropped short rates below 2%. Add to that of course the New Age chemotherapy called Quantitative Easing (QE) being employed everywhere (and now in double doses at the Bank of Japan,) and you have an “all in”, “whatever it takes” mentality that has successfully lowered longer-term interest rates, risk spreads, volatility and risk premiums to similar extremes. Granted, the astute observer might counter that corporate and high yield risk “spreads” have historically been lower – and they were in 2006/2007 – but never have corporate and high yield bond “yields” been lower. Never has your average B/BB company been able to issue debt at well below 5% and never – which is my point – never have investors received less for the risk they are taking. “Never (as I tweeted recently) have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.”

In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.

Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.

In addition, there are several other important coagulants that seem to block the financial system’s arteries at zero-bound interest rates and unacceptably narrow “carry” spreads:

1. Zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth.
   
   
2. Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of “carry” compression, and then nationwide retail branches previously serving as depository magnets are closed one by one. In the U.K. for instance, Britain’s four biggest banks will have eliminated 189,000 jobs by the end of this year compared to peak staffing levels, reports Bloomberg News. Investment banking, insurance, indeed the entire financial industry is now similarly threatened, which is leading to layoffs and the obsolescence of real estate office structures as well which housed a surfeit of employees.
   
   
3. Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living. Schumpeter would be shocked at this perversion of capitalism, which is allowing profits to be more than “temporary” at zombie institutions. Real growth is stunted in the process.
   
   
4. When ROIs or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment. This idea is far too complicated for an Investment Outlook footnote – it deserves expansion in future editions – but in the meantime, look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks. Apple is not unique as shown in Chart 1. Western corporations seem focused more on returning capital as opposed to investing it. Low ROIs fostered by central bank policies in financial markets seem to have increasingly negative influences on investment and real growth.
   

   
5. Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury “repo.” Again, too complicated for a sidebar Investment Outlook discussion, but the ability of private credit markets to deliver oxygen to the real economy is being hampered because most new Treasuries wind up in the dungeon of the Fed’s balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth. I have previously suggested that the Fed (and other central banks) are where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy.

Well, there is my still incomplete thesis which when summed up would be this: Low yields, low carry, future low expected returns have increasingly negative effects on the real economy. Granted, Chairman Bernanke has frequently admitted as much but cites the hopeful conclusion that once real growth has been restored to “old normal”, then the financial markets can return to those historical levels of yields, carry, volatility and liquidity premiums that investors yearn for. Sacrifice now, he lectures investors, in order to prosper later. Well it’s been five years Mr. Chairman and the real economy has not once over a 12-month period of time grown faster than 2.5%. Perhaps, in addition to a fiscally confused Washington, it’s your policies that may be now part of the problem rather than the solution. Perhaps the beating heart is pumping anemic, even destructively leukemic blood through the system. Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution. Perhaps when yields, carry and expected returns on financial and real assets become so low, then risk-taking investors turn inward and more conservative as opposed to outward and more risk seeking. Perhaps financial markets and real economic growth are more at risk than your calm demeanor would convey.

Wounded heart you cannot save … you from yourself. More and more debt cannot cure a debt crisis unless it generates real growth. Your beating heart is now arrhythmic and pumping deoxygenated blood. Investors should look for a pacemaker to follow a less risky, lower returning, but more life sustaining path.

The Wounded Heart Speed Read

1. Financial markets require “carry” to pump oxygen to the real economy.
2. Carry is compressed – yields, spreads and volatility are near or at historical lows.
3. The Fed’s QE plan assumes higher asset prices will revigorate growth.
4. It doesn’t seem to be working.
5. Reduce risk/carry related assets.

William H. Gross
Managing Director