I was in New York last week, and had the foresight to be in the city on the hottest, most humid day of the summer. I literally swam my way from Central Park down to 48th. When I walked into the lobby of my first meeting someone asked me if I had just finished a run. In my suit. Meanwhile it was 65 degrees in San Francisco.
During this trip I was fortunate enough to talk to several investors – primarily allocators – about their views on markets. I noticed three consistent themes people brought up, and true to my contrarian roots I had issues with all of them.
The first theme I heard a surprising number of times was that Russian equities were incredibly cheap and it was time to move in. The thesis here is that the Ukrainian situation won’t devolve into the hot war many fear (the Malaysian airline incident not withstanding) and that mid-digit PEs and $100+ oil offer an attractive destination for capital, all things considered.
There is no doubt that $100 oil helps the Russian current account. Since the crisis Russia has printed 24 positive quarters with a cumulative surplus of $403 billion. However, Russians sent $412 billion out of the country over the same time period.
Money comes in, money goes out (source: Bloomberg)
One thing I’ve learned in my years as a macro investor is that if the locals won’t invest in their own country, you shouldn’t either. And who can blame them? Russia is no longer the poster child of the BRICs. It’s more like a brick, sinking to the bottom of an ocean of hopes and dreams. Sanctions are coming, the economy has been in the dumps and is getting worse and it’s unclear what owning Russian equity actually means. There is a reason the MICEX trades at a discount to its emerging market peers. And as far as value goes, the 6.1 trailing PE the MICEX is trading at today is a 13% premium to the 5.4 the index traded at in 2011. I don’t think this is value, I think this is a value trap.
GDP approaching zero and equities far from the pre-crisis highs (source: Bloomberg)
The second theme that emerged from my conversations was the idea that the Fed was going to move sooner and faster than the market expected. I’ve written about this before, so my Fed views are well known. However, I have some new ammunition since my last post.
This month we got to pour over the June 2014 Fed minutes. Riveting reading – a real page-turner. But seriously, what caught my attention was the following: “…interest on excess reserves (IOER) should play a central role during the normalization process.” This seems logical, until you look at what’s happening to excess reserves.
Faulkner? Hemmingway? Nope, Fed minutes.
US Banks have been steadily accumulating reserves since the first QE program. At the points where QE has stopped, reserves leveled off but didn’t come down significantly, as banks were able to fund loans from the runoff of their portfolios.
Awash in reserves! (source: Bloomberg)
I took “Money and Banking” as a grad student from my esteemed colleague Dr. Mike Dooley, so I know that reserves are fungible. But here’s something to think about. If the banks aren’t deploying the excess reserves today, what good does paying more on excess reserves really do? The system is not awash with liquidity and without a very high rate (say 3%, which would cost the Fed $75B a year), there would be a negligible impact on marginal lending. Yellen gave us something to watch here. I think reserves need to start coming down before the Fed can tighten. Without that, the tool playing a “central role” in normalization won’t work. And there’s no sign reserves are coming down.
The final theme I encountered was a giddy optimism around how great the trajectory of US data looked. For example, I had an interesting conversation around new home sales, where I was shown data from late 2008 to present. It looked something like the following.
Back to the pre-crisis highs! (source: Bloomberg)
It’s hard to refute that new home sales have made it back to 2008 levels. But go back a little further in history and you get a very different picture.
But still not back to levels in the 1990’s (source: Bloomberg)
There is a large investment bank that has taking a very bullish view on the US recovery. My guess is they are sitting on a lot of short 5-year notes. Every day I get a chart like the first one – on housing, employment, wages – and nearly every time I can counter with a chart like the second one over a longer time period. People see what they want to see, and economists are enablers of this phenomenon. Which leaves me with a great joke to close this blog.
A firm called in a mathematician, an accountant and an economist to determine the mean of a set of data. The firm asked the mathematician what the mean was. “It’s 50,” she said. The firm asked the accountant what the mean was. “It’s 50, plus or minus 10,” he said. The firm asked the economist what the mean was. He looked around, shut the door, leaned in to the questionnaire and said “What do you want it to be?”
There is no doubt the US is recovering, but we’re a long, long way from normal. Even a new normal. Expect low volatility, low rates and a melt-up US equity market. At least until you see bank reserves start to fall.