After several years of market
swings, at times it can seem that searching for a safe haven investment might
be the best choice. Managed accounts, such as many mutual funds, often with
highly regarded firms and prominent names, failed to move to avert or minimize losses
during the market downturn of 2008, and the sell-off of 2009. Even Money Market
funds were not immune from failure, as dramatically shown with the Reserve
Primary Fund “Breaking the Buck”. Money market funds seek to return a
minimum net asset value of $1 for every $1 invested. In the 37 year history of
such funds, only three funds ever broke the buck. The Reserve Primary
Fund invested in asset backed commercial paper and U.S. Treasuries, though some
of that asset backed commercial paper was issued by Lehman Brothers. When
Lehman Brothers filed for bankruptcy on 15 September 2008, the Reserve Primary
Fund had to write-down the debt owed by Lehman Brothers. This caused the fund
to drop to 0.97¢ breaking the buck, forcing the fund to close. To this
day, despite the Securities and Exchange Commission filing charges against the
managers of that fund, former investors in the Reserve Primary Fund are still
awaiting some form of compensation payment.
Since that supposedly Safe Haven
investment downfall, the U.S. Treasury created an Exchange Stabilization Fund
(ESF) as a form of insurance for Money Market Funds. Investors who have funds
in a Money Market account are encouraged to see whether or not their Money
Market holdings fall under this protection. The events in late September 2008
and early 2009 led to a short run on some money market funds, as investors
sought to withdraw their holdings. Most money market funds at the time
liquidated their commercial paper holdings in order to pay redemptions.
Commercial paper loans have been used by many businesses and corporations to
finance short term activity, often with new commercial paper being issued to
partially pay previously issued commercial paper, rolling over short term debt.
Since money market funds were the largest investors in commercial paper loans,
the sudden increase in redemption demands caused a lock-up of the commercial
paper financial market. Companies unable to roll over debt, and short on cash
to pay maturing debt, found themselves in a severe liquidity crunch, unable to
find short term funding at any reasonable rate.
During that time, and still to this
year, Money Market Funds moved more towards purchasing U.S. Treasuries. The
demand for U.S. Treasuries is still so high that the yield is now quite low. A
look at the most issued note, the 10 year U.S. Treasury, indicates the yield
has fallen to under 2% and recently less than 1.6%. If the value of the U.S.
Dollar (USD) falls more relative to other currencies over the next ten years,
then the real return would be negative. While U.S. Treasuries may seem a safe
haven in uncertain times, the Federal Reserve through Operation Twist is
complicating the ability to gain a positive return over time. The real return on
Treasuries is now lower than the rate of inflation.
Operation Twist involves buying long
dated Treasuries and selling short dated Treasuries, with the hoped affect of
lowering long term interest rates, while raising short term interest rates.
Buying more Treasuries lowers the yield, effectively reducing the interest paid
over time. With the Fed Funds Rate now at 0.00% to 0.25% through at least 2014,
selling more short term Treasuries should lower the price, which should
increase short term yields. Unfortunately with Quantitative Easing 1 and 2 (QE1
and QE2), the Federal Reserve already bought short term Treasuries, which gave
them an excess supply. The market knows this all too well, so the intended affect is not working, making the yield on
2 year Treasuries near 0%. Operation Twist was recently extended until the end
of 2012, making U.S. Treasuries much less appealing investments.
Some considered QE1 and QE2 as money
printing, and indeed there was an increase in money supply, but only a
portion of it. Under our fractional-reserve system, when banks issue loans, new
sums of money are created. Recall that the short term loan market essentially
dried up, so when QE1 and QE2 were initiated, the affect was barely felt in
markets. The USD should have been devalued by the actions of the Fed, yet the
efforts of QE1 and QE2 barely changed the value. There was a more direct affect
of exchange rates, as large investors sought returns in other countries. Demand
for German Bunds, or other sovereign investments in Europe, created a demand
for Euros (EUR) for a time, which lowered the value of the dollar (USD). Now
with growing troubles in Europe, and politicians dragging their feet on
creating real solutions, the demand is shifting the other direction, and the
USD is gaining in strength. In the near term we may see the EUR drop more
against the USD, possibly under 1.20. This can present a buying opportunity for
investors wishing to initiate investments in large international corporations
who happen to be headquartered in Europe. In the longer run, over the next
several years, Europe will eventually solve some of their current issues, and
nimble companies there will learn how to work around the feet-dragging to
generate revenues.
We may indeed see QE3 and some form
of that from the European Central Bank, though I think long term investors
should not consider these possibilities with a high degree of certainty. The
issue behind loose monetary policy is that eventually the excess money
printing will need to be recovered, and the few tests we have seen of how
that will be accomplished have not looked very promising. Ideally the rate of
inflation would match the rates of population growth, so that the economy could
expand at the rate that ensures price stability. History has proven that this
has not been precise, and as we saw in the last bubble, central banks can get
policies completely wrong, which prompts a reset of the economy. Places with
slow population growth, or low immigration rates limiting population growth,
have shown low economic growth over long periods of time. Japan has been locked
in a slow growth cycle for over a decade, and is now facing deflation, despite
numerous efforts by their central bank to loosen monetary policy. The United
Stated and Europe should not ignore the policy decisions of Japan, or they will
be more likely to repeat them. The result of these policies is that we now see
more growth in emerging economies than in developed economies. This is likely
to continue for quite some time into the future.
When we look at investment opportunities in emerging
economies, we sometimes find what seems to be higher risk, through geopolitical
uncertainty, and at times due to a lack of currency stability. People in
emerging economies tend to want better food, and there is a need for more energy resources and raw materials. Sustainable growth can
run for long periods of time, if governments remain somewhat stable and do well
managing their resources. China and India have become great consumers of raw
materials as they build infrastructure and become more urbanized. The places in
the world that supply the energy and raw materials that allow China and India
to grow at a fast pace, helps drive the economies where the oil, natural gas,
and raw materials are located. Australia has a booming mining industry, which exports
large amounts of iron ore and coal, mostly to China. This demand has driven the
Australian economy and caused the Australian Dollar (AUD) to strengthen against
other currencies. Brazil, with large mining resources and oil, is also
experiencing a strong export driven economy. Chile, with some of the world's
largest reserves of copper, and rich in easy to access lithium reserves, has
started to grow at a faster pace, somewhat helped by a more stable government.
Chile also holds large reserves of minerals useful for fertilizing crops,
though they are somewhat matched by a more stable Canada in that regard. Much
of South America is experiencing expansion, mechanization, and modernizing of
farm lands, with exports of food and grains generating increasing revenues.
Short of creating more bubbles in their economies, the United States and Europe
are unlikely to see the growth that emerging economies are now enjoying.
There are also frontier economies, and some large
multi-national corporations are setting up in those countries, with the hope
that they will become the next emerging economies. Over the last few years I
have watched a great increase in oil and natural gas exploration in west
Africa, and greater mining activity in other inland areas of Africa. Many of
these places are not completely stable, nor do they have established central
monetary policy to create long term sustainable economies. These places are
much higher risk as direct investments, though it is possible to lessen the
geopolitical risk through investments in corporations now working to develop
these areas. Offshore oil is probably the best example of that, as Middle East
tensions are causing many of the oil majors to look at developing resources in
other locations. Since oil is priced in USD in most of the world, the financial
stability of local economies can have a negligible affect on operating in those
parts of the world. Offshore oil development is a highly specialized realm, and
difficult for emerging economies to operate on their own. Even Brazil, an
emerging economy with a long history of oil production and exploration, still
need outside technology and companies to provide the most profitable and
efficient production.
Over a long investing time period,
in an actively managed portfolio, we can look at macro-economic trends around
the world, and position our investments to capitalize on future areas of
growth. When calculating risk, we need to be flexible, and have some of our
assets positioned for more stable and predictable returns. Maintaining a cash
position is important for some of that flexibility, and that can be in money
market funds, bond funds, or Treasuries. Since we know the Federal Reserve will
continue Operation Twist through the end of 2012, direct investments in
Treasuries are unlikely to provide good returns for now, though if we look at
funds that buy Treasuries, we can be more flexible moving money in or out of
those funds. With the establishment of the ESF to back money market funds, most
of those are also a good choice to park cash. In our investments, it may be
tempting to jump onto shares of the latest company to make the news, but a
longer term investment plan, backed by research into companies with good future
growth prospects, may provide better long term returns.
We would be lucky to get in at the
bottom of the market, or take profits at the top of the market, so making a
choice of the size of a holding, and buying near a low point, should be easier
to attain goals than trying to hit exact high or low levels. One thing that can
help longer term investors is to acquire shares of companies that pay solid
dividends. At the moment companies that pay more than 2% dividend yield are
outperforming 10 year Treasuries, while some companies are generating more than
4% annual dividend yields. There are other investments outside of bonds and
equities that pay fixed returns, and may be a good choice in diversified
portfolios. Given the recent bankruptcies in Jefferson County, Alabama, and
Stockton, California, I suggest avoiding small municipal bond investments. Even
the debt of some countries should not be considered as a safe haven, nor risk
free, as witnessed in the forced write-down of over 75% of Greek debt. Moving
some investments to fixed return provides one source of revenues that are
easier to plan over time than simply relying upon profit taking from stocks.
In future articles in this newsletter, we will look more
in depth at some of the macro-economic trends identified in this article.
Investing is never without risk, so readers are encouraged to do their own
research, check many sources of information, and determine the path of their
investments. We hope the information we provide will be a launching point for
that research, and point you towards the path of being an informed and
successful investor.
