Here’s the investment dilemma of the day: if financial markets have already priced in several trillion dollars worth of quantitative easing from around the world, where can markets realistically go from here?
Stocks, bonds, commodities…all of them have raced higher in September, anticipating more free money from the Fed, the Bank of England, the Bank of Japan, and the European Central Bank. One interesting note from America is that bond fund assets of $2.6 trillion are now nearly equal to the assets of diversified equity funds assets of $3 trillion.
This is worth having a look at because it tells you of a shift in attitudes toward risk (or perceived risk). And to put the shift to bond funds in perspective, Morgan Stanley says more money flowed into bond funds in the last 12 months ($412 billion) than flowed into equity funds in the 12 months leading to the 2000 dot.com tech bubble high ($340 billion).
One obvious to today’s opening question, then , is: higher! That is, if all the folks who’ve been pouring money into bonds funds (and emerging market funds, and precious metals exchange traded funds) decide that September was no fluke, then they could become stock buyers again. You’d have another nice little rally.
This, by the way, is what Warren Buffett is yammering on about. Buffett told Fortune magazine’s Most Powerful Women summit last week that, “It’s quite clear that stocks are cheaper than bonds. I can’t imagine anyone having bonds in their portfolio when they can have equities … but people do because they lack the confidence.”
There are a lot of reasons people might lack confidence right now. But should they be buying bonds? Bonds are the mainstay of the deflationist camp. You buy them for fixed income when you expect disinflation or deflation. They are liquid and their value doesn’t rise or fall with earnings variations.
And by the way, you might even make a capital gain on bonds these days if your front running central banks. For example, the Fed has delivered a massive boost to U.S. bank earnings over the last two years by essentially subsidising their net interest margins. The banks can borrow from the Fed at near zero short-term rates and then lend long to Uncle Sam for 30-years at over 4%.
Free money to change your life!
With other central banks willing to dip into the bond and real estate markets with asset purchases to ‘get things going,’ bond investors might be thinking this is a low-risk way to front-run the early stages of Quantitative Easing part Two. It doesn’t seem like a very safe trade, though.
But then, nothing seems very safe today. This is frankly what keeps us awake at night, along with the neighbour’s cat. We’re a bit worried that the collateral securitising large debts in the Western world is a festering pile of crap. Unlike a wine, bad debt does not improve with age. Yet that’s what everyone hoped would happen in 2008 when the severe capital impairments at banks in America and Europe were addressed with short-term shenanigans.
Well, the short-term is over now. Welcome to the long-term.
Incidentally, the odds of another massive banking/housing crisis in the United States seem to getting shorter. The latest catalyst if the “robo-signing” scenario where banks apparently initiated tens of thousands of foreclosure proceedings against homeowners without having proof that the bank owned the home. A full primer can be found here.
This is a morbidly fascinating issue because it gets to the heart of what the housing crisis has done to America. It’s turned into a third-world country where contract is not only not enforceable, it’s optional. If you can’t prove you own title to a property, you certainly can’t foreclose on it. You can’t sell it either.
This is a big problem for banks. At the operational level, the cost of servicing such a large number of mortgages eats into earnings. If the bank is forced to go to court, the cost goes up. There is also the issue of the bank having securitised these loans and sold them. If the income from the mortgage dries up because the homeowner challenges the ownership of the loan, and the bank can’t prove who owns the loan, then the purchasers of securitised mortgages can “put back” to banks the securities and get paid for them.
This would force banks to repurchase securitised mortgages they’d offloaded onto entities like Fannie Mae and Freddie Mac. In other words, all that bad-loan risk would be repatriated right back home on the bank balance sheet. Banks have planned for this by adding a “reserve for loan repurchases” column to the balance sheet. The number, depending on the bank, is going to get a lot bigger.
Of course all this must seem like a terribly American problem and not have much at all to do with Australia. But the nut of it is this: a massive Federal bailout of the entire American housing market is looking likely in the early part of next year as the Obama administration deals with a largely Republican Congress. Both parties will want to engineer some kind of TARP Two well before the presidential election in 2012. And this program must keep people in their homes instead of just bailing out banks.
Not that we’re a big fan of such programs. But if it’s required, it’s going to mean even more money printing than markets are figuring in with QEII. In fact, we would be surprised if this bank recapitalisation issue does not soon become the decisive factor in expectations for more QE. But what does it mean?
It means the flight out of the dollar and into emerging markets and tangible assets will continue for longer go higher than you expect. While we’re on the lookout for a market that’s fully priced in a second round of QE, we think the deflationists have seriously underestimated the amount of new money that will come into existence and the affect that money will have on prices. Hint: they will not be going nominally lower.
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