Saturday’s New York Times ran a thoughtful piece that should send a shudder through any holder of long term bonds. While maintaining low inflation is typically in the DNA of every good central banker, some are starting to question the orthodoxy of a relatively inflexible approach to changes in the price level. While high inflation (10%+) is widely (and no doubt correctly) believed to be highly damaging, there is support for the notion that inflation above 2% (the Fed’s target) can ease price adjustments. This is because while few workers will willingly accept a cut in pay, 5% inflation with a 1% pay hike results in the same 4% loss in REAL earnings as a 2% cut with 2% inflation. In other words, a little bit of inflation allows companies to increase profit margins as long as their revenues keep better pace with inflation than their costs.

Presumptive Fed Chairman Janet Yellen has argued for the benefits of temporarily higher inflation, and many academics including some quoted in the NYTimes article have argued the same. It’s a logical extension of the strategy of financial repression currently being pursued. Interest rates that are equal to or below inflation are a fairly painless way to reduce the inflation-adjusted value of debt, and in the U.S. we have $36 trillion of debt if you add all levels of government, households and students as I showed in my book, Bonds are Not Forever; The Crisis Facing Fixed Income Investors.

It illustrates the shifting winds; because debt is so ubiquitous, minimizing its cost to borrowers is more important than appropriately compensating those who fund it. So far it’s sound public policy. But clearly holders of long term bonds yielding close to current inflation rates are scarcely being compensated for the risk that a drift up to 3-4% inflation may turn out to be a quite acceptable monetary policy outcome.

The equity market has had a great run, currently up around 24% for the year (S&P500). Tempting as it is to assess the risk of a reversal as high, we tend to avoid market calls like that. But two stocks that recently reported earnings provide an interesting contrast.

Netflix (NFLX) last night reported quarterly revenues of $1.1 Billion (up 22% year-on-year) and EPS of 52 cents (versus 13 cents a year ago). At $360 a share it’s currently trading at 106X next year’s forecast EPS of $3.41, or 4X next year’s forecast revenues. CEO Reed Hastings was moved to comment on the “euphoria” surrounding the stock. We don’t own NFLX, sadly, since it has rallied around 275% so far this year. It obviously was very cheap a year ago, but doesn’t fit our investing model of companies with reasonable earnings visibility and a persistent competitive edge. They have a great product though.

IBM reported last week and disappointed analysts with revenues of $23.7 Billion, about $1 Billion less than expected. IBM will probably earn around $16 in EPS this year, close to $18 next year and remains on target for management’s goal of $20 in operating earnings in 2015. It currently trades for less than 10X 2014 EPS. IBM is down about 10% this year, around half of which came as a result of their disappointing 3Q13 earnings last week. IBM’s revenues have been flat for years. In 2008 they generated $103 Billion in sales. They’ll probably do $101 Billion this year and somewhere between 100 and 104 in 2014. IBM is not a company with revenue growth. However, their EPS in 2008 was $8.93 and their operating margin has improved from 15.2% to around 20%. Over six years they’ve doubled profits on flat sales by operating more efficiently and providing customers what they want. They’ve also reduced their sharecount by 18% through buybacks, further supporting the growth in EPS. They will keep doing all of these things.

We own IBM. The contrasting stock performance of IBM and NFLX don’t mean the market is expensive, but at current valuations we would only ever own the former and not the latter.

Achilles Macris worked in the office of the CIO in JPMorgan’s London office during the time of the infamous “London Whale” trades. Achilles was a direct report to Chief Investment Officer Ina Drew. I worked with Ina for many years and I developed enormous respect for her abilities and judgment. The credit derivatives losses have undoubtedly been enormously painful for her and a tragic end to a highly successful career.

Achilles was the London head of the CIO, ultimately responsible for the execution of the ill-fated strategy. Although he’s no longer employed by JPMorgan he’s avoided any criminal charges related to the case. However, not wanting to move quietly on with his life he is now suing the UK’s Financial Conduct Authority (FCA), alleging he was unfairly identified and criticized in settlement papers involving the “London Whale” trading debacle. Although the FCA didn’t actually name him, he was apparently identifiable by inference (he was named in a Senate report on the episode). Achilles is seeking to clear his good name. It’ll have to be a creative defence. Perhaps he’ll claim that he was too incompetent to have understood exactly what risks his traders were taking. If nothing else, that would be consistent with the facts.

At least Ina Drew testified before the Senate and took responsibility. Incidentally, no case of the type filed by Achilles has ever been successful. His actions speak for themselves.

On Tuesday I attended the morning session of Agrium’s (AGU) Investor Day in NY (the second part was scheduled for Memphis to visit a couple of their facilities). We’re invested in Agrium, having been first drawn to the stock by Jana’s Barry Rosenstein. Last year Jana published a detailed criticism of the company, highlighting both its natural advantages in the production of Nitrogen-based fertilizer and its poorly performing retail division. AGU does look cheap, trading at an Enterprise Value to EBITDA multiple of around 6X, or about 10X earnings.

Natural gas is a significant input into the production of Nitrogen-based fertilizers, around 40% of AGU’s 2012 EBITDA. Like other North American based producers, cheap domestic natural gas has created a cost advantage versus foreign producers. Owning AGU is a good way to invest in the benefits of this cheap North American resource. Jana’s criticisms focused on the Retail division, which they argue is inefficiently run and has made some overpriced acquisitions. Earlier this year a bitter proxy fight broke out as Jana attempted to elect new board members that it felt would be more qualified to oversee the running of the company. The upshot of Jana’s interest was that it lost the proxy fight although perhaps not coincidentally AGU did take some steps to return money to shareholders through a newly instituted dividend and share buyback. However, the stock price has slumped since the proxy fight.

The investor presentation was a useful opportunity to see the company’s leadership team present its strategy. Although Barry Rosenstein was not there, his presence could be felt throughout the morning. The company went to great lengths to justify its retail strategy, to highlight their successful prior acquisitions but also to reassure that no major new acquisitions would be forthcoming and to explain that it would maintain its recently found focus on returning capital to shareholders. Their wholesale business has some solid advantages even while prices for its commodities remain under pressure. Its retail business continues to seek operating efficiencies so as to improve returns. The company’s stock price still seems to suffer from a conglomerate discount.

Michael Wilson will be retiring as CEO at the end of the year; no doubt having seen off the threat from Jana it feels like a good time to move on. The new CEO Chuck Magro seems a smart guy but the obvious question is why they didn’t select one of the two Presidents of their main operating divisions (Wholesale and Retail), both of whom have extensive careers with the company. Chuck Magro has far less operating experience than his two key direct reports, having spent much of his career in staff functions such as Internal Audit, Risk Management and Corporate Development and Strategy. He was only recently appointed to his current role of Chief Operating Officer (COO), in November 2012, creating the impression of a somewhat hasty decision on succession management by CEO Wilson. Chuck’s younger than Ron Wilkinson (Wholesale President) and Richard Gearheard (Retail President), and while that need not be a problem by itself, one can’t help but think that his relative youth and limited operating experience will be noted by the two presidents. In fact, the obvious question is why one of them wasn’t chosen to be CEO. While Retail President Gearheard might have been a controversial choice to run the company given the focus on Retail performance, he and Wilkinson must surely believe themselves to be qualified for the top spot. Both having been passed over for a younger candidate suggests perceived shortcomings in each of them.

The presentations by each division president were informative and interesting. They were also notable for what was not said. In both content and style, the impression was given of two entirely separate businesses that happened to share the same corporate owner. It was as if Agrium is a holding company with two unrelated enterprises. Neither president spoke even in passing about the other division and although Agrium claims to have an integrated strategy there was little integration in evidence down at the divisional level. Perhaps unfairly, this was somewhat exacerbated by cultural differences; the current and new CEO are both Canadian, as is the Wholesale head Wilkinson. Retail is run by Americans from southern states such as Oklahoma and Mississippi. In response to a question on identifying synergies between the two divisions, CEO Wilson noted that much of what the Retail division sells is sourced from Wholesale although Jana has previously asserted that 90% of Retail’s products are sourced from third parties.

Although AGU’s stock sold off following the investor day, possibly on cautious guidance for wholesale or maybe because others perceived the issues noted above, we continue to be invested in Agrium. The company has some clear advantages and its stock price is attractive. Barry Rosenstein’s previously articulated concerns hold some substance. We’ll see if the new management can rise to the opportunity their business model holds.

Here is the first in what may become a series of financial market oddities brought on by the Federal government’s shutdown and the threat of a debt-ceiling related default.

I noted a report that banks were stocking up their ATMs with additional cash in preparation for increased customer demand as we approach the October 17 deadline. Another thing that caught my eye was that T-bill rates have been going UP. In fact, certain T-bills, those presumably most vulnerable to an actual missed payment, have moved quite sharply. Specifically, the October 31 T-bill yield has positively jumped over the past several days, from around 0.02% to 0.13%. It rose 0.05% just today.

Presumably as investors in the safest of safe securities begin to contemplate the unthinkable, they are concluding that October 31 might be a poor choice of maturity. So something quite remarkable has happened. For probably the first time in at least five years, since short term rates plummeted to almost 0% as a result of the financial crisis, it’s possible to lose money on T-bills. For years all they’ve done is get issued at insultingly low yields and remain there. In a different era you could lose money holding T-bills if rates unexpectedly rose, but such has not been part of the landscape for a very long time.

Nonetheless, the investor who bought the October 31 T-bill yesterday at 0.08% and then decided today to become a trader and sell them at 0.13% actually lost money even after the (admittedly paltry) interest income due for holding for one day. A net loss of $35.28 on each $1 million face value held. A beer and a sandwich for two perhaps if all you held was $1 million worth, but there are $89 billion of these outstanding so yesterday’s holders collectively suffered a mark to market loss of $3 million.

I’m sure more oddities will surface courtesy of our leaders in DC.

Bill Gross’s monthly investment outlook is invariably worth reading, and this month is no exception. His writing is engaging as well as insightful, and as the overseer of $2 trillion in assets he’s worthwhile listening to. It turns out that like me, Bill has re-examined the Fed’s interest rate forecasts following the non-taper last month. He’s acknowledged the extremely gradual normalization of policy rates embedded in that forecast. Quantitative Easing grows the Fed’s balance sheet at $1 trillion a year, and as limitless as their appetite for bonds appears even this largesse must in due course end.

Bill elegantly makes the case for an extended period of low rates and therefore low returns on bonds, and links this to the deleveraging that took place following World War II. It was accompanied by “financial repression”, which is to say that savers received the short end of the stick compared to borrowers. He almost echoes my book, Bonds Are Not Forever, in making this point.

So now the question for the investor is this. In one corner you have the Fed’s $3.5 trillion balance sheet which is still growing. In the other you have Pimco’s $2 trillion collection of bond portfolios. The Fed is a non-commercial buyer unburdened by the need to demonstrate value added. As such they readily buy bonds at yields that are lower than private market demand alone would put them. Pimco has little choice but to hunt around for values in a market with fewer than it might otherwise have. They are in a real sense competing with one another, fighting it out for yield although the Fed has some unfair advantages in this contest.

The Bond King is hardly likely to throw in the towel on an entire asset class at this stage of the game. But for the rest of us, free of the commercial obligation to persist in investing in a market where yields offer scant return and no compensation for risk, we really can dial down our exposure to an asset class widely acknowledged to be expensive. Less bonds, more equities but importantly more cash too. You probably won’t hear Bill Gross make that recommendation, but his letter could just as easily have led to that conclusion.

Quarterly Outlook

As is so often the case, the near term outlook for financial markets hinges on the two channels through which the government influences economic activity: monetary and fiscal policy. The Fed’s decision to continue Quantitative Easing via its $85 billion a month buying program showed how difficult it is to communicate the subtle shifts in the precise level of monetary stimulus being provided. The subsequent drop in bond yields demonstrated a communication breakdown between the market, which had expected a reduction in the Fed’s purchases, and the Fed, who thought they’d been clear all along. No wonder Larry Lindsay, a former Fed governor, commented that less openness might well be better.

Personally, I found $10 billion per month more or less of bond purchases not as striking as the answer Bernanke gave to a question about when the Fed might allow short term rates to “normalize” back to the 4% rate that their website posits as the equilibrium level. Bernanke noted what is already public, that the majority of FOMC members expect to begin tightening short term rates around 2016, but then suggested that it might be another two or three years after that before rates reach 4%. Of course Bernanke has only a few months left at the Fed, but his reflection of the FOMC’s views suggests that one consequence of the 2008 financial crisis will be more than a decade of stimulative interest rate policies. So far such policies have worked better than many expected so there’s limited tangible evidence that they’re flawed. The FOMC’s current forecast for short term rates is on their website. On this basis, bond investors face many more years of unattractively low rates that will ever so slowly rise to the point of fair compensation. A ten year security bought at a 3% yield will approximately return zero if over the subsequent year its yield rises to 3.4%, since the drop in price will offset the interest income. Even after the “non-taper” bond rally, corporate bonds have returned -3%. Why, hedge funds have done better!

At the time of writing we are entering another period of brinkmanship in Washington over funding the government and raising the debt ceiling. It’s not the sort of thing that alters our investment posture, though we despair at the dysfunction in D.C. just like everyone else. The sight of Texas Senator Ted Cruz reading from Dr. Seuss’s “Oh, the Places You’ll Go!”  during his marathon monologue may not be the deliberative legislative process at its best, but then other countries’ elected officials have even been known to get into fistfights (for example, Kiev, Ukraine on March 19, 2013). The competition for legislative comedy champion is fierce. Although government policies can affect almost any company, we focus on those that we believe are less sensitive to variables we can’t predict.

MLPs

Master Limited Partnerships (MLPs) had quite a tumultuous month, buffeted both by moves in interest rates and also by critical research from a small firm in Connecticut called Hedgeye. MLPs are bought by yield-seeking investors, and although unlike bonds their distributions generally grow each year, monthly fund flows are sensitive to movements in other traditional income generating sectors. Over a three day period recently MLPs  rallied more than 4%, driven both by the drop in bond yields following the Fed’s “non-taper” and a reaction to the sell-off precipitated by Hedgeye (on which more below).

On September 18^th Rich Kinder, founder of eponymous Kinder Morgan (referred to hereafter as KM since there are multiple entities), sounded every bit the angry billionaire as he defended his company on a conference call to investors. Hedgeye’s research analyst Kevin Kaiser had issued a research report suggesting inadequate upkeep of KM’s infrastructure and questioning their non-GAAP accounting for “maintenance capex” (“capex” is shorthand for capital expenditure). Before releasing the report Kevin Kaiser referred to Kinder Morgan as “…a house of cards on the verge of collapse.”  Apparently, Hedgeye’s marketing strategy is to announce an impending report so as to attract new subscribers drawn by the stock’s sell off in anticipation. They evidently have too few paid up subscribers to justify providing them the report in time to act on it (i.e. before the stock has fallen). This need not reflect on the quality of their research, but is nonetheless worth noting.

KM consists of four publicly listed entities: Kinder Morgan Partners (KMP), Kinder Morgan Management (KMR), Kinder Morgan Inc (KMI) and El Paso Pipeline Partners (EPB) with a combined enterprise value of $105 billion. It is the largest MLP, and although we doubt Hedgeye’s Kevin Kaiser has spent much time with Rich Kinder, the former certainly got the attention of the latter.

The crux of Hedgeye’s report concerned Kinder Morgan’s definition of “maintenance capex”. An MLPs Distributable Cash Flow (DCF), the money available to pay distributions to investors, is calculated after the cost of maintaining their assets. A pipeline that costs less to repair means more money paid out to LPs. Hedgeye’s report argued that KM spends too little on maintenance, artificially boosting its returns, and subsequently makes up for it by replacing a pipeline and counting all of the cost as a capital investment.

Following price weakness induced in part by Hedgeye’s report, Rich Kinder’s initial response was to buy 500,000 shares of KMI to add to the 230 million he already owns (worth $8.3 billion). This was followed up a few days later with the September 18^th conference call during which the company provided some detail around its maintenance capex to show the weakness in Hedgeye’s analysis and conclusions. As they noted, energy infrastructure is a highly regulated business and operators have limited ability to skimp on maintenance.  Accounting treatments vary, particularly for non-GAAP measures like DCF, and where one company may attribute maintenance expense to operating costs another may allocate it to recurring capex making a more comprehensive analysis of the financials prudent before sounding the alarms. A quick look a KM’s record of spills and other accidents, the kind of thing that might point to such under spending, is at least comparable to the industry average. Furthermore, KM’s distributions have been growing reliably for 17 years. So although KM doesn’t quite rise to the “death and taxes” level of certainty, it still looks to us like a pretty good investment.

Although we didn’t find Kaiser’s analysis compelling, he did correctly note the substantial power General Partners (GPs) have over the Limited Partners (LPs) in many MLPs. The traditional MLP structure consists of a GP that owns 2% of the equity and is entitled to an increasing share of the Distributable Cashflows in the form of Incentive Distribution Rights (IDRs) before the LPs are paid. The GP’s “cut” of these can reach 50%, as it has in the case of KMP. GPs also exercise substantial operating control over MLPs, far more than is the case with businesses organized as corporations. GPs benefit whenever an MLP issues equity through a secondary offering, since the cash raised is typically invested in a new project that increases the funds to pay IDRs without enduring the dilution suffered by the LPs. In fact an MLP GP’s position is analogous to that of a hedge fund manager. KMI (which owns the GPs of KMP and EPB) owns a 2% GP interest in KMP and receives an almost 50% incentive fee on distributions paid rendering the ubiquitous “2 & 20” of the hedge fund industry almost frugal by comparison.

Just as the business of managing a hedge fund beats being a client, so it is with MLPs as well. Not all GPs can be bought on the public markets, but not all MLPs have a GP in their structure either. We have long recognized the similarity between hedge fund managers and the MLP GPs, and so around 60% of our MLP strategy is invested in MLPs with no GP, or in GPs themselves. We hold KMI in our MLP strategy and raised it to large position in our Deep Value strategy. We also run a variation of our MLP strategy for those investors who dislike K-1s. It is invested in C-corps that own GPs, and is designed to provide similar returns to the MLP benchmarks but with 1099s for tax reporting. As such it also represents a way for non-U.S. investors to access the underlying asset class.

As we’re all being reminded, 1996 was the last time the Federal government was forced to shut down, the result of a budgetary dispute between then House Speaker Newt Gingrich and President Bill Clinton. It didn’t last that long, was economically inconsequential and was generally believed to have worse consequences for the Republicans than the Democrats.

Politics has become generally more partisanship since then and at least according to many participants far less collegial. Disputes over the budget have become more frequent in recent years, with the last crisis over raising the debt ceiling in 2011 causing investors to contemplate the unthinkable, that the U.S. might miss a debt payment. The Federal government is currently operating under automatic sequestration, the result at the end of last year of the calculation by both parties that automatic spending cuts were preferable to a negotiated agreement.

In fact much of what the rest of us regard as dysfunction in Washington DC can be traced to the power of incumbency and the reduced turnover of elected officials. The House of Representatives in particular is increasingly unrepresentative of mainstream Americans and more reflective of the more liberal and conservative wings of each party. Gerrymandering, that process by which congressional districts are drawn as if by a blind chimpanzee, are intended to create electoral districts full of like-minded voters. While an original intention was to assure that racial minorities would be represented by one of their own, an unfortunate consequence has been to steadily reduce the number of Congressional seats that turn over. In last year’s election 90% of the House and Senate were re-elected.

While that might sound as if our legislators need not care much about what voters think given their success at retaining their seats, a great many of them are acutely tuned to the elections that really matter; the primaries through which each party selects its candidates to run in the general election. The polarized politics we watch is because of the increasingly powerful role played by primary voters. House seats that will reliably return a Congressman of a certain party are uncompetitive in the general election and therefore the primary of the dominant party becomes ever more consequential. It forces House members of both parties to be ever more sensitive to their party activists or risk being outflanked by an even more extreme candidate that better appeals to the “party faithful”. As a result, the centrist voter is increasingly marginalized. There doesn’t appear to be anything to reverse this trend, at least for now. In fact, if anything there’s some evidence that it’s further exacerbated by internal migration of Americans to districts and states that they perceive to be “red” or “blue”. I write about these developments in my book, Bonds Are Not Forever – The Crisis Facing Fixed Income Investors.

This analysis is intended to be non-partisan. For investors of either party or no party, the future is likely to include more frequent disputes that require one side to blink as the protagonists perform for their hard-core constituency. America’s challenges require compromise, and regrettably we are electing representatives for whom total victory is all that counts. It will become a more familiar landscape.

Credit Peter Thiel, Blackrock’s deputy chief investment officer for fundamental fixed income, for providing an honest assessment of the outlook for fixed income. “Overall returns of the market will continue to be negative as monetary policy shifts,” he said. So one of the biggest bond investors in the world has an appropriately cautious outlook on total return. Not that there won’t be good places to invest in the bond market. It is of course a vast place. But we might infer from Thiel’s comments that the less “equity-like”, and more “bond-like” your chosen market, the less satisfactory will be the results. Developed world sovereign debt would be at the bottom of the list of places to look for value, closely followed by agencies and investment grade debt.

At least Blackrock won’t be justifying bond investments based on historic performance, or because the diversification is still useful in spite of the poor return outlook, two explanations we’ve come across from brokerage firms for recommending high grade debt.

Fed Chairman Bernanke’s press conference on Wednesday was more interesting than usual. The decision not to “taper” (never a word the Fed has actually used) caught market participants by surprise. The Fed will continue to buy $85 billion of bonds every month until further notice. Perhaps the low interest rate bias of the presumptive Chairman Janet Yellen colored the debate. Those FOMC members keen to begin the Fed’s exit strategy might reasonably have felt it poor timing to taper when in just a few months Chairman Yellen might have to defend a policy moderation with which she did not agree.

Perhaps even more striking was the answer Bernanke gave to a question on when the Fed might reach its equilibrium interest rate of 4%. The FOMC publishes its members’ rate forecasts and from those you can derive what they think the yield curve out to about five years should look like. Bernanke noted that the consensus among members was that rates would be at around 2% at the end of 2016. He then added that it might take a few more years for rates to reach the Fed’s neutral rate of 4%. It was a quite extraordinary assertion, and even though Bernanke will not be around at the Fed for much longer, he bluntly told bond investors that it’ll be many years yet until yields are freed of government distortion and allowed to properly compensate investors for the risks of inflation and the costs of taxes. Holding bonds at current yields is unlikely to leave you better off in real terms than you are today.

Many large asset managers and brokerage firms have an enormous stake in seeing retail investors continue to plow their savings into this return-less asset class. Bond pricing is far more opaque than for equities. There’s no ticker tape that shows where a bond just traded. The typical individual investor buying a municipal or corporate bond is doing so through a broker with limited information about where the wholesale price is. In fact the inefficiencies of the municipal bond market are well known. In July 2012 the SEC issued its Report on the Municipal Securities Market and provided strong criticism both of the disclosure practices of issuers as well as the market structure itself. They described pricing to investors as “opaque”, noted the general unavailability of firm bid/ask quotes, and pointed out that price transparency available to the brokers was not similarly available to the clients.

Bond brokers like it this way because uninformed clients are more profitable for them.  For many years the tailwind of the secular bull market in bonds has deflected attention from transaction costs incurred by retail investors that are far too high.

The end of falling rates and eventually the beginning of rising rates should cause retail buyers of individual bonds to take a much closer look at how much profit their broker is making from their business. The SEC’s report found transaction costs of up to 2% were common for retail investors. Brokers don’t have to disclose their profit on a trade if they acted as principal, which conveniently is often the case. If clients had to write a separate check for such amounts they would no doubt be shocked into demanding far greater transparency.

Meanwhile, the challenge is on for new and more creative ways to convince clients that they should maintain a significant allocation of their portfolios in fixed income, in the face of a Fed that intends to drive all the yield-based return out of bonds and a market structure that provides a good living to brokers who have access to much better price information than their clients.

In recent weeks, I’ve heard one firm argue that bonds have never delivered a negative return over any two year holding period over the past thirty years; this ignores the current very low level of yields from which the next two year holding period begins. Another firm acknowledged the poor return prospects in bonds but claimed they were still needed for diversification – in other words, losing money unpredictably is somehow helpful.

Many investors hold “low-risk” investment portfolios which are substantially in fixed income. This includes a friend of mine whose taxable trust yields 1.5%, coincidentally the same as the annual management fee charged by the trust company. While the IRS and the trust company are both benefitting from this arrangement, my friend regrettably is not.

The Fed’s interest rate policies of recent years have so far turned out to be far more enlightened than many of their critics assumed. A slow but steady economic recovery has taken hold, and inflation has for now remained low. However, interest rates that are maintained at artificially low levels for an extended period should also spur investors to reconsider the appropriate allocation of their savings to fixed income and the significant drag that transaction costs represent.