The FT today has a dynamite article with the abovementioned title by Gavyn Davies, Chairman of Fulcrum Asset Management. As the title suggests, Mr. Davies speculates that the vast holdings of government debt create the possibility that central banks may forgive some of it so as to further stimulate growth. It’s a quite electrifying thought. In the U.S. and EU governments at all levels are grappling with the conflicting objectives of stimulating growth and reducing indebtedness. So far one can question their success on both fronts, especially in southern Europe where continued austerity is exposing its one-dimensional weakness in impeding exactly the type of real GDP growth necessary to reduce debt.

As a thought experiment it could appear quite alluring. After all, in the U.S. the central bank is part of the Federal government, so on a consolidated basis debt issued by the U.S. Treasury and held by the Federal Reserve simply nets out. The Wallace Neutrality Theory holds that because the public recognizes that this debt will ultimately find its way back into the private sector, its temporary residence at the Federal Reserve doesn’t alter behavior, similar to the way tax cuts funded by deficits don’t promote growth because households save more in anticipation of higher taxes later (Ricardian equivalence). Gavyn Davies is not a believer in the Wallace Theory, but rather than get into the theoretical difficulties instead consider the consequences of debt forgiveness.

The most compelling feature is that there is no obvious injured party. Putting aside for a moment the likely adverse market reaction of such a move, if the Federal Reserve did agree to a modification of terms on the debt it holds, there would be no direct private sector losses as a result. It could be done in many ways more subtle than a complete write-off, which might include taxing interest income to the Fed, extending maturities or even rolling over maturing debt at favorable rates. Carried out in small, incremental steps that sought to minimize any negative market reaction such an approach could be politically very appealing. At a time when Congress will be wrestling with a set of highly unpalatable choices involving spending cuts and tax increases, a modification in debt terms that was part of a wholesale improved fiscal outlook could gather populist support at a minimum. After all, if we owe the money to ourselves, which in effect we do for that component of the debt held by the Federal Reserve, why shouldn’t we be free to alter its terms.

All this of course creates the risk of increased inflation expectations and perhaps higher actual inflation down the road. The point of the thought experiment though is to highlight how politically such a course of action, in conjunction with other fiscally prudent moves, could happen. There’s no directly injured third party. If such a subject was broached without triggering a spike in bond yields (an important IF no doubt) it might gain support. Gavyn Davies notes in his article that one possible future Bank of England governor privately considers such a step worthy of serious consideration.

The fact that the steps outlined above are plausible albeit clearly not imminent supports the case for an investor to own assets that provide some type of inflation protection and to shun fixed income risk entirely. Companies with strong franchises and a history of earnings growth should represent an important part of any investor’s portfolio. For example, we like Microsoft (MSFT) which currently trades at less than 7 times 2013 earnings ex-cash on balance sheet and possesses two powerfully cash generative businesses in Windows and Office. We like owning the Gold Miners ETF (GDX) –although we don’t think gold is a good long term investment, the balance of risks and potential return as described above argue in favor of exposure to bullion. And Japan, with its lost two decades and periodic bouts of deflation, may be a candidate for the debt modification described above. We are long $/Yen through owning the ProShares Ultra Short Yen ETF (YCS).

Jim Stewart in the New York Times has noted the poor performance of many large university endowments, and in the process questions their large allocations to alternatives. Hedge funds figure prominently for many of them, and their investment committees are learning the hard way that uncorrelated returns are not unlimited, and that the hedge fund industry is overcapitalized. Jim is pursuing an important story and one that ought to make all institutional investors stop and reconsider what passes for conventional wisdom – a sizeable allocation to hedge funds.

Bill Gross is by any measure financially sophisticated. Which is why it’s entertaining to watch him reconcile his undoubtedly well-honed skills at investing with his firm’s management of one of the most overpriced closed end funds around. The closed end fund sector is one of the truly inefficient sectors in financial markets. Investors routinely confuse distributions with yield, and presume that a security sporting a 10% yield is offering good value that has just been overlooked by many other investors.

So it is that the Pimco High Income Fund (PHK) recently reached a price of $14, a heady 70% premium to the NAV of its assets. It reached this level because investors are searching for yield everywhere, and because Bill Gross is the portfolio manager. For many investors, Bill Gross at any price is better than the tyranny of low market rates, and who can blame them.

Barron’s ran an article on the weekend noting the absurdly high premium to NAV of this fund. Mr. Gross does eats his own cooking by investing a modest amount of his net worth in the fund. He would know as well as anybody that investing in a portfolio of high yield bonds at 70% above their market value is not a sensible strategy, and yet as PM he can hardly advise that way nor sell his own shares. This week PHK has fallen spectacularly (at least, by the standards of closed end funds) falling around 20% from its level of last week. It still sports a heady 50% premium, and perhaps that will be sustained. It’s not possible to short it, but let’s just say there are quite a few more sensible places to put your money than PHK. Unless you’re the PM there’s not much point in owning it.

The Fixed Income market has been a tough place to find much value for far longer than I can remember. And yet, that hasn’t stopped the returns from being nothing short of spectacular. In fact, it’s not hard to find securities that have outperformed equities, and most would agree that it’s been a surprisingly good year for stocks.

Take the iShares Investment Grade Bond ETF (LQD) for instance. Up 10.5% year-to-date, for high grade bonds debt. The current yield to maturity on the portfolio is 2.89%, and a good part of the return for the year has come from price appreciation of the underlying bonds as the Fed’s relentless buying of government and mortgage debt has drawn investors to bid up the prices of other fixed income securities. If LQD returns 10.5 over the next year, 7.6% of that return will have to come from price gains which, given its effective duration of 7.8 means the yield to maturity will need to fall to under 2%.

The JPMorgan Emerging Market Bond Fund (EMB) has generated 14.5% so far this year, only 2% or so less than the S&P500. The yield on this portfolio has drifted down to 4.1%. For EMB to return 14.5% over the next 12 months, the same Math as in LQD means that, with an effective duration of 7.7 the yield to maturity will need to fall to 2.75%.

Even more striking has been the performance in some of the closed end funds that invest in senior loans. We’ve liked the ING Prime Rate Trust (PPR) for quite some time, but evidently we’re not alone for it currently trades at a 4% premium to NAV. PPR has returned a staggering 28% so far this year as investors have piled into bank debt and high yield in general.

There’s never any easy money to be made, but none of these investments appears that compelling today. Earning the current yield would seem to be the best plausible outcome on LQD and EMB. This morning’s Employment report was also reasonably positive, with the Unemployment rate falling below 8% for the first time in over three years. We’ve owned these securities in our Fixed Income Strategy but recently exited. The risk/return just doesn’t appear attractive, though bonds have looked expensive for a long time with barely a pause in the march to ever lower yields.

Quarterly Outlook

September 2012 might well be regarded as the moment when the Federal Reserve committed itself unambiguously to reflation, as they came down clearly on the side of improved U.S. employment as the more important element of their twin mandate. In achieving “maximum employment and price stability,” as the Fed describes its statutory responsibility, it is clearly coming up short on the former. Whether monetary policy can do any more now that we are into open-ended Quantitative Easing (“QE Infinity” as it’s been dubbed) is a legitimate question. A “substantial” improvement in the labor market is the Fed’s chosen yardstick, and it seems that yields below inflation will confront bond investors indefinitely. For us, we take the world as we find it not as it should be, and highly accommodative monetary policy for a very long time combined with either unhelpful or dysfunctional fiscal policy accurately describes the investment landscape.

To run the Math: $100 invested in the ten year treasury note yielding 1.6% can, with interest reinvested expect to grow to $117 in ten years. The same $100 invested in the S&P 500 yielding 2.0%, assuming 4% annual dividend growth (the fifty year average is 5%), unchanged dividend yields in ten years and with dividends reinvested over this time would grow to $179. This is all pre-tax — the tax code currently makes stocks even more advantageous since dividends and capital gains are taxed more lightly than interest income, although that will probably change somewhat in 2013. The Math is similar though slightly less striking for corporate bonds since their yields are tethered to the U.S. government’s. However, the kind of deflationary, recession-prone environment that would result in today’s treasury bond yields turning out to be a good investment is unlikely to be kind to corporate credit risk. The Dow Jones Corporate Bond Index has returned 12% p.a. over the past five years, but absent a further drop in yields all you can expect to make is the current yield, around 3.5-4% for investment grade debt. Figure in taxes and inflation, and it’ll be hard to preserve purchasing power. It’s worth taking the long view, at least so as to avoid becoming the poor fellow in the cartoon.

Of course stocks can fall, which is why they are not considered a substitute for bonds. But you can make your own ten year treasury note at home with only $22 of the $100 noted above, because that’s how much you’d need to invest in stocks to achieve the same return as $100 in treasuries, with the rest in cash. $22 in stocks with $78 in 0% yielding cash will, in the plausible scenario described above, return the same as the ten year treasury note. If the S&P fell 50%, this home-made bond would lose 11% of its value. A jump in interest rates from 1.6% to 2.8% would do around the same damage to the treasury bond investment. Although one seems far more possible than the other, the fact that investors are indifferent between the two reveals the continued risk aversion in the market. Some investors, as fear of complete disaster in Europe and the U.S. has moderated have clearly become more comfortable with equity exposure of late. But since the U.S. government is both the biggest issuer as well as the biggest buyer of bonds (the Fed now owns approximately 25% of the duration of the entire treasury market) the distortion of free market prices is virtually complete. If central banks want to own bonds so badly, leave them to it.

Although “tail risk” has been reduced by central bank moves in the U.S. and Europe, corporate profit guidance continues to be very cautious. It’s becoming almost routine for companies to moderate their outlook; most recently Caterpillar reduced their 2015 guidance (orders for heavy earth moving equipment have a long lead time) and evidence of slowing demand is widespread. While the Math above continues to make equities an attractive investment, we have in recent months shifted away from stocks that we felt are highly sensitive to the economy. Our largest individual investment in our Deep Value Equity Strategy is Corrections Corp (CXW) which remains on track to become a REIT. We still like Berkshire Hathaway (BRK) with its diverse and attractively priced set of operating businesses combined with a well-run insurance unit, Microsoft (MSFT) with its twin highly cash-generative monopolies (Windows and Office) and Kraft (KFT) whose split into two companies should attract some new investors seeking more precise exposure to North American groceries (Kraft Foods Group, KRFT) or the global snacks business (Mondelez, MDLZ). A recent addition to the portfolio is Energizer (ENR) which sells batteries and razors, two products unlikely to go out of fashion. We also have a 10% position in the Gold Miners ETF (GDX) since many miners are cheap relative to the value of their holdings and we are inclined to bet with central bank efforts at either stimulating growth or raising inflation expectations (or indeed both).

Stable, dividend paying stocks with low beta (i.e. less volatile than the market) remain attractive both in a long-only format providing low-octane equity exposure or combined with a hedge to produce a more stable return stream. Turnover is light in this strategy, but we do own KFT here as well, (and therefore the two new components KRFT and MDLZ) so we will likely need a replacement for MDLZ which we expect to reinvest earnings for growth and pay a lower dividend than the rest of the names in this strategy. The Low Beta anomaly which is often an additional source of performance hasn’t generated any notable return this year as low beta names have provided about half the return of the S&P 500. A strong equity market with many active managers underperforming their benchmarks and reaching for beta doesn’t favor companies with stable earnings growth. Over time though, it’s been shown to be a reliable way to outperform.

MLP Update

MLPs have caught up lately, with the sector generating a year’s worth of performance in the last three months. The 8.6% third quarter return made up for a flat first half of the year. There have been some interesting recent IPOs, of businesses that have far more volatile earnings than is typical for an area characterized by yield-seeking investors where any deviation from steady distributions is quickly punished.

The Wall Street Journal recently highlighted some examples. Northern Tier Energy LP (NTI) runs a refinery in Minnesota whose profits are subject to fluctuations in refining margins. PetroLogistics LP (PDH), which produces propylene and is also subject to volatile earnings memorably warned in its registration statement that, “We may not have sufficient cash available to pay any quarterly distribution on our common units.” Both may be great investments, but they do highlight a recent trend in MLPs for private equity firms to IPO businesses that offer high current yields but not necessarily stable ones. Whether or not MLP investors will stay with these investments through a tough quarter or two remains to be seen; they are traditionally owned for their stable yields. We don’t currently own either of these names.

Midstream Business magazine noted that interstate liquid tariffs increased by 8.7% on July 1, that being the result of the 2.65% spread added to the annual change in the PPI lagged twelve months. Around half of the pipelines in publicly traded MLPs are governed by Federal Energy Regulatory Commission (FERC) pricing rules, and this illustrates the inflation protection that is built into many business models for the midstream MLPs (which is the MLP sector that we invest in). The IRS also expanded its definition of qualifying income (i.e. those businesses that can organize themselves as MLPs rather than corporations) to include (for example) the sale of hydrogen produced as a byproduct of fertilizer (since fertilizer is considered a natural resource, a requirement to qualify as an MLP).

It’s also worth noting that while taxes on most types of investment income are likely to rise in 2013, the deferred ordinary income that MLPs generate so far doesn’t look likely to receive altered treatment, although wholesale tax reform could plausibly change everything. The months following the election will presumably offer some clarity.

The evolving transfer of obligations from old to young is a theme that deserves more attention. It’s a slow-moving, demographic event so isn’t something that’s likely to produce a headline. But a consequence of the enormous debt the U.S., has built up and the under-funded entitlement obligations is that the bill will be paid by young people including many not yet old enough to vote (or indeed not yet even born).

The Economist, my favorite weekly magazine, wrote a piece this weekend highlighting the disparity between “net lifetime tax burdens” for different age groups. Today’s retiring baby boomers are likely to receive far more in social security and Medicare than they paid in taxes. Older people vote too, so a fairer distribution of the burden or a corresponding modification of entitlements is likely to meet ongoing political opposition.

However, in one sense an adjustment is being made. Retirees are suffering disproportionately from the slow wealth transfer that low interest rates represent. By keep bond yields so low, inflation and taxes steadily reduce the purchasing power of (older) savers to the benefit of (younger) debtors. So maybe there is a modest form of justice at work, albeit not articulated that way by Ben Bernanke.

On Monday Kraft (KFT) begins its new life as two new companies: Kraft Foods Group (KRFT) and Mondelez International (MDLZ). In fact, both stocks trade on a when issued basis already. The purpose of the split is to highlight the value in the company. The old Kraft consisted of a North American grocery business with low single digit revenue growth prospects and the possibility of modestly expanding operating margins, and a global snacks business with emerging markets exposure and higher growth potential. Kraft felt that operating both businesses under one corporate entity made the company less attractive than as two separate entities, since as two separate companies they could appeal to investors seeking stable income (who could invest in the grocery business) while investors seeking faster growing but more volatile earnings could choose the snack business. In effect they were suffering from the “conglomerate discount” such that investors looking for more specific exposure didn’t find the company attractive. The upcoming split results in two separate companies that can appeal to two different types of investor.

Although KFT has been a great investment over the past couple of years and especially since the split was first announced, now that the two new components of Kraft can be examined it reveals the purpose of the split. For every 30 KFT shares held, KFT owners will receive 30 shares of MDLZ and ten shares of KRFT. Recently the two new companies’ management teams made presentations and KFT responded poorly because the earnings guidance of the new bits of KFT added up to less than the prior guidance for the whole.

But when you look at each company, the figures aren’t that bad. KRFT, the North American grocery business, will pay a $2 dividend and based on the when-issued price yields 4.4%. Although that represents a heft 77% payout ratio, low single digit revenue growth with modest operating leverage should leave this dividend comfortably covered since they sell into less economically sensitive sectors. The 4.4% dividend yield compares favorably with its likely peers, such as General Mills (GIS) yielding 3.3% or Kellogg (K) yielding 3.4%.

Meanwhile MDLZ is more appropriately compared with global snack companies with decent emerging markets growth. MDLZ is guiding to $1.55 EPS which gives it a P/E of just over 17,and is no more expensive than, say Coke (KO) with a forward P/E of 17.3.

This illustrates the point of the split, because finding true comparables to the old KFT was difficult given its diversified business mix with very different margins and outlook.

Recently, the management teams for both new companies (KRFT and MDLZ) gave investor presentations. The reaction was cool, not least because together, the two companies’ 2013 earnings guidance added up to the equivalent of $2.30-2.40 for the old KFT, whereas KFT itself had previously been guiding to $2.60-2.80. It was this disappointment, that the sum of the parts was less than the whole, that pushed the stock down.

But here there’s probably a little gamesmanship going on. Neither management team of the new companies “owns” the prior guidance in the same way that old KFT’s CEO Irene Rosenfeld did (she’ll be running MDLZ). The leadership teams of the two new companies are most likely motivated to be cautious, both because of the transition to independence but also because stock options that will be part of executive compensation will be priced shortly after the two new companies’ stocks start trading. But it’s still the same set of businesses, with the same strong brands and growth prospects. So we think the two pieces of the old KFT remain reasonably attractive as an investment.

We think it’s also interesting to be long KFT hedged with a short position in the Consumer Staples ETF (XLP). When KFT splits into KRFT and MDLZ we think the two components of old KFT will appreciate relative to what the old KFT was worth, and against the basket of consumer staples stocks which is the most correlated hedge.

Disclosure: Author is Long KFT, Short XLP

Recently we’ve initiated a short position in Japanese Yen in our Fixed Income Strategy. Some observers have been forecasting economic catastrophe for Japan and its currency for many years based on its poor demographics and steadily worsening fiscal situation. Kyle Bass is one of the better known Japan bears, and he has written eloquently about the problems he foresees. Timing has been frustrating the Japan bears for years, in fact for decades, in spite of the compelling case that Kyle Bass and others like him make. Shorting Japanese Government Bonds (JGBs) is not a new idea.

So it is with a healthy respect for the unsatisfying history of such investments that we are cautiously venturing into this area. What makes this an interesting opportunity today is the presence of some optionality around events which could weaken the Yen.

Japan’s trade situation has been worsening in recent months. For decades Japan has been a huge net exporter and has consequently amassed hundreds of billions in foreign assets. But in August the country experienced another steep fall in exports, the 18th consecutive month of deficit (seasonally adjusted) following the earthquake and tsunami of last year. Japan’s phase-out of nuclear power and increasing reliance on imported natural gas and crude oil represent a structural shift in its trade flows. The source of Japan’s historic capital surplus from its trade sector is beginning to reverse.

While Japan is suffering from lower exports to the EU, it’s worth noting that China is Japan’s biggest trading partner. Any slowdown in Chinese growth will have a disproportionate impact on Japan’s economy. The ongoing dispute over the Senkaku islands (Japanese name) or the Diaoyu (China’s) will most likely amount to nothing as far as investors are concerned, but there’s always the chance that a miscalculation on either side could lead to something more serious. One might imagine that a dispute with its biggest trading partner would hurt the Yen, although historically Japanese investors have reacted to trouble at home by repatriating assets and driving the value of the Yen up, so this is a bit of a wild card.

More tangibly, growth differentials continue to favor the U.S., with Japan’s economy likely to experience only around 0.5% real GDP growth in 2013, down from 2% this year. Japan is also facing its own version of a fiscal cliff and last week the BOJ announced it would increase its version of QE from 70TN Yen to 80TN to offset the likely GDP headwinds from the legislature’s failure so far to pass a budget.

All these issues represent some optionality, in that they may be resolved without consequence but also create the potential for downward pressure on the Yen. Promoting a strong currency seems to be a quaint notion nowadays for developed countries, as the Fed, ECB and BOJ all engage in the “race to the bottom” in order to try to stimulate growth through stronger exports. Japan is as well equipped as any to weaken its currency.

Finally, the US$/Yen exchange rate hasn’t been that interesting lately. After running up to 83 and back during the Summer it’s been directionless and is not far above the lowest levels in many years. A 5% drop in the US$/Yen exchange rate from here would be substantial, and doesn’t seem that likely. It may do nothing but there are plenty of catalysts that could drive the exchange rate higher (i.e. weaker Yen) and the longer term outlook for the currency is negative.

We are long the ProShares Ultra Short Yen (YCS) as a way to express this view.

Coeur d’Alene (CDE)  is a silver and gold mining company that we have owned in the past but do not at present. Like many bullion miners, they seem to be cheap relative to the NAV of the assets they own. CDE was down quite sharply during the Summer before rallying strongly starting in August when central bank reflation started driving up bullion prices. And yet, spare a thought for CEO Mitch Krebs, because the poor fellow has barely participated in the recent stock rally. Mitch Krebs owns 74,812 shares according to the 2012 proxy statement, a mere 0.083% of the company. He’s a bystander, barely connected to the daily swings in the company’s value. In fact his 2011 compensation of $2.4 million was more than the entire value of his stockholding. How frustrating this must be for Mr. Krebs to show up for work every day helping to make his owners rich which working for a (not trivial) salary and bonus.

But Mr. Krebs is actually far smarter than he at first appears. The proxy statement describes a performance-driven compensation process which sounds reasonable enough. But rather than being based on increasing debt-adjusted per share earnings, which is what shareholders care about, the relevant metrics are production. His interests are to make CDE bigger, not necessarily to increase EPS. So in fact, the common equity is there to be used to make acquisitions, even though surely one of the best investments CDE could make would be to repurchase its own stock.

Mitch Krebs has made this clear. He recently said they expect to make an acquisition within the next 12 months. This will undoubtedly help him achieve some of the production metrics that drive his compensation, but may not make his shareholders richer. Perhaps that’s why former CEO Denis Wheeler owns no shares at all. He’s seen this movie before – in fact, he had a starring role in it for many years. The best way to make money out of CDE is to own what they’d like to buy. For our part, we are long the Gold Miners ETF (GDX), although it’s admittedly a little too big for CDE to buy.

There’s a thoughtful op-ed by Gavyn Davies in the FT today (Why did Bernanke change his mind). The Fed has a dual mandate of targetting maximum employment consistent with stable prices (which they take to mean inflation no greater than 2%). What’s become clear following last week’s announcement is that the priority the Fed attaches to each of these goals is likely to subtly shift in favor of tolerating higher inflation in the interests of achieving greater employment. Bernanke himself went to great pains to argue that no such change was contemplated, and traditionally Fed chairman have always argued that low inflation is the best way to support job growth.

But the Fed has little choice but to shift its emphasis, if for no other reason than one of its two mandates has been missing its target for several years now. Bernanke talked about skills atrophying as the long term unemployed become unemployable, and therefore move from cyclically unemployed to structurally so (a miserably dry way to describe a sad loss of many people’s ability to earn a decent living). Republicans have jumped all over this as being pro-Obama politics, which it is although almost certainly that’s coincidental. The Fed would be far too aware of the political season to do anything overtly political and risk being seen as less than independent.

The politics though are for others to contemplate. What does seem plain is that an open-ended and potentially long-lived QE 3 is probably negative for the US$ – especially so now that the ECB has enough firepower to support bond markets far longer than speculators can bet on a crisis. It’s probably positive for equities, although here it’s important to own names you’d like regardless of the near term direction of the economy. And the Fiscal Cliff isn’t receiving the attention it most likely will after the election when the focus shifts to whether Congress will avert a 2013 recession or not.

Our biggest position remains the gold miners ETF (GDX) which we like both because many miners are cheap to NAV but also for the QE 3 reasons described above. Both the Fed and the ECB are focused on reflation as their number one goal. Fiscal policy is likely to be at least modestly restrictive, but it seems that we’ll get QE (4,5…57) until employment improves. The Fed’s response to weaker growth is quite plain. When eventually growth does pick up expect those familiar “Fed behind the curve” headlines to last longer than usual. In fact, the most bearish case for gold is if the Fed fails. It’s not an attractive outcome to contemplate, and not one that’s likely in our opinion. So we like GDX as the most efficient way to align ourselves with government policy.

We also continue to own Corrections Corp (CXW) while we wait for further developments as the company finally decides to convert to  partial REIT status, a change likely in early 2013.

Most recently we invested in Energizer Holdings Inc. (ENR) which, at under 11 times next year’s earnings and with strong market share in both batteries and razors is attractively priced. The stock has been weak recently, and there are some questions about the long term outlook for disposable batteries. But management is still guiding to $6-6.20 per share for FY 2012 earnings (their fiscal year ends this month). They also continue to buy back stock, having repurchase $268 million in FY 2011 and $211 million in the first 9 months of FY 2012 through June. It’s likely they’ll dedicate substantial portions of their free cashflow to buying stock over the next couple of years, and so we’ve been accumulating a small position at current levels.