http://www.economist.com/node/21542452

Those of us who traded Foreign Exchange in the early 90s will have noticed something familiar today. A country is attempting to fend of a speculative attack on its currency by raising interest rates. Hungary, on the edge of the Euro-zone and its current recession, is expecting barely positive GDP growth this year of 0.5% and has policy rates at 7% with expectations that they will have to rise. The risk is that GDP will be lower than expected, and that the central bank will raise rates higher. Inflation is currently running at 4%, but that is not the main problem facing the country.

Hungarian homeowners took out mortgages in Swiss Francs because interest rates there were lower than domestic ones. Unfortunately, the Swiss Franc has appreciated against the Euro beyond all expectations as investors have fled the Euro (a currency and region with whom Hungary’s shares an almost umbilical attachment). So the debt owed by many Hungarians has soared in their own currency, since the Forint has also weakened against the Swiss Franc.

Back in the 90s when European countries were attempting to maintain stable FX rates as they proceeded towards eventual monetary union, occasionally they would raise short-term rates when their currency was weakening. It rarely worked; Hungary could double its short term rates and that would scarcely deter an investor seeking to exit the currency – indeed, it might strengthen his resolve given the risk to domestic growth.

So it’s deja vu all over again (as Yogi Berra memorably said). There doesn’t appear to be a Forint ETF to be short, but being short the Euro works nearly as well.

Disclosure: Author is Short FXE

Morningstar reported through the Wall Street Journal that PIMCO’s $244BN Total Return Fund (PTRRX) suffered the first outflow on its history last year. $5BN left the fund in 2011 including $1.4BN in December as investors soured on PIMCO’s mis-timed trades in U.S. government bonds. Bill Gross hasn’t achieved what he has by accident, and no doubt many more good years lie ahead. But the Federal Reserve’s distortion of interest rates, through Quantitative Easing (QE) Versions 1 and 2 and more recently Operation Twist illustrate the problem. Bond yields today do not reflect the private market’s appetite to lend money; they are being held down by the Fed’s buying. Consequently, ten year treasuries offering a yield of less than 2% are guaranteed to slowly erode the real value of the money invested in them even in a tax-deferred or tax-exempt account. For a taxable investor the erosion takes place more quickly.

Last Summer PIMCO publicly spurned U.S. debt as offering an insufficient return, and after lagging the indices badly while a Fed-induced rally took hold they reversed course. PIMCO no longer hates government bonds and a look a the holdings of PTRRX on Morningstar reveals several positions in long term government bonds. 2.3% is invested in the 3.5/8 of 2/2021; 1.5% in the 2.1/8% of 8/2021, and so on. 27% is in government debt – and yet, since the hold to maturity real return will most assuredly be negative, the justification for these holdings is that they will zig when other things zag. In a flight to quality, “risk off” trade (in which the market engages fairly often) holdings of treasuries can be relied on to retain their value or even appreciate. The negative return is in exchange for reduced volatility, and extracting real value from such holdings therefore requires that they be sold by a nimble PM at precisely the time of crisis. This is increasingly what active bond managers are faced with – they need to be good at market timing to justify some of their holdings.

PIMCO may well be good at that too, last year notwithstanding. As the government stealthily imposes loss of purchasing power on savers, successful bond managers will be those who are nimble enough to keep time to the music.

That the world’s a risky place has not escaped the recent attention of investors. The potential demise of the European single currency and perhaps with it European banks and the European project itself looms large over every investment decision, and has for many months. Economic slowdown in China, the uncertain consequences of the Arab Spring and more recently Iran’s nuclear ambitions all add to the global uncertainty. Within the U.S. a highly partisan Congress has led to legislative gridlock and no certainty about long term fiscal policy. It makes you wonder how investors get out of bed in the morning. And when they do, they are confronted with a choice of risky assets (such as equities) which may lose value immediately, or less risky assets (such as bonds) which will lose real value with certainty. That investors are choosing the certainty of lost purchasing power over the available alternatives reflects the seemingly poor choices on offer. Thus is the equity risk premium, the difference between the earnings yield (inverse of the P/E ratio) on the S&P500 and the ten year U.S. treasury yield, at its widest since 1974, a year that closed with the Dow Jones Industrial Average having dropped 45% from its peak only eighteen months earlier, and inflation at 12.3%.

Start with bonds. Today’s ten year treasury yield of around 2% assures even the tax-exempt hold-to-maturity investor of a loss in purchasing power if inflation over ten years exceeds 2%. The taxable investor of course will fare even worse. Even a portfolio of blue chip corporate bonds yielding around 4% will struggle to overcome the twin headwinds of taxes and inflation. But bonds have a big thing going for them, which is momentum. For those who draw comfort from investing with a tailwind, bonds are a warm and cozy place. The Dow Jones Corporate Bond Index has returned 10% per annum for the past three years including 8.5% in the most recent one.  Who’s to say that this won’t continue? And of course it may, although such forecasts will struggle mightily to overcome the Math; for bonds to return more than their current yield, their yields need to fall causing prices to rise. Corporate bond yields could drop from 4% to 3%, although such would presumably require a similar drop in treasury yields, to 1%. The world in which 1% ten year treasuries draws buyers is unlikely to be a friendly one for corporate credit, and at such a time credit spreads might be substantially wider, depressing the prices of corporate bonds. So, much as bonds investors might draw comfort from looking backwards, their best plausible outcome is that they’ll earn the current yield and suffer a steady depreciation in the real value of their assets.

In fact, relative pricing between stocks and bonds is such that $20 invested in the S&P500 yielding 2% will, assuming 4% dividend growth (and the 50 year average is 5%) generate the same increase in after-tax wealth as $100 in ten year treasuries. This assumes the $80 not invested in stocks earns 0% by sitting in cash, although holding cash provides the option to do something with it that might well earn a return later on. The Math works for corporate bonds as well (just change the $20 in stocks to $40).

So bonds have been good, but past performance is highly unlikely to be repeated. In fact, we believe there’s a strong case to be made for all investors to reduce their asset allocation to fixed income. Government policy is to maintain ruinously low interest rates while debtors rebuild their balance sheets. The Federal government is effecting a transfer of real wealth from investors to borrowers. This policy is likely to continue for quite a long time, not least because it’s popular (with those voters who contemplate such things). There are many more debtors than creditors, and regardless of how independent you think the Federal Reserve is, monetary policy is unambiguously populist, designed for the masses. The appropriate response is to allow the government’s voracious appetite free rein. If Chairman Bernanke likes bonds that much he can have the lot.

As a result, identifying alternatives sources of investment income is a task that consumes much energy on a daily basis at SL Advisors.

The stock market offers a risk to suit every taste. For those who like to wake without first worrying whether their holdings are solvent, many reasonably priced large cap companies with low levels of debt and a history of steady earnings growth are available. Kraft (KFT), Microsoft (MSFT) and Berkshire Hathaway (BRK-A) are all examples in our Deep Value Equity Strategy, along with less well-known names such as Corrections Corp (CXW) and Republic Services Group (RSG). Domestic energy exposure adds volatility and return potential through Devon Energy (DVN) and Comstock Resources (CRK). The former bond investor can allocate his new funds to a combination of stocks and cash (depending on risk appetite), or to other income generating strategies.

There are even examples of stocks whose dividend yield exceeds that on their own bonds – not because their fortunes have suffered and a high dividend yield reflects expectations of a cut, but because price-insensitive bond investors have driven bond yields low in their flight from equities. Johnson and Johnson (JNJ) is one such example. Our Dividend Capture Strategy consists of a diversified portfolio of such names combined with a hedge to eliminate most of the daily market moves. The result is a portfolio exposed to dividend paying stocks and dividend growth that is hedged against excessive moves in stocks.

Master Limited Partnerships (MLPs) are another attractive asset class for taxable investors tolerant of K-1s. I won’t repeat here the well-worn arguments that are familiar to regular readers, except to note that the sector’s unique structure renders it worth having in many income-seeking portfolios. MLPs offer tax-deferred distribution yields of 5-6% combined with growth expectations of 4-6% (suggesting a total return potential of 9-12% with no change in earnings multiples).

Disclosure: Author is Long KFT, MSFT, BRK-B, CXW, RSG, DVN, CRK, JNJ

From my book, with apologies to Sir Winston Churchill whose speech following the Battle of Britain in 1940 inspired this line. Fees have, without doubt been part of the problem for hedge fund investors. The financial press is picking up the story and some of the articles are linked on the book’s website. Meanwhile, sales have now reached the top 0.1% of books available on Amazon both in the U.S. and the UK.

Last week the Environmental Protection Agency  (EPA) issued emission standards tightening the rules surrounding the output of mercury and other harmful pollutants. These standards will have the practical effect of making natural gas relatively more attractive than coal for electricity generation since coal-burning plants require the installation of expensive “scrubbers” to clean the emissions they generate. Converting older plants to operate more cleanly often fails to make economic sense and as a result new power plants are increasingly burning natural gas. The Wall Street Journal noted this in an article on Friday.

Of course the shale revolution in natural gas has produced a glut of the stuff, and at $3.13 per MCF it’s barely possible to drill for it profitably. That the price has fallen so low at the onset of Winter when demand typically picks up is testament to the success of the drillers. But it does emphasize the importance of being invested in companies with low costs of production since there’s little near term prospect of higher prices.

But the longer term outlook is increasingly positive. U.S. based natural gas is now cheaper than anywhere in the world outside the Middle East, and that is drawing interest from other industries that rely on cheap sources of energy. States that sit atop the Marcellus Shale (such as Pennsylvania and West Virginia) are competing with one another to attract ethylene production facilities. And a Brazilian textile company recently chose Texas over Mexico to build a new denim factory because of a 30% cost advantage in electricity. Over time cheap natural gas will lead to cheap electricity, drawing in additional industries and creating manufacturing jobs. And this increased demand will no doubt help support prices.

It’s not a sector to own for a trade, but companies with low operating costs and minimal debt are best positioned to benefit from what’s happening. We recently added Southwestern Energy (SWN) to our Deep Value Equity strategy since it meets these criteria. We continue to own Devon Energy (DVN) whose liquids business provides a usefully profitable offset to today’s soft natural gas prices. The natural gas story continues to have many chapters.

Author is Long SWN, DVN

I’ll be discussing my book.

It’s taken many observers including me longer than it might to comprehend, but ECB chairman Mario Draghi has done something that should be very bullish for U.S. stocks. Floyd Norris noted some of the ramifications in today’s New York Times. The Long Term Repurchase Operation (LTRO) in effect is an extension of credit from the ECB to EU sovereigns.

How can this be, when Mr. Draghi said all along he would not lend directly to governments? Because of the symbiotic relationship that exists between EU governments and their banks. The banks own most of the debt. If the banks can’t afford to roll over maturing bonds governments will default. If governments default banks will go with them. Both are locked together, and we believed that the ECB was holding off from proving needed sustenance while the politicians showed some evidence of imposing fiscal austerity. They (sort of) did at the last summit, and now the ECB has taken a path from which it will be difficult to turn.

Eurozone banks took down 489 billion Euros of three year loans at 1% this week. Whether they choose to buy sovereign debt or not is really not the point. They can, and now whenever the banks appear sufficiently shaky that they won’t be able to finance what their sovereigns need, the ECB can be relied upon to provide it. There will no doubt be more brinkmanship and dire warnings about delaying needed economic reforms in the south, but the problem has always been the absence of a credible punishment to wavering countries. The Maastricht Treaty incorporated enormous fees (1% of a country’s GDP) that were soon shown to be implausible when Germany and France were among the first to breach the 3% deficit/GDP criteria. Forcing a country to default is clearly unacceptable. The Eurozone’s countries are all roped together, and the ECB recognizes that pushing one off the cliff endangers them all. The ECB is the lender of last resort to banks. It has become the lender of last resort to EU governments as well, and Germany as a guarantor of the ECB’s balance sheet is now part of this solution.

This is not necessarily bullish for the Euro, although the tail risk of a disorderly collapse has been removed. But it is assuredly bullish for U.S. equities. By far the single biggest question mark hanging over stocks has been Europe, and now the roped-together have stepped away from the cliff. Equities are attractively priced compared with bonds and have been for some time. This may just be the development that nudges investors off the fence.

Dislocure: Author is long diversified equities equivalent to SPY, and is long EUO

You’d think it would be hard to find much humorous in the kind of year hedge funds have had – down 8.5% for the year in their second worst performance in history. But there can be, depending on your perspective.

When I summarize my book, The Hedge Fund Mirage with the simple explanation that all the money ever invested in hedge funds would have been better off in treasury bills, I elicit a variety of responses. Rather like the concentric circles emanating from the point at which a tossed pebble hits the water, how people feel about this depends on how close they are to impact.

People I know in the hedge fund business almost invariably note that they’re not surprised. They may not have done the Math as I have to actually calculate the IRR of the industry, or examined the impact of fees on returns, but they do at some visceral level comprehend that it’s been a better ride for the managers of hedge funds than their clients. One individual who knows the numbers as well as most responded, “OMG, you’ve written THAT book?” But generally, the industry is not shocked by the result. That itself may be shocking.

One step farther removed are people who one might classify as financially sophisticated but not directly involved in hedge funds. This group includes professionals such as doctors, lawyers, accountants and other successful business people. They may serve on non-profit boards or investment committees, are in many cases wealthy enough to qualify as hedge fund clients and are reasonably in touch with the investment landscape. Their reaction is the most understandable, and a combination of shock and disappointment typically follow. They may be thinking back to investment committee meetings at which a consultant has promoted hedge funds for their non-profit’s investment portfolio. Or they may be hedge fund clients themselves through some helpful private bank. But they are genuinely dismayed at the result.

But most interesting is the response from those farthest from the center. Call them the 99%. Regular people that you might run into at Starbucks in the morning. Teachers, nurses, local town employees, individuals whose only knowledge about hedge funds is drawn from what they see on TV and who can only dream of the wealth that their qualified clients claim. If this group has any savings they’re largely in a 401K or other qualified retirement plan, and hedge funds are that mysterious but unbelievably lucrative area of Wall Street that’s way out of reach. These people have never met a hedge fund manager. And how do they feel about learning that investors should have been in treasury bills? They laugh. Without exception. The 1% (which is after all where hedge fund clients are to be found) may not pay enough in taxes and have enjoyed most of the benefits of economic growth over the past 30 years, but this is one place where the 99% have probably done better than the 1%.

Even if the un-invested spent their money rather than saving it, they probably got more out of it than the less-than-treasury-bills return earned by those closer to the center. It’s a satisfying feeling. Chuckles, smiles, laughter and guffaws quickly follow as the realization dawns that those with the fewest financial problems made at least one wrong move. In one arena, the 99% have outwitted the 1%. Maybe not intentionally, but that doesn’t matter. As Basil Fawlty crowed in one memorable episode (“Communications Problems”) “…for once in my life I’m actually ahead.” Of course, he wasn’t as became clear moments later, but that’s another story. For 99% (and I must admit that I probably belong in the 1%) hedge funds can be funny, and everyone deserves a good laugh from time to time.

Euroland euphoria has broken out – so say Ambrose Evans-Pritchard and Louise Armitstead of the Daily Telegraph. Mario Draghi rode to the rescue with Long Term Repo Operations (LTRO), and it’s now reported that Eurozone banks borrowed 489 billion Euros from the ECB for three years. If they are so moved they can engage in the carry trade, buying southern European sovereigns and steadily recapitalizing themselves. The symbiotic relationship between Euro area governments and their banks assures that they can only survive together.

It illustrates the multiple tools available to the ECB and the Eurozone to avoid catastrophe. And betting on a Eurozone collapse is to place your chips on one specific number at the roulette table, with a commensurate low likelihood of success but a big payout. But choosing red pays much better than 2:1, where red is defined as long U.S. equities hedged with a short Euro position. It’s analogous to borrowing money in Euros to buy risky assets. There is already so much excess debt issued by European governments that you can be reasonably assured they’ll do everything they can to stop the cost of funding it going up anytime soon. It’s clearly in their interests to keep borrowing costs low, and the ECB has few measures with which to combat a depreciating Euro. Ultimately the Eurozone needs real GDP growth, and so the current procyclical policies being followed (fiscal austerity during a recession) are likely to make it a long road back to better economic times.

The correlation between the Euro and the S&P500 (SPY) has been increasing in recent months, not surprisingly since Europe’s issues are the major risk visible to investors. But the attraction of combining long equities with short Euros, with a hedge ratio of around 0.4, is that the Euro is unlikely to rally strongly without an equivalent reaction in stocks, whereas a European disaster will see the Euro leading stocks down. The GDP 2.5%+ differential between the U.S. and Eurozone in 2012 provides a steady US$ bias.

MLPs have had another strong year, delivering 12% so handily outpacing high-grade bonds and far better than stocks. We own a diversified portfolio of midstream names including Kinder Morgan (KMP), Plains All America (PAA) and Williams Partners (WPZ). Identifying sources of income is every investor’s challenge given today’s punitively low interest rates. MLPs can be part of the solution.

Disclosure: Author is Long EUO, KMP, PAA, WPZ