October 2012 Market and Economic Conditions
By Adam B. Landau Permit Capital Advisors, LLC
There is an axiom in investing, speciﬁc to the two largest emerging economies, that “businesses in China succeed because of the government, businesses in India succeed despite of it”. Clearly we’re in the midst of a period in which recognizing the likely impact of government intervention is critical to understanding the risks that are littering the investment landscape. Identifying where and when a government will step in is one part of the equation, the other is identifying the outcome it is trying to inﬂ uence. The answer is not always obvious, and the impact on an investment outcome isn’t always consistent with the impact on societal conditions. While considerations such as these are an aspect of determining the appropriate allocation to emerging markets in a portfolio, developed markets are certainly not immune to the inﬂ uence of sovereign considerations on their long-term fate.
In Europe, we lay witness to the efforts of ECB president Mario Draghi as he goes into the lions’ den and tries to explain to German industrialists about the essential nature of potentially ‘unlimited’ (which along with ‘indeﬁ nitely’ seems to be the preferred vernacular in central banking circles at this stage in crisis management) bond-buying in the secondary market by the ECB. In the US we have the dysfunction of our political system, and the ﬁ scal cliff fears that has borne. By some measures we appear to be regressing. One such metric is the Economic Freedom Index, calculated by the British Columbia-based Frasier Institute. The index is an equal weighting of ﬁ ve components: size of government, legal system and security of property rights, sound money, freedom to trade internationally, and the level of regulation of credit, labor and business. This is not a partisan issue, as we were ranked number 2 in the world in 1995, saw our absolute peak score in 2000, and have steadily slid from that point to number 19. It is, however, an issue we would be well served to rectify, as academic studies (and recent empirical observations in the US) have shown the relationship between a country’s increase in economic freedom and its rate of growth.
While most informed observers believe the ultimate ﬁ scal cliff will be avoided, the impact that both the arbitration process and its result will have on the country going forward is less apparent. The potential scope of the ﬁ scal cliff (otherwise known as consequences of the Budget Control Act of 2011) is enormous. The budget deﬁcit would be forcibly cut from roughly 7.6% of GDP this ﬁ scal year to 3.8% of GDP next year. Getting there would involve rolling back Bush-era tax cuts and making deep cuts in the defense budget as well as more than 1,000 other government programs, including Medicare. Plans we’ve seen to bring the budget deﬁ cit down by a magnitude of 1% of GDP per year for several years seem like a more responsible way to spread the pain while providing a path towards responsibility. Unfortunately, such plans depend upon an element of legislative compromise, which is essentially an oxymoron.
While ﬁscal authorities ﬁddle, monetary policy burns – with the latest spark coming in the form of QE3. QE versions 1 and 2 have seemingly had little positive impact on generating global growth and bringing down the level of unemployment. The disappointing August employment report sealed the deal on that assessment. To wit, in the month of August there were more people who went on the food-stamp program (173,000) than those who found jobs (96,000). Beyond the appropriateness of speciﬁ c policy steps taken, it is clear and proven that monetary policy becomes increasingly impotent when private sectors are deleveraging to repair balance sheet damage. What is also clear is that the goal of the quantitative easing strategy has not been focused primarily on either employment or growth, but rather on the inﬂ ation component of the Fed’s mandate. Chairman Bernanke will not accept deﬂation without a ﬁght, and the 2% inﬂ ation target appears to be squarely in the Fed’s crosshairs. A quick glance at the chart below will crystallize the relationship, as each QE announcement occurred as CPI was trending below 2%. To this point, inﬂ ation has been subdued in large part because $1.4 trillion of the $2.5 trillion that the Fed has sent out into the ﬁnancial system through asset purchases is being held by banks, on deposit with the central bank in the form of excess reserves. How long this period of latency will continue is the great unknown.
All of this is not meant to imply that QE has been toothless, only that the impact might be seen as collateral (though not necessarily unintended), as opposed to direct. Where beneﬁ t has accrued from the liquidity that has made it out of the banks and into the system, it has come in the form of risk asset price appreciation. There has been one direct beneﬁ ciary of quantitative easing, and that has been agency mortgagebacked securities (MBS). They were the target of QE1 and are now the target of QE3, with the ubiquitous ‘indeﬁ nitely’ tag applied to the plan to purchase $40 billion of these securities per month, to indicate the Fed’s determination to own this market if need be. They already own 12% of all agency MBS, to go along with their cache of 16% of the Treasury market, and analyst projections have them headed to 20% with the advent of QE3. For better or for worse, the level of market manipulation marches on. Perhaps the die regarding the exact nature of QE3 was cast on August 17th, when the Treasury announced a set of modiﬁ cations to the Preferred Stock Purchase Agreements that deﬁ ne the terms under which the Treasury provides capital support to Fannie Mae and Freddie Mac. Under the changes the GSEs will no longer be required to make a ﬂ at 10% dividend payment, but instead will sweep all future net income generated by the GSEs directly into the Treasury. This ends the circular practice of advancing funds to the GSEs simply to pay dividends back to the Treasury. The modiﬁ cation improves the ﬁ nancial strength of the agencies as they are closer than ever to the government. In essence the GSEs have taken one big step towards nationalization, as Fannie and Freddie are basically off-balance sheet businesses of the government.
One thing we have learned during this period of historic interventionism is that every action has a reaction, and every reaction has a follow-on reaction. In this case one of the immediate spillover benefactors may be commercial real estate. With improving cash ﬂ ows, rising demand, a scarcity of new projects, improving credit conditions, and historically low interest rates, we could be in the early innings of a generational opportunity. These tailwinds on the investor side are supported by fundamental improvements in occupancy, rental rates, and property pricing, the combination of which makes this a particularly attractive proposition on a risk-adjusted basis.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC.
He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged.
Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can grow your wealth.
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