The Fellowship of The Ring
, one of three books in J.R.R. Tolkien’s timeless trilogy, balances on the possession and use of a magical ring that empowers its holder to rule over all of the free people of Middle-earth. While the power of central bankers is not quite that dramatic, there is a certain resemblance.
We’d like to think that free people act as Adam Smith described: Decisions are made by each individual acting as an independent agent exerting his or her modest influence on the margin. What we’re currently experiencing is quite different—a fellowship of central bankers, almost all of them former students of the formidable economist Rüdiger Dornbusch at M.I.T., is running the show. As Ben Bernanke, Dornbusch’s most famous protégé, has said, central banks have pushed asset prices to where he wants them to be: short-term interest rates at zero, long-term interest rates near historic lows and stock prices at historic highs. Parallel central-bank activity has occurred in continental Europe, Japan and Great Britain; Mario Draghi and Mervyn King, too, were students of Dornbusch at M.I.T. It is all reminiscent of a line of poetry from Tolkien: “One ring to rule them all.”
We are about to transition to a different fellowship, that of James Tobin’s students at Yale, who include Janet Yellen. Yellen describes the Yale school of macroeconomics as tending toward Keynesianism in the short run and neoclassical growth theory in the long run.
For 2014, central bankers will almost certainly keep pushing on the only two levers that move when pushed: the interest-rate lever of financial repression and the wealth lever of asset purchases.
The results in 2014 should resemble those in 2013, with three new twists:
||Risk assets are already fully priced to expensive.
||Growth is resuming, at least in the US.
||A weak yen has helped Japan, but what’s next—especially for Japan’s Asian competitors, who are dealing with a weak/weakening yen?
2014 US outlook
For investors who need income and whose appetite for credit risk is limited, 2014 will be another year of drought. Worse, as the end of QE¹ takes shape in the US and eventually elsewhere, the risk of owning duration is severe. It is difficult to find any asset with a decent yield and minimal duration and valuation risks. A few bright spots can be found in short-term high-yield bonds and some mortgage markets. Beyond these specialized areas, investors will have to rely on active-management strategies to stem the steady rise in interest rates.
For equities, growth at a reasonable price is a viable strategy in some markets. These markets include the United States at 15 times projected 2014 earnings, with earnings growth estimated at 6% to 8%, and the United Kingdom at 13 times projected 2014 earnings, with a similar growth outlook. Japan, still experiencing a cheap-yen-driven export boom, has a high risk of failure. But there are also pockets of value. Spain, which in a few short years has radically trimmed its labor costs, repaired its banks and moved to a trade surplus, is valued at a P/E² in the mid-teens. Meanwhile, Spain’s earnings have dropped 50%, presenting an attractive combination of earnings recovery and reasonable valuation.
Commodities and real estate.
Commodities are still in a one-way trend: down. Demand from China has moderated (infrastructure spending is no longer 40% of GDP³) and the supply response has been tremendous. Global REITs4
are still growing as capital-markets funding of real estate replaces bank funding, but the importance of yield to REIT returns and valuations make them bond-like, that is, highly sensitive to the envisioned end of QE.
We are still prisoners of what the fellowship of the central bankers actually does, and of the markets’ guess about what the central bankers will do in the future. This market is powered not by the fundamentals of real rates, earnings growth and valuation, but by these two unpredictable drivers.
But maybe the most profound risk in 2014 is that investors will “anchor” tightly to the horrors of 2008 and early 2009 instead of realizing that the world is slowly but relentlessly normalizing. Our 2014 outlook is for more growth, more balance-sheet repair and more financial repression—not a return to the misery of the recent past.