Divergence in the Dual Economies

An Interview with David Young of
Anfield Capital: 2/13/15

By John Harline, Elysian Capital Markets Group

We recently met with David Young, Founder and CEO of Anfield Capital, to discuss the condition of today’s world economy and financial markets. During our interview, David explained how the divergence of dual economies and asset bubbles lead to potentially catastrophic results for investors. David also explained how a “universal” fixed income approach offers a unique prescription to prevent portfolio destruction.

CAN YOU DEFINE THE DUAL ECONOMIES AND THEIR SIGNIFICANCE?

David: There are two types of economies that exist in the United States and in essentially every developed country in the world today. The real economy and the financial economy.

The real economy is the one with which we are most familiar. Microeconomics, macroeconomics and other sciences for over 200 years have been built upon this type of system. In a real economy, you wake up, go to work, earn a paycheck, go home, spend it on the weekend, and save for your investments and retirement. It is the system also referred to as the “Main Street” economy.

A financial economy is not as well known. It refers to things like Wall Street, global interest rate, bond markets, and credit default swaps. We can’t see it or feel it, but we know it’s there. It is often referred to in the press as an “Independent Ledger.” The financial economy is significant because it has been growing rapidly over the last 20 to 30 years due to the globalization of the world in the areas of economics, currency and trade.

In comparing the two economies, the financial economy always tends to be significantly greater than the real economy. For example, a 2012 Bundesbank study cites the worldwide real economy is valued at $63 trillion, while the global financial economy (volume of stocks, bonds, cash and currencies) is valued at nearly $1,700 trillion. This ratio is fairly consistent along most developed world markets, including the United States.

WHAT KIND OF ECONOMIC CYCLES EXIST WITHIN DUAL ECONOMIES?

David: Since there are two economies, there are going to be two types of economic cycles.

The first and most recognizable is the real economy cycle. In order to properly define it, we must look back in time to particular inflection points in history: Pre/Post World War II and Pre/Post 1970’s. Historically, these events interrupted the normal function of the real economy. As was the case in the post-1970’s era, the real economy cycle was considered a period of deregulation and democratization of investment accessibility wherein teachers, plumbers, cab drivers and lawyers were investing directly in stocks and bonds. (The “Every Person’s” Investment Period).

Real economy cycles are typically characterized by lower corporate earnings, increased layoffs and an overall decrease in consumer spending, which in turn leads to fewer sales throughout businesses. All of these events spill over into the stock, bond and real estate markets prompting the Federal Reserve to step in to stimulate the economy with a jolt of electricity — by lowering interest rates and injecting money into the stumbling economy. The real economic cycle continues until the central bank gets very clear signals from the economy like full employment, healthy GDP growth, a rise in wages and an increase in inflation, traditionally measured by the CPI. These signals result in the central bank acting to raise interest rates, which reduces the flow of liquidity and maintains the economic growth of the economy prior to potential destructive bubbles being formed.

However, central banks, by and large, do not have the ability to stabilize financial markets, or to avoid asset bubbles that may occur if too much liquidity is released, or left unattended for too long. Instead, the controls of financial markets tend to be disconnected from the central bank and left with the national treasury and other regulatory agencies like the SEC and FDIC to control.

This is where a financial economy cycle can potentially begin. Just like in the real economy cycle, the initial triage to fix a financial economy cycle is to dump money on the problem in an attempt to support troubled asset prices. But at some point, the monetary policy has to be controlled. In a financial economy cycle, the money cannot be left in the markets as long as it otherwise would in a real economy cycle, because the money will work its way deep into the financial economy, leaving the central banks with very little control to fix it. For evidence of this, one need only look to the stock market’s gleeful response to each round of QE stimulus, followed by a noticeable thud at the end of successive parties. A form of the same phenomenon can be seen with interest rates, which don’t always rise in the recovery from recession, as we were taught in Macro 101.

Although the Fed did the right thing by dousing the real economy in liquidity, when the asset markets stabilized, it should have realized this was a financial economy cycle flashpoint and used targeted tax cuts to put money (liquidity) more directly into the pockets of the real economy participants – both individual and corporate. This was the “quick math” at the peak of the various stimulus programs that said that rather than creating a multiple trillion dollar centralized government and bank program, just send the consumer their pro-rata share of the stimulus which is somewhere in the range of $25,000 to $50,000 per household. If the Fed had done this, I guarantee, in a practical sense, the result would have been very different! The consumer would have paid down debt, saved, invested, and bought all kinds of “things,” thereby creating jobs and frankly, paying a lot of sales tax by way of confident purchases.

However, this was never going to happen because the politics shifted to big government as the answer for systemic excess — which, of course, never works. The irony is, there was a chance to pull it off if our leaders had played it right and gone outside the system for a populist cure instead of staying within the system (and using their disdain for evil Wall Street bankers and sub-prime mortgage lenders, who were seen going through lower middle income neighborhoods, forcing good hardworking people at gunpoint to buy homes they would never make enough money to afford) for a plausible solution.

If we look at what has happened in the last four recovery periods, rates have actually gone flat to down. Specifically, in ‘82, ‘91, ‘01, and most recently, ‘09 cycles, rates actually went down during the recovery, and in the most recent ’09 cycle, rates have fallen during a recovery that has lasted five years plus. So, why is this important? Well, if you are the central bank, it is difficult to identify market signals that trigger when to reduce liquidity. Typically, these signals will be found in price inflation within asset bubbles, but controlling this area of a financial economy cycle can be trickier than just simply reducing liquidity.

This occurred in the late 90’s, when the United States was considered the “engine of global economic growth.” At that time, the Federal Reserve was considered the “lender of last resort.” Unfortunately, what that really meant was every time the Fed went to raise interest rates, something happened domestically or globally to stop them (the Russian debt default, the Long Term Capital hedge fund failure, or the Southeast Asia currency crisis.) The result was always the same: a delay in reducing liquidity. The delay in taking action in the 90’s resulted in the tech stock bubble, when the Fed kept the money in the system for too long and lost control of its liquidity function. In these situations, something has to stop capital markets from uncontrolled excesses, which can lead to a point of destruction, as evidenced by the bursting tech bubble. The moral of the story is that if the central bank does not control liquidity, an asset bubble will result and if left to its own devices, the bubble will burst.

HOW DOES THE RECENT CRISIS AND CURRENT RECOVERY COMPARE TO THOSE FROM THE PAST?

David: It’s funny. I get asked this question frequently by so many that are seeking answers. However, in order to answer it properly, it may be better for me to start with a simple analogy.

Think of a dam… a barrier constructed to block the flow of water. If water pressure builds uncontrollably, the dam will collapse. If the dam is well-constructed, increasing water pressure can be diffused with measured spillways, allowing a controlled flow of water to escape. Increasing water pressure would also trigger a series of warnings and sirens, signaling the apertures of water valves to be opened in order to bring the water pressure into equilibrium.

Likewise, if you consider the dam in our analogy as the real economy, where water liquidity turns turbines to produce electricity, the warning signals have been going off for the past couple of years. Despite the sirens, the valves within the dam of the real economy have not, thus far, relieved any building pressure. The apertures are not flowing properly, essentially clogged, because of problems in the banking system, the regulatory framework, the lack of corporate hiring due to a low-risk appetite, and even in the decrease in consumer spending due to unclear employment futures.

This scenario has the potential to force the pressure of liquidity to bounce off the real economy and spill over into the financial economy, thus creating multiple asset bubbles, and an uncontrollable flow of liquidity that will surely result in collapse.

This type of result is nothing new. Since the post-World War II decades, confusion in these dual economies, real and financial, has caused increased volatility due to the misdiagnosis of the real issues, and thus, the appropriate prescription for healing.

HOW DOES THIS RECESSION AND RECOVERY RELATE TO THE DUAL ECONOMIES AND THE EFFECT UPON THE FUTURE?

David: Arguably, the Fed keeping money in the market, unchecked, during the 2000’s was one of the root causes for the sub-prime, shadow banking, residual mortgage and commercial mortgage collapse. This led to one of the greatest economic downturns since the Great Depression and from which we are still feeling the effects.

The 2008 crisis was a function of the financial economy cycle spilling over into the real economy. This signaled the Fed to act, as if it were in a real economy cycle, and pump vast quantities of money into the system. However, according to the NBER (National Bureau of Economic Data), what has happened in the real economy since

April 2009, measuring from the trough of the recession to the present, is the following:

  • Employment rising cumulatively at a rate of 6%
  • Personal consumption is up cumulatively 13%
  • Real GDP is up cumulatively 13ish%
  • Hourly wages are up cumulatively 11-12%

This is an average increase of 1-2% per year for employment and 2% per year on working, earning and consumer spending. So, all this liquidity which the Fed has injected into the system has, for the most part, bounced off the real economy and landed back into the financial economy.

As a result of the bounce back, the cumulative growth of the financial economy over the last five years is as follows:

  • Bonds are up cumulatively by 27%
  • Commodities are up cumulatively by 12%
  • Commercial real estate is up cumulatively by 68%
  • US stocks (S&P 500) are up cumulatively by 118%
  • Residential real estate is up cumulatively by 212%

So, we are past the prior financial asset valuation peaks of 2007, while the real economy measures remain anemic. This puts the financial markets in a place where asset bubbles are forming again, while focus of recovery remains on the real economy metrics. Part of the issue that exists is the lack of guidance from the Fed, as well as the government, arguably due to the focus on real economy metrics. Thus, when the banks are unsure of what to do, and the markets are unsure of what to do, this leaves investors in a more vulnerable place than they have been in recent memory. This presents a challenging paradox.

WHAT MUST THE CENTRAL BANK DO TO MINIMIZE VOLATILITY OR THE POTENTIAL BURST OF AN ASSET BUBBLE?

David: In my opinion, this has been, by far, the most policy-driven and manipulated expansion I have ever seen… I cannot recall a time that this has been truer than over the last five years. However, I recognize the Fed has a tough job, because it does not want to abandon the real economy. The Fed also knows that this is going to be an economic expansion without traditional job creation, a trend resulting in increased use of independent contractors and a rise in part-time employment. This causes slower wage increases, lower consumer spending and confidence and thus, a boring GDP. It also realizes that this will likely be a recovery without traditional, measured economic inflation. Nevertheless, it must be careful not to unwind the recovery gains that have been made over the last five years either way.

The Fed is aware of the expanding asset bubbles and realizes its actions can directly result in a potential crisis. Still the fate of the building pressure in the asset bubbles will be directly related to their ultimate decisions. Despite its indecision, the Fed does not want to be too late to the party to have an effect.

If the Fed arrives just in time, or “fashionably” late, and still manages the process without bursting the expanding asset bubbles, they can still look like heroes in the eyes of investors. This simply means that the Fed can show up fashionably late to the party in time to have its desired effect. The desired effect, in this case, is Plan B. In the spirit of Plan B, we look back to our dam analogy. The Fed is aware of the flashing lights and warning signals indicating that pressure is building to the point of collapse and uncontrollable spill over. At this point, the apertures must be opened to prevent an uncontrollable flood.

However, I fear if the Fed waits too long, and the market gets ahold of these asset bubbles, the market will get to a point of uncontrolled excesses, which will result in a very disorderly and destructive unwind of either the liquidity cycle, interest rate cycle, asset cycle, or all three.

HOW CAN THE “UNIVERSAL” FIXED INCOME APPROACH GUIDE INVESTORS THROUGH THE UNCERTAINTY OF REACTIONS TO ANY CENTRAL BANK ACTIONS?

David: This recovery and the uncontrolled liquidity in the asset markets do not have to end badly. In fact, we are not saying the S&P 500 is going to collapse, I don’t believe it will actually, I believe it will be okay. These asset segments don’t have to collapse, if the appropriate action is taken. We are not calling for the bursting of the asset bubbles. In fact, we are pleading with the Fed to start addressing the problems before we get beyond the point of no return. We are ever hopeful that the Fed will take action. However, in the fixed income sphere, I do fear that it is actually too late. Fixed income markets don’t collapse or burst like other markets do, but in my opinion, the Fed is too far behind to negotiate an orderly normalization of this interest rate cycle. It is past the point of no return for treasuries and bonds.

We believe our Universal Fixed Income approach will allow our clients to avoid areas of concern within the fixed income portions of their portfolios. The Universal Fixed Income approach is at a basis, a replacement for Core Bond funds, and is best used to control interest rate risk, rather than trying to maximize returns, and has absolute return elements that will strive for performance 2% to 3% above inflation in this current environment.

At its core, the Universal Fixed Income approach looks at asset bubbles, the cycles, the divergence between the financial economy and the real economy, and the likely painful exit of liquidity and the effects on each. By way of analogy, when a train is approaching, this strategy gives you the ability to get off the train tracks all together, which allows your fixed income portfolio to disconnect from benchmarks and guidelines, which represent the binds that tie you to the tracks.

The Universal Fixed Income approach recognizes that benchmarks are a recipe for disaster. These market indices, which are a sampling of the issuance patterns of Wall Street, are going to take you down the wrong paths, even more so as you go late into cycles. We believe Wall Street will churn out ever-increasing quantities of lower-quality, longer maturity bonds, which are exactly what you don’t want or certainly need. Because of this, we believe that you need to eliminate the benchmarks and guidelines, because those only exist to force portfolio managers to stay in a pre-determined zone, but most importantly, force diversification blindly into portfolios.

 

Benchmarking: Two Epic Fallacies

  • Started out as a way to measure ex-post performance, then morphed into a way to categorize investment managers becoming the ex-ante paradigm
    • Now ALM drives Required Return, which drives asset allocation, and allocation drives manager selection because you have to fit into a box to get funded.
  • Desire to define manager risk via benchmark relative guidelines
    • This is in complete contravention to the reality and logic, and too often result in:
      • Increased concentration of risk factors
      • Reduced manager diversification (all have to operate the same zones)
      • And if you believe the opportunity set is non-stationary, and forced buying and selling at ranges (guideline limit) reduces tail risk; then the only logical conclusion is that stationary rules in a non-stationary world must result in a lower, flatter distribution of returns skewed to the left – and therefore a lower mean return with higher risk over time – the exact antithesis of the goal.

 

We believe that you should have the freedom to take your money out of harm’s way. Our way of managing fixed income assets provides our clients with a universal opportunity set, by giving them a way to get off the train tracks, while making sure they are not doing so while on a bridge. In reality, while making sure that we don’t have 100% of our investments in the US treasury market, (the asset class that is arguably going to be hardest hit), the prescription is to guide us to have holdings across more appropriate markets. We will not pile all of our investments into one or two big investment themes and hope we get it right. We prefer instead to have 6, 8, 10 different investment themes drive sources of total return. Moreover, each source is calibrated in such a way as to work together in synchronicity, and to avoid oncoming trains.

As a rule, our Universal Fixed Income approach seeks to provide four key deliverables. First, we strive to protect capital. We recognize that investors do not want to lose money. Second, we want to stay in the game by shifting to defense and allowing our clients to maintain their current asset allocation without any disruption. They should not have to decide when to exit the bond market, how they should exit (either totally or partially), what they should do with their assets in the meantime or how they should re-enter. This is our job. There are going to be a lot of decisions that will need to be made and it is our belief that having the freedom to make the right decisions will result in a more positive outcome. Third, we would like to contribute to the party with a modest inflation plus 2-3% increase. Finally, we want to be there for our clients and be ready to move – be their reservoir of dry powder. As the market presents chunkier opportunities, we want to be ready to make that journey on behalf of the client and to redeploy capital into riskier areas and higher expected returns.

At the end of the day, our mission in the Universal Fixed Income approach is very simple. The whole world knows that interest rates have to go up, and whether or not you buy our thesis that it will be sooner rather than later doesn’t matter. Basically, everyone knows that interest rates must rise, and the decisions that investors make prior, during and after the event, will be critical to the health of their portfolios.

David Young Profile

david_youngDavid Young is the Founder of Anfield Group, LLC and the Chief Executive Officer at Anfield Capital. As Anfield Capital’s CEO, David spends most of his time driving the strategic direction of the firm, leading the global macro strategy, and building strategic relationships with clients and partners.

With 26 years of investment experience, David has worked with many of the largest institutional and private investors. Prior to founding Anfield Group, he spent 15 years at Pacific Investment Management Company focused on investment strategy, portfolio management and asset allocation. In 1999, he was head of PIMCO’s account management group in London where he built a team of 25 investment professionals managing over 200 clients with $50 billion in assets.

David retired from PIMCO in 2008 as Executive Vice President to rejoin the University of California, Irvine Merage School of Business as Adjunct Professor of Finance, and launch Anfield Group.

David holds the Chartered Financial Analyst designation, an MBA with a concentration in Finance from the Paul Merage School of Business at the University of California, Irvine and degrees in Economics and Political Science from UC, Irvine. Over the years, David has taught finance and investment courses at the Paul Merage School, the Financial Times Knowledge programs (UK), and CFA exam preparation courses. David sits on several non-profit Investment Committees and Boards of Directors. David and his wife enjoy spending time with friends and family, collecting art and antiques. David is also an avid music buff.

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