Minsky Moment, Shadow Banking & the New Neutral: Key Terms Towards Understanding the Impact of Inflation

Well over a decade ago I sat in a large conference hall next to a fellow investment manager at a weekend boondoggle put on by a large institutional client. He had a great sense of humor and an intellect best described as down home wisdom that was downright scholarly. His name was Paul McCulley and he went on to become a fixture at PIMCO until he retired in 2010. McCulley recently rejoined PIMCO as chief economist, a role that again provides him a platform for sharing his erudite thoughts on the economy and the market. McCulley has had many prescient investment calls over the years and was responsible for coining the phrases “Minsky Moment” and “Shadow Banking.” When warning of the impending Russian financial crisis in 1998, McCulley cited the Asian Debt crisis of 1997 as a Minsky Moment, referring to the Keynsian economist, Hyman Minsky, who helped us to understand the fragility of the business cycle and the consequences of speculation and debt. Shadow Banking was McCulley’s reference to non-bank financial intermediaries, including hedge funds, credit insurance providers (AIG), and the like, which he suggested were causing the real estate bubble that led to the Great Recession.

For the last decade or more the Fed has set its policy rate (Fed Funds Target Rate) based on the assumption that nominal GDP growth of 4% could be sustained if inflation remained at a stabilized rate of 2% (see below). Accordingly, the Fed Funds target rate was 4% and the neutral or natural rate of interest was 2% (Nominal GDP minus stabilized inflation). The “New Neutral” is a phrase coined by PIMCO in May of this year and a concept that McCulley has been writing about for 10 years. PIMCO makes a compelling argument that the post-crisis world of deleveraging, deglobalization, reregulation, and austerity, has lowered domestic and global nominal growth prospects to the 2% range, which when offset by 2% inflation results in a New Neutral real rate of 0%!

Inflation: The New Reality

If PIMCO is correct that the New Neutral is 0%, then by historical formula the Fed would lower its target policy rate to 2%. It is important to remember that financial assets are priced off of this lower “risk free” rate of interest. Present value calculations that discount future earnings back at a lower rate of interest result in higher stock prices. As such, current equity market valuations seem far less extreme. To wit, over the last 15 years the S&P 500 has averaged about 15X earnings with a 10-year Treasury averaging 6.7%, which makes today’s S&P 500 earnings multiple of 16 with a 10-year Treasury rate of 2.5% seem quite reasonable. However, lower interest rates go hand-in-hand with slower economic growth and it is important to remember that slower economic growth begets lower rates of return on financial assets. As such, expectations for portfolio returns must be adjusted accordingly.

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Is This The Market Correction We Have Been Expecting?

The S&P 500 has gone about 1,030 days without a 10% correction, which is the third longest period without such a correction in 25 years. Of course, it is just a matter of time before we get a 10% decline in the broad equity indexes and when it comes it will be healthy for the markets’ continued run up. However, we shouldn’t be paralyzed waiting for stocks to drop – recall that between 1990 through 1997 equities went 2,573 days without a 10% correction and the market doubled in value from the 1997 peak. What makes the lack of such a correction now so surprising is that there has been no dearth of news that might serve as a catalyst for a meaningful market decline. The markets have taken in stride the events in Crimea, the downed passenger plane in Ukraine, escalating violence in the Middle East, concerns about China’s banking system, and ISIS in Iraq; any one of which might have frayed the nerves of investors and caused a wave of selling.

Within a few basis points one way or the other, the broad equity indexes declined 2.7% last week, the largest weekly percentage decline in just over two years. The S&P 500 is now down 3.2% from the July 24th record close. Not yet a 10% correction, but enough to get everyone’s attention. The market first began to slip last week with news of Argentina’s debt default and the ordered recapitalization of Portugal’s Banco Espirito Santo. However, Argentina has become a serial defaulter and the BES news was expected. So, more likely than not, it was economic data that supports an improving economy that was the catalyst for the market drop. In every economic recovery there is a point where good news becomes bad news, because good news provides a reason for Fed accommodation to be lifted. The Fed has been transparent with their intensions; they will continue to reduce and then terminate their bond buying program in October and they will maintain a zero-interest rates policy until such time as economic conditions warrant an increase in rates. Last week’s market drop registered investor fear that rates will rise sooner than otherwise expected.

However, investor concern over higher interest rates will dissipate as they come to the realization that rising interest rates are a sign of real economic improvement. Moreover, even though rates will rise in the months ahead, interest rates are likely to remain historically low. (See the most recent Telemus Quarterly Commentary.) Historically, the equity markets have performed well in rising interest rate environments, as long as the 10-year Treasury remains below 5%. We have very little concern that the 10-year Treasury yield will even approach 5% for years to come. Whether this market downturn will deteriorate to a 10% correction will prove itself over the days and weeks ahead. The cause of a further decline could be increased geopolitical tension or more concern for rising interest rates. However, the geopolitical situation will soften (as it always does) before it rears its ugly head again. As for interest rates, an improving economy will cause rates to rise, but for the right reason.

In the meantime, we continue to take action in client portfolios consistent with our view of the economy, our overall investment strategy, and client risk parameters. We have reduced our interest rate sensitive fixed income exposure and have increased our holdings to credit sensitive area of the bond market. The duration of our fixed income portfolios continues to be less than our benchmark because of our view that interest rates will rise. Global bond yields have actually decreased since the start of the year, so our shorter duration positioning has detracted from performance relative to our Barclays Global Aggregate benchmark. Given the improving economy and the likelihood of rising rates, we will maintain our shorter duration positioning.

Relative to our equity holdings, we continue to overweight international companies because of more favorable valuations than domestic stocks. However, economic growth outside of the US has been harder to come by and Russian sanctions certainly pose a risk to Euroland recovery. However, as the US economy builds strength there will be a spillover effect, which may mitigate some of the impact of Russian sanctions. In addition to last week’s strong GDP report, the existing homes sales number was very promising and the jobs report was decent, though it fell marginally short of expectations. Relative to jobs, the Fed is very focused on wage growth in determining interest rate policy and wage growth is likely to improve as corporate confidence builds and the jobs market tightens. Recent capital spending numbers have improved and M&A is robust, both of which signal strengthening corporate confidence. As always, economic fundamentals will drive the true direction of the markets and monitoring economic metrics will continue to be our focus.

We understand that short-term downturns in the market can be disquieting, so please feel free to reach out with any questions or concerns.

Telemus Capital, LLC Investment Committee

PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This market commentary is a matter of opinion and is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of Telemus Capital, LLC. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable, but not guaranteed.