There is something wrong in the world of investment strategy these days, in our opinion. Investment strategy has transformed from analyzing and hypothesizing where the markets and the economy were headed based on data and economic theory. Strategists were on the lookout for what had changed and what that might mean. It seems as strategy has morphed into an exercise in finding why conditions will revert to some theoretical mean or result in some desired outcome. All we see and read are exercises in wishful thinking. Oil prices can’t be correct at $45, $55 or $65 a barrel. Why? Because models were factoring in increased demand at certain levels and did not factor in either production or consumption efficiencies. We have heard strategists say over and over that there is no term premium left in the 10-year However, with the 10-year German bund at 0.41% and the 10-year JGB at 0.24%, the traditional relationship between rates and economic data have broken down and changed. To disregard the more global nature of the interest rate market and the hanging nature of the economy is irresponsible.
Einstein said that the definition of insanity is doing the same things over and over and expecting different results. What economists, strategists and pundits are doing is expecting the same results from very different demographic, technological and economic conditions. It is reverse Einstein. Why is a 4.00% Fed Funds Rate considered neutral? Because generally accepted theory (mainly developed since WWII) says so. What if the neutral Fed Funds Rate is 3.00% or 2.00%, given current economic realities? We have seen neutral rates much higher in emerging economies. Why can’t it be lower than 4.00% in a world filled with large economies which are very mature (almost elderly)?
To see a list of high yielding CDs go here.
Still classically trained “experts” cling to their models because that is what they have been taught. These are the same kind of people who had blind faith in mortgage default probabilities a decade ago even though lending standards and conditions had changed significantly. It seems as if investment strategy has devolved into an exercise in which highly educated professionals are tasked with searching for (manufacturing) reasons why correlations between interest rates, employment and inflation will revert to a mean developed after World War II. After World War II good jobs were plentiful and returning servicemen could go to college and buy homes thanks to the GI Bill. These veterans reached their mid-20s with little debt, decent wages and an education. Family formation started fairly early and families were large. The U.S. population was growing younger. Today we have young adults with large sums of student debt, a flat world for labor and an aging population. Who in their right mind would think that economic conditions and correlations would be the same today as they were during and immediately following the Baby Boom? Yet when we have strong job growth with mediocre wage gains, as we saw last week, the strategists and economists bloviate that there must be something wrong with the wage data. Why? Because if the problem was with the jobs data it might invalidate the models and theories on which they have built their careers.
Here is something to consider:
It is not disputed that many (if not most) of the jobs created in recent years have been part-time positions. However, most workers have “full-time expenses.” Thus it is very possible that some workers are working multiple jobs. It could be that the 250,000 jobs created last month employed only 175,000 individuals. However, since the models do not account for this, it can’t possibly be true. Let’s review some forecasts made using conventional models which have not come to fruition.
- A neutral Fed Funds Rate of 4.00% by now.
- A 10-year note over 4.00% or even 5.00% by now. Full employment strong wage growth.
- Inflation running at, near or even above historical trends.
- A weaker U.S. dollar as investors seek the advantages of stronger foreign economies and appreciating currencies.
The model worshipers missed on each and every one of these points. Their response: It is taking longer, just wait a while. The truth is: Unless conditions revert to those which existed when these models and theories were developed, the models and theories should prove incorrect. If doing the same thing over and over again is insanity then so must be expecting the same results while things are different.
The problem is that many strategists and economists fancy themselves as scientists of sorts. They try to break down economics into mathematical equations as a physicist might do with M-theory. The problem with this: While the laws of physics are uniform throughout the universe, the laws of economics are not, as they are subject to changing demographics, politics and the fickleness of human beings.
By Thomas Byrne – Director of Fixed Income – Investment Consultant – Wealth Strategies & Management LLC
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.