Economic Musings @economicmusings - Tumblr Blog

Marketplace Lending Takeaways

There's been a flood of news over the last few weeks in the alternative lending space involving LendingClub, Prosper, SoFi, and OnDeck. What are the takeaways so far? -Lending is difficult: In a tweet last evening I said: All the boring things that "disruptors" take for granted in banking institutions (procedures, underwriting, compliance, etc) are now rearing their head. There's valid reasons why FinTech has become popular since the financial crisis. The regulator burden at banks IS big and annoying, and regulations such as Dodd Frank, Volcker, and others HAS pushed risk outside the banking system. There's a reason why banking is a regulated space and for the most part that's a good thing. Have you talked to someone recently who went through a home mortgage refinance? It's like pulling teeth, and much more difficult than getting a subprime auto loan for instance. But this is ok. Even if underwriting has swung from one extreme to another, it's probably a good thing given what happened in '08. Having a solid culture of credit and compliance isn't a cheap endeavor. Just look at how many people are on bank CCAR/stress test teams. While some people blame the recent events at LendingClub on "ethical" missteps, in reality I believe regulated financial entities are far less likely to have a culture and environment where something like this can happen. Now think, if the industry bellwether had this happen, do we think that this could be happening elsewhere? -Is it possible these lenders can only survive in a low rate / easy credit world? The answer is probably to be determined. That being said, there's a whole host of reasons to be concerned. 1. We've seen the difficultly that these businesses have had with funding when the credit markets had hiccups in Q1. This is obvious but core deposit funded banks don't have to access the ABS market or have bank lines in place to fund loans. A stable funding base that's there regardless of the whims of the credit market is huge. Where do these lenders turn where credit tightens, and yield chase mentality isn't the only thing on investors minds? -It won't get better than this! In terms of credit quality and ability to tap the funding market, how can it get better than the last few years? So if these companies can't make it work (very well) now, I think there's reason to question their performance in a different part of the credit cycle. Very little of this is really "disruption" at all. Focusing on the lending is great, but there's a whole lot more that goes into making this work. While I am encouraged that technology folks are focused on the financial sector, and I'm hopeful that incremental improvements can be made, it appears that "disruption" will not be fast & furious. Instead, they will be forced to earn the trust of Wall Street investors who have not too distant scars from the financial crisis less than a decade ago.

The biggest carry trade in the world

By now, everyone knows that the Fed hiked rates yesterday. What most people don’t realize though is that the economics of the “biggest carry trade in the world” has now changed. To review, when the Fed purchased bonds they paid for them with newly created reserves which sit at banks earning IOR (interest on reserves). So before yesterday, the Fed was receiving interest on the bonds that they purchased (US Treasuries & Agency MBS), while paying out 25bps to banks on the corresponding reserves. Simply put this is/was a multi trillion dollar carry trade, borrowing in the overnight market (paying IOR to banks) while earning the yield on the longer maturity bonds that they purchased.

Starting today, the economics of this trade changed. Now the Fed is paying 50bps for IOR, while the yield on the bonds they’ve purchased is unchanged. At the margin, this is a positive stimulus for the private market with 50bps being paid on reserves instead of 25bps. I’ve always said that I believe this “carry trade” is disinflationary at the margin as the private sector does not earn the income on the bonds. Starting today this “margin” the Fed is earning is less. Does this have massive implications? No, as this “carry” is still very profitable as the Fed is essentially borrowing at 50bps and earning well in excess of that on their average holding. At the margin though, this is an additional 25bps being earned by the private sector on multiple trillion of reserves. This is stimulative for the private sector.

The Financial Wall of Worry & Who is Exposed

The wall of worry since the great financial crisis always seemed high in the moment. Extraordinary experimental measures put into place led to sentiment that the Fed was/is creating a bubble, or inflation, or whatever. The ex post realities thus far have proven much less sensational than most thought. The banking system is stable, housing is recovering (although in a different way than we thought with multi-family leading), and inflation is lower than anyone thought it would be at this stage. So going forward, given we like to find things to worry about, what should we worry about? Late last year in my 2015 outlook I predicted that we would see negative returns for both stocks and bonds. Maybe it happens, maybe not, still a third of the year left. My point though is that I believe the risk/reward of financial asset prices are a lot more vulnerable than the actual underlying economy. Just like the benefits of easy monetary policy generally benefitted the owners of financials assets, I believe the eventual era getting out of this environment (be it from a BoP crisis, Fed hike, etc) will lead to financial asset owners being hit and the general economy not hit much. This is more of an all else equal statement, if we see a global downturn, then sure, we could see the US economy with a downturn. I just believe that the asset owners & "rich" are more vulnerable to the excesses of this environment than previous times. On a broad asset class level, the risk/reward of owning many financial assets is marginal at best right now. Thankfully with the underlying economy looking stable, it won't be mom & pop that takes the brunt of the damage if markets tumble.

Late inning warning signals?

For market participants that were around during the 2006-2007 time period, the last few weeks brought up some memorable M&A names. For instance, this week First Data filed to go public. If you remember, KKR took First Data private in a $29bil deal which was the last “big” one before the crisis. The shareholders did well, and the company was left with nearly $22bil of additional debt, or 9x the amount on its balance sheet before the LBO.

The S-1 filed Monday shows operating profit has grown from $1bil in 2012 to $1.4bil in 2014, but the company has still lost money with interest expense from the debt between $1.7-1.9bil per year. Debt isn’t substantially lower at over $20bil, but arguably a lighter load with EBITDA trending higher. Despite a very untimely LBO in hindsight, First Data has reaped huge benefits of the low interest environment issuing monster leveraged loans and refinancing existing debt at lower costs.

It’s not just First Data, additional pre crisis deals such as Hilton and Sunguard are also expected to file and go public later this year - both deals scrutinized after the crisis but now back in the money.

Maybe the most fun example is yesterday’s Bloomberg article showing how Hostess Brands is issuing $1.2bil in term loans only two years after acquiring the company in liquidation for $400mil. $900mil of these new term loans will be used to pay the investors a dividend. Crazy? Well, the investors took the risk to invest in liquidation, but this does seem awfully “late cycle” like.

So, are these all warning signs that the debt cycle has gone too far? People are really investing in a Hostess dividend recap after two years? That even the worst deals from 06-07 are emerging looking good? I think there’s arguments on both sides. Economic healing and the benefits of the low rate environment have helped these companies heal & outgrow the debt somewhat, but investors should be cautious.

Book Review: “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches”

I have to be honest, I find many investment books incredibly boring & so much so that I sometimes don’t even finish reading. My friend Eric Freedman, CIO of Captrust, recently sent me a copy of “ The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches” by Larry Swedroe and Andrew Berkin. While there wasn’t anything earth shattering in the book, it was a thought provoking read that emphasized that while alpha does exist, it is more difficult to find in today’s environment. I will share some interesting tidbits from the book and leave you with some closing thoughts:

“A study by Wermers found that on a risk adjusted basis active equity mutual fund managers outperformed their benchmark by 0.7% per year on a gross basis. But after total expenses, the investors were left with negative net alpha. "economic rent" is going to the scare resource (ability to generate alpha), not to the plentiful resource (investor capital)”

This has been repeated in the media often lately, but individual ownership of equities directly has plummeted. At the end of WWII, households held more than 90% of US corporate equity. Fell to 48% by 1980 and 20% by 2008. The authors contend this trend has made markets more efficient.

The outperformance in Yale’s endowment fund was attributable to factor exposure and not skill in security selection The author says, “The Yale endowment fund's returns can be explained by consistent exposure to diversified, risk-tilted, equity oriented assets and extraordinary outperformed in PE and VC. The public equity returns are fully explained by exposure to factors (small cap & value), not skill in security selection.”

A simple factor model can explain nearly 100% of endowment returns: The authors tell of a 2013 study on university endowments by Barber and Wang which said that “a simple factor model shows that a 59% exposure to stocks and 41% exposure to the Barclays Agg explains 99% of returns” The authors conclude that “Despite taking on more risks such as opaque investments and illiquidity, there's no evidence that the average endowment delivers alpha relative to public bond or stock benchmarks.”

The paradox of skill: The authors use a sports analogy and remind readers of how rare it is in professional baseball for a hitter to hit for a .400 average. They correctly state that athletes are bigger, stronger, and faster today than at any other time in history, yet it is more difficult to hit .400 than it was 70 years ago. They conclude that the paradox of skill says that the average investor/athlete is better today, so outlier results are much more unlikely.

Younger funds outperform older ones: Funds aged up to 3 years outperformed those aged more than 10 years by a statistically significant 0.9% per year. The point of this is that younger funds lack a track record and are typically much smaller, so the majority of investors are not around in the early days of the fund to benefit from the higher returns.

Results of investing are more about relative skill than absolute skill. Again, the authors use a sports analogy about tennis to describe what market participants are going up against. This is the difference between Roger Federer playing a specific opponent or playing someone with Andy Roddick's serve, Andy Murray's backhand, and Rafael Nadal's baseline game. The market's collective wisdom is tough to beat.

Market impact costs eat into fund returns: The authors cited a MSCI Barra study that said, "A typical small cap or mid cap stock with 500mil in assets and an annual turnover rate of 80-100% could lose 3-5% per year due to market impact costs."

From 2004-2013 the HFRX Global Hedge Fund Index return was 1% yr, lower than every major asset class including 1 year treasuries.

Be careful investing in popular strategies or stocks which are HF favorites: "The lesson here is that whenever an investment strategy that is supposedly exploiting some market mid pricing has become popular, it may already be too late to join the party. And when a strategy becomes popular, not only will it have low expected returns due to crowding but the assets in it are weak hands that will panic at the first sign of trouble"

The authors conclude with a list of things that investors can do to combat this environment of ever shrinking alpha. I won’t post the list but will say that the book is a very easy read that is thought provoking and should only take an hour or two. To me, this book isn't so much about the efficiency of markets as it is the change in market efficiency over the last few decades. Going forward it seems like a foregone conclusion that lower cost alternatives such as ETFs will increase in popularity. Will this make extracting alpha even more difficult? Conversely, will it cause a large shakeup among investors whenever the market has another a prolonged period of losses and volatility?

What’s the worst rule of thumb commonly cited in the market?

Markets are complex and often investors search for short cuts or “rule of thumb” thinking to make it easier. Unfortunately this is not always the most prudent approach to investing and can result in mistakes. Yesterday on Twitter, I asked what’s the worst rule of thumb commonly cited in the market. Here are some responses:

@HFBondsTrader sell in may...

@EquityNYC Pigs get slaughtered

‏@BarbarianCap stocks trade at 15 P/E

@montoyan maximum pain

@modestproposal1 the crowd is always wrong

@zshrier Your bond allocation should = your age.

@DavidTaggart Just do what WarrenB does

@BluegrassCap CAPE

@CBHolsinger with the dividend, I am getting paid to wait i

@AlexRubalcava No one goes broke taking a profit

@LadyFOHF 'it's the algos'

@JFinDallas "It's down so much it has to bounce."

@DumbLuckCapital Gross margins are somehow indicative of business quality

@Royal_Arse active > passive.

@DumbLuckCapital ok if the a Tiger Cubs are doing it

@BarbarianCap stocks always go up in the long run (actually diversified, price momentum market indexes have do so for ~1% of human history)

@EquityNYC Diversification is the only free lunch

@DumbLuckCapital Leverage is bad

@hmeisler TINA

@MicroFundy "getting paid to wait"

@The_Analyst #x is cheap (expensive). Pick your multiple (if not level), it's almost always wrong or at least tunnel-vision view

@GeorgeManiereg Hold your nose and #BTFD

@MicroFundy risk = volatility

@VincePagano @delangedotcom "cash on the sidelines"

@BluegrassCap market cap to GDP

@PScatterpatter "this stock has valuation support."

‏@DumbLuckCapital PEG ratio of 1 or higher somehow means something good, even though 1 is an arbitrarily convenient cutoff signifying nothing.

@BrattleStCap assuming "the market has this one wrong" when the market is actually dead-on the vast majority of the time

@Valuetrap13 That a company is not a value because its P/E is too high, which ignores tons of factors

@TheStalwart “hope is not a strategy“

@spiegema to that end...'you have to be contrarian to make money'

‏@EquityNYC "value" = low P/E, P/B, EV/EBITDA

@LadyFOHF "More sellers than buyers" Or vice versa.

@BrokenBanker consensus is wrong

@kit_lowe That move was related to a physical deal...

@ArbCowboy default rates are at a historic low, we're in the sweet spot, anything on CNBC, follow the smart money, everyone's doing it

@JodyShenn Just use 15 CPR for the pricing speed?

@chigrl explaining every up move with "short covering"

@aneep if you liked it 40, you should love it at 30.

@HaidiLun Citi's "It's not a bubble until it doubles" call this week on China

@EdBorgato Viewing a stock at a discount to market as cheap and one at a premium as expensive rather than valuing it on absolute basis.

@ParHedge "Only price pays"

@awealthofcs stocks are riskier than bonds

@michaelsantoli That it's rigged.

@JBoorman "you'll never go broke taking a profit" (you will if u don't take losses even quicker)

@oknotsomuch buyside know what they're doing

‏@timothydh chiding any and all "this time it's different" arguments. It's always different

@cleverpur SOTP like no one else figured out the value of disparate businesses. $NUAN comes to mind as one of recent debacles of SOTP

@Vox_Magoo contrarianism

‏@ZipperTheory anything Jesse Livermore (investor not blogger) related x 10^2

What the Twitter "dots" are telling us about rate hikes

Right now the market is obsessed with figuring out if and when the Fed is going to raise interest rates. Rate participants closely watch the Fed's "dot plot" which shows the midpoint of the target range for the fed funds rate by year. The March dot plot released shows the end of 2016 with a median of 1.75% and the end of 2017 at 3.125% - both lower than the projections released in December. Even after this downward revision a large difference exists versus the market as futures are pricing in substantially lower rates than the dots indicate.

Enter the Twitter fed funds survey in which I asked followers to tell me where Fed Funds will be three years from today. 135 responses were used after trimming the highest and lowest three answers. The survey results are very close to what March 2018 Eurodollar futures (H8 contract) is pricing. More interesting though is the distribution and what it might be telling us about the different schools of thought.

Aside from a fun exercise, I hoped this survey would shed some light on the differences of how the market is viewing rates going forward versus the Fed. Here are a few things it might be telling us:

1. There appears to be two very distinct ideological camps in the responses. Roughly 20% of respondents see fed funds at or below 0.25% in three years while 35% see rates at or above 2.50%. The mean & median were both ~1.75% but the largest amount of responses were elsewhere - and the composition tells us important things.

On one hand you have the everything is going back to "normal" camp where participants likely point to month after month of strong employment gains, encouraging underlying trends of income gains, and inflation muted by commodity driven disinflationary pressures.

The other camp likely believes some or all of the following: the Fed will be unable to raise rates while maintaining stability, we're in a period of secular stagnation, international factors take a rate hike off the table, and the natural real rate of interest is now much lower than pre-crisis.

2. One faction of market respondents will be proven to be wrong and this could be painful for them. Pricing assets assuming multiple years of zero interest rates when 3-4% materializes would be a big miss. Similarly, it's conceivable that macro bulls could throw in the towel with another year of rates grinding here and the Fed unable to lift off. Both groups can't be right.

3. There's likely a recency bias: The pendulum swings quickly among Fed prognosticators. In mid January among plunging oil and European problems we saw 2y USTs fall to 0.40% and a June rate hike seemed unfathomable (yes, I said that too). Then in early March a huge payroll report sent 2y USTs above 0.70% and suddenly a June hike was a lock. Now only a few weeks later we have Fed minutes that show a lower GDP forecast without a 3% handle in sight, along with a lower "dot plot" as described above. The worry du jour today is the strengthening US dollar and the Fed's relative tightening versus other central bank's who have the pedal down. Whichever camp you're in, it pays to remember how short of a memory the market has with respect to this topic.

The Case For Slowing Reinvestment Before Hiking Rates

With Friday’s unemployment report showing a clear acceleration in both job gains and wage growth, the conversation turns to how and when the Fed should tighten policy. Since the onset of the financial crisis the Fed has loosened policy through both a zero interest rate policy (ZIRP) as well as large scale asset purchases (QE). The optimal way of tightening is commonly thought to be first a rate hike, and then a reduction of the Fed’s balance sheet, but I am going to argue that tightening in the reverse order might be worth considering. Here’s why: 1. The liability repricing cycle has mostly exhausted itself: A major benefit of lower long term interest rates and tighter spreads is that a large liability repricing cycle has occurred for both households (via mortgage refinancings) and corporations (refinancing corporate debt & issuing new debt). Between late 2011 and summer of 2013 a giant refinancing cycle occurred where 30yr fixed mortgage rates stayed under 4% and hit as low as 3.375%. In fact, as of 12/31/14 ,the US effective rate of interest on mortgage debt outstanding stood at 3.83%, down from 5.25% at the end of 2008. With mortgage debt outstanding at ~13.3Trillion, the annual savings works out to ~189billion. The same goes for corporations which have refinanced hundreds of billions of corporate debt into lower rates lowering than interest expense and freeing cash flow. 2. Reversal of portfolio balance channel One can debate the impact that the portfolio balance channel has had, but there's no denying that trillions of dollars worth of Agency MBS & USTs have been removed from the system forcing bond investors into other asset classes. The rationale for buying these bonds at the time was important & serves a great purpose. In 2009-2010 the market for lower rated credit securities was frozen with loss adjusted yields for non agency MBS, CMBS, and HY comfortably in the double digit range. The removal of so many safe bonds drove spreads lower and forced investors to take credit risk again. This was good, it was healthy, and it worked. But today is different, and it's not necessary to maintain a multi-trillion dollar balance sheet. The credit markets are roaring and fully thawed & if anything some moderation might be necessary. 3. Scarcity effect & the Impact of draining reserves via runoff In my opinion, draining reserves through the slowing of reinvestments (tens of billions of $'s of mortgages prepay each month which the Fed reinvests into new bonds to keep the balance sheet flat) would result in a few things in my opinion. The first is higher long term interest rates and credit volatility. I've discussed how & why that QE is the "greatest volatility sale ever" here on Ello https://ello.co/schawel The second impact would be through the steepening of the long end of the curve. Currently the Fed holds the vast majority of the long end duration. Slowing reinvestment would drain reserves and reduce the scarcity effect that is currently keeping longer UST yields lower than they would otherwise be. 4. Draining reserves is necessary to eventually have a "normal" fed funds market The lack of trading in fed funds is well documented and is easy to understand given the flood of liquidity in the banking sector from trillions of excess reserves. A rate hike without draining reserves requires the use of facilities such as RRP, TDF, and others to temporarily drain reserves. The permanent draining of reserves through letting the bonds runoff would start the process towards a system where a normal supply / demand market could exist for fed funds. Maybe these facilities they are proposing will work seamlessly & the quantity of reserves in the system will not matter, but I am skeptical of that. 5. Slowdown reinvestment & the hike In my mind the majority of risks that should be concerning are a bigger result of the size of the Fed's balance sheet versus ZIRP. In terms of bank lending, the quantify of reserves in the system is so large that banks would likely keep loan yields the same if the fed were to hike (thus lower loan spreads). This is a result of QE which has added trillions of dollars of deposits to the banking system. If those deposits were gone the fight for loans would be different & maybe 10y 3% fixed rate CRE loans wouldn't exist. So an overnight rate hike wouldn't slow/tighten the channel of lending as much as a gradual balance sheet reduction. Overall, the things that need to be cooled down are impacted more from the size of the balance sheet than the overnight rate. 6. There's no established playbook for the exit Although I feel confident this is the optimal way to proceed, we all need to realize this is a giant experiment and we don't know the implications of an exit. The unknown doesn't mean calamity but we should realize that this is unchartered territory.

Stocks & Bonds Fall - My 2015 Outlook

If we are to use recent history as a guide, something that's all too popular but rarely a good idea, investors should expect continued gains in equities in 2015 with the best exposure being index funds. Institutions gun-shy from the financial crisis have missed out the full runup in stocks since 2009 with many of them having large amounts of hedge fund exposure that only captured part of this historic rally. Hindsight analysts now proclaim "You would have been better off in an index fund without the crazy fees" - and they are obviously correct in that assertion. With the S&P nearing 2,100 nobody remembers the plethora of bear arguments over the last five plus years (hello greek debt crisis, fiscal cliff, tapering, and more). Of course today all that matters today in the average investors mind is how they've done. To my knowledge there's no bonus points for being "right" or "smart" if the P&L that accompanies it has suffered. There's no shortage of brilliant managers who have fought the Fed and lost miserably. Regardless of why your thesis has or hasn't worked out, we're sitting at the end of 2014 with 30y yields under 3% and the S&P nearing 2,100. The market seemingly believes there's no ceiling for stocks, and it's becoming more & more accepting of low long term treasury yields. The question is what will happen going forward - so here's some of my thoughts: 1. Negative returns for both the S&P 500 and the 10yr UST. This hasn't happened since 1969 but I believe it will happen this year. I am by no means predicting a crash for stocks, but it isn't difficult to foresee them lower by 5-10%. Does this mean I'm bearish on the economy? No, not at all. I actually see continued improvement, albeit small. Similarly, for longer UST bonds, the long end of the curve has flattened tremendously during 2014. We ended last year with the 30y at 4% and the 10y at 3%. It was very easy to buy duration with that much slope, and many thought I was crazy to advocate buying 30y California zero coupon munis! Today the 10yr UST sits at ~2.15%. Assuming a duration of 9.5, the 10yr yield needs to rise by about 25bps (factoring in a small roll) for a negative total return. Does a 10y yield of 2.40% seem outrageous? Not at all, but I also don't see a dramatic rise in rates either. 2. TIPS will outperform nominals If I recall correctly, TIPS have underperformed nominals 8 out of the last 11 years. Next year that will change. There's been a dramatic repricing in TIPS breakevens with the 5y BE currently at 1.20%. In my opinion this is a very cheap option on inflation, and one that has very little downside. 3. Oil won't fall to $40, but it's also not a screaming buy I am admittedly no expert here, but my feeling is that the dramatic move in oil is over. Maybe it slips a bit more, but the calls for $30-40 oil will not happen. 4. If you must own bonds, owning the 3-5yr will payoff There's a decent amount of slope at this point of the curve, and I'm still of the feeling that rate hikes either won't materialize as quick as expected, or if they do the market won't stomach more than one hike. The roll plus income on this point of the curve isn't super attractive, but should generally shield investors. 5. Volatility sellers will face a tough road Volatility has been suppressed in this market and it's by no accident. Through the Fed's QE program, the "greatest volatility sale" ever has occurred through the purchase of trillions of MBS without hedging them. Attempts by the Fed to normalize policy will lead to higher implied volatility in many corners of the market. 6. Hedge Funds will look a lot better Going back to my first bullet, I foresee 2015 as anything but an easy year for the average "index" investor. Hedge funds as an asset class will do well versus indices, and much of the scrutiny they've gotten will tone down. 7. Financials will perform well While financials have performed well since the crisis, they also haven't traded to historically high multiples such as biotechs, etc. Many of these financials can earn a sufficient ROE in this rate environment with positive optionality should the short end of the curve rise. 8. Cash has a place Unless you have the industry knowledge to pick the winners and losers within energy, chances are there's nothing so cheap out there that you shouldn't have some dry powder. Opportunities will open up during various points of 2015, and there's few things as frustrating as being fully invested during a volatile selloff. 9. EM bonds are buyable Difficult to buy in this environment given the carnage, but opportunities are available in various EM debt funds such as ELD and EDD. Many are reluctant to buy this local debt given the rapidly appreciating dollar, but over time I believe this will prove to be a good buying opportunity and risk diversifier. 10. We will all be wrong (in some ways) Each year events happen that participants wouldn't have expected. In 2013 it was the speed of the rise in interest rates, and during 2014 it was the speed in which the oil market repriced. Understanding that outside the box events happen regularly is important, as is the ability to change your mind as the facts change.

Why the Gross vs Ivascyn comparison is misleading

A lot has been made of the track records of Bill Gross and Dan Ivascyn managed funds since the sudden departure of Gross from PIMCO. Mainstream media has covered the aftermath in great detail, but explanations of the performance have gone relatively untouched. Was the performance of Bill Gross really that awful? Was it entirely attributable to a poor call on US Treasuries? Is the Ivascyn magic touch now about to change all of PIMCO's bond funds? Let's sort through the facts and establish some pragmatic views on the subjects.

1. Ivascyn knocked it out of the park

Make no mistake about it, the management of Dan Ivascyn's funds the since the crisis has been nothing short of superb. The PIMCO Income Fund (PIMIX) is up an average of 12.8% over 5 years versus the category average of 7.2%, ranking it better than 99% of peers according to Morningstar. Fund assets grew from $300mil in 2008 to $6.5bil at the end of 2011, and now $38.6bil at the end of September 2014.

Ivascyn and co-PM Alfred Murata targeted beat up credit assets that would benefit from a reflating of the financial markets. As central banks moved interest rates to zero and removed government bonds from the system, investors were forced to incrementally move out the credit curve.

An example of something that PIMIX has owned and done extremely well on is Spanish Covered Bonds. This is one the larger holdings in PIMIX. As shown, in three years, the price has risen from ~50 cents on the dollar to ~120 as the Euro debt crisis calmed.

Arguably the largest source of returns for the PIMCO Income Fund has been from non-agency MBS. There's been arguably no better place for outsized returns in fixed income than non-agency MBS since 2009. Ivascyn and team made shrewd bets that these assets would recover and they did.

All in all, Ivascyn's bets have been credit related and have centered around risk premium compression in the junkiest areas of credit. He has not been without misses - as his PIMCO funds held large amounts of Brazilian entrepreneur Eike Batista's bankrupt OGX, as well Mexican homebuilder Homex. The point is not that he got a few wrong, but that he bet big on a recovery in the weakest areas of the credit markets and has largely been correct. Gross himself recognized & apparently liked this opportunity set as he is the largest owner of the Ivascyn managed PIMCO Dynamic Income fund (I consider it a leveraged version of PIMIX) with over 1.6mil shares held.

2. Gross' Total Return Fund was not comparable to Ivascyn's Income Fund

The objective of the PIMCO Total Return Fund is to "maximize total return, consistent with preservation of capital and prudent investment management. The fund invests at least 65% of its assets in investment grade fixed income".

The objective of the PIMCO Income Fund is to "maximize current income and to seek for long-term capital appreciation..."

These objectives are not anything similar to each other. The Gross managed Total Return Fund by mandate must seek preservation capital and may only hold a maximum of 35% in non investment grade bonds. In contrast, the Income fund is seeking to maximize current income and long term capital appreciation. Gross was forced to hold a substantially larger amount of government bonds and lower yielding IG credit.

3. Even if he wanted to, the Total Return Fund was too large to buy the bonds that Ivascyn bought

Peaking at $293billion, the Total Return Fund is an absolute behemoth. Bottom line is that the types of bonds which had the most outsized returns (such as non-agency MBS) were not able to be purchased in great enough size to move the needle.

The size of the entire non-agency universe has fallen to under $750billion. After accounting for legacy holders, hedge funds, and banks, the universe to buy is very small. As an example, the large Maiden Lane auctions where the Government sold off amounts of non-agency MBS were only around $7bil if I recall correctly. If the Total Return Fund bought that whole thing it still would've been a very small allocation to the fund.

4. The performance of the Total Return Fund was largely based on duration calls

With a fund so large as Gross managed, the relatively performance of it came down to his call on duration. It's been well documented that he was wrong about US rates a few years ago and that lack of duration hurt his relative performance. Regardless of QE or "the new normal", his views on how much duration to take was the big determinant. He bet that rates would rise and inflation would as well (Gross funds were heavily long TIPS).

Yes, Gross and team made some mistakes but comparison to Ivascyn's funds are misleading. They were playing in very different areas of the bond market and the size of Gross' Total Return Fund were a big headwind. Astute readers will note that Ivascyn isn't on the PM team for the Total Return fund & that's probably a smart choice. Ironically, as Gundlach mentioned yesterday, the biggest mistake that Gross made might have been letting his flagship fund get too large.

Some thoughts on the markets

There's a lot happening underneath the surface in the markets right now and I thought It would be worth highlighting a few of these things.

Inflation Expectations Plummeting

Above is the 5yr inflation breakeven. As you can see, the annual inflation expectation has fallen from ~2.10% per year in July to ~1.65% today. This is a substantial drop in expectations. There's nothing in the current inflation data to indicate that, at the margin, expectations should be plummeting. That being said, the market looks to be somewhat taken off guard by the FOMC's higher than expected Fed Funds forecast for 2016 & 2017. This "tighter" Fed is driving much of this IMO.

Below is the chart for 5yr real yields. Goes without saying, but falling breakevens & rising nominal yields have caused real yields to shoot higher. As shown in the chart, 5yr real yields at 15bps are at their highest level in over 3 years.

Dollar rising

This is a surprise to nobody, but the dollar has been on an absolute tear with the DXY rising from 80 to 84.72 since July, but the move is actually fairly small in a longer historical perspective. The US economic cycle is much further ahead than other developed economies right now. In the US there's actually discussion about a rate hike while other places such as Europe the discussion is centered around further easing & fighting deflation.

Yen Weakening

The dollar strength has been broad based and has also included the Yen. The USDJPY has resume its upward climb and stood over 109 as of this morning. At current levels there's a substantial gap in inflation expectations between the two economies. In Japan 5yr inflation breakevens are ~2.3% while as discussed, in the US, they are at ~1.65%. There's been a lot of promises from Abe and the BoJ, but I am skeptical of this inflation materializing.

As of 6/30/14, Japan's current account balance moved to negative 0.12% of GDP after being positive for the last 20+ years. Part of this is the fact that Japan has had to import high cost energy after having to take the nuclear reactors off line. If/when the nuclear power comes back, this should materially help Japan's current account deficit and may potentially be a tailwind for Yen appreciation.

Gold

The chart of gold looks pretty bleak but I think there's a number of reasons for this. Many of the "memes" that gold bulls have pointed to are now gone or are coming to an end. QE, which some erroneously coined as "money printing" and inflationary, is coming to an end. Second, inflation is low and inflation expectations have plummeted as shown above. Third, the dollar has materially strengthened. Now this doesn't mean that gold can't go up, or won't go up, but many of the reasons commonly cited by gold bulls have now gone by the way side.

JPM on Fed exit, IOER, and Repo

"We learned a little bit more about the Fed's intention on exit strategies in this week's minutes. As expected, the Fed is leaning towards IOER as the main policy rate and the RRP playing a supporting role. The Fed plans to set the RRP rate "at or above 20bps" below IOER. Interestingly though, most participants also felt the Fed Funds Effective rate should also be examined and the calculation should be amended to obtain a more "robust measure of overnight bank funding rates." Which was an odd reference because we've learned post-crisis that setting the IOER rate doesn't control the Fed effective rate. Mainly because GSE's and a few non-bank institutions do not receive interest on their reserve balances. Incentivizing these counterparties to lend in the Fed funds mkt at rates well below IOER and widening the IOER/FFeff spd. GSEs now account for a vast majority of lending into the fed funds market. It wasn't initially clear to me why the Fed was focused on the Fed effective calculation in the mins though. But after a little research, and seeing Lockhart's comments today, it certainly makes more sense. The federal funds rate, is currently calculated on the basis of "brokered trades" of overnight loans of reserves between banks. However, this excludes "direct trades" and "eurodollar transactions" which is anything outside of the broker platform. Fed Funds are not traded on our desk but I would guess that meant a large portion of the overnight lending activity was not currently being captured in the effective calculation. "The Fed has already started collecting this data from 165 domestic banks and U.S. branches of foreign banks since 4/1st." Hard to tell what kind of an impact this will have on lending rates but it definitely makes sense that the setting should include all trades, something that needs to be fixed before official exit strategies are determined."

Gundlach takes down duration

The rate rally on the long end of the curve this year caught most big investors by surprise but Doubleline's funds were well positioned. Gundlach's funds had exposure via last cash flow mortgage bonds and "Z" bonds which price off of the 10yr or further point of the treasury curve. With the 10yr down ~50bps YTD, these bonds have had substantial price appreciation.

Looking at some updated holdings as of May month end, I noticed that Gundlach and team took down duration by selling out of many of the aforementioned long duration bonds. While this shouldn't be a declaration that "rates are going up", it's interesting to see that Gundlach who has been bullish on longer duration bonds has started to pare back exposure.

Thoughts on RRP, Term Deposits, and Fed Exit

I tweeted a few thoughts last night on lingering questions of how the Fed will eventually drain reserves. The more you look into this, the more problematic it becomes. On the bright side (or the dark side?), maybe things won't improve enough where they'll need to drain reserves and this whole "fear" will be null and void. The following are tweets of mine from last night on these topics:

The thing about TDF: goal is to reduce reserves from the system so their demand for reserves will force them to borrow from interbank mkt

Now think about that: banks will need to voluntarily enter into term deposits w hope that they'll need demand for those at a "natural" rate

Reserves were added by brute force (purchases) so you can't expect banks to have a demand to borrow them b/c they've locked them away in TDF

Would you put all your excess liquidity in a bank CD so that you'd have to borrow if something came up? Therefore TDF cannot be primary tool

Projecting the price at which participants will enter RRP is a fools game. No price for liquidity when you need it, esp in HQLA environment

Banks & Fed now forever intertwined in a big way- mass implications for functionality of banks & credit flow w all Fed exit options

The shifting of risk in the system

Speaking at an investor conference yesterday, Citigroup CEO Mike Corbat noted that they may finally be able to sell their OneMain Financial unit which is housed in Citi Holdings. This is interesting from a number of different angles including the resurgence of consumer lending as well as the path of global investment banks post the global financial crisis.

It is no secret that large banks have been hit with an avalanche of new regulations since the crisis including Dodd-Frank and new Basel III rules. Systemically it's understandable that regulators and policymakers looked back upon the previous banking system and saw great risks which they wanted to "fix". We are now almost six years past the crisis and the very institutions that are in position to help with the recovery are arguably being stifled from doing so.

This example of Citigroup and OneMain clearly shows how risk in the system is being transferred and who some of the new actors will be going forward. The reason that Citi has been reluctant to part with OneMain has to do with funding. Citi as a bank can fund the high yielding (usually 20%+) loans of OneMain financial with their deposits which have a very low cost of funds in this ZIRP environment. A private equity buyer wouldn't have the luxury of "free deposits" to fund with, thus the economics to them are substantially worse. OneMain's competitor, Springleaf, which i have written extensively about funds their loan book with a mixture of corporate debt and asset backed securities.

We're in an environment where net interest margins are under pressure, and Citigroup is going to eventually part with high yielding loans from OneMain at an uneconomic price. Again this is true because any non-bank buyer cannot fund these loans at the levels that Citigroup can. There's broader implications here, as private equity institutions such as Fortress, Blackstone, and KKR appear to be taking on risks (and rewards) that were previously reserved for the high powered investment banks. Is this a good thing that risk in the system is being shifted away from TBTF institutions? Maybe, but in the interim it's clear that big banks such as Citi are being forced to move away from profitable business lines where they enjoy advantageous funding to appease regulatory scrutiny.

2Q Twitter Smart Money Survey: Cash is King

Every quarter or so I survey twenty people in a wide variety of market occupations for their market views on the coming quarter. In order to force their hand and be decisive, I allocate three "investment units". The three choices are the S&P 500, the 10yr UST, and cash. They may choose three of one, and none of the others, or some combination. Short positions are not allowed.

As you can see below, the results show that bullish sentiment has decreased fairly dramatically since the survey was last done in late November. The shift has gone from stocks to cash as allocation to the 10yr UST has mostly stayed the same. All in all, participants are allocating 47% to cash, 37% to the S&P 500, and 17% to bonds.

Seven stock picks for 2014

Fresh off a year where major equity indices are up 25-30%+, many would suspect it might be difficult to have strong bullish conviction on equity names in 2014 but I couldn't’ disagree more. To be clear, I don't have a strong opinion on equity markets as a whole, but secular trends are setting up to provide fantastic opportunities for significant capital appreciation over the next few years in certain sectors.

There's a number of things that I won't be banking on for these particular plays. First, these plays are not dependent upon certain factors staying in place which have led to elevated corporate profit margins, namely weak wage growth. It's very likely the coming years will see wage pressures rising which will undoubtedly place margin pressure on a variety of companies which have reaped the benefit of sluggish wage growth caused by extreme slack in the labor markets. Second, these plays are largely not dependent upon valuation multiples staying or going above historical averages. All things equal, the segments I want to be most exposed to are ones tied to a pickup in consumer lending and a renewal of the securitization markets.

Bank Disintermediation Creates Opportunity in Non-Prime Lending: In early November I did a deep dive into Springleaf Holdings (LEAF) which is a non-prime consumer lender. All the ingredients are there for Springleaf to continue to excel. Upside exists in their legacy real estate segment for incremental losses to be lower as home prices recover and employment picks up. Competition from large TBTF like financial institutions has all but evaporated as regulators force the banks to stick to their core businesses. Regulatory risk does exist in the form of potential CFPB rulings, but Springleaf appears far more friendly than so called “payday lenders”. Despite the recent run-up in Springleaf’s stock price, I believe the company can earn $2.00 per share in the not too distant future pushing the stock up to roughly $30. Aside from Springleaf, one of my favorite plays now is JGWPT Holdings (JGW) which is the brand name in the structured settlements industry. After a busted IPO a few months ago, the company is primed to earn $2.25-$2.50 per share all the while only trading at ~$17. I think the stock can trade to $22-$25 as the story become more well known.

Bet on a phasing out of the GSE’s and a return of non-agency MBS securitization: Pressure continues to mount for the government to become a smaller part of the mortgage market. The equity plays that will do best in a scenario where reliance upon the GSE’s is reduced are interestingly priced very attractively. A company such as Redwood Trust (RWT) will benefit greatly from a surge in non-agency securitization issuance as their Sequoia securitization shelf would be front and center. The stock took a hit this summer as the bond selloff created an air pocket in securitization. Longer term there’s catalysts for a return of issuance including a reduction of the conforming loan limit from $417k, higher G-Fees, and increased loan level pricing adjustments. All of these things are very positive at the margin. Private mortgage insurance is another segment that might still have legs heading into 2014. Currently the FHA/VA share of mortgage insurance is at 64% versus 20% in 2007. The FHFA has no desire to remain such a large percentage of this market. Instead of more popular plays like RDN or MTG, I am bullish and long Essent Group (ESNT) which a new fast growing private mortgage insurer with no legacy issues. Other names in this space that I like for next year include PennyMac Financial Services (PFSI) where the GP aspect is being far undervalued, and Stonegate Mortgage (SGM) which is on track to build up a large MSR book while trading at only 5x EPS in the meantime.

Small Banks: The best optionality out of all of these picks may indeed be in small banks. Banks have struggled with loan growth as they’ve made a “student body left” from real estate loans to C&I loans. If there’s any froth in lending I believe it’s occurring on the C&I side and not the Real Estate lending side, thus all else equal I’d prefer a larger exposure to real estate. That being said, there are a number of very attractive risk reward opportunities available in sub $1bil banks which are trading at or near 1x tangible book. Many regional banks are trading close to 1.9x TBV but if you’re willing to do the work you can find plays such as First Citizens (FCNCA) trading just above 1x TBV but with credit quality metrics (0.83% NPAs/Assets) and profitability (4.30% LTM net interest margin) metrics in excess of larger peers. The positive optionality for banks comes in the form of interest rates as most banks are asset sensitive. For many banks as short term interest rates rise, the yields on their assets will rise quicker than the costs of their liabilities (deposits). As this happens net interest margins will expand and costs will be spread over a much larger revenue base. There’s nothing wrong with owning a bank at a reasonable multiple with a ROE of 8-10% in this rate environment, but the real upside comes if rates rise and book multiples expand as profitability takes off.

The financial services industry is very different than pre credit crisis but I believe very good opportunities exist in the above companies headed forward due to a number of secular themes. The phasing out of the GSE’s, return of securitization, and return of consumers taking on debt should all be powerful drivers of these companies. Arguably the best part is that these plays aren't priced for these things to happen, so you’re buying in at arguably very cheap valuations. It’s daunting to make stock picks after a year such as 2013, but great potential exists here, and it’ll be fun to watch.

***The views expressed here are mine alone and do not reflect the views of my employer***

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