What will "new neutral" rate be?

April 1, 2015 08:58 AM

Importantly, lower new neutrals speak to portfolio durations and yield curve positions on the bond side, P/E ratios for equity portfolios, and long term cap rates for real estate amongst other valuations. Ultimately they lead us most importantly to the prospect for future asset returns, which if 0% real is the New Neutral in the U.S. and correspondingly lower elsewhere, speak to an inability of savers and investors to earn sufficient returns to satisfy presumed liabilities. If real rates continue to be so low, then discounted income streams are dependent solely on growth and/or inflation instead of capital gains, which in the prior three decades have been substantially influenced by the decline in real rates. The lower real rate/capital gains ocean liner has taken us into uncharted waters, but waters, which we must know, that are hostile to investors.

Knowing how to maximize return vs. risk in these new waters will be key. There are at least several approaches, anyone of which may be the correct one. Dalio/Prince from Bridgewater cautiously advance the theme that if borrowing costs center around 0% real, then assets can be cautiously levered, being cognizant at the same time of the fat tails inherent in our new world of leverage and extreme monetary policy. Jeremy Grantham and fellow professionals at GMO hint at waiting it out in low returning cash under the assumption of a seven-year reversion to the mean, instead of a 20 year cycle hinted at by Rogoff and others. Grantham expects a stock market deluge in the near term future and he may be right, but if not, GMO may underperform while waiting. Then there is Warren Buffett, who has the benefit of a near perpetual closed-end fund purchasing stocks when fundamentally cheap. For most investors who don’t have the benefit of a closed-end business structure, perhaps Jack Bogle is right. One can’t be sure where markets are going, he consistently maintains, but one can be sure that the lower the fees the better.

Of the four approaches described above, unconstrained portfolios at Janus mimic most closely the strategic philosophy at Bridgewater. Cheap leverage is an alpha generating strategy as long as short rates stay low and mimic the 0% real new neutral. Of course if an investor borrows short term to invest longer and riskier, the potential alpha necessarily demands choosing the correct assets to lever. That is not easy these days since almost all assets are artificially priced. The challenge is to purchase the ones that might remain artificially priced over one’s investment horizon. For me, credit spreads are too tight and therefore expensive. Duration is more neutral but there is little to be gained from it in the U.S., Euroland, and the UK unless the global economy inches towards recession. The most attractive opportunity to me rests with the notion that Draghi’s 18-month QE, which roughly purchases 200% of sovereign net new issuance during that time, will keep yields low in Germany and therefore anchor U.S. Treasuries and UK Gilts in the process. I would not buy these clearly overvalued assets but sell “volatility” around them, such that much higher returns can be captured if say the German 10-year Bund at 20 basis points doesn’t move to –0.05% or up to 0.50% over three months’ time. Draghi’s QE should place a high probability on staying within that range; much like Kentucky has a high probability of winning March Madness in early April. We shall see.

Good luck to all of you in your office pools. I myself am not a betting man and cannot watch the Duke games for fear of an early heart attack. I didn’t make the team but my heart’s still with them. Wish I had made that layup though.


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