We open this commentary with a link to the October 31 policy statement of the Government Pension Investment Fund of Japan. Any serious investor who has not read it is invited to go to this link right now.
Simply put, one of the G4 has made its position clear with great transparency. The Pension Fund of Japan is going to raise its allocation to stocks, both domestically and internationally. It is going to reduce its allocation to government bonds denominated in its own currency. Internally, that means selling JGBs and buying an ETF that comprises 400 stocks. Meanwhile, the Bank of Japan will maintain a policy of very low interest rates so that the reallocation does not disrupt Japanese financial markets. For Japanese investors this is very bullish. Japanese stocks are headed higher – maybe a lot higher. The recent recession news means that this policy will be in place even longer and more robustly than expected just one week ago.
The other three in the G4 include the United Kingdom, where there is no interest-rate policy change (still stimulative) and where the focus of central bank policy is to acquire British pound-denominated government debt at a forecasted rate. The Bank of England will not buy stocks, nor will it acquire foreign-denominated debt.
Also in the G4 is the US. Our Federal Reserve has reached the end of tapering and is engaged in a rolling replacement of maturing assets. The Fed holds only US government securities. It has shifted the maturity of its holdings over the last 6 years. Its assets are now at duration of about 5.5 years. They were near 2 years at the start of the financial crisis. If one compares total available marketable federal debt and the Fed’s holdings, the conclusion is that any increase in holdings now might actually be disruptive to markets since the Fed holds so much already.
We believe the Fed is done with QE unless there is some truly global calamity. Since the onset of the financial crisis, the Fed has quintupled its holdings and tripled their duration. It will take years to unwind the cumulative effects of QE1, QE2, and QE3. The Fed is now expected to take most of the coming year to refine its working programs and tools and then begin a gradual program of rate normalization. Our guesstimate of the Fed’s policy interest rate one year from today is somewhere close to 0.5%, a slight increase from the present range of 0.0% to 0.25%. Even the structure of that forthcoming policy rate is still a subject of discussion. The Fed will not buy stocks. Nor will it buy foreign-denominated assets.
Let’s get to the last of the G4. The European Central Bank remains an enigma. It has yet to formulate a policy that is credible or understandable. It demonstrates internal division. And it looks at the economic landscape of the Eurozone and sees inflation near zero and growth elusive. The ECB cannot even find a way to buy government debt, let alone other assets. It has not resolved how to deal with the credit structures of some of its weaker banks and member countries. All we know is that the ECB says it wants to expand its holdings of assets to three trillion euros. Details remain to be seen, let alone implemented. And the policy interest rate is negative, marginally disruptive, and cannot go any lower, by the ECB’s own admission.
For financial markets the next year is easy to forecast. All four central banks will keep their short-term policy interest rates below 1%. Their GDP-weighted average will be below 0.5%. Their risk-free benchmark government bond rate will also remain quite low. Note that in the Eurozone the market differentiates between risk-free, as in Germany, and higher-risk, as in Greece. There is a risk hierarchy in the Eurozone. Note that the US offers the highest G4 bond rate, at less than 2.5% on 10-Year risk-free debt. Also note that Japan has raised the allocation that can be used to purchase US Treasury notes. In this present global scenario, it is hard to see the US ten-year treasury yield much higher.
It is also hard to see other US dollar-denominated high-grade bond interest rates rising a lot under this scenario, even if the US economy gains some strength. Corporate borrowers are really flush with cash. And also note that the amount of cash they hold outside the US in foreign subsidiaries of US corporations ($2.1 trillion) now exceeds their internal US dollar holdings of cash ($1.9 trillion). (Hat tip to Capitol Economics.)
Were Congress to pass repatriation tax relief as it did in 2004, the amount of transfer into the US would be huge. Capitol Economics notes that the 2004 legislation resulted in about 3% of GDP being repatriated in that one-year window and that most of it was used “to fund dividend payouts and share buybacks rather than boost investments.” The latest estimate is that a repatriation tax relief bill would have four times the impact today than it did in 2004.
Imagine the cash flow into an infrastructure-rebuilding program for America if Congress were to allow it through repatriation tax relief funding. But hope is not a strategy, and politicians maintain their despicable reputations for reasons that the rest of us understand only too well. They would rather fight for years over a pipeline than rebuild all the roads, bridges, schools, etc. in our country.
So let’s summarize. One of the G4 is acting bullishly for US stocks and for US bonds as well as bullishly for its own markets. Another is trying to figure out how to be more stimulative. A third is maintaining its stimulative policy at a predictable pace. And the fourth is at neutral.
We maintain our bullish stance on equities. We are using a $130 earnings estimate for the S&P 500 Index in 2015. That is the center point of a range of 123 to 137. We may be a little high at $130 but not by very much if the US economy continues its gradual, low inflation growth track. Our end of decade target for the S&P 500 Index is a range between 2600 and 3000. Several years ago we projected that the S&P would reach 2000. That is becoming an ancient milestone.
Cumberland remains fully invested in our US ETF strategy. Our other ETF strategies (we have four of them) are nearly fully invested. We use each of these four strategies in separate account management only.
Our bond strategies keep some hedges in place or are using a barbell. Why? We expect that the very low interest-rate period is coming to an end over the next year or two. We do not know when, nor is it easy to forecast that timing.
David R. Kotok, Chairman and Chief Investment Officer