Thematic Thursdays: Portfolio-Balancing Effects - Part 2

Zero percent short term rates along with Large Scale Asset Purchases (LSAP), a/k/a quantitative easing, are designed to help offset the de-stimulatory and deflationary effects of fiscal constraints within the overall thematic context of deleveraging. The primary and most direct channel for this is through the banking system (via liquidity and lower rates) into the economy. More money for banks = more loans (or so the story goes). But there are secondary and tertiary channels through which zero percent short term rates and LSAPs flow not all of which produce the desired effect.

For example, a secondary channel would be the portfolio-balancing effects, which was described in some detail in last Thematic Thursdays installment. Related to portfolio-balancing effects is the wealth effect in which higher asset values (fixed income and equities) lead to increased confidence among investors (who just happen to also be consumers) and, therefore, more spending. Businesses benefit, as well, including greater flexibility in the talent acquisition process (hiring) via more attractive stock option packages and M&A. And while the impact to the real economy may be minor*, it is nonetheless a positive one. However, the tertiary channel is another story. And it's a story where the phrase "financial repression" applies. To tell one version of this story, let me relate to you what I heard at a conference that I participated in Boston yesterday and what a gentleman by the name of John Keane, Executive Director with the Jacksonville Police and Fire Pension Fund, had to say.

The Jacksonville Police and Fire Pension Fund is a fair sized fund. However, as is typically the case with such funds, those charged with the management of the assets of the fund have limited investment decision-making skills. (Moreover, as is also typically the case with such municipal funds, politics plays a role.)

Now, as Mr. Keane described it at yesterday's conference, the fund has operated with the standard 60/40 split for many years (60% equities, 40% fixed income). It also has built into the future projects of its assets and liabilities (obligations) actuarial assumptions, which have been ratcheted down over the years from just above 8% to (I believe he said) right around 7%. The problem is that due to the 40% portion of the portfolio being rolled over at decreased rates of income, the fund will not meet its obligations with a 7% assumed rate of return. So, the fund's board is considering moving some of the money in the portfolio into (drum roll, please) ....alternative investments (which one would assume includes hedge funds and other non traditional investment vehicles).

So, what we have is a good sized pension fund managed by those with a limited skill set to evaluate more complex investment strategies and vehicles moving into more complex investment strategies and vehicles due to the fact they traditional investment choices will not produce what is needed to meet their actuarial assumptions. In other words, financial repression is producing a forced risk migration upon those not fully qualified to handle the risk. Sound familiar?

Investment Strategy Implications

Risk migration and the wealth effect are all well and good. But as noted in my May 2 blog posting (see below): "The benefits of what they are doing comes with costs and risks," El-Erian adds. These are "highly experimental policies. We are not sure what the side effects are [and] there is already collateral damage." And the "side effects" and "collateral damage" appear to be with us for some time to come, the consequences of which remain to be seen.

In next week's third and final installment, we will look at the impact that easy money has had on valuation models. And why the failure to adjust the current interest rate input into valuation models is equal to the failure to adjust risk metrics (such as backward-looking beta).

*Studies on the wealth effect's impact to the real economy point to a 3 to 5% number. Therefore, for every $1 trillion increase in equity value, there's a $30 to $50 billion increase in consumer spending. However, this does not take into consideration the impact of an increase in fixed income values nor the decrease in interest income.

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