Constance Hunter, KPMG’s Chief Economist / Alternative Investments, is known in economic circles for her insight into transitional trends and fundamental market shifts. We caught up with her to discuss her outlook in regards to some of the significant economic issues that could impact trading markets worldwide.
Mark Melin: With Janet Yellen as US President Barack Obama’s choice for Chairwoman for the Federal Reserve, she inherits a $5 trillion long bond position, the largest in Fed history, at a time when interest rates appeared to have touched bottom. What tools does the Fed have left to work with? What are the risks?
Constance Hunter: Anyone who thinks that the Fed doesn’t have any more bullets left, look what they did just with moral suasion. With moral suasion they were able to end this idea of Q ever, quantitative easing forever; we saw the long end move back over a 125 basis points and we saw people expecting a tapering.
Now, as the data started to come in, it wasn’t as strong as anticipated, so the Fed decided not to taper. They also told market participants multiple times that the activity was going to be data-dependent. The market chose not to listen to them, so that’s the market’s fault.
When you look at the risk of what the Fed is doing, you need to counterbalance that and look at the risk of what if the Fed were not doing this. Although there are a lot of issues, such as price distortions in primary bond markets; the converse issue, the issue of disinflation, of having companies’ inventories being worth less than what they were purchased for is a way more pernicious, way more problematic issue, and so this is something that the Fed is making sure does not happen.
The Fed knows very well that there are limitations to what they are doing. They know that there are what we call structural breaks in the labor market. So there are some shifts going on in the labor market that indicate structural problems rather than just cyclical problems. And they know that this means the natural rate of unemployment is higher than before the crisis.
If you read Janet L. Yellen’s speeches, which I advise everybody to do, because she is probably going to be our next Fed Chair, and she is also very smart, you will notice that she is very aware of the limitations of Fed policy. So with that backdrop, which is critical to have a complete understanding, we look at the risks of what they are doing.
Now, of course the first risk is that we have never done this before, and we don’t really know how exit is going to go. There are plenty of smart people who have looked at it theoretically and said it shouldn’t be a problem, but the reality is we it do not know. Markets don’t like uncertainty, they don’t like things that are unknown, and it certainly could create a lot more volatility than we traditionally see in the bond market.
I think the biggest risk to what the Fed is doing is we have an entire asset allocation system based on this notion that bonds dampen the risk in a portfolio and provide a stable yield. Assuming we solve the debt ceiling and continuing resolution problem, bonds will still provide a stable yield and will pay principal upon maturity.
In terms of total return, bonds have returned 21.4% or 3.95% per year for the past five years, and 53.1% or 4.35% over the past ten years. If you take the period from November 2007 until the end of October 2012, total return was 32.48% or 5.8% a year, this compares with a total return of 3.77% or 0.755 for equities. Over the past year the total return for bonds has been -2.55%. This is certainly not terrible, but if we look at the direction of yields over the next 2-3 years, rates are likely to move higher and total returns for the index will be negative. Although coupons will move higher, it will take some time before they are high enough to provide positive total returns and this will impact retail investors’ psychology and portfolio returns the most.
“Over the next 3-5 years, total (bond) returns may be negative and volatility will be higher.”
The other concern is how this data fits into models about risk and volatility. Over the past ten years, bonds have had a total return of 4.9% per year compared with 7.02% for the S&P500. The data will show that for a very low volatility asset, bonds, you can obtain a total return of 4.9%. Over the next 3-5 years, total returns may be negative and volatility will be higher. So using the recent past to make allocation models optimize is likely going to cause some surprises.
When you think of the entire asset allocation paradigm that we operate under, I think it’s very possible that we will see some changes. .
MM: You said we are in a different market environment. What is your projection for pricing patterns?
CH: From a retail perspective, I had a friend who works at a hedge fund, who is a sophisticated investor, say to me “My bond fund was down 4% in July, I can’t believe it. My total annual expected return for this fund is only 4%, how am I ever going to make that back? Should I reduce my bond allocation?” This is completely disregarding those bonds that have been showing a total return of nearly 5.8% per year during the crisis. There was no talk of reducing the portfolio while returns were high, when rebalancing would have suggested this is the best thing to do.
This is a person who knew what her expected return was and that her volatility in one month exceeded her annual expected return, was thinking “I need to think about reallocating a bit here.” People have been told, bonds are safe, bonds aren’t volatile. That reality is going to change and I think the perception will be magnified.
There is a feedback loop that will begin to take effect as well. As volatility increases, people will become concerned, they will start to sell, that will increase volatility and reduce prices, reducing total returns. This could well set in motion some unusual patterns that we have not seen for bonds.
When you look at return versus volatility on a bond going forward over the next five to eight years, I think that return and volatility relationship is going to be very, very different than it has been over the past five to eight years.
MM: I have heard professionals trading along the yield curve say fair value yield on a 10-year note right should be around 4.5%. If there wasn’t quantitative easing nor Fed asset purchases, do you have a projection on where would the yield of the 10-year note be right now?
CH: It’s interesting, if you look out at the five and ten year forwards, at the markets think rates will 4.5%, But to say that is where the 10 year should be now seems to overestimate the economic situation.
The economy really hasn’t experienced lift velocity yet, right? We are in 2.5% growth per annum growth mode. It would appear we can sustain this growth rate, but this growth rate is hardly setting the world on fire. If we were at 4.5% of the 10-year we would have a real yield of 3.0% , that is a bit high for an economy that has the level of economic output, unemployment and inflation the US is currently experiencing.
The US is only adding an average of 180,000 jobs a month, that is only enough to replace population growth. If we keep adding this much a month in a year, we are going to get back to our peak employment level at 2007. But between 2007 and 2014, a year from now, we will have added population, and we haven’t even accounted for that. We are not growing strongly. There is no reason for yields to be especially high. There is really no reason for us to have a positive 3.0% real yield on the 10-year.
MM: The difference is that investors think that US Treasuries are more of a risk asset now than five years ago. There is a risk in principle repayment that wasn’t previously in play to the same degree.
CH: Absolutely! And that’s what I was saying to you earlier with regard to volatility. If you look outside of professional bond traders retail brokers that are advising an asset allocation strategy for their baby boomer clients who are about to retire, or who are in retirement, that puts bonds in the portfolio as the safe asset. But total returns are unlikely to be good over the next 3-5 years and volatility is likely to be higher than in the past. So it could be the Chicago traders are on to something.
MM: Let me throw a couple of scenarios at you. Looking at a probability table of events, one negative possibility being discussed is the potential for the U.S. to lose its status as a reserve currency. Not that anyone is rooting for this, but facing the reality of the situation is important. One scenario is that China has been talking about taking on the U.S. as a reserve currency, and they have talked about backing their currency or some new unified currency in gold. Have you heard any of this talk and do you have any thoughts given your background?
CH: First, I go to China regularly. I am a member of the National Committee for U.S.-China Relations. I participate in the Track II Strategic and Economic Dialogues. We make recommendations to the Chinese and U.S. governments at the highest levels, on trade policy, on economic policy, and China certainly has some very bright minds in its government and amongst its academic community.
But you have to understand the implication of backing a currency with gold. Right now China is pegging its currency against the U.S. dollar, they are still doing that.
China is a command economy, it is not a market economy. It is run in a way where controlling the economy is the most important thing. We can see that controlling the exchange rate is quite important to them. This is a concept that is diametrically at odds with being a reserve currency. A reserve currency needs to be able to absorb shocks and allow its own and other economies to stabilize.
Second, China does not have a bond market to speak of. You think there are price distortions in the U.S. bond market? Go to China and you trade Chinese government bonds, now we are talking about price distortions and government intervention.
Third, China has not demonstrated itself as a global citizen that cares about anybody other than China. And justifiably so, China is very focused on getting its per capita income from $7,500 per year to a middle income level of $12-15,000 per year – it is very far from being in the business of providing public goods to the global economy.
Why is this important? Goods that are transported and priced in U.S. dollars are de facto guaranteed safe right of passage, right? Partly that’s our military, partly that’s our geopolitical stance in the world, partly that’s our involvement with organizations like NATO; that is not the case for China.
So those are three really important things, when you add them up, they make the prospect of a Chinese reserve currency quite distant, if not laughable.
MM: The other international players will say that the US couldn’t engage in quantitative easing, bond asset purchases and other measures of deficit spending if we were not the reserve currency, and that we are improper stewards of taking advantage of that reserve currency status.
CH: But reserve currency status is not something we plucked from the sky because we thought it would be nice. We earned it over several decades and this was a combination of our legal system, our federal reserve system, our military prowess and our economic strength. We do not force other countries to peg their currencies to the dollar, nor do we require them to hold US dollars in their central banks. It is a voluntary system. If fiscal fights in Washington fail to make any progress, we could well see a situation where foreigners do not want to hold US dollar assets such as US Treasuries. But we should all be aware that the deficit is much more pro-cyclical than most people – especially those in Washington – like to admit. During the recession we were in a vicious circle where reduced economic activity resulted in lower taxes being collected and more benefits being paid out. We then enacted a stimulus package which cost some money but very likely saved the global financial system. We went from a deficit of 10% of GDP during the crisis down to a 4.2% deficit today.
“Everyone in the US recognized the retirement age needs to be raised and benefits probably need to be reduced, they just want somebody else to bear those costs.”
In terms of our unfunded liabilities, quite honestly, you are right, we might not be able to get away with it as much if we were not the reserve currency. Everyone in the US recognized the retirement age needs to be raised and benefits probably need to be reduced, they just want somebody else to bear those costs. Nobody wants to be the one who pays for this. Oh yeah, you can raise the retirement age, but as long as it’s on the people who are younger than me.
MM: You and I look like we are about the same age (near 20 or so years from retirement age). Are we going to get Social Security benefits and are we going to get Medicare benefits?
CH: We are a rather small voting block by the way; it’s the echo boomers and the baby boomers who make up the large voting blocks. And you would think the echo boomers would be on our side here, and you would think they would want the baby boomers to experience later retirement, and we have gradually raised the retirement age, but not sufficiently enough. So we need to raise the retirement age by another 3 years at least and we need to do means testing.
MM: These are political issues that politicians haven’t been able to address to date. Just look at the debt ceiling debate, there is even no compromise on easy issues
CH: Well, nobody has elected them to do that! Neither Democrats nor Republicans want to mess with Social Security, neither of them do; neither of them want to mess with Medicare and Medicaid, it was under Bush that the prescription drug act came into being which costs a great deal of money each year. The increased costs for Medicare and Medicaid are split evenly between living longer and rising medical costs.
“The biggest policy mistake that Obama made in his presidency was commissioning Bowles-Simpson and then letting it die.”
Now, if you ask me, the biggest policy mistake that Obama made in his presidency was commissioning Bowles-Simpson and then letting it die; the biggest policy mistake. There was momentum, there was awareness, we just had a debt fueled crisis, people were aware that debt was problematic in a very visceral way.
Tax payers and voters were aware that even if they had personally been responsible, had personally paid off their mortgage, had personally not got overleveraged, they were affected, right? So you needed to have this sense that even if you were being good, you were going to be hurt by the system, if the system fostered a whole lot of bad behavior.
We were at a juncture where there was enough political awareness that we could actually do something about this, or there was some chance pigs might fly, but we squandered it, and now that the deficit is 4% of GDP, and economy has started growing again. , We have lost a lot of momentum here, there is almost zero bipartisan agreement and it’s quite unfortunate.
One possibility though is that medical costs might not continue to rise as fast as they have over the past decade. The CBO have forecast cost increases based the current increases in health care cost which have been growing much faster than general inflation for a long time. That is not going to continue. It cannot continue. It can’t continue because of the laws of physics and the laws of mathematics.
MM: You think it’s going lower?
CH: Well, it is already going lower, it’s not an opinion. The reality is if you look at medical costs, they are falling, and they have been falling for the last year, and the big question is, is this permanent, is this a new trend, or is this just an anomaly?
One thing that is happing is we are starting have a huge intersection of technology and medical care delivery. So what do I mean by this? When you go to a doctor and that doctor assesses your situation, your illness, it’s a bell curve usually that you are plotted against. The average response is this. Well, you know what, most people are not average; in many cases the mode and mean are far apart, and sometimes you may have bimodal distributions. You are still treated though as if it’s a bell curve.
So they will give people a cocktail of drugs with an attitude “let’s see if this works for you.” Six months later they may say, “Oh well, that didn’t really work out so well. We will try this new cocktail.” This is not only expensive, it does not lead to the best patient outcomes.
So the way we have been historically administering medicine and conducting medicine is based on averages. Current data analytic techniques now allow us to take heterogeneous populations and create customized treatments. We are able to analyze and process data in a dramatically different way, that’s the first thing.
The second thing is that, we are able to monitor patients in a dramatically different way, with devices. It doesn’t even require compliance from the patient. All you have to do is wear the wrist watch or swallow the chip, and we are going to be able to monitor what’s going on with you and adjust your treatment accordingly.
Thank God too, because it’s happening just in the nick of time. Just like peak oil went away, I think dramatically increasing healthcare costs forever is going to be going away.
MM: What are you most passionate about? Address what’s most interesting to you?
CH: Well, there is a lot that is really interesting. This whole concept with technology changing society isn’t over. By the way, it’s not just impacting healthcare, it’s impacting how we conduct economic research, how companies implement strategy.
The way people would analyze data and situations traditionally is: first is a hypothesis, The data is analyzes that might represent that hypothesis, or might be able to allow one to test that hypothesis. Regressions were run, more analysis was completed and researchers determine if the hypothesis valid or invalid. If it’s valid, then you might refine your model a bit so that you have the best fit and the best data and the best coefficients, and you proceed from there, and then you make forecasts. That’s all changing.
Now we have access to structured and unstructured data sets.. So big data technically means unstructured datasets, but you can take structured and unstructured datasets and work with them as if they are the same type of data. We have computing power that’s easily accessible, that allows you to then look at patterns in the data. So the way analysis is done now, from a technological perspective, allows researchers to see the patterns and form the thesis in a different way. This is a radically different way of thinking about problems.
Economists on the cutting edge are looking at this new data analyses methodology. At KPMG we are doing a lot of cutting edge economic research and coordinating with risk analysis. It is very exciting. If one w ants to assess complexity, it is now easier due to both computing power and technology such as data analytics. It’s going to change the way actuarial science is done; it’s going to change the way economics is done. Don’t underestimate technology.
Constance Hunter Background:
Throughout her nearly sixteen‐year career, Ms. Hunter has honed her ability to pick a needle from the economic haystack of data, synthesizing information to identify turning points for economies or markets. Ms. Hunter was most recently the Deputy Chief Investment Officer for Fixed Income at Axa Investment Managers. Prior to Axa, Ms. Hunter was a Managing Director and the Chief Economist at Aladdin Capital. Prior to joining Aladdin, she was with Galtere Ltd., a global macro hedge fund, where she served as a Chief Economist. Prior to and concurrently with, Galtere Ltd., she was the Managing Member and Chief Investment Officer of Coronat Asset Management. In that role, Ms. Hunter identified macro themes and invested in global equity, credit and FX markets to capitalize on these themes. Prior to founding Coronat, Ms. Hunter was a Partner and Portfolio Manager at Quantrarian Capital Management, a hedge fund that invests in Asian markets. In addition, she has worked as a Portfolio Manager at Salomon Smith Barney, Inc., and Firebird Management, LLC after starting her career as an economist at Chase Manhattan Bank in Foreign Exchange. Ms. Hunter received a Bachelor of Arts from New York University, as well as a Masters of International Affairs from Columbia University. Ms. Hunter is a regular guest on CNBC and Bloomberg TV, as well as being quoted in the Financial Times, Wall Street Journal, Barrons and New York Times to name a few. Ms. Hunter is on the board of the National Association for Business Economics (NABE), a member of New York Association of Business Economics, a member of Money Marketeers, Network 20/20 and 100 Women in Hedge Funds. She is a patron of the World Policy Institute.
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