Broyhill Asset Management annual letter for 2014.
Macro grandstanding is a popular affair. Extreme forecasts are a reliable tool to gain the spotlight but rarely provide practical or consistent investment performance. Forecasting the future can generate exciting returns when said future unfolds as expected. It can result in even more spectacular losses when it does not. As it is impossible to predict what lies ahead, investors are best served when guided by value and when focused on what is knowable. With that being said, we’d like to share with you what we deem to be “knowable” today rather than litter your circular file with another investor letter complete with short-term forecasts. Our observations are summarized below, followed by an overview of portfolio activity and current positioning.
Broyhill Asset Management: Growing Imbalances
Volatility is rising much more than indicated by traditional measures of risk. Markets have experienced waterfall-like declines across seemingly unrelated assets, such as Greek banks, oil, the euro, and the yen with some prices dropping as much and as rapidly as they had during the financial crisis. The Swiss franc is only the most recent example of today’s central bank driven imbalances.
During the twelve months leading up to the Swiss National Bank’s (SNB) surprise, the annual volatility of the euro/franc was about 1.7% and over the last three months of that period volatility was less than 1% or a daily standard deviation of about 10 basis points. The euro instantly collapsed almost 20% after the SNB scrapped the peg, which according to “modern” financial models represents about 180 standard deviations. For perspective, consider that a 7 standard-deviation move should happen about once every 390 billion days, or about once in a billion years. Surely, this is what Drew Niv, CEO of FXCM was counting on when he told Bloomberg Markets1 that, “Currencies don’t move that much. So if you had no leverage, nobody would trade.”
Broyhill Asset Management: Infinity and Beyond
Falling bond yields provided a tailwind for equity valuations for three decades, but this relationship breaks down when central banks control the price of money. Standard valuation models simply don’t work with rates at zero or below. Theoretically, the price of every financial asset should move toward infinity at a zero discount rate. And since tomorrow’s returns are negatively correlated with today’s price, by definition, future returns must be lower than recent experience. At some point, this paradox will be resolved, but the lack of a historical precedent for a major central bank to achieve “lift off” poses particular challenges for policymakers and investors alike. Price is not the only variable pushed toward infinity by negative rates; at zero, an asset’s duration is also infinite, which means that minimal changes in rates have enormous impacts on value.
Broyhill Asset Management: Broken Models
Negative rates pose a particular challenge for investors as the net present value function cannot be calculated below zero. Valuing financial assets becomes mathematically impossible. Without a fundamental anchor, changes in price are instead driven purely by shifts in sentiment and policy expectations. Put more simply, our job as fundamental investors, has become much harder, as has that of the macro forecaster.
The market-based signal with the best forecasting record of recession is also controlled by our friends at the Fed. An inverted yield curve has preceded all seven U.S. recessions since 1962, with a 9-12 month lead time. No U.S. recession has occurred without a yield-curve inversion. But what happens to the yield curve’s forecasting ability if, technically speaking, it can no longer be inverted?
Today’s ten-year bond yield is not too far from its lowest level since 1920 but it’s unlikely (though not impossible) it will fall below the near-zero cash rate. That means the yield curve is unlikely to invert, at least by traditional measures. Does the yield curve lose its predictive ability when yields are artificially low? Thankfully, no. Even if yields remain low indefinitely, the curve can invert at the longer end of the maturity spectrum, as it has at various times since WWII. In a zero interest rate world, the long-end yield spread is our alternative signal. History shows that the spread between the 30 Year and the 10 Year Treasury is also an able forecaster, and actually improves in low interest rate environments.
In low interest rate environments, the long-end yield spread needn’t be negative to forecast a recession; it need only be narrower than normal. In the past two decades, “normal” has been about 45 basis points. Notably, today’s spread is falling fast, from a peak above 140 basis points to January’s low, below 60 basis points. We aren’t making a forecast here; but we wouldn’t be doing our job if we failed to highlight where we are in the cycle today, which is certainly knowable.
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