This Message Will Self-Destruct

With my last thought piece of the year (except for our year-end letter), I thought it is a good time to put the year in perspective. It was a pretty amazing year for me and for Blue Elephant. I walked away from the only job I ever had, which is a big decision for someone who doesn’t like change. In parallel, JP and Ashees were busy getting the Blue Elephant Consumer fund running at full speed, with multiple origination platforms and adding the ability to leverage. The broad markets have had a pretty good year too. The truth is, unless you were sitting on commodities, cash or trying to be short of assets all year, it didn’t matter much what you invested in. The much-maligned “duration” trade was the year’s best through November, a good reminder that loving what the broad majority hates can be an investor’s best friend. That isn’t true in equities, where most forecasts were for a very solid year that actually came to fruition with only a few speed bumps along the way. Oh, and in October we had a once in 25 year move in bonds that everyone forgot about 3 days later – totally healthy markets, right?

Maybe it is just me, but the returns in the more liquid markets have felt bad despite being solidly positive. I just found a piece of paper where I had scribbled down a few thoughts about how the market felt – “like going for a run and then having a cigarette after, or working out real hard and then going out for chicken parm sandwiches.”

Indeed, as I look back on this year I worry that the market looks healthy on the surface but has gotten there despite falling in love with truly self-destructive habits. Usually these bad habits catch up at some point, but so far so good. I do think there are some important questions that need to be answered as we look to 2015. Here are a few:

1)   What does balance sheet expansion (QE) really accomplish, and what are the side effects?

While there are plenty of doomsday articles written on how QE “doesn’t work,” clearly it did something positive for asset markets. Yes, it steals from savers and forces misallocation of capital, but how does that unwind? It was supposed to be inflationary (Japan is still betting that it is) – but we seem closer to deflation more broadly? Maybe QE really does work just like lowering interest rates and the exit will be totally painless. I don’t buy it, but then again I don’t know anyone who does so it is worth considering.

2)   When will the Fed raise rates?

I’m on record as saying I think it is very difficult to exit zero interest rates. Every day that goes by, investors move capital into riskier assets to avoid the curse of negative real interest rates. Reversing this would mean reversing the capital flows, which will slow down the economy sharply. Now, if growth actually gets strong enough to offset this, of course they can. Unfortunately, the US had underperformed growth expectations for the last 4 years. Why would next year be different? Especially with China and Europe slowing – can we decouple that sharply given global relationships?

3)   Are interest rates globally on a continually downward trajectory?

If you believe that markets travel in the direction of the most pain, then the answer is unequivocally “yes.” Low rates guarantee that savers cannot reach their needed income to retire. As the world ages, yield becomes more dear and harder to find. At the same time, debt levels in developed countries seem unsustainable and the race to devalue currencies globally suggests higher inflation risk somewhere down the line.

4)   Where are we in the credit cycle?

Default rates are near historical lows. Low volatility and low interest rates have helped borrowers refinance and term out debt. What are the potential triggers for a turn in the credit cycle? Does it require higher risk-free rates, or is it more of a liquidity/race for the exit type of event that turns the tide? Oil prices weren’t on my list originally as a catalyst, but it certainly seems like it needs to be added.

For Blue Elephant, a big question is, “How will the bank disintermediation trade develop?” A lot of the development will be contingent upon getting the questions above answered correctly. It is unlikely that next year will be as easy as 2014 for any investors. We expect more volatility on the credit side as central banks diverge from each other and currency pressures push weaker economies to the breaking point. Our up-in-quality bias is built on this premise. We also expect banks to continue to struggle with balance sheet restrictions, meaning that more and more lending will look to the marketplace-lending model to attract capital.