Christine Lagarde, The Fed's Jelly Donut Policy and The Uncomfortable Truth

We’re back with another edition of Beach Reading! Let’s jump right in.

We kick this week off with an article from The Economist laying out the future of the European Central Bank (ECB) under Mario Draghi’s newly appointed successor Christine Lagarde. Ms. Largarde ran the IMF for a number of years and is generally regarded as a competent European bureaucrat, although she has very little capital markets experience. The significance of her appointment, though, is that she is unlikely to waver from the ECB’s current zero and negative interest rate policies. In our view, these policies have been counterproductive for most European Union countries and a perpetual continuation of said policies is unlikely to change the equation.

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A change of direction under Christine Lagarde is unlikely

When Christine Lagarde was asked last year whether she was interested in a job in Europe, the head of the IMF made an emphatic denial.

On the topic of zero and negative interest rates, we bring back an article from 2012 that discusses hedge fund manager David Einhorn's view of zero interest rates. Einhorn contends that initially lowering interest rates does indeed have the positive economic impact that is typically ascribed to easing policy. But he compares the successive and sustained stimulus from lowering rates to eating jelly donuts; the first one is great, the fourth is filling, the fifteenth makes you feel worse rather than better. “My point is that you can have too much of a good thing and overdoses are destructive…the textbooks presume that easier money will always result in a stronger economy, but that’s a bad assumption.” We manage many portfolios for income-oriented clients and agree that low rates have made retirees less secure in their ability to create income. This insecurity directly contradicts the transient and dubious wealth effect often cited by central bankers as the positive aspect of low rates. This is evidenced by both the overall U.S. savings rate since the financial crisis and the savings rate of those over 55 which we highlight below.

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The Fed’s Jelly Donut Policy

The Fed is filled with academics who thoughtlessly rely on econometric models that reflexively indicate that repeated Jelly Donut orgies are the best way to get a sugar rush into the economy.

Certainly the overall savings rates have been skewed upwards by the Baby Boomers socking more away for long retirements. The fact that no other cohort other than those over 55 is saving more than the national average proves this to be true. But the extremely high savings rate of those over 55 should lend some credence to the “jelly donut” argument that low rates are actually restraining retiree spending, not enhancing it.

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We finish up this week with a long missive from private equity giant KKR which the two savings charts are pulled from. Henry McVey, their head of Global Macro & Asset Allocation, pens what we consider to be one of the few must-read investment strategy reports on Wall Street. In his recent piece, The Uncomfortable Truth, he discusses KKR’s view (which we share) that global growth and interest rates are likely to remain low in the immediately foreseeable future. (He recently published another missive entitled “Stick to the Plan” but it largely reiterates the strategy laid out in “The Uncomfortable Truth.”) With that worldview in mind, KKR advocates for investors to take a “barbell” approach and own two types of assets in size: those secular growth companies that will be increasing their revenues whether the world is growing at 0% or 4%, and infrastructure and utility-like assets that can use low interest rates to finance stable cash-flow generating activities. We agree with this strategy and have been allocating assets towards secular growers like internet-enabled technology firms. On the infrastructure and utility front, we’ve been allocating assets towards modern-era “utilities” such as natural gas pipelines and broadband internet providers.

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The Uncomfortable Truth

With central banks once again feeling inspired to hold interest rates low around the lion’s share of the developed world, many investors with whom we speak are increasingly confident that the “trifecta” of sluggish nominal GDP growth, low rates, and paltry inflation may be back upon us.