Source:  Bloomberg

The above screenshot is a picture of (mostly) developed market five year government debt yields (in blue).  The Executive Summary is that unless you want to buy Greece with six-handle yields, you are looking at essentially zero yield - give or take a little bit - for  the rest of the decade.  The picture is even more dismal if you cut what little return you might make in half to pay the tax man.  From a risk-return standpoint, you can presume you are making or losing your coupon almost daily if yields fluctuate by 10 basis points.  Given the current extremely accommodative posture of most central banks, it is hard to see how this changes any time soon!

Consequently, the challenge for alpha generators is likely to only grow as all risk assets get priced closer to zero rates of return and managers with large stores of capital have to choose between moving farther afield to find returns or revert to the tried and true return generator - leverage - which is reaching all-time highs and is magic until the borrowing party stops.  Time will tell whether this ends with a whimper of no returns over an extended period or a bang of massive repricing of assets....

The most recent Fed Senior Loan Officer Survey implied mildly easier lending conditions and stronger demand for C&I loans.  The survey also seemed to indicate strengthening demand for mortgages with a net balance of 45% of banks reporting a rise in mortgage demand.  It is bewildering then that the very next day the Mortgage Bankers Association reported that total mortgage  applications fell by 3.4% in July and that applications have contracted for four of the past five months.  Some of this could be explained by a slow down in refis.  However, easier lending standards and still very good affordability make the decline in applications for home purchases a puzzle.  Could it be that we have stimulated all the "cheap money" housing activity possible over the last thirty years and are now hitting the zero barrier limit to stimulating this economic activity?

I recently read an investment newsletter from a not-so-prominent analyst cautioning his readers to 'Beware of Sideways Markets'.  He pointed out the obvious:  Margins are abnormally high, expectations for growth are high, and earnings multiples (cap rates for real  estate) are very high....All these result, directly or indirectly, from the Fed's zero interest rate policy.  The author concludes, 

Interest rates were much higher in the ’70s and early ’80s than they are today, and thus stocks may deserve higher valuations than they did then. This applies to all assets. But the Federal Reserve’s policy may inflate stocks’ valuations for a while. If the Fed succeeds and real growth resumes, then interest rates will rise and (expensive) stocks that were discounting all-time-low rates will get crushed. After all, they — like long-duration bonds — do great when interest rates decline and bite the dust when interest rates rise.

Of course, on many levels things are better now than they were in 2008. The financial crisis and real estate bubble are behind us; we are probably not going to see those again for a while. But their resolution came at a big price: much higher government debt and a command-control interest-rate policy that would have made the Soviets proud. We’re now living in a Lance Armstrong economy. We’ve consumed so many performance enhancement drugs through endless quantitative easing that it is hard to know how well the economy is really doing. Unfortunately, as Armstrong at some point did, we’ll have an Oprah Winfrey moment when the economy will have to fess up for all the QEs.

We are living through one of the most grandiose and untested lab experiments ever conducted by a central bank: QE Infinity. At the recent Berkshire Hathaway annual meeting, Warren Buffett said, “Watching the economy today is like watching a good movie — you don’t know the ending.” His sidekick Charlie Munger added, “If you are not confused about the economy, you don’t understand it very well.”

The Fed’s unprecedented intervention in the economy has increased the possible range and severity of negative outcomes, from runaway inflation to deflation or a freaky combination of the two (freakflation). Deflation (or freakflation) is not good for stocks or their valuations. Just look at Japan. Over the past 20 years, stock valuations declined despite interest rates being at incredibly low levels. Expensive stocks (as I’ve mentioned, stocks in general are very expensive) discount earnings growth. If growth fails to materialize, these P/Es will decline. Unknowns are simply unknown.

I could not help but nod my head in agreement with each paragraph.  Unfortunately, this is the dilemma for those investing in the current environment:  The expected return on most available investments is meager if even positive, and the tails are likely to be much fatter than in the past, i.e. the certainty of outcomes is much lower than at any time in recent history and the definition 'worst case' is also unknowable because there is no longer any available policy backstop to rescue an economy in crisis.

While we do believe finding good opportunities may become increasingly challenging for the next few months, we continue to like the notion of shorter duration loans with hard assets backing them at conservative loan-to-value ratios.  Clearly, holding a diversified portfolio of these loans does not completely eliminate downside in an economic collapse scenario.  Nonetheless, we do think it mitigates it significantly and will produce far better outcomes for investors than most other current investments offer.  Such a portfolio also performs acceptably in an accelerating inflation scenario given the increasing 'value' of the underlying asset and the ability to regularly reset rates on the portfolio.  Even in the new normal/new neutral scenario where growth is slow and erratic, a portfolio of senior secured private loans is likely to perform well because of the high rate of current income and possibility for a periodic workout that generates some additional capital gain.

Depending on whether you look at CoreLogic or the 20-City Case Shiller Composite, Home Price Appreciation (HPA) was between flat and up 2.6% in the first quarter. New home sales in March were dismal and remain at historical lows. Builder confidence is still very low and mortgage applications continued to decline. The offset to the weak demand side is a reduction in distressed sales and inventory generally as well as some improvement in the jobs picture. Still, the entire real estate market, or at least the resi sector, feels like it is running out of steam. Most of the Fed's stimulus and asset inflation efforts have now run their course and there is not much air left to put in the bubble. Perhaps lenders are beginning to sense this. More domestic banks reported tightening lending standards in Q1 than in any quarter since early 2010. Much of this tightening related to non-traditional or sub-prime loans. We expect these to be the prevailing conditions for the next few months to maybe next year or two. The tightening in lending standards will provide opportunity for TFP. However, it is definitely a time to be a little defensive as it relates to LTVs, types of collateral, and insisting on being well compensated for risk born.

We also note that RealtyTrac reported the average time to complete a foreclosure nationwide increased to 572 days in Q1 from 564 days in the previous quarter. This is the longest foreclosure time since RealtyTrac began tracking this metric in 2007. This implies to us that a greater percentage of foreclosure activity is happening in slow/judicial states as most non-judicial, more-efficient states have worked through a lot of the inventory already. This reaffirms our focus on pricing loans and setting LTVs based significantly on the location of the collateral. Judicial states require longer times to foreclose, and, thus, loans are priced with higher rates and lower LTVs. California is a lot different than Texas in many ways!