The Year of Trading Dangerously

(Originally published here.)

A funny thing happened on the way to the Great Rotation from bonds to stocks: Fixed-income assets have crushed equities so far this year.

That’s the exact opposite of what everyone was predicting at the end of 2013. When the CFA Institute asked its members which asset class would have the highest total returns in 2014, chartered financial analysts overwhelmingly thought that stocks would do better than bonds.

Towers Watson’s 2014 Global Survey of Investment and Economic Expectations, which is based on a survey of investment managers, concluded that U.S. interest rates would probably be little changed in 2014. Franklin Templeton’s Global Investor Sentiment Survey, which was conducted at the beginning of January, found that two-thirds of U.S. investors expected interest rates to rise in 2014. Instead, interest rates have declined, especially for long-maturity securities.

That has boosted bond prices even as U.S. stocks have gone nowhere.

How could so many smart people have gotten things so wrong? One explanation is that asset prices at the beginning of 2014 already reflected expectations that stocks would do better than bonds — purely a function of investors’ irrational assumption that the future would be just like the recent past. But equities and interest rates had no reason to rise further unless investors became even more optimistic about the U.S. economy’s prospects.

Then remember what happened as we started the year: weak U.S. data that was partly blamed on the rough winter; inflation slowed in the big rich countries; Chinese economic growth slumped; and tensions mounted amid the situation in Russia and Ukraine. Together they may have damped the optimism that colored investor sentiment.

The pattern of optimism giving way to dull reality is a familiar one for observers of U.S. markets. Just check out this great chart from analysts at Bank of America Merrill Lynch, courtesy of Saxo Bank A/S chief economist Steen Jakobsen.

Each colored line shows the expected path of short-term interest rates — a decent proxy for the state of the economy — while the black line along the bottom shows what has actually happened. For the past five years, traders have consistently (and wrongly) bet that growth is about to accelerate and interest rates will rise. In other words, irrational exuberance lives. If interest rates and stocks finally do go up, it probably won’t be until everyone has stopped expecting it.

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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Ambiguity Is Clear for Net Neutrality

(Originally published here.)

Lots of people are unhappy with the Federal Communications Commission’s latest efforts to protect the so-called open Internet. The New York Times led its news story on the subject with the assertion that “the principle that all Internet content should be treated equally as it flows through cables and pipes to consumers looks all but dead.” That’s an extreme interpretation. It’s more likely that regulators are embracing constructive ambiguity to encourage behavior without radically altering the existing rules.

The FCC is in this pickle because of the way it classifies Internet providers. It could say they are “common carriers” under the Communications Act. That would give the FCC broad authority to prevent broadband companies from discriminating among their customers — rules that have long applied to landline phone service. The FCC has resisted taking this step, however, instead preferring to treat Internet providers as information services, which both transmit and process data. Maybe regulators agree with the National Cable and Telecommunications Association that “common carrier regulation discourages infrastructure investment and network enhancements.”

Whatever the logic, the FCC’s restraint means that it lacks a firm legal basis for the strict rules so-called net-neutrality advocates desire, which is why the agency’s previous regulations were struck down by a federal appeals court in January. The new rules, like the ones that were thrown out, are supposed to prevent Internet providers from imposing tolls by threatening to block sites or slow traffic. However, they would allow broadband companies to make “commercially reasonable” deals with businesses such as Netflix Inc. or Amazon.com Inc. that want dedicated high-speed connectivity. The FCC would have to be told about the terms of each deal and would have discretion to assess whether they were “reasonable.”

This probably won’t change much. The term “reasonable” is so vague that most businesses will probably prefer to err on the side of caution. After all, despite warnings you may read about their nefarious market power, the big Internet providers know that if they step too far out of line the FCC could always reclassify them as common carriers.

Remember when Comcast Corp. bought NBCUniversal? At the time, advocates thought it would be dangerous to have a content company vertically integrated with a cable and Internet business. Regulators agreed and forced Comcast to abide by strict rules in its treatment of NBC and the subscription video service Hulu. Those rules will still be in effect until 2018 and no one seems to have seriously argued that Comcast has violated its agreements so far. It’s possible that Comcast could choose to discriminate against online content from ESPN to promote the Comcast Sports Network once the deal expires but that doesn’t seem likely when the threat of common-carrier reclassification remains hanging over executives’ heads.

Besides, Internet providers and content companies already make bilateral deals to improve speed and reliability. Most of those deals wouldn’t be affected by stricter regulation of the ways broadband companies distribute content along the so-called last mile to residential customers, which is the issue at hand. Regulators didn’t bat an eye when Netflix paid Comcast to connect directly to its backbone network, or when it was rumored that Apple Inc. would pay Comcast to get its content treated as a “managed service,” which Microsoft Corp. already does for Xbox Live. The newly permissive rules don’t affect any of this.

Even more important is that the mobile Internet, which now accounts for more than half of total U.S. Internet usage, has never been protected from discriminatory treatment by wireless carriers. AT&T Inc. recently patented technology that would let it track how you use the Internet and alter your data plan according to whether it approves or disapproves of your behavior. Imagine the outrage if a cable company said it would raise or lower your bill depending on which channels you watched! AT&T also sells sponsored data to content companies that want to let consumers exceed their monthly caps. Despite these potential dangers to the open Internet, the market for new (and unprofitable) apps is quite robust and content companies haven’t been complaining that they are being mistreated. The wireless carriers haven’t, as of yet, abused their position because they too could always be reclassified as common carriers.

Maybe it would be better for regulators to avoid the ambiguity and treat the Internet the way they treat landline phones. But the existing approach of keeping companies in check with ambiguous threats seems to be working pretty well.

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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How to Make Housing a Better Investment

(Originally published here.)

Many Americans think real estate is the best long-term investment, according to a recent poll by Gallup. That has prompted a lively debate during the past few days. The disagreement comes from the difficulty of measuring the value of homeownership. A big part of the problem is that housing is both an investment and consumption. Separating those components might be helpful.

Home equity has inflation-adjusted returns barely above zero across time and countries — and that’s before accounting for property taxes and maintenance costs. Catherine Rampell, writing in the Washington Post, went further and said that renting would have been better than owning during the past 30 years because you could have bought high-returning stocks instead of accumulating home equity. But as economics blogger Bill McBride noted, Rampell assumed that the choice was between buying a home for cash rather than taking out a mortgage that could be repeatedly refinanced as interest rates fell by about 15 percentage points. That cheap leverage juiced the returns to home equity and also produced big tax benefits, since people can deduct mortgage-interest payments and local property taxes from their income.

Even if home equity generates modest positive after-tax returns, the big danger with buying is the vast variations in local housing markets. Many people who bought Manhattan real estate in the early 1970s (and still own it) are now rich, especially compared with renters who don’t have the benefit of rent control. The same can’t be said for those who bought in Detroit 40 years ago. Making matters worse, housing is an investment that is highly correlated to your income, since you live where you work.

When it comes to consumption, buying a home is attractive if you don’t plan on moving for a long time because fixed-rate amortizing mortgages let you lock in your cost of shelter. (The downside is that you can end up in trouble if you lose your job or have to take a pay cut.) Rents tend to rise over time, so ownership can end up saving you a lot of money on the consumption side of the equation if you intend to stay put. Also, homes available for purchase tend to be nicer and larger than those on the rental market.

Ideally, there would be a way for people to separate payments for shelter from investments in individual properties. Even better, people ought to be able to diversify their holdings of real estate without literally buying houses all over the country. Nobody puts all their money into just one stock in the Standard & Poor’s 500 Index when they want exposure to the U.S. equities market.

Here’s one way to imagine how this might work: Most housing would be owned and rented out by large companies that sell real estate-investment trust shares to the public. Instead of paying a mortgage, which includes both principal and interest, you would pay rent and have the option to accumulate shares in residential REITs. Since the REITs would be diversified, those shares ought to be less volatile than the equity in many individual residences.

Moving to another home wouldn’t affect your ability to accumulate housing wealth since you could take your REIT shares with you wherever you went. And the best part is that you wouldn’t have to worry too much about rising rents since that money would flow back to you through your REIT shares. As a bonus, concerns about growing wealth inequality due to rising home values would be less salient if everyone could easily buy stakes — even small ones — in many homes across the country.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter at @M_C_Klein.)

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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When a Dividend Signals Weakness

(Originally published here.)

The frothiest corner of the fixed-income markets seems to have missed the memo that the Federal Reserve is lifting its foot off the gas. Despite concerns last summer that a reduction in bond-buying might wound the global economy by making it harder to borrow, Bloomberg News reports that U.S. companies owned by private-equity firms areborrowing more money than at any point since the go-go years. The New York Times reports today that the French company Numericable Group SA is poised to sell the most junk bonds ever, breaking the record set by Sprint Corp. in September. And lenders are barely getting any compensation for the risks they’re taking.

You might think that all this corporate borrowing is exactly what rich countries need to finish recovering from the great recession. (Today’s new home sales are a sobering reminder of how weak the U.S. economy remains.) Unfortunately, most of the new debt isn’t being used to finance productive investment or hire additional workers. Corporate spending’s contribution to U.S. economic growth shrank considerably from 2012 to 2013.

 

Instead, the debt is being used for acquisitions, as in the case of Numericable, or to pay shareholders dividends and to buy back shares. (Here’s an interesting article on the origins of this latter phenomenon.)

The ease with which private-equity firms can borrow from banks and investors to pay themselves and their limited partners helps explains why they are now spending more for companies than they were even before the crisis. Lenders are so desperate to earn a decent rate of return that they are even willing to accept payment-in-kind notes, which pay interest with additional IOUs in lieu of cash.

This is what we get when policymakers push people to borrow at the same time there is nothing worth investing in — the same problem we had 10 years ago. Businesses might be more willing to expand and hire if more customers were eager and able to buy their products. Right now that seems like a far-off prospect, but if central banks were able to boost worker incomes as easily as they can lower junk-bond yields, maybe rich countries wouldn’t still have such weak economies.

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: Lisa Beyer at lbeyer3@bloomberg.net

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Has Comcast Stopped the Cord-Cutters?

(Originally published here.)

Comcast Corp., America’s biggest cable provider and one of its least-liked companies, seems to have been getting a little love lately. According to the latest earnings statement, the company added 24,000 video customers last quarter and 70,000 during the past six months. After years of slowly losing subscribers to telecommunications competitors, could this be the harbinger of good news for an industry long considered in decline?

The short answer is: probably not, although it would be foolish to write off the company’s prospects on that basis.

First, it’s important to remember that some or even most of those subscriber gains probably were due to temporary promotions. In one, Comcast has been offering faster Internet and free cable for the same price as standard Internet alone. It would be surprising if Comcast hadn’t been able to add subscribers with that kind of deal.

Besides, most Americans aren’t permanently abandoning their pay-TV providers for content streamed over the Internet, despite what you may read about “cord-cutting.” What we’ve seen so far is mostly a switch from traditional cable to services such as Verizon Communications Inc.’s FiOS and AT&T Inc.’s U-Verse. The telecoms are the real competition and they have a lot of room to grow.

 

The cable companies have responded by introducing better set-top boxesconsolidating through acquisitions and adding lucrative high-speed Internet and landline phone subscribers, all while trying to avoid getting squeezed by the content companies. Comcast has been the most successful in the industry at these tasks. Owning a content producer has been helpful: About 55 percent of the total increase in Comcast’s first-quarter operating income during the past two years has come from growth in the NBCUniversal division — even though it brings in less than 40 percent of corporate revenue.

Maybe Comcast’s recent performance shows that it knows how to prevent customer defections to the telecom companies through a combination of better prices and a superior television interface. We might know more once Verizon and AT&T give us their first-quarter results.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter at @M_C_Klein.)

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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Will Sales Taxes Doom Amazon?

(Originally published here.)

There are lots of reasons to shop at Amazon.com Inc., though one stands out: Many customers don’t have to pay state sales taxes, saving them as much as 10 percent on everything from toilet paper to televisions. New research confirms that this taxpayer subsidy is worth a lot, although the evidence also suggests that changing tax rules may not help brick-and-mortar stores compete against online retailers.

Even before the age of Amazon, some shoppers avoided sales taxes by crossing borders. It only takes about 40 minutes to drive from Boston, where sales taxes are 6.25 percent, to New Hampshire, which has no sales tax, so it isn’t surprising that many consumers do so. The drive from Seattle to Oregon is a bit longer but the sales tax savings are even bigger at 9.5 percent. Scholars have found that consumers even cross international borders when the tax difference is big enough. (Here is a paper about Singaporeans shopping in Malaysia and here is one about Swedes buying alcohol in Denmark.)

Other research shows that U.S. shoppers are very sensitive to the tax impact of online shopping. In the late 1990s, Austan Goolsbeeestimated that “applying existing sales taxes to Internet commerce might reduce the number of online buyers by up to 24 percent.” Last year, scholars studied eBay Inc.’s online marketplace, which doesn’t reveal where sellers are from until after consumers express an interest in buying a specific item. They found that “a one percentage point increase in a state’s sales tax leads to an increase of just under 2 percent in online purchasing, and a 3-4 percent decrease in the volume of online purchases from home-state sellers.”

Until now, however, no one has looked specifically at the benefits that accrue to Amazon. Recent changes in many state tax laws provide us with an interesting natural experiment. The new paper, from economists at Ohio State University, looks at about 245,000 households that spent at least $100 at Amazon in the first half of 2012 and tracks their daily spending through the end of 2013. Slightly more than a third of those households live in the five states that compelled Amazon to collect sales taxes during those two years (California, New Jersey, Pennsylvania, Texas and Virginia).

The average Amazon customer in affected states cut spending at the online retailer by 9.5 percent after local taxes went up, relative to spending in the other 45 states that didn’t raise taxes. The effects are even bigger for big-ticket items, with purchases of $300 or more falling by a staggering 23.8 percent.

Much of that money went to Amazon competitors that already collected sales taxes. The economists found that competing retailers had sales increase of 3.4 percent, with much of those gains coming from greater online purchases rather than more buying from stores. Amazon’s competitors saw sales increase by 9.2 percent when shoppers were spending $300 or more. Shoppers also shifted their spending to vendors on the Amazon Marketplace, almost none of which collect tax but all of which pay fees to Amazon. These smaller operators experienced sales increases of 15.2 percent overall and a whopping 60.5 percent for big-ticket items.

Imposing state and local sales taxes on Amazon purchases would be good for municipal budgets and help level the playing field for other online retailers, but do little for brick-and-mortar establishments. The question is whether years of tax subsidies for Amazon ultimately benefited the rest of us by nurturing a company with the resources to invest in new products, distribution channels and lower prices. Would online shopping have taken off without the tax benefit?

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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Morgan Stanley’s Bond-Market Magic

(Originally published here.)

Maybe it’s luck, but Morgan Stanley, which reported earnings today, has been enjoying impressive growth during the past two years in a business that has been inflicting pain on the rest of Wall Street: fixed-income trading. The segment has been in decline almost everywhere, as John Carney has explained, but first-quarter net revenue in Morgan Stanley’s trading business is gaining ground against JPMorgan Chase & Co. and Goldman Sachs Group Inc.

Even more striking is the importance of Morgan’s revived trading operations to its total revenue growth. The common narrative is that Morgan Stanley became more conservative after the financial crisis and decided to focus on the safer businesses of wealth management and advising corporations while leaving trading to its rivals. Yet more than half of the total increase in Morgan Stanley’s net revenue during the past 12 months came from the firm’s fixed-income traders. That’s a big contrast to Goldman, where fixed-income revenue has continued to shrink.

There aren’t any definitive explanations for this performance. (You get slightly different answers if exclude debt valuation adjustments, but not enough to change the overall narrative.)

Ruth Porat, the firm’s chief financial officer, suggested that the rough winter weather was partly responsible for increased commodity trading. If so, Morgan Stanley shareholders may be in for a treat, since climate scientists expect bitter winters to become more common. Of course, Goldman also said in its latest quarterly report that it got a boost from commodities but that wasn’t enough to offset “significantly lower net revenues in interest rate products, currencies and mortgages.”

Keep this up long enough and conservative Morgan Stanley may end up with the reputation as the savviest trader on Wall Street.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter at @M_C_Klein.)

 

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

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