"Kee" Points with Jim Kee, Ph.D.

Economic (e.g. “nowcasting”) models for US GDP are pointing to a pretty strong third quarter, with the New York Fed’s model at 3% and the Atlanta Fed’s model at 3.6%. We’ll see when the advance estimate is published in October, but so far I would expect this to help the incumbent party in the November elections. That seems to be the case according to PollyVote, which shows a small but consistent widening in favor of Hillary Clinton (53%) versus Donald Trump (46.5%).


The big event this week is the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole, Wyoming. The conference began in 1978 in Kansas City (moved to Jackson Hole in 1982) and has become an annual event for the central bankers of the world to meet and present. Legend has it that the conference moved to Jackson Hole in the early 1980s in order to ensure that then-Fed Chairman, Paul Volker, an avid fly-fisherman, would attend. That in-turn attracted other global big-hitters, and it is now an invitation-only event (The Economist). Janet Yellen will give the opening speech this Friday, and Mario Draghi, President of the European Central Bank, will speak as well.


Another topic this week is the number of new European company bond issues that are being bought by the European Central Bank (ECB). Some of these are “private placements,” which allow companies to raise money among a group of investors (including now the ECB) quickly without having to draft a prospectus or otherwise disclose a lot of information. Put simply, companies can raise money (for operations, expansion, etc.) by either borrowing (issuing debt that must be contractually repaid) or by issuing shares of stock (an ownership interest that shares in profits, if any). The “optimal capital structure,” i.e. the optimal financing between debt and equity, is actually quite complex and has never been fully worked out and agreed upon by financial economists. But whatever it is, the lower interest rates – borrowing costs – go, the more debt you would think a company would issue (because it is now cheaper). In fact, one of the ways to change your capital structure is to borrow money (issue debt) and buy back your own stock (reducing outstanding equity). A lot of companies have engaged in this otherwise perplexing action during the current expansion. There are other costs to debt besides interest costs, like the fact that interest payments on debt are contractually fixed, which can really put pressure on a company and its management during hard times when cash flow is low. Interestingly, some scholars (most notably Michael Jensen at Harvard) have argued that, from a shareholder’s perspective, this is a benefit of debt as it tends to “discipline managers.” That is, having to make regular interest payments on debt keeps managers focused and reduces extraneous spending and acquisitions. Working against all of this is the fact that the more debt you have, the riskier each additional dollar of debt is because it increases the odds of default, i.e. not being able to make the increasing interest payments. In the end, each form of financing, be it debt or equity, has various costs and benefits, which is why a theoretical optimal is so hard to determine!


The last thing I wanted to share has to do with alternative investment strategies and option strategies, because there is a lot of press out there warning that many of them have been akin to “picking up pennies in front of a steam roller” (WSJ) (I like that analogy). I was looking through my notes from a national conference I attended about four years ago, in particular a break out session on energy MLPs (Master Limited Partnerships) with a panel comprised of people selling them. In my notes, I had quoted one of the panelists as saying, “zero price sensitivity to the price of oil” with regard to MLPs. As many of you may know, MLPs subsequently declined by over -50% (Alerian MLP index) during the oil price decline of the last few years. My point is that there is a never ending supply of alternative investment vehicles, and the first thought that crosses my mind when evaluating them is, “higher returns usually come with higher risk.” That’s a good starting point for evaluating any investment.