Standard & Poors Just Issued a Warning on US Government Debt. What a Great Time to Buy US Government Debt!
Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.
US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.
Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.
What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?
That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).
Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.
Monday, April 25, 2011
Monday, April 18, 2011
Ramblings of a Portfolio Manager
Which Asylum is Being Run by the Inmates?
Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.
One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?
There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.
The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.
Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.
One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?
There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.
The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.
Monday, April 11, 2011
Ramblings of a Portfolio Manager
Extra! Extra! Commodity Prices to Derail the Economy!
So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”
Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.
Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?
Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher
So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”
Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.
Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?
Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher
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