Canadian Real Estate – More Reasons for Caution (Bradley)

Thursday, April 26th, 2012

by Tom Bradley, Steadyhand Investment Funds

Last Sunday, while flying to the hottest housing market in Canada (Toronto), my airplane reading surfaced a couple more statistics about Canadian housing, both of which point towards caution.

In their quarterly report, Mawer Investment Management noted that an average home costs 84% more in Canada than the U.S. ($372,762 versus $203,100). Yikes, we complain about paying more on J. Crew’s Canadian website, but 84%?

Also in the briefcase was The Economist Magazine’s quarterly house price survey. In all the years I’ve been following the survey, I’ve never seen Canada featured so prominently. We were at the top of the list for 1-year price change (+7%) and near the top in terms of The Economist’s valuation measures. On price-to-income, our market is shown to be 32% overvalued and on price-to-rents, it’s 76% overvalued. Overall, the survey suggests that Canada’s housing market is 54% overvalued, only slightly behind Singapore, Hong Kong and Belgium. On the same measure, the U.S. market is 19% undervalued.

Also in The Economist was an analysis of Toronto prices over the last 5 years compared to Shanghai, London and New York. Toronto was up 32% in Canadian dollar terms, but 93% when adjusted for exchange rates. On the adjusted basis, Shanghai was up almost 150%, while the other two were down. What this shows is that Toronto has not only got more expensive for the people who live there, but has increased at triple the rate for foreign buyers.

The Economist’s numbers are rough measures of value, and like some others I discussed in my Globe column a few weeks ago (Real Estate as an Investment? Look Elsewhere) – RBC’s affordability index, home ownership ratio, mortgage rates – each can be explained, and maybe even justified. And each may or may not be representative of a particular local market. But what worries me is that there are so many valuation measures that are at extremes and they all point to lower prices in the future.

As my friend Francis Chou said in a recent report, “If there is a choice, it is better to rent rather than buy a house.”

Copyright © Steadyhand Investment Funds

Tags: Adjusted Basis, Affordability Index, Canada Toronto, Dollar Terms, Economist Magazine, Home Ownership, House Price, Housing Market, Investment Funds, J Crew, Last Sunday, Local Market, Mawer Investment Management, Mortgage Rates, Price Survey, S Market, Singapore Hong Kong, Steadyhand, Tom Bradley, Toronto Prices
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“Nothing To Spare”, Crude Could Reach $200 (Erste Group’s Complete 2012 Oil Price Outlook)

Tuesday, March 6th, 2012

The latest in a series of re­ports eval­u­at­ing the fu­ture of the en­ergy mar­kets, es­pe­cially in the con­text of the in­creas­ingly in­ev­it­able Ir­a­ni­an con­flict, may just be the best and most com­pre­hens­ive one (not just be­cause it looks at the com­mod­ity from an "Aus­tri­an" angle). In 82 pages, Aus­tri­an Er­ste Group has ex­trac­ted the key as­pects and vari­ables for the world oil mar­ket and come up with a simple con­clu­sion: "noth­ing to spare." To wit: "We see the risks for the oil price heav­ily skewed to the up­side. At the mo­ment, the mar­ket is well sup­plied, but the smoul­der­ing crisis in the Per­sian Gulf could eas­ily push oil prices to new all-time-highs should it es­cal­ate. We be­lieve that new all-time-highs can be reached in H1, at which point we could see de­mand de­struc­tion set­ting in. We fore­cast an av­er­age oil price (Brent) of USD 123 per bar­rel between now and March 2013…The lat­ently smoul­der­ing Ir­an crisis seems to be close to es­cal­a­tion. The most re­cent man­oeuvres, os­ten­ta­tious threats, sanc­tions, em­bar­goes and the shad­ow war cur­rently on­go­ing, have heated up the situ­ation fur­ther. It seems we may soon see the last straw that breaks the camel’s back. Even though Ir­an could prob­ably only main­tain a block­ade of the Straits of Hor­muz only for a very lim­ited peri­od of time, the con­sequences would still be dra­mat­ic. The oil price would def­in­itely set new all-time-highs and could reach levels of up to USD 200." En­joy those price dips while you can.

Some more high­lights:

Brent oil set a new av­er­age all-time-high of USD 111/bar­rel in 2011. This price also ex­ceeded the 2008 and even the 1979/80 ref­er­en­tial val­ues on an in­fla­tion-ad­jus­ted basis. The main drivers of the oil price last year were the sup­ply side and the un­rest in the MENA re­gion. Not even the lat­ent wor­ries about an eco­nom­ic slump in Europe, the US or es­pe­cially China had much of an im­pact on the oil price. The in­creas­ingly ex­pans­ive mon­et­ary policy of the Fed­er­al Re­serve, the ECB, the Bank of Eng­land, and the Bank of China also came with a stim­u­lat­ory ef­fect. Giv­en that the Fed will now con­tin­ue its zero-in­terest-rate policy at least un­til the end of 2014, this should sup­port the en­tire com­mod­ity sec­tor, oil and gold in par­tic­u­lar. This scen­ario seems to lay the basis for new all-time-highs.

Last year, we saw mainly up­side risks for the oil price, ex­pect­ing the wave of re­volu­tions to con­tin­ue rolling across the MENA re­gion more vig­or­ously than it ended up do­ing. For now the spill-over of the re­volu­tion has been pre­ven­ted by ap­pease­ment meas­ures worth bil­lions taken by the vari­ous gov­ern­ments. However, the sys­tem-im­man­ent prob­lems have only been covered up, not re­solved. The ini­tial eu­phor­ia of the Ar­ab Spring has mean­while giv­en way to a sense of sobri­ety.

The lat­ently smoul­der­ing Ir­an crisis seems to be close to es­cal­a­tion. The most re­cent man­oeuvres, os­ten­ta­tious threats, sanc­tions, em­bar­goes and the shad­ow war cur­rently on­go­ing, have heated up the situ­ation fur­ther. On top of this, the situ­ation in Ir­an seems tense, with a cut in sub­sidies and the on­set of hyper­in­fla­tion ex­acer­bat­ing the crisis. It seems that we may soon see the last straw that breaks the camel’s back. We will dis­cuss the polit­ic­al risks and their ef­fects on the oil price in the fol­low­ing pages.

On top of the afore­men­tioned is­sues, it seems that OPEC cur­rently con­trols the price more tightly than ever be­fore. In the cur­rent en­vir­on­ment, prices of USD 90-110 should not (yet) cre­ate any form of de­mand de­struc­tion. It seems as if the oil price were to test the pre­cise price level of that crit­ic­al threshold and then rise a bit high­er with every at­tempt. They say that the cure for high prices is high prices, as a res­ult of which both de­mand in the OECD coun­tries and sup­ply (un­con­ven­tion­al oil, new pro­duc­tion meth­ods, etc.) seem to ad­just.

A com­par­is­on of the oil price fore­casts from vari­ous oil pro­du­cers re­veals that, in the peri­od of 1999 to 2010 Mex­ico, Saudi Ar­a­bia, and Rus­sia made the most ac­cur­ate fore­casts. All three of them also came closest to the ac­tu­al price last year, which is why it makes sense to listen to their ex­pect­a­tions. For 2012 they pre­dict sub­stan­tially high­er oil prices. Saudi Ar­a­bia ex­pects an av­er­age WTI price of USD 97, Mex­ico fore­casts USD 116, and Rus­sia USD 120/bar­rel. Ir­an has giv­en the highest fore­cast at USD 137/bar­rel.

The Aus­tri­an School of Eco­nom­ics of­fers in­vestors a new angle on fore­cast­ing as­set and com­mod­ity prices. In con­trast to tra­di­tion­al eco­nom­ists, "Aus­tri­ans" do not re­gard the rising de­mand for oil or oth­er com­mod­it­ies as de­term­in­ing factor for rising prices. Rather, they view the on­go­ing in­crease in money sup­ply, which in our par­tial re­serve bank sys­tem en­tails an ex­pan­sion of cred­it, as the cru­cial factor of rising prices. For Aus­tri­ans, one thing is cer­tain: the more mon­et­ary units cir­cu­late, the lower their in­trins­ic value. As a res­ult, the sub­stan­tial in­crease in oil prices in the past year has come as no sur­prise, as for Aus­tri­ans it is not so much the de­mand for a good such as oil that de­term­ines a price in­crease, but simply the fact that, es­pe­cially since 1971, more and more pa­per and di­git­al money has been cir­cu­lat­ing glob­ally. The fol­low­ing chart sup­ports this fact im­press­ively. While the av­er­age in­fla­tion-ad­jus­ted oil price had been USD 6.1/bar­rel with­in the frame­work of the Bretton Woods agree­ment, it em­barked on a rap­id in­crease once gold had been dis­carded as mon­et­ary basis. Since the end of the gold stand­ard the price of one bar­rel of oil has av­er­aged USD 20.6 per bar­rel.

Full re­port:

Spe­cial Re­port Oil – Noth­ing to Spare – 2012

Tags: Ables, Adjusted Basis, All Time Highs, Blockade, Brent Oil, Dips, Economic Slump, Embargoes, Energy Markets, Ergy, Escalation, Hens, Ily, Iran Crisis, Ited, Itely, Ity, Kets, Last Straw, Mand, Mena Region, Muz, Oil Price, Oil Prices, Pects, Persian Gulf, Price Outlook, Shad, Shadow War, Shy Side, Straits Of Hormuz, Struc, Usd 200, World Oil, World Oil Market
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Credit Plunge Signals “All is Not Well”

Tuesday, February 14th, 2012

European (like US) stocks remain in a narrow range just above the cliff of the unbelievably good NFP print of 2/3. US and European credit markets have lost significant ground since then and it seems equity investors just want to ignore this ‘uglier’ reality for now. The BE500 (Bloomberg’s broad European equity index) is unchanged from immediately after the NFP ‘jump’, investment grade credit is +10bps from its post-NFP tights, crossover (or high yield) credit is around 50bps wider, Subordinated financial credit is +50bps off its post-NFP wides at 382bps, and senior financial credit is an incredible 36bps wider at 225bps (by far the largest on a beta adjusted basis). The divergence is very large, increasing, and a week old now and perhaps most importantly as we look forward to LTRO Part Deux, LTRO-ridden banks have underperformed dramatically (40bps wider since 2/7 as opposed to non-LTRO banks which are only 10bps wider) – how’s that for a Stigma? Some ‘banks’ have suggested the underperformance of credit is due to ‘technicals’ from profit-taking in the CDS market – perhaps they should reflect on why there is profit-taking as opposed to relying on recency bias to maintain their bullish and self-interest positioning as the clear message across all of the credit asset class is – all is not well.

European financial credit is at over a two-week wide here and across the board credit markets have underperformed since the NFP print – perhaps they saw through the headline numbers?

European financial stocks ignored credit last week and then caught up, we now see the divergence growing dramatically. If nothing else, its an arbitrage opportunity but the drift in spreads is much more than technicals here and we suspect is a realization of the growing impact on the capital structure of banks of the ECB sucking up all the collateral supporting it (while capital is not exactly being raised hand over fist).

The most glaring divide remains the ‘stigma-trade’ where we have seen LTRO banks underperform dramatically (wider by 40bps) over non-LTRO banks (wider by only 10bps) and this is perhaps the key for why banks overall are underperforming.

Either way, it should be drastically clear to any and all (that choose to look and not ignore relaity in the interest of a fiat-currency-numeraire-based stock market ‘hoping’ for more printing) that all is not well in the Euro-zone. It is also not just Europe (as we have discussed for a week now) as high-yield credit in the US is also sending warning signals.

Charts: Bloomberg

Tags: Adjusted Basis, Arbitrage, asset class, Bias, Capital Structure, Credit Markets, Crossover, Divergence, Drift, ECB, Equity Index, Equity Investors, European Equity, financial stocks, Hand Over Fist, Investment Grade, Plunge, Realization, Self Interest, Stigma
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Emerging Markets Radar (February 13, 2012)

Saturday, February 11th, 2012

Emerging Markets Radar (February 13, 2012)

Strengths

• The People’s Bank of China (PBOC) said on Tuesday that it will ensure first-home purchasers have access to credit, according to a statement published on its website. On Thursday, WUHU, a large city in Anhui Province, relaxed property restrictions, a sign that there are local-level adjustments to assist the housing market.
• China’s January exports were down 0.5 percent, less than the estimate of -1.4 percent, while imports were down 15.3 percent, worse than the market consensus 3.6 percent. There was also the Chinese New Year effect, according to analysts.
• The Natural Resources Defense Council (NRDC) has raised diesel and petro prices across China by roughly 3 percent each.
• Indonesia unexpectedly lowered its benchmark interest rate by 25 basis points to 5.75 percent, a third move after two cuts last year. The lower policy rate will add pressure to commercial banks on their net interest margins, but will be good for corporations and consumers, especially for developers and auto makers.
• Indonesia’s fourth quarter GDP rose 6.49 percent, better than market consensus. For 2011 the economy expanded 6.5 percent, the fastest since 1996.
• Philippine’s Consumer Price Index (CPI) rose 3.9 percent, easing to a 13-month low.
• In Turkey, December industrial production (IP) came in at 3.7 percent year-over-year, better than the consensus estimate of 2.6 percent.  While significantly down from 8.4 percent in November, base effects played a large role, as IP last December was very high at 16.7 percent.   On a seasonally and working day adjusted basis, IP has been trending up in the second half of 2011.

Weaknesses

• China’s January CPI was up 4.5 percent, higher than the market expectation of 4 percent. The vegetable price was up 26 percent, and was blamed for the higher-than-expected inflation number. The bad news didn’t dampen the market bullishness in China and Hong Kong since the consensus is that the disinflation trend is intact. The Producer Price Index (PPI) was down 0.1 percent for the month.
• Philippine’s exports dropped 20.7 percent year-over-year in December as electronics shipments dropped. The result was worse than expected and was a greater decline than November’s figure.
• The Hungarian regulator has released the latest data on foreign exchange (FX) mortgage repayments in the sector. According to this data, by the end of January 2012, 142,000 people have repaid FX mortgages worth Hungarian forint (HUF) 1,074 billion at spot FX rates and HUF 776 billion at fixed FX rates, causing the banking sector HUF 298 billion pre tax loss. Another 19,000 people have submitted the necessary documents by the deadline and are still expected to pay later on, potentially repaying another HUF 145 billion worth of FX mortgages at spot FX rates and HUF 105 billion at fixed FX rates, potentially causing a further HUF 45 billion pre tax loss to the banks before the whole scheme is wrapped up.

Opportunities

• China’s January exports were better than expected, and may have been supported by improving U.S. recovery in credit, payroll and consumer spending, and by the European Central Bank’s long term refinancing operation (LTRO) in increasing liquidities for European financial institutions. The U.S. ISM Manufacturing Purchasing Managers Index is a leading indicator for Chinese exports as shown below that it is pointing to improved demands for Chinese goods.

• There is generally a very strong correlation between GDP growth and non performing loan ratios of nations’ banks, and Turkey is no exception (see chart below). As evidenced by the strong industrial production number for December, the Turkish economy continues to expand, easing the provision burden on the banks.

Threats

• China’s higher-than-expected CPI for January may delay PBOC’s decision to cut the bank required reserve ratio (RRR).
• Bloomberg reported that Russia may charge a one-time levy on businessmen who acquired assets in “unfair” 1990s state sales, said Prime Minister Vladimir Putin, who is campaigning to return to the presidency in next month’s election. Thursday’s Vedomosti suggests that Putin may try to style this one-time “windfall tax” on the U.K. approach.  According to the article, in 1997 the U.K. imposed a one-time payment on the owners of assets acquired during privatizations of the 1980s.  The payment was a tax of 23 percent on the difference between: a) the average net profit of the privatized companies made in the first four years following privatizations, multiplied by the factor of 9.3 and b) the purchase price.

Tags: Adjusted Basis, Auto Makers, Bank Of China, Benchmark Interest Rate, Chinese New Year, Commercial Banks, Consensus Estimate, Consumer Price Index, Home Purchasers, Index Cpi, Inflation Number, Interest Margins, Market Consensus, Natural Resources Defense, Natural Resources Defense Council, Nrdc, Pboc, Property Restrictions, Quarter Gdp, Wuhu
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China’s Manufacturing PMI: Outlook Worsening

Thursday, November 24th, 2011

The HSBC Flash China Manufacturing PMI for November dropped to a 32-month low of 48.0 from 51.0 in October. According to Markit, new orders are contracting while stocks of finished goods are contracting at a faster rate. It is evident that local demand is slowing as new export orders are expanding more quickly. Although the stocks of finished goods are contracting at a faster rate, stocks of purchases are expanding again despite a contraction in the quantity of purchases, indicating that Chinese manufacturers remain overstocked relative to demand.

Although the HSBC PMI sometimes differs significantly from the official CFLP PMI, both gauges indicate a significant slowdown in China’s manufacturing sector. The CFLP manufacturing PMI has continued to follow the below-par trend since February this year. Although the PMI is likely to tick up in November thanks to seasonal strength, I expect only a slight rise to approximately 51.3 from October’s 50.4.

Sources: CFLP; Li & Fung; Plexus Asset Management.

On a seasonally adjusted basis I expect the CFLP manufacturing PMI to remain unchanged at 50.6.

Sources: CFLP; Li & Fung; Plexus Asset Management.

The slowdown in domestic demand as indicated by the HSBC report does not auger well for China’s non-manufacturing sector. November is normally one of the weakest months of the year from a seasonal point of view. I would therefore not be surprised if the CFLP non-manufacturing PMI fell to 49.5 or below in November.

Sources: CFLP; Li & Fung; Plexus Asset Management.

A fall to 49.5 will result in the PMI reaching the lowest level of 51.2 since February 2009 on a seasonally adjusted basis according to my calculations.

Sources: CFLP; Li & Fung; Plexus Asset Management.

The expected manufacturing and non-manufacturing PMIs will confirm that China’s GDP growth is likely to slow to below 9% in the last quarter of this year.

Tags: Adjusted Basis, Amp, Asset Management, China Gdp, China Manufacturing, Chinese Manufacturers, Contraction, Export Orders, Finished Goods, Flash, GDP, GDP Growth, Last Quarter, Manufacturing Sector, Months Of The Year, Outlook, Pmi, Point Of View, Slowdown, Stocks
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Growth Falters, with Exception of Japan – Global PMI Scorecard (Oct 2011)

Monday, November 7th, 2011

Growth in global economic activity faltered in October after accelerating in September. The global manufacturing sector slipped into recession territory while growth in the services sector slowed markedly.

The JP Morgan Global Composite Index fell to 51.4 after rising to 52.0 in September from 51.5 in August. The drop in the composite PMI is mainly attributed to a significant drop in my calculated GDP-weighted PMI for the Eurozone to 46.6 from 48.7 in September. Germany’s composite PMI at a 27-month low indicates that economic activity in the private sector has virtually stagnated while economic activity in France, Italy and Spain at 28 to 30-month lows has contracted severely. Growth in the U.K. weakened considerably to stagnation levels.

My GDP-weighted Composite ISM PMI for the U.S. in October eased to 52.4 from 52.7 in September, indicating continued but below-par growth.

Growth in China also eased on a non-seasonally as well as a seasonally adjusted basis.

Japan was the exception to the rule among developed economies. According to Markit, Japanese private sector activity rose for the first time since February as the composite output index breached the neutral 50.0 threshold. The composite PMI jumped from a contracting 47.0 to a highest reading of 52.4 since data were first compiled in September 2007.

Economic activity in emerging economies improved somewhat. Brazil has returned to growth again. Growth in India and Russia edged up marginally while the contraction in Hong Kong eased markedly.

Sources: Markit; CFLP*; ISM**; US Business Activity Index***; Plexus Asset Management.

The JP Morgan Global Services PMI for October eased to 51.8 from 52.6 in September on the back of a significant deepening in the contraction in the Eurozone and especially France, Italy and Spain. The Germans are holding out, though, and have managed to eke out some growth from contracting in September. The services sector in the U.K. continues to exhibit some growth but at a reduced rate, while growth in Ireland accelerated slightly. Australia’s services sector is under the water again while growth in the services sector in China is weakening. The U.S.’s ISM non-manufacturing PMI continued its slightly weaker trend with the PMI marginally lower at 52.9 from 53.0 in September. However, it surprised the market on the downside as the consensus was for a rise to 53.5. The Business Activity Index fell sharply from a robust 57.1 to 53.8.

Among the BRICS countries Brazil made a huge turnaround as its services PMI jumped to 53.6 from 50.5 in September. Russia experienced a slight acceleration in growth but the contraction in India’s services sector has deepened.

Tags: Activity Index, Adjusted Basis, Brazil, Business Activity, Composite Index, Composite Output, Contraction, Emerging Economies, Eurozone, Exception To The Rule, Global Economic Activity, Global Services, India, Ism, Jp Morgan, Lows, Manufacturing Sector, Output Index, Private Sector Activity, Scorecard, Services Pmi, Stagnation
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In Search of Fixed Income (Koesterich)

Tuesday, October 25th, 2011

Call #1: Reiterate Long-Term Overweight of Corporate and Municipal Debt Over Treasuries

In today’s low rate environment, many investors are looking for fixed income opportunities. As I’ve discussed in the past, for long-term investors, I favor corporate and municipal bonds over Treasuries.

Here are two reasons why I like corporate debt:

• Yield: Corporate bonds currently offer a rich yield relative to US Treasuries. Today, the spread between an index of Moody’s Baa-rated bonds and the 10-Year Treasury is 330 basis points, roughly twice the sixty-year average.
• Strong Balance Sheets: At the same time that corporate yields are high relative to Treasuries, corporate America’s balance sheet looks exceptionally strong. US companies are holding more than $2 trillion in cash, which represents roughly 7% of company assets and the highest level since 1963.

Here are also two reasons why I like munis.

• Yield: First, similar to corporate bonds, municipals currently provide a rich, after-tax yield versus Treasuries of a similar duration. An index of national long duration GO bonds is yielding roughly 3.8%. On a tax adjusted basis, that’s roughly equivalent to a 6% yield for a theoretical taxpayer in the 35% bracket.
• Unfounded Dire Predictions: Plus, while munis potentially offer investors a significant pickup in yield, I don’t believe investors in munis are taking on much more risk.  As I’ve stated in the past, some of the more dire predictions for munis have turned out to be unfounded. Last December, we all heard predictions that 2011 would see hundreds of billions of dollars in defaults. Year-to-date, municipal defaults are running at less than $1 billion.

While both municipals and corporate bonds look cheap, by most accounts Treasuries look very expensive. While I hold a neutral view of Treasuries in the near term, I hold a negative longer-term view of Treasuries. Unless you believe that the United States is about to, or has already, entered a Japanese-style deflationary spiral, it is hard to justify accepting a 2% nominal yield and a negative after-inflation yield while taking on significant duration risk. (Potential iShares solutions: MUB and LQD).

Disclosure: Author is long MUB and LQD

Source: Bloomberg

Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise.  A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

Tags: 10 Year Treasury, Adjusted Basis, Balance Sheet, Balance Sheets, Basis Points, Bonds, Company Assets, Corporate America, Corporate Bonds, Corporate Debt, Fixed Income, Income Opportunities, Japa, Municipal Bonds, municipal debt, Municipals, Munis, Neutral View, Rate Environment, Term Investors, Treasuries
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In Search of Fixed Income (Koesterich)

Monday, October 24th, 2011

Call #1: Reiterate Long-Term Overweight of Corporate and Municipal Debt Over Treasuries

In today’s low rate environment, many investors are looking for fixed income opportunities. As I’ve discussed in the past, for long-term investors, I favor corporate and municipal bonds over Treasuries.

Here are two reasons why I like corporate debt:

• Yield: Corporate bonds currently offer a rich yield relative to US Treasuries. Today, the spread between an index of Moody’s Baa-rated bonds and the 10-Year Treasury is 330 basis points, roughly twice the sixty-year average.
• Strong Balance Sheets: At the same time that corporate yields are high relative to Treasuries, corporate America’s balance sheet looks exceptionally strong. US companies are holding more than $2 trillion in cash, which represents roughly 7% of company assets and the highest level since 1963.

Here are also two reasons why I like munis.

• Yield: First, similar to corporate bonds, municipals currently provide a rich, after-tax yield versus Treasuries of a similar duration. An index of national long duration GO bonds is yielding roughly 3.8%. On a tax adjusted basis, that’s roughly equivalent to a 6% yield for a theoretical taxpayer in the 35% bracket.
• Unfounded Dire Predictions: Plus, while munis potentially offer investors a significant pickup in yield, I don’t believe investors in munis are taking on much more risk.  As I’ve stated in the past, some of the more dire predictions for munis have turned out to be unfounded. Last December, we all heard predictions that 2011 would see hundreds of billions of dollars in defaults. Year-to-date, municipal defaults are running at less than $1 billion.

While both municipals and corporate bonds look cheap, by most accounts Treasuries look very expensive. While I hold a neutral view of Treasuries in the near term, I hold a negative longer-term view of Treasuries. Unless you believe that the United States is about to, or has already, entered a Japanese-style deflationary spiral, it is hard to justify accepting a 2% nominal yield and a negative after-inflation yield while taking on significant duration risk. (Potential iShares solutions: MUB and LQD).

Disclosure: Author is long MUB and LQD

Source: Bloomberg

Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise.  A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

Tags: 10 Year Treasury, Adjusted Basis, Balance Sheet, Balance Sheets, Basis Points, Company Assets, Corporate America, Corporate Bonds, Corporate Debt, Fixed Income, Income Opportunities, Japa, Municipal Bonds, municipal debt, Municipals, Munis, Neutral View, Rate Environment, Term Investors, Treasuries
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Monetary Policy in 3-D (Hussman)

Monday, April 25th, 2011

Monetary Policy in 3-D

by John P. Hussman, Ph.D., Hussman Funds

One of the most important factors likely to influence the financial markets over the coming year is the extreme stance of U.S. monetary policy and the instability that could result from either normalizing that stance, or failing to normalize it. It is not evident that quantitative easing, even at its present extremes, has altered real GDP by more than a fraction of 1% (keep in mind that commonly reported GDP growth rates are quarterly changes multiplied by 4 to annualize them). Moreover, it’s well established – on the basis of both U.S. and international data – that the “wealth effect” from stock market changes is on the order of 0.03-0.05% in GDP for every 1% change in stock market value, and the impact tends to be transitory at that.

Still, by replacing an enormous quantity of interest-bearing assets with non-interest bearing money, quantitative easing has created profound distortions in asset prices, where Treasury bills now yield less than 5 basis points annually, while “risk assets” such as stocks and commodities have been driven to prices high enough that their likely future returns now compete perfectly (on a time-horizon and risk-adjusted basis) with the zero expected returns on cash.

Taken together, despite the limited and transitory real effects of QE on output and employment, the Federal Reserve has created an unprecedented monetary position that creates an extremely unstable equilibrium for the financial markets. There are several ways that this might be resolved. Based on the very robust relationship between short-term interest rates and the monetary base, it is clear that a normalization of short-term interest rates, even to 0.25-0.50%, would require the Federal Reserve to fully reverse the $600 billion of asset purchases it conducted under QE2. Alternatively, with the monetary base now exceeding 16 cents for every dollar of nominal GDP, any external upward pressure on interest rates (that is, not produced by a Fed-initiated reduction in the monetary base) would quickly provoke inflationary pressures.

Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet . John told me that he had received several nearly identical questions, along the lines of “Wait, now I’m confused – I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?”

So, this is where that phrase “external upward pressure” comes in. We have to distinguish between what economists would call an “endogenous” increase in interest rates – one that the Fed itself provokes by reducing the monetary base – and an “exogenous” increase in interest rates – one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.

See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an “anti-inflationary” policy. However, if interest rates rise independent of any change in the monetary base, then cash – which doesn’t bear interest – becomes a “hot potato” that is suddenly less desirable. In that case, you get one of two outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970′s).

As I’ve argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I’ll leave that feature of the argument for another time.

Monetary Policy in 3-D

The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.

Tags: Adjusted Basis, Asset Prices, Asset Purchases, Enormous Quantity, Extreme Stance, Future Returns, Gdp Growth Rates, Gold, Hussman Funds, Monetary Base, Nominal Gdp, Qe2, Quarterly Changes, Real Gdp, Stock Market Changes, Stock Market Value, Stocks And Commodities, Time Horizon, Treasury Bills, Unstable Equilibrium, Wealth Effect
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Canada Inflation Surges: Core Comes At 0.7% On 0.2% Consensus

Tuesday, April 19th, 2011

A surprise out of the Bank Of Canada, which just announced that despite expectations for CPI coming at a modest 0.6% and 0.2% for the core, inflation was a blistering 1.1%, and 0.7% ex-non core items. Has the inflation genie finally come out of the bottle in the northern neighbor? While Goldman attempts to talk down this “ugly report”, attributing the spike to a short-lived commodity spike (that’s that temporary word again), the currency market was not as easily fooled: USDCAD moved a good 50 pips from 0.963 to 0.958 in seconds, giving the dollar another push in the race to the global currency bottom.

From Goldman

Sharp Increase in Core, Likely on Commodity Price Pass-Through
Large upside surprise in core inflation, pushing year-over-year figure much closer to Bank of Canada’s target.

KEY POINTS:
1. Canada’s core CPI surprised sharply to the upside in March, rising 0.5% on a seasonally adjusted basis on the month and more than reversing the downside surprises of prior months. Two key factors explaining the sharp rise in the core index were clothing/shoes (+2.1% mom SA, the largest monthly increase on record, worth about 14 basis points on the SA core), and food (+1.6% mom SA, also the largest monthly increase on record; unlike the US core index, a large part of food is included in the Canadian core index–with a simple assumption that food prices rose equally across all categories, this would be worth about 30 basis points on the SA core). Given increases in cotton prices in recent months, commodity prices look to be a factor in both of these increases.

2. Headline inflation rose 0.8% on a seasonally adjusted basis, 3.3% year-over-year; while this was also an upside surprise relative to the consensus forecast, essentially all of this surprise is explained by the higher core. Gasoline prices rose sharply, as expected.

3. If there is any silver lining to this generally ugly report, it is that inflation due to commodity-price pass through is likely to be temporary. Without further increases in commodity prices, the peak impact on the CPI should be reached within the next few months.

Tags: Adjusted Basis, Bank Of Canada, Basis Points, Canada Inflation, Canadian, Canadian Market, Clothing Shoes, Commodity Price, Commodity Prices, Core Cpi, Core Index, Core Inflation, Cotton Prices, Currency Market, Food prices, Gasoline Prices, Global Currency, Gold, Headline Inflation, Northern Neighbor, Target Key, Ugly Report, Upside Surprise
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