Posts Tagged ‘Bondholders’
Sunday, July 22nd, 2012
by John Hussman, Hussman Funds
Just weeks after the enthusiasm over Europe’s plan to plan for the possibility of using the European Stability Mechanism to bail out Spanish banks, the subtle technicality – that direct bailouts would make all of Europe’s citizens subordinate to even the unsecured bondholders of Spain’s banks – has predictably deflated that enthusiasm. On the growing recognition that addressing Spain’s banking problem will mean taking those banks into receivership, wiping out unsecured debt (much of which unfortunately was sold to unknowing Spanish savers as secure “savings” vehicles), and having the Spanish government sort out the damage, Spanish 10-year debt plunged to new lows last week (see chart below), and Spanish yields hit fresh Euro-crisis highs. At the same time, interest rates in Germany, Finland, Holland, Denmark and Switzerland all moved to negative levels looking 2-5 years out. The world is paying these governments to lend money to them, because the only way to acquire other default-free, non-commodity assets is to hire armored trucks and secure vaults to take delivery of physical currency. This set of conditions is not normal or sustainable, and indicates extreme credit market strains in Europe.
The Euro also hit a fresh 2-year low last week at 1.21, just a shade above its 2010 crisis low of 1.20. Likewise, the yield on 10-year U.S. Treasury bonds dropped to 1.45%, matching the historic low it reached a few weeks ago. Yields were higher even in the depths of the Great Depression, when the S&P 500 was trading at less than 2 times the pre-Depression level of earnings, the Shiller P/E on 10-year normalized earnings was less than 5, and the S&P 500 was yielding 16%. As a side note, many analysts seem almost woozy at the “incredible value” that supposedly exists in stocks because the 2.3% yield on the S&P 500 exceeds the 1.45% yield on 10-year Treasuries. It’s worth pointing out that prior to the point that inflation took off after 1960, the yield on the S&P 500 exceeded the yield on Treasury bonds in fully 93% of the data.
Keep in mind that once you subtract out the necessary compensation for default risk (which is rapidly increasing in Spain, for example), interest rates represent the value that the economy places on time. Long-term interest rates have plunged to record lows, and real interest rates are negative after inflation. What interest rates are telling you; what the Federal Reserve is telling you; what the equilibrium created by lenders and borrowers is telling you – is that time is economically worthless and that economic malaise will extend for years.
This does not reflect a well-functioning economy. To the contrary, if you look across history and across nations, strong prospects for sustained economic growth are typically accompanied by high real interest rates, because the demand for capital is robust and good ideas have to compete for funding. Interest rates are an indication of both the demand for loans and the incentive to save. It is not “stimulative” to depress interest rates in an environment where households, businesses and governments are desperately trying to reduce debt. That policy may insult the value of time enough to deter people from saving, and to reduce the immediate penalty for assuming even larger amounts of debt (as the U.S. government continues to do), but it should be clear that these actions move the economy further from a sustainable equilibrium, not closer to it.
I do expect that it will be possible to navigate the coming years well, but it will not be by locking in negligible yields and depressed risk premiums in the futile hope that one plus one will end up being something other than two. Prospective returns vary a great deal over the course of the market cycle, and the strategy of varying risk exposure in proportion to the prospective compensation for that risk will be essential.
On the economic front, as we expected based on leading economic evidence, new orders and order backlogs have dropped abruptly in recent reports. These indices are short-leading indicators of production, which is likely to show a striking decline beginning in the July data. Note carefully whether any positive surprises are in May and June data, because these reports will still be mixed. I continue to expect negative employment changes in the coming months, though as I’ve noted before, we may only find this out later on revisions rather than the initial prints in real-time. In any event, I am convinced that we will ultimately learn that the U.S. economy, slightly trailing the global economy, entered a new recession in June.
While July components are still coming in, the chart below shows the most recent condition of coincident U.S. economic data, reflecting a variety of Fed surveys and Purchasing Managers surveys.
The key question – in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. – is why the S&P 500 continues to trade within a few percent of its April bull market high. The answer is simple: investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing. Good economic news may be a relief for investors, but bad economic news in this context is just as much of a relief because it brings forward the anticipated delivery date of the sugar. The follow-up question, however, is that if more QE is widely anticipated, and a market advance is widely anticipated to result, isn’t that the precise definition of an event that is already priced into the market?
If you look at the Federal Reserve’s own research on quantitative easing – large scale asset purchases (LSAPs) – nearly every paper emphasizes the “portfolio balance” effect. Put simply, as the Fed removes longer-term Treasury securities from the menu of portfolio choices available to investors, it forces investors to consider alternative securities, raising their prices and lowering their yields – with a particular impact in driving down the risk premiums of risky securities. Indeed, as we’ve noted, QE has generally been effective in helping stocks to recover the peak-to-trough loss that they have suffered in the prior 6-month period (though the most recent LSAPs in the UK and Europe have been failures in that regard).
Still, once risk premiums are already deeply depressed (we estimate the likely 10-year prospective total nominal return for the S&P 500 to be only 4.8% annually), once stocks are trading near their bull market highs, and once Treasury debt already sports the lowest yield in history, should investors really expect much of a portfolio-balance effect from further attempts at QE? Frankly, I doubt it, but in the eventuality of a third round of QE, we’ll focus on our own measures of market action – not on any blind faith in the Fed.
The more troubling issue is that Fed papers on the effectiveness of QE focus almost singularly on the effect of QE on interest rates and risk premiums in the financial markets, with the notable absence of any analysis of the resulting effect on the real economy. This is like showing that squirting gas into an engine will make the engine run faster, without any concern for the fact that there is no transmission that connects the engine to the wheels. In a nutshell, the problem with QE is the lack of any material transmission mechanism from monetary interventions to real economic activity. This is a problem that the Fed should have recognized years ago, because there is strong and consistent historical evidence that real economic activity has very weak “elasticity” with respect to financial market fluctuations, particularly in equity values. Invariably, a 1% change in the value of the stock market is associated with a change of just 0.03-0.05% in GDP, and even that change is transitory. What the Fed has been doing is little but bubble-blowing, while at the same time driving the global financial system further from equilibrium rather than toward it.
Unfortunately, I expect these efforts to continue, but I also expect that it will be useless in averting an unfolding global recession. If the Fed was to initiate a third round of QE near present levels, it would likely be disappointing in the sense that it would fail to reverse economic weakness and at the same time would fail to drive equity prices higher than they already are, or interest rates materially lower than they already are. This would damage confidence in the Federal Reserve and force it to resort to language about monetary policy working with “long and variable lags.” Moreover, at a 1.45% yield and an 8-year duration on a 10-year bond, any interest rate increase of more than about 18 basis points a year will now produce a negative total return for the Federal Reserve over the period that the bonds are held, which comes at public expense (reducing the amount of interest that the Fed would otherwise turn over to the Treasury). As a result, talk is presently much cheaper than action. It seems likely that another round of QE will await obvious economic weakness and a significant spike in risk premiums – probably best measured by the depth of the drawdown in the S&P 500 from its most recent 6-month peak. Still, given that the rationale for much higher risk premiums is very real, it’s not clear that QE will have durable effects on stocks even in that event.
In short, a broad array of observable evidence suggests extraordinary strains in Europe, and abrupt though expected deterioration in U.S. economic activity. The Federal Reserve certainly has policy options, but those options have no material transmission mechanism to the real economy. We’ve always viewed the Federal Reserve as having an important and legitimate role in providing liquidity to the banking system in the event of heavy withdrawals; creating new reserves in return for high-quality, default-free securities backed by the full faith and credit of the U.S. government. This remains an important role, but the Fed’s actions have gone far beyond this role into areas that distort financial markets without transmission to economic activity. That’s just a reality we have to accept, and we’ll respond to further interventions with particular attention to trend-following measures of market action.
Here and now, we remain defensive in the face of accelerating strains the global economy – new highs in Spanish yields, negative interest rates across more stable European countries, new lows in the Euro and U.S. Treasury yields, collapsing new orders and backlogs, a sudden plunge in the employment component of the Philly Fed index, collapsing M2 velocity, and other factors. Due to some modest interest-rate considerations, our estimates of prospective return/risk have improved negligibly from the most negative 0.5% of historical observations, and are now among the most negative 0.8% of historical data. This rare extreme keeps us on red alert for now.
As noted above, accelerating strains are evident both in the global economy – particularly Europe – and in the U.S. economy. Stock valuations remain stretched on the basis of normalized earnings. Profit margins are nearly 70% above their historical norms at present, but these margins reflect very high deficit spending and very weak savings rates – something that can be related to corporate profit margins through accounting identities. Unless one anticipates continued deficits indefinitely, either revenues will revert closer to the level of labor compensation, or less likely, labor compensation will increase toward the level of revenues, but in any event the gap will tend to narrow. This may not be an immediate outcome, but stocks are instruments with an effective duration of over 40 years (mathematically, the duration of stocks is essentially equal to the price-dividend ratio, regardless of growth rates or repurchases). The very long-term stream of cash flows matters enormously in asset valuation.
One of the immediate issues I have with stocks here is the “exhaustion syndrome” (see Goat Rodeo) that has re-emerged in recent weeks. Examining the rare past instances of this syndrome, in 1961, 1987, 2000, and early-2008 among others, the key feature is a breakdown in measures of market action from an overvalued, overbought extreme, followed by a recovery rally toward the prior high and accompanied by earnings yields below their level of 6-months earlier. Normally, the recovery carries the market back to the prior “line” of support that surrounds the peak. The emergence of this exhaustion syndrome may seem benign or unimportant, but it has historically been an important precursor of major market declines. Given what are already significant challenges for both the economy and for the prospective return/risk tradeoff in stocks, my concerns about the potential for deep market losses remain elevated.
Investors often have the impression that the market simply collapses once a bull market peak is set, but this isn’t typical. What is typical is exactly the sort of exhaustion pattern we’ve observed since April. To illustrate this, the chart below presents market behavior around several market peaks that were also followed by an exhaustion syndrome as we observe today. The bull market peaks are aligned at 1.0. The remaining scale is set as a fraction of that peak. Time is measured in trading days before and after the bull market peak. Note that after a quick initial decline from the bull market peak, it’s typical for the market to recover much of the lost ground before the downside progress continues, in some cases producing the “exhaustion syndrome” that we presently observe. Exhaustion syndromes can go on for several weeks, but have historically been very dangerous advances to trade, because more often than not, there is a bear market just behind them. This was not the case in three instances: the July 1998 instance – followed by a decline of only 18%, the July 1999 instance – down only 12% over the next several months, and of course the instance in late January of this year, which occurred at about 1326 on the S&P 500 and still hasn’t yet resolved into losses beyond the weakness we saw in May. It’s possible that the market outcome will be benign in this case, and that the market will go on to set further bull market highs. We have no intention of taking that improbable gamble in the face of present headwinds.
Strategic Growth and Strategic International continue to be fully hedged, with a staggered-strike option position in Strategic Growth (which raises the strike prices of the put side of our hedge). We presently estimate the time-decay or “theta” of the staggered-strike position at about 0.25% of assets monthly – which we are willing to accept based on the extremely negative outcomes that are typical of the current climate, and the expectation that we will not remain in this position for a long time. Strategic Dividend Value is hedged at about 50% of the value of its stock holdings, and Strategic Total Return continues to carry a duration of just over one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.
Copyright © Hussman Funds
Tags: 10 Year Treasury, Armored Trucks, Bondholders, Commodity, European Stability, Great Depression, Hussman, Hussman Funds, John Hussman, Lows, Receivership, Shiller, Spanish Banks, Spanish Government, Strains, Technicality, Time Interest, U S Treasury, U S Treasury Bonds, Unsecured Debt, Vaults
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Thursday, May 17th, 2012
Via Mark J. Grant, Author of Out of the Box,
Tragedy (Ancient Greek:, tragoidia, “the-goat-song”) is a form of drama based on human suffering that invokes in its audience an accompanying catharsis or pleasure in the viewing. While many cultures have developed forms that provoke this paradoxical response, tragedy often refers to a specific tradition of drama that has played a unique and important role historically in the self-definition of Western civilization.
The Synopsis of a Greek Tragedy
The days have passed since January 13, 2010 when I first expressed my opinion that Greece would default. Weeks and months have come and gone; Athens has been rescued by the Troika, private bondholders were forced into a Draconian swap as the Germans attempted to soothe their citizens and boatloads of money has been dumped into the Greek economy and into the Greek banks. The demands for “austerity measures” heaped upon the citizens and the economy of Greece has sent the marginally poor into the streets and into bread lines and caused a Depression in Greece based largely upon the imposition of the Troika’s demands that Greece must curtail the standard of living which was initially granted by Greece joining the European Union. The hand that fed the beast became the hand that began the slaughter and as the lifeblood was sprayed upon the concrete floor; the rest of Europe tries to decide when to turn off the life support while the patient agonizes between life and death in its present condition. Greece is, in fact, in the death throes of its existence as brought about by its addiction to the cash that was offered and then is being restricted. It is the bleakest of nights in Troy and the soldiers are slipping out from the horse.
“The god of wine looked around at the assembled crowd. “Miss me?”
The satyrs fell over themselves nodding and bowing. “Oh, yes, very much, sire!”
“Well, I did not miss this place!” Dionysus snapped. “I bear bad news, my friends. Evil news. The minor gods are changing sides. Morpheus has gone over to the enemy. Hecate, Janus, and Nemesis, as well. Zeus knows how many more.”
Thunder rumbled in the distance.
“Strike that,” Dionysus said. “Even Zeus doesn’t know.”
-Rick Riordan, The Battle of the Labyrinth
While some with knowledge of the actual conditions liken the situation to some sort of Armageddon, the markets largely ignore what is about to happen because they have been told and re-told a series of lies about the fiscal state of Greece and have focused upon the small size of the country which will turn out to be one grave mistake in judgment. The markets have had a slew of propaganda directed at them informing them that the horned goat was a passive sheep but the veil of deceit is about to be lifted which is why I think that the reality of what is about to take place is nowhere close, not in one hundred leagues, of the coming actuality which has not been priced into the markets with any sort of accuracy. I shall endeavor to explain.
Almost everyone has focused upon the sovereign debt, that it is no longer placed at the European banks and that it is resident at the European Central Bank which is protected by all of the nations in Europe. This is true, as far as it goes, but the summation does not go nearly far enough. The hit, when it comes, will require the ECB to be recapitalized, will be felt at the IMF where the United States will take 16% of the hit or around $16 billion which will be trumpeted in the Press by the Republicans and waved like a banner in the Press. The recapitalization of the ECB will require hard cash from the nations in Europe which is quite different than promises and contingent assurances so that nations may get downgraded as a result of their capital outflows. The EIB will also take a hit and it may get downgraded but all of this just focuses upon the sovereign debt and is non-inclusive of the rest of the story or even of the truth of the sovereign debt.
Greece has $90 billion in derivative contracts that will likely default and the losses will then have to be taken at the French, German and American banks. The contractual obligations of the nation will probably get revoked which will impact the health providers, Greek companies providing goods and services to the country and the Greek banks which have been lending money on these obligations. The number here is someplace between 20-40 billion dollars as far as I can find data to understand the breadth of the problem. The banks will probably renounce their obligations to other European banks which is not included in the sovereign debt figures and will certainly have a significant impact. The Greek banks who have their debt guaranteed by the sovereign in an amount just shy of $100 billion will also likely default and this $100 billion is NOT counted as a part of the Greek sovereign debt as it is a contingent liability and hence not counted by Europe except that the contingent is about to become a quite real liability and an additional hit to the ECB so that the number bandied about in the Press for the Greek liability at the ECB is nowhere close to reality. Then there is the municipal debt which is found throughout the European banks and insurance companies. Next is the loans, the mortgages and other debts that have been securitized and pledged to the ECB and other European banks which then rehypothecated the securities and also pledged them to the ECB as collateral so that there is a cubed effect that is going to be set-off as the house of cards implodes in upon itself. The number is approximately $1.3 trillion in total and all of it is going to default as Greece heads back to the Drachma and thumbs its nose at those that placed them in the “iron maiden” demanding not only confession but absolution which, in the end, will be denied.
Mark J. Grant is Managing Director of Corporate Syndicate and Structured Products for Southwest Securities, Inc.
Tags: Ancient Greek, Austerity Measures, Bondholders, Bread Lines, Catharsis, Concrete Floor, Death Throes, Goat Song, God Of Wine, Greek Banks, Greek Economy, Greek Tragedy, Human Suffering, J Grant, Lifeblood, Satyrs, Self Definition, Standard Of Living, Troika, Western Civilization
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Wednesday, March 28th, 2012
Germany’s recent ‘agreement’ to expand Europe’s fire department (as Goldman euphemestically describes the EFSF/ESM firewall) seems to confirm the prevailing policy view that bigger ‘firewalls’ would encourage investors to buy European sovereign debt – since the funding backstop will prevent credit shocks spreading contagiously. However, as Francesco Garzarelli notes today, given the Euro-area’s closed nature (more than 85% of EU sovereign debt is held by its residents) and the increased ‘interconnectedness’ of sovereigns and financials (most debt is now held by the MFIs), the risk of ‘financial fires’ spreading remains high. Due to size limitations (EFSF/ESM totals would not be suggicient to cover the larger markets of Italy and Spain let alone any others), Seniority constraints (as with Greece, the EFSF/ESM will hugely subordinate existing bondholders should action be required, exacerbating rather than mitigating the crisis), and Governance limitations (the existing infrastructure cannot act pre-emptively and so timing – and admission of crisis – could become a limiting factor), it is unlikely that a more sustained realignment of rate differentials (with their macro underpinnings) can occur (especially at the longer-end of the curve). The re-appearance of the Redemption Fund idea (akin to Euro-bonds but without the paperwork) is likely the next step in countering reality.
Section 4 below is the most critical to understanding the pitfalls of the consensus thinking…
1. EFSF Has Helped Contain Tensions in Peripheral Hot spots
The EFSF, which became operational in August 2010, was the first authority empowered to redistribute fiscal resources to support adjustment programs across EMU member states. The Facility has EUR54.5bn in bonds outstanding (including EUR30bn as part of the Greek debt exchange) and EUR8.9bn in bills. Earlier this month, it was authorized to raise a total of EUR241bn. This amount exceeds the aggregate committed capital to the three program countries by roughly EUR50bn, partly to provide for liquidity buffers. By comparison, the amount of bonds outstanding from the European Investment Bank—another supranational issuer—is in the region of EUR405bn.
The EFSF supply replaces the market funding programs (covering amortizations and deficit) for Greece, Portugal and Ireland. Thus, from a flow perspective—and taking into account that most EMU countries are reducing their borrowing requirements—the net supply of EUR government bonds available to private investors is declining.
The stock of Euro area government debt has increased substantially in the wake of the 2008 financial crisis, as has been the case elsewhere. Reflecting a process of ‘mutualization’ of the debt owed by the smaller issuers through the EFSF, the average quality of the pool of investable Euro area securities is progressively being upgraded. The ECB has contributed to this dynamic by removing around EUR200bn-worth of debt from private hands through its Securities Market Program (EUR150bn of which are Italian and Spanish bonds).
The EFSF issuance does not constitute a ‘Eurobond’, defined as a claim backed jointly and severally by the EMU countries. Rather, investors in EFSF securities effectively hold a (credit-enhanced) portfolio of Euro area sovereign issuers, excluding those currently under financial assistance programs. The country allocations of the portfolio map the ECB’s ‘capital key’, which roughly correspond to GDP size. Relative to a bond market capitalization, the capital key over-weights Germany and under-weights Italy.
The EFSF has no paid-in capital, but rather is backed by financial guarantees (amounting to EUR726bn) that exceed the maximum lending capacity of the facility (EUR440bn, corresponding to the sponsorship of the highest rated countries). After the downgrade of France, the weighted average rating of the sovereign guarantors is AA minus, and the weakest constituent (Italy) is rated BBB. EFSF long-term bonds are currently rated AA+ by S&P, and have the highest rating by both Moody’s and Fitch.
The EFSF securities currently span maturities ranging between 3 months and 20 years. They trade below the Euro-swap curve at the short end, and around 100bp above it at the long end. Benchmark 10-yr EFSF bonds currently trade around 10-15bp above the corresponding maturity government bond issued by France—the closest rated core sovereign issuer. EFSF bonds are also broadly aligned with the weighted average funding cost for the facility’s sovereign backers, indicating that the benefits of over-collateralization and the costs of lower liquidity broadly offset each other (the Facility lends on to program countries at funding costs plus operational costs, and the recovery on loans is assumed to be zero by rating agencies). If bond yields move in line with what our valuation work suggests, EFSF securities should increase in value against the Euro-swap curve, and trade tighter in relation to France.
Demand for EFSF bonds from the first issuances has been split as follows: 46% to the Euro area, 33% to Asia and 10% to the UK. Central banks and Sovereign Wealth Funds purchased 38% of the bonds, with banks buying another 29% (see charts on the next page). The share acquired by Euro area financial institutions has progressively increased, as investors in the core countries switch away from low-yielding German Bunds in favor of securities that reflect the sovereign risk syndication being conducted directly through the fiscal schemes and indirectly on the ECB’s balance sheet.
2. Two Ways to Increase Pressure in the Fire Hydrants
Pressures to increase the EFSF’s endowment at the height of the sovereign crisis last year eventually resulted in allowing the Facility to leverage its resources. This has now been crystallized into two Special Purpose Vehicles (SPVs): a European Sovereign Bond Protection Facility and a European Sovereign Bond Investment Facility. The first scheme aims to provide partial risk protection certificates for sovereign bonds (i.e., a ‘first-loss insurance’ scheme). The second is a co-investment fund open to both the private and public sector dedicated to EMU area government bonds.
We assessed the idea of ‘first loss protection’ favorably when it was first circulated last year. The advantages of ‘credit wrapping’ new issuance of government securities are associated with the combination of a credit risk transfer from the guaranteed sovereign to its guarantors (the AAA-rated backers of the EFSF), which, in turn, benefit from a decline in systemic risk; and the reduction in refinancing risk accruing to the previous bond holders, which over time mitigates the potential segmentation of the market.
However, faced with the largely unquantifiable risks stemming from a potential breakup of the monetary union, the scheme has become less appealing to investors. The Protection Facility has other shortcomings too. Based on the rating agencies’ published methodologies, the rating impact of a higher recovery assumption in the case of Investment Grade securities is small (a 1-2 notch increase at most), hardly changing the position of countries such as Italy or Spain. Particularly if associated with multiple instruments, the protection certificate could be treated as a derivative instrument in banking books, rather than a ‘financial guarantee’. As such, it would fall under mark-to-market rules, with detrimental impacts on demand.
The Sovereign Bond Investment Facility is a more interesting proposition, especially if directed at the primary market. The first loss tranche is remunerated at the EFSF’s cost of funds. This is to the advantage of senior investors, who access a levered return (maximized by the Facility’s manager under a set of guidelines) with lower risk. As an example, Italy’s main fiscal problem pertains to its high debt stock, which needs to be rolled over. The SPV could cover 2 years’-worth of Italian medium-to-long-term maturity bond supply (around EUR400bn). The ‘equity’ tranche could amount to 30% (or EUR120bn), the ‘senior tranche’ could be 50% (EUR200bn) and the remaining ‘super senior’ tranche 20% (EUR80bn). Assuming a recovery assumption of 50%, the expected risk-weighted returns accruing to the senior tranche are attractive. For reference, EFSF July 2021 trades at 3.0%, while BTP August 2021 trades at 4.9%, and 10-year EUR Libor at 2.3%. With the capital allocation used in this example, the expected return on the senior tranche is around 220bp over the BTP, with a higher recovery.
So far, however, it is not clear who would participate in this SPV. Suggestions that sovereign wealth funds and/or the BRIC countries could become potential investors have not led to reported progress and have overlapped with demands for higher contributions from the BRICs to the IMF. Seniority considerations, the legal regime that governs any shortfall and the mechanism for a possible transfer of the participation from the EFSF to the ESM would need to be clearly spelled out for the scheme to work.
3. The ESM—The Permanent ‘Fire Department’
The European Stability Mechanism, or ESM, is a permanent facility that will replace the EFSF from July 2012. The ESM will have an initial lending capacity of EUR500bn (reviewed periodically) and a total subscribed capital of EUR700bn, of which EUR80bn will be in the form of paid-in capital to be phased in with a maximum of five installments.
Under current agreements, the consolidated lending capacity of the EFSF and ESM cannot exceed EUR500bn. But the authorities are actively discussing whether this limit can be increased by combining resources, even though it may not be for the entire capacity of the two funds (EUR940bn). One possibility could be that EUR500bn from the ESM will be added to the existing commitments of the EFSF (EUR17bn for Ireland, EUR26bn for Portugal and EUR102bn for the second Greek package), or to the EUR241bn the EFSF has already been authorized to issue. A decision is expected at the Finance Ministers’ meeting on March 30.
Increasing the total amount of the combined EFSF and ESM fund could have positive effects on the valuation of EFSF bonds, as a greater potential for sovereign credit risk syndication can lower the yield differential between constituents—in practice, German bonds would lose value, while those of Italy and Spain would increase in value. However, a number of issues that could affect the liquidity of the EFSF bond market still need to be addressed. Also, EFSF bonds will be close, but not perfect, substitutes of ESM bonds, because the two facilities enjoy different creditor status.
On the first issue, it is not yet clear what the EFSF’s role will be after July 2012. The EFSF will remain in place until the last bond issued matures. But it has not yet been decided whether new lending programs starting after July will come under the ESM, or whether the EFSF will be able to continue issuing bonds of existing programs. This decision will affect the depth of the EFSF bond market.
On the second issue, both EFSF and ESM loans are junior to IMF loans. However, while EFSF loans have the same creditor status as other sovereign claims on a country basis (pari passu), ESM loans enjoy preferred creditor status over other sovereign claims. This clause does not apply to ESM loans relating to a financial assistance program that came into existence before February 2, 2012, when the new ESM treaty was signed. Hence, while in theory ESM bonds have a better credit status than those issued by the EFSF, in practice this will depend on whether or not lending programs to countries other than Ireland, Portugal and Greece will be activated.
4. Too Much Combustible Material Still Around
The Euro area is a financially closed region, with more than 85% of sovereign bonds held by residents of the area. If we add to this the fact that most claims against governments are held by financial institutions domiciled in the area, the risk of ‘financial fires’ spreading is high. The prevailing policy view that bigger ‘firewalls’ would make investors more comfortable about purchasing sovereign bonds of EMU countries. This is predicated on the idea that the existence of a funding backstop would prevent credit shocks in one of the EMU members from spreading to other issuers. That said, we doubt the current infrastructure can produce the same effects on markets as the ECB’s long-term liquidity injections (LTROs). Our view is based on the following considerations.
- Size: Even if we combine the full uncommitted capacity of the EFSF and the ESM (EUR700bn), the total would not be sufficient to backstop the bigger markets of Spain and Italy. The former’s borrowing requirement (amortization plus deficit) over the next two years is EUR305bn, while the latter’s amounts to EUR525bn.
- Seniority: The ESM holds ‘preferred creditor status’ over existing bondholders (art.13 of the Treaty establishing the ESM). In practice, this means that if the facility is used to provide an EMU member country under conditionality, it would subordinate existing bondholders (twice, if the IMF also participates in a bailout). Given that investors are aware of this, they would require compensation to bear such risk. This could exacerbate, rather than mitigate, a crisis.
- Governance: The existing vehicles cannot intervene pre-emptively in markets at signs of tension. Rather, they would be activated only after a full crisis has erupted. The procedure envisages that the ECB would ring an alarm bell should tensions threaten the stability of the Euro area. The sovereigns experiencing tensions would need to formally ask for help, and sign a memorandum of understanding, before any financial support can provided. Admittedly, a ‘fast track’ option is also available, based on ‘light conditionality’ and allowing the EFSF to intervene in secondary markets. Still, the fixed size of resources could raise questions on the effectiveness of the operations.
5. What Could Help?
As we have indicated in previous research, based on relationships with relative macro and fiscal factors prevailing over the past 20 years, Italian government bonds should currently trade around 130bp over their German counterparts, and Spain at 200bp over Bunds. These spread levels are well below the 320-350bp prevailing at the time of writing. By reinforcing the notion of a ‘conditional mutualization’ of sovereign EMU debt, the expected increase in the size of the firewalls could help stabilize inter-country spreads. But for the reasons mentioned above, we doubt this would lead to a more sustained realignment of rate differentials with their macro underpinnings, particularly at the long end of the curve where uncertainties surrounding subordination are particularly acute.
We would therefore advance two ‘normative’ considerations:
- At this juncture, Spain remains under close scrutiny because of the interplay between the recapitalization of the non-listed banks (saddled with exposure to the housing sector, which has deteriorated on the back of the increase in unemployment) and the challenging fiscal targets that it needs to meet in 2012/2013. On 30 March, the Spanish government will announce the 2012 budget, which should remove part of the uncertainty around the size and quality of the fiscal measures. But concerns about the recapitalization of the non-listed banks are unlikely to diminish any time soon. We have long been of the view that an agreement between the Spanish government and the EFSF to support the recapitalization of the banking sector would be a productive use of pooled fiscal resources. It would avoid an increase in the funding needs and borrowing costs that Spain would face if it had to recapitalize banks using funds from the FROB. In this way, Spain could take advantage of EFSF funds, avoiding the ‘stigma’ of a macro-economic adjustment program, while the planned restructuring/recapitalization would be reinforced by external incentives and controls, and EMU-wide resources would be directed at one of the obvious sources of weakness of the common currency area.
- More broadly, we continue to think that a more direct approach to the ‘debt overhang’ problem affecting the Euro area would remove ‘combustible material’ and speed up the recovery. In this context, the proposal advanced by the German Council of Economic Advisors to set up a Euro area wide Redemption Fund appears to be one of the most promising. We plan to elaborate on this solution in forthcoming research, but the outline is fairly straightforward. The Council suggests creating a fund that would be jointly and severally guaranteed by EMU member countries, in which each participant would transfer government debt (ideally across the maturity structure, and in parallel with ongoing market access) in excess of 60% of GDP. Countries would pledge collateral to the fund, earmark revenues of a specific tax, and commit to repaying their liabilities over a long period (20-25 years). Alongside the fiscal compact and debt brake rules, this initiative has the merit of finally establishing a liquid security (the expected float is in the region of EUR2.5trn) which would reflect the Euro area’s comparatively high aggregate credit quality and thus represent a sound ‘store of value’.
Tags: Backstop, Bondholders, Debt Exchange, Differentials, Efsf, Esm, Fiscal Resources, Garzarelli, Goldman, Hot Spots, Interconnectedness, Limiting Factor, Mfis, Pitfalls, Realignment, Reality Section, Redemption Fund, Seniority, Sovereign Debt, Sovereigns
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Monday, March 19th, 2012
China’s economic engines of growth have begun to accelerate again, but you wouldn’t know it by looking at the chart below. After approvals for new railroad projects spiked to a five-year high in the third quarter of 2010, the number of new plans slowed, then completely halted throughout 2011, decreasing 89 percent by value, says J.P. Morgan.
There were multiple reasons for the slowdown in railroad construction, says BCA. A bullet train crash caused heightened concern for safety last summer. Also, the government intentionally delayed projects as it pulled the brakes to decelerate growth and curb inflation.
Since China received signs of slowing inflation over the past few months, it can now shift its attention toward growth. Recent policies are sending a “full steam ahead” message to railway investment. According to J.P. Morgan, in December and January, China announced tax benefits on interest income for railway bondholders, issued bonds for railway projects, and injected cash into the two largest train makers. This concerted effort should help the country meet its long-term goal to connect 100 percent of cities with a network of high-speed rail.
Over the past two decades, China’s railway system has come a long way very quickly, with track length increasing 50 percent since 1995. Demand has increased at a faster rate, though, as “passengers travelling on the country’s railway system per year doubled during the same period, while railway freight increased by 150 percent,” says BCA.
And, on a per capita basis, China’s rail length is much lower than most major economies, according to BCA Research. When you compare the total length of railways in developed and emerging markets, Australia has the most rail per capital, with 1.77 kilometers of railway per 1,000 persons; Brazil has considerably less, with only 0.15 kilometers of rail track per 1,000. However, as you can see below, China lands in last place for the total length of railway per capita.
Although China has been busy constructing its railways over the past few years, this comparison shows that this infrastructure buildout has been more of a “catch-up process,” rather than an “overshoot,” says BCA.
New! Webcast on China
Learn more about China and what’s expected throughout 2012 by joining CLSA’s Andy Rothman and me for a webcast on April 5. Register today for Hard or Soft Landing in China? Navigating China’s Transition to a Consumer-Driven Economy.
Tags: Bondholders, Brazil, Bullet Train, China Railway, Concerted Effort, Economic Engines, Emerging Markets, High Speed Rail, Interest Income, J P Morgan, Kilometers, Long Term Goal, Per Capita, Railroad Construction, Railway Freight, Railway Projects, Railway System, Railways, Slowdown, Steam Railway, Train Crash
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Tuesday, February 21st, 2012
Think this time around finally the Greek deal is done? Think again. OpenEurope lists the “many” questions still surrounding the second Greek bailout that remain unanswered. We would add that this is hardly an exhaustive list, and believe the key question, to put it simply, is a CAC is a MAC? Because if the answer is yes, the deal is off.
Many questions around the second Greek bailout remain unanswered
We finally have an agreement on the second Greek bailout…in principle. It only took eight months. If you’re of the belief that a disorderly Greek default would have triggered Armageddon, the deal that was agreed (as ever ‘agreed’ is used loosely) by Euro finance ministers in the early hours of this morning is broadly good news.
Unfortunately, it is once again hopelessly optimistic and contains numerous gaps and unanswered questions which could still bring down the whole deal. This is nowhere outlined better than the damning leaked debt sustainability analysis (see here for full doc).
Below we outline a few key issues (not exhaustive by any means, there are many more) and give our take on how they could play out.
Greater losses for private sector bondholders: Reports suggest the Greek government was sent back to the negotiating table with bondholders at least four times during last night’s meeting. Nominal write downs for bond holders now top 53.5% (or around 74% net present value). The leaked Greek debt sustainability analysis (DSA) assumes a participation rate of 95%.
Open Europe take: 95%, really? We weren’t convinced the previous threshold of 90% with a lower write down would be reached and that was while potential ECB participation was still on the table. Although this target may have been agreed with the lead negotiators for the private sector, it is far from a cohesive group, diminishing the value of the agreement. It will be interesting to see how bondholders respond to the plan but we think that hold outs could well be more than 5%.
Greek ‘prior actions’: The deal includes a list of requirements which Greece must meet in the next week to get final approval for the bailout. These include: passing a supplementary budget with €3.3bn in cuts this year, cuts to minimum wage, increase labour market flexibility and reforms opening up numerous professions to greater competition.
Open Europe take: The now infamous €325m in cuts still needs to be specified. The huge adjustments to labour markets and protected professions mark a cultural shift in Greece – pushing these through will not be painless and could result in further riots.
Fundamental tensions in objectives of the programme: The DSA notes that the prospect achieving a return to competitiveness while also reducing debt is very small – the massive austerity could induce a further recession.
Open Europe take: As we have noted all along the assumption that Greece can impose massive levels of austerity and then return to growth in the next two years is a big leap and almost inherently contradictory. We’d also note that the cuts in expenditure in Greece are larger than have been attempted anywhere in recent memory (successful or failed). Likely to be substantial slippages in the austerity programme while the growth programme remains almost non-existent, essentially closing the book on Greek debt sustainability.
Further favourable treatment for the ECB: ECB and national central banks avoid taking losses on their holdings of Greek bonds but promise to redistribute ‘profits’ from these holdings so that they can be used in Greece.
Open Europe take: See our previous post for a full discussion of this issue. Markets still don’t seem too worried by suddenly being subordinated by central banks in Europe – they should be. This raises questions of the basic premise that all bonds are treated the same, based on who issued them not who holds them. As we’ve noted before, the whole concept of ‘profits’ is misleading, while any distribution would happen anyway – this is not a commitment from central banks but a further fiscal commitment by the eurozone (should really be included in total bailout funding).
Greece may not be able to return to the market even after three years: The DSA points out that any new debt issue will essentially be junior to existing debt, hampering the chances of Greece issuing new debt in 2014/2015.
Open Europe take: This point isn’t too clear but given that the eurozone, IMF and ECB will own such a larger percentage of Greek debt in 2014 any new private sector debt will be massively subordinated and at risk of taking losses if anything goes wrong with the Greek programme. Additionally after the restructuring the remaining private sector debt will be governed under English law and will have the EFSF sweetener – further subordinating any new debt issued to the market. Why would anyone want to purchase Greek debt in this situation (especially given the other concerns above)?
EFSF funding requirements: The EFSF will have to raise €70.5bn ahead of the bond swap – €30bn in sweeteners for the private sector, €5.5bn to pay off interest and €35bn to provide Greek banks with assets to use to gain liquidity from the ECB.
Open Europe take: We’ve already questioned whether raising these funds so quickly can be done and whether the approval from national parliaments will be forthcoming. Even if it is the €35bn is said to fall outside of the €130bn meaning it is expected to be returned swiftly – given the uncertainty over how long banks will need these assets (as long as Greece as declared as in selective default by the rating agencies) this may be a generous assumption.
There is also no talk of the money to recapitalise banks. This is a risky strategy given that Greek banks’ main source of capital (government bonds) will have just been wiped out significantly. The needs were previously specified at €23bn, although reports now suggest they could top €50bn. It’s not clear where this money will come from or when it will be raised. The bond restructuring will be like dancing through a minefield for Greek banks.
We’re still trawling through the responses, analysis and documents to come out of the meeting – meaning there are likely to be plenty more questions and uncertainties to come.
The one thing that is clear is that even if this bailout is ‘successful’, it will set Greece up for a decade of painful austerity and low growth leading to social unrest, while the eurozone will have to provide on-going transfers to help it keep its head above water.
Sorry to be killjoys but as Dutch Finance Minister Jan Kees de Jager put it, the deal isn’t “something to cheer about”.
Tags: Armageddon, Bailout, Bond Holders, Bondholders, Cac, Cohesive Group, Debt Sustainability Analysis, Dsa, Eight Months, Finance Ministers, Gaps, Greek Government, Least Four Times, Negotiators, Net Present Value, Open Europe, Participation Rate, Private Sector, Target, Unanswered Questions
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Wednesday, February 8th, 2012
While hardly new to anyone who actually has been reading between the lines, and/or Zero Hedge, in the past few months, the Greek endspiel is here, and as a note by Goldman’s Themistoklis Fiotakis overnight, the Greek timeline, or what little is left of it, “allows little room for error.” Furthermore, “Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage).” Once again – nothing new, and merely proof that despite headlines from the IIF, the true news will come in 2-3 weeks when the exchange offer is formally closed, only for the world to find that 20-40% of bondholders have declined the deal and killed the transaction! But of course, by then the idiot market, which apparently has never opened a Restructuring 101 textbook will take the EURUSD to 1.5000, only for it to plunge to sub-parity after. More importantly, with Greek bonds set to define a 15 cent real cash recovery, one can see why absent the ECB’s buying, Portugese bonds would be trading in their 30s: “Portugal will be crucial in determining the market’s view on the probability of default outside Greece… Given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.” Don’t for a second assume Europe is fixed. The fun is only just beginning…
From Goldman Sachs – Market Uncertainty Ahead from Euro Area Sources
News reports over potential progress in Greece’s PSI talks and the possible involvement of the ECB/EFSF in the restructuring deal have once again boosted the performance of risky assets, with S&P futures trading stronger and the dollar weaker. Peripheral Euro area bonds are trading flat-ish. Today is a quiet day in terms of data releases and markets are likely to start focusing on tomorrow’s ECB and BOE meetings…. In today’s note we discuss the reasons for managing our recommendations more cautiously, linked to Euro area sovereign uncertainties and the likely balance of risks around the ECB’s policy stance vs. market expectations.
A Tight Timeline For Greece Allows Little Room For Error
Greece remains an important source of risk to watch. As we have argued in the past, markets have interpreted the case of the Greek Private Sector Involvement as a precedent for restructuring within the Euro area. Over the last eight months of PSI discussions and preparations, the deterioration in Greek debt dynamics has been accompanied by a gradual deterioration in the terms of the deal for the existing bondholders (in an effort to achieve debt sustainability). In the end, the revealed preference of policymakers in the Greek case has been to pass a significant part of the cost of restructuring Greek debt to the private sector. Fundamentals in Greece may be much worse than in other countries, but the market has extrapolated the policymakers’ reaction function to the other peripheral countries with better fundamentals, thus pushing risk premia higher.
The next few weeks will be no exception. There are important issues to be resolved and further important precedents to be set thereby. To better grasp the complications at hand it is important to discuss the timeline of events ahead. The agreement between the Greek government and the creditors represented by the IIF is likely to be reached in parallel with an agreement between the IMF and the Greek government on the new austerity measures. Then the new austerity measures (including reductions in minimum wages and further reductions in pensions), which are likely to prove unpopular domestically, will need to be approved by the Greek parliament. All this needs to take place about 3-4 weeks ahead of the March 20th bond redemption, so that there is enough time for the IMF to sign off on the new loan package, for the offer to be extended across bondholders and for maximum participation to be pursued.
As we have discussed in previous pieces on the subject, outside official lenders, Greek bond holders and Euro-area banks, there are about EUR70bn of bonds scattered across different institutions. Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage). One way of staging such an involuntary restructuring operation for the holdouts would be the retroactive imposition of collective action clauses and their invocation following the conclusion of the voluntary restructuring operation. The introduction of such clauses would likely happen before the PSI exchange offer goes live – in order to further discourage investors from holding out.
The good news is that after a successful restructuring operation, Greece’s systemic importance as a source of risk declines meaningfully due to the limited refinancing needs, the meaningful reduction in debt servicing costs and the low levels of residual market exposure to Greek bonds post PSI.
Portugal’s Significance to Rise Post-Greece
Greece has created a market concern to do with low recovery rates in the event of a restructuring episode in the Euro area, which has been reflected across sovereign risk premia in peripheral Euro area bond markets. However, Portugal will be crucial in determining the market’s view on the probability of default outside Greece. This is because Euro area policymakers have gone out of their way to signal that Greece is a unique case, addressed with a one-off operation. Therefore it will be important that this commitment is maintained.
As Silvia Ardagna and Andrew Benito discussed in a recent Viewpoint, it is likely that Portugal may need an increase in assistance funds. The progress that Portugal has made in its adjustment programme and the reasonably limited resources that need to be put to work make it likely that a “top-up” of official funds to fully cover Portugal’s needs may ultimately be the preferred policy option.
But given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.
Tags: Bondholders, Broad Market, Bullish Signal, ECB, Eurusd, Goldman, Greek Bonds, Greek Timeline, Holdouts, Market Volatility, Npv, Optimism, Parity, Policy Statements, Preferential Treatment, Probability, Psi, Reading Between The Lines, Restructuring, True News
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Monday, January 30th, 2012
Investment Outlook, January 30, 2012
Warning: Goat Rodeo
by John P. Hussman, Ph.D.
Goat Rodeo – Appalachian slang for a chaotic, high-risk, or unmanageable scenario requiring countless things to go right in order to walk away unharmed.
Over the years, of the most frequent phrases in these weekly comments has been “on average.” Most of the investment conditions we observe are associated with a mix of positive and negative outcomes, so rather than making specific forecasts about future market direction, we generally align our investment position in proportion to the average return/risk outcome, recognizing that the actual outcome may be different than that average in any particular instance.
Increasingly however, we have observed sets of conditions that are so heavily skewed toward bad outcomes that they deserve the word “warning” (see Extreme Conditions and Typical Outcomes near the 2011 peak, Don’t Mess with Aunt Minnie before the 2010 market break, Expecting a Recession in late 2007, A Who’s Who of Awful Times to Invest at the 2007 market peak, and our shift from a modestly constructive investment position to a Crash Warning in October of 2000). While the downturns that followed have provoked increasingly large and desperate actions of central banks to kick the can down the road by preventing debt restructuring and financial deleveraging (in some cases by violating legal constraints – see The Case Against the Fed ), the fact is that the S&P 500 has achieved a total return of just 1.2% annually over the past 12 years, as a predictable outcome of rich valuations and still-unresolved economic imbalances.
I could admittedly do better, and would certainly have captured more upside from temporary speculation, had I committed myself to the principle that central banks will act strictly to defend the bondholders of the banks they represent, even if it means trespassing into fiscal policy, subordinating public interest, empowering the worst stewards of capital, violating legal restrictions, and inviting long-term instability. Still, none of those actions improve the long-term outcome for the markets, and more importantly, none have prevented repeated and serious downturns from occurring, despite all the can-kicking.
Once again, we now have a set of market conditions that is associated almost exclusively with steeply negative outcomes. In this case, we’re observing an “exhaustion” syndrome that has typically been followed by market losses on the order of 25% over the following 6-7 month period (not a typo). Worse, this is coupled with evidence from leading economic measures that continue to be associated with a very high risk of oncoming recession in the U.S. – despite a modest firming in various lagging and coincident economic indicators, at still-tepid levels. Compound this with unresolved credit strains and an effectively insolvent banking system in Europe, and we face a likely outcome aptly described as a Goat Rodeo.
My concern is that an improbably large number of things will have to go right in order to avoid a major decline in stock market value in the months ahead. We presently estimate that the S&P 500 is likely to achieve a 10-year total return (nominal) of only about 4.7% annually, which reduces the likelihood that further gains will be durable even if they persist for a while longer. In the context of present valuations and a probable Goat Rodeo in the months ahead, my impression is that the recent market advance may be a transitory gift.
Whipsaws, Noise and Exhaustion
In nearly all real-world data, there are short-term fluctuations, random effects, and other influences that create “noise” in the values that we observe. Typically, those sources of noise confound the “signal” that we want to identify, so unless the noise is filtered away, there is a risk of being misled by meaningless short-term fluctuations. In finance, there are countless approaches that essentially involve noise reduction. For example, a moving average is just a simple noise-reduction technique, where very short-term fluctuations (“high frequency components”) are averaged away, leaving the smoother influence of longer-term fluctuations. Similarly, the Coppock Curve – the 10-month exponential smoothing of the averaged 11-month and 14-month rate of change of the market – is really just a “low-pass” filter that cuts away high frequency fluctuations and allows the market’s long-term (low frequency) cycles to pass through.
In late October, I noted a condition that we characterize as a Whipsaw Trap – which essentially involves a breakdown in a broad set of market internals, followed by a recovery driven by some of the more volatile components (sectors such as financials and transportation stocks are good examples). I noted that only about 30% of these whipsaw traps were followed by further advances – a statistic that was based on subsequent market action over the following 6-8 week period. The real question is “What then?” The answer is both straightforward and troublesome. Specifically, whenever we’ve observed a whipsaw trap that then advances enough to a) drive the S&P 500 earnings yield below its level of 6 months earlier and b) raise advisory bullishness beyond 45% – or bearishness below 30%, the result has almost always been hostile. Essentially, what this combination picks up is an already fragile set of market internals that has enjoyed an “exhaustion rally” that both exceeds earnings growth and is met with overbullish sentiment.
The previous observations of this exhaustion syndrome, and the deepest decline from that point to the low of the next 7 months, on a weekly closing basis, were: November 1961 (-25%), August 1987 (-33%), July 1998 (-18%), July 1999 (-12%), August 2000 (-22%), May 2001 (-24%), March 2002 (-32%) and May 2008 (-43%). There were also two instances of this syndrome that were not associated with a market plunge: January 2006 during the housing bubble (which ultimately led to a market collapse well below those levels), and November 2010, just as the Fed was initiating QE2 (which still did not prevent the market from trading at lower levels about 9 months later).
If we think in terms of “exhaustion rallies,” the syndrome we’re observing here is a multiple indicator version of signals like the Coppock “killer wave” – which occurs when the Coppock Curve reaches a peak, declines, and the market then recruits an advance large enough to establish a second wave higher. Some technicians have debated how best to define the signal (e.g. the decline required to define a negative shift) – in our view, it’s not a good idea to use a single indicator in the first place – but in any event, the selloffs from those exhaustion waves have often been brutal, and a few overlap the syndrome outlined here.
In short, market action is presently showing features associated with “exhaustion rallies”, which have often been followed by deep losses over the following 6-7 month period.
As a side note, we’ve seen an similar whipsaw in various economic statistics recently, where I continue to view the modest but tepid “recovery” as a reflection of high-frequency noise. Here too, the underlying “signal” remains weak, but the more volatile components have been positive. Unfortunately, the typical result is that the divergence snaps shut in the direction of the signal.
[Geek's Note: What I call a "Whipsaw Trap" is basically a breakdown in a broad range of market internals, followed by an advance in more volatile, high-frequency components that isn't enough to survive moving averages and other low-pass filters. It's difficult to draw a true signal from noisy data unless you have a lot it, and unfortunately, the more data you need to use to infer a signal, the greater the "lag" there is in recognizing that signal. Think again of a moving average - the longer-term the moving average, the more it lags behind recent action. The better you want a microphone to cancel noise, the longer the delay you have to endure between the input and the output. Generally speaking, we get better and more rapid information about the true, underlying "signal" if we can draw that signal out of multiple indicators, each which carries part of that information. Methods to distinguish "signal" from "noise" run through much of my financial, economic, and scientific work, for example Market Efficiency and Inefficiency in Rational Expectations Equilibria , and A Noise-Reduction GWAS Analysis Implicates Altered Regulation of Neurite Outgrowth and Guidance in Autism . The benefit of inferring signals from multiple sources is why the rational expectations paper used vector ARMA models for inference, why the GWAS paper exploited the local correlation of association signals within the same chromosomal region across multiple data sets, and why good leading economic indices combine multiple series rather than using any single indicator as an acid test].
Recession risk remains high
Last week contained very little to alter our view that a global economic downturn is likely here. While we recognize the modest, low-level improvement in a variety of indicators (see Dodging a Bullet, from a Machine Gun ), and also estimate that recession risk is something less than 100%, this is far from a suspension of our recession concerns. To the contrary, a concerted global downturn that includes the U.S. remains the most likely outcome.
Last week, the Conference Board released its revised version of Leading Economic Indicators, which shows a sharply weaker trajectory than the former version if the LEI. Indeed, the revised LEI has already turned down, though to a lesser degree than just before previous recessions.
A few economic notes. In early 2010, we examined the seasonal adjustment factors used by the Bureau of Labor Statistics in the monthly employment report (see Notes on a Difficult Employment Outlook ). While we didn’t observe any striking divergences between the BLS adjustment factors and our own estimates, I noted that the effect of those seasonal adjustments typically amounted to anywhere between +1.9 and -1.3 million jobs, depending on the month. Presently, we estimate that the effect of these adjustments range between +2.1 million and -1.1 million jobs in any given month (see When Positive Surprises are Surprisingly Meaningless ). These are strikingly large numbers compared with the typical range of forecasts that often surround the monthly employment numbers.
Think of it this way – if there is typically a great deal of temporary job creation in the fourth quarter of the year (and there is), the effect of seasonal adjustment will be to subtract off a certain proportion of actual employment in order to smooth that bulge down. Accordingly the October-December adjustment factors range between -0.6% and -0.8% of total non-seasonally adjusted employment. In contrast, if there is a great deal of job destruction in January and February (and there is), the effect of seasonal adjustment will be to add back some amount of phantom employment, amounting to between 1.1% and 1.6% of total nonfarm payroll jobs.
Given that virtually all economic series undergoes some amount of seasonal adjustment, it isn’t difficult to see how the extraordinarily weak economic data in late 2008 and early 2009 may have produced an upward bump in a wide variety of seasonal adjustment factors for data around the turn of the year, adding to the short-term noise we’re already observing in various economic series. In any event, even without any skewed seasonal factors, the broad ensemble of leading economic evidence remains unfavorable here.
Finally, while we typically discourage drawing inferences from any single indicator, it’s at least worth noting that with the release of Q4 GDP figures, the year-over-year growth rate of real U.S. GDP remains below 1.6% (denoted by the red line below). A decline in GDP growth to this level has always been associated with recession, usually coincident with that decline, though with a two-quarter lag in two instances (1956 and 2007), and with one post-recession dip in growth during the first quarter of 2003. As it happens, the GDP growth rate dropped below 1.6% in the third quarter of 2011.
Given the strong and rather obvious relationship between the most recent year-over-year rate of GDP growth and the prospect of oncoming recession, it’s difficult to understand why Wall Street so completely rejects the likelihood of an economic downturn. Then again, that’s exactly why we’re expecting a Goat Rodeo.
As of last week, the Market Climate for stocks was characterized by conditions we associate with a “whipsaw trap,” coupled with overvalued, overbought, overbullish conditions and evidence of exhaustion that has only a handful of generally awful historical peers. Strategic Growth and Strategic International remain tightly hedged, though in both funds, we’ve clipped a few percent from our hedges to reflect the more defensive composition of our holdings. Though steep market declines tend to be indiscriminate (with even defensive stocks often acting as if they have a beta of 1.0), we recognize that “risk on” days can also be very uncomfortable when defensives lag the market and our hedges bite with full force. The modest change to our hedge is intended to maintain our downside protection while hopefully producing a little bit less day-to-day discomfort on days when Wall Street suddenly goes “risk on” and chases banks, financials, materials, and high-debt cyclicals, all of which we hold with smaller weight than the major indices reflect. Overall, however, we would still characterize our investment position as strongly defensive.
In Strategic Total Return, we’re seeing some moderate shifts in the Market Climates for bonds versus precious metals. We used last week’s weakness in bonds to increase the duration of the Fund toward a still moderate 4.5 years, while using the strength in precious metals shares to clip back our holdings below 10% of assets. Given the volatility of precious metals shares relative to bonds, the overall effect is to move the Fund to a somewhat more conservative stance, in the sense that day-to-day volatility is likely to be lower than it has been with a more significant precious metals position. While the Market Climate for precious metals shares remains positive, we observed a discrete reduction in our projected return estimates, and are aligning our investment stance proportionately.
Tags: Aunt Minnie, Bondholders, Central Banks, Debt Restructuring, Extreme Conditions, Fiscal Policy, Future Market, High Risk, Investment Conditions, Investment Outlook, Investment Position, John Hussman, Legal Constraints, Market Direction, Market Peak, Negative Outcomes, Predictable Outcome, Stewards, Typical Outcomes, Valuations
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Tuesday, December 6th, 2011
If French president Nicolas Sarkozy gets his wish to “Level the Playing Field” on sovereign bonds, a decade-long European recession is on its way.
French President Nicolas Sarkozy made it clear in a speech in Toulon last week that he wanted the private sector to be given a more-level playing field when it came to the threat of having to bear losses on their investments.
He said Greece, where there have been drawn-out negotiations between the government and the private sector over how much of a hit banks and insurance companies should take under a debt restructuring, should be a unique case.
“It must be clear that what has been done for Greece, in a very particular context, will not happen again, that no other state in the euro zone will be put into default,” he said.
“It must be absolutely clear that in future no saver will lose a cent on the reimbursement of a loan to a euro zone country.”
Reflections on the Un-Level Playing Field
What could possibly be more un-level than guaranteeing banks and bondholders will never take losses? When there are more losses, and there will be, the only way to guarantee banks do not take them, is to have someone else take them, namely taxpayers.
While pondering that, take look at the action in Portuguese bonds.
Portugal 10-Year Government Bonds
Portugal 2-Year Government Bonds
Do either of those charts suggest there will be no more losses? If there are, who will pay them?
If Sarkozy gets his wish, taxpayers, not bondholders will pay the price.The same holds true for Ireland, Spain, Belgium, and Italy.
The only true way to level the playing field is to make banks and bondholders who take foolish risks to pay the price for their foolish actions.
Monti’s “Save Italy” Package Sure to Cause “Super Recession”
Yesterday I wrote Monti’s “Save Italy” Package Sure to Cause “Super Recession”
Super Mario has a five-point plan to “Save Italy“.
- Raise more than 10 billion euros from a new property tax
- Impose a new tax on luxury items like yachts
- Raise value added tax
- Crack down on tax evasion
- Increase the pension age
The above package was dubbed the “Save Italy” package by Prime Minister Mario Monti. Supposedly it will boost growth.
While I agree pension reform is much needed, there is not a single thing in the package to boost growth. Italy is in recession. Raising taxes in a recession is the last thing you want to do, yet four of Monti’s five ideas raise taxes.
This proposal may temporarily placate the bond market, but Italy is headed for one “super recession” if Mario’s mix of idiotic tax hikes passes. Instead, Italy needs to cut wasteful government spending and lower taxes.
For there to be no more losses, we will need still more austerity measures in France, Spain, Portugal, Italy, Greece, and Germany.
The EU needs to reflect on the consequences of Sarkozy’s ludicrous proposal to “un-level” the risks on piss poor lending decisions.
Two Consequences In Order
- Europe will slide into a multi-year recession
- Voters in Greece, Spain, Portugal (likely all) will have had enough
Eventually, there will come a time when a populist office-seeker will stand before the voters, hold up a copy of the EU treaty and (correctly) declare all the “bail out” debt foisted on their country to be null and void. That person will be elected.
Mike “Mish” Shedlock
Tags: Bondholders, Country Reflections, Debt Restructuring, Decade, Euro Zone, French President Nicolas, French President Nicolas Sarkozy, Government Bonds, Insurance Companies, Losses, Negotiations, Nicolas Sarkozy, President Nicolas Sarkozy, Private Sector, Property Tax, Recession, Sovereign Bonds, Super Mario, Taxpayers, True Way
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Monday, November 28th, 2011
Let’s begin with a few notes on continuing credit strains in Europe and elsewhere.
The Greek 1 year yield shot to 270% last week, with Greek debt of every maturity trading at 35% of face value or less. The prospect of limiting writedowns to 50% is increasingly unlikely, which I suspect will put much greater strain on European bank capital than anyone is willing to admit. As expected, we’re beginning to see negotiations pushing for deeper restructuring than 50%. On Friday, Reuters reported:
“Greece is demanding harsh conditions from its creditors as it starts talks with lenders about a proposed bond swap, a key part of Europe’s plan to reduce its debt pile and save the euro… The Greeks are demanding that the new bonds’ Net Present Value — a measure of the current worth of their future cash flows — be cut to 25 percent… a far harsher measure than a number in the high 40s the banks have in mind… It is increasingly likely that Greece will force bondholders who do not voluntarily take part in the bond swap to accept the same terms and conditions, something that is possible because most of the bonds are written under Greek law.”
Should we care? Given the extremely high leverage ratios of European banks, it appears doubtful that it will be possible to obtain adequate capital through new share issuance, as they would essentially have to duplicate the existing float. For that reason, I suspect that before this is all over, much of the European banking system will be nationalized, much of the existing debt of the European banking system will be restructured, and those banks will gradually be recapitalized, post-restructuring and at much smaller leverage ratios, through new IPOs to the market. That’s how to properly manage a restructuring – you keep what is essential to the economy, but you don’t reward the existing stock and bondholders – it’s essentially what we did with General Motors. That outcome is not something to be feared (unless you’re a bank stockholder or bondholder), but is actually something that we should hope for if the global economy is to be unchained from the bad debts that were enabled by financial institutions that took on imponderably high levels of leverage.
Notably, credit default swaps are blowing out even in the U.S., despite leverage ratios that are substantially lower (in the 10-12 range, versus 30-40 in Europe). As of last week, CDS spreads on U.S. financials were approaching and in some cases exceeding 2009 levels. Bank stocks are also plumbing their 2009 depths, but with a striking degree of calm about it, and a definite tendency for scorching rallies on short-covering and “buy-the-dip” sentiment. There is a strong mood on Wall Street that we should take these developments in stride. I’m not convinced. Our own measures remain defensive about the prospective return/risk tradeoff in the stock market.
As for expectations of using the ECB to backstop the euro, as I noted last week ( Why the ECB Won’t, and Shouldn’t, Just Print ), we will not just all wake up one day to some surprise announcement that the ECB has started buying distressed European debt. If there is any potential at all to engage the ECB, the first thing to look for will be a concerted but unpopular change in EU treaties to subordinate the fiscal policies of each European country to one centralized fiscal body for all of Europe. In effect, the next step in the process will be an attempt to trade greater ECB flexibility in return for centralized fiscal control. We’ll probably see the phrases “cede sovereignty” and “fiscal union” quite a bit in the coming weeks.
Late last week, after a meeting between Merkel (Germany), Sarkozy (France) and Monti (Italy), the three leaders squashed market expectations that they would ask the ECB to intervene. Instead, they announced “propositions for the modification of treaties” that would have nothing to do with the ECB. The best chance to resolve the crisis, in Merkel’s words, is to “make clear that we must take steps toward a fiscal union; to express the conviction that we know policies must be more closely coordinated if you have a common, stable currency.”
Exactly. So now the main questions are whether the attempt at modifying the EU treaties will garner unanimous support from all the European member countries, and whether a greater fiscal union will ease the euro crisis. The answers, I think, are yes, and partially.
What I mean by “partially” is that provided an acceptable agreement for greater fiscal union, Germany is more likely to distinguish short-term fiscal instabilities from long-term ones, which may increase its willingness to provide direct backstops and allow greater flexibility for the ECB to (moderately) intervene in the markets. But there is one key issue remaining. The euro will not survive, in my view, unless the individual countries create an “out” over a period of perhaps 5-7 years by gradually rolling over their debt into new bonds that are convertible into their legacy currencies. If they solve their problems, no conversion would be necessary. But if greater fiscal coordination fails and various member countries continue to have intractable budget imbalances, they could exit the euro without causing a collapse in the entire system.
As I noted last week, the average maturity of Euro-area debt is only about 6-7 years, so introducing convertibility features could provide Europe a significant release-valve over a fairly short period of time. Introducing a convertibility option to Euro-area debt would certainly introduce additional “conversion premiums” for various countries, but those would largely substitute for the rising default premiums that are currently being tacked onto yields. Better for market concerns to affect individual European states than to threaten one-third of the developed world, and by extension, the entire global economy.
Are corporate balance sheets really the strongest in history?
It is freely accepted by investors as fact that U.S. corporate balance sheets are the stronger than ever before in history. This view is largely driven by the significant amount of cash (checking deposits, savings deposits, money market funds, commercial paper holdings) on corporate balance sheets. Our difficulty with this view is that no single line item on a balance sheet is a sufficient indication of “strength.” Most useful measures are derived from ratios at the very least, and ideally calculations across a variety of dimensions.
The best line item on corporate balance sheets today is typically “Cash and Equivalents.” But while the amount of cash and cash-equivalents on U.S. (nonfinancial) corporate balance sheets has increased significantly, particularly relative to the cash-strapped lows of 2009, corporate cash is certainly nowhere near historical highs relative to debt. As a side note, probably the dumbest use of balance sheet data that we hear from time-to-time is when analysts talk about the P/E multiple of a stock “after you back out the cash,” as if the cash line item can meaningfully be subtracted from the market cap of the equity. Really? If a company issues a billion dollars of debt, and then holds the proceeds in cash, does that suddenly make the stock “cheaper” because we can now back out that cash from the company’s market cap? Um, no.
While cash holdings are relatively high compared with total assets and net worth, even those figures are in the range of 5-10%, only about 3 percentage points above historical norms. Cash levels are “high” in the sense of being a larger percentage of total assets than normal, but the “excess” cash amounts to roughly $700 billion, versus total assets of non-financial corporations of about $28.6 trillion. The excess is fairly second-order from the standpoint of overall balance sheet “health.”
The best that can be said is that corporations are fairly liquid here, but this is a much different statement than saying that corporate balance sheets have “never been healthier in history.” In evaluating overall balance-sheet health, it is important to consider the overall debt burden of corporations.
As the following chart shows (based on Federal Reserve Flow of Funds data), the debt burden of U.S. corporations is near all-time highs, having retreated only modestly since 2009. Debt burdens are elevated regardless of whether they are measured against total assets or net worth. Certainly, corporations are presently benefiting from very low interest rates on corporate debt, which substantially reduces the servicing burden of these obligations. But the combination of high debt levels and low servicing burdens does create a potential risk to corporate health in the event that yields rise in future years. Overall, the picture is fairly stable at present thanks to low yields and high levels of cash-equivalents, but it is important for investors to keep in mind that cash can burn fairly quickly during economic downturns, and debt is not spread evenly across corporations.
The bottom line is that at an aggregate level, corporate balance sheets look reasonable, but are certainly not “stronger than they have ever been in history.” Cash levels are elevated, but this is at best a second-order factor (with excess cash representing only a few percent of total assets), while debt remains near record levels relative to total assets and net worth. In any event, balance sheet risks should be evaluated on a business-by-business level, rather than accepting the blanket notion that cash levels are so high that nobody needs to worry about corporate credit risk.
In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.
Finally, the Flow of Funds data include two handy series, one representing the total net worth of nonfinancial companies, and the second representing the market value of the equities (stocks) of those companies. Intuitively, if those calculations are any good, one would expect the ratio of equity market value to total net worth to be a reasonable valuation indicator.
In fact, that’s just what we see. Though the Flow of Funds data isn’t as useful as one would like in practice (since it is only reported quarterly with a lag), it turns out that a low ratio of equity market value to total net worth is a very good indicator of high subsequent total returns for the S&P 500 over the following 10-year period. In contrast, a high ratio of equity market value to total net worth is predictably followed by weak 10-year total returns for the S&P 500.
Let’s call this the price-to-net-worth ratio. As of the latest data, the market value of the equities ($15.21 trillion) for non-financial companies was nearly equal to the total net worth of those companies ($15.05 trillion) for a price-to-net-worth ratio of about 1.01. Note that this is NOT fair value – rather, the historical median and average of the price-to-net-worth ratio is just 0.75. The present level of about 1.0 has historically corresponded to a subsequent 10-year S&P 500 total return averaging only about 5% annually, which is fairly close to the estimate we get from a variety of other historically reliable methods, though the recent decline has improved our expectations a bit. Note that the right scale on the following chart is inverted, so higher levels of valuation on the left scale (blue line) correspond to weaker levels of subsequent return on the right scale (red line).
As of last week, the Market Climate in stocks was characterized by a combination of rich valuations, unfavorable market action, continued negative economic pressures on forward-looking indicators, and additional indicators (sentiment, credit spreads, etc) associated with a poor average return/risk profile in stocks. Recent market weakness has modestly improved valuations (our 10-year projection for S&P 500 total returns has improved to 5.6% annually). From our standpoint, the overall condition of the market has improved from hard-negative to modestly negative. That still holds us to a defensive position, but allows us to make modest changes in our hedges (shifting index put option strikes, for example) in a way that maintains a strong defense but reduces our vulnerability to blazing short-squeezes and other bursts of “risk-on” enthusiasm.
It’s worth noting that financial stocks represent a portion of the indices we use to hedge (particularly the S&P 500), but not much of the portfolio of Strategic Growth. As the financials got crushed last week, we slightly reduced that under-weighting in financials, though our weighting remains far below market-weight. We would hold no exposure to the banking sector at all if not for the fact that banks represent a portion of our most efficient hedges, but as the market values come down, it is more reasonable to “anti-hedge” a bit, in order to reduce our discomfort during periodic bursts of short-covering.
So the recent decline has given us a chance to “soften” our “hard-defensive” position somewhat, but we remain broadly defensive in both Strategic Growth and Strategic International. I expect that we’ll still experience a bit of discomfort on days when investors take a lopsided “risk-on” stance (chasing financials and materials while abandoning less volatile sectors), but I don’t expect as much sensitivity to speculative rampages as we’ve seen on some of the more exuberant days in recent memory.
In Strategic Total Return, we continue to carry a moderate duration of about 3 years in Treasury notes, and about 20% of assets in precious metals, and small single-digit exposures in (non-euro) foreign currencies and utilities, which we have increased slightly in response to recent weakness. The best characterization of our recent investment activity is that we have made very modest portfolio shifts in response to what we view as a very modest improvement in market conditions (particularly valuations) from what were, and remain, negative levels. I expect that major changes in our investment stance will accompany major changes in market conditions, and we don’t see that yet. I continue to be very concerned about global recession risks, and further deterioration in credit conditions.
That said, we constantly attempt to align our investment positions in response to shifts in prevailing conditions as new data emerges. We remain defensive here (with the exception of precious metals shares where the expected return/risk profile remains favorable on our measures), but are open to accepting much more constructive investment positions as the evidence changes.
Tags: 40s, Adequate Capital, Bond Swap, Bondholders, Cash Flows, Corporate Balance Sheets, Creditors, European Banking System, European Banks, Face Value, Greek Law, Greeks, Harsh Conditions, Hussman Funds, Issuance, Leverage Ratios, New Ipos, Present Value, Reuters, Strains
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Monday, November 7th, 2011
November 7, 2011
by John P. Hussman, Ph.D., Hussman Funds
A quick note on Greece – as of Friday, the yield on 1-year Greek debt has soared to 212%, up from 144% a week ago, just after the grand “solution” to the crisis was announced. Over the past week, the price of 1-year Greek debt has plunged by 20%, to 38.4 (bid 35.81, ask 40.97 to be exact). Which begs the question – if everyone has agreed that Greek debt will only be written down by 50%, why is the 1-year note trading at just 38% of face value, with longer maturities trading below 30% of face? This sort of incongruence isn’t inspiring.
Much of the reason Greece is seeking a voluntary exchange of debt from its bondholders is that an “involuntary” exchange would be a default event, which would trigger payments on credit default swaps. But across the global financial system, there are only about $3.7 billion in credit default swaps outstanding against Greek debt, and even in the event of an “involuntary” exchange, the actual amount of payouts would be less than that notional value.
One of the greatest advantages Greece has is that about 90% of its debt is governed by Greek law. The terms of any debt exchange, voluntary or involuntary, are more than simply technical details, as any restructuring should significantly reduce the discounted value of the new debt, and I suspect that the next stumbling block is that Greece will change its laws to impose “collective action clauses” on its debt, sufficient to restructure the debt more easily, given the consent of some supermajority of its bondholders. That would help to avoid any holdouts to “voluntary” restructuring, but it would also allow the possibility of a larger haircut. Little of this has been worked out, so even widely publicized “final” deals are not final until the details are settled. In any event, a 50% haircut still puts the Greek debt/GDP ratio above 100% by the end of the decade, so it’s possible that Greece will pursue a further haircut, even if it triggers CDS payments. We’ll see soon enough whether the widely accepted 50% figure actually holds up.
Here in the U.S., our broadest models (both ensembles and probit models) continue to imply a probability of oncoming recession near 100%. It’s important to recognize, though, that there is such a uniformity of recession warnings here (in ECRI head Lakshman Achuthan’s words, a “contagion”) that even an unsophisticated, unweighted average of evidence indicates a very high likelihood of recession. The following chart presents an unweighted average of 20 binary (1/0) recession flags we follow (e.g. credit spreads widening versus 6 months earlier, S&P 500 lower than 6 months earlier, PMI below 54, ECRI weekly leading index below -5, consumer confidence more than 20 points below its 12-month average, etc, etc). The black brackets represent official recessions. The simple fact is that we’ve never seen a plurality (>50%) of these measures unfavorable except during or immediately prior to U.S. recessions. Maybe this time is different? We hope so, but we certainly wouldn’t invest on that hope.
Meanwhile, nearly every traditional asset class is priced to achieve miserably low long-term returns. While Wall Street remains effusive about stocks being cheap on a “forward operating earnings” basis, that conclusion rests on the assumption that profit margins will sustain record highs more than 50% above their historical norms into the indefinite future. That assumption is terribly at odds with historical evidence (as it was in 2007 when Wall Street was gurgling exactly the same thing). Given that stocks are a claim on a very long-duration stream of deliverable cash flows, our money is clearly on more thoughtful and historically reliable valuation methods.
Consider the menu of traditional investment opportunities here. The yield on 10-year Treasury notes is just 2%, 30-year yields are at 3%, the Dow Jones Corporate Bond Index is yielding just 3.5%, our estimate for 10-year nominal S&P 500 total returns is now at just 4.5%, and our 10-year total return estimate for higher-yielding utilities is still at just 5.5% annually (a figure that, while higher than our estimate for the S&P 500, is still among the lowest 15% of historical observations). So Ben Bernanke has done his job well, given that he believes his job is to drive investors into higher-risk assets by starving them of yield on safer investments. The end result is that investors face a perfect storm – risky assets priced to achieve dismal long-term returns (except in comparison to equally dismal alternatives), coupled with the risk of an oncoming global recession.
In our view, investors should presently hold risky assets only in the amount they would be willing to hold through the duration of significant downturn, without abandoning them in the interim. For buy-and-hold investors, that amount may be exactly the same as they are holding at present, but the choice should be a conscious and deliberate one.
It’s easy to dismiss the probability of a recession because “you can’t see it in the data.” To some extent, that’s true, provided that you restrict the data to coincident and lagging indicators – our recession concerns are driven by leading indicators that are tightly related to subsequent economic outcomes, and are broad enough not to be influenced by any one or two components. (In contrast, the Conference Board index of leading economic indicators actually places most of its weight on M2 and the yield curve, resulting in curious “improvements” in the LEI that stem from safe-haven demand for U.S. bank CDs and U.S. Treasuries).
While Wall Street continues to celebrate the fact that coincident indicators such as the ISM survey and weekly unemployment claims have not worsened from a dead-stall, the global economy is already showing overt signs of a new downturn. For instance, German factory orders dropped by 4.3% in the latest report, with demand from other euro-area countries plunging by 12.1%. The Markit Eurozone manufacturing PMI weakened again to 47.1 in October (which isn’t a “lock” on recession in and of itself, but certainly isn’t helpful). The number of unemployed workers in Europe rose to 16.2 million – the highest number since the euro was created. Canada also unexpectedly reported job losses last month. Even China’s PMI dropped to borderline 50.4 reading – the lowest level in 3 years. We can understand that investors are inclined to hold off any concerns until an economic downturn can be seen and touched in actual (not just leading) U.S. data, but that inclination comes with the prospect of trying to reduce risk when a hundred million other investors suddenly become interested in doing the same thing.
As Pimco’s Mohammad El Erian said last week, “The big exposure to Americans is the general exposure to the equity market. You cannot be a good house in a bad neighborhood, that’s just a fact. The equity market is the house, and the global economy is the neighborhood. So if the global economy takes a leg down, the equity market is going to take a leg down too.”
All of that said, we have no intrinsic desire to remain defensive, except to get through the present set of risks intact, and to get us to the point where we can act on opportunities to establish a constructive position (even fractionally – in proportion to the expected return/risk profile). As my friend Richard Belton, a former football player, reminds me – “The job of the defense is to get off the field.” The problem, unfortunately, is that can sometimes take a while. I’m the last guy who should ever talk about football, since I’ve never caught a pass without dislocating a finger, but Richard’s analogy was interesting: “We used to call third down ‘money down.’ Fourth down, they’re going to punt, so if we could hold them back at third down, we knew our defense could get off the field. But sometimes they’d just keep converting, and you’d keep having to go three more plays. You just have to stick to your game.”
The financial markets are different from football in the sense that there is an elastic cord on the ball that eventually yanks things back when they’ve gone too far. Though that cord is terribly stretched already, every time we’ve reached “money down,” we’ve seen some increasingly large government intervention to move the ball down the field by just enough to maintain possession (the football equivalent of “kicking the can down the road”). While that has helped to dampen one crises after another, it just makes them more frequent, and it doesn’t change the outcome of the game. We’re very eager to get the defense off the field, but we’ll take things one play at a time.
As of last week, the Market Climate for stocks was characterized by a clearly negative expected return/risk profile, based on an ensemble of factors including rich valuations, oncoming recession risks, and an overall technical condition that has historically been very prone to “whipsaw” reversals. We saw some of that early last week, as the stock market dropped sharply from above its 200-day moving average to below that level. The fact that the market is dabbling with widely-followed technical levels does create some potential for some amount of speculation if we happen to get a reprieve in day-to-day news, despite persistent underlying valuation and economic negatives. In that event, there would be enough flattening in the return/risk profile to allow a slight loosening of our still tight hedges, but moving to a largely unhedged or aggressive investment stance would require a much broader set of shifts in the data (most probably involving a significant improvement in valuations as a result of a significant market decline). Strategic Growth and Strategic International remain tightly hedged. Strategic Total Return continues to have a duration of about 3 years in Treasury securities, with about 2% of assets in utility shares, and a 20% exposure to precious metals shares driving most of the day-to-day fluctuation in the Fund.
A final note. The overvaluation, misguided policy, and misallocation of capital that has produced more than a decade of dismal returns for the S&P 500 has also forced us to take a regularly hedged investment stance in response (though we know that the ensemble methods presently in use would have done things differently in several periods, particularly 2009 and early 2010). While our investment approach is by construction risk-managed, it is not by construction hard-defensive or fully-hedged. These are positions that have been thrust on us by conditions that have, predictably, led to a decade of stock market returns far below the historical norm. Though the present menu of prospective investment returns remains unappealing, those conditions can change quickly, particularly in a crisis-prone environment. This is important to mention here, because I strongly expect that we will begin seeing opportunities – probably not immediately but also not in the distant future – to significantly and perhaps sustainably reduce the extent of our hedging.
We emphatically don’t need to wait for the world to solve its problems before being willing to accept risk. What we do need is for those risks to be more appropriately priced in view of those problems. We’re not there by any means, but a significant change in the market’s return/risk profile could come quickly. To quote MIT economist Rudiger Dornbusch (who was a professor to the new head of the ECB, Mario Draghi), “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
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Tags: Bondholders, Canadian Market, Collective Action Clauses, Credit Default Swaps, Debt Exchange, Default Event, Face Value, GDP, Gdp Ratio, Global Financial System, Grand Solution, Greek Law, Haircut, Holdouts, Hussman Funds, Maturities, Notional Value, Stumbling Block, Supermajority, Technical Details, Voluntary Exchange
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