Posts Tagged ‘European Leaders’
Monday, July 9th, 2012
July 6, 2012
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
and Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. In this issue we highlight the bond markets cautious response to the latest EU summit agreement; Q2 2012 performance between sectors of the global bond market; we address the Stockton, CA chapter 9 bankruptcy protection filing and take a closer look at Floating Rate Notes.
Bond Markets Rule?
European leaders surprised the markets with a more substantial agreement to stabilize bank and sovereign debt than expected. Risk markets rallied in response, but signals from the global bond markets were more cautious. On the day of the announcement, stock markets in Europe rallied as much as 6%, and economically sensitive commodities like crude oil rose by as much as 8%. However, the response in global bond markets appeared more cautious by comparison. Bond yields in Italy, Spain and Ireland declined by over 50 basis points the day the agreement was announced, but are still high relative to levels that prevailed at the beginning of the year and are still high enough to make reducing debt loads difficult. Moreover, German and US bond yields—considered safe haven markets—rose only modestly. Since many of the provisions included in the agreement were designed to appease bond holders, the divergence between the bond market reaction and the equity markets is notable. What is the divergence signaling?
- We believe it’s wise to heed the cautious response of the bond markets. Europe’s recent agreement reduces the risk of an imminent crisis in the banking sector and appears to be a step towards closer fiscal union. However, like everything in the markets, the devil is in the details. There is political risk because some of the terms of the agreement will need to be ratified by individual countries and then there is execution risk, since many of the plans have never been implemented before.
Ten Year Bond Yields
Source Bloomberg, as of June 13, 2012
- The key elements of the agreement… allow the European Stability Mechanism (ESM) to provide direct funding to Spanish banks rather than lending to the sovereign and it eases conditions for the bailout fund to buy government bonds. In addition, private bond holders will not be subordinated to ESM as was originally the case. These concessions to the bond markets should help ease the strains in the peripheral bond markets. Also, the European Central Bank (ECB) is to have supervisory responsibility for Europe’s banking sector, but the agreement did not specify a deposit insurance program.
- While the agreement helps ease immediate pressures, longer-term concerns linger. The ESM will most likely need more funding to have the fire power it needs to deal with Europe’s bad bank debt. Additionally, it isn’t clear how the ECB will become Europe’s banking supervisor since there is presently no structure in place for them to do so. Meanwhile, much of Europe is in recession with the most indebted countries experiencing very high rates of unemployment and contracting growth, making debt reduction and implementation of structural reforms even harder.
- Bottom line: We tend to favor the bond markets’ less enthusiastic assessment of the EU summit agreement over the other markets’ reactions. Europe’s latest agreement has eased the immediate crisis, but there is a long way to go towards stabilizing the economies and bond markets longer term. Given weakness in economic growth in the developed countries and ongoing risks in Europe, it’s reasonable that investors are likely to remain risk averse. For investors interested in international diversification, we continue to suggest minimizing exposure to European bond markets.
Q2 2012 Sector Performance
The theme of the second quarter can be described as “risk-off,” as weak economic data and the ongoing European debt crisis weighed on the markets. As a result, investors flocked to “safer” assets, driving the 10-year Treasury yield to an all-time low in early June. Although safety was a theme for the second quarter, most fixed income indices, including riskier benchmarks, generated positive returns as investors continued to search for yield. We believe that disappointing economic data and the Fed on hold until at least 2014 will keep Treasury yields low, and we continue to favor intermediate term investment grade bonds.
- Treasury rally drives returns for the Barclays US Aggregate Bond Index. High demand for Treasuries, as investors worldwide continued to seek safe-haven assets, helped drive strong returns for the US bond market. Declining interest rates instead of coupon income were the major source of return. The result was a yield to maturity of only 1.98% on the index, with an average duration (i.e. weighted average timing of interest and principal payments, and a measure of interest rate risk) of just over 5 years. Treasury rates remained near all-time lows, so there is not much room for interest rates to drop further. We believe that income will have to be the key driver for returns going forward. Our “lower for longer” mantra has not changed, and we expect interest rates to remain at low levels through year-end.
Q2 2012 Performance
Source Barclays, as of July 3, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.
- Investment grade corporate bonds generated positive returns across the board. High grade corporate bonds posted strong performance in the second quarter, as investors continued to search for yield in the current environment. The higher quality investment grade segments performed the best, with Aaa-rated bonds outperforming their lower-rated counterparts, and the utility sector, generally considered defensive, outperformed both financials and industrials. Corporate bond spreads, or the amount of yield over a comparable Treasury security, increased for the quarter. Such a trend is generally a sign of risk aversion. But it can also create opportunities in higher yielding bonds. Corporations have continued to reduce debt and boost their liquidity. We continue to favor investment grade corporate bonds with intermediate maturities in this environment, specifically the 5- to 7-year range.
- High yield returns show shift in sentiment to safer assets. Despite generating a positive return for the quarter, the high yield market underperformed both the higher quality investment grade index and the Treasury index. When investor risk aversion rises, high yield bonds tend to suffer as investors sell those securities and invest in higher quality or lower risk investments. For the quarter, the relative yield over Treasuries rose, negatively affecting the price of the Barclays US High Yield Index, which dropped by roughly 0.14%, while the income/coupon return was 1.97%, leading to a positive total return. This demonstrates the potential value of the high coupon, and showed how high yield can still generate a positive return in risk-off environments. For more aggressive investors, we do see relative value in the high yield market, as it offers a yield advantage of roughly 6.15% compared to Treasuries, but would exercise caution as multiple headwinds could push the risk premium even higher.
- Risk aversion negatively affecting the international markets. Euro zone troubles continue to dominate headlines and risk appetite. The so-called success of the Greek election was short-lived, as all eyes have turned to Spain, the most recent country asking for a bailout, and to a lesser degree, Italy. Foreign currency-denominated markets were negatively affected by the rise in the US dollar, leading to negative 0.4% return for the Barclays Aggregate ex-USD, an index comprised of government and investment grade bonds generally denominated in non-USD currencies. The Barclays Global Emerging Markets index was able to generate a positive return of 0.9%, although that index is denominated in the US dollar and the euro, not local currencies. Most emerging market currencies experienced declines for the quarter. In the current low rate environment, we think emerging markets may make sense for the aggressive portion of a portfolio, but a hedged approach may be best.
Stockton, CA and Muni Bankruptcy
Last week Stockton, California (pop. 292,000) became the largest U.S. city to file for chapter 9 bankruptcy protection. To most muni market watchers, the filing was no surprise. Markets have been tracking other issues, including limited new issue muni supply coupled with strong demand for tax-exempt yield more than headline risk related to individual credit stories. Stockton’s bankruptcy is another case in the growing, but still short, list of local governments in default or distress. While we expect that local governments will continue to face pressures, we believe that bankruptcy for municipal governments will remain rare.
- Stockton’s bankruptcy was widely telegraphed. Stockton’s decision to file follows a dramatic housing boom and bust in this primarily agricultural city in California’s Central Valley, followed by two years in a state of fiscal emergency, $90 million in cuts to balance the city’s budget (which is required by California state law), and 90 days of negotiation under a state law passed last year (Assembly Bill 506) which requires that cities negotiate with creditors before been eligible to seek bankruptcy protection, according to news reports and city press releases. A federal court must still accept the city’s petition.
- Municipal bankruptcies remain rare. Since 1937, when chapter 9 was added to federal bankruptcy code to allow for municipal bankruptcy, there have been just over 600 municipal bankruptcies, according to legal experts. Of that total, 43 have been from city and county issuers and, 33 of those cases were dismissed by a judge or did not reduce or discharge bonded debt, according to Bloomberg. Harrisburg, PA is one example. The court in Pennsylvania rejected the Harrisburg case after arguments that it violated state law. In 22 states, bankruptcy for local issuers is not permitted. And in 28 other states that do allow filing, there are varying requirements and limits to entering bankruptcy.
- Corporate bankruptcies are far more frequent, and different, than muni filings. Corporations can choose from two types of bankruptcy—chapter 7 and chapter 11. Chapter 7 involves liquidation. Chapter 11 is a form of rehabilitation, like hitting the “pause” button to negotiate and restructure. Chapter 9 bankruptcy is more like chapter 11 bankruptcy. Sizable municipalities are not generally able to simply fold up tent, liquidate, and disappear. There is also less precedent for how municipal bankruptcies operate, largely because they’re so uncommon. That is one of the key issues that many will be watching. How successful will the city be in reducing costs, and who will be most impacted in bankruptcy—retirees, bondholders, city employees or some combination?
- Bondholder protections depend on a bankruptcy court—and the class of bonds. In the case of Stockton, city financial statements show that the city’s debt includes lease revenue and pension obligation bonds that are secured and paid from general government revenues. These bonds do not have a dedicated tax source supporting them. Enterprise bonds, such as water and sewer bonds, are secured by net revenue pledges of the city’s water and sewer systems, which have not been the source of the city’s financial problems. “Since the pension and lease bonds are unsecured city obligations, they do not enjoy special protections in bankruptcy, subjecting them to possible debt service default and loss of principal,” argues Moody’s in a report downgrading Stockton bonds following the bankruptcy filing.
- Bankruptcy is not the same thing as default. Defaults can happen without bankruptcy, and vice versa. Bonds with dedicated revenues for projects not the primary cause of a municipalities’ distress have often been paid. Debt service on bonds that carry bond insurance will likely be paid by the bond insurer, with negotiations and losses covered by the insurer, not individual bondholders.
We suggest diversification, and a focus on tax-secured general obligation and/or essential service revenue bonds. While we don’t expect a significant increase in municipal bankruptcies, we do expect that many will continue to face strains from rising costs and the weak economic recovery. So we suggest diversification and a focus on high quality debt with the strongest possible protections. We still like general obligation bonds, with a dedicated pledge of property taxes—often called an unlimited ad valorem tax pledge in a prospectus—along with essential-service water and sewer revenues bonds from stronger, more stable systems as the core for most muni portfolios.
Are Floating Rate Notes the Cure in a Low-Rate Environment?
With the Federal Reserve holding short-term interest rates at zero and suppressing long-term rates through its bond buying programs, investors continue to search for investments with higher yields. Lately some investors have looked to floating rate notes, anticipating higher yield and less risk if rates rise. Not surprisingly, this relatively small corner of the fixed income market has become popular with retail investors for these reasons. In addition to mutual funds that offer access to floating rate notes (FRNs) there are also some new ETFs that have been launched in the past few years. An even newer development is that some major corporations are offering floating rate notes directly to small investors including employees of the corporation and positioning them as alternatives to money market funds.1
- At first glance…floating rate notes appear to offer an attractive alternative to fixed-rate bonds and notes. FRNs typically pay interest based on an index—such as the London Interbank Offer Rate (LIBOR). The notes usually have a “floor”—an initial rate for a specified period of time—often a few years—and then the rate adjusts or “floats” with the index. So if interest rates rise over time, the coupon payment will rise with the index. Sounds great, so what’s the catch?
- Credit risk—no cash substitute. Based on the Barclays FRN index, most floating rate notes are investment grade but not without credit risk. (We are not including leveraged loans in this discussion. Some mutual funds combine FRNs with bank loan, leveraged loans and convertible bonds.) About 65% of the issuers are financial companies and about 26% are issued by international firms. So, it is possible that a FRN fund or ETF would have exposure to international banks—a sector of the market that has seen many credit downgrades over the past two years.
For mutual fund or ETF investors, we suggest looking carefully at the holdings to make sure the credit quality is consistent with the investor’s risk tolerance. They should not be viewed as alternatives to cash investments or CDs. Deposit insurance doesn’t cover FRNs; they are subject to credit and interest rate risk, so they are not appropriate cash substitutes.
Breakdown of The Barclays U.S. Dollar Floating Rate Note (FRN) Index
Source Barclays, as of July 3, 2012
- Duration risk—may not be what you’re expecting. The duration for most FRNs is short, but some are issued with long maturities or are even issued as perpetual preferred securities. If long-term interest rates rise faster than short-term rates, then the value of the note could decline due to its long duration, even if the coupon rate moves up. Moreover, once the note’s floor expires, the coupon rate might actually fall if short-term rates don’t move up rapidly.For example, consider a perpetual preferred FRN issued in 2011, indexed to LIBOR with a three-year 4% floor that expires in 2014. At the beginning of 2015, the coupon will float at 25 basis points over LIBOR. If the Fed begins to raise rates in early 2015, the coupon payment might actually drop if the Fed’s rate hikes don’t reach the 4% floor rate. Meanwhile, if long-term rates rise in anticipation of a shift in Fed policy, which is usually the case, then the FRN would most likely trade lower due to its long duration. It could be the worst of both worlds. This may not be the case for most FRNs, but we advise being careful about the maturity of FRNs and as well as duration risk in floating rate note funds.
- Liquidity—can be thin. The market for floating rate notes is small relative to the size of the overall bond market and there may not be ample liquidity, particularly in times of financial stress. For investors who are investing in fixed income for safety and liquidity, this may not be an appropriate area for investment.
- Bottom line. FRNs can provide current income in excess of what’s available in cash investments without significant duration risk. However, FRNs and FRN funds and ETFs are not cash substitutes. Investors are exposed to credit, liquidity and interest rate risk. We suggest looking carefully at the investment vehicle that offers FRNs and limiting allocation to a small slice of the overall fixed income portfolio.
For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.International investments are subject to additional risks such as currency fluctuation, foreign taxes and regulations, differences in financial accounting standards, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.Past performance is no guarantee of future results.Diversification strategies do not assure a profit and do not protect against losses in declining markets.Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.The Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component. Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody’s, S&P, and Fitch.Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market.. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).Barclays U.S. Dollar Floating Rate Note (FRN) Index measures the performance of U.S. dollar-denominated, investment-grade floating-rate notes across corporate and government-related sectors. This index is not part of the US Aggregate Index, which is a fixed coupon index. Government-related sectors include sovereigns such as Mexico and Chile.London Interbank Offer Rate (LIBOR) is a widely used benchmark for short-term interest rates. It is an interest rate at which banks borrow funds from other banks in the London interbank market; the LIBOR is fixed on a daily basis by the British Bankers’ Association and derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and a full year.Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Tags: agricultural, Banking Sector, Bankruptcy Protection, Basis Points, Bond Holders, Bond Market, Bond Yields, Chapter 9 Bankruptcy, Debt Loads, Devil Is In The Details, European Leaders, Global Bond Markets, Imminent Crisis, Political Risk, Reducing Debt, Risk Markets, Sensitive Commodities, Sovereign Debt, Stock Markets, Substantial Agreement, Summit Agreement
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Monday, July 2nd, 2012
U.S. Equity Market Radar (July 2, 2012)
The S&P 500 Index rose 2.03 percent this week on the back of a huge rally on Friday. Two noteworthy events this week included the Supreme Court ruling on healthcare legislation announced on Thursday, which the market negatively reacted to, and the EU Summit conclusion on Friday, which provided the market a positive surprise relative to low expectations. Key proposals of the EU Summit include the establishment of a single supervisory body for eurozone banks and the allowance for direct bailout of banks, essentially back stopping the banks and likely holding the Euro together if the details can be worked out. This was a major catalyst for the market which had become accustomed to being disappointed by European leaders.
- The energy sector rocketed 4.8 percent higher this week as oil rose by 6.5 percent. Much of this week’s move came on Friday when crude oil rose by more than 9 percent. Stocks that had been beaten up the most tended to be the ones that rallied the most.
- The materials sector rose 2.8 percent with leadership from construction materials, steel and fertilizer names.
- Homebuilders were also among the best performers for the week as Lennar reported strong quarterly results and housing data continues to be better than expected.
- The best individual stock performer this week was Constellation Brands which rose 39.7 percent as the company bought the other half of its joint venture with Grupo Modelo, giving the company sole distribution of Modelo’s brands in the U.S. including Corona.
- The technology sector lagged as tech heavyweights such as Intel, Hewlett-Packard and EBay all fell for the week.
- Retailers and related names also tended to struggle this week as disappointing earnings guidance from O’Reilly Automotive appeared to begin a negative cascade that took down several high flying stocks such as Chipotle Mexican Grill and Ross Stores.
- Managed care companies were negatively impacted by the Supreme Court ruling upholding the Affordable Care Act as Wellpoint, Coventry Health and Aetna were among this week’s worst performers.
- With the Fourth of July holiday in the middle of the week next week, expect muted trading activity. However, the European Central Bank is expected to cut interest rates on July 5 and unemployment data will be released next Friday.
- Europe positively surprised the market this week but the threat remains that the EU Summit proposals will be unable to be implemented in a timely fashion.
Tags: Bailout, Chipotle Mexican Grill, Constellation Brands, Ebay, energy sector, European Leaders, Grupo Modelo, Healthcare Legislation, Heavyweights, Low Expectations, Market Radar, Materials Sector, Noteworthy Events, O Reilly, Quarterly Results, Reilly Automotive, Ross Stores, Sole Distribution, Supervisory Body, Supreme Court Ruling
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Monday, July 2nd, 2012
Energy and Natural Resources Market Radar (July 2, 2012)
- In reaction to an insurance embargo on Iranian oil vessels, effective this Sunday, South Korea will halt all oil imports from Iran. These vessels rely on insurance to protect them against any accidents they may encounter, and most companies that provide this type of insurance are based in the EU. South Korea, Iran’s fourth largest oil consumer, is currently in talks with countries such as Iraq, Kuwait, Qatar, and the United Arab Emirates to find a new route to meet their demand.
- Strikes in Norway regarding pensions and retirement age led to the closing of three more oil fields, restricting more than 15 percent of the country’s oil supply and 7 percent of its natural gas supply. Last month, Norway produced 1.63 million barrels of oil per day, and Statoil has already reported losses of up to 250,000 barrels per day. Brent Crude Oil prices saw a slight increase as a result.
- Vale received an environmental license to expand the biggest iron-ore mine in the world, estimating that about $1 trillion worth of reserves are to be found. They hope to double their iron-ore capacity at Carajas in Northern Brazil, and by 2017 hope to increase their output to 230,000 tons per year.
- Crude oil futures (West Texas Intermediate) gained nearly 6 percent this week with most of the gain on Friday following news that European leaders had agreed to allow struggling European banks to borrow directly from bailout funds.
- Aluminum has dropped in value to $1,845 per ton, its lowest price since June 7, 2010. Because of these deteriorating prices, Rusal plans to curtail 8 percent of its smelting capacity by 2013. Furthermore, provincial governments in China have granted subsidies to smelters to increase aluminum production. This comes after the government faced a loss in tax revenue and higher unemployment from the reduction of output in Henan, a province that contributes 20 percent to China’s total aluminum capacity. After the news let out, aluminum prices dropped 3 percent on the Shanghai Futures Exchange.
- Arch Coal, in the midst of low natural gas prices and slowing electricity consumption, temporarily suspended mining operations across the country, resulting in 750 layoffs. SouthGobi Resources also has plans to halt its coal mining operations in Mongolia because of weak demand and an unpredictable future.
- Lennar Corp. is in talks and has signed a memorandum of understanding with China Development Bank Corp. regarding an approximate $1.7 billion loan. This loan would help transform two former naval bases into a $13 billion housing project and greatly benefit the timber industry.
- Within a year, Bangladesh is planning on boosting domestic natural gas supply by 63.25 percent to meet a demand that has been increasing by about 14 percent a year since 2003. Chevron and many state-owned companies have already prepared to increase supply to the country.
- In a slow diamond market, Botswana’s Minerals Minister believes the country can turn towards copper and silver, in addition to coal mining, to provide a more prominent source of revenue. This transition of focus may diminish the weight the diamond industry has on Botswana’s economy.
- Iraq’s oil output has reached a 20-year high, passing 3.07 million barrels per day for the month of June, as it seeks to overtake Iran in becoming OPEC’s second largest producer. Iraq plans on producing 70,000 barrels a day at Halfaya field during the first week of July and hopes to more than double its output by 2015. This increase in output will weigh heavily on global oil prices.
- Guatemala’s President, Otto Perez Molina, has proposed reforms to the constitution, essentially giving the government up to 40 percent ownership in mining and exploration companies in the area. Molina campaigned on increasing foreign investment, but there may be unintended consequences should these proposals be ratified.
Tags: Aluminum Production, Bailout, Brent Crude Oil, Brent Crude Oil Prices, Carajas, Crude Oil Futures, Crude Oil Prices, European Banks, European Leaders, Iranian Oil, Iron Ore, Market Radar, Northern Brazil, Oil Imports, Oil Supply, Provincial Governments, Retirement Age, Statoil, United Arab Emirates, West Texas Intermediate
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Tuesday, May 29th, 2012
Amid great uncertainty and huge challenges in Europe, it can be helpful to cut through all the detail and map out what we know and what we don’t know. This is at best depressing and, at worst, terrifying.
What are the known knowns?
First, Greece is spiralling out of control. No good outcomes appear possible for Greece or the eurozone. They face only bad outcomes that will be chosen or forced. Arguments over the economics of Greece’s programme and creditor country demand for adherence to what looks like an impossible task have run into political and social rejection in Greece. The country’s political system is fragmenting and social unrest is sure to persist. While there may be a way for Greece to remain in the eurozone, an exit looks far more likely.
Second, this is not merely a Greek or a eurozone challenge. Across the world, rich countries are trying to de-lever in a controlled way while maintaining growth and jobs. The eurozone’s institutional challenges make this difficult task far worse. Individual eurozone countries are like emerging markets, borrowing in foreign currency in their susceptibility to a run on the sovereign. During a crisis, investors will go to the safety of the strongest balance sheet, which in the eurozone’s case is Germany. Italy and Spain are not insolvent countries, but nor can they maintain stable debt dynamics with nominal yields well above their nominal growth rates owing to the absence of a predictable central bank lender of last resort.
Third, the eurozone’s monetary and fiscal interventions to date have not succeeded in stabilising its sovereign debt markets and crowding investors in, in part because they have been reactive and insufficient and also because of the public slanging matches between European leaders and with and between central bankers. Rather, these interventions have financed the exit of banks and other investors retreating back within their borders and the exit of foreign investors. Bank deposit withdrawals now threaten to accelerate the process.
Fourth, it is a known known that the eurozone’s most important challenges are political, rather than economic. Measured by debt and deficit levels, the eurozone is no worse off than the United States or Britain. The challenges are of co-ordination among countries and regional legitimacy, as governments try to overcome disagreements over how to mutualise the risks within the eurozone and on the proper role of the central bank.
Finally, it is clear that the eurozone status quo is not sustainable. A risk of a Greek exit and/or bank runs across the eurozone threatens to press fast forward on the crisis.
Turning to the known unknowns, it is unclear if the eurozone’s governments have the technical capacity to administer what will be a difficult process of managing the crisis in the short term and of integrating the eurozone over the medium term. It will require some combination of: policy and political coordination; measures to reduce the vulnerability of the banking system; the European Central Bank acting as a credible, committed lender of last resort for sovereigns to prevent self-fulfilling runs; closer fiscal union involving the mutualisation of debt in the form of guarantees or common eurobond issuance and a pooling of fiscal sovereignty; a more sustainable balance between the need for growth and the need for fiscal retrenchment; and, most likely, support to facilitate a managed Greek exit and limit the run on the eurozone as a whole. Indeed, the signal from a Greek exit that this is not an irrevocable currency union but a fixed but adjustable exchange rate could unleash a re-pricing of currency risk across the eurozone’s private markets, not only the government bond market, heightening the risk that the technical capacity to respond is overwhelmed.
This difficult prognosis is compounded by the huge known unknown over whether the eurozone’s leaders have the ability to overcome their co-ordination challenge and lay out an immediate plan to deal with a Greek exit, to defeat spiralling contagion risk in the short term and to build a more stable eurozone in the medium term.
Perhaps hardest of all, there is the known unknown of whether European populations will support or at least acquiesce in the face of miserable economic conditions, the pooling of sovereignty and greater transfers across borders.
Taking together the known knowns and the known unknowns, it seems likely that the eurozone’s big four — Germany, France, Italy and Spain — as well as other German satellite countries will find a way to hang together in a smaller currency union backed by stronger regional co-ordination and financing mechanisms.
But it will be difficult and costly and the tail risk of failure is very fat, indeed.
For investors, the balance of risks suggests preparing for the worst, even if, as citizens, we hope for the best. This would include limiting exposure to real confiscation risk in the eurozone and focusing instead on better global alternatives available in countries with stronger balance sheets, exposure to better growth prospects and less intractable governance challenges.
Copyright © PIMCO
Tags: Adherence, Balance Sheet, Balls, Bank Lender, Creditor, Debt Markets, Emerging Markets, European Leaders, Eurozone Countries, Foreign Currency, Impossible Task, Institutional Challenges, Interventions, Lender Of Last Resort, PIMCO, Rich Countries, Social Rejection, Social Unrest, Sovereign Debt, Susceptibility, Uncertainty
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Monday, April 2nd, 2012
by Mohamed El-Erian, PIMCO, via Project Syndicate
NEWPORT BEACH – The international community risks settling for second best on two key issues to be discussed this month at global meetings in Washington, DC: the lingering (if currently somewhat dormant) European debt crisis, and the selection of the World Bank’s next president. It is not too late to change course, but doing so will require the United States and governments in Europe to resist harmful habits, and emerging countries to follow up effectively on recent initiatives. In the last few days, European leaders, including French President Nicolas Sarkozy and European Central Bank President Mario Draghi, have declared that the worst of the eurozone crisis is over. Others, like French Finance Minister Francois Baroin, have gone even further, claiming that Europe “has done its part,” and that it is now up to other countries to do theirs.
These announcements should come as no surprise. Having experienced prolonged turmoil, the eurozone is currently in a period of relative tranquility. The courageous reform measures implemented by Mario Monti, Italy’s technocratic prime minister, have eased immediate concerns that Greek dislocations might tip other European countries – much bigger and harder to rescue – into insolvency. Europe’s decision last week to bolster its internal financial firewalls has reinforced the resulting positive impact on market sentiment. But, as important as these steps are, the recent tranquility has been more borrowed than earned. Since December, the ECB has twice deployed long-term refinancing operations, which provide unlimited three-year financing to banks at 1% interest. This has given the banking system more time to increase capital and improve asset quality. It has also reduced several governments’ financing costs. What it does not do, and is not meant to do, is resolve Europe’s twin problems of too little growth and too much debt.
If it is not careful, Europe risks falling into the trap of trying to shift responsibility for its problems onto others, rather than building on recent progress. That temptation is partly reflected in efforts to press officials from around the world to agree this month to a major increase in the International Monetary Fund’s resources, with emerging economies footing a significant part of the bill. In pivoting from internal to externally-financed firewalls, Europe is pushing a political agenda that is not yet warranted by economic and financial realities. Europeans are about to embark on another round of elections, in both core and peripheral EU countries, as well as a referendum in Ireland. Recent history suggests that these votes are unlikely to favor ruling parties unless they can signal some progress in resolving the crisis.
Copyright © Project Syndicate
Illustration by Paul Lachine
Tags: Asset Quality, Bank President, Debt Crisis, Europe Risks, European Leaders, French Finance Minister, French President Nicolas, French President Nicolas Sarkozy, Global Meetings, Harmful Habits, Mario Monti, Market Sentiment, Mohamed El Erian, Newport Beach, Nicolas Sarkozy, PIMCO, President Nicolas Sarkozy, Project Syndicate, Reform Measures, Relative Tranquility
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Tuesday, March 20th, 2012
Canada’s natural resources minister told delegates at the International Energy Forum in Kuwait that his country was on the cusp of becoming an “energy superpower.” Canada ranks No. 6 in terms of global oil production, but much of its crude exists in the form of oil sands. European leaders are considering a measure that would classify oil sands as an environmental issue, prompting Canada to threaten to take the issue to the World Trade Organization. With the U.S. political system in a deadlock over Canadian crude, the Ottawa government is now working to convince the international community that the global market is in jeopardy if polices “discriminate against oil sands.”
Drill-happy critics of the Obama administration are painting the Keystone XL oil pipeline planned from Alberta as a panacea to U.S. economic woes. Because of debates over the planned route through Nebraska, however, the White House has pushed the issue aside for now. The pipeline company behind the project, TransCanada, has opted for a smaller leg in the United States while the Canadian government has thrown its support behind the Northern Gateway pipeline meant for Asian exports.
Canadian Natural Resources Minister Joe Oliver said his presence at the IEF summit in Kuwait proved his country was “an emerging energy superpower.” Canada has around 175 billion barrels of proven oil reserves, which means it’s the only non-OPEC member in the global top five, just behind Saudi Arabia and Venezuela.
European leaders in March were unable to reach a decision on whether or not to characterize oil sands as an environmental issue. Critics of oil sands note that its production releases much more CO2 into the atmosphere compared with regular crude oil and its tendency to sink in water makes it a particular concern if spilled. Some critics have dubbed it the dirtiest form of oil on earth and advocate an outright ban. The European government is set to consider the issue by June.
Oliver, however, complained to IEF delegates that any policy that would discriminate against oil sands would be harmful to the global market and overall energy security. Last year, the global economy was threatened by a loss of crude oil from war-torn Libya, OPEC’s No. 7, so sidelining oil sands from Canada could be much more severe.
“Our government believes that the free market is the most efficient and cost-effective means to ensure the proper allocation of resources for the development and supply of energy,” said Oliver.
Just as Obama said there’s no “silver bullet” that can magically push U.S. gasoline prices to something American consumers consider fair, there’s nothing in a global market that’s easily replaced. Singling out Canadian oil means potentially sidelining an oil supply larger than Iran’s, something a depressed European economy could hardly stomach. But as with Iranian crude, if the Europeans don’t want it, they don’t have to buy it. While that’s an oversimplification of the issue, the world still needs as much oil as it can get. Europe is embracing a greener economy. But until global economic engines run on something other than petroleum products, when Canadian crude oil is at stake, it’s time to just let it flow.
Tags: Canadian, Canadian Market, Canadian Natural Resources, Cusp, Economic Woes, Emerging Energy, Energy Forum, Environmental Issue, European Government, European Leaders, Global Oil Production, International Energy, Joe Oliver, Natural Resources Minister, Northern Gateway, Oil Pipeline, Oil Sands, Outright Ban, Pipeline Company, Proven Oil Reserves, Transcanada, World Trade Organization
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Thursday, December 22nd, 2011
The Three R’s of Investing
by Mark Seidner, Managing Director, PIMCO
- The inability to achieve sustainable levels of economic growth raises the risk of recession in many developed world economies.
- Under financial repression, market interest rates are kept very low for a very long time period with the hope of stimulating investment, but repression also starves savers to the benefit of borrowers.
- Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices.
Volatile and manic movements are becoming commonplace in the financial markets. The pendulum that perpetually swings between optimism and pessimism is changing direction more frequently, driven by extrapolation of the latest economic data point, political rumblings and rumors.
We are aware of the traditional three R’s that constitute the foundation of elementary education: Reading, wRiting and aRithmetic. Investors, however, should increasingly be wary of the three R’s that impact investment outcomes today and in the period ahead: Recession, Repression and Risk.
In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, reregulation and deglobalization that act as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite. The result in many countries is a lack of automatic stabilizers that are so necessary in an increasingly volatile economic environment. Normally, political forces respond to economic and financial market outcomes. In the current environment, political actions (or inactions) drive economic and financial market results. Look no further than the debt ceiling debacle and subsequent complete failure of the super committee in the United States and the inability of European leaders to make necessary progress in resolving the sovereign debt crisis.
Stubbornly high unemployment and underemployment rates, stagnant income levels and growing unrest are the consequence.
In capitalist, or market-based economies, the inability to achieve sustainable levels of economic growth that fuel virtuous cycles of spending, investment and employment growth raises the risk that vicious cycles ensue, resulting in an ever-present risk of recession.
As a result, one hears concerns for an upcoming lost decade in many developed world economies growing louder and louder.
Financial repression is a simple concept with profound implications. Under financial repression, market interest rates are kept very low for a very long time period, starving savers to the benefit of borrowers. The hope goes beyond creditors subsidizing debtors. It is also to stimulate risk-taking, investment activity and economic growth.
The best means of managing mounting public sector debt levels is to generate real economic growth. If real growth is elusive, nominal growth rates fueled by inflation above average borrowing costs will reduce debt-to-GDP ratios. Two simultaneous conditions are necessary: Growth, either real or nominal, and low government borrowing costs.
In August 2011, the Standard & Poor’s rating agency decided to downgrade the rating of United States Treasury debt from the top tier AAA to AA+. What seemed like critically important news was quickly overshadowed the following week when the Federal Reserve announced a shift in communication strategy. In every statement since March 2009, the Fed had stated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Then on August 9, 2011, the language changed to “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”
The message to savers and investors was clear. For savers, there will be no income in bank accounts or money market funds for at least two years and likely longer. For investors, there is no means of achieving a positive real (or nominal for that fact) real rate of return on the presumed risk-free interest rate.
The market impact was immediate. The two-year U.S. Treasury note, which offered an average yield of 0.75% from March 2009 through July 2011, fell to about 0.25%.
The new commitment language is repressive to savers and low duration investors. Operation Twist, the Fed’s subsequent plan to adjust its balance sheet by selling Treasury notes with maturities less than three years and buying T-notes and T-bonds longer than six years, is repressive to all Treasury investors.
The 30-year U.S. Treasury currently yields little more than 3%. That is a fixed, nominal return with no growth potential and is eroded by any prospect of inflation. The reward does not seem compelling, and with price volatility over 20%, neither does the risk.
Risk and Implications
The continuous concern about recession and the increasing role of policymakers and other non-commercial participants in financial markets increases risks dramatically.
PIMCO frames this increasing element of risk in financial market and economic outcomes in the probabilistic context of a normal distribution, one that now has a flatter distribution of potential outcomes with fatter tails.
At PIMCO, we constantly ask questions in order to anticipate the full range of potential developments. Key questions include: What if the concept of a change in the distribution of expected outcomes does not go far enough? What are the implications of an environment characterized by a more pronounced set of outcomes exhibiting markedly distinct and contrasting forms? How should investors respond in an environment where what is considered an average outcome or expectation becomes the least probable event and the rare becomes commonplace?
Uncertainty and volatility can be paralyzing, and understandably so. But rather than become frozen with fear, now is the time to recognize regime change and consider making structural modifications.
The heightened risk of recession increases the importance of a strong balance sheet as volatile economic outcomes will likely have a magnified impact on the success and failure of countries, companies and individuals. In the near term, investment success will largely be defined as avoiding the risk of permanent principal loss by stress testing across meaningful possible tail events. Differentiated outcomes and failure are a near certainty. Capitalizing on distressed situations – most likely first in Europe and then elsewhere – will differentiate investment results over a longer time horizon.
Repression requires a keen focus on income, particularly in a world where aging demographics increase the need for known cash flow when traditional sources such as government bonds do not suffice.
Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices. A significant element in the investment management industry is built on the notion of a normal distribution. If the shape or characteristics of the distribution are questioned, then many related concepts – such as mean reversion and rebalancing – must also be questioned. Price change is not nearly sufficient as a signal for portfolio action. Price analysis accompanied by fundamental outlook is necessary.
Portfolios constructed with a carefully selected and diverse set of return drivers, a focus on income and a forward-looking approach to risk management may be able to avoid the pitfalls of the three R’s and increase the probability of navigating an increasingly uncertain economic and financial market environment.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. ©2011, PIMCO.
Tags: Asset Allocation, Automatic Stabilizers, Debt Ceiling, Education Reading, Elementary Education, European Leaders, Extrapolation, Financial Repression, Global Financial Crisis, Impact Investment, Manic Movements, Market Interest Rates, Market Outcomes, Optimism And Pessimism, Political Actions, Rumblings, Sustainable Levels, Traditional Models, Volatile Economic Environment, World Economies
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Sunday, December 11th, 2011
The Economy and Bond Market Radar (December 12, 2011)
Long-term treasury yields ended the week modestly higher as European leaders came together on Friday to form a fiscal pact that placated the market for the time being and led to a sell off in the long end of the Treasury curve.
While there was considerable anticipation and discussion regarding the outcome of the European Central Bank (ECB) meeting on Thursday and Friday’s European Union (EU) summit, the most important piece of data may have come from the other side of the world. The chart below depicts year-over-year inflation in China, which fell to the lowest levels in 14 months. The reason this may be so significant is that this could be a precursor to full-fledged easing in China, which has been the incremental global growth driver in recent years. If China were to cut interest rates, that would be a strong signal that global reflationary policies are back in force and boosts prospects for both global economic growth as well as appreciation in risky assets.
- The EU leaders came to an agreement, in principle, on a fiscal pact that will hopefully lead to real reform and stabilize markets in the near future.
- China’s November CPI fell to 4.2 percent and opens the door to more aggressive easing policies in China.
- The University of Michigan Confidence Index rose more than expected in the preliminary December release.
- Weakness is several Chinese indicators also increases the probability of an interest rate cut as China’s export growth and service sector PMI slowed.
- S&P put negative outlooks on 15 of 17 eurozone countries and the EU may lose its AAA rating as well.
- Factory orders in the U.S. fell 0.4 percent in October and September’s data was also revised lower.
- The Federal Open Market Committee meets next Tuesday and, while expectations are low for a significant change in policy, the Fed could surprise the market.
- The situation in Europe remains extremely fluid and negative news is almost expected at this point; unfortunately, it is politically driven and difficult to predict outcomes and ramifications.
Tags: Bond Market, Confidence Index, CPI, European Leaders, Eurozone Countries, Federal Open Market Committee, Global Economic Growth, Global Growth, Inflation In China, Market Radar, Open Market Committee, Outlooks, Pact, Precursor, Risky Assets, Service Sector, Strong Signal, Treasury Curve, Treasury Yields, University Of Michigan Confidence
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Friday, December 9th, 2011
by Russ Koesterich, Chief Investment Strategist, iShares
In recent weeks, governments across the world have stepped up efforts to address the European debt crisis. Major central banks announced a coordinated effort last week to support Europe, while European finance ministers agreed on a way to enhance the region’s bailout fund and the European Union seemed on the verge of more fiscal integration.
Investors are now focused on the European Union summit happening in Brussels this week and what action, if any, the European Central Bank (ECB) will announce on Thursday.
To truly resolve the crisis, the ECB needs to find some face-saving way to expand its purchasing program, while the PIIGS countries need to implement necessary and difficult reforms. Major issues relating to European fiscal integration and the necessity to bring down Spanish and Italian bond yields also remain unresolved.
The future of Europe is uncertain, and I expect the crisis to continue into next year with at least a mild recession in Europe. But I believe European leaders will address the outstanding issues in time to avoid a sovereign debt collapse.
Still, a long-term European debt crisis is a valid concern and investors with such concerns should adjust their portfolios accordingly. If you expect the European debt crisis to drag on, here are four investing ideas to consider.
1. Within your international equity exposure, overweight CASSH countries. Investors looking for international developed market exposure may want to consider a long-term overweight to Canada, Australia, Singapore, Switzerland and Hong Kong — what I’m calling the CASSH countries. These smaller developed world countries appear fundamentally stronger than their larger counterparts. They have better growth prospects, less debt and less strained public finances.
2. Within your international equity exposure, overweight emerging markets outside of Europe. With the developed world the epicenter of the recent global sovereign debt crisis, emerging markets may provide a defensive play in the event of a continuing sovereign debt crisis. First, the emerging world has become more attractive than it was in the past. Many emerging markets now appear to be pictures of fiscal rectitude in comparison to Europe and other larger developed markets. In addition, I expect emerging market inflation to decelerate in 2012. Finally, over the last year, emerging market valuations have compressed in an absolute sense and relative to developed markets.
If the European crisis worsens into a severe banking crisis and recession, the impact of a global recession would be ubiquitous, and emerging markets do have exposure to European banks. According to the Economist, emerging markets owe Europe’s banks $3.4 trillion and such credit could be cut off in a banking crisis, potentially hurting emerging market economies in the longer term. Still, I expect the long-term impact of a worsening crisis to be less severe for emerging markets outside of Europe. Within emerging markets, I particularly like Brazil and Taiwan.
3.) Overweight “safe-haven” assets. A continuing European crisis would mean continued market volatility as investors react to each bit of news. As such, I continue to advocate adopting a defensive stance in equities, particularly through global mega caps and telecommunications. A continuing crisis would also favor gold, partly because it would likely mean continued negative real interest rates.
4.) Within fixed income, overweight investment grade and munis. Investment-grade bonds currently offer a rich yield relative to Treasuries and historically have lower default rates during recessions than high-yield bonds. Similarly, munis offer the potential for a rich, after-tax yield and dire predictions about the bonds have turned out to be unfounded. Both munis and investment-grade bonds also look cheap.
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.
Tags: Bailout, Bond Yields, Canada Australia, Central Banks, Chief Investment Strategist, Debt Crisis, Drag On, Emerging Markets, Equity Exposure, European Finance Ministers, European Leaders, European Union Summit, Growth Prospects, International Equity, Ishares, Market Exposure, Public Finances, Sovereign Debt, Valid Concern, World Countries
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Sunday, December 4th, 2011
The Economy and Bond Market Radar (December 4, 2011)
Long-term Treasury yields ended the week higher as coordinated global central bank action helped alleviate immediate fears of a liquidity crisis in European banks.
The chart below depicts the 10-year Italian Government Bond yield which hit new highs last week but rallied sharply on this week’s central bank intervention. This was a “risk off” week with relatively risky assets rallying.
- Coordinated action by global central banks lessens the odds of another financial crisis.
- Economic data in the U.S. remained relatively strong as the economy created 120,000 jobs in November, consumer confidence jumped, manufacturing indicators improved and auto sales were generally better than expected.
- International data was mixed, but Japanese industrial production rose 2.4 percent in October, well ahead of expectations.
- The negative aspect of the central bank action this week was on rumors a European bank was on the cusp of a liquidity crisis and the central bankers were forced to act to avert a crisis.
- S&P downgraded many large global banking institutions.
- China’s purchasing managers index (PMI) fell into negative territory for the first time since 2009.
- The European Central Bank (ECB) indicated a willingness to provide additional support if European leaders agree to a fiscal union.
- The situation in Europe remains extremely fluid and negative news is almost expected at this point, unfortunately it is politically driven and difficult to predict outcomes and ramifications.
Tags: Banking Institutions, Bond Yield, Central Bank Intervention, Central Banks, Consumer Confidence, European Banks, European Leaders, Global Banking, Government Bond, Italian Government, Liquidity Crisis, Market Radar, Negative Aspect, Negative News, Negative Territory, New Highs, Purchasing Managers Index, Risky Assets, S Central, Treasury Yields
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