Mythbusting: Emerging Market High Yield Bond Risk

Friday, August 3rd, 2012

by Del Stafford, iShares

Emerging market high yield bonds – about as risky as an asset class can get, right? After all, emerging markets are known for carrying a significant amount of risk, and high yield bonds are one of the more speculative sectors within fixed income. Put the two together, and aren’t you doubling down on risk? I thought the same myself before researching this very topic, but to my surprise I found that is not [always/necessarily] the case.

First, most investable emerging market high yield indices contain bonds that are issued in US dollars (USD), so with these indices there isn’t additional risk from owning other currencies. Also, emerging market high yield generally includes sovereign bonds (issued by a government) and quasi-sovereign bonds (issued by an agency backed by a government), while US high yield generally only includes corporate bonds.

Corporate bonds are typically viewed as riskier than government bonds, even when they have the same credit quality rating. In times of market volatility and stress, you can see that play out in what is commonly referred to as a “flight to quality”. For example, we saw this happen during the credit crisis of 2008 when the market largely sold out of corporate bonds and bought US Treasuries.

The sovereign and quasi-sovereign exposure in emerging market high yield caused it to behave differently from other risk assets during 2007-2009. The below chart shows correlations of emerging market high yield (Barclays EM High Yield Index), US corporate high yield (Barclays US Corporate High Yield Index), emerging market equities (MSCI Emerging Markets Index) and developed international equities (MSCI EAFE Index) to US equities (S&P 500 Index) during this time period. You can see that developed international equities, emerging market equities, and US high yield increased in correlation but emerging market high yield decreased in correlation.

In addition, when you look at historical volatility in the below chart, emerging market high yield has experienced comparable levels of risk to US high yield over the past seven years.

Now, the intent here isn’t to say that emerging market high yield bonds are for everyone, but rather to challenge investor assumptions about the investment’s risk profile. Investors interested in emerging market high yield debt should still consider whether it suits their portfolio needs (Matt Tucker’s recent post may be helpful).

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.
Correlation is a statistical measure that captures the degree of the historical relationship between the returns of a pair of investments or indexes.

Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.

Standard deviation is the statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. It is widely applied in modern portfolio theory, where the past performance of securities is used to determine the range of possible future performance, and a probability is attached to each performance.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Copyright © iShares

Tags: asset class, Barclays, Corporate Bonds, Correlation, Correlations, Credit Crisis, Credit Quality, Emerging Market, Emerging Markets, Fixed Income, Government Bonds, High Yield Bond, High Yield Bonds, International Equities, Ishares, Market Volatility, Markets Index, Sovereign Bonds, Time Period, Treasuries
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The Economy and Bond Market Radar (July 30, 2012)

Sunday, July 29th, 2012

The Economy and Bond Market Radar (July 30, 2012)

After hitting a new low on Tuesday, Treasury yields bounced back sharply on Friday as ECB president Mario Draghi vowed to do whatever it takes to save the euro. This news sparked a “risk on” rally driving risky assets higher and bond prices lower. Yields on Spanish 10-year government bonds reversed course and dropped sharply on the news as it appears the likelihood of a sovereign default has diminished.

Strengths

• In addition to the ECB news discussed above, there was a front page story in the Wall Street Journal earlier this week that was widely believed to be leaked from the Fed to prep the market for potential Fed policy actions as soon as next week. Monetary policy-makers are taking action around the globe.
• Second quarter GDP grew 1.5 percent. While this is a slow level of absolute growth, it modestly beat expectations.
• Several homebuilding companies reported earnings this week which indicated orders in the second quarter were very robust.

Weaknesses

• June durable goods orders ex-transportation fell 1.1 percent, indicating broad-based weakness.
• The U.K. economy contracted by 0.7 percent in the second quarter, while Mexico’s economy shrank by 0.36 percent in May.
• Markit’s July eurozone manufacturing Purchasing Managers Index (PMI) fell to the lowest level since June 2009. The more traditional PMI reports will be released next week, but the indications obviously look weak.

Opportunity

• The Fed and ECB are both talking about additional monetary stimulus. Interest rates are likely to remain very low for the foreseeable future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.

Tags: Bond Market, Bond Prices, Durable Goods Orders, Ecb President, Fed Policy, Government Bonds, Homebuilding Companies, Mario Draghi, Market Radar, Markit, Monetary Policy, Pmi, Policy Actions, Purchasing Managers Index, Quarter Gdp, Risky Assets, Shifting Focus, Stimulus, Treasury Yields, Wall Street Journal
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Energy and Natural Resources Market Radar (July 30, 2012)

Sunday, July 29th, 2012

Energy and Natural Resources Market Radar (July 30, 2012)

Strengths

• The yield on 10-year Treasury notes closed the week at 1.534 percent, still below the June Consumer Price Index of 1.7 percent. The dividend yield of the stocks in the Global Resources Fund’s portfolio increased from last week to an average of 3.68 percent.
• Eagle Ford oil production more than tripled in May year-over-year, according to the Texas Railroad Commission, and this may be an underestimate. Experts believe that production here in Texas may reach one million barrels a day in the next couple of years.
• Speculation of Europe’s plan to spur economic growth by purchasing government bonds caused oil to increase 2.2 percent this week. Copper also climbed 2.1 percent from Tuesday this week on the New York Mercantile Exchange. Mario Draghi said that the ECB will do whatever it takes to “preserve the euro.”
• Peru’s mining ministry reported that from January to May, production of copper increased 2.5 percent. It was also noted that production in May was up 8.04 percent year-over-year.

Weaknesses

• The same report from the mining ministry of Peru also showed a decline in zinc and iron ore production. Zinc declined about 4.5 percent during the January-to-May time period and iron ore declined further at 16.02 percent.
• The Western Australian Mines Minister has banned coal mining in the Margaret River region based on the “potential ground water impacts.” All applications to mine in this area will be denied and companies have already started to withdraw their requests. Mineral titles already granted, however, will remain intact but any coal mining project proposals will be rejected.

Opportunities

• Tenova Mining and Minerals was awarded a contract to design a copper ore handling and processing system as well as a solvent extraction and electro-winning plant, which could potentially produce 80,000 metric tons per year of copper cathodes. This will support Minera Antucoya’s copper oxide deposit in Chile.
• Aluminum Bahrain BSC (Alba) has hired BNP Paribas to assist the company in a $2.5 billion dollar expansion plan to add 400,000 metric tons of capacity annually (currently 881,000 metric tons) to its operations. According to Reuters, this could be completed by 2015. Alba is currently the fourth largest aluminum smelter.
• In China, the capital of Hunan Province has announced plans of a 195 project undertaking for 2012. It will involve airport, urban transit, and residential infrastructure development.

Threats

• Iron ore prices are now at $116.20 per metric ton, the lowest since December 2009. Small traders in China are now selling their stockpile for a loss, and this would have a very negative impact on the commodity if larger traders were to follow.
• Lakshmi Mittal, CEO of ArcelorMittal, the world’s largest steel and mining company, said that the steel market would remain week going into the second half of the year, especially in Europe. The company lowered expectations of European consumption to between 3 percent and 5 percent for 2012.

Tags: 10 Year Treasury, Coal Mining, Consumer Price Index, Copper Cathodes, Copper Ore, Dividend Yield, Eagle Ford, Government Bonds, Handling And Processing, Margaret River Region, Mario Draghi, Market Radar, Mineral Titles, New York Mercantile Exchange, Ore Production, Project Proposals, Resources Fund, Texas Railroad Commission, York Mercantile Exchange
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Bonds: We Don’t Dislike Them All

Thursday, July 26th, 2012

by Scott Ronalds, Steadyhand Investment Funds

We’ve been vocal about our aversion towards federal government bonds. We noted in our Q2 Report that the Government of Canada 10-year benchmark bond yield dropped below 1.6% in June, and 10-year U.S. Treasury yields sit below 1.5%. Both Canadian and U.S. government bond yields are at or near all-time lows. Further, the German government issued 2-year bonds at auction last week which produced a negative yield for the first time ever. In other words, investors are willing to pay the government to park their money for two years.

These record low yields are an indication that investors much prefer the safety of bonds over stocks. We feel this safety is misplaced. Government bond yields have little room to fall further, thereby limiting their capital appreciation potential (when yields fall, prices rise), and the interest they are paying is paltry. Further, a rise in interest rates would be detrimental to government bond prices. We feel there are better opportunities elsewhere, notably corporate bonds. And in particular, U.S. banks.

The manager of our Income Fund, Connor, Clark & Lunn, believes that select bonds issued by large U.S. financial institutions offer compelling value. This is a contrarian view as negative sentiment still overhangs the U.S. financial sector, but many banks are in much better financial shape than they were a few years ago. They have recapitalized their balance sheets and restructured their housing exposures. Further, CC&L has a more positive outlook for the U.S. housing market as there are increasing indications that the sector has bottomed. While the manager doesn’t expect a rapid recovery, they feel the downside is limited and certain companies are well positioned to benefit from stabilization in the housing market. More specifically, they have increased the portfolio’s holdings in bonds issued by Citigroup and Bank of America (all foreign currency exposure is hedged).

Higher interest payments and yields are one attractive aspect of these bonds – they offer yields that are currently 2½ – 3% higher than 10-year U.S. Treasuries. Another benefit is that the manager believes their prices will be correlated (positively) to interest rate movements, which will help protect the portfolio in a rising rate environment, yet still provide a higher income stream until such an occurrence materializes.

The high yield sector is another area where CC&L is seeing value. The manager is finding opportunities in bonds issued by financial and consumer-related businesses as well as real estate investment trusts (REITs). Their focus is on businesses that are in a sound financial position and are producing strong operating results and growing their earnings. Examples include Great West Life, Hertz and Norbord (a producer of engineered wood-based panels used in the construction industry).

We’ve been advising clients for a while to be light on bonds in relation to their strategic asset mix, as we feel stocks are more attractively valued. That said, we don’t dislike all bonds. Corporate and high yield securities are our friends. This is reflected in the positioning of our Income Fund.

Tags: Bank Of America, Bond Prices, Bond Yields, Canadian, Canadian Market, Capital Appreciation, Connor Clark, Contrarian View, Corporate Bonds, Currency Exposure, Financial Shape, Foreign Currency, Government Bond, Government Bonds, Government Of Canada, Negative Sentiment, Q2 Report, Rapid Recovery, Steadyhand, Time Lows, Treasury Yields, U S Treasury
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Rethinking Asset Allocation (PIMCO)

Wednesday, July 18th, 2012

by Curtis Mewbourne, PIMCO

• Asset classes are likely to be affected by the situation in Europe and, more broadly, by high debt levels in developed countries. The related political debate about austerity vs. growth is also critical.
• Fixed income investors should note whether countries control their own currencies and can monetize their debts. Those that can may be greater inflation risks. Those that cannot may be greater credit risks.
• These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes.
• We encourage investors to broaden their opportunity sets, for example, looking more closely at emerging market government bonds. They also may consider assets such as real estate and commodities, which may partially replace traditional domestic equities.

Navigating the global landscape these days is tough. Macro risks range from uncertainty about the future of Europe to mixed messages about the U.S. economy – not to mention a host of concerns about indebtedness, policy and politics.

In the following interview, portfolio manager Curtis Mewbourne discusses how investors can approach asset allocation in such an environment and over the longer term.

Q: What are the most critical factors likely to affect asset classes over the next three to five years?
Mewbourne: Investors need to monitor the situation in Europe, whether they are directly invested there or not, because of the systemic implications of a potential shock to Europe’s banking system or sovereign debt. The eurozone has the second largest economy and the largest banking system in the world, and the slowdown that we are already seeing in emerging market growth is partially driven by slower demand for goods and services from Europe.

More broadly, asset classes are likely to be affected by high debt levels in Japan, the U.S. and other developed countries as well as the related political debate about the trade-off between austerity and growth. Unemployment levels remain elevated in many countries, partly as a result of austerity measures.

These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes. For example, European equity markets in some cases are at the lowest levels in years, and, as a result, investors may be questioning the notion that European equities provide reasonable returns above inflation – a key point for pension-fund managers and other investors.

Similarly, the low policy interest rates that central banks are implementing around the globe contribute to government bonds in several countries trading at very low levels. These low yields create an asymmetric return profile: There is not much room for further price appreciation, while concerns about possible future inflation could lead to significant volatility and price declines. For fixed income investors, it is critical to understand whether bonds have credit risk, inflation risk or both. Countries with their own currencies have more flexibility to print money and monetize their debts, and hence typically have more inflation risk and less credit risk. Countries that do not have the ability to print their own currencies have the opposite. This largely explains the divergence between Europe and the U.S./U.K./Japan in terms of government bond yields and knock-on effects on risk premium valuations.

Put simply, nominal government bonds and traditional equity investments, at least in the case of Europe, have not performed in the way that investors have expected and likely may not perform according to textbook expectations going forward.

Q: Will we see more convergence – or divergence – in the behavior of asset classes?
Mewbourne: It depends on which asset classes we are talking about, but there are a few high level themes that are relevant to understanding how asset classes may behave. Very high global debt levels and unconventional monetary policies mean that balance sheets are more levered and the global economy is more vulnerable to policy changes. Under such conditions it is likely that certain macro factors, such as policy changes, will affect many asset classes in roughly the same way at the same time. Over the past few years, we have seen periods of heightened correlations between regional markets as well as between previously uncorrelated asset classes.

This is not set in stone. In some cases capital will move from one area to another, or fundamental economic differences will lead to divergence of asset classes. We have seen that recently in currency markets where there has been a large shift away from emerging market currencies and into the U.S. dollar.

Q: PIMCO has talked about the emergence of credit risk in the sovereign market. How will this affect portfolio construction?
Mewbourne: As I was saying before, fixed income is an asset class that has become quite different from textbook explanations. For example, five to seven years ago it was a reasonable decision for a European citizen saving for her child’s education to invest in government bonds, counting on a low probability of principal loss, little volatility and a modest return. Fast forward to today, and government bonds in many European countries have behaved quite differently than expected. The clearest example is the loss of principal on the restructuring of Greek bonds; but also prices of other European sovereign bonds suggest higher probabilities of potential losses. In all, the expected volatility, risk and returns on such bonds have changed, and therefore they likely play a different role in investors’ portfolios.

This shift is a challenge for certain institutional investors, such as insurance companies and some banks, whose business models or regulatory requirements require high-quality bonds with low probability of principal loss and low volatility.

Q: Staying with the topic of risk, what are some other risk factors investors should be managing, and how should they go about doing so?
Mewbourne: Investors need to think about the potential loss of principal on bonds of overly leveraged countries and companies. They also need to think about the loss of purchasing power from inflation as a result of central banks pursuing very low interest rates. When interest rates are lower than inflation, the resulting negative real yields eat away at investors’ purchasing power.

Given the issues that we have discussed, the time they need to spend thinking about and focusing on political risks has increased significantly, and they need to increase significantly their efforts in understanding and factoring such risks into their investment decisions.

Q: Let’s talk about opportunities: Are there new or emerging opportunities that investors should be thinking about? And can you offer some insights into alternative ways for investors to capture these opportunities?
Mewbourne: Markets are still healing from the major financial dislocation of 2008 and 2009 and, in a sense, the recovery creates opportunities in many areas for investors to identify and take advantage of attractive risk-adjusted returns. This requires a very active focus, as those opportunities can be in sectors that have become more credit sensitive and require more resources to review.

For example, in the non-agency mortgage market in the U.S., investors need to understand the underlying loans, a process that can take considerable time and knowledge but also lead to some very good opportunities.

Another example is the U.S. municipal bond market. That asset class has become much more credit sensitive and requires much more credit focus, but investors can really benefit from rolling up their sleeves and doing their credit research.

Also, the heightened market volatility that we expect in the years ahead can lead to greater risks but also opportunities during periods in which investors look to exit the same strategies at the same time. Given the geopolitical landscape, we expect overshoots in currency and commodity markets to result in buying opportunities.

Q: Ultimately, what are the key things investors should be thinking about or doing in their portfolios, considering PIMCO’s secular outlook?
Mewbourne: As risk and return characteristics transform, our view is that investors need to transform the way they think about using asset classes. We encourage them to broaden to the greatest degree possible their opportunity sets, for example, looking at emerging market government bonds as a replacement for some more traditional developed market government bonds.

Developed market government bonds have become riskier in some respects, and emerging market bonds are becoming less risky, and in cases where they pay a higher rate than inflation, they may be less risky both in terms of credit risk and the risk of purchasing power erosion.

We also encourage investors to broaden the type of financial instruments they consider. While they need to appreciate the risks of different instruments, they may benefit from investments in areas such as real estate and commodities as part of overall portfolio construction, and those areas can replace some of the roles that traditional domestic equities have played in the past both in terms of expected returns and volatility.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.

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 or are suitable for all investors 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 opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes. 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.

Tags: Asset Allocation, Asset Classes, Austerity, Banking System, Critical Factors, Debt Levels, Domestic Equities, Emerging Market, Eurozone, Global Landscape, Government Bonds, Indebtedness, Inflation Risks, Investor Expectations, Market Volatility, Mixed Messages, Other Developed Countries, PIMCO, Political Debate, Portfolio Manager, Sovereign Debt
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What if the Fed Throws a QE3 and Nobody Comes? (Hussman)

Monday, July 9th, 2012

The financial markets were largely unresponsive to news of further easing by the European Central Bank, the Bank of England, and the People’s Bank of China last week. Notably, Spanish bonds plunged, while German short-term government bonds now yield -0.17%, indicating growing concern about sovereign default risk in the Euro area. Every few days will undoubtedly bring word of new “agreements” and “mechanisms” – arcane enough to mask their futility – that promise to solve the European crisis. The headwinds remain very strong. The key distinction here remains liquidity versus solvency. There is little doubt that liquidity will be provided at every opportunity, though the continual degrading of collateral standards by the ECB suggests that all the good collateral has been pledged already. More importantly, with a global recession visibly unfolding, solvency risk will only increase.

The odds remain against European countries agreeing to the surrender their national sovereignty to the extent needed to create a “fiscal union” and enable massive and endless transfers of public resources from stronger to weaker European countries. Barring a catastrophe severe enough to either prompt European countries to hand fiscal control to a central administrator, or to prompt Germany to agree to unconditional bailouts, the least disruptive move would be for Germany and a handful of stronger countries to leave the Euro first, and allow the remaining members to inflate as they wish.

With regard to the economy, I noted two weeks ago that the leading evidence pointed to a further weakening in employment, with an abrupt dropoff in industrial production and new orders. Mike Shedlock reviews the litany of awful figures we’ve seen since then, focusing on the new orders component of global purchasing managers indices: U.S. manufacturing new orders and export orders plunging from expansion to contraction, Eurozone new export orders plunging (only orders from Greece fell at a faster rate than those of Germany), and an accelerating decline in new orders in both China and Japan.

Recall that the NBER often looks for “a well-defined peak or trough in real sales or industrial production” to help determine the specific peak or trough date of an expansion or recession. From that standpoint, the sharp and abrupt decline we’re seeing in new orders is a short-leading precursor of output. As the chart below of global output suggests, I continue to believe that we have reached the point that delineates an expansion from a new recession.

On the employment front, Friday’s disappointing report of 80,000 jobs created in June may be looked on longingly within a few months, as we continue to expect the employment figures to turn negative shortly. That said, it remains important to focus on the joint action of numerous data points, rather than choosing a single figure as an acid test. I noted last week in Enter, the Blindside Recession, GDP and employment figures are subject to substantial revision. Lakshman Achuthan at ECRI has observed the first real-time negative GDP print is often seen two quarters after a recession starts. Earlier data is often subsequently revised negative. As for the June employment figures, the internals provided by the household survey were more dismal than the headline number. The net source of job growth was the 16-19 year-old cohort (even after seasonal adjustment that corrects for normal summer hiring). Employment among workers over 20 years of age actually fell, with a 136,000 plunge in the 25-54 year-old cohort offset by gains in the number of workers over the age of 55. Among those counted as employed, 277,000 workers shifted to the classification “Part-time for economic reasons: slack work or business conditions.”

What if the Fed throws a QE3 and nobody comes?

To date, the stock market has largely shrugged off the evidence of oncoming recession, in the confidence that the Federal Reserve will easily prevent that outcome and defend the market from any material losses. On that point, it is helpful to remember that the real economic effects of Fed actions in recent years have been limited to short-lived bursts of pent-up demand over a quarter or two. Not surprisingly, as interest rates are already low, and risk-premiums on more aggressive assets are already remarkably thin, the impact of quantitative easing around the globe continues to show evidence of diminishing returns.

With the help of some preliminary work from Nautilus Capital, the following charts present the market gains, in percent, that followed versions of quantitative easing by the Federal Reserve, the European Central Bank, and the Bank of England on their respective stock markets (measured by the S&P 500, the Dow Jones EuroStoxx Index, and the FTSE Composite, respectively). In order to give QE the greatest benefit of the doubt and account for any “announcement effects,” the advances in each chart are based on the 3-month, 6-month, 1-year and 2-year gains in each index following the initiation of the intervention, plus any amount of gain enjoyed by the market from its lowest point in the 2 months preceding the actual intervention. The effects of most interventions would look weaker without that boost.

Remember that quantitative easing “works” through central bank hoarding of long-duration government bonds, paid for by flooding the financial markets with currency and reserves that essentially bear no interest. As a result, investors in aggregate have more zero-interest cash, and feel forced to reach for yield and speculative gains in more aggressive assets. Of course, in equilibrium, somebody has to hold the cash until it is actually retired (in aggregate, “sideline” cash can’t and doesn’t “go” anywhere). Increasing the quantity simply forces yield discomfort on more and more individuals. The process of bidding up speculative assets ends when holders of zero-interest cash are indifferent between continuing to hold that cash versus holding some other security. In short, the objective of QE is to force risky assets to be priced so richly that they closely compete with zero-interest cash.

Understanding this dynamic, it follows that QE will have its greatest impact on financial markets when interest rates and risk-premiums have spiked higher. If interest rates are low already, and risky assets are already priced to achieve weak long-term returns (we estimate that the S&P 500 is likely to achieve total returns of less than 4.8% over the coming decade), there is not nearly as much room for QE to produce a speculative run. Leave aside the question of why this is considered an appropriate policy objective in the first place, given the extraordinarily weak sensitivity of GDP growth to market fluctuations. The key point is this – QE is effective in supporting stock prices and driving risk-premiums down, but only once they are already elevated. As a result, when we look around the globe, we find that the impact of QE is rarely much greater than the market decline that preceded it.

To illustrate, each of the Fed, ECB and BOE quantitative easing interventions since 2008 are presented below as a timeline. The shaded area shows the amount of market gain that would be required to recover the peak-to-trough drawdown experienced by the corresponding stock index (S&P for Fed interventions, EuroStoxx for ECB interventions, FTSE for BOE interventions) in the 6-month period preceding the quantitative easing operation. The lines plot the 3-month, 6-month, 1-year and 2-year market gain following each intervention, adding any gain from the low of the preceding 2 months, to account for any “announcement effects.” Technically, the lines should not be connected, since they represent the gains following distinct actions of different central banks, but connecting the points shows the clear trend toward less and less effective interventions, with the most recent interventions being flops. Notice also that central banks have typically initiated QE interventions only when the market had somewhere in the area of 18% or more of ground to make up.

Of all the experiments with QE, the round of QE2 from late-2010 to mid-2011 was most effective, in that stocks recovered their prior 6-month peak, and even some additional ground. Yet even with QE2, the Twist and its recent extension, as well as liquidity operations such as dollar swaps and so forth, the S&P 500 is again below its April 2011 peak, and was within 5% of its April 2010 peak just a month ago (April 2010 is a particularly important reference for us, since that is that last point that the ensemble methods we presently use would have had a significantly constructive market exposure). The largely sideways churn since April 2010 reflects repeated interventions to pull a fundamentally fragile economy from the brink of recession, and recessionary pressures are stronger today than they were in either 2010 or 2011. Investors seem to be putting an enormous amount of faith in a policy that does little but help stocks recover the losses of the prior 6 month period, with scant evidence of any durable effects on the real economy.

In short, the effect of quantitative easing has diminished substantially since 2009, when risk-premiums were elevated and amenable to being pressed significantly lower. At present, risk-premiums are thin, and the S&P 500 has retreated very little from its April 2012 peak. My impression is that QE3 would (will) be unable to pluck the U.S. out of an unfolding global recession, and that even the ability to provoke a speculative advance in risky assets will be dependent on those assets first declining substantially in value.

Our economic problems run far deeper than what can be healed by more reckless bubble-blowing by the Federal Reserve. At the center of global economic turmoil is a mountain of bad debt that was extended on easy terms by weakly regulated lenders with a government safety net. Global leaders have done all they can to protect the lenders at the expense of the public – to make good on the bond contracts of mismanaged financial institutions by breaking the social contracts with their own citizens. The limit of this unprincipled madness is being reached.

The way out is to restructure bad debt instead of rescuing it. Particularly in Europe, this will require numerous financial institutions to go into receivership, where stock will be wiped out, unsecured bonds will experience losses, senior bondholders will get a haircut on the value of their obligations, and loan balances will be written down. Bank depositors, meanwhile, will not lose a dime, except in countries where the sovereign is also at risk of default. Even there, depositors will probably not lose any more than they would if they held sovereign debt directly. In the U.S., the pressing need continues to be mortgage restructuring, and an emerging recession is likely to bring that issue back to the forefront, as roughly one-third of U.S. mortgages exceed the value of the home itself.

Liquidity does not produce solvency. Bailouts from one insolvent entity to another insolvent entity do not produce solvency. Efforts to stimulate growth will not produce solvency if a large fraction of the economy is overburdened with debt obligations that cannot be repaid. What will produce solvency is debt restructuring. The best hope is that global leaders will recognize the necessity and move ahead with debt restructuring in an orderly way, particularly in the European banking system. The worst nightmare is that global leaders will deny the necessity and belatedly discover that they have squandered the last opportunity to avoid a disorderly finale.

Market Climate

A quick note on performance – as we’ve noted since the inception of Strategic Growth Fund in 2000, our investment horizon is specifically focused on the complete bull-bear market cycle, measured from bull-market peak to bull-market peak, or bear-market trough to bear-market trough. My view that stocks have entered a new bear market makes it reasonable to examine the most recent cycle, measured from the bull market peak of October 9, 2007 (on the basis of total-return) to the recent peak on April 2, 2012.

During the 2000-2007 peak-to-peak cycle, Strategic Growth outperformed the S&P 500 by a cumulative margin of 119.79% vs. 20.70% (11.46% vs. 2.62% on an annual basis). During the 2002-2009 trough-to-trough cycle, Strategic Growth outperformed the S&P 500 by a cumulative margin of 37.95% to -1.25% (5.10% vs. -0.19% on an annual basis). As I observed in numerous annual reports, that full-cycle performance margin was “as intended” – neither extraordinary nor disappointing from the standpoint of our long-term expectations.

In contrast, the most recent peak-to-peak cycle from 2007 to 2012 was challenging. For most investors, everything went wrong in the downturn and then everything went right in the recovery. For us, everything went reasonably as expected during the downturn, but my insistence on making our methods robust even to Depression-era data led to a significant “miss” of the market’s recovery in 2009 and early 2010 that will not be repeated in future cycles even under identical conditions and evidence. Largely as a result of that miss, Strategic Growth lagged the S&P 500 during the most recent cycle, by a cumulative margin of -12.91% vs. 0.08% (-3.01% vs. 0.02% on an annual basis). The Funds page includes full historical performance data on all of the Funds, as well as annual reports and other information.

In every cycle, Strategic Growth has experienced just a fraction of the downside experienced by the S&P 500 (-6.98 vs. -47.41% for the S&P 500 in the 2000-2007 cycle; -21.45% vs. -55.25% for the S&P 500 in the 2002-2009 cycle). I recognize that nobody can feed a family with reduced downside. It does, however, make it far easier to recover from difficult periods. The most recent market cycle was an outlier on nearly every basis that investors can imagine. It was – and I am confident it will remain – an outlier from the standpoint of our own full-cycle performance as well.

As a side note, from the presumptive bull market peak on April 2, 2012 through Friday of last week, the S&P 500 is down -3.95%, while Strategic Growth is down -0.78%. Needless to say, if the recent bull market establishes a new high, some of the above calculations will change. The essential point remains that our “two data sets” challenge in 2009 through early 2010 more than accounts for the cumulative performance shortfall of less than 13% between Strategic Growth and the S&P 500 in this cycle, and the methods we brought to bear on that problem leave us well prepared for a very wide range of market outcomes in the cycles ahead. We’ll go forward from here.

As of last week, our estimates of prospective market return/risk in stocks remained in the most negative 0.5% of historical observations. We’ve examined a range of possible outcomes that could produce a shift in our investment stance. While a further advance would moderately take the “edge” off of our present defensive stance, we also estimate that a fairly small advance would also re-establish an overvalued, overbought, overbullish condition that would weigh on any material risk-taking. So the greatest amount of latitude to accept market risk would be from substantially lower levels. Of course, that’s the most likely point at which another round of QE would be initiated as well. As usual, our willingness to expand our exposure to market risk will remain focused on observable measures, not on some untestable faith-factor. For now, we remain tightly defensive. Strategic Growth remains fully hedged, with a staggered strike hedge (just over 1.5% of assets being committed to raising our put option strikes), Strategic International remains fully hedged, Strategic Dividend Value is hedged close to 50% of its stock holdings (its most defensive stance), and Strategic Total Return has a duration of about one year, just over 10% of assets in precious metals shares, and a few percent of assets in utilities and foreign currencies.

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Tags: Bank Of China, Bank Of England, Central Administrator, Default Risk, ECB, European Countries, Export Orders, Fiscal Control, Global Recession, Government Bonds, Growing Concern, Headwinds, Hussman, Litany, Mike Shedlock, National Sovereignty, Public Resources, Purchasing Managers, Qe3, Solvency
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The Plight of the Conservative Retiree (Nairne)

Friday, July 6th, 2012

The Plight of the Conservative Retiree

Only a few short years ago, investors demanded a 5.0% yield to invest in AAA rated US Treasuries. Those days are a distant memory. As illustrated below, the yield of Treasuriesi, now AA rated, plummeted to a miniscule .87% at the end of May. Market historians have to go back to World War II when rates were set by the joint agreement of the Federal Reserve and the Treasury Department to find rates so low.

There are a number of reasons behind this precipitous fall. Worldwide there is a growing scarcity of “safe” government bonds as runaway sovereign debt reduces the number of top rated issuers. It is easy to forget that the bonds of both Italy and Spain were once rated triple A by Moody’s. The ultra-low interest rate policy of the Federal Reserve as well as quantitative easing has been a critical factor. Heightened demand has also played a role. Since 2007, US investors have poured nearly a trillion dollars into bond funds, a pace over four times greater than the previous four years.

Today’s extraordinarily low rates on top of a lower equity premium leave conservative retirees with the risk of heightened capital depletion as poorer portfolio returns may be inadequate to offset the combined impact of withdrawals and inflation.

To illustrate the crucial significance of this issue, we analyzed a conservative balanced portfolio of $1,000,000 comprised of 60% US long-term government bonds and 40% US large company stocks. We assumed annual inflation-adjusted withdrawals are made equivalent to 4% of the starting portfolio value for a 30 year period – in other words, an inflation-adjusted annual income of $40,000 for three decades.

To establish a baseline, we initially analyzed this portfolio using historic returns and inflation (as detailed in Appendix I) and the 4% withdrawal rate. We ran 5000 simulationsii to calculate the expected real value of the portfolio. The following graph Illustrates the expected real value (in 000’s of $) of the portfolio over the next 30 years at different levels of probability – the 5th, 25th, 50th, 75th and 95h percentiles. All numbers are inflation-adjusted in 2012 dollars.

As shown above, an investor withdrawing an inflation-adjusted $40,000 annually has a median expected real portfolio value (i.e. at the 50th percentile in yellow) of $1,281,000 at the end of 30 years. In approximately 50% of future scenarios, they can expect their portfolio to fund their lifestyle and maintain its real value. Even at the 25th percentile (in light green), they never face the issue of capital depletion with an expected real portfolio of $559,000 at the end of three decades. Only at the 5th percentile (in blue) do they eventually deplete their portfolio and even here this does not occur until year 28. Roughly speaking, in this historically based example there is only about a 1 in 20 chance of an investor outliving their capital in the next three decades.

Unfortunately, given current bond yields and stock valuation levels, we believe that neither bonds nor equities offer the prospect of expected returns near historic rates. We therefore ran 5000 simulations using expected annual returns of 2.7% for bonds and 7.0% for stocks (see Appendix II for more details). The following graph Illustrates the expected real value of the same portfolio (in 000’s of $) over the next 30 years based on the 4% withdrawal at various levels of probability.

As illustrated above, there is a dramatic rise in the likelihood of capital depletion compared to the historic case. The probability of maintaining the portfolio’s real value at $1,000,000 is now at the 75th percentile instead of the 50th percentile. Capital depletion now occurs at the 25th percentile in the 30th year. In effect, the chance that an investor in this portfolio will outlive their capital over 30 years has risen to about 1 in 4 – dramatically higher than the historic odds of 1 in 20.

Investors are rightly concerned with today’s magnified economic uncertainty and market volatility. Conservative investors nearing or in retirement have a much greater challenge – unless they have a plan that accounts for today’s lower yields and expected returns, they may unknowingly exchange safety today for peril tomorrow.

Disclosure

Tacita Capital Inc. (“Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Footnotes:
i The Barclays US Treasury Bond Index reflects the public obligations of the US Treasury with a remaining maturity of one year or more.
ii Morningstar Encorr was used to provide the historic return and inflation information and to model and simulate the hypothesized portfolio. Long-term bond and large company stock returns are from the Ibbotson series.

Tags: Balanced Portfolio, Bond Funds, Company Stocks, Critical Factor, Distant Memory, Few Short Years, Government Bonds, Interest Rate Policy, Plight, Portfolio Returns, Portfolio Value, Precipitous Fall, Scarcity, Sovereign Debt, Three Decades, Treasuries, Treasury Department, Withdrawal Rate, Withdrawals, World War Ii
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What Went Down in Europe (Last Thursday Night) per Der Spiegel

Monday, July 2nd, 2012

I always wish to be a fly on the wall in these meetings just to see how things chronologically played out, so this piece by Der Spiegel is quite fascinating to me.  Read on if you want to see how Italy and Spain broke Germany; it appears Monti was the pivotal man last night.

Monti’s uprising began at 7:00 p.m. on Thursday evening. That was when European Council President Herman Van Rompuy wanted to conclude the summit’s first working session and announce the growth pact to the press. According to participants, Monti was furious and asked Van Rompuy where he was going. Had the president perhaps not understand correctly, Monti reportedly asked. The Italian prime minister said he could not leave the summit without concrete measures to fight the high interest rates on Italian government bonds. He would not agree to the growth pact until that issue had been clarified. Rajoy lent his support to Monti and said that he too could not yet approve the pact.

The threats apparently made an impact on the other delegates. Danish Prime Minister Helle Thorning-Schmidt asked pointedly whether the attendees were now all hostages. Van Rompuy remained seated. It was only after 10 p.m. that he made another attempt to appear before the press. Merkel urged him to announce an agreement on the growth pact. French President François Hollande, however, told him to tell “the truth.”

At 10:30 p.m. Van Rompuy appeared in the press room and announced an “interim status.” In principle there were no objections to the growth pact, he said, but two countries were not yet able to agree on it.

After midnight, when the blockade had still not been resolved, representatives of the 10 non-euro EU members headed back to their hotels. Leaders of the 17 euro-zone countries remained in their seats and began a decisive round of negotiations. At this point, members of the German delegation were still insisting they would not give up their hardline position.

A few hours later, however, Monti and Rajoy had the chancellor where they wanted her. She agreed that countries would in the future be able to receive funds from the ESM without having to submit to troika oversight. Instead, only the European Commission’s annual targets will have to be met. Monti said that Italy would not ask the ESM for help. For now, he only wanted to send a signal to the financial markets in order to take the pressure off Italy.

The session ended at 4:20 a.m. on Friday morning. Ten minutes later, Van Rompuy and European Commission President José Manuel Barroso announced the breakthrough at a press conference. At 5:00 a.m., Monti, the winner of the evening, appeared at the Council building’s exit. He gave a press conference on the way to the car — and announced that he will travel to the European Championship football final in Kiev on Sunday.

Tags: Concrete Measures, Council President, Danish Prime Minister, Der Spiegel, Euro Zone, Fly On The Wall, Francois Hollande, French President, German Delegation, Government Bonds, Growth Pact, Helle Thorning Schmidt, Herman Van Rompuy, High Interest Rates, Interim Status, Italian Government, Italian Prime Minister, Last Thursday, Point Members, Spiegel
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Welcome Back (Kotter or Otherwise)

Tuesday, May 29th, 2012

U.S. investors return from the long weekend to find futures up and shell games continuing across the pond.   What has been interesting during almost the entire month of May is despite a market that has stunk during normal hours, a lot of buying by ‘someone’ has been happening in the thinly trading futures market.  This has led to a lot of frustration for those seeking a bottom who wish to find a ‘wash out morning’ which can never happen with that persistent bid.   Anyhow, looking back at a chart I posted late last week not much changed Thursday and Friday, nor will today barring a massive rally.

The S&P 500 has yet to claim even a 38.2% retracement (Fibonacci talk) of the drop from recent peaks, which would be near 1340.  This appears to be an area those of a bearish bent are waiting to make their stand.   So the chart is a few days old but the roadmap is not any different.  Until (if and when) we get nearer to 1340 we remain in the white noise area, waiting for more interesting levels to surface.  Very oversold conditions are being worked off, and a ‘bear flag’ appears to be forming.   The longer the market stays under this 1340-1350 level the more bearish it would appear to be.  That said, massive central bank intervention – which can be announced at any second of any day – makes all charts moot points.

Over in Europe some of the news is getting downright silly.  Greece is recapitalizing their banks with … what money?  Spain is trying to get around collateral rules by proposing a shell game that would have made a major Las Vegas magician act proud.

• Spain may recapitalize Bankia with Spanish government bonds in return for shares in the bank which last week asked for rescue funding of 19 billion euros ($24 billion), a government source said on Sunday.  Bankia could use the sovereign paper as collateral to get cash from the European Central Bank, forcing the ECB to get involved with restructuring Spain’s banking sector.
• “The biggest problem here is that the ECB could object. That’s a legal issue, but technically it is possible,” said Jose Carlos Diez, economist at Intermoney Valores.

Whatever the shell game, the key is Spanish yields are approaching mid 6%s, which means the market is not buying the shells.  So why are futures up? Who knows – fatigue, hopes for intervention, technical reasons, QE3 announcement in 3 weeks, Chinese easing sooner rather than later, etc etc.  We are not seeing any glee in the U.S. bond market or currency which are the more important tells.  One could argue the U.S. dollar has indeed become parabolic – which is a bit scary.

Back in the U.S. some economic news will provide a “respite” from Europe – mainly Thursday and Friday with the ADP employment data/Chicago PMI (Thu) and monthly jobs data/ISM manufacturing (Fri).  Chinese PMI also will be released, but at this point one does not know whether to root for bad (more intervention!) or good.

Bottom line, keep an eye on the bond and currencies market – the equity markets seem a sideshow for now as we play out the latest iteration of “waiting for intervention”.   That said, a reminder than any +1.7% move on substantial volume this week would trigger an IBD “Follow Through Day” as it would come in the 4 to 10 day window from last Monday’s “Day 1″ of a rally attempt.

Tags: Banking Sector, Bear Flag, Central Bank Intervention, Collateral, ECB, Few Days, Frustration, Futures Market, Government Bonds, Government Source, Magician, Massive Rally, Restructuring, Roadmap, Shell Game, Shell Games, Spanish Government, Trading Futures, Welcome Back Kotter, White Noise
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David Rosenberg: “Despair Begets Hope”

Sunday, May 20th, 2012

Presenting the best weekly self-contrarian segment from everyone’s favorite Gluskin Sheff-based skeptic – David Rosenberg:

DESPAIR BEGETS HOPE

… Over half of the 2012 price advance has been reversed in barely over a month as the broad market drifts down to its lowest level since February 2nd. The Financial Times makes the point that the 10-day relative strength index at 29.2 is deeply into oversold territory. The Canadian TSX index is officially in bear market terrain, having declined 21% from its cycle high (posted in April last year) and is back to levels prevailing on October 2011.

Fading risk appetite is also underscored in the credit markets where BB-rated corporate spreads have widened to 450 basis points from the recent low of 420bps. Until we see some resolution to the latest round of euro area angst, one can reasonably expect spreads to widen further, but we would look at this as a nice buying opportunity as the link between the problems there and corporate default rates here is extremely loose. The fact that gold and other commodities are slipping while core government bond markets — gilts, bunds and Treasuries — are rallying strongly suggests that deflation risks are getting repriced into various asset classes. Greek bonds are trading at pennies right now and implicit probabilities in peripheral bond markets are highly discounting exits from the monetary union by year-end. Spanish bond yields have blown through 6% (Italy getting closer too) and 10-year spreads off Germany have hit a new record high of 485bps.

This is where the LTRO has proven to have actually been a dismal failure. Domestic banks used the program as a carry trade to play the yield curve and are now choking on losses on the sovereign government bonds they were enticed to buy. So thanks a lot, Mr. Draghi — ECB policies are at least partly responsible for why it is that euro area bank shares have sunk all the way back to March 2009 lows. Non-domestic investors have been dumping the peripheral government bonds just as the Italian and Spanish banks have been loading up — these foreign entities, we see in the FT, have been net sellers of Italian government bonds to the tune of 200 billion euros in the past nine months and 80 billion of Spanish debt over the same time frame. And guess what? They can unleash even more supply damage because they still own roughly 800 billion euros worth of combined bonds of both basket-case countries.

The most bizarre quote we have seen in quite a while came from a strategist in the FT. Get this:

We can take comfort from the fact that while the Greek electorate are against austerity, the support for staying within the eurozone is even stronger”.

I can replace that with this real-life comment:

We can take comfort from the fact that while my three sons are against doing their homework, the support for getting a passing grade is even stronger”.

How utterly lame.

If the Greeks want to stay in the eurozone, it’s probably because they know they can continue to suck at the teat of the Troika. More bailouts please and on easy terms since “austerity” is the new dirty nine-letter word globally.

The best lines actually came from the FT Lex column:

“All balled-out eurozone countries will ultimately have to decide whether they can make the fiscal adjustments and achieve economic growth more quickly in, or outside, the euro. That is where Greece now finds itself.”

Now that is a thoughtful comment.

There was another really good zinger in the Markets and Investing section. To wit:

“it’s naïve in the extreme to think you can limit the knock-on effect. As soon as Greece leaves or defaults, contagion will pass like a cannon going off in Spain”.

That was from an executive at a U.K. bank.

Arvind Subramanian penned a truly brilliant piece in the FT as well, titled Why Greece’s Exit Could Become the Eurozone’s Envy. In a nutshell, Greece’s challenge is that it is woefully uncompetitive and as such needs wages and prices to adjust sharply lower. You either do that organically or you devalue the currency — which then sharply boosts exports and fosters import substitution. Of course, the initial impact is recessionary and deflationary, but only for one to two years, if history is a guide, followed by a boom. This is exactly what happened to Asia a decade ago. As Arvind concludes, “the ongoing Greek tragedy could yet turn out not too badly for the Greeks. But tragedy it might well be for the eurozone and perhaps the European project”.

Indeed, the cost estimates I have seen published for the euro area would be in the neighbourhood of 400 billion euros — in terms of immediate direct financial losses. Second round impacts are far more difficult to assess, but would be enormous. While there are a myriad of legal complexities surrounding a Greek departure, it is not an impossible task. The bigger issue would be how the ECB would manage to ring-fence the banks in Portugal and Spain and prevent a contagion.

But let’s talk about what we do know with some certainty.

The Greeks voted against the status quo. It isn’t working for them. An election is likely around mid-June, and the party in the lead is dead-set against the initial bailout terms. The government, meanwhile, runs out of cash by early August when a bond payment comes due and that could well be the trigger for default and exit. It is tough to see this process being orderly — confusion, turmoil and volatility all come to mind. But if we do get a cathartic event, we will be able to buy assets for our client base at excellent prices. There always is a silver lining. You just have to find it.

We also know that Angela Merkel this far is not being swayed by her party’s recent electoral setbacks — at least that is the indication we are getting from her latest rhetoric.

Tags: Bond Yields, Broad Market, Bunds, Carry Trade, Credit Markets, David Rosenberg, Default Rates, Dismal Failure, Domestic Banks, Domestic Investors, Draghi, Financial Times, Gilts, Government Bond Markets, Government Bonds, Greek Bonds, Relative Strength Index, Risk Appetite, Sovereign Government, Yield Curve
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