Friday, April 5th, 2013
As the fast-money flabber-mouths stare admiringly at the rise in nominal prices of Japanese (and the rest of the world ex-China) stock prices amid soaring sales of wheelbarrows following Kuroda’s ‘shock-and-awe’ last night, it is Kyle Bass who brings these surrealists back to earth with some cold-hard-facting. Out of the gate Bass explains the massive significance of what the Japanese are embarking on, “they are essentially doubling the monetary base by the end of 2014.”
It is a “Giant Experiment,” he warns, but when you are backed into a corner and your debts are north of 20 times your government tax revenue, “you’re already insolvent.” Simply put, Bass says they have to do something and they have to something big because they are “about to implode under the weight of their debt.” For a sense of the scale of the BoJ’s ‘experimentation’, Bass sums it up perfectly (and concerningly), “the BoJ is monetizing at a rate around 75% of the Fed on an economy that is one-third the size of the US!”
What they are trying to do is devalue the currency to attempt to become more competitive while holding their rates market flat – the economic zealots running the world’s central banks believe they can live in that Nirvana – and Bass believes that is not the case, as they will lose control of rates, since leaving the zone of insolvency is impossible now. His advice, “if you’re Japanese, spend! or take it out of your country. If you’re not, borrow in JPY and invest in productive assets.” Do not be long JPY or Japanese assets as he concludes with the reality of Japan’s “hollowed out” manufacturing industry and why USDJPY is less important that KRWJPY.
Saturday, August 18th, 2012
Submitted by Alex Gloy of Lighthouse Investment Management,
Some of my clients like to challenge my (admittedly gloomy) views, forcing me to think – which isn’t such a bad thing to do.
It started off with Cam Hui’s “A Dalio explanation of Evans-Pritchard’s dilemma“. After laying down his strategy on winning the game of Monopoly, Dalio goes on to model the economy onto the board game. So far so good.
Then, Dalio is quoted in a Barron’s interview, describing the current phase of the U.S. deleveraging experience as “beautiful”. He goes on to explain the three options for reducing debt: austerity, restructuring and printing money.
“A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.”
That sounds pretty good and makes sense. Or does it?
- I think Mr. Dalio would not be too upset if we labeled him a “Keynesian” (believing the government has to step in where private sector spending falls short).
- You could respond that it was Keynesian policies which brought us to the current situation in the first place (to which Keynesians will respond that their policies did not work out because there was not enough spending. Which is like saying “the kid is not behaving because you didn’t hit it hard enough“).
- Furthermore, how is the government sector on a different “planet” than the household sector? In the end, isn’t government debt (and hence fiscal deficits) supported and borne by taxpayers (read: household sector)? No sovereign entity in the world would be able to issue debt unless backed by taxpayers (or, for that matter, gold).
- As governments incur additional debt it is actually taxpayers’ future income that is on the block (as tax rates will have to go up to pay for additional debt service burden). Leverage is simply being shifted around. Oh, and for that time-shift argument (“tax receipts will have increased by the time the debt comes due”) – I believe it when I see it. There has been not a single country which has paid back its debt incurred under the fiat money system.
- If the future rate of inflation is below the interest rate paid on additional government debt, the net present value of deficit spending is negative (we are neglecting the argument over whether government can spend efficiently or not).
- Interest rates at issuance are fixed (exception: floaters). The decision whether to run fiscal deficits boils down to the following question: will future inflation exceed the interest paid (in order to devalue debt faster than accrued interest)?
- This makes the success of Keynesian policies dependent on elevated inflation. Governments are motivated, in a perverse way, to work towards reducing the value of money.
- This is in contradiction of central bankers’ (presumed) goal of preserving the function of money as a store of value, setting them up for a clash with governments (assuming they are not in cahoots anyways).
- However, there is no known case of a government successfully printing its way out of excessive debt (while there are plenty of examples for the opposite).
- It’s a lose-lose-situation: Should the government succeed in creating inflation, (1) financially prudent savers are punished, (2) low-income families are hurt (as they have no means to invest in assets benefiting from inflation) and (3) debt service costs are likely to increase as existing debt matures and needs to be rolled over.
- Should the government not succeed in creating inflation, future consumption will be burdened by additional taxes, lowering future growth and making excessive debt unsustainable.
- Will printing money “compensate” for money destroyed by debt write-offs? Turned the other way ’round, was money ever “un-printed” to compensate for money created from fractional banking and/or increased levels of debt?
- Cullen Roche of Pragmatic Capitalism states “QE [quantitative easing] doesn’t do much – it’s the great monetary non-event” (“Why QE is not working”).
- In the comments section of above article Cullen points out that
“It is flawed economic thinking to target nominal wealth. Stock prices are not real wealth until realized gains are taken. More importantly, stocks are based on the underlying value of the assets they represent. Pushing stock prices up does not make the companies more profitable. So hoping that people will spend more of their current income because of a false price appreciation in the market is a misguided policy.”
- So let’s take a look at Mr. Dalio’s “beautiful deleveraging”. Here’s US debt by sector:
- Households are de-leveraging; so are financial corporations.
- This happens at the expense of the government sector, which continues to lever up.
- Total debt (government + households + corporations) is actually higher (by $800bn) than when the “beautiful deleveraging” began.
- Peak debt-to-GDP has been reached in Q1 2009 for households, financial and non-financial corporations.
- Since then (latest data Q1 2012), households have de-levered by 11%-points of GDP (or $654bn).
- Non-financial corporations reduced debt by 3%-points (or $406bn).
- Financial corporations, however, de-levered by a stunning 33%-points (or $3,375bn).
- The flip-side of this: Federal debt-to-GDP increased by 27%-points (or $4,030bn).
- While the household sector has done “it’s thing” it usually does during recessions (de-lever), it become clear who the main beneficiary of additional government debt is: the financial sector.
Looking at quarterly changes in sector debt visualizes it nicely:
- Mr. Dalio and his firm (Bridgewater Associates, the world’s biggest hedge fund) are part of this financial sector. No wonder he describes this kind of deleveraging as “beautiful”.
- Mr. Dalio, who, according to a recent Bloomberg story (Connecticut offers millions to aid Bridgewater expansion), “was paid $3.9bn in 2011? is taking all kinds of tax breaks / “forgivable loans” to be lured to move from Connecticut to… Connecticut (at least UBS and RBS moved to the state when receiving tax breaks).
- I have walked through the waterfront area of Stamford. A lot of low-income families, often minorities, living in simple homes. The city is building new, expensive apartments for the new, well-paid arrivals, gentrifying the area.
- From Bloomberg:
“If the region [Fairfield county] were a country, it would be the world’s 12th-most unequal in terms of income, ranking just below Guatemala.”
- As for debt write-downs, this Zerohedge post speaks for itself: Deleveraging needed in next 4 years: $28 trillion
While Mr. Dalio’s narrative reads well, it doesn’t stand up to common sense. Unfortunately there is lingering suspicion his views on government spending are a mere ploy to advocate for transferring even more debt from “his” sector onto taxpayers, while at the same time transferring taxpayers’ money to his firm via tax breaks.
Tags: Austerity, Barron, Board Game, Current Situation, Dalio, Debt Restructuring, Evans Pritchard, Fiscal Deficits, Government Debt, Government Sector, Household Sector, Incomes, Investment Management, Keynesian Policies, Keynesians, Lighthouse, Monopoly, Printing Money, Reducing Debt, Sovereign Entity, Winning The Game
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Wednesday, August 8th, 2012
Every now and then we prefer to sit back and let some of the smartest money speak, especially when said smart money agrees with us. In this case, we hand the podium over to none other than Paul Singer’s Elliott Management, which after starting with $1.3 million in 1977 was at $19.8 billion most recently. No expert networks, no high frequency trading, no “information arbitrage”, no crony capitalism and pseudo monopolies of scale, and most certainly no bailouts: Singer did it all the old fashioned way: by picking undervalued assets and watching them appreciate. The timing is opportune because while Elliott has much to say about virtually everything in their latest 20 pages Q2 letter, it is the billionaire’s sentiment vis-a-vis US Treasury debt that may be most critical, and may be the catalyst that resulted in today’s abysmal 10 Year bond auction. To wit: “long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward.” There is little that can be misinterpreted in the bolded statement. And while many have taken the other side of the Fed over the past 3 years, few have dared to stand against Paul Singer because if there is one person whose opinion matters above most, certainly above that of the Chairsatan, it is his.
More deep thoughts from Elliott:
On QE and the nanny state:
- Printing money and overstaffing government offices may look like growth for a period of time, but it is actually the road to poverty, corruption and, ultimately, political upheaval.
- Opaque, overleveraged and vulnerable Financial Institutions which need to be propped up by the implicit or explicit guarantee of sovereigns does not make for a solid financial plumbing system for the global economy…this is a formula for power entrenchment, favoritism and shady deals behind closed doors.
- Not only will it fail to make the system safer, but we believe it will likely be an actual accelerant of the next financial crisis
- Dodd-Frank was supposed to “fix” the American financial system and end “too big to fail.” Unfortunately, the law, born in a political steamroller, does the exact opposite: it will be the accelerant of the next crisis.
- The 2008 crisis was episodic and took a while to get rolling. The next one could well be a black hole, and Dodd-Frank will bear responsibility for that.
On why Americans are angry:
- The government, lacking deep understanding of these firms, wants to pretend that their gigantic efforts (most notably Dodd-Frank) actually fixed the situation. But we believe that citizens are angry at what their guts tell them (correctly, basically) about the special treatment and riskiness of Financial Institutions.
On public data reporting:
- Decades ago, the balance sheets of the Financial Institutions contained most of the information you needed to know to understand their risks. Today the picture is profoundly different, predominantly due to the growth of leverage through derivatives….As a result, there is no major Financial Institution today whose financial statements provide a meaningful clue about the risks of the firm’s entire panoply of assets and liabilities including derivatives, nor how the firm’s performance, or even survival, will be affected by market movements in the future.
- Including derivatives, nearly all the world’s largest Financial Institutions are levered 50-100 times (not 10-20 as reflected on their balance sheets), so the exact composition of their derivatives books is essential to an understanding of their risks and stability….no hedge fund is remotely as leveraged as the Financial Institutions, and no hedge fund actually had to be rescued during the crisis.
On European banks:
- European institutions are in worse shape than before. Not only is their leverage (including derivatives) still at pre-crash levels, but they are choking on vast holdings of questionable sovereign debt which regulators more or less forced on them with lenient risk-weightings.
- These banks are stuffed with paper that private investors would not buy, as part of the “three-card Monte” shuffle that characterizes the European banking/sovereign system today.
On “peak fragility” in the bond and stock market:
- People are still buying bonds despite pitifully low yields because, well, they continue to go up in price, albeit in a self-reinforcing process goosed by central bank and momentum buying. When these forces exhaust themselves, the reversal could and should be swift and large.
- A decade ago, stocks were overpriced, but institutions who owned them were generally happy… Stocks looked predictable and safe at the very moment that they were maximally unsafe. That is where long-term bonds of these four currency blocs (euro, U.S., U.K. and Japan) now stand.
- “Safe haven” could be the two most expensive and painful words for investors in the financial lexicon this year.
On market sentiment:
- Global financial markets currently feel like they are in a period of calm before a storm, possibly centered on the European situation. The problem is that no one can foresee when the storm will make landfall, or how severe it will be.
On why Europe is making one wrong decision after another:
- Raising taxes to confiscatory levels (75% top rates are absurd and self-defeating), lowering already-too-low retirement ages, making it hard or impossible to fire people (which obviously discourages hiring them in the first place), increasing the scope of regulation and making it more complicated and subject to greater discretion by hostile, inadequately informed regulators, and making threatening noises at every turn about “the rich”, are the precise opposite of the actions and statements that policymakers should make to attract businesses and encourage expansions of existing businesses.
- Nobody is forced to locate a business in Europe, and in fact capital flight today from several countries is already large and relentless.
On the future of Europe:
- Since all of the euro bloc surprises in the last couple of years have been negative, and since the answer to every question about the ultimate cost of preserving the euro is “more than you thought yesterday,” the metaphor of a slow-motion train wreck seems quite appropriate.
- The overall situation is not going sideways or up. It is drifting down.
On Socialists – in this case in France, but applicable everywhere:
- The Socialists are unlikely to be terribly successful at preventing the destruction of jobs, but they may be all too effective, however unintentionally, at stifling job creation.
On tax policy:
- Dramatic increases in taxes and regulation, together with a repeatedly punitive tone, are understandably extrapolated by capitalists and investors as indicators of hostility toward business and profits. The societal loss from the business decisions occasioned by such signals is self-reinforcing. Businesspeople sitting on their hands leads to lower growth and more angry rhetoric and hostile actions by government.
On the lack of job creation:
- Since the top 20% of taxpayers (which includes a great number of people making less than billions and even millions) pay the overwhelming bulk of taxes, this promise to raise taxes has not exactly generated enthusiasm or jobs.
On US (small) business uncertainty:
- Under ACA and the scheduled rise in overall federal income tax rates, one of the largest aggregate tax increases in American history is scheduled for five months from now. This is occurring at the same time that several strapped large states are also raising their top tax brackets.
On shifts in paradigms:
- Businessmen are inherently optimistic, typically always looking for reasons to do business, expand and innovate.
- Historical experience shows that when established perceptions are wrong, it can take a long time for contradictory data points to accumulate before such perceptions start to adjust and to cause alterations of behavior. However, at a certain moment, shifts in perceptions and trends could be abrupt, especially given modern tools of instant communication.
- Today the hostility of the American and European governments to private enterprise, wealth and profits is used by those governments as vote-buying tactics. The impact on growth and jobs is already visible, and capital flight (already seemingly underway in France) may accelerate unless the policies, and tone, change.
On the US welfare state:
- If [Social Security, Medicare, Medicaid and government pensions] are not reformed, such entitlements simply cannot be paid as promised, regardless of the levels of future growth or taxes on “the rich” or anyone else.
- The numbers are just too big, the result of a form of corruption: politicians made big promises in exchange for votes, not worrying about whether the promises could be fulfilled.
On the US “recovery”
- Three and a half years after the bust, the massive spending, guarantees and money printing have left America with 8.2% unemployment (which vastly understates the actual level, since millions of people have simply left the workforce, while others have migrated from receiving unemployment benefits to getting long-term disability payments), sluggish growth, $5 trillion in additional federal debt, and $3 trillion of freshly-printed dollars on the Fed’s balance sheet. This is not a success. This is a national tragedy, in a society in which the world’s greatest engine of prosperity has historically been fueled by innovation, optimism, entrepreneurship, flexibility and opportunity.
On Congress handing over the decisionmaking process to the Fed:
- We believe that relying on monetary authorities to pick up the considerable slack in growth by printing money by the boatload is completely wrongheaded. It distorts both the price of money and the risks of holding long-term claims denominated in paper money, builds a future risk of large inflation, supports economic activity only in an oblique and unfair way, and creates something that is going to be very hard to unwind.
On the consequences of the printing money “alchemy”:
- Somehow many policymakers and citizens have come to believe that money printing is some kind of magical process, that good things can be produced literally out of thin air, and that if leaders don’t create growth from obviously-needed changes in wrongheaded policies, then poof!… printing more money will solve it. This is pathetic.
- The range of inevitable costs to societies practicing such alchemy is somewhere between “a lot” and “utterly catastrophic.” The damage is already becoming evident, particularly in the distortion between the rise in financial asset prices and the sluggishness of the real economy. When consumer prices soar across the board or there are other painful consequences, we wonder what excuses the blameworthy policymakers will make to deny their responsibility.
Finally, on what nobody wants to discuss, but could very easily be the final outcome:
- A loss of confidence in paper money could result in searing and startling inflation, evaporating life savings and turning every stolid worker into a frantic speculator.
- If that were to occur, nobody could possibly say in hindsight that the conditions for such a sorry state of affairs were not in place.
- The people who are telling us now that inflation is impossible because there is slack in the global economy, and that central banks can print trillions of dollars more without a significant risk of inflation, are the same folks who not only failed to predict the financial crisis, they did not even have a clue that a crisis of such kind was possible.
Indeed the “smartest money” is just that because it calls it how it is.
Tags: 10 Year Treasury, Arbitrage, asset class, Billionaire, Bond Auction, Crony Capitalism, Deep Thoughts, Expert Networks, Financial Institutions, Government Debt, Government Offices, Monopolies, Nanny State, Paul Singer, Political Upheaval, Printing Money, Qe, Smart Money, Sovereigns, State Printing
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Monday, July 30th, 2012
by John Hussman, Hussman Funds
The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?
Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.
Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate of productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.
Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.
With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over – will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.
For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l’Allemagne et l’Italie sont d’accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”
In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.
In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.
What worries me most
Investors sometimes ask what I worry about most from the perspective of our investment strategy. Do I worry that the Fed will initiate another round of QE and distort the markets to such an extent and duration that our approach will not capture new realities? Do I worry that government interventions have created a world where old economic rules and relationships no longer apply? Do I worry about the quality of government statistics or the potential for misreporting or seasonal adjustment distortions in the data we use? The answer is that all of these issues can exert a short-run influence on the course of our investment approach, but none of them alter the relationship between valuations and long-term returns, and I don’t expect any of them to significantly reduce the effectiveness of our strategy over the complete market cycle.
As I noted as the market approached its highs a few months ago, what I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market – not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss. Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000-early 2001, 2007-early 2008, and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.
Certainly, for our shareholders in Strategic Growth Fund, I’ve compounded this impatience, because our “miss” in 2009-early 2010 – which I would not expect to be repeated in future cycles even under identical conditions – blends in with our defensiveness since early-2010, which aside from a few differences related to option positions, I would expect to be repeated in future cycles under identical conditions. The result is one long period of defensiveness, which understandably leaves those unfamiliar with that 2009-early 2010 period with the assumption that our approach will never be constructive.
I view these weekly comments as something of a conversation with shareholders, so I do my best to address questions that come up more than once or twice in a short period of time. In Strategic Growth Fund, understanding performance in recent years is one of those questions, so I ask the indulgence of shareholders who have walked through this discussion before, and I hope that the comments are useful even for those that have. Thanks.
Let’s first address the period since early 2010. Given the policy of central banks in recent years to provide what amount to free put options to investors, there are certainly ways we could have saved a few percent in actual put option premium (incorporated in our present methods as added criteria related to trend-following measures). But the fact is that the S&P 500 Index was within 5% of its April 2010 peak only a few weeks ago, and there remains a strong risk that the market will move significantly below that level in the months ahead. From a historical standpoint, the conditions we’ve seen since early-2010 have warranted a generally defensive position, and the negatives have accelerated significantly in recent months. We would expect to adopt a similarly defensive position again in future cycles under the same conditions. The only way to get around that would to be to take actions that would have produced significant losses if they were taken regularly on a historical basis.
Unfortunately, the warranted and repeatable defensiveness we’ve adopted since 2010 blends in with a non-recurring intervention during 2009-early 2010 (which I discussed regularly during that period) to ensure that our hedging approach was robust to Depression-era data.
Recall that this intervention was not driven by any problem with the performance of our investment approach. Indeed, by the beginning of 2009, a dollar invested in Strategic Growth Fund at its inception in 2000 had grown to about four times the value of the same investment in the S&P 500 Index. The Fund was ahead of the S&P 500 at every standard and non-standard investment horizon, with dramatically smaller losses. For example, from the 2007 stock market peak, the S&P 500 Index had suffered a peak-to-trough loss of 55.25%, while the deepest loss experienced by Strategic Growth Fund was 21.45%. To put that difference in perspective, note that simply moving from a 55.25% loss to a 21.45% loss requires an offsetting recovery of 75.53%. It takes extraordinary good fortune to recover from deep drawdowns, which is why we make such an effort to avoid them.
Still, as the credit crisis worsened in 2009, it became clear that both the economy and the financial markets were behaving in ways that were “out of sample” from the standpoint of the post-war data on which our existing return/risk estimates were based. That kind of situation demands stress-testing; a concept that too few investors take seriously until it’s too late. I took our existing approach to Depression-era data and found that though it performed reasonably well over the full period from a return perspective, it also allowed a number of very deep interim losses before recovering. Even though our approach had performed well, a Depression-like outcome could not be ruled out (and to some degree still can’t), so I insisted that our methods should be robust to “holdout” data from both the Depression era and the post-war period. I discussed that challenge repeatedly in the weekly comments and annual reports as our “two data sets” problem. We reached a satisfactory solution in 2010 through the introduction of ensemble methods in our hedging approach. But by that point, we had also missed a significant market rebound.
The result has been my elevation to the title of Permabear, Doomsayer, and other lovely aliases. It’s kind of tragic that I both lessened my reputation and missed returns for shareholders – though I expect only temporarily – because of what I viewed (and continue to view) as fiduciary duty. At least shareholders can be sure that I’ll never knowingly lead them down a rabbit hole. While we have – apart from the most recent cycle – been successful in strongly outperforming the market over complete cycles (bull-peak to bull-peak, bear-trough to bear-trough) with substantially smaller drawdowns, it’s important to recognize that we do have a much greater tolerance for tracking differences versus the S&P 500 over the course of the market cycle than some investors can accept. Our investment approach is simply not appropriate for those investors. Significant tracking differences will occur again and again over time, because they are inherent in our approach, particularly in the richly-valued portion of a given market cycle.
Meanwhile, I’m confident that that our stress-testing miss during the most recent cycle (which works out to a cumulative lag of just under 13% over the peak-to-peak market cycle from 2007-2012) is something we can more than offset in future cycles. Also, given our willingness to remove the majority of our hedges in early 2003 at valuations that were in no way compelling from a historical standpoint, it should be clear that we don’t require Armageddon to adopt a constructive or even aggressive investment stance.
So what do I worry about? I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard, and misallocation of resources that monetary authorities have encouraged. I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.
Our measures of prospective stock market return/risk deteriorated slightly last week, from the most negative 0.8% of market history, to the most negative 0.6%. These are minor distinctions, of course, but it is important to emphasize how rare and negative present conditions are from a historical standpoint. I recognize that many analysts consider stocks to be cheap on the basis of “forward operating earnings,” but I continue to believe that the 50-70% elevation in profit margins relative to historical norms is an artifact of extreme deficit spending and depressed savings rates, and that as a U.S. recession unfolds, profit margins and forward earnings estimates will collapse. This is currently seen as heresy (as was my assertion just before the tech-collapse that technology earnings would turn out to be cyclical), but that’s how earnings and profit margins work.
Looking out anywhere from 2 weeks to 18 months, our measures remain very defensive, with the worst horizon being about 7 months out. Additional firming in market action from here would modestly improve our near-term measures of prospective return (which are more dependent on trend-following factors), but would generate little improvement beyond a horizon of several weeks. Meanwhile, our estimate of prospective 10-year S&P 500 total returns (nominal) is now only 4.7%. This figure may seem appealing relative to a 1.5% yield on 10-year Treasury bonds, but as I’ve noted before, you don’t “lock in” a long-term return on an investment; you ride it out over time. My expectation is that this ride will be extremely uncomfortable for passive buy-and-hold investors over the coming decade, and that there will be numerous opportunities to accept both stock and bond market risk at substantially higher prospective returns.
Strategic Growth and Strategic International remain tightly hedged, Strategic Dividend Value remains hedged at about half of the value of its holdings – its most defensive stance, and Strategic Total Return continues to carry a duration of about one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.
Tags: Austerity, Bad Debt, Brink, Corporate Profits, Debt Reduction, Draghi, Economic Growth, Economic History, Economic Problem, Economic Recessions, Evidence To The Contrary, Financial Institutions, Financial Markets, Fluctuations, Full Force, Government Debt, Hussman, Hussman Funds, John Hussman, Public Debt, Receivership
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Sunday, July 15th, 2012
by Sober Look
Would you pay Denmark’s government 0.6% to hold your money for two years? Sounds strange, but that’s exactly what investors are now doing. Denmark’s government paper yields just hit new lows. And it’s not only the short-term bills with the negative yield (short term bills sometimes go negative when investors seek immediate liquidity). The 2 and 3-year notes are now also comfortably in the negative territory as Eurozone’s investors simply can’t get enough.
Denmark’s 2 and 3-year government yields
Why do the Eurozone investors love Demark’s bonds so much that they are willing to lock in negative yields for 2-3 years? Here are 3 key reasons:
1. Eurozone based investors are not taking much FX risk because Denmark keeps EUR-DKK exchange rate tightly pegged.
DKK per 1 euro
2. Investors love Denmark’s economic fundamentals, particularly the relatively low government debt and deficit.
3. Keeping funds outside the Eurozone may provide a hedge against potential problems associated with the monetary union’s stability.
Bloomberg/BW: – If the euro crisis worsens, foreign capital may keep pouring in, negative rates or no. Says Ian Stannard, chief European currency strategist at Morgan Stanley in London: “For an international investor with euro zone exposure, buying Danish assets can be a hedge against the extreme scenario of the euro breaking up.”
Tags: Bloomberg, Bw 3, Currency Strategist, Demark, Dkk Exchange Rate, Economic Fundamentals, Euro Zone, Extreme Scenario, Government Debt, Government Paper, International Investor, Key Reasons, liquidity, Lows, Monetary Union, Morgan Stanley, Negative Territory, Stannard, Term Bills, Zone Exposure
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Sunday, May 13th, 2012
Looking to China to Fire Up its Economy
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
Following on the heels of renewed concern over Europe’s debt situation, China released its monthly economic data. Fixed asset investment, industrial production and retail sales all rose in April, yet growth was not as strong as analysts anticipated. “Weak” is the word to describe China’s April figures, says CLSA’s Andy Rothman in his Sinology Report.
While data were lower than expected, they weren’t disastrous, says Andy. According to CEBM Group, slower growth was the government’s intention. China wants the ability to manage a “stable decline” to “promote medium-to-long-term structural reforms” as well as avoid a hard landing, says CEBM.
Because they weren’t devastating results for the country, more fine-tuning, rather than a major stimulus plan, is likely to come from this emerging market if growth continues to stall. “The government should move forward to introduce accommodative policies stabilizing economic growth,” says CEBM.
Easing policy for China is only a matter of willingness. Unlike the developed countries of the West that have overworked their printing presses and are now strapped with a tremendous burden of debt, China is in good shape. According to BCA Research, the country’s overall gross debt is only 42 percent of GDP, significantly lower than all of the G-7 countries which have the most debt of the countries listed below. Of the E-7 countries, only Indonesia and Russia have less government debt compared to GDP.
To offset the country’s liabilities, BCA says China also has “a massive net asset position,” including owning interests in publicly listed firms, large companies and the country’s land mass. According to BCA, if you look at only state-owned enterprises, the net assets are nearly “as large as the total public (local and central combined) debt.” By these stats alone, it appears the emerging country does not have a solvency issue.
However, rather than serious stimulus, CLSA anticipates that China will make a move to ensure its two primary goals are met, which include new loan growth as well as M2-money supply growth of about 14 percent. Andy says, to accomplish these goals, the government will likely boost its spending on infrastructure and low-income housing, ease restrictions on new home purchases by first-time buyers, and offer more credit to the private sector.
We believe government policy is a precursor to change, and when China feels the need to fire up its fiscal or monetary firepower, we believe the flow of money will send Chinese stocks—along with commodities—higher.
CEBM notes an interesting correlation between the A-Share market and economic growth, which points to a possible improvement. The research firm compares today’s economy with what we saw in late 2008. While the data is not as ominous and the government has grown comfortable with slower growth today, there is still a resemblance to the situation in 2008, where the market rebound led improved economic growth by four months. CEBM believes it may be seeing the same signs of bottoming of the market today, and if the 2008 trend holds, economic growth should now be in the bottoming process.
Fine-Tuning Your Portfolio to Potentially Benefit
As economic data is released over the next few months, China will be keeping a close eye to determine when to open the spigots. Before this happens, we believe investors should position their portfolios to potentially benefit. Here are two ways:
1. Invest in emerging markets companies and commodity equities. Emerging markets continue to offer the most potential for growth, and as you see below, over the past five years, as the Shanghai Composite Index rose, the S&P Global Natural Resources Index soon followed.
2. Get “paid to wait” with dividends. This week, investors fled any asset that was perceived as risky, including stocks of any country and commodities, including gold, in favor of “safe” government Treasuries. The 10-year note on U.S. Treasuries fell to 1.85 percent, which is lower than the dividend yield on numerous stocks. Currently, the annualized dividend rates on the S&P Global Natural Resources, MSCI Emerging Markets and the S&P 500 indices are nearly 2.9 percent, 2.8 percent, and 2.1 percent, respectively, all higher than a 10-year investment. Along with steady income provided by dividends, these stocks offer potential appreciation on your capital.
On May 14, I’ll be presenting at the Hard Assets Conference in New York, sharing more investing insights about China, commodities and how to apply Super S-Curves in a portfolio. I’ll be in good company, as Pam Aden, Adrian Day, Ian McAvity, Jay Taylor and Gregory Weldon will be presenting as well. I hope to share some of their thoughts as well as my takeaways in the coming weeks.
Tags: Asset Investment, Asset Position, Chief Investment Officer, Clsa, Debt Situation, Developed Countries, Economic Data, Emerging Market, Frank Holmes, Good Shape, Government Debt, Gross Debt, Land Mass, Net Assets, Printing Presses, Retail Sales, Rothman, State Owned Enterprises, Stimulus Plan, U S Global Investors
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Sunday, April 22nd, 2012
April 20, 2012
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 discuss the upcoming FOMC meeting and what we’re expecting, Moody’s downgrade of GE, the growing divide in the municipal bond market, and strategies to help investors build a diversified bond portfolio.
The Fed’s Next Move?
“If everything seems under control, you’re not going fast enough”—Mario Andretti. If you’re an investor, you might hope that policy makers in the developed world would heed the wisdom of Mario Andretti. After a burst of confidence in the first quarter, when things appeared to be running smoothly, the markets have re-focused on the challenge of trying to reduce government debt in the absence of economic growth. Here in the U.S., the next opportunity bond investors will get to observe shifts in policy will be the Federal Reserve’s next meeting on April 24-25th. The Fed may feel reasonably confident that they’re “in control,” but it seems less likely to us that they’ll feel we’re going “fast enough.”
- We don’t expect any change in policy at the Fed’s April 24-25th meeting. But the market will be scrutinizing the Fed’s economic projections for hints about further quantitative easing, the end of Operation Twist and the length of the Fed’s commitment to low interest rates. At the January FOMC meeting, the committee made the historic decision to publish forecasts on rates and economic measures from the 17 committee members, along with the “central tendency” (i.e. where the bulk of the projections reside.) It’s the range that we’ll be watching most closely for signs of shifting expectations.
- Projections for GDP growth are likely to indicate a moderate, but not exceptional, growth rate. The range is likely to remain in the 2.5% to 3.0% range, in our view. Based on the January projections, the range of forecasts for GDP wasn’t very wide, though there was a wider range of views on inflation and unemployment. Positive growth is encouraging, of course, but the pace of growth remains sub-par compared to a more robust recovery.
- The unemployment rate has already fallen to the low end of the Fed’s range, based on the January projections. Therefore, it seems reasonable to anticipate that range will be lowered from the 8.2% to 8.5% projections published in January. FOMC members appear to disagree on the reasons for the recent path of unemployment. Fed Chairman Ben Bernanke and the more “dovish” Fed members (meaning, they favor lower rates and more accommodative monetary policy) suggest that the drop in unemployment is largely due to discouraged workers dropping out of the labor force. In contrast, some more “hawkish” members (those who tend to lean toward a tighter monetary bias) believe that unemployment is high due to a structural mismatch of skills with job openings. It’s no surprise to report that the Bernanke “dovish” camp is still driving policy.
- On inflation, the views also diverge between the hawks and doves. The January Fed report showed a wide dispersion of projections for the deflator for personal consumption expenditures (PCE, one of the Fed’s preferred inflation measures) between 1.3% and 2.8% for 2012. The central tendency narrowed to 1.4% to 1.8%, but clearly this is where there is some disagreement on the outlook. The more dovish Bernanke camp, expecting lower inflation, will hold sway here (in our view) as well, until data showing higher prices driven by increased lending and/or wage growth clearly changes.
- We don’t expect that the Fed will hint at or announce further quantitative easing. GDP appears to be growing at 2% to 2.5% rate or higher, unemployment is falling and core inflation is holding near the 2% level. Lending growth is improving, pointing to a more stable banking sector and adequate liquidity in the financial system. Returns from each round of easing appear to be diminishing. However, we also expect that Bernanke will leave the possibility of QE3 (i.e. a third round of bond buying from the Fed designed to help keep interest rates low) on the table. He has consistently said that the Fed is prepared to do more if economic conditions warrant it.
- What would warrant more action by the Fed? We’re encouraged by stronger signs from the U.S. economy, as well as efforts to stabilize the European credit crisis. But two risks we worry about are the upcoming fiscal tightening that may happen in 2012—the so-called “fiscal cliff”—as well as a worsening of the European debt crisis.
- On fiscal stimulus. Bush-era tax cuts are set to expire, automatic spending cuts are set to trigger and stimulus programs are winding down. Cuts to stimulus alone even with an extension of tax cuts will likely be a drag on the U.S. economy in the short-term. The effect of this is estimated to be in the vicinity of 3% of GDP by many economists.
- On Europe. If European sovereign debt problems threaten to spread over to the U.S. banking sector and affect U.S. growth, the Fed may be pushed to respond with some form of monetary stimulus.
- Bottom line. While we don’t expect an official policy change at the upcoming FOMC meeting, the release of a new set of economic expectations, if they vary greatly from the last projections in January, could be a market moving event. For bond investors, there’s nothing to indicate to us that the tilt won’t remain toward accommodative rate policy until 2013 and beyond until there’s rate of change in growth speeds up.
Central Tendency of Fed Forecasts—January 2012
Source: Federal Reserve, January 25, 2012. Numbers in the table are year-over-year percentage change for real GDP, PCE inflation, and core inflation.
Moody’s Downgrade of GE
While it may not have been a major news event to most market watchers, Moody’s downgraded the debt ratings for General Electric Company (GE) to Aa3 along with the rating on its wholly-owned financial subsidiary, GE Capital Corporation (GECC), to A1. GE was once one of the seemingly ‘untouchable’ Aaa/AAA-rated industrial corporations, so the changes aren’t insignificant. In Moody’s view, GE still has “many AAA-like credit characteristics.” But their view also reflects the “heightened risk profile inherent to finance companies like GECC,” they say, a significant part of GE’s operations. The broader takeaway to us is not so much a comment on GE specifically. We are not making a company-specific comment or investment recommendation. It’s more about the inherent sensitivity of lending and financial companies to smoothly functioning financial markets as well as access to money when they need it.
- The credit crisis continues to reveal the risks in market funded financial institutions, a risk that rating agencies and markets strive to understand. Moody’s indicated that the GE downgrade was a reflection of risk stemming from its financial arm, GECC. While the downgrade isn’t good news for investors, it’s not a major surprise. On March 19, Moody’s revised its global rating methodology for financial institutions and warned that others may be downgraded as well, some, potentially, by several rating notches. Their views, they say, reflect ongoing market and structural developments as well as insights gained from the recent global credit crisis and 2007-2009 recession.
- “During the credit crisis, [credit] markets were unreliable for even the strongest issuers.” While oversight has improved, the sensitivity of banks and financial firms to market conditions is still a fundamental part of the business model of finance firms. Financial institutions, including GECC, involve risks associated with a “high reliance on confidence sensitive funding,” even though, in Moody’s view, GECC is “one of the strongest finance companies in the world.” Even with its fundamental strengths, and connection to General Electric, GECC still “relies on the capital markets” to fund its portfolios.
- For investors, be careful about credit quality and too much exposure to a single sector or security. Most banks and financial institutions have taken steps to build capital and strengthen reserves. Regulatory scrutiny, including Dodd-Frank and the Volker rule, are seeking to put rules in place to manage and limit risk. Other banks continue to deal with legacy issues from the financial crisis. Still, this is an area to be wary of lower-rated issuers and investing based on higher yields only.
- We divide corporates broadly into financial institutions, industrials and utilities. We’re not committed to the notion that investors should strictly benchmark their exposure to individual bond sectors, such as corporate bonds, to an index or snapshot of the market. But it’s helpful to understand the composition of markets as a whole as a reminder to spread out investments in a way that provides diversification and limits exposure to any single sector alone. The table below shows this market balance, over time, using the widely-followed Barclays US Corporate Bond index.
Composition of the U.S. investment-grade corporate market by sector
Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012.
Financials including banks currently account for roughly 35% of the U.S. investment-grade corporate market, a level that’s fallen from nearly 50% prior to the 2008 credit crisis. Industrials, including conglomerates like GE and a wide range of other non-financial issuers excluding utilities, now accounts for 54%.
- Yields should be higher, in our view, compared to similarly-rated industrials and utilities. This is market pricing in compensation for ratings volatility, the potential for future changes in regulatory policy and methodology from the rating agencies as well as fundamentally leveraged, market-reliant business models. The chart below shows these yield spread over time. Currently, it looks to us that investors are generally being compensated, relative to the risks, if they can stomach some price volatility and diversify adequately against risk in any single issuer. Whether you are receiving adequate compensation for your needs should be an individual decision, depending on your risk tolerance and the role in the rest of your portfolio.
Yield Spread of the U.S. investment-grade corporate market by sector
Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012. Option-adjusted spread (OAS) is the basis point spread relative to Treasuries, net of the cost of any embedded options.
The Growing Divide in Muni Bonds
The direst predictions about muni defaults haven’t materialized. The revenue picture for state and, to a lesser degree, local governments, is stabilizing in our view. Still, municipal governments are caught in the bind of rising social service needs and employment costs and the “age of austerity”—the fundamental need, as well as the political tide, of limited revenue and taxing ability. We think that we’re well into a process of divergence in credit quality in state and local government muni bonds—that is, the division between the vast, silent majority that are managing challenges and the vocal minority who are not. It’s our view that defaults in state and local government bonds will remain isolated events. But issuers have become less homogenous, less interchangeable with each other without investigation or credit analysis.
- We think the top priority for municipal governments will be managing multiple stakeholders and obligations. This is generally the case for the wide range of 50,000+ state and local municipal bodies, whether they’re active bond issuers or not. That’s the reality of a tight revenue climate and a tough balance of employment and healthcare costs, service obligations, and other obligations like employee pensions that have been promised and funded. This is a much tougher task when resources are limited. It’s not a surprise to see debate and headlines focused on these issues. This will be a challenge for the next decade or more, in our view. We’ll likely see more idiosyncratic cases of these pressures leading to distress. For the most part, we expect that that the impact to bondholders will remain isolated, but not zero.
- Stockton, California and others are case studies. What happens, exactly, when a municipality reaches the end of its rope and needs help? We’re finding out, with the widely-publicized examples of Vallejo, CA, Jefferson County, Alabama and now Stockton, CA. As we said, there will be exceptions. And other issuers will watch the cases to see if they’re “successful.” Note: Vallejo, CA is one example that has been widely cited as an example of the enormous expense, and limited benefit, of a municipal bankruptcy filing. The city was able to negotiate very few concessions with stakeholders including unions. And individual bondholders—not the primary source of most of Vallejo’s problems—were largely unaffected.
- Pay close attention to the bonds you buy, and own. There’s more and more information available every day to help with this, thanks to ongoing reforms from municipal security governing bodies such as the Municipal Securities Rulemaking Board (MSRB). The MSRB’s website, EMMA, has links to current municipal bond disclosures. But the consistency and quality of the disclosures is being watched closely by the MSRB and other rule-making authorities. Even with current disclosure, investors must also have some sense of how to use the information they receive. This is still a challenge, given the complexity and idiosyncrasies of municipal credit analysis.
- Few municipalities will broadcast in plain English pending credit stress. Unlike corporations, municipalities aren’t profit-seeking organizations. And they don’t have quarterly reporting requirements, their budget processes can be opaque and they don’t have publicly traded equity as a measure of current and future success. (The flip-side to this, we’d note, is that you’d have to work hard to find a way for a municipal government to shut-down and disappear. This is not the case with corporations where liquidations happen regularly.) As a result, you won’t hear much in plain English about credit risk unless you’re well-trained in reading between the lines and finding the fine line between ordinary business and signs of real stress.
- Outsourcing credit analysis using funds and professional managers is still a good option, for many. Professional managers, whether for funds or managed accounts, can help look for problems, but also provide the variety of individual muni issuers to diversify against idiosyncratic, issuer-specific risk. We don’t expect that we’ll see a widespread shift in defaults, as we’ve said previously. But credit analysis and active monitoring may be increasingly important in the “next phase” for the historically stable, but strained, universe of state and local government bonds.
Diversification and Bond Benchmarks
What’s a good benchmark to build a bond portfolio around, and is it adequate as a starting point in the current market for most investors? The Barclays U.S. Aggregate Bond Index is a commonly-used taxable bond index. Over time, it has become heavily skewed toward government bonds, with very low yields and limited exposure to other sectors. Does this provide enough diversification for most investors focused on a broader range of investments as well as income now?
- The Barclays U.S. Aggregate Bond Index is now dominated by Treasuries and government-backed securities. Since the financial crisis, a concern we have is that the index has a greater proportion in government bonds, including agency-backed securities, many of them mortgage bonds from Ginnie Mae as well as Fannie Mae and Freddie Mac. Both Fannie and Freddie mortgage bonds, a multi-trillion dollar part of the U.S. taxable bond market, are currently supported by the U.S. government. Only about 20% of the index represents corporate bonds. Note: This index does not include tax-exempt muni bonds. Many investors could consider using highly-rated munis, in our view, as the foundation for a core bond portfolio in taxable accounts.
- The index is now more concentrated in one issuer—the Federal government—and has been delivering a lower yield than many clients may want for an income-oriented portfolio. It will be no surprise to most fixed income investors, but the yields on government bonds remain low, with the yield for the Aggregate Bond Index 2.1% as of April 16, 2012. The average maturity of bonds in the index has also become slightly longer, currently at 7 years. This may be longer, with lower yield, than many investors will be comfortable with, even in their core holdings. Keep in mind that the Aggregate Bond index does not incur management fees, costs and expenses and cannot be invested in directly.
- One strategy is to diversify into other sectors of the bond market, subject to need and risk tolerance. We continue to favor credit (i.e. investment-grade corporate bonds) in the current climate, for up to 30% or so of a core bond portfolio, as well as certain types of municipal bonds in taxable accounts. In the current climate, a core portfolio may benefit from “tilts” in credit away from an 80% exposure to Treasuries and government-related mortgage bonds. The key point to us, as always, is diversification and not pushing the boundaries here too far. A “core and explore” strategy, starting with bonds with low credit risk, supported by exposure to intermediate-term corporate and muni bonds using ladders, still makes sense to us for most income-oriented investors in the current climate.
- We also continue to believe that investors can also “expand the core” using mutual funds or exchange-traded funds to build a diversified bond portfolio. For examples of portfolios using funds, clients can log-on to Schwab.com and go to Products, then Portfolio Solutions, and then look for the Schwab PortfoliosTM link. They’ll find an online tool they can use to view a pre-set list of mutual funds allocated according to the risk profile they select. Consider using the list as a starting point, boosting diversification using other funds—such as credit-specific exchange-traded funds (ETFs) or multi-sector and world bond funds—to expand your portfolio.
For additional help or a look at the mix of maturities and credit in your portfolio, talk with your financial consultant or a Schwab Fixed Income Specialist at 800-626-4600.
Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.
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.
Some specialized exchange-traded funds can be subject to additional market risks.
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.
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.
“High yield” securities are subject to greater credit risk, default risk, and liquidity risk.
International investments are subject to additional risks such as currency fluctuation, political instability, differences in financial accounting standards, foreign taxes and regulations and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
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.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the US 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.
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: April 24, Bond Investors, Bond Markets, Bond Portfolio, Central Tendency, Committee Members, Diversified Bond, Economic Growth, Economic Measures, Economic Projections, Federal Reserve, Fixed Income, Fomc Meeting, GDP Growth, Government Debt, Low Interest Rates, Mario Andretti, municipal bond market, Schwab, Strategist
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Wednesday, April 11th, 2012
Chinese Gold Imports From Hong Kong Rise Nearly 13 Fold – PBOC Likely Buying Dip Again
Gold’s London AM fix this morning was USD 1,654.00, EUR 1,261.63, and GBP 1,040.25 per ounce. Yesterday’s AM fix was USD 1,643.75, EUR 1,255.92 and GBP 1,037.72 per ounce.
Silver is trading at $31.66/oz, €24.08/oz and £19.87/oz. Platinum is trading at $1,591.50/oz, palladium at $636.30/oz and rhodium at $1,350/oz.
Gold climbed $17.70 or 1.2% in New York yesterday and closed at $1,659.00/oz. Gold gradually ticked lower in Asian trading prior to tentative gains in Europe and is now trading around $1,655/oz.
Gold’s 1.2% gain yesterday was the largest since March 26 and its four sessions of gains is the longest winning streak in two months.
A positive sign for gold was that US COMEX futures volume was the strongest in a week and gold rose despite a sharp 1.5% drop in the S&P 500 and other equity indices and a large fall in crude oil and grains.
Gold appears to be catching a breather today and is taking a break after the four sessions of consecutive gains driven by safe haven flows on a cloudy global economic outlook.
Gold’s proven safe haven attributes were clearly seen again yesterday as the sharp bout of risk off in international markets saw gold again have an inverse correlation with riskier equity and commodity markets.
Markets continue to digest the very poor US employment number which has led investors to again question the rose tinted view of the US economic ‘recovery’.
The Fed’s beige book will be released at 18.00 GMT. Investors will also watch the European government debt market, after Italian and Spanish debt was met with decreased demand due to shaky euro zone economies and renewed contagion concerns.
Chinese Gold Imports From Hong Kong Rise Nearly 13 Fold – PBOC Likely Buying Dip Again
Chinese gold demand remains very strong as seen in the importation of 40 metric tonnes or nearly 40,000 kilos of gold bullion from Hong Kong alone in February.
Hong Kong’s gold exports to China in February were nearly 13 times higher than the 3,115 kilograms in the same month last year, the data shows.
Shipments were 72,617 kilograms in the first two months, compared with 10,564 kilograms a year ago or nearly a seven fold increase from the record levels seen last year.
China’s appetite for gold remains strong and Chinese demand alone is likely to put a floor under the gold market.
Mainland China bought 39,668 kilograms (39.668 metric tons), up from 32,948 kilograms in January, according to export data from the Census and Statistics Department of the Hong Kong government.
Demand has picked up again after the Lunar New Year and demand has climbed in China as rising incomes and concerns about inflation lead to store of value buying.
There is also a concern about the Chinese stock market which has gone sideways since 2001 (see chart) and increasing concerns that various property markets in China look like bubbles ready to burst.
Consumer demand for gold beat India for the first time in almost three years in the fourth quarter and China may replace India as the biggest buyer annually this year.
The massive gold purchases may signal the People’s Bank of China is continuing to secretly accumulate gold reserves.
Reuters report that there are suspicions that the number could include purchases from the public sector, as the market was largely quiet during a post-Lunar New Year holiday slump in February. “On the public level, China’s central bank will continue to accumulate gold, which is easier than liberalising their capital account and currency,” said Friesen of SocGen, adding that building gold reserves would help China’s push to turn the renminbi into a global currency.
Accommodative monetary policy will remain an incentive for private investors to buy into gold, he added.
The nation last made its reserves known more than two years ago, stating them to be 1,054 tons.
The PBOC’s gold reserves remain small compared to those of the Federal Reserve and many European nations. Their gold reserves remain tiny when compared to their massive foreign exchange reserves of $3.2 Trillion.
It is important to note that in past years, Hong Kong gold imports have accounted for about half of China’s total gold imports. China itself doesn’t publish gold import data and the very high and increasing demand from Hong Kong is only a component of overall Chinese demand.
The per capita consumption of 1.3 billion people continues to increase from a near zero base meaning that this is indeed a paradigm shift and not a blip or ‘flash in the pan’.
It means that gold will likely see record nominal highs – possibly before the end of the year.
Prudent western buyers wishing to protect and grow wealth will again buy gold on the dip as the Chinese are doing.
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(Bloomberg) — China’s Feb. Gold Imports From Hong Kong 39,668 Kilograms
Hong Kong government announced Feb. gold exports data on its website.
(Bloomberg) — Russia’s FinEx Plus Plans Gold Exchange Traded Product This Year
Asset Management Co. FinEx Plus LLC plans to start a gold exchange traded product in Moscow and expand that to other commodities this year.
FinEx is in negotiations with the Micex-RTS exchange in Moscow to list the gold product, said Evgeny Kovalishin, general director. FinEx is partly owned by Andrei Vavilov, Russia’s former first deputy finance minister, according to Kovalishin.
(Bloomberg) — Raw Materials Group Sees Gold Averaging $1,775 an Ounce in 2012
Gold will average $1,775 an ounce this year, 13 percent more than in 2011, Raw Materials Group said in a statement today.
Silver will drop 6.3 percent to an average of $33 an ounce, platinum 1.1 percent less at $1,700 an ounce and palladium 2.9 percent lower at $710 an ounce, RMG said.
Gold pauses after 4-day rally; investors turn cautious – Reuters
Gold futures retreat in electronic trading – MarketWatch
European stocks stage tentative recovery – Financial Times
Sovereign bonds ‘most overvalued asset’ – Financial Times
Was That The Bottom In Gold? – MarketWatch
JPM’s TV Appearance – Silverseek
Spain’s crisis exposes limits of ECB help – Financial Times
Tags: Beige Book, Bloomberg, Comex, Commodity Markets, Contagion, Currency Table, Debt Market, Economic Recovery, Euro Zone, European Government, Global Economic Outlook, Gold Imports, Government Debt, Index 2002, International Markets, Inverse Correlation, Longest Winning Streak, Rhodium, Safe Haven, Share Index
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Sunday, April 1st, 2012
The Economy and Bond Market Radar (April 2, 2012)
Time to Pay the Piper
If you haven’t filed your 2012 federal income taxes yet, the clock is ticking. Beginning Monday, you will only have 11 business days to get them in by the filing deadline of April 17, 2012.
Like many nationwide debates, Americans are nearly split down the middle when it comes to taxes. Recent data from Gallup shows 50 percent of Americans believe federal taxes are too high while 43 percent believe they’re about right. Note: the responses are “about right” and “too high;” I don’t believe there are many in the “should be higher” camp. However, after 11 years of the Bush Tax Cuts, it looks like America’s tax rate structure will shift upwards next year. Five of the six tax brackets will increase with the largest earners paying nearly 40, up from 35 percent currently.
One way investors can offset higher tax rates is through municipal bonds. In general, interest generated from municipal bonds is exempt from all federal income taxes and some state and local taxes (depending on your state).
While municipal bonds carry a greater amount of risk than Treasury bonds, tax advantages and higher yields make them extremely attractive to Treasuries on a relative basis. The yield on government debt is currently in the doldrums just above 3 percent while the yield on the Bond Buyer 40 Index of munis is above 4 percent.
This gap gets even greater when you consider tax exempt income. The tax equivalent yield on a taxable investment (such as U.S. Treasuries) would need to be more than 6.5 percent in order to outpace the muni bond index cited above. This means the yield on U.S. Treasuries needs to roughly double from its current level in order to be attractive to munis on a relative basis.
If you’re one of those investors writing Uncle Sam a big check this year, you should consider adding tax-free bond funds to your portfolio. Explore our Near-Term Tax Free Fund (NEARX) and Tax Free Fund (USUTX). However, investments and tax planning is complicated and each investor’s situation is unique—you should consult a tax advisor to determine whether or not muni bonds are right for you.
This information does not constitute tax advice and is provided for informational purposes only. Please consider speaking with a legal or a tax adviser regarding your individual situation.
- February durable goods orders in the U.S. rose 2.2 percent, bouncing back after a weak January.
- German unemployment fell to 6.7 percent in March and to the lowest level since reunification in 1990.
- Japanese retail sales rose 3.5 percent in February, well ahead of expectations and the best growth since August 2010.
- With rising gas prices lifting inflation concerns and dragging down future expectations, the Consumer Confidence Index fell in March.
- Pending home sales were expected to increase in February but data released this week showed a decline.
- Initial jobless claims edged higher this week but nothing too concerning just yet.
- Bonds have staged a rally the past couple of weeks as investors reassessed the global growth outlook. As long as China is comfortable with slower growth, that trend appears likely to continue.
- Rising oil and gasoline prices combined with liquidity implications of global easing may raise the prospect of reappearance of higher inflation going forward.
Tags: Bond Buyer, Bond Funds, Bond Index, Bond Market, Doldrums, Federal Income Taxes, Federal Taxes, Government Debt, Market Radar, Muni Bond, Municipal Bonds, Munis, Relative Basis, Tax Brackets, Tax Equivalent Yield, Tax Free Bond, Tax Rate Structure, Taxable Investment, Time To Pay The Piper, Treasury Bonds
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Wednesday, March 14th, 2012
In what could prove to be the most critical unintended consequence, [last week] of the ECB’s LTRO program, we note that as of March 2, the ECB has started to make very sizable margin calls on its credit-extensions to counterparties. While the hope was for any and every piece of lowly collateral to be lodged with the ECB in return for freshly printed money to spend on local government debt, perhaps the expectation of a truly virtuous circle of liquidity lifting all boats forever is crashing on the shores of reality. This ‘Deposits Related to Margin Calls’ line item on the ECB’s balance sheet will likely now become the most-watched ‘indicator’ of stress as we note the dramatic acceleration from an average well under EUR200 million to well over EUR17 billion since the LTRO began. The rapid deterioration in collateral asset quality is extremely worrisome (GGBs? European financial sub debt? Papandreou’s Kebab Shop unsecured 2nd lien notes?) as it forces the banks who took the collateralized loans to come up with more ‘precious’ cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets – to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle – especially given the leverage in both the ECB and the already-insolvent banks that took LTRO loans that now back the main Italian, Spanish, and Portuguese sovereign bond markets.
This huge increase in margin calls can only further exacerbate the stigma attached to LTRO-facing banks – and as we noted March 7, (somewhat presciently) both the LTRO-Stigma-trade, that we created, and the potential for MtM losses on the carry-trades that LTRO ‘cash’ was put to work in could indeed start a vicious circle in European financials, just as everyone thought it was safe to dip a toe back in the risk pool.
What should also start to worry the Germans is the fact a 37x levered hedge-fund central bank with EUR3 trillion balance sheet that has extended credit in a ‘risk-managed’ approach on what appears to be an ever dwindling supply of performing collateral is starting to see dramatic ‘gaps’ in its asset-liability exposure (but rest assured Bernanke told us that our FX Swaps are safe as houses).
One last point should be noted – the hopes of an LTRO3 or some such are surely now out of the window as clearly banks have run dry of any and all reasonable collateral or can the sovereign bonds purchased using LTRO1 and LTRO2 funds be lodged once again in a rehypothecated miasma circling the drain?
Since last week, the ECB has increased its margin calls on European banks by EUR162 million this week to another record high of over EUR17.3 billion. While our pointing out of this huge jump from ‘average’ historical margin calls last week was met with – it’s temporary/transitory due to temporary/transitory ineligibility of defaulted (and since undefaulted) Greek bonds (which given the rise this week has now been proven incorrect) or the more prosaic “don’t worry, be happy”, we remain concerned at both the velocity and now sustained size of these margin calls (as clearly collateral quality has dropped rapidly and remained weak). This is concerning since it would appear we had a good week for collateral (risk assets) in general, so we can only imagine what garbage is clogging the ECB’s balance sheet. The side-effect of this appears to be (as we pointed out here) that Gold (the banks’ remaining quality collateral) is being sold to cover these margin calls just as it was in September 2011 (though lease rates have not squeezed as much this time). We can only imagine the size of these margin calls should we happen to have a week where AAPL stock drops or BTPs don’t rally (broad collateral actually loses value), but that seems impossible anyway.
ECB Margin Calls to European Banks rose once again to record highs…
And Gold remains offered as the need to fund these margin calls means finding money under every mattress and selling whatever banks have to meet the central banks demands…
Interesting that gold lease rates did not drop (soar from the other side) in a squeeze this time – as they did in September 2011.
Tags: Asset Quality, Bond Markets, Capital Structure, Collateral Asset, Dramatic Acceleration, ECB, Government Debt, Insolvent Banks, Kebab Shop, liquidity, Mtm, Papandreou, Profitable Trades, Rapid Deterioration, Risk Pool, Shortfalls, Stigma, Unintended Consequence, Vicious Circle, Virtuous Circle
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