Posts Tagged ‘Sovereign Debt’
Thursday, August 9th, 2012
by Matt Lloyd, Advisors Asset Management
European fears have subsided a bit as the European Central Bank’s (ECB) president continued to offer words of support for a more comprehensive solution…though he appeared to dampen the statements with concessions about the ECB’s ultimate subservient role to the governments. As we noted a couple of weeks ago, the German government’s resounding approval of $120 billion of support for Spain’s banks was significant. The more important number wasn’t the $120 billion, but the 5 to 1 in favor of it in light of the public’s concerns about troubling countries and their potential drain on German prosperity. We noted that the solution ultimately lies in Germany, and with their ultimate benefit from adopting the Euro, the only solution for the future prosperity of German exports is to maintain the Euro largely as is.
The other two options leave Germany extremely vulnerable to a significant drop off in the exports competitiveness.
This has had a large impact on equity markets and certain debt markets in Europe:
- The German DAX market is up 16.40% year to date with a nearly 4.00% gain in today’s trading alone. The EURO Stoxx is only up 2.42% for the year, but had a 4.83% move in today’s trading alone.
- Italy’s two-year sovereign debt issue has dropped to a 3.13% yield after hitting an intraday high of 5.26% just last week. A stronger indicator that fear has subsided is measured in Spain’s two-year debt. The yield hit an intraday high of 7.15% last week and now sits at 3.96%.
China looks to have bottomed to most analysts, but expectations remain very tepid for their recovery. We actually see a starker rebound in growth by the fourth quarter and through 2013. Consider the last two times China’s Central Bank embarked on substantive rate cuts to their Required Reserve Ratio (RRR) and you will notice some significant expansion in equities and housing. In June, after lowering the RRR, home sales jumped 41% in one month and home prices increased in 25 of the 70 largest cities. May only saw an increase in five of the 70 cities. Consider that the Shanghai Composite Stock index rose nearly 80% over the four years after their initial cut in 1997, and again when they cut rates in 2008 they saw an immediate bounce back of 73% in their equity markets. They have also begun to prime the pump for a varied form of stimulus as they have utilized state-owned companies to raise investment and accelerated the approval process for certain projects. We would expect a more consumption-focused stimulus, though as we have seen recently a stimulus package of nearly any kind appears to be the high tide that lifts all boats.
Another aspect to raising our bullishness on the China story is the fairly undervalued current state of the equities in China. The average PE (price/earnings) multiple in the Shanghai Composite index over the last 15 years has a median of 31.95; currently it stands at 11.50 times. This represents the dire expectations of profits going forward. When one looks at the previous two periods that the RRR was cut PE multiples expanded 30% and 39% respectively. The current multiple is near the 15-year low. We always note that when expectations are so heavily skewed in one direction, the antithesis usually transpires.
Last but not least, the jobs report in the United States was better than expected and caught the bearish predisposition off guard. The U.S. Treasuries have been getting whipsawed over the last week; however, the bias has been to selling. I guess an intraday 10-year yield of 1.38% isn’t attractive enough to hold until maturity. It may be hard to remember since it was so long ago, but the 10-year was yielding a 2.40% and the 30-year yielding a 3.49% back in late March.
Because we wrote about the trending jobs environment last week (read here), we won’t rehash the trend line and base line aspects we see in the marketplace. However, in looking at the earning reports, consider that expectations for the second quarter were greatly reduced throughout the last three months. And while we are seeing some of the concerns come across in the revenue numbers as 43% of the companies reporting earnings have beaten revenue estimates, 70% have come in above earnings estimates. We continue to see this as a confirmation that lack of hiring by American businesses of all sizes has actually assisted them in maintaining certain levels of profitability and cash flow margins. Though we can understand some of the hesitations about future expectations since a large amount of companies are offering lower guidance for the third quarter, it appears there are more dire expectations built in.
What we take note of is the relative outperformance of earnings over the last couple of years relative to the performance of the S&P 500.
Though it is always a bit presumptuous to take solitary trading days and extrapolating them into a future expectation, it may not be as fool hardy if these singular events are affirming trends. Markets and emotions are not linear, but over time they tend to become more efficient. As events continue to tell us that the economy is growing, if only slightly, it could also bode well for China. We continue to see opportunities abound in the domestic and global equity markets and would consider adding exposure to China as well as select European markets where appropriate.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com
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Tags: Competitiveness, Comprehensive Solution, Concessions, Debt Issue, Debt Markets, Ecb President, Euro Stoxx, European Fears, German Dax, German Exports, German Government, Low Expectations, Market Surge, Reserve Ratio, Resounding Approval, Rrr, S Central, S Trading, Sovereign Debt, Subservient Role
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Saturday, July 21st, 2012
Michael Pettis at China Financial Markets has some interesting comments via email regarding much needed China rebalancing and a timeframe for a possible Spain exit from euro.
Pettis On Spain Exit …
How will Spanish households react to a default on preferred shares and subordinated bonds, or even a very public discussion about the possibility of such a default? I don’t know, but I assume that it will speed up deposit withdrawals from the banking system even more. For that reason it continues to be a very good idea to keep an eye on Target 2 balances. These serve as a pretty good proxy, I think, for the behavior of depositors.
Things are evolving in Spain exactly as we would expect them to evolve according to the sovereign-debt-crisis handbook. Unless we get real fiscal union in Europe, or Germany leaves the euro, or Germany stimulates its economy into running a very large trade deficit, or the euro depreciates by 15-20% against the dollar in the next year – all very unlikely, I think – I really see no reason to doubt that Spain will leave the euro and restructure its debt within the next few years.
Mish Comments on Target 2
Target 2 stands for Trans-European Automated Real-time Gross Settlement System. It is a reflection of capital flight from the “Club-Med” countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.
Please see Target2 and the ELA (Emergency Liquidity Assistance) program; Reader From Europe Asks “Can You Please Explain Target2?” for a more compete description.
There is much misinformation floating around on how Target 2 works, what Germany’s liabilities are, so please click on the above link if you are interested in target 2 balances.
The following chart from PIMCO article TARGET2: A Channel for Europe’s Capital Flight shows the capital flight through March. The problem has accelerated since then, because of fears in Spain and Italy.
Pettis On China Price Deflation…
China’s official GDP growth rate has fallen sharply – on Friday Beijing announced that GDP growth for the second quarter of 2012 was a lower-than-expected 7.6% year on year, the lowest level since 2009 and well below the 8.1% generated in the first quarter. This implies of course that quarterly growth is substantially below 7.6%. Industrial production was also much lower than expected, at 9.5% year on year.
In fact China’s real GDP growth may have been even lower than the official numbers. This is certainly what electricity consumption numbers, which have been flat, imply, and there have been rumors all year of businesses being advised by local governments to exaggerate their revenue growth numbers in order to provide a better picture of the economy. Some economists are arguing that flat electricity consumption is consistent with 7.6% GDP growth because of pressure on Chinese businesses to improve energy efficiency, but this is a little hard to believe. That “pressure” has been there almost as long as I have been in China (over ten years) and it would be startling if only now did it have an impact, especially with such a huge impact occurring so suddenly.
Adding to the slow economic growth, the country may be tipping into deflation. Last Monday the National Bureau of Statistics released the following inflation data:
In June, the consumer price index (CPI) went up by 2.2 percent year-on-year. The prices grew by 2.2 percent in cities areas and 2.0 percent in rural areas. The food prices went up by 3.8 percent, while the non-food prices increased by 1.4 percent. The prices of consumer goods went up by 2.3 percent and the prices of services grew by 1.9 percent. In the first half of this year, the overall consumer prices were up by 3.3 percent over the same period of previous year.
In June, the month-on-month change of consumer prices was down by 0.6 percent, prices in cities and rural went down by 0.6 and 0.5 percent respectively. The food prices dropped by 1.6 percent, the non-food prices kept at the same level (the amount of change was 0). The prices of consumer goods decreased by 0.9 percent, and the prices of services increased by 0.3 percent.
My very smart former PKU student Chen Long, who follows monetary conditions in China as closely as anyone else I know tells me:
The most interesting thing is that even if CPI remains stable month-on-month, it will turn negative year-on-year in January 2013. And if it continues to decline month-on-month at current rates, we could see negative year-on-year CPI as early as August/September.
Unlike some other analysts, in other words, I am not concerned about deflation persisting for long unless the PBoC cuts interest rates much more sharply than any of us expect. I know this may sound strange – most analysts believe that cutting interest rates will actually reignite CPI inflation – but remember that the relationship between inflation and interest rates in China is, as I have discussed many times before, not at all like the relationship between the two in the US. It works in the opposite way because of the very different structure of Chinese debt and consumption.
Pettis On China Rebalancing…
After many failed attempts, over the past six months we may be seeing for the first time the beginning of China’s urgently needed economic rebalancing, in which China reduces its overreliance on investment in favor of consumption.
Regular readers of my newsletter may be surprised to see me say this. For the past four or five years analysts have been earnestly assuring us that the rebalancing process had finally begun, and I had always insisted that it couldn’t have begun yet.
Why? Because as I understand it rebalancing is almost arithmetically impossible under conditions of high GDP growth rates and low real interest rates. Once the real numbers came in, it always turned out that in fact imbalances had gotten worse, not better. Typically many of those too-eager analysts have resorted to insisting that the consumption data are wrong, although even if they are right this does not confirm that rebalancing had taken place since errors in reporting consumption have always been there.
But this time seems different. Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.
Of course the process will not be easy. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.
How to rebalance
The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates.
Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.
And this seems to be happening. [Yet] Beijing has reduced interest rates twice this year, and reluctant policymakers are under intense pressure to reduce them further. [However] The students in my central bank seminar at PKU tell me that there are new rumors about the way the cuts were implemented. “Usually it is the PBoC that submits a proposal of rates cut to the State Council,” one of them wrote me recently, “but this time (July 5th) it was the State Council who handed down to the PBoC the decision to cut rates, so that the PBoC was not fully aware of the rates cut before July 5th.”
If my student is right (and this class has an impressive track record), this suggests that monetary easing is being driven by political considerations, not economic ones, which of course isn’t at all a surprise. But even with the rate cuts, perhaps demanded by the State Council, with inflation falling much more quickly than interest rates the real return for household depositors has soared in recent months, as has the real cost of borrowing. China, in other words, is finally repairing one of its worst distortions.
China bulls, late to understand the unhealthy implications of the distortions that generated so much growth in the past, have finally recognized how urgent the rebalancing is, but they still fail to understand that this cannot happen at high growth rates. The problem is mainly one of arithmetic. China’s investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of rapid growth.
As China rebalances, in other words, we would expect sharply slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that Beijing is finally resolving its problems.
As an aside, we need to make two adjustments to the trade surplus in order to understand what is really going on within the balance of payments. First, one of the causes of last month’s weak imports has been a sharp decline in commodity purchases. I have many times argued that commodity stockpiling artificially lowers China’s trade surplus by converting what should be classified as a capital account outflow into a current account inflow. If China is now destocking, then China’s real trade surplus is actually lower than the posted numbers.
Second, we know that wealthy Chinese businessmen have been disinvesting and taking money out of the country at a rising pace since the beginning of 2010. One of the ways they can do so, without running afoul of capital restrictions, is by illegally under- or over-invoicing exports and imports. This should cause exports to seem lower than they actually are and imports to seem higher. The net effect is to reduce the real trade surplus.
Since these two processes, commodity de-stocking and flight capital, work in opposite ways to affect the trade account, it is hard to tell whether China’s real trade surplus is lower or higher than the reported surplus. But once de-stocking stops, we should remember that the trade numbers probably conceal capital outflows.
How does all this affect the world? In the short term rebalancing may increase the amount of global demand absorbed by China, but over the longer term it should reduce it. Rebalancing will inevitably result in falling prices for hard commodities, and so will hurt countries like Australia and Brazil that have gotten fat on Chinese overinvestment. Rising Chinese consumption demand over the long term and lower commodity prices, however, are positive for global growth overall, and especially for net commodity importers. Slower growth in China, it turns out, is not necessarily bad for the world. The key is the evolution of the trade surplus.
There is much more in his email that I wanted to use, but I stretched the bounds of fair use already.
Those wishing to see more can follow Michael Pettis on his blog China Financial Markets which I consider one of the very few “must read” sites.
The above report should appear on his blog shortly, with more details. Thanks Michael!
Tags: Banking System, Capital Flight, China Gdp, China Price, Club Med, Debt Crisis, Deflation, Depositors, GDP Growth, Gross Settlement, Michael Pettis, Northern Europe, Preferred Shares, Rebalancing, Settlement System, Southern Europe, Sovereign Debt, Subordinated Bonds, Target 2, Trade Deficit
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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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Thursday, July 12th, 2012
Last month, in my Investment Directions monthly commentary, I predicted that we’d see further stimulus from China this yearas officials try to keep Chinese growth at a respectable rate ahead of a fall 2012 leadership transition.
And as I suggested would happen, the Chinese central bank last week announced its second surprise rate cut within a month. The action from the central bank was an acknowledgement that the world’s second largest economy is slowing. In the first quarter, China’s growth decelerated to 8.1% year over year, the slowest pace since the summer of 2009 as a slowing United States and ongoing European sovereign debt crisis took a toll on Chinese exports.
Still, despite China’s economic slowdown, I continue to hold an overweight view of Chinese equities for the following four reasons:
1.) Valuations: Chinese stocks are selling at a significant discount to both other Asian emerging market countries and to their own history, especially when you consider that Chinese inflation is decelerating. In addition, current discounted valuations appear to be already reflecting the risk of a hard landing, which I don’t believe is the most likely scenario for China.
2.) Growth Expectations: While China is experiencing a slowdown, it’s important to put China’s growth in perspective. I expect second quarter Chinese growth to come in around 8%, a level consistent with a soft landing scenario, and not anywhere near the United States’ truly slow 2% growth. In addition, the preponderance of evidence – and the few bright spots among weak recent economic data — still suggest that China can engineer a soft landing and even if China ends up growing at 7% to 7.5% next quarter, Chinese equities still look cheap.
3.) Economic Policy: That China lowered interest rates twice within a month suggests that Beijing is refocusing on, and is willing to go the distance to stabilize, growth. In fact, I continue to expect more stimulus from China as it tries to ensure a smooth upcoming leadership transfer and as cooling inflation in the country gives the government more room to focus on growth. In addition, the gradual liberalization of the financial industry is also a plus for long-term growth.
4.) Relatively Low Risk: Based on my team’s analysis, China is not one of the 15 riskiest markets. In addition, China enjoys a relatively stable currency, which reduces the volatility of its USD returns.
To be sure, Chinese equities, along with other risky assets, are still vulnerable to the fortunes of the global economy, and an exogenous shock, such as a worsening eurozone crisis, could certainly knock China off of its trajectory. But in the absence of such an event, most evidence suggests that China can engineer a soft landing and its outlook seems more positive than investors may be discounting. I prefer to access Chinese equities through the iShares MSCI China Index Fund (NYSEARCA: MCHI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS).
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.
Tags: Acknowledgement, Chinese Central Bank, Chinese Exports, Chinese Growth, Chinese Stocks, Debt Crisis, Economic Data, economic policy, Economic Slowdown, Emerging Market Countries, First Quarter, Growth Expectations, inflation, Investment Directions, Leadership Transition, Preponderance Of Evidence, Sovereign Debt, Stimulus, Surprise Rate, Valuations
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Monday, July 9th, 2012
Principal and Portfolio Manager Francis “Frank” Gannon provides thoughts regarding the economy, the markets and small-cap investing. Frank, a former panelist on Louis Rukeyser’s Wall Street, has 19 years of investment management experience and joined our team in 2006.
“I know what is around the corner—I just don’t know where the corner is…”*
- Kevin Keegan, Former International Footballer and former manager of the England National Football Team
Sentiment once again shifted dramatically in the second quarter of 2012, just as it did in 2011 and 2010. Now-familiar concerns over contagion from the ongoing sovereign debt crisis/fiscal crisis/recession across Europe, coupled with fears of decelerating growth in China and a fragile economic recovery in the United States, pressured the equity markets.
Even the Federal Open Market Committee (FOMC), at its most recent meeting in June, added to the air of uncertainty, as they lowered their expectations for economic growth and raised the forecast for the unemployment rate. At the same time, lack of clarity regarding fiscal policy and the coming “fiscal cliff” in January 2013 is building, further weighing on domestic economic activity and the markets.
After gaining more than 12% in the first quarter of 2012, the Russell 2000 Index lost 3.47% in the second quarter and was up 8.53% year-to-date through June 30, 2012. Interestingly, the small-cap Russell 2000 Index will soon mark the five-year anniversary of its pre-financial crisis peak, July 13, 2007. From this peak through the end of 2012′s second quarter, the Russell 2000 gained 0.04%.
To be sure, it has been an eventful five years for equities, the global economy, and geopolitics. We live in a world that craves certainty, yet the range of possible outcomes in today’s world feels infinite. To that concern, we are often asked how in today’s uncertain environment we marry the various top-down macro views and our bottom-up stock picking approach.
In today’s interconnected world, where random, unpredictable events across the globe are being priced into the markets at lightning speed, one’s ability to react is paramount to achieving consistent, long-term results. Our discipline of responding rationally without making predictions is built for just this type of environment.
Predicting what will be the next macro drivers of the markets has long been a favorite pastime for many strategists, fund managers, and market commentators alike. It is not ours. Our expertise is in smaller-company investing. We typically have little if anything to say about the economy in general and even less to say about large-scale, macro trends.
That being said, we are in the business of responding rationally to opportunities as they are created and being prepared to do so when they occur. In today’s interconnected world, where random, unpredictable events across the globe are being priced into the markets at lightning speed, one’s ability to react is paramount to achieving consistent, long-term results. Our discipline of responding rationally without making predictions is built for just this type of environment.
We once again find ourselves in another out of sync moment, where those same daily macro headlines are creating long-term micro opportunities. Not surprisingly, since the Russell 2000′s most recent peak in March the most defensive areas of the market have performed best while those more economically sensitive areas have dramatically underperformed. It is the same performance pattern we have witnessed during the market’s corrective phases over the last two years.
From our perspective, however, those defensive areas of the market (consumer staples, utilities, and REITs) remain expensive. At the same time, many of the economically sensitive areas of the market that have been hit the hardest are fraught with opportunity. Ironically, lost among the economic headlines and fear of owning these cyclical businesses are the quality standards we tend to focus on. For the moment, economic sensitivity is trumping quality, a byproduct of our macro-driven world.
*A favorite quotation of mine from a presentation courtesy of Dylan Grice, global strategist for Societé Generale, entitled “Macro & the Margin of Safety” that was delivered to the Value Intelligence Conference 2012, summing up the futility of macro investing.
Important Disclosure Information
Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index.
Tags: Contagion, Debt Crisis, England National Football Team, Federal Open Market Committee, Fiscal Crisis, Fiscal Policy, Fomc, Footballer, Frank Gannon, Global Economy, Kevin Keegan, Louis Rukeyser, Macro Views, national football team, Open Market Committee, Portfolio Manager, Russell 2000 Index, Small Cap, Sovereign Debt, Term Opportunities, Unemployment Rate
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Monday, July 9th, 2012
July 6, 2012
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
and Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. In this issue we highlight the bond markets cautious response to the latest EU summit agreement; Q2 2012 performance between sectors of the global bond market; we address the Stockton, CA chapter 9 bankruptcy protection filing and take a closer look at Floating Rate Notes.
Bond Markets Rule?
European leaders surprised the markets with a more substantial agreement to stabilize bank and sovereign debt than expected. Risk markets rallied in response, but signals from the global bond markets were more cautious. On the day of the announcement, stock markets in Europe rallied as much as 6%, and economically sensitive commodities like crude oil rose by as much as 8%. However, the response in global bond markets appeared more cautious by comparison. Bond yields in Italy, Spain and Ireland declined by over 50 basis points the day the agreement was announced, but are still high relative to levels that prevailed at the beginning of the year and are still high enough to make reducing debt loads difficult. Moreover, German and US bond yields—considered safe haven markets—rose only modestly. Since many of the provisions included in the agreement were designed to appease bond holders, the divergence between the bond market reaction and the equity markets is notable. What is the divergence signaling?
- We believe it’s wise to heed the cautious response of the bond markets. Europe’s recent agreement reduces the risk of an imminent crisis in the banking sector and appears to be a step towards closer fiscal union. However, like everything in the markets, the devil is in the details. There is political risk because some of the terms of the agreement will need to be ratified by individual countries and then there is execution risk, since many of the plans have never been implemented before.
Ten Year Bond Yields
Source Bloomberg, as of June 13, 2012
- The key elements of the agreement… allow the European Stability Mechanism (ESM) to provide direct funding to Spanish banks rather than lending to the sovereign and it eases conditions for the bailout fund to buy government bonds. In addition, private bond holders will not be subordinated to ESM as was originally the case. These concessions to the bond markets should help ease the strains in the peripheral bond markets. Also, the European Central Bank (ECB) is to have supervisory responsibility for Europe’s banking sector, but the agreement did not specify a deposit insurance program.
- While the agreement helps ease immediate pressures, longer-term concerns linger. The ESM will most likely need more funding to have the fire power it needs to deal with Europe’s bad bank debt. Additionally, it isn’t clear how the ECB will become Europe’s banking supervisor since there is presently no structure in place for them to do so. Meanwhile, much of Europe is in recession with the most indebted countries experiencing very high rates of unemployment and contracting growth, making debt reduction and implementation of structural reforms even harder.
- Bottom line: We tend to favor the bond markets’ less enthusiastic assessment of the EU summit agreement over the other markets’ reactions. Europe’s latest agreement has eased the immediate crisis, but there is a long way to go towards stabilizing the economies and bond markets longer term. Given weakness in economic growth in the developed countries and ongoing risks in Europe, it’s reasonable that investors are likely to remain risk averse. For investors interested in international diversification, we continue to suggest minimizing exposure to European bond markets.
Q2 2012 Sector Performance
The theme of the second quarter can be described as “risk-off,” as weak economic data and the ongoing European debt crisis weighed on the markets. As a result, investors flocked to “safer” assets, driving the 10-year Treasury yield to an all-time low in early June. Although safety was a theme for the second quarter, most fixed income indices, including riskier benchmarks, generated positive returns as investors continued to search for yield. We believe that disappointing economic data and the Fed on hold until at least 2014 will keep Treasury yields low, and we continue to favor intermediate term investment grade bonds.
- Treasury rally drives returns for the Barclays US Aggregate Bond Index. High demand for Treasuries, as investors worldwide continued to seek safe-haven assets, helped drive strong returns for the US bond market. Declining interest rates instead of coupon income were the major source of return. The result was a yield to maturity of only 1.98% on the index, with an average duration (i.e. weighted average timing of interest and principal payments, and a measure of interest rate risk) of just over 5 years. Treasury rates remained near all-time lows, so there is not much room for interest rates to drop further. We believe that income will have to be the key driver for returns going forward. Our “lower for longer” mantra has not changed, and we expect interest rates to remain at low levels through year-end.
Q2 2012 Performance
Source Barclays, as of July 3, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.
- Investment grade corporate bonds generated positive returns across the board. High grade corporate bonds posted strong performance in the second quarter, as investors continued to search for yield in the current environment. The higher quality investment grade segments performed the best, with Aaa-rated bonds outperforming their lower-rated counterparts, and the utility sector, generally considered defensive, outperformed both financials and industrials. Corporate bond spreads, or the amount of yield over a comparable Treasury security, increased for the quarter. Such a trend is generally a sign of risk aversion. But it can also create opportunities in higher yielding bonds. Corporations have continued to reduce debt and boost their liquidity. We continue to favor investment grade corporate bonds with intermediate maturities in this environment, specifically the 5- to 7-year range.
- High yield returns show shift in sentiment to safer assets. Despite generating a positive return for the quarter, the high yield market underperformed both the higher quality investment grade index and the Treasury index. When investor risk aversion rises, high yield bonds tend to suffer as investors sell those securities and invest in higher quality or lower risk investments. For the quarter, the relative yield over Treasuries rose, negatively affecting the price of the Barclays US High Yield Index, which dropped by roughly 0.14%, while the income/coupon return was 1.97%, leading to a positive total return. This demonstrates the potential value of the high coupon, and showed how high yield can still generate a positive return in risk-off environments. For more aggressive investors, we do see relative value in the high yield market, as it offers a yield advantage of roughly 6.15% compared to Treasuries, but would exercise caution as multiple headwinds could push the risk premium even higher.
- Risk aversion negatively affecting the international markets. Euro zone troubles continue to dominate headlines and risk appetite. The so-called success of the Greek election was short-lived, as all eyes have turned to Spain, the most recent country asking for a bailout, and to a lesser degree, Italy. Foreign currency-denominated markets were negatively affected by the rise in the US dollar, leading to negative 0.4% return for the Barclays Aggregate ex-USD, an index comprised of government and investment grade bonds generally denominated in non-USD currencies. The Barclays Global Emerging Markets index was able to generate a positive return of 0.9%, although that index is denominated in the US dollar and the euro, not local currencies. Most emerging market currencies experienced declines for the quarter. In the current low rate environment, we think emerging markets may make sense for the aggressive portion of a portfolio, but a hedged approach may be best.
Stockton, CA and Muni Bankruptcy
Last week Stockton, California (pop. 292,000) became the largest U.S. city to file for chapter 9 bankruptcy protection. To most muni market watchers, the filing was no surprise. Markets have been tracking other issues, including limited new issue muni supply coupled with strong demand for tax-exempt yield more than headline risk related to individual credit stories. Stockton’s bankruptcy is another case in the growing, but still short, list of local governments in default or distress. While we expect that local governments will continue to face pressures, we believe that bankruptcy for municipal governments will remain rare.
- Stockton’s bankruptcy was widely telegraphed. Stockton’s decision to file follows a dramatic housing boom and bust in this primarily agricultural city in California’s Central Valley, followed by two years in a state of fiscal emergency, $90 million in cuts to balance the city’s budget (which is required by California state law), and 90 days of negotiation under a state law passed last year (Assembly Bill 506) which requires that cities negotiate with creditors before been eligible to seek bankruptcy protection, according to news reports and city press releases. A federal court must still accept the city’s petition.
- Municipal bankruptcies remain rare. Since 1937, when chapter 9 was added to federal bankruptcy code to allow for municipal bankruptcy, there have been just over 600 municipal bankruptcies, according to legal experts. Of that total, 43 have been from city and county issuers and, 33 of those cases were dismissed by a judge or did not reduce or discharge bonded debt, according to Bloomberg. Harrisburg, PA is one example. The court in Pennsylvania rejected the Harrisburg case after arguments that it violated state law. In 22 states, bankruptcy for local issuers is not permitted. And in 28 other states that do allow filing, there are varying requirements and limits to entering bankruptcy.
- Corporate bankruptcies are far more frequent, and different, than muni filings. Corporations can choose from two types of bankruptcy—chapter 7 and chapter 11. Chapter 7 involves liquidation. Chapter 11 is a form of rehabilitation, like hitting the “pause” button to negotiate and restructure. Chapter 9 bankruptcy is more like chapter 11 bankruptcy. Sizable municipalities are not generally able to simply fold up tent, liquidate, and disappear. There is also less precedent for how municipal bankruptcies operate, largely because they’re so uncommon. That is one of the key issues that many will be watching. How successful will the city be in reducing costs, and who will be most impacted in bankruptcy—retirees, bondholders, city employees or some combination?
- Bondholder protections depend on a bankruptcy court—and the class of bonds. In the case of Stockton, city financial statements show that the city’s debt includes lease revenue and pension obligation bonds that are secured and paid from general government revenues. These bonds do not have a dedicated tax source supporting them. Enterprise bonds, such as water and sewer bonds, are secured by net revenue pledges of the city’s water and sewer systems, which have not been the source of the city’s financial problems. “Since the pension and lease bonds are unsecured city obligations, they do not enjoy special protections in bankruptcy, subjecting them to possible debt service default and loss of principal,” argues Moody’s in a report downgrading Stockton bonds following the bankruptcy filing.
- Bankruptcy is not the same thing as default. Defaults can happen without bankruptcy, and vice versa. Bonds with dedicated revenues for projects not the primary cause of a municipalities’ distress have often been paid. Debt service on bonds that carry bond insurance will likely be paid by the bond insurer, with negotiations and losses covered by the insurer, not individual bondholders.
We suggest diversification, and a focus on tax-secured general obligation and/or essential service revenue bonds. While we don’t expect a significant increase in municipal bankruptcies, we do expect that many will continue to face strains from rising costs and the weak economic recovery. So we suggest diversification and a focus on high quality debt with the strongest possible protections. We still like general obligation bonds, with a dedicated pledge of property taxes—often called an unlimited ad valorem tax pledge in a prospectus—along with essential-service water and sewer revenues bonds from stronger, more stable systems as the core for most muni portfolios.
Are Floating Rate Notes the Cure in a Low-Rate Environment?
With the Federal Reserve holding short-term interest rates at zero and suppressing long-term rates through its bond buying programs, investors continue to search for investments with higher yields. Lately some investors have looked to floating rate notes, anticipating higher yield and less risk if rates rise. Not surprisingly, this relatively small corner of the fixed income market has become popular with retail investors for these reasons. In addition to mutual funds that offer access to floating rate notes (FRNs) there are also some new ETFs that have been launched in the past few years. An even newer development is that some major corporations are offering floating rate notes directly to small investors including employees of the corporation and positioning them as alternatives to money market funds.1
- At first glance…floating rate notes appear to offer an attractive alternative to fixed-rate bonds and notes. FRNs typically pay interest based on an index—such as the London Interbank Offer Rate (LIBOR). The notes usually have a “floor”—an initial rate for a specified period of time—often a few years—and then the rate adjusts or “floats” with the index. So if interest rates rise over time, the coupon payment will rise with the index. Sounds great, so what’s the catch?
- Credit risk—no cash substitute. Based on the Barclays FRN index, most floating rate notes are investment grade but not without credit risk. (We are not including leveraged loans in this discussion. Some mutual funds combine FRNs with bank loan, leveraged loans and convertible bonds.) About 65% of the issuers are financial companies and about 26% are issued by international firms. So, it is possible that a FRN fund or ETF would have exposure to international banks—a sector of the market that has seen many credit downgrades over the past two years.
For mutual fund or ETF investors, we suggest looking carefully at the holdings to make sure the credit quality is consistent with the investor’s risk tolerance. They should not be viewed as alternatives to cash investments or CDs. Deposit insurance doesn’t cover FRNs; they are subject to credit and interest rate risk, so they are not appropriate cash substitutes.
Breakdown of The Barclays U.S. Dollar Floating Rate Note (FRN) Index
Source Barclays, as of July 3, 2012
- Duration risk—may not be what you’re expecting. The duration for most FRNs is short, but some are issued with long maturities or are even issued as perpetual preferred securities. If long-term interest rates rise faster than short-term rates, then the value of the note could decline due to its long duration, even if the coupon rate moves up. Moreover, once the note’s floor expires, the coupon rate might actually fall if short-term rates don’t move up rapidly.For example, consider a perpetual preferred FRN issued in 2011, indexed to LIBOR with a three-year 4% floor that expires in 2014. At the beginning of 2015, the coupon will float at 25 basis points over LIBOR. If the Fed begins to raise rates in early 2015, the coupon payment might actually drop if the Fed’s rate hikes don’t reach the 4% floor rate. Meanwhile, if long-term rates rise in anticipation of a shift in Fed policy, which is usually the case, then the FRN would most likely trade lower due to its long duration. It could be the worst of both worlds. This may not be the case for most FRNs, but we advise being careful about the maturity of FRNs and as well as duration risk in floating rate note funds.
- Liquidity—can be thin. The market for floating rate notes is small relative to the size of the overall bond market and there may not be ample liquidity, particularly in times of financial stress. For investors who are investing in fixed income for safety and liquidity, this may not be an appropriate area for investment.
- Bottom line. FRNs can provide current income in excess of what’s available in cash investments without significant duration risk. However, FRNs and FRN funds and ETFs are not cash substitutes. Investors are exposed to credit, liquidity and interest rate risk. We suggest looking carefully at the investment vehicle that offers FRNs and limiting allocation to a small slice of the overall fixed income portfolio.
For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.International investments are subject to additional risks such as currency fluctuation, foreign taxes and regulations, differences in financial accounting standards, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.Past performance is no guarantee of future results.Diversification strategies do not assure a profit and do not protect against losses in declining markets.Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.The Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component. Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody’s, S&P, and Fitch.Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market.. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).Barclays U.S. Dollar Floating Rate Note (FRN) Index measures the performance of U.S. dollar-denominated, investment-grade floating-rate notes across corporate and government-related sectors. This index is not part of the US Aggregate Index, which is a fixed coupon index. Government-related sectors include sovereigns such as Mexico and Chile.London Interbank Offer Rate (LIBOR) is a widely used benchmark for short-term interest rates. It is an interest rate at which banks borrow funds from other banks in the London interbank market; the LIBOR is fixed on a daily basis by the British Bankers’ Association and derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and a full year.Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Tags: agricultural, Banking Sector, Bankruptcy Protection, Basis Points, Bond Holders, Bond Market, Bond Yields, Chapter 9 Bankruptcy, Debt Loads, Devil Is In The Details, European Leaders, Global Bond Markets, Imminent Crisis, Political Risk, Reducing Debt, Risk Markets, Sensitive Commodities, Sovereign Debt, Stock Markets, Substantial Agreement, Summit Agreement
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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.
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.
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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Sunday, June 10th, 2012
Submitted by James Miller of the Ludwig von Mises Institute of Canada
Mark Carney Kicks The Can
Bank of Canada Governor Mark Carney takes a lot of cues from his U.S. equivalent and fellow central banker Ben Bernanke. Both took interest rates to anorexic levels in light of the financial crisis in 2008. Both used their positions of power as stewards of the people’s money to bail out the big banks. Both take credit for the gains of their respective stock markets and for guiding their economies through the global recession. Both are forever on a quest to rid of the world of the boogeyman of deflation.
And both are sewing the seeds of their own destruction by keeping interest rates artificially low and ultimately driving unsustainable investment that must eventually be liquidated. All around the world, the boom bust cycle continues to occur due to central banks attempting to induce economic growth with money printing. China’s economy is continuing to come apart as manufacturing output and real estate prices plummet. These sectors were bid up by double digit increases per annum in the country’s money supply over the past decade. Since inflationary growth, by definition, can’t go on forever, as its continuance results in what Ludwig von Mises called the “crack-up boom” and destruction of the currency, the chickens of the People’s Bank of China’s reckless monetary policy are finally coming home to roost. The PBOC has responded to the downturn by recently cutting interest rates for the first time since 2008 in what will likely be a vain effort to reinflate the bubble.
Over in Europe, the year over year change in the broad money supply has dropped dramatically since 2010. This provided the spark for the sovereign debt crisis which shows no sign of slowing down unless Angela Merkel and Germany concede to further inflationary measures by the European Central Bank. Just like her support for the big banks and the austerity measures that ensure idiotic bankers don’t take too much of a loss on their holdings of euro government bonds, Merkel will likely give in to money printing in the end as she has already endorsed the push for a political union.
And now in Canada, Mark Carney announced a few days ago the Bank of Canada will keep its benchmark interest rate steady at 1%. This announcement comes despite his previous warnings over the enormous increase in Canadian private debt. But of course the run up in debt couldn’t have occurred if interest rates were determined by market factors only. Had supply and demand been allowed to function freely, interest rates would have risen as a check on the swell in debt accumulation. Carney won’t admit this though. Like all central bankers, he has made a habit of boasting the positive effects of his low interest rates policies while avoiding blame for the negative consequences.
He is a bartender who gleefully takes the drunk’s cash while replying with “who, me?” when said drunk drinks himself to death.
What makes the promise of continually low interest rates especially worrisome is not only does it tell the market to keep accumulating debt, but it is also an attempt to keep what some are calling a nation-wide housing bubble from deflating. Over the past decade, Canadian home prices have shot up at a far steeper pace compared to the decades that preceded it. In recent years, the acceleration in home prices has been fueled by the Bank of Canada’s historically low overnight lending rate which went from 3% before the financial crisis to .25% in 2009 and now rests steadily at 1%. The BoC has already acknowledged that its interest rate policies directly affect mortgage rates. Many Canadian media publications and investment newsletters are pointing out this trend and warning of a potential collapse. The BBC even did a report on it. There is nothing potential about a sharp downturn in home prices however; it will happen. It’s only a question of when.
With China and Europe leading the pack, the world economy is beginning to take a turn for the worse. The orgy of money printing which took place over the past few years has slowed down significantly; even in the U.S. Central bankers are standing at a precipice in which they must decide if they will forge ahead and prime the monetary pump to paper over the various malinvestments caused by their previous interventions or actually allow for a contraction and the market to adjust to a new path of sustainable growth. If history is any indication, the latter is not a considerable option as it would be devastating to the banking sector which is reliant on piggybacking credit expansion off of an uninterrupted flow of newly printed monies.
Carney’s decision to keep interest rates suppressed is yet another instance of a central banker unable to face reality. The malinvestments will continue to accumulate and will have to be liquidated at another date. What Carney has done to mitigate the looming debt and housing bubble is effectively kick the can down the road. He has revealed through his actions the undeniable truth which holds for all central bankers: that they have no other card to play but the printing press. As legendary investor Marc Faber has noted,
“I do not believe that the central banks around the world will ever, and I repeat ever, reduce their balance sheets. They’ve gone the path of money printing… And once you choose that path, you’re in it and you have to print more money.”
The Austrian theory of the trade cycle developed by Mises a century ago tells us that credit expansion is bound to end in depression. To quote Herbert Stein’s Law, the business cycle theory essentially boils down to “if something cannot go on forever, it will stop.” The debt fueled boom in Canada is a house of cards. No matter how much money printing or interest rate manipulation Carney attempts, the collapse in inevitable. His record, along with Ben Bernanke’s, will eventually be one of dismal failure.
Tags: Angela Merkel, Bank Of Canada, Bank Of Canada Governor, Bank Of China, Ben Bernanke, Bust Cycle, Central Banks, China, Crack Up, Debt Crisis, Digit Increases, Global Recession, Ludwig Von Mises, Ludwig Von Mises Institute, Mark Carney, Money Printing, Money Supply, Pboc, Sovereign Debt, Vain Effort, Von Mises Institute
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Thursday, May 31st, 2012
by Axel Merk, Merk Funds
May 30, 2012
The analysis below is based on our letter to shareholders in the annual report of the Merk Funds*.
The 12-month period ended March 31, 2012 (the “Period”) could be described as one of contrasting halves. The first half of the Period was marked by increased pessimism and concern regarding Europe, particularly the periphery nations. In contrast, market sentiment was more optimistic through the second six-months of the Period, and markets exhibited significant strength. During the first six-months ending September 30, 2011, the market – as measured by the S&P 500 Index – returned -13.78%, while the market returned 25.89% during the second six-months ending March 31, 3012.
News emanating from Europe dominated market gyrations for the majority of the Period. Specifically, the periphery nation sovereign debt crisis and concerns surrounding its global contagion effects – particularly on countries previously considered immune to the fallout, like China – held the market’s attention. Concerns appeared more acute through the first half of the Period, where we witnessed heightened levels of market volatility and general selling of perceived risky assets. The VIX index – widely followed as a bellwether for market volatility – reached a high of 48 in August 2011, as concerns mounted regarding the Greek debt situation and focus shifted to the larger European countries, particularly Italy and Spain, where political upheaval only muddied the waters. Policy makers on this side of the Atlantic compounded the problem, with Washington leaving the decision to raise the U.S. Government’s debt ceiling to the last minute causing further market distress.
During the second half of the Period, the market appeared to ascribe a more optimistic assessment to the European situation and the global economy. Particularly in the U.S., we saw the release of many economic data points that beat consensus expectations, including notable improvements to the unemployment rate. European policy makers also appeared to alleviate the market’s concerns regarding Italy and Spain, where austerity measures were finally agreed to and put in place, while much needed clarity was provided surrounding the Greek situation when bondholders agreed to participate in a debt swap. At the same time, we witnessed a number of central banks following much easier policies through the second half of the Period. The U.S. Federal Reserve (Fed) became evermore dovish in its rhetoric regarding easing measures and extended the calendar date that low rates are anticipated to be kept in effect, moving it out to the end of 2014 from mid-2013 previously. The Bank of England expanded its quantitative easing program by £50 billion pounds and the Bank of Japan also increased its expansionary asset purchases by ¥10 trillion and concurrently set an inflation target. Additionally, the ECB expanded its balance sheet via two long-term refinancing operations (LTRO’s), together totaling over €1 trillion. All of which helped alleviate market concerns and underpinned significant strength in equity markets, as indicated above, and a substantial reduction in the VIX index, which fell to a low below 14 in March of 2012.
Going forward, we consider that central banks around the world are likely to err on the side of further monetary policy easing. Our analysis finds that the composition of voting members on the Fed’s Federal Open Market Committee (FOMC) is more dovish in 2012 compared to 2011 and is set to become even more dovish in 20131. We therefore consider it very likely that rates will be kept low for an extended period of time in the U.S. and, should economic fundamentals deteriorate, further easing policies may be put in place. Elsewhere, the Bank of Japan appears committed to generating inflation via easing policies, while the Bank of England appears to be more concerned about deflation despite the existence of what we deem to be elevated inflationary pressures (as measured by the consumer price index). We consider it likely that the Bank of England announces further stimulus measures should economic growth in the United Kingdom disappoint. At the same time, there is renewed pressure on the ECB to purchase periphery nation debt to stave off further fiscal deterioration in the region. While ECB President Draghi appears committed to provide the banking system with unlimited levels of liquidity (through the two three-year LTRO facilities), pressure is mounting to intervene directly through the Securities Market Program (SMP) and buy the likes of Spanish debt. Notwithstanding, the ECB is likely to do everything in its power to stop the financial industry from collapsing, which may mean further liquidity provisions, such as the LTRO’s already seen.
All of which should serve to underpin those currencies most correlated with the outlook for economic growth and of countries set to benefit from increases in the price of commodities and precious metals. We believe as central banks continue to follow expansionary, inflationary policies, that those assets exhibiting the greatest monetary sensitivity should benefit – such as commodities, natural resources and precious metals. As such, we favor the currencies of commodity producing nations, such as Australia, Canada and New Zealand. In particular, we do not consider that China will experience too severe a slowdown in economic growth – the recent announcement to expand the trading band of its currency should be seen as a signal that policy makers there believe the risks to the economy have satisfactorily abated. We think Australia and New Zealand are well situated to benefit from ongoing Asian economic strength, while both countries’ fiscal positions are in stark contrast to the U.S. and Europe, for all the right reasons. Canada, too, should benefit from ongoing commodity price appreciation, and is well placed should the U.S. economy continue to pick up steam ahead of consensus forecasts.
In Asia, we continue to favor the currencies of nations who are producing more value-added goods and services while concurrently focusing on the development of the domestic economy as a source of long-term sustainable economic growth. China in particular checks these boxes. We consider building inflationary pressures brought about by increases in global commodities and a tightly managed currency, may ultimately force the Chinese into allowing the currency to float more freely2. While there have been recent hiccups regarding China’s upcoming leadership transition, the ultimate goal of the Communist Party remains intact: to maintain social stability, so as to remain in power. We believe there are several aspects to this notion, none the least being the support of strong, sustainable economic growth and the containment of inflationary pressures. Regarding the latter: should inflation get out of hand, the risk of social upheaval may become elevated. China’s close management of the dissemination of any news discussing the “Arab Spring” uprisings is indicative of the strength of its resolve in maintaining social stability. One of the contributing factors causing the “Arab Spring” was runaway inflation.
In China and other Asian nations, allowing the respective currencies to float more freely may act as a natural valve in alleviating the inflationary pressures being experienced. Moreover, we consider China and countries such as Malaysia, Singapore, South Korea and Taiwan to have the pricing power to allow their currencies to appreciate. These countries now produce relatively higher value-add goods and services compared to other Asian nations; therefore we believe they have the ability to pass on price pressures to the end consumer – Western consumers. With a concurrent focus on the development of their domestic economies, we believe Asian nations will eventually be less reliant on exports to the West, with a renewed focus on domestic demand, as well as demand within Asia, as a source of future growth. The result may be stronger Asian currencies over the medium to long-term, while western nations may experience increases in import prices going forward.
Regarding the U.S. dollar, we consider the more dovish FOMC voting member composition to be a negative for the currency, as it will likely lead to more expansionary policies relative to global central bank counterparts. In our view, the aforementioned debt ceiling debacle is just one increment in the ongoing marginal deterioration of the U.S.’s safe haven status; concurrent degradation to the long-term sustainability of the U.S.’s fiscal situation may ultimately erode confidence that the U.S. will honor its future obligations. Importantly, we do not doubt these obligations will be fulfilled, but the manner in which they are likely to be fulfilled gives us grave cause for concern. In our assessment, future obligations are unlikely to be met through much needed austerity measures, either from spending cuts or revenue increases, as neither side of the political aisle has shown a willingness to comprehensively and satisfactorily address the issues. Rather, future obligations are likely to be met through the path of least resistance: inflation. Said another way, devaluation of the currency.
We continue to believe the currency asset class may provide investors with the opportunity to access enhanced risk-adjusted returns and valuable diversification benefits. We are excited about the outlook for the asset class and believe many investment opportunities continue to exist in the space.
Please make sure to sign up to our newsletter to be informed as we discuss global dynamics and their impact on currencies. Please also register for our upcoming Webinar on June 13 where we will discuss the investment strategy and objectives of the Merk Absolute Return Currency Fund. We manage the Merk Funds, including the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.
Manager of the Merk Hard Currency Fund, Asian Currency Fund, Absolute Return Currency Fund, and Currency Enhanced U.S. Equity Fund, www.merkfunds.com
Tags: Bellwether, Contagion Effects, Debt Ceiling, Debt Crisis, Debt Situation, Economic Data, ETF, ETFs, European Situation, Global Contagion, Global Economy, India, Letter To Shareholders, Market Gyrations, Market Sentiment, Market Volatility, Merk, Optimistic Assessment, Periphery, Pessimism, Political Upheaval, Risky Assets, Sovereign Debt, Vix Index
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Tuesday, May 29th, 2012
Amid great uncertainty and huge challenges in Europe, it can be helpful to cut through all the detail and map out what we know and what we don’t know. This is at best depressing and, at worst, terrifying.
What are the known knowns?
First, Greece is spiralling out of control. No good outcomes appear possible for Greece or the eurozone. They face only bad outcomes that will be chosen or forced. Arguments over the economics of Greece’s programme and creditor country demand for adherence to what looks like an impossible task have run into political and social rejection in Greece. The country’s political system is fragmenting and social unrest is sure to persist. While there may be a way for Greece to remain in the eurozone, an exit looks far more likely.
Second, this is not merely a Greek or a eurozone challenge. Across the world, rich countries are trying to de-lever in a controlled way while maintaining growth and jobs. The eurozone’s institutional challenges make this difficult task far worse. Individual eurozone countries are like emerging markets, borrowing in foreign currency in their susceptibility to a run on the sovereign. During a crisis, investors will go to the safety of the strongest balance sheet, which in the eurozone’s case is Germany. Italy and Spain are not insolvent countries, but nor can they maintain stable debt dynamics with nominal yields well above their nominal growth rates owing to the absence of a predictable central bank lender of last resort.
Third, the eurozone’s monetary and fiscal interventions to date have not succeeded in stabilising its sovereign debt markets and crowding investors in, in part because they have been reactive and insufficient and also because of the public slanging matches between European leaders and with and between central bankers. Rather, these interventions have financed the exit of banks and other investors retreating back within their borders and the exit of foreign investors. Bank deposit withdrawals now threaten to accelerate the process.
Fourth, it is a known known that the eurozone’s most important challenges are political, rather than economic. Measured by debt and deficit levels, the eurozone is no worse off than the United States or Britain. The challenges are of co-ordination among countries and regional legitimacy, as governments try to overcome disagreements over how to mutualise the risks within the eurozone and on the proper role of the central bank.
Finally, it is clear that the eurozone status quo is not sustainable. A risk of a Greek exit and/or bank runs across the eurozone threatens to press fast forward on the crisis.
Turning to the known unknowns, it is unclear if the eurozone’s governments have the technical capacity to administer what will be a difficult process of managing the crisis in the short term and of integrating the eurozone over the medium term. It will require some combination of: policy and political coordination; measures to reduce the vulnerability of the banking system; the European Central Bank acting as a credible, committed lender of last resort for sovereigns to prevent self-fulfilling runs; closer fiscal union involving the mutualisation of debt in the form of guarantees or common eurobond issuance and a pooling of fiscal sovereignty; a more sustainable balance between the need for growth and the need for fiscal retrenchment; and, most likely, support to facilitate a managed Greek exit and limit the run on the eurozone as a whole. Indeed, the signal from a Greek exit that this is not an irrevocable currency union but a fixed but adjustable exchange rate could unleash a re-pricing of currency risk across the eurozone’s private markets, not only the government bond market, heightening the risk that the technical capacity to respond is overwhelmed.
This difficult prognosis is compounded by the huge known unknown over whether the eurozone’s leaders have the ability to overcome their co-ordination challenge and lay out an immediate plan to deal with a Greek exit, to defeat spiralling contagion risk in the short term and to build a more stable eurozone in the medium term.
Perhaps hardest of all, there is the known unknown of whether European populations will support or at least acquiesce in the face of miserable economic conditions, the pooling of sovereignty and greater transfers across borders.
Taking together the known knowns and the known unknowns, it seems likely that the eurozone’s big four — Germany, France, Italy and Spain — as well as other German satellite countries will find a way to hang together in a smaller currency union backed by stronger regional co-ordination and financing mechanisms.
But it will be difficult and costly and the tail risk of failure is very fat, indeed.
For investors, the balance of risks suggests preparing for the worst, even if, as citizens, we hope for the best. This would include limiting exposure to real confiscation risk in the eurozone and focusing instead on better global alternatives available in countries with stronger balance sheets, exposure to better growth prospects and less intractable governance challenges.
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Tags: Adherence, Balance Sheet, Balls, Bank Lender, Creditor, Debt Markets, Emerging Markets, European Leaders, Eurozone Countries, Foreign Currency, Impossible Task, Institutional Challenges, Interventions, Lender Of Last Resort, PIMCO, Rich Countries, Social Rejection, Social Unrest, Sovereign Debt, Susceptibility, Uncertainty
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