The Twillight Zone

The Twilight Zone

We have been silent on the Euro zone mess for quite some time. We get plenty of calls on this topic, and, yet, we haven’t been able to bring ourselves to say much in writing. Why is that?

The simple fact is that the trouble in Europe is in many ways unknowable. The news stories over the past months show that clearly: an Italian prime minister makes a pronouncement on afternoon, only to be contradicted by the German chancellor hours later. The German chancellor announces an accord with the Greek prime minister one day, only to have the Greek prime minister back away from the agreement and refer it to the Greek people. And what accompanies each of these news swings? Swings in stock and bond prices, of course. As we write, the latest news that a group of central banks have come together and agreed to lower the price of a type of inter-bank lending has pushed the DJIA up 400+ points. Never mind that the reasons that this type of action were needed are terrifying to contemplate (large European bank failure, anyone?), the market is desperate to hear that something concrete is being done to “fix” things.


The question, then, is exactly what needs fixing in Europe? We can nuance the issue, but the plain truth is that the Euro Zone (countries that agreed to use the Euro as a single currency) has participants who have not played by rules and others, people fear, may not be willing to play by the rules for much longer. Entry by countries into the Euro was contingent on having and maintaining certain acceptable levels of budget deficits (not more than 3% of GDP). The idea was that this would keep everyone in-line and countries would do what was necessary to keep deficit spending to less than the 3% of GDP limit. Unfortunately, the Euro entry committee failed to foresee two problems: no country’s deficit level was verified prior to admission to the Euro, and the political will of a country to live up to the 3% deficit limit was assumed to be solid.

Greece is the first example of a country that, so far, is failing on both those assumptions. Its deficits were revealed in 2009 to be not 3%, but, instead, approaching 14%. Cutting the budget to get down to the 3% limit brought into clear focus the nature of the second assumption. We have all seen the images of Greek citizens rioting and striking as the budget was cut, testing the political will of the Greek government to live up to the 3% deficit limit.

The simple truth is that the members of the Euro have just two choices: bail them out or toss them out. Both will be very expensive propositions. If you bail them out, how do you say “no” to Italy or Spain when they, too, want help? Toss them out and you risk unwinding the Euro currency altogether, along with a rush of capital from other shaky countries into safe ones (if you think a run on a bank is bad, wait until you see a run on a country). Either way, the costs will be enormous, and we simply do not have the ability to predict which path will be taken. Will German citizens be willing to shoulder a disproportionate amount of the burden to support floundering countries? What price might they demand for that support? Will Greece (and others?) be willing to pay that price? The questions are important ones and not solved overnight. Pundits abound with predictions for what this means to the US markets, but those predictions change throughout a given day. In light of this, we stay believers in a long-term investment strategy founded upon a prudent allocation in light of our clients’ goals and risk tolerance.

Don’t Give Up on the U.S. Just Yet

Yes, things look pretty glum when you take a look around the U.S. today (not to mention, the world). Unemployment is hovering around 9.2%, the housing market is still near the depths of its slump, the politicians can’t or won’t play nicely in the sandbox together, as of 10/10/11 the S&P 500 was down 18% from its high on April 29th, and so far no one can determine whether or not “Operation Twist” is going to do anything other than confuse us. It is easy to see how there is so much pessimism out there.

However, one could also argue that now is not the time to give up on the U.S. Believe it or not there are some bright spots out there that just might suggest the good ol’ U. S. of A. can make a comeback in the next decade. Let’s look at several factors.

Corporate America has not been this lean in a long time. Unfortunately for workers, bad economic times cause businesses to lay off employees and figure out how to provide their goods and services with less man power. While this is bad for our employment figures, it is actually good for corporate profits. If Company ABC can make just as many widgets with 20% less labor (overhead) then they can either sell the widgets for less or they can make a greater profit, or the best of both worlds, they sell them for less and still make a greater profit. Furthermore, corporate America is sitting on in excess of $1.2trillion in cash. At some point companies are going to have to spend that cash. They will either give it back to shareholders in the form of higher dividends (such as Intel announced earlier this year) or share buyback programs (like Dollar Tree just announced they would be buying back $1.5billion of its common shares) both of which ultimately give shareholders more wealth and/or value in their shares. Still, another choice is to invest this excess cash in new R&D, facilities, or technology. All of these investments can only mean good things for our economy (as long as that occurs in the U.S., and we’ll get to that later) as more people will be put back to work either; constructing new facilities, working in the new facilities, or inventing new technology to propel companies forward.

Speaking of technology, many people say we are no longer a manufacturing country, but have you taken a look at how many people are employed at some of the largest technology companies out there today? Google announced in January that it will hire 6,200 additional workers this year and may surpass 31,000 total employees by year end. Most of these current employees work in the U.S.. Facebook has 2,000+ employees, with again, the majority of those working in the U.S. The whole social media revolution whether you understand it or not, is creating jobs and it is doing so on a daily basis. According to an article in ComputerWorld in June of 2009, the Internet economy at that time had created 1.2M jobs. Spinoffs funded from all the major technology players such as Microsoft, Apple, Intel, etc. also provide new jobs all the time. Let’s not forget that at one time both Amazon and Ebay were start-ups that as of 2010 collectively employed over 51,000 employees.

Finally, many people feel that China is taking over the world (or at least all of our jobs) and that there is no hope in sight for domestic manufacturing jobs. But, that might not be the case in the next decade as China’s wages rise, their workforce diminishes, and their quality controls suffer, all of which leads to higher costs for us to outsource to China. China spent two decades building itself to be the manufacturing powerhouse that it is today and with a population of close to 1.3 billion people it did so by throwing as many workers at a job as needed for the equivalent U.S. wages of pennies. That worked well for the several decades it took to become the low cost outsourcing answer to manufacturing solutions, but it might not be the case for too much longer. First of all, the birthrate in China is declining due to strict family planning policies. Factory workers ages 16-24 will drop by one third over the next twelve years (as cited by an article entitled “Average Chinese Worker’s Life” on 7/13/10 for the Association for Asian Research). At some point, the sheer number of workers will no longer be the viable source it once was for China. Furthermore, the factory workers today have a much different view of the world than their parents did. Thanks to technology like cell phones and e-mails workers can now compare working conditions in different factories which can encourage them to look for better paying jobs or better working conditions. This means that companies are having to increase wages in order to keep their workers which in turn means higher costs for production. An article appearing in the Economist on July 29, 2010 cited a 17% increase in wages in China from 2009 to 2010. One can reason that this will only continue to be the case as the population growth either stalls or declines and workers have more power to demand higher wages. With the rise in the value of the yuan, U.S. products produced in China become more expensive for foreign markets to import and thus become less competitive. Additionally, quality control issues have also recently been a reason for some companies to relocate back to the U.S.. In some instances even if production costs are higher in the U.S. these costs are offset by a higher volume of quality products which in turn means less lost inventory. Several weeks ago there was an article in the WSJ showcasing a furniture manufacturer that will be building a new factory in North Carolina which it estimates will employ roughly 135 workers. The article also mentioned that Ford has announced it would start building some auto parts in the U.S. that it previously had been outsourcing to China. Of course there is India that is more than happy to become the next biggest manufacturing country but they too have their issues among them their labor laws which make it incredibly cumbersome to employ more than 100 workers at a company.

No doubt there are many issues that need to be addressed to get America back to work and back to expansion. Not the least of which is taxes. Until corporate America knows what type of tax hurdles it will face it is not likely to start their investments and hiring sprees. Nor will the glut of housing be solved overnight especially with the financial institutions’ lending requirements. And, perhaps our biggest obstacle is to figure out how politicians can work together to pass legislation that helps stimulate business and not hinder it. Despite all of this, one can make the argument that now is not the time to give up on America. There are positive signs out there, and just like we did after the Great Depression, we can come back and be stronger than ever.

Twisting the Fed Away

Today, the concern of the Fed for our economy was shown through actions dubbed Operation Twist in the popular press.  Citing “significant downside risks to the economic outlook,” the Federal Reserve Open Market committee today announced they would enter the bond markets and start buying $400 billion of bonds with maturities of between six and thirty years.  To provide the cash to make these purchases, the Fed also announced it would be selling $400 billion of bonds it already owned with maturities of less than three years.  Hmm – selling bonds and buying them back again? What gives?

The Fed is charged with fostering maximum employment (measured by the unemployment rate) along with price stability (measured by inflation).  This is also a good description of what the US Congress wants, but each of these groups comes at the problem with different tools.  The Federal Reserve has at its disposal the amount and price of money in the financial system as its tools, and today it announced that it wasn’t satisfied with the price of money, specifically the price (read: interest rate) of money borrowed for longer than six years.  The mechanics of how this change in longer term interest rates occurs is pretty straight-forward: the next time an investor wants to sell, say, some of his 10 year treasury notes, there will be more competition to buy that note (from the Fed), driving the price of that bond a bit higher. Since the price of a bond moves the opposite way from its yield, this higher price means the interest rate earned on that bond will be lower.  And since the opposite is true, when the Fed sells its short term bonds, the flood of supply will drive prices lower, increasing the effective interest rates earned for those bonds. The movement up of short term rates while long term rates go down is that “twist” you hear about.

The theory is that by lowering the cost of borrowing for longer periods of time, companies will take advantage of this and borrow the funds necessary to invest in their expansion. Additionally, the hope is that mortgage rates will be even lower, encouraging home buyers to step up to the plate at this time.  These may both turn out to be true, but we suspect the real goal of the Fed is to put an end to what is known in the arcane circles of the fixed income world as The Carry Trade.  Most people assume that banks make money by borrowing from depositors and lending those funds to borrowers for longer periods of time, earning a spread between the two.  While that is true generally-speaking, the Carry Trade is what occurs when a bank borrows from depositors at cheap rates and uses those funds to buy treasury notes instead of lending them to commercial borrowers.  For example, at the beginning of this year, banks could borrow money from you and me at cost of somewhere between zero (think your checking account) and 0.25% (1 year CD rate).  The bank could then turn around and buy 10 year treasury notes yielding 3.36% netting a risk free return of better than 3.1%.  If you are a bank that is under increasing regulatory pressure and have a portfolio of questionable commercial loans, the Carry Trade starts to look better and better!  By implementing Operation Twist, the Fed is seeking to take much of the fun out of the Carry Trade.  If we look at the same interest rates today after the Fed announcement, one year funding may cost a bank 0.1% today, but the ability to invest it into 10 year government bonds yields them 1.85% for a net benefit of just 1.75%.  That change may not seem much to you and me, but that’s actually a 43% drop in net interest income, and any bank that showed that for its quarterly report would soon show its CEO to the door.

To be sure, the regulators are still out there ready to pounce and second-guess any number of bank credit officers, but that’s an issue for Congress to tackle.   The Fed has done what it can to encourage both borrowing and lending with the Twist.  Let’s hope it is effective.


Bond Swap

Some of you will be seeing confirmations coming in the mail from your custodian showing we have been busy buying and selling Morgan Stanley bonds recently.  In fact, many of you will see that we sold your Morgan Stanley bonds the same day as we bought you different Morgan Stanley bonds.  What gives you say?  It’s all part of a bond swap we’d
like to explain.

We’ve owned Morgan Stanley 4.75% bonds due in April 2014 for quite a while, having bought most of them at a nice discount during the crisis times of 2008.  These particular bonds are subordinated to most of the other Morgan Stanley bonds, meaning they rank lower in payoff priority.  However, they are still a high-quality bond, with an A3/A- rating from S&P and Moody’s.  We were content to hold this bond until maturity, especially in light of the extraordinarily low rates offered in the market today.

However, Morgan Stanley came to market this week with a new bond that caught our eye.  This bond is known as a fixed-to-floater bond – a bond that has a fixed rate of interest for a period of time followed by a period when the interest paid floats up and down based upon market conditions.  In this particular case, this bond pays a fixed 5% for the first year.  That’s a nice 0.25% bump up from the 4.75% paid on the Morgan Stanley bond we sold. This new bond also ranks higher in priority, so it carries a rating of A2/A – a notch higher than the other bond.  The icing on the cake is that we were able to sell the MS 4.75% bond at a price of $101 and buy the new, higher-rated, higher-paying bond at $100.

How is it possible to get a higher-paying bond from the same issuer with a better rating and pay less for it?  As you might (should!) suspect, there is no free lunch.  As we mentioned above, the new bond is a fixed to floater bond, so the 5% coupon payment is only fixed for the first year.  After that, the bond will pay interest quarterly (most bonds pay semi-annually) based upon what the 3-month LIBOR rate is plus 2% all the way until this bond matures  four years from now.   Today, 3-month LIBOR is just 0.33%, so the rate we receive could drop to just 2.33% if LIBOR stays the same until next year. However, we do get some protection from that happening, as the bond has an interest rate floor of 3%.  Of course, it’s hard to predict interest rates (or stock prices, for that matter) on a short term basis, but we like the idea that this new bond will pay us 3-month LIBOR plus 2%.  Below is a chart of the last 5 years of 3-month LIBOR rates:

As you can see, 3-month LIBOR is as low as it’s been.  That’s been true for just about interest rates of all types, and the press is starting to print stories about the Bond Bubble some believe exists.  Does that mean rates are about to go up significantly? Not necessarily, but the longer we stay in these economic doldrums with startling-low interest rates, the closer we are to resuming reasonable economic growth and, with that, higher interest rates.  All in all, we think the opportunity to profit from the sale of our 4.75% bonds and upgrade the credit quality of our portfolios was worth some uncertainty of future interest payments.  Time will tell.

Watch what consumers do rather than what they say

Consumer confidence may well be in the dumps, but it is more important to watch consumer behavior when judging the economy. In June, consumers added $15.5 billion to their credit lines (revolving plus non-revolving). According to the Federal Reserve Bank of Atlanta, that was the largest monthly increase since August 2007 (see chart). Non-revolving credit (e.g., auto loans) increased by $10.3 billion while revolving credit (e.g., credit card balances) increased by $5.2 billion. This data is, of course, before the contentious debt ceiling debate and all of the alarmist headlines about defaulting so we may still see some pull back in July’s data, but the trend is up for the economy based on this data.

Additionally, we watch the Aruoba-Diebold-Scotti Business Conditions Index (ADS Index) to get a read on the real-time performance of the U.S. economy.  Figures above zero indicate economic measures are coming in above average while figures below zero, you guessed it, indicate economic results are coming in below average as reported.   If we look at the ADS Index (see chart below), one can see the slowdown from Q4 2010.  Growth in the economy appears to have bottomed out about midway through Q2 of 2011 and picked up since that time.

While the economy seems to be frustratingly stuck in first gear (and at more risk from some economic shock), we don’t anticipate a new recession.





Testing Your Risk Tolerance

If any traders’ proverb has been further from the truth this summer it is “Sell in May and go away.” It used to be that summer was a time where the stock, bond, and commodity markets didn’t do much because everyone was on vacation (either literally or figuratively). As we all know that sure hasn’t been the case this summer in large part due to the Debt Ceiling deadline of August 2nd. Combine that with the S&P 500 downgrade of our U.S. Government debt, add the European economic woes, and some lackluster U.S. economic reports and it’s no wonder no one had time to “go away”.

Individual investors are having their risk tolerance tested to the nth degree this summer. But, we would argue that that isn’t all bad. Sure, investors can pick a chart on a risk tolerance questionnaire that they feel they can withstand on the downside and enjoy on the upside. However, it is a whole lot different when the upside and downside is actually happening. It is more of a barometer of an investor’s true risk tolerance in a down market than in an up market. As another saying goes, “The pain of a loss is felt more acutely than the pleasure of a gain.”

The concept of asset allocation is not a new one but sure can get lost when markets seem to do nothing but go up (either stock or bond). At the beginning of the year investors were feeling more risk tolerant as the stock market took off. It is times like now when having the appropriate asset allocation to meet investment needs and objectives proves to be the best strategy for the long term. Couple asset allocation with having an investment advisor take the emotional element out and the individual investor should be sleeping better at night. No one can predict market gyrations with a 100% accuracy but one can try and build portfolios to withstand them.

We are always available to discuss your asset allocation.