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Friday, December 30, 2011
Sunday, November 6, 2011
Aged to Perdition
Greece is still a mess and will continue go be a mess. The bottom line is that the growth rate of the country is not sufficiently robust to support the generous entitlements to which the Greek people have become accustomed. The draconian austerity measures needed to keep Greece out of default are economically and culturally unfeasible. One would be asking to Greek people to cease being Greek (the same can be said for austerity measures needed to save Portugal, Spain and, possibly, Italy). Greece will default. It may conduct an orderly default by negotiating with creditors or it may default in a disorderly fashion and leave the Eurozone. Greece may default now, in December or next year, but default it will. The sooner the investor community, banks and European regulators acknowledge the better.
Economic troubles are not unique to Europe. The United States has its own issues, as evidenced by Friday’s Nonfarm Payrolls report. I am not referring to the latest print of 80,000, but to the upward revisions of the prior data. How can upward revisions be bad news? If the revisions just get you up to about the replacement rate when population expansion is accounted for, that is not very good. There is a current phenomenon which can make the data seem better than it might really be.
At one time 200,000 new jobs were needed every month to keep pace with the growing population. Last year 150,000 new jobs became the benchmark. Now, some are saying it may only take 125,000 jobs to keep pace with the population. The result could be that the unemployment rate falls more rapidly than what many economists and the Fed predict. However, this does little for economic activity.
The unemployment rate had been in the past a good indicator of current prevailing economic conditions. However, increased productivity and slowing population growth may erode the reliability of the unemployment rate. Increased productivity and outsourcing have reduced the need for workers. This has helped to keep the unemployment rate stubbornly high during the current recovery. Now we may see the unemployment rate because the number of U.S. workers is shrinking. This addition by subtraction may cause the unemployment rate to fall. However, with fewer workers (for whatever reason) economic activity must slow.
Fewer workers mean fewer consumers, fewer home buyers, fewer car buyers, etc. Currently, there are more than enough homes to meet the needs of the U.S. population growth for more than a decade. If population growth slows further, it could even take longer for housing and the remainder of the economy to recover. Slowing population growth means an aging population. One only needs to look at Europe where the ratio of workers versus the number of retirees is about one to one.
This does not mean that the best days of the U.S. are behind us. It only means as conditions, trends and phenomena change we must change with it. This is why using the words “always” and “never” in economic forecasting and economic strategies is very dangerous (and foolish).
Economic troubles are not unique to Europe. The United States has its own issues, as evidenced by Friday’s Nonfarm Payrolls report. I am not referring to the latest print of 80,000, but to the upward revisions of the prior data. How can upward revisions be bad news? If the revisions just get you up to about the replacement rate when population expansion is accounted for, that is not very good. There is a current phenomenon which can make the data seem better than it might really be.
At one time 200,000 new jobs were needed every month to keep pace with the growing population. Last year 150,000 new jobs became the benchmark. Now, some are saying it may only take 125,000 jobs to keep pace with the population. The result could be that the unemployment rate falls more rapidly than what many economists and the Fed predict. However, this does little for economic activity.
The unemployment rate had been in the past a good indicator of current prevailing economic conditions. However, increased productivity and slowing population growth may erode the reliability of the unemployment rate. Increased productivity and outsourcing have reduced the need for workers. This has helped to keep the unemployment rate stubbornly high during the current recovery. Now we may see the unemployment rate because the number of U.S. workers is shrinking. This addition by subtraction may cause the unemployment rate to fall. However, with fewer workers (for whatever reason) economic activity must slow.
Fewer workers mean fewer consumers, fewer home buyers, fewer car buyers, etc. Currently, there are more than enough homes to meet the needs of the U.S. population growth for more than a decade. If population growth slows further, it could even take longer for housing and the remainder of the economy to recover. Slowing population growth means an aging population. One only needs to look at Europe where the ratio of workers versus the number of retirees is about one to one.
This does not mean that the best days of the U.S. are behind us. It only means as conditions, trends and phenomena change we must change with it. This is why using the words “always” and “never” in economic forecasting and economic strategies is very dangerous (and foolish).
Sunday, October 30, 2011
A Hole in the Deal
Europe finally agreed on a solution to the Greek question, sort of. European leaders persuaded banks holding Greek debt to accept 50% haircuts and have given banks until next June to raise capital. Banks will raise capital from private sources if they are able and from government sources, if necessary. This is not, we repeat not, a Greek default. Greece is not haircutting investors. European banks are voluntarily accepting a 50% haircut. Investors not agreeing to a voluntary haircut will receive 100% of par for their Greek debt at maturity, if Greece is solvent at the time. Among those NOT participating in the haircut is the IMF. The result is not a 50% reduction in debt for Greece, but according to sources on the street, something closer to 20%.
I mentioned earlier in this piece that this was sort of a final solution. We say sort of because there are details which need to be worked out. For instance, European officials agreed to expand the size of the EFSF to $1.4 trillion, but there are no details as to who is adding what capital to the program. Banks have been told to recapitalize, from private sources if possible and from government sources if necessary. Specifics of how banks may be able to receive public recapitalization and what restrictions may be put on such banks (dividend cuts, pay restrictions, core asset, etc.) have yet to be worked out. The way it stands is that banks which are unable to raise sufficient capital in the open market must first tap their national governments and only approach the EFSF as a last resort. Banks have until June 2012 to recapitalize. No word of what action might be taken, should a bank run into difficulties prior to raising sufficient capital.
The threat of contagion persists. It is possible that public pressure could force the governments of Portugal, Spain and Italy to request haircuts of some degree. Given the size of the Spanish and, especially, the Italian government bond market, even small haircuts to the sovereign debt issued by the European periphery’s two largest members could significantly affect banks and necessitate even more capital raising.
The EU did win not-specific support for the expansion of the EFSF from both Japan and China. China’s Premier Hu Jintao told Chinese television that he hoped measures taken in Europe will stabilize markets.
Which banks might need recapitalization? The Wall Street Journal reported that British and Irish banks will probably not need recapitalizations. However, banks in Germany, France and remaining periphery nations will probably need additional capital. Bloomberg News is reporting that French Banks BNP Paribas and Societe Generale (the two largest banks in France) are hastening cuts in their trading books (believed to be a combined $1.5 trillion, to avoid having to raise capital. French banks have already scaled back dollar-funded lending operations for items such as aircraft. Now BNP Paribas and Societe Generale are reluctantly shrinking their trading and derivative businesses. One European fund manager told Bloomberg News:
“It’s a striking sin of pride. They all want to keep their rankings, but French banks risk not having the necessary capitalization.”
European banks may find it increasingly difficult to shed assets at anything close to their fair values. As one London analyst told Bloomberg News:
“Everybody is trying to reduce risk-weighted assets as soon as possible. They’ve already all started, but they’ll probably find it harder than expected because the environment is clearly getting tougher.”
When a crowd tries to escape from a burning building via one door, some people get burned.
Already the holes in the deal are letting light in. For one, this does nothing for Greece. Oh sure, it reduces the country’s debt load for awhile, but unless Greece stops its profligate ways, its debt load will rise. However, since Greece can only obtain financing from the EU, it will default. It is nearly impossible for Greece to avoid a default. The contagion then spreads to Portugal. If it ever makes it as far as Italy, watch out. Italy has the third largest government bond market in the world. Just a10% haircut on Italian debt would cause turmoil among European banks.
Europe is a mess. Officials do not know how to pay for the “solution” or even or how the haircuts will be acknowledged. Meanwhile Europe hurtles toward recession. The rescue is nothing of the sort. Greece may end up leaving the euro (but not the EU) and devalue its way out of its mess. It is Greece’s only hope.
The bond markets are already telling us the bloom is off the Greek rose. Italy had to pay higher interest rates with its 10-year yield topping 6.00% on Friday. Spreads of periphery debt widened versus German bunds and money flowed back into U.S. treasuries.
I would advise investors not to be sucked in by stock jockey pundits and look at the situation for what it is. The periphery is an unsustainable mess. Common and preferred dividends are likely going away for awhile. If you must invest in Europe, be at a senior level on corporate capital structures. If not, invest in the U.S., at least we can keep printing money. :o
I mentioned earlier in this piece that this was sort of a final solution. We say sort of because there are details which need to be worked out. For instance, European officials agreed to expand the size of the EFSF to $1.4 trillion, but there are no details as to who is adding what capital to the program. Banks have been told to recapitalize, from private sources if possible and from government sources if necessary. Specifics of how banks may be able to receive public recapitalization and what restrictions may be put on such banks (dividend cuts, pay restrictions, core asset, etc.) have yet to be worked out. The way it stands is that banks which are unable to raise sufficient capital in the open market must first tap their national governments and only approach the EFSF as a last resort. Banks have until June 2012 to recapitalize. No word of what action might be taken, should a bank run into difficulties prior to raising sufficient capital.
The threat of contagion persists. It is possible that public pressure could force the governments of Portugal, Spain and Italy to request haircuts of some degree. Given the size of the Spanish and, especially, the Italian government bond market, even small haircuts to the sovereign debt issued by the European periphery’s two largest members could significantly affect banks and necessitate even more capital raising.
The EU did win not-specific support for the expansion of the EFSF from both Japan and China. China’s Premier Hu Jintao told Chinese television that he hoped measures taken in Europe will stabilize markets.
Which banks might need recapitalization? The Wall Street Journal reported that British and Irish banks will probably not need recapitalizations. However, banks in Germany, France and remaining periphery nations will probably need additional capital. Bloomberg News is reporting that French Banks BNP Paribas and Societe Generale (the two largest banks in France) are hastening cuts in their trading books (believed to be a combined $1.5 trillion, to avoid having to raise capital. French banks have already scaled back dollar-funded lending operations for items such as aircraft. Now BNP Paribas and Societe Generale are reluctantly shrinking their trading and derivative businesses. One European fund manager told Bloomberg News:
“It’s a striking sin of pride. They all want to keep their rankings, but French banks risk not having the necessary capitalization.”
European banks may find it increasingly difficult to shed assets at anything close to their fair values. As one London analyst told Bloomberg News:
“Everybody is trying to reduce risk-weighted assets as soon as possible. They’ve already all started, but they’ll probably find it harder than expected because the environment is clearly getting tougher.”
When a crowd tries to escape from a burning building via one door, some people get burned.
Already the holes in the deal are letting light in. For one, this does nothing for Greece. Oh sure, it reduces the country’s debt load for awhile, but unless Greece stops its profligate ways, its debt load will rise. However, since Greece can only obtain financing from the EU, it will default. It is nearly impossible for Greece to avoid a default. The contagion then spreads to Portugal. If it ever makes it as far as Italy, watch out. Italy has the third largest government bond market in the world. Just a10% haircut on Italian debt would cause turmoil among European banks.
Europe is a mess. Officials do not know how to pay for the “solution” or even or how the haircuts will be acknowledged. Meanwhile Europe hurtles toward recession. The rescue is nothing of the sort. Greece may end up leaving the euro (but not the EU) and devalue its way out of its mess. It is Greece’s only hope.
The bond markets are already telling us the bloom is off the Greek rose. Italy had to pay higher interest rates with its 10-year yield topping 6.00% on Friday. Spreads of periphery debt widened versus German bunds and money flowed back into U.S. treasuries.
I would advise investors not to be sucked in by stock jockey pundits and look at the situation for what it is. The periphery is an unsustainable mess. Common and preferred dividends are likely going away for awhile. If you must invest in Europe, be at a senior level on corporate capital structures. If not, invest in the U.S., at least we can keep printing money. :o
Wednesday, October 19, 2011
Europe to Your Ears
Housing Starts rose more than expected on the strength of multi-family construction, such as apartments and condominiums as an increasing number of Americans choose renting over home purchases. This was the strongest read for multi-family construction since October 2008. Building Permits fell to a five-month low as a glut of existing homes, a backlog of foreclosures and real estate values, which continue to decline, weigh heavily on the home building industry. Moody’s analyst Aaron Smith told Bloomberg News prior to the report:
“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”
This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.
As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.
Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:
“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”
Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.
Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.
CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.
This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?
Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.
How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.
Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.
Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.
Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.
Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.
“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”
This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.
As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.
Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:
“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”
Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.
Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.
CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.
This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?
Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.
How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.
Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.
Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.
Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.
Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.
Sunday, October 16, 2011
The Undead Economy
Recent economic data indicates that the economy is not quite dead. However, it is not quite alive either. Consumer spending picked up in August, but recent measures of consumer confidence indicate that consumers are remaining jittery. Home prices remain depressed and the existing neglected stock of homes decomposing in the field. The unemployment rate remains at a disturbing 9.1%, but that only counts people who applied for jobs during the past four weeks. The real unemployment / underemployment rate (the U6 report from the Labor Department) stands at 16.5%. Meanwhile policy makers point figures at one another and youthful protesters being encouraged by celebrities, who believe that they have earned their millions in a manner the deem to be respectable, to demonize people who have made large sums of money in other ways, and by political opportunists.
Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.
Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.
Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.
We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.
Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:
“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.
We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.
Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.
Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.
Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.
We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.
Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:
“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.
We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.
Friday, September 23, 2011
Please Don't While They Fiddle About
Twisting by the Pool
I economic data has been lackluster (I am being kind), European leaders are in denial and the Fed has taken dancing lessons.
The economy is slowing. Is any one really surprised? With food and fuel prices elevated going into the third quarter, how in the world did anyone believe that consumers would keep on spending? When prices of goods with inelastic demand curves rise, consumers must make choices, if incomes were rising the situation might be different, but with employment in the dumps, wage growth is just not happening.
Some thought it was just a matter of time before companies making handsome profits exporting affordable goods (thanks to the weak U.S. dollar) would hire workers. However, few pundits were paying attention to new factories going up overseas or the cheap financing paying for new equipment and more efficient processes here in the U.S. Machines are cheaper than humans.
What will these pundits say now that the U.S. dollar has rallied against most major currencies? The one blessing is that the consumption tax on households has been reduced as lower food and energy prices, resulting from the stronger dollar, could put discretionary cash in the hands of consumers. Worst case is that households can delever (pay off debts) more quickly. Speaking of taxes, will somebody tell the President that we tax and spend too much and that temporary stimulus does a better job encouraging consumers to save or pay existing debts rather than spend? How are consumers to make large purchases, such as an automobile, when the extra cash in their budget lasts for a year and their loan is for five years? We won’t even the discuss the folly of limiting the tax benefit of municipal bonds and creating infrastructure banks. I am not even sure if the Federal Government has the power to tax municipal bonds used to fund essential services and projects.
Then there is the Fed. I come here to praise Mr. Bernanke, not to bury him. It is thanks to him that we have avoided recession as the President and Congress fiddle while America burns (Roman enough for you? Yeah, yeah I am mixing Nero and Julius Caesar, but cut me some slack). Seriously, the Fed is supposed to foster full employment and price stability. It is not supposed to keep the economy growing while the executive and legislative branches of the government bicker and pursue their own interests. However, this is exactly what has happened for the past two decades. Please stop looking for the Fed to solve all problems. The problems are structural, fiscal and not monetary. When will that penetrate the thick skulls of politicians, pundits, market participants and consumers?!!!!!!!!
Meanwhile all the Fed can do is dance, dance, dance, dance to keep the economy out of recession. Mr. Bernanke had better have his dancing legs ready because it looks like fiddling time in DC.
I economic data has been lackluster (I am being kind), European leaders are in denial and the Fed has taken dancing lessons.
The economy is slowing. Is any one really surprised? With food and fuel prices elevated going into the third quarter, how in the world did anyone believe that consumers would keep on spending? When prices of goods with inelastic demand curves rise, consumers must make choices, if incomes were rising the situation might be different, but with employment in the dumps, wage growth is just not happening.
Some thought it was just a matter of time before companies making handsome profits exporting affordable goods (thanks to the weak U.S. dollar) would hire workers. However, few pundits were paying attention to new factories going up overseas or the cheap financing paying for new equipment and more efficient processes here in the U.S. Machines are cheaper than humans.
What will these pundits say now that the U.S. dollar has rallied against most major currencies? The one blessing is that the consumption tax on households has been reduced as lower food and energy prices, resulting from the stronger dollar, could put discretionary cash in the hands of consumers. Worst case is that households can delever (pay off debts) more quickly. Speaking of taxes, will somebody tell the President that we tax and spend too much and that temporary stimulus does a better job encouraging consumers to save or pay existing debts rather than spend? How are consumers to make large purchases, such as an automobile, when the extra cash in their budget lasts for a year and their loan is for five years? We won’t even the discuss the folly of limiting the tax benefit of municipal bonds and creating infrastructure banks. I am not even sure if the Federal Government has the power to tax municipal bonds used to fund essential services and projects.
Then there is the Fed. I come here to praise Mr. Bernanke, not to bury him. It is thanks to him that we have avoided recession as the President and Congress fiddle while America burns (Roman enough for you? Yeah, yeah I am mixing Nero and Julius Caesar, but cut me some slack). Seriously, the Fed is supposed to foster full employment and price stability. It is not supposed to keep the economy growing while the executive and legislative branches of the government bicker and pursue their own interests. However, this is exactly what has happened for the past two decades. Please stop looking for the Fed to solve all problems. The problems are structural, fiscal and not monetary. When will that penetrate the thick skulls of politicians, pundits, market participants and consumers?!!!!!!!!
Meanwhile all the Fed can do is dance, dance, dance, dance to keep the economy out of recession. Mr. Bernanke had better have his dancing legs ready because it looks like fiddling time in DC.
Friday, September 2, 2011
Cauliflower Power
According to today’s Nonfarm Payrolls Report, the U.S. economy added no, nil, nada, zero jobs in the month of August. Nonfarm Payrolls data for July and June were revised lower by a combined 56,000 jobs. Although it is true that the strike at Verizon contributed to the majority of the 48,000 jobs lost in the information sector, adding back each and every lost communications job would have resulted in a print of 48,000 new jobs. Pundits should stop trying to spin the economic data.
The truth is that the economy, which had only gained limited traction since the recession ended two years ago, is sputtering. Politicians, pundits and the American people should stop looking to the Fed for solutions. The Fed has done almost all it can do. QE3 will be like pushing on a string. The best it can do is to “twist” and move its bond holdings farther out on the yield curve (10-year or so) to have a direct effect on driving down mortgage rates. The Fed can also set inflation, growth and employment targets to instill confidence among capital market participants. All of this is well and good, but these are cyclical tools to remedy cyclical problems. The troubles facing the U.S. economy are of a structural nature.
The problems facing the U.S. economy are:
1) Too many homes and too few qualified buyers. Not all of it is due to exceptionally tight lending standards. There are far too many homes even if banks adhered to any kind of prudent lending standard.
2) U.S Households are overleveraged. Just as a person must work through a hangover after a long weekend of partying and alcoholic imbibing, U.S households must endure a period of pain as they correct imbalances on their personal balances sheets. The idea of curing too much debt by having consumers incur more debt is nonsensical and irresponsible.
3) The U.S. offers businesses very few comparative advantages versus their global competitors. The U.S. has the second highest corporate tax in the free world. On economically-stagnant Japan has a higher corporate tax rate. U.S. businesses are reluctant to repatriate dollars earned overseas. Instead money is held, spent and invested overseas. Production occurs close to local customers as well. The actions taken by the National Labor Relations Board attempting to block Boeing from opening a factory in low-tax, non-union South Carolina demonstrates how anti-business or current crop of policymakers really are.
This is not about political ideology or social justice, it is about a malfunctioning alleged market economy that has been hamstrung for far too long by nonsensical, albeit well-intentioned, government policies the negative effects of which have been offset by Fed policy since the early 1990s. The Fed can do no more. It is time for policymakers to hold their collective noses and eat the cauliflower that are economically-friendly policies to get the growth engine running.
Bond investors may have read articles this week, one from Bloomberg News and one in the Wall Street Journal, which espoused the opinion that the bond market held a positive outlook for the economy because the yield curve (between its short-term and long-term benchmarks, the two-year and 10-year treasury notes was positively-sloped by a fairly sleep 200 or so basis points. The articles each stated, correctly, that the U.S. economy has never fallen into recession when the yield curve was positively sloped and that the curve flattens or inverts before that happened.
At the risk of insulting the intelligence of the two respective authors, are they kidding? The Fed has the Fed Funds rate at effectively zero. Since Fed monetary policy rules the short end of the yield curve, the two year note is anchored below 20 basis points. However, the 10-year is beyond the Fed’s influence. Ten-year yields respond to growth and inflation expectations. A 10-year treasury yield in the low 2.00% area reflects very poor growth. We could see it dip below 2.00% and remain there for an extended period of time if and when the Fed begins reallocating its holdings farther on the curve. However, because of extremely low short-term rates, the yield curve cannot go flat or invert.
The yield curve is about the journey, not the destination, especially in this environment. The fact that, prior to today, the curve between two-years and 10-years had flattened by approximately 70 basis points since the end of June is a more accurate indicator of the bond market’s sentiments regarding the U.S. economy.
The September 20th – 21st FOMC meeting should be interesting. Following today’s employment data we are likely to see one hawk, Minnesota Fed President Narayana Kocherlakota, defect to the doves. However, I do not believe we will see a full-blown QE3. The Fed is more likely to set targets (jawboning), either hard or soft, and announce that it is going to perform extension swaps farther out on the yield curve.
With commodity inflation already elevated and blamed for much of the slowdown in consumer demand and for hampering job creation, aggressive easing could be death for the U.S. economy with the holidays and winter’s cold just months away.
I would wish everyone a happy labor day, but these are not very happy times for labor in the U.S.
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