Cutwater - Asset Management
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MARKET COMMENTARY
Cliff Corso, chief executive officer and chief investment officer at Cutwater, along with other members of the team, will regularly provide commentary on the marketplace offering insight into our investment philosophy and approach to the credit markets.
6/8/2010
Euro Condition Leads to Worldwide Sclerosis
Sclerosis is the hardening of arteries, and based on the continued stress on Euro debt prices, the credit arteries in Europe have hardened due to years of a poor and steady diet of large entitlements and government spending. By the looks of the drop in global risk markets for bonds and stocks, the sclerosis in Europe has impacted the overall circulatory system across the world. Spreads on some of the riskiest assets are now back at Fall 2009 levels due to uncertainties over excessive global debt loads as well as uncertainties surrounding banking regulation and how these issues may impact the real economies of the world. And as we all know, if there is one thing markets hate, it is uncertainty. How all of this plays out is what we are all wrestling with now. We anticipated three phases to this recovery and we are now in phase two (phase one being a strong rebound from the March 2009 lows). We are now in a phase of sorting out the uncertainties which will lead to a period of perhaps 12 months of volatility. We peg this time frame because we believe some of the bigger issues will be resolved (such as the final bank regulatory framework), and while far from perfect, the Euro rescue package does provide a respite to liquidity issues in the smaller periphery countries. If we take a step back and look at a longer term view, we still expect a slow "checkmark" shaped recovery to evolve driven by the U.S., Asia and Latin America (with GDP forecasts of 2.5%, 6%, and 3.5% respectively). In our opinion, this should lead to a third phase of a decreasing volatility and tighter spreads, albeit with a slower than normal period of economic growth for the U.S. which is weighed down by still large debt loads on consumers and our own government. Assuming growth at about 2.5% in GDP, the U.S. engine over time should support lower unemployment and an improving consumer, which is the largest segment of our economy. Given this view, we believe that the recent backup in spreads offers an attractive re-entry point for certain corporate and ABS sectors. Taking a step back to consider the longer view, where some of the larger uncertainties are likely resolved and we continue on an economic growth track, we can envision a "calming of the circulatory system" which supports a solid recovery of risk assets in the credit markets.
5/11/2010
Is Vol the New Normal?
With the advent of trade and trading globalization, massive debt loads shifting to all manner of sovereign governments requiring hard tax versus spending cut choices and "bot" trading increasing the velocity and amplitude of market moves, are the days of "great moderation" in markets a relic of the past? In our opinion, the answer is yes. There are too many large questions posed to investors left unanswered. In the shorter term, where will banking regulation end up? Will it help or hinder growth? How will the markets react in 2011 when the fiscal and monetary support legs are kicked out from the real estate and job stimulus stool? And as we have seen in Europe, when will the bond vigilantes begin to move on to the UK and perhaps even the US to impose fiscal sobriety on over-levered governments? Market action is a collective psyche comprising of millions (billions) of human decisions reacting to changing information. In our opinion, there will be times when a spell of positive news engenders calm periods. However, it would not surprise us to see a series of what seems like "mini black swans" upset the calm surface as "surprises" around the aforementioned dynamics pop up from time to time. For us, this implies three keys to the investing landscape. First, there is no substitute to doggedly sticking to the fundamentals of picking solid credits. Second, search out and don't be afraid to take advantage of buying into volatility spikes (when the margin for safety is wide). Third, when volatility is low, seek opportunities to buy cheap "out of the money" protection on portfolios. After all, in a world where volatility might become the "new normal", buying flood insurance is best procured when the sun is out.
May 6, 2010
Greek Tragedy Part 3 – IMF-Euro Plan Jams a Wedge under the Sisyphus Debt Boulder
Progress was made yesterday as Spain successfully issued term debt at 3.5 percent, reducing some of the short-term fear of a total euro meltdown. Equally important, Greek and German parliaments are moving through the approvals necessary to ratify the now much larger 110 billion euro package. Italy has also locked arms with opposing political camps to clean up some of its weaker banks in an effort to show they are on top of their economic and debt situations. Assuming a speedy passage (quickness is critical to prevent more fear to build over uncertainty), is this enough to quell the flames of contagion for now? As we posited in part 2 of our commentary, we believed that euro zone officials would come up with a bigger package, pass it and then "observe" the situation and hope (really a version of the U.S. mortgage crisis "extend and pretend" strategy) that time buys calmness. The slowness upon which the solution has unfolded has been perhaps the biggest risk now to the observation period. Markets have had too much time to think about, debate and build fear scenarios about the other countries. The package still has a fair chance to calm markets upon passage but other countries need to be much more proactive and communicative around their plans to solve their debt issues. That said, the flight-to-quality in U.S. Treasuries has driven the 10-year down to a low 3.50 percent. This is in the face of continued solid economic figures. We think the package will take some of the flight-to-quality bid out of the market and so, we believe there is a greater probability for U.S. rates to move higher from here. We also believe shortening duration could pay return dividends over the indices if the euro flames abate and focus turns to our growing economy (and longer term, on our own "debt boulder").
April 28, 2010
Greek Tragedy Part 2 – All the World's a Stage
The "Greek Tragedy" is now playing out on the world stage, driving up global volatility (and investors' pulse rates). As we warned nearly two weeks ago, the temporary euphoria surrounding a "rescue package" for Greece was woefully lacking in clarity. The key missing ingredient was clarity around a requirement that Greece evidence "trouble" issuing debt. It was left unclear whether that meant they actually couldn't issue or that the cost or spread of the debt was too steep to go forward. We predicted that the market would test this lack of clarity and boy did it ever! Spreads on Greek debt blew out to over 600 bps. We then posited that the market might possibly "run the table" on the other PIIGS (Portugal, Ireland, Italy, Greece, Spain). We called Greece "Sisyphus" -- the mythical Greek figure destined to roll a boulder (of debt in this case) uphill only to watch it roll back down over and over again for eternity. It must feel this way to Greek authorities now. The "table is being run" on the other PIIGS as we speak as it is apparent that Sisyphus has euro cousins with similar problems. This is now playing out towards an end game. Germany, the strongest country in the Euro block is caught between a rock and a hard place (forgive the pun). They must ultimately carry the lion's share of the backstop. Here's a key problem: with regional elections in Germany on May 9th (and a wildly angry populous which is against the rescue plan), Germany might drag its feet until after that date. The debt time bomb ticks however, as Greece has several billion in debt it must roll by mid-May. This will make for white knuckle volatility ride in between. We still believe the odds favor a rescue plan at the end that, at a minimum, "kicks the can down the road" to buy some breathing room for Greece to regain some footing and perhaps show a plan to handle reducing its debt over the longer term (not an easy task). The complication now is the quickness and force of the "run" on the other Euro countries. This may drive a more encompassing solution for the Euro zone overall. However, despite monetary union, we believe a full scale plan at this point will be difficult given the varied political and economic situations of the players involved. Having said that, any failure of policy that endangers the Euro will not be tolerated as the "Euro experiment" has gone too far, the countries are too intertwined and the union is too important to see it break apart at this point. So, it is possible to see a rescue plan for Greece followed by an "observation period" by the EU to see if that is enough for now to stop the carnage. Our guess is that a more permanent and cohesive plan will need to be addressed before long as the market recognizes its power to pressure spreads which can "force" the Euro's hand. As we said in the last note on this subject, we should be mindful that the U.S. is unquestionably on the same path as the Greek Sisyphus -- over the next few years our projected debt-to-GDP ratio is projected to hit Greece's level of 100% or more (excluding some huge entitlements that we will also need to deal with beyond that!). Now is the time to address this issue before the market does it for us.
April 15, 2010
Greek Tragedy
Greek Mythology has a character called Sisyphus who is doomed to an eternity of pushing a boulder up a hill, only to see it roll back down so he can start the pushing again. This is akin to the current situation in Greece where the Greek government must push a "boulder of financing" into the market at "acceptable spreads" or otherwise risk aggravating an already dire debt load of over 100% of GDP. So why has the boulder rolled back down the hill when we have read about the "Euro/IMF" rescue package? Since then, spreads on Greek CDS have widened nearly 100 basis points. The trouble, in our view, is that the package is still too vague and requires three hurdles be met. First, all 16 EU members must approve the plan (likely, but not a slam dunk). Second, Greece must ask for help (likely again). The third condition is the rub... Greece must evidence that it is unable to finance itself. This is still too vague. Does that mean it can't issue at any cost? Or... does it mean it can issue but spreads of a certain level are too high? We believe the markets will force the answer. Without clearer communication on this plan, the market will likely test the spread pain level to see if Greece then asks for help. While it is anyone's guess what this spread threshold is, Greece has made noise that rates above 5% add to the debt burden over the long haul. I would note that the EU borrowing rate offered to Greece for three years is about 5% and the IMF facility is a low 2.71%. I think the most likely outcome is the "financing boulder" must be pushed to the 5% before the curse is lifted by the rescue package. If this occurs, it would not surprise us if the market then tries to "run the table" on the other remaining PIIGS (Portugal, Ireland, Italy, Greece, Spain) who are pushing a similar size boulder of oversized debt positions as Greece's financial Sisyphus. A good way to play this is to go long Greece at wide spreads, and short the other PIIGS which are much tighter. We believe a rescue is likely for Greece, which would move spreads in more dramatically for Greece than would occur on the short side of the other PIIGS which are currently trading much tighter. Added protection is the tail risk of a systemic run on the remaining PIIGS post-Greece bailout as highlighted above. Regardless of the outcome, this tragedy bears watching as a potential warning for the U.S. if we don't address our own looming "boulder" which grows by the year.
March 23, 2010
Healthcare Reform Sends "Unearned Income" to the Hospital
President Obama pulled out all the stops to get this legislation passed. It may be a while before we fully understand the impacts of back room deals and how a $1 trillion program supposedly "saves us" nearly $150 billion, as the Congressional Budget Office has projected. One way we "save" is by raising taxes on "unearned income." I don't know about you but I believe that income from investments is "earned" as it takes work to have investments and savings. A tax on these "unearnings" seems a deterrent on investments and savings at a time where we need both to boost our economy. One Winner will be munis where the tax exemption becomes more valuable. Dividends seem a loser which will also raise the "cost" of paying them. On the whole however, the market's current positive emotional momentum is shrugging off some significant long term questions. Stay short treasuries over the long term.
March 16, 2010
U.S. – China Relations: Falling into the same old pattern?
Last month, Cutwater produced a research paper on U.S. – China relations and recommended
that, among other things, the two economic giants need to leave behind "zero sum"
thinking, end the negative rhetoric, be tactful about military buildups, and increase
fiscal responsibility. Since that time, the United States has angered China by selling
more arms to Taiwan, hosting the Dalai Lama, and ratcheting up protectionist rhetoric.
For its part, China has apparently spied on Google, been uncooperative over sanctions
on Iran, and has steadfastly refused to do anything about its currency's peg to
the dollar. Indeed, tensions have increased to the point that on March 15, 130 U.S.
lawmakers signed a letter calling on the Obama administration to get tougher with
China by raising tariffs on Chinese-made imports and to demand that China let the
yuan float. Just the day before, Chinese Premier Wen Jiabao explicitly said he didn't
think the yuan was undervalued and rebuffed U.S. pressure on the issue. "We oppose
countries pointing fingers at each other and even forcing a country to appreciate
its currency," Wen remarked. He went on to note that recent strains on the relationship
were almost entirely due to U.S. actions, saying the Taiwan and Dalai Lama ordeals
"violated China's territorial integrity." It is precisely this old way of thinking
and politicking that we warned about in our paper and it is counterproductive not
only for both nations, but also for the global economy. The United States and China
need to find a better way of harnessing the benefits of their respective comparative
advantages. With China closing in on Japan to become the world's second largest
economy, the U.S. should be courting the opportunity to view China as a customer
for American exports as China consciously looks to grow its domestic consumer base.
However, with the U.S. economy still fragile and as we enter the election season
in the United States, we may well see continued tension and heated exchanges.
For Cutwater's White Paper on U.S. – China Relations please click
here
March 12, 2010
Consumer debt pared while lenders are "tarred" and ultimately... the consumer winds up being "feathered"
Today's Wall Street Journal headline article discusses how consumers are decreasing debt at an historic rate (the first drop since 1945). How? By defaulting and declaring bankruptcy at a record rate. Hmmm... Surely consumer deleveraging is needed to repair spending but it is a zero sum game. Lenders are the losers by being "tarred" with these losses. This destroys bank capital and hampers lending to that same consumer sector. In fact, recall that in some cases the bank tarring was so severe the government had to take over the institutions (including Fannie and Freddie who are experiencing spiking defaults and losses). Who ultimately pays for these losses in a zero sum game? We, the consumers do, ultimately through higher taxes--a cycle of "pare the debt, tar the banks, and feather the consumer" with constrained lending and higher taxes. From our perspective, deeper thought needs to be given to the "excitement" of this headline and its longer term implications for GDP growth in a world of rising taxes.
March 8, 2010
Why Raising Rates Now Might Create Faster Growth Now
Students of "efficient market theory" would say that everything that is known is already embedded in the market prices of stocks and bonds. In the case of interest rates, that would argue for the "known Fed Policy" that short rates will stay low for "the foreseeable future". At the same time, this fosters a historically steep yield curve of over 400 basis points, as the "known" policy of zero rates for an extended period creates concerns down the road over the "unknown" effects of easy money on inflation and hence, higher long-term rates. This is what must be "known" to be priced into an efficient market. Here is the problem with this theory: even at zero interest rates, lending has dropped off by the most in 60 years while short-end investors are being crushed by NEGATIVE real returns on a historic level (there is after all, some inflation eating away at those zero returns). So, the Fed is pushing on the proverbial string while their attempts to jump start lending with zero rates appears to be about as successful as trying to nail jello to a wall. Here is a Heretical solution: if the Fed RAISED RATES to say 50 basis points AND stated that they were "done for the foreseeable future and will keep rates low for an extended period of time, but recognize that a zero interest rate policy is no longer consistent with a zero-to-positive growth economy" (roughly the same language they are using today but augmented for the recognition that we are no longer headed into a Great Depression), then two benefits might occur. First, I would argue that longer rates might DECLINE as the uncertainty around a too easy Fed abates due to their rational realization (and the market's recognition of such) that rates are too low now and are not fostering lending anyway. Lower longer term rates are the catalyst of finance as most borrowings for investment are longer term in nature (mortgages and corporate borrowings are two key examples of economic drivers of borrowings that would benefit from lower long term rates). Second, and this will hit home for most of our readers, interest earned on short-term investments will move from NEAR ZERO to 50 basis points or higher! This will provide significant boost to earnings for reinvestment or even, gulp, added savings. Both of these positive impacts would boost economic growth now. So, a carefully communicated rate increase today that is NOT a signal of a continued pattern of increases divorced of economic reality would (pardon the heresy) lead to faster economic progress through a flatter curve and higher returns on investment capital for either spending or augmenting savings.
March 2, 2010
March to come in like a lion, while January and February started out like a lamb?
Compared to the roaring double digit stock and bond returns of last year, the first
two months of 2010 certainly were as soft as a lamb's downy coat. Equities were
down about 1% and in fixed income, the Barclays Aggregate Bond Index up about 1.5%.
The soft start no doubt has much to do with the see-saw pattern of economic statistics
(housing and consumer confidence down last week while corporate earnings were surprisingly
strong). Creeping concerns over burgeoning global government budget deficits in
Greece and the "PIIGS" (Portugal, Ireland, Italy, Greece and Spain) have garnered
the world spotlight due to high debt-to-GDP levels of over 100% and budget deficits
approaching 13%! This is merely evidence of the market's growing concern
over the
massive shift of borrowing from the consumer and private sector to the government
sector -- a piper that must be paid for someday. In Greece's case, the market is
concerned that if Germany and the European countries don't step up to back Greece,
that someday might be today.
The classic Macroeconomic 101 Keynesian response to
our European and U.S. "Great Recession" is the "Great Inflation" of Government
borrowing and spending. This is one of the key concerns we expressed in our recent
CIO quarterly letter. After all, once the economy's recovery becomes a bit clearer
and more stable, the "flight to quality" investment benefitting our government debt
and U.S. dollar are likely to abate as well. We think it is telling that the U.S.
yield curve is the steepest it's been in a generation with a slope of close to 4
percent! It is also telling that while the majority of the total return of
the Barclay's Aggregate Bond Index so far this year was due to price gains driven
by lower treasury rates in the short and intermediate part of the yield curve (down
about 35 basis points), the 30 year treasury barely budged!
This investment flow is currently parking itself in shorter maturities, while the
long end is being relatively neglected. Meanwhile our budget deficit is close to
Greece's at 13% and with a growing debt-to-GDP burden not far behind Greece, the
neglect of our longer dated issuance seems a prelude toward higher rates down the
road (see our last two previous week's market commentary on a way to soften the
blow of higher rates). Hence, we patiently stay on the cautious side of duration
allocations for now. Finally a note on spread sectors for the first two months.
Two notable winners were CMBS (up 6.5%) and short dated consumer ABS (cards and
autos). These are areas we outlined as constructive opportunities for outperformance
in our CIO letter. While the speed of the rally in CMBS came quicker than we thought
(and we could see a slight give back) we remain on course with Cutwater's original
expectations for these ABS sectors.
February 24, 2010
Is it time for the banks' "profit pacifier" to be taken away by the Fed?
The Fed engineered yield curve is the steepest in a generation as emergency easing
puts short rates at near zero, while longer rates hover at 4%+ higher. This historically
steep yield curve allows banks an easy "pacifier" to regenerate profits by paying
little on deposits and purchasing securities out the yield curve. This is known
as the "carry trade".
The problem here is that banks are not lending and are able to hide behind the profits
generated from the carry curve. While we clearly are not against banks adding more
to their capital base through improved profitability, we merely suggest that one
way to get the banks to lend again is to take away this pacifier. As I argued in
our recent CIO letter and in last week's market post
(see www.cutwater.com for a
copy), a more aggressive Fed would lead to a flatter yield curve. This could then
incentivize the banks to think about how to generate profits by lending instead
of just purchasing securities. This would target a core problem with this recovery,
a lack of lending.
Rather than riding the yield curve through the carry trade, the banks would be more
pressured to lend and thus, as the old Smith Barney commercial once said, "make
money the old fashioned way...earn it".
February 19, 2010
The Fed's psychiatric prescription for keeping a lid on longer rates: a dose of a discount rate hike
We applaud the Fed's early move towards signaling the beginning of the end of an unprecedented easing campaign. As I argued in my recent quarterly economic commentary, one of our main concerns was that the Fed would follow a "lazy campaign" of raising rates, increasing the risk of much higher long-term rates down the road. While the Fed needs to cautiously balance fears over pulling the punch bowl away too quickly versus too slowly (as it did in the Greenspan era), we believe that moving early is the best prescription for keeping long-term yields under control. I've often said, sometimes the best way to lower rates is to raise rates. By moving now on the short end of the curve, the Fed dampens fears over long-term inflation, cushioning the ultimate rate rise that will likely occur as we continue to recover. If they maintain this signaling, we expect the curve will begin to flatten.