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.
08/08/2011
Democracy is the worst form of government, except for all the others that have been tried
While a one notch downgrade is historic and worthy of headlines, most portfolios in the
global market are not pressured to rebalance at this rating level. In fact, since the rumor
and fear of downgrade came about, treasury rates are much lower. Still, with tail risks in
Europe and a fragile psychology after the Washington cliffhanger, we shouldn't be surprised to
see a potential market reaction with increased volatility in the short-term, particularly given
the sensationalist headlines in the media over the weekend. After that, I would expect the market
to settle in and focus on the true underlying drivers (for better or worse). Remember, markets
hate uncertainty and the threat of a downgrade has been hanging over the market's head for
quite some time. The U.S. is now at AA+ (but still rated triple-A by Moody's and Fitch and
importantly, A1+ by S&P – its highest short-term rating). With the downgrade done, It's not
uncertain anymore.....time to move on to something else, Mr. Market. Unfortunately, that something
else is a slower U.S. economy and an unresolved periphery Europe. This is generally what we at
Cutwater have been saying for quite some time (recall, we are in the "Volatility Phase" with these
tail risk flare-ups expected). That is why we have been steadily reducing risk in our broad accounts
for the past few quarters!
However, the fact remains that the U.S. is still the safest place to invest in the world with the best legal, military
and political systems (despite all of its faults). In the end, many disagree with the AA+ rating (Warren Buffett said the
U.S. should be rated quadruple-A). The direction of our markets will ultimately be driven by the underlying fundamentals,
not a one notch move from a rating agency. Remember, as Winston Churchill said, "Democracy is the worst form of government,
except for all the others that have been tried."
05/20/2011
European Leaders Lean Toward Cutwater's View
In our previous commentary, "To Bail or Not To Bail, we argued that the costs of not bailing out the weaker EU economies may exceed the costs of providing a bailout. It appears that the European Central Bank ("ECB") is against the idea of a soft restructuring of Greek debt, which has been floated by key EU politicians in the past week. A key ECB Executive Board member said any restructuring would undermine the collateral Greek banks used to gain loans from the ECB and that "this holds true for all kinds of restructuring". Another Board member said a Greek "debt restructuring would cause shockwave throughout Europe." And so it seems the politicians are recognizing, as we argued in our paper, that the costs of a bail out may indeed be the least expensive way out. As Ben Franklin said, "We shall hang together or assuredly, we will hang separately."
03/18/2011
Keep faith in the Checkmark recovery
As you know, we here at Cutwater take the long view when it comes to investing
and the economy. While first and foremost on our minds should without doubt be
the human cost to the tragedy in Japan, an essential U.S. ally and trading partner,
inevitably we also need to consider the economic costs. This horrific event will
certainly have idiosyncratic effects for a wide range of industries, particularly
for nuclear power companies and insurers, which will likely shake confidence in
the industry, as we are already seeing. Germany has come out strongly against
expanding nuclear energy and there is also more hesitation in the United States,
where before this event we saw an unusual alliance between conservatives and
environmentalists pushing for more nuclear production. The earthquake/tsunami in
northeastern Japan is already said to be the most expensive natural disaster in world history.
Fortunately, Japan is the third largest economy in the world and has the means to cope
with it financially. However, Japan already has a massive debt load and this is going
to add hundreds of billions of dollars to it. But spend they will and must.
Rates are likely to go up in Japan and this will hurt the United States.
Rates after the flight to quality will abate for two reasons: 1) yen repatriation;
and 2) real yield comparisons -Japan's real yields are going to head up and look attractive.
I am confident in our moderate short duration.
It's always problematic to guess on flight-to-quality trades as they are driven
by black swans and tail events that pop to the fore. But unless we are heading toward
another recession, we will ultimately understand what the nuclear impacts will be
(the world is not going to blow up, despite the Mayan calendar ending in 2012).
When we understand the impacts, the huge panic will subside and volatility will ease.
Again, this is why Cutwater stresses the "Abnormal Normal."
Looking at long term spread averages and standard deviations from a multi-decade
period of the "Great Moderations" doesn't quite capture the potential go-forward
volatility of the "Abnormal Normal" tail risks.
03/15/2011
The "Abnormal Normal" comes in like a lion in March
We expect noise in the coming weeks in credit and rate markets as events pop up
all over the globe. If we step back and take our customary "long view," we shouldn't
be surprised or too nervous yet. Recall our position that we are in a phase we call
the "Abnormal Normal," where a recovering global economy is paired with fatter tail
risks than have historically been the case over the past several decades. Some tail
risks are frankly "known," such as the crisis in Europe, which we had warned earlier
this year was not resolved despite the market dropping this concern from the radar
at the start of 2011. Some risks are unknowable, such as the tragic disaster in
Japan. Higher oil prices, higher rates globally, and turmoil in the Middle East
and North Africa are all tail risks that have moved closer to the middle part of
the market's conscious psychological bell curve. No wonder spreads are wider!
It was just two months ago when many conversations in the market centered on the
central tendencies of positive economic growth and dismissed concerns over tail
risks. This is why we were cautious on our risk budgeting and began to pull back
on some of the risk sectors in our portfolios earlier in the quarter. All that said,
when we consider the "long view," we remain constructive on selective areas of the
spread markets. The global economy still seems to be entering into the "self sustaining"
phase of growth. Recent economic data in the U.S., such as indicators for manufacturing
and services, were expansionary and quite strong. We will look to any significant
pull backs as potential opportunities to add risk when the margin for safety has
grown. Since fatter tail risks are with us for the foreseeable future, we seek to
flatten our own portfolio "tail risk" by carefully allocating to the less index
correlative sectors, such as municipals and CLOs, and away from the crowded index
beta names, which, in our view, have run too far. After all, when the crowd jumps
to a de-risking mentality, where do they go to first? The bigger, more liquid sectors
as a "ready, fire, aim" atmosphere takes over. We remain patient and believe the
recovery is still on a "check mark like" path of slightly below-trend GDP growth
of about 3 percent and would note the "jumpy nature" of many other forecasts that
were pumped as high as 4 percent recently, only to be notched back this past week
due to the nature of the aforementioned tail risks. Looking out over the next year,
we believe a higher quality, less correlative and carefully allocated risk budgeting
will pay off more than a rapid fire "risk on, risk off" hair trigger mentality.
12/20/2010
We must all hang together, or assuredly we shall all hang separately - Part 2
Since I last wrote on the topic of rescuing the weaker peripheral economies in Europe, some have argued for a mechanism or facility to keep borrowing rates down. This mechanism would be used to avoid the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) coming back to market in 2013 by providing liquidity for an extended period of time, at a subsidized borrowing cost. After all, it is this borrowing cost that is a key determinant of sovereign solvency itself, but solvency can only eventually be obtained if better economic figures are achieved over time figures on which the liquidity support must hang its hat. On the one hand, today's announcement of a permanent liquidity vehicle is encouraging, but on the other, if the borrowing cost is maintained at the current bailout cost of 350 basis points over Germany's funding cost, then the PIIGS have a slim hope (nay, pray) of achieving debt sustainability. Aggressive fiscal consolidation is imperative under any scenario; however a shortfall may stress the political resolve of the monetary union, bringing into question once again whether the political will is there to see it through. The Bank of England highlighted the interconnectedness of not only the eurozone, but the wider trading block as a whole, when they advised that UK banks ditch "bonuses for buffers" in case of a prolonged and deepening euro crisis. This forces us to return to our whiteboards. Even though UK banks have limited exposure to peripheral European debt, they do have almost GBP 300 billion of claims against French and German banks, that in turn are heavily exposed to the PIIGS, highlighting the domino effect on the "no rescue" whiteboard and lowering the net present value (NPV) of the UK, as well as Germany and France. This potential scenario surely brings us back to the "rescue" whiteboard and its eventual higher NPV as a result of the longer-term liquidity support now in place and the hope of achieving debt sustainability. However, there is an old saying in the markets, "when you hope...you should fear." This fear may keep rates on peripheries higher than normal, because at the end of the day, it's about solvency.
12/13/2010
We must all hang together, or assuredly we shall all hang separately
The great experiment of a unified currency without fiscal unity needed a crisis to test how the structure would truly handle countries who gorged on spending and borrowing under the "halo" of a common euro currency. Now the bills are coming due for the PIIGS, who have large and unsustainable debt-to-GDP loads (north of 100 percent in most cases). Patchwork rescues of Greece and Ireland only serve to provide temporary liquidity relief until 2013. Then what? Even bigger temporary funding support doesn't end the real issue - the longer term solvency of these countries. No surprise to us then that spreads in periphery countries continue to widen. Indeed, this type of temporary solution combined with Germany's mention of future loss sharing by creditors only serves to tee up fears of a run on the bank. After all, why hang around to find out what that means? Selling begets price drops which begets even more selling in a vicious circle. The way to end the debate is to determine whether the Euro union stands (by having all members guaranty sovereign debt) or let the weaker members go (by devaluing them which in essence is akin to default) and attempt to preserve some two tiered system with France and Germany at the center. Which way will it go? To rescue or not to rescue, that is the question. While either outcome is possible, we believe a rescue of the sovereigns is the more likely outcome. A student of this past rescue era would find a strong correlation between the type of note holders and counterparties of those who were chosen for rescue versus those left twisting in the wind. More often the case, the more systemically connected entities were rescued to prevent further domino effects. After all, the Government didn't rescue AIG for AIG's sole benefit --in doing so it also rescued Goldman Sachs! So, if we got out the white boards and looked at Germany and France's "NPV" on the rescue versus no rescue decision (after all Germany and France would bear the brunt of either decision), we might discover some interesting facts. On the "no rescue" whiteboard, we would need to significantly mark down the economic growth of the peripheries. Also, we must mark down German and French GDP as a secondary consequence. Uncertainty and volatility would spike with the failed experiment giving way to a new one. And what of the "new and stronger" German and French Euro? Would it jump higher like a cork under the surface of the ocean cut free from the heavy drag of the periphery anchor? Germany's export oriented economy in particular would suffer. Ok, not great, but maybe tolerable? But wait, what did we forget to add to the white board?...oh yes...who owns all this debt anyway? Well, while the exact figures are not clear, what is clear is that the German and French governments and banks own quite a large sum of Euro debt. This sounds all too familiar in high correlations to rescues. Painful bottom line on this "no rescue" whiteboard for sure! Ok, let's see what the "rescue" whiteboard looks like? Rescuing the Euro through a guarantee or "E Bond" scheme means it is an "all for one and one for all" system. Germany and France take most of the burden, but the solution effectively "spreads the burden" at a "federal level" akin to the United States. On that score, the overall combined debt-to-GDP would be a tolerable 80s percent estimate. This is slightly elevated and no slam dunk, but it is below the level of the U.S. European growth might not be robust, but we would argue the benefits of stable currency, stable borrowing rates and the removal of massive uncertainty of where the current daisy chain breaks, who owns what debt and who can survive and who can't winds up at a better "NPV" than the previous whiteboard. Perhaps this is why Germany's finance minister, Wolfgang Schauble, warned markets on Friday not to underestimate Berlin's mettle to protect the Euro. After a view of our two whiteboards, Germany may have concluded, "We must all hang together, or assuredly we shall all hang separately."
11/30/2010
Eurozone Endgame: The Road to Resolution
The bond market vigilantes didn't take long after the first "rescue" of Greece
(see Cutwater's Market Commentaries from April and May 2010) to move on to the next weakest periphery
country, Ireland. The original 440 billion euro (roughly 580 billion US dollars) stability rescue
fund quieted markets for roughly one quarter but left much uncertain about the future for not only
Greece but also for the rest of the periphery countries. The "patch" of liquidity offered to these
countries only lasts until 2013 when the ability to tap the fund expires.
Then what? Presumably, the can has been kicked far enough down the road so that Greece and the others
have time to show meaningful signs of economic recovery to dig their way out of significant debt loads.
Results on this score thus far, however, haven't been impressive and an impatient bond market has
moved on to the next link in the chain, Ireland. A forced rescue package totaling approximately 85
billion euros was approved and dedicated to a shaky banking system. It seems to me that recent comments
from Germany about a future "resolution" regime of bailing-in institutions
(i.e. having creditors taking a loss versus rescuing them holistically) aggravated an already fragile
situation and put an endgame in play. After all, comments from certain EU officials that post-2013
bond investors might face haircuts should cause investors to question relatively low yields and high
prices on shakier countries' debts. In a way, the comments ignited a self fulfilling prophecy with all
the signs of a potential classic "run on the bank" (and on sovereign credit).
If prices hadn't moved down, why not sell due to the risk of haircuts and resultant uncertainties?
Enough global conversation along these lines can reach a tipping point of significant
sales and price drops. There now exists a setting where the bond market "runs the table" all the way to
Spain to test, and in a way force, a resolution to the still lingering question -what happens after 2013
to a country and/or its banking system that can't meet its payments? The market wants to know now,
not in 2013. The International Monetary Fund (IMF), European Commission (EC), and
European Central Bank (ECB) may be forced to answer more clearly and much sooner, as pressure on
borrowing rates for periphery continues to build and creates a larger financial hurdle for countries
trying to dig out of their debt financing holes.
What are some solutions? The authorities should now commence working on and clarifying what the
resolution regime will look like. First, they need to establish rules for the resolution of financially
troubled countries. Defining systematically important institutions and defining the level of bail-in risk
(all the way through subordinated debt) seems logical. After all, a bond market at risk would act like
a governor on future risky activities at these institutions. This would involve more near-term pain to
be sure, but this is what uncertainty is causing anyway. As for countries, the consensus now is that
the EU could afford to bail out Greece, Ireland, and Portugal, however countries the size of Spain
would be too large a burden to carry. This consensus now acts almost like a dare to the bond market, which
may now test this thesis by driving Spain's borrowing costs painfully higher. Here, the EU needs to
take a stand. If they collectively believe the euro can withstand the pressure, the weaker countries
can be rescued, and the burden resolved through spreading the pain, then they would need to be clear
that the euro will indeed stand and create a mechanism to back this. Perhaps a joint and several
guarantee regime over a much longer time horizon (perhaps as long as 10 years) could be one alternative.
This results in a bigger burden on Germany and France but would quell the run on sovereigns and give
appropriate breathing room to recover. Conversely, if the collective majority view is that the weaker
countries' financial positions are too fragile to recover without help, a clearer mechanism for
determining a resolution of sovereign debt needs to be put in place. For example, a permanent
capital fund alongside a bail-in of debt holders wherein debt is extended and coupons are lowered
creates a framework on analyzing the value of existing debt. This likely forces quicker tests on
weaker countries but helps resolve the issue now rather than leaving current volatility to run amok
and then have the same need three years hence. Finally, stronger capital rules for banks and stricter
fiscal targets for sovereigns (also as a condition to receive permanent capital contributions) would
do much to reduce the risk of both moral and real financial hazard in the markets going forward. Whatever
the outcome, even the recently "paved road of rescue to 2013" has given way to the bumpy road of the
unknown. The drivers in the bond market don't want to be on a highway where they can only see
so far. After all, the paved road may give way to uncertain twists and turns and even end at the
edge of a cliff.
11/17/2010
The best way to raise rates.... is to lower them!
Much has been written about Quantitative Easing 2 (QE2), wherein the Fed stated they will
"print money" by purchasing $600 billion in intermediate maturity Treasuries in the next six months.
The Fed is trying to lower rates and force investors to bid up riskier assets, such as stocks and
non-Treasury bonds, like corporates, high yield, and structured securities.
Interestingly enough, since the details of the announcement outlining these large scale asset purchases,
rates have actually risen! The Fed is trying to engineer lower rates but in so doing, it opens the risk
to future inflation. The reaction in the bond market has been stiff with yields backing up by 25 to 50
basis points across the curve over the past month, and with about half of this rise occurring since
the Fed announcement on November 3rd. The specter of lower rates has also tested the U.S. dollar,
which has dropped along with the announcement. This has not pleased the world's central banks to say
the least -a devalued dollar makes the U.S. a more competitive exporter.
The risk now is that the Fed loses some control over intermediate and longer maturity interest rates,
which are set by the market, not the Fed. We forecasted this risk earlier in the year and specifically
pointed out that the "right cross" knocking rates higher would be a resetting of real yields, or the
rate after inflation. The bond market's temporary euphoria over the potential for QE2 lead inflation
protected treasuries toward NEGATIVE real yields, as highlighted in the recent Cutwater CIO
quarterly letter. When I wrote that piece, five-year Treasury Inflation-Protected Securities (TIPs)
carried a whopping negative 50 basis point real yield. In effect, one had to pay the government for
inflation protection. Since then, those securities are now closer to zero. This should not come as a
surprise when attractive real yields are offered in markets away from the U.S. We positioned for higher
rates across our portfolios and perhaps that trend is finally appearing, despite the Fed's efforts.
However, this is likely a volatile ride toward higher rates that takes more than a few quarters to work
its way through the markets, given the Fed's efforts to forestall higher rates for now. Or... Perhaps they
should end talk of QE2 (raise rates) in an attempt to lower them!
10/7/2010
Ready, Fire, Aim
The developed world's central banks have embarked upon a monetary war wherein each country attempts to move the value of their currency lower in order to improve their relative attractiveness as an exporter. A lower currency cheapens the cost of the goods of the seller and therefore improves the chances of increasing their exports overseas. Unfortunately we see several issues brewing. In an effort to drop their currency rates, countries such as Japan are purchasing their own bonds to force lower interest rates, which "drive" money away, and thus lower the value of their currencies. In fact, Japan in particular has been aggressively moving in this direction in anticipation of the U.S. implementing the Fed's Quantitative Easing Two strategy (shooting first, and asking questions later - Ready, Fire, Aim!). The concern grows as major developed countries follow a similar path in a "race to the bottom." These attempts to "beggar thy neighbor" can easily turn into a zero sum game. The monetary pump of global central bank bond purchases creates even easier global monetary policy. However, at some point, the rampant easy money turns from simple reflation towards global inflation (or perhaps even stagflation), causing the opposite of the intended action -higher global rates! For this reason and others, we remain cautious about the long term outlook for rates at Cutwater and therefore maintain a cautious rate posture in portfolio construction.
8/26/2010
The Fed as the new "Shadow Bank"
On August 27, we will hear from Fed Chairman Ben Bernanke from his speaking perch at Jackson Hole.
To be sure, we will hear more explanation about his outlook for the slowing economy.
However, of equal interest to us will be his explanation of how and why the recent decision to stabilize
the quantitative easing program (now in the form of reinvesting proceeds of maturing mortgage bonds back
into Treasuries) was determined. After all, this is really a minor move and yet it turned out to be a major
story in the market. In effect, the Fed spooked the market, which interpreted the move as evidence that things
are worse than they may actually be.
Indeed, the recently released minutes from the Fed meeting show this exact concern was heavily debated among
the Fed committee members. We expect Bernanke's speech is in part an attempt to "unspook" the market,
which has traded with much more volatility since the announcement of this new quantitative easing "lite" program.
Beyond this meeting, we have argued that the Fed balance sheet could be put to better use than simply buying
Treasuries. We argue that the Fed should widen its purchase universe to those securities which support lending
to businesses and consumers. In essence, if the Fed is in the investing business (as it now is with a balance
sheet that has more than doubled to over $2 trillion) it should do so not merely to lower rates.
In fact, lower rates have not helped credit growth rebound much at all with bank balance sheets still
constrained and financial regulatory details on capital and liquidity still not finalized.
We believe the Fed needs to use this balance sheet in a less "blunt" fashion to unclog the flow of
credit to businesses and consumers.
At its peak, the non-bank "shadow banking system" was as sizable a lender to consumers and businesses as
the banks were. This was done through the securitization of credit cards, auto and residential loans,
as well as business loans in the form of collateralized loan obligations (CLOs), which were sold to the
market and many of the entities that constituted the shadow banking system. If the Fed were to create
a diverse purchase program targeted at top-quality, newly-created consumer and business securitizations,
it would add much more punch to helping the economy grow than through lower rates driven by Treasury purchases.
Indeed, targeting these borrowers helps not only by providing credit but also by tightening borrowing spreads
for these important economic constituents. For example, at their peak, the asset-backed commercial
paper (ABCP) programs held over $1.2 trillion of similar assets. This has shrunk to less than $400 billion.
The Fed could replace a significant component of this market now while
the markets reconstitute and repair themselves. This makes sense compared to merely pushing rates
to historic lows. With real yields (yields after inflation) now less than half long term averages,
the Fed has not only spooked the market but is now "pushing on a string" of little value.
Perhaps with a newly regulated and chastened banking market, the Fed should take over the mantle of
the inactive shadow banking system and allow credit, our economic blood stream, to once again flow to
where it is needed.
8/11/2010
The Fed's Actions May Cause Market Psychology to Also Be "Unusually Uncertain"
On August 10, the Fed fast-fowarded easing policy actions after a series of comments about
what Chairman Ben Bernanke termed the "unusual uncertainty" surrounding the economic outlook.
At the Federal Open Market Committee meeting, the Fed acknowledged that the economic recovery
was "more modest in the near term than had been anticipated." Unsurprisingly, they kept the fed
funds rate at around zero (after all, zero is pretty low). Perhaps less expected was the decision
to reinvest proceeds from their mortgage portfolio into long-term U.S. Treasury bonds in an effort
to keep long-term interest rates low. The hope is that these actions will have a modest positive
effect on the economy by making it cheaper for consumers and businesses to borrow.
The immediate effect was a rise in bond prices and decrease yields.
Yields on 10-year treasuries fell to their lowest level in a year to 2.77 percent from 2.83 prior
to the announcement. The decision appears to have caused a little confusion in the market as
initially stocks rallied and then sold off and bond spreads widened modestly.
Clearly, the Fed is trying to keep rates low and stable as well as quell any risk of deflation.
However, deflation is also very much a psychological phenomenon in the form of delayed purchases
in anticipation of cheaper prices down the road.
Cutwater's concern is that in its goal to lower rates and support the economy, the Fed may be
coming closer to "spooking" the consumer and the market into believing the economy is much worse
than it may actually be. The continued swoon in stocks and widening of spreads underscores
this potential effect. After all, most economists and the Fed itself forecast positive
(admittedly slow) GDP growth in the coming quarters.
With economic growth and historically low rates, perhaps a better signaling for the
right psychological impact would be for the Fed to craft a more stable, better-telegraphed,
and more predictable monetary policy. While we at Cutwater expected a slowing of the economy
to the current pace of growth, low rates should support growth further, and it would
not surprise us to see higher rates in 2011 (with volatility in between).
Hence we remain cautious on the direction of rates as we look out over the horizon.
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.
The information contained in this page comes from public sources which Cutwater Asset Management believes to be reliable. All opinions expressed in this document are solely those of Cutwater. A list of sources used for this document is available upon request.