The market bulls' and v-shaped recovery advocates' are beginning to crumble. This morning, foreign markets trended lower as the realization that corporate profits have been the result of reduced expenses and not higher revenues. The U.S. markets followed suit, in spite of economic data which was better than the street consensus.
Not only have profits not been based on revenue improvements, but some companies have reported better earnings and reduced revenues. Even a neophyte business person knows that one cannot cut their way to success. What about the consumer coming back online and spending the economy back to health? That is probably not going to happen. Consumers cannot borrow as they had in the past. This is not just because credit is tight in general, but because lending practices are more prudent. Many consumers who had credit in the past cannot get it now and should not have received it before. It appears as though stock jockeys are wishing, hoping and betting that consumers receive access to easy credit. That probably won't happen now as it will take banks a few more years before they repeat their mistakes of the past or make new creative mistakes.
Realists are even appearing more frequently on Kudlow and Co. Guests, who Larry probably scheduled as bearish foils for his own and his cohort's bullish tones, are winning the debate. Guest Doug Kass of Seabreeze Partners put forth the argument that consumer spending will be buffeted by a weaker dollar, higher interest rates and business and consumer unfriendly tax policy. He stressed that it is consumers who lead to business growth and not the other way around. Finally, someone actually acknowledging that consumers will not be able to borrow and spend our way out of this. I have mentioned previously that economic growth could be reminiscent of the post-war era. Mr. Kass is thinking along the same lines. He told Larry Kudlow that consumers could be returning to a mentality of preservation as they were post depression. I think Mr. Kass is right on.
Markets usually overshoot on the way up as well as on the way down. Mr. Kass correctly called the bottom of the U.S. equity markets in March and now he is calling a top to the market now. With business data not supporting current market levels and market participants returning from summer vacations, we could see profit taking during the next several weeks. The traditional autumn market swoon could be upon us.
Corporate bond investors should also take heed. Corporate bond spreads have tightened dramatically. Ten-year industrial bonds, such as Wal-Mart are trading inside 80 basis points to treasuries and banks such as JPM are just over 100 basis points above treasuries. These are now withing historical spread ranges for good economic environments. I do not suggest selling high-grade bonds here if they were purchased for income. However, the trades among us may want to take some money off of the table. This is especially true of preferreds shares and more so for high yield bonds. Levels appear rich considering the head winds which probably lie ahead. Preferreds and high yield bonds look rich at these levels.
Monday, August 31, 2009
Wednesday, August 26, 2009
B-B-B-Benny!
President Obama's decision to nominate Fed Chairman, Ben Bernanke for another four year term had pundits chattering, both approvingly and disapprovingly. Those who believe that Mr. Bernanke deserves another term point to his calm under fire and his in-depth knowledge of the great depression as the reason for averting a catastrophe. Detractors point to his previous time at the Fed when he was part and parcel to then Fed Chairman Alan Greenspan's policy of keeping short-term borrowing rates very low for an extended period of time as a prime cause of the housing bubble. There is some truth on both sides of the debate.
We should all be thankful that it was Ben Bernanke who was at the Fed's helm when this crisis erupted. However, he was on board with Alan Greenspan's policy. There is one factor that few pundits seem willing to discuss. That is Wall Street's responsibility in the housing crisis.
Low rates alone did not cause the crisis. Sure, lower rates spurred home buying and put home ownership within the reach of more people, but it was Wall Street "innovation" which permitted borrowers with poor or no credit history to obtain credit. It was "innovation" which permitted 100% (or more) financing and the incredibly stupid pay option ARM. Mr. Bernanke, like investors who purchased packages of these loans, assumed that banks, investment banks, credit ratings services and investors were doing their respective due diligence. That was not the case. Even if the Fed had tightened sooner, we could have had a violent correction, but probably not as violent as have seen. The criticism should be shared by the Fed, FDIC, SEC, FINRA, The Comptroller of the Currency and the GSEs. Regulations were in place, but were ignored.
In spite of all of the aforementioned dropped balls and the shell game known as the "Stress Test" the economy does so signs of improvement. Inventories are being replaced as the worst is over. Auto sales are higher, thanks to Cash for Clunkers and home sales are rising thanks to a tax credit for first time home buyers. These are all positive events. However, just as the economy turned out not to be as bad as some feared, stimulus driven growth should not be considered normal or sustainable.
Here is where Mr. Bernanke can add value. During the Great Depression, the economy did show signs of recovery only to be torpedoed by bad tax and trade policy. Maybe Mr. Bernanke can be the soothsayer warning politicians of what might happen should they choose to make the same mistakes of their 1930s predecessors. He can also set Fed policy to minimize the damage of unwise legislation.
Mr. Bernanke will have his hands full. Taxes will probably increase, a weaker dollar will weigh heavy on food and energy prices and the huge deficits could put upward pressure on interest rates. These are formidable headwinds and could moderate, but not eliminate growth. The U.S. is the most dynamic economy in the world and, in spite what the nouveau smart will have you believe, is the prime long-term driver of global economic growth.
Opportunities abound for those who understand the fixed income markets. High yield buyers have experienced significant, albeit illogical, gains this year. These investors should not become too greedy. Corporate defaults will rise as many junk-rated companies will not be able to refinance maturing debt affordably, if at all. Many regional banks are time bombs and are clearly not too big to fail.
Treasuries have a significant amount of downside price pressure due to the potential for rising rates due to continued large supply of treasuries and rising deficits. The best places in the fixed income market are agency debt on the short end of the curve and high grade corporates (especially large true banks) farther out. Investors who can tolerate time uncertainty of maturity should consider agency-issued mortgage-backed securities, especially GNMA bonds which enjoy the full faith guarantee of the U.S. government.
Any questions, please ask.
We should all be thankful that it was Ben Bernanke who was at the Fed's helm when this crisis erupted. However, he was on board with Alan Greenspan's policy. There is one factor that few pundits seem willing to discuss. That is Wall Street's responsibility in the housing crisis.
Low rates alone did not cause the crisis. Sure, lower rates spurred home buying and put home ownership within the reach of more people, but it was Wall Street "innovation" which permitted borrowers with poor or no credit history to obtain credit. It was "innovation" which permitted 100% (or more) financing and the incredibly stupid pay option ARM. Mr. Bernanke, like investors who purchased packages of these loans, assumed that banks, investment banks, credit ratings services and investors were doing their respective due diligence. That was not the case. Even if the Fed had tightened sooner, we could have had a violent correction, but probably not as violent as have seen. The criticism should be shared by the Fed, FDIC, SEC, FINRA, The Comptroller of the Currency and the GSEs. Regulations were in place, but were ignored.
In spite of all of the aforementioned dropped balls and the shell game known as the "Stress Test" the economy does so signs of improvement. Inventories are being replaced as the worst is over. Auto sales are higher, thanks to Cash for Clunkers and home sales are rising thanks to a tax credit for first time home buyers. These are all positive events. However, just as the economy turned out not to be as bad as some feared, stimulus driven growth should not be considered normal or sustainable.
Here is where Mr. Bernanke can add value. During the Great Depression, the economy did show signs of recovery only to be torpedoed by bad tax and trade policy. Maybe Mr. Bernanke can be the soothsayer warning politicians of what might happen should they choose to make the same mistakes of their 1930s predecessors. He can also set Fed policy to minimize the damage of unwise legislation.
Mr. Bernanke will have his hands full. Taxes will probably increase, a weaker dollar will weigh heavy on food and energy prices and the huge deficits could put upward pressure on interest rates. These are formidable headwinds and could moderate, but not eliminate growth. The U.S. is the most dynamic economy in the world and, in spite what the nouveau smart will have you believe, is the prime long-term driver of global economic growth.
Opportunities abound for those who understand the fixed income markets. High yield buyers have experienced significant, albeit illogical, gains this year. These investors should not become too greedy. Corporate defaults will rise as many junk-rated companies will not be able to refinance maturing debt affordably, if at all. Many regional banks are time bombs and are clearly not too big to fail.
Treasuries have a significant amount of downside price pressure due to the potential for rising rates due to continued large supply of treasuries and rising deficits. The best places in the fixed income market are agency debt on the short end of the curve and high grade corporates (especially large true banks) farther out. Investors who can tolerate time uncertainty of maturity should consider agency-issued mortgage-backed securities, especially GNMA bonds which enjoy the full faith guarantee of the U.S. government.
Any questions, please ask.
Monday, August 24, 2009
Nowhere Man Please Listen
Nowhere Man Please Listen
He's as blind as he can be,just sees what he wants to see,Nowhere Man can you see me at all? – John Lennon / Paul McCartney
Noted NYU professor of economics, Nouriel Roubini published an article in the Financial Times explaining why, in his opinion, the U.S. economic recovery will me lengthy and gradual. Immediately, the bulls and equity market cheerleaders (stock jockeys) attempted to discredit Professor Roubini. I take umbrage (on Professor Roubini’s behalf) at the attempts to discredit and, in some instances, belittle his opinion. Judging by the statements I have heard on the opposite side of Mr. Roubini’s argument, I believe that many market bulls are “Nowhere Men”, seeing just what they want to see.
If it appears as though I give more credence to Professor Roubini’s arguments than to certain CNBC pundits and their guests it is because Mr. Roubini presents well thought out arguments to state is opinion. Many on the opposite side of the spectrum (predicting a v-shaped recovery) state that the economy has to recover sharply because of government stimulus, pent up demand, leading indicators say so or (I love this one) because it always has been this way. Of the arguments for a v-shaped recovery only leading indicators make a rational case. However, when one considers inventory replacement which is currently under way, strength as reported by leading indicators could evaporate once inventories have been built up to levels in line with consumer demand.
My biggest concern is that consumer demand will be at levels which are far below to what we have become accustomed. Remember, demand we experienced during the past to recoveries was mostly due to cheap, easy to obtain credit and the resulting rising real estate values. Although credit is currently historically cheap, the demand from credit from those who qualify to obtain credit is relatively low. For a credit-fueled recovery to materialize, banks would have to once again lower their lending standards. That is not going to happen.
Why won’t the banks take the risk and open the credit gates? After all, doing so could be a self-fulfilling prophecy. Banks open the credit spigot, consumers borrow, spend and create jobs and push wages higher, making everyone more credit worthy. Sounds good, right? Wrong. The truth is that banks never thought they were taking such risks before and they are not going to take such risks now.
If you have read Mr. Roubini’s article you may have noted that he stated:
“Fourth, the financial system – despite the policy support – is still severely damaged. Most of the shadow banking system has disappeared, and traditional banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalised. “
The so-called shadow banking system (securitization) was very important for economic growth during the past two economic expansions. The ability to package loans and sell them to investors in the form of asset-backed securities, collateralized debt obligations and various conduits permitted than banks to open the credit spigots and lend to consumers who could not repay their debts. Once it was off their balance sheets the banks were insulated from any potential credit problems, or so they thought. Some actually believed their own, often manipulated, models and began holding some of these toxic loans on their balance sheets. With no way to move newly-created subprime loans off of their balance sheets and no desire to hold onto such loans, banks are not going to give credit to those whose ability to repay is suspect. That removes a substantial amount of consumer activity (pent up demand) from the equation.
Mr. Roubini is also correct about banks being seriously undercapitalized. Even traditional bank bull, Dick Bove’ is warning that approximately 200 banks (mostly regional banks) could fail in the near future. Mr. Bove’ is correct. There is at least one large bank which was technically insolvent if not for a government backstop and the charade of solvency put forth by moving Tier-1 capital to tangible common equity, but not raising a penny more of new equity capital.
The U.S. economy will recover. There is no economy which is as dynamic and has such creative participants, but head winds created by deleveraging, a weaker dollar (resulting in higher food and energy prices) and anti-growth tax and labor policies will buffet U.S. economic growth.
He's as blind as he can be,just sees what he wants to see,Nowhere Man can you see me at all? – John Lennon / Paul McCartney
Noted NYU professor of economics, Nouriel Roubini published an article in the Financial Times explaining why, in his opinion, the U.S. economic recovery will me lengthy and gradual. Immediately, the bulls and equity market cheerleaders (stock jockeys) attempted to discredit Professor Roubini. I take umbrage (on Professor Roubini’s behalf) at the attempts to discredit and, in some instances, belittle his opinion. Judging by the statements I have heard on the opposite side of Mr. Roubini’s argument, I believe that many market bulls are “Nowhere Men”, seeing just what they want to see.
If it appears as though I give more credence to Professor Roubini’s arguments than to certain CNBC pundits and their guests it is because Mr. Roubini presents well thought out arguments to state is opinion. Many on the opposite side of the spectrum (predicting a v-shaped recovery) state that the economy has to recover sharply because of government stimulus, pent up demand, leading indicators say so or (I love this one) because it always has been this way. Of the arguments for a v-shaped recovery only leading indicators make a rational case. However, when one considers inventory replacement which is currently under way, strength as reported by leading indicators could evaporate once inventories have been built up to levels in line with consumer demand.
My biggest concern is that consumer demand will be at levels which are far below to what we have become accustomed. Remember, demand we experienced during the past to recoveries was mostly due to cheap, easy to obtain credit and the resulting rising real estate values. Although credit is currently historically cheap, the demand from credit from those who qualify to obtain credit is relatively low. For a credit-fueled recovery to materialize, banks would have to once again lower their lending standards. That is not going to happen.
Why won’t the banks take the risk and open the credit gates? After all, doing so could be a self-fulfilling prophecy. Banks open the credit spigot, consumers borrow, spend and create jobs and push wages higher, making everyone more credit worthy. Sounds good, right? Wrong. The truth is that banks never thought they were taking such risks before and they are not going to take such risks now.
If you have read Mr. Roubini’s article you may have noted that he stated:
“Fourth, the financial system – despite the policy support – is still severely damaged. Most of the shadow banking system has disappeared, and traditional banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalised. “
The so-called shadow banking system (securitization) was very important for economic growth during the past two economic expansions. The ability to package loans and sell them to investors in the form of asset-backed securities, collateralized debt obligations and various conduits permitted than banks to open the credit spigots and lend to consumers who could not repay their debts. Once it was off their balance sheets the banks were insulated from any potential credit problems, or so they thought. Some actually believed their own, often manipulated, models and began holding some of these toxic loans on their balance sheets. With no way to move newly-created subprime loans off of their balance sheets and no desire to hold onto such loans, banks are not going to give credit to those whose ability to repay is suspect. That removes a substantial amount of consumer activity (pent up demand) from the equation.
Mr. Roubini is also correct about banks being seriously undercapitalized. Even traditional bank bull, Dick Bove’ is warning that approximately 200 banks (mostly regional banks) could fail in the near future. Mr. Bove’ is correct. There is at least one large bank which was technically insolvent if not for a government backstop and the charade of solvency put forth by moving Tier-1 capital to tangible common equity, but not raising a penny more of new equity capital.
The U.S. economy will recover. There is no economy which is as dynamic and has such creative participants, but head winds created by deleveraging, a weaker dollar (resulting in higher food and energy prices) and anti-growth tax and labor policies will buffet U.S. economic growth.
Friday, August 21, 2009
The Truth About Internotes
There is a disturbing article from Bloomberg News this morning regarding CIT Internotes. It appears as investors did not know what they were buying and investment advisers either did not know what they were selling or misrepresented the investment. From my nearly two decades of experience with medium term notes, I can state that most investors do not fully understand the structure of most medium term note structures, including Internotes can say the same for most advisers as well.
Let's review what an Internote really is.
Internote (or Ford COBRA or GMAC Smartnote):
Senior Unsecured Note: No MTN (issued via weekly programs) is secured by specific assets. They are all general obligations of the respective issuer.
Illiquid: Weekly MTNs are issued in small sizes. Typical deal sizes range from 5mm to 20mm bonds. These would be considered good trade sizes in the institutional (real) bond market, never mind deal sizes. Bids to sell are often difficult to obtain and may be lower than were a similar (and equally senior) global issue is trading.
Survivors Options: Most issuers now include minimum holding periods of six months or one year. This means the investor must own the bonds (purchased either in the primary or secondary market) for the minimum holding period. If the investor dies before the minimum holding period passes, the survivors option may not be exercised. If the bonds transfer to heirs before the survivors option is exercised, it will be exercisable upon the death of the heirs. Most trusts are ineligible to exercise survivors option. Check with the issuer before purchasing.
Internotes and other small MTNs carry the same credit risk as any other senior unsecured corporate bond. Investors and advisers should be familiar with the credit story of each issuer before purchasing any corporate bond, including MTNs with survivors options.
Let's review what an Internote really is.
Internote (or Ford COBRA or GMAC Smartnote):
Senior Unsecured Note: No MTN (issued via weekly programs) is secured by specific assets. They are all general obligations of the respective issuer.
Illiquid: Weekly MTNs are issued in small sizes. Typical deal sizes range from 5mm to 20mm bonds. These would be considered good trade sizes in the institutional (real) bond market, never mind deal sizes. Bids to sell are often difficult to obtain and may be lower than were a similar (and equally senior) global issue is trading.
Survivors Options: Most issuers now include minimum holding periods of six months or one year. This means the investor must own the bonds (purchased either in the primary or secondary market) for the minimum holding period. If the investor dies before the minimum holding period passes, the survivors option may not be exercised. If the bonds transfer to heirs before the survivors option is exercised, it will be exercisable upon the death of the heirs. Most trusts are ineligible to exercise survivors option. Check with the issuer before purchasing.
Internotes and other small MTNs carry the same credit risk as any other senior unsecured corporate bond. Investors and advisers should be familiar with the credit story of each issuer before purchasing any corporate bond, including MTNs with survivors options.
Thursday, August 20, 2009
Over There
Fitch announced it was downgrading the hybrid securities (preferreds) of eight European financial institutions. They are:
Lloyds Banking Group Plc, Royal Bank of Scotland Group Plc, ING Groep NV, Dexia Group, ABN Amro Holding NV, SNS Bank, Fortis Bank Nederland, and France's BPCE
The reason for the downgrade is that European regulators may order the aforementioned institutions to halt dividend payments. The European Commission has ordered Bayerische Landes Bank and Anglo-Irish bank to halt dividend payments for because the received assistance.
These actions should not come as a complete surprise to my readers. On March 28, 2009 I wrote the following:
"Following my piece on foreign bank leverage, a reader responded with information that a certain German bank had leverage of over 50 time as of last autumn. I have heard similar stories about a number of European institutions, but have been unable to verify actual numbers. I am often asked about other shoes to drop. One large shoe could be the European banks. That may be a sector that all but speculative investors should avoid."
However, I am ashamed of my actions in recent weeks. During the course of my professional duties, I have taken many buy orders from financial advisers for preferreds issued by ING, RBS and ABN AMRO. In the past I would have warned advisers against such purchases. However, I have been pressured by my superiors not to express an official opinion on such matters. Thanks to my management, many advisers and their clients purchased these preferreds not knowing that they were still in danger or believed them too big to not pay dividends. All banks still owing money to their respective government's are in jeopardy of not paying dividends.
Lloyds Banking Group Plc, Royal Bank of Scotland Group Plc, ING Groep NV, Dexia Group, ABN Amro Holding NV, SNS Bank, Fortis Bank Nederland, and France's BPCE
The reason for the downgrade is that European regulators may order the aforementioned institutions to halt dividend payments. The European Commission has ordered Bayerische Landes Bank and Anglo-Irish bank to halt dividend payments for because the received assistance.
These actions should not come as a complete surprise to my readers. On March 28, 2009 I wrote the following:
"Following my piece on foreign bank leverage, a reader responded with information that a certain German bank had leverage of over 50 time as of last autumn. I have heard similar stories about a number of European institutions, but have been unable to verify actual numbers. I am often asked about other shoes to drop. One large shoe could be the European banks. That may be a sector that all but speculative investors should avoid."
However, I am ashamed of my actions in recent weeks. During the course of my professional duties, I have taken many buy orders from financial advisers for preferreds issued by ING, RBS and ABN AMRO. In the past I would have warned advisers against such purchases. However, I have been pressured by my superiors not to express an official opinion on such matters. Thanks to my management, many advisers and their clients purchased these preferreds not knowing that they were still in danger or believed them too big to not pay dividends. All banks still owing money to their respective government's are in jeopardy of not paying dividends.
Thursday, August 13, 2009
It's Just Another Day
After yesterday's weaker than expected 10-year auction I was wondering if foreign investors were losing their taste for long-dated treasuries. Then I began to think (always dangerous thing). The auction took place prior to the FOMC statement, a statement in which the Fed stated that inflation is expected to remain subdued. If the Fed had made its statement before the 10-year auction it is quite possible that the auction would have attracted more interest.
Another factor which encouraged investors to extend out on the curve were today's poor Initial Jobless Claims and Advance Retail Sales reports. Backing out the Cash for Clunkers influenced auto sales data and retail sales fell 0.6%. Even with the help of gasoline sales, retail sales came in at -0.4%. No one has yet explained to me how the consumer (who has accounted for 70% of U.S. economic activity) is going to lift this economy off of the financial ocean floor without jobs and without irresponsible leverage and lending practices? The answer is that the consumer is not leading us out of this. Slow positive growth will settle in once the benefits of inventory replacement is over.
Better late than never Mr. Gross. Pimco announced that is sees value in bonds in the utility, large bank and finance and energy sectors. This means that PIMCO has already acted and has gone long these sectors. Fund managers always tell you what to do after they have acted for their clients. I have been advocating such bonds for months.
Bloomberg News reported:
Yield premiums have now returned to about what they were before the collapse of Lehman Brothers Holdings Inc. in September, Curtis A. Mewbourne, a managing director and portfolio manager at Newport Beach, California-based Pimco, said in a research report today. While systemic risk has subsided and investors have re-entered the market, economic and business conditions are "significantly worse" than in the third quarter of last year, Mewbourne said.
Mr Mewbourne went on to say: "Yield spreads for high-quality investment grade corporate bonds are still wide relative to historical levels, and we think attractive risk-adjusted value still exists in certain areas of this market," he said. "There is a clear disconnect between financial markets and underlying fundamentals."
I would agree with that but would caution investors against expecting financial sector bonds from moving much tighter than the widest of their historical spread ranges. I would also caution against expecting spreads tightening anywhere near levels seen during the middle of the past decade. Increased debt loads, softer earnings and more cautious investors will keep spreads somewhat wide, but somewhat more narrow than today's levels.
Another factor which encouraged investors to extend out on the curve were today's poor Initial Jobless Claims and Advance Retail Sales reports. Backing out the Cash for Clunkers influenced auto sales data and retail sales fell 0.6%. Even with the help of gasoline sales, retail sales came in at -0.4%. No one has yet explained to me how the consumer (who has accounted for 70% of U.S. economic activity) is going to lift this economy off of the financial ocean floor without jobs and without irresponsible leverage and lending practices? The answer is that the consumer is not leading us out of this. Slow positive growth will settle in once the benefits of inventory replacement is over.
Better late than never Mr. Gross. Pimco announced that is sees value in bonds in the utility, large bank and finance and energy sectors. This means that PIMCO has already acted and has gone long these sectors. Fund managers always tell you what to do after they have acted for their clients. I have been advocating such bonds for months.
Bloomberg News reported:
Yield premiums have now returned to about what they were before the collapse of Lehman Brothers Holdings Inc. in September, Curtis A. Mewbourne, a managing director and portfolio manager at Newport Beach, California-based Pimco, said in a research report today. While systemic risk has subsided and investors have re-entered the market, economic and business conditions are "significantly worse" than in the third quarter of last year, Mewbourne said.
Mr Mewbourne went on to say: "Yield spreads for high-quality investment grade corporate bonds are still wide relative to historical levels, and we think attractive risk-adjusted value still exists in certain areas of this market," he said. "There is a clear disconnect between financial markets and underlying fundamentals."
I would agree with that but would caution investors against expecting financial sector bonds from moving much tighter than the widest of their historical spread ranges. I would also caution against expecting spreads tightening anywhere near levels seen during the middle of the past decade. Increased debt loads, softer earnings and more cautious investors will keep spreads somewhat wide, but somewhat more narrow than today's levels.
Wednesday, August 12, 2009
Curve Balls and Change-Ups
I stand corrected. The 10-year auction was weaker than expected. Concerns about the deficit, $15 billion of 30-year bonds coming due tomorrow and a very strong 3-year note auction were the culprits. Keep mind however, at $23 billion, this was the largest 10-year auction ever.
Fed Funds rate was unchanged. The Fed sees conditions warranting excessive policy continuing, but a leveling off and stabilization of conditions. It sees modest growth (because of inventory replacement) and resource slack keeping inflation under control. Fed will purchase up to a total of 1.25 trillion Agency MBS and $200 billion agency debt by year end. The FOMC stated that it could end treasury purchases as soon as October.
The reality is that the Fed sees what most of us see. The worst is probably over, there will be a pop to economic growth, but that is a correction on the downside overshoot. Growth that follows will be below historic levels (probably 1.5% to 2.0% area).
What will happen to treasury yields. As I have said for some time, they will move gradually and modestly higher. Growth, debt issuance and dollar printing will force long-term interest rates higher. Foreign investors will moderate the pace and extent of long-term interest rate rise, but not prevent it from happening. Economic growth will be slower than what has been typical in recent cycles as the consumer cannot return to previous spending levels with out a return to prior, irresponsible levels of leverage.
One must now look at the corporate bond and preferred markets. Sectors such as industrials, telecom and utilities may be fairly valued spread wise. This means that their yields could follow treasury yields higher. In the financial arena, the large ex-TARP banks are almost fairly valued. Their bonds and preferreds should be purchased for income. The weaker large banks are also fairly valued given their glow-in-the-dark assets. The best preferred values lie in National City (guaranteed by PNC) and Countrywide (guaranteed by BAC). Note: Merrill trust preferreds ARE NOT guaranteed by BAC. High yield bonds are fairly to over valued given fundamentals and projected defaults.
Fixed income investors should continue to ladder or barbell. Ladders should oveweight the belly of the curve while barbells should overweight the short end of the curve. Neither barbells nor ladders should extend past the 10-year area of the curve.
What to buy:
CDs are offer the best values on the very short part of the curve, callable agency bonds two to five years out and large bank and finance bonds from five to ten years out.
Fed Funds rate was unchanged. The Fed sees conditions warranting excessive policy continuing, but a leveling off and stabilization of conditions. It sees modest growth (because of inventory replacement) and resource slack keeping inflation under control. Fed will purchase up to a total of 1.25 trillion Agency MBS and $200 billion agency debt by year end. The FOMC stated that it could end treasury purchases as soon as October.
The reality is that the Fed sees what most of us see. The worst is probably over, there will be a pop to economic growth, but that is a correction on the downside overshoot. Growth that follows will be below historic levels (probably 1.5% to 2.0% area).
What will happen to treasury yields. As I have said for some time, they will move gradually and modestly higher. Growth, debt issuance and dollar printing will force long-term interest rates higher. Foreign investors will moderate the pace and extent of long-term interest rate rise, but not prevent it from happening. Economic growth will be slower than what has been typical in recent cycles as the consumer cannot return to previous spending levels with out a return to prior, irresponsible levels of leverage.
One must now look at the corporate bond and preferred markets. Sectors such as industrials, telecom and utilities may be fairly valued spread wise. This means that their yields could follow treasury yields higher. In the financial arena, the large ex-TARP banks are almost fairly valued. Their bonds and preferreds should be purchased for income. The weaker large banks are also fairly valued given their glow-in-the-dark assets. The best preferred values lie in National City (guaranteed by PNC) and Countrywide (guaranteed by BAC). Note: Merrill trust preferreds ARE NOT guaranteed by BAC. High yield bonds are fairly to over valued given fundamentals and projected defaults.
Fixed income investors should continue to ladder or barbell. Ladders should oveweight the belly of the curve while barbells should overweight the short end of the curve. Neither barbells nor ladders should extend past the 10-year area of the curve.
What to buy:
CDs are offer the best values on the very short part of the curve, callable agency bonds two to five years out and large bank and finance bonds from five to ten years out.
Tuesday, August 11, 2009
Strange Days Indeed
It is a strange day indeed when I agree with strategist Dick Bove', but it happened today. Mr. Bove', formerly of Ladenburg Thalmann, formerly of Punk Ziegel and now of Rochdale stunned the markets when he announced that bank stocks have not risen on substance and that will not do better in the second half of 2009. In fact, he later told Larry Kudlow that most banks, including some very large banks, will probably lose money in the second half of 2009.
This is big news because Mr. Bove' has been a bank cheerleader, specifically singing the praises of a bank which is now essentially nationalized. However, just when I thought Mr. Bove had returned to reality, he told Larry Kudlow that that his favorite bank pick was the one which is a ward of the state and has memoranda of understanding with both the Comptroller of the Currency and the FDIC (which mean that the bank;s management can't do much more than order lunch without the approval of its regulators.
Here is a bit of news for you all. If you really looked (I mean really looked) at the assets which are on the books of the two largest, most troubled banks, you would faint from the shock of how bad they are. In fact, if not for the government, one large bank would not be here. Some argue that with a steep yield curve and nearly 0.00% short term borrowing rates, banks can make money. They can, if they have enough qualified customers needing credit. Unfortunately, the demand for credit from those who should receive credit is not great enough for some banks to earn enough to offset the constant drain caused buy assets which rival Chernobyl in terms of radioactivity. So much for mark to market reform. Most toxic assets are held on balance sheets in the form of loans, not securities. Loans are not subject to marking to market when on bank balance sheets. Many, if not most, toxic loans on bank balance sheets have been marked little if at all.
I had previously warned the those looking for foreign investors to abandon U.S. treasuries that foreign central banks are committed to investing in dollars. Today's three-year treasury note auction was for a record $37B with record interest from foreign central banks. Expect strong foreign demand from foreign central banks in tomorrow's 10-year note auction and Thursday's 30-year bond auction.
I expect no surprises in tomorrows FOMC statement. It is status quo for now.
This is big news because Mr. Bove' has been a bank cheerleader, specifically singing the praises of a bank which is now essentially nationalized. However, just when I thought Mr. Bove had returned to reality, he told Larry Kudlow that that his favorite bank pick was the one which is a ward of the state and has memoranda of understanding with both the Comptroller of the Currency and the FDIC (which mean that the bank;s management can't do much more than order lunch without the approval of its regulators.
Here is a bit of news for you all. If you really looked (I mean really looked) at the assets which are on the books of the two largest, most troubled banks, you would faint from the shock of how bad they are. In fact, if not for the government, one large bank would not be here. Some argue that with a steep yield curve and nearly 0.00% short term borrowing rates, banks can make money. They can, if they have enough qualified customers needing credit. Unfortunately, the demand for credit from those who should receive credit is not great enough for some banks to earn enough to offset the constant drain caused buy assets which rival Chernobyl in terms of radioactivity. So much for mark to market reform. Most toxic assets are held on balance sheets in the form of loans, not securities. Loans are not subject to marking to market when on bank balance sheets. Many, if not most, toxic loans on bank balance sheets have been marked little if at all.
I had previously warned the those looking for foreign investors to abandon U.S. treasuries that foreign central banks are committed to investing in dollars. Today's three-year treasury note auction was for a record $37B with record interest from foreign central banks. Expect strong foreign demand from foreign central banks in tomorrow's 10-year note auction and Thursday's 30-year bond auction.
I expect no surprises in tomorrows FOMC statement. It is status quo for now.
Monday, August 10, 2009
Foreigner
The market is firmly focused on this weeks U.S. treasury auctions and the FOMC meeting. Prices of U.S. treasuries rallied today on speculation that long-term bond yields have risen too far, too fast considering it is unlikely that the economy will generate inflationary pressures to warrant significantly higher long-term interest rates. The market is looking to this week's auctions and the FOMC statement for guidance.
Market participants were mostly in agreement that this week's 10-year treasury note and 30-year government bond auctions will be well-received by foreign investors. As I have stated before, foreign central banks and producers have a vested interest in buying treasuries. First: They want to support the dollar to keep their home currencies relatively week to make their goods affordable in the U.S. They also wish to keep our long-term borrowing costs low. I do not think that they will abandon the dollar any time soon.
This does not mean that long-term yields will never rise or that the dollar will not weaken. Both will happen to some extent. This makes U.S. companies with export potential attractive. The last time the dollar weakened, companies such as Caterpillar experienced rising overseas sales. If you think that developing countries will eventually be purchasing equipment to build modern infrastructure or improving agriculture, companies such as Cat and Deere could do well.
The U.S. consumer is likely to be less active than in recent recoveries. It could be U.S exports which help lead us out of the "Great Recession".
Note: I am on vacation next week. I will be publishing sporadically (if at all) for the next two weeks. Feel free to leave a message on this blog if you need assistance.
Market participants were mostly in agreement that this week's 10-year treasury note and 30-year government bond auctions will be well-received by foreign investors. As I have stated before, foreign central banks and producers have a vested interest in buying treasuries. First: They want to support the dollar to keep their home currencies relatively week to make their goods affordable in the U.S. They also wish to keep our long-term borrowing costs low. I do not think that they will abandon the dollar any time soon.
This does not mean that long-term yields will never rise or that the dollar will not weaken. Both will happen to some extent. This makes U.S. companies with export potential attractive. The last time the dollar weakened, companies such as Caterpillar experienced rising overseas sales. If you think that developing countries will eventually be purchasing equipment to build modern infrastructure or improving agriculture, companies such as Cat and Deere could do well.
The U.S. consumer is likely to be less active than in recent recoveries. It could be U.S exports which help lead us out of the "Great Recession".
Note: I am on vacation next week. I will be publishing sporadically (if at all) for the next two weeks. Feel free to leave a message on this blog if you need assistance.
Friday, August 7, 2009
Turn and Turn and Turn
Today's employment data truly exhibited some encouraging signs. The unemployment rate unexpectedly declined to 9.4% from 9.5%. Average weekly hours came higher at 33.1 hours versus a prior 33.0. This was due to businesses replenishing depleted inventories and the restarting of shuttered auto plants (which made the numbers look better than what they were). Is this the beginning of the end? Probably not, but it could be the end of the beginning.
What should we expect over the next twelve months? The next two quarters should exhibit positive GDP growth as businesses rebuild their inventories. However, when that is over, we could see GDP flat line or remain moderately positive. Why won't it go straight up? A good portion of consumers will remain on the sideline. Actually, before the days of easy credit, these consumers had been on the sidelines. Economic growth cannot return to levels seen during the last bubble if a quarter of consumers are not consuming much above subsistence levels.
Is there a way to get these consumers back in the game? Yes, but that may do more harm than good in the long run. One way is to make credit available in way which is similar to what was done during the housing bubble. That is probably not a good idea. The other way is to increase employment. However, unless employment growth is due to fundamental economic expansion, the gain will be short-lived (I.E. the tech bubble). Government hiring won't do the trick either as that would result in higher taxes. Essentially, money would be taken from one consumer, in the form of taxes, and given to another consumer in the form of wages, but it is a zero-sum game. Worse even, it could result in two consumers being able to purchase inexpensive or small-ticket items instead of higher-priced, big ticket items. Last time I checked, the U.S. economy was more dependent on the sale of big-ticket items.
Growth will come, but we all need to manage our expectations. What we have here is what I call the great correction. Since the Paul Volker Fed, we have had shallow, short-lived recessions as the economy recovered from the malaise and policy mistakes of the 1960s and 1970s. With the Fed having to resort to quantitative easing and lending practices returning to more prudent standards that correction is done. Barring poor economic policy or mass insanity among lending officers, the U.S. economy should begin a gradual march higher, but don't discount the poor policy or insanity scenarios.
Assuming that prudence and sanity prevail, what will keep growth modest? Higher taxes (they are coming), anti-business legislation (it is being mentioned) and higher interest rates. The latter is inevitable. That will make credit more expensive for those who can still qualify for loans. This should not discourage investors from participating in the markets. However, investors should manage expectations. With some exceptions, companies which provide goods and services that people need will be better investments than those which provide goods and services that people want.
There is an interesting development happening in the fixed income markets. Now that credit spreads have tightened, retail investors are pouring money into preferred securities. What they may not realize is that preferred credit spreads to benchmark treasuries are approaching or have reached their historical range versus treasuries. Many of preferreds, especially those of high quality telecom and utility companies and banks which have paid or are about to repay TARP funds will follow long-term interest rates in almost lock-step fashion. This means that more price depreciation may be on the horizon. If you own a preferred trading over $26, sell it. Its call feature will prevent it from rising much farther. Also, remember that a company only calls in a preferred or bond when it is economically advantageous for them to do so. This means that it is done when it is economically disadvantageous for investors. LIBOR-based floating rate preferreds may present opportunities, but remember that they perform best when the yield curve flattens. This is due to their short-term coupon reset benchmarks (LIBOR) and their long-term trading benchmarks (long-dated U.S. treasuries.
What should we expect over the next twelve months? The next two quarters should exhibit positive GDP growth as businesses rebuild their inventories. However, when that is over, we could see GDP flat line or remain moderately positive. Why won't it go straight up? A good portion of consumers will remain on the sideline. Actually, before the days of easy credit, these consumers had been on the sidelines. Economic growth cannot return to levels seen during the last bubble if a quarter of consumers are not consuming much above subsistence levels.
Is there a way to get these consumers back in the game? Yes, but that may do more harm than good in the long run. One way is to make credit available in way which is similar to what was done during the housing bubble. That is probably not a good idea. The other way is to increase employment. However, unless employment growth is due to fundamental economic expansion, the gain will be short-lived (I.E. the tech bubble). Government hiring won't do the trick either as that would result in higher taxes. Essentially, money would be taken from one consumer, in the form of taxes, and given to another consumer in the form of wages, but it is a zero-sum game. Worse even, it could result in two consumers being able to purchase inexpensive or small-ticket items instead of higher-priced, big ticket items. Last time I checked, the U.S. economy was more dependent on the sale of big-ticket items.
Growth will come, but we all need to manage our expectations. What we have here is what I call the great correction. Since the Paul Volker Fed, we have had shallow, short-lived recessions as the economy recovered from the malaise and policy mistakes of the 1960s and 1970s. With the Fed having to resort to quantitative easing and lending practices returning to more prudent standards that correction is done. Barring poor economic policy or mass insanity among lending officers, the U.S. economy should begin a gradual march higher, but don't discount the poor policy or insanity scenarios.
Assuming that prudence and sanity prevail, what will keep growth modest? Higher taxes (they are coming), anti-business legislation (it is being mentioned) and higher interest rates. The latter is inevitable. That will make credit more expensive for those who can still qualify for loans. This should not discourage investors from participating in the markets. However, investors should manage expectations. With some exceptions, companies which provide goods and services that people need will be better investments than those which provide goods and services that people want.
There is an interesting development happening in the fixed income markets. Now that credit spreads have tightened, retail investors are pouring money into preferred securities. What they may not realize is that preferred credit spreads to benchmark treasuries are approaching or have reached their historical range versus treasuries. Many of preferreds, especially those of high quality telecom and utility companies and banks which have paid or are about to repay TARP funds will follow long-term interest rates in almost lock-step fashion. This means that more price depreciation may be on the horizon. If you own a preferred trading over $26, sell it. Its call feature will prevent it from rising much farther. Also, remember that a company only calls in a preferred or bond when it is economically advantageous for them to do so. This means that it is done when it is economically disadvantageous for investors. LIBOR-based floating rate preferreds may present opportunities, but remember that they perform best when the yield curve flattens. This is due to their short-term coupon reset benchmarks (LIBOR) and their long-term trading benchmarks (long-dated U.S. treasuries.
Wednesday, August 5, 2009
Back In Black
Most of my posts during the past several months have had a decidedly negative tone. All the while, the equity markets have rallied and corporate bond credit spreads have narrowed. It has been difficult being a curmudgeon during this time of euphoria, but as with all periods of euphoria, investors and pundits can become overly exuberant, sometimes irrationally so.
Let's look at corporate profits. In many instances they have been better than expected. However, the profits have been by and large the result of cost cutting, not increased business activities.
What about smaller job losses as measured by the Non-farm Payrolls report and falling jobless claims. Job losses are declining because we are approaching the "right-sized" number of workers for current and expected levels of economic activity. After all, businesses cannot fire everyone. Employers are running out of workers to lay off. The same is true about jobless claims. Initial claims are falling (but disturbingly high) and continuing claims remain over 6 million. This is not a sign of recovery. Reductions in firings is not a sign of an employment recovery when the unemployment rate is approaching 10% (and should blow through it in the near future). The economic bubble was so large that jobs were created which fundamentally should not have existed. There lies the rub.
Bulls are waiting for banks to lend and credit to be freed up. I cannot believe that so many smart people do not understand lending in the United States. Approximately 70% of all lending in the U.S. is done via securitization.
Securitization has been impaired compared with what was the norm for the 10 years ending 2006. However, what these young raging bulls have to realize is that the lax lending standards and easy leverage of the early part of this decade was the exception, not the rule. It was unsustainable. Securitization still takes place. However, that usually requires GSE backing of the mortgage security, full disclosure of the quality of the underlying assets or higher yields for taking on the risk.
The result is that those borrowers with good credit, a comprehensive credit history and documented income which indicated the ability to repay the loan can get credit. What is so bad about that? The problem is that, since the popping of the tech bubble (and to some extent during the tech bubble), the U.S. economy and businesses have adapted to the levels of economic activity which can only be generated by a system of fog a mirror and get a loan. Those days are gone, at least for the next five or ten years as current investors have long memories and it takes five or ten years to get enough new players who do not know the past, but think the know everything being recently out of school.
We should all expect GDP to stabilize and even grow during the coming six to nine months as businesses replace inventories which had been permitted to deplete as cautious executives held back production while waiting for the economy to bottom. By next year, I think GDP growth will settle in at between 1.00% and 2.00%.
Tighter lending standards and slower growth spell trouble for Detroit automakers once the Cash for Clunkers program ends. I seriously doubt that GM and Chrysler can survive without more government help and / or shifting some production (especially smaller vehicles) overseas or at least to non-UAW plants in the American South.
Bank profits will decline once the profitable carry trade afforded by the steep yield curve disappears when the Fed begins raising short-term borrowing costs, thereby flattening the yield curve.
The companies which will do best from an investing standpoint will be telecom, utilities, consumer staples, discount retailers and cutting edge (only) consumer electronics). Housing will suck wind and large distressed banks could still be broken up, especially if the FDIC (Sheila Bair) becomes the dominant bank regulator.
I also publish articles on Seeking Alpha under the nom de plum Bernard Thomas.
Let's look at corporate profits. In many instances they have been better than expected. However, the profits have been by and large the result of cost cutting, not increased business activities.
What about smaller job losses as measured by the Non-farm Payrolls report and falling jobless claims. Job losses are declining because we are approaching the "right-sized" number of workers for current and expected levels of economic activity. After all, businesses cannot fire everyone. Employers are running out of workers to lay off. The same is true about jobless claims. Initial claims are falling (but disturbingly high) and continuing claims remain over 6 million. This is not a sign of recovery. Reductions in firings is not a sign of an employment recovery when the unemployment rate is approaching 10% (and should blow through it in the near future). The economic bubble was so large that jobs were created which fundamentally should not have existed. There lies the rub.
Bulls are waiting for banks to lend and credit to be freed up. I cannot believe that so many smart people do not understand lending in the United States. Approximately 70% of all lending in the U.S. is done via securitization.
Securitization has been impaired compared with what was the norm for the 10 years ending 2006. However, what these young raging bulls have to realize is that the lax lending standards and easy leverage of the early part of this decade was the exception, not the rule. It was unsustainable. Securitization still takes place. However, that usually requires GSE backing of the mortgage security, full disclosure of the quality of the underlying assets or higher yields for taking on the risk.
The result is that those borrowers with good credit, a comprehensive credit history and documented income which indicated the ability to repay the loan can get credit. What is so bad about that? The problem is that, since the popping of the tech bubble (and to some extent during the tech bubble), the U.S. economy and businesses have adapted to the levels of economic activity which can only be generated by a system of fog a mirror and get a loan. Those days are gone, at least for the next five or ten years as current investors have long memories and it takes five or ten years to get enough new players who do not know the past, but think the know everything being recently out of school.
We should all expect GDP to stabilize and even grow during the coming six to nine months as businesses replace inventories which had been permitted to deplete as cautious executives held back production while waiting for the economy to bottom. By next year, I think GDP growth will settle in at between 1.00% and 2.00%.
Tighter lending standards and slower growth spell trouble for Detroit automakers once the Cash for Clunkers program ends. I seriously doubt that GM and Chrysler can survive without more government help and / or shifting some production (especially smaller vehicles) overseas or at least to non-UAW plants in the American South.
Bank profits will decline once the profitable carry trade afforded by the steep yield curve disappears when the Fed begins raising short-term borrowing costs, thereby flattening the yield curve.
The companies which will do best from an investing standpoint will be telecom, utilities, consumer staples, discount retailers and cutting edge (only) consumer electronics). Housing will suck wind and large distressed banks could still be broken up, especially if the FDIC (Sheila Bair) becomes the dominant bank regulator.
I also publish articles on Seeking Alpha under the nom de plum Bernard Thomas.
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