Today I received many calls from brokers looking to position clients for soon-to-materialize higher interest rates. This sudden reignition of higher interest rate fears caught me off guard. After all, treasury auctions have been strong (today's seven-year was a bit weaker than expected, but still good), economic data has been pointing toward a modest recovery and job growth has been disappointing. I was perplexed by such sudden fears until one branch manager revealed their source, fund wholesalers. Apparently some fund wholesalers have been pushing floating rate funds for the eventual popping of the" interest rate bubble."
I don't think the U.S. will become another Japan, nor do I think long-term rates can remain at current rates forever, but the early 1980s are not about to make a comeback. The Fed is not ready to move to a tightening bias at this time. We could be a year away from the first Fed tightening. Since the Fed usually moves 25 basis points at a time, pausing along the way, it could take years before Fed Funds hit 3.00% (at this point 5.00% looks unlikely in the foreseeable future). That would mean that USD LIBOR, which tracks Fed Funds, will remain low as well. Buy floaters at your own risk. Stop trying to hit home runs. Ladder and diversify accounts. Adjustable rate bonds are designed to benefit issuers more than investors. Invest to benefit you and your clients. Also, DO NOT BUY T-BILLS unless you absolutely have to. Rolling up with the Fed could result in sub 2.00% average returns over the next 4 to 5 years.
I would rather put my money in 10-year bank and finance corporate bonds. Credit products over interest rate products whenever possible.
Thursday, July 29, 2010
Wednesday, July 28, 2010
Hell Freezes Over
For the second time in the past few months I find my self in agreement with Pimco's Bill Gross. That I agree with Mr. Gross may not seem odd to many of my readers, but I have been very critical of his talking his book of holdings in the financial media while being portrayed as giving altruistic advice. I have not been especially critical of Mr. Gross's strategies, only that he is not the good-hearted soul dispensing free advice to the investing public he is believed by many to be.
However, Mr. Gross's letter to clients expresses opinions very much in line with my own. First: Mr. Gross is of the opinion that government efforts to achieve artificial levels of consumption are wasteful or in his words: (It)can be compared to flushing money down an economic toilet." Secondly: He states that deleveraging, stiffer regulations and protectionist policies create strong headwinds which hold back growth.He refers to the aforementioned conditions the "new normal."
I believe Mr. Gross is dead on. Consumers cannot and will not borrow as they did before. How much more can the Fed stimulate the economy than it has already has? Consumers are tapped out from over two decades of living through an almost a constantly stimulated economy. The amount of consumption required to achieve growth levels and unemployment rates seen during the past two-plus decades are fundamentally unsustainable.
Mr. Gross makes reference to Japan's perennially stagnant economy. Japan has had over a decade of rates down near 0.00% and still consumers save instead of spend. I do not believe U.S. consumers will go to the same extremes as their Japanese counterparts, but gone are the days of homes, cars and expensive appliances for anyone who can fog a mirror. Unfortunately, that is what it will take to create growth rates similar as to which we have become accustomed.
What about hiring? Balance sheets are strong, won't businesses hire? The will hire only if absolutely necessary. CEOs are being rewarded for doing more with less. Shareholders are pushing efficiency and productivity. It is not surprising that the one stronger sector in today's Durable Goods report was machinery. Still no signs of Luddites.
The Fed's Beige Book did not tell an encouraging story. The Fed's report on activity from its 12 regional banks stated: "Nearly all districts reported sluggish housing markets” since the home buyer tax credit expired last April 30th and several districts reported that manufacturing "slowed or leveled off. Growth is moving forward on the whole albeit at a modest pace.
The bond market is still on board with the modest growth story. Both yesterday's two-year treasury note auction and today's five-year treasury note auction were very will bid for, pricing at yields at or near record lows.
However, Mr. Gross's letter to clients expresses opinions very much in line with my own. First: Mr. Gross is of the opinion that government efforts to achieve artificial levels of consumption are wasteful or in his words: (It)can be compared to flushing money down an economic toilet." Secondly: He states that deleveraging, stiffer regulations and protectionist policies create strong headwinds which hold back growth.He refers to the aforementioned conditions the "new normal."
I believe Mr. Gross is dead on. Consumers cannot and will not borrow as they did before. How much more can the Fed stimulate the economy than it has already has? Consumers are tapped out from over two decades of living through an almost a constantly stimulated economy. The amount of consumption required to achieve growth levels and unemployment rates seen during the past two-plus decades are fundamentally unsustainable.
Mr. Gross makes reference to Japan's perennially stagnant economy. Japan has had over a decade of rates down near 0.00% and still consumers save instead of spend. I do not believe U.S. consumers will go to the same extremes as their Japanese counterparts, but gone are the days of homes, cars and expensive appliances for anyone who can fog a mirror. Unfortunately, that is what it will take to create growth rates similar as to which we have become accustomed.
What about hiring? Balance sheets are strong, won't businesses hire? The will hire only if absolutely necessary. CEOs are being rewarded for doing more with less. Shareholders are pushing efficiency and productivity. It is not surprising that the one stronger sector in today's Durable Goods report was machinery. Still no signs of Luddites.
The Fed's Beige Book did not tell an encouraging story. The Fed's report on activity from its 12 regional banks stated: "Nearly all districts reported sluggish housing markets” since the home buyer tax credit expired last April 30th and several districts reported that manufacturing "slowed or leveled off. Growth is moving forward on the whole albeit at a modest pace.
The bond market is still on board with the modest growth story. Both yesterday's two-year treasury note auction and today's five-year treasury note auction were very will bid for, pricing at yields at or near record lows.
Friday, July 23, 2010
No Laughing Matter
European regulators released the results of their stress tests of European banks.The report indicated that seven banks failed the stress test. None of the banks are large institutions with significant numbers of individual U.S. investors. Two of the banks, Hypo Real Estate Bank of Germany and ATEbank of Greece have already been nationalized making the test and its results moot in their cases. By and large the test was considered a joke, but no one should be laughing.
Only sovereign debt exposure held by trading areas of the respective banks were counted. sovereign debt held at other parts of the banks and other risky or potentially risky assets were not counted. German banks, which initially balked at the prospects of a stress test, participated, but did not publicly reveal their sovereign debt exposure. Anyone who is comforted by the results of the European stress tests are immaturely optimistic or have questionable mental faculties. The test does little to determine whether or not European banks could withstand a severe shock to the financial system.
The 84 banks which did "pass" the test reportedly proved they could maintain a Tier-1 capital ratio of at least 6%. Tier-1 capital includes cash reserves (including deposits), common and preferred stock and certain hybrids.
The equity markets recovered and bond yields have risen during the last two trading sessions following a portrait of modest growth painted by Fed Chairman Bernanke. Equity markets are responding to good earnings (such as Ford which as recovered by trimming capacity and unnecessary jobs) and the treasury market is pricing in a modest recovery.
I have been of the opinion for some time that the recovery would be modest and the trends of the past two decades no longer apply because we haven't had an economy that was permitted to function without headwinds (Great Society spending of the late 60s / early 70s) and then constant stimulus (Volcker through Greenspan). Here is what an economist from a major Wall Street firm had to say:
"The secular bear and bull bond markets of the past 50 years have been largely a reflection of the Great Inflation of 1965-81 and the unwind that resulted when the Fed recaptured its independence and commitment to price stability. Current super-low bond yields reflect a combination of that complete adjustment overlaid on a cyclical
low point in income."
Sorry technical guys, the game has changed. Trends just don't happen. Trends occur because people make them happen with policies and sentiment.
Only sovereign debt exposure held by trading areas of the respective banks were counted. sovereign debt held at other parts of the banks and other risky or potentially risky assets were not counted. German banks, which initially balked at the prospects of a stress test, participated, but did not publicly reveal their sovereign debt exposure. Anyone who is comforted by the results of the European stress tests are immaturely optimistic or have questionable mental faculties. The test does little to determine whether or not European banks could withstand a severe shock to the financial system.
The 84 banks which did "pass" the test reportedly proved they could maintain a Tier-1 capital ratio of at least 6%. Tier-1 capital includes cash reserves (including deposits), common and preferred stock and certain hybrids.
The equity markets recovered and bond yields have risen during the last two trading sessions following a portrait of modest growth painted by Fed Chairman Bernanke. Equity markets are responding to good earnings (such as Ford which as recovered by trimming capacity and unnecessary jobs) and the treasury market is pricing in a modest recovery.
I have been of the opinion for some time that the recovery would be modest and the trends of the past two decades no longer apply because we haven't had an economy that was permitted to function without headwinds (Great Society spending of the late 60s / early 70s) and then constant stimulus (Volcker through Greenspan). Here is what an economist from a major Wall Street firm had to say:
"The secular bear and bull bond markets of the past 50 years have been largely a reflection of the Great Inflation of 1965-81 and the unwind that resulted when the Fed recaptured its independence and commitment to price stability. Current super-low bond yields reflect a combination of that complete adjustment overlaid on a cyclical
low point in income."
Sorry technical guys, the game has changed. Trends just don't happen. Trends occur because people make them happen with policies and sentiment.
Tuesday, July 20, 2010
Burning Down The House
Those looking for signs of economic expansion in today's housing data were certainly disappointed. Housing starts fell to their lowest level since last October as demand for new homes waned following the expiration of government tax incentives. It is becoming apparent to policy makers and to all but the most ardent market bulls that it is nearly impossible to stimulate our way to economic expansion when the economy was already in a stimulated state when the bubble burst. There is a glut of housing on the market. The way to clear the surplus is to permit prices to reset to levels at which potential home buyers can afford a mortgage for which they can be approved. However, no politician wants to preside over such a repricing of most American's most valuable asset. Building permits were up, but that was due to a 20% jump in multi-family housing construction. Single family housing, the biggest segment of the market, fell by 3.4% to 421,000. This was the poorest total since April 2009.
Not everyone agrees with my opinion that economic performance and job growth will be modest in the near future. Noted economist Brian Wesbury (someone whom I respect a great deal) believes that easy Fed policy, thin inventories and strong corporate profits will lead the economy back to its former glory. I agree that these factors will lead the economy back to sustainable growth, but sustainable growth is a far cry from the overstimulated expansion during the housing bubble and the irrational expectations of the tech bubble.
Businesses are reluctant to hire. Why should they hire? Taxes are slated to rise (many small businesses are taxed at the owner's personal rate), the current administration is pushing a labor-union-friendly agenda and healthcare reform concerns weigh heavy on the minds of business owners and executives. It is safer and more cost-effective to keep staffing thin and using technology, outsourcing and temporary workers to meet the need for increased production. Face it. 4.00%+ growth and 5.00% and lower unemployment are probably unsustainable (with current dynamics unemployment below 8.00% may be difficult).
Remember all those calls to buy floaters to be positioned for WHEN rate rise? The bond market tells us that the cost of waiting at low current floating rates for rates to rise is a losing proposition. So is staying in cash. Credit products such as corporate bonds, GSE debt and a smattering of carefully chosen preferred securities are the way to go.
Goldman Sachs reported a second quarter profit which was down 82% due to a decline in trading revenue. Goldman was not alone in experiencing a decline in trading revenues, but as an investment bank Goldman has little in the way of banking revenue on which to rely. It is for this reason that Goldman and Morgan Stanley tend to trade at somewhat wider spreads to treasuries than similarly rated money center banks. GS paper is trading only slightly wider following today's earnings report. Analysts interviewed by Bloomberg News spoke positively regarding Goldman's ability to maintain its client base and have confidence in the firm's risk management capabilities.
What about Goldman's fraud charges? Goldman wrote a check and is moving on. Goldman 10-year bonds are yielding over 200 basis points above the 10-year treasury. Not a bad deal where I come from.
Not everyone agrees with my opinion that economic performance and job growth will be modest in the near future. Noted economist Brian Wesbury (someone whom I respect a great deal) believes that easy Fed policy, thin inventories and strong corporate profits will lead the economy back to its former glory. I agree that these factors will lead the economy back to sustainable growth, but sustainable growth is a far cry from the overstimulated expansion during the housing bubble and the irrational expectations of the tech bubble.
Businesses are reluctant to hire. Why should they hire? Taxes are slated to rise (many small businesses are taxed at the owner's personal rate), the current administration is pushing a labor-union-friendly agenda and healthcare reform concerns weigh heavy on the minds of business owners and executives. It is safer and more cost-effective to keep staffing thin and using technology, outsourcing and temporary workers to meet the need for increased production. Face it. 4.00%+ growth and 5.00% and lower unemployment are probably unsustainable (with current dynamics unemployment below 8.00% may be difficult).
Remember all those calls to buy floaters to be positioned for WHEN rate rise? The bond market tells us that the cost of waiting at low current floating rates for rates to rise is a losing proposition. So is staying in cash. Credit products such as corporate bonds, GSE debt and a smattering of carefully chosen preferred securities are the way to go.
Goldman Sachs reported a second quarter profit which was down 82% due to a decline in trading revenue. Goldman was not alone in experiencing a decline in trading revenues, but as an investment bank Goldman has little in the way of banking revenue on which to rely. It is for this reason that Goldman and Morgan Stanley tend to trade at somewhat wider spreads to treasuries than similarly rated money center banks. GS paper is trading only slightly wider following today's earnings report. Analysts interviewed by Bloomberg News spoke positively regarding Goldman's ability to maintain its client base and have confidence in the firm's risk management capabilities.
What about Goldman's fraud charges? Goldman wrote a check and is moving on. Goldman 10-year bonds are yielding over 200 basis points above the 10-year treasury. Not a bad deal where I come from.
Wednesday, July 14, 2010
Happy Bastille Day
Just a quick note. Retail sales declined for the second consecutive month and the minutes of the June FOMC meeting indicated that the Fed's outlook for inflation and economic recovery has softened. The treasury market responded by rallying. The equity markets initially headed lower before recovering and finishing the day slightly higher. Stock jock pundits touted the equity markets' predictive power and downplayed the Fed minutes by accusing policy makers of being behind the curve and a lagging indicator.
In my two decades in the capital markets I have found no better predictor of economic direction than the bond market (among the capital markets). Although the Fed is not infallible (they are human after all), one dismisses Fed opinions and policy at their own risk. More times than not Fed policy is grounded in reality while equity markets are driven higher on optimism and hope. Hope is not a strategy.
The recovery will be sluggish and inflation will remain tame. The credit markets (especially bank bonds which will benefit from the Dodd bill by making balance sheets more conservative in nature) remain attractive. TIPS are not attractive and should be used only as hedges against eventual inflationary pressures, modest though the may be. Investors should consider TIPS with prices close to par or a discount and with an inflation factor as close to 1.00 or below if possible.
In my two decades in the capital markets I have found no better predictor of economic direction than the bond market (among the capital markets). Although the Fed is not infallible (they are human after all), one dismisses Fed opinions and policy at their own risk. More times than not Fed policy is grounded in reality while equity markets are driven higher on optimism and hope. Hope is not a strategy.
The recovery will be sluggish and inflation will remain tame. The credit markets (especially bank bonds which will benefit from the Dodd bill by making balance sheets more conservative in nature) remain attractive. TIPS are not attractive and should be used only as hedges against eventual inflationary pressures, modest though the may be. Investors should consider TIPS with prices close to par or a discount and with an inflation factor as close to 1.00 or below if possible.
Tuesday, July 13, 2010
As Tiers Go By
Today was the second arguably the most important (although few would argue the point) treasury auction this week. The U.S. Treasury sold $21 billion 10-year notes as the new supply and strong corporate earnings help to push treasury yields higher. Listening to the financial media one would have thought that demand was soft for the reopening of the 3.50% due 5/15/20 notes. However, demand was strong as the bid to cover ratio was 3.09 versus an average of 3.03 for the 10 previous auctions. Indirect bidders (which include foreign central banks) purchased 41.7% of the new supply versus an average of 40.7% for the 10 previous auctions.
So if the bid to cover ratio indicates strong investor interest and foreign central banks have not lost their appetite for U.S. treasuries, why were commentators and market participants, such as Richard Bryant of MF Global (who said: "Investors didn't see a lot of value at today's yield levels") declaring the party over for long-dated treasuries? Maybe it was because the auction was priced to yield 3.119% versus an expected 3.109%? Maybe it was because it was only a short time ago that the 10-year yield dipped below 3.00%. Maybe people see just what they want to see.
The fact is that an extended period below 3.00% the 10-year would be priced for an extended malaise and possibly a double-dip recession. The market is coming to the realization that a double-dip recession is not the most likely scenario. Of course a 3.11% 10-year does not indicate an economic boom is on the horizon either. It appears as though that what is in store for the U.S. economy is a long road higher with persistent headwinds from more restrictive regulation, anti-growth tax policies, sub-par job growth and consumers who continue to deleverage.
There has been much discussion of the Collins Amendment to the Dodd Bill (AKA Fin Reg) and what it means for trust preferreds and their investors. First: It means that it is unlikely that financial institutions will use such structures in the future as trusts (or hybrids as they are also known) will no longer we counted towards a bank's Tier-1 capital levels (there will be some grandfather provisions for smaller banks). However, Tier-1 classification was not the only reason why banks issued these securities. A clue is the word "hybrid."
Trust securities are debt / equity hybrids. Depending on the specific structure an issuer could count a portion of the capital as debt and a portion as equity. The equity portion would count toward a bank's Tier-1 capital requirement. However since hybrids pay interest instead of dividend (even though the payments on $25-par securities appears to be dividends the payments are in fact interest) banks could take advantage treating payments as an expense as is customary with interest payments. When banks really wanted to raise Tier-1 capital without diluting common shareholders they would issue non-cumulative preferred equity as they did in 2008 when mounting mortgage losses deteriorated the values of their existing Tier-1 capital.
There is another more basic economic benefit banks that banks receive from hybrids, which is cheap financing. During the mid portion of the past decade treasury yields were low and credit spreads were tight allowing banks to issue hybrids with very low coupons for long-term debt. Coupons below 7.00% or even 6.00% were common. For economic reasons banks may choose to not call lower-coupon hybrids because they are sources of cheap financing. Some newsletters and even a money manager or two suggested buying low-coupon hybrids at discounts as they are essentially short-term bullets as banks will call them in. Good luck with that. The Street knows full well that the Dodd Bill is practically a done deal. If they thought these issues would be called in short order they would not be trading at deep discounts. Sorry folks, such a strategy is a low percentage play.
Other experts have been advocating buying high coupon hybrids as banks will not want to call them away from investors at par so as not to anger they very people needed to purchase Tier-1 structures which they will need to issue. Good luck with that strategy as well. There are many $1,000-par hybrids with coupons over 8.00% (some are over 9.00% or over 10.00%). It is unlikely that a bank would leave a high-coupon hybrid outstanding when it is not receiving a Tier-1 benefit. Absent the Tier-1 capital status, banks will probably simply treat hybrids like very subordinate debt and retire the more expensive issues first. Remember, banks do not have to do anything for two years and then they have three years to gradually restructure their capital.
The main sources of Tier-1 capital (as per Basel II) are equity (common and true preferreds) and deposits, both time deposits (CDs) and demand deposits (checking and savings accounts). This is why smaller banks which do not need large enough quantities of Tier-1 capital to issued securities offer above average CD rates (relatively speaking). It is is a main source of Tier-1 capital.
I will be away from the computer for much of the rest of the week. Talk to you soon.
Tell your friends. I am looking for more subscribers.
So if the bid to cover ratio indicates strong investor interest and foreign central banks have not lost their appetite for U.S. treasuries, why were commentators and market participants, such as Richard Bryant of MF Global (who said: "Investors didn't see a lot of value at today's yield levels") declaring the party over for long-dated treasuries? Maybe it was because the auction was priced to yield 3.119% versus an expected 3.109%? Maybe it was because it was only a short time ago that the 10-year yield dipped below 3.00%. Maybe people see just what they want to see.
The fact is that an extended period below 3.00% the 10-year would be priced for an extended malaise and possibly a double-dip recession. The market is coming to the realization that a double-dip recession is not the most likely scenario. Of course a 3.11% 10-year does not indicate an economic boom is on the horizon either. It appears as though that what is in store for the U.S. economy is a long road higher with persistent headwinds from more restrictive regulation, anti-growth tax policies, sub-par job growth and consumers who continue to deleverage.
There has been much discussion of the Collins Amendment to the Dodd Bill (AKA Fin Reg) and what it means for trust preferreds and their investors. First: It means that it is unlikely that financial institutions will use such structures in the future as trusts (or hybrids as they are also known) will no longer we counted towards a bank's Tier-1 capital levels (there will be some grandfather provisions for smaller banks). However, Tier-1 classification was not the only reason why banks issued these securities. A clue is the word "hybrid."
Trust securities are debt / equity hybrids. Depending on the specific structure an issuer could count a portion of the capital as debt and a portion as equity. The equity portion would count toward a bank's Tier-1 capital requirement. However since hybrids pay interest instead of dividend (even though the payments on $25-par securities appears to be dividends the payments are in fact interest) banks could take advantage treating payments as an expense as is customary with interest payments. When banks really wanted to raise Tier-1 capital without diluting common shareholders they would issue non-cumulative preferred equity as they did in 2008 when mounting mortgage losses deteriorated the values of their existing Tier-1 capital.
There is another more basic economic benefit banks that banks receive from hybrids, which is cheap financing. During the mid portion of the past decade treasury yields were low and credit spreads were tight allowing banks to issue hybrids with very low coupons for long-term debt. Coupons below 7.00% or even 6.00% were common. For economic reasons banks may choose to not call lower-coupon hybrids because they are sources of cheap financing. Some newsletters and even a money manager or two suggested buying low-coupon hybrids at discounts as they are essentially short-term bullets as banks will call them in. Good luck with that. The Street knows full well that the Dodd Bill is practically a done deal. If they thought these issues would be called in short order they would not be trading at deep discounts. Sorry folks, such a strategy is a low percentage play.
Other experts have been advocating buying high coupon hybrids as banks will not want to call them away from investors at par so as not to anger they very people needed to purchase Tier-1 structures which they will need to issue. Good luck with that strategy as well. There are many $1,000-par hybrids with coupons over 8.00% (some are over 9.00% or over 10.00%). It is unlikely that a bank would leave a high-coupon hybrid outstanding when it is not receiving a Tier-1 benefit. Absent the Tier-1 capital status, banks will probably simply treat hybrids like very subordinate debt and retire the more expensive issues first. Remember, banks do not have to do anything for two years and then they have three years to gradually restructure their capital.
The main sources of Tier-1 capital (as per Basel II) are equity (common and true preferreds) and deposits, both time deposits (CDs) and demand deposits (checking and savings accounts). This is why smaller banks which do not need large enough quantities of Tier-1 capital to issued securities offer above average CD rates (relatively speaking). It is is a main source of Tier-1 capital.
I will be away from the computer for much of the rest of the week. Talk to you soon.
Tell your friends. I am looking for more subscribers.
Saturday, July 10, 2010
Act 1, Scene 3
Neither a borrower nor a lender be. The advice given by Polonius to Laertes in act 1, scene 3 of Hamlet is being taken by banks and consumers today.
In spite of record stimulus, banks are reluctant to lend and consumers and businesses are reluctant to borrow. Why? They there is little need for them to do so. Banks can make enough money via the carry trade. Consumers are still debt-laden. Businesses, without new demand on the horizon, do not need to borrow to expand.
Businesses rarely expand proactively preferring to see demand or at least consumer sentiment to become optimistic and stay that way for a period of time. When it comes to either expanding too soon or too late, later is usually better, or at least cheaper than sooner.
Consumer debt loads have been shrinking. According to the Wall Street Journal U.S. household debt was 122% of disposable income. Although this was down from 131% in early 2008, it is higher than the 100% seen as the highest sustainable level by most economists. With consumer debt loads still high and a lack of new products or service on which to spend (few ground-breaking, must-have big-ticket items or sectors), consumer demand will probably remain below trends to which we have become accustomed.
There has been much discussion of the possibility of a double-dip recession. Not surprisingly, these fears have been stoked by the financial media (the folks who brought you the can't miss "v"-shaped economic recovery). The double-dip is not the scenario most economists believe will play out. The more likely scenarios may be a protracted period of economic stagnation.
Nariman Behravesh, chief economist for IHS Global Insights told the Wall Street Journal:
"The risk here for a lot of countries is not a double dip but a protracted period of stagnation, which is bad news for creating jobs."
I believe Mr. Behravesh's concerns are legitimate. There should be enough economic activity in the U.S. to keep the economy in positive territory, but just. Although consumption is not necessarily a zero sum game, it is not infinite either. Any time sales are increased by stimulus programs or sale incentives we get more than sales which wouldn't have happened at all without incentives. We also get sales which would have happened at a later date moved forward (ask the Detroit automakers about this). Now we have consumers who, under normal circumstances, would have purchased vehicles and homes in 2010, 2011 or 2012 now out of the market because they have taken advantage of sweetheart incentivized deals. Not only has the ability to spend diminished the desire to do so have diminished as well.
Further slowing growth are the headwinds emanating from Washington D.C. Anti-business rhetoric does not instill confidence among business executives. Higher taxes and more restrictive labor practices have executives and business owners frightened.
Forthcoming economic polices are also helping to keep consumers on the sidelines. With debt averaging north of 120% of disposable income, consumers are reluctant to spend with the knowledge that they will have even less disposable income in the near future. One must question economic policies which will inhibit consumers' abilities to reduce debt to where it is at an acceptable ratio with disposable income. Consumers will be like a dog chasing its tail.
It is not like there are no historical precedents to which policy can refer before pulling the legislative trigger. One only need look back to the policy mistakes of the mid-1930s. At that time trade policy became more protectionist, tax rates where increased dramatically and the Fed tightened monetary policy. The rhetoric coming out of the Obama administration, tax increases and soon a more highly regulated business environment promises to slow economic recovery. The one saving grace is that Fed policy is unlikely to tighten any time soon. This will help prevent a double-dip recession.
Fed policy will also keep corporate profits high as borrowing costs will remain low and the carry trade will remain available for banks. With more restrictions on banks' ability to trade, take risk and lend, they will remain more dependent on the carry trade than the have in the past.
Individual investors are puzzled as to why corporate credit yields remain low. They are amazed that anyone will by a ten-year Verizon bond at 4.00% or a ten-year Bank of America bond at 5.00%. What they don't understand is that institutional investors determine value differently than retail investors.
Retail investors tend to view yield in absolute terms. They consider a good return and rate of return on which they can live. Institutional investors view value on a relative basis. five percent for a ten-year Bank of America bond may not thrill the hearts of mom and pop, but to an institution that 200 basis point spread over the ten-year treasury looks comparatively good. Because treasury yields are bound to remain low and because institutions will buy corporate bonds at these spread levels all day long, individual investors should reconcile themselves with this new reality and get out of cash. Laddering across the curve (overweight the 5 to 7 year "belly") of the curve is a good place to start when looking to invest in the fixed income markets. Investors should use caution when reaching for yield by investing in lower-rated bonds or far out on the yield curve. The reward may not justify the risk.
Next time I will discuss Tier-1 capital and what it means to you.
In spite of record stimulus, banks are reluctant to lend and consumers and businesses are reluctant to borrow. Why? They there is little need for them to do so. Banks can make enough money via the carry trade. Consumers are still debt-laden. Businesses, without new demand on the horizon, do not need to borrow to expand.
Businesses rarely expand proactively preferring to see demand or at least consumer sentiment to become optimistic and stay that way for a period of time. When it comes to either expanding too soon or too late, later is usually better, or at least cheaper than sooner.
Consumer debt loads have been shrinking. According to the Wall Street Journal U.S. household debt was 122% of disposable income. Although this was down from 131% in early 2008, it is higher than the 100% seen as the highest sustainable level by most economists. With consumer debt loads still high and a lack of new products or service on which to spend (few ground-breaking, must-have big-ticket items or sectors), consumer demand will probably remain below trends to which we have become accustomed.
There has been much discussion of the possibility of a double-dip recession. Not surprisingly, these fears have been stoked by the financial media (the folks who brought you the can't miss "v"-shaped economic recovery). The double-dip is not the scenario most economists believe will play out. The more likely scenarios may be a protracted period of economic stagnation.
Nariman Behravesh, chief economist for IHS Global Insights told the Wall Street Journal:
"The risk here for a lot of countries is not a double dip but a protracted period of stagnation, which is bad news for creating jobs."
I believe Mr. Behravesh's concerns are legitimate. There should be enough economic activity in the U.S. to keep the economy in positive territory, but just. Although consumption is not necessarily a zero sum game, it is not infinite either. Any time sales are increased by stimulus programs or sale incentives we get more than sales which wouldn't have happened at all without incentives. We also get sales which would have happened at a later date moved forward (ask the Detroit automakers about this). Now we have consumers who, under normal circumstances, would have purchased vehicles and homes in 2010, 2011 or 2012 now out of the market because they have taken advantage of sweetheart incentivized deals. Not only has the ability to spend diminished the desire to do so have diminished as well.
Further slowing growth are the headwinds emanating from Washington D.C. Anti-business rhetoric does not instill confidence among business executives. Higher taxes and more restrictive labor practices have executives and business owners frightened.
Forthcoming economic polices are also helping to keep consumers on the sidelines. With debt averaging north of 120% of disposable income, consumers are reluctant to spend with the knowledge that they will have even less disposable income in the near future. One must question economic policies which will inhibit consumers' abilities to reduce debt to where it is at an acceptable ratio with disposable income. Consumers will be like a dog chasing its tail.
It is not like there are no historical precedents to which policy can refer before pulling the legislative trigger. One only need look back to the policy mistakes of the mid-1930s. At that time trade policy became more protectionist, tax rates where increased dramatically and the Fed tightened monetary policy. The rhetoric coming out of the Obama administration, tax increases and soon a more highly regulated business environment promises to slow economic recovery. The one saving grace is that Fed policy is unlikely to tighten any time soon. This will help prevent a double-dip recession.
Fed policy will also keep corporate profits high as borrowing costs will remain low and the carry trade will remain available for banks. With more restrictions on banks' ability to trade, take risk and lend, they will remain more dependent on the carry trade than the have in the past.
Individual investors are puzzled as to why corporate credit yields remain low. They are amazed that anyone will by a ten-year Verizon bond at 4.00% or a ten-year Bank of America bond at 5.00%. What they don't understand is that institutional investors determine value differently than retail investors.
Retail investors tend to view yield in absolute terms. They consider a good return and rate of return on which they can live. Institutional investors view value on a relative basis. five percent for a ten-year Bank of America bond may not thrill the hearts of mom and pop, but to an institution that 200 basis point spread over the ten-year treasury looks comparatively good. Because treasury yields are bound to remain low and because institutions will buy corporate bonds at these spread levels all day long, individual investors should reconcile themselves with this new reality and get out of cash. Laddering across the curve (overweight the 5 to 7 year "belly") of the curve is a good place to start when looking to invest in the fixed income markets. Investors should use caution when reaching for yield by investing in lower-rated bonds or far out on the yield curve. The reward may not justify the risk.
Next time I will discuss Tier-1 capital and what it means to you.
Wednesday, July 7, 2010
Heat Wave
Is it hot enough for you? With two consecutive days in the triple digits here in the Northeast it is too hot for me (I am a fall and winter person). That heat boiled over into the capital markets today. The Dow Jones Industrial Average rose 274 points to close above the 10,000 mark. Stronger retail sales data, opinions from around the street that corporate profits will be impressive and news that details of the stress tests for European banks turned investor sentiments bullish. This is all well and good, but what does it all mean for the economic recovery.
Today's news and market reaction are positives indeed, but it does not mean that the recovery is going to be rapid or robust. Strong corporate profits may not result in a strong employment recovery. A good portion of the recovery in corporate profits is due to productivity gains (companies doing more with less). Although more hiring is likely to occur, it is likely to be below to what we have become accustomed.
Tell me, which companies will need to hire significant numbers of U.S. workers? Don't have an answer? Neither do I. During the last two recoveries job growth was driven by two industries, tech and housing. Since another Internet bubble is not likely to occur and the housing market cannot expand like it had during the mid part of the last decade cross them off or your lists.
Until the Fed overstimulated the economy by keeping rates too low too long and the GSEs helped engineer loans for those who could not afford them, the economic recovery following the previous recession was called a jobless recovery. If not for the housing bubble, job growth would likely have remained lackluster. There is nothing apparent on the horizon that is going to push the unemployment rate back down to 5.00% (or to 6.00% or 7.00% for that matter).
The other hope for job growth, small business, faces headwinds from spotty consumer demand, a lack of credit and what appears to be an unfriendly administration in Washington. Unless there are philosophical changes in Washington or an area of the economy takes off to the point that business activity consumes all areas of productivity improvement (technology and overseas production), employment is likely to remain strained and the economic recovery modest. Let's not forget the likelihood of more government and municipal worker job losses.
The Fed is just about ammunition. Bearing out this opinion were comments from Fed officials. Today, Kansas City Fed president Thomas Hoenig advocated a move of the Fed Funds target rate to 1.00%. Dallas Fed president Richard Fisher said that the Fed has done all it can do to foster an economic recovery. To me this sounds like Fed jawboning to get us accustomed to the fact that the modest recovery is what it is.
Look for earnings to be strong for the seconds quarter. Look for the markets to react positively (long-dated treasuries may sell off, but they should still be well bid for at next week's auctions), but also look for reality to slap us all in the face with elevated jobless claims data and another soft employment report on August 6th.
Last week I said that I would discuss Freddie and Fannie. I just wanted to note a comment I heard on CNBC that the GSEs are spending approximately $40,000,000 per day maintaining properties they have acquired since the housing bubble burst. The GSEs' balance sheets look worse now than they did before the bubble as they are being used to support a weak housing market and continue to do the bidding of influential politicians. According to the Chicago Tribune FRE and FNM owned a record $6.9 billion of foreclosed homes as of March 31, 2010. That compares with 8.56 billion owned by all U.S. commercial banks and S&Ls combined.
Freddie and Fannie bonds and MBS should be ok because the government has no choice but to keep them solvent to prevent a total collapse of the housing market, but it certainly appears that there will be little, if any, hope of recovery for common and preferred shareholders.
Do not reach for yield. Keep duration short (but maturities out to 10-years). Do not reach for yield buy taking on more risk than you would normally tolerate. Stay cool.
Today's news and market reaction are positives indeed, but it does not mean that the recovery is going to be rapid or robust. Strong corporate profits may not result in a strong employment recovery. A good portion of the recovery in corporate profits is due to productivity gains (companies doing more with less). Although more hiring is likely to occur, it is likely to be below to what we have become accustomed.
Tell me, which companies will need to hire significant numbers of U.S. workers? Don't have an answer? Neither do I. During the last two recoveries job growth was driven by two industries, tech and housing. Since another Internet bubble is not likely to occur and the housing market cannot expand like it had during the mid part of the last decade cross them off or your lists.
Until the Fed overstimulated the economy by keeping rates too low too long and the GSEs helped engineer loans for those who could not afford them, the economic recovery following the previous recession was called a jobless recovery. If not for the housing bubble, job growth would likely have remained lackluster. There is nothing apparent on the horizon that is going to push the unemployment rate back down to 5.00% (or to 6.00% or 7.00% for that matter).
The other hope for job growth, small business, faces headwinds from spotty consumer demand, a lack of credit and what appears to be an unfriendly administration in Washington. Unless there are philosophical changes in Washington or an area of the economy takes off to the point that business activity consumes all areas of productivity improvement (technology and overseas production), employment is likely to remain strained and the economic recovery modest. Let's not forget the likelihood of more government and municipal worker job losses.
The Fed is just about ammunition. Bearing out this opinion were comments from Fed officials. Today, Kansas City Fed president Thomas Hoenig advocated a move of the Fed Funds target rate to 1.00%. Dallas Fed president Richard Fisher said that the Fed has done all it can do to foster an economic recovery. To me this sounds like Fed jawboning to get us accustomed to the fact that the modest recovery is what it is.
Look for earnings to be strong for the seconds quarter. Look for the markets to react positively (long-dated treasuries may sell off, but they should still be well bid for at next week's auctions), but also look for reality to slap us all in the face with elevated jobless claims data and another soft employment report on August 6th.
Last week I said that I would discuss Freddie and Fannie. I just wanted to note a comment I heard on CNBC that the GSEs are spending approximately $40,000,000 per day maintaining properties they have acquired since the housing bubble burst. The GSEs' balance sheets look worse now than they did before the bubble as they are being used to support a weak housing market and continue to do the bidding of influential politicians. According to the Chicago Tribune FRE and FNM owned a record $6.9 billion of foreclosed homes as of March 31, 2010. That compares with 8.56 billion owned by all U.S. commercial banks and S&Ls combined.
Freddie and Fannie bonds and MBS should be ok because the government has no choice but to keep them solvent to prevent a total collapse of the housing market, but it certainly appears that there will be little, if any, hope of recovery for common and preferred shareholders.
Do not reach for yield. Keep duration short (but maturities out to 10-years). Do not reach for yield buy taking on more risk than you would normally tolerate. Stay cool.
Friday, July 2, 2010
Crossroads
I went down to the crossroads, fell down on my knees.
I went down to the crossroads, fell down on my knees.
Asked the Lord above for mercy, "Save me if you please."
~ Cream (Robert Johnson)
Today’s employment data could be a crossroads for the economic recovery. On one side the private sector did add jobs and the unemployment rate fell. On the other side the economy shed jobs for the first time this year. Let’s tear through the data so we can avoid becoming road kill.
Nonfarm Payrolls reported a decline of 125,000 jobs. Yes, the consensus was calling for a drop of 130,000 jobs but that estimate was changed yesterday from -125,000 jobs (which was changed from -115,000 jobs earlier in the week). Private sector jobs, the real growth engine of the economy (especially in the absence of insane amounts of consumer borrowing) came in with a gain of 83,000 jobs. While this was better than the prior gain of 43,000 jobs it fell short of the consensus estimate of 110,000 jobs. Manufacturing added 9,000 jobs, but that was far below the street consensus of 25,000 jobs and the prior revised 32,000 jobs. The unemployment rate fell from 9.7% to 9.5%, but that was because discouraged people answered that they were not looking for work and are therefore not counted as unemployed. Where were jobs lost? Total government employment fell by 208,000 jobs. The construction sector shed 22,000 jobs.
More bad news came in the way of a decline in average hourly earnings and a slight decline in average weekly hours. Although today’s data is not catastrophic it does tell us that consumption and economic growth could be much softer than expected and even softer than in the first half of this year.
Truthfully, I do it know where all the optimism was coming from earlier this year. It appears as though many optimistic economists were pinning their hopes that improvement in the manufacturing sector would lift the economy and start the job creation machine. There is a problem with that. Manufacturing is responsible for less than 10% of the U.S. economy. The sector provides relatively few jobs, U.S. factories are highly automated and increased production could be sent overseas where labor is cheaper and customers are geographically closer. Also, we will probably see further government worker cuts, especially at the state and municipal level as shrinking tax revenues force governments to cut payrolls.
The amount of economic growth we have experience during the past 25 years was the result of ever cheaper leverage and ever easier access to credit. This is not perpetually sustainable. It will take years to replace the jobs we have lost, but the overall job situation may not improve much. About 150,000 new jobs are required just to keep up with the growth new people entering the work force. This could result in an elevated unemployment rate for many years and subpar growth as well.
The question being bandied about is: Will we experience a double-dip recession? The answer: Probably not. However, Americans have become accustomed to historically low levels of unemployment and the ability to spend at will for nearly any item. Those days are gone for a very log time (if not forever). Economists would be well advised to pick their heads up from their spread sheets and take a look at what is really happening in America and maybe, just maybe, look beyond or at least revise their models.
Look for the Fed to keep rates low for a very long time and for long-term rates to stay low before rising modestly. The Fed is almost certainly on the sidelines for 2010 and possibly for most or all of 2011. Please resist the urge to cherry pick pieces of data to justify strategies, bullish or bearish. Leave that to the politicians and media talking heads.
The markets are now filled with vigilantes. They are now voting no on government polices and the strength of the recovery. The Obama administration, if they value the good of the country over ideology, may want to reverse its views on tax policy and how it treats business, especially small and medium-sized business. On time tax credits or rebates do not result in long-term positive economic trends. Consumers want permanent or, at least, long term tax benefits. I am not holding my breath. Either are the markets.
P.S. Stop blaming Greece for our renewed economic malaise. This is home grown.
I went down to the crossroads, fell down on my knees.
Asked the Lord above for mercy, "Save me if you please."
~ Cream (Robert Johnson)
Today’s employment data could be a crossroads for the economic recovery. On one side the private sector did add jobs and the unemployment rate fell. On the other side the economy shed jobs for the first time this year. Let’s tear through the data so we can avoid becoming road kill.
Nonfarm Payrolls reported a decline of 125,000 jobs. Yes, the consensus was calling for a drop of 130,000 jobs but that estimate was changed yesterday from -125,000 jobs (which was changed from -115,000 jobs earlier in the week). Private sector jobs, the real growth engine of the economy (especially in the absence of insane amounts of consumer borrowing) came in with a gain of 83,000 jobs. While this was better than the prior gain of 43,000 jobs it fell short of the consensus estimate of 110,000 jobs. Manufacturing added 9,000 jobs, but that was far below the street consensus of 25,000 jobs and the prior revised 32,000 jobs. The unemployment rate fell from 9.7% to 9.5%, but that was because discouraged people answered that they were not looking for work and are therefore not counted as unemployed. Where were jobs lost? Total government employment fell by 208,000 jobs. The construction sector shed 22,000 jobs.
More bad news came in the way of a decline in average hourly earnings and a slight decline in average weekly hours. Although today’s data is not catastrophic it does tell us that consumption and economic growth could be much softer than expected and even softer than in the first half of this year.
Truthfully, I do it know where all the optimism was coming from earlier this year. It appears as though many optimistic economists were pinning their hopes that improvement in the manufacturing sector would lift the economy and start the job creation machine. There is a problem with that. Manufacturing is responsible for less than 10% of the U.S. economy. The sector provides relatively few jobs, U.S. factories are highly automated and increased production could be sent overseas where labor is cheaper and customers are geographically closer. Also, we will probably see further government worker cuts, especially at the state and municipal level as shrinking tax revenues force governments to cut payrolls.
The amount of economic growth we have experience during the past 25 years was the result of ever cheaper leverage and ever easier access to credit. This is not perpetually sustainable. It will take years to replace the jobs we have lost, but the overall job situation may not improve much. About 150,000 new jobs are required just to keep up with the growth new people entering the work force. This could result in an elevated unemployment rate for many years and subpar growth as well.
The question being bandied about is: Will we experience a double-dip recession? The answer: Probably not. However, Americans have become accustomed to historically low levels of unemployment and the ability to spend at will for nearly any item. Those days are gone for a very log time (if not forever). Economists would be well advised to pick their heads up from their spread sheets and take a look at what is really happening in America and maybe, just maybe, look beyond or at least revise their models.
Look for the Fed to keep rates low for a very long time and for long-term rates to stay low before rising modestly. The Fed is almost certainly on the sidelines for 2010 and possibly for most or all of 2011. Please resist the urge to cherry pick pieces of data to justify strategies, bullish or bearish. Leave that to the politicians and media talking heads.
The markets are now filled with vigilantes. They are now voting no on government polices and the strength of the recovery. The Obama administration, if they value the good of the country over ideology, may want to reverse its views on tax policy and how it treats business, especially small and medium-sized business. On time tax credits or rebates do not result in long-term positive economic trends. Consumers want permanent or, at least, long term tax benefits. I am not holding my breath. Either are the markets.
P.S. Stop blaming Greece for our renewed economic malaise. This is home grown.
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