A Taste of the Orient

I am once again under the weather (but improving). The bright side (for me at least) is that I have the opportunity to write. Yesterday, prices of long-term treasuries rallied as China raised its bank reserve requirements in an effort to curb bank lending to slow down its over heating economy. Chinese policy makers are trying to avert a bubble. The result will be (if successful) is that China's ability to lead the globe out of the economic doldrums will be impaired. Other results are as follows. Chinese domestic consumption should moderate. This means that foreign companies counting on the Chinese consumer for a significant portion of its revenues will be disappointed. One report last week indicated that although Chinese auto sales were up about 50% in 2009, they are expected to rise only by 5% or 6% in 2010 and that was before yesterday's news.

Another outcome of China's policy change will be more U.S. asset purchases. If Chinese banks need to hold reserves, they will hold in dollars. Global growth will also slow. This means more buying of U.S. dollar-denominated securities as exporting nations seek to keep currency exchange rates favorable versus the U.S attempting to maintain what is likely to be a smaller U.S. consumer market (but still the largest in the world by far). This means that today's 10-year treasury reopening auction should garner much business from foreign central banks.

In response to the aforementioned developments I have sold my position in TBT. I still believe that the general tend for long-term rates is higher, this could be a speed bump at that journey and I believe I will be able to re-establish a long position in the near future. Investors buying floating rate securities of any type will are likely to experience underperformance, especially in terms of coupon performance. This is true of both LIBOR-based floaters and the poorly-described CPI floaters. Why? The Fed is not raising the Fed Funds rate anytime soon, possibly not at all in 2010. Also, the year-over-year change of the rate of inflation, as measured by the CPI Urban Consumer Index Non Seasonally Adjusted (CPURNSA) is not likely to be great anytime soon. Floaters to way too rich given the probable economic and interest rate conditions we are likely to experience.

There are opportunities out there. Why is anyone holding corporate bonds in the industrial sector (anything non bank, finance, telecom or utility) inside of five years? Government agencies are between 100 and 250 basis points cheaper in the 2 to 5 year area. Don't be worried about Freddie or Fannie debt. Those bonds have an effective, but not explicit, government guarantee. It is EXTREMELY unlikely GSE bonds would be permitted to default as it is the GSEs alone which are preventing an implosion of the mortgage market. Why own a 5-year Walmart Bond yielding 2.00% when one can buy a 5-year callable agency bond yielding 3.50%?

Have a nice day

I Would Hate My Dissapointment To Show

Friday's disappointing Non-Farm Payrolls report surprised many on Wall Street. It was not only the pie-in-the-sky optimists who were stunned, but also more realistic prognosticators such as yours truly. I thought the report would indicate flat job growth due to seasonal hiring. While an upward revision due to seasonal hiring may be in the cards, it does not appear that the holidays were merry for many aspiring workers. It just may be that the revised positive November data is all she wrote for temporary holiday employment. That remains to be seen. The Non-Farm Payrolls report is arguably the most difficult to predict.

The economy is truly showing signs of healing. So why aren't jobs coming back more robustly? First: The U.S. economy has lost more than 7 million jobs since the great recession began. Secondly: Technology and global competition for jobs (cheaper overseas labor) has led to greater productivity. Sub par job recovery has been the theme of every recovery since the early 90s. In fact, the two periods of robust job growth occurred during two bubbles, the tech bubble of the late 1990s and the late, great housing bubble. Stock market gurus and equity investors are fond of using the "Always Strategy."

The "Always Strategy" is based on the idea that certain phenomena always occur. Nothing occurs just because. There have to be circumstances which create outcomes. In the past we have "always" had V-shaped, strong recoveries because monetary and economic policies stimulated demand. However, during the past few cycles, an extraordinary amount of stimulus was needed to create a strong expansion.

What is different this time around? Each succeeding recovery since the 1990s required longer periods of copious stimulus to drive economic recoveries. The intent of the Fed and the presiding administrations was to stimulate the economy to create sufficient economic growth to create a sufficient number of jobs to spark a self-sustaining expansion. The problem was (and remains) that due to improvements in technology and a global labor market, economic activity must be greater than before to have low levels of unemployment. Recall that it was the so-called "jobless recovery" which induced the Fed to keep the Fed Funds rate very low (at 1.00%) for an extended period of time (a year) and to remove accommodation gradually (25 basis points at a time).

So how is the Fed and the Obama administration going to set the economy on the road to rapid expansion? They are not. This is not necessarily a bad thing. To have a fundamentally strong economy, fundamentals must be in order. When consumers repay a significant portion of their debt, they will be able to spend. The spending will come from both disposable income and renewed access to credit. However, economic growth cannot be sustained at levels seen during the last two expansions.

Why won't banks lend and what can be done to make them lend? Those who ask that question have little understanding of the modern economy. You may recall back in 2008 there was much mention of the "shadow banking system." The shadow banking system consists of non-bank lending. I.E. lending by non bank entities and / or via securitization. The amount of credit being extended during the latest two decades could not have been done using the traditional banking model.

In the old days, banks would take in deposits and make loans versus those deposits. If banks had to rely on deposits banks would be lending less than they are currently. At least now they can securitize mortgages via the GSEs. Conservative investors who were responsible for the purchasing much of the asset-baked supply will only purchase the most secure structures backed by the highest quality assets. Speculators willing to buy lower-quality ABS want rates of return too high to make lending economically feasible. Clearing out the tremendous overhang of consumer debt is required before we see sustainable economic conditions. Even then, demand will not be strong enough to generate the kind of growth to which we have become accustomed. Growth will have to come from elsewhere. But where?

At this time there is no alternative source of growth. There had been high hopes that China would lead the world to recovery. That is unlikely as Chinese growth is dependent almost exclusively on exporting to the U.S. It's pegging the renminbi to the dollar is causing inflationary pressures. China is now trying to discourage internal demand. No folks, unless something unexpected occurs, we are probably looking at modest growth with significant Fed accommodation to persist for years. The good news is that the U.S. remains the most dynamic economy on the planet and there is the possibility that someone develops a product, service or financial innovation which drives the economy to new heights. Look domestically for economic growth.

If the U.S. is the great driver of the global economy, why is the dollar weakening? The weaker dollar is the result of low rates, large deficits, fear of anti-business policies and legislation and a case of "the grass is greener in your neighbors yard." In the 1990s we had the bond vigilantes who took long-term bond yields higher is response to President Clinton's spending plans. In late 2008 and early 2009 we had the bank vigilantes who beat down banks stocks and even help ignite bank runs until the government assisted banks and proved their health with the (dubious) stress test. Now we have the dollar vigilantes. Currency market participants will bash the greenback until the U.S. government defends it.

This leaves the government between a rock and a hard place. Defend the dollar by removing stimulus too soon and there could be a double-dip recession. Leave the accommodation in place too long and prices imported commodities, such as oil, may rise creating head winds hindering the economy. Factor in proposed anti-business, anti-investors and anti-bank legislation and it is becomes obvious that an economic recovery as we have come to expect is not that likely. However, a recovery similar to what our parents or grandparents experienced is entirely possible. Such a recovery is probably better for the country and the markets in the long run.

Investors can be successful in such an environment, if they manage expectations. We are in a mature market cycle. There is nothing on the horizon which will result in a strong bull market. There is also nothing on the horizon which will call long-term rates to blow out. Investors should behave like the investors they are and not the traders which they are not. One way to increase returns is to keep investment expenses (fees and charges low). I am not suggesting that every investors open up accounts at discount brokerages and begin trading their own money (most investors are ill-equipped for such a task). What I am suggesting is for investors to not pay unnecessary fees. Pay 2.00% or 3.00% to have a money manager "manage" a portfolio of bonds for the purpose of generating income is not a wise choice. A qualified financial adviser at a full service firm can assemble a portfolio of bonds which will generate income for no annual fee. Bonds are instead purchased on a net basis. Equity investors may wish to use a manager, but it is often the case that a mutual fund is just as good. Income oriented investors should avoid using bond funds as fund managers often must liquidate positions due to client distributions. This can cause unreliable income streams and, in the case of municipal bonds, taxable events.

2010 will be a year of learning. U.S. consumers and investors will learn that fundamentals and responsibility matters.

Cold Turkey

Watching the U.S. capital markets on a daily basis has become akin to riding a roller coaster, up and down with a few twists and turns thrown in for good measure. Investors had better get used to it. The markets are responding to economic data. The economic data is going to be mixed going forward. The net result should be a mild, but fundamentally sound, recovery. However, because government stimulus has been driving the recovery in the financial, manufacturing and housing sectors, we could see the pace of the recovery slow as the stimulus is removed.

This is not sitting well with some economists, financial media pundits and equity market participants. To them a sharp V-shaped recovery is almost an inalienable right. Due to the tendency for people to have short-term historical perspectives, a sharp V-shaped recovery is expected because that is what "always" happens. Although it is true that recent recoveries have been sharp and V-shaped, there is nothing written which states that is how it always has to be. In fact, the Fed's (and other areas of the government) reluctance to allow the economy to revert to an unstimulated pace of growth by engaging in very accommodative monetary policies at the sign of an economic slowdown created artificially sharp recoveries. The economy was never permitted to come down from its growth binge. As soon as the signs of an economic hangover were showing the Fed gave it more of the hair of the dog.

Now the Fed's whiskey barrel is empty. Last year was the pounding hangover. 2010 is the difficult recovery, but recover we will. Just as the bulls were too optimistic, the bears may be too pessimistic. The U.S. economy is the most dynamic in the world. Only bad policy emanating from Congress can impede the recovery. Some of the proposed regulatory changes and current policies are not conducive to a strong economic recovery. How much money are we going to pump into GMAC and do we need Czars? This is America damn it!

I believe the U.S. economy will grow in the 2.25% to 2.75% range in 2010 and for the balance of the next decade. It is not to what we have become accustomed, but it is sustainable. The Fed would love to juice growth, but it is out of economic spirits. The sooner the economy goes cold turkey the better.

So where should investors look to place capital in 2010? My opinion has not changed. Heading toward year-end 2009 I was of the opinion that the run up in the equity markets and credit markets were about finished. I still believe that. Pimco's Bill Gross recently stated that he is moving capital out of corporate and treasury bonds. I agree with Bill. In fact I was stating that these bonds had run too far, to quickly late last year and took a short position on the long end of the treasury curve. The biggest difference between Bill and myself (besides our levels of compensation and public notoriety) is that I told you in a timely manner and Bill told you after he made his trades. One can make a lot of money investing with Bill Gross, but not nearly as much by acting on his free, but less timely, information.

Fixed Income investors should play defense by investing in higher quality securities and keeping average duration to about five to seven years. this does not mean that one should put all one's capital on that area of the curve. Spread it out, but keep the average duration (as opposed to maturity) in the five to seven year area of the curve. Using higher-coupon bonds and preferreds helps to lower duration. This also does not mean that investors should not invest in lower quality securities. Investors who can tolerate the risk and volatility of such investments may want to strategically include lower-rated bonds in an otherwise high-quality portfolio. Do your homework when investing in high yield bonds. They are not created equal.

This should give my readers a good starting point for investing in 2010. As always, questions regarding specific investments and strategies are always welcomed. I am only an e-mail away.

A Long Winters Nap

Although the street will be thinly staffed for the next week, markets often go nuts this time of the year. The cause is the reduced number of market participants. While many individual investors are scurrying to make year end trades, most market makers are snug in their beds while visions of sugar plums dance in their heads. Notable exceptions are hedge funds. The Ebenezer Scrooges among them will not permit them to enjoy the season. They are all business. This can be a very dangerous time for small investors. It is true that volatility brings opportunity, but it also brings danger. This is alright fro traders who have large pools of capital with which to play and the ability to hedge bets, but such market environments can spell trouble for investors. There is a vast difference between a trader and an investors.

Market conditions prevalent during the past 25 years has turned many investors into traders. Market conditions have made trading relatively easy. One need only buy a portfolio of high-quality stocks and wait. If one waited long enough one experienced a profit of varying amounts. Why was this so? Because the preceding 25 years were terrible for the markets. Tax and economic policy changes, along with lower interest rates and (I hate this term) financial innovation, sparked the longest period of economic growth in U.S. history. What we witnessed was a prolonged recovery from a prolonged slump. The recovery matured in 2000. Efforts to rekindle growth created a bubble which could not be sustained. As with mature economies, mature markets are more stable, Growth and corrections will be more subdued. This had caused many investors to allocate assets outside their stated risk tolerance levels. Some may not realize they have done so.

Emerging markets have been an attractive destination for investor capital. Thus far the bet has been a good one, but it has coincided with the recovery in U.S. equity markets. This is merely a rebound from last years' crisis. The truth is that there is no decoupling. Economies around the globe are more intertwined than ever. Another problem facing investors in emerging markets is that they may be sowing the seeds of their own demise.

The influx of capital from the U.S. has begun to hurt export driven economies by strengthening their home currencies. Stronger currencies versus the U.S. dollar mean that goods produced cost more in terms of dollars. The results are higher prices, reduced profits or both. Countries such as Brazil are considering tax penalties to discourage foreign investment to keep the real week. Several other nations have acknowledged they are also considering similar moves. Then there is China.

China, being a command economy,. can add and remove stimulus at will thereby managing internal consumer demand. Banking on Chinese consumers to lift the global economy to new heights is a pipe dream at this time. China will only permit consumers to spend to meet its specific goals. If the government believes that the economy is overheating and inflation is becoming a problem it will engage in polices limiting consumer spending. The Chinese economy is likely to exhibit strong growth for the foreseeable future as the country is so far behind the West it will take many years of strong growth just to build the necessary infrastructure to make China a truly developed nation. Also, Chinese economic data are difficult to verify. The government controls the release of all data, including corporate earnings data. If China reports 8% growth one must take it at its word.

Domestically-focused investors have been placing bets on inflation. Their thinking is that low interest rates, the printing of dollars and record U.S. debt issuance will result in inflation pressures. The effect may be far less than many investors believe. Interest rates and debt issuance are just two factors influencing inflation pressure. One must also consider consumer demand, foreign exchange rates and corporations willing to erode profit margins to maintain their share of a smaller U.S. market. Allusions to the stagflation days of the late 1970s disregard the changes within the U.S. economy which have occurred since then. The U.S. economy is less insular and is no longer manufacturing-based. Back in the days of polyester leisure suits job growth (or losses) and inflation sprang forth from places such as Detroit, Pittsburgh, Cleveland and Bethlehem, PA. Now job production is scattered around the country in service industries such as technology, retailing, healthcare and financial serviced. The production of goods is primarily done overseas and these exporters would rather erode their significantly-wide profit margins than raise prices and lose valuable market share. This, combined with reduced spending as consumers live closer to their means, promise to keep inflation relatively low.

Subdued inflation make TIPs bad bets as trading vehicles. All are at premiums and have inflation indices over 1.00, some significantly so. Short-term TIPs (inside five years) could result in net losses for investors should inflation be tame. TIPs should be used as a hedging vehicles rather than speculations. The best TIP is the 1.375% due 7/15/18 as it is priced near par and has an inflation index near 1.00. Corporate inflation-protected notes are (how should I say this?) garbage. They adjust versus a year-over-year calculation of inflation. Even if inflation ran a steady 3.00% year after year there is now upward adjustment if the coupon as the rate was unchanged. If inflation declined from 3.00% to 2.50% coupons fall even though inflation was positive. This is a simplified but accurate explanation of how such bonds work.

I don't think there will be a double dip recession, but growth charts could more resemble a Nike "swoosh" as consumers rely more on income and less on borrowed fund. Also, much of the growth we have seen this year has been due to government stimulus plans. This was to be expected. However unlike in the recent past, such stimulus may not prime the economic pump, but rather give a temporary boost resulting in the economy settling back to a fundamental growth rate lower than to what we have all become accustomed during the past two decades. Recent home sales data illustrate the effect government stimulus is having. Existing home sales were surprisingly positive due to home buying benefits, but new home sales fell as the data reflects contracts to build new homes not closings. These home buyers would not be able to take advantage of government programs unless extended. Since it takes upwards of a year to bring a home from plans to completion, counting on government programs still being in effect when it is time to close is a risky proposition.

Less volatile markets present a problem to those investing via fee-based accounts. Growth rates and lack of volatility will make it difficult to justify paying management fees of two or three percent. Why pay annual fees to sit and watch a portfolio. This is especially true of fixed income accounts. The best plan is to construct a portfolio which meets your current needs consisting of appropriate securities and adjusting it only when your needs change or when an unforeseen event affecting an investment requires reallocating capital.

Enough of this talk of business. It is Christmas Eve, a time for those who observe the holiday to be with friends and family. Tonight as I sit by the fire with those I love, I will raise a glass of Old Fezziwig ( a great ale brewed by Samuel Adams) and wish a happy holiday season to all my readers and health and prosperity in the New Year. I shall be back the first week of January.

Slacker

I am of the opinion that the peak Fed Funds rate during the coming cycle will be somewhere around 4.00%. My thinking is that with consumers forced to live closer to their means, growth and inflation will lag recent past cycles. To make sure I wasn't being too pessimistic, I asked a very respected fixed income strategist (one who has been somewhat more optimistic than I) his opinion regarding where he thinks Fed Funds will peak before the Fed begins to ease again. Imagine my surprise when he tells me that he believes Fed Funds will peak around 3.00% during the coming cycle. This is bad news for investors determined to stay in cash or who think they can eliminate interest rate risk by purchasing LIBOR-floater longer-term bonds and preferreds.

Please understand that the Fed SHOULD remain extraordinarily accommodative for an extended period of time. I am a cruel sot. I believe in responsible borrowing and investing. Corporations and individuals should be permitted to suffer the consequences of their actions. Keeping rates too low for too long could create new bubbles. Fed policy is certainly at least partially responsible for higher gold and oil prices.

So what is a fixed income investor to do? Diversify. Ladder, barbell and use different products, CDs on the short end, agencies on the belly of the curve and bank and finance bonds seven to ten years out. Also, please understand what makes a bond tick. Features such as calls, floats and steps are structured to benefit the issuer, not the investor.

A TARP Christmas

"I'm dreaming of a TARP Christmas."

That is the Christmas carol ringing in my head. First we had Bank of America repay its TARP funds, then Citi will pay back a portion of its TARP funds. Well Fargo is the latest to announce its TARP repayment. Well will sell approximately $10.4 billion of stock and will repay all $25 billion of government aid. This is in contrast to Citi which will pay back only $20 billion of the $45 billion of aid money it received from the government. The Treasury will also sell up to $5 billion of Citi shares. That would still leave another $20 billion of aid money Citi would have to repay. It also means that the government will continue to have a major ownership stake in the most troubled large bank in the U.S. Baby steps Vikram, baby steps.



Today, JP Morgan came with a sweetheart of a preferred deal. A sweetheart deal for JPM that is. The new preferred will have an initial coupon in the 7.25% to 7.375% areas. That is a fairly low coupon for long term debt. However, it gets better for JPM. After five years the coupon will float off of three-month LIBOR. Typically these deals float 400 or more basis points over three-month LIBOR and have no floor or ceiling. However since Three-month LIBOR cannot go below 0.00%, the effective floor is the spread. Investors and financial advisers became all giddy at the prospect of rising coupons. However, if the coupon rises above where JPM can issue long-term securities, JPM will simply call it away at 25. A flat or inverted yield curve is usually required for such a situation. If the yield curve remains steep and the coupon remains below the trading yield, the preferred will trade at a discount, regardless of how high "rates" rise. Although as long as rates rise one is at least compensated with higher rates while one suffers with a $22 trading price.

The truly negative outcome is for the yield curve to be steep and short-term rates to remain low. That is probably the most likely scenario for 2014. Why do I believe this? Let's look at typical Fed policy cycles. The economy slows, the Fed eases, rates fall, but short-term rates fall more significantly than long-term rates. The economy shows signs of recovery. Inflation expectations cause long-term rates to rise, thereby further steepening the curve. The economic cycle matures and to combat inflation the Fed tightens by raising the Fed Funds rate, moderating inflation pressures casing the curve to flatten. It is often the case that the Fed overshoots resulting in a flat or inverted yield curve. It usually takes a number of years to go through this cycles, often three to five years. This would be perfect timing for this JPM preferred to experience a coupon decline when it begins to float. Floaters DO NOT eliminated interest rate risk for investors. If they did issuers would be exposed to such risk. Floaters are like Las Vegas. Investors can win, but the deals are structured to favor the house (the issuer).

Happy Chanukah and Merry Christmas.

In The Year 2010

2009 is winding down, but the year will not go quietly. First their was the Dubai default. Then there were the Greece and Spain credit ratings downgrades. Even the U.S. and UK received stern warnings about their respective credit ratings coming under pressure in the near future. The grass isn't greener in the neighbors back yard. In fact even China, that vaunted engine of growth, is not is nearly as strong as its economic data and its cheerleaders would have us believe. Nearly all of its growth has been driven by huge amounts if government stimulus, which is sustainable. What the Chinese government is hoping for is that it can keep its economy expanding (and its people happy) until demand increases from (drum roll please) the U.S.!!! The good ole USA is still the world's main source of economic activity.

There is a mistaken belief that U.S. banks are the worst on the planet. Although U.S. banks (even healthy banks) remain impaired when compared to their typical condition, European banks (along with others in various parts of the world) have their fair share of impairment and foreign governments are feeling the pain of propping them up. It may be fair to say that the worst of the financial crisis is over, but it may be a long time (if ever) before we return to conditions common during the past 25 years. Why if ever? Let's answer a question with a question. Why do many people assume that the economic conditions of the past 25 years are "normal" After all, those conditions never existed prior to that time period. The truth is that there is no "normal" The economy is evolving and ever-changing. One thing is for sure. Consumers cannot spend more than they make ad infinitum. Eventually one becomes over leveraged and can no longer spend like a drunken sailor. When that happens, demand falls and prices follow. All of the government spending or shovel-ready jobs the government can conjure up can create sustainable economic expansion similar to what we saw during the days of ever-cheaper and ever-easier credit.

So what does this mean for the markets? As it becomes apparent that the U.S. remains the best of a fermenting (I won't say rotten) bunch, the dollar will strengthen. Equity markets will begin to trade sideways (possibly correcting mildly), non-industrial commodities will fall (see gold) and the dollar will strengthen. At some point the Fed tightens further strengthening the dollar. Tighter money takes away the bank carry trade and makes leverage more expensive which in turn makes borrowing to play the markets more expensive. The result will be credit spreads stop compressing and corporate bond yields begin to follow movements of treasury yields. The reason is that bank profits will moderate from levels seen in 2009. Most other sectors of the markets will see spreads remain constant or widen slightly. Junk bonds could see a significant correction in a year or two as weaker firms struggle to refinance debt at affordable levels (if at all). I think Fed Chairman Ben Bernanke has it right when he says that the economy will grow, but will face significant headwinds. Investors will have to accept that they are in fact investors and not traders because trading opportunities will be fewer and farther between than to what they have become accustomed. Ladders and barbells anyone?