Economic & Capital Market Outlook|2012

Courage is doing what you’re afraid to do. There can be no courage unless you’re scared. –Edward Rickenbacker

 

We expect the challenges investors will face in 2012 will be as formidable as last year. As we look at our economy, the capital markets, and our political environment since the Financial Crisis of 2008, it seems we still haven’t addressed the big issues; and, it appears we don’t have much of a plan to address these issues in the near future. So, with a pragmatic sense of the current environment, we offer three general themes for 2012:

 

1. Our economy is deleveraging which raises unique challenges for investors;
2. Traditional monetary and fiscal policies are running out of ammunition;
3. The structural problems imbedded in the economy and capital markets, which include the political environment inWashingtonDC, will hinder economic progress.

 

The single biggest risk to the rate of economic growth in this country is the debt burden of the federal government. It took 228 years for our country to achieve $7 trillion in federal debt. It only took us the last seven years to double it to $14 trillion.  Like Europe andJapan, we have reached the limit to how much debt we can assume and we lack the courage to address the problem effectively.

  

There is a difference between an economy that is in a recession and one that is deleveraging. An economy that is deleveraging is plagued with benign growth, dismal credit expansion, and low demand. In a recession, banks loosen lending standards to extend credit which stimulates growth. In a deleveraging, credit remains tight as banks focus on increasing capital levels. Domestically, we have not experienced the pain of a sustained deleveraging since the 1930’s. The process will likely last the better part of a decade and will be complicated by the lack of consistent financial regulation. We expect the backdrop of deleveraging will be a constant theme for developing investment strategies and assessing relative value in the capital markets.

 

Since the Financial Crisis, we have recognized there are structural problems that exist in both the economy and the financial system. We believe that these structural problems are so powerful and deterministic to the performance of financial assets that we need to break them out separately to better assess risk and return. By reference, in last year’s Economic and Capital Market Outlook | 2011, we wrote:

 

…we believe that the inherent risks to investors are deceptively high in today’s markets given the extended government intervention in our capital markets, the huge budget deficit, the muted outlook for job growth and the lack of business formation that currently exists. The Fed is hopeful that the economy can grow its way out of these excesses and generate enough demand to drive tax revenues and consumption to absorb the slack resources in the system. Our concern is that a massive global debt crisis has already formed and, left unaddressed, will ultimately threaten the fragile economic recovery that is taking place.  Thus, our investment theme for 2011 is again focused on conservatism and principal preservation and less on extended risk strategies.

 

As we look at 2012, our view remains consistent with last year’s. We are cautious on the fragile state of theU.S.economy and believe that some markets are not pricing risk efficiently due to the Federal Reserve’s intervention. We are in the throes of a global debt crisis and world leaders have not been effective in addressing the problems. And, we believe volatility will remain at last year’s escalated levels.

 

Gregory J. Hahn, CFA

President & CIO

Investment Perspective

Financial Regulatory Reform is being Diluted

 

 

 

October 11, 2011

As we move into earnings season, we believe the two key drivers to financial market direction today are the problems in Europe and their inability to deal with Greece’s debt burden and the outlook for the U.S. economy. Soon, investor attention will turn to next year’s election campaign and what that means for entitlement programs, debt reduction, spending, and tax policy. However, a quiet cancer creeping through the capital markets is the disconnected process of financial regulatory reform. The combined effects of inadequate regulation of the financial industry will likely perpetuate many of the inadequacies that lead to the Financial Crisis, and ultimately may lead to further severe capital market turmoil.

Financial Regulatory Reform

One of our main tenants for analyzing the capital markets and developing investment strategies after the financial crisis is that we need to see financial regulatory reform. More specifically, we need financial regulatory reform that has teeth and provides a set of rules that everyone in the financial services industry follows, and can deal with the complex securities and transactions that are prevalent in the markets. As capital markets and securities have become more complex over the past 15 years, the regulatory framework has remained largely untouched since the securities laws that were implemented following the market crash of 1929. After the Financial Crisis, Congress passed the Dodd-Frank Act, which provides a framework for regulatory reform; however, it requires that roughly 100 rules be written which will address some of the gaps in the financial regulatory framework. We are growing more discouraged by the slow progress toward financial regulatory reform.

The incremental changes in the capital markets that have occurred over the past decade which include the repeal of Glass-Steagall, the unchecked growth in the use of derivatives, the rapid electronic trading systems that now account for over 60% of the volume on the exchanges, and the pervasive misrepresentation within the industry of structured securities (which are not registered with SEC) to individual investors, in the aggregate have shifted the stability of our capital markets and financial system resulting in a “buyer beware” oriented market. Last month Reebok settled with the Justice Department for $25 million over false claims advertising its athletic shoes that tone your legs better. While the company has no proof of the claim, the company paid the fine, yet continues to stand by their assertions. Unfortunately, that illustrates the American business culture today – see if you can get away with it and deny it if you get caught. We believe that investors need the Consumer Protection Agency which was formed as a result of the Dodd-Frank Act to better protect us from the predatory practices that are still pervasive in the investment industry. Also, we believe that investors would benefit from all securities, regardless of their offering status, being registered with the Securities & Exchange Commission.

The Fed Extends its Purchase Program

Yesterday, the Federal Reserve announced its newest initiative to spur economic growth by investing a portion of its massive portfolio in US Treasury securities with maturities between six and thirty years. Up until this point the Federal Reserve has initiated two asset purchase programs since 2009 totaling $2.4 trillion. Each program was designed to lower short term interest rates in order to stimulate economic growth in an environment clouded by health care reform, financial regulatory reform and partisan infighting in Congress. On the heels of the downgrade of the credit rating of the US Treasury debt to AA+, interest rates are at the lowest levels in history. Now, the Fed is stepping in to further manipulate the capital markets in an effort to lower long term interest rates even further, and flatten the yield curve to further stimulate economic growth.

We believe that it is important to recognize that we have entered another chapter in a huge central bank experiment that has never been tested before. The fundamentals that apply to security valuation matter less as central bank manipulation overshadows unconstrained free market forces. The Federal Reserve has taken its balance sheet from $914 billion to $2.4 trillion in the past three years in an effort to provide capital market stability and stimulate economic growth in the absence of private credit expansion. Clearly, the Fed sees trouble in the economy and Fed Chairman Bernanke is not inclined to let market forces work independently. First, we’ll explain the Fed’s latest initiative. Then we’ll attempt to provide some context for the actions of the Federal Reserve and why current monetary policy is ineffective.

The Federal Reserve – “Operation Twist”

By our estimates, the Federal Reserve currently owns $2.1 trillion in US Treasury and mortgage-backed securities. Through the Fed’s two asset purchase programs, known as quantitative easing, banks were able to sell securities which met certain maturity requirements to the Fed and free up capital to redeploy in other investments. In turn, the Federal Reserve accumulated a securities portfolio with the ultimate goal to lower short term interest rates. The result is an orchestrated transfer of debt from the private sector to the government sector.

The Fed has pushed the Federal Funds Rate, generally described as the rate in which banks lend to one another, from 5% in 2008 down to 0.25% today. Given the structural problems in the capital markets and the economy, traditional monetary policy initiatives which include adjusting the money supply and short term interest rates have proven ineffective in spurring economic activity. As a result, our central bank initiated the quantitative easing programs to step in where traditional monetary policy was ineffective. However, the Fed has determined that it should do more to adjust the term structure of interest rates. In addition to lowering short term interest rates, the Fed is now attempting to lower long term interest rates including yields on ten year and thirty year US Treasury securities, by selling short dated securities as well as reinvesting the coupon payments, prepayments, and maturities in longer dated US Treasury securities.

The result of the Fed’s newest initiative will be to reduce the slope of the yield curve – the difference between yields on short US Treasury notes and long dated US Treasury bonds. As students of the capital markets, we believe the yield curve is still the best predictor of economic activity. However, in the absence of meaningful policy initiatives to create jobs and real incentives for the banks to expand credit, the Fed is attempting to push long term interest rates lower to allow cheaper financing for those who can take advantage of it.

We believe that we have entered into a new monetary regime where our central bank directly manipulates interest rates through open market purchases. These are not temporary programs; we believe that the Federal Reserve’s asset purchase programs will exist for a prolonged period of time and that any thought of a Fed exit plan is naïve. We are concerned that the unintended consequences of the Fed’s initiatives will result in more harm on the economy and financial system. These concerns include insurance companies’ inability to profitably fund certain insurance products, retiree’s inability to earn enough interest income on their savings to maintain their life style and fixed income mutual funds inability to earn a total return that exceeds their investment expenses. And, while we acknowledge that that the Fed’s initial response to the financial crisis was necessary and largely successful, moving further down the path of manipulated lower interest rates without fixing the structural problems in the economy which are prohibiting capital formation, credit expansion and business investment will only make it harder to wean ourselves back to free market policies.

The Downgrade of the U.S. Government – The Implications for Investors

We are in a new paradigm for investors. In our view, the role of banks in the economy has changed, leverage in the capital markets is massive, financial regulation is not keeping up with the complexity of the markets, and the credit quality of the US government is deteriorating. In addition, the structural problems in our economy and capital markets are impeding business development and the expansion of credit. In our recent article The Downgrade of the United States we discuss the issues that may impact investors as a result of the deterioration in the credit.

1. Repurchase Agreements and Collateral Transactions.
   While there may be some initial pressure on the repo market, US Treasury securities are still some of the most liquid and safest investments in the world. As a result, we expect collateral transactions in the money markets backed by US Treasuries will remain stable over the near term. US Treasuries also are the primary collateral for the swaps and derivatives markets and given the unregulated nature of these transactions, we expect to see higher margin requirements over time. Higher collateral requirements will ultimately restrict credit growth which will negatively impact credit expansion and economic growth.
2. Interest Rates will Increase.
   We live in a world with government manipulated interest rates. With the deterioration in the credit fundamentals of the United States and the rise in the expected rate of inflation, a rational investor should expect the nominal rate of interest to increase. Yet, we have historically low interest rates.
3. The Marginal Cost of Credit will Rise.
   The deterioration in the credit quality of the United States is first and foremost a credit issue. US Treasury securities are used as collateral for all types of global securities transactions including credit derivatives, certain swap agreements and repurchase agreements. To the extent that any bank around the world requires a counterparty to post a higher level of collateral against a US Treasury position, we expect to see a marginal tightening of credit. As a result, we would expect over time to see higher interest rates which would further impair the expansion of credit, business development and economic growth.
4. Volatility will Increase.
   As we adjust to a new paradigm where the debt of the United States is rated AA+, we expect volatility will increase. Buy and Hold investment strategies will suffer in a range bound market given the low expected returns for cash and fixed income asset classes. Tactical strategies that take advantage of the dislocations in the market or changes in the value of risk should perform well if volatility increases.
5. Equity Prices will Remain Range Bound.
   We expect corporate earnings will continue to show strength; however, the structural problems in the economy will limit the incentive for business investment and employment growth. The downgrade of the United States will not immediately affect the earnings of Johnson & Johnson, Caterpillar and other domestic companies. However, until there is clarity to corporate tax policy, regulation and the solution to the global debt problem, management will focus on stock buy backs, dividends and their own compensation. Given the recent sell off, with the S&P 500 trading at 1220, we believe equities offer good relative value.
6. The Municipal Bond Market will Survive the Downgrade.
   A significant portion of the $2.9 trillion municipal bond market is prerefunded or escrowed to maturity with US Treasury bonds. With the downgrade of Treasury securities, these municipal bonds will also be downgraded. However, since most of these securities are held by individuals, we expect the downgrade to be a manageable event for the municipal bond market.

End of the Second Quarter – A Good Time to Reflect

Well, we’re at the half way point for the year and time to reflect on investment strategy and the economic recovery and the overall health of the capital markets. This may be a little random so we apologize up front.

1. Measured by the S&P 500, stocks are up 5.01% so far this year. We are about to go into earnings season next week and we expect earnings on the S&P 500 to exceed $96. We are watching top line growth for indications on overall economic health and growth in demand. More on that in a minute. Corporate America remains extremely healthy. Operating margins will remain strong; however, will likely be negatively impacted by higher commodity prices. The dividend yield on the S&P 500 is 1.77% – better than the 1.75% yield on the five year US Treasury note.
2. Equity prices will be buoyed by an increase in M&A activity, increased share repurchase programs and increased dividend payouts. The Obama Administration believes that they have saved the business sector from near ruin three years ago but can’t figure out how to translate the improved earnings into tax revenue and job growth. Healthcare reform continues to inhibit job creation. Loans to small business are up 25% year-over-year. This will do more to stimulate the economy and create jobs.
3. We are looking for three things before we are bullish on financial assets including financial regulatory reform that has teeth, a plan to reduce the deficit, and a plan for the Fed to withdrawal its money from the capital markets.
4. Financial regulatory reform is taking too long. The SEC released new rules for derivatives this past week and so far we are under whelmed since they address disclosure requirements and counterparty due diligence (which should have been done all along). The process of financial regulatory reform is a proving to be a prohibition to increased bank lending as it is inhibiting loan growth, capital formation and business expansion. The uncertainty is forcing banks to hoard capital.
5. The plan to reduce the deficit is political sausage in the making. We expect ultimately both Republicans and Democrats will claim victory but any progress in reducing the deficit will be masked by a cloud of assumptions that ultimately will prove elusive. As a result, five years from now we will still be under the shadow of a huge debt burden trying to figure out how to reduce it without cutting spending.
6. And the Fed still hasn’t figured out how to withdraw its money from the markets without spooking the bond market forcing interest rates higher and negatively impacting economic growth. In the end, rising interest rates will compound the debt burden as higher interest expense curtails economic expansion. This is the “Keynesian Trap” and it will make the early 1980’s look like a time of prosperity in comparison (it wasn’t).
7. The bond market is offering investors negative real rates of return. In other words, the rate of inflation is actually higher than the yields on intermediate US Treasury securities. Yes, this is distorted. However, we’re going to be here for a while so be careful. This is another unintended consequence of the Fed’s low interest rate policies designed to stimulate increased economic activity and bailout the banking sector.
8. Ah, the banking sector. Bank of America announced an $8.5 billion settlement with investors covering its role in perpetuating fraudulent practices in creating and selling mortgage-backed securities leading up to the financial crisis. Bank of America will take a $20.6 billion charge tied to its acquisition of Countrywide, the embattled mortgage company that underwrote many of the troubled mortgages. So, Bank of America bought Countrywide for $4.5 billion in 2008 and has incurred $30 billion in charges and losses on the Countrywide acquisition since it closed the deal. And, the executives still make millions of dollars.
9. We believe the economy is not going to roll over in the second half of the year but approach stocks with a caution. We remain opportunistic. It is hard to convince ourselves that bond investors are compensated for taking risk out by extending out the yield curve. still, bonds play an important role in diversifying a portfolio today given the global challenges investors face.

The Fed Meets Again Today

1. The Federal Open Market Committee meets again today and is expected to maintain its current interest rate policies over the near term. Also, we expect the Fed will probably affirm a decision to end bond purchases and repeat a pledge to keep the benchmark interest rate close to zero for an “extended period,”.
2. We believe the Fed understands the issues surrounding the huge national debt burden; however, is not inclined to push hard right now to reduce it given its concern on stumbling economic growth.
3. If the economy should weaken further, there’s little more the Fed can do to spur growth and create jobs with interest rates near zero and the balance sheet at a record $2.83 trillion.
4. The structural problems in the economy are hampering credit formation, business development and job growth.
5. Until the structural problems are addressed, the economy will likely show signs of slowing. By next year, uncertainty in tax policy will become a bigger issuer as the extension of the Bush tax cuts would be closer to expiration.

Stocks Rally on Confidence Vote in Greece

1. US Stocks had one of the biggest one day rallies of the year yesterday as the markets anticipated the result of Greek Parliament’s confidence vote.
2. Greek Prime Minister George Papandreou’s victory in a confidence vote bolsters his new government’s chances of pushing through austerity measures to secure further international financial aid for the country.
3. However, there still is not a consensus on a way forward to keep Greece from defaulting on its debt next month.
4. The International Monetary Fund controls the purse strings and wants to continue to provide financial assistance. However, unless the European Union can come up with concrete assurances on financing for the next year, the IMF is not expected to disburse any funds.
5. In addition, several members of the EU would like to see the private sector take a hit to principal in the restructuring of Greek debt which would effectively be a default.
6. Greece won’t be able to pay wages and pensions after July 15 if the government doesn’t secure the EU financing, government spokesman Elias Mossialos said yesterday.
7. Every global financial crisis is spread through the banking system and Moody’s has place several of the largest banks in France on review for downgrade due to their large exposure to Greek debt. In turn, the money market funds in the United States have over $ 1 trillion in the debt of European banks effectively putting US investors at risk.
8. Greece will be a continual problem for the EU and the Euro over the next several years. Next up – Portugal…..then Spain and Italy. The problem is not going to fix itself. We would not be surprised to see the Euro currency reformatted within five years.

The Economy is on Track. Market Expectations Were Just out of Line.

The stock market posted its fourth straight week of declines after digesting last week’s economic news, the growing US debt crisis, and the inevitable default of Greece’s debt. It was a big week. However, we believe the equity market had discounted a lot of good news and the reality of the news from last week only served to move market expectations back into line as the economy sputters through severe spring weather and the aftermath of Japan’s earthquake.

1. First, the headline. The unemployment rate last month remained unchanged at 9.1% but only 54,000 jobs were created during the month of May. The market was expecting over 100,000 jobs for the month.
2. We believe the economy will have difficulty producing jobs consistently month over month due to the structural problems and lack of credit expansion. However, the manufacturing workweek for all employees increased by 0.2 hour to 40.6 hours over the month, while factory overtime was unchanged at 3.2 hours.
3. While jobs weren’t created at the 200,000 per month pace of the prior three months, we didn’t see deterioration in manufacturing or the private sector overall.
4. In addition, the average hourly earnings for all employees on private nonfarm payrolls increased by 6 cents, or 0.3 percent, to $22.98. Over the past 12 months, average hourly earnings increased by 1.8 percent. The trend is not yet deteriorating in our view.
5. Also, the Institute for Supply Management (ISM) index survey was released on Friday. The ISM index declined sharply by 6.9 points to 53.5, its first reading below 60 for 2011.
6. The ISM report indicated expansion in the manufacturing sector for the 22nd consecutive month.
7. Even though the market did not take the report well, ISM Chairman Bradley Holcomb stated that the release of this figure is consistent with an economy that is expanding at a 3.8% real rate. We expect that the supply disruptions resulting from the Japanese earthquake have filtered into this data.
8. Finally, the Standard & Poor’s/Case-Schiller National Index of Home Prices was released last week. The released showed that the U.S. National Home Price Index declined by 4.2% in the first quarter of 2011, after having fallen 3.6% in the fourth quarter of 2010.
9. The National Index hit a new recession low with the first quarter’s data and posted an annual decline of 5.1% versus the first quarter of 2010. Nationally, home prices are back to their mid-2002 levels.
10. The housing market is critical to the sustained economic recovery. However, we do not expect housing prices to stabilize until the foreclosure mess is cleared up with the banks and there is a mechanism to allow qualifying mortgage loans to be repapered and the banks actually start lending consistently on new mortgage loans.

Until we have a credible plan to reduce the massive budget deficit, a plan for the Federal Reserve to withdrawal its stimulus from the market and clarity to financial regulatory reform we believe stock prices are range bound and interest rates will stay low. The unintended consequences of pursuing these policies will impact investors well into the next decade.

The Fed Starts to Talk about its Exit Strategy

1. The Federal Reserve released minutes from its April FOMC Meeting which discussed, for the first time, how the central bank would begin to withdraw its massive stimulus from the capital markets.
2. While no decisions were made or a firm plan established, we are encouraged that the Fed is beginning the discussion.
3. During and after the financial crisis of 2008, the Federal Reserve forced short term interest rates to zero percent and pumped $2.4 trillion into the capital markets which was used for open market purchases of mortgage-backed securities and US Treasury securities, as well as direct investments in banks, insurance companies and a few auto manufacturers.
4. We believe that, with this government intervention in our capital markets, the price of risk is distorted and in many cases investors are not compensated appropriately for the risk they are taking investing in the markets. We believe that an important milestone for investors is when the Fed eventually releases a plan to withdraw its stimulus from the capital markets.
5. The discussion at the April meeting, which cynically we believe was probably well scripted, is designed to manage market expectations and not spook investors when the time comes.
6. As we expected, the first thing the Fed would do is discontinue reinvesting coupon and prepayment cash flows into additional open market purchases which effectively will start the process of allowing principal to decline.
7. We were not surprised by the discussion that the unwinding might take as long as five years. In this new paradigm of open government intervention in the market, we expect the Fed will continue to manipulate interest rates in this manner as long as it can.
8. The timing of the Exit Strategy is important – getting the timing right may determine whether the Fed can contain inflation without unnecessarily harming economic growth and employment. The economic recovery is still too fragile for the Fed to begin withdrawing its stimulus. This is just one manifestation of the global debt problem we expect to be navigating well into this decade.