Revolts in the Air – Looking for Progress
Well, 2011 has started off with a bang of sorts. The Internet has finally caught up to the developing world of autocrats and dictators. The leaders of Egypt, who reportedly have never written an email, were ousted by a youth movement harnessing the power of social networking. Not that the events have created any progress in that country – it is still run by the military and the constitution is now suspended – but change creates opportunity. And that change is trying to propagate throughout the Middle East. Our hope is that this change creates real progress. Unfortunately, history bodes otherwise.
As we look to the US and our little corner of the global economy, things have gotten a bit brighter during the past few months despite the blanket of snow covering my backyard. Or at least, that is what we are led to believe by the financial news. We’re not as bright on the news. As you’ll read below, we are of the same perspective from the past few quarters: the economic damage from the events of 2008 is going to take us years and possibly a decade to correct. Do not expect that all will be resolved quickly – do expect more volatility.
The Key Factors – Unemployment, Inflation and Real Estate
As you can see from the chart below, our employment level in the US has remained at rock
bottom for many months now despite the “good news” that unemployment dropped to 9.0% last month. The disparity in these facts has to do with the way that unemployment is calculated,
which masks the true numbers. Unemployment claims each week are still at exceedingly high levels, roughly 400,000 depending on the week. But the anomaly is that fewer people are actually in the workforce. Due to months and years of being out of work, folks stop looking and simply don’t get counted. The number of folks who have dropped out of the labor force over the past year is roughly equal to the number of new jobs. No change, no progress.
Combine that fact with regular population growth, and we are backsliding each month when we don’t have substantial jobs growth. January was no exception – 37,000 jobs growth in non-farm payrolls is nothing against the needs of a larger population. The problem grows, not improves.
A stagnant and immobile labor force leads to a tightening of the qualified labor pool, and hence our second concern for the current economy – inflationary pressures. Inflation is the silent erosion of future purchasing power. In a simplistic sense, you need to grow your assets and income at the rate of inflation to keep your standard of living. It seems like a simple task when inflation is typically 2-3% per year, but not so quickly. An ongoing study by Crescent Research points out that real growth in the stock market (gains from price changes and dividends, less inflation and taxes) is often flat or negative when viewed over a 20-year investment period. This data places a severe challenge to the notion of buy-and-hold equities to safely grow your portfolio.
Given where we stand today, we believe that inflation is prepared to once again enter us into a period of negative real growth if portfolios are not properly hedged. The factors are all present:
- The Fed has again entered a period of loose monetary policy: near-zero short-term interest rates and massive amounts of liquidity infusion through the Quantitative Easing program.
- Energy and food prices are escalating at a rapid clip due to global factors: namely general population and income growth in developing markets and failed harvests from the effects of climate change.
- A tightening labor pool.
But wait, you say. A tightening labor pool? I thought we just established that people need jobs? In fact, the unemployment situation will factor heavily into the inflation problem because of the lack of mobile, qualified professionals and skilled workers. Those folks who are falling out of the job hunt are often times permanently out of the labor market. Skills degrade, their ongoing training is limited and they find ways to adapt to life without permanent employment. With many of these folks out of the competitive labor pool, you have rising labor costs as firms compete for the fewer qualified candidates.
Adding to the problem is the real estate market. Prices are still down 30% across the country from their highs in 2007 and back to 2003 levels. A third to half of all mortgages are under water, with no short-term prospects of improving. The only way to move is to hope for a short-sale or some other concession from the bank and torch your credit report. Yet the jobs have moved on, to other industries in other regions or in other countries. We have severely limited the portability of the labor pool even as they seek new jobs created by advancements in American productivity and innovation. In short, a tighter labor pool for those firms who are looking to hire skilled workers and professionals.
Contributing to the problem are the banks, those bastions of capitalism who create the efficiencies for our economy to prosper (if you listen to Jamie Dimon and a host of other bank executives). Talk to anyone who has applied for a mortgage of late, and you get an interesting mix of dismay, disgust and a desire to disembowel. With Bank of America/Merrill Lynch losing billions each quarter, they are not exactly inclined to lend money even if they have a claim on your first-born. They’re just trying to survive and justify their next engorged bonus. In the mean time important segments of the economy are starved for credit, the fuel for growth.
So we are left with an interesting mix of circumstances. All the monetary factors are present for inflation, raw commodities are in tight supply, and the labor pool is tightening. Yet, these same factors lead to tougher circumstances for many Americans – fewer jobs, higher costs for daily living, and a dramatic loss of family wealth from market volatility and decimated real estate values.
Companies are Profitable – Why Worry?
Not surprising, companies in the US are doing pretty well. They have managed to keep costs down considerably (lower payrolls is a big start), gained in production efficiencies and have learned to serve a global market. Most companies have beaten earnings projections for the past quarter (which makes one suspect of earnings projections). The stock market is doing well. Corporate bond spreads are very tight, a market belief of nominal credit risk in these firms. Apple has a cash balance larger than most economies. Life is good for the big firms. Life is even good for some of the smaller firms. So what is the worry?
The worry is around tensions. We have created an untenable situation – one that cannot last more than a few years at the current pace. The most obvious tension is the US government debt. Our receipts as a percentage of GDP have fallen dramatically in the recession, by over 20%. Yet government spending, and the annual deficit, continues to grow. From the trillions spent on defense and wars during the Bush administration, to the ongoing state aid in the Obama administration, we are running up the credit card balance. And unless the entitlement programs (Social Security, Medicare and Medicaid) are harnessed and tempered, it will get worse, not better.
That spending has caught up in a dramatic fashion. As Tim Geithner, Secretary of the Treasury
quietly noted in front of Congress, annual debt service will soon be 73% of the annual deficit. Simply put, we will spend a half-trillion dollars a year to keep current with our national credit card bill (kindly issued to us by the First National People’s Bank of China). And that teaser rate is about to expire. Interest rates are going up, slowly, and for every few basis points increase in the cost of borrowing for the US government, the interest costs go up by billions. Not a pretty picture for a consumer who is still shopping at the Blue Light Special on that same credit card.
Municipal Bonds – Another Ratings Game
We are seeing the first signs of this problem in the municipal bond market. Muni bonds, for anyone who has been following, took a drumming in the last half of 2010 despite every other asset class doing well. The problem is state budgets. States have run out of money, and some will face impossible decisions on budget cuts. Remember that in 2010 there was Federal Stimulus money to help cover their deficits – no longer the case in 2011. That means a host of issues for cities, towns and municipalities who depend on the states. Some of these entities might fail – some of their bonds might go into default. One of the most conservative, risk-free, stable asset classes is headed for a Lehman moment.
Analysis: Muni Bond Market from the view of an Institutional Trader
This first chart shows the historical spread between the Generic U.S. Treasury 10-year yield and the Generic General Obligation AAA Municipal Bond 10-year yield (in Bloomberg speak: 049M10Y Index USGG10YR Index HS). The top chart shows the two rates going back to early 2006: Treasuries being the orange line and munis the white line. The bottom chart shows the difference in the two rates, with green indicating munis trading at a lower yield than Treasuries, and red is when they reverse. The top chart is measured in percentage points – the bottom chart is in basis points (100 basis points = 1 percentage point).
Back in the day (pre-summer 2007 when the sub-prime crisis began) AAA-muni’s typically yielded 1% less than Treasuries to account for their tax benefits, inferring that their credit risks were effectively the same. This relationship was broken during the crisis, and while the market attempted to restore the relationship in early 2010, it again fell apart at the end of the year. Today, AAA-munis and Treasuries yield approximately the same rate, despite the wide disparity in tax treatment and after-tax yields.
This second chart shows the same data for the Generic BBB G.O. Municipal Bond yield compared to the Generic U.S. Treasury 10-year yield (Bloomberg: 631M10Y Index USGG10YR Index HS). Note that, as in the previous chart, back in the day BBB-munis had a lower yield than Treasuries by roughly 0.6%. This wasn’t as large as the 1% difference between AAA-munis and Treasuries, but still reflected an institutional trader’s view of them as a “safe” tax-free asset class warranting the lower returns.
Today, BBB muni yields have shot straight through Treasury yields by 1.5% (and peaked at 4.1% in March 2009), indicating a relatively risky asset class despite the tax benefits. Compared to a history of zero losses from defaults (as far as I’m aware), the institutional market has effectively established this as the next crisis asset class, and doubts the validity of the AAA ratings as seen in the first HS chart. Remember that once upon a time, a whole market existed for AAA-rated sub-prime CDOs, many of which trade near zero today. Lesson learned: don’t rely on the credit rating agencies to spot the next crisis.
Next… Patience
Where this goes next, we cannot predict. But in the big picture we need time to heal, with a bit of additional carnage along the way. Our feeling is that the stock market rally is another bubble, inflated by a cycling of asset classes. As an investor over the past few months, there are few places to invest and gain yield. Short-term debt is paying next to nothing (thank you, Fed), risky debt is just that, municipal bonds look like the next crisis, and people feel like they need to restore their 401k plan now. So what-the-hey, let’s get into the stock market! In short, a predictable outcome from the Fed’s policies – create some sense of calm by inflating the one asset class that everyone understands and can play through their web browser.
With all this in mind, our investment direction for 2011 has some of the same from 2010 along with a few new twists. We are maintaining an underexposure to equities in general, and will do so for the foreseeable future. Those equities that we do hold have a handful of important characteristics:
- The ability to increase cash flow to shareholders in the event of strong inflation. High current dividend yield is an immediate indicator – strong cash flow is an intermediate indicator – and correct market/global positioning is the final indicator.
- Revenue base that is global. Most of the firms that we hold have at least 50% of their revenues from overseas, and we look for those firms that are able to tap into emerging markets as well. This helps us hedge against a weaker dollar and a weak domestic economy.
- Lower volatility in the event of a market dislocation. We do expect for increased market volatility, of the sort that we saw in the Flash Crash. Firms with currently low betas that tend to be less volatile are a start, those with stable cash flows augment the approach.
We expect for there to be continued uncertainty in the emerging markets as they grapple with inflation in many cases, and political instability in others. While we currently do not hold an emerging markets exposure, we consider it important to long-term growth in the portfolios. Entry points will be determined by specific events and inevitable market over-reaction.
The remainder of the portfolio is split between alternatives (namely commodities), fixed-to-floating rate corporate bonds, floating rate corporate bonds, and inflation-indexed US Treasuries. The mix will depend on available inventory, current pricing and individual risk profiles. Some interesting opportunities may also arise in the municipal bond market with any volatility or capitulation due to credit defaults.
Irrespective of the actual asset class or security, we will look for the opportunity to generate income to portfolio irrespective of the market conditions and in several cases use the asset to hedge against elevated inflation in the coming years.
Until our next market update, let’s hope that these markets sort themselves out in an orderly fashion and the snow gets a chance to melt. (I think our recycling bins are still buried out there somewhere!)
Regards,
David B. Matias, CPA
Managing Principal
