Washington Square Capital Management Blog

In our last few letters, we have discussed the extraordinary measures undertaken by governments across the world to support aggregate demand, and the extensive borrowing required to do this.  Over the past three months, both of these issues have been thrown into stark relief by events.

The dramatic and extremely sudden deterioration of Greek sovereign credit in the marketplace forced the European Central Bank (ECB) into a rapid about-face.  Germany’s elected representatives blinked and committed to a vast fund to support Mediterranean nations. Very few people expected to see the IMF lead a rescue package for European Monetary Union member-states in their life-times.  Eroding confidence in the ECB and EMU led to a deterioration in the value of the Euro as talk of this currency supplanting the US Dollar as the new global reserve currency did a sharp 180 degree turn and even sober commentators began to talk of a break-up of the European monetary union and the Euro’s death.  Meanwhile, bond-holders have turned their sights on the increasingly precarious state of sovereign balance sheets in most of the developed world.  Shocked by the speed with which Greek bonds lost value, most bond buyers are thinking seriously about sovereign credit risk in the developed world, awakening from a period that lasted two generations during which these risks were largely ignored.  Meanwhile, treasury officials the world over review the results of their bond auctions nervously, wary of any sign of demand slacking.  In many cases, their own central banks are becoming the most reliable buyers or financiers of new debt.

Three months ago, we wrote in an earlier post:

Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.

We believe this process has begun and the initial signs do not augur well for the global economy.  We have seen a debate re-kindled recently about whether the withdrawal of stimulus at this juncture is a repeat of “errors” made in the 1930s, when stimulus spending was reduced to control deficits.  However, with aggregate debt levels in the developed world as high as they are, we see few alternatives to a steady reduction of the extraordinary fiscal and monetary measures undertaken to control the crisis.

We also feel it’s necessary to discuss the “Flash Crash” of May 6^th.  In our blog post the next day, we wrote that:

Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop.  But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery.  It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.   …

Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.  …

The major conclusions we draw from the trading action of the past week is that:

1. Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
2. The Euro-zone crisis will continue to roil markets until it is properly addressed.
3. There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.

Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.

All three major indices, Dow Jones Industrials, S&P 500 and Nasdaq composite closed out this quarter below the intraday lows reached that day.  The ten-year treasury is now below 3%, and no amount of commentary on US federal and municipal debt-levels appear to impact the decline.  Meanwhile, the Baltic Dry Index has dipped below 2500 again (amidst talk of expanding fleets and falling Chinese imports).  Speaking of China, we see more commentators openly questioning the solvency of Chinese banks and the reasons behind big IPOs.  All of this underpinned by the fact that unemployment and underemployment rates in western countries remain stubbornly high.

Not only is it increasingly difficult to write off the events of May 6^th as a mere technicality, we believe that sudden decline has lead to deep distrust and uncertainty amongst investors.  Investors were already wary of fundamental economic and market conditions, the flash crash gave them reason to cast suspicion on the technical organization of the market.  This coupled with the SEC’s indictment of the premier US Bank, Goldman Sachs on charges of fraud, has fueled suspicion of large player’s motives and methods.  Many individual investors now believe the market is rigged against them, for the benefit of the largest trading firms and their most senior traders.  In our view, it was always thus.   Professional traders, whether they be electronic market-makers or specialists on the trading floor have always enjoyed a privileged position, which is completely appropriate given their role as liquidity providers and their responsibility to maintain orderly markets.  What we find difficult to accept is the extension of these privileges new players, without them being asked to shoulder the same responsibilities.

We do not see many silver linings amidst a climate of mutual suspicion and bad news.

A very interesting, disturbing, but perhaps unsurprising article in today’s FT, about how Russia may have tried to get China to simultaneously dump GSE securities on the market to exacerbate the US financial crisis.  Sounds like a cross between international espionage and hostile takeovers, but scarier:  Paulson claims Russia tried to foment Fannie-Freddie crisis

The Financial Times’ John Tasker writes about conflating economic growth and investment opportunity in Insight: Busting the myth of the Brics

1. Who’s Hiring? We expect to see the US unemployment rate peak in 2010 at 11%.  While seeing a peak will certainly be an encouraging sign, we don’t believe this will be followed by a rapid economic recovery creating the millions of jobs necessary to lower the unemployment rate down to pre-recession levels (5%).
2. I’m fine with fixed returns: The credit crisis of ‘08-‘09 saw many individual and institutional investors badly burned by overexposure to riskier assets like stocks, commodities and real estate.  While there has been a strong recovery in many risky assets over the past 10 months, we expect investors will continue to re-allocate towards less volatile investment classes, such as bonds, with a trend towards a classic 50% stock 50% bond allocation.
3. Collecting from sovereigns: 2009 ended with warning signs emerging from Dubai and Greece that there is a potential for default or credit deterioration among sovereigns that have over-extended themselves.  We expect to see a number of credit downgrades for developed nations as their persistent deficits, long-term pension/health-care liabilities and weak growth come into focus.  2010 may well see a sovereign nation default on foreign-currency debt obligations.  We expect the US Dollar and US treasury credit to strengthen in any ensuing flight to safety.
4. Reading tea leaves at the Fed: On December 16, 2008, in an effort to encourage banks to lend and provide liquidity for the financial markets, the Federal Reserve lowered interest rates to effectively 0%.  This rate held throughout the entirety of 2009.  We expect this run to end in 2010 with the Fed raising interest rates in 4th quarter of the year.  We expect the Fed to tighten rates to the 1-2% range and then pause for a few quarters.  This will likely result in the yield curve flattening since long term yields will not rise as quickly.  Unlike many other market commentators, we do not expect high inflation despite large increases in measured money supply.  A sharply lower velocity of money and reduced money-creation via private sector credit will dampen inflation.
5. Pay me my money down: Continuing the trend from 2009, we believe paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order.  This will disrupt a strong recovery in corporate profits, particularly retailers (which rely on consumer spending to drive growth), as some businesses will misjudge the new environment.  However, this is very good for the long term health of the US economy.
6. A cold year for growth: We expect the US economy will see almost negligible growth in 2010.  Margins will continue to contract for US businesses and profit growth will remain slim. The expiration of stimulus programs and slim prospects for their renewal in a mid-term election year will reduce aggregate demand.  Cost cutting and efficiency measures will continue to be necessary to offset top-line deterioration.
7. Arranged Marriages: With margins slimming, interest rates at historic lows, the unemployment rate in double digits and the US consumer cutting spending, we see corporations increasingly turning to mergers and acquisitions in order to grow market share, particularly in the cash rich tech and energy sectors.
8. New kids on the block: Emerging markets proved to be more resilient to the global recession than developed economies.  We expect growth in emerging markets will continue to out-pace growth in developed economies.  But this growth will not be enough to offset the stagnation in developed economies or lead to a robust global recovery.
9. Red alert: We believe there is continued risk for a massive correction in China.  We remain skeptical of the veracity of the economic data released by the government and don’t see how the white-hot level of growth can be sustained when China’s main trading partners (namely the US, Europe, Japan) continue to suffer from the effects of the global credit crisis.
10. Fool’s gold: We believe certain commodities are poised for a sharp sell-off over the next year.  Highest on our list for a correction are gold (which only has value if others think it does) and oil (many Iraqi and South American fields coming online and low growth implies low energy use).

In our view, as long as a society enjoys relatively free markets and the rule of law, long-term economic growth rates are largely determined by two factors: demographic trends and the pace of technological advancement.

In terms of demographics, birth rates high enough to keep a country’s population relatively young, replenish the work force and keep dependency ratios low are crucial to sustained growth. Because of low birth rates, limited immigration and rapidly aging populations, Japan and Western Europe face significant challenges ahead as their population continues to age. Two recent articles on demographic trends in different parts of the world served as reminders of the importance of demographics. The first is an article in the Economist on demographic trends in Africa and another in China Daily about rapid demographic changes in China.

Technological advancement allows a society to produce goods and services with less effort and resources, allowing its population to be more efficient. The classic example is the mechanization of agriculture, which has allowed much of the world to satisfy its demand for food while freeing most of us to pursue careers other than farming. In some cases, technology can even help make demographic transitions easier, for example, Japanese firms have been developing robots to help care for their rapidly growing elderly population.

For us, the impact of technological advancements was underscored earlier this week while reviewing an official statement for a municipal bond initially issued in 1993. The entire 75 page document had been hand typed (on an actual typewriter) and made us realize how far word processing has evolved from the days of the humble Smith-Corona. We can only imagine the amount of effort it required to calculate various tables on a hand-held calculator and the toll repeated revisions must have taken on the typist’s fingers. Inexpensive electronics, modern word-processing and spread-sheets have transformed this process entirely, and let us use our time far more productively. Happily for global growth, the pace of technological progress continues unabated and we fully expect that by 2025 we will look back at 2009 and find much that is amusingly archaic.