Washington Square Capital Management Blog

Bonds and Bubbles

Over the course of the summer, various market commentators have put forth the idea that we are in the midst of a “bond bubble”.  Since we advise substantial allocations to bond or fixed income investments, we thought it would be worthwhile to weigh in on this theory.  Since we are fully aware that bonds, like every investment, carry risk and have the potential to lose money for the investor, we think it’s important to review those risks and explain why we believe that in the current environment bonds continue to be a preferred investment option over stocks and other higher risk securities.

We believe talk of a “bond bubble” is over-stated because their limited return potential (maximum return is repayment of principal and interest) tempers speculative excess (unlike stocks, which are far more sensitive to cycles of euphoria and despair).  In general, we view bonds as less risky than stocks because bond-issuers have a contractual obligation to repay bond-holders, whereas holders of common stock are entitled to residual earnings.  Bond holders are creditors and thus rank higher in the capital structure than stockholders; this makes recoupment of bondholders’ principal more likely in the event of a bankruptcy or default.

Bonds drop in price due to three main factors, rising interest rates, credit or default risk, and inflation worries.  All these risks stem from the fact that a bondholder is essentially making a loan to an issuer who agrees to repay a fixed amount of principal, along with some interest.

In our view, the Federal Reserve cannot keep the fed funds rate at the extraordinarily low level of 0-0.25% for much longer.  Fed officials see the dangers in maintaining extremely low rates since we have just lived through a large scale credit crisis fueled in part by central-banks suppressing rates for far too long.  We expect spirited discussion after the mid-term elections on raising rates, and expect the Fed to raise short-term rates to 1.5-2% followed by a pause.  We believe interest rate risks for holders of medium and long-term bonds are substantial at this juncture.  That said, interest rate moves are typically measured and somewhat telegraphed by the Fed, and we expect any raise to be executed incrementally.

Bond prices also drop when investors are worried about default risk.  This has typically been a concern for investors in corporate or local government debt.  However, sovereign issues are not immune to default concerns, as demonstrated vividly by the collapse in Greek, Irish and Portuguese bonds this year.  This default risk exists for all issuers who do not control the repayment currency.  In the Euro-zone, monetary policy is controlled by the European Central Bank, not individual country’s governments or their central banks.  In this respect, individual Euro-zone countries are closer to individual US states than the United Kingdom, USA or Switzerland which control their own currencies.

US investors have begun to focus on default risk for municipal bonds after a rash of high profile defaults or near-defaults (Harrisburg PA, Vallejo CA, and Jefferson County AL).  Historically, municipal bond defaults have been lower and recovered amounts after default higher than those for corporate bonds.  However, numerous US states and localities are extremely stressed by the real-estate crisis and recession so historic comparisons may be unreliable.  Weak economic conditions, coupled with longer-range questions about pension obligations and eroding tax bases in certain regions have negatively impacted most US state and local finances.  We recognize these risks, but are reasonably confident that the political process in most states will tackle fiscal issues responsibly and issuers will honor pledges made to bondholders.  We do expect fundamental pension reform by states to control costs, and state workers will see retirement ages extended and rely on 401k-style retirement plans rather than defined pensions.  Both corporate and municipal bond markets have weak issuers and our role as investment advisors is to identify and avoid them.  Just as we analyze companies and industry conditions, when we invest in municipal bonds, we review regional economics, taxing ability, project viability and overall financials to gauge credit risk independent of ratings.  In 2009, we recommended purchases of corporate and municipal bonds as concerns about repayment were elevated and bonds were available at very attractive levels.  Over the past year and a half, these concerns have receded and prices for corporate and municipal bonds have risen to the point where we have considered taking gains by selling positions.

This brings us to the last risk to bonds: inflation. Inflation is the most difficult risk to manage because it’s unpredictably influenced by an array of macro-economic factors (commodity prices, money supply, interest rates, factory/labor under-utilization etc).  Its impact on the bond market is profound since it destroys confidence by undermining the real-value of future principal and interest payments.  Bond investors are justifiably fearful of inflation.

We recognize the risks in bonds, and our goal as investment advisors is to make intelligent decisions while balancing risks and potential rewards.  We know of no investment that carries zero risk.  The risk of any particular investment performing poorly rises if we pay too high a price to acquire it.  Even sound securities can be bad investments if we pay too much for them.  This is part of the reason we consider ourselves value investors – we like knowing what things are worth before we buy them, we like to buy when levels are cheap, and we generally intend to hold investments for the long term (for individual bonds, this usually means to maturity).  This applies equally to bonds and stocks, and it is undeniable that many bonds are currently above the price a prudent investor would pay.  As a result, we are looking for opportunities to sell bonds where we believe price appreciation has changed the risk-reward scenario.

If we do sell these bonds, we have to consider re-investment options.  We have discussed the possibility of purchasing stocks of high-quality, financially strong companies with cash on hand if the opportunity arises.  Since we will continue to hold some bonds for all clients, we have sought to limit interest rate and credit (repayment) risks by shifting investments towards financially stronger issuers and limiting bond maturities (i.e. focusing on shorter-term bonds or bond funds).  We believe inflation risk for US based investors are low, yet we have opted to limit inflation risk by keeping maturities short.  We are presently not recommending investments in long-dated bonds (over 7 year maturities).

Risk On, Risk Off

Over the past few months, we have seen an increase in the degree to which different markets move up and down together.  As various writers have noted, correlations between different stock markets have increased.  Surprisingly, this has been happening with equity market volumes at very low levels in developed countries.  Indiscriminate buying or selling can create opportunities for value investors and we are willing to take risk when rewarded well for it.  We are actively on the lookout for such opportunities.

Political Update

It’s a mid-term election year in the US and we have begun to see a lot of posturing and maneuvering by the political establishment to prepare for the November 2^nd election.  The big story for this election will continue to be the state of the economy and persistent high unemployment levels.  The national mood is anti-incumbent, anti-Washington and we expect Democrats will lose House and Senate seats in this election cycle.

It is difficult for politicians to support free trade when unemployment is high, and these are certainly trying times for many workers in the US and Europe.  Every developed country would like to export its way out of this recession, but the entire world cannot do this at the same time.  High unemployment, low growth, large budget deficits and an impatient electorate can lead to irresistible pressures to enact protectionist policies in a short-sighted attempt to “keep jobs and industry at home”.  Rising trade barriers slows growth since it disrupts the global supply chains that virtually every industry relies on.  Only sustainable, balanced growth in both demand and supply can cure what ails developed economies, and we would be better served if elected representatives focused on encouraging sustainable global growth rather than protectionism.

Breaking BRICs

One of the great challenges confronting the world is how the rapidly developing economies of Brazil, China, Russia and India will be integrated into the broader global economy.  Thus far, they have been very successful as production centers of exportable goods and services.  However, as consuming and investing economies, their collective record is far more checkered.  China is a particular concern since many industries remain firmly under state control and consumption is a very small portion of GDP.  Capital and currency controls remain very rigid in China and most of the recent international tension has surrounded the floating peg maintained by Chinese authorities between the CNY and USD.  There are other fundamental institutional issues which affect China’s economic links to the world.  The Chinese legal system for one remains unpredictable and tightly under the administration’s control.  We have seen a number of instances where prosecution and arrest have been used to compel certain outcomes and actions from foreign businesses.  The recent wave of worker-led strikes and suicides at factories in China also betrays the fact that state-sponsored trade unions have not been representing workers’ interests.  Severe political repression of both workers and citizens leaves us concerned that discontent could quickly boil over into civil unrest provoking an unwelcome response from authoritarian regimes in both Russia and China.

In previous letters, we’ve written about the many imbalances and distortions we see in the Chinese economy.  We believe these concerns remain valid and we have begun to think about them and about the BRIC economies as a whole, in a slightly different way.  We now see a distinction between Brazil and India on one hand, and China and Russia on the other.  China and Russia remain heavily state-controlled, resource-intensive economies with repressive political environments, weak domestic consumption and a poor demographic outlook.  We believe future high growth in these two economies is not based on sustainable foundations.  In contrast, while growth in Brazil and India has been slower than in China and Russia, we believe it is more sustainable.  Political institutions in both countries are relatively democratic, state control of industry is limited and their legal systems, though notoriously slow and complex are not blatantly unfair.  Both Brazil and India have young populations with large numbers entering the workforce and this “demographic dividend” should lead to impressive growth over the next two decades.  This is not to say that Brazil and India do not face challenges; poor basic education and high inequality for instance are two issues that demand attention.  Still, it seems to us that these two countries are on a far more sustainable path than either China or Russia.  We will be taking a closer look at investments in India and Brazil, while our macro-view on China and Russia is more downbeat.  As always, we do not anticipate investing unless prices are attractive.

The Social Network

On the social media front, we wanted to let you know that you can now follow us through the following platforms online:

• blog.wsqcapital.com – our blog.
• facebook.com/wsqcapital – our page on Facebook
• twitter.com/wsqcapital – our Twitter feed

We look forward to speaking with you during our quarterly review.

1. We expect to see the US unemployment rate to peak at 11% in 2010. We may have been a bit aggressive with this call.  While the US job market remains anemic, the unemployment rate now stands at 9.5% (the lowest all year), partly because of workers who have dropped out of the labor force (stopped looking for jobs).  A falling unemployment rate would normally be encouraging news, but private sector job-creation continues to be very slow, despite the record amount of stimulus that has been pumped into the economy. In addition, the most recent jobs data has been disappointing, so the looming threat of a “double-dip” recession remains high and 11% unemployment later in the year is not out of the question.
2. Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010. This scenario has been playing out as we expected.  According to ICI[1], only $7.82 billion in new money has been invested into equity funds through June 23^rd 2010, while bond funds have seen $154.35 billion of net inflows.  Over the last eight weeks (where we’ve seen equity markets correct), net inflows into stock funds have been -$31.29 billion, while bond funds have seen +$33.98 billion over that same period.  We continue to believe demographic factors in the US and Europe as well as an increasing wariness towards stocks after two major bubbles in 10 years will lead investors to allocate larger portions of their portfolios to fixed income investments with a higher claim on corporate cash-flow than stocks.
3. We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety. This prediction has been right.  Since the start of 2010, we’ve seen credit downgrades to Greece, Portugal and Spain, as well as a massive bailout plan for Greece.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6^th and has recently bounced back to the 1.25 range.  We expect continued pressure on the Euro until a workable solution for the sovereign debt crisis has been reached.
4. Interest rates will remain effectively at 0% until the 4^th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range. So far this prediction has been accurate.  The Fed has kept the fed funds rate at historically low levels.  It remains to be seen whether or not the Fed opts to raise rates in the 3^rd or 4^th quarters.  While most commentators believe the latest round of economic statistics have made a hike unlikely until 2011, we still believe there’s a good chance the Fed raises rates to the 1-2% level after the mid-term elections in Q4 2010 and then pauses for an extended period.
5. Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order. This trend appears to be holding up.  In May, the personal savings rate reached 4%, which is the highest level it has been in 8 months and a far cry from the .8% we saw in April 2008.  Outstanding consumer revolving debt also continues to decline.   The most recent data from the Fed (for April) shows revolving debt at $838 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
6. The US economy will see almost negligible growth for 2010. It’s a bit early for this call since we won’t see this year’s GDP data until 2011.  Current GDP estimates are on track for 3% growth in 2010.  The caveat, of course, is that this has been accomplished with record government stimulus.  If the economy is unable to stand on its own without the crutch of stimulus, it’s entirely possible the second-half will be much weaker.
7. Corporations will increasingly turn to mergers and acquisitions to grow market share. This prediction could go either way.  According to the NY Times, the first half of 2010 has seen $810.3 billion in global mergers and acquisitions.  Through the same period in 2009, this number was $814.6 billion.  However, many of the 2009 deals were a result of government activity in the banking sector, whereas 2010 has seen deals taking place across a range of industries.  A recent Ernst & Young study of more than 800 senior executives across the world showed that 57% of businesses surveyed said they are likely to acquire other companies in the next 12 months.  This number was 33% in the last survey (in November of 2009).  Whether or not these executives follow through on this sentiment remains to be seen.
8. Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery. This trend appears to be holding up in 2010.  After a year of gaudy returns, the global equity rally faded in the second quarter.  As of June 30^th, the MSCI emerging markets index was -7.22% year to date, the MSCI EAFE index (which tracks developed markets in Europe, Australasia and the Far East) was -14.72% year to date and the S&P 500 was -7.57%.  We continue to believe equity market returns across the world will be negative in 2010.
9. We believe there is continued risk for a massive correction in China. While we have not yet seen a “massive” correction in China, the Shanghai composite index is now at a 15 month low and is down over 25% through the end of Q2.  We continue to believe equity and real-estate markets in China are over-valued and there is further to fall.
10. In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil. This call has produced a mixed result.  Gold is up over 13% through the end of Q2 while oil is down over 14% over the same period.  While gold remains a popular investment alternative to faltering currencies (Euro, USD), we believe its big run-up over the past few years puts it firmly into bubble territory.   We believe oil prices will remain depressed until the global economy is back on its feet.

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[1] The Investment Company Institute, which tracks mutual fund flows

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.

Like most market participants, we watched the market moves yesterday afternoon with a certain degree of amazement.  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.

While there have been some theories put forth to explain what happened yesterday, we do not have a definitive explanation for the rapid decline and subsequent recovery.  That said, we would like to share a few observations about yesterday’s trading and its broader implications:

1. Equity markets were already down substantially (on the order of 3-4%) before the sudden drop occurred between 2:30 and 3:00pm. During their (brief) lows, the broad indexes were down over 9% before recovering.  We closed the day down 3-4% across the major indices.
2. The sudden decline took us through multiple significant technical support levels. Volume was steady through the morning, picked up around noon and rocketed after 2:30.  Yesterday was the second highest-volume day on record.
3. There were various (as yet unsubstantiated) rumors of “trader error” causing the decline. There have also been reports that many high-frequency trading operators stopped trading entirely since they hit internal limits which kick in under extreme conditions.
4. 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 last point is the most significant for investors. There is a reasonable suspicion is that yesterday’s activity in the currency markets was part of an unwinding of the carry trade. Carry-traders are very sensitive to risk since they run large, leveraged positions which can be quickly wiped out. If this is correct, the events of this week were broadly similar to moves that occurred in August 2007, which affected quantitative hedge funds mostly, and marked the beginning of the declines of 2008 and 2009. See Andrew Lo’s paper, What happened to the quants in August 2007.

The technical reasons for the stock market decline are what have received the most scrutiny in the press. In our view, the steady surrender of volume and responsibility from trading floors (where participants meet market-makers face to face) to electronic exchanges with liquidity provided by automated high-frequency trading systems certainly exacerbated the sudden acceleration of the decline, but did not cause it.

Not-withstanding purely technical reasons affecting the speed and steepness of a 15 minute decline, the underlying reasons for increased risk-aversion are real. We also believe it betrays extremely short-term memory to claim that such sudden declines do not occur in a specialist managed market. We only need to point to Black Monday (October 19, 1987), when the market dropped 22% over the course of the day.  In 1987, most stock was traded via specialists on the physical floor of the NYSE.   In that instance, automated selling by “portfolio insurance” providers accelerated the decline.  Yesterday, the NYSE maintained a relatively orderly market, the extremely low-priced trades appear to have occurred on secondary exchanges with low liquidity where numerous market sell or stop loss orders may have encountered a limited number of bids and shallow order books.   In and of itself, this is not unusual, stocks always decline suddenly when there are a lot of sellers and no buyers.

This is an interesting debate, but in our view is largely irrelevant for investors.  One market commentator remarked:

For starters, let’s all keep in mind that these things don’t happen in a healthy tape. The jitters from Greek rioting and possible contagion were the necessary preconditions for a crash like that.

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.

Further reading:

Felix Salomon’s initial take: How a market crashes

Felix after taking a deep breath: Deconstructing the crash

Bloomberg’s Nina Mehta and Craig Nagi: Market fragmentation may get review after stock drop

For the past several months, we have been thinking about the broader Euro-zone’s economic malaise.   In the course of conversations, we sometimes use analogies, and we thought we’d share this one with our readers.

As part of the aim to integrate Europe and limit the future likelihood of war, European countries have sought to develop deep political links (by joining the European Union) and integrate their financial markets (by joining the shared currency regime).  As a result of this process, large, developed, stable economies in Europe (Germany, France etc.) have lashed themselves to smaller, relatively under-developed, unstable economies (Greece, Portugal, etc.).

Imagine each of these countries as boats on the open ocean.  Some of them are large, modern vessels carrying many passengers, while others are smaller, rickety affairs.  In creating the European Monetary Union, these countries sought to create a larger water-craft by roping together many different boats.  There are definitely advantages to doing this.  Passengers on the boats (citizens) can now easily trade and transact with those on other boats.

However, it takes generations for all passengers to develop a sense of common destiny and values.  The Eurozone has not had that much time, yet finds itself in the middle of a large storm.  The big problem is that there is no mechanism defined to detach the larger unit from a vessel that has begun to sink in a storm.

Passengers on the sound, stable sea-craft (German burghers) do not want to put themselves at risk by stepping onto the sinking ships to help bail water, yet their captains are calling for them to do so.  Meanwhile, the combined craft made of many mis-matched boats continues to tilt and take on more water.

To compound the problem, we saw a riot on one of the sinking boats yesterday.  Some passengers (Greek nationals) on that boat tried to set it (literally) on fire.  The rest of the world does not expect such things to happen in developed economies and looks on in disbelief.

What we find remarkable, is the speed with which assumptions have changed.  Nine short months ago, virtually everyone was calling the demise of the US dollar and the rise of the Euro as the new global reserve currency. Now we are at a point where the dissolution of the Euro is being openly debated.  Greek citizens riot in the streets because their elected representatives have chosen to call a halt to profligate policies and crack down on pervasive tax-dodging and fudging of statistics.  The rest of the world stares aghast. Meanwhiles, the rats (speculators) are deserting the ship.

For a less metaphorical take on the crisis, please read Edward Chancellor’s FT Opinion piece  Greece a bad omen for others in debt.