Washington Square Capital Management Blog

2011 Themes: These Go To Eleven

1. Raise ‘em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members.  We expect rates to end the year in the 1% to 2% range. We think it is likely that the Fed raises rates to the 2% range this year because moves during the 2012 presidential election year would be politically toxic.  A rise in the short-term rate will result in a flatter yield curve (compared to the extremely steep levels today) and reduce bank earnings.
2. Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25[1], prices are at the upper end of historical range.  Governments across the world have provided immense demand support and a low rate environment over the past couple of years.  We also believe investor wariness and demographic changes (a large cohort of new retirees who will begin drawing down on savings) suggest much support for asset prices is weakening. We believe investors will continue to focus on fixed income investments, and rightfully should.
3. United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe.  This will doubtless further strain the Euro and all European establishments.  We believe the stresses created by the currency union existing outside of a strong federal structure will be resolved with a more federal Europe.  The alternate solution where certain states opt to leave the currency union is less likely, but not outside the realm of possibility.  In general, we believe European sovereigns will begin to be treated more like US states (which do not have the power to issue currency either) by the markets. Over time, we expect a move towards additional bond issuance at the European Union level, with each state having access to a certain amount of borrowing against the EU federal credit in exchange for heightened oversight and restrictions.
4. Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion.  We expect certain weaker revenue and real-estate project linked bonds to default, we also expect acrimonious budget debates on benefits for public sector employees and pensions in many states.  We think large scale defaults by major issuers (state GOs, water/sewer) are very unlikely, but investors will continue to discriminate between strong and weak credits and heavily discount informal support expectations and bond insurance.
5. Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011.  Overbuilding and overinvestment in physical infrastructure during the past few years has left a glut of underutilized buildings and this could lead to a sharp downturn in Chinese property prices and construction activity.  Any such downturn would also impact Chinese banks, and potentially have a wider impact in the region, affecting commodity-driven economies like Australia and Canada.
6. Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages.  This will make for a more difficult general retail environment and generally depress big-ticket discretionary spending.  The real-estate bubble has altered an entire generation’s perspective on housing, and we expect households and financial institutions both to be skeptical of high mortgage indebtedness and expectations of large capital gains in residential real-estate.  We expect similar deleveraging to occur in commodity-boom fueled economies like Australia and Canada. We do not believe US residential housing prices will rise in 2011, and may indeed fall further.
7. Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year.  We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%.
8. Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course.
9. Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent.
10. Feast and Famine: We expect 2011 to be a very volatile year for commodity prices.  We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well.  Such a correction would be far more likely if China has a hard landing from the withdrawal of extreme stimulative fiscal policy and over-building over the past few years. We expect food prices to become a focus of attention in many parts of the developing world (as they were in 2008), and that governments will be forced to respond in whatever manner they can.  In the developed world we expect a resurgence of interest in agricultural and timber land investment.
11. Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform.  Corporate and higher-income tax-payer earnings will be the center of discussion and there is an off chance that the byzantine US tax code is simplified. In particular, trial balloons have been floated to withdraw the deductibility of mortgage interest, and tax life insurance benefits and municipal bond interest income.  Similarly, we have seen increasing discussion of doing away with the estate tax and replacing it with an income tax on proceeds received by heirs. Each of these deductions is supported by sizable vested interests and we think it is unlikely that they would all be swept aside and the tax code completely over-hauled.  Nevertheless, the possibility exists with a president and congress who are both eager to demonstrate their independence and fiscal sobriety to an irate electorate.

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.

We noticed an editorial by Andy Grove in Bloomberg a few weeks ago titled How to Make an American Job Before It’s Too Late.  Andy Grove, a founder of Intel, makes a number of very important points in the piece, chief amongst which is the link between production and future innovation.  Mr. Grove makes a powerful case for rethinking outsourcing (at both the corporate and national levels).

Meanwhile, in the Financial Times, Michael Spence wrote an equally strident piece titled America Needs a Growth Strategy.  Mr. Spence highlights the role capital formation (of all sorts) plays in spurring and sustaining future growth. Both authors make the argument that a steady decline in US manufacturing has removed important capital goods, including modern factories and assembly lines, from our economy with potentially dire consequences for innovation, business and eventually politics.  We find the argument that innovation and research cannot occur for long without a close link to production facilities very compelling.

The US case is in stark contrast to China, which, in the past 20 years, has managed to accumulate both capital goods and build the world’s largest manufacturing center.  Mure Dickie writes about how Chinese joint-venture partners emerged as strong competitors to Japanese high-speed rail firms in an article titled Japan Inc Shoots itself in foot on Bullet Train.  Mr. Dickie then followed up on this story with a full length analysis of the global high-speed rail industry, highlighting how Chinese state sponsored companies have “digested” technology from foreign partners and emerged as competitors at all levels, not simply for low value components.  The rapid rise of Chinese firms in industries that have taken decades to develop is neatly encapsulated in the Californian anecdote.  California, in many ways the cradle of modern high-technology, is considering a Chinese firm to build its high-speed corridor between San Francisco and LA. Similar trends have been visible in other clean technology industries, from photo-voltaic panels to high-efficiency batteries.

Which brings us to the curious case of Huawei, the world’s third-largest manufacturer of communications equipment, which has been shut out of the world’s largest market (the US) due to fears about the potential for espionage. Since US-based companies closely linked to the defense industry have been leaders in the communications industry for decades, we wonder whether we’re seeing frenzied jockeying for the prime eavesdropping territory in our newly networked world.  Paul Taylor and Stephanie Kirschgaessner  write about the company in the FT, Huawei in drive to land big US deal, and the Economist covered the company’s meteoric rise last year in Up, up and Huawei.

All this is occurring in the context of increasingly vocal complaints and criticism by senior executives at GE, Microsoft, Google, Siemens and BASF about the business climate in China for foreign firms.

We don’t believe governments are better resource allocators than free markets in general.  But it is difficult to be sanguine about an industrial policy intentionally developed to facilitate the transfer of technology from foreign participants with the goal of weakening them.  Technology is not a traditional resource, it is difficult and expensive to develop, but easy to copy and reuse.  We know that an industrial policy designed to accumulate a resource like iron ore or oil will drive up prices and be counter-productive.  But it seems to us that “digesting” technology while purchasing implementations has few ill-effects we can see.  That said, legal protections for intellectual property were developed with this in mind. Intellectual property rights are notoriously difficult to enforce within China’s opaque, arbitrary and unequal legal system, but we will be interested in following the intellectual property cases that arise when Chinese technology firms begin to compete for contracts in the global marketplace.

A couple of news articles on the topic of China caught our attention last week.  In an article titled Cooling Property Market Tests Beijing’s Nerves, the Financial Times reported on the sudden, marked slowdown in apartment sales within mainland China and the potential government response to this phenomenon.  What stood out amongst all the anecdotal information is that apartment prices in Tongzhou (a suburb of Beijing) are currently hovering around USD $3,500 per sq. meter (or USD $325 per sq. ft.), perhaps more if you consider the CNY (Chinese Yuan or Renmindi) is undervalued to the USD.  We admit that we’ve never visited China, so we don’t have firsthand knowledge of real estate market trends in Tongzhou (it could be the Greenwich of Beijing for all we know, and in fact, it looks like a pretty nice place from space).  We also readily admit that we aren’t experts when it comes to navigating the complexities of the Hukou system of permits.  Perhaps Tongzhou is the recipient of pent-up demand from people who cannot buy apartments within Beijing proper.  Still, we think $325 per square foot is a bit high, especially when you consider the real estate market in suburban New York (the wealthiest city in the wealthiest nation in the world).   We conducted a quick (completely unscientific) analysis of the property market by looking for new developments in the NYC suburbs (accepting at face value sq. ft. area claims made by the developer).  We end up with asking prices in the range of $250-400 per sq. ft. (across the river in Jersey), $400-600 per sq. ft. (in Brooklyn and Queens) and $250-400 (Westchester).  Median household income in New York City (2008) was $56,000.  Beijing’s statistical bureau doesn’t publish median household income, but they do say that in 2009, disposable income per capita was CNY 26, 700 (USD $4,000).   By our estimate, that puts median household income around USD $12,000-15,000, or 20-25% of that in New York.  Yet prices are roughly comparable.   In our view, these levels are unsustainable and highlight the growing disparity between real estate prices and what Chinese citizens can reasonably be expected to pay for these properties.

Last week also saw the IPO of the Agricultural Bank of China (ABC), the last of China’s major state-owned banks to go public.  Like all the other state-owned banks, ABC spun-off a package of bad loans prior to going public.  What we’re wondering is whether they’ve also spun-off all the employees who made those bad loans (over 10% of ABC’s USD 828 Bn balance sheet at end 2007).  We’re also wondering it is possible to make USD $110 billion in bad loans in an economy that is growing at a 10% clip.  Fitch Ratings has some ideas.