Washington Square Capital Management Blog

“It’s like deja vu all over again.” — Yogi Berra

Let’s take a look at some economic bullet points, shall we?

* The stock market, after peaking in April, is in the midst of a summer swoon.

* The sovereign debt crisis in Europe is getting progressively worse.

* Unemployment remains stubbornly high and the housing market remains stagnant.

* Gold continues to climb as investors speculate that safe haven currencies like the USD, Euro and Yen will see continued pressure as debt levels mount.

*Quantitative easing from the Federal Reserve has recently expired and Government Stimulus money has run dry.

*Investors wait with baited breath as Fed chairman Ben Bernanke is due to give a highly anticipated speech at the annual Jackson Hole economic summit.

Sound like a good encapsulation of where the financial markets are today?   Perhaps,  but I’m actually describing where things stood last summer on the eve of the Jackson Hole summit.  While a lot has certainly changed in the past twelve months, many of the problems facing the global economy remain the same.

And so here we are, almost exactly a year later, and the markets are waiting/hoping/praying that tomorrow Ben Bernanke can pull a rabbit out of his hat in his Jackson Hole address like he did last August, when it looked as if the stock market rally was sure to falter.

So how did things play out last summer?

As we wrote in our last quarterly letter:

“When Ben Bernanke announced the QE2 plan on August 27^th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23^rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.”

Many stock market bulls believe that a third round of quantitative easing will deliver similar results.  While we concede that another round of QE will likely give the stock market a short term boost, we don’t believe it will cure any of the underlying ills that the economy suffers from (high unemployment, anemic housing market, low consumer confidence etc).

But never mind all that negativity, a stock enthusiast might say, will there be a QE3?

It’s hard to predict.  The Fed’s dual mandate is to provide economic growth and boost employment.  While it can be argued that the last two rounds of quantitative easing helped the US economy avert a depression, the main beneficiaries of these market interventions, particularly the last round, seems to have been stock holders — not exactly the constituency most in need of the Fed’s support.   And to compound the problem, two byproducts of these policies have been rising commodity prices and a weakening dollar, which creates a whole host of other issues for consumers.

Given that the Fed’s fiscal policies have come under increasing criticism from all corners of the financial and political world, including from some of the Fed’s own Board of Governors, it seems to us that another QE round would be enacted only as a policy last resort.  It’s also entirely possible that the next fiscal action from the Fed would not be a QE package, per se, but rather something resembling Operation Twist, which was an approach used in the 1960′s.

But if the financial markets continue their move further south, the question becomes: what other entity could possibly intervene to provide support?  Congress has demonstrated, through the debt ceiling fiasco and the rise of Tea Party influence over the Republican party, that a stimulus bill would almost certainly be dead in the water.  And as we get closer to the 2012 elections, it becomes increasingly difficult for our elected leaders (namely Obama) to institute major economic policy decisions without being accused of playing politics, particularly in the toxic partisan environment of Washington.

So, really, that leaves the Fed as perhaps the only game in town when it comes to market intervention.  If things get worse, then there may be increased pressure on the Fed to act since they have the mandate and resources to step in — whether that means tomorrow or at a future date remains to be seen (and regardless what your views are on the Fed’s policies, at least they can reach a decision and act on it in a timely manner — unlike our distinguished members of Congress).

So, has this summer sell-off and rampant speculation of potential Fed action hanged our investments thesis?  Not really.  We remain cautious and reiterate what we said in our last quarterly letter, in July, before the stock sell-off began:

“We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.”

The second quarter of 2011 saw equity markets close down slightly over the last quarter – the S&P 500 began the quarter at 1,325.83 and ended at 1,320.64.  Losses were on track to be far more substantial until the last week of June when the S&P 500 rallied over 50 points in the final 4 trading days after news of the Greek bailout and some encouraging US economic data.

Commodities, after experiencing an impressive two year long run-up, fell sharply in the second quarter.  Crude oil, which touched $115.52 per barrel on May 2^nd, sold off to $89.61 by June 27^th as economic indicators pointed towards a slowing global economy.  Mirroring the equity market rally, crude oil (and commodities as a whole) rebounded a bit in the last week of the quarter, closing at $95.08 on June 30^th.

Perhaps the biggest news this quarter was the highly anticipated end of the Federal Reserve’s second quantitative easing program.  QE2, as it has come to be known, saw the Fed invest $600 billion into US treasuries in an effort to keep interest rates low, promote economic growth and stave off any signs of deflation.  It is debatable whether or not this program resulted in any long-term benefit for the US economy, but it certainly did provide monetary rocket-fuel for the rally in stocks and commodities.

When Ben Bernanke announced the QE2 plan on August 27^th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23^rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.

Now that the second round has expired, and the possibility of a third round looks ever less likely, market participants may wonder whether equity markets can continue to move higher without that monetary stimulus.  We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.

Greek Debt. Another summer and another quarterly letter with a section devoted to the debt problems in Europe. And despite the passage of the latest round of bailout/austerity measures in Greece, we don’t believe this problem is going away anytime soon. Most observers expect Greece to restructure its debt over the next few years. As with the Russian default of 1998, any restructuring or default, though widely anticipated, will shock the markets. We expect concern will move rapidly to other countries in peripheral Europe as Portugal, Ireland, Spain and Italy will likely be the next group to find themselves sitting in the debt crisis crosshairs. As with most crises of confidence, European authorities will have to decide where best to build a firewall. Tough decisions will be made and in its exhaustion, Europe will likely realize that not every troubled sovereign can or should be saved. We believe neither Spain nor Italy can be abandoned, and we do not believe Ireland deserves to be. But as with many things that spur strong emotions, these events may take on a life of their own and force elected representatives to act in a knowingly destructive manner, simply to deflect virulent public opinion.

Debt ceiling debate. Meanwhile back on our side of the pond, a similar dynamic is playing out. With their 2010 reclamation of the House still fresh, Republicans appear determined to use their voting power to force budget cuts before approving a raise in the debt ceiling. Democrats, meanwhile, strongly prefer reducing corporate tax breaks and other revenue raising measures as a solution. Both sides are still far apart, but we expect they will find a workable solution before the August 2^nd deadline.  In our view, a workable long-term solution must involve both revenue raising measures and cost-savings in major programs, especially Medicare/Medicaid. We agree with many market commentators that a default on US debt would be catastrophic and hope cooler heads will prevail ending this game of debt/budget chicken sooner rather than later.

Regards,

Louis Berger                                                                                        Subir Grewal

We recently re-read a very good piece on Risk management lessons to remember from the credit-crisis 2007-2009 published by BlackRock. The document is well worth a read, and we recommend it highly for all professional investors.

There are, however, a couple of things we wish the authors had added to the note. Particularly with regard to understanding the institutional and legal context within which investments are made.

Portfolio managers must understand what happens when the market fails and a security enters liquidation: Investors should examine a potential investment through the eyes of a distressed investor prior to committing capital. Investing in distressed securities is a very specialized field that requires a lot of specific expertise. However, that should not dissuade the average investor from subjecting the investment to a  simple smell test. What happens to this security if the issuer becomes financially distressed?Who will they choose to pay first, and whom will the courts force them to pay and in which order. Part of our investment process focuses on what would happen in a distress or liquidation scenario (and what conditions would bring the issuer to that point). This occurs naturally to us because we invest in debt instruments, where return of principal is the paramount concern. We always evaluate both bonds and stock whenever we consider an investment in a company, i.e. look at the entire capital structure. We try to understand how decisions would be made in a liquidation, who would have authority to make decisions, and who would receive what portion of the liquidation proceeds in which order. We are generally wary of anything that has been through multiple layers of securitization. Understanding issuer and obligor motivation in a complex securitization requires peeling many layers of control. This is generally not worth the effort unless the returns being offered are extraordinary.

Investors should understand the financial history of the jurisdiction they are operating in, and how that impacts both law and convention: This usually falls under the rubric of operational risk, and is often an after-thought, but we believe portfolio managers must understand this. Many supposedly astute investors found themselves on the wrong side of the pond when Lehman Brothers failed (see NYTimes and DealBook). Hedge Funds with assets held within Lehman Brother’s UK prime brokerage operation found themselves facing an uncertain claim on securities they had believed were in segregated accounts. In marked contrast, the experience of the ’29 crash led to very different rules and conventions in the US, and this limited the impact on US prime brokerage clients. The lesson here is larger than a simple admonition to read custody and brokerage agreements carefully. You really do need to understand the cultural environment within which the law of the land came to be formed, and the environment in which it will be interpreted. This is part of the reason investments in China always give us pause. We’re simply not sure what underpins property rights in a jurisdiction where the collective memory of private ownership goes back half a generation at best. For that matter, we have similar concerns about Russia.

This brings up a much larger, third issue. As many ivory towers exist on Wall Street and the City of London as in Cambridge and Oxford. Many portfolio and risk managers in the institutional investment management world operate in the rarefied, highly specialized world of large corporations with armies of highly paid professionals in each division. The rough and tumble world of actual business, where businesses fail, frauds exist and people go bankrupt, is often as alien as Titan’s toxic atmosphere.

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.