The Middle Eastern turmoil that began in Tunisia and Egypt spread to Yemen, Bahrain, and Libya in February, driving oil prices to $100 per barrel. At the same time, bond spreads in Greece, Ireland and Portugal continued to widen (albeit under the radar) as investors demand a higher premium to embrace the risk of these sovereign issuers. In fact, as I write this, the Greek 10-year yield has surged to 12.76% while the Portuguese 10-Year moved to 7.66%. The tumult drove gold prices up by nearly 6% in February, closing the month at $1, 411 per ounce. In February, the US Government racked up its largest monthly deficit in history — $233 billion. To put this into some kind of perspective, February’s deficit was larger than deficit for the entire year of 2007.
February brought with it, however, some encouraging news. People seeking unemployment benefits fell to the lowest level in nearly three years during the last week of the month. Both retailers and the service sectors have posted positive reports, and the unemployment rate dropped below 9% — ending February at 8.9%. Manufacturing activity (as defined by the ISM report) rose to its highest level in nearly 7 years; marking the 19th consecutive month of expansion for the economy as a whole.
Against the backdrop of these conflicting ominous and encouraging indicators, and a nearly 2% stock market decline during the last week of the month, the S&P 500 managed to add 3.4% to its already massive (+28%) gain since the Fed’s Jackson Hole meeting last August. For yet another month, Quantitative Easing coupled with pockets of good news pushed investors into risk assets with little regard for macro-environmental risk.
Our position has been (and remains to be) that the forces driving the economic recovery are not particularly solid and based almost exclusively on massive amounts of liquidity. Further, we continue to contend that the global financial issues that were exposed during the crisis remain largely unresolved, and for the most part, politicians and policymakers have merely attempted to push the problem into the future rather than structurally repairing it today.
To quote Citigroup’s Steven Englander, “It’s hard to argue with this line of analysis except that it has been dead wrong in market terms.”
Englander also made an observation that is dead-on with what we have observed in this uni-directional market: Investors have grown tired of being told to hedge against risks that have not emerged. In fact, he opines, the downward trend in volatility (as the stock market continues to melt up) may reflect that too much capital was dedicated to hedging risks that didn’t happen and that capital is now being deployed back into the market.
Since 2007, we have taken the position that the probability of a high magnitude, negative event (or a series of such events), remains higher than normal. We were rewarded for that observation in 2008 and penalized for it in the succeeding years. Like Mr. Englander, we have increasingly heard from more clients and prospects that either resist or reject the notion that such events may occur in the near- or intermediate-term. Basically, the line of reasoning is that they have heard this song many, many times since 2009, while the markets for all things risky have marched onward and upward.
If you subscribe to the theory that the ending of the financial crisis of 2008 and the subsequent recovery in risk asset prices is almost exclusively the result of trillions of dollars of money creation, it begs the question as to what policy tools remain to address a future crisis. Do countries simply print more and more money? Do they draft new, more restrictive and cumbersome legislation? Do they try to find new and creative ways of deferring the painful solutions to yet a later date?
I am not confident that policy-makers possess the tools required to address another significant crisis; and as a result, the absolute magnitude of a negative event has risen while the probabilities have, at best, remained the same. At worst, the probabilities have increased as well.
I will not go into itemizing the specific risks we see in the present environment. Those who have read our monthly letters or listened in on our prior calls should be acutely aware of the factors we view as problematic. Rather, I’ll conclude my prepared remarks with another quote from Mr. Englander: “When we see volatility so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if price action is apparently indicating otherwise.