I Still Can’t Get No Satisfaction

As a follow-up to my previous blog post (and in keeping with the theme of questions asked by my clients), I was recently queried the following:

“Why do you seem consistently filled with doom and gloom?”

I would have felt a little better if the question ended with “doom and gloom in the financial markets.”  I’ll assume that was the context of the question; if for no other reason than to soothe my ego!    Notwithstanding that, the short answer is that, against the backdrop of facts, I try my best to use reason instead of hope.

Let me take a few minutes to share our macro view, and it may help explain why our investment process has led us to where we are today.

In the big picture, the banking crisis of 2008 was never resolved.  The crisis was, as Kyle Bass put it, “smothered by the full faith and credit of rich Western Governments.”  What was already dangerously high public debt became even higher as bank debt was transferred to the public.  Compound that with the fact that debt accumulation was accelerating in reaction to the financial crisis and you are left with what we’re now seeing in Europe and potentially here in the US.

Anyone watching the European crisis has to be getting the sense that pain can only be delayed; not avoided.  Austerity cuts reduce public deficits, but they also crimp economic growth.  As we watch the race between increasing stimulus and debt, and that stimulus ultimately translating into meaningful economic growth, we are doubtful that growth will arrive quickly and materially enough before most of Europe’s debt reaches a tipping point.

On Monday, Spain was forced into a state bailout of its third largest bank, Bankia.  This represents a 180 degree reversal of Spanish policy and will cost between 7 and 10 billion Euros.  For those keeping track of post-crisis acronyms (TARP, LTRO, etc.) it will provide you the opportunity to add another to your list:  “COCO” — meaning contingent convertible bonds – the vehicle that will be used to inject capital into Bankia.

But Europe may not be the initial catalyst for Crisis Part II.  Hugh Hendry lays out a pretty cogent argument about why China may be the epicenter of the next pullback.  Briefly (and I’m happy to forward the full article to anyone who would like a copy), the argument goes like this:

  •  China’s massive currency manipulation punished its bank savers, so the citizens went on a home-buying spree figuring that homes were an appreciating asset.
  • The scale of China’s housing bubble dwarfs that of the pre-crisis US bubble
  • There are trillions of dollars of loans from underground creditors, who do not have rigorous (or any) underwriting standards.
  • China is aware of this, and to curtail the activity has been handing out death sentences to some of the underground lenders.  If this sounds too unbelievable (as I am occasionally prone to hyperbole), Google “Wu Ying.”
  • China’s government has spent so much money boondoggling unnecessary infrastructure under the assumption that exports will cover the costs; a global economic slowdown will crush their balance sheet.

Then Japan…

Japan has its own set of problems from awful corporate balance sheets to unbelievably dilutive corporate actions, to lousy demographics, to linkage to China’s growth.  We see no reprieve for the beleaguered Japanese stock market.

As for the US, reasons for optimism include the economic growth likely to be brought on by new oil and gas development projects.  You only have to look at North Dakota to get a sense of how powerful this can be.  The US is also experiencing record corporate profitability.  Earnings, driven by productivity gains, have been nothing short of stunning.  Yet, you can only increase productivity and maintain record margins for so long.  As the belt-tightening reaches its peak, earnings growth will no longer have that tailwind.  Further, top line growth will likely be hampered by a contracting global economy.  We also have a Presidential election coming up that will have significant tax and healthcare implications.  At best, we rate US stocks as a neutral.  But, its stocks are being treated like a strong buy on a relative basis when compared to bonds, cash, Europe, etc.

Finally, across the globe we are witnessing social unrest of varying degrees.  From the Arab Spring, to Greece’s anti-austerity riots, to the UK’s tuition protests, to Occupy Wall Street, the populous is becoming increasingly agitated.    Socialist and far right political ideology is gaining strength in Europe – France and Greece in particular.  The French just elected only their second socialist president since Mitterrand, and Greece’s neo-Nazi (Golden Dawn) party won 20 seats in Parliament by garnering 7% of the popular vote in last Sunday’s election.  Wealth disparity in the US is at record levels.  Unemployment in Spain exceeds 24%.  The list could go on and on, but you get the gist.

In an environment characterized by global fiscal distress, dangerous global monetary expansion, social unrest, and political upheaval, I find it difficult to hit the street with bullish optimism.

I look forward to the day when these blog posts are about how bright the future looks.  And I’m sure that day will come.  But right now, every developed country in the world has their pedal to the monetary metal yet has only managed to slow the bleeding.  If that is the best result that all out, globally-coordinated government action can deliver, it begs the question as to just how bad the underlying problem is.

Achtung Baby!

Surprisingly negative news from the German bond market this morning set the stage for yet another day of losses in global equities.  The $6 billion Euro 10-year bond auction failed to find adequate bids, resulting in the Germans being forced to take down over $2 billion Euros of their own bonds.

This was the worst bond auction in Germany since the introduction of the Euro.

The ripple effects were instantaneous, with yields in Italy and Spain rising to the point where the ECB was forced to intervene and lend pricing support.  Further, the Euro fell dramatically versus the USD and the US equity futures tumbled.

Since November 15, the Dow Jones Industrial Average has fallen nearly 7%.

The prevailing school of thought regarding this auction goes something like this:  German bond buyers essentially went “on strike” in order to pressure Germany into allowing the ECB to exercise more power to stem the crisis.  It would be nice if that school of thought turns out to be true.  Otherwise, the word contagion comes to mind.

But, Germany wasn’t alone in pressuring the markets today.  China and Belgium had a hand in the mess as well.  China’s Purchasing Manager’s Index fell to 48 (a number below 50 indicates contraction).  This sent commodities (as well as stocks) broadly lower.  As for Belgium, a rumor began circulating that they will be unable to pay their share of the Dexia bailout.  This would place the burden of the bailout on France — and this is a burden that could result in a French debt downgrade.

As is usual on these “flight to quality” days, US Treasuries were aggressively purchased; with the 10-year yield falling to 1.9%.  This is somewhat ironic, considering the uber-committee managed to squander its opportunity to begin working off the US deficits just a few days ago.

We continue to favor high cash balances and well-hedged income positions in this environment.  Holding cash with a negative real yield is painful… but not nearly as painful as the alternative.