November 2012 – Commentary
At first glance, economic and market activity in November was much as it has been throughout the year. The economy continued to add jobs at a modest rate, and at a pace that isn’t meeting the growth target of the Federal Reserve. Retail sales bounced back from the weaker level witnessed in October, as the notorious “Black Friday” and “Cyber Monday” shopping days blended into a four day shopping spree. Retailers garnered much attention with their decision to open stores on the evening of Thanksgiving, but the bigger story was that internet shopping captured an even greater proportion of holiday spending. We’ll be watching closely to see if retail sales hold up into December, especially given the heightened nervousness of consumers as they face the prospect of the higher taxes in the New Year. At the time of this writing, the president and Congress have been unable to resolve the dual mandates of rising tax rates and across the board budget cuts. It’s been estimated that no resolution would result in a contraction in annual GDP of approximately 3%, with such an outcome likely tipping the United States back into recession. Federal Reserve Chairman Bernanke has warned about such an outcome and is taking steps to offset the negative impact should Congress and the President fail to act. In his speech to the Economic Club of New York, Bernanke hinted that the Fed will extend its bond buying program when the current “Operation Twist” concludes at the end of this year. As with consumers, it’s difficult to conclude if investors are prepared the potential “cliff.” The bond and stock markets don’t seem to be in agreement regarding the risks of a failure to compromise. With interest rates again trading close to crisis lows, bond investors are assigning a high probability that the fiscal cliff will either directly or indirectly cause an economic slowdown. However, equity investors seem to be much more sanguine as the stock market has shrugged off the temporary weakness witnessed in November and is now trading well above the 1400 level on the S&P 500. A failure to avoid the fiscal cliff would likely result in a meaningful weakening in the stock market.
Moving from the macro to the micro, we continue to see inconsistencies in the credit valuation and the performance of specific issues. The volatility leader continues to be the financial sector, as it has been since the crisis first evolved, and as we expect it to be for the foreseeable future. Financial spreads were marginally wider during the month as investors attempted to handicap the impact of the fiscal cliff on banks and brokers. At the opposite extreme, Emerging Market fixed income, ex-Europe, demonstrated remarkable stability in the face of uncertainty. We’ve written on several occasions that we find the emerging markets debt recommendation to be an interesting concept, but one that lacks substance. The investment thesis for the trade is that with a lower debt-to-GDP profile than Developed countries and positive leverage to global growth, the emerging markets will enjoy improving credit quality and an appreciating currency. As we’ve discussed previously, the argument breaks down with the leverage to the developing world. If the developed market isn’t growing, emerging markets stall. Nonetheless, we continue to witness “head-scratching” disequilibrium in valuation. An example of which is the Republic of Uruguay’s issuance of 33-year debt last month. The Republic of Uruguay, rated Baa3/BBB-, issued bonds at a spread above 30-year Treasury Bonds of +140 basis points. To put that into perspective, just two weeks prior, BBB3/BBB-rated Macy’s department store issued 30-year debt at a spread of +160 basis points. While similarly rated, we consider Macy’s to be of a higher credit quality and, with an additional 20 basis points of yield, to be the cheaper issue. To understand why Uruguay is trading at a premium is to understand the segmentation of the bond market. An Emerging Market mutual fund manager will have a mandate to maintain a portfolio of Emerging Market Debt. That Emerging Market debt is trading at a premium to domestic corporate debt is of no consequence to the fund manager. His job is dependent on the performance of his Emerging Market portfolio versus other portfolios with a similar mandate. As we’ve explained before, we look beyond the idea of specific fixed income “buckets” in an attempt to maximize valuation to the portfolio. If the Republic of Uruguay issued debt that offered a spread of +240 basis points above Treasury Bonds and +80 basis points above Macy’s debt, it’s possible that we would consider an investment. At +140 basis points, we have no interest at all.
 No client accounts hold either of the bond issuances, and the issuers are mentioned for illustrative purposes and should not be construed as an investment recommendation.