Echoes of October 2008 were evident in the capital markets through much of August, as investors reacted harshly to ongoing deficit bickering in Washington and the downgrade of U.S. Government debt by Standard and Poor’s. While volatility was not near the level witnessed in the fall of 2008, the performance of the capital markets certainly felt similar in many ways.
The aggressive price-insensitive buying of Treasury notes continued and volatility in the equity market as represented by the VIX index averaged 32% for the month. While the temporary resolution of the debt ceiling issue offered a brief reprieve from the fear of U.S. default, that return to normalcy was short lived as Fed Chairman Bernanke confused the market with his speech at the Central Bank retreat at Jackson Hole Wyoming. In advance of the speech, consensus opinion was that Chairman Bernanke would announce some form of additional stimulus. Instead, he disclosed that the September FOMC meeting would be lengthened to two days giving the Fed time to discuss the need for additional stimulus and the manner in which such incremental stimulus would be implemented. However, since then, additional comments from members of the Federal Reserve Board indicate that it’s highly likely that the Fed will pursue some manner of additional quantitative easing. The most widely discussed tool is yield curve manipulation euphemistically named “operation twist.” The objective of operation twist is to artificially depress long-term interest rates through the direct purchase of U.S Treasury notes with maturities of more than 10 years. Still to be clarified is whether the Fed will purchase the long-dated notes with income from their existing portfolio of securities or will they sell shorter maturity securities out right to fund the purchase. As we’ve discussed in previous letters, we are not in favor of such manipulation of interest rates and are wary of the unintended consequences.
Another casualty of the investor nervousness was the high yield bond and bank debt market. The sectors were down 4.0% and 4.7% for the month, respectively, which was comparable to the nearly 6.0% loss incurred by the S&P 500. The high yield market, while technically categorized as fixed income, has a high correlation to the equity market during times of market stress. The rationale for the correlation is that weakness in stocks portends economic weakness which would likely result in heightened default risk to lesser-quality borrowers. The fund had no exposure to either sector as the month began, but we did make a 1% allocation to bank debt in the final days of the month. While it’s possible that it could experience additional price depreciation, we think current levels represent an attractive entry point.