September 2016

To state the obvious, capital markets are complicated and susceptible to occasional problems related to supply and demand imbalances.  Typically, the problems become magnified at quarter-end, and the just-ended quarter was especially so.  With the October 14^th money market reform deadline looming, money funds continued to flood the market with corporate and municipal note sales, while boosting their demand for Treasury Bills and Notes.   That demand added to the quarterly “window dressing” that banks engage in to give their balance sheets the appearance of being of higher quality than would otherwise be the case.  The confluence from banks and money funds drove the yield to maturity of T-bills down to 0.00% in the days prior to quarter end.  Simultaneously, the Federal Reserve’s reverse repurchase facility, designed to help financial institutions invest excess funds during times of stress swelled materially.  Typically, the average balance deposited at the facility is in the $50 billion area.  At quarter end, that number rose to $412 billion.  Since quarter end, demand has waned modestly with the size of the operation on October 10^th still sizable at $226 billion.  The importance of the increase is that it is a direct expense to the U.S. government with the current interest paid of 0.25%.  While immaterial compared to the yawning annual deficit, it nonetheless is an unnecessary expense and distortive to the market.

Compounding the quarter-end madness was the U.S. Justice Department’s announcement of the intention to levy a $14 billion fine on Deutsche Bank for its role in the sub-prime mortgage crisis.  The equity capital at Deutsche is only $67 Billion, so a $14 billion dollar hit to equity would put the German bank’s capital well below regulatory requirements.  With the specter of issuing additional shares to meet some or the entire penalty, Deutsche’s stock price plunged to a 52 week low of $11.18, well below the $30 at which it was trading last fall.  German government officials said they had no intention of coming to the aid of the lender, which exacerbated the selling.

Several analysts have said that Deutsche Bank is very small compared to other money center banks and that regulators should allow the bank to go under.  Granted, at a market capitalization of about $15 billion, the value of the bank is less than 10% of J.P. Morgan.  However, we think to focus on market capital is to ignore the opacity and enormity of the risk on its balance sheet.  Total assets held, at $1.6 trillion, are equal to approximately one half of Germany’s annual GDP, and derivative exposure totals more than one half trillion dollars.  Arguably, the $67 billion of equity is not nearly enough to support such a balance sheet, which is why the bank’s stock price has been falling for years and the credit rating has fallen from Aa1 in 2007 to the current Baa2 – just two notches above junk.  The argument in favor of such a large derivative book is that it’s mostly paired off with hedges and in many instances over counted.  Our counter to that argument has been that if counterparties deem Deutsche too risky and it loses access to liquidity, there’s no telling how those securities would be valued.  Moreover, there’s no way of knowing the impact they would have on Deutsche Bank’s solvency or the risk it would pose to the global banking system.

Given that unknown, we wonder what the Federal Reserve and the European Central Bank were thinking.  The U.S. has the concept of a “living will” for the banking system, which details how a bank would dismantle itself in the event of a solvency crisis without collapsing the financial system.  Deutsche is one of five foreign banks that are subject to the living will concept, but the Fed and the ECB have been conspicuously silent on the matter.  Given the direness of the situation, it seems as though the Central Banks should have either been supportive of the bank or should have wound it down.  Is the concept of “living will” no more than a panacea to quiet the concerns of Senator Elizabeth Warren, Bernie Sanders, and others critical of Wall Street?

Deutsche bank has since stabilized amid talk of a much lower DOJ fine and the sale of $4.5 billion senior unsecured debt, but that doesn’t do anything to address years of seemingly poor management and their enormous derivatives business.

July 2016

Summer finally caught up with the bond market in July with the 10-year Treasury note virtually unchanged for the month. The benign backdrop was beneficial for the S&P 500, as the index finally broke to a new all time high, closing the month at 2,174. That rally came amid confounding economic data. Favorably, the employment report registered 287,000 new jobs in June assuaging concerns that job growth was stalling. Recall that the April and May reports initially showed job growth of 38,000 and 11,000, well below the 228,000 average monthly gain registered in 2015. Those reports have since been revised to 144,000 and 24,000, respectively. Moreover, the report for July further drove home the point that economy is on sound footing with a gain of 255,000 new jobs and another 2.6% year-over-year rise in average hourly earnings.

On the other hand, investors were not prepared for the first look at Q2 GDP. Forecasters had expected the broad measure of economic activity to show an annualized quarterly gain of 2.5%, bouncing back from the previous two quarters, both of which registered sub 1.0% growth. Indeed, anecdotal evidence, including retail sales, home sales and unemployment insurance seemed to indicate that 2.5% was a safe bet. However, the first estimate of activity registered well below that number, coming in at 1.2%. Digging into the number revealed that growth was not nearly as anemic as the headline number suggested. In fact, consumer consumption grew at a quite healthy annualized pace of 4.2%. Roughly two thirds of the U.S. economy is driven by consumer consumption, so if one judged economic activity on that measure alone, the conclusion would be that growth is robust. The drag on the overall number came from inventory liquidation and a decline in residential construction, with each subtracting 1.16% and 0.52% from the total, respectively. When producers use inventory without replacing it, that amount subtracts from economic growth, as it did last quarter. While it initially subtracts from the calculation, as that inventory is replaced back to sustainable levels, it becomes additive GDP. We’re expecting that to be the case in the current quarter.

Fearful that Great Britain and their impending exit from the European Union would be a negative shock to the economy, the Bank of England took extraordinary steps to stimulate economic activity within the country. The action was a trifecta of accommodation; the overnight lending rate was reduced from 0.50% to 0.25%, bond buying in the secondary market was expanded by GBP70 billion, including GBP10 billion in corporate debt, and a term lending scheme designed to encourage banks to expand lending will be implemented. In the post-meeting press conference, BOE Chairman Mark Carney explained that the committee believed that the growth outlook had deteriorated materially since the vote and that uncertainty was likely to weigh on investment and consumer spending until clarity is reached with the European Union. The committee left their forecast for GDP growth this year unchanged, which didn’t seem to comport with their assessment that activity has already slowed, and they cut their 2017 GDP forecast from 2.3% to 0.80%. To further drive home the BOE’s conviction to protect the English economy from the downside, Carney said that he expects the overnight lending rate to be cut to 0.00% by the end of this year.

Given the return to robust growth in the hiring sector and the strength of the equity market, we believe investors will begin again to debate the timing of the next rate. However, with the uncertainty surrounding BREXIT and the coming U.S. presidential election, we expect the FOMC will likely continue to delay a rate hike. We are looking to Chair Yellen’s speech at the monetary policy gathering in Jackson Hole, Wyoming later this month for clues.

May 2016

Investors were left bewildered with the release of the employment report on June 3 when the Bureau of Labor Statistics reported that the economy added a paltry 38,000 jobs in May, far below the 160,000 new jobs economists had been expecting. Adding to the disappointment was the 37,000 downward revision to the prior month’s report. What’s perplexing is that the government measure is at odds with the private employment report tallied by the ADP Research Institute. That report typically precedes the government report by a day or two every month, with the two registering a correlation to each other in excess of 90%. Given that ADP reported a gain of 173,000 for the month and a 10,000 job upward revision to the prior month, it seems likely something skewed the BLS report to the downside. The government report is also at odds with other measures of job growth including the JOLTS job openings report, the weekly unemployment insurance report, and the various regional surveys. With that, we’ll look to the next report for further clarification on the health of the job market. Certainly the report all but rules out the chance of a rate hike later this month when the FOMC meets. While recent data has clearly shown an uptick in activity versus the first quarter of this year, the employment report is enough to keep the Fed from acting. FOMC members will also release their economic forecast at the conclusion of the meeting, which will offer insight into their thoughts on economic growth and monetary policy. Although, we ask ourselves what good is that insight given that they haven’t put forth an accurate forecast since they began the exercise four years ago.

Several months ago we wrote about contingency capital bonds and how the risk/reward balance is skewed against investors. As we explained, if the balance sheet of an issuing bank deteriorates in a predetermined manner, the principal of the bond is converted to equity. We say skewed because as investment grade bond investors, we expect to earn a rate of interest for a nearly non-existent probability of default. The contingency structure promises a rate of interest with the possibility of a number of loss inducing outcomes. That doesn’t comport with our definition of investment grade. Credit Suisse last month issued a bond which performs in a similar manner to a contingency capital bond. The new issue is known as a catastrophe “cat” bond. In this particular cat bond, principal would be extinguished if the bank suffered a loss in excess of $3.5 billion. To give bond investors some protection, any single catastrophic loss would be capped at $3 billion. Therefore, the bank would need to suffer at least two catastrophic losses totaling more than $3.5 billion to trigger the extinguishment. What’s especially vexing is that included in the list of qualifying catastrophes is insufficient internal controls, errant systems, and most egregious, rogue trading. In effect, buyers of the Credit Suisse bonds are on the hook to guarantee the bank against losses from everything from corporate malfeasance to a “fat finger” trading mistake.

Another example of the perils of ultra low interest rates is Dell Corporation’s recent bond deal. Recall that three years ago Michael Dell, Blackstone Group, and Carl Icahn were involved in a bidding war for the company. Michael Dell, along with Silver lake partners, ultimately prevailed and paid $24.9 billion for the entire company. The transaction seemed to be a risky one given the declining sales of personal computers, the bread and butter of Dell. Nonetheless, the company was able to finance the purchase with a massive bond sale. Dell, which has operated as a private company since the takeover, came to market again last month with another massive deal. This time the funding was to finance its acquisition of EMC Corporation, the network storage company. The six part deal was met with enthusiastic demand with dealers tallying $85 billion in orders for the $20 billion in issuance. The new issues are rated BBB-, just one notch above junk bond status. While the company paid an above market rate of interest for the notes, we worry that the compensation was not enough for the risk assumed by investing in a privately held corporation, especially a highly levered one. Should the company sustain a downgrade, we anticipate that many investment grade funds would be forced to sell. Given the size of the issuance, less liquid nature of the Junk market, and Dell’s overall interest burden, we could envision a scenario where the price of Dell’s debt plunges.

March 2016

The first quarter of 2016 was dissimilar to the first quarter of last year in many ways, except that both periods felt as though the U.S. was at risk of slipping into recession. Last year’s dreadful winter weather brought economic activity to a standstill in the Northeast and the ongoing West Coast Port strike slowed growth in the west. Gross Domestic Product for the period was originally reported as contracting before being revised to a meager 0.6% annualized gain. The weather this year was unseasonably warm and snowless allowing construction, transportation, and general economic activity to continue unabated throughout the winter. The recession threat this year was, instead, investor manufactured. Last year we worried that the Fed engineered rate hike in December would have an adverse effect on the markets during the liquidity constrained holiday period. Instead, investors waited until the first day of the New Year to panic and dump stocks. The selling continued into February as investors digested the Fed’s forecast for four rate hikes in 2016. The panic culminated in February when the specter of a European banking crisis briefly resurfaced. European Central Bank Chairman Draghi stymied the selling with his announcement that the ECB would effectively double their quantitative easing program and expanded their asset purchases to include non-financial investment grade corporate debt. Since reaching the nadir, the S&P 500 came roaring back to close Q1 at 2,063, just below the 2,084 level at which the index closed out the first quarter of last year.

That 200 point round-trip in the index and the corresponding volatility in the commodity and foreign exchange markets must have worried Fed Chair Yellen. She went from confidently communicating the beginning of the rate normalization process in December to sheepishly describing the risks buffeting the U.S. economy at the post-meeting press conference in March. She offered a laundry list of worries, including continued slow economic growth in Europe, China, and Japan, the deflationary impact of falling oil prices, and the economic challenges posed by a strong dollar. The accompanying statement indicated that the FOMC had reduced the anticipated number of rate hikes from four to two this year. Despite that forecast, she inadvertently suggested that only one rate hike would be in the cards in 2016. Speculating on her thinking, it seems to us that she must have been severely shaken as stock prices cratered, fearful that her vote to raise rates might have reignited a new financial panic. From that perspective, we hypothesize that she wanted investors to understand that she was aware of their concerns and that she wouldn’t do anything to disappoint them.

Despite her “dovish” press conference, we imagine the open market committee meeting was a contentious one, with Yellen defending her decision to the regional Presidents who have argued that interest rates no longer need to be maintained at crisis levels. That’s a salient point that we’ve made on many occasions. With core consumer price inflation rising 2.3% annually, an investor holding the five-year treasury, which currently yields 1.14%, is destroying the value of their investment by more than 1% a year.

To follow-up on the European Central Banks intention to purchase non-financial corporate bonds, we worry that they are likely to encounter a host of unintended consequences. In buying corporate debt, they will be taking a position in the capital structure of publicly traded companies. One could argue that in doing so, they’re interfering in relative competitiveness of the corporate landscape. Which companies will be the beneficiaries? Will demand for corporate debt be met with additional supply? Will the additional supply be so large as to cause a deterioration of the credit quality of the entire sector? Those are just a few of many questions that remain unanswered regarding the operation. On the other hand, how would the central handle a corporate credit that had deteriorated and was at risk of being downgraded. If their policy would be to sell on the downgrade, it seems to us that investors would move to sell before the ECB and could quite possibly hasten a down grade or worsen the selloff. It’s as though having a negative interest rate term structure and printing 85 billion Euros a month is not bad enough policy. To ensure that they inflict maximum distortion on their economy, they are now in the credit allocation business. There may very well be significant negative consequences!

January 2016

Market volatility erupted in the first few trading days of the New Year and continued into early February. By the third week of January, the S&P 500 was down by nearly 10% before reversing course and erasing about half of those losses. Reacting to the panic, investors sold risky assets and bought Treasury notes en masse, resulting in a 35 basis point rally in the 10-year note for the month. The severity of the selling prompted market bears to warn that “as goes January, so goes the year.” To test that thesis, we studied the performance of the S&P 500 in every January since 1990. Of those 27 observations, 12 January’s were negative, and of those twelve losing months, only five preceded a losing year. So a losing January had a mere .185 batting average at foretelling full year performance. The worst January performance was in 2009, following the financial crisis. The S&P 500 fell index fell 8.5% that month, then reversed course and registered a full year return in excess of 30%. Of course, that’s not to suggest that this year will be a repeat of 2009. At that time, the market was rallying back from a vicious selloff that took approximately 50% off of the value the S&P 500 index, the Fed was in the early stages of quantitative easing, and the widespread use of corporate buybacks was just getting started. However, as we’ve discussed on a number of occasions, there are solid fundamentals in place that should be supportive of the markets and could quite possibly drive stock prices back to previous highs. However, if investors panic, the selloff could have further to go.

In many ways investors are behaving exactly as expected given the conclusion of seven years of Federal Reserve “hand-holding.” Ironically, with a little over a month since the rate hike, some forecasters are calling for a rate cut and resumption of quantitative easing later this year. Despite that, the money markets are functioning in a remarkably smooth fashion. Fed funds, 3-month LIBOR and overnight General Collateral repo, three measures of a well functioning money market have all been rock solid and steady since the rate hike. Similarly, the massive reverse repo program the Fed launched to ensure they would be able to sob up the excess liquidity in the system has been little used and is nowhere near its mandate cap.

Then why the suddenly bearish stock market performance? Seemingly, the best answer is that traders are speculating that a combination of falling oil prices and higher interest rates will tip the U.S. economy into recession. Supporting that theory is the slowdown in manufacturing that’s been going on since last summer. To be sure, multinational earnings have been impacted by the strong dollar. While that’s certainly a drag on profitability, we’re seeing indications that the move has run its course and the currency market may be on the verge of stabilizing. What’s gone unnoticed is that with those earnings releases, in many cases management has announced further expansion of corporate stock buy backs. On a trailing twelve month basis through Q3 2015, corporations bought back $556 billion of stock. With some stocks trading 10% to 20% below their recent peaks, CEO’s will be more incentivized than ever to issue corporate debt and buy back the shares. As we’ve discussed on numerous occasions, doing so improves the perceived performance of the company, enabling the CEO to point to a rising stock price and rising earnings per share, and pay herself handsomely for a job well done.