June 2016

The madness continued in June as markets convulsed on economic and political surprises. As the month began, investors were debating whether the Federal Reserve would raise rates at its mid-month meeting, with committee members seeming to prepare investors for an imminent rate hike. That view quickly reversed with the release of the May employment report which showed a tepid gain of only 38,000 new jobs (subsequently revised lower to 11,000). With that outturn, the conversation shifted from worry that the economy was on the verge of overheating to fear that the economy was again at risk of recession. Despite that fear, stocks and bonds traded sideways for much of the first half of the month. Of mild concern was the British referendum on continued membership in the European Union, colloquially referred to as BREXIT. Despite warnings of financial catastrophe should the British vote to terminate membership, concern seemed to fade as the vote approached. However, the United Kingdom shattered the calm and surprised the world by voting to leave the Union, causing global stock prices to plunge, led by European banks. In an effort to stabilize markets, the European Central Bank assured investors that the banking system would remain solvent. The British Pound collapsed by more than 10% on the news and continues to remain under pressure at the time of this writing. Prime Minister David Cameron added to the confusion by announcing that he would tender his resignation in October, citing his disagreement with the outcome of the vote. That decision was a double-edged sword as it would mean that exit negotiations would not commence immediately, as preferred by the members of the EU, and would result in a three month void in leadership. However, since the vote, much has changed. David Cameron has been replaced by Theresa May as Prime Minister, and investors have concluded that the exit would be more orderly than at first feared. On the back of that and renewed belief of further global Central Bank stimulus – the S&P 500 reached a new all-time high on July 11, eclipsing the previous high set last summer and coming on the eve of earnings season. Investors seem to be concluding that the economic impact of the “Brexit” would not have the global impact that was feared. Moreover, the 287,000 increase in nonfarm payrolls gained reported in July indicates that the US economy is not on the verge of rolling over as was feared in late June.

We’ve written about the coming changes to Prime money-market funds on several occasions since the Securities and Exchange Commission mandated the rule changes two years ago, and with the October deadline rapidly approaching, thought it relevant to again highlight the new rules. The most significant change, at least initially, is that Institutional Prime money-market funds will no longer be allowed to maintain a stable Net Asset Value and will, instead, be required to allow the NAV to float. In addition, all fund companies, individual as well as institutional, will be allowed to temporarily block investor redemptions, also known as gating, and impose a redemption fee of as much as 2% in the event of a mass exodus of investors. Such an exodus would be defined as a 10% fall in assets under management over the course of one week. When investors come to understand that a 200 basis point fee could be imposed on a money market fund that’s paying them no more than a handful of basis points, they’re likely to look for an alternative.

The likely alternative to Prime funds would be U.S. government MMF’s, funds that invest only in U.S. Treasury, GSE (Fannie Mae and Freddie Mac) debt and repurchase agreements. Those funds will be required to hold at least 99.5% of their assets in government paper, that’s an increase from the current minimum of 80%. Additionally, U.S. government MMF’s will not be subject to the mandatory redemption gate or fee imposed on Prime MMF’s. That is unless the board of the fund decides that a gate or a redemption fee is needed, in which case they can apply either or both. It’s estimated that approximately $350 Billion in Prime money market funds will migrate to government only money market funds by the October deadline. We are watching for opportunity as those funds become forced sellers of corporate paper and buyers of government-related debt.

April 2016

Central Bankers continue to confound markets with their contradictory statements and unconventional monetary policies. The European Central Bank recently decided to pay banks to borrow Euros and use that cash to lend to borrowers. ECB Chairman Draghi vows to do whatever it takes to propel the European economy to growth, and that includes printing 80 billion Euro’s a month to buy government and corporate bonds in the open market. On the other side of the globe, the Bank of Japan moved to a negative interest rate policy earlier this year despite signaling that they were against such a policy just the week prior. Presumably, their intention was to weaken the Yen, but the reversal had the opposite effect, sending the yen higher in value versus most currencies and frustrating Prime Minister Abe’s plans to stimulate growth. The Federal Reserve was not expected to change policy at the April meeting, and they held true to expectations. However, the post-meeting statement was ambiguous indicating that they will continue to watch data and adjust rates accordingly, which doesn’t do much to help investor’s divine direction and value.

The conflicting messages wreaked havoc on the markets in April, resulting in wild, counterintuitive price moves. The Euro was relatively stable versus the dollar for the month, despite expectation that the ECB would drive interest rates further into negative territory. The Yen, on the other hand, rallied 5.3% versus the dollar when the BOJ failed to meet expectations. Despite no expected rate hike from the Fed, long bonds fell nearly 2% in price, while the S&P 500 barely budged, up 0.38% for the month. The stock market tranquility was especially perplexing given that we’re in the early days of earnings season and forecasters are expecting earning to decline both year-over-year and sequentially. Looking to the commodity markets, the price movements were equally befuddling. Gold, the universally accepted inflation hedge was up 4%, while silver, also considered an inflation hedge, rallied 14.5% for the period. We think much of the price action was attributable to “crowded” trades, investment themes that are shared by many. When crowded trades reverse, they often cause extreme market movement. The price action of the Euro last fall versus the dollar is an example of such an outcome. As investors prepared for the Fed’s first rate hike, the dollar was widely expected to appreciate to the point that it would trade at parity with the Euro. In a case of “buy the rumor, sell the fact,” just prior to the hike the trend reversed and at the time of the writing, one Euro buys $1.15 delivering an enormous blow to the competitive advantage of the Euro.

We’ve written on several occasions about the illogical way the Commerce Department presents economic data and the equally illogical willingness of investors to accept that data as fact. Such an example crossed the tape last month with the release of Housing Starts data for March. The annualized number of new homes started was reported to have declined by a seasonally adjusted 91,000 units, a 7.7% decline. The media touted the news as “disastrous” coming just as building activity should be accelerating. However, seasonally adjusting economic data can distort it in such a way that positive data is twisted into negative as was the case for housing starts. We believe a better measure is to compare unadjusted economic activity on a month-over-month, and year-over-year basis. In doing so, the government “fudge” factor is eliminated. The unadjusted housing starts rate of growth, month-over-month gain was 16.5% and the year-over-year gain was 7.8%. That’s undeniably a robust outcome.

February 2016

Since the Federal Reserve ended quantitative easing in October 2014, the capital markets have become much more volatile and correlations among asset classes have risen. That condition has further intensified since the first rate hike in December. We fully expected a rise in volatility as monetary policy became less expansionary, but have been surprised by the magnitude of the change. Price action in February continued to reflect that volatility, and at one point, investors briefly feared that European banks were going to trigger a repeat of the 2008 banking crisis.

After the financial crisis, regulators were adamant that taxpayer money would not again be used to bailout a failing bank. In doing so, they shifted away from the “Too Big to Fail” mentality and replaced it with the concept of “Systemically Important Financial Institutions” (SIFI’s). Those entities that were deemed systemically important included money center banks, superregional banks, and the largest insurance companies. Being designated a SIFI subjected those financial institutions to rigorous oversight and extensive stress testing. The goal of the testing is to identify risky exposure and take steps to reduce that risk prior to a financial panic. The first and most sensible step was to increase the amount of capital held in cash and U.S. government securities, known as tier 1 capital. A higher percentage of tier 1 capital relative to total assets increases the balance sheet buffer banks maintain to ensure against loan losses. The increase also conveniently dovetailed with the explosion of debt issued by the United States, and had the added benefit of aiding the Federal Reserve in keeping interest rates low. However, despite the increased tier 1 requirement, regulators still worried that a repeat of 2008 would wipe out even a more-well capitalized balance sheet. With that in mind, they took balance sheet fortification a step further and suggested that banks issue a completely new fixed income structure dubbed contingency convertible (CoCo) bonds. Like standard bank debt, CoCo’s are issued with a fixed coupon and a final maturity, although the maturity is usually quite long, exceeding 30 years in most cases. The difference between standard bank debt and CoCo bonds is that the latter convert from debt to equity if the issuing bank’s tier 1 capital falls below a preset level, usually in the 5% to 5.5% range. Upon conversion, the liabilities of the issuing bank would immediately shrink, thereby improving the tier 1 ratio and hopefully enabling the bank to survive the crisis. The idea got a cool reception in the United States, and for good reason. Investors quickly deduced that if a bank balance sheet was under such extreme pressure as to cause its tier 1 capital to fall to 5%, then equity investors would be questioning the survivability of the bank and would likely be dumping the stock. In such a case, converting the bank debt to equity would accelerate the selling as the number of newly converted shares would flood the existing float of shares. Despite that side effect, European regulators liked the idea and pushed banks to issue CoCo debt. Yield starved investors around the globe gobbled up the CoCo’s, eager to earn the incremental yield offered by the securities. Much like the higher rated senior bank debt, the market for CoCo’s was actively traded, transparent, and moved mostly in line with senior bank debt. That is until earlier this year when worry about the solvency of European banks again intensified and the sector began to sell off. Then, in February Deutsche Bank announced an enormous quarterly loss and investor began to panic. One Deutsche Bank CoCo bond fell to a low of $70 during the month, before stabilizing just above that level. That was a price drop of nearly 25 points in less than six weeks. But selling of the debt wasn’t limited Deutsche Bank CoCo’s. Investors dumped CoCo’s of all issuers and for the first few days of the month, stock and bond market reacted as if we were on the verge of another financial crisis. Deutsche calmed market jitters by announcing that they were not at risk of triggering a contingency event and that, in fact, they would buy back outstanding senior debt in the secondary market. The market stabilized in the closing days of the month, with most of the sector recouping about a third of their price swoon. However, we wonder if that price action might be the death knell for the contingency capital fixed income market. Bond investors like stability, liquidity, and orderly price discovery and the CoCo episode demonstrated none of those qualities. At the very least, there may be a whole class of investors that will never buy a CoCo again.

December 2015

As we expected, December was a tumultuous month for the capital markets. The FOMC finally raised interest rates and in the days following the move there were three obvious outcomes. First, the Fed was successful in raising the Fed Funds rate. We’ve written in the past about our concern over the committee’s ability to move interest rates higher given the enormous amount of liquidity in the system. They were able to work around the liquidity issue by lifting the cap on overnight reverse repo’s (the effective interest rate floor) from $300 billion to $3.75 trillion. Clearly, such an enormous facility is more than sufficient to sop up excess liquidity. However, they further confused investors by promising a gradual path of rate hikes but put forth a more aggressive forecast that indicated four rate hikes in 2016. That confusion, paired with the diminished liquidity of the season caused stocks, bonds, and currencies to react violently. The volatility has continued into the early days of the New Year, haunted by many of same worries of last year. Namely, global monetary policy, falling energy prices, slowing economic growth in the emerging markets, and soon to be released fourth quarter earnings.

We’ve written on numerous occasions about the illiquidity risk implicit in the Exchange Traded Funds and “liquid alternative” mutual funds. That concern came to pass on December 10th when Third Avenue Management halted redemptions from their liquid alternative mutual fund. With year to date losses exceeding 26%, the Third Avenue Focused Credit Fund, was unable to meet redemption requests. While certainly distressing news for its investors and Third Avenue Management, it’s likely to prove distressing to most of the liquid alternative industry as well. Following the financial crisis, investors became reluctant to invest in the liquidity constrained limited partnership hedge fund structure. Recall that during the crisis, many segments of the high yield credit sectors ceased to trade. As a result, investor redemptions were suspended until liquidity returned to the market. Given the challenge that episode posed, the hedge fund industry responded by obtaining approval from the Securities and Exchange Commission to create a daily liquidity mutual fund structure. The resultant “liquid alternative” funds offered daily liquidity similar to a plain vanilla mutual fund and was marketed as enabling retail and institutional investors to access exotic and levered strategies once available only to the ultra wealthy. The problem, as we see it, is that those funds quite often focus on less liquid investments where valuation is somewhat opaque and subjective. Excluding the managed futures strategies, where exchange traded futures allow their mutual funds to be truly liquid, critics have raised the question, “if a fund experiences significant redemptions, would it be able to continue to offer daily liquidity?” The Third Avenue Focused Credit Fund answered the question. No it can’t! What’s worse is that since the fund is a mutual fund, the holdings are publicly disclosed. With that information, the fund is at risk of having unsavory speculators push the price of its holdings lower in advance of the mutual fund liquidation.

Simultaneously with the Third Avenue fund gating, the High Yield ETF’s came under intense selling pressure as sellers significantly outnumbered buyers. This is the third time this year selling has overwhelmed these ETF’s and each instance has been followed by a new low in the security. There have been unsubstantiated speculation that the ETF sponsors stepped in to provide support during the panic, only to sell the holdings when markets normalize. While that’s debatable, what seems true is that investing in a daily liquidity security that gives you exposure to illiquid markets is not a sensible investment strategy.

October 2015

Following two consecutive months of disappointment, the October employment report far exceeded expectations, adding 271,000 for the period. With the big addition, the unemployment rate fell to 5.0% and could fall below that measure as early as next month. Reflecting the tightening of the labor force, average hourly earnings rose 2.5% year-over-year, which has accelerated from the 2.0% year-over-year growth witnessed in the first half of this year.

With the blockbuster October jobs report, we believe the FOMC has all the ammunition they need to finally lift emergency monetary policy for the first time in seven years. However, we’re reluctant to say that a Fed rate hike in December is a lock. Chair Yellen has done the “bait and switch” on too many occasions for us to say that it’s a certainty. Also, the December committee meeting concludes on the 16th of the month, which is likely to pose a problem. By that time, trading desks have virtually closed their books for the year, with liquidity thin and trading sporadic. Nevertheless, the strength in the employment report is likely to force them to move on or before that meeting or risk further erosion of their credibility. One option would be to schedule an interim meeting and a follow-up news conference prior to the December meeting. Of course, once such an event was announced, the markets would immediately interpret the move as a rate hike and react accordingly. That outcome would probably not be palatable to the committee, but we think that keeping investors guessing until markets reach the nadir of illiquidity would be even less palatable.

Ironically, before Friday, investors had been debating whether the August into September stock market swoon and the slowdown in manufacturing were precursors to a recession or simply a mid cycle slowdown. Contributing to the worry, Minnesota Federal Reserve President Kocherlakota, in September, advocated that the Fed Funds target should be lowered -0.25%. While we took note of the slowdown, we weren’t convinced that it was anything more than coincidental. Anecdotal evidence of that could be found in the ongoing pace of automobile and home sales. New Cars sold at an 18.12 million annual rate in October, eclipsing the 18.07 million annual rate registered in September. Typically an annual sales rate of 16.5 million vehicles is considered strong. Similarly, the housing market continues to surprise to the upside with the home builder’s index, building permits, and housing starts all registering impressive gains. New home sales are an especially potent driver of economic activity, as increased building pulls workers into the workforce. Moreover, the material, equipment and supply purchases creates a virtuous cycle of demand. The virtuous cycle is perpetuated as the new occupants purchase household goods, including furniture, carpeting, drapes, appliances and all the various items that go into turning a house into a home.

The rebound in economic activity has coincided with a blistering rally in stock prices, as short sellers were forced to cover as prices rose. The S&P 500 rallied 8.3% in October as the short sellers scrambled to cover losing positions. As expected, bond yields rose on the bullish stock market and rebounding economy with the yield-to-maturity of the 2-year note rising to 0.88% from a recent low of 0.60%. Similarly, the yield on the 30-year bond rose to 3.08% from a recent low of 2.74%. Despite the sharp rise in yield, the market-implied level of Fed Funds next October is only 75 basis points. With that, investors are implying that the Fed will only hike rates two times over the course of the next twelve months. If the economy has moved to full employment, as we believe may be the case, the Fed is likely to become a little less patient than they have communicated.