As written in last month’s update, we feared the Chinese monetary authorities risked losing investor confidence due to their manipulation of the capital markets. That fear came to pass in August and it wasn’t limited solely to the Chinese market. With investors grappling with whether the Federal Reserve would raise overnight rates in September, price volatility in the capital markets continued to soar.

Spooked by the continued weakness in commodity prices, especially the price of crude oil, nervous investors were pressuring stocks lower. That nervousness spiked on August 11th when the Peoples Bank of China did the unthinkable and devalued their currency. It was done under the guise of moving to a market driven exchange rate. The bank said that they would reference the closing rate of the major commercial banks in setting the closing price. On the first day, after losing 1.9% versus the dollar, the PBOC “intervened” to sop-up the selling, allowing the currency to close above the low of the day. The following day, the currency fell another 2% before the central bank intervened, bringing the Yuan back to down only 0.90%. As the Peoples Bank of China described it, after months of stability, the Yuan had succumbed to commercial bank selling. Despite what has been characterized as a Soros-like attack on their currency, the PBOC was able to step in and absorb what no one wanted, especially the United States; namely a sharp devaluation in the Yuan. However, it’s all a contrivance. The Commercial banks are state owned and operate at the behest of the government. In essence, the government directed the commercial banks to “hit the bid” only to have the central bank step in and absorb most of the selling. In this way China can claim to allow a free floating currency and simultaneously devalue their currency versus the dollar. Brilliant! The problem with their solution is that other emerging markets followed their lead and devalued their currencies, echoing the behavior observed in the emerging markets in 1998. Recall that multiple currency devaluation destabilized the global capital markets at that time and ultimately led to the demise of the hedge fund Long Term Capital Management. Investors quickly digested the similarities and dumped stocks around the globe, leaving the S&P 500 down more than 6% for the month. Stock markets around the globe suffered similar loses.

In early September trading, the stock market continues to gyrate wildly and we’re just days away from what may or may not be the first rate hike in 10 years. Consensus is that there are two potential outcomes. The first is that the FOMC raises rates 25 basis points and “promises” not to hike again for the foreseeable future. The second is that they leave the rate unchanged and communicate that they will continue to be data dependant. However, we think there is a chance that they do a less than expected rate hike of 12.5 basis points and deliver a neutral assessment at the press conference. In doing so, the FOMC would be able to maintain a modicum of credibility, begin a move toward interest rate normalcy, and give the open market desk time to figure out if they actually have the technical tools needed to raise interest rates. As we’ve explained on several occasions, raising the overnight interest rate is a highly technical operation. Given that the Fed has flooded the markets with liquidity, they will need to drain some of that liquidity to bring supply and demand into balance at their newly targeted rate. How much will need to be drained is anyone’s guess. One thing that’s for sure is that the Fed’s policy paralysis has added to market volatility. It’s been nearly a year since Yellen stated that it would be appropriate to raise rates in a few meetings. That inaction has confused markets and distorted risk appetites.

The bond market was under selling pressure for most of June as the economic data released during the month was unequivocally positive. On the back of that, stock prices soared and interest rates drifted higher. Reacting to the upturn in economic activity, Fed Chair Yellen, at the post Open Market Committee meeting, said that the market should prepare for a rate hike before year end. Reflecting that comment, the FOMC’s year end forecast for Fed Funds, also known as the “dot plot,” indicated two rate hikes by year end. Despite clearly bearish fundamentals, the selling pressure reversed with two trading sessions left in the month when Greek Prime Minister Tsipras broke off talks with European creditors. On the evening of the last Friday of the month, Tsipras did the unthinkable and announced that Greece would hold a July 5th referendum on austerity. Because that vote would occur after the June 30th IMF debt maturity, the penniless country would be forced to default on its debt. Initial market reaction was as expected with bonds up and stocks down. The first opportunity to trade came on Sunday evening as the Japanese trading day began. Bond futures opened two points higher, and then rallied by another 2 points over the course of the first 20 minutes of trading.

While Greece represents a very small percentage of the European monetary union, investors are fearful that a default would have a contagion effect and kill the nascent economic recovery in the bloc. Understanding that countries in the north want to avoid that, the Greeks seem to be willing to use that fear as a bargaining tool. We deem that strategy to be a risky one. Presently, the Greek economy is being supported by the Emergency Lending Authority from the European Central Bank (ECB). If the ECB terminates that emergency lending, economic destruction would likely ensue as the Greek financial system collapsed and its economy grinds to a halt. If that were to happen, the Greeks would likely be shut out of the capital markets and be forced to reestablish the Drachma as a currency. While reintroducing the Drachma would provide the economy with needed liquidity, the value of the currency would likely plunge unleashing a destruction of savings, a sharp increase in the Euro-denominated debt burden, currency controls and a sharp spike in inflation. The only bright spot in the Pandora’s Box of currency devaluation is a newly introduced and devalued Drachma would likely make Greek exports competitively attractive.

Also weighing on the fears of investors is the potential for Puerto Rico to default on their debt. While Greece stole the headlines at month end, investors held their breath that the island nation would make June 30th and July 1st debt payments. Governor Padilla last year assured investors and citizens that the fiscal situation could be managed and that default was not an option. At the end of last month, he reversed that optimism saying that the debt is “unpayable,” and that bondholders should share the pain being suffered by Puerto Rican citizens. Just as is the case in Greece, years of fiscally irresponsibility and excessive borrowing have left the country on the brink of default. And, as is the case with Greece, debt restructuring is a distinct possibility.

In addition to angst emanating from the Mediterranean and the Caribbean, the Chinese stock market became a cause for concern last month as the ferocious rally seen this year reversed course. Much has been written about the explosion of new retail trading accounts being opened this year as the Chinese considered the local stock markets as offering easy money. When it peaked last month, the Shenzhen A share index had a year to date total return of more than 125%. When the Chinese government attempted to deflate the mania last month by raising margin requirements, they unintentionally popped the bubble. Since then, the index has fallen by 38% in the last three weeks and at the time of this writing; the government has halted trading on more than 600 companies, and has banned many institutional accounts from selling. Many are speculating that the losses are responsible for the price drop in Crude Oil, Gold, and precious metals, as holders of those commodities are forced to sell to meet stock-related margin calls. The episode is yet another example of the unintended consequences of government intervention into the capital markets.

For most of the month, bonds traded at the high end of the price range as investors continued to fret that the muted Q1 economic activity might be the start of a trend rather than simply weather related. However, in the last few days of the month, those concerns abated with decidedly improved economic activity. While Q1 GDP growth registered an abysmal 0.2%, compared to Q4 2014, when measured versus the year ago quarter, the economy grew at a solid 3% pace. We believe the latter measure is more relevant, especially given the especially harsh winter endured for the second consecutive year. With that, bonds came under pressure during the final two days of the month, finishing at a loss for the period.

Investors continue to focus on the Federal Reserve for clues as to when the Open Market Committee will move to raise rates. All but the most dovish members have conceded that the current level of interest rates no longer makes sense. However, they also openly worry about the market volatility they expect to occur when they ultimately move to raise rates. Current consensus is that the Fed will wait until September to initially move, believing that the committee will want to ensure that Q1 weakness wasn’t anything more than weather related. We would argue that the Fed should look past that data and focus instead on the pattern of economic activity witnessed last year. Recall that the weak first quarter growth yielded to rapid economic expansion as the year progressed. As a result, the unemployment rate plunged from 6.6% to 5.6% for the year. At the current 200,000 new jobs per month run rate, the unemployment rate would likely drop to approximately 5% by September. The Fed should consider that the FOMC meeting concludes on September 17^th, just nine trading sessions before October, the month most feared by equity investors. If they are concerned about destabilizing the market then they certainly don’t want to adjust policy in late September. The June meeting would make much more sense for a number of reasons. First, the capital markets have been suffering from heightened volatility recently, reacting to a mildly disappointing earnings season, crowded fixed income and currency trades, and confusion as to when and how the Fed is going to raise rates. If the Fed moves in June and presents a cogent path forward at the press conference, we believe that after initial volatility, markets would stabilize. Another consideration is that the Fed is not entirely certain if their intended plan to raise rates will be successful. As we’ve discussed on several occasions, the extraordinary amount of liquidity in the system render their traditional tools useless. Given those considerations, raising rates in June would seem to be more prudent than waiting until later this year. Of course, there are those that would argue that the economy is not strong enough to endure a rate rise. While that argument may have held water a few years ago, it no longer does. The zero interest rate policy distorts markets, penalizes savers, and encourages heightened risk appetite as investors reach for yield wherever it can be found. Despite the sensibility of a June rate hike, the odds of an early move are falling.

General Electric, one of the largest issuers of corporate debt, shocked the investment community in their April 10^th announcement that they planned on selling the vast majority of their GE Capital assets and exit the sector over the next 24 months. They will retain financing units related to their Aviation, Energy, and Healthcare units, but that will represent a very small percentage of revenue. GE began the process last year when they spun off and sold a portion of their retail credit card business, renaming it Synchrony. In their latest move, the company sold their real estate assets and loan portfolio. In addition to the asset sales, the company announced that they had authorized the buyback of up to $50 Billion in GE stock in the secondary market. By exiting the finance business, the company will no longer be subject to the cost and reporting burden of being a significantly important financial institution (SIFI). Equally important, in exiting financial services, GE will lessen the volatility in their earnings. Under most circumstances, such a massive share buyback program would cause the price GE debt to fall, as the buyback would be interpreted as being at the expense of creditors. However, as industrial bonds trade at a significant premium to bank and finance debt, the move to 100% manufacturing resulted in a rally in both stock and bond prices.

February 2015

In a polar opposite of the scorching rally witnessed in January, 30-year bond yields soared last month, rising 50 basis points in the first three weeks before settling 43 bps higher.

The change in the bullish tone of the market was entirely attributable to the employment report. Naysayers had been ignoring the robust job growth and instead focused on subdued wage gains and the low participation rate, characterizing job growth as lacking in quality. That opinion was difficult to support following the release of the January employment report early in February. In it, payroll growth for the month registered 257,000, well above the consensus expectation of 219,000. Even more surprising was the revision to the December and November reports, which on a revised basis, totaled 329,000 and 423,000, respectively. With such a robust report we were a bit concerned that the February jobs report would give back some of those gains, especially given the lost productivity due to the repeated snow storms endured during the month. That worry was for naught. February witnessed another 295,000 jobs added, bringing the cumulative gain in new jobs to 3.3 million over the last twelve months, with more than one million of them coming in the last ninety days. Moreover, the report noted that the average hourly earnings rose 2.0% over last year’s rate indicating that not only is the economy adding jobs at a robust pace, workers are seeing wages rise. Our expectation is that as the demand for labor continues to rise, wages will begin to rise at an accelerating pace as employers find themselves competing for workers.

While one would think that such obvious economic strength would pressure bond prices lower in anticipation of an imminent rate rise, the opposite has been occurring. Despite pronouncements by several members of the Federal Open Market Committee (FOMC) that they intend to raise interest rates in the foreseeable future, many in the marketplace argue that such a rate rise will not occur this year. We have difficulty understanding that logic. The FOMC continues to implement emergency monetary policy with a zero percent interest rate policy. While they have ended their quantitative easing experiment, the Central Bank continues to reinvest the proceeds of the coupons and maturities of their portfolio holdings back into the market. In doing so, they effectively ensure that the value of their portfolio continues to grow and interest rates remain depressed. The good news for investors is that the distortion continues to drive stock prices higher. Because of the artificially depressed interest rates, corporations are able to borrow in the corporate bond market at very low rates. In turn, they use those proceeds to buy back the equity of their company, while also steadily boosting the dividends they pay to shareholders. CEO’s especially like the buyback option in that it reduces the number of shares outstanding which, de facto, improves the earnings per share by lowering the denominator. When stock prices are changing hands at a reasonable multiple of earnings, the buyback game makes sense. However, buying back at a price to earnings multiple in excess of 20, as many blue chip CEOs do, is folly and may ultimately result in a destruction of wealth for the corporation.

December 2014

As we expected, volatility remained elevated in December despite holiday-abbreviated trading.

As 2014 came to a close, investors were decidedly at odds over the growth prospects for the economy and the risk and reward inherent in the capital markets. The growth bulls, with whom we include ourselves, believe that evidence abounds that growth has accelerated and will continue for the foreseeable future. Data released during the month was surprisingly strong. New cars continued to sell at a near record pace, closing out the year with nearly 17 million vehicles sold. Despite that robust pace, the average age of the American vehicle still remains high at 11 years, which is likely to be supportive of continued robust demand. The labor market continued to expand, adding 252,000 jobs in December, which was larger than expected and follows the outsized gain of 353,000 jobs added in November. For the year, the economy added 2.95 million jobs and the pace of hiring has exceed 200,000 a month since the weather-depressed month of January 2014. In addition, retail sales continued to grow at a robust pace as the sudden and unexpected drop in energy prices has been a boon to discretionary income. The biggest surprise, however, came on the 23^rd when the Bureau of Economic Analysis reported that Gross Domestic Product grew at the torrid annualized pace of 5.0% in the third quarter. In deconstructing the report, the individual subcomponents all registered surprising strength. The members of the Federal Open Market Committee must have had a peak at the GDP report prior to their December 17^th meeting. At the post-meeting press conference, Chair Yellen was decidedly “hawkish” indicating that while the committee will be “patient” before moving to raise interest rates, she cautioned that her patience may be a short as two meetings. Conventional wisdom now holds that the Fed will raise rates at the conclusion of the June 17^th meeting. However, if growth continues at the pace we’ve seen in the second half of 2014, the lift off date for rates could be as soon as the April 29^th meeting.

Despite the backdrop described above, the upward price trajectory of the bond market going into year end and during the first few trading days of the New Year reflected skepticism that the economy would remain strong. The naysayers cited the sharp drop in the price of oil as the reason for caution although the logic in that scenario varied. One school of thought is that the price drop has made domestic oil production unprofitable and as many of those businesses are highly levered, the industry is at risk of suffering a wave of bankruptcies. That premise is correct and at current prices, the oil industry is likely to suffer. However, estimates of cost savings range from 650 billion to $1.2 Trillion and industries outside of energy production are likely to enjoy a profit windfall from increased consumer demand for goods and a lower cost of producing those goods. The less likely oil-related concern is that the price drop reflects a global drop in demand and foretells a global recession. That argument seems to ignore the large contribution domestic oil has added to supply and the disappearance of speculative buyers of commodities. Prior to the Volker rule money-center banks owned commodity trading desks that routinely engaged in commodity speculation. Recall that JP Morgan in 2009 hired a supertanker to store the oil it had purchased on the cash market to speculate that prices would move higher. The third concern, which seems absolutely absurd, is that the impact of the price drop on headline inflation will prompt the FOMC to postpone their intended rate hikes. That premise ignores the acceleration in activity that we expect will be driven by the incremental increase in discretionary income. Moreover, members of the FOMC have explicitly said they will continue to use core inflation to gauge price stability, which of course, excludes food and energy.