Investors grappled with the fear of “what if,” as the European debt crisis continued to drag on through much of June. Commencing with the first trading day of the month, risky assets swooned in favor of the relative safety of U.S. Treasury debt. Driving the fear was a concern that the Greek legislature would fail to approve austerity measures mandated by the International Money Fund before additional aid was released. Assuming that the messy and sometimes violent protests in the streets of Athens would convince the parliament to vote against austerity, investors deduced that Greece was certain to default. The financial media worsened the fears by outlining a worst case scenario in which the sovereign crisis caused a repeat of the Lehman Brothers failure. It was suggested that a default by Greece would render many European banks insolvent, resulting in worldwide financial collapse. As the month wore on, the worries deepened. At one point the yield-to-maturity on the 10-year Treasury note had fallen to a 2011 low of 2.86% and the S&P was more than 7.3% lower than the 2011 high. Similarly, High Yield bonds and Commercial Mortgage-Backed securities sold off sharply. Just as investors seemed to conclude that the worst would come to pass, the Greek Parliament, on June 27th, voted in favor of the austerity terms. Investors were not positioned for that constructive turn and, over the last four trading days of the month, markets staged a sharp reversal. Moreover, the reversal was intensified in that it came amid light pre-holiday trading and in advance of the quarter-end. Over the course of the last four days the S&P 500 rallied 4.1% and the price of the 10-year Treasury note fell -2.47%.
A troubling bit of information surfaced amidst the market gyrations and the European debt turmoil. Specifically, that U.S. regulated 2A-7 Money Market funds, those meant to be the safest, held significant overweight exposure to European financial institutions. Moreover, their holdings extended beyond the large, closely regulated European Money-Center banks, to include smaller regional banks in the most fiscally stressed regions of the continent. Rule 2A-7 permits Money Market funds to maintain a steady Net Asset Value of $1.00 by pricing their underlying securities based on straight line accrual accounting, instead of marking the securities to market. However, during the 2008 panic a number of funds experienced large redemptions that could only be met by selling the securities at a price below the accrued value. In doing so, they were forced to realize a loss which resulted in the value of the portfolio falling below the $1.00 NAV. In industry parlance, such an outcome is known as “breaking the buck,” and a very unfavorable occurrence for a money fund. On numerous instances in 2008, money market fund managers injected capital into their money market fund to maintain liquidity and avoid marking the portfolio to market. In the worst case, a very large money market fund suspended redemptions, which proved disastrous for the fund and its investors. Understanding that a collapse of confidence in Money Market funds had the potential to be systematically destabilizing, the Federal Reserve and the regulators were quick to aid the industry with a line of credit and a temporary principal guarantee from the government. In addition, the government vowed to review and correct any unforeseen risk so as to avoid a future panic. With that in mind, investors were shocked to learn that some of the biggest and most recognized money market funds had more than 50% of their portfolio in securities issued by European Financial Institutions. A Wall Street Journal article titled “Money-Market Mayhem,” published on June 27, 2011 was especially critical of the oversight.
As we commence the second half of 2011, we believe there are a number of indicators that have changed from negative to positive. Namely, retail sales and manufacturing both improved meaningfully in June, as reported by the U.S. Census. Similarly, auto sales by U.S. manufacturers posted very impressive gains which should continue throughout the year, as the annual selling rate for automobiles reverts to a mean that is more than 2,000,000 units higher than the monthly selling rate for the last 10 years, as calculated by the U.S. Commerce Department. Moreover, there are signs that the downward pressure on home prices has subsided, as witnessed by the Case-Shiller home price index and FHFA House price index. While we don’t expect a meaningful improvement in prices anytime soon, we believe that a simple stabilization in home prices would go long way to boosting confidence of the American consumer.