As readers know, I was in Europe a few weeks ago, making a LOT of presentations. My London-based partners seem to feel that an hour or two of down time is wasted and only for sissies. I learn as much as I impart, and come away with lots of interesting information. Every now and then I learn something that gets into the category of what in the wide, wide world of (multiple expletives deleted) economics is going on? Subprime was like that when I first read about it. Could you really design CDOs that were so patently absurd and then sell them to the Europeans and Asians? Turns out you could.
Last week, Niels Jensen (head of Absolute Return Partners) and I were talking with a variety of pension funds. They started telling us about this thing called Solvency II. Outside the arcane world of European pension funds and insurance companies, it is not on the radar screen of most people. But it may be one of the more explosive problems in our future. Cutting to the chase, the new rules require insurance companies and pension funds to buy more bonds to match their liabilities. But as yields go down they are required to buy yet MORE bonds and then yields go down some more. And so on. The possibility of serious defaults by these same pension funds in the wake of these new rules (setting aside whether it makes sense to actually require pension funds to set aside enough assets to pay their obligations) is all too real. And more pervasive than we now think.
Niels, in his latest Absolute Return Letter, wrote up what we learned, and it is Today’s Outside the Box. Wonder why yields in Europe are falling? Read on.
“I am not sure if policy makers understand how potentially dangerous this situation is. We are on the road to insolvency. And, even if pension providers manage to stay solvent, future generations of retirees are likely to run into serious financial difficulties as their retirement savings earn next to nothing, because our political leaders forced new rules on the industry, the implications of which they did not grasp.”
I know, I am just a bundle of fun. But this really is stuff we should be aware of. And tomorrow I am off to discuss this and more (with some serious play time thrown in) at the Barefoot Ranch Symposium. Enjoy your week!
Your ready for some R&R analyst,
This week we look at two brief essays for your Outside the Box. The first is my friend Barry Habib talking to us about where mortgage rates are headed. Barry gives us a very simple, but logical analysis on why rates are headed up. Then we jump to Spencer Jakab writing in the Financial Times about the problems in the municipal markets. Seems we may be under funded on our public pensions by about $3.5 trillion. As a tease to his column:
"Taking a page out of Greece's playbook, the peeved treasurer of America's largest state fired off letters this week to the chiefs of Goldman Sachs and other banks questioning their marketing of credit default swaps on California's debt . The instruments, he complained, "wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan."
"Insulting indeed, but who exactly should be insulted?"
It helps if you have seen Borat, or at least a trailer, but the message is the same.
I am off to Phoenix and San Diego, the NYC next week, so I will be writing on the road. Have a great week.
Today I am sitting listening to Ralph Merkle lecture on nanotechnology, part of a 9-day-long series of lectures on how accelerating change in technologies of all types will affect our world. 15-hour days and intense discussions are stretching my brain, but I still have to make sure you get your Outside the Box. Fortunately, I came across today's OTB last week from my friends at GaveKal, who offer a way to think about the Greek crisis and what it means for all European bonds.
There are a lot of allegations about manipulation of European bonds. It's those nasty traders. GaveKal shows us data that bond yields are actually quite logical, given the debt of various countries. But they also warn us, as part of their conclusions:
"As of today, there seems to be no additional risk premium related to the possible dislocation of the Eurozone. Clearly, this possibility would have such devastating effect on world financial markets that investors cannot even think of it (even if many talk about it)."
I suggest you read at least the beginning and then the end of this piece, even if the data makes your eyes glaze over. (I must admit the data made me feel all warm and fuzzy, but then I am somewhat of a wonk.)
Have a great week. I am getting overwhelmed here in California, learning about the future. It is going to be amazing, even if our bonds drop in price. We will live in what may be the most interesting and exciting period of human history. What a contrast between the financial markets and what the scientists continue to amaze us with. It is one of the reasons I think we Muddle Through, in spite of our rather negative economic environment.
There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation to be all about rising inflation and not a serious problem with deflation.
As Niels Jensen pointed out last week, the most important question that an investor can ask is whether we are in for deflation or inflation. And this week we read a well reasoned piece on deflation. This is one of the more important essays I have sent out. You need to set aside some time to absorb this one.
Van Hoisington and Dr. Lacy Hunt give us a few thoughts on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.
And let me quote a few sentences in the middle of this letter about taxes which you need to think about.
"Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth."
"The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."
Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter-intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable....
There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter does just that. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation and our experience to be rising inflation and not a serious problem with deflation.
Van Hoisington and Dr. Lacy Hunt give us a seminar on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.
Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter- intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable.
Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And their track record over the last 20 years suggests we should pay attention. And now let's jump right in to the essay.
This week we look at yet another rather obscure credit market that is in essential lockdown as the subject of your Outside the Box. My London partner Niels Jensen, head of Absolute Return Partners, has written a very interesting piece on the leveraged loan and bank loan markets, which are now upside down and getting more so in the recent weeks. This situation cannot continue, as what are clearly inferior products are selling for more than there high class cousins.
Essentially the sources that bought these loans such as SIVs and highly leveraged funds no longer exist to buy the loans. They have simply gone away and are not coming back. Because many of the funds are being would down through forced liquidations, senior secured loans are selling at a discount to high yield junk from the same company. Until the market digests this overhang, which will take months, Niels points out the opportunities in a distressed market. Like buying a home at auction, while it is not good for the person who lost his home, it means a buyer can get a better value.
I work closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com. The numbered footnotes are at the end of the letter.)
This week in Outside the Box, we take a closer look at the bond market and its underlying drivers. HMIC's Van Hoisington and Dr. Lacy Hunt anticipate lower inflationary pressures on account of faltering consumer spending and further deterioration in the housing market.
Hoisington Investment Management Company focuses on long-term investment strategies based on Economic Analysis. The firm is a registered investment advisor specializing in fixed income portfolios with over $3.5 billion under management for large institutional clients. Van R. Hoisington is the President and Chief Investment Officer and has produced an outstanding fifteen-year performance record. Dr. Lacy Hunt, an internationally known economist, joined the firm in 1996 adding depth and expertise with his in-depth research and analysis.
Today's article is from their Second Quarter Review and Outlook which I am delighted to present to you with their consent. While constructing their assessment for bonds, Van and Lacy walk through each building block, providing analysis on the predominant driving factors in the bond market and their respective implications.
As I glanced over at the TV in my office this morning, the latest news on the ticker wire was that American Home Mortgage Investment Corp. (AHM) is trading down over 16%. While the company is not of any particular importance to me, it spurred my thinking regarding how the housing market will affect the economy throughout the remainder of the year. And as I have written it is not really a matter of the housing market affecting the economy so much as it is a matter of tightening credit spreads that will do the damage.
This week's Outside the Box is written by PIMCO Managing Director Bill Gross where he discusses his views regarding the correlation between housing, credit spreads, the bond market and FED policy. In his article "Grim Reality," he goes on to point out that losses on loans, in and of themselves, are not the real monster lurking in the night for this economy, but rather it's the tightening of credit standards the could have a materially adverse effect. Bill does an excellent job explaining this as he so often does with his usual great style and wit.
I believe that you will find this Outside the Box to be a good read on what the implications behind a decline in the housing market really are.
On Friday, I wrote my annual forecast, "The Goldilocks Recession," on what investment themes I expect in the coming year. This week's Outside the Box will follow up on the subject with an excellent piece written by Van Hoisington and Dr. Lacy Hunt. In their fourth quarter review of 2006, they address how the current status of the bond market measures up against historical interest rates and inflation. From there, each of the six major sectors of the economy, Personal Consumption Expenditures (PCE), Residential Investment, Nonresidential Fixed Investment, Government Expenditures, Inventory Investment, and Net Exports, are covered specifically and analyzed to depict the trends for 2007.
This letter is one of the more in-depth and fundamentally heavy articles I've featured as it is chock-full of data, or what I like to call the "hard facts." Van Hoisington and Dr. Lacy Hunt have done a stellar job collecting a great deal of information and dissecting it to form some well-thought investment conclusions. For those of you unfamiliar with Hoisington Investment Management, the firm is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the company has over $3.5-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.
Each year presents its own set of both opportunities and risks for us investors. I trust that you will find value in this Outside the Box and use it to form your own independent investment conclusions.
Today's "Outside the Box" will be a combination of 2 different writings. The 1st is an email that I received from Research Affiliates Chairman Rob Arnott in response to my letter last Friday, "Honey, I Created a Bubble." The 2nd is the latest article by the well-known fund manager, John Hussman. Upon reading both commentaries, I was struck by the similarity between the two. It behooves us to pay attention when two very intelligent gentlemen that both actively (and successfully!) manage billions of dollars are marching to the beat of the same drum.
For those of you who are unfamiliar with Rob and John, let me say that both have stellar credentials. Rob is Chairman of Research Affiliates where he manages a multi-billion fund for PIMCO. In addition, he is editor of the Financial Analysts Journal and creator of a new index fund concept. John is the President of Hussman Investment Trust where he manages the Hussman Strategic Total Return Fund - HSTRX and the Hussman Strategic Growth Fund - HSGFX.
In their commentaries below, both Rob and John take a look at what inflation and bond yields mean for the market. I strongly recommend that you read each piece thoroughly and hope that you will find them to be "outside the box."
This past week I sent a special edition Outside the Box titled "Breakpoint in Iraq." I hope that you found it to be both timely and insightful. Today's article should be equally interesting with a unique take on the behavior of bond yields. My good friend Richard Duncan thinks rates were acting a little funny over the past couple of years, and he sheds some light as to why that might have been.
Richard Duncan has worked as a financial analyst in Asia for more than 18 years, conducting research and publishing investment reports on companies, industries, and economies from India to Japan. One of the first to warn of the impending economic crisis in Thailand in the mid-1990s, Mr. Duncan worked as a consultant for the International Monetary Fund at the height of the Asian financial crisis and subsequently joined the World Bank in Washington, D.C. He is also author of the widely acclaimed book The Dollar Crisis, published in 2003. Mr. Duncan currently works for ABN AMRO Asset Management as the Head of Investment Strategy.
I religiously read Bill Gross of PIMCO. I particularly enjoyed this month's piece. Gross is talking to his clients about the problems of bond investing. Given that he sits on top of the biggest pile of bonds in the world, I find it always useful to pay attention to him. This month he discusses the problem of valuation, risk and indexing. He comes to some novel conclusions. Let me quote one line deep into the piece:
"What I'm suggesting is essentially this: to be successful in the future a money manager/plan sponsor must in today's market be willing to embrace more risk outside of index space by accepting (remarkably) less risk in absolute space. Ultimately your absolute returns should benefit and the volatility of those returns may in fact be significantly lowered."
This is a piece that is truly Outside the Box. Enjoy.
Whether short term rates are high today is one of the louder debates among economists. And why are long rates so low? Will an inverted yield curve mean what it has for the past 40 years, i.e., a slowdown and/or a recession?
This week's letter is a recent essay by Bill Gross, the Managing Director of Pimco, also known as the Bond King. Gross sits on top of the largest pile of bonds in the world. He thinks short term rates are high and nearing a peak for this cycle and that the economy will begin to slow down next year. He includes the main points, sent to their investment committee, which Pimco is looking at when viewing the bond market.
Will he be correct in his assessment of rates? When someone as large as Pimco offers their view of the market, we should keep an eye on them and that is why this was picked for Outside the Box.
Once again we take a look at some comments from the HCM Market Letter written by Michael Lewitt of Harch Capital in Florida. This is a private letter for his clients and we are excited to have permission to share it with you. Michael is one smart guy with a deep understanding of the markets, especially the credit markets, and how they work. The firm manages domestic and offshore debt and equity hedge funds and separate accounts.
I really look forward each month to getting Michael's insights. Michael recently traveled to Europe and Israel and offers some insights on global economic conditions. In classic economics the markets should be falling and interest rates spreads widening, but we currently see the opposite. Michael examines some of the market reactions and interest rate trends taking pace and that is why it was picked for this week's Outside the Box.
This week's letter is once again from two of my favorite economists, Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company in Austin, Texas. They specialize in management of fixed income portfolios for large institutional clients by setting long-term investment strategies based on economic analysis. They have been one of the most successful of bond managers in the country. (I have no affiliation with them.) I eagerly read all of their writing and analysis, and find it to be some of the most thought-provoking anywhere.
Their second quarter 2005 Quarterly Review and Outlook looks at the secular forces that are keeping inflation and long term interest down and why that might continue for an extended period of time. They argue that interest rates only look high from a 1945-1990 reference point and that in fact they may now be closer to the long term historical average and that is why I picked it for this week's "Outside the Box."
This week's letter is again by one of my favorites, Stephen Roach of Morgan Stanley. We will look at two pieces, one from May 31st and another from June 3rd. The first article lays out why Roach is moving from a bond bear to a bull or at least neutral stance. Low inflation, slowing china, and low relative rates in other parts of the world will help keep our long end rates down.
The second article examines the movement of the dollar. If the current account deficit is to narrow, the dollar must fall and interest rates must rise. The first part looked at why Roach does not expect rates to rise on the long end of the curve, which means the dollar rally must end and Asian currencies should rise. This type of insight is why Roach is one of the smartest economists around and picked for this week's Outside the Box.
This weeks article comes from one of my must read economic analysts, Bill Gross of Pimco. Bill sits on top of the largest pile of bonds in the world and is often referred to as the Bond King. His latest Investment Outlook is called "The Strange Tale of the Bare-Bottomed King." Pimco had a Secular Forum in May and this is Bill Gross's take on some of the issues discussed.
Bill sees our current prosperity built not on productivity and technology but on finance-based consumption fed from asset appreciation based on the [Fed's] Pump. He worries about increased market liquidity, leverage and systematic risk. While he does not predict when and how the imbalances will change, he clearly believes it must (as do I). Let's hope it is an orderly and not a precipitous event.
I have talked a lot about Bretton Woods 2 recently and that is why this was picked for Outside the Box.
This week's letter is from John P. Hussman, Ph.D., President of Hussman Investment Trust. His firm is one of the few that has employed hedging techniques, similar to the hedge fund world, in a mutual fund structure. John is also one of the really, really, really smart guys in the running money business. John manages the Hussman Strategic Total Return Fund - HSTRX and the Hussman Strategic Growth Fund - HSGFX.
Hussman's Weekly Market Commentary on March 21, 2004 takes a look at the importance of dividends to long term returns. Many readers know that in my past letters and book I point out the role dividends play in the total return to investors. Equity valuations are high and dividend levels are low so the buy and hold market cheerleaders, who trot out their long term average market return studies, won't help you much unless your time horizon is 70 years.
This commentary does a great job of explaining the role of dividends and why equity returns may not be as high as the long term market average over the next 10-15 years and that is why it became this week's Outside the Box.
This week's letter is once again from two of my favorite economists, Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company in Austin, Texas. They offer a view on bonds which, as Van noted in a conversation with me this week, disagrees with my 2005 forecast of last week. It is important to read well-reasoned opinions which disagree with your own, which is one of my foremost thoughts when selecting each week's article for Outside the Box.
And there are reasons to pay attention to their views on bonds. They specialize in management of fixed income portfolios for large institutional clients by setting long-term investment strategies based on economic analysis. They have been one of the most successful of bond managers in the country. (I have no affiliation with them.) I eagerly read all of their writing and analysis, and find it to be some of the most thought-provoking anywhere.
Their fourth quarter 2004 Quarterly Review and Outlook is an economic forecast of the coming year which looks at the consumer's financial condition and offers a contrarians view to long-bond yields. Let's explore where the economy might head in this weeks "Outside the Box."