Stock markets continued to move sideways following the latest announcement of Quantitative Easing (QE3) and Mortgage Backed Security (MBS) purchases from the Federal Reserve. After the recent round of major corporate earnings announcements, there are now more companies issuing lowered revenue guidance, than there are companies issuing higher guidance. This is the first major decline in guidance in the last three years. To put this in some perspective, if guidance and indicators were trending higher, then there would be less reason for the Fed to launch QE3. The economy appears to be slowing in the near term, though the affects of additional stimulus measures are not yet being seen.
It is not just the Federal Reserve increasing the money supply. China recently put forward a large loan program to Venezuela, through China Development Bank, for various infrastructure projects. Over the last five years, China has loaned Venezuela over $42.5 billion, while Chinese government run companies gain lucrative contracts in Venezuela. Under Hugo Chavez, much of these loans has gone into housing for the poor, and a nationwide railway expansion. Repayment, ironically in U.S. Dollars, is based upon future oil sales, and fluctuating oil prices. Inflation has soared in Venezuela, and most of the projects are seen as an attempt to prop up re-election chances for Chavez. Venezuela will have elections the weekend of 7 October, so we will watch for any surprise outcomes. China wants access to raw materials, especially oil, so the loan agreements should not be surprising. The U.S. still purchases just under 10% of foreign sourced oil directly from Venezuela, though production increases and agreements with Canada and Brazil could easily make up any difference, if Venezuela decided not to export oil to the United States. Including the recently announced infrastructure spending in China, there are more such moves to extend loans to emerging markets, especially in Africa. As the U.S. moves to spur domestic growth, China is moving increasingly towards growth in other markets. This is another indication that the robust cycle of growth in China, which drove much of the global economy the last few years, is now starting to slow.
Additional capital spending on projects, even while sourced through loans, can drive economic growth, but when tied to natural resources there is a limit to the effectiveness over the long term. All the additional stimulus, and the possibility of more in Europe, leads some analysts to expect more currency devaluation. If this proves true, we may see gold prices rise over the course of the next couple years. So far gold futures have not passed above $1800 an ounce. A break above that level may indicate a continuation to $1900, or perhaps as high as $2000 an ounce. Above that is somewhat speculative. It’s not a bad idea to have some investment in gold in a portfolio. This can be in the form of physical gold, shares of Electronically Traded Funds (ETF) that hold gold and gold futures, or through shares of mining companies. The mining companies tend to lag the appreciation of gold futures by at least one or two quarters. Some of the ETFs engage in financial hedging that may impact the return to investors. Physical gold is tougher to quickly sell, and other than gold coins is tough to purchase. I consider gold more of a hedge, or alternative investment, and currently hold a position in one of the largest gold mining companies in the world.
FT Alphaville have been re-running news clippings from the 1930s New York Times recently. Many of the same concerns about the direction of the economy that are being voiced now, appear much the same as in the 1930s. Scarcity of money in circulation brought about some unusual problems in the 1930s, and even led to increased bartering. The parallel to today is that extra measures from the Federal Reserve are going directly to the largest banks, who continue to funnel the excess into reserves to prop up their capital ratio. So far we have not seen an increase in commodity prices, as with QE2, though we see some concern in that direction. Both inflation and deflation concerns appearing in the 1930s match similar news stories of today. Over production of commodities created a surplus, though the previous solution was to lower production, essentially causing a shortage, though prices remained depressed due to lack of demand. Probably one of the more interesting parallels was that inventories decreased as corporations hoarded cash, which should sound somewhat familiar. I’m not suggesting we are headed towards a depression, yet we do appear to be headed towards slower growth, and possibly a recession. If you read through that piece in FT Alphaville, consider the current moves by the Federal Reserve. Ben Bernanke is one of the for most scholars of the Great Depression, and is likely to be more aware of parallels than anyone. While some may think Bernanke is crazy, the reality is that stimulus measures will have a marginal affect on lending. While QE3 might not get too many investors thinking about growth, a concern over inflation could spur capital spending in the worry of avoiding a devalued U.S. dollar (USD). The Federal Reserve is increasing internal assets through purchases of various bonds, which increases the reserves held at the largest financial institutions. This is not technically money printing, though it isbalance sheet shuffling (and monetary expansion), which drives up the cost of bank funding. According the to Federal Reserve Bank of San Francisco, the average cost of bank funding was 1.09% in July 2012.
While the Federal Reserve may be spurring U.S. markets, economies globally still move together in mutual influence, and there remain many problems to solve in Europe. Due to the complexities of the European Union, and the need for at least 17 countries to completely agree upon changes to the monetary union, I feel we are unlikely to see solutions in the near term. Economies in peripheral countries have pushed through spending cuts in a rush to austerity, though in the process that push is reaching the limits of potential. While Greece is somewhat of an outlier, due to internal issues, we now see increasing civil unrest in Spain and Portugal, and a slowdown in the United Kingdom. Portugal may be the interesting example, in that the country has hit austerity targets, yet the lack of export growth is not driving the economy. In Spain, high unemployment and the movement of funding to banks, are leading to mass protests, and a high possibility of a change of government. Spain faces regional elections in October, which may change the balance of power. The balance that is missing in many troubled parts of Europe is that of reducing sovereign debt, while keeping wages and employment levels propped up. In the absence of capital spending by the private sector, internal country demand declines. Lower wages and high unemployment levels decrease tax revenues, making debt repayment more difficult. The utopian economic idea of austerity is a return to an export driven economy, and enable an account surplus, making debt repayment easier. Theory is now reaching the limits of reality, as the stress of fixing long term economic issues is hitting the public. As civil unrest grows, and existing politicians face an angry public, we may experience some shocks to European economies. A devaluation of the Euro would help, though this is not within the power of any one country to accomplish. More likely is debt forgiveness, or a sovereign default, and it might not be Greece as the first to go. Investors in the U.S. may be exposed to European issues through money market funds, as Fitch Ratings notes that European repurchase agreements make up 39% of most money markets funds, and near 37% of money market funds are exposed to European based banks. It would be unusual for a money mark fund to be affected, though the last such event was the failure of the Reserve Primary Fund following the collapse of Lehman Brothers.
While sales of homes are still near historical lows, the pace of increase in new construction, and the pace of resales, are outpacing the U.S. economy. When August housing starts figures are reported soon, the expectation is that housing starts will exceed 770K units, a rise above the 746k starts in June. Housing starts have increased more than 20% in the past 12 months. Since we now have many months of figures for 2012, it appears that 2011 may have been a record low in new home sales, since record keeping began in 1963. Loan standards remain tight, so we have yet to see lenders relax standards to make use of historically low mortgage rates. Despite the improvements in the housing market, 10 citiesCME Group operates one of the largest commodities and futures exchanges in the world in Chicago. They also handle a large portion of the derivative and financial transaction clearing market. The large banks, corporations, and financial companies who use CME Group for transactions must meet collateral requirements in order to trade or initiate positions. Currently U.S. Dollars (USD) are valued at face value for collateral, while other currencies, bonds, various assets, and gold can be used at lower valuations. The lower valuation is termed a “haircut”, meaning a percentage of face value is used for collateral. In theory a larger haircut should point towards reduced demand to hold some assets, for example a 15% haircut on gold as collateral, based upon current futures market prices. This does not mean these assets are overvalued by this amount, though it does indicate some expectation of a decline in value. The interesting item for us to look at is Fannie Mae and Freddie Mac guaranteed Mortgage Backed Securities. Those MBS used as collateral now are valued at a 11% haircut on market value. If the Federal Reserve program of buying $40B of MBS each month is successful, we should see demand for MBS increase, and this would prompt CME Group to lower the haircut on these assets used as collateral. The reverse would also be true, in that it the Fed purchases are not effective, the haircut amount should increase. We will continue to watch this and keep you up to date in the future to any changes, which would affect the housing market.
On 25 September 2012, the latest Case-Shiller Home Price Indice was released. The 10 city indice showed an annual increase of 0.6% in July 2012, while the 20 city indice registered an increase of 1.2% compared to a year ago. Both are near 2003 levels. Phoenix posted the largest one year increase at 16.6%, while San Diego saw just 0.8% increase. The largest decrease in home prices was seen in Atlanta, with a 9.9% decline over the year ago period. The May through June period saw greater increases across all cities, than the June through July period, suggesting some slow down in housing price appreciation, though this should not be surprising in normal seasonal sales trends. An Argus Market Research report indicated that analysts felt some banks and potential sellers may be holding back, considering the continued low price levels. Price gains are expected to draw some shadow inventory into the home market, though the back-log inventory is still huge. Prime mortgage delinquency rates are now above 10%, which is an area of some concern. August new home sales came in at 373k, below estimates of 380k expected.
We have several reports from Fitch Ratings from September. In commercial mortgages and Commercial Mortgage Backed Securities (CMBS), FItch notes an increase in work-outs of delinquent loans, but notably some loss taking from some banks, though no more than a 7.5% write-down. The highest loss rates appear in transactions originated in 2006 and 2007 CMBS, at 10.6% and 13.5% respectively. One of the more troubling aspects of the Fitch research indicates that about 2/3rds of CMBS in delinquency eventually moved towards bankruptcy, which led to losses. Higher priced properties, and higher priced CMBS, tended to have a higher default rate. If you are investing in commercial properties, it appears that bigger is not always better, and could lead to larger losses, though most of the recent losses are tied to transactions over five years ago. This trend has declined from 2009, and conditions appear to be improving. The chart at the right is a measure of debt to GDP, and shows historical moments when that ratio exceeded 100%. Recently Fitch placed the United Kingdom on credit watch negative, with the possibility of the UK losing their AAA rating. The projections from Fitch indicate that the UK may approach a general gross government debt level of 100% of GDP in the 2015/2016 time frame. We can also see in this chart that Japan is in serious trouble with debt levels. Japan is now considering buying foreign bonds, which might turn around their debt levels through currency devaluation. If the United States can manage avoid a Fiscal Cliff in 2013, there is some possibility that the AAA rating may remain intact. This would generally keep borrowing rates low, even without Federal Reserve efforts.
On 1 October, the latest Manufacturing Purchasing Managers Index (PMI) was released with a surprising 51.5 reading, above an expected 49.7 level. This might be due to inventory declines, if we do not see a continuation of this level on the next report. The WallStreet Journal compiled a listing of Global PMI levels from many countries. Above 50 indicates better than average manufacturing activity. The surprise in that data set is Australia, who have a large export market with China, somewhat confirming a contraction of the economy in China. As economic growth continues to slow, it has become more difficult to find profits. Low inventories may cause some improvement in capital spending this quarter, though many corporations are holding onto large cash piles. Money left on the sidelines can lead to spending declines. Housing appears to be somewhat stable, though far below historical levels. So far the additional stimulus measures of various central banks, especially the Federal Reserve, are not giving clear indications of improvement. Bonds remain somewhat unattractive due to low yields, or in the case of some European bonds too high a risk level. Over the next series of articles, we will look more into some alternative investment strategies that may provide better yields than available in many markets. As always, maintaining a flexible cash position allows us to take advantage of market corrections, or simply allows us to be more flexible in our diversified investment choices.
G. Moat
