All Quiet on The Fiscal Front

All eyes were on the Greek Bond Buy-back recently to see if this important step in the Greek saga could be completed. The first barrier was the four largest Greek banks agreeing to participate in the debt buy-back. This was important since Greek banks will be receiving most of the next aid tranche in order to recapitalize. Greek banks are some of the largest holders of Greek debt, due to rules put in place by the Greek Central Bank biasing holdings of Greek bonds. The buy-back would allow a revaluation of assets, in order to boost Tier 1 capital ratios. Unfortunately most trading borses (stock or commodity exchanges) already place holdings in Greek debt at a zero rating (effectively worthless) for purposes of collateral, which limits the ability of Greek banks to trade outside the borders of Greece. More importantly it seems that the worry of a bank run, or a return to large withdrawals from Greek banks, is the primary concern of this move. Initial offerings from private Greek bond holders topped €30 billion(Euros), roughly equal to the holdings of participating Greek banks. The bidding ranged from €0.302 minimum to €0.401 maximum per Euro of face value, depending upon maturity dates. Since this is a voluntary buy-back, participating investors would be writing down their holdings in Greek debt, in the hopes of some future pay-back on the swapped Greek bonds. Compared to earlier in 2012, when Greece forced losses with the use of Collective Action Clauses (CACs), this buy-back was more orderly, and is unlikely to trigger pay-outs on Credit Default Swaps (CDS) against Greek sovereign default. The benefit to Greece would be a reduction in debt near €20 billion (Euros). The early 2012 application of CACs caused a 75% devaluation of Greek bond holdings, so further devaluation in the form of a buy-back was expected to face some opposition. Given that some hold-outs (namely hedge funds) may choose to not participate in the hopes of some full payment many years from now, Greece is beginning to look like Argentina. Perhaps it was not too surprising that initial participation in the debt buy-back was dismal enough to prompt an extension of the deadline. In doing so, Greece may hope to reduce their overall long term debt more than €20 billion (Euros). As mentioned in a previous article, Greece needs about €10 billion (Euros) additional funds to complete the debt buy-back, though it was not clear from where those funds would come. In a report in Ekathimerini, it appears that the Eurogroup will provide that funding, if buy-back participation is high enough. That amount was never mentioned in the original aid tranche and agreement reported earlier. At 12:00 GMT 11 December 2012, we heard that the debt buy-back fell short of the target amount by about €450 million (Euros). Greek debt-to-GDP is expected to fall to 126.6% by 2020 instead of a target 124%. Total bids and offers where €31.8 billion (Euros) with an average offer of €0.335, or about a 66.5% devaluation. In the early 2012 application of CACs on private debt holders, the forced devaluation was about 75%. This sets a bad precedent for valuation of sovereign debt holdings, at least for any countries without an A or higher credit rating. Early on 13 December, the European Union approved the latest disbursement of Greek aid. It would not surprise me to see this action play out again prior to 2020 for Greece, especially with 24.8% unemployment. At any rate, we can put the Greek issue behind us for at least another year, or until the next round of Greek elections.
Greece is certainly not investment grade with a credit rating of CCC, one level above official default, though there remain some solid bond choices in other countries. Sovereign credit ratings will also affect the ratings of corporations in those countries, which impacts the pricing of corporate bonds. The announcement that Mario Monti is resigning as Prime Minister of Italy send secondary market Italian bond prices soaring. The announcement appears to have been prompted by a failure of support from the People of Liberty party, of former Prime Minister Silvio Berlusconi. Just to add some possible turmoil to the direction of the Italian economy, there is now a rumour that Berlusconi will once again run for Prime Minister. Spain has a BBB rating, while Portugal is one step lower at BB. While two Spanish headquarterd banks have managed to maintain a higher credit rating than Spain, that situation is reversed in Portugal, with major Portuguese banks credit ratings under the level of the sovereign rating. Portugal remains in recession despite €78 billion (Euros) in aid from the Eurozone and International Monetary Fund (IMF). Despite the recession in Portugal, and ongoing concern over debt levels in Spain, European markets rallied to new 2012 highs following the Greek debt buy-back. Investors seemingly ignored comments from the German Economic Minister that weak industrial output will slow the German economy through this winter. It is difficult to see what could drive equities markets in Europe higher, though with many companies share prices still under late 2010 or early 2011 levels, some investors may find holding into late 2013 or longer could be more profitable. The downgrade of France under AAA makes it difficult to find better safe haven bond investments. In the European Union, Germany, Austria, Denmark, Finland, Luxembourg, the Netherlands, Sweden, and the United Kingdom maintain a AAA through Fitch Ratings. Outside the European Union, Canada, Australia, Singapore, Switzerland, Norway, and the United States still enjoy AAA, though there have been some downgrades from Moody's and S&P Ratings recently. In early 2009 my feeling was that Swiss and Norwegian companies would fair better than other companies, and that formed the basis of my investment research at that time. Looking forward many more years, I feel we may see more economic improvement in Asia, though not through A+ rated China. Even with Australia still a good investment direction, the economy is very much tied to infrastructure spending in China, and the continued exports of raw materials to China. We now see some slowing in business activity in Australia, which may indicate some slowing in the near term. Many individual southeast Asia countries should be viewed as frontier economies, though we may soon see a few emerging market investment opportunities there. One country that is poised at the hub of trade in southeast Asia is Singapore, the location of one of the largest shipping ports in the world. Singapore operate a sovereign wealth fund and a stringent monetary authority. Despite that Singapore does not need to issue bonds, doing so helps the credit ratings of companies in Singapore. M&G investments has a great report and video on Singapore. We will be researching southeast Asian investment opportunities, and some west African frontier investment opportunities through early 2013. My feeling is that these frontier economies, with large mobile workforces, largely untapped natural resources, and open trade routes, may become the next long term investment opportunity.
The S&P 500 has continued to languish as various politicians release statements about Fiscal Cliff negotiations. Despite extensive news coverage, there is still no concrete deal in place. It appears that negotiations will go down to the self-imposed 21 December 2012 deadline, though we may see some last minute changes prior to the end of the year. At the moment market participants seem cautiously optimistic that some form of a deal will be put together prior to 21 December. Tuesday 11 December saw a slight early rally in the S&P 500 as investors expected some statement out of the Federal Open Markets Committee (FOMC) meeting and Federal Reserve Chairman Ben Bernanke. Gold futures remained largely unchanged ahead of an FOMC announcement. On 12 December the Federal Reserve released their latest Monetary Policy statement. One item of interest was whether the Federal Reserve would officially replace Operation Twist, which is set to expire on 31 December 2012. Operation Twist involves the purchases of long term US Treasuries, and the sale of shorter term US Treasuries. The Federal Reserve announced that starting in January 2013, they will begin a new round of $45 billion in open market bond purchases, and continue purchasing up to $40 billion per month of Mortgage Backed Securities (MBS). The new round of bond purchases will add to the estimated $1.65 trillion in previous bond purchases, making the Federal Reserve one of the largest holders of US debt. The worry in this is that the Federal Reserve is distorting the bond market. The WallStreet Journal has a great project tracking Federal Reserve statements, for those more interested in the nuances of change in monetary policy. The major changes of note are the target 2.5% inflation rate, and targeting 6.5% unemployment. The last time the unemployment rate was 6.5% was in September 2008. While the Fed acknowledges that the economy is expanding at a "moderate pace", they did not place a time limit upon the newest round of asset purchases. Historically bonds are a safe haven investment decision, but with continued monetizing of U.S. debt, investors may want to limit their exposure to US Treasuries for the next few years.
The idea behind the Federal Reserve action, especially with purchases of MBS, is that the additional stimulus will drive demand for housing and mortgages, and spur job growth. The expectation is that banks will initiate more mortgages, and bundle those new mortgages in new MBS, since they have at least one ready buyer with the Federal Reserve. There are numerous issues with this idea, though one notable barrier is that many of the largest banks are facing lawsuits over MBS issued during the housing bubble. The major banks are much more cautious initiating new mortgages, and the slow pace of economic improvement, including a persistently high unemployment rate, are hindering a greater recovery in housing. We may see some improvement through 2013, though housing gains may be limited by the decline in unemployment. Weekly jobless claims did decline slightly to 343k against an expectation of 372k claims. Part of the decline may be due to expanded holiday hiring, with retailers adding the most seasonal workers since 2000. With consumer confidence levels low, it remains to be seen whether the holiday shopping season will be more active than in the last several years. The US trade deficit declined to $42.24 billion against an expected $46.6B, though it is notable that both imports and exports declined to the lowest levels since April. Retail sales will be one very important economic indicator, though any improvement there may be tempered by Fiscal Cliff negotiations. So for now we await 21 December, and some news of a resolution to Fiscal Cliff negotiations.
G. Moat