Q2 2011: The Straight Messina
“Time is a great teacher, but unfortunately it kills all its pupils.”
-Louis Hector Berlioz, French composer
THE STRAIGHT MESSINA
Between the eastern tip of Sicily and the toe of Italy’s boot lies a natural whirlpool separating the Mediterranean island from the European landmass at a distance of less than two miles. This Strait of Messina has two claims to fame; literary tradition cites it as the location of the mythical sea monsters in Homer’s Odyssey, Scylla and Charybdis, twin dangers in such close proximity sailors could not avoid both. Trapped between the devil and the deep blue sea, Odysseus chose to sail near the hydra-headed monster Scylla and lose only a few sailors than risk his entire ship in the swirling maw of Charybdis. A classic tale, all things considered, but very overwrought and a typical ham-handed metaphor of Greek tragedy. The other interesting Messina Strait factoid is one of the great boondoggles of modern public works, the long-planned suspension bridge joining Sicily to Italy; and when we write long-planned, we mean the toga-wearing Romans first discussed the idea. Subject to amazingly high winds, violent seas, built smack over an earthquake zone, and connecting two areas of dubious economic value, the world’s longest suspension bridge, if ever built, may be done in 2016 at a cost of €6B, or may not, depending on which day’s headline you read. So, an area of violent natural forces book-ended by two monsters with a top layer of government incompetence…talk about ham-handed metaphors, is that a great way to describe the 2nd quarter of 2011 or what?
Let’s discuss the first monster, Europe: In 1463, George Podiebrad, the last King of Bohemia, proposed to King Louis XI of France the novel idea of a European confederation with a central political assembly, court of justice, standing army and federal budget. Almost six hundred years later we still have not figured out that you cannot tie the currency of a small country with a runaway spending problem, say Greece, to a large country with an eins, zwei, drei approach to fiscal matters, say Germany, without also intertwining their budgets, despite King George figuring this out in the Renaissance. Because Greece cannot devalue the shared currency of the euro it has only two choices, pay its debts or default. However, the math of Greece doesn’t work: Public debt is estimated at half-a-trillion dollars or so with a three hundred billion dollar GDP and an annual operating deficit that can run into the tens of billions. Some people see these numbers and say, “Well, Greece has been paying up to now, why can’t they just continue to pay?” Fair observation, but the market isn’t that dumb and investors have realized this is a Ponzi scheme to make Bernie Madoff blush. With these numbers and no ability to devalue the currency or stomach to balance the budget, just the annual debt service would cripple the Greek economy and force more borrowing instead of less with the eventual endgame of sovereign default. Politicians can call it an exchange, they can call it a restructure, they can call it whatever they think voters will buy, but you have a better chance of being repaid by Frank McCourt than returning par value on Greek debt: Greece is a bankruptcy awaiting a timestamp.
You know what the funny part is? On its own, Greece is meaningless in terms of global finance, it’s Iceland with better beaches, it’s eleven million people and less than 3% of Europe’s GDP, it could never repay a single drachma and the global financial system could handle the whole thing easier than Lehman’s fall and without the HBO movie except…Ireland and Portugal are just as bad. Ireland now has a debt-to-GDP ratio rapidly approaching Greece’s lofty perch with sky-rocketing unemployment and a ballooning annual budget deficit with Portugal in a similar position. Credit-default swaps, insurance-like products on debt, have spiraled in price for both countries, along with Greece, and the spreads between these guilty three and gold-standard Germany have widened to unsustainable levels. Germany is financing two-year debt at 1.3% as we go to print. Greek, Irish and Portuguese two-year’s are trading at 25.8%, 13.1% and 12.9%, respectively. Again, countries cannot share a currency and finance debt at such differing levels, it’s economically impossible as currency relative values help balance relative interest rates.
So the concern becomes the relative non-issue of Greek default is suddenly joined by both Irish and Portuguese defaults and then holes appear throughout European money center bank balance sheets where these bonds lay like landmines. We do know some of the debt these banks own because big players like Deutsche Bank are already writing down sovereign holdings and purportedly cutting risk. What we don’t know is how the credit default swaps they’ve written and hold and off balance sheet assets we don’t see act in a blow up. Then the fear is all these big banks have to go to market at the same time, hat in hand, begging for capital. Sure, there’s the European Central Bank, the de facto Euro Fed, backstopping the whole thing, but the ECB has purchased approximately €74B of Greek, Irish and Portuguese debt since May 2010 and no one knows how much of just Greek debt it actually has on its books because the ECB does not disclose. Troll through newsfeeds and you’ll see analyst estimates of €100B? €140B? Who knows? As the money center banks go to the ECB might the ECB have to go to Germany and France, the two biggest Euro economies, for capital at the same time? How about the Euro/U.S. repo/repurchase market that funds banks globally? That total market is estimated as high as $10 trillion – with a T – and no one knows how it could break down if a major money center in Europe were to find itself without a chair when the default music stops. What about U.S. money market funds? They hold a lot of short-term commercial paper from Euro banks like Societe Generale, BNP Paribas, etc., etc…long-story-short it’s all intertwined and no one knows what happens if the dominoes start to fall too quickly.
Notice we haven’t even mentioned Italy and Spain. Italy is the world’s third largest bond market – a fact we find amazing – with less than half its bonds held domestically, meaning the global market can punish it at will. But this is the epitome of contagion: Italy and Spain, and their money-center banks, falling into the same debt-death spirals as Greece, Ireland and Portugal is a logarithmic problem set, one the ECB would probably not be able to solve without major haircuts for public and private bondholders, a severe recession for the continent and diminished growth forecasts for a number of years. In listening and speaking to investors here and abroad our sense of the financial community has Greece, Ireland and Portugal as foregone rescue conclusions. Italy and Spain, to date, are more in the “cross your fingers” camp and market nervousness continues because the various rescue plans debated, discussed and passed are trying to ring-fence Greece, Ireland and Portugal while leaving Italy and Spain be. Yes, last week’s second Greek bailout with its dizzying array of rollovers and exchanges from the TARP-like European Financial Stability Fund was designed for Greece only, but does anyone think it won’t be the precedent for Ireland and Portugal when the time comes? That precedent, in light of the inability to devalue currency, is the outright reduction of debt. The market can certainly withstand Greek debt reduction, and most likely Irish and Portuguese haircuts. But, if Italy and Spain crumble, we are in a different situation entirely.
Considering the last several paragraphs have been unceasingly depressing, the natural questions are: How have the markets held up so well? Where is the optimism? Well, 2008 taught officials and investors some useful lessons, mainly in the value of being proactive and expanding the spectrum of worst-possible outcomes. The European debt crisis is a slow-moving train wreck we’ve closely watched for over eighteen months. Comparatively, Lehman’s bankruptcy filing was a lightning bolt on a clear day. Greece, Ireland and Portugal are a fait accompli we’ve had time to embrace and markets prize slow-moving certainty above all else. Although you can fault the Euros typically oblique approach to what should be direct statements to private holders of toxic debt, you cannot argue they have been consumed by the issue, with most likely detrimental outcomes to Merkel’s and Sarkozy’s future political careers. Europe is not being left to burn; it will be healed, even if the cure is painful.
Another reason for market optimism is this sovereign debt crisis will and must bring about a change in how the European continent evolves. As we’ve belabored, there is no rational means to run countries tied by a common currency with differing fiscal budgets. It’s more of a miracle it took twelve years for this to happen and we suspect history will look back upon these events and shrug, “of course.” The prediction here is this crisis is the next step to fully realizing King George’s vision; a United States of Europe with a common currency, budget and infrastructure, filled by member states separated by culture and local custom more than bright line rules of law and money. Luxembourg and Greece are on their way to becoming Idaho and Florida; because that’s the only way the grand European Union experiment can effectively handle continental immigration and demographic patterns and maintain viable economic competition with the U.S. and the emerging Asian block. It’s interesting that there was never a mechanism written into the Union accords for countries to exit the euro, as if the mere possibility was unthinkable. Europe is travelling a one-way path, one that will open up an entire continent to renewed investing enthusiasm in the long run, and despite all the short term turmoil that is reason for great hope.
Yet, we understand why Europe is having these issues; the continent is dealing with a vast array of countries defined and limited by histories and customs stretching millennia. The European bloc has to overcome language barriers and a diverse group of people relatively intransigent within their cultures. We believe they will work out their issues with pain and time but integration will occur. What we cannot understand is the second monster of this piece: How a young country filled with one people – Americans – one money, one language and one law has allowed the state of political discourse to dissolve into a partisan street fight choking to death all we’ve built. If we brought up the Bohemian King George for Europe, let’s quote Alexander Hamilton from his 1790 Report on Public Credit: “For when the credit of a country is in any degree questionable, it never fails to give an extravagant premium, in one shape or another, upon all the loans it has occasion to make.”
It’s a waste of your time to have us pick apart the argument and find the bad guy in this battle. Ultimately, we are all at fault for what is happening. We have cast the votes and allowed all of our elected leaders to set upon the course of jeopardizing America’s longstanding AAA credit with either a technical or outright default. Unlike Greece and its downtrodden cohorts, America can control its currency, effectively print money and avoid an outright default at any time. It’s obvious the market believes this, as the benchmark 10-year U.S. treasury note bounces between 2.80% and 3.10%, give or take, depending on the news flow out of Europe and Capitol Hill. Surely, no one would actually seek out debt instruments in times of crisis that will imminently default, right? As we’ve written in this space before, the good news is an outright default is and will continue to be unthinkable within a global financial context. It is akin to the Cold War and why the U.S. and Soviet Union would never engage in a nuclear exchange due to mutually assured destruction. If you believe our politicians to be incompetent hacks, that’s fine, but they are not insane incompetent hacks.
But, a technical default and/or ratings downgrade is a bit hazier to forecast. We’re not even entirely sure if the Treasury runs out of money on August 2nd as receipts may cover bills through that time frame and extend the drop-dead out a week or two, so it depends on how technical you want to define a default. The risk isn’t that a delay of a day or two of payments extends into an outright default, as covered above; the risk is the panic even a small hitch may engender in market participants. Even a mildly technical default may give large foreign creditors, such as China and Japan, pause to participate in future auctions, and more impetus to diversify their current holdings; as Hamilton warned it will spike up yields and cost us more to finance ourselves, putting more strain on a budget already built in quicksand. Yet remember, the wisdom of Congress didn’t pass TARP the first time out…
The matter of Moody’s or Standard & Poor’s downgrading U.S. debt is entirely different. Egan-Jones, Dr. Ed Yardeni and a plethora of the punditry have already downgraded U.S. debt to the AA range, and they are correct to do so. At some point, the absolute level of debt in addition to debt-as-a-percentage-of-GDP matters, and $14T – trillion with a T – and annual deficits in the several hundred billion to trillion dollar range is well past that point. Between the absolute level of debt, the rising percentage of GDP, the percentage of government revenue devoted to interest payments and entitlement programs not designed for shifting demographics, the U.S. is not a AAA credit. That’s just reality and, in theory, there’s nothing wrong with AA status; we’ll pay our bills and won’t default or restructure. Sure, we will officially devalue our currency at some point, despite public protestation to the contrary, to make paying everything down easier to swallow, but everyone will get their agreed upon principal amounts back. Money market funds, insurance companies and bank balance sheets will be forced to deal with a portion of their book formally reserved by regulation or internal risk compliance to AAA treasury debt but we doubt there will be a “run on” selling treasuries. Again, the market action of prices tells us investors do not believe outright default is possible and even a technical default is relatively innocuous. Once again, Moody’s and Standard and Poor’s are behind the curve of what we already know, and when they finally bring themselves to swing the axe there will be a new round of infighting over who was responsible for losing the exalted AAA status, but the market will have far more say over the ramifications.
Is it possible to have an upside to this sad tale of America? Oddly enough, yes. We’re hopeful that a technical default and/or ratings downgrade is that proverbial final straw for we, the voting public, to demand accountability of our elected officials to spend what they are provided and no more, much like any good parents would tutor their child. It is the only way we can conclude the trilogy of restructuring that has defined this writer’s investing career; as I came into the business in the late ’90′s corporations had binged on needless acquisitions, become fascinated with share buybacks near record high levels and been beguiled by financial gurus into taking on debt to limit management. The Internet Bubble popped, and companies discovered over the next decade it was a good idea to keep their balance sheets flexible, wean off limiting debt and have a lot of cash on hand for down times. As companies righted themselves, consumers leveraged themselves up in the Credit Bubble buying houses, flat-screens, second houses, new kitchens, third houses and whatever else came to mind. Since the fall of ’08, consumers are actually saving again and paying down revolving debt, all while avoiding the temptation of a new home at a price they can’t afford. This may be painful in the short-term to sales figures but is crucial to our long-term health as a nation. Yet, it must be noted that while corporations and consumers cleaned their acts up over the last ten years, it was all made easier by the presence of background governments priming the Keynesian pump, issuing debt and spending cash to prop us all up.
Hence, fixing the Government Bubble worldwide will be the last, most painful part of this saga. There is no entity or combination of entities capable of backstopping governments de-leveraging and the real fear is not in imminent default but in a sudden recession brought about by governments ending fiscal stimulus they can no longer afford and not having the political will to realize sovereign expenditures must be in the form of investment as opposed to consumption. This writer believes, unfortunately, that the human condition does not allow us to fix things until they are truly broken, so I am almost happy with anticipation that through reaching this ultimate point of failure we can finally admit our fiscal problems and begin to repair the damage done, despite the immediate pain and uncertainty. There are positives to all of this, despite the steady drumbeat of negative news.
But, in the short term, we have a huge threat to the markets in panic selling on a U.S. technical default, and inevitable downgrade, and a breakdown in European cooperation, particularly between Germany and France, on how to resolve troubled countries’ debt. In the intermediate term, we have the risks partisan politics will continue and possibly intensify in the U.S., and we are wrong in assuming the political establishment realizes this is a watershed moment. In Europe, we risk Italy and Spain falling into the Grecian camp and engulfing the Eurozone in a conflagration no one can quench. How do we protect investor portfolios? More to the point, how can we continue to profit? Spending huge quantities of time on the macro environment, as we have ad nauseum in this letter, is the key to portfolio construction at this moment. No money manager focusing on one asset class will want to hear this, but correlations between assets are high once again and will skyrocket in the event of a crisis as traders sell risk indiscriminately. Watching the market on a daily basis, it is obvious asset swings are coming from the news ticker instead of the earnings ticker. It’s not ideal but that’s just the way markets trade right now so our first task, as stewards of all asset classes, is to gauge the macro risk level and act accordingly. Despite all the silver linings we’ve outlined above, and honestly believe in, the macro threats to the global economy between the U.S., Europe, an earthquake-shaken Japan and an overheating China, are quite real and we’ve sold risk steadily throughout the year to bring cash levels to our highest point since the Bear Stearns fall from grace in spring ’08. Focusing on that cash, we’ve transferred the assets held in corporate-backed money market funds to money markets holding only U.S. treasuries, which may, at first blush, seem ironic given the worry of U.S. default but we reiterate that any default will be technical in nature and not an actual lack of return of capital from the U.S. government. Again, a full U.S. government default is an unthinkable and untenable scenario and will not come to pass.
Next, in the face of dollar weakness given this political wrangling, euro wobbles due to their sovereign crisis, and what is largely viewed as unsustainable yen strength, the world’s three major currencies are seen as all having faults large enough to continue support for gold. We’ve maintained our position and expect a minor pullback once some sort of U.S. political compromise is reached; we would view this as an opportunity to add to the position as a continued global paper currency hedge. As an aside, we’d also view any rise in the yen to the low 70′s in dollar/yen terms to be an attractive entry point as a short. Given our views on imminent threats to spiking risk and assets correlating indiscriminately, we’ve sold equity holdings in Industrials, Materials and Small Cap through the year and sold our Technology and additional Small Cap assets this past quarter. We’ve tried to flatten our exposure to financials, once again in the bull’s-eye of this storm, and will take a hard look at limiting our European equity exposure if we get any sense their banking mechanisms are breaking down, or political will is fraying. We’ve maintained our equity Energy assets and will continue to do so as a hedge to geopolitical issues brought on by any social unrest throughout these next few months. We’ll also maintain our Japanese-specific equity holdings as we feel the yen strength is temporary, the internal rebuild will continue, and their exporters will have favorable comparative sales figures in the future coming off the tsunami-stretch. Coupled with very fair valuations, we feel confident the Japanese story will be one of our favorite investment ideas over the intermediate term. Finally, we’ll be looking to take a small portion of assets, perhaps 3 to 5%, and hedge a major index like the S&P 500 against a temporary plunge through a liquid, inverse exchange-traded fund. This will be the first time we’ve engaged in this activity but we feel the global macro risks warrant this type of conservative strategy.
On the fixed income side, we’ve maintained our long-held zero weighting in U.S. treasuries, established a small position in a short treasury trade through an exchange-traded fund, and we’ll continue to look for entry points on that trade. We don’t feel longer-dated treasury bonds can maintain low yields given the debt profile of the U.S.; we view any sustained time the 10-year note trades below 2.80% as a good opportunity to add to our short-treasury position. We’ve also continued to focus on shortening the duration of our fixed income assets on a portfolio-wide basis, whether dealing with taxable or tax-exempt assets. We’ll hold our investment-grade corporate bond positions and smaller high-yield and floating rate positions through this period but we’ll view pressure in the U.S. and European markets as an opportunity to diversify into emerging market bonds and continue to look for beyond-the-normal-toolbox opportunities like our oil & gas Master Limited Partnership position. We’ve said it many times in this space before, going forward thoughts on the risk level of fixed income will have to be revamped in the minds of investors. Focus on the real level of return and independent appraisals of actual creditworthiness will come to the forefront instead of nominal return levels and dubious third-party rating judges. Equities, in our mind, continue to be a more effective long-term investment.
In conclusion, we can’t say this has been the most light-hearted letter, but the Chinese curse of interesting times is truly upon us and the interplay between macro events and bottom-up asset analysis has reached a necessary blending point; one cannot and should not exist without the other. We maintain investing is a viable alternative to the locked-in negative return of holding cash, or cash-like instruments, and the firm belief that times of great upheaval and uncertainty provide us with the best investing opportunities providing patience and perseverance are maintained. Again, we use our usual sign-off but we write it with renewed sincerity this tumultuous quarter: Thank you for entrusting us with your financial well-being and for taking the time to read our thoughts. We remain humbled by both.
*Pricing and statistical information obtained from Bloomberg LP
Sincerely,
Jason S. Morad
Chief Investment Officer
The Standard & Poors (S&P) 500 index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. Indices are not managed and do not incur fees or expenses. It is not possible to invest directly with an index. Past performance is not a guarantee of future results.
Investment advisory services offered through Capital Formation Group, Inc., an SEC Registered Investment Advisor. Securities offered through ValMark Securities Inc, member FINRA SIPC, 130 Springside Drive Suite 300 Akron, OH 44333-2431* 1-800-765-5201. Capital Formation Group, Inc. and John Williams are separate entities from ValMark Securities Inc.
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