Mind the Curve

There is concern about the US treasury yield curve. It has flattened, meaning the difference between long term rates and short term rates has narrowed.  Yields on the two maturities are a mere 35 hundredths of a point apart. Some believe that the curve will invert. Inversion has often been a harbinger of recessions. It is possible that inversion, if and when it comes, will foreshadow the next downturn. Before you start hyperventilating about that possibility, be aware that there are other reasons the yield curve flattens, uncertainty among them.

2s10sJune2018
2s10s has narrowed, but will it invert? The late 90s show another potential outcome.

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Another House, Are We Nuts?

We’re buying another house. We sold the last one in August 2017. Serendipitously, we sold before the new tax bill laid waste the deductions homeowners in high tax states held so dear. At first we thought: “We’re home free. Prices should fall. Maybe we should rent for a year or two and see how things play out”.  Then we looked at rentals. Apartments, too small. What if the kids come home and where am I going to put all my bikes?* Houses, very expensive, in terrible condition, or too far from where we want to be. So, we’re buying another house, but does this make economic sense, especially given the new tax bill? The answer is that it might.

The keys to whether it does are:

  1. Will the tax bill cause a fall in home prices?
  2. Will other factors, like supply and demographics, dominate taxes?
  3. Will the benefits from homeownership outweight the costs?

The answers are:

  1. Perhaps.
  2. There’s a good chance they will.
  3. Probably

So, here we go:

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Highway Robbery

Everything is always decided for reasons other than the real merits of the case.  – John Maynard Keynes

police-traffic-stop

Minnesota DWI Center/ Creative Commons

Recently, I had the pleasure of sitting through a day and a night in traffic court. Traffic court today seems to be more about municipal finance than about ensuring safety on the road.  I suspect that the recently passed tax overhaul is only going to make this worse. The elimination of the state and local tax deduction will pressure municipalities to hold or cut taxes while trying to maintain services.  Drive carefully.

The first time I went to court was to fight a parking ticket. The ticket was uncalled for; I’ll spare you the details. Suffice to say, I had a good case so off to court I went. Huge mistake.

I arrived at the county traffic court to find that I had to wait in line to get into the building. It took two plus hours before I saw the inside of the courtroom. What I found when I got inside was a plea bargaining mill. If you truly believe in your case, you can schedule a trial for a future date, take another day from work, waste another 5 hours, if you’re lucky and aren’t forced into an adjournment. Most people take the plea, especially if the plea comes without points on their record. Insurance surcharges for three years far exceed the plea amount. That’s how they get you.

When my turn came, I was offered a small fine reduction. I began to make my case, but the prosecutor stopped me in my tracks and said “OK, we’ll schedule a trial date”. I asked: “When?”. The response: “Sometime in the next six months”.  I said something like, “This is a waste of my time. Even though I think I’m innocent, I’ll take the deal”. Despite the fact that this is what they are relying on, the prosecutor looked annoyed and said “Don’t let the judge hear you say that when you go in front of him”. I took his advice.

My second go round was for a moving violation. It occurred in a local village court. Another plea mill, just at night and with nicer court employees. I was amused to hear one guy say almost exactly what I had in the county court, but he said it to the judge. He said that he thought he wasn’t guilty, but he didn’t want to waste the time. The judge told him that if he felt that way she didn’t think he should deprive himself of a trial. She sounded sincere.  He took the plea bargain anyway after repeating that it was a waste of his time.

The going rate is $250 for a moving violation, if you have a clean record. You get your violation reduced to a parking ticket and they get money in the coffers. Fifty of those a court session times fifty court sessions a year is $625,000. The take is much higher on the county level. They had 4 or 5 prosecutors bargaining simultaneously in open court.

Unfortunately, there is a huge incentive for municipalities to have their cops hand out a lot of questionable moving violations. They make it (barely) palatable to pay a large fine by not affecting your insurance rates while making it inconvenient and problematic to fight. It’s the cop’s word against yours and it’s a judicial trial. Maybe there’s a positive effect on road safety, but it seems more like a foolproof way to raise revenue.

I feel like I can’t run to the store where I’m living without seeing someone pulled over. Be careful out there: It’s only going to get worse.

Posted in Governance, Municipal Finance, Municipalities | Leave a comment

Bonds: Is a Massive Selloff in Order?

The other day there was a video clip in my Twitter feed from a strategist who stated on CNBC that rates were going much higher in the second half of this year. He went on to say that those who had bought long duration bonds were pigs being fattened up for slaughter or something to that effect. Aside from reminding me why I don’t watch “bubblevision”, it made me think about how high the 10 year benchmark treasury could go in the current environment.  Big reveal: the answer to the question posed in the title is no. We’ll probably end the year higher than the 2.27% of today, but not as high as some might think, especially that guy.

I’ve never cared about forecasts per se, but about the thinking that goes into them. I believe that when you’re thinking about what can happen, you should have a process that is grounded in reality.  You want forecasts that are within the realm of possibility rather than continually calling for Ragnarok. Ragnarok in the financial markets happens more often than it should in a log normal world, but far less often than the would be Jeremiahs on bubblevision want you to believe. Ragnarok as your central case wreaks havoc on your ability to invest rationally. Let’s leave it aside.

My current belief is that the 10 year note will end the year around 2.5% or roughly about 25 basis points higher than now.  Such a yield would cause about a 2% loss on a 10 year security held for the next 6 months. That’s bad, but not enough to cause long duration holders to puke, as the saying goes. So, how did I get to that conclusion?

Let’s see:

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Chinese Debt for Equity Swaps, 3 Card Monte By Another Name?

The Chinese government is bandying about debt for equity swaps as a potential cure for the overhang of corporate debt in the middle kingdom.  Much, if not most, of the bank loans in China have been made by government owned banks to state owned enterprises (SOEs). This is a game of three card monte. Between the government, the SOEs and the banks, it’s just a matter of deciding where the losses are concealed.

3cardmonte2

According to the Caixin article, when last done in 2004, special purpose asset managment companies took the debt off the hands of the banks at face value. No writedowns, no restructurings of underperforming companies, just a shell game. Eventually the government absorbed the losses from the asset management companies. With 10% real growth and higher nominal growth that worked very well.  High Chinese growth rates in the century’s first decade more than doubled GDP, minimizing the size of the hit Beijing took on the bad debts.

This time is different. High nominal growth will not bail out China. The debt is too large and growth has slowed. Caixin is advocating that this be used as an opportunity to let market players restructure the SOEs into efficient firms using techniques drawn from the private equity and distressed investment playbooks.  Of course the market players they point to are government controlled. This is a policy choice, not a private sector solution.

Will Beijing repeat the past by keeping companies alive via cheap loans, taking the hit on their balance sheet for bad debt and screwing savers through low rates? Or will they take the restructuring path suggested by this trial balloon?  Are they willing to take the credit policy lever and turn it, through debt for equity swaps, into a restructuring mechanism? It will take cast iron will, because, if they do this, many will lose their jobs.

Whether or not they are willing to make this choice will help decide whether or not China differentiates itself from Japan in how it handles its economic transition. This has the potential to get China moving in the right direction. Keep an eye on it.

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Is This Time Different?

I’m a cyclist.  Typically, I ride the tarmac, but in the cold my friends and I will get out our mountain or cyclocross bikes and hit the dirt roads. Those roads are sheltered, offer stunning scenery and have enough steep pitches to ensure a good workout. Another feature of the dirt roads and their surrounding woods are the stone walls built from the colonial era through the mid-nineteeth century. They are evidence of an industry that began leaving the Northeast almost two centuries ago, farming.

ElephantMom

It has been estimated that there were once over 250,000 miles of stone walls in New England, New York and New Jersey. The stones were there due to the abrasive action of advancing and retreating glaciers. They were gathered into walls to denote boundaries when European settlers turned the forests into farms.

The Erie Canal put paid to the Northeastern farming industry. The canal opened the midwest to commerce. Grain flowed east. Manufactures floated west.  It is a classic case of comparative advantage and the gains from trade. It was not without its costs. Over time the northeastern farms returned to forest.  It has been said that the Northeast is more heavily forested now than when the Europeans arrived.

We are in transition today. Some, like nineteenth century New England farmers, will lose from the transition.  Manufacturing will not return to these shores in the same form it took when the U.S. owned most of the world’s capital stock and produced the bulk of its goods. Whatever manufacturing jobs are created will require different skills than they did before. They will not be for the high school grad…or the dropout.

This is true in finance too. The heyday of the vast trading floor is past. FX and government bond trading are largely automated. The specialists are gone from the exchange floor. Heck, the floor is gone. The neutron bombs that hit manufacturing are now dropping on the banks and the broker-dealers. It’s like the joke about the factory of the future that can be run by a man and his dog. The dog is there to bite the man if he tries to assume the controls.

This is the way it has been since the inception of the industrial revolution. Industries are born, grow, consolidate, are undermined by new technologies and processes.  Sometimes they survive in altered form as manufacturing has done and the financial sector will do. Sometimes they shrink to mere curiosities like the horse drawn carriage industry of Central Park.

There is a lot of angst about what the future will bring.  The presidential campaign, the attention to income inequality and questions about productivity growth are all symptoms of the economic transformation being caused by globalization and innovation.

Managing money taught me that the sector or driving idea behind the last bull market was never the sector or idea that drove the next cycle. Bull markets feed on euphoria. Bear markets and their aftermath stoke anxiety; the world focuses on the attempt to put humpty-dumpty together again rather than looking for opportunities elsewhere.

This time is not different. The sun will come out tomorrow. It just won’t be shining on the stone walls in the woods.

 

Posted in Cycling, Investing, Market Cycles, Trade | Tagged , , | 3 Comments

Banking the Fire

The narrative of the current market downturn, bear market, correction or whatever you prefer to call it had been about oil, China and the emerging markets.  Now the banks have been put into play.  Year to date their decline has outstripped that of last year’s whipping boys: energy, materials and industrials. Does it make sense that US banks, who were forced to raise equity via TARP, to hold more capital by Basel 3, to derisk by Dodd-Frank and the Volcker Rule, should follow European and EM banks into the vortex? I’m not sure.

SPsectorsYTD021616

S&P sector ETFs: YTD return to 2/16/16. Source: sectorspdr.com

No question that profitability will be permanently impaired by the need to hold more capital. That could lead to, and perhaps has already led to, a rerating of US bank stocks. However US banks should not be facing existential crises due to the above measures. I could see US banks becoming something like pro-cyclical utilities, given lower profitability and the decrease in riskiness afforded by higher capital and tighter regulations. What has occurred recently may have more to do with what is happening with banks in the rest of the world.

European banks still have issues. Many have been restoring capital by shrinking their balance sheets rather than by raising equity. There are genuine questions about their true capital positions, because they have extended loan maturities and ignored losses, realizing them as they accrue capital via earnings. It is a slow path towards balance sheet health. Inconsistencies surrounding the treatment of bondholders in the event of their resolution cannot have helped matters either. The recent swoon in their shares and bonds may be sudden, precipitous and, daresay it, overblown, but it is (somewhat) understandable.

Chinese banks may yet reap the whirlwind from their country’s astounding credit expansion . Pretty impressive 60+% increase in total credit to GDP between 2008 and 2014. It was probably higher still in 2015. Increases of that magnitude are generally good predictors of banking crises.

CN SocialFin2GDP

Source: IMF

If that doesn’t convince you, Chinese bank loans outstanding surpassed the stock of US bank loans in 2010.  And they have continued climbing at a vertiginous rate. Yes, US firms do finance via the bond market, so the US stock of loans should be lower relative to GDP than in a bank financed economy. But really, a bank loan stock that is 175% of the US loan stock for an economy 60% the size of the US economy? The Chinese government probably has the capacity to bail out its banks again. China will just grow slowly in the aftermath, unlike after the 2004 bailout.

CN US bank loans

Source: Yardeni

US banks have had their crisis. They have been through the fire and are going to be less profitable than they once were, but they are much less likely to bring down the system or themselves. Increased capital requirements mean reduced leverage. Reduced leverage means lower returns to equity holders. Returns on equity (ROE) has dropped post crisis and should remain lower until the great recession passes from living memory.

US bank ROE

Bank profitability has also been squeezed due to the decline in net interest margins (NIMs). NIMs have come down along with interest rates since about the mid-90s. This may have something to do with the excess of capital chasing returns, i.e., Ben Bernanke’s “savings glut” or with the disappearance of inflation. I don’t know, but bank lending spreads have compressed and profitability along with them. That is not likely to reverse anytime soon.

US NIM and 10sSo in the end, I believe that bank equities should have lagged as they have done since the crisis. If banks are going to be low beta pro-cyclical utilities that seems right. The question is whether US banks should be exhibiting such stark differentials in performance versus the rest of the equity market at this time. That is not so clear to me.

BankStox

Source: Financial Times

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Focus on the Chinese Currency, Not the Equity Market

Chinese equities have started the new year with a series of implosions, implosions exacerbated by the authorities’ ham handed attempts to dampen volatility. Despite the sound and the fury, the Chinese stock market is a sideshow. Ownership of Chinese equities is low, both in China itself and in the rest of the world.  The renminbi (CNY) exchange rate is a better indicator of what might be going through the minds of policy makers with regard to the real economy.

The Chinese authorities have set the reference rate for the CNY lower for most of the last few weeks.  This has spooked the Chinese equity market and the rest of the world. There seems to be a fear that China is turning away from rebalancing its primary economic driver towards domestic demand and back towards export driven growth. This may be a wish to “dance with the one who brung you“, to go back to what they believe made them successful.

CNY Jan 2016

It makes sense from that perspective, because it’s what they know and what generated a huge amount of employment in the last 15 years. It won’t work due to a lack of demand in, and stiffer competition from, the rest of the world. China must look within, as they had been doing.  It will just take longer to make the domestic economy the primary driver of growth than it did to build an export machine.

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Strategy and Structure

Strategy and Structure is a classic management book.  It is about the evolution of structures suitable for managing large complex organizations.  The book gets across the idea that form should fit function in organizational design.  In asset management, it is the vehicle that should fit the time horizon and the liquidity of its underlying investments. Consider your time horizon when you are picking the vehicles for your own investments. If it is long enough to invest in illiquid assets and you have the sitzfleisch to do so, pick an appropriate vehicle.

Third Avenue Focused Credit Fund (TFCIX), which was closed on December 10th following its implosion, had a structure that was glaringly inappropriate for its investment strategy. Structured as it was, TFCIX was the apotheosis of investment malpractice. TFCIX held highly illiquid distressed debt and other low rated illiquid bonds in an open end mutual fund that offered daily liquidity. Although I believe that investing in distressed bonds and other illiquid, low quality debt is a sound strategy at times, it should be done in a vehicle that reflects its illiquid nature. TFCIX should have been a hedge fund with a long lock up, a closed end fund or an interval fund.

Most investments are, or should be, long term.  There is no reason that they need to be accessible at a moment’s notice.  Yes, a proper asset allocation should have liquid assets for current needs or emergencies, but those are likely to be a small portion of the overall portfolio.

The greatest investor of our time, Warren Buffett, owes some part of his success to the fact that he invests via those pools of long term stable capital known as insurance companies. He can navigate the tides without worrying about whether his capital will be redeemed. David Swensen of Yale built the endowment model of investing on a similar insight, the notion that long term investors can capture a premium for illiquidity. Neither of those great investors uses a liquid vehicle to invest in illiquid strategies, nor should you.

 

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Junk Bonds or Equities With Coupons?

“Equities with Coupons” is a cynical description of high yield  bonds.  The expression, like many of its kind, contains more than an element of truth. Usually it’s invoked when trying to illustrate the risk of owning bonds priced near par. You may collect your coupons and see your bond mature at par if things go well or, if they do not, you could end up with a severely depreciated or worthless piece of paper, suitable only for framing.  The flip side of being a par holder of high yield bonds, one who bought their paper at issue price, is being a buyer of junk when it is stressed or distressed. Such buyers often are rewarded with strongly positive returns that rival those of the stock market.  Given the fall in the junk bond market over the last several months, it may be time to think about whether it’s safe to go back in the water.  Continue reading

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