Fear Itself?

As 2018 fades to black, we find ourselves in more volatile markets than we have seen in a while. Multiple large daily drops, at times followed by enormous upswings like the 5% surge on December 26th, are par for the course. Almost all asset markets are negative in the year to date, even former stalwarts of positive return like US stocks and high yield bonds. No developed country stock market is up for the year. Emerging markets, whose outcomes are more varied, are also in the red thus far, though change may be in the air; seven have been rallying for the last three months. Treasury bonds are now positive in reaction to the equity selloff. Short and intermediate corporate bonds have also eked out small gains.

Markets are nervous. Are problems coming down the pike or, as FDR would have put it, do we have nothing to fear but fear itself? No one can say in the moment what is driving the volatility and the selloffs. History will judge. What we can say is that the stock and bond markets are sending us signals, signals about participants’ beliefs regarding economic and political developments. These signals are hard to read, cloaked in noise as they are. We don’t yet know the answer, but we do know that concerns can be overblown and that overreacting to volatility can be counterproductive.

Below are some issues we have seen raised in the press or by market participants. It is not a comprehensive list, nor does it imply a clear direction. Don’t read too much into it; it is far easier to enumerate a list of fears than to see the opportunities. Those will come in time. In the meanwhile, don’t let volatility drive you off course.

  • Fed tightening: The US central bank has raised the funds rate upper bound to 2.5% from just 0.25% in December 2015. It has also been shrinking its balance sheet by letting treasury notes and mortgages it holds mature rather than reinvesting all the proceeds.
  • Yield curve inversion: Some short term bond yields rose above longer term yields earlier in December causing a yield curve inversion.  Yield curve inversions have often preceded recessions, though it has taken as long as two years from the initial inversion for the recession to arrive.
  • US tax cuts boosted earnings for many firms in 2018. In 2019, there will be no such boost. Tax rates will still be low, but the comparison will be apples to apples. Earnings growth will have to come from business growth, not outside forces.
  • Leverage in the US corporate sector is very high, as it is in the rest of the world. There may not be a systemic risk from this debt pile, as there was ten years ago, but higher rates and slower growth could strain many companies.
  • China’s growth is decelerating. The easy gains from urbanization and industrialization are petering out and the trade war may be taking its toll. Debt issuance has been high for the last decade, much of it for uneconomic projects. If the government takes on the distressed debt, it will diminish its capacity to stimulate the economy. Chinese equity markets have been among the worst performers this year. Will China follow Japan into stagnation or is there a productive way to reignite growth?

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Floating Interest, Not What You Think

A theme of the past several years has been the need to protect yourself from the bond market selloff, a selloff that seems to have arrived. The idea that you should protect against this has led to the suggestion that you should buy floating rate funds. This sounds like a great idea. Maybe yes, maybe no.

There are two very different kinds of floating rate funds. The first kind, exemplified by ETFs like FLOT and FLRN, hold investment grade floating rate bonds issued mostly by banks. Modest issuance by other sectors makes up the balance. Loan funds are also floating rate, but that’s where the similarity ends.

The investment grade funds will provide you with yields tied to short term rates like LIBOR. FLRN’s yield fully reflects the Fed’s tightening cycle. Each point on the chart shows the yield you would have earned over the prior 12 months. Looking forward, the fund is paying 2.6%, versus the current funds rate of 2.2% or 1.94% more than it was paying before the Fed started raising rates.


Loan funds pay a juicier yield that is tied to LIBOR, just as in investment grade floating rate funds. That’s where the similarity ends. The yield of the SRLN ETF, where SRLN stands for senior loans, did not follow the Fed as rates rose. It’s up just 0.15%, from 4.29% to 4.44%.


Loan yields have barely budged as the Fed has tightened

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Markets Fluctuate

“Markets fluctuate.” That was the entire comment by Ace Greenberg, the CEO of Bear Stearns, in a special issue of Institutional Investor magazine dedicated to opinions from the great and the good regarding the causes and consequences of October 1987’s 508 point/-23% market crash. Others said more. Much more. None of it is memorable. I suspect that (almost) all of it was wrong. We don’t know in the moment what is causing markets to move, despite what they say on CNBC.  Nor can we foresee the ramifications of large and volatile market movements. Sometimes, as in 2008, they are profound. Other times, like in 1987, they are speed bumps, nothing more. Ace understood that.

We don’t yet know if we are experiencing fundamental changes in the markets or the economy. We do know that markets are likely to stay volatile for a time. Volatility has a tendency to stay high once it spikes.


Volatility remains elevated for a while before it mean reverts

Given that our understanding of volatile market events is limited in real-time, I have found that making sudden changes in investments or asset allocations is not helpful. What has worked best for me through episodes like this, over many cycles, has been to assess the landscape and, if I can discern a change in the market environment, to look for opportunities.

The other thing that I have seen work well is rebalancing back to a target portfolio. If a downturn becomes deep, you want to be exposed to equities for the rebound. It’s an easy thing to say and a difficult thing to do. Historically, it has been the correct move.

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Incentives Matter

We’ve had a Toyota RAV4 for over eight years now. It’s been great because it’s reliable and can hold a ton of stuff with the seats down. However, every once in a while we receive a recall notice from Toyota, because while it’s great, it’s not perfect.

The last time we received such a notice it was related to the rear seatbelts being improperly anchored. I went to the dealer service facility and almost as soon as I arrived, a couple of mechanics started slapping devices resembling Denver boots on each of the four wheels. An Indy 500 pit crew couldn’t have done it much faster.

I asked: “What are those for?” They said: “Oh, we’re checking to see whether your wheels are properly aligned.” I suppressed my inclination to point out that I was a) there for a recall relating to my rear seatbelts, b) was not interested in having them do an alignment, since it was sure to be overpriced. Luckily, the wheels were aligned properly so I didn’t have to deal with it. Continue reading

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Home Is For Your Heart, Not Your Portfolio

A number of years ago I took over a portfolio that held corporate bonds from both developed and emerging markets. As I looked through the holdings a name popped out at me, Ipiranga. I turned to my credit analyst and said something like: “Hey Mike, what the hell is Ipiranga? I never heard of it.”

I had been investing globally for ten years, but my focus was on sovereign bonds or sovereign linked bonds up until then. I bought the bonds of utilities, banks or telecoms that would be supported by the government if trouble came calling. Ipiranga wasn’t that kind of company. Continue reading

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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.

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


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.

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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.


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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