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August 19, 2010 Economic Commentary
MARKET MUSINGS & DATA DECIPHERING
Breakfast with Dave
WHILE YOU WERE SLEEPING Asian equities were higher today but the action in Europe is broadly mixed. The Nikkei bounced 1.3% to 9,362 and JGBs sold off on mounting speculation that the Bank of Japan is going to reverse the yen’s strength and thereby stimulate export growth. It seems these days that nobody wants a strong currency, hence the sustained uptrend in gold — the yellow metal is riding a five-day winning streak. Government bond markets are selling off in this morning. The news is all good with the Bundesbank raising its 2010 growth forecast for Germany, to 3% from 1.9%, but frankly, this was just a ‘mark-to-market’ exercise after those blowout Q2 GDP numbers last week. Corporate bond risks are fading in Europe as per the improvement in the CDS market and we are seeing 3-month euro LIBOR/OIS spreads come in sharply today — helping today was the EU stating that Greece’s efforts to rein in its budget deficit are surpassing expectations, as a result, the country is on track to receive more EU financing. The U.K. also printed some solid industrial data, as per the CBI survey for August — across-the-board improvement in exports, output, orders and pricing. And, oil and copper are both firming alongside the better tone to the European data as well as the positive tone to the Chinese stock market, which is a decent leading indicator for the commodity group. What doesn’t square with all this pro-risk trading is the strength in the USD at the current moment — usually risk trades are being pulled off the table and the U.S. dollar is bid so far today. Another piece of news that does not totally fit the bullish bill is the move in the 30year German bund yield to below the 3% mark (2.96%). Deflation odds would still seem to be nontrivial based on that move alone. As for the major U.S. averages, yesterday’s tenuous up-move took them to their 50-day moving averages but resistance may be setting in and the missing link in many of these positive-actionsessions is still the lack of volume. In other words, conviction levels are low regarding the sustainability of any rally. If there is good news out there it is that the hard work from Mr. Bond (see more below) has taken key borrowing costs for households down to levels that have touched off a decent increase in mortgage refinancings — up 17% last week and at their highest levels since the ‘green shoot’ days of May 2009 — every penny in consumer pocketbooks counts in these frugal times. Morgan Stanley estimates that there is potential for $46 billion of cash-flow for the U.S. consumer that would be the equivalent of a 0.5% pay increase; modest perhaps but better than a kick in the pants. IN THIS ISSUE • While you were sleeping: Asian equities were broadly higher today but the action in Europe is broadly mixed; government bond markets are selling off this morning • The bond bubble debate revisited: “One Rosie” takes on “Two Jeremies” • Frugality gaining more acceptance • Investor sentiment swings • The polls don’t lie: the latest polls showed that only 41% of the public approve of President Obama’s handling of the economy, down from 44% in April • Bond yields must go down more • Credit strains linger: bankwide loan delinquency rates actually rose in Q2, to a new high of 7.32% from 7.26% in Q1 and 6.44% a year ago
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August 19, 2010 – BREAKFAST WITH DAVE
And while deflation is still not part of anyone’s base-case scenario — save for us, Gary Shilling, Doug Behnfield, Robert Spector, Albert Edwards, Lacy Hunt and Van Hoisington (we need one more for two tables of bridge) — the risks are rising nonetheless. For a real-world example, look no further than page B8 of today’s NYT, Pizza Hut Cuts Prices again to Counteract the Slow Recovery. A large pizza is now going to sell for ten bucks and we have pundits out there talking about hyperinflation — stop eating at the French Laundry! Also, have a look at what P&G is up to on the front page of today’s WSJ as it moves to recapture share of the global market for consumer goods — “Consumers might be willing to shell out for iPads, but their day-to-day spending reflects an entrenched frugality that often means leaving P&G’s relatively inexpensive products on the shelf. Nearly two-thirds of U.S. consumers said they switched to a cheaper substitute for at least one basic household product, food or beverage, in the past year …” This probably includes saki and sashimi because this was definitely the pattern that emerged in post-bubble Japan (oh, but we’re different … right). Meanwhile, if you are looking for where the next proverbial shoe is going to drop, look no further than public sector pension funds and how their actuarial liabilities estimated between $1 and $3 trillion are going to have to be addressed — and it is not going to be through a federal bailout and the PBGC only covers private plans. Big reforms and shared sacrifice are coming soon — have a look at the op-ed article on this topic on page A17 of the WSJ. THE BOND BUBBLE DEBATE REVISITED: “ONE ROSIE” TAKES ON “TWO JEREMIES” I was desperately trying to resist the temptation to retort to yesterday’s op-ed piece on page B13 of the WSJ (The Great American Bond Bubble by Jeremy Siegel and Jeremy Schwartz). But alas, I have succumbed, for the following reasons: 1. I was inundated with emails from our readership to respond. I finally said, “enough is enough.” 2. Since I already took on the “Two Jimmies” (Grant and Caron) in the spring on their 5½% forecasts on the 10-year Treasury note yield, I thought, in the name of acting in a consistent manner, that it would only be fair to refute the arguments made by the “Two Jeremies.” 3. Almost three months ago, I submitted an op-ed piece to the WSJ for its consideration titled “Bond Bubble” but my request was turned down. Not that this is a case of sour grapes because the FT went ahead and published it. But, the fact that the WSJ turned my piece down while printing the diatribe by Messrs. Siegel and Schwartz goes to show that for whatever reason, there seems to be this bias on Wall Street against the bond market (the “enemy”).
If you are looking for where the next proverbial shoe is going to drop, look no further than public sector pension funds
I was desperately trying to resist the temptation to retort to yesterday’s op-ed piece on page B13 of the WSJ (The Great American Bond Bubble) … alas, I have succumbed
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4. Finally, after such a tortuous read, I simply felt that the assertions made in yesterday’s WSJ op-ed piece could not go unchallenged. Everybody is entitled to their opinion but if I had to make the case that bonds were a poor investment — and someday I will, believe me — I surely would not lean on the spurious reasoning provided in yesterday’s column. The case against the bond market that was made was pretty weak, which goes to show that just because you have the pedigree of being a professor from Wharton doesn’t necessarily mean your call on the Treasury market will prove to be any more prescient than your call on “Stocks for the Long Run.” Here’s why. The “Two Jeremies” stated that “from January 2008 through June 2010, outflows from equity funds totalled $233 billion while bond funds have seen a massive $559 billion of inflows.” They describe this as a “rush into bonds.” The question is: so what? If anything, this shows that the retail client has developed some real financial acumen considering that Treasury bonds have generated a total return of 13% over that timeframe versus -21% for equities. In fact, both the absolute and risk adjusted return on Treasury bonds have been spectacularly superior to equities for the last 10 years. To be sure, past trends cannot be relied on for future performance, but what is not mentioned in the WSJ piece is that households may be deliberately rebalancing their asset allocation because 27% is represented by equities, another 27% in real estate, but a mere 6% is in fixed-income securities. So maybe Ma and Pa Kettle are moving to correct this mismatch on their balance sheet and adjusting it to capture more income, limit their risks and preserve their capital. We do know with certainty that the median age of the baby boom cohort is approaching 55. As strategists we have to come to the understanding that a powerful demographic trend is gathering momentum, which is generating this insatiable appetite for yield — an era of correcting the underweight in bonds in the aging (but not aged) boomer asset mix while correcting the lingering overweight in equities. This may prove to be a secular shift and it just makes sense to come to grips with what is likely to be a continued divergence in bond and stock performance in the future. The “Two Jeremies” compare this apparent “bond bubble” to the “technology mania” a decade ago. Some bizarre comparisons, using an estimate of a P/E multiple on the Treasury market of 100x, were cited but were far too opaque for me to fathom. At the same time, it is a legitimate question as to how to quantify whether bonds are overvalued or undervalued at any given point in time. What is more important to identify, at least in my opinion, is what the critical forces are that drive yields up or down. It’s nice to compare what we are seeing in bonds today to what the dotcoms did a decade ago but it’s hardly relevant because the variables that influence speculative stocks are completely different than those that affect the direction of long-term interest rates. Alan Greenspan thought that growth stocks were “irrationally exuberant” six years before the bull market ended.
The move to fixed-income assets may indicate that Ma and Pa Kettle are adjusting their balance sheet to capture more income, limit their risks and preserve their capital
The “Two Jeremies” compare this apparent “bond bubble” to the “technology mania” a decade ago
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What finally did end it was not any particular valuation metric but perhaps Cisco missing by a penny on the other side of consensus expectations, leading to a dramatic reassessment of the earnings landscape. If there is one thing we do know, equity prices will track earnings-revision-ratios very closely. Then of course, we had a capital spending-induced recession that practically nobody saw coming in 2001, and we’ve never had a recession without cyclically-sensitive equities enduring a severe bear market. So let’s fade valuation comparisons between bonds and growth stocks. It’s such a silly argument. Nortel did go bankrupt, as did a slate of tech stocks. Your capital wasn’t preserved — it was extinguished. Nortel was the darling of the day, at one point representing more than 30% of the Canadian stock market capitalization. Equities, by their nature, are riskier than Treasury bonds — some more than others. Obviously, the Bill Millers, Warren Buffetts and Ira Gluskins of this world have in their professional lives managed to find some real gems that generated significant returns for their unit holders. But at no time was your capital guaranteed. So how can anyone compare that to a government obligation with an ironclad guarantee of interest and principal payments? Do we use a tech stock as the risk-free benchmark for funding actuarial liabilities? Or is it the long Treasury Strip? Does a tech stock, or any piece of equity paper, tell you with full certainty what you are going to be paid upon maturity? Or is that the long Treasury Strip? Why even bother comparing these two investment vehicles, they serve completely different purposes and are purchased by two very different mandates. Furthermore, I feel strongly that this notion that the U.S. government, with all its taxing power and vast holdings of the national assets and treasures (dare we say, including what lies beneath Fort Knox) is going to default someday is completely ludicrous. All we seem to talk about is the gross debt burden. This is not to downplay the fiscal situation, which is dire, but becoming hysterical could lead to poor judgment and decision-making. Canada faced similar structural deficits in the early 1990s, had its credit rating downgraded several times, and there were hues and cries back then as well over Canada’s ability to service its debts. However, years of shared sacrifice cured those ills and there were no defaults, late payments, haircuts or even a move to inflate the liabilities away. So give me a giant break on U.S. sovereign credit risks. Talk of default is complete and utter nonsense — and frankly, it’s obnoxious. More likely, America is going to go on a multi-year path towards fiscal probity, which will involve more taxation, sharply lower spending on nonessential services, and shared sacrifice, as was the case in the 30s and north of the border in the 90s. So let’s go back to first principles. It matters little what level Treasury yields are sitting at. You could be sitting there with a 10% coupon but if yields, for whatever reason, were to jump to 20% and stay there, you would likely suffer a huge loss if you had to sell before maturity. So the fact that yields are at 10% or 3% matters little in this debate.
But really, let’s fade valuation comparisons between bonds and growth stocks. It’s such a silly argument
I feel strongly that this notion that the U.S. government, with all its taxing power and vast holdings of the national assets and treasures is going to default someday is completely ludicrous
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To reiterate, it was the macro economic landscape, not the valuation backdrop, that proved to be the undoing for tech stocks in the opening months of 2000. It is far more relevant and useful to discuss what the triggers would possibly be to drive yields higher and on a sustained basis. I did the research on this long ago. Budget deficits (and surpluses) have a 40% correlation to bond yields. Just as a deficit of $1.5 trillion did not prevent bonds from staging an impressive rally this year, surpluses in 1999 did not stop the Treasury market from enduring its second worst year in recorded history, in total return terms. You see, in 1999, we had the Fed tightening policy and inflation pressures percolating. In 2010, we had the Fed reiterating its commitment to keep policy rates to the floor. At the end of last year, the consensus was convinced the Fed would be hiking rates by now ... the fact that the central bank hasn’t done that, let alone start to shrink its pregnant balance sheet, has to be one of the biggest surprises so far this year. We are rapidly running out of disinflation and we are staring deflation in the face — the year-on-year trend in the core CPI (which excludes food and energy) is just 88 basis points away from breaking below the zero-line. Our research show that Fed policy has a near 90% correlation with the direction of bond yields — you just don’t go into a sustainable bear markets when the Fed is not taking the “carry” away. Moreover, inflation as measured by the year-over-year change in the CPI, for all its blemishes and imperfections, commands a near 80% correlation with the Treasury market. Yet in this whole discussion of the bond market, nowhere do the “Two Jeremies” talk about their forecasts on the Fed and on inflation. These are the two most vital components of interest rate determination and they are not even discussed in this “bond bubble” piece. Look, instead of debating bubbles maybe it is more appropriate to identify where bond yields could go before they ultimately bottom. This would seem to be more relevant for investors than lamenting how low they already are — as if that would have helped anybody figure the JGB market out over the past decade (and with a Japanese government debt-to-GDP ratio of 200%!). Well, the Fed just told us that it has no intention of hiking rates for a long, long time. So, Fed tightening risks are off the table and at a time when the policy rate is almost zero. And we have a long bond yield of 3.6%. That is a 360 basis point curve from overnight to 30 years, and historically, that spread averages out to be 200bps. As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached. If we are right on -1% to -2% deflation in coming years as the post-bubble excesses continue to unwind, nominal yield will actually be quite juicy in “real” terms.
We are rapidly running out of disinflation and we are staring deflation in the face
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Interestingly, when Ben Bernanke gave his “What If” speech in November 2002, he mentioned that in a 0% funds rate world where deflation risks intensify, he would begin to target long-term rates — and cited how in the decade to 1951, the Fed established an explicit ceiling on the long bond yield at 2.5%. The “Two Jeremies” go on to then bash “the purveyors of pessimism” and in a manner we can only describe as convoluted. Admittedly, I couldn’t comprehend their thought process. They are of the view that no matter what, “U.S. economic growth is likely to accelerate.” No mention is made of the fact that the miniinventory cycle has run its course and that we are past the peak of the monetary, fiscal and bailout stimulus. The economy slowed to stall-speed in the second quarter and is on the precipice of contracting in the current quarter. What do the “Two Jeremies” see that the Fed didn’t see when it cut its macro forecast last week for the second time in the past six weeks? What is the exogenous positive shock to the economy that turns the tide back to one of positive momentum? At least in 2003 the Fed could cut rates and Bush could dramatically cut taxes. On top of that, we had the proliferation of subprime mortgages, interest-only mortgages, no-doc loans, low-doc loans, liar loans as well as the feel-good effect of a 20% annual home price appreciation. The securitized loan market that blazed the trail for that wonderful leveraged “ownership society” bull market and economic expansion from 2003 to 2007 is 60% the size today of what it was three short years ago. Do the “Two Jeremies” realize that a huge chunk of the credit market that financed the false prosperity of the last great bull run in risk assets and the economy is no longer around? Nowhere in the article is there a convincing case for above-trend growth, which will be needed at some point to chip away at the widespread excess capacity and touch off the inflation and Fed tightening cycle that would truly make the bearish case for bonds a compelling one. There was emphasis in the article on dividend yield and dividend growth and indeed, this is part of our own Safety and Income at a Reasonable Price strategy (S.I.R.P.). This is an era of income orientation, and to be sure there are many areas of the market in which an income stream can be derived — REITs, trusts, corporates, muni’s, oil and gas royalties, preferreds, and reliable dividend growth. Agreed. But the “Two Jeremies” use this as an argument against the Treasury market. We don’t get it. Okay, there’s an average 4% dividend yield in the blue-chip stocks they cited. That's fine. But why not complement the bonds in your portfolio with these income-oriented equity investments? Why do the “Two Jeremies” make it sound like it’s one or the other? Why can’t they co-exist within the S.I.R.P. thematic? The fact that AT&T has a decent dividend yield is the reason there’s a perceived bond bubble? How does that make any sense?
As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached
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As an aside, there was no mention of where the bonds trade for these bluechip companies — we only read in the article about the dividend yield and the earnings yield. Nothing on their bonds, which are probably also alluring with the added bonus that you line up in a better part of their capital structure. Keep in mind that no matter how “safe” an equity investment is, it is all relative — your capital is not guaranteed. No equity is totally safe. Even in the corporate bond space — mortgages too — investors face call risk and that can certainly be a nuisance. In a period when interest rates are falling and corporate and household debtors move into refinancing/prepayment mode even non-Treasury debt has its risks. Nowhere in the WSJ op-ed piece is there a word mentioned about the unique non-callable nature of government bonds, and that investors may well be putting an increasing “price premium” on Treasuries in light of this feature that is practically non-existent in other segments of the fixed-income universe. This really appears to be a case of one’s assumptions driving one’s conclusions (or maybe in this particular case, the conclusions drove the assumptions). The “Two Jeremies” cite stellar productivity growth (“almost twice the long-term average”) as a reason for their bullish view on the economic landscape. But there is no mention of what role this productivity is playing in keeping the unemployment rate so elevated and as a result dampening wage pressures. Why? Moreover, there was no mention as to the huge role this productivity has played in depressing unit labour costs, which, in fact, is deflating at a record pace. These guys are bullish on productivity and yet bearish on bonds, even though the productivity they cherish is one big reason why inflation is melting and bond yields are rallying to the levels they are at today! Think about the logic in that. The comment that households are “pouring money into bond funds” also ignores the fact that much of this inflow was not directed into Treasury bonds (see Investors Buy Consumer Debt on page C14 of yesterday’s WSJ — not everything the retail client did this cycle necessarily dovetailed with our S.I.R.P. theme). In fact, over the past two years, less than $60 billion or only 12% of the net inflows to bond mutual funds were devoted to Treasuries — these “retail investors” ploughed in nearly twice as much into corporates. This fact was not mentioned in that op-ed piece. Moreover, the implicit assumption here is that “retail investors” (the general investing public) don’t know what they are doing — they always do the wrong thing at the wrong time. It is a comforting refrain, but keep in mind that retail investors were actually shedding their equity exposure at a faster rate than institutional investors were raising cash levels going into the financial crisis. You just can’t look at the “flows” without also looking at the “stock” and as we stressed above, what we are likely witnessing is a deliberate asset mix shift. Then there is the one-sided comment that if the 10-year note yield were to rise back to 3.15% in the next year, total returns would be nil. Fair enough, “if” that were to happen.
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Now interest rates will of course fluctuate, but if the intermittent spasms occur alongside a primary trendline that is down (in yields) then there should hardly be concern about these periodic setbacks. If we are correct that we are still in the throes of a secular bull market in bonds, even if in the mature stage, then moves to 3% or above, should they occur, will prove to be great buying opportunities, not unlike the repeated tests of 4% that saw over the past year (and as early last April). If the conditions for a continuation of the bull market in bonds is intact, then think of what the potential returns would be if the long bond yield were to grind down towards 2.0% or 2.5%. The “Two Jeremies” failed to mention that such a move would generate total returns of around 30% for long coupon bonds and 65% on the long strip! Ah, the power of convexity at low levels of interest rates — every basis point move magnifies the total return. The same bearish arguments about the bond market being “overvalued” could have been made at the start of the year, and to be sure, they were made in various circles, which is why the broad consensus was for equities to outperform Treasuries again this year. Meanwhile, even in the face of low yields, the price appreciation has been so powerful that the long-dated Treasury Strip (30-year) has generated a net positive return of nearly 30% so far this year versus -2% for the S&P 500. It may be a mistake to argue with success. In sum, there is no bond bubble. The latest Commitment of Traders (CoT) report show there to still be a small net short position among non-commercial accounts, as far as the long bond is concerned, and basically flat for the 10-year T-note. The long-standing net short position has been closed but one can hardly look at this data and conclude that there is rampant bullishness among speculators. So, while there may be a technically overbought technical condition and while bullish sentiment readings are very high, indeed according to some recent surveys, we are still a long way from capitulation (epiphany?) by Wall Street economists and strategists. One critical element missing is the speculative fervour, which hit the dotcoms in 2000 and real estate by 2006. Be assured that you know the lows in yield have been turned in when the CoT report shows there to be massive amounts of “net speculative longs.” Fundamentally, what we have on our hands is a powerful demographic appetite for yield at a time when income is under-represented on boomer balance sheets. At the same time, while fiscal deficits are very high, they are unlikely to expand any further given the recent political backlash against more expansion of the government debt-to-GDP ratio. All the while, the two most significant determinants of the trend in long-term bond yields — Fed policy and inflation — continue to flash “green”, and at a time when the yield curve is still historically steep and destined to flatten. With the process led by ever-lower long-term rates since the central bank has already assured us that short-term rates will remain at rock-bottom levels for as long as the eye can see.
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FRUGALITY GAINING MORE ACCEPTANCE Page B1 of yesterday’s WSJ ran with Retailers Are Sold on Frugality —and the opening line went like this: “American retailers are becoming as frugal as their shoppers, cutting expenses to maintain stable profits through what is increasingly looking like another challenging holiday season.” I can’t help but smirk a little bit because it was two years ago that I invoked this as part of my deflation theme and hopefully some will recall my old chart package dubbed “The Frugal Future”. To be honest, when I marketed that view in my last 18 months at Merrill Lynch, people thought I had really lost my marbles. Back then, it was universally believed that one should never ever count out the never-say-die, shop-till-you-drop American consumer. Indeed, old habits die hard but at some stage, denial will turn to acceptance. Who in the economics community was calling for a 6½% personal savings rate by now? And it’s not over. While Wal-Mart managed to beat its EPS targets, its U.S. same-store sales numbers have been negative on a YoY basis for five quarters in a row. Retailers are only managing to scrape by via reductions in employee hours, maintaining very tight inventory controls, gaining concessions from suppliers — in other words, aggressive cost-cutting. Here is what Wal-Mart CEO Mike Duke had to say about the consumer spending environment: “The slow economic recovery will continue to affect our customers, and we expect they will remain cautious about spending.” Home Depot CEO Carol Tome had this to say — the firm just sliced its full-year sales growth forecast to 2.6% from 3.5% (even as it raised its EPS guidance). “How in the heck can you increase earnings with tighter revenues? The answer is that we expect some expense relief.’ And the CEO for Urban Outfitters, Glen Senk, said this: “I am not bullish about the second half. We're facing a slow and lengthy recovery that will be punctuated by periods of uncertainty.” Target’s CEO Gregg Steinhafel added this: “It’s clear that the second quarter marked a change in recent trend. Following stronger results in the last two quarters, gross domestic product growth softened considerably and our sales trends leveled off as well.”
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Target managed to post a 14% YoY profit gain but this largely reflected the benefits of luring its debit/credit-card holders into its stores with 5% discounts (no deflation, eh?) as well as a general improvement in delinquency rates (debtors today only stop paying their mortgages — the credit card has ostensibly become a consumer staple). In any event, Q3 sales expectations right now is a mere 1%. On Monday, Lowe’s also managed to raise its 2010 profit forecast but at the same time lowering its annual revenue projections. Abercrombie & Fitch is another case in point — sales are up even with average prices for its merchandise down 15%. Call it deflationary growth. However, for some retailers it is just deflationary — even for discounters like TJX, which is forecasting second-half sales to be flat to down. And, companies like Wal-Mart are reporting that they are detecting the return of the paycheck cycle. In fact, the NYT reported (page B3 of yesterday’s paper) that “steeper priceslashing did not lure customers into spending more at Wal-Mart, while shoppers at Home Depot spent less and put off big home improvement projects of bigticket items like appliances.” That last comment had a certain Japanese feel to it and is a reason why Ben Bernanke is so concerned about deflation — the distorting impact it can have on economic behaviour. In inflationary times, like the 1970s and early 1980s, when everyone begins to expect more inflation, households and businesses tend to buy more now and stockpile to get ahead of the next round of price increases. But the very action to buy more now boosts demand and fuels the very inflationary pressure that “economic agents” are attempting to bypass. So inflation becomes deeply embedded in expectations and leads to tremendous distortions and resource misallocation. The same is true but in reverse in deflationary times — as we are seeing take place at Wal-Mart. In this condition, people put off their spending plans in the hope of getting a better bargain down the road. This reduces demand, leaves unwanted inventory on the shelves in the retail sector, and this in turn reinforces the downtrend in pricing. Finally, part and parcel of our frugality theme two-years ago was the need — the desire, in fact — to get small: smaller homes, smaller cars, smaller credit lines, smaller workforces, smaller budgets for discretionary goods and services. This is why the article on how commercial tenants are finding ways to economize on “space” in yesterday’s WSJ was so fascinating (Office-Leasing Rebound Could Be Deceiving on page C6). Just another example of the ‘new normal’.
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SENTIMENT SWINGS Equity and market sentiment is swinging wildly week to week, but in the most recent Investors Intelligence Poll, there is at least a sparkle of capitulation (though we likely need to see a lot more). The bulls lost ground, to 36.7% from 41.7% last week, and the bear camp expanded, to 31.1% from 27.5%. We suppose it says something that the landscape is still populated with more bulls than bears, but it is only fair to point out that the bull/bear spread shrank a considerable 8.6 points this week. We have also been hearing that bullish sentiment towards Treasuries is now 98%, according to some surveys, approaching the incredible 99% on December 16, 2008, right as yields were plunging to their trough (the 10-year note approaching 2%). It was at that time that I wrote a report (while still at Merrill) titled “Saying Goodbye to an Old Friend” in which I had suggested that Treasuries were overbought and that there were better opportunities in the fixed-income market (in mortgages, corporates and even muni’s). I never turned outright bearish on Tnotes and bonds but thought we could be in for a correction, which we endured for about a year and almost 200 basis points on the 10-year. The rally in late 2008 also took place right after the Fed made an announcement to buy bonds, and to some extent we have seen a déjà vu in the past week. Although, back then the bond market did a lot of the rally off the April high in yields all on its own — without any help from Ben Bernanke or China for that matter. But there are some differences. The bounce in yields off the December lows occurred as depression talk was rampant, not to mention the implosion of the banking system. All it took was for the government to safeguard the financials and come up with a massive fiscal stimulus program to prompt a major short-covering rebound in the stock market and a shift out of the safe haven provided by the Treasury market. Back then, all we had to do was take GDP growth from negative terrain to flat and “green shoots” would sprout across the economic garden. So, we had the stimulus to look forward to, we had the peak in growth still ahead of us, and a new activist government that had everyone excited over a new path, both politically and economically. We had the shorts running for cover. So, it may well be the case that bond market sentiment has swung to extreme levels. At the Grant’s Conference in April, Jim labelled the event we closed down together on stage as “Bonds are for losers.” Even in June, the Barron’s poll showed the vast majority of forecasters calling for higher yield activity. Now every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old shop who are now broadly filled with perma-bulls (now are calling for a 2.5% yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel.
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So yes, we could well see a near-term reversal in this impressive bond rally. But no, it won’t be nearly as severe as it was in 2009 and there is still a very strong likelihood that yields out the Treasury curve do what the front end has already done and move down to new lows. The peak in growth is behind us, not ahead of us anymore. There is nothing to be excited about politically, unless you think the GoP winning the House and the Senate in November by default and with no articulated vision of its own is a reason to be bullish. When leadership is wanting, sorry, gridlock is not good. Not at all. And, there are no more fiscal rabbits to be pulled out of the hat — the majority of Americans are saying enough is enough on this experiment in testing the outer limits of our deficit financing capabilities as government debt relative to GDP approaches a game-changing 100% ratio. Remember, back in early 2009, all it took was a move to zero percent growth — just stop the economy from falling off a cliff! — to prompt a multi-month bond selloff and an equity rally. That says something about “expectations” back then. Fast forward to today, and imagine if yet again we move to zero percent growth — we doubt we will get the same investor reaction this time around, especially with the market primed for over 20% earnings growth over the course of the next 4-6 quarters. THE POLLS DON'T LIE There are 11 weeks to go before the November 2nd mid-election in the U.S. and based on the just-released Associate Press poll, one would never have thought that 1) the Fed had cut the funds rate to zero, 2) tripled the size of the balance sheet all in the name of regenerating a credit cycle, 3) the federal government would have initiated at least eight different housing programs to underpin the real estate sector, and 4) would have embarked on a historic fiscal stimulus plan. The latest poll showed that only 41% of the general public approve of President Obama’s handling of the economy, down from 44% in April. Fully 56% disapprove. And get this, 61% think the economy has worsened since he took office. How is that possible? In June, 72% believed the economy was “poor or very poor” and just two months later than share has risen to 81%. In June, 19% said the economy was “improving”; that number is now down to 12%. BOND YIELDS MUST GO DOWN MORE We don’t understand it. The equity bulls hate the Treasury market and seem as though they are fanatic in their calls for higher rates. Yet if you are bullish in equities, wouldn’t it make more sense to want the cost of credit to go down to stimulate economic growth (and last we say, the earnings that equity investors pay for are part of the economy)? The bond market is now the only game in town — with policy rates at 0% and tapped out on the fiscal front. It’s all up to the bond market — long-term interest rates — and at least Ben Bernanke understands this even if most portfolio managers and market commentators do not.
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The bond market has worked hard — without the rally in Treasuries, mortgage rates would not have tumbled 60 basis points in the past year. The problem in a credit contraction is that it is difficult to revive demand unless interest rates decline to microscopic levels. But, as we saw in Japan, even then there is no certainty that spending will turn around. What we know is that mortgage applications for new home purchases — these are not approvals but rather a true proxy for home purchases, slid 3.4% last week even in the face of the huge bond rally and they are now down 38% from depressed year-ago levels. Again, this is a sign, to us at least, that the bond market is going to have to work that much harder. This in turn means that longterm rates will head even lower, and not until they do the job in generating sustainable growth will this bull phase in the Treasury market fully run its course. CREDIT STRAINS LINGER Here we were led to believe by all the analysts that we had somehow moved to a new and better inflection point as it pertained to U.S. credit quality, but that doesn’t seem to be the case. At least not if the reported Q2 data out of the Fed is accurate. Bank-wide loan delinquency rates actually rose to a new high of 7.32% in Q2 from 7.26% in Q1 and 6.44% a year ago. While there were improvements in credit cards and C&I loans, there was significant deterioration in the real estate sector — the delinquency rate for residential mortgages climbed to 10.05% from 9.74% in Q1 and 8.21% a year ago; and commercial real estate loan delinquency rates edged up to 8.79% from 8.65% in Q1 and 7.85% in 2009 Q2. Yesterday’s NYT ran with a nifty little article that came up with solutions for the future in terms of reining in credit bubbles before they start (see Rein in Borrowers to Fix Mortgages). For example, repealing the ‘sacred cow’ that allows mortgage interest deductibility (this “goodie” costs Uncle Sam about $100 billion every year); giving banks full recourse (as we have in Canada); more aggressive down-payment requirements; limits on mortgage refinancing; and more stringent underwriting criteria.
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Gluskin Sheﬀ at a Glance
Gluskin Sheﬀ + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted investment returns together with the highest level of personalized client service.
As of June 30, 2010, the Firm managed 1 assets of $5.5 billion.
INVESTMENT STRATEGY & TEAM
We have strong and stable portfolio management, research and client service teams. Aside from recent additions, our Gluskin Sheff became a publicly traded Portfolio Managers have been with the corporation on the Toronto Stock Firm for a minimum of ten years and we Exchange (symbol: GS) in May 2006 and have attracted “best in class” talent at all remains 54% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and We have a strong history of insightful governance with a private company bottom-up security selection based on commitment to innovation and service. fundamental analysis. Our investment interests are directly aligned with those of our clients, as For long equities, we look for companies Gluskin Sheff’s management and with a history of long-term growth and employees are collectively the largest stability, a proven track record, client of the Firm’s investment portfolios. shareholder-minded management and a share price below our estimate of intrinsic We offer a diverse platform of investment value. We look for the opposite in strategies (Canadian and U.S. equities, equities that we sell short. Alternative and Fixed Income) and investment styles (Value, Growth and For corporate bonds, we look for issuers 2 Income). with a margin of safety for the payment of interest and principal, and yields which The minimum investment required to are attractive relative to the assessed establish a client relationship with the credit risks involved. Firm is $3 million for Canadian investors and $5 million for U.S. & International We assemble concentrated portfolios — investors. our top ten holdings typically represent between 25% to 45% of a portfolio. In this PERFORMANCE way, clients benefit from the ideas in $1 million invested in our Canadian Value which we have the highest conviction. Portfolio in 1991 (its inception date) 2 Our success has often been linked to our would have grown to $11.7 million on long history of investing in under-followed March 31, 2010 versus $5.7 million for the and under-appreciated small and mid cap S&P/TSX Total Return Index over the companies both in Canada and the U.S. same period. $1 million usd invested in our U.S. Equity Portfolio in 1986 (its inception date) would have grown to $8.7 million 3 usd on March 31, 2010 versus $6.9 million usd for the S&P 500 Total Return Index over the same period.
Our investment interests are directly aligned with those of our clients, as Gluskin Sheﬀ’s management and employees are collectively the largest client of the Firm’s investment portfolios.
$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) would have grown to $11.7 million2 on March 31, 2010 versus $5.7 million for the S&P/TSX Total Return Index over the same period.
In terms of asset mix and portfolio construction, we offer a unique marriage between our bottom-up security-specific fundamental analysis and our top-down macroeconomic view.
For further information, please contact questions@gluskinsheﬀ.com
Unless otherwise noted, all values are in Canadian dollars. 1. Preliminary unaudited estimate. 2. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation. 3. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses.
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