Bill Gross: Investment Commentary (Jan. 2009)

Wednesday, January 14th, 2009

In his January issue of Investment Outlook, Bill Gross, PIMCO’s CIO, wonders, after all that has been said and done:

“Was it necessary and productive to mutate 21^st century American-style capitalism into a thinly disguised knock-off of the New Deal?“

Better, some thought, to have followed the advice of early 1930s Treasury Secretary Andrew Mellon: “Liquidate labor, liquidate stocks, liquidate the farmers – purge the rottenness from the system.” The Mellons of the world argued that bailouts were akin to pouring gasoline on a fire, adding trillions of dollars of new debt to a domestic and global economy that had broken down because of, because of, well, because of – too much debt.

Wall Street, the Fed, and Newport Beach took the other side. Those steeped in economic history felt that the Great Depression and more recently the “lost decade” in Japan had both experienced a “liquidity trap,” a monetary black hole where lenders, savers, and ultimately consumers were frightened into stuffing their money into a mattress rather than circulating it in classic capitalistic fashion. Sensing a freezing of credit markets following the default of Lehman Brothers, policymakers decided it was better to become a bailout nation than a sunken ship.

The debate, of course, can never be resolved. You can’t prove a negative nor recreate history to show what might have been.

What of Bernie Madoff?

Bernie Madoff? As with every financial and economic crisis, he will probably go down as this generation’s fall guy – the Samuel Insull, the Jeffrey Skilling, of 2008.

But Madoff’s scheme has a host of culpable look-alikes and one has only to begin with the mortgage market to understand the similarities. Option ARMs or Pick-A-Pay home loans allowed homeowners to make monthly payments that were so small they did not even cover their interest charges. Two million mortgagees either chose or were sold this Ponzi/Madoff form of skullduggery, believing that home prices never go down and that shoppers never drop. One can add to this the trillions in home equity/second mortgage loans that extracted “savings” in order to promote current instead of future consumption, and one begins to realize that Bernie Madoff and  our cartoon’s Wimpy had company all these years.

We’ve all been living in one big Ponzi scheme and we didn’t realize that we’ve been deferring the most essential long term ideals in return for instant gratification.

…we have met Mr. Ponzi and he is us – all of us: auto companies that siphoned sales dollars to make labor peace instead of research and design expenditures; hedge funds that preposterously billed investors for 2% and 20% of nothing; a President and politicians who thought they could fight a phony war for free and distract the nation’s attention from $40 trillion of future social security and health care liabilities. Ponzi, Ponzi, Ponzi.

Read the complete newsletter here.

Tags: 21 St Century, Andrew Mellon, Array, Bernie Madoff, Bill Gross Pimco, Credit Markets, Great Depression, Gross Investment, Investment Commentary, Investment Outlook, Jeffrey Skilling, Lehman Brothers, Liquidity Trap, Mortgagees, Newport Beach, Option Arms, Rottenness, Samuel Insull, Skullduggery, Sunken Ship, Treasury Secretary
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Jim O’Neill Discusses World, BRICs

Wednesday, January 14th, 2009

Jim O’Neill, Chief Economist, Goldman Sachs , who invented the “BRICs” asset class is interviewed by FT.com’s David Oakley regarding world markets, BRICs and Emerging Markets. Click on the image to watch Part I (the player will automatically play all three segments:

Click here for the second video on the BRIC economies.

And click here for his view on investment in emerging markets.

Here is a synopsis of the interview, which is worth watching:

Part I: World Markets

• I suspect [2009] its not going to be as bad as 2008.
• The worst quarter for the world economy may very well be the 4^th quarter of 2008.
• In some ways it was extremely bad, with -4-5% GDP growth annualized drop.
• Indicators suggest that there’s been a huge improvement since November.
• In the first 5 days of the year there was a slight gain in the S&P500, and those of us who look at that believe that as goes the first 5 days so goes the year.
• 80% of our clients are very negative about the world economy.
• Markets are markets, and if that is truly representative, then aren’t that many more who can get negative and improvements in anything will be a surprise.
• In think its possible for the US to have a similar outcome as Japan, and because of the Japanese experience, US policymakers have learned from their mistakes, and I don’t think that’s going to the case in America.
• After all the financial shocks that we got last year, especially during September and October, where it was one every two or three days at one point, which were so demanding. I’m assuming we got all the surprise shocks; if there is another surprise shock at this stage, then I would be once again concerned, that would be extremely worrying, it would force me to have a different view.

Part II: Regarding the BRICs (O’Neills favourite subject)

• Manchester United is actually Jim O’Neill’s favourite subject.
• BRICs come close to favourite.
• If you look at last year in the context of where its come from, its pretty obvious that in the midst of a major slump in the developed markets the BRICs would be affected.
• At the beginning of 2008, the BRICs, at least India and China, were trading at 2X the valuation of the US market. There’s no way they could cope with a 20-30% drop in a major markets with that valuation and slowing.
• When we started this thing [BRICs] the idea that these markets would go up every year forever was something we never believed.
• If you actually look at the returns, they’re still showing over 120% total returns since we started 7 years ago, and the S&P 500 is down 25% over the same period.
• Anybody who thinks the BRICs thing is over because of last year is living in a dream world, its just because they may have gotten in late.
• I think Russia is the independent weak link and the Russian story is by and large an oil price story, plus some political view as well.
• I’ve always believed for the last 3 years that we needed to see commodity prices dropping in order to see what would happen to Brazil and Russia who are very dependent on commodities.
• Clearly with the price of oil going down, that was not good for Russia. What you need to see there is a quicker changes about policy, or for oil prices to go up otherwise they’re going to have another tough year.
• One of my favourite ideas across the board, not just for the BRIC, is investing in Chinese domestic demand.
• Look at the fiscal and monetary policy response in China. It’s huge. There is some evidence already of monetary growth is already picking up in China. The freight indices such as the Baltic Dry Index and others have started to turn around again. I suspect that is a sign of Chinese demand already starting to turn for commodities which ultimately is going to be good for places like Russia (and Brazil); at its worst it will take a while; Russia will look like it’s in a recession, but the idea that Russia is finished is risky in itself.
• I’m surprised at the attention the bad Chinese export numbers are getting, given what’s happened to the US economy; obviously Chinese exports are going to be weak given that at one point China was exporting up to 10% of its GDP to the US.
• What you need to do is look at what’s happening going forward with China’s domestic demand policy, and on that score, I am very optimistic.

Pat III: Looking at opportunities in Sub-Saharan Africa

• I don’t think of BRICs as emerging markets, in the traditional sense. I think of them as the lynchpin of the modern globalized economy, because they’re all so big in terms of population.
• I do think it’s a different question to ask about emerging markets beyond the BRICs.
• If what I said about some recovery in some of the world’s major equity markets doesn’t happen then I think that a lot of emerging markets will struggle, but if I’m right and we do see some shoots of recovery in major markets, I would guess even some of the riskier ones will end up surprising people by showing strong returns.
• By and large, EM will be at the riskier end of the spectrum, so when things go down, they tend to suffer the most, and when things go up they tend to do the best.
• Recovery in the emerging markets will depend on the risk appetites of foreign investors.
• If things continue poorly in the US, I think that there are a number of places such as Eastern Europe that could become a really big problem, some parts of Asia and Latin America with large external deficits, would have major problems attracting funding.
• Outside of the BRICs where I spend most of my time, I’m very intrigued about Africa.
  • We have (Jacob) Zuma coming on the scene in South Africa, and that could be a very big issue. Zuma could do a Lula, and surprises people positively, that he’s not some kind of raving lunatic, keeps sensible economic policies and South Africa does better than people think.
  • Obviously Zimbabwe. That’s been a mess. Will that change, and if it does, that will be another source of positive surprise for the continent in general.
  • The last one, which is the biggest in many ways, Nigeria. People started to warm to Nigeria, the past couple of years. It ended up struggling, there seems to be perennial problems about certain areas of geography about Nigeria and the politics. If that carries on then Nigeria might become a source of disappointment. On the flipside of that, if you get the governance on side, then maybe Nigeria’s the place to look at.
  • I have a bit of my money in Africa, I wouldn’t put too much of my safe money there, but its the one that I’m most excited about in terms of where I’m willing to take risk.
• I think its time to take a bit of risk. We started by talking about how cautious people are, and that’s a good sign. Last year at the same time, there weren’t many people cautious, and when we got all the bad news we were all vulnerable to it. Now, people all over the world are scared, paranoid. Now, we’re going to climb a wall of worry, I suspect, so long as policy is helpful.

Tags: asset class, BRIC, BRICs, Case In America, Chief Economist, David Oakley, Days Of The Year, Emerging Markets, Financial Shocks, GDP, GDP Growth, Goldman Sachs, India, Japanese Experience, Manchester United, Midst, O Neill, P500, S David, Segments, Th Quarter, World Economy, World Markets
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Credit Crisis Watch: Gaining Positive Traction

Wednesday, January 14th, 2009

In order to gauge the progress being made to unclog credit markets and restore confidence in the world’s financial system, I monitor a range of financial spreads and other measures. By perusing these, as summarized in this “Credit Crisis Watch” review, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

First up is the LIBOR rate. This is the interest rate that banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world.

After having peaked on October 10 at 4.82%, the three-month dollar LIBOR rate declined sharply to 1.09%. LIBOR is therefore trading at 84 basis points above the upper band of the Fed’s target range - a great improvement, but still steep compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Source: StockCharts.com

Importantly, US three-month Treasury Bills have started making their way higher to 0.12% after momentarily trading in negative territory in December as nervous investors were in desperate search of safety.

US three-month Treasury Bill yield

Source: The Wall Street Journal

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10, the measure has eased to a five-month low 0.97% - well above the 38-point spread it averaged during the twelve months prior to the start of the crisis, but nevertheless a strong move in the right direction.

Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October is also a move in the right direction.

Source: Fullermoney

Despite the interbank lending rates having declined from their peaks, banks have significantly curtailed the amount of money they are actually lending. The US Depository Institutions Aggregate Excess Reserves continue their ascent at levels far in excess of the amount that banks need to keep on deposit to meet their reserve requirements (see chart below). This measure indicates that the balance sheets of banks remain under pressure, especially in view of the fact that the value of some assets is not known. As mentioned before, a peak in the Excess Reserves graph should coincide with a turning point in the recovery of banks.

Source: Fullermoney

Not illustrated by a chart, the spreads between ten-year Fannie Mae and other Government Sponsored Enterprise (GSE) bonds and ten-year US Treasury Notes have also tightened significantly over the past few weeks.

The national average rates for a US 30-year fixed mortgage yesterday declined to 5.08% from 5.33% a week ago and 6.46% in October last year. However, the rate is still 399 basis points higher than the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis, indicating that lower rates are not being passed on to consumers.

Source: Fullermoney

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low quality) and AA (high quality) 30-day non-financial commercial paper. The spread has declined markedly to 2.23% from almost 5% at the end of December.

Source: Federal Reserve Release - Commercial Paper

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch US High Yield Index. The Index dropped by 22.9% to 1,682 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable US Treasuries was 1,682 basis points by the close of business on Tuesday. With the US 10-year Treasury Note yield at 2.32%, high-yield borrowers have to pay 19.12% per year to borrow money for a ten-year period. At these exorbitant rates it is extremely difficult for companies with a less-than-perfect credit status to conduct business profitably.

Source: Merrill Lynch Global Index System

The excellent gains of the iBoxx Investment Grade Corporate Bond Fund (LQD) (+25.8%) and High Yield Corporate Bond Fund (HYG) (+23.1%) since their October/November lows, provide more evidence that the credit markets are moving in the right direction. However, from a short-term technical point of view, the rallies seem overdone and pullbacks will not come as a surprise.

Source: StockCharts.com

Source: StockCharts.com

Another indicator worth monitoring is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been an up-tick in the ratio since its all-time low in December, showing bond investors are growing a little more confident and have started opting for more speculative bonds over high-grade bonds.

Source: I-Net Bridge

Deutsche Bank reports that the implied default rates on corporate bonds are at an extreme level, but that it is not inconceivable that especially high-yield bonds could see defaults remaining high for long enough to see a cumulative five-year default figure above the 30% to 35% range of the early 1990s and early part of this decade. “… the chances are far higher of such an occurrence than seeing the investment-grade cumulative five-year rate climbing into double digits,” the bank said.

According to Markit, the cost of buying credit insurance for European, Japanese and other Asian companies has shown a further improvement since the previous “Credit Crisis Watch” of three weeks ago, as shown by the tighter spreads (expressed in basis points) for the five-year credit derivative indices listed in the table below.

The notable exception has been the US where the CDX Investment Grade Index and the CDX High Yield Index both edged up. The increase of 29 basis points in the High Yield spread means an increased cost of $29,000 (up from $1,233,000 to $1,262,000) to insure $10 million of debt annually over five years.

• CDX (North America, investment-grade) Index: up from 211 to 218
• CDX (North America, high-yield) Index: up from 1,233 to 1,262

• Markit iTraxx Europe Index: down from 181 to 169
• Markit iTraxx Europe Crossover Index: down from 1,008 to 978

• Markit iTraxx Japan Index: down from 295 to 291
• Markit iTraxx Asia ex Japan IG Index: down from 347 to 307
• Markit iTraxx Asia ex Japan HY Index: down from 1,263 to 1,132

The graphs of the CDX indices are shown below, with the red line indicating the spreads easing over the past month.

CDX (North America, investment-grade) Index

Source: Markit

CDX (North America, high-yield BB) Index

Source: Markit

As far as the outlook for the credit derivative indices are concerned, Markit said: “Optimists have been declaring that all of the bad news has been priced into spreads, and we are set for a lengthy rally. The implausible default rates implied by current spread levels give this theory a measure of support. But the coming weeks are likely to see a torrent of negative news, and it is improbable that the CDS market can continue its stoic resistance. The upcoming US earnings season will be key, as will the progress of Obama’s fiscal stimulus package through Congress. We have already seen several defaults this year, and we are sure to see many more in the coming months.”

Lastly, the tables below show some country CDS statistics, again courtesy of Markit. These prices represent the cost per year to insure $10,000 of debt for five years. For example, Italy is in most trouble among the G7 countries with a cost of $155 per year to insure $10,000 of debt.

It is noteworthy that Germany, Japan and France at the moment all have a lower default risk that the US. It now costs $55 per year to insure $10,000 against US default for the next five years. Although this is down from $65 a month ago, the corresponding numbers were $8 early last year and $36 in November. As in the case of the US, UK CDS spreads are also trading close to record levels as unease over the level of national debt takes its toll on their sovereign credit risk.

Not shown in the table, three of the weaker members of the eurozone (Spain, Ireland and Greece) yesterday saw their CDSs come under renewed pressure following negative rating agency action. Spain’s spread widened by 13 basis points to 112 basis points, whereas Ireland and Greece are trading at the widest levels of any eurozone member.

The past few weeks saw steady progress on the credit front, with the TED spread, LIBOR-OIS spread and GSE mortgage spreads having narrowed markedly since the record highs, although spreads are still elevated compared to pre-crisis levels. More recently, corporate bonds have also seen a strong improvement, but high-yield spreads remain at distressed levels.

Furthermore, the CDX and iTraxx credit derivative indices have mostly shown a solid improvement since the peaks in November. And even US Treasury Bills have started edging up from panic levels.

Action taken by the Fed and other central bank has resulted in ongoing progress being made to fix the broken credit machine. Although the credit markets are gaining some positive traction, interbank lending has not really picked up and the financial system is still fragile. In short, the thawing of the credit markets has a way to go before liquidity starts to move freely and the world’s financial system functions normally again. The Fed’s Senior Loan Officer Opinion Survey will provide a useful update on credit conditions when it becomes available on February 2.

Tags: Acronym, Bank Liquidity, Basis Points, Capital Injections, Commercial Banks, Credit Crisis, Credit Markets, Credit Risk, Desired Effect, Desperate Search, Financial Spreads, Libor Rate, London Banks, London Interbank Offered Rate, Negative Territory, T Bills, Target Range, Treasury Bill, Treasury Bills, Wall Street Journal
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