Issue 86 - January 4, 2013


The Fiscal Alps

As 2012 wound down, our political leaders were able to craft a modest alternative to what had popularly come to be known as the fiscal cliff. The cliff referred to the simultaneous event of the expiration of the 2010 Tax Relief Act and the implementation of the Budget Control Act of 2011. In brief, the Tax Relief Act extended the Bush Tax rates for two years along with a number of additional provisions intended to stimulate the economy, while the Budget Control Act incorporated cuts to spending across numerous Federal Agencies. Both of these laws would, on their own, have presented a slowing effect on the US economy. The combination of the two was projected to have anywhere from a negative 1-4% impact on GDP. Given that the current pace of growth is around 2%, the math of these policies would have left us with the high likelihood of a recession. The tax legislation that was passed ultimately memorialized the majority of existing tax policies while raising rates and phasing out deductions on higher income households. The AMT tax was permanently patched, but the temporary 2% reduction in the payroll tax was not extended for any filers. Capital gains and dividend taxes were increased modestly for higher income households. On the matter of the Budget Control Act; its implementation was deferred for two months setting the stage for yet more ongoing rancorous debate.

While there were those pundits who suggested that a resolution at this late date would not present significant problems, life is significantly more complicated “down here on earth”. Payroll providers for example, had never incorporated the ability to change rates on the fly and as such were left with a Hobson’s choice of either programming for over or under withholding for payrolls in the first quarter. The IRS warned that they expect 100 million people to have to delay their filings and with that, any anticipated refunds, as the agency has been delayed in printing the forms and tables to allow households to calculate their taxes. Given the unnecessary level of complication being inflicted, it only seems fair that it be required that every member of congress be required to prepare their own tax returns as a reminder that their actions do have consequences.

Our title – The Fiscal Alps – is meant to evoke the sense of challenges which lie ahead. Just as Lewis and Clark looked out from the Lemhi Pass to an endless sea of the Bitterroots, elected leaders have much farther to go than navigating one simple “cliff”. Monetary policy provided by our own Federal Reserve and other global central bankers in the form of massive liquidity injections have provided valuable healing time for those economies clever and brave enough to make the best use of it. But liquidity is no long term substitute for solvency. The work now must turn to fiscal policy makers whether they (or we) like it or not.

The Paradox & the Rub

Mervyn King, the Governor of the Bank of England, four years ago referred to the “Paradox of Policy” where he acknowledged that “measures that were desirable in the short term are diametrically opposite to those needed in the long term”. The advanced economies throughout the world need to make substantial adjustments to their growing debt levels which have grown from some $80 Trillion to $200 Trillion in the past decade. At 340% of global GDP, this is the largest peacetime accumulation of debt the world has ever seen. Quantitative Easing, the purchasing of government bonds by one’s own treasury department, along with zero benchmark interest rates has been this paradoxical policy.

Using more debt to buy time to theoretically work off much larger imbalances has lead to what David Rosenberg has termed “the rub”. Here the recovery remains weak by historical standards, but the interest rate policy gets more mathematically stimulative, thus raising the present value of future profits. The 30,000 foot macro investing view might look grim, but the view from the ground of individual companies looks substantially better, particularly in the context of other alternatives. The “paradox and the rub” have thus given us a brave new world in regards to the traditional relationship between stocks and bonds and one that is likely to be with us for years to come.

Next up - Zero Rates Forever (practically)

The Federal Reserve at their December 12th meeting changed their language surrounding the term of expected low rates from mid 2015 to the following:

“Anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent,...”

Why did they make this change? Was a three year promise of low rates considered too long or was it more likely that it was considered too short? By making the new benchmark an economic number which might be charitably called “fuzzy”, the Federal Reserve can effectively keep rates at the zero bound for as long as they like. It is also a strong possibility that the committee made the change at this time in light of the lack of meaningful progress in DC on fiscal policy. Ben Bernanke has practically begged congress to get into the game. He knows that his policies have allowed the politicians to remain largely AWOL throughout these past four years and he also can not help but see the diminishing returns from each successive round of QE.

The US is now spending 11% of tax revenues on interest on debt when over 50% of this debt carries a rate close to zero. An increase of 1% would increase debt service by $150BB annually for starters. So when the pundits call for higher rates what exactly are they asking for? 25 basis points? 50? That is probably all that is in the cards given the ruinous impact of much higher rates. We spoke in our last newsletter about the challenge of unwinding current Fed policy. Their securities portfolio now has over an 8.5 year average maturity. With an active exit of selling Treasury securities a virtual impossibility given the sheer size of their holdings, a passive exit would be the only avenue available and would take many years. Their recent change in language would be an acknowledgement of that practical reality.

2013: Promises & Plausibility

In reviewing our year end missives from the past few years, we hope that we have conveyed a consistent focus on investing in quality businesses and reliable income thereby creating resilient portfolios. We remain, as we have been, cautiously optimistic on the growth in the economy with the belief that the trajectory of the recovery will remain shallow and fairly tepid. It will also be uneven at times. This is most obvious at the global level where different economies around the world are proceeding at much different speeds.

The accumulation of global debts are now realistically well past the point of ever being repaid in their entirety. Who for instance, thinks Greece will ever pay more than pennies on their debts. Europe for all of their financial machinations has yet to recapitalize their banks which are now well more levered than their US counterparts. And then there is Japan. They are now spending more than 1⁄4 of their tax revenue on debt service with zero effective interest rates! They have had 10 finance ministers in the past 6 years. Japan’s aging demographics are amplifying and accelerating their challenges along with their escalating tensions with China over the disputed islands. Isolation from the Chinese market and a struggling Euro zone economy leave Japan’s exporters with less end market to work with.

None of these dark global clouds mean that individual companies can not be singularly successful. It simply is an acknowledgement that limitless credit creation does in fact have practical limits. 4 years of flat out support by global central banks, has brought us closer to those limits. While a country specific debt restructuring would certainly be a disruptive event, these financial catharses have happened before and allow the parties to eventually move forward.

It is not just on the global level where restructurings might be part of the 2013 landscape, legal rulings in California on the sanctity of pension liabilities will also be argued. Both the City of Stockton and San Bernardino are engaged in separate legal battles regarding their bankruptcies and the California Public Employee Retirement Systems. CalPers argues that sums that are owed to them are not subject to change (at least not to the downside) and that they are senior claims to any other obligation; therefore they lie outside the purview of the bankruptcy process. CalPers is by far the largest creditor of both cities. Lawyers for Stockton and the bond insurers have made two points: that a process which does not include the largest creditor is both flawed and not valid and also is simply a waste of time, since the other parts of the budget are a mere fraction of their pension liability. San Bernardino has simply stopped paying into the pension while they navigate their process. Rulings in these matters are expected in the first quarter and will have far reaching implications if the judge finds for the cities. It would open up a path for the 450 cities whose employees pensions are governed by CalPers to rationalize their plans to be consistent with the times and resources of each municipality. Just as European banking systems were able to grow well beyond their native gross domestic production putting both their systems and sovereign credits at risk, many of these US municipal pension plans have grown well beyond their intrinsic ability to be plausibly serviced at the current level of promised benefits.

On a Positive Note

Just as the story of individual companies can paint a much brighter picture of our surroundings, there are a number of elements within our domestic economy which do the same. The numbers coming out of the continuing development of natural gas are remarkable. Even as the market remains unbalanced in terms of inventory – the beneficial gap between prices in the US and the rest of the world creates an enormous, positive tail wind to both producers of energy and manufacturers of many kinds. It will also drive interest in export of liquefied natural gas as well as the on-shoring of new manufacturing. Housing has been another bright spot in the past year, as the combination of time and low rates has teamed up to further clear the market. The “overhang” of unsold or foreclosed properties has been less impactful than was feared as the banks have not flooded the market. Congress extended for one more year the forgiveness of debt on short sales which has been instrumental in clearing out underwater properties without having to force the hand of the banks into the foreclosure channel. The actual supply of houses that are above water and that are thus freely tradable and for sale is not overwhelming. In fact, inventory remains practically “tight” in many urban areas. Auto sales have also surprised to the upside as several years of depressed sales combined with strong incentives and a better set of fleet offerings are encouraging consumers to make the investment.

These positive undercurrents will certainly have their hands full contending with the number and variety of negative influences, but we should not lose confidence. The energy story in particular is powerful and it impacts our economy at the very beginning of its food chain and as such its impact will be leveraged many times over. The early part of 2013 may well feature more than its fair share of turbulence as our politicians lace up for another round and the full impact of the tax changes and expirations are felt. However, the improving trends in housing and manufacturing and the good work done by corporations over these past few years will persist. As always, we will look to the quality and strength of our portfolios to help us navigate.

Wishing you all the best for 2013,

Jen & Patsy


In this Edition

  • The Fiscal Alps
  • The Paradox & the Rub
  • Next up - Zero Rates Forever (practically)
  • 2013: Promises & Plausibility
  • On a Positive Note

Huntington Steele

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Suite 3700
Seattle, WA 98104



Past Issues

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward



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Market Highlights



6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,362 1,408 1,258 1,258 1,115
Nasdaq US
2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,423 1,553 1,413 1,658 1,581
5 Yr Treasury .74 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .9 .86 1.03 .94 1.75
10 Yr Treasury
1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 2.94 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.16 3.56 3.72 3.82 4.9
EUR Currency 1.32 1.26 1.33 1.29 1.34
JPY Currency 86.10 79.49 82.08 77.36 81.32
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