Issue 92 – January 6, 2014

2013 – Year in Review


2013 proved to be a very good year for many financial assets. Equity markets in the US and in the developed parts of the world posted solid, and in some cases spectacular, returns. Long-term interest rates began a journey toward normalization, while short-term consumer-oriented rates remained quite low, providing further support to recovering home and auto markets. The improvement in returns was far from a steady process and was an apt reflection of the many conflicting attitudes towards this recovery. Many bright and well respected analysts continue to adamantly disagree as to the drivers of performance, but this attribution is particularly important, as it directly speaks to what lies ahead in the New Year. Was the equity market artificially inflated due to the influence of the Federal Reserve’s Quantitative Easing program of open market purchases of US Treasuries and Mortgages?  Or was the performance a reflection of improving fundamentals and earnings? We would submit that while lower interest rates were certainly of help, the lion’s share of improvement was due to the hard work and perseverance of those companies and municipalities which had spent the past 5 years working to repair business models and balance sheets. Consider that while the S&P index is now 29% higher than the year end close in 2000, the earnings have essentially doubled.  2013 may have “borrowed” some small amount of return from 2014, but we would look for improving trends to continue.


While developed equity markets enjoyed a banner year, other markets such as long-term US Treasury bonds, emerging markets, and gold did not enjoy investor favor, each for their own reasons. Long-term US Treasuries and Mortgages were re-priced to reflect an improving economy and the long awaited “tapering” of the Fed’s open market purchases. Emerging markets languished due to nagging worries of a potential major slowdown in activity in China as well as the ongoing economic lethargy in the EU.  Lastly, as the chart shows, gold lost much of its sponsorship as fears of accelerating inflation never materialized.



The municipal bond market witnessed a number of material events which should have lasting implications. The biggest single event was the bankruptcy filing by the city of Detroit and it was a watershed development. The judge in the case ruled, that just as in private pensions, public pensions are also contracts which may be renegotiated in bankruptcy. To date, many underfunded public unions had effectively argued that their liabilities were not subject to modification. This interpretation had left municipalities with declining resources for other mandated services such as infrastructure and safety while pension liabilities grow unabated. While Detroit is the first major metropolitan area to use the bankruptcy court to restructure their finances, they will certainly not be the last. In this same vein, Moody’s took the next logical step and began re-rating major municipal issuers to incorporate unfunded pension liabilities. This brought much needed attention to the city of Chicago which has the largest unfunded liability of any metropolitan area. Interestingly, our own King County fared reasonably well in this review as the public pension program remains one of the best funded in the country. This new scrutiny, long overdue, along with Detroit’s legal pathway, are the first steps to allow the most impacted municipalities to return to better financial balance over time.


Individual municipal bonds showed great resilience in light of higher underlying US Treasury rates as well as ongoing bond fund redemptions. The overall benchmark was off - 2.20% for 2013. Going forward, however, a strong technical argument can be made that yields are unlikely to go substantially higher. Consider that long term municipal bonds still trade at percentages well in excess of US Treasuries versus their historical norm of 82-85% of the benchmark. This persists despite higher income tax rates. A return to more traditional valuations should be forthcoming and would provide a great deal of cushion versus higher US Treasury rates. Supply is also somewhat tighter as overall issuance was down by about 15% in 2013 due in part to the fact that many practical refundings have already been completed. Finally, as an important sign of a healthy market, we continue to see real differentiation between credits. Better credits should be rewarded with relatively lower costs. All of these factors should combine to provide a strong technical backdrop for municipals throughout the new year.


As we consider how to best navigate the evolving fixed income landscape, there are those who believe that demand for fixed income will decline with the advent of higher rates. We strongly disagree. Demand for fixed income from many institutional quarters continues to grow in terms of both income and duration to match-fund liabilities The fact that these needs have been serviced in large part these past few years with dividend paying equities rather than hyper-low interest paying instruments, says more about those stocks in particular than bonds in general. Higher rates will attract traditional pension and insurance buyers and this will come at the expense of overbought high dividend paying names. The beginning of this rotation was particularly evident in the mid cap value sector of the market throughout the latter half 2013.


The coming year will likely feature numerous re-adjustments to valuations with coincident opportunities. Accentuating this trend will be the fact that “market making” capability is not what it was even a few years ago. The consolidation of firms coupled with new regulations have left the marketplace with less traders and less capital committed to principal positions, especially on short notice. We should not, however, confuse short-term liquidity disruptions with the advent of a true crisis. Rather, minor dislocations might be more of the norm than not as thinly traded markets adjust to more normal interest rates and valuations for income-like equities.




In This Edition


·         2013 – The Year in Review

·         2014 – The Year of Capex

·         $4 Trillion Flood in the Basement

·         The US vs. the World – a Differential in Speed



Huntington Steele

1700 7th Avenue

Suite 2210

Seattle, WA 98101



206 204 0320



Past Issues


91 - 09.25.13
Implications/ Opportunity/ No Taper for Now

90 - 07.08.13
Half Time 2013/ Shape of Things to Come/ The Path Forward for Detroit/ Second Half Outlook

89 - 05.31.13
Strong Hands/ #1 The New Federal Funds/ #2 Income as a Commodity/ #3 New Buyers, Fewer Markets, New Terms/ #4 Changing Demands for Leverage/ Measuring Our Multi Speed World with a 12 inch Ruler

88 - 03.27.13
European Union?/ Global Arbitrage/ 1940s Fed

87 - 03.08.13
Pulling & Pushing/ Deus ex Machina/ Perfect as the Enemy

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

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






2014 – The Year of Capex


Capital Expenditures: “Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.”


Capex is the driving force of a healthy economy and has been conspicuously absent during the recent financial episode. Financial leverage, which skyrocketed in the mid-decade, was replaced with thrift and balance sheet repair. The Federal Reserve’s many programs were designed to mitigate and fill the credit air pocket that was left by the crisis beginning in 2007/8. We have argued for some time that corporate balance sheets are in terrific shape compared with many historical periods. Technology has driven productivity gains well beyond what pundits thought plausible just five years ago. However, it is fair to argue that further earnings improvement will require some sort of leverage to re-enter the system. It could come in the form of financial leverage as it did in the period that led up to the crisis, but it is much more likely to come from a far more sober approach.


Gains in domestic energy production have set the US up to be the go-to global manufacturer of materials for years. Our resources drive low cost and predictable power and are re-writing business plans around the world. US natural gas prices remain at less than 1/2 of Europe’s and 1/3 of Japan’s. This is an overwhelming business advantage. If we couple this reality with ever improving technology and the terrific shape of US corporate balance sheets, then we have set the table for the next leg of productivity gains through old fashioned capex. Real employment gains will be present, but the structural changes to the labor market brought on by technology will not be reversed. Consider what this means in the context of the Federal Reserve’s policy. They plan to dial down their absolute open market purchases, but they state that they are committed to keeping the benchmark rate low until “overall employment” improves further. However, if employment trends improve some, but not in line with historical norms as a result of these productivity gains, how will the Fed react? The answer is of course: we shall see. But the committee will likely have great latitude to make changes to policy very deliberately, especially if the economy is improving. That leaves the challenge of planning for the reduction of the massive $4 Trillion balance sheet as job number one for the Federal Reserve in 2014.


$4 Trillion Flood in the Basement


The Federal Reserve has been a powerful force in financial markets since the onset of the crisis in 2007. Though their various programs and interest rate policy, they have (hopefully) bought sufficient time for the economy to recalibrate and recover. This “time” however did not come without cost. The Federal Reserve now has a balance sheet that is some 4000x larger than it was historically. This matters for a number of reasons. The Federal Reserve cannot afford to allow their Treasury and Mortgage holdings to sit unattended due to the risk that bank driven loan demand could suddenly re-accelerate. The tepid pace of M2 or the “velocity of the money supply” has been a key ingredient in allowing the committee to maintain such an accommodative policy for all this recovery time.




While a certain amount of improving loan growth would be very welcome; unbridled demand would destabilize the delicate interest rate balance that has been created. On the other hand, the Federal Reserve cannot simply sell their massive positions. This level of potential supply would totally swamp the existing market. What is needed is a plan to put the Fed’s balance sheet to work while the bonds “roll down the yield curve” to final maturity. Enter the concept of the “Reverse Repo”.


A “Repo” transaction on Wall Street is simply a financing. A financial institution may finance US Treasury holdings by lending out these securities to institutional customers overnight for a small rate of interest. A “Reverse Repo” is simply the mirror image. At present, the Federal Reserve pays 0.25% only to banks with assets on deposit. However, a new plan could include additional investors such as Money Market funds, as well as Freddie Mac and FNMA - the mortgage behemoths. In this way, the Fed would have a much larger audience for financing and therefore encumbering their balance sheet and could raise short-term rates in a controlled fashion as they had done in the past through traditional open market operations. In addition, this new “market rate” could also become the current Fed Funds benchmark index. While we appreciate that this may seem like “inside baseball” kind of stuff, it is incredibly important to the health of the market that this massive pool of US Treasuries is stabilized during its roll off period which will take many years.



The US vs. the World – a Differential in Speed


As the US begins to exit the period of “quantitative easing”, Japan and the Euro region remain years away from potential exits. This differential has real investing implications. The world’s central banks have been largely synchronized in their efforts to fight through the deflation of the past 5 years and this has amplified the impact of their policies as no one part of the world was really “competing” for assets via interest rates. This is about to change. If rates in the US rise at the same time that the US is perceived as being the best among global options for the reasons laid out previously, then money will flow out of struggling geographies further complicating recovery. Now this is not to say that the non-US world will be poor investments. Rather, the nature of the investments may morph into more of a “value” world as defined by non US and a “growth” world as defined by US centric opportunities and we may see in 2014 a period of adjustment to reflect this new reality.


As you can see, there are lots of moving parts to consider as we enter the new year. Slightly higher interest rates and expanding capex should be the dominant themes in the US while continued progress towards recovery and domestic consumption will dominate the news abroad. We look forward to navigating what should be an exciting 2014 with all of you.


Best Wishes & Happy New Year,


Jen & Patsy


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