Issue 88 - March 27, 2013


European Union?

Events in the Eurozone continued to fill the headlines in March. A long festering financial crisis in its smallest member Cyprus, briefly threatened to engulf the entire Eurozone banking system. Having requested assistance as far back as last summer, the heads of the ECB, EU, and IMF finally signed off on a plan which would have among other actions, threatened Cypriot deposits below the €100,000 threshold, long considered the gold standard for deposit insurance. That such a plan would be conceived is plausible given ever increasing levels of frustration with the peripheral countries, formerly known as the PIGS. Leaders in Germany, Finland, and the Netherlands, all of whom have looming domestic elections, are loathe to continue providing support. However, that such a plan would get the sign off from banking leaders who had to know that they were creating optimal conditions for a system-wide banking run is unbelievable. This is the same group who said last year that they would do “whatever it takes” to maintain the integrity of the confederation. To complicate matters further, the stakes were high, yet the total sums were relatively minor (€6BB in total, far less than was afforded to Greece or Ireland). Why this place and time to make a point? Cyprus had become an offshore banking destination for large pools of Russian money. The Cypriot banking system was along the lines of 7 times the size of the country’s modest GDP. There was no other source of funds to join with the ECB for assistance other than deposits. The temptation to solve the problem at the expense of a longstanding enemy proved too great. Dreams of a Pan-European banking union be damned.

Beyond the immediate shock of violating a widely held depository safety tenet, this action could have potentially tipped the tenuous balance of European sovereign debt issuance. Consider that the Eurozone banks, particularly those in the peripheral countries, are now the largest buyers of their native sovereign debt. Their long term capital structure repair has been neglected in favor of short term schemes that have propped up domestic bond markets. The leaders of Europe certainly received a global reprimand for their cavalier treatment of smaller depositors, but the real risk they took on was the possible destabilization of their national funding.

We have long argued that the Eurozone is really a geopolitical construction rather than an economic union. It was established as much as a blocking tool to limit the ultimate power of any one member (read Germany) as it was hoped that the collective economic power could better compete on the global stage with the likes of the US, China, and Russia. The benefits of this confederation are clearly bumping up against ever increasing costs and long standing nationalistic feelings are beginning to cloud judgments. Global markets have dramatically discounted their expectations for this area and have shown a willingness to allow the evolutionary process to evolve. However, events may be starting to outpace the ability of the leaders to react, especially those sitting for re-election. The Eurozone needs a path forward which recognizes the reality of 2013 rather than the dreams of the Maastricht Treaty of 1992. Meanwhile, the companies based in the Eurozone are not waiting for political salvation. They have been for many years driving their businesses toward the growing parts of the world. This includes both production and distribution. No longer can investors just look at the zip code of the corporate headquarters and glean anything useful as to the geographic sources of revenues and expenses. This cuts both ways as many US companies also derive much of their earnings from abroad. The case for continuing to own European based companies in light of the ongoing drama remains that these businesses offer compelling valuations on both an absolute and relative basis to their US based peers. The continuing globalization of business models thoroughly complicates traditional notions of what was historically understood to be a domestic or an international company. However, much more importantly, changes in labor utilization and energy costs are driving us toward a much more interesting investing climate.

Global Arbitrage

The Economist, in the January 19th issue, ran a special report on “outsourcing and offshoring” where they noted that around the world, companies are rethinking production plans. The widely held belief of shipping production to low cost labor markets no longer makes singular sense as labor has trended to be a smaller percentage of final costs. Energy costs, shipping expenses, expertise and time to delivery are just a few of the many variables now going into the “where to build a factory” calculation. This trend bodes very well for US companies in particular with our growing energy cost advantage, but will be a boon for high quality companies of all nationalities which have developed strong execution capabilities and which also enjoy the cheapest sources of capital. As investors, this process suggests that companies still have much room to improve upon their business models and margins.

Perfect as the Enemy

The Wall Street Journal featured an Op-Ed on March 24th where they compared the current policies of Ben Bernanke to those of the US Treasury from 1942 until 1951 when the rate on long terms bonds was fixed at 2.50%. For the record, we noted these similarities in our August 18th, 2010 newsletter. While using different tools, the outcome has largely been the same – the suppression of rates which provides a supportive backdrop for a lengthy and shallow recovery process. These policies have not been without significant costs, most notably the massive expansion of the Federal Reserve’s balance sheet. As signs of an improving economy in such areas as housing and autos are found with more regularity, the pundits have turned their attention to when the Fed might withdraw their accommodative positions of a zero benchmark rate coupled with open market purchases. The chairman has had three opportunities to address the market this past quarter: two open market committee meetings and the semi annual Humphrey Hawkins testimony to both chambers of congress. In each of these settings he has reiterated his commitment to continuing their present course until he sees substantial improvement in labor markets in the form of an unemployment rate below 6.5% (currently 7.7%) and unless measures of inflation rise above the target of 2%. Undeterred, a chorus of bond bears continues to call for substantially higher rates on a daily basis. As we have noted in previous newsletters, the market could very well see slightly higher rates, however many factors argue against a return to the rate environment which existed prior to the 2008 financial crisis where 10 year US Treasury rates where above 4.50%.

The Federal Reserve has the ability to pare down their open market purchases at any time, and the decision to do that would be independent of raising the benchmark rate. The stated policy of looking for a lower unemployment rate before changing policy has been modeled extensively and provides an answer that looks something like a 2015 time frame at best.

In addition, a growing appetite for income products is likely to be with us for the foreseeable future as aging demographics stoke demand. Finally, the chairman did address the concern of the disposition of the large holdings on their balance sheet by stating that they may just allow the existing inventory to mature rather than putting that merchandise up for sale. Given the duration of their portfolio, this process would add even more time to their stated outlook. Let’s then consider what an investing climate might look like with rates of current or slightly higher levels, coupled a modestly improving economy. It might look like the quarter we just finished: uneven, but on balance, a definite step in the right direction.

Rick Reider, the CIO of Fixed Income for BlackRock hosts a monthly call where he lays out his views in a “stream of conciseness” PowerPoint presentation. In his March piece entitled “The Battle of Twitter vs. the Data”, he argues that the data, which gets far less air time than what qualifies as news on various Twitter feeds, is both far more relevant and promising. Headlines lack perspective. He then went on to comment that the improving domestic energy picture, along with improving housing numbers, is providing a relatively unappreciated backdrop. He then noted that the last two times the S&P index approached this level the annual earnings were $54.32 and $84.61. Today, that estimate is $98.32. In addition, the 2 year US Treasury was 5.10% and 3.05% vs. 0.25% today. So we have higher earnings and lower rates. This is not to say that those previous levels represented absolute values, but it does provide context of the current drivers.

As we conclude the first quarter of 2013, the headlines will be filled with the challenging situation in Europe, but the data driven story remains the improving economic situation domestically and corporate picture globally.

Best Wishes,

Jen & Patsy


In this Edition

  • European Union?
  • Global Arbitrage
  • 1940s Fed

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

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



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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
13,104 12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,426 1,362 1,408 1,258 1,258 1,115
Nasdaq US
3,020 2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,604 1,423 1,553 1,413 1,658 1,581
5 Yr Treasury .82 .74 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .88 .9 .86 1.03 .94 1.75
10 Yr Treasury
1.81 1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
1.99 2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 3.13 2.94 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.21 3.16 3.56 3.72 3.82 4.9
EUR Currency 1.29 1.32 1.26 1.33 1.29 1.34
JPY Currency 94.28 86.10 79.49 82.08 77.36 81.32
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