Issue 82 - June 29, 2012


Half Time 2012

The first half of 2012 witnessed a multitude of “economic seasons”. For the first three months of the year, winter gave way to a mild spring. The confluence of earnings, economic data, and geopolitical headlines resulted in a picture of a world modestly improving on many counts. Corporate earnings, while not of the robust variety that we would typically see three plus years into a recovery, demonstrated the continuing ability of a wide variety of corporations to manage their way through the new normal. The economic data painted a picture of modestly improving conditions especially as it related to top line employment results. Headlines out of Europe heralded lower sovereign interest rates in the peripheral countries (formerly known as the PIGS) as the second round of Long Term Repo Operations brought short term relief and the talking news heads shifted focus to other matters with a dismissive “now that the Euro Zone problems are behind us”. If only…..

April brought with it a change in the economic season. While corporate earnings remained on course, employment data began to show signs of weakness. Euro Zone interest rates began to creep back into unsustainable territory driven by fears of the looming May elections in France and Greece. When the dust settled, the S&P was virtually unchanged, up 16 basis points for the month. Market concerns that 2012 would be a rerun of the roller coaster 2011 were swept aside for the moment. Unfortunately European election results coupled with genuinely disappointing employment data in early May, let loose the fears that events were overtaking leaders' abilities to keep up.

France voted in the first socialist government since Francois Mitterrand in the early 1980s, a result that is certain to complicate relations with Germany. Greece made good on their second try at a general election and cobbled together a coalition government. While this result did not address the practical matters confronting the nation's finances, it did relieve the immediate concern of social unrest that might have resulted from a second failed election. US employment data continued to disappoint. Price appreciation of stocks and commodities melted away while the flight to quality brought the 10 year US Treasury yield down from just below 2% to just below 1.50%. Germany sold 2 year Bunds with a zero coupon and Swiss 5 year notes traded at negative yields (investors receive less than their initial investment back!). June did manage to pass without further significant deterioration in the headlines and the market was able to right itself from what were rapidly becoming oversold conditions. With expectations on economic data now more muted, results were met with general acceptance rather than frustration.

It was a remarkable shift in attitude from the euphoria of a decade's best first quarter to the disappointment of financial markets that limped across the finish line in late June. However, the net results were not entirely unsatisfactory. US equity markets did post respectable net positive returns and for all of the fireworks, international markets were plus or minus a percentage point or two. It is interesting to consider what if anything really changed during these 6 months. You have read our previous rants on the poor quality of economic measurements. Given the seasonal adjustments coupled with one of the warmest winters on record in much of the US, it is not too hard to imagine that what appeared as employment strength early in the year was in fact more similar than not to the level of employment running currently without “seasonal” makeup. Earnings, while trending modestly lower, did not display the same level of volatility as seen in employment reports. Given that earnings are for the most part recorded data as opposed to economic releases which are for the most part retrospective weather forecasts, we would expect to see an economy going forward that continues to grow albeit at a modest pace. We are now four years into this episode and one constant has been the level of disappointment with the pace of recovery. But why? Other than impatience, common sense would tell us that 60 plus years of expanding leverage which was turbo charged in the last 10 might need something more than 48 months to rebound.

Central bankers around the world have flooded the system with cheap money but much of it remains sidelined as individuals, municipalities, and corporations are working off debt rather than looking to add new debt, despite record low rates. The chart above speaks to just how long a process this is going to be. Sweden’s recent experience took 7 years. There is simply no point in losing patience as investors. Realistic expectations of earnings, economic progress, and timelines, are essential elements in navigating these markets.

19 Euro Summits - A Tiger by the Tail

At this point it seems clear that for the short term, European leaders will neither consider amending their fiscal union for fear of short term dislocations, nor will they be able to craft a path forward to a United States of Europe. “Solutions” proposed are now simply a way to get from today to tomorrow. The long term “answer” remains practically what is has always been – “Let Germany pay for it.” The lack of forward progress is starting to show predictable results in weakening European economic readings. Eighteen summits have collectively provided only the mildest of episodic, short term relief. Maybe nineteen will be the lucky number, but we would not bet on it. They truly have a tiger by the tail, but this is not the first time that the leaders of some of the world’s largest economies faced such a tangled mess of their own making.

In 1931, The Bank of England went off the gold standard. This followed more than a decade of efforts by the “Lords of Finance” as defined by Liaquat Ahamed, to restore the world’s financial health following the devastation of World War I. Beginning in November, 1918, the central bankers of the United States, France, Germany, and Great Britain tried and failed to find a way to make good on the tremendous debt and reparations incurred by the war. The Bank of England was in the unique position of having operations and therefore assets throughout the world as a result of their wide reaching empire.

“Britain’s problem was not its budget deficit, but rather that it has clung to the role of banker to the world without any longer having the money or resources to do so and at a time when most of the world was a damn poor risk.” Liaquat Ahamed

British pounds fell by 30% and 25 additional countries followed their lead in devaluation. Central Banks around the world sustained substantial losses. The timing of this move will also not be lost on our readers as the beginning of what was to become a truly miserable period throughout the world. Our point in this historical reference is not to suggest that we are on the precipice of something dramatic, but rather to show that unsustainable debt is just that – unsustainable, no matter how hard leaders may try to square this circle. Europe is an extremely wealthy and technologically advanced part of the world, and it is not suffering with the calamitous results of a World War. That they have managed to bolt this dead weight anchor of a currency confederation on top of a geopolitical alliance is a tragedy. Europe has incredible history and it can not be simply swept away as if the rationale for this alliance never happened. The Euro itself on the other hand is not a well worn, centuries old institution. It is a 13 year old experiment.

“What is with this ongoing bent among the media as well as the economic and political intelligentsia to want to continue with an experiment that has clearly failed at delivering its objectives?” David Rosenberg - Gluskin Sheff

A smaller Euro Zone that encompasses the northern members whose economies move at similar speeds could work well. Or perhaps a two stage Euro – a northern and a southern could also address the needed currency flexibility that would allow the southern members to restore growth over time. What seems obvious is that the current scheme is not going to work much longer and that hopes to use this crisis as a lever towards debt mutualization without sovereign subordination all on Germany’s dime is going nowhere with Chancellor Merkel. Meanwhile the parade of temporary bailout plans would make a Three Card Monte hawker blush.

The ECB uses a series of collective programs to lend money to a troubled sovereign so that it may turn around and lend it to their native banks. In turn, the banks turn around and buy the bonds of the sovereign! Oh, and these collective agreements require each member to be responsible for a percentage. In the case of Spain, Italy is on the hook for 22% which practically means that Italy has to go to the public market to borrow at 6% to then turn around and lend to Spain at 3%! And if that were not enough silliness, this financial jujitsu also manages to subordinate all of the private debt already outstanding in said troubled foreign. We spoke about the pernicious effect this would have in our March 5th newsletter. Private capital is now as scarce as hen’s teeth in the peripheral nations and there is zero chance any private capital will return until the rules are dramatically different and well established. The leaders in Europe clearly fear the consequences of amending their current confederation but it is becoming apparent that their medicine is at least as bad at the illness.

Bank deposits meanwhile, in the periphery continue to seek safer homes in Northern Euro Banks.

As we noted in our last newsletter, these fleeing deposits are creating an ever growing liability on the balance sheet of the Bundesbank via the Target 2 system, further exposing Germany to the peripheral nations.

Late June saw both Spain and Cyprus officially asked for bailout funds making them members #4 and #5 following Greece, Ireland, and Portugal to make such a request. Previously unspoken conversations are now more commonplace. “How to save the Euro” is evolving in response to the stalemate to “Is the Euro worth saving”? This is important because it raises the possibility of the ECB and other central banks of having to recognize losses on the “loans” and bond purchases that they made to the peripheral countries in Euros which would likely be repaid in Drachmas or Pesetas if they are repaid at all. This is the very situation the ECB fought tooth and nail to avoid with their efforts like the collective action clauses in Greece. Those provisions clearly demonstrated the ECB’s willingness to put their own interests above all others: private investors and the very countries themselves that they are ostensibly trying to assist.

Stay Tuned……

The Crystal Ball

The historical drama surrounding the Euro will not be the sum total of the investing landscape of 2012, not even in Europe. First, European domiciled companies are able to compete globally not just in the peripheral countries. With the Euro down to €1.25 versus €1.45 of last summer, European goods are now more competitive. Second, Major European companies are not sitting around worrying about whether Francois Hollande’s policies will adversely impact French operations. They are planning and acting in advance of their initiation. The UK and other northern Euro Zone countries will be the beneficiaries of French commercial emigration. Estonia will be more than happy to absorb every French entrepreneur that wants to flourish in an environment that brought SKYPE to the world. Third, global banks beyond Europe’s field will be able to feast on the vacuum being left by their impaired banks. Pricing of European assets are getting a bit of baby and bath water treatment which will also create good opportunities for longer term investments.

An intriguing second half story is lining up to be here in the US. The headlines are filled with enough doom and gloom to dispirit anyone. There are however a handful of positive themes that have lately moved well below the fold.

We have spoken at length about the improving state of Municipal finances and how that relates to Municipal bond credits and pricing. This is not to say that enormous challenges do not remain, it simply acknowledges that the issues are now being addressed in constructive ways. We have also spoken about the strength of corporate balance sheets and their ability to operate successfully through this episode. Low rates have not been the complete answer (and have certainly created some unintended consequences) to stoking this economy but they have eased the burden of massive deleveraging. Two more themes are now worth adding to this mix – demographic and energy advantages.

David Rosenberg notes that there are now 80 million millenials, those Americans under 20. That makes the US the envy of the rest of the industrialized world and it compares very favorably with the 76 million baby boomers whose contributions to the economy are now beginning to wane.

The energy story is a simple one: $5 versus $13 natural gas. The US has found vast supplies of natural gas in the past few years so much so that pumping this past fall and winter well outstripped storage capacity which, when combined with a mild winter, sent natural gas prices plunging to just under $2. However, prices are now recovering and rig counts have been brought down to levels that will allow the market to find its new normal and let’s just call that $5. The energy equivalent of a barrel of oil equates to 6 units of natural gas and for many years that equivalence ran true. Now however, the two have widely diverged – oil at $80 would equate to natural gas at $13 which is exactly where it trades in Europe and Asia where is it largely imported. This differential is going to provide the US with an extraordinary opportunity to refurbish a whole host of industries and manufacturing. From power generation to home heating to transportation to manufacturing the US will enjoy a 2x+ input cost advantage for years.

We certainly do not wish to appear complacent in light of the current headlines. Our consistent message of locking in long term income and quality equity investments speaks to our view that the market has been in and will continue to be in a long term gradual recovery. Investing is a marathon and this summer may well feel like mile 20. But, there are some very interesting trends and themes emerging and all of the balance sheet work that has been done in these past 4 years has not been done in vain. There is just much more left to be done. We will be following events in Europe as well as our own “Fiscal Folly” closely and will continue to focus our efforts on building and maintaining resilient portfolios.

Best Wishes,

Jen & Patsy


In this Edition

  • Half Time 2012
  • 19 Euro Summits - A Tiger by the Tail
  • The Crystal Ball

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

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



More Past Issues
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Market Highlights



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


1,408 1,258 1,258 1,115
Nasdaq US
3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,553 1,413 1,658 1,581
5 Yr Treasury .716 1.07 .85 2.02 2.71
5 Yr AAA Muni .86 1.03 .94 1.75
10 Yr Treasury
2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.24 2.08 3.44 3.26
30 Yr Treasury 2.70 3.33 2.914 4.325
30 Yr AAA Muni 3.56 3.72 3.82 4.9
EUR Currency 1.24 1.33 1.29 1.34
JPY Currency 79.39 82.08 77.36 81.32
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