Issue 73 - August 29, 2011


The Confluence

Global markets have been reeling since late July. Concerns surrounding sovereign debt defaults and the impact on European bank capital came to a head with Germany agreeing on July 22nd to provide an additional 109 Billion Euros to Greece. The Congressional debate and subsequent agreement over the rise in the debt ceiling came to an unceremonious conclusion with the first ever downgrade of US Debt on Friday, August 5th. Finally, Economic data in the US remained weak throughout the major monthly announcements calling into question the overly rosy assessments that had been “disappointing” investors all year long. The common denominator of all of these events is their history. None of these streams was in any way new or novel information.

• The challenges surrounding the Euro presented themselves in April of 2010 and the ECB had kept itself busy with meetings and ineffectual bank stress tests that demonstrated nothing of substance.
• That Standard & Poor's followed through on their intention to downgrade the US debt in the absence of a meaningful debt reduction plan apparently came as a shock to our congressional leaders who had managed (among other things) to operate in the absence of a budget for 2 plus years.
• Economic data had never reflected pre-2008 momentum. Despite this fact, economists had been outdoing each other to increase their GDP and other forecasts this year until another late July reading of 0.4% for Q1 and 1.3% in Q2 laid truth to the wishful thinking that we would rebound sharply from a financial rather than an inventory driven recession.

Why this confluence at this point in time? Perhaps that is a question best left to Malcolm Gladwell and his interesting read “Tipping Point”. But here we are. This is the economic environment we have and will continue to have for some time with a set of global leaders who, for better or worse, are going to have to cooperate in very major ways to address these intractable problems.

The ECB - All about Germany

“Germany definitively decided that it will allow its wealth to underwrite the union, but only in exchange for political control over how its wealth is used. With these changes, the Germans have staked their claim to European leadership.“
Stratfor- August 4, 2011

The crisis that has rolled across the Euro Zone for these past 18 months has set the stage for the most significant geo-political realignment since the fall of the Berlin Wall in November of 1989 and the effective end of the Cold War. While we are not geo-political junkies, to not recognize the seismic economic implications of the rising role of Germany in the Euro Zone is to simply not understand the path forward.

The Euro Zone was established ostensibly for economic benefits, but in many respects, these were simply the icing on top of much broader goals. These regions were financially and emotionally exhausted from two horrific world wars followed by another 40 plus years of the Cold War. That a confederation could be established that both promoted economic activity and potentially bottled up and leveled the geo-political playing field was a goal too attractive to pass up. That the confederation as designed contained what in hindsight were obvious flaws relating to Governance was not a high priority at the signing of the Maastricht Treaty in February of 1992.

The path forward for Germany and the Euro Zone is not without all manner of complications. Other strong financial members of the EU will want to assert their role such as Finland’s recent demands of “collateral” from Greece in exchange for their cooperation. These episodes however will remain sideshows to the real transformative process taking place before our eyes.

Why would Germany ever agree to effectively underwrite the rebuilding of the EU? Germany wants to be a player on the world stage on par with the US and Russia. Germany therefore needs a far bigger platform than Germany proper from which to project their prowess. In addition, Germany has little interest in seeing all their financial efforts of the past two plus decades including picking up the total tab for reunification and accepting what were significant discounts in the Euro-Deutschemark go to waste.

The mechanisms required to repair the sovereign finances are just now being established. No solvent member of the EU would ever suggest simply forgiving the debts of the P.I.G.S. There has been floated the concept of a “Eurobond” which would have the implicit backing of the EU and therefore of Germany. These bonds would be used to retire all or a portion of the outstanding debt of the impaired nations. This is an attractive concept for a couple of reasons. It would compel further financial integration of the Euro Zone which is of interest to the major members and international investors have been searching for some time for a Euro denominated asset class that they could buy in large size. There is however a long way to go to get to this point and again there are likely to be many potholes along the way. But we should not lose sight of what the goals of the single largest member economy with the largest member population might be. The German people will obviously need to be on board with this program and this too will present challenges. The supplicant nations can not be seen as having the better of the situation than the German citizenry. Chancellor Merkel has to balance the benefits of becoming the defacto Euro Zone central banker versus the costs. Given the state of current affairs, she is clearly in an advantageous position and has the ability to dictate all of the terms.

Where does this realignment of political interests leave the European Banks? Let’s just say that Germany would probably vote to clean up their balance sheets and raise needed capital in a far more expeditious manner than what has currently transpired. Markets have begun to force the issue by selling the shares of major European banks hard: Societe Generale is down some 43% in the past month with Deutsche Bank down another 29%. Despite mechanical efforts such as banning short sales of financial institutions, markets will be relentless until such time as there is far better clarity around leverage ratios and sovereign debt exposure. This could well follow the process that US banks followed in 2008 and 2009. These banks could be compelled to write down the value of the sovereign bonds or perhaps they will just have to raise a great deal of capital in advance of any write downs or retiring of the impaired bonds. Time will tell, but these new valuations probably represent a far better starting point for the recapitalization of the euro banking system under the watchful eyes of their most fiscally conservative member.

US Economy - Distinction without a Difference

Economists are fascinated by statistics – a sort of “Inside Baseball” approach to the world. Their faith distinguishes them from the majority of the population which tends to be more focused on reality. The fact that we may have GDP growth of either plus 0.4% or minus 0.4% is of tremendous interest to the pundits while the vast majority of Americans would tell you that the reality on the ground of those differences is not material. We have for years been measuring the economy with tools designed in the 1960’s and have been assigning to them “three decimal point” precision which they simply do not possess. This singular focus on measuring may also mask the failure to address the causes of underlying issues.

In the three years since the Fall of 2008, The Federal Reserve has taken rates from 5.25% to zero and recently pledged to keep them there for at least another two years. They have dramatically expanded their balance sheet to over $2.8 Trillion and may now opportunistically roll their shorter maturity US Treasuries into longer bonds in an effort to flatten the yield curve even more. Yet all of this ample liquidity and lifetime low rates has not been able to accelerate the healing process required of a global financial recession. For market participants who either demand or expect instant gratification, this economy has been one long three year “disappointment”. However, it is interesting to consider where might we be if a more sober approach to forecasting had been applied back in those early days of recovery? We would suggest that the economy has in fact actually behaved in a fashion entirely consistent with a financially ignited recession resulting in a low trajectory recovery. Would employment or industrial production or retail sales be any different? It is impossible to say. However a different set of expectations would have certainly questioned for example, as we did, the repetitive prognostication of higher interest rates.

A Different Kind of Exit

With the Federal Reserve’s statement of August 9th, the committee effectively acknowledged that they have run through their solution set.

“The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.”

Ben Bernanke and his board of governors have provided the most accommodative backdrop of modern times and have now pledged to keep it that way for what amounts to a five year period. But there are practical limits to what monetary policy can achieve.

Low rates have been cold comfort to those responsible homeowners who would hugely benefit from today’s low mortgage rates but who find themselves in either negative or insufficient home equity. We wrote in our August 2010 newsletter, if a fairly simple refinancing plan were available to these responsible homeowners, allowing for the fact that the banks already hold insufficient equity, it would be an enormous boon to these consumers which now represent by some estimates over 1/3 of all mortgage holders.

Low rates have been a bonanza for large US and multi-national businesses that have been able to access the global bond markets and borrow at both remarkable rates and for remarkable terms. We have even seen a handful of Century bonds (100 years) issued by such different credits as the University of Southern California and Norfolk and Southern Railroad. However, not all credits have been welcomed with such open arms. Ask a variety of small businesses and you will likely hear a much different response. Bankers have responded that they are not seeing lending demand at the smaller company level but that may also be a self fulfilling statement. If the perception is that credit is hard to come by, businesses may opt to wait until the backdrop is more favorable.

Historically, investors ultimately respond to lower rates by some combination of reaching for yield in longer duration or lower quality bonds or by increasing their allocation to higher risk assets like traditional equities. In this episode however, we have seen some very different responses.

Gold as a Thermos

Many investors have opted to keep their fixed income investments short in the hopes that higher rates will be available in the not too distant future. This asset allocation decision has been costly as rates have remained low in the short end and have now plummeted in longer maturities. Equity allocations do not appear to have grown judging by mutual fund flows, yet businesses broadly speaking have done a superb job of navigating these past three years. We have seen enormous flows in the direction of commodities facilitated in no small part by the introduction of commodity linked exchanged traded funds. Oil which historically traded at 7-8x natural gas reflecting the energy relationship now trades at a whopping 20x+. This certainly reflects in part the many new natural gas discoveries and the uncertainties surrounding Mid East supplies but asset allocation decisions have surely also played their part.

And then there is gold. Historically, investors in gold had two routes to pursue: they could buy physical gold coins or bars and keep them in a secure location or they could invest in shares of gold mining companies. That all changed in November of 2004 with the introduction of exchange traded fund GLD, listed on the New York Stock Exchange.

Commodities have been the darlings of the past few years. The ease of access coupled with disdain for fixed income markets have led more and more investors to consider those assets which have no income stream, no board of directors, no operating companies. They just go up.

First we were told that gold is a terrific hedge against inflation and gold went up. Then we were told that gold is a great hedge against deflation and gold went up. It reminds us of the old joke about a thermos.

“A Thermos keeps cold fluids cold. A Thermos keeps hot fluids hot. How do it know?”

Where to Now?

During the debate around the debt ceiling, a few commentators shared their gallows humor by stating that at least we were now focused on the right things. We would agree that accepting our current reality is a critical step in the process of crafting effective long term solutions. That this moment of clarity came at this time across a broad array of markets is of course interesting but perhaps not that important in the end.

That the Euro markets are getting serious about sovereign debts and implications on bank capital is enormously positive. We have said time and time again that markets can deal with bad news but will pitch unpleasant fits at uncertainty. Check.

Will the Super Committee be able to agree to a solution? We will remain optimistic. The markets sent a super clear message to congress after their last demonstration of ineptitude.

State and Local governments have, broadly speaking, also shown good progress in dealing with their financial requirements. Should short rates remain at these levels for a while, we would expect to see a wave of pre-refunding announcements which would provide even further relief to issuers and a nice credit boost to bond holders.

We hope that as we reflect upon the market action of 2011, it denotes the point at which policy makers transitioned to the hard work of crafting long term solutions and that this work will be the basis of finally moving the global economy forward.

Best Wishes –

Jen & Patsy


In this Edition

  • The Confluence
  • The ECB – All about Germany
  • US Economy - Distinction without a Difference
  • A Different Kind of Exit
  • Gold as a Thermos
  • Where to Now?

Huntington Steele

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Past Issues

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

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009


More Past Issues
can be found in our

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Market Highlights



12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 11,285
11,578 10,428
S&P 500 US 1,177


1,258 1,115


Nasdaq US 2,480
2,653 2,269
EAFE Int'l Equity 1,455
1,658 1,581


5 Yr Treasury .94 1.75 2.02 2.71
5 Yr AAA Muni .95 1.27 1.75


10 Yr Treasury 2.26
3.38 3.92
10 Yr AAA Muni 2.33
3.44 3.26
30 Yr Treasury 3.55 4.39 4.325
30 Yr AAA Muni 3.97 4.38 4.9
EUR Currency 1.44 1.45 1.34
JPY Currency 76.95 80.44 81.32


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