Issue 74 - September 29, 2011


Broken Transmission

Global markets were buffeted in the third quarter. Against a backdrop of “disappointing” economic news, global leaders poured pure fuel on their respective fires. Here in the United States, the congressional melt down over the debt ceiling began in late July. While we fully expected a period of debate before a resolution, it was shocking to watch and destabilizing in reality to see the lack of understanding and seriousness demonstrated by all parties.

The relief provided by the actual agreement was short lived. By Friday afternoon of that week, S&P followed through on their very clear intentions to downgrade the debt of the US Treasury by one notch from AAA to AA+ if “meaningful” debt reduction was not incorporated into the bill. S&P did not opine as to whether debt reduction should result from increased revenues or through cut backs in spending or any possible combination. They simply drew a line in the sand at $4 trillion and said in their opinion that was where “meaningful” started and the final bill fell well short of that. The immediate reaction among the pundits was to excoriate S&P reminding all that this was one of the firms to miss the mortgage market structural flaws. This however misses the point. S&P is a rating agency offering their opinion. Having made one glaring error does not relegate them to never having a proactive call again.

This bombshell was followed four days later by a scheduled Federal Reserve meeting where the committee stated:

“Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected.”….

“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.”

That the Federal Reserve was essentially admitting to being surprised by economic conditions was devastating to market confidence and the timing just could not have been worse.

Meanwhile European leaders did no better. After 18 months of debate and delay regarding the disposition of insolvent sovereign bonds, the markets became the final arbiter. Stocks of leading European banks were devastated. Société Générale and

BNP were both off in the neighborhood of 50% while Deutsche Bank was down some 38% during the period.

Germany offered to pass a plan to inject badly needed capital into the Greek drama, in exchange for much improved control over the bailout fund known as the ESFS. However, it was August, and there would not be a quorum available to vote in these emergency measures until fall. Amazing. Some 60 days later, leaders are no further along in any concrete plans to raise bank capital or provide for a default procedure. The euro zone issues are further complicated by the need to address the 17 voting member’s wishes, but make no mistake, there is essentially only one vote that really matters and that is Germany’s. Germany is the only country with the economic horsepower to drive the zone.

Without structure or procedures that allow for meaningful modifications of the original Maastricht Treaty, the immediate answer falls to Germany to use their resources to buy more time. This is what has essentially taken place to date. But the German citizens are losing patience with the process as well and this may complicate matters further by weakening the current set of leaders in the government or potentially ushering in an entire new set of players.

Despite the fact that the financial crisis in the US had its roots in the housing markets and the Euro Zone had theirs in sovereign bonds, both markets are suffering from the consequences of over leverage. The vacuum in leadership haunts both sides of the Atlantic and is no doubt making tough matters that much worse. The reality is that the cure for over leverage is less leverage and this process has historically taken a long time. The Federal Reserve with their policy statement of August 9th should make this perfectly clear. After three years of extraordinary steps in monetary policy and lows in rates that rival anything that has been seen in 75 years, the committee still felt compelled to say that it would be another two years before the economy might be delevered sufficiently to begin a normalization of interest rates.

Chickens and Eggs

Further aggravating the situation is what appears to be the next chapter in consumer behavior; secular changes in attitudes regarding spending habits, reliance on debt, and home ownership. Given the overweighting of consumer behavior in our GDP, it is no small wonder that significant changes in these critical areas would impact economic growth and in particular employment.

These changes are likely not happening simply because the consumer has discovered thrift. The deleveraging process is being turbo charged well beyond the control of policy makers by the contraction of credit provided. Banks are the transmission of the economy – taking monetary policy and delivering credit as priced by the Federal Reserve and market forces. Banks both here and abroad however are not playing that role particularly well at this time.

US banks are working through defaulted mortgages, foreclosed homes, and a rising tide of potential liability resulting from shabby underwriting. In Europe, the banks for years used sovereign bonds as a cheap source of capital. The problems surrounding the P.I.G.S. have left them with an extremely thin capital layer or in some cases with none at all. Collectively, they are certainly in no position to advance new credit. These European problems are made so much more immediate as bank lending represents a far greater percentage of total credit than it does here in the US with our broad and deep capital markets.

The broken transmission phenomenon is at a minimum slowing the recovery inclined forces within the economy. Banks will say their loan demand is slowing and they are responding appropriately but there are undoubtedly qualified borrowers who are put off. One pundit suggested that we have gone “pillar to pillar” when it comes to the psychology of offering credit. That says it all.

Without the banks, the deleveraging process is accelerating. Close to 1/3 of all home purchases are now made for cash. This compares to less than 15% previously. While it is good news that homes are trading under any terms, what does it say about our policies when with historically low rates, the number of cash buyers has more than doubled?! This is a clear example of why the Federal Reserve could and would make the two year statement as to their intentions. The full impact of their policy cannot fully take effect until we are much further along the deleveraging continuum and when the banks and other financial intermediaries are not fighting for survival.

Where to?

The problems presented by the global economies and the questions surrounding leadership’s ability to address these matters drove investors from commodity and equity assets in recent weeks and into the safety of the sidelines and US Treasuries. This trend was further fueled by the latest actions of the Federal Reserve named “Operation Twist”. At their September 20th & 21st meeting the committee decided to shift the duration of their massive US Treasury holdings by selling some shorter dated bonds and buying a like amount of longer dated bonds specifically targeting those bonds in the 20-30 year sector. The idea behind this exercise is to further flatten the yield curve. This should in due course encourage investors to again look towards traditionally higher yielding assets.

However, the fact remains that recovering from financial excesses takes time. As we noted before, banks are currently fully consumed with cleaning up their distressed positions and no amount of super cheap money is going to change this situation immediately. Those three Fed governors who opposed these latest measures are concerned on two fronts. At some point in time all of this accommodation will have to be taken away and they are not entirely convinced that more of anything is the cure to what ails the market at this time. These are certainly legitimate concerns but time is one thing that the Federal Reserve can provide the markets and the majority on the Committee felt this was an appropriate next step. The market reacted to the news with a monster rally in the longest of US Treasuries which rallied some 40 basis points before profit taking kicked in. US 10 year notes also saw interest driving their yields down to 1.76% at one point. The reality of low long term rates for what is really an extended period of time has some profound investment implications. Consider as just one example, the pension fund community.

Pension plans are required to account for their liabilities by using a discount factor that the plan and its actuaries consider a long term achievable investment return. So, if the plan thinks it can earn 8%, the liabilities are discounted back at 8%. If that figure drops to 7% the present value of those liabilities grows considerably. If long term interest rates settle in at say 2 or 2.5%, the trustees of these plans are going to have to think long and hard about what the long term return potential should be and what would be the appropriate asset allocations in light of this. Could this ignite a new round of interest in equity investments? What market multiple would investors accept in light of such a change in interest rates? All of these are going to be hot topics in the coming year.

For the near term, investors are likely to see continued volatility as markets respond to the good and the bad of policy decisions. Corporations have demonstrated remarkable resilience throughout these past three years and a compelling case can continue to be made for owning high quality, individual businesses. Long term municipal bonds have rallied along with US Treasuries. While the absolute level of offerings is not what we have seen in the past, there is still value to be had at this time.

As we have articulated in previous writings, it took some time to create the conditions that set the stage for the current global macroeconomic environment and it is going to take some time work through this episode. We should not expect our collective desire for instant gratification to be rewarded. However, we can take advantage of opportunities to create and fine-tune resilient investment portfolios that meet individual needs and succeed in the long-term.

Best Wishes –

Jen & Patsy


In this Edition

  • Broken Transmission
  • Chickens and Eggs
  • Where to?

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

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

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
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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 11,011
11,578 10,428
S&P 500 US 1,151


1,258 1,115


Nasdaq US 2,492
2,653 2,269
EAFE Int'l Equity 1,395
1,658 1,581


5 Yr Treasury .98 1.75 2.02 2.71
5 Yr AAA Muni 1.04 1.27 1.75


10 Yr Treasury 2.09
3.38 3.92
10 Yr AAA Muni 2.15
3.44 3.26
30 Yr Treasury 3.14 4.39 4.325
30 Yr AAA Muni 3.87 4.38 4.9
EUR Currency 1.37 1.45 1.34
JPY Currency 76.38 80.44 81.32


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