Puku Ridge

The soft yellow-orange glow of the camp’s night light casts delicate hues over the plain below the ridge.  It is a dark African night.  Ten billion stars and a thin crescent moon are the natural illumination.  The herd of impala moves close to the camp because the night light gives them more protection.  Light reflects in the eyes of the predator cats, and the camp’s glow allows the herd to see the eyes sooner.  Things will change when the camp generator is turned off at 10 PM.  Permanent power is expected in only a few weeks. 

Across the plain large shadows track the huge forms that lumber toward a grazing area.  Hippos have come out of the water and seek their nocturnal feast.  One after another these monsters emerge from the river and cross within our view.  Far on the right side, the impala are nervous and jumping.  We see a hyena on the prowl.  In Africa, on the grassland, night means eat or be eaten.

I am writing this over the weekend from the Puku Ridge tent camp in the South Luangwa National Park in Zambia.  Google will tell you the details for the park.  For Puku Ridge, see:  www.sanctuaryretreats.com.

We have finished the three-day event co-sponsored by the Global Interdependence Center www.interdependence.org and its global partners and hosted by the Central Bank of Zambia at Livingstone.  Meetings allowed interludes to visit the famous Victoria Falls, which is a sight to behold and one of the true wonders of the world.  Wondrous, too, was the conference discourse and the “takeaways.”

The public conference included ministers, members of parliament, four central banks, six commercial banks, and investors and academics.  Private roundtable sessions delved into central bank policymaking and the impact of the financial crisis.  Due to the Chatham House Rule, I have to limit the details reported in this text. 

Suffice it to say the global financial crisis has hurt certain emerging-market economies, and African countries are among them.  Terms of trade are changing and the ability to finance trade has been impaired. This is especially true in agriculture.  There is a deep distrust of banks here and a loud call for more regulation and direction from government.  Clearly banks are on the defensive.

Another important issue is the changing source of foreign direct investment (FDI) in African countries.  In Zambia the Chinese have pledged nearly $5.5 billion USD in investment.  China will own copper mines and smelters as well as industrial parks, agricultural facilities, construction companies, and some health investments.  China is advancing its stake in African countries, and we see it in Zambia.

While Zambians welcome the FDI, they also quietly worry about elephant ivory leaving for China surreptitiously and about the 99-year leases that China will hold and about the special zones in which the Chinese investor firms will operate with some autonomy.  Like all developing and emerging regions that attract monies from a foreign and different culture, Zambia too confronts a double-edged sword with FDI.  But they do not get that much FDI from the West, and they do see inflows from China, India, and other countries that have built up large US dollar reserves and are now spending their dollars on harder assets.

Potential in Zambia is large; their natural resources are abundant.  Forty years ago the Zambian economy and South Korea’s were about the same size.  South Korea has flourished and is a regional economic power. At our conference, Zambians asked why they cannot do the same.  We leave noting that there is movement here and serious interest in the advancement of capital markets and economic growth.  Investment opportunity in Africa, and especially in countries like Zambia, needs to be watched and reviewed. 

Let’s go back to Puku Ridge.

It is midday.  The nocturnal coolness has given way to heat.  I sit in the shade and watch herds of elephants, zebras, and impala graze.  Flocks of multi-colored birds rise and fall and transit the space above the plain.  No worries about the US Treasury deficit here in Puku Ridge.  The giraffe doesn’t care.  Neither do the kudu.

But next week the US banking system gets a jolt from credit-card securities going into liquidation and from commercial real estate loans deteriorating and from the ongoing saga of General Motors, ancestral home of a modern Impala.  I will stop.  Keenan, our ranger guide, is calling for us to come on the nighttime game drive.  Will we see a leopard?

India Votes for Stability and Growth

On May 16, the results of a month-long election in the world’s largest democracy were announced.  India’s 420 million voters had decisively supported the Congress Party-led government of Manmohan Singh. This note discusses the implications of this election for India and for international investors.

India’s population, the second largest in the world, has often appeared to be barely governable, plagued by the conflicts inherent in its caste system, Hindu nationalism and sectarian violence, and divisive regional parties.  These centrifugal forces are still present, but voters gave the Congress Alliance coalition a stable and secular majority, to an unexpected extent. The explanation lies in part in the efforts of the highly competent Mr. Singh to open up India’s economy and the success of the Ghandi family in relaunching the Congress Party. Events in late 2008 also appear to have shaped this outcome.

In recent years the booming Indian economy has significantly raised living standards for many but not all Indians, following decades of underperformance. Economic growth was a strong 6% in 2008. Then India was hit by the fallout from the global credit crisis, causing the economy to slow dramatically in the fourth quarter, and leading to fears of a loss of recent prosperity gains. Also in November, the terrorist attacks in Mumbai shocked the nation and raised Indian-Pakistan tensions to a dangerous level. Following these developments, it is not surprising to us that voters opted for stability and economic growth, but Indian experts did not expect such an outcome. It is notable that, according to the Financial Times, Rahul Gandhi, a great-grandchild of Nehru, in his campaigning in Uttar Pradesh, was the first Indian politician with mass appeal in decades to point out that economic growth is a necessary but not sufficient condition for removing poverty.

Domestic and international investors strongly welcomed the election results, rapidly propelling the Sensex benchmark index on the Bombay Stock Exchange to a 17.2% gain Monday morning, May 18, triggering circuit breakers that halted trading early. The increase was the largest since 1992.  Investors see the election results as permitting the government to move decisively on the large backlog of needed economic reforms. The Communist party, which raised many serious obstacles to past reform efforts, was decimated in its former stronghold of West Bengal and should not be a significant factor going forward. Early reform action is expected in the areas of privatization, removal of barriers to investment, increasing private-sector participation in infrastructure, educational reform, and elimination of wasteful subsidies.  The latter, along with tax reform and the expected return of economic growth to the 5-6% range, should permit the government to resolve current fiscal problems. On the geopolitical front the stronger mandate of the government is regarded as a positive development in the difficult relations with Pakistan.

Developments in the Indian economy are of global significance.  The Indian economy is the 12th largest when measured in US dollars.  Using the more meaningful measure of purchasing power parity, its global rank shoots up to fourth place.  The US is India’s most important market, followed by the UAE, China, and the UK. The high rank of the UAE as a market is probably explained by India’s third most important export, gems and jewelry. The most important Indian export is engineering goods.

Recognizing the improved prospects, we moved rapidly to increase the weight of India in our International, Emerging Market, and Global Multi-Asset Class ETF portfolios. We use for this purpose the WisdomTree India Earnings Fund, EPI, which tracks an index that weights companies based on their earnings, adjusted for a factor that takes into account shares available to foreign investors.  This ETF was already recovering strongly from the large decline of emerging market stocks in 2008 and further decline in the first quarter. By May 15th (the day before the election results were announced) EPI had already increased by some 55% from its March 9th low.

EPI gives diversified exposure to the Indian market. The top sector weights are energy (29.1%), information technology (12.8%), materials (12.7%), and financials (10.1%).  Among the 142 Indian firms included in the fund, the top holdings include globally important firms such as Reliance Industries (18.4%), which led the market advance on May 18; Infosys Technologies (12.8%); and Oil & Natural Gas Corp. (5.6%), which provides 77% of India’s crude oil production and 81% of its natural gas.

We will follow developments in India closely, particularly because of the volatile situation in neighboring Pakistan.

Strategy Update Plus Victoria Falls

Some bullets on different asset classes follow.

US Stocks 

It appears that the March 9 low is seriously established.  Since then, the market has powered higher with broadened participation.  The market has confirmed a determined upward bias.  We can see evidence of this broadening by examining the S&P 500 Index and its component parts four different ways.  Let’s look at four ETFs to support this view. 

RSP is the stellar performer among them; it is the equal-weighted version of the S&P 500 stocks.  From March 9 through May 18 it delivered a total return of 50%.  Compare this with RWL, the revenue-weighted version of the same S&P 500 index; it delivered a total return of 43.5% for the same period.  SPY is the ETF that tracks the cap-weighted S&P 500 index; it was up 35%.  OEF is the cap-weighted largest 100 stocks within the S&P 500 index; it was up 32.7%.  Conclusion: market leadership has been broadening, which is why the specially designed ETFs are outperforming the standard cap-weighted ETF.  Disclosure: RSP is Cumberland’s largest ETF position and a current core holding in US ETF portfolios.

Contrast the above with the performance of these same four ETFs during the period of January 1, 2009 through March 9.  Then the market was in steep decline.  Selling was uniform and impacted all four ETFs nearly equally.  RSP declined 28.4%, RWL was off 29.3%, SPY fell 26.7%, and OEF declined 26.8%.  Conclusion: during the sell-off nearly all stocks fell; after the bottom was formed on March 9 the market leadership changed, which is why the highly correlated performance during the decline morphed into the diverse and less-correlated outcome of the recovery. 

International Stocks

Emerging markets have been the stellar performers in the rally since March.  Brazil and China have been leaders among them.  Many believe that China’s stimulus response to the global financial crisis has been and remains more effective than that in the US.  Cumberland has been overweight China and overweight the emerging markets in international ETF accounts.  Bill Witherell will be writing about the details.  Cumberland continues to overweight this sector.

Tax-Free Bonds

It is safe to say that the Muni market has caught fire.   Interest rates in Muniland are falling rapidly from extremely priced levels.  The 7% high-grade tax-free Muni at the peak quickly gave way to 6% and then to 5%.  Accounts that were funded were rapidly invested and have been able to participate in this rally.  This tax-free bond sector is still cheap.  The ratio of taxable fixed-income to tax-free suggests that the fall in Muni yields (rise in bond prices) is only partially over.  John Mousseau will have more details to offer about this sector and about the demise of the bond insurers.  Cumberland’s tax-free accounts are nearly fully invested and favor longer durations and a selective focus on refunding candidates.  This asset class is still very attractive.

Taxable Municipal Bonds

With the introduction of the Build America Bonds (BAB), this asset class has taken on a life of its own.  BAB issuance is replacing traditional tax-free new issues in many jurisdictions.  Nearly all new municipal bonds are constructed and priced on both a traditional tax-free and a BAB structure.  The issuer is then able to choose which is more economical.  The effect has been to compress the spread to the tax-free new-issue yield and also orient the spread between taxable and tax-free so that it approaches the tax arbitrage of 35%.  We expect that to continue.  Peter Demirali will have more details on this exciting new issue.  Cumberland has been active in taxable municipal bonds for years and is able to apply that experience to this new and rapidly expanding asset class.

Certificates of Deposit

The temporary FDIC insurance limit of $250,000 is scheduled to expire on December 31, 2009.  Pricing in the CD market reflects the risk that it may revert to $100,000.  Some CD investors are altering their behavior when they consider CDs with maturities into 2010 and beyond.  Congress knows this.  The Senate version of the FDIC limit bill extends the insurance to 2013.  The House version makes the insurance limit of $250,000 permanent.  We expect that the $250,000 limit will be extended beyond December 31.  Fast Congressional action would relieve fearful investors in the CD sector.  Getting it from Congress is problematic.  Because there is some political risk, albeit small, we are limiting longer-term CDs to $100,000 until Congress actually passes the extension.

Victoria Falls

We are flying to Africa this Saturday and will participate in the Global Interdependence Center (GIC) conference in Livingstone, Zambia next week.  Details at www.interdependence.org.  We look forward to the central banking discussion workshop, which will focus on how smaller open economies apply monetary policy options when faced with exogenous price shocks.  The genesis of this discussion was in Cape Town over a year ago when GIC learned firsthand of the problems that US ethanol policy was causing in Africa and elsewhere.  Washington’s ethanol subsidy drove corn prices higher, and maize-based small economies like Zambia experienced high food inflation.  About 70 countries in the world were impacted to some degree.  GIC has partnered with the Zambian central bank and other central banks and institutions around the world in an effort to develop dialogue about this issue, which harms about 2.5 billion people in the world and has caused about half of them to be “food insecure.”  We will report on our findings.  

Football and Financial Regulatory Reform

Professional football has a lot to tell us about financial reform, and in particular what we should seek to achieve.   A comparison also suggests a way to think about restructuring the financial regulatory system.

In pro football, there are rules and regulations which govern three key aspects of the game.  One set lays out the basic parameters and nature of the game, such as the dimensions of the field (100 yards long with 10 yard end zones), the number of permissible downs to gain 10 yards or the ball turn overs to the other side, how points are scored, the number of men on a team, how many men must be on the line of scrimmage, how many men on offense can be in motion at one time before the ball is snapped, etc.  They play football in Canada too, but the initial rule parameters are so different that Canadian teams can’t play U. S teams.  The field is longer, the end zones are bigger, the scoring is different, there are 12 not 11 men on a team, more than one player can be in motion on offense, there are 3 not 4 downs to make a first down, etc. 

The second set of rules ensures safety and permissible and impermissible behaviors that define fair play.  This includes the definition of off sides, what constitutes a personal foul, when is a catch a catch, etc.

The third set of regulations are more global in nature and attempt to ensure that over time all teams have a reasonably equal chance to succeed.  The league imposes a salary cap which constrains total team budgets to ensure that big market, high revenue teams can’t fully exploit that advantage to buy the best talent.   But the league does not set or determine individual player salaries.  The draft is structured to give weaker teams priority access to talent, and yearly team schedules attempt to match up weaker teams with weaker teams and stronger teams with stronger teams as a form of handicapping.  Together, these regulations are designed to create a more level playing field and to prevent one team from long dominating others.

Over time, all these rules can change, for example, as offensive or defensive innovations evolve to give one a permanent advantage over the other, as certain blocking or tackling techniques threaten player safety, or as other innovations, such as the forward pass come into existence.  However, such changes occur gradually.

These three sets of rules are analogous to financial regulations.  One set of financial regulations sets up permissible powers for banking organizations, where they can operate, under what circumstances they can merge, coverage limits for deposit insurance, etc.  A second set of regulations – fair play regulations – govern primarily what must be disclosed to investors, what information must be given to depositors about the products they are contracting for and what the rights of debtors and creditors are in the case of default.  Financial institutions are also subject to anti trust and anti fraud regulations and standards which again define the rules of the game in terms of how they may compete with each other for business.  The third set of regulations govern institution safety and soundness to ensure that firms don’t exploit moral hazard incentive in government sponsored deposit insurance. 

Once the game begins, in the case of football, it is overseen by supervisors – referees – whose job is to enforce the rules of play and determine when violations of fair play occur.  There is not one referee, but four who are located on different parts of the field and specialize in watching the defense and offensive line play, the back field and defensive backfield.  In spite of this specialization, however, each can call violations and when two referees see the same play differently, they quickly resolve the issue and play goes on, perhaps with the benefit of instant replay.

In financial services, supervisors function as referees, and institutions’ actions may be scrutinized by more than one supervisor as well as by representatives from the Securities and Exchange Commission and Federal Trade Commission.  They can specify and enforce the applicable rules and also ensure that the participants are financially sound and can meet their obligations.

In football, the best referees are invisible in that they enforce the rules but don’t participate or interfere with the playing of the game.  Teams can succeed or fail, but they can do so on their own, within the rules.  It is critical that referees’ decisions not determine the outcome of the game, especially if an important play is either allowed or disallowed in error.  This too, should be the goal of financial regulation.  Financial institution supervisors should not be interfering with the playing of the game (such as allocating capital within healthy institutions) but instead should simply be determining whether institutions are competing fairly while being operated in a safe and sound manner and reporting their financial performance in a meaningful way.  Unfortunately, this is not the case.

In responding to the current financial crisis, the financial services game has now been altered in hurried and ad hoc ways that differ from the ideal just described.  Imagine a football game in which the referees can now specify not only who plays quarterback, but also how much he can be paid?   This is what the government is doing by dictating executive salaries and determining which CEOs must leave and who can stay in charge of their firms.   In some instances, the referees can even call the plays in that government representatives are “suggesting” that mortgage terms be renegotiated, certain business lines be terminated, etc.  The government is also now giving some institutions a financial advantage by liquefying illiquid assets, providing capital injections, granting special access to the Federal Reserve’s discount window, and making direct loans to troubled institutions. Over the longer term, should too-big-to-fail be maintained as a policy – explicit or implicit – this will be the equivalent to giving large market teams permission to exploit their financial advantage.   Should the present regulatory approach continue, it is also not hard to imagine the conflicts of interest that will confront the regulators.  As participants, rather than simply disinterested arbitrators of the financial game, they will inevitably have a stake in the outcome of the institutions that they have supported, be those institutions primary dealers or those in which the government has invested funds. 

Given the current regulatory approach, it is also easy to prioritize the areas that should first be the target of financial reform.  For example, re-establishing the regulatory agencies as unbiased supervisors and not participants in the game should be a top priority along with removing capital support, government ownership, and involvement in intuition management.  Similarly, ensuring that all institutions are adequately capitalized and eliminating the financial advantage that large institutions have over small ones due to implicit guarantees or too-big-to-fail polices are critical, as well.  Setting executive salaries may seem like an easy target, but will only get government more deeply involved in the micro management of institutions in an unproductive way.  Reforming regulatory structure should also be a lower priority activity compared with changing the underlying incentives to enforce the existing rules of the game, to ensure sharing of information and to resolve regulatory and jurisdictional conflicts promptly.  Football has multiple supervisors with over lapping responsibilities, but the referees’ incentives are better aligned.  Finally, as financial services have evolved into a global business, we now have firms competing with each other under unequal terms.  It is like having professional teams from Canada playing ones from the U.S. but with different rules, scoring and numbers of players. It just won’t work in the long run.   Hence, international cooperation and coordination are a must if the financial game is to be played fairly. 

This homely analogy suggests a litmus test question for assessing and prioritizing financial and regulatory reform proposals.  Would they make sense for football?

Quick Bullets

Quick bullets:

1)  Some of our cash-reserve contingency, built as the swine flu risk intensified, has been redeployed in US and foreign markets.  Longer-term swine flu risk for the next flu season remains.  The race between the technology of vaccine development and the clock ticking toward autumn is now underway.

2) Bank Stress test data at 5 pm tonight will reveal macro-sector numbers, as well as individual numbers for each of the 19 banks.  Requirements for capital and tangible common equity (TCE) will be established.  Pathways for deficient institutions remain to be seen.  This stress test conceptual process will unfold over the next year and a half.  It is built on assumptions.  By definition, that means it is problematic, not certain.

3) Commercial mortgages and commercial real estate remain among the looming issues.  In this sector, deterioration is intensifying and accelerating to the downside.

4) This Friday will reveal the continued erosion of employment conditions in the US.  This is normally a lagging indicator.  We must remember that falling labor income is doubly dangerous when de-leveraging occurs in a financial market crisis.  Such is the case today.

5) China is rightly concerned regarding impacts coming from quantitative easing (QE) by the world’s major central banks.  We see this concern reflected in market responses that deliver rising interest rates on US Treasury notes and bonds.  This collides with the Federal Reserve’s attempt to stimulate residential housing by buying Treasuries to keep the same interest rate lower than it would otherwise be.  The vast majority of the world’s internationally traded debt is denominated in US dollars, euros, British pounds, and Japanese yen.  Those four currencies constitute the bulk of the world’s reserves.  Three of the four have zero interest rates because of QE.  The fourth, the European Central Bank, just cut its policy rate to 1%, the lowest in its history.  No one knows the eventual consequences of this global policy posture.  We can only guess.

We’re off to the Atlanta Fed’s conference next week.  As one of the discussants, we will examine the current banking crisis and its aftermath.

Stress Tests & Tim Geithner’s Bar Mitzvah

Thursday is stress test day. Not on a treadmill, but it may just as well be so.

We are now going to add some Geithner-Bernanke-Summers-esque formula of bank strength or weakness assessment to an already long list that includes Tier 1, Tier 2, TCE, and CAMELS and BOPEC. Tier 1 and 2 capital measures are released by banks in their public disclosures. TCE (tangible common equity) can be calculated from public documents.

Two other ratings are kept confidential. They are critical to regulators; and, in an affront to democracy and transparency, we are not permitted to learn them. Banks are not permitted to reveal them and the penalties for doing so may be harsh. Welcome to modern banking in America.

The BOPEC acronym stands for the five key areas of supervisory concern: the condition of the Bank Holding Company’s (BHC) bank subsidiaries, other nonbank subsidiaries, Parent company, Earnings, and Capital adequacy. BOPEC ratings are assigned according to an absolute scale, from the highest rating of one (indicating strong performance) to the lowest rating of five (very poor performance).

CAMELS ratings are assigned to banks within a bank holding company. Since the condition of a BHC is closely related to the condition of its subsidiary banks, the off-site BHC surveillance process includes monitoring recently assigned CAMELS ratings. The CAMELS system is used by the three federal banking supervisors (the Federal Reserve, the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient summary of bank conditions at the time of an exam. The acronym CAMELS refers to the six components of a bank’s condition that are assessed: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and a bank’s Sensitivity to market risk.

For a critical discussion of the coming stress test environment see Dick Bove’s guest commentary on Cumberland’s website: (The link is no longer available). We thank Dick for giving our readers access to his essay. We agree with him.

We also thank the San Francisco Fed Research Department for their assistance. Readers may wish to consult the 2009 Economic Review. A paper by John Krainer and Jose Lopez excellently sets forth the variability of regulators’ ratings over time. I wonder if Treasury Secretary Geithner read it. I also wonder if it shouldn’t be mandatory reading for anyone hired in any bank regulation capacity. The authors note how the goal of FIDICIA (acronym for Federal Deposit Insurance Corporation Improvement Act) was to (1) “assure the least-cost resolution of insured depository institutions that were sufficiently near insolvency” and (2) “improve bank supervision.”

Dear reader: how would you rate the government on their success? What makes you think any new systemic regulator can do any better? Isn’t it time we finally let some sunlight fall on this mess? Why are we persisting with a sequence of questionable programs? The next ones will be TALF and PPIP. See: http://www.cumber.com/a-lynch-mob/.

Let’s add a specific note about commercial real estate and bank holdings of commercial mortgages. We think this is the next shoe to drop. In fact, it may become a boot!

Banks and insurance companies hold billions in commercial mortgages. Unlike residential housing loans, these mortgages are not heavily securitized. And they are not marked to market on the bank’s balance sheets. The securitized version is marked under the new FASB rules, but if the loan is held by the bank a different set of rules is applied. The banks reserve for expected actual loan losses over the future 12 months (four quarters) and update those reserves quarterly when they report earnings.

We may soon find out what the stress tests will tell us about this asset class. Or it may be hidden from us, as are the key ratings or BOPEC and CAMELS. If it is hidden, it should be worrisome. Transparency is something that gets lip service in Washington, but somehow doesn’t get implemented into credible policy.

There is a falling price level in the commercial real estate (CRE) market. It is a national problem and it is accelerating to the downside. Furthermore, CRE lacks the political constituency that surrounds residential housing. No Washingtonian would sponsor foreclosure protection for a mall developer. That means market forces will drive the price level for CRE.

Those prices will be influenced by rising vacancy rates, which continue unabated nationally, coupled with the major upheaval occurring in the automobile industry. The latter is important because the franchise agreements that protect individual auto dealers are going to be broken in bankruptcy. That means many dealers will close. Some already have.

Picture CRE with thousands of empty auto dealer facilities lining our highways around the United States. These are splotches of commercial space that will be empty for years. Financing to save them is nearly impossible under the present banking industry status. And the demand for that space is negligible.

All this weighs on CRE. We think the best metaphor for CRE nationally lies in the three-decade-old picture of Houston with its “see-through” buildings of the mid-“80s energy bust. But that CRE bust was limited in geography to the nation’s oil patch. The present CRE is truly national. Want stress tests to tell you something, Mr. Geithner? Give us the details on this sector and each bank’s exposure to it.

A second disturbing aspect of CRE lies in the existing loans and projects. A client case study is appropriate here. We will call the client Mr. K. He has a project about to be completed. It will convert to permanent financing. His cost is $5.7mm. He has a first-rate tenant for a ten-year triple net lease. In the old days he could easily get credit insurance or enhancement for the lease payments, to give additional security on the mortgage. Those days are gone.

He was set to borrow 75% of his $5.7 million cost. Now the bank wants a new appraisal under more stringent lending rules imposed by regulators. The new appraisal reflects a value estimate for $4.7 million even though the cost is $5.7. The bank will now lend only 65%, not 75%. This is an actual example of the new paradigm in CRE

This paradigm shift anecdote demonstrates how the deleveraging in CRE will act to intensely depress CRE prices. Our client is financially strong and will be able to fund the additional cash and complete the project. But he will be a lot more cautious about any new project and will require a higher return on equity due to these changes. A less well-managed business with weaker credit will be frozen out of the market. That weaker business may fail.

Will there be bargains ahead in CRE? Yes. At what price level? No one knows. We have seen estimates ranging from 15% down to 35% down. CRE, like residential housing, is ultimately dependent on local geography so the national number is just a composite of many local numbers.

We don’t like some of the federal government’s solutions to the financial crisis. Some of them are making things worse. The results have been delayed and dampened by politics because they are centered in the housing sector. That is about to change. CRE will be the first free-market test of an adjustment in the real estate price level; provided that the government doesn’t manipulate that sector with programs like TALF and PPIP. Remember: all government intervention and subsidy Is ultimately at taxpayer expense.

Cumberland remains underweight this CRE sector in its ETF accounts and in its selection of bond sectors.

We want to end with this marvelous quote from Congressman Barney Frank. It seems he has turned on Mr. Geithner and is defending the banks’ right to repay the TARP money, while Geithner is objecting to the repayment. In an interview with the Financial Times (April 25), Frank said: “They made a mistake with Geithner: they put him out there when he wasn’t ready. Geithner sometimes gives the impression that he’s giving a bar mitzvah speech and his voice is going to crack.”

A bar mitzvah speech from the Secretary of the Treasury of the United States of America: now that is stress test!

Many thanks to the San Francisco Fed Research Department, Dick Bove of Rochdale Securities, and to Chris Whalen, our friend and a driving force behind Institutional Risk Analytics, www.institutionalriskanalytics.com. Chris publishes an independent bank-rating service, which we use. Readers may wish to try it as they follow a particular bank of interest to them.

The Deepening Recession In Europe

In its latest, very gloomy “World Economic Outlook” (available at www.imf.org) the International Monetary Fund revised sharply downward its economic growth projections for the euro area, to – 4.2% for the current year, followed by -0.4% in 2010. The most recent OECD projections for the region, published in March (available at www.oecd.org) are almost identical (-4.1% and -0.3%). The European Central Bank’s forecast for this year is a much more optimistic -1.7% decline, with recovery taking hold towards the end of the year.  There admittedly have been some positive signs (“green shoots”) such as a surprisingly strong rise in purchasing managers indices for the euro area and a revival in French business confidence.  On the other hand, however, the German Finance Minister recently indicated “The downwards dynamic is not letting up.”  While we do not fully share the pessimism of the IMF and the OECD with regard to the global economy, we do agree that the euro area is in the midst of a deep and probably prolonged recession.

These projections by the international organizations as well as the above mentioned surveys were done before governments and health authorities around the globe went on alert for a possible influenza pandemic. While the swine flu outbreak is centered in Mexico, suspect cases have been identified in a number of countries around the globe, including in Europe. There is still great uncertainty as to how serious this threat will become and its effects on markets. If the euro zone avoids a pandemic outbreak, the weakest economies would still be hit by any global increase in risk aversion that this threat could cause. Should the euro area countries be hit hard by the flu, the IMF projections would likely prove to be optimistic.

The euro area (or eurozone) consists of the sixteen European countries that have accepted the euro as their currency:  Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.  The central bank responsible for monetary policy in the euro area, the European Central Bank (ECB), has been acting as if it believed its own more-optimistic projections, that is, its latest, restrained 25-basis-point cut of the repo rate in April leaves that rate at 1.25% (in comparison with the US discount rate, which was reduced to 0.5% four months ago, and the UK repo rate, which was reduced to 0.5% a month ago).  The actual market overnight interest rates, however, have been driven down below US and UK levels due to the liquidity resulting from the ECB’s liberal lending to banks. The ECB has also been very reluctant to engage in so-called “quantitative easing” through buying assets (commercial paper, bonds) directly to boost liquidity in markets, an approach that has been used by the US Federal Reserve and a growing number of other central banks. The ECB is likely to take some further, probably modest, actions this week.  Thus far, an unwillingness to take prompt and effective action in the face of the severe recession has left the ECB appearing to be reactive and behind-the-curve.

Financial-sector problems in the euro area are continuing to unfold. It is striking that although the US has been the epicenter of the global financial crisis, the economic contraction in the euro area is more pronounced and problems in the euro area banking systems also appear to be more severe, with corrective actions generally being too little and too late.  The IMF calculates the capital injections needed by euro area banks are at least $350 billion, far above the estimated $275 billion for US banks.  While US banks are estimated to have so far recognized about 50% of the toxic assets on their books, euro area banks are far behind in this process, having recognized only about 20%.

While some of the toxic assets relate to real estate loans, others relate to lending to Central and Eastern Europe. Some of the latter states, such as the Baltics, have seen their fortunes change from being the fastest-growing economies in Europe to now having to seek assistance from the IMF. Latvia, for example, received $10 billion from the IMF in December and is anticipating a GDP decline of some 13% in 2009. Hungary also has received IMF support, and Romania is requesting the same.  Austrian banks have been the most active in extending loans to the region, followed by Belgium, Germany, Italy, and Sweden; and the Central and Eastern European subsidiaries of these Western European banks have suffered significant deterioration in their financial condition.

This grim story evolving in the eurozone is to some considerable degree a result of the constraints imposed by a single-currency regime covering sixteen quite diverse economies. During the present decade, three of those economies, Greece, Spain and Ireland, experienced prolonged booms, with pronounced overheating and resulting wage and price inflation, along with booms in property markets.  Over the same period, economic growth, job creation, and wage growth in Germany and France have been very restrained. Evidently a one-size-fits-all monetary policy can not adequately address the diverse situations of these economies.

Further aggravating the situation, the absence of any euro area discipline with respect to external borrowing has permitted the three booming economies to borrow excessively abroad, and their current account deficits have reached levels that raise solvency concerns. Since the usual adjustment mechanism of changes in exchange rates is not available, severe depression of domestic demand (deflation) is unfortunately the probable adjustment path in Greece, Ireland and Spain.

Turning the above situation around would require very significant new supportive action by the ECB and/or the IMF. Possibilities include a large IMF rescue package, direct support by the Germans and the French, and having the stricken euro area nations issue bonds that are purchased by the ECB (monetization of this debt). There are difficult political and budgetary obstacles to such measures, and continued policy inaction is probably the most likely situation going forward.

The implications for international investors are that euro area equity markets are likely to underperform relative to global markets for some time, and over the medium term the euro-US dollar exchange rate is likely to weaken as the more-rapid recovery of the US economy becomes apparent. Among the euro area countries, we expect the best relative performance from the equities of German, French, Dutch, and Belgian firms. At Cumberland, our International and Global Multi-Asset Class ETF portfolios have underweight positions for the euro area.

Swine Flu Strategy Update

Type A, H1N1 “swine flu” responses range from complete complacency to proactive prevention.  We see both in the United States and elsewhere in the world.  Some of the leading epidemiologists at the Milken Institute Global Conference give this version of flu a 50-50 chance to be a large-scale killer, according to Barron’s journalist, and my good friend, Jim McTague (see Barron’s, page 34, May 4, 2009).

Cumberland is in the “take this seriously and hope we’re wrong” camp.  In our market actions we raised a cash reserve last week.  This was easier to do after an eight-week, 30% stock market rally.  So I guess it’s fair to say that the swine flu timing was opportunistic.  Selling and raising cash at 850 on the S&P 500 index at the end of April is a lot easier than selling and raising cash when the S&P 500 is 666 and the date is March 9. 

So far, AH1N1 “swine flu” is looking like the SARS outbreak when it comes to economics and market impact.  Swine flu (so far), SARS, and avian flu (H5N1) were and are limited to a few thousand worldwide cases that have been documented and confirmed by lab tests.  So far, they have triggered deaths counted in the hundreds.  

SARS in 2002-3 had a death rate of about 9.5%.  Swine flu (so far) has a death rate of about 6.5%.  Avian flu has not jumped to an easily transmissible form.  It is still a bird disease.  It is also a killer.  The cumulative 421 cases in the 2003-9 period have a death rate of 61%, according to the confirmed lab tests.  Remember, when it comes to flu, the statistics only count those cases in which a certified lab was able to confirm the virus as the cause of death.  Epidemiologists believe that there are many unreported cases in third-world countries and emerging economies.

There are three references for big flu shocks. 

The first and the most infamous is the 1918-20 period involving the “Spanish flu.”  That was also a variety of the H1N1 strain.  Global deaths in 1918-20 attributable to that flu are estimated at between 40 and 100 million, or somewhere between 2% and 5% of the total world population.  In the US about 25% of the population was infected with “Spanish flu” and about 500-700 thousand died.  In 1918 the first outbreak came in the spring and was as small as the current flare-up of H1N1.  The real killer phase occurred in the subsequent flu seasons of late 1918-1920.

In the Asian flu episode of 1957-58, the virus form was H2N2.  Estimated global deaths were 1 to 1.5 million. 

The third reference is the Hong Kong flu of 1968-9.  It was the H3N2 strain and had a low death rate but a high infection rate.  Globally it killed about 1 million people.

We have no idea how the current H1N1 “swine flu” risk will play out.  We do know that media coverage and information flow is heightened, and that is good thing.  Sensitizing large segments of the global population induces many to act preventively rather than remain complacent.  We hope that it only takes a few deaths for folks to take this seriously.  Preventive actions like closing schools, frequent hand washing, and wearing masks all combine to reduce spread of the virus.  A race for a "swine flu" vaccine is underway; scientists now compete with the clock which ticks toward autumn flu season.

At Cumberland, we have distributed masks and hand sanitizers to all our staff; we have a flu pandemic contingency plan and have activated it.  I wear an N-95 mask in public places like airports and on flights.  We practice risk management in the portfolios we manage and in the business life we conduct.  And we hope that the outcome will be inconvenience and not something more severe.  It will be another year or two before we know the full outcome of this “swine flu.”

Many thanks to our medical friends who must remain anonymous but who confirm the seriousness of the risk.  And also thanks to Barclays Capital, Credit Suisse, Wachovia, and Barron’s for data and concept assistance.


Investing Globally Under an International Health Emergency Alert

The World Health Organization (WHO) on Monday evening, April 27, raised the level of the influenza pandemic alert to “Phase 4.” This means that while a pandemic is not inevitable, the risk that one will occur is “significant”. A WHO spokesman indicated that any attempts to contain its spread have been abandoned and they are stressing instead the need to mitigate its effects.

Earlier in the day on Monday, global equity markets reacted negatively to the swine flu worries. At this point there is insufficient information to judge whether a pandemic serious enough to impact global economic activity will develop.  If, as we hope, this can be avoided, negative market effects would prove to be transitory.  On the other hand, should a serious global pandemic occur, the prospects for the recovery of an already fragile global economy would be dealt a heavy blow. As long as the current uncertainty about this global threat continues, equity markets are likely to be volatile and experience a reduction in the readiness of investors to take on additional risk.

As a precautionary measure, we have decided to build up a cash reserve in our International, Emerging Market, and Global Multi-Asset Class portfolios.  In doing so, we have given emphasis on taking some of the profits from the recent sharp run-up in emerging-market equity markets. We continue to believe that over the course of 2009, the emerging-market equity markets will outperform the global average, but they may have gotten a bit ahead of themselves.

In recent years, the months November through April have typically been the strongest period for emerging-market equities, followed by pullbacks. Also, any general increase in risk aversion on the part of international investors is likely to hit the emerging markets hardest.  If the risk of a pandemic becomes an actuality, many emerging-market economies are likely to suffer from having less advanced medical systems. The ongoing experience of Mexico in comparison with that of the United States may serve as an illustration of the importance of this systemic difference in ability to address such a medical challenge.

We recognize that raising cash in portfolios as a precaution in such times can mean foregoing some of a future market advance in the absence of adverse developments.  The move, however, will cushion portfolio performance if the markets fall. Capital preservation is Cumberland’s overriding priority in managing portfolios.

Mexico Back to Zero

Things had finally started to look up for Mexico following a steep economic contraction in the fourth quarter of 2008 (GDP down -10.3%) and the first quarter of 2009 (-12%) and an increasingly violent drug war.  President Obama’s visit to Mexico City signaled increased American support in the battle with the drug gangs and, more generally, a higher profile for Mexico in US foreign and commercial policies. Also, the increasing signs of a nascent recovery in the US economy have very positive implications for the closely tied Mexican economy.  The IMF will be helping backstop the Mexican economy with a Flexible Credit Line (FCL).

International investors had started returning to the Mexican market.  The iShares MSCI Mexico Investible Market Fund ETF, eww, shot up by 50.7% between March 9 and April 24.

The outbreak of the swine flu virus has changed Mexico’s prospects dramatically.  The tourism industry, already hit severely by the high level of violence in some regions, will be crushed.  With the country at the epicenter of this global health alert, Mexico’s ability to carry out international business will likely be constrained.  Should the flu spread widely within the country, commercial activity in all sectors could be seriously affected.  It is too early to judge whether efforts by authorities to contain the spread of the disease will be effective.  The risk of a more prolonged recession has suddenly become high.

At Cumberland, we have reversed a recently added small Mexico position in our emerging market portfolios. We now hold no Mexico-specific securities in our managed accounts.