Is the Municipal Bond Market Sleepy?! Pension Doomsday?

Today’s municipal bond market is anything but “sleepy,” as Spencer Jakab characterized it in his Wall Street Journal article “Prophet of Muni Market Doom Wasn’t Wrong, Just Early” (10/26/2018). The Prophet of Doom he referred to was Meredith Whitney, who shortly before the financial crisis successfully predicted the damage to Citibank by bad mortgages. In 2010, on 60 Minutes, she contended that municipal market participants were not addressing or recognizing pension risk that would contribute to “50 to 100 sizable defaults” on municipal bonds over the next year. This comment caused a rout in the municipal bond market, but we now know that a large number of defaults did not materialize.

Market Commentary - Cumberland Advisors - Is the Municipal Bond Market Sleepy - Pension Doomsday
The market is heterogeneous. There are over 80,000 municipalities in the United States, and each of those entities can issue various types of debt, from general-obligation bonds backed by the taxing power of the municipality to revenue bonds that are secured by user fees such as water and sewer rates. Municipal bonds fund everything from fire trucks to schools to major road projects. Bond maturities can exceed 30 years. Thus, there are many investments to choose from. Municipal bonds offer tax-exempt income and can be used for impact investing,  because municipal bonds finance projects that have environmental, social, and governance (ESG) implications.

Many participants in the marketplace are aware of pension-funding shortfalls as well as the growing burden of providing healthcare to retirees and paying for long-term debt. They understand that if the problems aren’t dealt with, the financial implications down the road could be severe. Jakab’s article does not mention the states and municipalities that are taking action to improve pension funding status and what those actions are. That perspective could have helped WSJ readers and others, whether they are taxpayers, pensioners, or bond investors, to understand their towns and states better and take some action instead of being afraid.

Pension obligations are long-term and large. Just as an ocean liner takes a long time to turn, so, too, municipalities must anticipate in advance how to proceed. The pension issue does need to be addressed; however, it may not be an immediate threat in many jurisdictions. Actions that can improve pension funding include lowering the assumed rate of return on investments and fully funding or overfunding the actuarially required annual contribution (ARC) to the pension, (funding at this level keeps the funded level growing to meet future obligations). The municipality can alter certain pension benefits, for example by reducing cost-of-living adjustments or changing the level of benefits for future employees – all difficult decisions. Because liabilities can mushroom, it is important for municipalities with underfunded plans to make changes sooner rather than later. An increasing pension burden, just like your personal credit card debt, can balloon if you do not make more than the minimum monthly payment.  These payments can compete for spending on other items.

States that have been able to implement pension reforms include Ohio, Colorado, Minnesota, and Kentucky. Although the Kentucky changes are being challenged, there is now more recognition in the state that something needs to be done.

Many observers look at the unfunded status of a plan. For example, Pew Charitable Trust annually calculates those figures.  The average funded level of a state pension fund based on 2016 data is 66% with the lowest funded at 31% for New Jersey and Connecticut and the highest funded plan was Wisconsin at 99% funded.  Moody’s calculates an Adjusted Net Pension Liability (ANPL) by making changes in assumed rates of return, among other variables, to all state pension funds.  This makes state funded levels more comparable and realistic. Moody’s uses discount rates between at 3.0%–4.0% while most pensions still assume 6.5% to 7.5%. A lower discount rate increases the unfunded status of a plan so is more conservative.  Moody’s compares the ANPL with state revenue to rank the states based on the metric.  The highest ratios are for Illinois (600%), Connecticut, Kentucky and New Jersey (290%) while North Carolina, North Dakota, Wyoming and Utah have ANPL well lower as a percent of revenue at 45% or under.

Other post-employment benefits (OPEB), mostly healthcare, were historically funded on a pay-as-you-go basis. OPEB liabilities are now required to be recognized in accordance with accounting standards recently implemented for periods beginning after June or December of 2017, specifically Governmental Accounting Standards Board (GASB) Statements 74 and 75. This is a positive development, allowing a municipality and its citizens a more transparent view of fiscal health. It is even more important as retirees live longer and the cost of healthcare rises. Many healthcare benefits are not contractually fixed, as pension benefits are; however, reducing benefits may be politically unpopular, in effect making healthcare benefits almost as difficult to change as pensions are.

Technological improvements have helped improve efficiency at municipalities, but the improvements have also led to there being fewer current employees to support a growing retiree population, which further exacerbates the pension issue. Further developments in technology may give municipal managers pause as they determine which direction to invest in for the future.

There are other risks to the long-term economic viability of municipalities – exploding pensions are just one of them. There is the widely publicized issue of deferred infrastructure spending, which reduces livability and could be a negative for economic development and a safety risk to a community. Deferred spending also makes projects more expensive. In addition, there is the prospect of having to prepare for sea level rise, coastal erosion, and more extreme weather and fire events.

The increasing wealth gap and affordability issues affect social service spending and tax-rate and service-fee-rate increase management. Municipalities have many competing spending needs.

I’m not trying to paint a dire picture, but I am trying to impress upon readers and casual observers of the municipal market that market participants are in fact aware of long-term challenges. Ratings and credit analysis are based on many factors, including the strength of the service area economy, financial operations, long-term plans, and management performance. Ratings are not based on one item unless that one factor is overwhelming.

The fear of widespread municipal defaults in 2010 and the ensuing rout in municipal bond prices created a buying opportunity for investors that knew the market. For many investors, the timing of when to exit a bond is the issue. Do investors exit as soon as they see the light of the pension crisis train barreling down the track, or just before the train wreck? Conservative investors generally do not invest in the state obligations of Illinois, New Jersey, or Connecticut because of those states’ burgeoning pension and OPEB obligations (additionally these states suffer from slow or negative growth in population and dysfunctional governance). Cumberland, as a conservative investor, has avoided the bonds that would have suffered from the multiple downgrades of those states.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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Cumberland Advisors Week in Review (Nov 12, 2018 – Nov 16, 2018)

Cumberland Advisors Week in Review

The Cumberland Advisors Week in Review is a recap of news, commentary, and opinion from our team. These are not revised assessments, and circumstances may have changed in the market from the time of original publication. We also include older commentaries that our editors have determined may be of interest to our audience. Your feedback is always welcome.

MATT MCALEER’S WEEKLY RECAP

Taking a look at Global Markets. “Embrace the Grind!” The day to day has had some whip to it. What prices looked good? Where did we put cash to work? How about energy? We have an update for you about International and Emerging Markets. WATCH HERE.

 

Cumberland-Advisors-Matt-McAleer-Update-November-09-2018-Video

 

MARKET COMMENTARY

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FEATURED VIDEO

David Kotok shares the latest on Trump, the Trade War with China, & Trade Relations.

Cumberland-Advisors-David-Kotok-Trade-Update-November-15-2018

David Kotok contends that the China-US Trade War policy is failing and that it can be reversed. He goes on to say that Trump could achieve a truce with Xi Jinping and that the world and markets will respond positively and businesses will then be able to plan capital expenditures, their expansion, and growth with some certainty. He further states that chaos coming out of Washington, which is seeded in a failing trade war policy, is causing our financial markets to be punished and it’s self-inflicted wounds. Watch this brief clip to see David enumerate in detail.

The video is available here.


IN THE NEWS

 

 


IN CASE YOU MISSED IT

    • Mexico and Trade

      Robert Eisenbeis, Ph.D. 2/07/2017

      With Trump, Trade, China, BREXIT, and NAFTA in the headlines, we revisit this commentary from Feb 2017. The state of US trade with Mexico is on the front page as policy makers attempt to stem the outflow of firms, jobs, and goods production from the United States. To put the issues in perspective, it is first helpful to have some facts on US trade in general and trade with Mexico in particular. By comparison with many countries, the US economy is still dominated by domestic production and consumption. In the euro area, for example, trade amounts to about 69% of GDP, and in the UK it is about 38%. In the US economy, by contrast, exports amounts to less than 16% of GDP, and imports are only about 12.5% as of yearend 2015. Our trade deficit in goods and services is slightly less than 3% of GDP in total, down from a peak in 2005 of slightly more than 5%. Continued…

 

  • Bursting Bitcoin Bubble?

    David R. Kotok 7/06/2018

    We have been asked again about Bitcoin and “bubbles” following the recent gyrations and the plunge. “Should I buy it?” asked a reader. First, we offer the required disclosure: We don’t own any cryptocurrency in any Cumberland managed account. And we don’t own any derivative or other form of crypto. We have avoided the group. We don’t see crypto as a deep-enough and mature-enough assemblage of tokens to qualify as an asset class – yet. That assessment may change at some point but not likely soon. Nick Colas and Jessica Rabe have been tracking Bitcoin for a while. They write about it from time to time. “We’ve been tracking Bitcoin wallet growth and Google search term volumes… as the carnage has unfolded. Our repeated message in these pages: the former is growing only slowly, and the latter is in outright decline. Bitcoin is ultimately a technology, and without incremental adoption growth it has a tough row to hoe.” Later in their research they add the following warning: “To be clear: we’re not calling a bottom on Bitcoin, but its complete decoupling from stocks may be one sign of a washout [s]ince it now resembles the time before anyone but computer nerds really cared about it.” Continued…

Have you subscribed to our YouTube Channel?Thank you for engaging with us, your comments always welcome.

 

Cumberland Advisors
Weekly Update
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BREXIT Breakthrough Followed by Threat of Breakdown

On November 13, British Prime Minister Theresa May and her Brexit negotiating team reached agreement with the European Union (EU) negotiators on a draft withdrawal treaty. The next day, after a very difficult five-hour meeting, May secured the agreement of her cabinet. Following the cabinet meeting, she told reporters “The choice before us is clear: This deal, which delivers on the vote of the referendum, which brings back control of our money, laws and borders, ends free movement, protects jobs, security and our Union; or leave with no deal, or no Brexit at all.” She reportedly told her cabinet that the deal, while not perfect, was as good as the UK can get.

It was evident the deal was not good enough for some of her cabinet members, and resignations were likely. Still, the country was shocked today (November 15) by the resignation of May’s Brexit secretary, Dominic Raab, her chief Brexit negotiator, who could not support the deal. Several other secretaries have resigned, and more may follow. A deep political crisis is developing for May, for the country, and also for the EU.

The deal may be the best the UK could have obtained at this point, considering that, as the Financial Times said today in an editorial, “The UK has a weak negotiating hand, and the May government has played it poorly.” The 585-page draft agreement had to address many issues. The most difficult has proved to be the Irish border. Recall that Northern Ireland is part of the UK and along with the rest of the UK will be exiting the EU next March, while the Republic of Ireland is an independent nation that will remain in the EU. A very important element in the Irish peace process has been the elimination of a visible border with checkpoints. Both the UK and the EU are committed to avoiding the restoration of such a border. In addition, the UK and particularly Northern Ireland are opposed to creating any border between Northern Ireland and England.

The draft agreement involves a so-called “backstop arrangement,” which is a common customs arrangement for the UK and the EU, a “single customs territory” (which would eliminate the need for border checks), together with some provisions specific to Northern Ireland, requiring alignment to some other EU rules and standards. This arrangement is supposed to be a temporary solution. There would be a transition period ending in December 2020, during which there would be negotiations on a permanent arrangement. The transition period could be extended until an agreement is reached on an arrangement that negates the need for border checks. During this period, the UK would continue to follow all EU rules and therefore would remain under the jurisdiction of the European Court of Justice. It appears that the UK probably would be unable to negotiate trade agreements with other countries during this period.

Dominic Raab’s resignation letter summarized the main reservations of the pro-Brexit MPs. He believes the proposed regulatory regime for Northern Ireland, which includes provisions not required of the rest of the UK, “presents a very real threat to the integrity of the United Kingdom.” He also opposes what could become an “indefinite backstop arrangement where the EU holds a veto over our ability to exit.” He also underlines the evident fact that the proposed deal falls short of the Tory party’s promises in its election manifesto. Indeed, as the Financial Times notes in its editorial, the draft withdrawal agreement exposes the “harsh realities of UK’s position.” Under the agreement the UK will weaken its many ties with its most important trade partner while having “less say over the rules that govern its economy.” Unfortunately, the alternative of a no-deal Brexit would be much more disruptive to the UK and also to the EU.

The immediate threat to May is the real possibility of a challenge to her premiership, led by pro-Brexit hardline Tory MPs in the European Research Group. They have been encouraging cabinet members to resign and say they have in hand the 48 requests from Tory MPs that would be needed to call for a vote of no confidence. Should these requests be tabled, it would take a majority of the Conservative law makers, at least 148, to force a leadership change. Whatever their reservations about the draft agreement, the Tory party members would have to consider the implications of rejecting May and thereby the terms of this agreement. Doing so would mean that the prospect of a no-deal Brexit in which the UK is ejected from the EU with no transition period becomes highly likely and would increase the likelihood of a new election and the threat of a Labour government.

Should May survive the leadership challenge, the next essential step will be to seek the agreement of Parliament sometime before Christmas. The intense political debate within the UK now begins. She does not have a majority and has had to rely on the Northern Ireland Democratic Unionist Party (DUP) for key votes. Arlene Foster of the DUP has indicated they will not support May on the Brexit vote. Nor will a number of the Eurosceptic Tory MPs. The Labour Party has indicated that it is opposed to the deal, although a number of Labour MPs have supported May’s Brexit efforts to date. The Liberal Democrats have issued a statement indicating their opposition to the deal. While the Tory party whips express confidence, the prospects for getting this deal through Parliament are not looking good. Success may depend on whether members recognize the highly disruptive implications for the UK of a no-deal Brexit.

The European negotiators, like their British counterparts, had to make significant concessions in order to reach the agreement on the draft exit treaty. An EU summit to seek agreement from the 27 remaining EU states will be held on November 25, assuming the UK parliament approves the deal. EU approval appears to be likely. Donald Tusk, the president of the European Council, said today that “We have always said that Brexit is a lose-lose situation, and these negotiations were always about damage control.” Difficult negotiations to produce the final text of the withdrawal agreement and a political declaration outlining the future relationship between the UK and the EU will need to proceed. Time is very short, as the UK is due to leave the EU on March 29, 2019.

For investors, Parliamentary agreement of the proposed deal would reduce but not eliminate uncertainty. Financial markets in both the UK and the EU would likely respond positively, and the pound and the euro would likely strengthen somewhat. However, the long-term future relationship of the UK with the EU would remain in limbo. The incentive for financial firms in particular to move operations to the EU would remain. Rejection of the deal would increase the odds of a no-deal Brexit significantly and would be strongly negative for markets.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: BBC.com, Financial Times, Bloomberg, New York Times, The Economist


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Failing Trump Navarro Trade War

The United States seems to be losing the ill-conceived Trump-Navarro trade war. The evidence of this loss continues to mount.

Market-Commentary-Cumberland-Advisors-Trade-War-Worsens

Here is an important Bloomberg catalog of specific facts and items and actions. (Note that this is not “fake news.”) “These Products Show How Hard It’ll Be to Beat China in Trade War,” https://www.bloomberg.com/news/articles/2018-11-11/trump-s-china-cold-war-yields-hard-look-at-global-supply-chains.

Meanwhile, Peter Navarro is doing a creditable job of shooting himself (and the country) in the foot. In POLITICO’s Morning Money for Nov. 12, POLITICO’s Doug Palmer reports,

“White House trade adviser Peter Navarro on Friday accused Wall Street ‘globalist billionaires’ of trying to sabotage … Trump’s handling of trade relations with China. ‘Consider the shuttle diplomacy that is now going on by a self-appointed group of Wall Street bankers and hedge fund managers between the U.S. and China,’ Navarro said in a speech at the Center for Strategic and International Studies.

“ ‘As part of the Chinese government influence operations, globalist billionaires are putting a full-court press on the White House in advance of the G-20 in Argentina. The mission of these unregistered foreign agents … is to pressure this president into some kind of a deal,’ he said. The blustery language came ahead of a planned meeting between Trump and Chinese President Xi Jinping later this month, which many hope will lead to a deescalation of trade tensions. However, Navarro seemed to downplay chances for major progress at the upcoming meeting.”

(The POLITICO article is behind a paywall, but for those who subscribe or wish to subscribe, the article link is http://go.politicoemail.com.)

Business Insider agrees with our assessment of the Trump-Navarro actions on trade and offers what it calls “the best hard evidence yet that the tariffs are causing major disruptions in the economy.” In an article titled “Trump’s trade war took a stunning bite out of the US economy, and it’s the strongest evidence yet that he’s shooting himself in the foot,” BI points to last week’s report on third-quarter US GDP and makes the point that while GDP growth came in at 3.5%, that figure would have been a whopping 5.3% if trade had not dragged it down by 1.9% – the largest negative contribution to GDP growth for trade in 33 years. (See https://www.businessinsider.com/gdp-trump-tariff-trade-war-us-china-2018-10.)

The Wall Street Journal’s editorial on November 13, 2018 was rightly harsh. It castigated Navarro statements and arrogance and ended with “Maybe the question to ask is whether Mr. Navarro is a Democratic Party agent.”

Trade War economic data bear out this view.

US GDP growth peaked in Q2. On examination, we can see that part of the Q3 growth was inventory building in anticipation of more tariffs. Who can rationally blame any American company from trying to protect itself from an unpredictable and incoherent policy?

Selectively, some US prices are rising as a result of tariffs. That trend is to be expected, and more prices are likely to rise if the tariffs are expanded or increased. Remember: A tariff the US imposes on an import is really a sales tax on you and me.

The Fed faces a dilemma and knows it. Does the Fed raise interest rates to fight an anticipated inflation caused by the Trump-Navarro tariffs? Or does the Fed view tariffs as a shock and ignore them? The Fed is now seeing the results of tariffs in its information gathering. At the December meeting we expect the Fed to raise rates a quarter point.

So far there are only limited indications that the Trump-Navarro trade war is impacting credit spreads. To follow this item, one must look at the spread in interest rates between the high-yield bond sector (rated below BBB) and the comparable US Treasury yield. Right now those spreads are tight, which means we aren’t seeing damage in credit sectors because of tariffs. If Trump gets a truce with China at the end of this month, we expect credit spreads to stay tight. If Trump and Navarro fail, we expect spreads to widen early next year as trade war damage mounts.

Note that an entire bureaucracy is expanding in Washington as the business of gaining tariff exemptions becomes an employment bonanza for lobbyists, lawyers, and consultants. So much for draining the swamp.

Where does this ill-advised trade war end? The best outcome is a resolved trade deal acceptable to both sides, one that has longevity and features dispute resolution, so that American business can make capital commitments with some confidence. Right now, capital investment is being deferred, since policy under Trump-Navarro is erratic.

Navarro now is under attack for the policy he has influenced. Post-election, the Trump administration is experiencing chaotic turnover. But Trump and Navarro will never admit any policy error. That is why Navarro now attacks “Wall Street” for its criticism of his policy design.

Apologies and rhetoric blaming China abound. Meanwhile, thousands of tariff-exemption applications are slowly being processed.

At the moment, US stock markets have accepted this trade war situation and seem to have completed their October-Halloween correction. The ghoulish Trump-Navarro trade war inflicted that correction. Now, the market likes the earnings picture. The market goes on climbing, finding toeholds in a wall of worry over trade war folly. But market agents are fraught with uncertainty and Trump Navarro policy is the cause. Add divided government and that uncertainty premium rises.

We now send a Saturday morning summary of the week’s commentaries and add video and press references. This a free link from the Cumberland website. Here is last Saturday’s note: “Cumberland Advisors Week in Review (Nov 05, 2018 – Nov 09, 2018),” https://www.cumber.com/cumberland-advisors-week-in-review-nov-05-2018-nov-09-2018/.

Meanwhile, the evidence of Trump-Navarro trade war damage to the US grows.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Leveraged ETFs

Our quantitative strategy at Cumberland Advisors is a trading model that combines fundamental indicators and quantitative analysis into a binary output – either fully invested or all in cash. The strategy trades the S&P 500 in two versions: unleveraged and leveraged. Specifically, the leveraged portfolio uses a leveraged ETF as our vehicle to track 3X the market movement. As many may wonder whether one should use a leveraged ETF, we would like to express our opinions on leveraged ETFs today.

Market Commentary - Cumberland Advisors - Leveraged ETFs

First, what is a leveraged ETF? It is simply an ETF using derivatives and debt to track and amplify the return of an index. However, a leveraged ETF does not expose investors to traditional margin risk; rather, investors just pay the ETF cost. A leveraged ETF resets each day and targets to track an index’s daily movement. A leveraged ETF is usually considered a trading tool. It is typically held for less than a week at most, and oftentimes just daily. Investors are generally told not to buy and hold this type of security due to “time decay,” a term that is often misused when applied to leveraged ETFs. Time decay is a term used to describe the loss of value of an option as time approaches the expiration date. However, leveraged ETFs are not subject to option expirations. What “time decay” really refers to, in connection with leveraged ETFs, is the compounding effect. For example, if the market went up 10% on day 1 and went down 10% on day 2, one would lose 1% at the end of day 2; with 3X leverage, one would go up 30% on day 1 and down 30% on day 2, being left with a 9% loss at the end:

1 – (1+0.1) x (1-0.1) = 0.01     (1)
1 – (1+0.3) x (1-0.3) = 0.09     (2)

Time has nothing to do with the math above. It is compounding that magnifies the leveraged number. In other words, anything that increased 30% and then decreased 30% would have the same outcome regardless of leverage. Imagine that equation (2) represented a scenario where the market went up 30% on day 1 and down 30% on day 2 – one would be left with 9% loss without any leverage or so-called “time decay” effect. Another example: If the market dropped 1% a day for 10 consecutive days, one would suffer a 9.56% loss, while the loss would be 26.26% with 3X leverage:

1 – (1-0.01)10 ≈ 0.0956     (3)
1 – (1-0.03)10 ≈ 0.2626     (4)

Again, the math demonstrates that time is not the reason for the significant difference; compounded return is the master behind the scene. To understand the power of compounding, let’s take a look at a famous motivational poster that some people have as their desktop – if you improve just 1% a day, you will be much better in a year:

Chart 1. 1% a day difference
Now that we have clarified the mathematical misconception, let’s dig into the more important question: Should one buy and hold leveraged ETFs? The chart below compares the 3X leveraged ETF SPXL against the benchmark S&P 500.

Chart 2. S&P 500 vs. SPXL, 11/5/2008–11/9/2018. Data source: Bloomberg

Clearly, the 3X ETF has substantially outperformed the S&P 500 since its inception on November 5, 2008. However, not every investor would have had the stomach for the volatility that was experienced along the way. Leverage can be a powerful tool to take advantage of a bull market if used properly, but one must possess extensive risk management skills. At Cumberland Advisors, we prioritize risk control by keeping our focus on risk-adjusted returns.

If you are interested in obtaining information about our quantitative strategy, please email me.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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California, Land of Natural Disasters?

Last week we conducted a review of our California municipal bond holdings along the San Andreas Fault looking for holdings that may be more susceptible to credit deterioration in the event of a disaster. At the time, little did we know that wildfires would engulf large swaths of California.

Market Commentary - Cumberland Advisors - California, Land of Natural Disasters
The Advanced Rapid Imaging & Analysis (ARIA) team at NASA’s Jet Propulsion Lab in Pasadena, CA, created these Damage Proxy Maps (DPMs) depicting areas in California likely damaged by the Woolsey & Camp Fires.

First, our hearts and prayers go out all those affected by the wildfires and their loved ones and friends, including firefighters, volunteers, and those housing the displaced.

We monitor our portfolios on a regular basis. The majority of our holdings are in AA-rated credits that have economic diversity, good wealth and income indicators, and strong financial management, exemplified by ample reserves and liquidity.  During the monitoring process we look for changes in credit quality of our holdings and we evaluate bonds that new clients have sent us to manage; and if they do not meet our credit parameters we sell them.

A state of emergency and a major disaster have both been declared in California. The declarations by the governor of the State of California (and the governor elect) and the president ensure that the Federal Emergency Management Agency (FEMA) will provide funding and other resources to help rebuild and provide shelter and other aid in the wake of the fires. We have seen from other disasters that the rebuilding effort generally produces an increase in spending and other economic activity, such that sales taxes and other revenues flow to the municipalities in the state and sometimes improve credit quality in the long run.

Many areas of the state have been affected, including the town of Paradise, which lies in ruins, and no socioeconomic class has been spared. See this CNN piece on the fire damage: “44 dead in California fires as the Camp Fire becomes the deadliest in state history,” https://www.cnn.com/2018/11/12/us/california-wildfires-woolsey-camp-hill-missing/index.html. And here is a Bloomberg report: “California Ablaze: The State’s Devastating Wildfires in Pictures,” https://www.bloomberg.com/news/photo-essays/2018-11-09/massive-wildfires-rage-across-california. Statewide, damage estimates are large and continue to grow. Some of the damage will be covered by insurance proceeds and local money, in addition to FEMA funds.

The state and many local California governments do have the liquidity to foot the initial costs – though as we have written, some municipalities do not have reserves as robust as might be expected this far into an expansion. See our Q3 municipal credit commentary: http://www.cumber.com/q3-2018-municipal-credit-commentary/http://www.cumber.com/q3-2018-municipal-credit-commentary/. So there could well be initial financial stress as communities address the damage.

The continual onslaught of disasters afflicting California this year, on top of the fires last year, gives us pause. What do these events mean for the livability of the state, and what will be the effect on population flows going forward? The past has shown that the state remains desirable, but from time to time growth and related financial stability have varied. We should also remember that California is the fifth largest economy in the world in terms of GDP. It has substantial financial wherewithal to mitigate concerns.

Diversification is a tenet of investment management. The proverbial “Don’t put all your eggs in one basket” comes to mind. Cumberland strives to construct diverse portfolios of municipal bonds, including state-specific portfolios where the client benefits from state tax exemption. The portfolios of many of our California clients are also state-specific, because of the high local income taxes charged in the state. We look for geographical diversification, including having out-of-state bonds in state-specific portfolios. We also diversify among types of credits or sectors, from general-obligation to water or healthcare-system revenue bonds. In addition we diversify through bonds that have been prerefunded (secured by US obligations in an escrow account) or that are insured. Diversification provides a level of insulation from a regional disaster or an industry dislocation, among other risks.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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Cumberland Advisors Week in Review (Nov 05, 2018 – Nov 09, 2018)

The Cumberland Advisors Week in Review is a recap of news, commentary, and opinion from our team. These are not revised assessments, and circumstances may have changed in the market from the time of original publication. We also include older commentaries that our editors have determined may be of interest to our audience. Your feedback is always welcome.


MATT MCALEER’S WEEKLY RECAP

 

Matt McAleer gives us his take on the market this week. What about cash? Is it good to have it? Matt offers some insight into how Cumberland Advisors leverages cash and their strategy to use it for advantage. WATCH HERE.

 

Cumberland-Advisors-Matt-McAleer-Update-November-09-2018-Video

 


MARKET COMMENTARY

 

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FEATURED INTERVIEW

 

Can Smallcaps Regain Status as Market Leaders After October Selloff? Matt McAleer Weighs In.

Matt McAleer discusses opportunities in the market, what about FAANG, active vs. passive trading, what position are investors truly in financial markets, and what types of value in the market he gravitates toward. His conversation is with Oliver Renick, host of “Market On Close” at TDAmeritrade.

The interview is available here.

 


IN THE NEWS

 

Quoted: David R. Kotok 11/09/2018

Quoted: John R. Mousseau, CFA 11/09/2018

Quoted: David R. Kotok 11/02/2018


IN CASE YOU MISSED IT

 

    • The Rise Of Municipal Separately Managed Accounts 2018 Update

      Patricia Healy, CFA 9/18/2018

      Cumberland has utilized separately managed accounts to execute its fixed-income strategy since its inception in 1973, long before separately managed accounts (SMAs) were popularized in the early 2000s. Market Commentary – Cumberland Advisors – The Rise of Municipal Separately Managed Accounts 2018 Update What exactly is an SMA? Per Investopedia: “A[n] SMA is a portfolio of assets under the management of a professional investment firm. In the United States, the vast majority of such firms are called registered investment advisors, and operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the US Securities and Exchange Commission (SEC). One or more portfolio managers are responsible for day-to-day investment decisions, supported by a team of analysts, operations and administrative staff. SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single account (hence the name). In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts.” The reasons for managing money in this fashion are the same today as they were then. Continued…

    • How Safe is Your Bank?

      David R. Kotok 7/25/2008

      In 1790, Edmund Burke, the founder of Anglo-American conservatism, waxed eloquently about the power and responsibilities of a government’s agencies in a democracy. He said: “To execute laws is a royal office; to execute orders is not to be king. A political magistracy, though merely such, is a great trust.” This warning came before there were central banks like the Federal Reserve, before there were bank regulators & supervisors, and before there were bank deposit insurers like the FDIC. Was Burke prescient and thinking about them? Two hundred and eighteen years after Burke’s admonition, we can ask: Is your money safe in the bank? Here is what we know about banks and your bank deposits. And there is a lot we don’t know. Continued…

 

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Cumberland Advisors
Weekly Update
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Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Midterm Elections – The Quick Muni Note

Here’s our first take after the midterm elections.

Market Commentary - Cumberland Advisors - Midterm Elections – The Quick Muni Note

The polls actually got it right, with the Democrats taking the House of Representatives and the Republicans enjoying a slight pickup in the Senate.

Divided government, with different parties in control of the House and Senate, has sometimes led to gridlock.  It also tends to keep spurious legislation from being passed; and so overall, markets are OK with this outcome.

 

Regarding munis, we feel that this election certainly eliminates the concern that a Republican House would have introduced legislation to cut income taxes further.  With the Dems in control of the House, that notion is off the table; and fears that tax-exempt munis would suffer price erosion from lower marginal tax rates should dissipate.

From a spending standpoint, the divided Congress will most likely keep the President’s spending in check, and this may slow the current rise in the deficit (a good thing from our perspective).

We’re still checking final results, but we know that California voters rejected almost $9 billion in bonds for water projects, and Colorado rejected over $3 billion in a transportation bond.  There’s more to come on this issue of bond rejections, but our thought is that the specter of the SALT provisions of last year’s tax bill is forcing voters’ hands. If state income taxes and local property taxes are no longer deductible, anything that raises the level of spending and potentially higher taxes is likely to get a cold shoulder, as people’s EFFECTIVE taxes will rise in any case with SALT provisions.

We do believe that with the current low unemployment level, a national infrastructure program with federal subsidies is not needed and is now more unlikely with divided government.  We have seen large infrastructure bond deals done in the past year in the municipal market, and the issuers have had no problem selling the bonds.

Coming out of the elections, we feel especially constructive about longer-term tax-free bonds. With longer tax-free munis yielding over 4%, and with a taxable equivalent yield of 6.35% and muni/Treasury yield ratios of almost 120%, we feel longer tax-free paper is a real bargain and continue to manage portfolios in a barbell fashion, with longer-maturity bonds being a focal point.

The large December and January reinvestment periods are almost upon us. Supply is running 15% behind last year, and that will be another positive force for the market, along with the core inflation rate, which has been dropping for two months.

More to come.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Deficit, Fed, Post-Midterms

“In 2016, President Trump pledged to eliminate the national debt ‘over a period of eight years’ (“In a revealing interview, Trump predicts a ‘massive recession’ but intends to eliminate the national debt in 8 years,” https://www.washingtonpost.com/politics/in-turmoil-or-triumph-donald-trump-stands-alone/2016/04/02/8c0619b6-f8d6-11e5-a3ce-f06b5ba21f33_story.html).

Market Commentary - Cumberland Advisors - Deficit, Fed, Post-Midterms

He then signed a $1.5T tax cut bill and a two-year spending deal that could push annual deficits above $2.1T, according to the CRFB (“Budget Deal Could Lead to $2 Trillion Deficits,” http://www.crfb.org/press-releases/budget-deal-could-lead-2-trillion-deficits).

“For the rest of his term, Trump plans to add $8.282T more to the federal debt, which will push the debt levels to about $30T in total (“New White House Report Shows Deficit Projections Have Doubled,” http://www.crfb.org/press-releases/new-white-house-report-shows-deficit-projections-have-doubled). That represents a 41% increase from the $20.245T debt under the Obama administration. Trump will add as much debt in four years during a time of economic prosperity as Obama did in eight years while fighting a recession. That will make Trump the second biggest contributor to debt in history.” (“Obama: US spends more on military than next 8 nations combined,” https://www.politifact.com/truth-o-meter/statements/2016/jan/13/barack-obama/obama-us-spends-more-military-next-8-nations-combi/). Source: https://seekingalpha.com/article/4204900-drowning-debt-road-30-trillion.

Some of my fishing buddies like to write alarmist newsletters and wring their hands over debt. One of those newsletters hit my inbox on Saturday morning, November 3. That one forecast dire future outcomes.

My fishing buddy may be right someday, but I will bet my fly rod against his bait-casting device that, for the next few years, the increased debt financing of the United States will not be a problem for markets. That will remain the case as long as the US dollar is the unchallenged world reserve currency, as it has been for decades.

When you survey the world and look at other countries’ economic systems and current situations, the US emerges as the best or, if you are a hand-wringing detractor, the least troubled. It is true that the expansion of debt slows down productivity growth. Debt service, even at low interest rates, is an allocation of a cash flow away from growth investment in capital deepening. There, the newsletter writer was correct. But by itself, rising debt issuance will not trigger a debt-service crisis for the US.

Comparisons with Italy or Greece are dramatic. But they are neither helpful nor accurate. And they are not true of our political system versus European systems.

It is true that the US is likely to run deficits exceeding $1 trillion annually. It is also true that President Trump said one thing about the deficit and did the opposite. It is true that the cyclically adjusted federal deficit is probably a lot larger under Trump than it was under Obama. Of course, Trump will never admit such a thing. And expect no such admission from a Republican Senate, nor from a Pelosi-led House.

And it is true that we are approaching a debt-ceiling fight, which will break out shortly after the 116th Congress is sworn in on January 3. Note that the new Congress will commence this activity amidst the ugliness of a politically divided government. The coming debt-limit fight will occur in the shadow of the recent nasty midterms and as the 2020 presidential election cycle fires up in earnest. No serious deficit-reduction measures are expected to advance in the forthcoming lame duck session. If anything, the deficit will be increased by the outgoing 115th Congress if they have a way todo it

Estimates are that the US Treasury will end 2018 with a cash balance of $410 billion (source: US Treasury and Barclays). That balance will be reduced to about $200 billion by March 1, 2019. Note that a reduction of the Treasury cash balance acts as an increase in bank reserves since it is an actual transfer of the cash from the Treasury to the banking system. That’s right: the higher the Treasury cash balance at the Federal Reserve, the lower the excess reserves in the banking system and vice versa. Remember: The Fed acts as the banker for the Treasury.

The deficit is being financed mostly by the rising issuance of Treasury bills, so a small shock is coming to the short-term funding markets in the next few months. We will see this in the spreads among the various measures in the short-term, riskless end of the yield curve. We may also see the Fed have to make another adjustment in the spread between the upper end of the fed funds limit and IOER (interest on excess reserves) as rates press the upper bounds of the Fed’s policy target. Note that for many technical reasons the Fed’s task is becoming more and more difficult as the Fed shrinks its balance sheet.

There is a debate among observers about the Fed’s policy direction and an additional debate about the Fed’s trying to do two things at once. It is hard enough for the Fed to get one thing “right.” Yet this Fed persists in trying to shrink its balance sheet and raise the target policy rate at the same time. We think by March or April or May the Fed will have reached a point where the short-term funding markets will no longer have the luxury of those large balances of excess reserves. The timing is uncertain here, and the list of factors that could change things stretches longer than a page. That said, the short-term funding markets are already showing increasing pressures, albeit small ones. I agree with Zoltan Pozsar, at Credit Suisse, that the additional pressures will soon be apparent.

When we see these pressures surface, there will be many who point to the rising federal deficit as the cause. We can almost hear the chorus now. But that will not be the reason, in our view. The reason will be that the Fed is doing two things at once, with impacts that are likely to collide. Therefore the Fed will add to the confusion about causality. As Ben Bernanke rightly pointed out, the Fed will eventually have to increase the size of its balance sheet. Any shrinkage now is temporary and counterproductive for the longer term.

Will there be a policy change? Will the Fed stop shrinking its balance sheet soon? I would like to say yes, but I doubt that it will. The Fed seems hell-bent on maintaining its schedule unless some shock occurs. Why we might need the shock as a wake-up call is beyond me. Will a new Congress ask that question?

President Trump hasn’t helped matters by bashing the central bank, though the decisions of the Fed are not likely to be influenced by any bashing. Most of the central bankers that I personally know take their roles very seriously and see themselves as avoiding politics and focusing on policy outcomes. But they are also doing two things at once without really explaining how the two policies intersect and interact. The Fed hasn’t explained, for instance, the market impact of raising rates while forcing duration into the market. But that is exactly what they are doing, and that is why they are risking a shock.

It would help if the Fed could offer markets clarity on the pathway to normalcy in the US. My expectation is that we won’t get it. And the task of interpreting the Fed will be increasingly difficult. Key indicators to watch are the spreads among the short-term funding instruments in markets where credit risk is not the issue. In our firm we review them daily. We look for a shift of a few basis points as a sign of pressure. And we look for nuances in Fed policy changes.

For the average investor these are difficult tasks. They require a lot of data surveillance. One has to track spreads between T-bills and repo and SOFR and fed funds and IOER. For those who wish to dig deeper into this subject, there are discussions and serous research papers at the websites of the Fed Board of Governors and the twelve reserve banks. The NY Fed is the center of this daily activity.

In the management of bond and ETF portfolios at Cumberland, we rarely make changes based on these minor basis-point shifts in funding markets, but we do watch them carefully. Our clients’ portfolios are separately managed accounts structured with investment objectives that are not adversely affected by these very small shifts. The opposite is true for very large institutional portfolios. Still, for us the daily watchful waiting remains critical, since it provides early-warning signs of trouble.

Right now there is little pressure evident in the high-credit-quality funding markets. There is excess liquidity, though it is being gradually withdrawn. As of now, the federal deficit is easy to finance, and there is no rollover risk (that is, no risk in refinancing short-term debt).

We don’t expect such risk to surface in the US in our post-midterms period. My friend who likened the US to Greece and Italy is in error. They have rollover risk; we don’t.

David R. Kotok
Chairman and Chief Investment Officer
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Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Cumberland Advisors Week in Review (Oct 29, 2018 – Nov 02, 2018)

The Cumberland Advisors Week in Review is a recap of news, commentary, and opinion from our team. These are not revised assessments, and circumstances may have changed in the market from the time of original publication. We also include older commentaries that our editors have determined may be of interest to our audience. Your feedback is always welcome.

 

MATT MCALEER’S WEEKLY RECAP

Matt McAleer talks about the market this week and Cumberland Advisors’ broad positions. David Kotok jumps in with some Q&A about trade talks and the midterm elections: are they having an effect on the market?

 

 

MARKET COMMENTARY

 

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FEATURED INTERVIEW

David Kotok, Chief Investment Officer/Co-Founder, Cumberland Advisors, joins Chuck Jaffe on his program, Money Life.

David Kotok and Chuck Jaffe discuss what’s normal for financial markets, the Great Recession, thoughts on the volatility of October 2018, trade wars, and how does he see the year and the decade finishing out.

The interview is available here.


IN THE NEWS

 

BLOOMBERG – Markets to Head Higher After Rocky Period (Radio)
Quoted: David R. Kotok 10/31/2018

The Queensland Times – Puerto Rico’s revised fiscal plan shows surplus; bonds rally
Quoted: Shaun Burgess 10/23/2018

Sarasota Herald Tribune – MOUSSEAU: The Cumberland World Series Theory of the Bond
Quoted: David R. Kotok 10/19/2018


 

IN CASE YOU MISSED IT

 

    • Fed Independence

      Robert Eisenbeis, Ph.D. 7/23/2018

      In the wake of the turmoil in Washington, DC, over his performance in Helsinki, President Trump also took a sideswipe at the Federal Reserve, criticizing the FOMC’s recent efforts to normalize policy. Most presidents – though not all – have understood that Fed independence ensures separation from the Treasury and serves as a check on fiscal excesses. When a central bank takes orders from the fiscal side of government, history shows that inflation and economic decline soon follow. Continued…

 

  • Tuplip Fever

    David R. Kotok 10/15/2017

    Three levels are apparent in the wonderfully crafted movie Tulip Fever, in which the impeccably cast Judi Dench is both abbess (mother superior) and tulip-speculating vault keeper. The film is a cinematic lesson about trading momentum and human emotions overtaking investment reasoning. But there is also a lesson in Dutch history, with a marvelous depiction of early 17th-century Amsterdam and only by surmise and projections Amsterdam’s upstart cousin Nieuw Amsterdam, otherwise known as New York. Bottom line: NYC really was and still is a Dutch town. Continued…

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Cumberland Advisors
Weekly Update
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Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.