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Market Commentary

The 'Good Guys' and the 'Bad Guys'
June 6, 2012   David Kotok, Chairman & Chief Investment Officer

This remarkable bond market continues to surprise.Yesterday morning at 7:00 am, Erik Schatzker and Sara Eisen interviewed Gary Shilling on Bloomberg Television’s Inside Track.  I find myself increasingly having morning coffee with Erik, Sara, Stephanie Ruhle, and Scarlet Fu, and with an occasional piece inserted by Dominic Chu and others.  The high-quality content of this fast-paced show has attracted attention among colleagues in my firm and an increasing number of clients.

Gary Shilling talks to Erik about a worldwide recession and a ten-year US Treasury note yield of 1%.  In response to a question, he discusses the possibility of a thirty-year US Treasury bond yield of 2%. 

Erik cites the work of David Rosenberg, Chief Economist and Strategist with Gluskin Sheff.  David is widely known for his consistent predictions of interest rates.  He supports the notion that economic growth will be slow and deflation risk high.  Rosenberg is reported to be forecasting a 2% thirty-year Treasury bond yield. 

In our recent piece, we described actions in the bond market as “bizarre.”  We cited a number of yields and will add these new yield forecasts to that evidence.  We also note a report from Art Cashin that the British perpetual bond (gilt) traded at its lowest yield in three centuries.  That is correct: a reported transaction at the lowest yield in 300 years. 

We further note a comment by Jim Bianco, who has studied long-term yields.  He indicated that certain longer-term US-dollar-denominated bonds are at the lowest yields he can find in American history.
 
On Cumberland’s website, www.cumber.com, we list and update ten-year sovereign yields from around the world.  We divide them into categories of “good guys” and “bad guys.”  The worldwide yield on “good guys” is approaching an average of 1%.  One can get that in a number of different currencies.  This is not just a phenomenon attributable to the US dollar, British pound, or euro.  In other words, in the currencies perceived as high-grade, reliable, and credit-sensitive, the ten-year average yield worldwide is approximately 100 basis points.  If present trends continue, it will shortly fall below 100 basis points.

The yields of the “bad guys” continue to rise.  The club in which the “bad guys” find themselves continues to grow.   In Greece, yields are so high that people do not pay much attention to them.  Yields are extremely high in Portugal, and they are unusually and threateningly high in Spain and Italy. 

The spread in Europe between Germany, the benchmark and largest euro zone economy, and France, the second largest economy, has widened to over 100 basis points.  Is France a “bad guy”?  Certainly not today.  Are the markets beginning to worry about the French component of the euro zone?  The answer appears to be yes.  Credit spreads do not lie.

In a conversation with a banker yesterday, we were asked about our view of credit default swaps.  Are they the right indicator to measure the differentials between the good and bad guys?  Our answer is simply that we are not so sure.  The credit default swap market is not fully transparent and is of questionable value to us.  We would prefer to look at the actual credit spreads in the marketplace.  We believe the credit spread is a sensitive indicator and reflects the consensus view of credit quality of each sovereign issuer at any moment in time. 

Worldwide finance in currencies and sovereign debt is the largest liquid, active market around.  It exceeds the stock markets of the world in size, and it is traded in nearly every exchange and venue where transactions occur. 

We will update the charts on Cumberland’s website – the “good guys,” the “bad guys,” the credit spreads, and other key data weekly.  We thank our readers for their emails and requests for us to continue to update this information.  We originally posted these charts in our presentations during speeches and conferences, and have now made them public on a current basis, after many requests.
 
Now, let’s return to the opening issue raised by Erik Schatzker and Sara Eisen in their interview with Gary Shilling.  There is no question we are in extraordinary and bizarre times.  There are no modern historical references for these interest rates. 

In the United States, one has to look at the four-year period in which the Federal Reserve assisted the US government in financing World War II.  There you will find the long-term Treasury interest rate at 2% and the short-term rate at 3/8 of 1%.  Then, the Federal Reserve System’s twelve regional banks made unlimited purchases of US government debt in order to finance the war.  The patriotic requirement of survival of the United States set the interest rates.  During World War II, the Federal Reserve was driven by only one purpose, and that was to finance World War II. 

At the end of WWII, the United States had a debt-GDP ratio of over 100%.  During the war, inflation hit double digits, according to the reported numbers.  There were black markets in certain goods and prices, so unreported or actual transaction prices might suggest the inflation rate was even higher.  The Federal Reserve financed the war; it did not fight inflation.  The Federal Reserve did its patriotic duty in the interest of the survival and protection of the United States.

Global economic forces are now locked in a different type of war.  In the US, the biggest battle happened in 2008 with the failure of Lehman and AIG.  The largest policy failure in recent memory occurred with Lehman Brothers, a primary dealer with the Federal Reserve, a firm whose CEO sat on the board of directors of the Federal Reserve Bank of New York.  Lehman, a stalwart in the financial world, failed.  What does that say about the supervision applied to the private club of primary dealers by the Federal Reserve in 2006, 2007, and 2008?
 
That was a seminal event in the United States.  After Lehman/AIG, everything changed.  The Federal Reserve recognized that the United States was threatened.  It has tripled the size of its balance sheet since Lehman failed.  It is currently in the throes of debate between those who fear future inflation and those who fear deflation and an  approaching slowdown and possible recession.  The debate inside the Federal Reserve is polite, friendly, intense, and unlike anything in recent times.

In other places in the world we see similar debates.  In Europe, the powers within the euro zone and at the broader European Union level are trying to achieve changes in their banking, finance, and deposit structures.  The are now operating under immense pressure.  For a decade, they ignored what they knew.  They accepted and benefited from economic integration and convergence of interest rates.  They were seduced by the sweet succor of converging interest rates, low inflation, and what appeared to be the acceptance of this grand experiment of a new currency and monetary union. 

Integration and convergence have morphed into disintegration and divergence.  The experiment in the euro zone now requires a coalition based on patriotic duty.  It requires the European Central Bank and the leadership in Europe to respond to their equivalent of a Lehman/AIG moment.

It appeared in the beginning that Mario Draghi, the new leader of the European Central Bank, understood the demands made on his institution.  He reversed former policy and implemented several very large and longer-term operations between the European Central Bank and larger, more established commercial banks within the euro zone.  Markets greeted that approach with energy and enthusiasm.  The injection of liquidity reduced some of the pressure.  Credit spreads reflected the response by narrowing.  It appeared in the few weeks following those actions that the actions themselves would suffice. 

Again, the leaders in Europe were seduced by the sweet succor of the short-term response.  They were wrong.

Now, we see banking systems unraveling, with runs on banks and movement of deposit monies away from peripheral countries and their banks into more secure places.  One agent at a time is altering the composition and venue of his or her cash.  This is a process that will accelerate and debilitate the euro zone if it is not stopped.  Every day that goes by in conference calls, conversations, waiting for elections, and meetings that seem to be interminable– every day that goes by, another agent somewhere moves a bank deposit to some other perceived safer place or safer currency. 

The way to stop bank runs, the way to overcome this erosion and divisive, malignant spread, is to act with a huge insertion of liquidity and an iron-clad commitment to the protection of deposits.  In order to do that, certain weaker banking structures must fail.  Their shareholders must be completely destroyed.  Their debt holders must pay a price for not monitoring the risk.  There has to be a distinction between “good guys” and “bad guys.”

In our view, that is the inevitable outcome of this crisis that now grips Europe.  Americans have had their cycle and are still resolving the “good guy” versus “bad guy” debate.  Witness the activity of the FDIC every weekend, as a couple more banks get closed and resolved.  Witness the reactions in the markets that are pricing banks and financial institutions at levels that suggest another 2008 Lehman failure is imminent.
 
In our view, the American system is now repairing itself.  It is doing so while in the throes of political debate.  The discussion is fierce, and in an election year it has become nasty.  That is the nature of our politics.  We in America do not like it; we find it distasteful, and many would like to “throw them all out and start over again.”  In the end, it is our system; and to paraphrase Winston Churchill, it is “worst system of government, except for all the others.” 

The euro zone has to resolve its issues.  It will do so.  It will have no choice, because markets will force it to do so if it does take a proactive stance.  The political characteristics of Europe are not conducive to proactive leadership.  So far, finance ministers, government officials, central bankers, and policy makers in Europe have been merely following events.  By doing so, they make them worse. 

Will we see a substantial change in the euro zone?  That remains to be seen.   But the policy question is different from the investment question.

Cumberland continues to underweight its exposure to Europe in its international accounts.  The only euro zone country that is held in the managed ETF accounts is Germany.  There are positions in the European Union countries of Sweden, the UK, and Poland.  Please note that those three countries are not part of the euro zone.

In the United States, we think most of the bad news about the financials – banks and institutions – is out.  It is widely known and discussed daily in the press.  What is not discussed is the low price at which the stocks representing the banks and financials are trading.  You can buy the entire banking system of the United States for less than its book value.  That occurs at a time when four years of write-offs, increased reserves, restatements, and audits have been applied to the banking system.  Our conclusion is that there is no auditor left who would understate a loan-loss reserve.  Any executive who would not promptly admit possible losses would have to have his head examined.  The banking system has been shocked for five years.  The banking sector is a despised sector in the United States.
 
I just recited some of the characteristics of a stock market sector that is desirable for purchase, not for sale.  The time to sell the financials was in 2006 and 2007.  At that point in time they were priced for perfection.  They constituted almost 23% of the weight of the S&P 500 Index.  They were reporting earnings that constituted almost 40% of the earnings coming from that benchmark index.  That was prior to the losses; that was before the reserve adjustments.  Then, there was a huge love affair between the financials and the investing class. 

That love affair is over.  This despised and hated group is now very inexpensive. At Cumberland, we continue to be a scaled buyer of banks.  We imagine that we will continue to buy them for some time.  Our time horizon is three to five years.  We expect that in three or five years, or perhaps a little longer, this group will double or triple from its present level.  When the entire banking system is available below its book value, below the capital it would require to start anew, in our view it is time to be a buyer, not a seller.

Investors have to make their own decisions.  Do I want to own them when no one wants them?  Do I want to own them when everyone wants them?  Can I distinguish between the “good guys” and the “bad guys”? 

It is a fascinating and challenging time in finance and economics around the world.  We are rewriting the textbooks of the last half-century.  What a stimulating time to be in this business.  We are now overweight banks in our US ETF accounts. 

For a discussion of ETFs and banks, see my new book From Bear to Bull With ETFs.   There is a chapter devoted to financials.

David Kotok, Chairman & Chief Investment Officer
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