October 2007: Repricing Risk: Is the "Great Unwind" Behind Us or Only Beginning?
“Our last letter focused on what we thought the fixed income markets were telegraphing about global financial conditions. The concern was that investors world-wide were rethinking their willingness to assume investment risk in financial markets then awash in liquidity. Apparently, as that letter was drafted, two very large independently managed hedge funds, each holding essentially similar lists of securities in nearly identical proportions, decided to substantially unwind the bulk of their positions. Usually such a “coincidence” could be absorbed in the context of normal securities market trading activity, but by definition most hedge fund portfolios are leveraged, some as much as four to six times their base. So in that first or second week in July when this cascade of equity sales and short covering orders hit the traders’ desks, screens lit up all over Manhattan and near gridlock in the equity transaction world ensued. The trades were executed in due course, but those involved and many others on Wall Street had been traumatized.
A week or so later, when the sub-prime mortgage issue began to take on more prominence in the financial media, the scene was set for a near-panic scenario in the global credit markets. Suddenly, no one was prepared to lend money to anyone else. Many banks even declined to provide overnight money to other banks. Private equity transactions were put on hold. Corporations were unable to sell their commercial paper. Interestingly, despite all the hand wringing by pundits about the declining value of the U.S. dollar and our trade and Federal budget deficits, the first place many risk-averse investors turned to was short-term U.S. Treasury Bills and Notes. Yields on U.S. government securities dropped precipitously as panicky investors bid up the prices of these investments of last resort.
As the credit markets froze, bond and equity prices began to decline, forcing margin calls upon a number of equity- and fixed income-based hedge funds. Many of these alternative vehicles are managed through computer models back-tested against past market behavior with risk control algorithms triggering trading responses to normal market volatility. Last July’s letter questioned whether hedge funds really knew how to hedge. It appears that many of these computer models, perhaps understandably, had neglected to factor in the possibility of a six standard deviation series of events (i.e., a 1 in 500,000,000 occurrence). Mea culpas offered by a variety of alternative investment portfolio managers abound today, but the fact remains that a number were unprepared for the very circumstance for which they might have been expected to anticipate. As many hedge fund investors reassess their rationale for participation in such alternative vehicles today, the accompanying chart of hedge fund annual performance is instructive.
Since 1990, hedge funds have produced returns no better than the overall U.S. stock market as represented by the S&P 500 Index. If hedge fund comparative benchmark indexes were further adjusted for forward and survivor bias, the numbers for these investment vehicles would be even less impressive (see our October 2006 client quarterly letter on our website: www.tfcfinancial.com).
The Fed Intervenes
In the Boston area, as the credit market turmoil continued, prompted by a margin call, the Sowood Capital Management hedge fund (entirely invested in fixed income securities, but reportedly leveraged as much as eleven times its base) went under. Harvard’s endowment lost $350 million in one day, the State of Massachusetts nearly $30 million.
As other anecdotal evidence of the credit market problem continued to build into the second week of August, the Federal Reserve Board and central banks around the world began to pour liquidity into the banking system, and in an unprecedented very visible policy shift started to urge uneasy bankers to borrow from, and lend to, one another. Shortly thereafter, Chairman Bernanke engineered a one half percentage point (50 basis points) cut in the overnight interest rate at which banks lend to one another and shifted the FED’s policy focus statement from controlling inflation to “prolonging U.S. economic growth.”
Slowly the credit markets have begun the healing process, but the damage in the case of many financial intermediaries (i.e., mortgage brokers, non-bank mortgage originators like Countrywide Financial, and late entry sub-prime lenders such as Merrill Lynch) has been extensive. Even supposedly savvy credit providers such as Citigroup have had to realize massive write-offs recognizing uncollectible residential mortgages. It seems certain these write-offs will severely impact third quarter earnings reports for these financial services firms. Faced with the prospect of unexpectedly poor quarterly announcements, many of these firms may clean out their closets, clearing through their profit and loss statements other questionable valuations on their balance sheets. October may be a month of unpleasant earnings news for some corporations which the media will no doubt trumpet with dire headlines.
The Big Question: Can the U.S. Avoid a Recession?
In the long run, common stock prices are closely correlated with trends in corporate earnings. Until this decade, the fortunes of most U.S. corporations have been tightly connected to the underlying growth of our economy, so an important issue today is whether the U.S. economy can withstand the August credit market shock and continue along the path of modest growth in Gross Domestic Product (GDP) which had been the expectation of mid-summer.
In short, the prospect of a U.S. recession would not appear to be in the cards yet. Strong global GDP growth (the growth rates in nearly 120 countries outside the U.S. will exceed 4% this year), a weak U.S. dollar (demand for U.S. exports is rising as a result), abundant liquidity worldwide, possibly a further FED-mandated interest rate reduction and a surprisingly low inflation environment would appear to indicate a slower U.S. economic pace, but not recessionary conditions. No doubt the continued decline in U.S. residential housing prices and sales activity will moderate the tempo of domestic growth, but as the fourth quarter of 2007 moves along the events of August should recede into the status of a footnote to an otherwise reasonably positive year for the U.S. economy and those of our global trading partners.
As the remainder of the year unfolds, clients should keep in mind that a good portion of their equity portfolios are directly invested in non-dollar denominated international companies, as well as in large U.S. multinational companies which derive a substantial portion of their profits from overseas. The larger companies in the S&P 500 Index, for example, derive approximately 45% of their revenue from non-U.S. sales.
Smaller U.S. companies, on the other hand, tend to obtain a lesser amount of their revenues from non-U.S. sources and thus, although a generally positive result for this year is expected, have somewhat diminished earnings growth probabilities near term. This was part of the reasoning behind our shift in the latter part of 2005 from a heavy overweight in small companies to large companies (today roughly 65% of our domestic and international equity funds).
Today’s changing world economic geography in which developed, and emerging countries as well, build their wealth trading in a free market environment means globally other countries are now less dependent on the U.S. as the engine of international economic growth. The U.S. benefits from improving demand from our trading partners; it’s a positive sum equation. If one’s goal today is to build capital to provide for tomorrow’s needs, globalization, with all its apparent faults, is a rising tide destined to benefit the vast majority of investors.
Most people today embrace the concept of free markets, except, as has been pointed out, the Cubans, North Koreans, and possibly the likes of Bernie Sanders. The major threat to continued global prosperity is in part what the media sensationalizes, but also the politically motivated tendency of some of our politicians to micro-manage the economy through tax “reform” (which in the near term seems to mean income tax increases) and other remedial business policy measures.
Doing Our Sums on China: Do the Numbers Add Up?
China’s economic growth statistics today are monotonously reported by its government indicating rising GDP rates of 8-10% per year. Lester Thurow, past Dean of MIT’s Sloan School of Management, in a New York Times article earlier this summer, takes these numbers apart and finds inconsistencies which substantially deflate official figures. He points out that 70% of the Chinese economy is based in poor rural areas virtually not growing at all, implying that the country’s urban centers had to be growing at an unrealistic rate of 33% annually. Also, comparing increases in energy usage with reported economic growth reveals a disconnect indicating lower-than-reported rates of overall economic activity.
He concludes a more realistic expansion rate for China’s GDP would be 4.5-6% per year inflation-adjusted, still solid but not as claimed officially. Further, he notes that no large country has ever been able to sustain GDP improvement above 3.5% per year for extended periods of time without interruption, and that Chinese demographics (one-child policy) point to a population decline later in this century.
For those concerned that China’s economy will overtake ours in the next 20-30 years, keep in mind also that a growth rate of 3% per year on our $13.5 trillion GDP base versus even a 5% annual rate on China’s $2.6 trillion current GDP base indicates a formidable mathematic challenge. Applying Thurow’s calculations, year 2100 inflation-adjusted per-capita GDP for China would be $40,000 vs. almost $650,000 for the U.S. (today the spread is $1,000 per person for China vs. $43,000 for the U.S.). China’s future role in the world’s economy should not be discounted, but perhaps just as we became overly concerned about the Japan Inc. economic steamroller in the late 1980’s, a more balanced view of China’s potential should be incorporated in one’s global growth equation.
A Shift in Portfolio Bond Duration
In client bond and balanced accounts, during the past 7-8 years, we have held to a bond investment approach of short maturities of the highest quality, preferring to accept diminished current interest income in return for capital protection. This decision was in part driven by a flat yield curve (one was not paid to take on increased maturity risk) as well as concern about the leverage building in the credit markets. Today, the yield curve is beginning to assume a more normal slope and there is a sense that the credit markets are sorting out the difficulties of August. In the near term, we have decided to gradually move out on the maturity line by a few years (i.e., from 1.5 years in steps closer to 5 years). If the yield curve steepens further, we may well lengthen maturities into the intermediate range, possibly extending duration to as much as 7 years. In all-fixed income and balanced accounts you will be seeing transaction confirmations during the weeks ahead representing this shift in maturity structure.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO