Rockwood Capital Advisors

Despite the doom and gloom of 2011, the US economy showed some signs of revival in the later stages of Q4. The most pleasant surprise was the 200,000 increase in jobs revealed in the December employment report. In addition, the unemployment rate dropped to 8.5%. Other measures of economic activity also surprised to the upside. In some ways, however, US economic data has become almost irrelevant, as events in Europe have cast a long shadow over the global economy.

As we approach the two-year anniversary of the Greek debt crisis, the Euro situation appears to be deteriorating. We have been consistently skeptical of the various “solutions” offered by European leaders. This drama has followed a familiar pattern of celebrating the latest plan, enjoying a few months of bliss, and then experiencing panic again when the “plan” fails. Greece’s days in the Euro appear to be numbered as a default seems more and  more likely. The next Greek bailout installment is due in March ( €100 billion), and it is difficult to imagine Germany throwing more good money after bad.  We expect a very rocky road in Europe, and it is uncertain how tall the resulting tsunami wave will be once it reaches US shores.

We anticipate continued, world-wide central bank quantitative easing (money printing) in 2012. Last September, the Fed launched “Operation Twist,” a plan in which the Fed bought Treasuries in a bid to lower long term interest rates. Fed officials have recently leaked the outline of a new quantitative easing plan, QE3, involving purchases of mortgage backed securities. The Fed is apparently determined to manipulate interest rates, creating distortions in the US economy that policy leaders will be forced to address for years to come.

Given the historically low level of interest rates and world-wide central bank money printing, higher rates are inevitable at some point. However, the situation in Europe has added much uncertainty to the outlook. While we see little value in Treasuries at current yields, we are maintaining a market weight in Treasuries as a hedge against a poor outcome in Europe. We are also neutral from a duration (average  maturity) standpoint, overweight credit (US corporate bonds) and underweight mortgage-backed securities. As visibility improves, we plan to redeploy our Treasury position into high yielding sectors. Our duration position will be largely dictated by events in Europe. A positive outcome would most likely lead to higher interest rates, and we would shorten duration to protect our clients’ invested principal. If events in Europe spiral out of control, the demand for Treasuries, as well as their returns, would be great, much as they were in 2011. 

Twist and “Shout”

Despite hundreds of billions of “stimulus” spending and tremendously accommodative monetary policy, the US economy continues to sputter as we enter the final quarter of 2011. To add insult to injury, S&P downgraded the credit rating of the US Government in August, losing the AAA rating that it had held since 1941. S&P cited a massive debt burden and the apparent inability of political leaders to agree on a realistic fiscal plan that would put the US back on sound financial footing.

In addition to our domestic difficulties, 18 months after the Greek debt crisis first hit the headlines, leaders in Europe are still searching for solutions.  Greece continues to miss its budget targets, and other nations are becoming less interested in extending additional credit. For the first time, there appears to be serious discussion of holders of Greek bonds taking a 50% “haircut” on their investment. In our view, this is a positive step as leaders are finally facing the realization that more borrowing for Greece is not the remedy for their woes.

QE2 expired at the end of June, and it didn’t take long for the Fed to determine that the US economy did not have the strength to go “cold turkey” when Dr. Bernanke removed the I.V. needle of monetary stimulus. Whispers of the Fed’s next plan, dubbed “Operation Twist,” began circulating in August. On September 2, the monthly employment report revealed that the economy created ZERO jobs in August.  That disappointing report guaranteed the implementation of Operation Twist, a plan whereby the Fed would “twist” the yield curve by selling short-term US Treasuries and buying long-term Treasuries in a bid to lower long term interest rates. We are highly skeptical of the merits of Operation Twist. In fact, long term rates have risen since the program began. Once again, the Fed seems determined to manipulate interest rates, creating distortions in the US economy that policy leaders will be forced to address for years to come. Risk-averse savers have been punished by the Fed’s low interest rates. In search of higher returns, investors have been forced into higher risk assets like high yield bonds and equities. This is fertile ground for the creation of investment bubbles.

During Q3, the releases of consistently weak economic data increased speculation that another recession is on the horizon. This drum beat of dour news sent Treasury yields tumbling in Q3, resulting in very good fixed income returns (the 30 year Treasury bond was up 31% in Q3!). Stocks, on the other hand, had an awful quarter. The S&P was down 13.9%, while small and mid-cap stocks fared worse.

Over the course of the last quarter, we shortened our portfolio durations to capture some gains. We are currently duration neutral. The economic data in early October has improved, and there is more “happy talk” out of Europe, with policy makers claiming to have the situation under control. As a result, interest rates have moved higher since quarter end. However, more bumpy times and lower rates probably lie ahead. We think the odds of a double-dip recession are at least 50%, and we anticipate more fireworks out of Europe before a lasting solution is found. Continued volatility is likely, and we will focus on positioning our clients’ portfolios in order to capitalize on those market movements.



Withdrawal Symptoms?

At the risk of sounding a bit gloomy, many parts of the world are truly a mess right now:  Nuclear accident in Japan, unrest in the Middle East (Syria, Egypt, etc), the rolling sovereign debt crisis in Europe and our own debt ceiling battle in the U.S.

QE2 did indeed expire at the end of June, and so far, there are only whispers of renewed stimulus (QE3).  We posed the question last quarter: “Will the financial markets have the strength to go “cold turkey” when Dr. Bernanke removes the I.V. needle of monetary stimulus?  Or will the markets exhibit severe withdrawal symptoms?”  The initial prognosis is not good.  Most of the economic data releases over the past several weeks have been less than stellar.  The gut punch was the June employment report which revealed that only 18,000 jobs were created in the month, and the unemployment rate rose to 9.2%. 

In addition to the poor economic news, the raging debt ceiling battle continues unabated in mid-July.  We are confident that the debt ceiling will be raised.  However, if there is a delay in raising the debt ceiling, the government will be forced to prioritize its payments and reduce spending.  Any talk of the US defaulting on its debt service of US Treasury securities is ridiculous.  US government revenues FAR exceed the amount due for US Treasury debt service.  Some have argued that a debt ceiling impasse and the threat of “default” would lead to much higher interest rates.  On the contrary, we believe that economic weakness and lower rates are a more likely result should the government be forced to temporarily curtail spending.

Then there’s the seemingly never-ending sovereign debt crisis in Europe.  The Greek saga has drug on for over a year now.  Leaders in Europe seem unwilling to face the realization that there is no way out for Greece short of some type of default/restructuring.  The contagion is spreading to Ireland, Portugal, and now Italy.  Italy has the third largest debt market in the world, and Italian government bond yields are near a 9-year high.  Until the Europeans confront these issues head on, the problem will continue to fester, pushing down US Treasury yields as investors seek the relative safety of US debt.

We continue to lament the fact that the Fed’s “zero interest rate policy,” money-printing, and bailouts have created distortions in the US economy that policy leaders will be forced to address for years to come.  Risk-averse savers have been punished by the Fed’s low interest rates.  In search of higher returns, investors have been forced into higher risk assets like high yield bonds and equities.  This is fertile ground for the creation of investment bubbles.

Over the course of the last quarter, we gradually extended the duration of our portfolios as the economic data began to exhibit signs of stress.  The European debt crisis is also exerting downward pressure on US interest rates.  We continue to look for opportunities to add yield to our clients’ portfolios through the purchase of high quality corporate bonds.

Cold Turkey

The Fed’s current round of Treasury purchases (QE2) is scheduled to expire at the end of June.  Nothing is etched in stone, but barring any exogenous shocks to the economy, the Fed will complete its goal of $600 billion in purchases by the end of Q2.  The big question for the economy, stocks and interest rates is: what happens next?  Will the financial markets have the strength to go “cold turkey” when Dr. Bernanke removes the I.V. needle of monetary stimulus?  Or will the markets exhibit severe withdrawal symptoms?  Are a relapse and the introduction of QE3 on the horizon?  The next several months will be telling.

Bernanke is no doubt pleased with the results of QE2 with respect to equity markets.  The S&P 500 was up another 6% in Q1 2011 after a 10% gain in Q4 2010.  Now Bernanke can only hope that his stock market magic translates into a positive wealth effect and higher consumer confidence.  According to the Fed playbook, giddy consumers should dust off their wallets and spend, spend, spend, boosting the economy to escape velocity and leaving behind this era of economic malaise. 

However, it appears that the Fed’s grand scheme may have to maneuver past a few chunks of space debris on its path to success.  While Bernanke is quick to take credit for rising stock prices, he claims that QE2 is not responsible for the meteoric rise of virtually all commodities, most notably gold and oil.  Nor will he accept blame for the plummeting value of the US Dollar. The biggest threat to the US economy, in our view, is inflation.  Despite the dramatic increase in oil and food prices, the Fed refuses to admit this is a problem. Bernanke insists that food and energy prices are historically volatile and should be ignored.  Instead, investors should focus on “core” inflation (excluding food and energy prices).  However, core inflation is also rising; just not as quickly as overall inflation.

Unfortunately for Bernanke, the market is not complying with his plea to ignore rising food and energy prices. Since the introduction of QE2, long term interest rates have risen substantially, apparently due to investors demanding a greater yield premium to compensate for the increased likelihood of inflation. The TIPS breakeven inflation rate has risen 1% since August and is at its highest level since 2008. In other words, inflation expectations have risen substantially in recent months.

The European sovereign debt crisis continues to fester. Investors are finally coming to the realization that the European Central Bank’s strategy of issuing more debt to cure a debt crisis is pure folly. The only solution is some type of default (the less frightening term is “debt restructuring”). Despite the problems in Europe, our bet is that the US economy will gradually improve, and interest rates will move higher from their current artificially depressed levels. In our view, the Fed’s “zero interest rate policy” has created distortions in the economy that policy leaders will be forced to address for years to come. The inflation genie is emerging from the bottle, and long term rates will move higher as a result. We intend to maintain a defensive duration position, and look for opportunities to add yield to our clients’ portfolios through the purchase of high quality corporate bonds.

QE2

In early November 2010, the US Federal Reserve officially announced a specific plan to purchase $600 billion Treasuries to stimulate the economy.  This new policy became more popularly known as QE2 (as in quantitative easing, part 2).  The Fed’s Treasury purchase program is a rather desperate move; something pulled from the central banker playbook when all other monetary policy options have been exhausted.  History is littered with episodes of money-printing that ended badly; typically culminating in a nasty bout of hyper inflation.  Former Reagan administration Budget Director David Stockman had a colorful quote on this topic: “I think that the Fed is injecting high grade effective heroin into the monetary system of the country and one day it is going to kill the patient.”  Mr. Stockman’s views may be over-the-top, but we do agree that excessive inflation is far more likely than deflation, which the Fed has consistently referenced as the biggest threat to our economy. 

Bernanke has been criticized for failing to clearly articulate the goals of QE2.  Based on a number of interviews and speeches over the past couple of months, Bernanke has telegraphed that the purpose of QE2 is twofold: (1) make interest rates go down, and (2) make stock prices go up.  Lower interest rates can spur economic growth by encouraging companies to borrow and spend.  Unfortunately, the Fed has failed miserably in their first goal.  Since the introduction of QE2, long term interest rates have risen substantially, apparently due to investors demanding a greater yield premium to compensate for the increased likelihood of inflation. The TIPS breakeven inflation rate is approaching a 5 year high, an indicator of rising inflation expectations. 

On the stock market side, however, the Fed has been very successful.  The S&P 500 was up more than 10% in Q4.  Mr. Bernanke has said that higher stock prices are supposed to make people feel better so they go out and spend (the wealth effect).  But think about that line of reasoning for a moment.  Aren’t higher stock prices supposed to be the RESULT of higher earnings and improved economic activity and not the CAUSE?  Almost by definition, the Fed is attempting to inflate a stock market bubble.  We remain concerned that the Fed’s “zero interest rate policy” (ZIRP) is creating distortions in the economy that may have long term negative consequences. 

In our view, the direction of interest rates (and stocks) over the first half of 2011 will be largely determined by a battle between two opposing forces: The Fed (and QE2) vs. the European sovereign debt crisis. If QE2 works, the economy will gain traction. Inflation, interest rates and stocks will all move higher.  On the other hand, the European debt crisis continues to fester. The European Central Bank’s solution to the rolling Euro debt crises seems to be the issuance of even more debt! Unless real fiscal solutions are found, this Ponzi scheme will eventually collapse spurring a flight-to-quality rush into US Dollar assets, especially Treasuries, pushing interest rates lower.  Risk assets such as stocks would take a beating in this environment.  Despite the problems in Europe, our bet is that the Fed will eventually win out, the US economy will improve, and interest rates will move higher in 2011.  However, investors are likely to experience many twists and turns in this real-world financial market drama shaping up in the year ahead.