Spring Is Here Print E-mail
Spring Is Here
Well it’s April 26th. Spring has sprung! The last snows of the season are likely behind us here in Colorado. It’s time to pop the top on my jeep and dust off the fishing gear. The sports calendar is also quite robust. Major league baseball is in full swing. The second season for hockey and basketball has begun. The NFL draft is about to make millionaires of college boys and goats of at least a few scouts. My honey do list appears to be growing in conjunction with my weeds. With all these distractions I’m certain some very important tasks have “slipped” my mind or have been subject to some well directed procrastination. It has been my personal experience that procrastination has it’s origins in either fear (think dentist) or disinterest (think yard work). I’m certain that many of you too have suffered from spring’s overload of distractions and may have let a few things “slip”. But some of the more disciplined and organized among us may be wondering, “Where is that stimulating Quarterly Report from ICM?” I know it’s late. I confess I’ve procrastinated. Not because sports or fishing has pushed my love of economics to the back seat. No, I have been waiting (and waiting) for some clarity on the economy and the bond market. I blame my procrastination not on fear or disinterest but on the words of a philosophy professor named Dr. Tehera. His advice went something like this. Think before writing. Test your ideas in your mind before they leave your pen. Written words are your legacy. With heady stuff like that floating around my brain who can blame a guy for being a bit cautious about putting index fingers to keyboard. Its not that I fear being wrong, I’ve been married far too long for that. It is only that I wish to pay heed to the good Dr. Tehera’s idiom concerning testing ideas in the mind before releasing them for public consumption. So I have accumulated and digested massive amounts of economic data, text and opinions and ruminated on the pile for a period that should satisfy even the great Tehera, but to no avail. Then it came to me. The cure for my procrastination is not to be found in a lightening bolt of inspiration that spawns scintillating economic analysis. No the cure is far simpler. It seems I am all that stands in the way of the release of the Quarterly Reports. All I really needed was a deadline.
Risk Management
Procrastination is anathema to risk management. The deer in the headlights invariably winds up on the bumper. Risk management is a proactive thinking man’s or woman’s game. What makes risk management so invigorating is that one must confront a broad range of possible outcomes on a risk and reward scale. This means that we must consider an assortment of potential outcomes recognizing that there are a far greater number of possibilities than will be occurrences. The “what ifs” vastly outnumber the “what will be s”. Success in culling the highest probability occurrences and identifying the most likely consequences of these outcomes often determines success in portfolio management. ICM’s approach to risk management is simple in concept and complex in execution.  We contemplate current economic conditions and compare our analysis to investor assumptions and the market structure these assumptions produce. We evaluate the myriad of potential risks to the investor’s assumptions and weigh the prospective market outcomes should the most probable risks play out.
Current Investor Assumptions
Current investor assumptions are really quite rosy. Economic growth is anticipated to be “moderate” with solid corporate earnings and strong employment. Price volatility in both stocks and bonds is expected to be subdued with stocks generally rising and bonds stable. Interest rates are expected to remain low and accommodative to commerce. Inflation is expected to recede in the coming months freeing the Fed to stimulate growth if necessary, a good omen for both debt and equity markets. Many in the equity markets expect the Fed to cut rates should the economy falter. The slump in housing should be short-lived and remain contained. Service sector job growth is expected to offset the vanishing manufacturing sector. Capital spending by corporations is estimated to pick up slack if the consumer slows spending. Global capital coupled with the massive derivatives markets will ensure generous liquidity and increased protection against financial calamity. The falling U.S. Dollar will boost exports helping to alleviate trade imbalances with little or any consequence to the economy or investor fortunes.  In short investors the world over expect a low risk, moderate growth, low inflation and a high liquidity global market environment for as far as the eye can speculate.
Current Market Structure
Investors have enjoyed a “Goldilocks” scenario of economic conditions - not too hot, not too cold, but just right. These expectations have produced the kind of market structure one might expect in a fairytale. The Dow Industrials have powered ahead to record after record topping 13,000 on April 25th. The anticipation of looser monetary policy could propel equities even higher.  Global equities are matching or out pacing the Dow. Emerging markets are becoming better integrated into the Global economy and capital flows and investors are showing increased confidence in future performance. Most emerging economies are toting around a hefty current account surplus of U.S. Dollars. Foreign investors love dollar denominated notes and bonds.  The US Yield Curve remains inverted because investors anticipate low inflation and are willing to make longer term bets. In fact the entire U.S. Yield Curve endures “negative carry”, meaning that the cost to borrow overnight Fed Funds in the U.S. exceeds all yields available in U.S. Treasury Bills, Notes and Bonds. If an investor is willing to borrow funds at a higher cost than current yields that investor must be confident the Fed is going to lower borrowing costs significantly and soon. In fact an increasing minority of brokerage firms and money managers are calling for exactly that in the second half of 2007. Risk spreads or the difference in yields between a Treasury security and private sector debt is minimal. These tight spreads reflect investor confidence that default risks are all but eliminated due to a sound economy, ample liquidity and the modern marvel of financial alchemy- the credit derivative.
Risks to Investor Assumptions
The risk to investor assumptions is pronounced. In the real world the bears may catch Goldilocks lingering over the porridge and have her for lunch. The Gross Domestic Product numbers for the U.S. for the first quarter of 2007 hit the tape at 1.3%, below the investment community’s already low expectations of 1.5%.  The preliminary reading reflects the slowest economic growth since the first Quarter of 2003. In fact the domestic economy has just completed four consecutive quarters of sub 3% growth, which has always been followed by recession in the past 60 years. Manufacturing and housing are major drags on the decelerating economy. Consumer spending continues to carry the load for the aging expansion. And the consumer may be buckling just a bit. Confidence numbers have dipped as has spending in the first quarter. Corporate profits have fallen sharply from record levels. Energy prices are draining dollars from every pocket whether capitalist or consumer. Productivity is slowing and the new Democratic Congress may well respond to a slowing economy with accelerating calls for protectionism. The Conference Board’s index of Leading Economic Indicators (LEI) has declined on a year on year basis for three consecutive months. With exception of 1967 this type of decline in the LEI has been followed by recession. The familiar drum beat regarding the woes of the housing market spreading to consumer spending and perhaps employment has gained in prominence. It helps to have a famous percussionist. Alan (Ringo) Greenspan accompanied by Fed economist Jim Kennedy produced a little number, actually a few numbers, which feature the memorable lyric “my house was an ATM”. The numbers reveal that while inflation adjusted wages actually declined between 2001 and 2006 consumer spending rose by an average of 3.2% annually. How did American’s do it? Sing along with Alan, “my house was an ATM”. Citing home equity extraction and cash out loans the duet noted these two sources of liquidity rose from $37 billion in 2001 to $532 billion annualized by the fourth quarter of 2005. Counting all mortgage equity withdrawal, figures reach $1 trillion or 8% of GDP. Now that’s enough to keep any economy rocking, at least until the beat slows down. Interest rates generally rose during the past few years and lenders began to relax credit standards to keep the beat pumping along with fee income. Subprime loans became the instrument of choice rising from 5% of the mortgage market in 2001 to 20% of the mortgage market in 2006. Foreclosures have risen more than 35% compared to the same quarter in 2006 with half those attributed to subprime loans. Nevada leads the nation with one mortgage foreclosure for every 75 households. Foreclosures bounce back onto the market fuelling the glut of supply slowing the construction industry and generally depressing prices and thus home equity. In Florida, just one state hit hard by the housing slowdown inventories are bulging. If not another house hit the market in St. Lucie County current inventory would last 34 months at March sales rates; 29 months in Palm Beach, just over two years in Broward and Miami-Dade Counties. When Existing Home Sales dropped 8.4% for March to levels last seen in 1989 the Wall Street Journal’s Jim Hagerty sang out “lenders, stung by a surge in defaults have rediscovered the virtues of caution.” Tight credit spreads reflect the smug attitude investors have toward default risk. Because investors have lost fear in financial markets they are taking greater and greater risks for lower and lower returns. At ICM we believe that the excess global liquidity has sloshed from market to market in search of a host. We watched money run from the U.S. to Asia in the 1980’s to Tech stocks in the 1990’s to real estate in this century. We think it may be headed to the Leveraged Buy-out markets of Private Equity. The same lax lending standards that infected the housing market have been evident in the corporate world. It is possible that the subprime real estate mess is the tip of a larger iceberg, namely the Credit Derivatives market. Both markets are subject to the moral hazards associated with risk abatement. Consider the subprime market. Lenders who keep loans profit from good underwriting and lose money on defaults. They are more likely to scrutinize a borrower’s financial health than lenders who securitize loans and pass default risk on to faceless institutional investors in the form of collateralized debt obligations (CDOs). When a loan is packaged and sold the lender has transferred financial risk while collecting a fee for his efforts. The fee driven lender may care more about quantity than quality. The global Credit Derivatives market has reached $25 trillion and the same moral hazard applies. Derivatives are worth nine times Global GDP. The potential for a day of financial reckoning is increasing and the amount of risk being created grows exponentially. The subprime mortgage market would seem to indicate that derivatives encouraged investors to take more risk. David Roach is quoted in the April 21st issue of the Economist as follows,” Derivatives have created many more assets and liabilities. By reducing the cost of buying assets to just 3%-5% you increase demand.” At ICM we agree that derivatives have created funny money inflating asset prices (real estate and equities) while likely reducing liquidity in down markets for those very assets. All this current liquidity is being created outside the control of the world’s central banks and hinges on the generous “AAA” credit ratings supplied by Moody’s and S&P. A lower probability risk is that spreading defaults in subprime and low
 or no document “liar loans” forces credit downgrades of mortgage backed securities that would set off downgrades in the CDOs that bought the securities. A contagion could spread to the other debt markets, slow corporate loans and the leveraged buy-outs that have helped power the world’s stock markets. A good old fashion “credit crunch” could be the result. A second path of contagion could be the spread of subprime credits woes to other sectors of the economy.  General Motors announced that for the first quarter it suffered a $115 million loss in it mortgage division GMAC, more than the $85 million it lost on autos in North America. Remember that GM sold 51% of GMAC in ’06. Things could have bee much worse. While contagion is unlikely it is not unprecedented. Any response from the world’s central bankers could be muted as their influence is limited in the derivatives markets. David Henry sums up the mortgage contagion issue well in the May 7th edition of BusinessWeek, writing “history has never seen a time with mortgage debt so high relative to the national economy, with house prices having gone up so much amid rampant speculation with so many risky mortgages, and with delinquencies surging at a time when jobs are plentiful.” A final note on moral hazards and derivatives. Derivatives positions owned by speculators often dwarf the underlying security or asset they bet upon and allow speculation on price without direct ownership- a kind of Voyeur Market. With so little skin in the game and much to gain what would deter speculators from turning a market stumble into a rout? An expectation for low price volatility in investment asset prices has encouraged greater leverage to magnify paltry gains. The explosive growth of leverage and derivatives has come at a time of benign economic conditions and low interest rates. The danger is that markets work both ways-producing gains and losses. What if things go in reverse? What if borrowing costs rise, perhaps due to inflation concerns or if rising defaults curb investor appetite for risk? Liquidity could vanish and derivatives would be hit hard. The likely result would be falling asset prices.
That brings us to the risk that has shaped Federal Reserve Policy and the slope of the inverted yield curve. Inflation. The Bernanke Fed has identified it as the #1 priority in determining monetary policy. The assumption is that it will remain contained and even decline with a moderating economy. But what if inflation remains stubborn in the face of economic malaise? In the April 30th edition of Barrons Randall Forsyth brings back the eighties with an article referring to stagflation. But wasn’t Globalization and particularly India and China, with their unlimited supply of labor, expected to help keep prices contained and productivity high? Nobel Prize winning economist Arthur Lewis developed a theory of labor costs that may ring true with our most important trading partners. He said that industrial nation’s wages begin to rise quickly at the point  when surplus labor from the countryside tapers off. Has global capitalism already burned through the tens of millions of Chinese and Indian laborers? No, only those qualified with skills to function in the Techno-Global Revolution. China is considering financial incentives to encourage peasants to remain in rural areas until education catches up with tech skill demand. Tight labor markets have emerged in Mexico, China, India, Japan, Canada and Europe. Higher pay and training costs may well turn up the flame of inflation. U.S. auto makers are facing increasingly difficult times. General Motors was passed by Toyota in the first quarter as the world’s #1 manufacturer. The German auto giant Daimler is regurgitating Chrysler with only private equity buyers interested in the struggling firm. We will get a glimpse of the future when private equity uses Credit Derivatives to finance the purchase and then carves the company into bite sized pieces for leveraged bargain hunter’s consumption. Jobs and legacy costs will be shed to make deals work..
ICM’s Risk Management Strategy
ICM’s client base is by its nature risk averse. Local governments avoid risk in favor of safety and liquidity. With this in mind it is our task at ICM to protect our client’s financial resources from the excesses of market exuberance while identifying long term trends that shape market interest rates. For us it all begins with the economy. There is little doubt that growth has slowed. It is quite possible that growth rates could spend a good bit of the year below 2%. That leaves the U.S. vulnerable to shocks that can pull the economy into recession. The manufacturing sector remains weak and is being transformed by the demands of global competition. Housing remains the primary concern. These are the largest investments most American’s have made and prices are declining. The wealth effect of personal real estate is evident in our consumer spending patterns. The combinations of subprime loans and derivatives have taken us to a new and unexplored place. We fear that the housing slump will last longer and hurt more American’s than initially anticipated. As 2007 unfolds we will know the answers to many important questions about housing and these new fangled investment products. Consumers also face higher fuel costs with gas back over three bucks in much of the country. Gasoline inventories are inadequate for the coming summer driving season. $3.50 per gallon may not be out of the question. The good news is that the labor market looks stable for now; wages are on the rise and should continue to grow at a moderate pace. While stocks are inflated in our opinion the gains are substantial and the dollars spend just like real money. The consumer should weather the real estate storm with only minor flooding in the basement. Derivatives play far too large a roll in our finance based global economy. Leverage cuts both ways. We hope that the twenty-something MBAs that structure the Credit Derivatives and those who run the CDO portfolios will learn a cheap lesson from the subprime market and perform due diligence on all future loan packages and balance prudence with profit. The moral hazards associated with these geared up derivatives puts fear in our
 hearts. The excess liquidity they have produced has certainly inflated asset prices and this form of inflation is out of the hands of the Central Bank. That would leave the markets to settle any real damage and relegate the Fed to the sidelines flooding the markets with low cost cash.
The Markets
The Yield Curve has remained inverted for all of 2007 with securities yielding less than cash equivalents. It is difficult to move money to longer term lower yielding investments without a high degree of comfort that the Fed will cut rates.  Economic data has been largely mixed regarding growth and inflation. But and it is a big but, the economy has weakened and risks are higher that a response in monetary policy may be required to stimulate growth and protect the expansion. At ICM we believe the most likely outcome for Fed Policy is to remain on hold for 2007. Inflation is hovering at 2.2% year on year, just above the Fed’s comfort zone of 1%-2%. Certainly Ben Bernanke does not wish to face Congress and explain a recession or job losses over 2/10ths of a percent in its favored inflation index.
Investment Strategy
ICM client portfolios carry durations of just less than one year. Cash flows will be plentiful for the remainder of 2007 and our response to additional signs of economic slowing will be to extend durations moderately to lock in current yields. For our clients with high concentrations in cash we suggest the following: examine liquidity needs and where possible consider re-balancing cash and investments to protect against lost future investment income. Monetary policy can shift to a looser posture from the current “data dependent” Fed stance with little warning. A high concentration of cash equivalents has rewarded investors with low risk and the highest yields on the curve. Deteriorating economic fundamentals puts this strategy at moderately higher risk.
New Format
Spring is a time of regeneration and fresh growth. Our new format for commentary is intended to be less rigid than the former. We welcome your feed back and hope to remain informative and slightly entertaining. Enjoy the thaw of the lakes, the blooming flowers and the greening of the golf courses. Know that we remain on the job, ever vigilant in our pursuit of safety, liquidity and yield-in that order.