Do you see what I see?

In April 2011 a UK film team along with several renowned neuroscientists produced a documentary examining the science behind how humans perceive color. Color is often mistaken as a property of light when it really is a property of the brain.  At first blush the question as well as the answer of whether we all see the same colors may seem trite and obvious but considering that experts estimate that humans can distinguish (perhaps) as many as 10 million colors^[1], researchers are in the early stages of being able to adequately answer the question.  The documentary detailed an 8 week period where  neuroscientist Dr. Beau Lotto conducted different experiments on volunteers to determine what - if any- effect that age, nationality, gender and time may have on our perception of color.  The results surprised UK researchers because it appears that the human perception of colors does vary from person to person^[2] and is dependent on our individually unique experiences.

This got us thinking about how investors view the current global capital markets; at first blush the question as well as the answer (again) seems obvious when considering the seemingly never ending European sovereign debt saga and the Gordian knot of daily political gridlock in Washington DC.  However, much like the findings of UK researchers, we believe that how we perceive what is in front of us is critically dependent on how it is contextualized; meaning how investors specifically put opportunities/challenges into their individual context matters.

Let's consider how global investors perceive and contextualize current sub 2% yields on US Treasury 10 year securities^[3].  In a highly uncertain world investors will tend to invest in areas of perceived relative safety.  Much has been written about the generational low rates on US  Treasury securities and the positive impact these rates should/will have on US housing and credit markets specifically, and the overall US economy generally.  For many that context gives the perception that the current low interest rate environment - caused by the flight to safety trade and Fed monetary actions, e.g. Quantitative Easing and TWIST - is an unequivocal positive for the economy and capital market investors.

Hmmm, well what happens when we change the context from the impact on individuals to the impact on say, institutional investors.?

For example, if you are CALPERS, managing an investment portfolio of approximately $229 billion (as of May 2012) with an estimated “unfunded liability” of $38.5 billion (meaning the shortfall in projected assets needed to pay for pensions over the next 30 years^[4]), how does the current low rate environment effect your investment strategy? Is it an unequivocal positive?

As an institutional investor CALPERS is not necessarily happy. Why? 

Earlier we mentioned CALPERS' estimated “unfunded liability” of $38.5 billion of their state worker plans.  In order to meet their contractual pension obligations CALPERS MUST achieve at least a 7.50%5 rate of return on their investment portfolio every year for 30 years.  With sub 2% yields on US 10 year Treasury securities ANY allocation to Treasuries makes CALPERS ability to meet their investment rate of return target difficult at best.

Furthermore, remember that all securities are priced off of the Treasury curve, so whether an investor is building a portfolio which includes US corporate bonds or equities or options, the current sub 2% US Treasury rate environment and any corresponding (meaningful) movement from the current generational low point in yields could have a dramatic impact on investors, both large and small.

At the conclusion of the documentary neuroscientist Dr. Beau Lotto commented that "in thinking about 'do you see what I see', the answer depends on what it is we're looking at.  If it's something that's shaped by our own individual [circumstances], then we can see the world very differently.6

Truer words have never been spoken.

---

^[1] Wyszecki, Gunter. Color. Chicago: World Book Inc, 2006: 824.                   

^[2] BBC TV: Horizon: Do you see the same colours as me?

^[3] Source: Bloomberg: 1.51% UST 10 Yr yield, July 31, 2012 

^[4] http://calpensions.com/2012/05/17/calpers-ignores-brown-delays-pension-payment/

5 For further calculations please contact Saddle Peak Asset Management, LLC

6 http://www.bbc.co.uk/blogs/tv/2011/08/horizon.shtml

I am Oz, the great and powerful.

In 1939 Warner Brothers released the American movie classic The Wizard of Oz.  Over ensuing generations the story of Dorothy and Toto being swept away to the magical land of Oz by a Kansas tornado has been told and re-told countless times.  While there are many notable characters, the Wizard may be the most intriguing.  Recall that when the intrepid band of travelers arrive at the Emerald City to ask the Wizard for help, they soon discover that the Wizard is ”the man behind the curtain” pulling levers and pushing buttons in order to keep Oz running smoothly.  This got us thinking – Has Fed Chairman Bernanke been channeling his inner wizard?   Over the last 12 months we have opined on several potential economic turning points, from Washington’s broken politics -- to how the US inches ever closer to the fiscal precipice - to the (continuing) debt laden drama playing out in the Euro zone.  Embedded within each commentary detailing these impactful situations was our belief that US interest rates are TOO low and, except for direct actions by the Federal Reserve, market participants would move Treasury rates higher, perhaps significantly so.  To date we have not seen a significant and sustained rise in Treasury rates -- as such, it behooves us to review and challenge our assumptions/opinions regarding the current level of interest rates.   It is clear that US equity markets have shrugged off the aforementioned impactful situations leaving Treasury yields during the latter part of 2011 below core inflation for the first time since 1980.  Note that this Fed’s preferred inflationary price gauge is the core Personal Consumption Expenditure (PCE) index; Bernanke has indicated that he chose this index as the basis for the Fed’s inflation target because it better reflects changing purchasing habits of individuals.  However, it makes no difference whether we consider CPI or PCE because based on the historical relationship between economic growth and real yields, 10 year Treasury yields appear to be approximately 1% to 1.5% below expected levels. Much like the Wizard in Oz, the Fed has pulled levers and pushed buttons to manipulate and manage rates  down to levels that are TOO LOW.  This begs the simple question – Why?  Or more accurately why has the Fed continued to do so?   The Fed has historically opened its tool box during times of economic stress/crisis.  History shows that the Fed using economic tools is indeed standard behavior — Macroeconomics 101 tells us that the most effective tool the Fed has - and the one it uses most often - is the buying and selling of government securities in its open market operations. The Fed will buy securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.  In the simplest example the Fed purchases securities from a bank and then pays for the securities by adding a credit to that bank's reserve for the amount purchased. The bank can then lend the newly added money to another bank in the federal funds market.  Interbank (reserve) lending increases the amount of money in the banking system and lowers the federal funds rate.  When the Fed funds rate is decreased this example of expansionary monetary policy ultimately stimulates economic growth, exemplified by increases in business and consumer investment/spending.   Reviewing first quarter indicators it certainly appears that the US economy is on an increasingly positive trajectory—Industrial Production has been trending positively, the same is true (over the past 6 months) of new orders of durable good; automobile sales have crested 15 million units for the first time in years.  Perhaps the Fed’s use of TWIST since the latter part of 2011 while the banking system was/is already awash with liquidity shows Bernanke’s continuing uneasiness about the current economy.   Obviously he is motivated to get this right and over the recent past Bernanke has been both praised and criticized over Fed action during the current challenging times.  We submit that given the aforementioned bright spots as well as solid first quarter profitability being reported by companies and higher than expected consumer spending, Mr. Bernanke should take a lesson from former chairman Volcker and place his faith in the capital markets.  He should take his foot off the monetary gas pedal  and let the fruits of his energy and labors present themselves.   Simply put- Bernanke should remember that doing nothing IS doing something and he should allow the markets to work without over extensions of liquidity by the Fed.   With capital market indexes cresting highs, equity investors should be wary as they follow the yellow brick road for the wizard is holding rates TOO LOW and a tornado of rising rates may be just over the horizon.  While no one can ever be certain what the future holds, one thing is true—Toto, I've a feeling we're not in Kansas anymore.   

Merkel v. Markets

As we think about 2011 there is an undeniable fact that a number of impactful capital market issues remain unresolved. One such ongoing issue is the Greek debt swap deal, the outcome of which would essentially push/pull Greece in to/out of the abyss of a sovereign default. On its surface the negotiation as to the “best” course of action is essentially pitting public and private sector investors against one another over the size of payout to current holders of Greek bonds. However, if we look a little deeper perhaps this negotiation is more fundamental than the overarching complexities lead observers to believe; we submit that ultimately it comes down to whether investors believe that European politicians will prevail, i.e. Germany’s Chancellor Merkel – OR- that capital markets are providing true and accurate information.

Almost daily media outlets like Bloomberg and Reuters report someone close to the talks saying “that the Greek debt swap deal is progressing” or “a deal is imminent”, while Credit Default Swaps (CDS) on Greek debt – essentially insurance purchased by investors in case of a negative Greek credit event/default – still remain at stratospheric levels. Experience tells us that both insider reports and the CDS market cannot be right. Case in point, in October 2011 when European political leaders announced that a Greek debt deal had been agreed to, CDS on Greek debt came down only marginally and for a brief period before reversing course to head even higher, indicating an increased chance of a negative credit event/default. Obviously as of this missive although a deal was announced almost 4 months ago nothing has come to fruition. And again, the financial world nervously awaits an outcome.

While no one can be certain of what will happen leading up to Greece’s March 20th debt repayment, we can say that politicians, like Chancellor Merkel, continue to reassure capital markets participants that a Greek debt swap deal will happen, all while CDS spreads for Greek (and another euro using country - Portugal) continue to indicate that the sovereign debt crisis is far from over.

Debt Still Matters

In October 1981 the collaboration of the rock band Queen and David Bowie released “Under Pressure”. The song evolved from a jam session the band had with Bowie into arguably the greatest rock anthem of the 1980s. The song begins simply with scat singing of “umm boom bah bay, umm bah boom bah bay“ then launches into a familiar refrain that topped billboards globally:
“Pressure, pushing down on me
Pressing down on you, no man asks for
Under pressure”

Under pressure may be understating the gravity of the European debt crisis German Chancellor Merkel , French President Sarkozy and European Central Bank President Draghi need to solve during the upcoming European Union Summit. Over the past several months we have witnessed dramatic leadership changes in Italy and Greece, continued pledges of austerity from other troubled European nations and an unprecedented coordinated effort of the Federal Reserve, ECB and other Central Banks to ensure liquidity in the event of a global financial crisis. Amidst all of these efforts one issue remains undeniable, unchanged and (comprehensively) unaddressed – the underlying high levels of debt that precipitated the current crisis.

Let’s get back to basics; debt is created when one party provides funds to another party who has the contractual obligation to repay the first party. In its simplest form essentially this is how loans work. As anyone who has ever taken out a loan knows there are finite ways to remove the loan obligation - 1) pay it off, 2) work it off or 3) negotiate with the lender to change the terms/payment of the loan. That’s it.

Now consider the contractual obligations of the third largest Eurozone economy, Italy, which has a debt-to-GDP ratio of approximately 119% . The Italians would ideally like to decrease debt levels to a more manageable level but if we go back to the three basic ways to remove debt obligation, the Italian situation seems dire. First, to pay off debt in a sovereign context primarily comes from having a growing economy. Over the period January 2007 through September 2011 Italy has not seen any quarterly annualized GDP growth above 0.6%; furthermore over this period nearly 60% of the time Italy’s GDP experienced negative growth . Secondly, in the contemporary vernacular of discussing the sovereign debt situation the idea of “working it off”, is equivalent to austerity. The newly elected Italian Prime Minister Mario Monti has proposed significant austerity in the form of higher taxes and more job cuts in an effort to save Italy but the reaction of the Italian populous was predictably rioting in the streets of Milan . Beyond the very real problem of an unhappy citizenry, even with Prime Minister Monti’s €30 billion ($40.4 billion) austerity plan , moving from a lofty 119% debt-to-GDP to sub- 100% debt –to-GDP in a low/negative growth economic environment is near impossible without more austerity. Lastly, negotiating the terms of the debt is, at this point, a nonstarter as most of the debt holders are banks.

We submit that if banks were to accept less than the full amount owed to them these institutions would have to write-down asset levels to amounts that would likely put greater pressure on the already beleaguered European banking system.

“It's the terror of knowing
What this world is about
Watching some good friends
Screaming let me out
Pray tomorrow takes me higher
Pressure on people
People on streets”

While Italy is the current poster child for the sovereign debt debacle, let’s not forget that debt-to-GDP ratios for the likes of Greece (142.8%), Belgium (96.8%), Portugal (93.0%) and even Germany (83.2%) are well above the maximum 60% debt-to-GDP the 27 European Union members agreed to under the stability and growth pact enacted when the currency was first introduced in 1999 .
Merkel, Sarkozy and Draghi now must deftly lead those 27 member states during the upcoming European Summit to directly address the current sovereign debt crisis. With the world watching and expectations rising they are significantly under pressure to deliver a solution. We suspect that any solution put forth will in all likelihood not be viable and/or comprehensive but rather a shiny veneer giving investors a false sense of security. That said, whatever the ultimate outcome of the European Summit, we continue to believe that the underlying fiscal problems need to be addressed before sustainable economic growth can occur because in the end – debt still matters.

“Chippin' around
Kick my brains 'round the floor
These are the days
It never rains but it pours
This is our last dance
This is ourselves under pressure
Under pressure”

Debt Still Matters

In October 1981 the collaboration of the rock band Queen and David Bowie released “Under Pressure”. The song evolved from a jam session the band had with Bowie into arguably the greatest rock anthem of the 1980s. The song begins simply with scat singing of “umm boom bah bay, umm bah boom bah bay“ then launches into a familiar refrain that topped billboards globally:

“Pressure, pushing down on me
Pressing down on you, no man asks for
Under pressure”

Under pressure may be understating the gravity of the European debt crisis German Chancellor Merkel , French President Sarkozy and European Central Bank President Draghi need to solve during the upcoming European Union Summit. Over the past several months we have witnessed dramatic leadership changes in Italy and Greece, continued pledges of austerity from other troubled European nations and an unprecedented coordinated effort of the Federal Reserve, ECB and other Central Banks to ensure liquidity in the event of a global financial crisis. Amidst all of these efforts one issue remains undeniable, unchanged and (comprehensively) unaddressed – the underlying high levels of debt that precipitated the current crisis. 

Let’s get back to basics; debt is created when one party provides funds to another party who has the contractual obligation to repay the first party. In its simplest form essentially this is how loans work. As anyone who has ever taken out a loan knows there are finite ways to remove the loan obligation- 1) pay it off, 2) work it off or 3) negotiate with the lender to change the terms/payment of the loan. That’s it.

Now consider the contractual obligations of the third largest Eurozone economy, Italy, which has a debt-to-GDP ratio of approximately 119%^[1]. The Italians would ideally like to decrease debt levels to a more manageable level but if we go back to the three basic ways to remove debt obligation, the Italian situation seems dire. First, to pay off debt in a sovereign context primarily comes from having a growing economy. Over the period January 2007 through September 2011 Italy has not seen any quarterly annualized GDP growth above 0.6%; furthermore over this period nearly 60% of the time Italy’s GDP experienced negative growth[2] . Secondly, in the contemporary vernacular of discussing the sovereign debt situation the idea of “working it off”, is equivalent to austerity. The newly elected Italian Prime Minister Mario Monti has proposed significant austerity in the form of higher taxes and more job cuts in an effort to save Italy but the reaction of the Italian populous was predictably rioting in the streets of Milan[3]. Beyond the very real problem of an unhappy citizenry, even with Prime Minister Monti’s €30 billion ($40.4 billion) austerity plan[4], moving from a lofty 119% debt-to-GDP to sub- 100% debt –to-GDP in a low/negative growth economic environment is near impossible without more austerity. Lastly, negotiating the terms of the debt is, at this point, a nonstarter as most of the debt holders are banks. We submit that if banks were to accept less than the full amount owed to them these institutions would have to write-down asset levels to amounts that would likely put greater pressure on the already beleaguered European banking system.   

“It's the terror of knowing
What this world is about
Watching some good friends
Screaming let me out
Pray tomorrow takes me higher
Pressure on people
People on streets”

While Italy is the current poster child for the sovereign debt debacle, let’s not forget that debt-to-GDP ratios for the likes of Greece (142.8%), Belgium (96.8%), Portugal (93.0%) and even Germany (83.2%) are well above the maximum 60% debt-to-GDP the 27 European Union members agreed to under the stability and growth pact enacted when the currency was first introduced in 1999[5].

Merkel, Sarkozy and Draghi now must deftly lead those 27 member states during the upcoming European Summit to directly address the current sovereign debt crisis. With the world watching and expectations rising they are significantly under pressure to deliver a solution. We suspect that any solution put forth will in all likelihood not be viable and/or comprehensive but rather a shiny veneer giving investors a false sense of security. That said, whatever the ultimate outcome of the European Summit, we continue to believe that the underlying fiscal problems need to be addressed before sustainable economic growth can occur because in the end – debt still matters.

“Chippin' around
Kick my brains 'round the floor
These are the days
It never rains but it pours

This is our last dance
This is ourselves under pressure
Under pressure”

---

[1]CNN “European public debt at a glance”, July 21, 2011

[2]Trade Economics, http://www.trading economics.com/Italy/gdp-growth

[3]ABC News “Reforms spark riots in Italy, Greece”, updated November 18, 2011

[4]Bloomberg, “Treasuries Erase Drop After S&P Warns of European Credit Rating Reductions” Dec 5, 2011

[5]CNN “European public debt at a glance”, July 21, 2011

..Hello? Is anyone paying attention?!

As time has marched on since the debt ceiling debate we are left wondering where is the sense of urgency from Capitol Hill?  Former Federal Reserve Chairman Alan Greenspan recently said as much when he told a subcommittee of the Senate Finance panel “if we presume that we have a year or two before starting serious long-term restraint, and we turn out to be wrong in that optimism, the impact on financial markets could be devastating.” Not only have politicians glossed over the longer term implications of current financial issues the country faces, by their inaction they seemingly have little understanding of the importance of taking corrective measures in 2011 or the stomach to communicate to the electorate what will be unpopular solutions.

Indecision and/or ineffective actions now set the stage for higher deficits and a more difficult economy going forward.  The projected $1.4 Trillion deficit is the largest (nominally) in US history but more importantly without a change to the fiscal direction the total US debt owned by other countries could move to nearly 100% of GDP, leaving America in the worst financial situation since WWII.  Think about it-  if all of the money generated from all of the US’ output equals the debt this will hamper growth and prolong the current financial pain we feel.  Democrats and Republicans would likely agree that the current US fiscal issues need to be corrected but agreement on the big picture problem has never been - well - the problem. Both parties seem reticent to make the tough decisions to get America out of harm’s way and the ideas proffered are unrealistic and ineffective.

 The White House’s Budget forecasts that the current deficit will be reduced to $900+ Billion by the end of 2012 and decidedly smaller in subsequent years.  While we would welcome a lower deficit in the near future, the devil is in the details. The $500 Billion question is - where is the money coming from?  The Administration’s Budget shows that the decrease is primarily based on an increase in (tax) revenues from individuals and corporations to the tune of $580 Billion over the next two years. We believe that to achieve that magnitude of tax revenue increase requires GDP growth well above the anemic .4% and 1% growth seen in the 1st and 2nd quarters of 2011 respectively; additionally there has to be significant reduction in the (current 9.1%) unemployment rate for this math to work. In an economic recessionary environment having substantial GDP growth with a considerable decrease in unemployment without some catalyst is unrealistic.  Some believe that Fed action will be that catalyst for growth but the methods proposed thus far i.e., a third round of Quantitative Easing or a “TWIST” – the recent process whereby the Fed sold short term treasury securities and bought longer term treasuries - do not address the underlying problem;  reviving a recessionary economy requires individuals and companies to spend and invest with banks lending the necessary funds. We believe the Fed's actions so far have not and do not encourage spending, investment or lending. Essentially we are out of the traditional bullets used to get the country growing to fix the fiscal problem.

Given the need to address the problem sooner than later and ineffective Fed action-  now what? Simple-- to reduce the fiscal deficit on a go forward basis US politicians must realize both unpopular decisions must be made- Democrats must accept deeper spending cuts and Republicans must accept higher tax increases.  Proposing and implementing significant reductions in entitlement programs and requiring others to dig much deeper in their pockets is both uncomfortable and difficult - particularly in an election cycle - but that is the professional politician’s job.  Politicians on both sides of the aisle must show the political will to put the US economy first and not their own agendas. 

It’s the (Global) Economy, Stupid

Miguel de Cervantes wrote what is considered by many to be the most influential literary work from the Spanish Golden Age - Don Quixote.   The story of Don Quixote tells of a gentleman nearing fifty, with a distorted perception and wavering mental faculties, who enlists the help of his dimwitted friend, Sancho, to help Quixote sneak away from their tiny village and search for grand adventure.  From this story we get the term quixotic, foolishly pursuing certain ideals or beliefs. 

As we assess, then re-assess and then (re)re-assess our analyses on the state of the global capital markets we are left wondering - are we being quixotic.  Long before the political brinksmanship of the debt ceiling debate or the US downgrade by S&P or civil unrest in places like Greece, Portugal and Spain we have stated a number of times that global capital markets are teetering precariously.  Still without any meaningful improvement in the fiscal and/or economic landscape since summer 2011 we continue to watch US capital markets trade irrationally higher on rumor, speculation and emotion.  

Even though emotionality is dictating the direction of market moves, we believe it is paramount that rationality and logic be used when trying to understand what is happening in the world around us.   In previous commentaries we have discussed the challenging situations in Greece (“Rebirth of the Drachma”) and the US (“Sword of Damocles”), as well as the possibility of global financial contagion (“It’s a Small World”); and beyond choreographed press conferences and financial summits, we have seen little action or information that changes our belief that things are likely to get worse before they get better.  Simply, we do not believe we are channeling our inner Don Quixote and fighting windmills in our minds.

If the aforementioned commentaries haven’t sufficiently alerted investors to current global economic frailty - let’s talk about Italy.  With the focus so squarely on Greece, Italy has gone comparatively under the media’s radar.  Much like Greece (and the US) Italy has been piling up debt to unsustainable levels given their low growth economy (Italy’s 2010 GDP was 0.9%).   But compared to Greece’s €350 billion (approximately $480 billion) outstanding sovereign debt that continues to give investors heartburn, Italy’s €1.9+ trillion (approximately $2.6 trillion) is heart stopping.  Recently S&P downgraded 24 Italian banks and financial institutions reasoning, “Renewed market tensions in the euro zone's periphery, particularly in Italy, and dimming growth prospects have led to further deterioration in the operating environment for Italian banks”.  Also noteworthy is that the European Central Bank (ECB), much like the US’ Federal Reserve Bank, has been artificially holding interest rates down below market equilibrium.  The ECB has been the primary purchaser of Italian debt in secondary markets. At September month-end yields on Italian debt stood at 5.14% and as of October 18^th debt yields increased 72 basis points to 5.86% which includes the ECB buying program.  Increasing yields indicate that investors want higher returns/greater compensation for taking increased risk when buying certain debt.  Greece’s outstanding debt, which is speculated to be worth only 30 – 50% of original value and is prompting concerns about how to recapitalize affected European banks, is analogous to the potential risk inherent in Italian debt.

Even if the European leadership does manage to solve or ring-fence the current Greek crisis, we believe that Italy’s debt situation shows that sizeable downside risks to capital markets around the world still remain.  At the conclusion of Cervantes’ Don Quixote, Quixote returns to his small village and a short while later wakes up having fully recovered his sanity – As sanity and rationality return to the global financial markets, investors will wake up to the undeniable realization that significant debt overhangs and low growth economies mean lower equity prices .