Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 2015

Over the years the increasing public indebtedness of certain countries has at times become an issue that has risen to the level of public consciousness and gained media attention. Now the matter of debt has become a crisis in Europe, where Greece, its European neighbors, and international institutions such as the International Monetary Fund, have struggled for three years to find a solution to Greece’s inability to meet its obligations. In particular, Germany (which in 1953 negotiated its own debt restructuring, including significant debt forgiveness) has pushed the Greeks to institute tough reforms in return for assistance.

But the Greeks are not alone in suffering the affronts of debt collectors. Closer to home, in late June the governor of Puerto Rico announced the U.S. territory would be unable to fully repay its $73 billion of obligations, and that creditors would have to “share the sacrifices” needed to restore economic growth and fiscal balance. This frank admission could unsettle part of the U.S. tax-advantaged bond market. Puerto Rico had been one of the largest issuers of municipal bonds. Due to their tax-free status for American buyers (free from both state and federal taxes), Puerto Rican bond issues were especially popular with high-bracket taxpayers in high-tax states.

In addition to being an attractive place for bond buyers, Puerto Rico enjoyed tax benefits in the form of incentives designed to attract businesses to the island. These policies worked well (pharmaceutical companies, for example, invested heavily in Puerto Rican facilities) until they lapsed about a decade ago. Since then both investment and the Puerto Rican economy have been in steady decline, to the point where the population has fallen as residents decamped to the U.S. mainland seeking better prospects. Projected and actual tax receipts have fallen as well, making financial planning difficult and resulting in the territory’s debt climbing to 100% of GDP.

The governor’s comments aside, Puerto Rico’s territorial status prevents it from taking advantage of U.S. bankruptcy protections, although there has been some talk of devising a plan to grant it relief. The repercussions of such actions would fall heavily on some municipal bond mutual funds that had loaded-up on Puerto Rican obligations, the hedge funds that now own a chunk of the island’s outstanding debts, plus a couple of bond insurers. Hedge funds are often attracted to financial disasters and have their own ways of dealing with them. Already at least one fund has objected to any debt restructuring talk—expect more news from that quarter in the months ahead.

Greece promises to be even more “newsworthy.” Its crisis is very serious, and the impact on the lives of ordinary Greek citizens has already been severe. Given the variables and uncertainties at play, the impact of a solution (or non-solution, kicking the can further down the road) to Greece’s problems from an investment standpoint is speculation at this time. Markets have a way of “discounting” unsettled conditions, a characteristic that helps make them unpredictable. What does appear to be highly likely, however, is the outcome of a continuation of austerity and imposed reform. A humanitarian crisis is possible, and there is talk of a “failed state on Europe’s doorstep.” That possibility is potentially much more serious and costly than demands for financial sacrifices on the part of the Eurozone, an idea fiercely rejected by some of its member countries.

Perhaps Europeans’ impatience with the Greeks has roots that are really closer to home. Much of the Greek “bailout” money extended so far has flowed to the big European banks that were, in years past, only too happy to lend to poor Greek credits. Little has gone to helping the Greek economy restructure and recover. Whether they like it or not, in one way or another Europeans will be dealing with Greece for a long time to come. Sacrifices will be needed, not only on the part of Greece. The International Monetary Fund (one of the institutions overseeing the Greek bailout) announced in early July that loans to Greece will need to be extended, and that additional funding, perhaps totaling 60 billion Euros in the coming years, will be required. Failing a resumption of economic growth, a large part of the country’s debts may have to be written off even if it accedes to creditors’ current demands.

Even as the Greek debt crisis comes to a head, China may be incubating yet another. Potential problems involving non-bank lending in the country (by so-called “wealth-management funds,” for example) have been discussed for years. But during the past year a new threat has emerged in the form of margin debt, or loans secured by stock holdings. China’s stock market began a spectacular rise in July 2014. In early April 2015 stocks had gained 68% in the previous six months alone, as Chinese savers put hundreds of billions of dollars from property, deposits, and wealth management accounts into the stock market. Last March saw 4.8 million new retail stock accounts opened, followed by an additional two million during the first two days of April. In the fashion typical of unsophisticated market players everywhere, margin lending also saw “explosive growth,” rising to $258 billion in early April, fully 2.5 times the total six months earlier.

Buying stocks on margin is an ill-advised step for most market participants, especially so for the first-time punters that appear to be driving the Chinese market boom. Stock price declines can lead to margin calls (demands that debts be repaid) that can deplete a brokerage account in short order as stocks are sold at a loss. As if on cue, the Chinese market ran into difficulty as new companies rushing to sell their shares and cash in on a market bubble diverted interest from existing stocks and sucked liquidity from the markets—in other words, supply and demand at work. After peaking on June 12, stock prices fell sharply. As typically happens during a speculative frenzy, the declines took on a momentum of their own. The Shanghai Composite Index dropped 22% by June 29, losing $2.3 trillion of market value (more than the market capitalizations of France and Canada). Daily declines of 7% took place, and many individual stocks fell the daily limit of 10%. Government efforts to provide “market support” and institute a “soft landing,”—steps that include the corralling of funds to purchase shares and easing the terms of margin loans—are indicative of the seriousness with which Chinese authorities view the market turmoil. In spite of these measures, sizable declines continued into July.

 

While the flow of negative news put a damper on sentiment, U.S. stocks chugged along nonetheless, experiencing only a small amount of selling at quarter’s end. The major indexes finished the three-month period a little lower, and flat for the year-to-date. Bond yields have risen modestly in anticipation of changes in Federal Reserve monetary policy, as well as expectations of better economic performance both here and abroad. Interest rates remain abnormally low, however, with all of the market distortion that breeds, from excessive debt accumulation to the impact of low discount rates on future obligations such as insurance and pensions. How the fiscal and monetary authorities deal with the “normalization” process to come will undoubtedly be the source of much Wall Street opinion and chatter during the next few years.

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Liquidity Redux

Once again market observers have become obsessed about “liquidity,” or the ease with which financial assets can be purchased or sold without affecting the price too much. This time the bond markets are the focus of concern, and even the Federal Reserve is getting into the act, fearing that limited liquidity could be a significant problem “if it acted as an amplification mechanism” for market disruptions. This mechanism could come into operation if, say, the large institutional investors that have come to dominate securities markets were suddenly pressured  (through an unexpected increase in redemptions, for example) to liquidate holdings en masse.

From a policymaker’s perspective, there are some grounds for concern. As a result of their bad behavior prior to the financial crisis, money center banks face a regulatory environment that prevents them from holding and trading large inventories of securities for their own accounts—“market-making” activities that were an important source of liquidity (and bank profits) prior to the crisis. These functions have now been curtailed. The Fed itself, through its “quantitative easing” programs, has hoovered up a large amount of treasury securities, effectively removing them from the market. The growth of huge investment management operations has also served as a sink for large amounts of bond assets. While the investment managers vehemently deny their institutions represent any sort of “systemic” risk to the financial system, their enormous securities holdings, and the risk of redemptions by investors demanding cash in a crisis, certainly seem to be subjects worthy of inquiry and analysis at the very least.

We believe the concerns about liquidity are vastly overblown. Some discomfort would no doubt occur during market stress, but we would expect that speculators—those wagering on favorable price moves—would bear the brunt of the losses. Leveraged players—those using borrowed money to buy securities—could suffer grievous financial damage as well. Speculation is financial Darwinism at work, and losses are deserved in such cases. Furthermore, in our view, much of the bellyaching over liquidity comes from banks trying to escape tighter regulation. Would we really want to return to the heady days of 2007, when taxpayer-subsidized banks engaged in lots of trading only to be bailed out when their bets turned sour? Finally, liquidity has always been an issue during times of stress in the markets. In the past, traders at bank desks simply stopped answering the phones.

Investors who are worthy of the designation can and should have a more sanguine view of liquidity. Market squalls come and go, but as “permanent” holders investors generally do not need to respond to these short-term fluctuations and trading issues. Importantly, genuine investors should always stand ready to provide liquidity to those who need it—for a price. Conversely, investors will mop up excessive liquidity through sales of securities to those whose views of future prospects are exceedingly optimistic. Curiously enough, we have found that there is usually ample liquidity available when you really want it.

 

Dennis Butler, MBA, CFA