This note was originally published at 8am on January 18, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“It's been 84 years, and I can still smell the fresh paint. The china had never been used. The sheets had never been slept in. Titanic was called the Ship of Dreams, and it was. It really was.”
In the quote above from the blockbuster film “Titanic”, an elderly Rose DeWitt Bukater reminisces on the grandeur and splendor of a vessel once described as “unsinkable” – even by God. More deeply, her allusion to the Titanic’s former nickname triggers feelings of grief as she turns to the memories of a lost life that could’ve been so many years ago.
Unfortunately global risk managers don’t have the luxury of dwelling on the past like Old Rose here. We must constantly be playing the game in front of us; this week global markets are tuned squarely to Europe’s bond auctions and statement’s from the region’s leaders on its sovereign debt issues as a proxy for market performance.
Over the short term we’d expect European markets to continue to make gains on the heels of announcements from China (earlier this month) and Japan (on Tuesday) to buy European bonds and statements from EU Economic and Monetary Commissioner Olli Rehn (yesterday) that EU officials are trying to forge a “comprehensive” plan to contain the sovereign debt crisis and from German Chancellor Angela Merkel who indicated a desire to do “whatever is needed to support the euro.” Rehn also ruled out debt restructuring for Greece or any other euro-area member state.
With this kind of support, it’s no surprise that investors cheered, markets boomed, and the European auctions have found plenty of demand. Yesterday saw substantial outperformance from the peripheral equity markets, with gains from: Spain’s IBEX +5.4%; Greece’s Athex+ 5.0%; Italy’s FTSE +3.8%, as credit markets have improved over the last 3 days.
As we head in to earnings season, MACRO seemed to return to the forefront as the high-profile upside driver to global equity prices as concerns over sovereign debt auctions diminish. The dampened European sovereign contagion concerns fueled a pickup in risk appetite on the back of a better-than-expected Portuguese bond auction yesterday and Spain’s auction today. This is leading to outsized gains in the financials around the world.
Yesterday in the US, financials extended their 2011 outperformance with the leadership coming from the banking sector, with the BKX +1.5% and the broader XLF up 1.7%. Despite disappointing Machinery orders out of the Japan, the Japanese megabanks followed their American peers higher, leading Japan to +0.73%. Like in the US, the potential for increased dividends is driving equity prices higher as both Sumitomo Trust & Banking and Chuo Mitsui Trust Holdings rose 5% overnight on the potential of higher dividends.
As we’ve seen throughout market history, it’s typically when everyone is expecting smooth sailing ahead that certain “icebergs” tend to derail things. If we’ve learned anything from the movie “Titanic”, it’s that hubris about our top ideas (the ship) and a disregard for risk (not having enough lifeboats on board) can get us into trouble.
Certainly a few Macro Icebergs are scattered across our domestic waters. How we navigate them individually will be the key to getting paid in 2011; currently, the collective is “full speed ahead”.
Below we’ll highlight one of the largest Macro Icebergs that a) has the potential to capsize our ship; and b) is out of consensus – at least for now:
Municipal Debt Dichotomy
Yesterday we published an intraday report titled: “The Municipal Bond Market: Silent But Deadly” (email email@example.com if you want to see our work on muni bonds). In it, we took a deep dive at the headwinds affecting this sector of our financial markets and the systemic risk therein. The key takeaways from the article were:
- Fiscal austerity at the State and Federal Government level and a strong political will in D.C. to avoid bailing out States and municipalities will perpetuate budget woes at the municipal level (together, State and Federal support account for ~34% of municipal budgets);
- Local governments are running out of room with their accounting “tricks” and are staring at potentially 2-5 years of declining property tax receipts, which are ~26% of their budget;
- Calls for State defaults are overblown; the real issues lie within the municipalities and municipal authorities across the nation; the States that have the most severe fiscal issues will see a disproportionate number of their municipalities go bust (though bankruptcy is not permitted in 23 States, defaulting on payments to vendors and creditors will be the more likely outcome in many cases); and
- The equity markets are misinterpreting the recent back up in yields as “growth” and not “risk” and this risk isn’t going away any time soon.
While still largely ignored by consensus, it was certainly interesting to see some big names in our industry come out on both sides of this debate yesterday:
PIMCO’s Bill Gross: “Ultimately, municipal bankruptcies will be at a lower level. I don’t subscribe to the theory that there will be lots of them.”
JPMorgan’s Jamie Diamond: “There have been six or seven municipal bankruptcies already. I think unfortunately you will see more… If you are an investor in municipals you should be very, very careful.”
“Smooth Sailing Ahead” vs. “Icebergs A’Cometh”.
We certainly aren’t crying wolf for the sake of attention like some analysts with ulterior motives. We don’t do ratings, banking, trading or manage assets; we only get paid for being right. Considering that we’re still in business after three of the most volatile years in the history of financial markets, we’ve been blessed to be more right than wrong over this duration.
For the sake of our economy (yes we are patriots), we hope we are not right on this one. The last thing America needs right now is another financial crisis on its hands perpetuated by blow-ups in the $2.9 trillion dollar muni bond market and Housing Headwinds Part II (not mentioned here; email us for more details). Unfortunately, hope is not an investment process. That’s why we’ll continue to help you navigate these murky waters as Global risk managers.
We’ll discuss these risks and how to play them on the long and short side on our Q1 Quarterly Themes Conference Call tomorrow at 1:00pm. Qualified prospective institutional subscribers please email firstname.lastname@example.org for more details.
Keep your head on a swivel.