Juggling Dynamite

I admit it, I am a market junkie. I spend most of my waking hours thinking about world risk markets. But then our clients pay me to think and worry about this stuff. I have an excuse. Understanding how the many parts and players fit and move together and against one another is what makes this field so fascinating, all consuming, daunting and incredibly humbling. It is truly the biggest Rubik's Cube ever designed.
Like the most unruly child in a family, stock and commodity markets have been demanding most of the world's attention this year. But in our management firm, about half of our investable assets are allocated to fixed income, so we do need to pay a lot of attention to what is happening in the world of interest rates, credit spreads, and overall price trends. In recent weeks bonds have slowly picked up their boil on the back burner.
We noticed prices for the highest quality issuers spiking in October. Bonds that we already owned were enjoying nice gains, but capital we needed to reinvest on the fixed income side was becoming harder and harder to place. Prices have climbed so high, and yields have dropped so low that bonds worth buying on our rules have literally dried up.
Admittedly we are very picky and have a couple of key buy rules about fixed income: all individual issuers must be investment grade or higher; we never pay more than par and wherever possible buy at a discount to par. We also manage the duration (think weighted term to maturity) in accordance with our outlook on interest rates. When it comes to corporate bonds we seek to minimize company specific risk (that’s why we call it “fixed income”, the interest payments need to be paid to us, otherwise there is nothing “fixed” or stable about the “income”), so for corporates we prefer corporate bond ETFs over individual company issues. We also know that corporate bonds and preferred share prices follow the equities cycle. Their prices drop with equities and their prices rise with equities. In times of crisis all “risk assets’ fall together.
Over the past few months we have seen this normal correlation to equities play out in preferred shares, where prices have plummeted with common share prices across the board. With bonds we have seen a rather incredible and unsustainable trend. In the past few weeks, the fear bubble has driven US government bond holders to pay more than they are worth just for the “peace” of holding them, as explained in this article yesterday:
Investors buy US debt at zero yield:
“In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager on Tuesday to park money in the world's safest investment, United States government debt that they agreed to accept a zero percent rate of return.
The news sent a sobering signal: in these troubled economic times, when people have no gain is tantamount to coming out ahead. This extremely cautious approach reflects concerns that a global recession could deepen next year, and continue to jeopardize all types of investments.”
In Canada we have seen a similar theme in soaring bond prices with one year Government of Canada T-Bills offering a paltry 1.3% as of yesterday. I can recall similar challenges when searching for high quality yield back in 2004-2005 when Canadian government bond yields offered a meager 2.7%. But 1.3% is truly a new low. Meanwhile even longer term 10-year government issues are offering less than 4.3%. And governments around the world will inevitably be pumping out new bond issues in the New Year to make up for budget deficits aggravated by simulative spending. With real interest rates already steeply negative, we have to be concerned with the pick up in inflation and interest rates this will breed again down the road. Overpaying for bonds now will surely be painful to capital two or three years in the future. All bubbles burst eventually. This bond bubble is unlikely to be an exception.
We are sorting through preferred shares and corporate bonds again for fixed income options. The yields are looking better than they have in many years, and we have many targets on our radar. Their price risk here lies in the length and depth of this economic downturn. We know it will be longer and deeper than most we have seen. We suspect that credit spreads may widen further for some time yet. This means corporate bonds and preferred shares are at risk of getting cheaper still before prices bottom. But the further we get through this downturn, the more low-risk rewarding homes we will find for our cash, and that is truly something to get excited about.

Ms. Park will be a guest on CBC News Business on Thursday Dec 11 at 6:30 pm, and MoneyTalk with Patricia Lovett-Reid on Monday Dec 15 at 8 pm.

This week the International Monetary Fund (IMF) released its economoc outlook report for October 2008. Some lowlights:
• World growth will slow amid most dangerous financial shock since 1930s.
• The advanced economies grew at a collective annualized rate of only 1 percent from the fourth quarter of 2007 through the second quarter of 2008.
• No growth in many advanced economies until at least mid-2009.
• Emerging and developing economies have not decoupled from this downturn.
• After 5% global growth in 2007 the IMF now predicts 3.9 percent in 2008 and 3.0 percent in 2009, with a modest recovery expected to start in the later half
of 2009. -Global growth is not expected to return to trend until 2010.
They also cite significant downside risk to present forecasts:
• Persistent financial stress and the credit constraints from deleveraging, which could be deeper and more protracted than in the baseline scenario.
• Further U.S. housing market deterioration, which could be deeper than forecast.
• European housing markets could weaken more broadly than envisaged in the baseline.
• Potential disruptions to capital flows to emerging economies and the risks of rising protectionism represent additional risks.
Meanwhile TD Economics released its Quarterly Economic Forecast today, which now adopts their previously most pessimistic scenario as their base case going forward. Key points:
• World economy expected to expand by a meagre 0.5% in 2009. We are witnessing a rare instance in history of a synchronized global recession.
• The U.S. recession is one-year in progress and the hardest leg of the downturn has just begun.
• Canadian economy is likely to contract until mid-2009.
• Tumbling commodity prices will have a unique impact on the real Canadian economy, contributing to an unprecedented 3.2% contraction in nominal GDP, which
is the equivalent of shaving $51 billion from domestic income.
Their conclusion:
“First, we project great weakness through the first half of 2009 across all major economies. Second, a solid recovery is expected in the second half of 2009 and through 2010. Third, the economic outlook can’t be seen through rose-colored glasses beyond 2010. A lot of imbalances will still need to be unwound, including those that afflicted the global economy before this crisis – such as the saving imbalances between countries. In many respects the situation will have become worse, due to recapitalization, deleveraging among businesses and households and huge public sector dissaving.”
My take:
These are the fundamental reasons why we have historically always had long secular bear markets after long secular bull markets. The leverage and over-spending of the secular bull have to be paid back and rebalanced during the secular bear period.
The good news is that in the not too distant future, as pessimism runs rampant, I suspect the stock markets of the world will start into their next cyclical expansion within this secular bear, and we will have an opportunity to ride the wave up again for a while. But the contraction after the next expansion will come hard and sharp, just as it did in 2000-2002 and 2008-2009, and defending our capital from losses will be the key throughout.
In these past few weeks of 2008, I am being asked to do many media interviews looking back on 2008 and the number one question asked is how did we at our firm know these bad economic conditions were coming and how did we know to protect our clients and their capital from this bear market. I wish I could say it was superior intelligence. It was not. Mostly it was just humble, diligent study of history, market cycles and human behaviour. Each cycle is slightly different, but human behaviour is remarkably consistent through time. The hubris and dumb-risk taking of the boom is the DNA that always breeds the bust.
It is crucial to have our eyes open and train ourselves to read the signs. It is also crucial to have a plan to protect our financial health from the fall-out. Those that say they see the signs but do nothing to protect capital are unfortunately of no value.
This recent article by Economist Joseph Stiglitz is refreshingly candid about how we got here today:
“Was there any single decision which, had it been reversed, would have changed the course of history? Every decision—including decisions not to do something, as many of our bad economic decisions have been—is a consequence of prior decisions, an interlinked web stretching from the distant past into the future.”
“The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.”
'Twas ever thus. This is not rocket science; not brilliance. It is simple human nature. The more complex the world seems, the more understanding of our behavour will cut through the noise. In the end, EQ or emotional intelligence trumps IQ every time.