Lower oil can hurt

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The precipitous decline in oil over the last few months is not news and is really a matter of higher supply with lower demand. Some believe this imbalance will continue for some time. This is up for debate but the market inter connectivity is very much alive and continues to be painful for investors in a number of asset classes.

Brent Crude is down approximately 27% from its June high. While that is seemingly good for consumers, the speed and ferocity is truly a worry as the deflation fears are here and are leaving the Federal Reserve with a tougher time with interest rate policy.

The ETF (XLE) is down over 20% in the same time frame as the large energy producers equity valuations have been hit very hard. They have fared well however vs the smaller energy exploration companies whose balance sheet and credit quality is not as robust.

XOP is the SPDR ETF that represents a large portion of the oil exploration companies and is down from June peak 32%. That is the equity and depending on your high yield bond fund, there may be additional pain. Some of these companies at the lower end of the credit spectrum issued bonds at or near par(1oo centS/$) and are trading in ranges from 55cents to 70 cent on the dollar.

As equity is at risk of losing all value, these bonds can default and leave the investors with little to no residual value. They were sold most likely with optimistic scenarios to warrant the par pricing but reality has set  in.

A broad based investment in commodities has not helped either as they are down close to or over 20% from peak as well.  They say a strong dollar is partly to blame but diversification away from the dollar has been the asset allocation advice for a long time. Now markets are converging against that thesis. It is time to delve in the intricacies of the models.

We suggest that you hold a conference call with each of your managers to determine their risk profile with respect to their positions and how they plan to maneuver this treacherous environment.

As always, we are happy to help with that discussion preparation to aid in the market and manager due diligence.

 

Sincerely,

Tom Koehler, CIO

 

 

 

 

 

 

 

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Taper but no initial tantrum

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  • The Federal Reserve decided to lessen monthly purchases to $75 billion from $85 billion.
  • They said further measured steps are possible on tapering.
  • They said exceptionally low rates until jobless rate well below 6.5%.

            We sense that they gave a very token reduction in the pace of purchases since $75 billion worth of debt purchases is going to continue to grow the Fed’s balance sheet.

           They likely did this for a few reasons and most importantly to foster a sense of credibility. Data dependency is their mantra for the decisions they make and a better jobless number apparently warranted a slight taper. If they seriously thought the economy had full wind in its sail, they would have taken $20-$25billion off of the table.

            The big key is the last of the three statements in terms of what we feel is a bargain with the market. To mitigate the risk of a tantrum such as the one in Spring when bonds sold off significantly, they are anchoring rate expectations for quite some time while they take their foot off the accelerator ever so slightly. Bonds are broadly softer this morning although a massive unwinding is unlikely at least for now.

            This Fed action simply let some air out of the ever growing “anticipation balloon”. Now we know they can taper based in part on improving data. Here is a thought. What if in their tapering campaign, data comes out that is both deflationary and recessionary sometime in late 2014 for instance?   Will they begin to ramp up again?

            While some believe this is the first in a series of measured reductions, we feel that the path and direction of the Fed’s purchase program is not likely to be a linear move. The data both for inflation and labor markets is too uncertain to predict such an exact policy change.

            Bonds continue to be one of the most difficult areas of the capital markets to invest in as investors are “forced” into credit products that are in many cases overvalued and into reasonably unknown areas such as Emerging Market debt where clarity of policy is even more uncertain and less studied.  

            A small bit of evidence with regard to the difficulty that bond investors face came to us as we examined a few ETFs.  Here are two brief examples.

AGG-I-Shares US Total Bond Market

  • 2.21%  SEC yield
  • 5.06 duration
  • 60% weight to Treasuries and Mortgage Backed securities
  • AUM $15 Billion

            This is evidence of either a strong belief in this ETF with 60% of the portfolio highly influence by Fed policy or or a degree of discomfort with more robust options. Even if this $15 Billion of investor money liked mortgage backed debt, why not utilize an adept active manager in this space? That 2.21% is wiped out with that duration as high as it is if rates move up.

IGOV-I-Shares International Treasury Bond

  • 1.41%  SEC yield
  • 6.76 duration
  • 18% weight to Japanese debt and 37% in “other”
  • AUM $603 Million

         This is even more vexing as I am not sure how $603 Million worth of investor money can hold any conviction on a product where 37% is other and 18% is Japanese Debt. Possibly a move is proving difficult in a market where spreads have come in and EM Debt is perceived as too precarious.

            We would absolutely sell these products as soon as your team is able to formulate a well vetted alternative solution. They do not in our opinion represent a solid risk to reward scenario.

            This is our last blog of the year and while that is a relief for some who are weary of Zenith’s insight;), we will be back in the new year identifying solidly good situations as well as the poor ones such as the two listed above.

            Our closing thoughts are as disparate as the markets we cover. As the year comes to a close we wish for a few things.

  • A solid resolution to the Ukrainian revolutionary storm so that the people can develop as a nation free and prosperous.
  • The projected global wine shortage does not occur.
  • That every and all ski resorts continue to receive regular and heavy snowfall through spring.
  • The US Ski Team dials it up and does well in Sochi. This holds for all of our athletes.

 

Sincerely,

 

Tom Koehler-CIO

 

 

“Bond markets represent a complex asset class and while we covered a small amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”

 

Fed Taper Guess

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We would love to hear your comments with regard to the timing and magnitude of Federal Reserve purchase reduction potential.

Back ground economic information that the Fed monitors and weighs heavily

They are uncomfortable with the low level of inflation and that argues for continued monthly purchases with little to no taper.

Unemployment is lower but the participation rate is lower as well. Since it hit the 7% threshold, that argues in favor of a taper.

Housing is showing signs of weakening but certainly not of falling off a cliff. Uncertain earnings guidance from a major homebuilder is worrisome and their stock is reflective of that as they are down in some cases over 2-3% today. This has been an area of strength so they may not want to burst this bubble.

Budget “deal” is reached and stocks sell off as taper has now been moved to the Dec time frame  (they meet next week) according to traders.

1. Does the Fed curtail purchases within the next 6 months?

2 How much do they decrease?

 OR

1. Will they be forced by deflationary forces to maintain?

2. Do they possibly increase?

We welcome predictions and thoughts in the comment section.

 

Sincerely,

Tom Koehler-CIO

GDP, Unemployment and the Fed

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11/8/13

 Zenith Portfolio Strategies Economic update

 GDP

            The quarterly 2.8% 3rd quarter growth rate is encouraging although inventories contributed 1% to that and so already some economists such as  Jan Hatzius at Goldman are revising downward their 4th quarter numbers since inventories are not likely to be a major contributor again in the very next quarter.

           A closer look at other components while still positive is somewhat sobering.

1. Year over year  3rd quarter comparison for the last three years;

  • 2013-1.6%
  • 2012-3.2%
  • 2011-1.5%
  • 2010-3.0%

2. Consumption is approximately 70% of GDP. Here are the year over year numbers.

  • 2013-1.8%
  • 2012-2.2%
  • 2011-2.5%
  • 2010-2.0%                                                                                             

Employment

Total non-farm payroll jobs created were well above estimates.

  • Jobs created 204,000
  • Unemployment rate increases from 7.2% to 7.3% due to the next point
  • Labor participation rate 62.8% a low level that has not been seen since 1978

            While the increase in jobs is a good sign the lower labor force participation rate is a very serious worry to us.  The GDP numbers and employment picture lead us to believe that any taper would be minimal whether it starts in Dec, March or later next year. Also, keep in mind that a taper does not equal a net stoppage. It simply means that instead of driving 140mph , they are potentially going to slow to 120mph. That is still speeding.  

Sincerely,

Tom Koehler-CIO

THE FED and Taper Tantrum

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We were going to hold off on a more substantial piece until later this week until we came across an article that we could not pass up sharing with our readers. As you all know, when the Fed announced it would being at some point reducing QE or the purchase of Treasury and Mortgage Backed Securities, the market had a “tantrum” and drove fixed income yields higher. This included Treasuries, Mortgage Backed Debt as well as Emerging Market bonds. It was a rough time for long only duration heavy bond managers and investors.

Currently the thresholds for a taper are 7% unemployment(currently 7.2%) and for an actual increase in the Fed Funds rate, the rate of unemployment should be around 6.5%.  It seems then that the short end of the curve will remain anchored for now.

It seems as though 2% is the number for inflation and since it is “comfortably” under that at 1.2%, they have room to continue the current rate of purchases.

The guessing game on a taper continues daily as economic numbers are analyzed and the words of the ever consistent Fed officials are listened to by the minute to determine if the doves or the hawks are going to win.

The article from “zero hedge” cited Jan Hatius a top economist at Goldman who believes that Taper could begin in December based on two separate studies from two officials at the Fed. Basically, they need to taper based on new models but to keep the tantrum under control they will likely announce a lower threshold for increasing the Fed Funds rate to 6.% or even 5.5% unemployment.

The most basic conclusion we have is that they will keep short rates low to lessen the severity of the potential reduction in asset purchases. We do believe that the economic growth rates and labor force issues do not give the Fed much room to reduce purchases much even when they begin.

Lastly, if they are correct in the threshold 6% unemployment as the new level before raising short term borrowing costs, we believe it could be beyond 2015 before they do.

The bond battle is in the early innings.

Sincerely,

Tom Koehler, CIO

Market risk- the talked about and the tail

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1. Debt ceiling-VERY talked about. The fallout of not raising it is not completely certain as I mentioned in my last blog.

2. Taper-EXTREMELY TALKED ABOUT -This is discussed so much that it would normally cease to be important but 85billion/month in security purchases is very important.  There is a potential slowing of purchases, the potential end of purchases and when OR even the expansion should economic numbers disappoint.  We disagree with Bill Gross who is mainly focused on the Fed Funds rate. The shape of the yield curve and the implications for mortgage rates, banks earnings and housing is very important and the amount and direction of QE/Taper will hurt or help the financial markets.

3. Mortgage REITS funding via REPO- This is a TAIL as it is not on the radar screen of many firms-Here is the excerpt from Market Watch-

Looking at the big picture, there’s concern among officials about the possible systemic risk posed by mortgage REITs and other entities that use repo markets for short-term funding. A new financial-stability report from the International Monetary Fund cited vulnerability to risks from rising and volatile rates if collateral is liquidated, leading to fire sales and funding interruptions, among other problems.

“Given that the repo funding of the two largest mREITs is comparable to Lehman Brothers’ precrisis repo book, at the very least the mREITs point to a microcosm of fragilities in the shadow banking system that deserve closer monitoring,” according to the IMF.

A separate report from U.S. regulators reported similar findings, according to the Financial Stability Oversight Council, a federal watchdog created by the Dodd-Frank bank-reform bill.

“A shock to agency REITs could induce repo lenders to raise margins or pull back funding, which in turn could compel agency REITs to sell into a declining market, potentially impacting MBS valuations significantly,” the FSOC’s report says.

It is worth at least a discussion at your next investment committee meeting.

Tom Koehler-CIO

The Debt Ceiling and Default

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This short summary by Moody’s help place the current debate into logistical context.

  • “There is no direct connection between the debt limit and a default,” says Moody’s Steven Hess, believing the government would continue to service its borrowings even if the debt ceiling isn’t raised by the Oct. 17 deadline. The debt limit, he notes, restricts government expenditures to the amount of incoming revenues – it does not prohibit servicing existing debt or issuing new paper to replace maturing debt.
  • Interest could be a different story, and technically is an expense the Treasury could decide not to pay. Even still, the first interest payment isn’t due until October 31, and it’s a relatively small $5.9B. Mid-November’s payment is $30.9B.

We still believe that if it is not raised at least initially risk premiums across credit products might widen and possibly with less net debt, there could be a bid for Treasuries and Mortgage Backed Securities as the Fed would be buying the same amount of a lesser total since they decided not to taper.

Tom Koehler

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