Posted by David Tillson - Second Quarter Commentary July 2015
The second quarter was another essentially flat quarter for the U.S. stock market as investors tried to make some sense out of all of the headlines and data flows that hit news outlets daily. Economic growth remained tepid, and while some of this was weather related in the first quarter, it is now clear that our current economic weakness has other causes. One of the larger headwinds for companies is the strength of the U.S. dollar. Both trying to compete with a stronger currency and translating profits earned overseas back into U.S. dollars are having a depressing effect on companies’ earnings. Several quarters ago most analysts were expecting S&P 500 earnings for 2015 to be at least 15% higher than 2014. Today, the expectation is that they will only roughly match 2014’s level. Worries over growth in China and the Eurozone’s Greek drama have also contributed to business’s caution when it comes to investing and hiring. The U.S. equity markets seem to be both excited about and afraid of the Fed’s intention to raise interest rates. On the one hand, investors believe that a rise in interest rates will result in falling stock prices; on the other hand, investors believe that a rise in interest rates will signal that the economy is finally taking off. Time will tell.
Even though there are many who wish that it would be much stronger, our slow growth economy has actually provided somewhat of a Goldilocks period. The collapse of the tech bubble in 2000 and the housing bubble in 2008 were sharp and it was surprising how far those tentacles spread. In the aftermath many companies were bankrupt, surviving companies and state and local governments became much more cautious with capital spending and hiring plans, and people themselves recalibrated the level of risk that they were willing to take. It is the government’s job to step in to provide a safety net when the private sector cannot function normally. It is also the government’s job to step back once the private sector regains its footing. The problem is that there are no bright lines delineating where we are at any given point in time. However, if we look at S&P 500 earnings over the last 90 years, we can see that current earnings are effectively on the trend line. Thus, we conclude that the government (in the U.S. at least), is probably on track in terms of supporting corporate profits and can thus begin to step back. Whether government does is another question. Post-crash regulatory vigilance is a difficult thing to give up.
The Great Recession of December 2007 to June 2009 was extremely painful. Historically, when something as potentially catastrophic as this occurs, societies work hard to prevent the same thing from recurring. In this case, governments worldwide enacted new regulations and exacted massive punishments on the alleged culprits. Most of these new regulations have made our financial systems safer and the culprits (primarily banks) have paid approximately $200 billion in fines in the past six years (and are still on the hook for fines in 174 more cases). With this perspective it should not be surprising that our economy has experienced slow growth. In order for any economy to grow, it needs at a minimum the following: 1) a strong financial system willing to accept some risk; 2) an optimistic population that believes that “things are ok;” 3) a regulatory/legal system that everyone can understand and trust; 4) positive inflation; and 5) a government sector that is disciplined enough in its spending, taxing and borrowing policies to ensure long term viability. In the U.S. banks are much better capitalized and are more risk averse than they have been in probably decades. A strong capital base is critically important, but a willingness to accept some risk is also important and we expect that over the next several years, bank lending standards will become less onerous. If the Fed is successful in simultaneously raising interest rates and engendering inflation, then more borrowers will be able to access loans, banks’ profitability will rise, and our economy will grow as money flows through the system more rapidly (the velocity of money will finally begin to increase).
During the past six years regulatory authorities have grown much stronger, tax policies have become murkier, and our legal system has evolved in ways that some people would not have imagined 15 years ago. The unintended consequences of the Dodd-Frank law, the Affordable Care Act, the Consumer Financial Protection Bureau, and other creations of Congress are still coming to light. For investors, it is not that any particular law or regulation is good or bad; it simply defines our playing field. A pendulum is always swinging back and forth between governments having too much power and too little power. Human behavior is such that we want to avoid unpleasant circumstances and thus try to protect ourselves from bad events. Governments, just because they are large and powerful, cannot prevent all bad things from happening in the future. The innate competition that exists between the public sector and the private sector means that there is no perfect balance - the tension is very dynamic. Laws and regulations will evolve over time to meet the needs of the people. It is this evolution of laws and regulations that we believe will become critically important for investors in coming years and decades.
We are beginning to get a glimpse of how investors will be treated as the developed world comes to grips with their public sectors’ huge debts, their current spending and their future promises. Whether it is Greece, Chicago or Puerto Rico, when governments run out of other people’s money (all the lenders finally believe that they will never be repaid), something drastic and usually unexpected occurs. Each case is different because the parties involved, the laws, and the politics are always different. The best way out of the morass of too much debt and future liabilities is economic growth. When economies grow, the tax base increases, and as long as future promises can be tempered, obligations can eventually be met. However, as we see over and over, it is nearly impossible for politicians to convince their constituents that they must tighten their belts. Kicking the can down the road for someone else to fix is the easiest road to take. Blaming the problem on someone else is another avenue for many chronic spenders. And it is this avenue of which investors should be most leery. Bonds are generally considered a safe way to earn income and have your principal returned. Today’s very low interest rates essentially negate the “income” rationale. Return of principal is still valid for the majority of bonds. However, when a public entity gets into trouble, solutions become murky. When citizens are suffering, it can seem heartless or worse to lay all of the restructuring burden on them. The pensioners, workers, welfare recipients, etc. were not the ones who caused the problem; it generally was the leaders from years before who enacted irresponsible programs. Regardless of contract law, past agreements, or Federal and state laws, courts will usually decide who will suffer and by how much. There will always be a trade-off between current spending needs and servicing the debt from past over-spending.
In the case of Detroit’s bankruptcy, the court ultimately decided how much pain each stakeholder would receive. Bond holders who believed that they were “guaranteed” full repayment discovered otherwise. Greece continues to be a slow moving train wreck and it is still unclear whether they will be able to remain in the Euro. They clearly have run out of other people’s money and the northern tier of Europe 3 (primarily Germany) now realizes that Greece is incapable of paying back what is already owed, to say nothing of future loans. Essentially German taxpayers are being asked to gift, not loan, money to Greece. It is not unlike New York taxpayers seeing some of their tax payments being spent in Ohio, which we view as reasonable because our country is united. Europe does not have the same history and is therefore faced with the very significant challenge of uniting numerous nationalities. Puerto Rico is another case of a government facing default by having had uncontrolled spending and thus accumulating too much debt. Chicago, Connecticut and New Jersey among others face nearly insurmountable unfunded pension liabilities that to this day continue to be kicked down the road.
While Greece, Puerto Rico and possibly Chicago will be dealt with in the next few years, most of the other “below the radar” troubled debtors will surface slowly over possibly decades. However this plays out, it is certain that bond holders will be part of the solution. Some monies will be needed to keep cities/states operating and pensions will still be paid (possibly at a reduced rate), but it is “the rich” who own the bonds, and they can afford to pay their “fair share.” Bankruptcy law will continue to evolve to allow more entities to take advantage of Chapter 9. Puerto Rico currently unable to declare bankruptcy, will likely be allowed to by Congress since it is the most logical solution. The beauty of bankruptcy for any entity, but particularly for a state or city with pension funding problems, is that it wipes the slate clean and allows them to again access the bond market while still paying current employees’ wages and retirees’ (somewhat reduced) pensions. This is not to say that bankruptcy is easy or painless. One’s destiny is in the hands of the court which may require drastic changes to current operations. But without doubt, the court will require bond holders to write-off part of their investment. Once that occurs, it is as if all is forgiven by the bond market because there will be plenty of new eager investors ready to lend money to the new, better disciplined, highly rated credit once again. Events such as this generally move at a very slow pace and develop over a long period of time. The benefit of time is that it gives people a chance to adjust and accept what has happened. The cost of time is that with that acceptance, complacency and inertia creep into investors’ psyche allowing them to tolerate the gradual, yet inevitable slide into crisis.
Interest rates have been declining for 35 years since 1980. In all likelihood, they will be in a rising trend over the next several decades, but it will likely be a slow rise. Nevertheless, a rising rate environment will be much harder on borrowers than they have experienced in the past three decades. Thus, it is imperative that lenders/bond owners truly understand the risk profile to whom they are lending. Getting an extra 1% yield on a lower quality bond may not be worth it if it is possible that you get only 75% of your principal returned. Risk is sometimes difficult to quantify and complacency and inertia can work against an investor even when they have correctly identified the risk. As we saw in 2008-09, just because the rating agencies classified some mortgage backed bonds as investment grade, if investors truly understood what they were buying, they would have saved themselves a lot of pain, and money. Two of the cornerstones of our investment process are Fundamental Research and Common Sense. Know what you own and why, and ask yourself from time to time, does it make sense?