The ‘Muni’ Menace:

Financials have been underperforming the other sectors in the earnings reported this month in the United States. The below estimated earnings of investment giants such as Goldman Sachs and Morgan Stanley in the last quarter of 2010 have been largely attributed to the lacklustre performance of their fixed income divisions. Municipal bonds (or “munis” as they are affectionately called by investors) are state issued bonds in America, and portfolios with significant exposures to munis have not received the sort of benefits that are traditionally attributed to holding such bonds. Wall Street has certainly been hurt by the downturn of municipal bond prices over the last quarter, and there seems to be no respite in sight in the near future.

Municipal bonds are traditionally considered to be one of the safest bonds to hold, and according to rating agency Moody’s, only 0.3% of rated municipal bonds have defaulted between 1970 and 2009 (albeit there were many more defaults of unrated munis in the same period). General obligation bonds are typically considered to be the safest of the subcategories of municipal bonds, followed by revenue bonds. Municipal bonds generally produce a rate of return that is higher than that of government issued debt but are not much riskier and hence prove to be attractive investment opportunities for investors looking for less than extraordinary returns.

Ever since the recent financial crisis hit, and after the much publicised default of the city of Vallejo in California, the safe haven status of municipal bonds has been repeatedly questioned. Off late, municipal bonds in the United States are being compared to sovereign bonds of the member countries of the Euro zone. Much like their European counterparts, the Federal states in USA have been racking up ever increasing deficits and are trying to finance ever increasing spending. The question of how to be austere while continuing to spend in order to stimulate positive momentum in sagging economies is one that has not found any practical answers. It is more than evident from the experiences of the peripheral economies in the Euro zone that the two contradictory approaches to pacifying increasing bond yields cannot work in tandem.

The yields on municipal bonds have been rising for a variety of reasons. The yields on the ten year T – Notes are a good leading indicator of where the yields on municipal bonds are heading. T notes have had a rally back to the 3.5% levels over the last few months after decreasing substantially on expectations and announcement of the second major asset purchase programme known as QE2 in the beginning of November by the Federal Reserve. Although yields on T Notes remain in a long term (30 year) downtrend, I am concerned by the fact that investors have not been assuaged by QE2. Bond yields have crept up rapidly after the initial optimism driven by the announcement has worn out even though the asset purchase programme is scheduled to last until June.

Another factor that is a cause for concern for investors in the municipal bond market has been the termination of the Build America Bonds programme which was started to alleviate some of the lack of funding issues that federal governments were battling with after the collapse of the real estate bubble. The programme was terminated on the last day of 2010 on the basis of a Senate vote, and I suspect there are going to be many more filibusters that impede correct economic decisions from being made because of the resounding victory of the Republicans in the Mid –Term elections.  

Build America Bonds were taxable municipal bonds that carried special tax credits and subsidies and were pretty considered to be a big success by bond investors. In California, which is considered to be the state with the gravest fiscal concerns, about $36 billion of taxable debt was issued following the creation of this programme. This programme has been responsible for shifting about $185 billion of debt into the taxable market from between early 2009 and 2010. Now that the programme has been terminated, there seem to be indications that the bond market is bracing for long term effects of Federal governments and other issuers forgoing the opportunity to collect taxes and tax breaks respectively.

There are growing concerns that there is little in the way of a further collapse in municipal bond prices (bond prices are inversely correlated to yields). This has lead to a large number of bond indices and ETFs underperforming. The SPDR Nuveen Barclays Capital California Municipal bond ETF has seen a quarter end decline of -3.33% (ticker symbol CXA). In the face of increasing spending on things like pensions (New York City’s cost to pre fund pensions spiralled from $2,530 per full time employee in 200 to $20,333 in 2008) and healthcare (Medicaid spending went from an estimated $2 billion in 1970 to $158 billion in 2008), there seems to be little hope for a long term consolidation at current levels without more bond purchases by the Federal Reserve beyond June. This does not bode well for the American economic recovery, as the day is not far when debt reaches 100% of GDP. Although having a sovereign currency means that America will not default on its debt like the Euro zone peripherals have threatened to do time and time again, there is no doubt in my mind that in the face of increasing spending and increasing deficits, the municipal bond market faces many more defaults in quick succession than have been previously seen in their history so far.

Portugal's Many Curses

Portugal is a mixed economy and Portugal is different from the other European peripheral economies. Yet, Portugal is headed for a traditional EU bailout package. So what are the problems in Portugal? I think the problem is that it is cursed.

The First Curse:

In 1974 the Carnation Revolution changed Portugal's destiny forever. In a revolt against the Estado Novo (New State); the authoritarian dictatorship headed by a council of ministers, the country's left rose up in unison to support a military coup to start a democratic process. The military had been fighting colonial wars and by 1974 when the revolution occurred, it was under-supplied, and overstretched. The proposed introduction of some new legislation to sustain the army's need for soldiers and equipment, perfectly coincided with the growing frustrations of the intellectual and political left winged forces in the country.

When the Carnation revolution occurred, the Portuguese economy had been growing at a steady pace. In 1973, the total output of the country had grown by 120% compared to 1961. A lot of the economic growth in the pre-revolution days could be attributed to the forward looking structural changes brought about by Antonio Salazaar; who served as the Prime Minister of Portugal for almost four decades. Salazaar was greatly concerned with financial reform, and under his leadership financial stability was given top priority (together with keeping the colonies in Africa intact), and in fact Portugal was one of the first signatories of the OECD. Under Salazaar, trade and foreign investment blossomed, and Portugal could break free of the shackles of slow and unorganized growth.

However, after the revolution, the economy once again fell into a tailspin. The much hyped freedom's of a democratic set up brought with it the complications of administration and planning. Hindsight is always too late, and by the time the new government woke up to the fact that there was a drastic loss in efficiency and competitiveness, Portugal was being outperformed by most of its trade partners, the biggest ones being Spain and Germany. In the quest for a socialist upheaval and a revolt against the ghastly consequences of colonization, Portugal managed to loose the economic momentum it had going from the later part of the fifties.

The Second Curse:

Portugal became a member of the European Communities in 1986. Membership brought along with itself, new opportunities for trade, and foreign investment. Portugal started growing at about 3% of GDP on a yearly basis, but never came close to the expansive growth before the Carnation revolution. However, its growth rates remained above the EU average consistently in the eighties and the better part of the nineties. Everything seemed rosy for the economy, even though it was asked to implement structural changes to reduce deficits before going on to join the European Economic and Monetary Union in 1999. On January 1, 1999, Portugal made its seemingly correct decision to be amongst the first 10 countries to adopt the Euro.

I do not think the reader's of this blog need to be explained how currency unions work and the disadvantages they bring about to member countries which are not structurally ready to adopt a common currency. Portugal's second curse has been playing out over the last decade, which has also been termed "the lost decade" for the country as a result of severe lack of trade and wage competitiveness. In 2006, Portugal grew at 1.3%, which was the slowest rate amongst the Euro zone members. The productivity gap in Portugal is largely a result of low wages compared to its competitors. Portugal's per capita income is estimated at approximately $24,000, while Germany boasts of $36,000. An interesting statistic to follow up is GDP per hour worked; this is $30.3 in Portugal as oppose to $53.3 in Germany.

The low wages in Portugal have been attributed to a variety of causes. One of the usual suspects is low population, and not enough immigrants leading to structural problems such as firms not being able to reach "optimal size" at low wage rates. The second contender is the influence of the gray economy in the country, which has been contributes to over 20% of GDP. The evasion of labour taxes is certainly not helping Portugal's ballooning deficits, and is in addition a disincentive for larger firms to be organised and law abiding. Another surprising problem is Portugal's public sector premium over private sector jobs is to the tune of 51%, while in Germany it is a more reasonable 7%.  Lastly one may also note that Portugal's decent growth in the eighties after joining the European Commission up until the formation of the single currency union, is highly correlated with foreign direct investment in the country. The FDI flows have depleted as a result of the lack of the rigid labour market conditions and complicated regulations and red tape, and so has the country's GDP growth.

The Final Curse?:

Last week, the 12th of January was Portugal's date with destiny. Portugal conducted bond auctions for its October 2014 and June 2020 bonds. Many commentators had expressed concerns over Portugal's widening bond spreads, and over 7%  yields on the 10 year bonds was largely touted to be the tipping point for the economy. The auction resulted in good bid/covers as expected and yields on the 10 year bonds remained below 7% (albeit not by much at 6.79%). So Portugal is not going to get bailed out just yet. The yield curve suggests however that this auction was just a matter of buying time:

The ECB and other domestic EU banks have been largely behind the good auction results. Japan and China have also bought into EU debt in a big way, and China in particular has had no qualms in announcing this to the world. The Euro has also reversed its losses since the start of the month against the dollar, and is once again trading above the 1.3 handle. However the question remains, how long can this quantitaive easing or rather quantitative pleasing of bond vigilantes prop up the dying European economies. It is more or less certain that Portugal will be in need of a bail out, and what is also certain is that the market's will not be surprised when it does get one and there will not necessarily be a big sell off such as the summer of gloom last year after the Greek crisis. The final curse that this country will face could be its most easily avoidable. It could try to hold out against bond vigilantes for months but would probably be better off asking for a bailout sooner rather than later. The cost of being stoic could be higher than the benefit, and as far as the ECB's buying programs are concerned, the vigilantes might want to remind Trichet of the old adage "in theory there is no difference between theory and practice, but in practice there is".

The week of January 3rd: Correction Time?

The first trading week of the year started with subdued activity with people still getting over their holiday hangovers. However, lackluster volumes were expected until the big non farms data released on Friday. There were a few dominant themes for this week's market action in European and American sessions, and they all point towards chances of some small corrections and confusion about market direction over the next week:

Commodities sell off:
The week started of with a sell off across the board in commodities. This could be attributed to two factors. Firstly, it could be some profit taking coming into the new year for longer term traders/investors. Commodities finished 2010 on a high, with exceptional performance in the metals, with copper leading the bull run. Gold finished above 1400, and has now corrected to 1369. (This is certainly not a very big move and does not suggest that the bull run in gold is over, especially given the fact that inflation will tend to be the dominant theme for the global economy over the next year. Buying dips in gold and silver would be the obvious thing to do in such a scenario, although the market does tend to punish those who fall for the obvious more often than not. Still, there are a significant number of bullion bulls out there and I would definitely not like to sit on a short in gold and hope for a bust.)
Secondly, floods in Australia's Queensland province added to the zest for the sell off. Queensland is one of Australia's commodity rich provinces and cotton futures in particular took a big hit after the flooding news came out.

Crude oil finished lower for the week below the $90 mark. $100 is largely seen as the inflection point for oil, that is prices above it would not be good for equities. In crude related news; Russia has recently opened a pipeline to China. The Chinese contributed significant amounts towards laying of the pipelines and this is a big step for the two countries. The world's no.1 producer of oil is supplying directly (20 year deal) to soon to be the world's no.1 consumer!

FOMC minutes and unemployment data:
The Federal Open Markets Committee released their December minutes on Tuesday. It was interesting to note the reasons given for a rise in government bond yields which were discussed in my previous post. The minutes stated that "market participants pointed to abrupt changes in investor positions, the effects of the approaching year-end on market liquidity, and hedging flows associated with investors’ holdings of MBS as factors that may have amplified the rise in yields". This essentially means that the Fed is of the opinion that the slight rise in government bond yields has been a result of normal market activity as suggested by me in my last post. It is interesting to note that the yields have not broken out of their 30 year long downtrend and until they do, there is no reason to believe that the rise is indicative of nervousness about the fiscal situation in the US.

The vast array of unemployment data that came out this week did nothing but confuse investors. First there was the ADP number of 297,000 for December which came out on Wednesday, which was triple the market estimates and lead to a decent market rally after the commodity sell off in the beginning of the week. This number was truly unbelievable and there was a fair amount of skepticism regarding this number and its inflated outlook due to the number of holidays in December skewing the data collected. The non farms number of 100,000 or so jobs created in December was significantly below the market estimates which had been skewed upwards due to the over optimistic ADP numbers. Surprisingly (for me) the headline number which came out on Friday was in line with the Goldman Sachs consensus (a real turn around for the analysts at GS!). However, the bearish headline number did not move the markets as much as it would generally because the unemployment rate fell to 9.4%, a healthy decline from the previous 9.8%. As a result of the mixed data, markets might be in for a turbulent ride next week, however they will recognize the fact that the Fed will not stop it QE2 programme on the basis of the slight drop in the unemployment rate, with their mandate stating that they are looking to achieve a 7% rate before reconsidering the magic market injections.

Euro weakness:
The Euro continued to tumble this week against the dollar, trading at 1.29 on the spot price. This is the first time the Euro has been at these levels since the summer of gloom with the Greece crisis etc. The week started off well with an amazing increase in German factory orders but later in the week news also filtered out about another Spanish Caja in trouble, needing about $1 billion in aid. With investors looking to focus on only the positives in the American economy with the 9.4% number, dollar strength might continue to be the theme over the next week, which may in turn cap the upside for US equities. Trichet and co. have a load of work to do this year, convincing investors that the bigger economies are not in trouble. Facts floating around such as Iraqi bonds being safer than the peripheral countries debts, are not going to make life easy for the ECB. China has stepped in a few times over the past weeks to say that they are buying Spanish debt etc, but I dont think that markets are looking at these statements by the Chinese as a panacea. Any practical investor would know that the Chinese are just trying to diversify their currency holdings, and are desperate to have something to hold on to other than the dollar.