Guest Post: QE Canaries In The Coal Mine?
Submitted by Contrary Investor
QE Canaries In The Coal Mine?
For My Baby, And One More For The Road...If you don't mind,
this month we want to address canaries, coal mines, and the whole issue of
yet another round of Fed quantitative easing. As you may
remember, when the Fed stopped its last official QE effort, our
comment at the time was that there was absolutely no way this was
the grand finale of money printing for the current cycle.
Not a chance. Our thoughts were that QE would resume either
later this year or early next at the very latest due specifically
to continued lack of meaningful money growth. At the time, we did not
have a whole lot of company with this line of thinking as very few
other folks were calling for this, especially in the mainstream.
As of now, it has become consensus thinking as we survey the
landscape. In fact broker after broker have been putting out
research pieces over the last few months handicapping just when
and why QE will begin anew. A few comments and then maybe
some curveball thinking, as we at least need to consider the next
round of QE being sparked by a source the Street is not looking
for and has not discussed at all up to this point as far as we can
tell. Question being, would QE sparked by a left field
source elicit the positive response most anticipate as per
consensus thinking of the moment?
In brief and
in all seriousness, we believe QE resumption is now mainstream
thinking. Important why? With so much commentary and
so much near universal anticipation, we need to at least think
ahead to financial market impact once it occurs. The
original QE program announced in March of 2009 was a good bit of a
surprise to the mainstream, especially in terms of magnitude. Although a number of folks had
anticipated such an outcome, it was not mainstream thinking at the
time so these folks were considered extreme. Moreover, at
least in retrospect, the initial QE number was a bit mind
boggling. Few could believe the Fed would mushroom cloud
their balance sheet in a size that indeed came to pass.
As everyone and their brother knows, the impact on the financial
markets was very substantial. Equities obligingly bottomed
and began one of the greatest straight line rallies in market
history, pausing for now as of April of this year.
Institutional investors, Bill Gross and PIMCO being the poster
child example, suggested investors "front run" the Fed
and buy both MBS and Treasuries immediately as the Fed would be
the secondary buyer over the remainder of last year and into this.
Check, that worked. Mortgage rates dropped to record lows,
although that has not been enough to rejuvenate the residential
real estate market nor forestall record foreclosure activity as of
late and a trip back to double dip for housing.
So as we look
ahead, two issues stand out regarding forward QE. First,
although it's just our personal opinion, it is too well
anticipated at this point. And that tells us financial
market impact post the next announcement of QE will be shorter in
terms of "shelf life" effect on financial asset prices.
That also leads us to the second issue that remains a question
mark in terms of potential impact and that is magnitude of the
next program. Again, although just our personal insight,
here's how we see it. The Fed did $1.5 trillion the in the
first round. Yes, they got mortgage, Treasury and broad
fixed income yields down to generational if not historic lows.
But the impact on the real economy has been negligible at best and
now that the domestic US economy is slowing and housing is rolling
over again, we believe it's very fair to say one can make the case
that the first round of QE was failed monetary policy.
Again, failed if you look at the real economy, not in terms of
Goldman's bonus pool. Our thought is that the Fed and
Administration's fatal mistake is that they missed the primary
target. They focused on the wrong balance sheet. The
ground zero issue is the household balance sheet. So, that
would imply that the next round of QE needs to be substantially
higher to positively impact the real economy and a financial
market that is theoretically anticipating forward economic
outcomes. It also needs to somehow address the real balance
sheet problem, not the balance sheets of the US's largest campaign
contributors. Does that imply something in the $3-5 trillion
dollar range would be needed to get the market's
"attention" from a longer lasting standpoint? We have seen recent Street research
suggest another $1 trillion in QE is coming. If indeed that
is to be the reality of the number then we believe the important
question in light of so much recent QE anticipation from the
Street becomes, "will the equity market sell off on the
news", deeming another mere trillion inadequate now that the
anticipation is so hot and heavy?
again our own personal thoughts, should the next round of QE fail
to generate a positive domestic US real economic outcome, the Fed
will be seen as completely impotent perceptually and investors
will act accordingly. The real economic outcome failure of
the first round of QE certainly dented investor confidence in the
Fed. Another failed round and the Fed may as well close up
shop. It seems clear that mom and pop investors have lost
faith, except of course when record and rapid fire Fed POMO's help
levitate equities vertically over short spaces of time. Can
you imagine if institutional investors come to believe the same in
terms of faith in the Fed? In our eyes, the next round of QE
is the last bullet for already questionable investor confidence in
the Fed, so its timing and impact are critical. Sorry for
the rambling, but we believe these are at least very important
issues to think about vis-à-vis forward investment decision
making. QE is now widely anticipated. $1.5 trillion
did not do the trick with the first go around so the Fed will need
to up the ante. Finally, Fed timing will be very important
as the next one is the last bullet to save confidence broadly.
Canaries In The Coal Mine?...Back to the issue at hand.
As we said, Street anticipation and commentary regarding QE is now
ubiquitous. In fact, with virtually every important headline
economic stat we see these days, there is accompanying QE
commentary from the Street that goes something like this. If
the stat is a disappointment relative to sacred expectations of
the moment, then the comments of "the Fed will begin
quantitative easing sooner than expected" accompanies the
analysis. Of course if the reported economic stat is better
than expected, then we hear "the Fed may hold off on
quantitative easing for longer than investors expect".
To be honest, we have no idea what "investors expect",
but its sounds so good in Street research, right? The point
is that QE commentary and supposed expectations of timing are
being linked to headline economic stats. This discussion is
about the fact that we need to broaden our thinking.
Today we want
to quickly throw a curve ball into the mix of quantitative easing
expectations and ask whether the real spark for the next round of
QE comes from what may be considered in mainstream thinking
something out of left field. To the key point, could it be
that a problem in the muni market is the spark that lights the
next QE conflagration? We are forcing ourselves to ask this
question based on recent events we've seen in the local San
Francisco Bay Area that we believe are not unique in the least,
but rather indicative of what is happening nationwide.
Here's the deal. The City of San Carlos is a mid-peninsula
city a little more than half way between San Francisco and Silicon
Valley. San Carlos is disbanding its police force that has
been in existence for 85 years and "contracting out"
police services to San Mateo county (sheriff's office), of which
San Carlos is a part. Half Moon Bay is a city along
California's incredible Highway 1 coast line, close to due
directly east of San Carlos and also a part of San Mateo County.
35% of Half Moon Bay's fiscal city revenues are driven by hotel
taxes given its tourist related location along the coast.
Half Moon Bay is now contemplating unincorporating. And what
does that mean? It means that city services will likewise
roll back to the same San Mateo county.
You get the
picture. Are these isolated examples of what is occurring in
the relationship of individual municipalities to their counties?
And ultimately the relationship of individual counties to their
respective States if indeed increasing cost burdens at the county
level become untenable? The goings on in San Carlos and Half
Moon Bay are not isolated in the least. It's either this
(cease city specific services) or bankruptcy contemplation as a
major theme of the moment for so many smaller and even larger
municipalities. Just ask holders of Harrisburg, PA's trash
related bonds how they feel about just narrowly missing a
potential skipped interest payment a few weeks back. Of course in the bond
market frenzy of the year-to-date period, most muni investors have
their hands firmly over both their eyes and ears, disregarding
this key critical ring of fire that has started to burn at the
local level because municipal funding has hit the end of the road.
You'll remember that in the 2009 stimulus bill that we reviewed
quantitatively in detail when it was released, close to a third of
the package was in some form or another going back to the States.
That's over. And so now is San Carlos' police force and
potentially Half Moon Bay's city services. No worries
though, right, as the Wall Street Journal in an article about the
Harrisburg issue recently assured us municipal bond default rates
remain miniscule. Alternatively the mayor of Harrisburg
addressed the narrowly missed muni interest payment by saying "the
chickens have come home to roost". Does the Journal
have it right or are the comments by Harrisburg's mayor
foreshadowing what will be a growing issue? By the way, as
you know, the State of PA stepped in to make good on Harrisburg's
interest payment at the eleventh hour. The transmission
mechanism is problems at the local level ultimately become county
and then State issues. Of course the irony is that county
and State finances are in most cases just as bad, if not worse,
than local municipalities.
directly ahead, we believe the key linkage that could indeed
change muni market perceptions is the relationship of individual
municipalities to their counties, and ultimately the counties to
their respective States. Harrisburg just skipped the county
part of the equation. In other words, the issue of municipal
under funding and service cutbacks will run upward to the State
level first through the counties. And we know that municipal
and county cost cutbacks are far from over when we see data such as the
question being will the next round of Fed QE germinate in the
problems of the municipalities and the States? We wish we
knew for sure, but no one does. All we do know is that we
see no one even talking about it. Absolutely no one.
That's why we are interested and are dedicating time to it.
Investor QE anticipation eyes seem firmly and solely fixated on
headline macro US economic stats, not the micro of what is
occurring at State and local municipal levels. Interesting
when State and local municipal level fiscal issues are literally
on fire, no pun intended. Again, we wish we knew exactly
what is to come, but no one does. As usual we are just
hoping to be looking in the right corners of the market and asking
the right questions. So what do we do to help us potentially
prepare for another round of QE at least in good part driven by
the crumbling of State and municipal finance? Our suggestion
is to put a few "canaries" on your watch list.
Assuming the financial markets will efficiently anticipate
ultimate economic outcomes, we think it's time to start watching a
few muni market anecdotes. At worst it's a worthless
exercise. At best you'll be able to duck when an
unanticipated ball from left field comes flying toward your
let's have a quick look at just how far muni bond rates of return
have come over the recent past. We all know that since the
dawn of 2000, investors stuck (by their own hand) in equity index
funds have at best earned the dividend. But investors in
munis have come near doubling their money or better. The
following chart is actually an index. Have a look.
What you see
above is the Nuveen Muni ETF total rate of return index.
From a level of roughly 1400 as the year 2000 dawned to 3100
today, total return here has been over 120%. Buy and hold
equity investors could only have dreamed of this over the past
decade. In fact you may remember Mark Faber and a number of
others commenting on the hindsight of historical market experience
citing the fact that investors had to make very few macro
decisions to be very right maybe once every ten years. Ten
years ago, now in the clarity of hindsight, the correct trade was
to liquidate equities and buy bonds, in this case munis.
Will this continue to work ahead, or have we come to the end of
the cyclical decade long bull in muni debt given generational lows
in muni yields and generational highs in the reality of actual
municipality specific fiscal problems? If you would have
suggested this trade as a key investment decision in 2000, folks
would have thought you had lost your mind. That's usually
the response to really good investment ideas or themes, as you
Back to the
specific canaries hopefully worthy of your vigilance in the here
and now. Below are a series of charts, but they are just
thematic examples. If there is going to be muni trouble
ahead, we hope to "see" it first in these vehicles long
before it hits the Wall Street Journal, so to speak. First,
levered closed end muni bond funds are a watch point for us in
terms of hopefully foreshadowing the dawning of a change in
investor perceptions regarding the macro muni market. We
happen to have some exposure to the Nuveen Cal Muni Fund (NVX) and
the PIMCO Cal Muni Income Fund (PCQ).
By the way,
both NVX and PCQ are levered closed end funds. We think this is very
important given that they can sell at premiums and discounts to
NAV that might indeed also be part of the total market
"tell" at some point. NVX currently sells very
close to NAV (net asset value). The fund is right now
levered at about 37.6% and the average maturity of the positions
in the fund is 18.8 years. What's not to like, right?
Leverage, long dated maturity exposure in an historically low rate
environment, and best of all levered to California. The fund
has 14.8 million shares out and trades an average daily
volume of 22.5 thousand shares. If there were ever a
perceptual problem here, you own 'em, as they say. This is
the canary characterization icing on the cake - lack of meaningful
liquidity. Alternatively, the saving grace here is that just
shy of 80% of fund holdings are A rated or better for now.
NVX and funds like it literally imploded over the 2008 period as
markets began discounting a depression environment. Of
course the irony is that in 2008 fiscal circumstances at many a US
municipality and State were much better than is actually the case
today. Go figure.
Next up is
the PIMCO fund. Current leverage is 39.1%, average maturity
rests at 15.9 years, very close to their Nuveen Cal Fund friend.
As of month end, PCQ sold at a 5.3% premium to NAV. The fund
has 18.3 million shares out and trades a touch less than 30,000
shares on an average daily basis. Lease rev's and hospital
revenue bonds make up the bulk of sector exposure. As you
know, a ton of hospitals in the US are technically insolvent,
they've just simply forgotten to tell everyone just yet.
For now the
multi-year double top in PCQ is clear as a bell.
Technically, the moment of truth has arrived. So one watch
list item ahead for us as to the potential for perceptual change
on the part of the investment community towards the muni market is
closed end levered muni bond funds. Although we showed you
two Cal funds, by no means is California the only state to watch.
These are just two examples.
Next up on
our watch list hit parade are "high-yield" muni funds.
Yes, just like their corporate brethren, high yield means low
quality. Below is the Dreyfus High Yield Muni Fund simply as
an example. Unlike PCQ and NVX above, in terms of quality
78% of current holdings are BBB rated and below. Of course
as an open end fund it's not levered. So this go around it's
about pure credit quality. Average maturity is likewise long
at 22.7 years. In a potentially rising rate environment, it
seems a good bet that this guy will feel the heat. Just look
how long the fund has sat in overbought territory as measured by
RSI. Very rare to see something like this in an RSI
indicator, especially a weekly version of the RSI.
We know you
get it. If there is to be trouble in the land of muni's from
a macro sense we believe it will first be seen in low quality bond
funds and leveraged closed end funds. These would be the
most vulnerable to a change in fundamentals and/or investor
perceptions. We're certainly not there yet. In fact
not even close as these funds have been a yield and momentum
oriented investors dream over the recent past. For now they
continue to make new highs. But with generational lows in
rates and the reality of fiscal issues now coming onto the front
page for individual municipalities and State's, we believe they
will be very important canaries as we think about a potential
spark or acceptable Fed justification for the next round of QE.
As we see it,
the Fed is not going to simply wake up one morning and announce
the next round of QE because they have nothing else on the daily
agenda. They are going to need a serious reason. A
catalyst for which they will not be immediately criticized.
And remember, at least as we see life, the next round of QE may be
the final one in terms of holding up investor confidence or
otherwise. So why the focus on the Fed? Could not the
Federal government step in and bailout the States and
municipalities? Sure they could, but the populist voter
backlash may be simply intolerable. Remember, the polls tell
us voters are looking for revenge in November for acts the
legislators did or did not take in 2008-2009. And of course for
an Administration obsessed with political polls, what has polled
extremely well over the recent past is the concept of Government
budget reductions. We believe it would be very tough for the
government to do yet another meaningful stimulus/bailout package,
regardless of just whom is being bailed out. Moreover,
future bailout action may need to be borne of crisis or near
crisis to be acceptable to voters and investors. Hence the
focus on the Fed as the most likely provocateur of further
academic stimulus in the form of the next round of QE. But
again, they will need a serious reason. And the only reasons
we believe are valid right now are a stock market crash (whatever
that means), another huge TBTF failure, a bond market implosion, a
dip back into official recession, or a municipal crisis.
Yes, we have our eyes on the headline economic stats. And
yes, they could indeed serve as justification for further QE.
But we think it's also important to consider left field issues not
caught in current consensus thinking. Implicitly, recent
strategist commentary considers the next round of QE as being
beneficial to financial markets. But if investors were to
see rapidly failing municipal fiscal finance as the driver of the
next QE program, can we necessarily assume their macro outlook and
resulting investment decision making behavior would be positive?
Left field market outcomes usually result in increased volatility.
Like we don't have enough of that already, no?