Submitted by Contrary Investor
QE Canaries In The Coal Mine?
One More 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?
Finally, 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.
QE 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
Again, key 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 portfolio.
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 know.
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?