a view from fixed income land

My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s.  He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals.  His most recent quarterly letter to clients gives a polished industry veteran’s view of the current global economic situation.  It’s very worthwhile reading.  (Sans charts), here it is:

Where We Are

Economic setbacks come in many different forms. Some are self inflicted – like those caused by over-investment in business assets (inventories, plant
and equipment) or excess spending by individuals. Others are caused by higher interest rates and tighter lending practices in response to inflation
fears or credit risks. Over a relatively short time, the excesses can be worked off and, as inflation and credit fears abate, credit begins to expand again.
The economy recovers. Wealth and the total value of goods and services quickly surpass their old high water marks.

Then, there are economic declines that fall outside the realm of the usual business cycle downturns. These are the ones that occur after a debt-
fueled boom goes bust – the bubble pops. We have just experienced such a pop – caused largely by over investment in housing, not just in the U.S.
but in many other countries. The resulting credit losses and credit contraction will persist over an extended period. And while the root cause can be
traced to one sector of one economy, the resulting credit contraction will trigger shocks in unexpected places. So, the collapse of the U.S. sub-prime
housing market causes banks in Iceland to default. Then, investors worry whether the financial extended countries around the edges of Europe will be
able to pay their debts. Maybe, you shouldn’t even put much faith in paper currencies at all.

It takes a long time to clean up the aftermath of credit cycle bubbles. For example, in the wake of All-Time Depression, it took over a decade for
Gross National Product to reach the level recorded in 1929.   Japan experienced a credit crisis in the late 1980’s caused by over expansion in the
manufacturing sector. Since 1990, that economy has grown on average 0.8% a year and ten year Japanese government bonds yielded just 1.3%. So, it should come as no surprise to investors that ten-year U.S. bond yields recently dipped below 2% especially since the Federal Reserve recently stated that they plan to keep short term interest rates near zero for two more years.

Few are predicting a Japanese style period of malaise for the U.S. economy. They cite the flexibility of the U.S. labor market, the willingness of
American consumers to borrow to support spending, an entrepreneurial spirit, and actions by the federal government and central banks to spur
spending. Perhaps they’re right but the jury is still out.


At the core of the recent economic collapse is housing – or specifically, housing speculation that encouraged people to leverage in order to
maximize their gains from rising home prices. Buyers had both solid reasons and strong incentives to play the game. According to data from the
National Association of Realtors, housing prices rose 85% between 1996 and 2005. The Case-Shiller Index of home prices advanced 12% a year from
2001 to 2005. Interest rates were low, home ownership received favorable income tax breaks, and the government mandated rules that made it
easy to qualify for mortgages regardless of income level, assets, or down payment amount.

The U.S. housing sector is very cyclical. In fact, by raising interest rates and choking mortgage credit, the Federal Reserve used housing as a swing
factor in regulating economic growth during most of the post-World War II period. But this housing downturn was different. It wasn’t caused by a
contraction of credit and a reduction in building activity. It was caused by a price collapse. The Federal Housing Finance Administration produces an
index of housing prices based on same home sales extending back to 1975. While there have been slight price declines over a short period, the 16%
decline that occurred during the four years ended June 30, 2011 is an anomaly.

Real estate is a major component of household wealth in the United States. It totaled $18.1 trillion on June 30, 2011. As per statistics compiled
by the Federal Reserve, owners equity in household real estate was $13.2 trillion in 2005.  By June 30, 2011, the equity in homes had fallen to $6.2 trillion. Meanwhile, stock prices were tumbling and interest rates were falling. Both factors eroded the value and earning power of most consumers’
financial assets, like their 401k’s.

The natural reaction to these forces was to curtail borrowing. And that’s just what happened. The borrowing binge of the early 2000’s has been followed by the borrowing bust of the last few years. Since the consumer accounts for two-thirds of the total economy, it’s no surprise that this new found spirit of frugality produced first, a sharp recession and second, a weak recovery.

The housing sector led the way into the current financial quagmire and that’s the place to look for the route out. Higher home prices would do much
to improve consumer sentiment and balance sheets. Recent data from Case/Shiller indicate the price decline in housing is moderating, but we have
seen false signs of a recovery before.

A New Twist

…on an old theme. The Federal Reserve’s got a new dance and it goes like this. They plan to sell a bunch of the $1 trillion worth of notes they bought
during Quantitative Easing I and QE II. With the proceeds, they will buy a bunch of longer term government bonds. The plan was announced on
September 21st, but was rumored to be in the works since August. The goal is to drive down the spread between yields on long term securities –
those with maturities beyond ten years – and those on shorter dated items. They figure this will stimulate economic activity. (It’s more likely to
stimulate speculative activity and push up the price of “risk” assets like stocks. But the Fed probably would settle for that, too.)

Based on a Federal Reserve study of an earlier twist operation in the early Sixties, they estimated the new twist would narrow the spread by fifteen basis points (the study) or thirty basis points (Chairman Bernanke’s comments in September). The market – ever the efficient discounting mechanism – took the guess work out of these estimates. Between mid-August and the end of September, it narrowed the yield spread between 10- and 30-year U.S. Treasury bonds by forty basis points, helping to spur a huge rally in longer dated bonds.

This occurred even as the year over year increase in core CPI reached 2.0% compared with 0.8% last December. In fact, core inflation has risen every
month this year. The same is largely true if you add back food and energy to get the full inflation picture. The year over year total consumer price
index is up 3.8% through August. These inflation numbers compare with zero yields on money market securities, a 2% yield on ten-year notes, and a 3% yield on thirty year government bonds. Obviously, the goal of Federal Reserve policy is to push investors into riskier assets by creating negative yields in safe securities. They hope such investments will promote stronger economic growth. It might – or it might just create another mini-bubble somewhere.

Still Lost in the Woods

In the last few weeks, there has been some encouraging news. Recent employment data in the U.S. have put to rest fears of a renewed economic
contraction. Based on the number of new hires and hours worked, we’ll probably see 2% GDP growth for the third quarter. In Europe, the French
and Germans have put together a number of plans to keep Greece from defaulting and dragging the European banks with them. One Belgium bank
has been successfully pulled from the brink – even as that meant splitting it apart. When the positives became news, investors flocked to risky
assets – like equities and industrial commodities – and sold safe investments – like U.S. Treasury bonds and the Swiss franc.

Unfortunately, many of the positive developments are rooted in an ever growing mountain of public debt. It remains to be seen whether this is
sustainable either politically or practically. Some reversal of the recent bond price gains is likely before year end and there may be an opportunity
to profit from such market volatility. But any significant rise in long term interest rates will require a turnaround in consumer sentiment and home
prices in the U.S.

Note:  This Market Environment reflects the views of the Investment Advisor only through the date of this report. The Investment Advisor’s views are subject to change at any time based on market and other conditions. September 30, 2011.

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