FINANCIAL REVIEW

Bond King Exits

Sinclair Noe — September 26, 2014

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Financial Review

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DOW + 167 = 17,113
SPX + 16 = 1982
NAS + 45 = 4512
10 YR YLD + .02 = 2.53%
OIL + .53 = 91.83
GOLD – 2.50 = 1220.40
SILV + .16 = 17.76

This week proved quite a roller coaster ride for the major indices. The Dow Industrial Average moved by at least 100 points in each of the five sessions, and finished the week down 1%. The S&P 500 climbed above its 50-day moving average today after dropping below the level yesterday for the first time since August. The S&P 500 was 1.4% lower on the week, and the Nasdaq lost 1.5% for the week. The Russell 2000 Index of smaller companies extended its September loss to 5.5 percent yesterday after dropping 6.1 percent in July.

The Gross Domestic Product increased at a rate of 4.6 percent in the second quarter, according to third and final revision on GDP; up from the earlier estimate of 4.2% growth, and up from 2.5% growth in the same period a year ago. It represents the fastest rate of growth since the last three months of 2011. Spending on personal consumption increased 2.5 percent in the second quarter, up from 1.2 percent in the first. Durable goods, such as cars, homes and electronics jumped 14.1 percent, compared with an increase of 3.2 percent in the last quarter.

The latest revision of GDP growth for the second quarter showed business investment rose 9.7% in the three months ending in June. That’s better than the 8.4% increase reported as part of the second revision of the GDP numbers, and much better than the 1.6% rate of growth in the first quarter. The improvement was broad-based. Investment in nonresidential construction was revised up to 12.6%, from 9.4% in the second revision. And investment in business equipment was up 11.2%, better than the 10.7% previously reported.

This is good news, because business investment is a big driver of demand. It’s also a crucial part of keeping an economy productive over the long term. On the flip side, it might also indicate a shorter-term rotation; as companies plow money into strengthening long term growth it means less cash for things like stock buybacks and that have helped profit growth look so strong in an otherwise sluggish economy. The gain in business inventories was little changed at $84.8 billion, a high level that could induce companies to scale back a little in the third quarter. The strong dollar could hurt exports. Business investment has generally been soft for more than 6 years now, and one quarter of a bounce in business spending might be considered an omen, but not necessarily a trend.

While the level of real gross domestic product has increased by more than $1 trillion since the beginning of 2008, inflation adjusted spending and investment by the federal government in the second quarter of 2014 was essentially unchanged from the level in the first quarter of 2008. Federal spending and investment has declined in 13 of the past 15 quarters, falling 13.2% since the third quarter of 2010. Investment outlays have dropped 20% and are now as low as they were in 2005. Real spending by the federal government has fallen for 7 consecutive quarters; in the second quarter, real federal spending and investment fell by $2.5 billion to $1.1 trillion, down at an annual rate of 0.9% from the first quarter. In the second quarter, federal outlays accounted for 7% of GDP, the lowest in 12 years.

And whatever money hasn’t been spent by the federal government is about to be spent. Defense Secretary Chuck Hagel said today that conducting a sustained campaign of airstrikes against ISIS will mean the Pentagon’s budget will have to be increased. The new commitments for Iraq and Syria have created a budget shortfall in the Defense Department’s $554 billion request for fiscal 2015, which includes $58 billion for warfighting. The request for the year that begins Oct. 1 is pending before Congress. Meanwhile, Congress is in recess until after the midterm elections.

The final September reading on the University of Michigan/Thomson Reuters consumer sentiment index remained steady at the preliminary reading of 84.6. This is the highest level since July 2013 and well above a final August level of 82.5.

Bill Gross, the co-founder of Pimco, the guy who earned the nickname “Bond King” is leaving the firm. Gross quit his job as Chief Investment Strategist; his timing was excellent because it was rumored that he was about to be fired. Bill Gross will now take his talents to Janus Capital.

Allianz SE, the German insurer that owns Pimco, slid 6.2 percent in Frankfurt trading. Shares of Janus Capital Group rallied 43 percent to $15.89 in US trading. Pimco’s Global StocksPlus & Income Fund slipped 5.7 percent to $23.67 at the close in New York, while the firm’s High Income Fund decreased 6.1 percent to $11.69, the biggest drop in 16 months. The Pimco Corporate & Income Opportunity Fund slid 6.6 percent to $17.18, and the Pimco Total Return ETF declined 0.3 percent to $108.57.

A little background: Bill Gross co-founded PIMCO in 1971. But his star really started to rise in 1987, when he launched the PIMCO total return fund. His timing was excellent. Interest rates were in the early days of a decades long decline, and bond prices were just beginning their very long bull run. Pimco and investors and Bill Gross all prospered. Bill Gross was also well known for his newsletters, or blog posts really. And for a guy who ran the largest bond fund, much of his writing seemed off-topic, even a bit eccentric.

After roughly 30 years of bond markets moving higher, things have changed recently, because inflation has fallen across the globe, and falling inflation means that fixed income securities get more valuable. But interest rates and inflation pretty much can’t go any lower, so bond funds have entered a tougher market. And although being the largest bond fund certainly conveys advantages, generating outsized returns becomes progressively harder, because your trades move the markets.

Gross’ performance at Pimco hasn’t quite lived up to “bond king” aspirations. In 2011, Gross made a very public decision to lighten up on US government bonds in the expectation that interest rates would rise. They didn’t. Last year, the bond market went through a Taper Tantrum, a fit of whining about the Federal Reserve intentions to exit QE that pushed long term interest rates up sharply for a while. Gross didn’t see it coming. Earlier this year, former Pimco CEO Mohamed el-Erian, left the company amid some public squabbles with Gross. The Wall Street Journal published a report describing how El-Erian’s previously close relationship with Gross had soured as the firm’s investment performance deteriorated last year. Then Gross told Reuters that his one-time lieutenant was trying to “undermine” him.

Leading up to today’s departure there were reports that Gross’ behavior had become increasingly erratic and relations with the Pimco executive committee became increasingly tense. Earlier this week, Pimco said the Securities and Exchange Commission is investigating whether it inflated the returns of its Total Return Exchange-Traded Fund, also managed by Gross. Gross recently sold billions in US Treasuries and bought derivatives to hedge against rising rates. Pimco says the investigation was not a trigger for Gross’ departure.

Investors pulled cash out of the Pimco Total Return fund for the 16th consecutive month in August. Sanford Bernstein said in a report today that Pimco could see withdrawals of 10 percent to 30 percent. They expect a “good deal” of Pimco clients to follow Gross to Janus. The departure raises questions about the future performance of the firm, which counts tens of thousands of ordinary Americans and major institutions including the CalPERS pension fund as investors in its mutual funds, exchange-traded funds and other products. There is some concern that Pimco may have to liquidate some positions, but the impact may not be devastating because Pimco is the world’s biggest bond fund. Still, a lot will depend on how Pimco has to sell and at what prices. Bond spreads widened this this morning as dealers prepared for redemptions, again, because being the biggest bond fund in the world moves markets.

A new report from ProPublica and This American Life says the Federal Reserve Bank of New York commissioned a secret internal investigation of itself in 2009, uncovering a culture of suppression that discouraged regulatory staffers from voicing worries about the banks they supervised. And when they got the report, they suppressed it and fired the regulatory staffers that had voiced concerns about the banks. The report covers the story of a former New York Federal Reserve bank examiner who claims she was fired in 2012, after seven months on the job, for examining Goldman Sachs a little too aggressively. Based on nearly 48 hours of secretly taped conversations among Fed officials and Goldman Sachs, the reports make a strong case that bank regulators are terrified of offending the banks they’re regulating. This suggests that, despite the worst financial crisis since at least the Great Depression and financial reform that was supposed to put Wall Street on a shorter leash, regulators still bow to banks as much as they always have. That makes a future crisis seem even more likely, with banks still able to persuade regulators that they’re not taking crazy risks.

Next week’s economic calendar includes the monthly jobs report on Friday. The August payroll gain of just 142,000 new jobs could be revised away in the September report. Looking back at the previous three years, the August payrolls change has been revised up each time, by an average of 42,000 in the second print. The September report is expected to come in around 215,000 net new jobs.

Economists think real gross domestic product is growing at about 3% in the third quarter. One expectation behind that solid rate is a narrowing in the net-exports figure that would be a positive contributor to GDP growth. The Commerce Department will report on August trade flows Friday.

Wednesday brings a report on September auto sales, probably selling at an annual rate of about 17.4 million.

Monday brings a report on personal income and the personal consumption expenditures, which is a measure of inflation. The core PCE price index has been running at 1.5%, well below the Fed’s target of 2% inflation.

Wednesday, June 11, 2014 - Nowhere to Hide

Financial Review with Sinclair Noe

DOW – 102 = 16,843
SPX – 6 = 1943
NAS – 6 = 4331
10 YR YLD + .01 = 2.64%
OIL + .14 = 104.49
GOLD + .70 = 1261.60
SILV un = 19.30

The US posted a $130 billion budget deficit in May and the smallest shortfall for the first eight months of a fiscal year since 2008. The deficit last month was about $9 billion less than May of last year. For the fiscal year, which began Oct. 1, the government is running a budget deficit 30% smaller than it was a year earlier; or about $436 billion compared with $626 billion. Revenues for that period are 7% higher than a year earlier and outlays are 2% lower.

The Congressional Budget Office in April projected that the federal deficit will decline to $492 billion this fiscal year, the smallest in six years; down from $680 billion in 2013 and down from a record $1.4 trillion in January 2009. The CBO estimates that next year, the shortfall will decline further, to $469 billion. The 2014 deficit will be 2.8% of gross domestic product, compared with 4.1% of GDP in 2013.

The World Bank has cut its global growth forecast, predicting the world economy will grow 2.8% this year, below its previous forecast of 3.2% made in January. In its twice-yearly Global Economic Prospects report, the World Bank said tensions between Ukraine and Russia hit confidence worldwide.

The bank also cut its growth forecast for the United States to 2.1% from 2.8%, citing the bad weather at the start of the year that resulted in economic contraction in the first quarter. The good news is that the lower forecast is largely a result of things that have already happened, and the US economy appears to be rebounding.

The World Bank expects growth to quicken later this year as richer economies continue their recovery. It kept its global growth forecasts for the next two years unchanged at 3.4% and 3.5%, respectively. Provided the problems in Ukraine don’t get worse, or something else nasty doesn’t pop up.

In Ukraine, government forces and rebels claiming allegiance to Russia continue to clash in the east of the country. In Brussels today, the European Union served as broker for talks between Ukraine and Russia over future natural gas deliveries. Russia offered to supply gas for about 20% below the current price if Ukraine would settle its outstanding debts; Ukraine rejected that deal.

Maybe the World Bank is looking for trouble in the wrong place. Sunni rebels from an al Qaeda splinter group overran the Iraqi city of Tikrit; you remember Tikrit is Saddam’s hometown. The other day, the rebels captured Mosul, the second largest city in Iraq; now they’re closing in on the biggest oil refinery in the country.

The point is, we don’t know where the next black swan event will occur. Maybe an app will backfire.

Yesterday we told you about Uber, the ride-sharing app; now valued at $18 billion. Today, Uber brought the city of London to its knees. Actually, taxi drivers protesting Uber got fed up and parked their taxis on the streets, and London town suffered a massive case of gridlock. In Paris, taxis slowed traffic on major arteries into the city during the morning commute. Hundreds choked the main road to Berlin's historic center while commuters packed buses and trains, or just walked, to get to work in Madrid and Barcelona. Taxi drivers across Europe say Uber breaks local taxi rules, violates licensing and safety regulations and its drivers fail to comply with local insurance rules.

Mohamed El-Erian is the chief economic adviser at Allianz and the former co-chief investment officer of Pimco, and he says “investors might be surprised to learn that they have a lot riding on something that they pay very little attention to: macro-prudential regulation, or what central banks and other government agencies do to reduce the risk of systemic financial disasters.

“The aim of such regulation is to lower both the probability and potential costs of financial accidents. It does so by enhancing the resilience of the system, establishing circuit breakers to prevent problems in one area from contaminating others and, at the extreme, containing the detrimental impact on the broader economy when failures occur.

“Authorities around the world have imposed higher and more intelligent capital requirements, required financial institutions to value their assets more conservatively and to hold more easy-to-sell assets, placed constraints on allowable risk-taking, insisted on more stable funding, and demanded greater provisions against bad loans.

“The impact of the revamped regulation has gone far beyond the targeted banks and other financial companies. It has allowed central banks to be bolder in maintaining and evolving exceptional monetary and credit stimulus, which in turn has significantly bolstered the prices of stocks, bonds and other assets as a means of stimulating the economy.”

In other words, the Fed has pumped up financial assets in the hope it will trickle down to the rest of the economy and jumpstart consumer spending and jobs and wages and such. But what if the economic recovery doesn’t follow on the heels of the pumped up financial assets? This is the lasting question for investors. What to do when the prices of assets rise above what history and fundamentals warrant?

If you think that prices are too low, you can buy. But if you think prices are too high, what should you do?  One option is to sell short; borrow the security whose price you believe to be inflated, sell it and wait for the price to fall, then buy it back at a lower price and pocket the difference. That is a very dangerous move when the markets are trading at record highs. You might pick the exact top or prices may move higher for a while, and the markets can remain irrational longer than you can remain solvent.

Policymakers face a similar asymmetry.  It’s true that for a central bank, liquidity isn’t tied to solvency, so experiencing temporary losses is more a political than an economic or operational concern, but losses still matter. Central bankers can play with the value of a currency, making moves to keep a currency from falling or appreciating; happens all the time.

Sometimes policymakers are trapped in the box that they built. It is precisely investors’ belief in the commitment of policymakers that makes them willing to view some very risky investments so casually. However, when many such investments are made over an extended period without adequate compensation for risk, sharp investors expect a round of bubble trouble on the horizon.

One of the funny things that tends to happen in times like this is that investors rush into areas they think should be safe, looking for a place to hide. Largely ignored during much of last year's 30% rally in the S&P 500 Index, the stocks leading the US market this year rank among its usually sleepiest components.

The best sector in 2014 is utilities, including Consolidated Edison, about as staid a group as one can get. They're up 14.5% on a total return basis this year, compared with 6.4% for the S&P 500 as a whole.

What's happening is the opposite of what ordinarily happens in a moving market. It relates to an investing concept known as "beta," which refers to the amount of risk a particular stock adds to a portfolio. Stocks that tend to rise or fall with the market – but in a more pronounced way – are called "high beta." They generally outperform in up markets and fall the most in down markets.

Best Buy and Priceline, two discretionary stocks that were among the S&P's strongest in 2013, are good examples because their sales and profits rise along with the economy, and they led the way last year. This year, those stocks are lagging the more boring "low beta" stocks – those that tend to move less dramatically than the market. It's a signal that investors are worried about earnings growth and U.S. economic demand, and don't want to bet as heavily on the types of stocks that generally qualify as high beta – often cyclical names in the technology, discretionary and energy sectors.

To be sure, this may change if growth picks up, but after US GDP contracted in the first quarter for the first time in three years, investors are cautious. People are still scared. They're still more worried about protecting to the downside than accentuating the upside. That's helped drive equities' rotation into the more defensive, high-dividend paying names, also typically part of the low-beta camp.

So far this year, the 50 stocks in the S&P 500 with the lowest beta scores, a group that includes ConEd and McDonald's, are up on average by 12%. Meanwhile, the 50 highest beta stocks, which include Citigroup and Best Buy, are up an average of 7%. In 2013, the 50 highest-beta S&P 500 stocks rose an average of 51.4%, compared with 21.3% for the 50 lowest-beta stocks.

Investors who have pursued the high-beta contingent have suffered. Among them are hedge funds, which kept a heavy exposure to momentum-type names and the "beta" strategy. Hedge funds now have 3.8 times more net cyclical exposure to defensive stocks. In January, that measure was 4.7 times - bets that went sour as the market corrected through the first quarter. Once that trade began to break, that also accelerated a rotation back into more value-oriented names and sectors. So, what happens when these defensive plays get overvalued? I’m not saying it has happened; today was just one day after a string of record highs. I’m just posing the question.

Monday, March 24, 2014 - Dance With the Devil

Dance With the Devil

by Sinclair Noe
Financial Review

DOW – 26 = 16,276
SPX – 9 = 1857
NAS – 50 = 4226
10 YR YLD - .02 = 2.73%
OIL - .15 = 99.45
GOLD – 25.10 = 1310.60
SILV - .34 = 20.03

Manufacturing activity slowed in March after nearing a four-year high last month, but the rate of growth and the pace of hiring remained strong. The flash Markit US Manufacturing Purchasing Managers Index dropped to 55.5 from 57.1 in February.

China's manufacturing engine contracted in the first quarter of 2014, according to the flash Markit/HSBC Purchasing Managers' Index.

This week’s economic calendar includes the Case Shiller home index, FHFA home prices, and new home sales reports tomorrow; plus the March consumer confidence index; Wednesday includes the February durable goods orders; Thursday brings another revision to fourth quarter GDP, and Friday’s reports include the consumer sentiment report, consumer spending, and an update on personal spending.

Ukrainian troops and their families are evacuating from Crimea, as Kiev effectively acknowledged defeat by Russian forces who stormed one of the last of their remaining bases on the peninsula. President Obama is in Europe to kick off a week-long visit that includes a G-7 meeting. He called for European allies to adopt tougher sanctions against Russia, saying Moscow’s actions must have costs.

Mohamed El-Erian, the former co-chief at Pimco says markets have “brushed aside” concerns about Iran, Iraq, North Korea and Syria, to say nothing of rising tensions in Turkey and Venezuela. With Ukraine, the market had a single day of fear over Russia’s annexation of Crimea. He lists four key reasons for market inaction: the countries involved are less systemically important; there’s little will from outside powers to get embroiled with these situations; the story of a recovering economy in developed markets has been a distraction; and extraordinary central bank support for markets has provided a layer of insulation. El- Erian went on to say things could get much worse. Consider how ugly it would be if there was an outright war between Russia and Ukraine. Or if Russia somehow decided to tap dance around US sanctions on Iran.

The point is that things can get dicey, quick. And suddenly 2014 starts to look a bit like 2008. The long lists of visible stresses in the global financial system and the almost laughably hollow assurances that there are no bubbles, everything is under control; the Fed can exit QE with no repercussions. Yea, sure. Remember when the subprime mortgage meltdown was already visible and officialdom from Federal Reserve chairman Alan Greenspan on down were mounting the bully pulpit at every opportunity to declare that there was no bubble. First, he claimed no one foresaw the crisis, and second, he attributed this failure to a lack of insight into “animal spirits,” the emotional drivers of behavior. There are plenty of indicators we could look at, and then it’s just one little spark that gets the herd running toward the cliff.

So far, sanctions against Russia look very weak, but there has been some effect: the Russian stock market is down, the currency has weakened, and sovereign bond yields are up. Russia’s central bank unexpectedly raised its benchmark interest rate by 150 basis points after the armed takeover of Crimea triggered a rout in the ruble. Even before the standoff with the West, the worst since the Cold War, Russia’s economy was facing the weakest growth since a 2009 recession as consumer demand failed to make up for sagging investment. Russia will probably dip into a recession in the second and third quarters of this year as domestic demand is set to halt on the uncertainty shock and tighter financial conditions.

The US doesn’t have a great amount of trade with Russia, so it is credible to talk about the threat of additional sanctions. The biggest damage to Russia would come from lower oil prices, and lower oil prices might be possible if Russia does anything that might hurt developed markets such as the Euro-Union. If the purpose of sanctions was to get Russia out of the Crimea, that ship has already sailed; if the purpose of sanctions is to restrain Russian proclivity for intervention, there is still a chance.

Of course the Euro-zone economies are far from solid, but the European Commission has a plan; they are apparently willing to dance with the devil. In the immediate aftermath of the financial crisis regulators called for a tough crackdown on the $71 trillion global shadow banking sector that also includes debt market repurchase agreements, securities lending, money market investment funds and some hedge funds.

With the worst of the crisis now over, Euro-commission regulators attention has turned to growth and with it the regulatory mood music has also changed; this Thursday they will publish proposals on how to fund long-term investments to boost Europe’s economies; the plan includes a fundamental shift in how the continent raises money for investment in infrastructure like roads and technology (and maybe even energy) while at the same time moving away from over-reliance on banks for fueling economic growth.

A core element involves reviving securitization, or the bundling of loans into interest bearing bonds; you may recall this market took a hit 7 years ago in the financial crisis. Now, the market for asset backed securities is only about half its pre-crisis size, or about 700 billion euros. The EC estimates that a trillion euros is needed in long term finance for transport, energy and telecoms up to 2020 to boost competitiveness and jobs and hopes that by encouraging market-based financing it can reduce the continent's reliance on banks for raising up to 70 percent of funds for the economy.

The developments in Europe come ahead of leaders of the Group of 20 economies (G20) meeting in November to endorse new rules for shadow banking. A harsh, uniform approach across all sectors has now been ruled out; the new plan is to embrace shadow banking and regulate it a little closer. If it sounds risky, well it probably is, but the Euro-zone now recognizes they need the cash and this is one way to get it, and so they are willing to dance, and put up with the heat.

Meanwhile, the United Nation’s World Meteorological Organization is meeting in Japan, and they reckon 2013 was the 6^th warmest year on record. Thirteen of the 14 warmest years have occurred in the 21st century. The UN weather agency says much of the extreme weather that wreaked havoc in Asia, Europe and the Pacific region last year can be blamed on human-induced climate change. A rise in sea levels is leading to increasing damage from storm surges and coastal flooding, as demonstrated by Typhoon Haiyan, and Australia experienced its hottest year on record, with some temps topping 129 degrees.

The costly weather disasters included $22 billion damage from central European flooding in June, $10 billion in damage from Typhoon Fitow in China and Japan, and a $10 billion drought in much of China.

Only a few places, including the central US, were cooler than normal last year, but 2013 had no El Nino, the warming of the central Pacific that happens once every few years and changes rain and temperature patterns around the world.

If climate change continues, here’s what the panel’s report predicts in terms of consequences.

For the first time, the panel is emphasizing the nuanced link between conflict and warming temperatures. Participating scientists say warming won’t cause wars, but it will add a destabilizing factor that will make existing threats worse. Global food prices will rise between 3 and 84 percent by 2050 because of warmer temperatures and changes in rain patterns. Hotspots of hunger may emerge in cities. About one-third of the world’s population will see groundwater supplies drop by more than 10 percent by 2080, when compared with 1980 levels. For every degree of warming, more of the world will have significantly less water available.

Major increases in health problems are likely, with more illnesses and injury from heat waves and fires and more food and water-borne diseases. But the report also notes that warming’s effects on health is relatively small compared with other problems, like poverty. Many of the poor will get poorer. Economic growth and poverty reduction will slow down. If temperatures rise high enough, the world’s overall income may start to go down, by as much as 2%, but that’s difficult to forecast.

Past panel reports have been ignored because global warming's effects seemed too distant in time and location. This report finds "It's not far-off in the future and it's not exotic creatures: it's us and now. According to the report, risks from warming-related extreme weather, now at a moderate level, are likely to get worse with just a bit more warming. While it doesn't say climate change caused the events, the report cites droughts in northern Mexico and the south-central United States, and hurricanes such as 2012's Sandy, as illustrations of how vulnerable people are to weather extremes. It does say the deadly European heat wave in 2003 was made more likely because of global warming.

Earlier this month, the world's largest scientific organization, the American Association for the Advancement of Science, published a new fact sheet on global warming. It said: "Climate change is already happening. More heat waves, greater sea level rise and other changes with consequences for human health, natural ecosystems and agriculture are already occurring in the United States and worldwide. These problems are very likely to become worse over the next 10 to 20 years and beyond."

Scientists in the past may have created the impression that the main reason to care about climate change was its impact on the environment. The reality is that it's going to affect nearly every aspect of human life on this planet.