Investment Strategies Newsletter
This past quarter sent mixed signals regarding investors’ appetite for risk. It was characterized by continued volatility in the bond markets, but the month of December seemed to close with stronger demand. With the exception of foreign sovereigns and foreign agencies, the remaining sectors of the taxable bond market produced positive returns for the period (as of this writing – 12/28/2011). In general, even high-yield bonds posted strong positive returns as they rebounded from a clearly negative 3rd quarter. The municipal bond market was also among the strongest performing sectors during the quarter and for the entire year of 2011.
Municipal Bond Defaults-- The Warning that Fell on "Deaf Ears"?
Meredith Whitney received a great deal of attention in the financial markets due to her analysis of the issues facing Citigroup in October 2007. Whether it deserved the notoriety it received is debatable. However, she did focus on the weaknesses of the bank’s balance sheet and did correctly raise concerns that financial institutions could potentially be at risk if they did not take proactive steps to improve their balance sheets by selling assets, reducing debt, and increasing capital.
It is not surprising that Ms. Whitney's warning about a spate of municipal bond defaults on the December 19, 2010, broadcast of 60 Minutes created such a stir. In spite of this dire prediction's temporary negative effect on the bond markets earlier in the year, municipal bonds have been viewed by the markets as a value proposition relative to Treasury Securities. As I have already noted, municipal bonds have turned in a very strong year of performance in 2011 in spite of two major bankruptcy filings (not the 50 to 100 or more sizeable defaults Ms. Whitney is on record for predicting) in the sector (Jefferson County, Alabama, and Harrisburg, Pennsylvania). Both of these defaults have occurred within the last couple of months and both are being contested in the courts. There is some doubt regarding whether or not these municipalities could legally be afforded bankruptcy protection. In the case of Harrisburg, a bankruptcy judge ruled that the city could not file for bankruptcy in order to get out of paying its debt. Pennsylvania law requires state approval before a municipality may file for bankruptcy protection under Chapter 9 of the US Bankruptcy law.
The way her ominous prediction was reported and discussed in the media shortly after it was made would lead us to think that this person is a “scaremonger.” However, when I reviewed the transcript of the broadcast, her opinion, in general, makes a great deal of sense.
Whitney believes the states will find a way to honor their debts, but she’s afraid some local governments which depend on their state for a third of their revenues will get squeezed as the states are forced to tighten their belts. She’s convinced that some cities and counties will be unable to meet their obligations to municipal bond holders who financed their debt. Earlier this year, the state of Pennsylvania had to rescue the city of Harrisburg, its capital, from defaulting on hundreds of millions of dollars in debt for an incinerator project.1
I do not believe the opinion is irrational. It is an accurate statement that states are cutting back on the amount of revenues they provide to local municipalities and school districts. In essence the budgetary problems at all levels of government are being pushed down the “pipeline” of public finance. The federal government is cutting back on the funds it passes along to the states, and the states are cutting back on the funds they pass down to the local levels and state agencies. This has led to an outcry from mayors, county executives, school boards, and school administrators that reducing state aid without a reduction in state and federal mandated expenditures will undoubtedly lead to a cutback of services and public programs along with increased taxes. Many local governments and school districts have very little left in the way of discretionary spending that can be reduced.
Therefore, the warning about public finances may not have led to the defaults anticipated by Ms. Whitney in 2011, and may not ever materialize if municipal government administrators can continue to reduce costs elsewhere. However, that raises other questions regarding the quality of public services that taxpayers are currently funding. No one wants to pay for something and get less of it. Local governments and school districts will eventually have to explore more ways to deliver services more efficiently; otherwise all municipal government obligations may be negatively affected. That being said, I do believe that other creditors will be more negatively affected than bondholders. As was the case in Pennsylvania, no state that relies heavily on the public finance market for bonds wants to create a situation that would make it difficult for them to refinance their own debt.
The European Problem-- No Easy Solution in Sight
The uncertainty over the fiscal imbalances of some members of the European Union not only continues to make headlines, but is the single most important contributor to the volatility in the global markets. Yes, there are other economic and political variables that are having a marginal impact on the global capital markets, but the European story continues to be most influential, because it has the potential of being the most unsettling to the global banking system.
Greece is still a problem, but most of the focus this past quarter has shifted to Italy, with Spain most likely the next target of the capital markets. It is not surprising that the focus would have shifted given that Greece’s public debt is approximately € 408 billion as of 3-31-2011 (or at an exchange rate of 1.3 $/€ - almost $530 billion), while that of Italy is € 1,847 billion as of 9-30-2011 (or almost $2.4 trillion). If we include Spain in the conversation, that would be € 1,772 as of 9-30-2011 (or almost $2.3 trillion).2
Each of these countries has gone through a change of government during the past quarter, directly related to the problems surrounding their fiscal imbalances. In the case of Greece and Italy, the governments are “provisional” and not currently elected—an emergency measure to deal with the lack of confidence in the previous governments’ ability to lead during this turbulent economic time. It has been widely publicized that each new government’s approach is to try to implement radical structural changes in spending on pensions and other public services and try to eliminate obstacles to competition in the private sector. But, the predominant theme is austerity.
While austerity measures will certainly begin the stabilizing process desperately needed to improve confidence in the global capital markets, the key to any of these economies is real growth. All countries compete for a bigger piece of the economic pie in order to improve standards of living for their citizens and for their continued prosperity. However, this will not be easily accomplished during this cycle and therefore, austerity may be the only real solution at the present time.
I am not aware of other preferrable solutions, or at least any that would realistically be implemented voluntarily. One of the important advantages of a common currency like the euro is the notion that it facilitates capital flow from member state to member state without barriers. So, if good capital investment opportunities existed in Greece, a German investor would be able to move capital to Greece without barriers. The investor would be able to efficiently allocate capital, and the business entity in Greece would be able to find capital more efficiently. This dynamic may be changing because of the lack of confidence in some of the Southern European members. Greece and Italy are trying to stem the potential for capital flight and unfortunately, any policy implemented to reduce this risk will also have the unintended consequence of limiting new capital investment from foreign accounts.
A solution that has been talked about recently is the “break-up” of the European monetary union, promoting the exit of the weaker economies or the exit of Germany. Either option is not very realistic nor without severe consequences that would extend beyond the European continent. Either option would have an immediate impact on the weaker, struggling economies. Even the strongest economy in Europe, Germany (and particularly its banks), would feel the negative effects of its neighbors’ deep recession in the aftermath of a euro exit. Aside from the technical uncertainties of how any of these countries would “de-peg” from the euro, the market would have a difficult time establishing a valuation on the new Lira or Drachma or Peseta. All of these had an established exchange rate when each country entered the euro, but those exchange rates would not apply today.
Perhaps a good example of the effects of such a break from a fixed exchange rate system is that of Argentina in 2001. For approximately a decade, Argentina had maintained a fixed currency exchange of 1:1 with the US dollar. The goal was to reduce economic instability due to persistently high inflation rates and hopefully gain the confidence of international investors to bring capital investment to Argentina. It worked well, until the global recession of the late 1990s and early 2000s made the fixed exchange with the US dollar unsustainable. In the aftermath of the “de-pegging,” Argentina’s economy went through a major crisis that included debt restructuring, runs on banks, limits on withdrawals from banks, looting and rioting, suspension of payments on public debt, and a devaluation of approximately 75% and a sovereign default of over $100 billion.
Even if we were to adjust the $100 billion for inflation, it is still far less than the amounts I mentioned earlier for Greece, Italy, and Spain. The banking system in Europe and worldwide would be severely impacted, creating dangerous insolvencies. Surely, this is not a preferred solution and one I hope we never have to put to the test.
1www.cbsnews.com, State Budgets: The Day of Reckoning – December 19, 2010, CBS News: Producer: Scott Jacoby.
2Ned Davis Research – Greek, Italian, and Spanish Total External Public Debt. Data provided by Haver Analytics to Ned Davis Research.
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