HS Dent

The Emerging Market Bond Bubble

Charles Sizemore — Tue, 16 Mar 2010 15:10:49 +0000

The first quarter of 2010 saw record issuance of emerging market bonds. It also saw the spread on those bonds fall to only 2.57% over the US Treasury rate, according to the Financial Times (see “Emerging market bond sales hit record high“). The FT writes,

Sovereign bond markets in developing countries have seen a record $129bn in new deals so far this year, a 42 per cent increase over the same period last year, the previous record for issuance, according to Dealogic.

Emerging market yields narrowed to 2.57 percentage points over US Treasuries on Monday compared with 3.5 percentage points a month ago, according to JPMorgan’s Embi+ index…

That is a sharp fall from the recent cyclical peak of 6.84 percentage points in March last year and just a fraction of the all-time peak of 16.64 percentage points over US Treasuries in September 1998.

Risk appetites have certainly returned!

There are several ways this data can be interpreted. One contrarian view I’ve seen is that the spread between U.S. and emerging market debt has narrowed not because emerging markets are seen as safe but rather because the U.S. is now seen as more risky. This is ridiculous, of course. American bond yields remain ridiculously low, showing that for all the wailing and gnashing of teeth, bond investors do not view the United States as being risky.

An optimistic view would be that emerging markets has simply come of age. They’ve emerged, and their bond yields now reflect the maturity of their capital markets and institutions. The optimist in me would like to believe this.

But then, common sense intervenes. Is a 2.57% spread really adequate compensation for the additional risks associated with investing in emerging markets? And isn’t this lax attitude to risk exactly how all emerging market debt crises start? And how we got into the mortgage / housing mess here in the U.S.? (more…)

Is It Still Stimulus When It Is Pored Into The Same Old Black Holes?

Rodney Johnson — Tue, 16 Mar 2010 13:29:50 +0000

Of the $787 billion in stimulus from 2009, over $200 billion was “spent” on state budget gaps. Those gaps have gotten even wider, with 2010-2011 shaping up to be one of the toughest years for state budgets on record. What is the solution? More federal dollars, of course. Just as forecast by, well, everyone, as original stimulus money runs out, states are coming back and asking for more. California has actually put in their budget the expectation of a $6.9 billion handout, er, grant, or whatever they call it.

This doesn’t address the problem. States have created structural spending that cannot be sustained. It’s not the revenue, it’s the spending. Same problem, different year; same solution, your money.

Suddenly State Pensions Are In Focus

Rodney Johnson — Mon, 15 Mar 2010 15:02:45 +0000

We’ve been discussing the disastrous state of State Finances for many years, starting in earnest in 2006 with our Death of Pensions Report. We have highlighted underfunded pensions and underfunded (and almost never-discussed) healthcare benefits, which states call Other Post Employment Benefits (OPEB’s). Our position was that not only were these items a cause for concern, but that the dual forces of a market meltdown and slower economy would cause the issue to become much, much worse.

And here we are.

The Pew Center released their latest report last month showing the most recent state of things. It’s not pretty. And it gets worse. The Pew Center’s data is through June 2008. Yep, pretty much right before everything fell apart.

Barron’s cover article this weekend is “The $2 trillion Hole,” which outlines where states are today, given an estimate of how things have changed since the ugly, but better than now position of the Pew report.

I would link to the Barron’s article, but they go under a paid site for content. The interesting part to me is not the general discussion, as that shouldn’t be news to anyone who reads our work. What is interesting is the example of Vallejo, CA. This city gave very generous (over $100,000 per year) pensions to many workers. As property values soared, so did tax revenue. But then the music stopped. Property value tanked, tax receipts fell, but the pension obligations remained. The city cut services to the bone and then some. Finally, they gave up the ghost and declared municipal bankruptcy.

The final details of the bankruptcy haven’t been nailed down, but as the very end of the Barron’s article states,

“Though Vallejo is still months away from getting a court decision on whether it can go ahead with its debt-adjustment plan, it has succeeded through contract renegotiations and major layoffs in cutting its employee costs by nearly a quarter.

But the fallout has been brutal. Employee health-care benefits have been decimated. Holders of the city’s municipal bonds are unlikely to get all their money back. And violent crime rates have shot up dramatically as a result of reductions in its police force from 158 to 104 officers.

The only thing that will be left untouched? The very thing that tipped the California city into Chapter 9 — its $84 billion in future pension obligations.”

I added the emphasis. This is not over. This is not the end. The fact that these obligations were not reduced, no matter how painful that would be, means that the issue will be revisited. Does the state of California, in its curren fiscal mess, take on the obligation? How about the US government? Now multiply that across the country.

Follow-Up: Is Japan Now On the Mend?

Charles Sizemore — Mon, 15 Mar 2010 14:26:25 +0000

We read on Bloomberg this morning that “Japan’s household sentiment rose for a second month in February as the economic recovery began to generate jobs… Japan’s export-led revival is beginning to stabilize the labor market, helping build the base for a broader recovery that includes households. Spending by consumers accounts for more than half of the world’s second-largest economy.” Link to Bloomberg article.

We’ll see about that “broader recovery.” At HS Dent, we have held out hope for quite some time that the rise of Japan’s small Echo Boom generation (the children of the Baby Boomers) would allow Japan to enjoy a mini-boom, of sorts. While we viewed a return to Japan’s heyday of the 1970s and 80s as out of the question, we did expect at least a mild improvement in the economic malaise that has come to define Japan. That mini-boom might still come; hope springs eternal. But given all of Japan’s other problems, we expect any boom to be VERY small. It might be more of a pause in the decline rather than a bona fide boom. We shall see. But we wouldn’t hold our breath on that. “Mini boom” or not, Japan may be headed to the largest sovereign debt crisis in world history. (see “Japan, the perpetual crisis tease“)

This won’t end well.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Japan: The Perpetual Crisis Tease

Charles Sizemore — Fri, 12 Mar 2010 15:08:24 +0000

“Cassandra’s curse was that her warnings would never be believed,” writes the Economist. “Doom-mongers in the Japanese government-bond market have suffered a milder fate: they were just far, far too early.”

At HS Dent, we’ve been firmly in the Japan “doom-monger” camp for quite some time. We’ve hesitated to take active bets against the Japanese bond market (believing that deflationary forces would keep bond yields low), and have even held out hope that the country might enjoy a mild “mini boom” with the maturing of that country’s small Echo Boomer generation. But our long-term view has remained unchanged — that Japan, as a country and economy, was on a slow, steady track to oblivion.

The Economist largely agrees though thinks that Japans day of reckoning could be at least a few years off. But come it will:

It certainly seems likely that at some point the worst fears of the bears will come to pass. Debt servicing already uses up some 35% of government revenues. Imagine what that figure would look like if Japan paid the same level of yields as Germany (or worse still, Greece). A fair chunk of Japanese debt is owned by government agencies, a financing pyramid that will eventually collapse. Historically countries with very high levels of government debt have defaulted or, more usually, inflated the problem away.

From “Apocalypse, Not Now“

It remains to be seen how the Japan saga will end. It’s hard to imagine a good ending for the country’s bondholders, however.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Emerging Economies That Emerge

Charles Sizemore — Thu, 11 Mar 2010 15:43:44 +0000

I read in the Financial Times today that Israel is to be officially upgraded from “emerging market” to “developed market” by Morgan Stanley Capital International (”MSCI”), the creator of the popular index that the EEM exchange-traded fund is based on (see “Israel Set for Bumpy Ride to the Top“).

Well, it’s about time. Israel has had a standard of living comparable to Western Europe for years. The country has world-class high technology companies and some of the world’s best scientists. The same can be said for Taiwan and South Korea, two of the largest countries by weighting in the EEM.

This is not a personal gripe; it’s a portfolio management problem. When investors want exposure to “emerging markets,” they’re not getting it when they benchmark to the standard emerging market indexes. They are getting only minimal exposure to up-and-coming countries like Brazil, China, and India. Instead, they are getting oversized exposure to countries like Israel, South Korea, and Taiwan — countries whose high-growth emerging phase has largely passed.

This is not to say that Israel, South Korea, or Taiwan are bad investments. All three have fine, world-class companies. But if you want real exposure to emerging markets, you might have to look beyond the popular mutual funds and ETFs and dig a little deeper.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

The Incredible, Shrinking Detroit

Charles Sizemore — Wed, 10 Mar 2010 16:58:21 +0000

Everyone knows what ails Detroit. The inexorable decline of America’s auto manufacturing has created a large city with a gaping black hole where its leading industry used to be. So, there is no real reason to dwell on how Detroit got into its current state. What is interesting is how the city is attempting to cope with its demise. Take a look at this AP headline:

“Detroit wants to save itself by shrinking.”

The AP writes,

Detroit, the very symbol of American industrial might for most of the 20th century, is drawing up a radical renewal plan that calls for turning large swaths of this now-blighted, rusted-out city back into the fields and farmland that existed before the automobile. (more…)

Taxes Up, Services Down

Charles Sizemore — Tue, 09 Mar 2010 16:32:19 +0000

Dallas was not exactly ground zero in the mid-2000s real estate boom and bust. Outside of a few isolated neighborhoods, prices never rose very much. And outside of a few new developments on the suburban fringe, oversupply was never much of a problem. It was as if the city were splendidly isolated from the problems of the rest of the country.

So, when I went to visit my mother at her house in Dallas, I was a little surprised to see her trash bin overflowing.

“They only pick up the trash once per week now,” she told me, shaking her head.

The city of Dallas, in an attempt to rein in costs, has cut its garbage collection services in half. Of course, they have not cut the fees charged to homeowners by a single red cent.

This is not technically a tax hike. But effectively, it is the same thing. Homeowners are paying more for a given level of service. And I expect this trend to be the norm at all levels of government.

We’ve written about this for years at HS Dent. The “solution” for the government budget and debt crisis is some combination of lower services and higher taxes. It’s as true for Social Security and Medicare as it is for Dallas trash collection. We will all be paying more to all levels of government and getting less in return.

It doesn’t make for happy taxpayers and voters, of course. But there is little alternative. “Cutting spending” sounds like a better alternative than raising taxes or cutting service, but how do you cut spending on something like Social Security? These are contractual obligations, and millions of seniors depend on it.

Don’t get me wrong, there is plenty of government waste that can be cut. But one man’s government waste is another’s pet cause.

And it gets worse at the local level. Everyone is “for” cutting government spending in the abstract. But what if that means that your favorite local park has to be closed? Or that you have to store a week’s worth of rotting trash in the baking Texas sun?

I have no solution to this problem because there is no solution. We could take to the streets and protest like the Greeks are doing over that country’s proposed austerity measures, but that would be no more effective than English King Canute’s attempt to command the tides.

Perhaps the only advice I can give is to prepare to fight hard for your piece of what promises to be a shrinking pie for the next several years.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Job Security: Be cool, stay in school

Charles Sizemore — Mon, 08 Mar 2010 22:13:19 +0000

Interesting chart from Chart of the Day forwarded to me by one of our Dent advisors:

It appears that there really is a benefit to higher education in the form of greater job security. As you can see in the chart, unemployment is higher the lower on the educational scale you go.

There are several points to take from this chart. Those workers without high school diplomas are the most “marginal.” That is, they are the last workers to get hired when times are good, and they are the first to get laid off when times are hard. Their employment is clearly the most volatile of all the groupings on the chart.

Another interesting point is that the unemployment rate for those with college degrees is only around 5%. This says nothing of underemployment, of course. Some of these college grads may well be employed as pizza deliverymen. But the fact remains that unemployment is lowest and least volatile the higher up the educational scale you go.

It’s important not to confuse correlation with causation, of course. There are qualitative factors at work here as well. People who are not motivated enough to graduate from high school are also not likely to be the most assertive job seekers. At the same time, someone who invested the time and money to go to college is going to be hungry to get a return on that investment and will thus make more of an effort to get a job.

Still, all things considered, it would appear that the advice from the old 1980s commercials is sound. If you want job security, “be cool, stay in school.”

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Will Greece Pawn its Islands?

Charles Sizemore — Fri, 05 Mar 2010 14:53:05 +0000

The Greek debt crisis is now reaching the levels of the absurd. There seems to be a growing consensus that Germany will step forward and bail Greece out. The problem with this? The idea is WILDLY unpopular in Germany. In fact, German lawmakers have suggested Greece sell off its island to pay off its debts rather than run to the EU’s more responsible members for help: “Greece Can Sell Islands to Cut Debt.”

Even if Germany wanted to help Greece, it’s not entirely clear that they can. According to the Financial Times, Germany is
forbidden by a 1993 Constitutional Court decision that stipulated that Germany would be forced to leave the eurozone if the union did not follow the principles of monetary stability. So, in a nut shell, if Germany bails out Greece to save the euro…Germany will have to leave the euro.

Politicians are masters at circumventing laws and court rulings, of course, and it is entirely possible that Germany may still come to Greece’s rescue. But for now, the crisis continues, and investors are left to ask “what next?”

Charles Sizemore, CFA

Greek Mythology

Update on Greece