SNW Asset Management | A Minute in the Market

Pension Reforms; Different Approaches

Galen True, Portfolio Manager — Tue, 29 May 2012 15:27:05 +0000

Last week, a story about the Northern Mariana Islands’ pension fund describes its attempt to declare bankruptcy as a standalone entity, separate from the commonwealth. This is a new approach to pension reform and could set a very important precedent for other public pension plans, as they, too, face large shortfalls and increasing current payout requirements due to the increasing ratio of retired-to-active workers. Meanwhile, the State of Illinois claims to “get it”, regarding the need to make meaningful changes to avoid financial ruin in the state pension plan. The governor has proposed raising the retirement age and the portion of pension funding paid by employees. While these changes would be beneficial, and do indicate a shift in policy from the “do nothing” stance previously taken, it does not address some of the structural issues that public pensions face. The Financial Times highlights this structural flaw in an article discussing the divergence between corporate and municipal pension reporting standards. While corporate pension plans are required to use the prevailing yield on Treasury bonds as the discount rate, public plans are allowed to use “return assumptions” as the discount rate, with the national average somewhere around 7 to 7.5%. Lower discount rates equate to higher present value figures for the pension liabilities. This means that the current level of underfunding is actually much worse than reported, and compounding that, rather than reform benefit obligations, most plans have increased their allocation to risky asset investments (from 53% in 1992 to 75% today), hoping to juice returns. Pension underfunding is one of the biggest challenges facing municipal finances today, and although we are glad to see states and other municipalities begin to tackle this growing problem, we feel that many still need a reality check and for some, such as Illinois, these incremental changes may be too little too late.

Spanish Banks in the Crosshairs

Anthony Baruffi, CFA, Sr. Portfolio Manager — Tue, 29 May 2012 15:24:56 +0000

The Spanish government announced last Friday that Bankia SA, Spain’s third largest lender by assets, would receive a 19 billion Euro bailout. The Wall Street Journal reported that the bailout, effectively nationalizing Bankia, raises concerns that the Spanish government may be on the hook for further funds to prop up its fragile banking sector. The fear has driven Spanish ten-year yields to over 6.40% - the widest spread versus German ten-year yields since the Euro was established. The entire Spanish banking sector may need an additional 50 billion to 60 billion Euros in fresh capital, according to Nomura analyst Daragh Quinn. The challenges to the Spanish banking sector come as the Spanish economy is slowing dramatically, as shown by the announcement that retail sales fell 11.3% compared to one year ago. News reports hinted that the Spanish government may recapitalize Bankia with Spanish government debt as opposed to the traditional cash infusion, in an apparent attempt to have Bankia use the bonds as collateral to borrow Euros from the ECB. The challenges facing the Spanish banking system underline the dire situation that southern European countries are facing, and how the need for fiscal transfers from northern countries may be required. How we get to those fiscal transfers is far from clear, and until we see a political solution to this problem, we expect Europe to continue to be a source of volatility in US debt markets.

Slowing Growth in China

Tim Benzel, CFA, Portfolio Manager — Tue, 29 May 2012 15:24:12 +0000

Chinese leaders are breaking historical tendencies by admitting that the economy is weakening, with a cabinet member stating last week that there is a “sharp slowdown in the economy.” Key growth metrics such as imports of raw materials, power usage, and fixed investment are growing at the slowest pace in years, causing concerns about what a Chinese slowdown may mean for the global economy. Real estate prices are falling in over half of the country’s top 70 cities. In the past, China would have introduced a massive stimulus package to induce growth. Today, many are questioning the effectiveness of that strategy, as large numbers of new developments from past stimulus packages such as apartment complexes and factories lie empty and idle. We have grown concerned with these developments, as many U.S. multinational corporations are also reporting a slowdown in the region. To get ahead of this trend, we have reduced our exposure to corporate bonds issued by companies that are highly levered to continued growth from China. We have favored domestically focused corporations, as the U.S. economy, while not growing sharply, is performing quite nicely compared to other regions around the world.

Greek Euro Membership Could End Without Even Trying

Anthony Baruffi, CFA, Sr. Portfolio Manager — Mon, 21 May 2012 16:42:23 +0000

The Washington Post ran an article last week discussing the challenges that Greek banks are facing, stating that,if recent trends continue, the country may be forced to leave the Euro altogether. Recently, Greeks have been withdrawing about 3 billion Euros from Greek banks each month, and the trend is accelerating. Between May 6th and May 15th, Greeks drew an average of 700 million Euros a day from Greek banks, and it seems that the majority of these Euros are ending up in German banks. This would make sense if you felt there was a credible risk that the Greek government was going to leave the Euro and replace any Euros in Greek banks with less valuable drachmas. It is happening while the Greek government is having a very difficult time collecting revenue, potentially causing a situation where the government no longer has enough Euros for day to day operations. Currently, Greek banks are able to borrow Euros from the European Central Bank to cover liquidity needs, but the recent withdrawals, if permanent, could cause the loans to become uncomfortably large. If this type of situation also happens in Spain, and there are reports that deposits are leaving certain Spanish banks, it could force a major change at the European Central Bank if the loans it is making to banks in the periphery become too large. There are many ways the crisis in Europe could be averted, but it will take some big changes in how the monetary union and the EU itself is structured. At SNW, we are managing our client exposures to corporate bonds to make sure that we are not overly exposed to the crisis in Europe.

Getting Ahead of Potential Stress in the Credit Markets

Tim Benzel, CFA, Portfolio Manager — Mon, 21 May 2012 16:41:41 +0000

As mentioned above, events in Europe and elsewhere are contributing to stress in credit markets here at home. Two-year interest rate swap spreads, a gauge of volatility, widened last week to the highest level since January. Fears over a Greek exit from the Eurozone, a slowdown in Chinese growth, and a less robust than expected corporate earnings season have all contributed to the anxiety. Interestingly, high-grade corporate bond spreads have not moved a significant amount, and most bond prices have kept the strong gains they experienced in the first quarter. We believe these divergent movements present an opportunity to lock in gains experienced in certain corporate bonds, and reinvest proceeds into safer and less volatile sectors, such as Government Agencies and taxable municipals. By doing this, we can reduce potential volatility in client portfolios, while standing ready to take advantage of lower prices if we see them.

Municipal Bond Issuance

Galen True, Portfolio Manager — Mon, 21 May 2012 16:40:26 +0000

The Bond Buyer projects just over $9 billion in municipal bond issuance this week, which would make it the 3rd largest weekly issuance of the year. Generally, July and August are slow months for municipal issuance before it rises through the end of the year. Over the last few weeks, we have looked to the new issue market for opportunities to purchase attractive new issues and pull forward upcoming summer maturities. Oftentimes, new issues have long settlement dates, so a deal purchased in May might not settle until 6/1 or later, thereby allowing us to pre-invest for clients with the understanding that supply trends indicate less opportunity in the later months of summer. As an example, Oregon Health & Science University brought a new issue recently that provided us an opportunity to buy attractively priced bonds in an improving credit with a strong balance sheet, using mid-May to mid-June maturities to cover the purchase. With the increase in supply this week and expectations for it to continue for the next several weeks, we will be looking to continue this opportunistic approach so that our clients are not stuck with reinvestment risk during a seasonally slow issuance period.

Lower Gas Prices Improve Consumer Confidence

Tim Benzel, CFA, Portfolio Manager — Mon, 14 May 2012 19:05:00 +0000

The April producer price index, a measure of what manufacturers and wholesalers pay for goods, fell 0.2% in the month. Compared to a year earlier, prices were up 1.9%, the lowest increase in two and a half years. The slowdown in price growth is being driven by lower energy prices (down 1.4%), as concerns over economic growth and a reduction of tensions in the Middle East drive down the price of oil. These price declines have led to improved consumer confidence, with the University of Michigan consumer sentiment index hitting a 4-year high on Friday. Retail sales will be reported tomorrow and should continue to be strong, as lower gasoline prices put more money in consumers’ pockets. This environment bodes well for manufacturers and retailers, whose costs are falling at the same time demand is holding steady. The result is higher margins, which will improve the already strong credit profiles of the companies whose bonds we own in client portfolios. In the low yield environment we are in today, it is these credit investments that boost yield and income without taking unnecessary risks.

Treasury Yields Reach Record Low at Auction Despite Deficits

Anthony Baruffi, CFA, Sr. Portfolio Manager — Mon, 14 May 2012 19:03:03 +0000

Last week the U.S. Treasury auctioned 10-year notes at a record low yield of 1.855%, despite the federal government running a deficit of over one trillion dollars for the fourth year in a row. Along with weaker domestic employment statistics and continued turmoil in Europe, Bloomberg News noted that the record low yield was reached in part because of a lack of high quality investment choices for pensions and banks that are being forced by regulators to hold higher quality investments. Citigroup says the pool of “high quality” debt from the U.S., U.K, Germany, and nine other European countries is 72% of what it was in 2007. This reduction in high quality debt has allowed yields to fall in the face of the amount of Treasurys outstanding doubling to $10.4 trillion since 2007. The same trend is being felt in Germany, with 10-year German bunds yielding 1.44% today, a record low. Still, if Treasury yields are expected to stay this low for the long term, there will have to be a credible path towards reducing the deficit, something that we have not seen yet.

Municipals Attempt to Take Action

Galen True, Portfolio Manager — Mon, 14 May 2012 19:00:19 +0000

TriMet, the organization that runs the public transit system in the greater Portland area, is entering binding arbitration today with its union as it struggles to agree on a healthcare package for union workers. Currently, healthcare costs represent 32% of TriMet’s operating budget, which is up from 12% in 2000. If no changes are made, the cost is expected to balloon to more than 50% by 2020. The current plan was agreed to in 1994 and has not been changed since despite rapidly rising healthcare costs and extremely generous benefits, such as 16 years of free healthcare for spouses and dependents after the death of a union employee. Meanwhile, high-profile municipalities State of California and City of Chicago continue to struggle with their own financial difficulties. California Governor Jerry Brown announced last week that the state budget deficit would be closer to $16 billion than the $9.2 billion estimated in January. This increase is due in part to lower income tax collections than projected, but also to spending of about $2.1 billion more than anticipated. Brown effectively threatened voters with cuts to services if they didn’t approve proposed tax increases, and the state finally has brought union officials to the table to discuss payroll cuts. City of Chicago Mayor Rahm Emanuel sent a citywide e-mail to employees defending his proposed changes to the city’s pension plan, which include reductions in what the city will pay for both current and new employees. Emanuel recognizes that workers have done nothing wrong, and that the blame lies with union and city officials, but presents the tough choice in plain language: “If we follow along the current path, we know we will confront two stark choices: Either the city’s pension payments will squeeze its ability to offer the essential services that you provide, or each of our pension funds will go bankrupt, leaving you and your families without retirement security.” It is encouraging to see that government officials are getting the message that changes must be made to ensure fiscal sustainability.

Nonfarm Payrolls Prints a Miss

Galen True, Portfolio Manager — Mon, 07 May 2012 16:42:38 +0000

Last week’s highly anticipated report from the Bureau of Labor Statistics showed an increase in Nonfarm payrolls of 115k for the month of April. This was well below expectations for adding 160k workers, however, upward revisions to the March report added another 34k to the print. The unemployment rate dropped unexpectedly to 8.1% from 8.2%, although this primarily resulted from workers exiting the labor force. Meanwhile, average hourly earnings, an important aspect of the BLS report, came in at 1.8% year/year growth for the month. This is below the year/year change in the PCE deflator for the month, which is the Federal Reserve’s preferred measure of inflation. The trend of income growth below the inflation rate has been consistent over the last year, and is causing a worrisome decline in the savings rate, which may eventually flow through to reduced consumer spending and ultimately lower GDP growth. We continue to monitor economic data for signs of strength and/or inflationary pressure, as the economy continues to plod along at a low growth rate.