Broken Bonds & Taxing Situations


Highlights This Month

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The NWM Portfolio

During February, we experienced sharp corrections in a couple of our holdings in the Strategic Income Fund. We still like these companies and, while we understand why the shares corrected, we believe the correction provided an interesting entry point. Because of this, we purchased shares up to our target weight.

In terms of balancing our portfolio, we are looking to reduce our REIT holding and use the proceeds to buy more Canadian banks and we are still looking to add to our U.S. equity position.

For those who made it to our Market Outlook event, first: thank you; second: much of what you’re about to read will seem quite familiar.

FEBRUARY in Review

By Rob Edel, CFA

Equity markets extended their New Year’s rally, with the S&P/TSX gaining 1.5% in February while the S&P 500 and Dow gained 4.1% and 2.5% respectably.

Of course a rally in January and February does not guarantee prosperity for the rest of the year, as evidenced by last year’s strong start to the year. Early gains last year were quickly lost as markets were roiled by European debt concerns.

Individual investors certainly remember, as many have used the recent rally as an opportunity to take profits. Financial data tracking system “EPFR Global” estimates individual investors have pulled $8.3-billion out of U.S. equity funds this year while adding $10.6-billion to bond funds.

Individual investors have been cautious for a while, however, as EPFR hasn’t measured a single positive inflow week into U.S. stocks since July 2011 and only two positive inflow months since March 2009.

On the other hand, institutional investors – commonly referred to as “the smart money” – have been buying. EPFR notes that if all investor buying is totaled, net inflows into U.S. stock funds equaled $588-million.

MMC-2012-02-Disconnect

So who’s right?

According to a little known indicator pointed out by Barron’s Alan Abelson, the Sports Illustrated annual swimsuit issue might provide the answer. Since 1978, when an American model has appeared on the cover the S&P 500 has gained an average 14.3% and ended the year in the black 88.2% of the time. When a foreign model appears on the cover, the S&P 500 has gained only 10.5% and ended the year positive only 76.5% of the time.

If this isn’t irrefutable enough, anecdotal evidence from recent fashion shows indicate the “hemline indicator” (first introduced by Wharton Professor George Taylor in 1926) has turned decidedly bullish. With shorter skirts in fashion, the hemline indicator is predicting markets will move higher.

While we are skeptical of both the “swimsuit” and “hemline” indicators, it would behoove us to ignore our professional obligation to thoroughly research each as closely as possible – certainly easier on the eyes than the Fed Chairman.

What we won’t need to research any more is the debt crisis in Greece.

A deal finally seems finally seems at hand. In exchange for their “broken” Greek bonds, investors will receive 46.5% of their principal back, though not in cash. Instead, 15% will come in the form of short-term bonds issued by the Euro-zone rescue fund and 31.5% in new Greek bonds maturing over the next 11 to 30 years.

All in, investors are estimated to be looking at a total haircut of around 74% and counting. We say this, because in a show of just how confident the market is in Greece’s financial future, the new Greek bonds are currently trading in the “grey market” (this is an unofficial market for securities before that are officially issued) around 15 to 17 cents on the Euro for the 11-year tranche and 20 to 22 cents for the 30-year tranche.

Granted the coupon rate is well below the market and the bonds were expected to trade substantially below par, but according to these prices, the market is saying the coupon should have been around 17% rather than the official 2 to 4%.

Because only 83% of investors “voluntarily” tendered their bonds, the recently legislated collective action clause was invoked, forcing all holders of the bonds issued under Greek law to take the deal. Invoking the clause doomed the bond swap to be officially classified as a default, thus triggering $3.2 billion in credit default swaps.

It is estimated about 4% of bonds holders who held foreign-law bonds have opted not to participate, but have been given another two weeks to change their minds. Greek Officials appear resolute in stating these holdouts will not be repaid in full. 

MMC-2012-02-TheDeal

In exchange for successfully completing the bond swap (aka default) and inflicting additional austerity cuts on the Greek people, Greece will now be blessed with a €130-billion bailout package.

It’s unlikely to be their last, however, as deep spending cuts are likely to drive Greece deeper into recession, thus moving their debt-to-GDP ratio even higher. Already, Greek GDP was estimated to have contracted an annualized 7% in the fourth quarter with unemployment hitting 20.9%. The unemployment rate for workers 15-24 years old is nearly 50%.

Ok, so maybe we will have to continue researching Greece.

MMC-2012-02-BailOut 

Problems in Greece continue to spread across the Euro-zone with unemployment for the entire region hitting 10.7% in January, a fifteen year high.

Not all are created equal in the 17-member currency bloc, however. Unemployment in Germany was only 5.8% while Austria was even lower at 4.0%. Spain, however, was more Greece-like at 23.3%.

Economic growth showed a similar pattern, with overall GDP growth falling an annualized 1.3% in the fourth quarter, though the magnitude of the contraction was far greater for the fiscally challenged South.

Only France managed to deliver positive growth with even Germany ending the quarter in the red, though still up 3% for 2011.

MMC-2012-02-ShrinkWrap

This is certainly not what the global economy needs; particularly China, which lists Europe as their largest trading partner.

China has already seen its GDP growth decelerate over the past year and U.S. think tank “The Conference Board” sees China’s growth rate declining to 8% in 2012 and 6.6% over the following four years versus an average growth rate of 10% the past 30 years.

A Chinese think tank is even more pessimistic and recently published a report titled “China 2030” that challenges China’s current economic model and warns of a rapid deceleration in growth similar to that experienced by other rapidly growing emerging economies such as Brazil and Mexico.

Deutsche Bank economist Jun Ma believes China’s reliance on industries that copy foreign technology rather than create their own makes China vulnerable to a sharp slowdown.

 MMC-2012-02-CatchUp

    
While China certainly has its challenges, we do not see an imminent collapse in growth.

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Apart from the negative impact from lower European exports, much of the recent slowdown is self-inflicted as China tightened monetary policy in order to rein in inflation.

Slower growth is something China expects. In fact, the official growth rate has been set at 8% since 2005. For 2012, China is targeting growth of 7.5%, and while they are likely expecting higher, they realize slower economic growth is inevitable as the economy continues to grow and evolve.

No one is able to grow their economy 10% forever. With the goal of shifting towards a consumer economy and away from an export led economy, slower growth is all part of the bargain.

While economic growth in China is slowing, the U.S. economy is finally starting to show signs of turning the corner.

Many, however, are becoming increasingly concerned growth could be derailed in 2013 by what is being referred to as “Taxmageddon.”

Unless the Republicans and Democrats can work a deal, not only are the Bush-era tax cuts scheduled to expire at the end of the year, but the Social Security payroll tax is set to increase back to 6.2% from the recession fighting 4.2% presently being levied. These two measures alone would increase taxes by an estimated $500-billion a year.

Even worse, spending cuts agreed to last year in a deal to lift the federal debt ceiling are also expected to begin kicking in during 2013. Moody’s economist Mark Zandi estimates all three could shave 3% off GDP next year.

While the recent agreement to extend the payroll tax to the end of 2012 leads one to hope Republican and Democrats will be able to work together to avert an outcome neither side wants, President Obama’s recent budget and steadfast resolve to increase taxes (or not extend the Bush tax cuts) for those earning over $250,000 per year, makes one wonder if any deal between the Republicans and Democrats is possible.

Unless one of the parties sweeps the November election – and it is doubtful that they will – 2013 could start off on a sour note for U.S. tax payers, and investors.

MMC-2012-02-MakeTheRichPay

The U.S. Economy

MMC-2012-02-EconomicGrowth-Table-US

U.S. economic growth continues to move in the right direction with fourth quarter GDP revised up to 3.0% from 2.8% previously.

Only durable goods delivered disappointing news, suffering its largest decline in three years. We suspect the decrease was due to companies pushing forward capital spending plans last year in order to take advantage of favorable depreciation rules that expired in December.

Manufacturing continues to be the economic growth star with most purchasing manager indexes pointing towards continued growth in manufacturing.

MMC-2012-02-MadeInTheUsa

MMC-2012-02-Employment-Table-US

It was another strong month for U.S. employment in February. Not only did the U.S. add a higher than expected 227,000 jobs in February, but January’s tally was revised 41,000 higher. Over the past 6 months, the U.S. has created 1.2 million jobs, a pace not seen since 2006.

The U.S. is still down about 5.2 million jobs versus four years ago, however. The unemployment rate remained at 8.3%, but only because the labour force grew by nearly half a million workers. Also moving in the right direction was jobless claims, which are now well below 400,000, indicating a healthy job market where hiring easily outpaces layoffs.

In another sign the job market recovery might be sustainable: more big cities are participating in the growth. Moody’s Analytics reports 82 out of the 100 largest metro areas experienced year over year employment growth last year versus only 71% in 2010. HIS Global predicts all 50 U.S. states will experience job growth in 2012.

All very good news.

MMC-2012-02-FebruarySnapshot

So where are all these jobs coming from?

Certainly manufacturing has been a surprising contributor, adding over half a million jobs over the past few years. Another source is the oil and gas industry. New drilling techniques have created a renaissance in the U.S. energy sector with over 150,000 new jobs created over the past five years. And unlike some manufacturing jobs, these are well paying jobs.

President Obama even cited rising energy production in his State of the Union Address as a potential source of approximately 100,000 direct new jobs by the end of the decade with the potential to add four times as many jobs in related industries.

Low natural gas prices, which are a result of the current energy boom, help lower consumer heating bills and also make manufacturers more competitive by providing cheaper electricity.

MMC-2012-02-BouncingBackJobsGusher  

One area where we would expect the U.S. to gain jobs is in the science and engineering fields, given the U.S. is perceived to be a leader in technological innovation. Sadly, this seems to be an area where the U.S. is losing ground. In 2010, the percentage of the work force employed in technical positions decreased to 4.9% versus 5.3% in 2000.

While companies like Apple and Facebook are hiring for positions in software design and applied mathematics, old-line industries have seen a lower demand for mechanical engineers. The U.S. is building more websites and less bridges and the workforce is going to need time to adjust.

 MMC-2012-02-Inflation-Table-US

Inflation was a little higher in January and core CPI and PPI are still above the Federal Reserve’s comfort range. Given the slack in the employment market, however, inflation is not perceived to be a major threat for the time being.

This could change if oil continues to move higher, however. At well over $100 a barrel, higher oil prices are translating into higher prices at the pump, which comes straight out of consumer pocketbooks.

Gasoline prices in excess of $4 a gallon are generally perceived to be the breaking point for consumers, a level that many States are approaching with the national average hitting $3.647 on February 24. This is up 27 cents in a month and 11 cents higher than a mere 7 days previous. The threat of war with Iran is the major driver, a situation that doesn’t seem likely to be resolved any time soon.

As mentioned above, partially offsetting higher gasoline prices are lower natural gas prices, which translate into lower heating bills. Natural gas prices have plummeted with weak demand due to a warmer than normal winter increasingly unable to keep up with surging supply.

Deutsche Bank economist Joseph LaVorgna estimates lower natural gas prices are offsetting approximately half the impact of higher gasoline prices for consumers.

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 MMC-2012-02-ConsumerConfidence-Table-US

Higher gasoline prices usually translate into lower consumer confidence, making recent gains in consumer confidence even more impressive. The strong employment market is most likely the driver. A warm winter doesn’t hurt either.

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 MMC-2012-02-TheConsumer-Table-US

January retail sales were lower than expected, but February is shaping up to be a strong month with same store sales up over 6.5%.

Maybe more significant than how much consumers are buying is how they are paying for it. Consumer credit expanded for the fifth month in a row in February in a sign the stronger employment market maybe giving consumers the confidence to pull out the plastic again.

In the fourth quarter of 2011, household debt increased an annualized 0.25%, the first increase since the second quarter of 2008 and the Lehman Brothers collapse. While we believe the deleveraging cycle still needs further to go, some borrowing is a good thing and shows the economy is continuing to mend.

MMC-2012-02-TheBorrowers

 MMC-2012-02-Housing-Table-US

Prices continue to move lower but sales activity remain robust and the inventory of unsold homes is at level not seen since 2005.

Yes, there are still a lot of foreclosed homes waiting to hit the market, but lenders appear disciplined and more likely to sell in bulk to large institutional investors than flood the market and depress prices even more. Unfortunately, lenders are also more disciplined as to who they lend to, leading to more deals falling apart at the last moment.

We still hold hope that the housing market has turned the corner. Price might still drift a little lower, but low inventories should put a floor on prices and should also lead to increased new home construction.

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 MMC-2012-02-Trade-Table-US

While the U.S. economy looks to be regaining its footing, the rest of the world seems to be stumbling.

The result is deterioration in the trade deficit as exports growth is out paced by imports. Higher oil prices means the trend should continue to be negative in the near future. The good news is the U.S. is not as reliant on exports to Europe as emerging market economies. 

  
The Canadian Economy

MMC-2012-02-EconomicGrowth-Table-CAD

Fourth quarter GDP growth decelerated to 1.8% versus a robust 4.2% in Q2. For all of 2011, GDP grew 2.5% versus 3.2% in 2010. So why the slowdown, particularly since our southern neighbors appear to be finally showing some growth?

A stronger Canadian dollar is certainly part of the problem. The Canadian dollar is highly correlated to oil prices, which is fine if you live in the oil blessed Prairie Provinces, but not so good if you are a manufacturer in Southern Ontario.

Canada has lost approximately half-a-million manufacturing jobs over the past 10 years and the sector currently comprises only 12% of GDP versus 20% a decade ago. The U.S. has also lost manufacturing jobs, but as a percentage of GDP, manufacturing has maintained a 12% share. Manufacturing-centric Ontario began receiving equalization payments in 2009-10 and it is estimated they could hit $5.5 billion by 2020.

First we have to watch the Leafs on Hockey Night in Canada every Saturday night, and now we have to give them our hard earned tax money? Let them eat cake I say.

MMC-2012-02-Employment-Table-CAD

Another weak month for the Canadian employment market. The unemployment rate went down, but only because 37,000 workers left the labour market.

Over 13,000 public sector jobs were lost in addition to 1,700 private sector positions. They were partially offset by just over 12,000 low quality self-employed jobs.

MMC-2012-02-Inflation-Table-CAD

Inflation ticked back up above the Bank of Canada’s 2% target range. No need to panic, however. Central Banks remain focused on Europe and its potentially deflationary fallout. There is little chance interest rates will be headed higher in the short term.

MMC-2012-02-ConsumerConfidence-Table-CAD 

MMC-2012-02-TheConsumer-Table-CAD

Higher consumer confidence does not seem to be translating into higher retail sales as December saw Canada experience its first decline in retail sales in five months. Lower auto and gasoline sales were cited as the main culprits.

This isn’t necessarily a bad thing as consumers need to start deleveraging.

MMC-2012-02-Housing-Table-CAD

The housing market is taking a breather from its torrid past of the last few years. This is a good thing, as household debt as a percent of income has risen to 153 percent from 110 percent only a few years ago.

Seventy percent of household debt is estimated to be mortgage related. We are not saying the housing market is correcting, it’s just not as robust as last year. If the employment market continues to soften, then a correction might be in the cards.

Strong machinery and equipment exports kept Canada’s trade surplus expanding in December. At almost $2.7-billion, the surplus hit its highest level since October 2008.

We are becoming more concerned with the Canadian economy. Job growth has slowed and the consumer needs to deleverage. The best news for the Canadian economy is the prospect of stronger growth in the U.S.

 
What did you think of February’s market activity? Let us know in the comments below!