Investing in a Grave New World

We know (or at least are pretty sure) that the US economy is near the end of a long-lived period of consumption-fueled growth.

Since the end of the 1990-91 recession, US housing prices have generally been moving higher. That trend has helped to fuel economic activity, as huge numbers of consumers tapped the equity in their homes to go on an extended spending spree. Over the past several years, low adjustable-rate, no-interest and no-money-down mortgages have lured many to purchase homes that, in a more typical (i.e., higher) interest-rate environment, they could not have afforded. The housing industry has boomed supplying their demand, and in turn has triggered similar booms in related sectors.

The impact of low interest rates has also been felt on the corporate side of the street. The junk bond market has thrived through much of this period, as companies – including those with less-than-pristine balance sheets – borrowed money for (nearly) nothing at a pace not seen in many years.

However, the housing market now appears to be cooling, while interest rates, under pressure by factors ranging from the Fed to volatile commodity prices, are heating up. If, as we expect, these trends continue, both consumer spending and economic growth are likely to slow.

US banks have already begun to tighten lending requirements; we suspect they have only just begun. As for the Fed, while it may be ready, or nearly so, to end its long string of discount rate hikes, it has raised its benchmark 16 times since June 2004 and could well impose another quarter-point increase this month.

Moreover, the central bank has, not infrequently, overshot its mark. We think it might have done so again, particularly given the likelihood of inflationary pressure from tightening in the labor market and further increases in oil, gas and other commodity prices driven not just by demand, but also by speculation. In addition, we think that rising concern over inflation may prompt more rate rises even as the economy slows.

What Happens Next?

The bill for that “free lunch” comes due – perhaps as early as the end of this year or the beginning of next.

As inflation and interest rates rise, we expect a significant number of credit defaults and bankruptcies. Individuals with ARMs may be stuck with mortgages they cannot pay; buyers who tapped into their homes for equity may find themselves tapped out. The combination of higher energy prices, higher mortgage payments and overextended homeowners could put a serious crimp in consumer spending. Expansion in the corporate sector hardly appears robust enough to offset that slowdown.

Indeed, many of the mass of junk bond issuers may not have the strength to withstand higher rates and a weaker consumer, leading to – among other potential outcomes – a series of corporate bankruptcies.

Given the magnitude of the issuance of credit default swaps, structured notes and CDOs, these defaults could ripple through financial markets as well as institutional and personal investment portfolios in surprising ways.

We have similar concerns on the international front.

For example, despite the recent success of the Bank of China's $9.7 billion IPO, the potential for rising bad debts looms as loan growth continues. In early May, Ernst & Young published a report estimating China's total liabilities for non-performing loans at as much as $900 billion – outstripping the country's massive foreign exchange reserves.

In our view, moreover, BOC’s success is not likely to trickle down to those who invested in it. Instead, the bank’s oversubscribed offering is more a reflection of a credulous world avid for yield than it is of “high-growth emerging markets.”

Going forward, BOC’s primary claim to success is likely to be as a leading producer of non-performing loans. On this issue, we can do no better than to quote Jim Grant in the June 2 issue of his Interest Rate Observer:

The prospectus is a catalog of misgovernance, theft, reckless lending, lack of controls and other such trifling flaws in the Bank of China business model.

Rather than catalog further examples, suffice it to say, we don’t see risk being priced appropriately in this or other emerging markets.

In summary, we think that:

• The US as a place to invest is deteriorating.
• The economies of Japan and, to a lesser extent, some other Asian and European countries are expanding.
• These portfolio shifts are affecting the exchange rate, which in turn prompts a move into non-US assets.
• Some foreign-denominated assets will do well.

What Are We Doing About It?

We are assuming a defensive stance to correspond to our expectations for the markets. We have made tactical changes around our core portfolio strategies, enabling us to position our client portfolios to deal with looming challenges.

More specifically:

• We believe that, in light of recent spikes of volatility, a high degree of risk exists in both domestic and international small-cap equities. From a risk/return perspective, these investments do not look very attractive.

Thus, we are substantially reducing the proportion of domestic small caps and eliminating international small caps from our current equity mix, while moving into “blue chip” large-cap and high-quality mid-cap stocks, both of which tend to be less sensitive to interest-rate changes than small caps.

• We are employing both passive and active managers. However, to take advantage of inefficiencies that exist in the mid-cap market, we will overweight toward the latter.
• We are further hedging against inflation risk by integrating investments in energy infrastructure and Treasury Inflation-Protected Securities (TIPS) into our commodities allocation, while maintaining the current overall allocation to real assets.
• We are shifting our fixed-income focus to high-quality short- and intermediate-term government, agency and municipal bonds, while moving out of the corporate sector until such time as we believe the anticipated returns are reasonable relative to the risks incurred. While credit spreads are still tight by historical standards, we expect them to begin widening soon. As they do, we will continue to assess the market.
• We are investing in control-oriented “distressed” plays: Investing in proven managers that can restructure companies that have declared bankruptcy. We believe that, at this juncture, significant upside potential exists for distressed investors. We favor an active approach to this market niche rather than a passive one, e.g., buying junk bonds for 20 cents on the dollar and hoping they’ll recover to 30 cents.
• We are negative on the value of the dollar relative to the euro and the yen. Unlike many who believe the dollar’s decline is a function of the current account deficit, we believe that the main driver of the dollar’s value is no longer a demand/supply exchange-rate argument, but rather portfolio shifts among assets denominated in different currencies. As a consequence, we are selectively investing in foreign-denominated assets.

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This economic update is based on information, assumptions and market conditions believed by Contango Capital Advisors to be accurate as of the time this was prepared. It is offered for informational purposes only, and should not be construed as investment or financial advice. Please consult an investment professional concerning your own needs and circumstances and to obtain any specific advice with respect to the topics discussed above.

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