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Volume 27, Issue 7
July 5, 2012
An Era of Economic Stagnation
By: Mark R. Shenkman
T
he beleaguered financial markets ended June with a relief
rally. The catalyst for the rally
was the apparent agreement that the 17
European nations may have snapped a
three-year stalemate to recapitalize
debt-laden banks and to bolster several
nearly insolvent governments.
After nineteen make-or-break summits,
beginning in 2009 when Greece ran out
of cash, the markets have been constantly rattled by headlines proclaiming
a slow response to the eurozone banking and sovereign debt crisis. With five
countries seeking a bailout (Greece,
Ireland, Portugal, and most recently
Spain and Cyprus), the European leaders threw a financial lifeline to the
banks to prevent a vicious downward
cycle where weak banks and governments were dragging each other down.
The apparent breakthrough reached in
Brussels on June 29th provides an added
backstop for banks, whose assets often
dwarf the economies of individual sovereigns, and offers financial support for
those sovereign governments. The deal
has the potential to break the debilitating link between the troubles of banks
and the solvency of governments. By
pooling resources and authority, it
represents an important step toward the
kind of political union needed to make
the euro area viable. The breakthrough
arrived when the eurozone leaders
agreed to drop the preferred status of
taxpayers over bondholders in Spanish
banks. This cleared the way for direct
bank funding using bailout funds, as
well as establishing a single bank supervisor.
In the end, Chancellor Angela Merkel
of Germany will be the decisive vote in
the survival of the eurozone. Germany
is constantly being pressured by other
European leaders to step up its effort to
salvage the euro currency. However,
Germany’s balance sheet may not be as
strong as perceived. Germany’s $3.57
trillion debt, stands at 83% of its GDP.
Germany’s recent intransigence appears
to be dissipating as polls show that 43%
of Germans would vote to keep the
Euro, while 41% would vote to return to
the Deutschmark. However, 64% of
German voters indicate their country’s
failure to tackle the euro crisis represents the greatest danger to a common
currency. Without a resolution of the
European debt crisis, the markets should
be subjected to continued fear and uncertainty.
Exhibit 1 highlights June, 2nd quarter
and year-to-date performance for various asset classes.
The U.S. economic engine is stalling
as the data remains decisively mixed.
Many economists had predicted the
consumer would drive the recovery,
but it appears that the consumer sector
is sputtering. In May, the Commerce
Department revised downward first
quarter spending growth from 2.9% to
2.5%. Meanwhile, adjusted for inflation, hourly wages are currently lower
than they were when the recession
ended in June 2009.
Another driver of the economy should
be small businesses, as they account
for approximately 64% of new hires.
However, the number of small business formations in America is down
23% from its peak in 2007 according
to the Brookings Institution.
An ominous sign for the economy is
that the ISM’s factory index fell to
49.7 in June from 53.5 in May. The
median forecast was 52. Readings below 50 indicate contraction.
Obviously, the Federal Reserve is
concerned about the
PERFORMANCE FOR KEY BENCHMARKS
As of June 30, 2012
vulnerability of the
U.S. economy as it
Jun-12
Q2
YTD
extended its Opera(1)
10-year U.S. Treasury
-0.60%
+5.81% +3.44%
tion Twist program
BofA Merrill Lynch U.S. Corp. Index(1)
+0.50%
+2.37% +4.87%
by $267 billion until
BofA Merrill Lynch U.S. HY Index(1) (H0A0) +2.03%
+1.83% +7.08% year-end.
This enS&P LSTA Loan Index (2)
+0.69%
+0.75% +4.54% tails selling shortBofA Merrill Lynch Convert(1) (V0A0)
+2.16%
-2.68%
+6.91% term securities and
the same
S&P 500 Index(2)
+4.12%
-2.75%
+9.48% buying
amount
of longer
(3)
Dow Jones Industrial Average
+4.05%
-1.84%
+6.83%
term
debt
in a bid to
Russell 2000(3)
+4.98%
-3.48%
+8.52%
reduce borrowing
NASDAQ(3)
+3.91%
-4.76% +13.32% costs and spur ecoMSCI Emerging Markets Index(3)
+3.89%
-8.79%
+3.97% nomic growth.
Exhibit 1
MSCI World Index(3)
Sources: (1) BofA Merrill Lynch (2) S&P LSTA
(3) Bloomberg
+5.18%
-4.85%
+6.30%
Governments cannot
prevent economic decline, but they
can affect its speed.
(Continued on back side)
CONTINUED
high yield market at this time.
After a gloomy May, the tone of the high
yield market turned decisively positive in
June. The average of the five major high
yield indices gained 2.03% during the
month, while second quarter performance
showed a return of +1.70%. On a year-todate basis, the same five indices posted a
return of +7.11%. In contrast, the S&P
500 showed a loss of 2.75% for the quarter, but a gain of 9.48% year-to-date.
In the bank loan market, the S&P LSTA
Leveraged Loan Index recorded a gain of
0.69% in June and +0.75% for the second
quarter. On a year-to-date basis, the index
advanced 4.54%.
During June, there were no high yield
bond defaults, and 16 for the year. June
default rates have remained tepid, at a
historically low level of 2.17%. As a result of this benign environment, investors
have again fallen into the trap of perceived safety amongst the riskiest assets.
Under this scenario, triple-C’s have been
the star performer of the market. Year-todate, high yield market performance has
been driven by the riskier triple C-rated
bonds. Returns by rating category were as
follows: double-B’s returned 6.57%; single-B’s added 6.42%; while triple-C’s
posted a spectacular +10.19% according
to the BofA Merrill Lynch US High Yield
Index. Clearly, despite the climate of
global uncertainty, investors sought the
higher yield of weaker credits.
Cash inflows into the high yield asset
class have been substantial this year, with
the expectation that new issue supply
would follow. Unfortunately, the volume
of new issuance has steadily declined as
the year progressed. In the first quarter,
there were 214 transactions, aggregating
$107.7 billion. Meanwhile, in the second
quarter, there were only 124 deals, totaling $54.3 billion. Despite the low cost of
funding and the need to extend maturities,
many CFOs have been reluctant to tap the
Another important phenomenon that
has plagued the high yield market this
year has been the dramatic slowdown
in M&A and LBO activity. According
to Dealogic, buyouts involving U.S.
companies aggregated only $376 billion for the first six months of 2012,
the lowest first half since 2003.
The U.S. economy has entered a decelerating mode, primarily due to the uncertainty and trepidation about the direction of America. Presently, the U.S.
is ideologically polarized. Since neither party has a clear mandate about
the size and role of government as it
affects businesses or individuals, the
political gridlock has paralyzed policies on taxes, spending, deficits, regulations, and now healthcare. Even such
guardians of America’s great traditions
and heritage as the Supreme Court and
the Federal Reserve have been politicized in recent times.
The U.S. has encountered 11 recessions since World War II. The average
growth rate for the three years following these recessions was 4.3%, while
the current recovery has experienced a
disastrously anemic 2.4%. As a result,
America may be entering a prolonged
era of stagnation as the nation undergoes a transformation from an entrepreneurial and risk-taking society to a
centralized, entitlement-oriented society. During this epic battle for the
“heart and soul” of America’s future,
economic activity may be subdued by
mounting debts, shifting demographics, and diminished expectations.
Although America’s economic leadership may be challenged during the next
decade, investors continue to flock to
the safe haven of American investments. Amazingly, 43% of U.S. Treasuries are held by foreign investors. As
the political and economic risks en-
SHENKMAN CAPITAL MANAGEMENT, INC.
461 FIFTH AVENUE, 22ND FLOOR
NEW YORK, NEW YORK 10017
(212) 867-9090
262 HARBOR DRIVE, 4TH FLOOR
STAMFORD, CONNECTICUT 06902
(203) 348-3500
gulfed the world, more investors
poured capital into the U.S. for dollar
exposure, a play on our recovery and
the stability of our financial system.
While the markets experienced a relief
rally at the end of June, several risks
cannot be overlooked. First, many
companies may report disappointing
second quarter earning results. Second,
the slowdown in the Chinese economy
could reduce the rate of global growth.
Third, business confidence has been
shaken; therefore, increased capex to
bolster job creation appears unlikely.
Finally, the resolution of the fiscal cliff
in early 2013 could undermine and
hamper GDP growth for several years.
The U.S. economy could be wrestling
with a recession in 2013 based on a
new monthly leading economic indicator called Chemicals Activity Barometer (CAB). Entering a recession, the
CAB leads business cycle troughs by a
median of 8 months. Since 1947, there
is a 0.90 positive correlation with industrial production. Importantly, the
June CAB of 88.0 was down 2.5%
from a peak of 90.3 in March. Any
decline of 3% or more has predicted 10
of the last 11 recessions.
In light of this cautious backdrop, the
technical underpinnings of the high
yield market appear sound. The quest
for higher income remains insatiable. If
the Federal Reserve maintains its ultra
low interest rate policy until late 2014,
the global demand for greater income
should be voluminous. At the same
time, new issue supply (not just refinancings) has been sporadic and
somewhat disappointing. With spreads
relatively wide on a historical basis and
default rates de-minimis, the high yield
market offers attractive opportunities
for capital preservation and income.
Many investors hope for a modest recovery, but perhaps they should plan
for an era of economic stagnation!
SHENKMAN CAPITAL MANAGEMENT LTD
7 CLIFFORD STREET
LONDON UK W1S 2FT
+44 (0) 20 3371 8234
www.shenkmancapital.com ~ Copyright © 2012 Shenkman Capital Management, Inc. ~ All rights reserved.
This letter is for informational purposes only. While the data and statistics
-2- contained in this letter are based on sources believed to be reliable,
Shenkman Capital Management, Inc. does not represent that-2they are accurate or complete and should not be relied upon as such.