Download Fixed Income Markets Face QE2 and Midterm Elections

November, 2010
Investment process:
Global Macroeconomic / Fundamental
Total firm assets: $4.6 Billion
Fixed Income Markets Face QE2 and Midterm Elections
John Chalker, Co-Founder & Managing Director
Fixed income market participants attempted to position themselves for the mid term elections and the
announcement of a second round of quantitative easing (QE2) by the Fed in early November. Domestic
fixed income market sectors have posted volatile and uncorrelated returns since mid year as news events
related to mortgage backed securities, the foreclosure process and QE2 negatively impacted each fixed
income market sector. QE2 was viewed to have both positive and negative impacts on the fixed income
market and these had to be integrated with the expected mid term election results and the soft economic
data. Specifically, QE2 is viewed positively for all domestic sectors except longer maturity Treasuries. This
reflects both the target area of expected Fed purchases and the fears of inflation brought about by QE2.
Additionally, the Fed strategy should have a negative impact on the value of the US Dollar versus other key
currencies, and this may bring about a negative impact from foreign purchasers of US Treasury securities.
Our domestic strategy accounts performed very well in this confused environment due to a slightly long
portfolio duration position, coupled with an underweight in the Treasury and MBS sectors. There have been
no major changes to the portfolio since mid year, although extreme short and long maturity Treasury
positions were swapped to the belly of the curve, resulting in slightly shorter portfolio duration. The
underweight position in the Treasury sector and the overweight to the corporate sector continue to contribute
positively to portfolio performance.
performance
Outlook and Strategy
We continue to believe that the economic fundamentals are very sluggish and that high GDP growth rates,
i.e., three percent or better, are not sustainable. Inflation appears well contained and the threat of deflation
appears reduced
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d due
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th expected
t d impact
i
t from
f
QE2 We
QE2.
W expectt that
th t another
th round
d off quantitative
tit ti easing
i
by the Fed will be a positive for the fixed income markets. In our minds, the key question centers on what
future action will be taken by the newly elected Congress, with a strong Republican and Tea Party majority,
regarding the size of the federal budget deficit and federal debt. Political decisions on these issues, and tax
policy, will no doubt have significant impact on the fixed income markets in the year ahead. Our scenario
calls for a continued period of slow economic growth with no inflation. Therefore, we are employing a
strategy that will maintain portfolio duration slightly beyond the benchmark index, as supported by our Trend
Identification Score.
401 B Street, Suite 950
♦
San Diego, CA 92101
♦
619.814.1401
♦
www.lmcapital.com
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November, 2010
Investment process:
Global Macroeconomic / Fundamental
Total firm assets: $4.6 Billion
Emerging Markets Economic Commentary
Luis Maizel, Co-Founder and Senior Managing Director
The third quarter was positive for EMD as more money flowed into funds seeking higher returns in an
environment of very low yields.
The past 14 months have seen net additions to the category and have pushed prices to levels not seen in
almost a decade. Eliminating issues from countries with non financial issues like Venezuela and Ecuador,
the spread has narrowed to record levels and returns are now very similar to comparably-rated US
corporations. Mexico issued a 100 year bond with a coupon of 6 1/8% and it was oversubscribed 2.3 to 1. In
the aftermarket the paper traded at yields of 5.80%; unheard of for an emerging market for such a long
maturity.
Brazil, the darling of the emerging markets, had an election where a former guerrilla became president, but
nothing can derail that train as it continues to soar. We are seeing more and more long local currency issues
at rates below 10%, something we hadn’t seen in a long time. Even an increase in the taxes on foreign
investment has not cooled the appetite for new Brazilian paper.
Europe is still in a monetary and social crisis and although Ireland is not an emerging country,
country its problems
are impacting the paper of other countries in the region like most former socialist governments who are
emerging economies. Issuance is way down and prices have started to drift downwards as investors don’t
like uncertainty.
China is trying
y g to p
put the brakes on its economyy and is limiting
g foreign
g investment in real estate, shortlyy after
raising rates for the first time in 3 years. The one thing they refuse to do no matter how much pressure the
US puts on them, is revalue the Yuan as it would somewhat curtail exports and make the creation of jobs
more difficult; a social cost the Chinese government cannot afford.
There is no doubt in my mind that the EMD will keep on growing as an asset class, but the low hanging fruit
has been picked and a lot more work will be needed to get the positive results everybody expects from this
investment.
401 B Street, Suite 950
♦
San Diego, CA 92101
♦
619.814.1401
♦
www.lmcapital.com
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November, 2010
Investment process:
Global Macroeconomic / Fundamental
Total firm assets: $4.6 Billion
Another Day, Another Dollar
Todd Crescenzo, CFA, Vice President - Research
During the third quarter of 2010 we increased our Non-Dollar exposure in LM Capital Group’s Core Plus
strategy on the basis that the Federal Reserve would continue to maintain the size of its balance sheet even
as its mortgage backed securities holdings rolled off. Halfway through the quarter it became increasingly
apparent the US economy had further slowed and additional monetary easing was probably warranted via
another round of asset purchases. What was unclear was how aggressive the Federal Reserve would be in
purchasing Treasury bonds and what additional implications it would have for the US Dollar. Since quarter
end, QE2 is a thing of the past and we now know the Federal Reserve will be buying an additional $600
billion in US Treasury securities through June 30, 2011 along with the ~$35 billion per month in mortgage
backed securities roll off.
Here are our observations:
ƒ The Federal Reserve’s balance sheet will expand to something close to $3 trillion from its current $2 trillion
level once QE2 is over and done with.
ƒ Since QE1,
QE1 the trade weighted dollar basket has weakened by almost 10% (see chart below).
below)
ƒ The Federal Reserve wants me, you and everyone else to short dollars or more precisely exchange those
dollars for something else. If you don’t have dollars in your pocket or corporate coffer you can get even
shorter US Dollars by borrowing (the essence of the carry trade, short dollars for future delivery).
ƒ Of course in exchange for those dollars you exchanged (sold), the Federal Reserve wants you to go out
and buy something (consumption). For corporate America, the Federal Reserve wants you to go out and
invest in something
g ((capital
p
expenditures).
p
)
1.95
1.02
Monetary Base versus Trade Weighted Dollar
(Index Levels, 3/11/2009 = 1)
1.80
Federal Reserve Balance Sheet, Lhs
1.00
Trade Weighted Dollar Index, Rhs
1.65
1.50
0.98
1.35
QE 2 Start & Projected Fed B/S Levels
1.20
1.05
0.90
0.96
QE 1 Start
0.94
0.75
0.92
0.60
0.90
0.45
QE 2 Start & Projected USD Depreciation
0.30
0.88
0.15
0.00
0.86
Mar‐09
Jun‐09
Sep‐09
Dec‐09
Mar‐10
Source: Federal Reserve & LM Capital Group LLC
401 B Street, Suite 950
♦
San Diego, CA 92101
Jun‐10
♦
Sep‐10
Dec‐10
619.814.1401
Mar‐11
♦
Jun‐11
www.lmcapital.com
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November, 2010
Investment process:
Global Macroeconomic / Fundamental
Total firm assets: $4.6 Billion
Another Day, Another Dollar (cont’d)
Investment Implications:
• The Federal Reserve’s balance sheet is not the only indicator we look at when we move in to Non-Dollar
denominated bonds, but given the Fed’s recent action coupled with the strong balance of payment
situation of several countries around the globe, there continues to be a place for Non-Dollar exposure in
our Core Plus portfolios.
• During the next eight months with QE2 in play we expect the trade weighted dollar to depreciate by
another 3% or so. As a result, we will look to opportunistically add to our Non-Dollar positions. We favor
countries that meet the following three criteria: fundamentally sound balance of payments, attractive real
yields and strong commodity based economies.
• Generally speaking it is unclear how much QE2 will boost the US economy. We know the Federal
Reserve’s intent – increase consumption and investment so that job creation occurs; however,
consumers and corporations remain extremely risk averse as economic uncertainty weighs heavily on
their minds so the follow through is unclear. What is clear is another day, another dollar – there will be
more dollars floating around the globe looking for attractive return on investment.
This commentary is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and
opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on
current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted
as, recommendations to purchase or sell such securities. There is no guarantee that these investment strategies will work under all market conditions, and each investor should
evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
401 B Street, Suite 950
♦
San Diego, CA 92101
♦
619.814.1401
♦
www.lmcapital.com
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