The Great May Swoon

Bond Anamolies

At Pauley Financial, we believe clients’ portfolios should be customized to match one’s risk tolerance as closely as possible, and should take into account one’s years until retirement. Introducing bond exposure to portfolios usually not only can help reduce risk, but also can diversify one’s exposure geographically. As a firm that is rooted in military service, we believe our role is to ensure our clients are disciplined about maintaining their target exposures to U.S. and international markets in the face of material market movements, and in spite of how distorted and inconsistent the media is about covering these movements.

As an example, after reading so many headlines, you might guess that Greece (161%) is in the deepest debt hole, or perhaps the United States (103%). According to International Monetary Fund statistics, what country has the highest government debt levels, compared with its economic output, in the world?

You might be inclined to guess troubled or developing nations like the African nation of Eritrea (134% of its 2011 GDP), Lebanon (136%), or Jamaica (139%)--or, if you were aware that it existed, the sovereign nation of Saint Kitts and Nevis (153%), a former British colony is located in the beautiful Caribbean Leeward Islands north of Venezuela.

As it happens, none of these countries is even close to the runaway leader in government debt as a percentage of its economic output: Japan, which is paying interest on bonds whose face value equals more than 229% of Japan's GDP.

Perhaps the most interesting thing about this bit of trivia is that bond traders don't seem to be worried about Japan's ability or willingness to pay back its creditors. As you've probably seen from the headlines, when investors are worried about a country's soaring debt levels, they will often demand higher rates--so the rate that a country pays is a pretty good proxy for how concerned (or not) investors are about the country's solvency. With that in mind, look at the little table below, which shows the debt to GDP levels of various countries next to their 10-year bond rates. Think of it as a comparison between how much global bond investors SHOULD be alarmed vs. how alarmed they actually are.

Comparing the right-hand column with the one in the middle, you see some head-scratching anomalies. Greece, which has the second-highest debt-to-GDP level in the world, pays by far the world's highest interest rates on its debt, which seems appropriate. But Italy, which is not far behind on the debt list, is paying interest rates somewhere near the middle of the pack, and the U.S. and Singapore, which have significant debt levels compared with the rest of the world, are paying almost nothing for the privilege of borrowing from global investors. Meanwhile, relatively thrifty countries like Colombia, Peru and Indonesia are paying much higher yields than debt-burdened Belgium, France and Singapore.

By far the biggest outlier on the table, however, is Japan, with debt-to-GDP levels more than twice as high as the U.S., paying rates lower than anybody on the table but Switzerland. How can that be? Because more than 90% (some estimates say more than 95%) of Japan's government bonds are owned by Japanese citizens, compared with an estimated 57% in Italy, and 54% in the U.S. In other words, the global bond markets cannot demand higher interest rates on yen-denominated government bonds because they don't own Japanese debt; global investors are looking for more return on their money than Japan is currently offering.

The Great May Swoon - Unemployment and the Eurozone

As we often discuss with our clients, we do not believe it is feasible to consistently forecast events such as the direction of the U.S. job market or how/when the Eurozone resolution might come to pass. While we may have views on these current events, we recognize fully that they are inherently unpredictable. Our years of experience yields confidence in our disciplined, strategic asset allocation investment approach. This strategy allows the "rational" brain not to be overcome by the "emotional" brain in our very dramatic, media-frenzied world. There will always be some news to fret about; yet, with a multi-portfolio approach designed to protect your short-term and medium-term needs, you can free yourself of the stock-ticker watch post - time recaptured and better utilized to develop yourself, your education, your family or your community (might just be the best investment you ever made!).

Below, please find a different perspective on recent events - one that you might not read about in the popular press:

By just about any measure, May was an awful month for investment performance, which is another way of saying that the past month has made stock indices 5% to 10% more affordable than they were in April.

The stock market is fundamentally a gauge of optimism or pessimism for investors. If we think the future is bright, as most shareholders apparently believed until the end of April, there is more demand for more shares and prices go up. So we have to ask: why did sentiment turn around so dramatically; and, does the herd of investors know something important about the future?

The headlines have suggested two reasons for gloom. The first is jobs. The latest employment report from the Labor Department shows the first increase in U.S. unemployment in 11 months, as the jobless rate ticked up from 8.1% to 8.2%. In the simplest possible terms, these numbers are interpreted as meaning that companies aren't hiring new workers as quickly as new workers are coming on the market. However, buried in the Labor Department report is a statistic on "labor force participation" that shows that more than 600,000 people got off their couches and rejoined the work force in May, along with the influx of newly-minted college graduates. Somebody, somewhere, is feeling more optimistic about the jobs picture.

The report also said that the overall economy had added just 69,000 new jobs. However, a survey from the payrolls processing company Automatic Data Processing (ADP) showed that the American private sector added 133,000 new jobs in May, meaning that much of the job loss was in government and public sector payrolls.

Is this true? If you look at the chart below, the trend is very different from what you are likely hearing in the news reports. The red line, which is trending depressingly downward after a brief stimulus-related spike in 2010, is federal government employment, which corresponds with the numbers on the right-hand side. As you can see, Washington's payroll is declining dramatically, as the country works to restore its fiscal balance. Since the beginning of 2009, over half a million government jobs have been slashed or eliminated altogether.

The blue line looks a bit more hopeful. That represents the total number of private sector jobs in the U.S., corresponding with the numbers on the right-hand side. The Great Recession caused a dramatic freefall in total private employment that bottomed out around January of 2010. Since then, you can see a steady (and largely unreported) improvement in the jobs picture exactly where we would want it: in the private sector, in the for-profit companies that most of us invest in.

The other reason why investors have become allergic to stocks, according to the press, is the continuing fiscal problems in Europe. Overall Eurozone unemployment has reached 11%, and economists believe that a recession has either begun or is imminent. There are worries that Spain and Ireland could fall into the same economic precipice as Greece. Spain's 10-year bonds are now trading at a 6.7% yield, their highest level since November.

You can see, in the map below, a kind of "cheat-sheet" on where the sovereign debt problems are most acute. Purple countries are not in danger, the orange countries are facing worrisome conditions, and the bonds issued by countries painted in red are basically downgraded to junk bond status.



The recent selloff suggests that many investors are expecting widespread defaults in Europe that will spread (the word "contagion” is often used) to the U.S. banking system, and from there into the U.S. economy, not unlike the way the collapse of U.S. investment banks caused the Great Recession.

However, if you read the news reports closely, you see that the European governments have a solution at hand, which some are reluctant to put into place. The new French government has proposed that the European Central Bank be authorized to issue its own bonds. This would make Europe function more like the U.S. system, where the states (comparable to the individual European countries) issue bonds, and our government (comparable to the ECB) also has borrowing power to sell Treasuries. The money raised by those Eurobonds would be used to contain the crisis, and the interest rate to Eurobond investors would be dramatically lower than what the countries in orange and red are currently paying in the open markets.

Presto! The ECB would step in as their surrogate borrower, swap their high rates for its lower rates, and eliminate the threat of contagion. Of course, this would also expose the purple countries to the credit risks of the orange and red ones (this is why Germany is dragging its feet on the idea), but presumably any deal would come with guarantees about future fiscal discipline, and would remove the crushing borrowing costs from countries as they dig out of their debt. That, in turn, would allow these countries to begin re-growing their economies, which might reduce the size and extent of the expected Eurozone recession.

As always, we welcome your calls/emails if you have concerns about your specific situation.