Sunday, June 28, 2015

Do Minor Price Changes Lead to Major Moves?

The Risk that Greece Will Not Leave the Euro

While much of the world worried about “Grexit” and its impact on the world’s economies and markets, much larger risks loom if the central banks continue to ignore the fundamentals, allowing governments in stress to thumb their noses at the laws of supply and demand and other realities faced by the rest of the world. My historical reaction is that if Greece remains in the Eurozone, it may mean the “Fall of France” eventually out of the Euro along with a couple of others that consistently run large deficits that threaten the value of the central currency. One could envision with France and possibly others out of the Euro, it will look like the old Hanseatic League. Led by German Baltic ports and allied with England, the Hanseatic League dominated free trade in northern Europe for the years between the late Middle Ages and the 1700’s.

Factors Behind Declining Interest Rates

Interest rates being quoted on US Money Market Deposit Accounts (MMDA) declined to a low of 0.31% and a weekend rate of 0.34% vs. 0.36% a week ago. Could this be that a number of banks don’t want to show “excess” deposits on June 30th reports? Perhaps these rates are dropping  because some banks do not want to have too much in the way of excess deposits as they might be of interest to an unwanted acquirer. Or is there a recent drop-off in the demand for short-term loans, as the average short/intermediate US Government & Treasury mutual fund dropped ‑0.14% for the week when the average general domestic taxable fixed income fund was flat on the week? The only major fixed income fund category to gain was the High Yield funds +0.11%.

Equity Funds Show Divergent Trends

The only domestic funds that showed gains in the week ending June 25th were Financial Services +0.09% and Health/Biotech +0.07% among the majors, plus Dedicated Short Bias funds +1.41% and Alternative Equity Market Neutral funds +0.14%. All the other domestic equity funds showed declines as somewhat predicted by the continued net redemptions of domestic equity funds. In contrast, every global and international fund posted gains for the week led by the average Indian fund rising in US dollar terms +2.36%.  In spite of the attention to the Greek stand off, international markets in local currency terms showed gains for the week of +3.9% for the Nikkei 225 and +3.36% for the Xetra DAX.  

While this was happening the internal Chinese market was crashing and had entered at least a correction (­­‑10%) or a bear market after a one year bull market gain in excess of +100%. Morgan Stanley is publicly telling its clients not to buy into this particular dip. Early Monday morning prices are down in Asia reacting perhaps to Greece. But more likely it is the need of the Chinese authorities to liberalize bank reserves and lower interest rates to stop the slide in their stock market. Some have even suggested restricting buying on margin. As a reaction to these moves on Sunday night in the US, the DJIA futures are being quoted off some 260 points.    

To some degree what didn’t happen was the most interesting occurrence of the week. Friday was the day when the annual reconstruction of the Russell indices took place with the DJIA going up marginally, the broader S&P 500 and the NASDAQ declining marginally.

Apparent Conservative Funds may be Risky

For the last seven weeks the oldest form of mutual fund,  the Balanced fund has seen net additions, with $1.6 Billion net coming in for the week alone. Is this just a sign of confusion as to direction or conservatism? Possibly the rise is due to 401k and similar defined contribution plans for employees being treated as mixed asset funds (bonds and stocks) which are somewhat more modern Balanced funds. If that is the case I hope that fiduciaries supervising these accounts have sufficient memory and education to recognize the risks of underperformance of mixed asset portfolios in sharply rising and falling markets. The Investment Company Institute, the fund business’s trade association, indicated that there were $741 Billion in retirement target date funds and another $400 Billion in somewhat similar “lifestyle” funds at the end of the first quarter. Under the correct personal conditions and understandings these vehicles might prove to be satisfactory; for others they may in the future prove to be problematic as these funds will own fixed income securities which may not perform well (as discussed below).

Fixed Income Risks

John Authers of the Financial Times had a very thought provoking column on Thursday exploring the “Bondification” movement to address the fundamental concerns that have led bond fund managements to under-perform. Most bond investors start with the assumption of a “risk free” interest rate based on local country Treasury yields. The problem is that with various bouts of qualitative easing as managed by many central banks, these interest rates have proven to be quite volatile. In my opinion, the restructuring of bond markets in a period of diminished capital on trading desks makes bonds anything but stable. The bond professionals have responded by developing a culture of unconstrained fixed income portfolios that allow managers ultimate flexibility in terms of maturity, credit quality and inclusions of derivatives and in some cases commodities. While this flexibility can, if well executed, produce good relative results, they bring into question how bonds should be used to provide some risk-dampening to a mixed asset portfolio. I hope the owners of target date funds and lifestyle funds understand these changes from past performance records.

Liquidity Concerns

Exchange Traded Funds (ETFs) have become an important institutional trading device; the US Securities & Exchange Commission (SEC) is showing concerns as to the use of derivatives both within ETFs and their marketing partners. For the most part institutions and individuals buy and sell ETFs through market makers called Authorized Participants (APs). When a buyer or seller of an ETF operates through the limited number of APs, they are utilizing the liquidity of the AP for each ETF. Some of this liquidity is in the form of derivatives. The SEC and other analysts would like to understand the size and nature of the liquidity that exists for specific ETFs. My particular concern is primarily based on sector and some single country vehicles. We will see whether the SEC will get the details on a timely basis and make them publicly available.

The use of public disclosure of how various funds manage their portfolios can add some reassurance. For example, the National Economic Research Association (NERA) has published a white paper examining if a fund broke any of the constraints being applied to Money Market funds. Among their findings was a theoretical conclusion that at worst there may be a temporary 1-3% break from the dollar NAV with most of that happening in the first two days followed by a recovery likely by the end of the first ten days. I hope that they are correct as I have regularly used Money Market funds to hold required firm capital.

Outliving Retirement Capital

Many people are  living longer. As a group, they have not changed their spending and savings habits. Also, governments have not fully recognized these implications. Both the workplace and retail distributors are behind in adjusting to this reality.

GDP for the first quarter in the US was revised to a decline of only 0.2% from 0.7% as originally reported. As previously pointed out in these posts the change was not a surprise. In this case the markets were a better forecaster than government agencies. The size of the adjustment is too large for those who steer our ship of state to put reliance on their own statistical collection approaches.

Question of the Week:  Based upon the week’s news, do you remain a Bull or a Bear?
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