FYI | Mar 26 2010
By Greg Peel
There is little doubt long term investor Warren Buffet is the closest thing one can get to a stock market deity in the US. Known as the “Oracle of Omaha”, Buffet's investment entity Berkshire Hathaway has netted obscene compound returns since its listing and made many a loyal investor very well off.
But one man does not an economy make. If we consider the European Union not as a single bloc but as a group of disparate economies, the US economy remains to this day by far the largest in the world. China's is rapidly growing and by now has probably secured second place (if we accept Europe as separate entities), but there is still a huge amount of daylight from first to second.
So if you had to decide who was the safest credit risk, meaning who would you be the most comfortable lending money to, despite Buffet's track record you'd still have to say the US economy and the reserve currency must ultimately be a safer bet than one (aging) American's investment portfolio. Wouldn't you?
Apparently not.
This week Berkshire Hathaway, rated AA plus, issued debt at a yield 3.5 basis points below the equivalent US Treasury maturity, rated AAA. This implies investors see Buffet as a better bet than the entire US economy. Why? Because Buffet does not operate on a mind-boggling, never-to-be-repaid gearing ratio.
History was made in US bond markets this week when the ten-year swap spread flipped over into the positive for the first time. The simple implication here, of a more complex relationship, is that investors are more keen to buy US corporate debt than US government debt. Credit spreads on US corporate debt issues have contracted back to post-GFC levels which make them attractive investments compared to low-yield government paper issued in an environment of a near-zero cash rate.
But there's more to it. Having been taken to the cleaners in 2007-08, US investors have learned a harsh but perhaps valuable lesson: stock markets do not go up forever. There is always risk. A balanced portfolio spread between equities, cash and fixed interest investment provides more risk diversification than a portfolio heavily weighted in equities.
This year's pathetic volumes on the NYSE are testament to this lesson learned. Wall Street may be “melting up”, as the latest buzz-word suggests, but not with the conviction of the wider investment community. In the meantime, “cash on the sidelines” remains at elevated levels and investors are pouring into corporate fixed interest bond issues like never before.
Previously they were pouring into Treasury bills and bonds as an investment safe haven while the troubles still raged. Gold was also sought, and still is, but gold pays no interest. So panicked were US investors that they even sent the implied yield on the one-month Treasury bill into the negative.
But that is now changing. National Australia Bank interest rate strategist Peter Jolly suggests that perhaps the now positive swap spread can be attributed to investors buying US corporate paper and then hedging with Treasury paper, but realistically the spread is more a pointer to sliding confidence in the US government with respect to the budget deficit.
Jolly believes the US will lose its AAA sovereign credit rating if not this year, then next. One would assume that if it did, the UK would have been downgraded earlier.
Jolly notes the credit ratings agencies have now become more proactive than reactive about credit warnings and downgrades, evidenced not only by downgrades of debt-ridden European economies, but also by bold warnings to the UK and, in particular, the US.
One might be tempted to ask here: aren't credit ratings scales (such as AAA, AA and on to BBB etc) simply relative? If the world's biggest economy falls below the top rate of AAA, wouldn't everyone else then simply shuffle down? But no – Jolly sees Australia, for example, having no trouble keeping its AAA rating even in the face of a US downgrade.
Despite the current large spread between the US ten-year and Australian ten-year bond yields (which owes itself mostly to a zero cash rate versus a 4% cash rate), Jolly's econometric modeling suggests the spread is currently “about right”. But were the US to lose its AAA rating, and the Fed forced to raise its cash rate, even if the RBA keeps raising, the relationship makes Australian bonds good value at this time.
If Buffet is the local stock market deity, then his bond market equivalent is Pimco's Bill Gross. Gross's compound returns from his bond funds rival Buffet's in terms of market outperformance over time.
US-based broker BTIG noted this week that Gross has coined a new phrase, being the “Unicredit Bond Market”. Gross explains this as “if core sovereigns such as the US, Germany, UK and Japan absorb more and more credit risk, the credit spreads and yields of those sovereigns should look more and more like the markets they guarantee”.
What Gross is suggesting is that once upon a time, governments ran sovereign risk by balancing fiscal inputs (taxes and other receipts) with spending outputs (on hospitals, schools, roads etc and, of course, defence) and if the latter exceeded the former they would borrow money from the market. In the meantime, private companies generated their own risk by operating in risky capital enterprise. Whoever lent money to companies assumed that risk.
Then the GFC hit. Governments across the globe, and particularly in the US, had two choices in response: (1) let the free market capitalist world collapse under its burden of debt, or (2) assume responsibility for that debt by using printed money. They chose the latter. So what Gross is saying is that now that public hands are carrying private debt, that public entity must now assume the credit risk of the private debt. Ergo, “unicredit”. There should no longer be a spread between US government and corporate debt yields.
And now there isn't.
While Gross has not directly spelled it out, BTIG suggests the world's most famous bond trader is now bearish bonds, and Treasury bonds in particular. “Rates face a future bear market,” said Gross this week, “as central banks eventually normalise quantitative easing policies and 0% yields if global reflation is successful”.
In other words, if the money-printing exercise works, and the printers are now withdrawn, you don't want to be holding sovereign debt.
In a surprise statement, Gross added that he expects stocks to outperform bonds in the next three months. This from a man who suggested stocks were on a “sugar high” in 2009.
BTIG is complicit in this view, but makes the caveat that size and strength are important. The BTIG analysts interpret Gross's comments as one of an increased belief in recovery. “For over a year,” they note, “we have argued that Large-Cap Corporate America was the healthiest and most liquid area of the economy, superior to the Government or Consumers”.
BTIG is speaking only with a US view, but the analysts' thoughts have oft been echoed more universally by analysts and traders outside the US ever since the stock market recovery began. Buy the big-caps, they say. Buy the safe, longstanding, proven names.
The implication is that Big Companies (and particularly those which did not need to be “saved”) are emerging as a safer bet than Big Governments.
Omigod – I just had a flashback to Rollerball.
