April 2007

It's Delightful, It's Delovely, It's Deleverage!

Asset Inflation Nation...For any of you living the in SF Bay Area or familiar with NFL football in general, we're quite sure you've heard the term "Raider Nation" as it applies to the silver and black of the Oakland Raiders.  For those quite enamored with political satire at its finest, you are certainly more than familiar with the Colbert Nation.  But we suggest that probably the most important "nation" character description of the moment applies directly to the broad US economy itself, otherwise known as the Asset Inflation Nation!  Don't believe us, Nation?  Well, just have a little glimpse at the chart directly below.  As is described in the chart, we're looking at the annual increase in household real estate and equity holdings as a percentage of the annual change in household net worth.  Clearly, real estate and equity price inflation has driven two thirds of the increase in household net worth in the current decade.  The largest number we've seen in six decades at least.  Move over Steven Colbert.  Move over Raiders fans everywhere.  People, we are the Asset Inflation Nation!  And at this point, clearly in numbers too big to ignore.  
                

Without belaboring the point, this change in character of household net worth creation over the last three decades has indeed influenced household consumer behavior as is clearly depicted in the chart below.  Quite simplistically, have the drivers of household asset inflation beginning in the early 1980's influenced consumption patterns and the character of the US economy since that time?  If the following graphical view of life doesn't answer that question, then we just don't know what does. 
             

To be honest, we know asset inflation has been a huge macro force for some time.  So just why is this all of a sudden important now?  It's important because, as we all know, in very large part the character of continued household asset inflation over the last three decades has been accomplished by the macro theme of accelerated leveraging of household assets.  We're not going to go into some long discussion regarding household leverage.  You've seen it all before and we've discussed it far too many times.  The following chart really says it all and ties directly back into the breakout periods of the prior two charts shown.  In very large measure, all of these charts reflect baby boomer demographics.  So, as we look ahead, we can ask a few very simple questions.  We already know that the baby boom generation has been more than willing to lever up their personal balance sheets over the last quarter century without so much as batting an eye.  As is clear, since 1980, household leverage as a percentage of GDP has doubled, after remaining relatively constant in the prior quarter century.  Questions being, as this baby boom generation pushes ever closer to retirement years where income and liquidity will most certainly be two primary concerns, just how much more leverage requiring long term cash flow servicing will they be willing to accept?  How many more assets do they have left at the household level that are both appreciating in price and can be further levered?  At this point, for all intents and purposes, it's clear that the process of leveraging has had a profound influence on both household net worth growth as well as the character of the real consumer driven US economy.  
               

We're an asset inflation dependent nation that has been brought here on the horse called leverage.  And over the recent past, leveraging household real estate assets has been the ticket to continued net worth acceleration and GDP growth dependent household consumption patterns.  So far, its been delightful.  So far, its been delovely.  But up to now, let's face it, it has really been driven primarily by deleverage.  So as we look ahead, it's the character of the macro credit cycle that we believe is THE most important area to monitor.  If households balk at further levering their own balance sheets ahead, what happens to real estate prices?  What happens to consumption?  Although these sound cliché at this point, with the change now occurring in the US mortgage credit markets, we believe it's of central focus.  Willingness to lever has been a key aspect of the household asset inflation phenomenon for decades now, and the ripple effects of this phenomenon in terms of shaping and driving the broad US consumption based economy have been more than quite meaningful.  No arguments.  But the important corollary to this willingness has been the availability of credit at ever lower prices for really over two decades now.  We humbly suggest that anything acting to upset this symbiotic willingness and availability relationship changes the game.  And although it's more than obvious at the moment, a credit contraction in the land of widespread mortgage credit  availability would do the trick in about five seconds in terms of being a marker of important change.

Overextension of credit in the mortgage markets has now come home to roost.  Deterioration in sub prime is self obvious.  The spillover is already being seen on the edges of the Alt-A paper world.  And although so many talking heads have put forth the premise recently that the "worst is already behind us" or that "sub prime credit deterioration is contained", events in the mortgage credit markets as of late are EXACTLY how broad credit contractions begin.  They always begin at the margin.  Initial problems are always contained, until they spill into other areas, of course.  Moreover, in our current circumstances, what absolutely lies ahead are credit rating downgrades for CDO vehicles (collateralized debt obligation).  With so many sub prime blow ups and with surely more to come, the downgrades in CDO ratings may indeed come fast and furious in the months ahead.  We expect this to commence after 1Q period end.  Moody's already has a black eye for its recent ratings changes involving the large global banks.  Many investors have already commented that their credibility has been seriously wounded as of late.  To maintain some semblance of integrity, they are going to have to hustle to get ahead of the credit erosion in the CDO markets.  And, as you know, many an institutional investor is precluded from holding below investment grade paper.  So to suggest that the worst is already behind us in sub prime and other questionable mortgage credits is lunacy.

And during the current cycle, we believe the thought that the Fed will ride to the rescue is a good bit misplaced (although they will surely try).  Why?  Because in the current cycle, as we have explained in past discussions, so much credit creation has taken place outside of the banking system.  The Fed is no longer large and in charge when it comes to the total credit cycle, and especially mortgage credit in our current circumstances.  Private credit markets have absolutely no incentive whatsoever to "accommodate" or "provide liquidity" to ease the pain once a credit cycle turns dark.  And it is private credit markets that have largely funded mortgage credit creation for years now, not the Fed or the US banking system.  For a direct example of this characterization, just think back to how quickly funding was pulled from New Century Financial.  Does blink of an eye sum it up?  Asset Inflation Nation, you are on notice sir!

Its Delightful, Its Delovely, Its Deleverage!...We want to switch gears a bit.  As explained above in very simplified form, there is no question in our minds that leverage is the horse that brung us to the US household asset inflation party of the last quarter century.  The character of household leverage acceptance ahead is of critical importance to both real asset markets and the broad economy as a whole.  But what we suggest we also need to importantly keep in mind is that leverage has increasingly been a keynote of the acceleration in financial asset prices, especially during the current decade.  One of the important premises of hedge investing is the ability to use leverage.  The carry trade is about nothing but leverage.  The derivatives markets, as we have written about so many times, do nothing but support leverage.  And new age wrinkles such as CDO vehicles center directly on insuring against leverage gone bad.  Of course, many of these are themselves leveraged in the almighty attempt to generate ever greater rates of investment return.  You get the picture.  Much like the household sector dependent on leverage for household asset inflation, the financial asset markets have likewise become quite the animals dependent on the ever greater use of leverage in the investment process.

One of the clear results of so much leverage being employed in the financial asset markets of today is that on a global basis, so many markets and asset classes really trade as one directionally.  Our recent swoon in February and March certainly proves that out.  Where the US financial markets travel ahead is as much a function of the character of the global financial market as it is specific to the current attributes of the US markets.  And you know that the credit/liquidity cycle we have spoken of so many times is really global in nature.  Again, if we had to simplify and characterize the most important events of the last few months, it's the relatively abrupt and coincidental breaks in the global equity markets in addition to the simultaneous rapid deterioration in the sub prime corner of the US credit markets.  Both of which, again in our minds, go directly back to the central issue of leverage.  Without sounding too philosophical or conceptual, as we move forward we believe we need to watch for evidence of change in the character of leverage.  And this goes well beyond the US equity markets specifically.  After all, at least as we see it, directional change in leverage has been responsible for real world economic outcomes for years now.  Same really goes for financial market outcomes.  So as we move forward, we need to ask the question, is macro leverage accelerating or decelerating in both the real economy and the financial markets?  At any point in time, are we releveraging or deleveraging?  Simple enough?  Recent events simply force us to at least think about the process of deleveraging.  And that has implications for both the real economy and financial markets.  So here comes the big question, what do we watch if deleveraging is to take hold at some point?

First, the real world.  We all know at this point that the blow-ups in the world of sub prime mortgage credit will act to close off what has been an important avenue of credit creation in the US economy, clearly influencing real world outcomes for the economy as translated through the housing cycle.  We need to remember that funding this corner of the credit market world in years past has been the hedge fund community, institutional investors such as insurance companies, pension funds, the large investment banks, other assorted carry trade players, etc.  As the credit environment has turned so abruptly in sub prime, former sub prime lender after lender has been cut off from further "funding" in recent weeks.  This is credit contraction in action.  Unless the Fed is going to fund the sub prime lenders directly (although they've been pumping money at the NY Fed window recently), former sub prime loan funding benefactors aren't walking away from the game, they are running.  It's a process of contraction in credit availability that, as you know, has been quite absent from the markets and real economy in recent years.

But maybe more importantly, many in the fast money community are finding, and some to their surprise believe it or not, that they are exposed to sub prime problems via investments in CDO's, other structured products, etc.  As leveraged investors begin to feel pain in their portfolios, not only do they begin to question broader risk exposure in a much more meaningful manner, but many are both forced to and many choose to deleverage, at least for a period, to stop the short term hemorrhaging.  You know that macro growth of credit has been a one way street for many a moon.  So now we've hit our first important credit market speed bump that in our hearts we all knew was coming.  Important question number one.  If the problems in sub prime spread (which we believe they will), and/or investors begin to reprice risk vis-à-vis credit spreads in alternative credit market asset classes, will investors as a whole relever anew or begin a process of deleveraging (that we believe has just begun)?  In a world and global financial marketplace grown accustomed to ongoing acceleration in leverage that has been supporting asset prices, any change in the process of what has been ongoing acceleration in leverage is wildly important.  Remember, as we discuss this, we're referring to deleveraging in the investment process now, not homeowners, for instance, paying down debt.  This is all about the dynamics of structured/leveraged finance that has come to characterize the US, and in good part global, financial markets.  That's the issue.

Below is a quick look at the current credit spread between the 10 year UST and seasoned Moodys Baa yields.  The key watch point is cyclical reversion.
            

We all know that credit spreads in the land of sub prime and now Alt-A mortgage paper have widened meaningfully.  We've also seen like widening activity in recent weeks in high yield (the Merrill high yield index).  Not only is there clearly heightened attention and questioning of investment risk implicit in this action, but also surely the influence of deleveraging somewhere in the investment community.  Without sounding melodramatic here, we believe one of the key watch points and actual risks for the financial markets ahead is reversion to the mean in any number of credit market asset class credit spreads.  Remember, in many senses, the private credit markets are the ones to watch.  If spread widening continues in mortgage and high yield paper, and ultimately spreads more broadly in the fixed income markets, credit spread widening will beget acceleration in the process of deleveraging in what is the very highly levered hedge, prop desk, etc. community.  And this has direct implications for real world interest rates and the broader direction of financial asset prices.

Not only will it be important to monitor credit spreads in the weeks and months ahead, but we believe the potential process of accelerated deleveraging, if it is to come, will be directly observable in what have been some of the best asset class performers of the last few years at least.  Remember, investment leverage has not been employed to invest in GE stock, per se, but rather in emerging market debt, emerging equities, etc. as well as high yielding sub prime and junk debt paper.  The following is the chart of the Templeton Emerging Markets Income fund.  By no means are we trying to single out Templeton/Franklin as a fund provider.  This is just an example of a fund that invests in an asset class that has been the beneficiary of levered investing really globally.  Moreover, this is a theoretical indicator of emerging market debt freely available to most investors who do not have access to global credit market data as provided by a Bloomberg for instance.  As is clear, this is up 100% from late 2001, and this return does not account for any distributions from the fund along the way.  
         

It just so happens that this fund is invested in the heartland of assets clearly benefiting from leveraged global investing.  As of September first of last year (the latest available data), here are this fund's tops holdings:

You get the picture.

So our first watch point of importance in terms of the potential for macro investment deleveraging is credit spreads of all types and the direction of emerging market debt specifically.  Again, trying to keep it simple and focusing on the singularly large issues of the moment, the potential for the blow up in sub prime to mark a change in the global fixed income credit spread environment is very important as we move forward.  Widening spreads mean a much greater potential for broad based deleveraging by what really is the larger than ever leveraged investment community.  And any acceleration in the process of deleveraging by those exposed to these markets will act to reinforce this very process itself.  Where would it all end?  When the last hedge fund capitulated.  Of course in today's world, when there's blood in the water, you can bet your last dollar it will quickly attract sharks intended to further punish the already wounded.  Conceptually, the reinforcement of short term price trends in both directions has probably never been stronger.  Thank you "miracle" of leverage.

Second simple watch point item of the moment are what have been the global equity market beneficiaries of leveraged investment.  Pretty easy to watch.  We'll move through this very quickly.  The EEM - the iShare for the MSCI emerging markets index - is the poster child for emerging market equities in aggregate.  From the beginning of the US equity rally in early 2003, the EEM is up fourfold.  Have emerging market equities been the beneficiary of levered global investment?  C'mon, are you kidding us?  They have been ground zero.
        

From a very short term standpoint, watch the recent lows on the EEM.  If we break the low $100's to the downside, selling will accelerate.  We expect the EEM to be a very important tell ahead.  

When we really think about the long term, we're pretty darn convinced that the Asian community will play a very powerful role in both driving the global economic landscape as well as the global financial markets.  As we've said for years now, all investment decisions need to be made within the context of thinking globally.  Having said that, we also all know that over the short term, financial markets can be notoriously volatile beasts, regardless of long term fundamentals.  So although we're long term believers in the all too popular China/India/etc. stories, we need to remember that equity markets in these countries have been the direct beneficiary of meaningful investment popularity, especially over the past few years.  You'll remember that we've chronicled to you many a time in recent years that equity mutual fund inflows in the US have overwhelmingly been directed to foreign exposed funds.  Same deal goes for the levered institutional global investment community.  Again, no one is taking on investment leverage to buy the GE's of the world, but it's an entirely different story when it comes to China, India, Brazil, Russia, etc.

We never plunk down hard earned capital on speculations driven by charts that appear to rhyme in terms of historical versus current behavior, but the following says something about the potential downside for leveraged speculation.  As you know, the poster child of the moment for global equity speculation has to be the Shanghai index.  Below is simply a look at the Shangai index since the start of 2006 and the comparable NASDAQ of 1999 to March of 2000.  Okay, here's the deal.  From August of 1999 to March of 2000, the NASDAQ doubled, as you remember all too well.  As is also clear, we saw exactly the same pattern in the Shanghai index From August of last year to present.  There is absolutely no question in our minds that leverage played a role in the SSEC index doubling over this very short space of time.  Hence, we would sure as heck expect to see any effect of potential macro investment community deleveraging in the Shanghai index ahead.  A key tell?  One of many, but a clear poster child.  
           

Again, hopefully without sounding overly simplistic, we believe watching equity markets such as Russia, India, Brazil, and even a Mexico (as an example) will be very important in the weeks and months ahead.  If these very popular markets do not recover to their most recent highs and push ever northward, then it's a very good bet that the process of macro deleveraging in the levered global investment community to at least some degree or magnitude has begun and will continue for a period.  It is absolutely clear in the chart below that key turning points in these markets over the last few years have been completely coincidental.  They trade as one.  They are, for lack of a better characterization, the emerging markets equity trade, not individual country specific driven trades.

Notice that each of these markets had gains in excess of 50% from the lows during the summer of 2006 to their most recent peaks.  The minor exception was Brazil, which was not that far off the 50% up mark.  Of course the Shanghai Index makes these returns over the same period look conservative.  And this wasn't done at least in part with speculative levered money?  C'mon.  Levered hedge money is a heat seeking missile.  And these markets where throwing the heat.  Of course to be fair, downside breaks in animals such as these can be quite the religious conversion experience.
           

Again, in very simplistic characterization, we believe the impact of leverage is a key focal point for the here and now.  In our minds, the process of acceleration of leverage among the global investment community has been a huge positive for both real world economic outcomes as well as financial market outcomes in recent times.  So too will an ultimate, and even temporary, process of deleveraging be a big negative.  A very big negative.  We've never before lived in a global environment, let alone the US specifically, characterized by so much in play leverage, both in real economies and financial markets.  So although we won't be able to keep ourselves from watching the day to day market character of volume, moving averages, new highs and lows, put/call averages, etc., we suggest it is vitally important to both recognize and monitor the manifestations of leverage in the global investment community.  Leverage that has already turned against its practitioners and former benefactors in the land of US sub prime mortgage paper.  From a macro overview standpoint, we can't overemphasize how important it will be to keep an eye on fixed income credit spreads as well as emerging market debt and equities.  These have been the primary areas most heavily influenced by macro leveraged investment/speculation over the last three to four years.  So too should they be the areas to "tell" us change, in terms of potential deleveraging, has arrived.

One last comment for clarification.  When we speak of deleveraging, we're not talking about every hedge fund and their brother swearing off the use of leverage on a dime.  We're not talking about the derivatives markets being frozen in time.  Rather, we're talking about rate of change and the potential for some nominal cutting back on margin/leverage in the investment process.  It's clear to us that market participants of today are wildly complacent about, or simply do not understand, the potential for risk in structured finance vehicles and the layering of levered investment, especially in the hedge community.  The fact that a number of hedge funds were "surprised" to find they had sub prime exposure in their CDO investments simply tells us that even the masters of the universe, if you will, do not have all of their hands around the question of investment risk.  In straight up markets, there are few questions.  But in the current environment, we have the distinct feeling there will also be very few questions asked if meaningful downside is to unfold.  Rather, those being hurt by leverage in what could become a punishing market environment will shoot first and save the questions for later.  The double edge sword of leverage tends to evoke those types of responses.  Little time for philosophical debate when one is losing money.  Funny how that works.  We'll be referring back to this issue of deleveraging ahead as these asset classes we have referred to in this discussion show us where their next ports of call lie.