Investment Insights Podcast – July 18, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded July 16, 2014) the subject matter pertains to the Congressional Budget Office’s release of their long-term outlook. It’s important to note that this forecast is a 75-year time horizon; so focus should be on the near-term debate in Washington:

What we like: Raised the long-term growth rate of the economy; lowered healthcare costs and interest rate costs which is a positive in the near term

What we don’t like: Healthcare and interest rate costs in the long term; interest rates likely to rise eventually; Social Security likely to rise in the near future; defense spending cutbacks

What we are doing about it: As citizens, being thoughtful when exercising the right to vote; keeping an eye on higher interest rates and impact on fixed income

Click the play icon below to launch the audio recording or click here.

Source: CNBC

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Stalemate

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

The ongoing dysfunction in Washington D.C. reached a fever pitch this week, as the failure of lawmakers to agree on a bill to fund the Federal Government resulted in the President ordering its first shutdown since 1995.  The inability of Congress to effectively legislate has led to the furlough of more than 800,000 Federal workers, and a shuttering of all non-essential services.  Although equity markets around the world have remained relatively sanguine about the current state of affairs inside the beltway, the looming deadline to raise the debt ceiling, which the Treasury Department has declared to be no later than October 17, has heightened the stakes of the current impasse immeasurably, as a breach of this borrowing limit would have dire consequences not just for the United States, but for the global economy in aggregate.  It is the presence of this possibility that provides us with cautious optimism that a resolution might be forthcoming; as our belief is that the closure of the government and the subsequent pressure being applied by the electorate to end the stalemate has pulled forward the debt ceiling debate, which may result in a bargain that addresses both issues.  However, we intend to remain hyper-vigilant about the progress of these negotiations as we fully recognize the severity of the impact of a failure to honor our nation’s debts.

10.4.13_Preisser_Stalemate_1The current standoff has resulted from a multiplicity of factors, chief amongst which is a fundamental ideological difference between the parties over the Affordable Care Act, popularly known as “Obamacare”, which went into effect this week.  It is the vehemence of both sides in this debate combined with the extreme partisanship in the Capital that have made this situation particularly perilous.  Despite assertions to the contrary, the shuttering of the government comes at an exorbitant cost.  According to the New York Times, “ the research firm IHS Inc. estimates that the shutdown will cost the country $300 million a day in lost economic output…Moody’s Analytics estimated that a shutdown of three or four weeks would cut 1.4 percentage points from fourth-quarter economic growth and raise the unemployment rate.”  With consensus estimates for GDP currently at only 2.5% per annum, the present state of affairs, if not soon rectified will take an ever increasing toll on the nation’s economy.

Since 1970 there have been a total of 18 shutdowns of the Federal Government, including this most recent closure.  Although each situation was unique, what is common amongst them is that investors have, on average, approached them with relatively little trepidation.  According to Ned Davis Research, “during the six shutdowns that lasted more than five trading days, the S&P fell a median 1.7%.”In fact, optimism in the marketplace has tended to follow these periods of uncertainty.  Bloomberg News writes that, “the S&P has risen 11 percent on average in the 12 months following past government shutdowns, according to data compiled by Bloomberg on instances since 1976.  That compares with an average return of 9 percent over 12 months.”

Source: Ned Davis Research Group

Source: Ned Davis Research Group

There is one glaring difference between this year’s shuttering of the government and those of recent history, and that is the presence of the debt ceiling.  According to the New York Times, “the Treasury said last week that Congress had until Oct. 17 to raise the limit on how much the federal government could borrow or risk leaving the country on the precipice of default.”  Though we can look to the past as a guide to use to try and gauge the impact of a government shutdown, there is no way to accurately predict the effect of a failure of the United States government to fulfill its obligations, as this would be unprecedented. The need for Congress to raise the debt ceiling cannot be overstated, as the very sanctity of U.S. sovereign obligations depends upon it.  The importance of this faith to the global economy was captured by Nobel Prize winning economist, Paul Krugman, “Financial markets have long treated U.S. bonds as the ultimate safe asset; the assumption that America will always honor its debts is the bedrock on which the world financial system rests.”

The State of Municipal Bonds

 Amy Magnotta, Brinker Capital

In December 2010, analyst Meredith Whitney made a prediction of hundreds of billions of defaults in the municipal bond market. While we have experienced defaults, we have not yet seen anything close to the magnitude of that statement. Prior to that statement, in October of that same year, Brinker Capital released a paper that discussed our positive view on the municipal bond market due to technical factors and improving municipal credit. Because we invest in municipal bond managers with strong, deep credit research teams and a focus on high quality issues and structures, we encouraged our investors to remain invested in municipal bonds. Investors have been handsomely rewarded with close to 20% cumulative returns in municipal bonds since they bottomed in January 2011.

The financial health of municipalities is again hitting the headlines. Moody’s has warned of more problems for California cities after San Bernardino, Mammoth Lakes and Stockton have each sought bankruptcy protection. Scranton, Pennsylvania, which made the news after the mayor cut the pay of all city employees to minimum wage this July, is now seeking help from hedge funds in an effort to delay a bankruptcy. Even Puerto Rico municipal bonds, widely held by municipal bond strategies because of their attractive yields, are being seen as a greater credit risk.

We don’t believe the headlines are representative of the broader municipal bond market. There are more than 50,000 municipalities across the country, each with their individual issues. This makes municipal credit research in this environment extremely important, especially without the fallback of bond insurance. A positive corollary of these types of headlines is that it forces change. Many state and local governments have made the necessary changes to their budgets to set them on a sustainable path, but many still have more to go. Often, the largest owners of a municipality’s bonds are their own constituents – they need to maintain a good relationship with these investors in order to access financing in the future.

We feel the technical factors in the municipal bond market remain positive. Demand is very strong. While supply has been higher in recent years, most of it is refinancing, so net new supply remains at low levels. The budgets of state governments continue to improve while local governments remain under pressure. Rates are low, offering the opportunity for refinancing. The fights over pension and healthcare benefits for public workers will continue, but these issues do not present an immediate cash flow problem. However, this is a broad characterization of the municipal bond market. We will continue to invest with managers that have deep credit research teams and focus on high quality issues, seeking to avoid the problem issues as a result.