In the first two installments of 2022 In Review we looked at how our model portfolio performed compared to the stock market (favorably) and why investments in index funds or funds and investment managers that mirror index funds too closely will likely underperform in coming years. If you haven’t read them, you might want to consider giving them a once over.
There were a number of things that pushed the market down in 2022. Valuation and interest rates are the two most people easily observe, but there was much more to it than that. Below, we will take a look at a couple of the most influential that haven’t made much news. Their impact, so far, has been contained – but they are still very critical issues that we are watching.
European Sovereign Debt Crisis
This past summer, a number of warning signs popped up that caught my attention:
- a liquidity crisis in British debt markets that has led to the firing of the Chancellor of the Exchequer (their version of a Treasury Secretary) and today’s resignation of the Prime Minister;
- British pension funds, banks, and insurance companies faced margin calls that forced the liquidation of derivative positions used to hedge against falling interest rates;
- derivatives used in the hedging of German Sovereign Debt exploded to levels not seen since even in the 2008 Great Financial Crisis;
- swap rates on German Sovereign Debt skyrocketed to levels above those seen in 2008;
- the Swiss National Bank suddenly loaned $11 billion to 17 of its national banks to finance the increase in Swap Line Margins with the Federal Reserve who doubled the margin requirements as fear of European bank failures;
- Credit Suisse was forced to call its largest funding sources and its largest shareholders on Monday to assure them that they were not facing imminent collapse and had a plan to resolve their liquidity issues; and
- Credit Suisse announced Tuesday that they had decided to sell their American banking and investment business.
Central Bank seemed to be in a state of panic, particularly in Europe, as they face a liquidity crisis in the financial industry. The banks are all taking serious losses for being positioned wrong in their interest rate and currency hedges. The skyrocketing value of the Dollar compared to their domestic currencies took them by surprise and they didn’t act to hedge against the Pound and the Euro being at par with the Dollar. The Dollar’s bull run higher is believed to be fueled by the Fed raising interest rates, however the money flowing into our treasury market from foreign investors looking for a safe haven is also adding to the rise. During the summer, foreign money moving into the US, particularly from Europe, increased over 5%.
One major cause of the crisis is the widely adopted balance sheet management practice of Liability Driven Investment used by large banks, insurance companies, and pensions. In this process, derivatives are used by the financial institutions which use their fixed income holdings as collateral to buy enough additional investments to cover their future liabilities. When the value of the collateral goes down the derivative forces a liquidity problem as the institution is required to put up more collateral or have the derivative liquidated at a loss. This loss flows through to reduce the already thinly capitalized European banks equity position. This then leads to their funding sources raising margin requirements and charging higher rates for the additional risk, much like we saw from the Fed last week.
What’s scary to me is that a derivative based upon a computer model that most people have never heard of has developed into a $1.5 trillion market that could easily swamp the impact of the computer model driven sub-prime disaster in 2008.
Although in the latter months of 2022, the measure adopted by the Fed and Treasury to address the debt crisis has calmed down the bond markets, as noted above, the debt crisis leads to a liquidity crisis – the most devastating type of crisis. It has moved to the back burner for now, but we still need to be aware of what could happen and watch for the signs. If one were to occur, it would be a global issue much like the liquidity crisis caused by the 2008 SubPrime Mortgage Crash – it would impact all economies, but not to the same extent.
A liquidity crisis in the US, if it comes about, will be tempered by foreign investors wanting a safe haven to park their investment money as they move out of Europe. As noted above, last summer saw an increase of 5% in international capital flows moving into the US, however that was simply a taste of what could transpire. Just as happened in the 1930’s when European Sovereign Debt was crashing and currencies were bordering on worthless, money will move out of Europe and other countries to the US. In the 1930’s, President Hoover ran a balanced budget. The treasury market at that time was the big draw as a safe haven because the US was viewed as fiscally responsible with minimal debt whereas Europe had significant levels of debt stemming from World War One.
Unlike during the Hoover presidency, today the US does not have a balanced budget and minimal debt – far from it. Money will flow into treasuries as a safe haven investment, but to hedge the increased risk of treasuries today over previous decades, money will also likely move to the stock market focused on quality low-to-no debt companies, gold, oil and solid cashflow producing real estate as safe havens. Unlike Europe, we have well capitalized banks that can provide liquidity to quality corporations and they will be viewed as alternatives for investment dollars as the treasury market struggles to keep investors buying bonds to fund our government deficits, but doesn’t break.
Part 4 Preview
In tomorrow’s final issue of this 2022 In Review series, we will look at the strategy we used in 2022 to manage risk for our clients and to outperform the indexes (and index funds). It will combine the management of our model portfolio (as discussed in Part 1 and a focus on the other Macroeconomic Influences not described above.
Part 5(?) Preview
Although not part of 2022 In Review, but certainly related, I will give you our Top 10 Macroeconomic influences I see that could impact 2023 investment management and some of the investments I will focus on to benefit our clients.