I was driving out to Burlington this morning to get a new crown installed on an implant I had put in this past Spring. You may ask, "Why the heck do you drive to Burlington for dental work?" Because, like managing money, the relationship between a dentist and a patient should be based on trust and I happen to trust that my friend Dr. Bruce Gardner will do the right thing. My dentist of 30yrs, one block from my office, did not do the right thing a year ago (he is no longer my dentist).
So as I drive, I constantly flip through the pre-programmed satellite radio stations in my car: Fox, CNN, Bloomberg, CNBC and POTUS. I have to mention that all of those stations all air commercials at the exact same time. Brutal. And we thought satellite radio was commercial-free. Not if you want news it ain't (and that is all I listen to really...ask my wife and my three sons).
This morning, there was a talking head on one of the stations (can't remember which one because I constantly channel surf) who I think was some sort of retired Deputy US Treasury Secretary. The guy was waxing on about how great shape European banks were in...more regulated, no proprietary risk, etc etc.
If that is so, maybe he could explain the following three charts:
1) Credit Suisse 16yr stock chart (worse than 2008)
2) Credit Suisse 5yr Credit Default Swaps (CDS) YTD (worse than Feb/16 wides)
3) Deutsche Bank 5yr Credit Default Swaps (CDS) 15yrs (way worse than 2008 and bordering on 2011 wides)
Perhaps someone should explain a few things to this talking head:
1) The market is always right, at least eventually, and right now the market seems to be telling us that there are problems with European banks and, arguably, they are as bad or worse than 2008. Maybe the market is worried about cross-default risk (a chain reaction or contagion risk)? Maybe negative rates?
2) The talking head says nothing of the risk of "bail-in" and contingent capital securities cascading into common stock. (European banks have a hard trigger on whether they are forced by the regulator to effect a "bail-in". Canada has a soft trigger determined by our regulator). Maybe that will happen, maybe it won't, but as we have also said numerous times, the new "bail-in" regime and various country forms of non-viability contingent capital have created a much more volatile environment for bank securities, especially common stock. IE, if there is an event that brings any one bank close to default (a triggering event) then it is not tax payers who will bail out the bank(s), it is the common equity holder as most of the bank's debt will convert automatically to equity...read, Massive Dilution for the common equity holder. No one thought this would happen, at least so soon, but the market feels like there is a risk it might happen. Perception is reality, or at least can become so.
Can it happen in North America? I honestly hope not but who knows what kind of risk any of these large global banks have taken? Recall we wrote recently about the fact that they are most certainly a helluva lot bigger today than they were in 2007. Do you think with no proprietary revenue left, very low rates, a flat yield curve, more regulation, etc, that banks around the world haven't done other stupid things to drive revenue to replace all of those traditional sources that have evaporated?-- I worked at Merrill Lynch where the CEO had the treadmill moving at 15mph in the never-ending pursuit of revenue...nothing bad happened with that strategy though!? And do you think the regulators understand exactly what risk the banks have on their page?
I hope so.
I thought I would check in and calculate how we did on Friday, given it was a rough day in global markets. I had a pretty good mental calculation of how we would do on Friday because Scott and I are right on top of the risk we are taking but the performance report confirms.
Securities law allows us to show "actual client" performance only and given this is only one day's performance, I thought I would show my own performance for my own account, as I am an actual Private Client at High Rock (and we manage our client money the same way as our own money although weights to our models can be slightly different so individual client performance can be slightly different).
My RRSP account was -.1065% on Friday alone (Source: Dataphile/RJCS June 24, 2016). I hate losing money but at -.11% I think we can call that a pretty big win. (past performance is no indication nor guarantee of future performance). (Because client's weights to our High Rock models can all differ, according to their Wealth Forecast and Investment Policy Statement, individual client performance may vary slightly from client to client).
Compare that to a few other potential portfolios (Source: Bloomberg, June 24, 2016)::
So, how did we only lose about -.11% last Friday?
Again, this is only one day's performance and, although we have solid views, we are not 100% sure what the next days, months and quarters will bring but a properly diversified and researched portfolio can help mitigate draw-downs during periods of volatility, like wee have upon us right now. Protecting our collective capital is our number one goal at High Rock.
I have written a fair bit over the past few weeks on banks, bail-in, non-viability contingent capital, yield curve effects on net interest margin, etc. Blah blah blah.
Just one more on the topic of banks, I promise and it is the most important of all...Risk-Adjusted Returns.
As Scott and I often write and tell clients, we are 100% focused on creating the strongest risk-adjusted returns we can. A lot of Advisors talk about how they "reduce risk and create low volatility" (how do they do that and with what metric do they measure it?), Well, at High Rock, we really do attempt to reduce risk and lower volatility and we actually do the math and measure it! Here's how.
Its not rocket science really, just a bit of work, some experience, some knowledge, an excel program, and a ton of research. We take different asset classes and sometimes even individual securities and calculate their monthly total returns across a period of time, usually 5yrs. We then regress all of these total returns and calculate the Annualized Compound Total Return and also the Annualized Standard Deviation (a common measurement of risk or volatility). Our goal at High Rock is to get the highest returns while taking the lowest amount of volatility of those returns. Simple.
So then we plot all of the data on a scatter plot graph and see where our data lies. The top-left quadrant always represents the best risk-adjusted returns (GREEN), while the bottom-right quadrant represents the worst risk-adjusted returns (RED).
It looks something like this:
Now that we have an understanding of risk and return, lets look at where our "safe" Canadian banks fall into the graph. They are all denoted with RED SQUARES in the top-right. As you can see, TD, BMO, RBC and CIBC all show 5yr monthly annualized compound total returns of about 10%...pretty good, eh? But they also show risk or volatility of about 14%...pretty high. It is not enough to say "That is a pretty good return" or "My Advisor does pretty well for me because I am up money". Well for Pete's sake, how much risk are you taking to produce those returns? (For another time but it is also important to measure performance against a relevant benchmark). By comparison, the S&P500 is in BLUE and has a similar risk/return profile.
Now look at poor BNS and National Bank in the circle on the right. Returns of only 6% but volatility of 15-17%! Crazy. Probably fair to say these two banks exhibit poor risk-adjusted returns, or at least over the past 5yrs and especially against their peers. (And all of these returns are after a pretty good run in Canadian bank stocks the past 5 months. They might not even be as high on the return scale if we used 5yr data but ended in Feb 2016 instead of May 20216...volatility would be the same or worse tho).
Also, for comparison purposes, I add in the S&P/TSX and a 5yr Gov't of Can bond. The S&P/TSX pretty much...stinks over the past 5yrs. Is it a candidate for re-balancing and a period of out-performance? Maybe (we did add some Cdn equity exposure in the first half of 2016). A 5yr Gov't of Can bond clips along at 4% return with super low volatility of 3%...not so bad is it?
And lastly, I add a 60/40 Equity/Fixed Income portfolio as indicated by ACWI and XBB ETF's. Top-left quadrant...isn't that the best quadrant to be in? Indeed it is.
So why on earth would you be totally invested in Canadian bank stocks to get roughly the same return (10%) but to take 2.25x the amount of risk of a 60/40 diversified portfolio??
Typical Client Answer: "because Canadian banks are "Safe", pay a dividend, are steady", etc.
My Response: Insanity! I have written a fair bit about the new Basel III capital requirements and the possible draconian measures that are bail-in capital regimes and non-viability contingent capital. You can read all about the massively changed landscape for banks in my Apr 29, 2016 Blog titled "I lost 28% in my preferred shares last year".
If your Advisor has not explained bail-in or NVCC in detail to you, I suggest you ask them for an explanation or educate yourself. Or call me...happy to wax on about the potential perils lurking and what these new capital rules have done to increasing volatility across the bank capital structure.
Suffice to say, these are no longer you Father's Banks. What the capital requirements have done is created more volatility in Bank Equity the world over. Canadian banks have the same capital requirements as every other Systemically Important Bank (SIB) and, in fact, some consider the new bail-in regime here, once finalized, could be even more draconian than other jurisdictions.
If it is volatility you want in your portfolio, then by all means, call your broker and start waving in bank stocks, If it is stronger risk-adjusted returns you would like, then call High Rock.
Numbers don't lie.
Full Disclosure: High Rock portfolios do not own any bank securities directly (shouldn't come as a surprise).
"You Can't Make Money in Bonds at These Levels. My Broker Tells me I Shouldn't Own Any Because They Don't Yield Enough"
If I had a $ for every time a prospective client, friend, family member, BNN host or BNN viewer told me that...I wouldn't need to own any.
I read a good piece from a former colleague of mine at Bank of America Merrill Lynch (BAML) today. I thought I would reflect some of it here as it laid out more succinctly our macro views on the state of the world today and our reasoning for owning long gov't bonds. We have been writing on this topic a fair bit lately, but it is laid out well here.
Michael Hartnett (not that we were friends while I was at Merrill but I was at a few conferences both in Toronto and NYC that we had him speaking at) describes the "war against deflation" being lost by global central bankers. We have been saying for some time that there is a risk that the world is in a deflationary state and that central bankers efforts with monetary stimulus have now become far-less effective than they were the past 8 yrs.
Hartnett claims that all of the central bank qualitative easing has failed to "lift the animal spirits depressed by the 4 D's: Excess Debt, Deleveraging, aging Demographics and technological Disruption". Well put by Hartnett. Our thoughts exactly...fiscal and monetary policy have failed to perform as originally hoped.
And look at the fact pattern...deflation and negative rates started in Japan, now have moved through Europe. But surely it can't happen in North America?
Well as I have written over the past week or so, gov't bonds are rallying like crazy the world over, because of Hartnett's reasons above
And now onto the title of this blog..."you can't make money in bonds". Really? And for Pete's sake, they can keep going and go negative, as they have in Japan and Europe...follow the fact pattern...it seems to be moving East to West, doesn't it?
Look at the global gov't bond returns on an annualized basis over the past 30yrs:
Fairly impressive, isn't it? And if we did regress all of those 30yrs of annual returns back and plot them against their annualized volatility, I bet we would find volatility to be very low.
I wanted to look at the effect a negatively shaped yield curve (where 30yr gov't bonds yield less than 2yr gov't bonds) or where the entire yield curve is in negative rates, has on commercial/investment banks.
Given rates are largely moving to a negative posture in Europe it makes sense to look at the situation there, but keep in mind, it is moving that way in North America too so have some foresight on what is happening there to protect yourself from it happening here.
First of all, let's look at the Swiss Gov't bond curve where 30yr bonds just went to negative yields this morning! That's right, you are paying the Swiss National Bank about .03% to hold on to your money for 30yrs. Why? A couple of main reasons: 1) safety of principal and 2) the threat of deflation. (Top line is the Swiss curve just before the 2008 crisis and the bottom is today).
Now lets look at the largest Commercial/Investment bank in Europe...Deutsche Bank. Deutsche Bank (DBK) tries to make money in many different ways but Capital Markets activity and Lending are probably the two key ones. Well Capital Markets (trading/sales revenues, structured products like CLO's etc) have come off substantially. As for lending, well it has now been turned on its head. Two reasons negative rates and inverted yield curves suck for banks: 1) they typically borrow from the central bank on an overnight basis and invest out the curve but when the curve is inverted, they can't put that trade on and 2) when rates go negative, how do they borrow and lend with the same Net Interest Margin...it gets squeezed hard.
So here is the result. See DBK's 5yr CDS (Credit Default Swaps) as a metric for what credit markets think about DBK. The higher the CDS Spread is, the worst the view on DBK and the higher the potential for a Credit Event...(read, Default). Moving higher...
And here is a DBK stock chart. Note that CDS and the Common Equity of DBK will move in the opposite direction but CDS (remember how Scott says every week that Bonds (and Credit, like CDS) lead all financial markets?) has a slight advance lead on the trend.
So, can this happen to US and Canadian Banks? Caveat Emptor because the bond markets in North America are moving rather quickly to the same level and shape of bond curves across the globe.
Another reason why High Rock accounts do not own any bank securities.
Next up on this Mini-Series on Banks and Yield Curve will be the Debunking of the Myth that Canadian Banks are "safe and steady".
I will write more on Banks later but I thought I would just highlight where banks, US specifically, sit with regards to their overall asset size. As I have written before, there are new Basel III capital requirement rules that came into play in 2013 which require systemically important banks (SIB's...any large bank around the globe, obviously including our beloved Canadian banks) to meet these capital ratios on a scale from 2013 through to 2020.
I think there is a bit of a myth out there that global banks are "more safe" today than they were pre-2008 because the banks are more regulated. They are more regulated, that much is true, but what is also true is that banks are WAY BIGGER today than they were pre-2008. And more importantly, the new regulatory regime effectively puts all of the risk on the Common Equity holder...so if there is a "triggering event" then the Common Shareholder bears all of the brunt (not taxpayers) as a cascading waterfall from more senior parts of the capital structure convert to Common Equity on a ratio basis that is very dilutive to the Common Shareholder. This is a pretty complex regulatory regime that requires work/research to comprehend but, to be sure, it has changed the risk-reward skew on global banks since 2013. It has effectively made them more volatile...and we hate volatility, for the most part.
So how big are the US Banks now? Big. 2008 was just a blip in their overall asset size growth. What's in there?...Loans, leases, Securities, Real Estate, Revolving Home Loans and even Government bonds (a good asset). With interest rates plummeting and the yield curve flattening (neither are good for banks), the banks drive for profits elsewhere. In general, they make more loans. US Bank assets have gone from around $10 trillion pre-crisis to almost $16 trillion today...+60% growth.
So where could problems for these banks lie? With Bank asset growth as it has been, we should search for what and where problems could arise.
How about Auto Loans? Now some auto loans may have been securitized (takes the risk off the bank's balance sheet as investors buy the securitized loans) but we know the securitization markets are still no where near the size they were pre-2008. How much is still on their books? I am trying to find out but for now, Motor Vehicle Loans have gone parabolic at now over $1 trillion:
And the other potential problem for US Banks may just very well be Student Loans. Again, some of these may be securitized but if not, and Hillary wins, the US Gov't will probably just forgive all of the defaults on these and bail out the students and the banks. What will Trump do should he win? Either way, there has been huge growth in this bucket of consumer debt...now at $1.3 trillion.
Just a quick look and analysis on where problems could arise. Our job is to do the research on what and how events might affect our portfolios and then invest accordingly. Full Disclosure: High Rock portfolios do not directly own any Canadian or US bank securities in any part of the capital structure.
An old colleague, and good friend of mine, from my days at Merrill, was a hockey playing superstar in his days at the University of Michigan. He had the great fortune of getting not only his pair of seasons tickets for football early but also got two pair pretty much beside each other. So he has four tickets to the 6-7 home games each season.
Being the father of three boys, I thought it would make a great "boy's weekend" for me to take my youngest son Nicholas down to London, ON on a Friday afternoon, take out our eldest Macallum and middle son Harrison (they both attend UWO) for dinner and then all four of us could go to Ann Arbor, MI for the game on the Saturday. And my good friend John was gracious enough to sell us all four tickets. for the uninitiated, these are hot items as it is quite a scene there for a home game.
But now I am starting to wonder if the price of the tickets might just come down? I know it is only 6 months away, and they probably won't, but I wonder if the price will come off in the next 5-10yrs?
The University of Michigan just released their monthly economic statistics (Sentiment, Current Conditions, Expectations, 1yr Inflation and 5-10yr Inflation). Given I am concerned about the price of my four football tickets, I will focus on Inflation. 1yr Inflation Expectations were at 2.4% which is about as low as it has been since Sept 2010. However, 5-10yr Inflation Expectations just plumbed to new lows at 2.3% from May at 2.5%...2.3% is a level not seen since...well, ever!
I wonder why long bonds around the world are on fire?
The first Friday of each month, typically, brings the most-highly anticipated economic statistic from the Bureau of Labor in the USA...the Non-Farm Payroll report. The Non-Farm Payroll number is, at its simplest, the number of new employees who were hired (actually via a survey report) by businesses over the preceding month.
I won't get into exactly how it is calculated but want to show the trend over the past four months. There is an old adage in the economic forecasting community that, "one number doe not a trend make", however, this US Non-Farm Payroll report has been in decline for four months in a row, along with lower revisions:
Feb/16 - Was +242k but Revised to +233k
Mar/16 - Was +215k but Revised to +186k
Apr/16 - Was +160k but Revised to +123k
May/16 - Was +38k (we will have to wait until early July for June's report and any revisions to May)
Is that a trend?
With earnings season over, I have more time on my hands as our research models are up-to-date and hence...my third blog in three days!!
Presented with little comment:
Monetary Policy - the Fed's balance sheet and the S+P. When the Fed's balance sheet stopped growing (2015) all we have seen is a year of wicked volatility.
Fiscal Policy - The US Gross National Debt, as per the IMF, stands around $25 trillion. And Labour Force Participation is essentially at an all-time low with pretty much stagnant wage growth.
Its not often that I blog twice in as many days...usually not even twice in one month. But, given the move in the bond market today (rates lower), I thought I would try to explain our views on long-dated gov't bonds.
We will look at the shape of the yield curve in Canada the last time the Fed went through a rate hike cycle.
They started to hike Fed Funds in Mar 2004 (dark green dotted line...notice the positive slope?) and ended in June 2006 (light yellow dotted line). Note how the yellow line in 2006 is totally flat? That represents about a 90bp move in 30yr bonds over that 2.25 year period. A huge move by any standard.
Now the bottom of the chart shows the yield curve as of today in a dark green solid line. The curve has already flattened a fair bit but our expectation is that it will flatten a whole bunch more. We bought 30yr bonds a few weeks ago at 2.07% and today they are at 1.90%, which represents over a 3% move...but that could end up being nothing compared to if the curve flattens like we think it will. These long bonds could drop to 1-1.50%. It is highly unlikely that there are too many participants in the market looking for such a move...which is why it should get there.
(Full disclosure - Scott and I do tend to be somewhat contrarian. As Sir John Templeton famously said, "If you want to have a better performance than the crowd, you must do things differently from the crowd". At High Rock, we think we do things a lot differently than the crowd).