Dear Colleagues, I was up very late last night watching measures of European short term funding go to the highest levels seen since March 2009 during the last financial crisis. Had they risen about 2 basis points higher, we would have broken into a new and dangerous zone. Along with several bank downgrades after the close yesterday, this was shaping up to be a potentially serious day. A Forbes article today, “Big European Bank Failure Averted: What Central Banks Did Not Tell Us”, confirms that a major bank was having difficulty funding liquidity needs.
Early this morning there was a coordinated response by several foreign central banks to provide liquidity to Europe and European financial institutions. These actions were not factored into the market but were always a possibility. I’ve been looking for some type of European bilateral fiscal agreements, along with ECB and IMF participation, to help stem the crisis. My estimate has been that something had to be done between December 2 and 9 that played into key upcoming ECB meetings. Any announcement that did not contain a substantive response from these meetings could unravel the financial markets further.
Having said all this, the central bank moves are only a temporary band aid. This policy does not attack the core issue of the unfolding crisis and that is uncontrolled fiscal spending along with non sustainable sovereign debt levels. Non competitive economies are driving these negative trends. Europe still has to deal with these basic issues. Additionally, back stopping their financial institutions and weaker economies will entail trillions of Euros. How Germany participates is key. Germany faces a Devil’s bargain. It is still unclear to me, and I am highly doubtful, that the necessary and very long term fiscal austerity measures required can be done successfully and thus, all this financial/fiscal maneuvering will only addresses short-term challenges.
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In much the same way that liquidity and swap lines were thrown at the U.S. economy during the last financial crisis, fundamental structural reforms, both fiscally and financially, have not been done, thus, in my opinion, we continue to be in an interim environment with final determination yet to come.
Initially, these liquidity type measures only had a short-term positive impact in the U.S. Follow on non-traditional monetary policies added to the attack. The final costs for these actions have not yet been totaled. Again, we live in financially dangerous and volatile times.
Rodriguez has long believed that another financial crisis is looming. Here is an interview with him from February of this year:
Invigorated after a year-long sabbatical renowned fund manager Robert Rodriguez, CEO of First Pacific Advisors, sternly warns that markets and the economy are threatened by the government’s tardiness in addressing fiscal reform. Unless restructuring begins within seven months, he says, a new financial meltdown will likely befall us in a few years.
Rodriguez, whose firm manages assets of $15 billion, forecast the global financial crisis of 2008-09. In 2007, he moved to a cash level nearly 12 times that of the industry. Today, FPA equity funds are at all-time highs. The compounded rate of return of the FPA Capital Fund, Sept. 30, 2007, through Jan. 31, 2011, was 5.3%. The FPA New Income Fund hasn’t had a down year in 32.
After a 12-month holiday circling the globe, Rodriguez, 62, remains a managing partner of his Los Angeles-based firm. As planned, partners who ran Capital and New Income in his absence continue as day-to-day managers. Rodriguez is an advisor to both funds.
AdvisorOne chatted by phone for more than two hours with the value manager, who makes his office in Lake Tahoe, Nev. Here are excerpts from that conversation:
What is your most pressing concern?
When I left, I informed clients that if present trends continue, we’d face another financial crisis of equal or greater magnitude within three to seven years. Many of the questionable practices that were being employed are back in the game. Banks and investment firms that fed at the public trough — none of that’s changed. Too big to fail is still operating.
There are shifts that are positive, the question is: Will we proceed at a fast enough rate?
So are we going the way of Greece?
Yes. If we continue to grow our debt at a rate of more than double our GDP growth. We have a $15 trillion Treasury debt and a budget deficit of 9% of the economy. From June 2003 through December 2010, debt in the U.S. has grown 10.26% [per year], whereas nominal GDP has grown at 4.5%. That’s a non-sustainable trend.
But the government says that the economy is back to its pre-recession growth rate.
That’s the flow concept: the rate of change of GDP growth. The other is a stock concept — income statement vs. balance sheet. They don’t want you to look at the balance sheet. They want you to focus on the income statement. How many times have you heard that from corporations? It’s called bait-and-switch!
What needs to be done then — and when?
We need significant fundamental reductions in expenditures at the Federal level this year because they’re not going to happen in 2012, which is an election year. If not, by 2013 we’ll be sitting on more than $17 trillion in debt. Therefore, the window to start reform is only about seven months.
But President Obama has talked about saving $400 billion over a decade.
With a $3.5 trillion budget, that’s a joke!
What are the consequences if reform doesn’t begin within the next seven months?
It’s about: When does the market start to get uneasy? Where is the tipping point when these trends become destabilizing, and are you being compensated sufficiently in the capital markets for these uncertainties?
What do you suggest to solve the fiscal problem?
As I proposed some time ago, one solution is to increase our export position. That would require a whole host of things to be done in re-engineering and re-training. Instead, the government produced a temporary narcotics hit; i.e., short-term fixes: the cash-for-clunkers program and an $8,000 credit to buy a home.
How significant is the Dow Jones’ rising above 12,000?
Means very little. Are the balance sheets scrubbed clean of their problem loans? I doubt it. I look at investor sentiment, and it’s very high. The confidence factor has come in, and that’s one of the things the Federal Reserve was trying to create. But at what price?
How solid is the stock market rally?
A lot of what the market has been discounting is a large expansion of corporate earnings. But that’s a function of aggressive cost reduction, not top-line revenue growth. Now we’re engaging in a period of cost push. The $64,000 question is: Will companies be able to pass on the higher cost inputs to maintain margins?
What market sectors and stocks do you like?
In equities, we’re continuing to operate with a high degree of defensiveness. We’ve been reducing some exposure to energy. That has been our largest exposure and still is. There’s no hot new area that I’m saying, “God! I have to focus in on that!”
What are your concerns about the bond market?
We still won’t lend long-term money to the Federal government nor to other high-quality creditors because the interest-rate level remains inadequate to compensate. If we’re correct — that is, if present trends don’t change — we’ll be proven right about the conservative position we’ve taken on fixed income.
Why have you given liquidity such high priority?
You have to keep a margin of safety because you don’t know what the foolishness will be on the part of clients and shareholders. You never know the value of liquidity until you need it and don’t have access to it. That’s what a lot of people learned in the last crisis, but I fear many are forgetting again…Crises [remind] you that you have to set up a rainy day reserve account.
Should investors stay away from municipal bonds?
I’ve been quite cautious about them for several years. You’ve seen their yields blow out. There are probably some good values now, but you have to really pick through them.
How about corporate bonds?
We’re staying very short in duration with [any type] of bond because we honestly don’t know how this thing is going to unfold. Some managers are adding equities into their bond portfolios. It isn’t because they think equities are attractive; I would say they’re not enthusiastic about bonds.
What do you think of the new Congress?
Better than the last Congress! There’s some positive talk, but there are so many ingrained constituencies that feed from the public trough that it makes it very difficult to restructure.
Assume you don’t think the last round of the Fed’s quantitative easing will propel the economy into a sustainable expansion?
It’s the height of lunacy! The purpose of QE2 is to lower interest rates and encourage asset price appreciation so that consumer balance sheets are improved and there’s a higher propensity to spend. You do not build long-term, productive resources by encouraging people who are overleveraged to go out and borrow more.
The consumer added more debt to his balance sheet between 2000 and 2007 than in the prior 40 years.
What are your thoughts about the historic low interest rates’ effect on retirees?
The Fed policy is an abject, unmitigated attack on savers — and a horrendous attack on people who are in or near retirement.
What will it take to get the jobs market going?
Re-training and re-directing. Various tax policies should be changed. I talked about that more than two years ago. You’re looking at higher levels of unemployment for a prolonged period.
Any good ideas on how the housing problem can be resolved?
Housing won’t be a robust contributor to the economy for the next few years. Until you get sustainable stability in employment, I don’t see housing turning around in a significant way. Two of the 12-billion-pound elephants that aren’t in that wonderful book of semi-fiction, The Financial Crisis Inquiry Report, are Fannie Mae and Freddie Mac. In order to reform and rebuild, a lot of toes will have to be stomped on.
This will create friction. But that’s positive because it means we’ll be starting the recovery process. But if we don’t begin in short order, things will get more painful and the options will be even fewer.
What’s your opinion about the SEC’s recommendation that all financial advisors be subject to a fiduciary standard?
Unless people making the decisions believe in the standard, it won’t change anything. The will has to be there. It gets down to whether the people advising have your best interest at heart. After the Enron fiasco, they came out with the Sarbanes-Oxley Act (2002). Obviously, that didn’t prevent any of this. The patient was sick over many years, and the doctors — be they regulatory or financial entities — were quacks.
And you’re obviously no fan of the Federal Reserve.
It had the power to constrain the unsound lending practices prior to the housing crisis. It missed the two greatest bubbles in the U.S. over the last hundred years: technology and real estate. We imbued [many] powers to the Fed, but they didn’t exercise them.
And other regulators?
The New York Fed had the power with regard to investment banks. The SEC and other agencies had the power too. But they didn’t exercise it because the will wasn’t there. How you prevent a crisis is with a system that says, “We’re getting into an area of too-high risk.”
What should the financial services industry do to help correct the country’s financial woes?
It bears a responsibility to compel government leaders to return to prudent fiscal management. And if it does not, long-term capital should be withheld. If elected officials don’t adhere to strict fiscal discipline, they should be kicked out of office. Well, we’ve just kicked out a lot of people in the last election. That’s encouraging!
What advice do you have for financial advisors in view of your forecast for a new meltdown?
Don’t follow the herd. Be very careful in the selection of assets over the next decade. It’s fundamentals, fundamentals, fundamentals. One of the biggest challenges is what I call “electronic quantitative money management”: ETFs, index funds, that kind of thing.
What’s the best way for advisors to attract and retain clients in these dicey times?
If you’re not adding value, there’s no reason for you to exist. This is Darwinian competition! Without a value-add, you’re going to be out of business. I run scared about 120% of the time because clients will take money away whether you’re right or wrong. But if you have an investment discipline that you adhere to, odds are you’ll be more successful than somebody who doesn’t.
Has the last crisis changed the psychology of the public and elected representatives enough for us to restructure?
I don’t believe so. But there’s no question that we have the ability to recover. Again, there has to be the will. I do see some positives out there, but we’re just now starting the hard work.
We all make errors. The question is: Do we make fewer errors than our competitors, Europe and Asia? Over the next 10 to 15 years, we’ll find out.
H/T to Canadian Value