“I gotta have more cowbell, baby...  I got a fever and the only prescription is more cowbell.”  - Actor Christopher Walken on Saturday Night Live

 

One of the most popular Saturday Night Live skits aired April 2000 featuring Christopher Walken as a music producer and Will Ferrell as a fictional cowbell player for the Blue Oyster Cult.  To the dismay of the rest of the band, Ferrell emphatically plays the cowbell as they record “Don’t Fear The Reaper”.  When the band expresses displeasure, Christopher Walken surprises everyone and backs up Ferrell saying “I gotta have more cowbell, baby”. 

Over the last three years, since the crisis began in 2008, fiscal and monetary authorities around the globe have been clamoring for more and more “cowbell”, government generated stimulus and financial support.  But there are increasingly clear signs now that the effectiveness of more cowbell is on the wane while opposition to more cowbell is on the rise. 

 

Calls for new rounds of stimulus in the United States are being met with growing antipathy.  Of course, I find the whole debate over another stimulus program to be very dishonest at the core.  The U.S. is running a $1.4 Trillion deficit this year which, by definition, is one whopper of a stimulus program!  The idea that more is needed is preposterous and would only exacerbate the difficulty in getting the economy to run on its own two feet.  Sentiment has definitely shifted away from more fiscal cowbell with Republicans in the House of Representatives suddenly playing hardball in their drive to cut fiscal expenditures and to close the budget gap without increasing taxes.  Even “Helicopter Ben” Bernanke, who earned his nickname when he referenced Milton Friedman’s helicopter drop of money in a 2002 speech, is finding it difficult to convince fellow central bankers that more monetary stimulus is needed.  Three Federal Reserve Governors dissented from the most recently adopted policy stating that rates would remain low until at least mid – 2013.  It’s been nearly 20 years since that many dissented on the Board.    

 

The United States of Europe

As a means to deal with the current debt crisis in Europe, many are calling for a common Euro Bond that would effectively link the finances of all member states of the European Union.  Italian Economic Minister Giulo Tremonti recently stated, “The strong idea that must be supported is euro bonds.  The only way to invest in our future is euro bonds.”  Mr. Tremonti may be right that euro bonds are “the only way to invest” in Europe, but that does not mean they represent a workable or even legitimate solution for Europe’s woes.  There are constitutional issues bubbling up to the surface as we speak.  The 440 billion euro European Financial Stabilization Fund (EFSF) may have breached Treaty law and the German Bundestag is expected to vote on the legality of the EU’s bail-out package in the coming weeks.  According to a column written by Ambrose Evans-Pritchard for The Telegraph, German Chancellor Angela Merkel does not have enough coalition votes to secure backing for the most recent series of artifices designed to stabilize the financial system.  There is real concern that the European Central Bank has gone beyond its mandate with the purchases of Spanish and Italian debt before European parliaments were even able to vote on the plan.  Christian Wulff, Germany’s president, stated, “Decisions have to be made in parliament in a liberal democracy.  That is where legitimacy lies.” 

As I write this note, Italy auctioned 10-year debt for the first time since the ECB started buying Italian and Spanish debt earlier in August.  The issuance was not well received with a bid-to-cover ratio of just 1.27 times (versus 2.71 times for last week’s U.S. 5-year auction) and yields rose to 5.16% from about 4.9% a week ago.  Confidence in the European financial markets remains lacking.

 

In Japan We Trust?

Japan continues to be a safe haven for investors seeking refuge from global market volatility.  Rates on Japanese bonds are the lowest in the world with the 10-year Japanese Swap rate at about 1%, down from 1.4% in April.  This is despite the challenges facing Japan as we outlined in our last monthly update.  The sixth Prime Minister, Yoshihiko Noda, in five years was just elected this week after Naoto Kan stepped down following a no confidence vote.  Japan is spending more than twice as much as it collects in tax revenues and its demographics will deteriorate rapidly in the next decade.  Moody’s recently lowered Japan’s credit rating to Aa3 and said the government needed to take steps to reduce the budget deficit to avoid additional downgrades.  The problem is there may be no solutions to Japan’s fiscal quandary.  Cutting the budget and / or raising taxes risks sending the faltering economy back into recession which would be very bad for the budget.  Perhaps that is why Japanese Credit Default Swaps (CDS) have risen to match the highs seen in March 2000 and April 2011, shortly after the tsunami struck the nation.  Another push higher will be a key signal that global investors are losing faith in Japan’s ability to right the ship.

Cash is the new “Black”

Earlier this year I wrote about favoring the equities of companies with lots of cash, little debt and strong cash flows.  So far in the third quarter, investors have started paying attention to quality as lower quality stocks fall faster than those with more stable balance sheets and predictable income streams.  We continue to stick with quality and look to market declines, such as we’ve experienced, to incrementally add to our positions. 

Meanwhile, U.S. Treasuries have been the star performer in fixed income land with very high quality corporate bonds performing well but lagging somewhat.  In our November 2010 update, titled “Hail Mary Pass”, we stated; “The magnitude of the debt overhang is far greater now than at any other time in our history, making the relatively trivial QE1, QE2, QE3, etc. ultimately doomed to failure.” This view that the Fed’s actions were too feeble to turn back the deflationary tide led us to hold a significant (25+%) allocation of our portfolio in U.S. Treasury securities with an average duration exceeding five years.  As those Treasuries have risen in value this summer, we’ve begun trimming back the position in favor of other high quality sectors and cash.  Cash is one of the cheapest options in the market now with little or no opportunity cost for holding it.  With yields on five-year U.S. Treasury notes now under 1%, and credit spreads not substantially wider by historical standards, we are not giving away much upside. 

Jeffrey Gundlach, of Doubline Capital LP, was quoted in an August 24^th interview, “I want fear. I want to buy things when they are afraid of it, not when they think it’s a gift being handed to them.” Gundlach’s Doubleline funds reportedly hold almost 15% in cash. 

 

In a world with no more cowbell, cash and high quality assets are good places to hide out in anticipation of greater opportunities to profit from market uncertainty.  While it may be true that we should not “fear the Reaper”, a healthy dose of skepticism and some dry powder are essentials for the well-equipped investor.

 

 

 

(c) Sextant Investment Advisors

www.sextantinvestment.com