Market Musings Blog

The Third Avenue Focused Credit Fund, aka a junk bond mutual fund, moved swiftly to prevent redemptions by transferring the fund’s assets into a liquidating trust today. With the assets locked up, and no cash flows in or out unless at the behest of the fund manager, the manager hopes the underlying junk bonds can be sold in a rational way, rather than at fire sale prices forced by shareholders wanting their money. The fund owns some of the shakier issues available in the market, on the theory that many of these could heal themselves and prove to be more valuable later.

But the market has moved against the fund as the situation in the oil patch begins to spread beyond energy alone.

Unfortunately, the formation of the liquidating trust means shareholders can’t get their money until Third Avenue decides to make sales. So this is what can happen to a mutual fund in a distressed situation. In an extreme situation, if an investor’s whole portfolio was invested in, say, three funds that behaved this way, his money turns out to be locked up.

We are not fans of mutual funds, and this situation just provides more ammunition against these overblown products.

Aside from recognizing this event as an investment risk, it shows how fragile some areas of the economy are. Liquidity has dried up in some assets. Who needs the Fed when you have the markets to make interest rates for shaky credits leap well into double digits? And now, with the Fed actually on the brink of a rate hike, we’ll see who else is naked as the tide goes out.

The Fed’s zero interest rate policy, aka ‘ZIRP’, was devised to turn the 2008/09 downturn from a potential depression into merely the Great Recession, and as far as anyone can tell, it worked. However, ZIRP has continued far longer than anyone thought likely.

A change from ZIRP does not necessarily mean increasing rates across the board. It will mean short rates will rise, when and if the Fed finally acts. We call that ‘normalization’ these days, since zero as a rate is abnormal. The question is when is the Fed going to act. The past couple of years have offered many opportunities but none has been quite good enough, apparently.

This last time around, the Fed held up because the global economy looks as though it is weakening. Worse yet, third quarter earnings reports look paltry, and layoff announcements are increasing in the US. This could amount to a mere slowdown or it could mean a shallow recession. If enough such signs proliferate, we expect ZIRP to persist into 2016. It’s not that 25 basis points makes that much difference. It’s that once the Fed hikes, the next topic of speculation will be when will it happen again – another element of uncertainty. The mere fact that investors are so focused on ‘will they, won’t they’ tells us that there isn’t enough else that is good about the economy.

What if ZIRP itself is causing the slowdown at this point? ZIRP has led to overcapacity in many industries, and now it is braking the process of correcting those bubbles, which is deflating many commodity prices. And low interest rates have not helped much to reduce household or other indebtedness in the US; in fact, ZIRP is akin to solving a borrowing crisis by spurring more borrowing. Student loan debt, subprime auto loans, energy company debt – there’s a lot of it. Economies expand when borrowing starts from a low base, but we are already at a very high base. There aren’t many people left who need to, want to, or even can borrow.

So while ZIRP has undesirable elements, we may be stuck with it for a while, because the cost of a hike is growing by the day.

The media’s preoccupation with China’s slowing economy is the crucible for a stock market correction, but it’s not the whole answer.

Until today, stocks’ decline was about in line with the 5% to 7% declines that happen every calendar year for no particularly good reason, but today the Dow cracked into official ‘correction’ territory at -10%. Of course, the market has been bearish for months now; it just hasn’t shown up in the market averages until the last few days. When Intel and Oracle are down double digits, and Apple and Facebook are up double digits, there’s something fishy going on.

Everyone wants to know why, of course. We can blame China, but the reality is that valuations for a select few stocks are on the very high side especially in light of mediocre revenue growth, and those high valuations make stocks vulnerable. The trigger for the correction could have been almost anything, but China is handy, especially since its market is vaporizing in a much bigger way. How does a 60% decline feel? Be Chinese and you’ll know.

And there isn’t much other good news to counter the China threat, either. Two weeks ago when Apple said, ‘well, we had great earnings but China looks soft’, and the stock lost a swift 10 points, opinions about stocks – what was good and bad, what should be at what price – changed. We are in the midst of that change now.

In the last few years, we’ve seen certain municipalities in the US fail to pay their debts, Detroit being the largest. On August 3, Puerto Rico defaulted. Around the same time, Greece defaulted.

This is the tip of the iceberg. While the debt crazed real estate bubble is largely in the rear view mirror, problems with pension and other retiree obligations promised by politicians all over the world are on countdown to explosion. Many of these were papered over in the bear market, with more debt being issued to cover the then-current debts, making the problem worse. Pension liabilities in the US have increased 400% in just the last ten years, and we doubt it’s much better overseas. And I am not even addressing everyday budget deficits in Japan, Europe, and the US;  or the giant debt bubble forming in China.

Issuing debt to cover obligations brings trouble if the borrower is not principled, or the lender is not.

By all rights, Detroit, Greece, and Puerto Rico should be disciplined by the markets, which should refuse, for many many years, to lend to them. But the markets are way too forgiving, which is one reason we have debt problems on a routine basis. Greece has now defaulted on its sovereign debt well more than 50% of the time since it has been independent. It’s a puzzle as to why anyone would lend to the country, but they do.

No one contemplates the humanitarian cost of debt loads. In Stockton, in Detroit, in Puerto Rico, in Greece, in every place where debts are too high, people are suffering. Somehow it is seen as noble to pursue debts in order to cover services and payments to the have nots, but as the tide turns, it is those projects and payments that are cut in order to fund debt service. Consequently, a new group of ‘have nots’, who may not have even been alive when the cycle started, suffers. The morality of debt loads is skewed. It is ok to borrow at first to make life better for citizens, but then it somehow becomes ok to cut those same benefits after everyone is used to the better life.

Will we ever be wise enough to strike a balance between current wants and having a more secure future tomorrow, which might mean saying ‘no’ to politicians’ promises? As debt problems proliferate, it’s easy to see we have not yet acquired this wisdom.