It remains to be seen whether anybody was playing a cosmic joke when Hurricane Wilma was tearing South Florida apart at the same time that President Bush was appointing Ben S. Bernanke to succeed Alan Greenspan as chairman of the Federal Reserve. At the end of January, Bernanke will replace a living legend who has lorded over the financial markets since 1987. This appointment is every bit as important for the American people as the Supreme Court appointments that ignited so much controversy during the second half of 2005.
Many presume that Bernanke, a former Princeton University economics professor, will follow the same policies as his predecessor, the now lionized Greenspan. But if memory serves correctly, Bernanke is the same economist who once suggested that the Federal Reserve could simply drop dollar bills out of helicopters to battle deflation. While demonstrating a greater sense of humor than his predecessor (not a particularly difficult accomplishment), Bernanke's comment also suggests that the new chairman may be even more inclined than Greenspan to intervene when the financial markets seize up. Some observers would consider this a good practice. There are many — myself included — who worry about the increasing level of moral hazard that such interventions introduce into the markets. Among the legacies that Greenspan leaves behind is the “Greenspan put,” that is to say, the belief that the Federal Reserve will rescue the market from disasters of its own making (remember the Long Term Capital Management crisis). Were the market to adopt a belief in a “Bernanke put,” all bets could be off, as the level of risk-taking is already uncomfortably high. Greenspan leaves behind a series of gargantuan imbalances — record current account and budget deficits, unsustainable consumer and corporate debt levels — that threaten global economic harmony. Will Greenspan's sins haunt Bernanke's term as central bank president? That is one of the key investment questions for 2006.
As the end of his term approaches, Greenspan has been working to address the most egregious economic imbalances he's leaving behind. At press time, the Federal Reserve had raised overnight interest rates (also known as the “discount rate”) 13 straight times, pushing it from 1.0 percent in June 2004 to 4.25 percent in December 2005. From a number of vantage points, however, these interest rate increases had yet to achieve their aim of slowing the economy, dimming inflation, or squelching financial speculation. Despite the string of hurricanes in the summer of 2005 that devastated a swath of the country from East Texas to Florida (and, among other things, caused oil and natural gas prices to spike above already elevated levels), the U.S. economy continued to show surprising strength. U.S. gross domestic product (GDP) grew at a surprisingly strong rate of 4.1 percent in the third quarter, a truly impressive number. In view of this strength, I believe the Federal Reserve will continue to raise the overnight borrowing rate to at least 5.0 percent before the end of the current tightening cycle.
Despite the Federal Reserve's interest rate hikes, though, monetary conditions have hardly tightened at all. The 10-year Treasury yield is barely back to below where it was when the Fed started tightening it in June 2004 (4.6 percent). The unhappy truth is that in today's financial system, more credit creation occurs outside of the Federal Reserve system than inside it. As a result, the Federal Reserve's moves do not have the same impact they once did. The Federal Reserve's Open Market Committee appears to recognize that fact, and as of late 2005 was not suggesting that it views monetary conditions as tight, stating in its Nov. 1, 2005 communiqué that: “[M]onetary policy accommodations, coupled with robust underlying growth in productivity, [are] providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas.” While raising the inflation flag again, the committee noted that “core inflation has been relatively low in recent months and longer term inflation expectations remain contained.” It also noted that it expects underlying inflation to be contained and expects to be free to continue to raise rates at a measured pace.
In Greenspan's Congressional testimony on Nov. 3, 2005, the Federal Reserve chairman raised the inflation flag again, however, arguing that the deflationary effect of the entry of China, India and the former Soviet bloc into the world economy would eventually fade. He pointed out that the addition of more than 100 million educated workers from former Soviet countries, large segments of China's 750-million strong work force, and workers from India “would approximately double the overall supply of labor once all these workers become fully engaged in competitive world markets,” a development that “has restrained the rise of unit labor costs in much of the world and hence has helped to contain inflation.” He admitted that these forces “may well persist for some time” but argued that they would ultimately wane. His evidence? He provided none that we heard, but it sounded good to those who want to continue to fight the last war (the one against inflation).
Instead of raising rates to deal with inflationary pressures, which remain muted, the Federal Reserve should raise them to quell financial speculation which is running amok. Some commentators viewed the Open Market Committee's statement on inflation as “hawkish.” I consider it nothing more than boilerplate. Inflation provides the Federal Reserve with intellectual cover to raise rates, but the real reason to do so is speculation. The forces of deflation — globalization and technology — remain as potent as ever and continue to counterbalance the inflationary effects of high-energy costs.
The credit markets are the best evidence of the failure of Federal Reserve policy to achieve its traditional goals. Less-than-investment-grade corporate bond spreads are still well below 400 basis points, very low by historical standards.
Moreover, the corporate bond default rate in 2005 has been less than 2 percent, which is also very low by historical standards. This is partly attributable to the ability of many companies of dubious quality to refinance their debt as investors remain hungry for yield. Another factor has been the explosion of credit derivatives, particularly credit default swaps, which have contributed to the enormous expansion of credit. By creating a huge derivatives market in which investors can express their views on both individual credits and broad sectors of the market, the credit derivatives market has drawn investors away from the high-yield bond market and increased the overall liquidity in the credit markets. Increased liquidity, which is a technical phenomenon, has led to tighter spreads (that is to say, a measure of risk, with tighter spreads denoting lower risk) than are justified by credit fundamentals. The low default rate also has lured investors into feeling complacent about their ability to hedge credit risk through credit default swaps, as well as about their ability to sell corporate bonds in the event of a market sell-off.
As we enter 2006, corporate bonds remain overpriced and offer poor return prospects. Only time will tell whether the December 2005 default of Calpine Corp. was a sign of significantly higher defaults to come in 2006. Calpine Corp., the overleveraged energy merchant with $22.5 billion of debt, could no longer sustain itself after the cost of its primary raw material, natural gas, soared after Hurricanes Katrina and Rita cut production. The Calpine bankruptcy, while certainly not unexpected, sets a negative tone for the credit markets as they enter 2006.
The real question is what happens in other sectors of the U.S. industrial landscape that remain under tremendous pressure and will be treacherous for investors in 2006 and beyond. The most obvious example of this is the automotive sector. Among the areas to watch out for will be the continuing deterioration of General Motors (GM) and Ford Motor Company bonds, a possible spin-off transaction of General Motors Acceptance Corp. (GMAC), which could cause a short-term rally in GM bonds.
General Motors is suffering from a broken business model. On Nov. 1, 2005, Moody's downgraded GM's long-term corporate credit to B1, three notches above CCC+. The rating agency did not pull any punches in explaining its decision: “The ongoing erosion of GM's competitive position and market share is evident in the company's significant third quarter operating loss, which contributed to $6.6 billion of cash consumption for the nine months that ended September 30  … At the same time, GM continues to face a significant competitive cost disadvantage because of a burdensome North American wage and benefits structure within its own operations and those of its major supplier, Delphi Corporation.” Moody's acknowledged the company's plans to monetize part of its investment in GMAC, writing: “[T]he B1 rating anticipates that GM will be successful in selling a majority stake in GMAC.” But such a transaction creates another problem for GM: “Dividends received from GMAC have been a major source of cash to GM and have provided a lift to its credit metrics. The potential reduction in dividends from GMAC due to a partial sale would contribute to a longer term erosion of the company financial profile.” In other words, GM needs to sell its most valuable and viable asset in order to have a chance to maintain its current credit rating and regain its footing. On Dec. 12, 2005, Standard & Poor's jumped into the fray and downgraded GM to B from BB-, stating that “[t]he downgrade reflects on increased skepticism about GM's ability to turn around the performance of its North American automotive operations.” Standard & Poor's automotive analyst Scott Spinzen was later quoted as saying that “[a]t this juncture, it's our feeling that [a GM bankruptcy] isn't a far-fetched conclusion, if the deterioration we've seen over the past few quarters is continuing.” In my view, a GM bankruptcy is a certainty. More than 40 percent of companies rated single-B default. The true kiss of death, of course, was GM Chairman Rick Wagoner's denial that GM will enter bankruptcy. This statement, which nobody (even Wagoner, I suspect) believed, is no different than the vote of confidence a football general manager gives his coach a week or two before firing him. The minute Wagoner denied the company would go bankrupt, you could bet your bottom dollar a Chapter 11 filing was in the cards. The only question is: how soon will it occur?
The credit markets are increasingly treating GM like a near-term default candidate. The credit default swap market, which is a much more accurate barometer of credit quality than the high-yield bond market (due to its far greater structural flexibility and liquidity), is now demanding upfront payments in addition to annual premiums for derivatives contracts that protect owners of GM's debt should it declare bankruptcy. This is the same status that was shared by Delta Airlines and Delphi Automotive just before their bankruptcies. According to Bloomberg News Service, Delphi's default-insurance sellers started demanding upfront payments six months before that company filed for bankruptcy.
The stock market is hardly treating GM better than the debt markets. Nevada-based billionaire Kirk Kerkorian's GM stock investment is looking worse every day (See “GM's Woes,” p. 34). Kerkorian is increasingly looking like a prizefighter who decided to enter the ring one time too many.
It used to be said that what's good for GM is good for America. No one is saying that anymore. It's not that GM's condition is no longer relevant to the U.S. economy; on the contrary, it's all too relevant. The problems that are sinking GM — bulging legacy costs, globalization, the consequences of an oil-based economy — are the same problems that will ultimately spell the end of U.S. economic hegemony unless our political and business leaders emerge from their stupor and take serious steps to amend current economic policies. Today's slogan should be: What ails GM ails America, and the solutions to GM's and America's economic woes are the same. What Robert “Steve” Miller, Delphi's new chairman and chief executive, pointedly says of GM's largest parts supplier is equally true of GM: “Delphi is a flashpoint, a test case, for all the economic trends and social trends that are on a collision course in our country and around the globe.”1 Unfortunately, our political and business leaders show no indication that they are going to address these issues any time soon. General Motors will enter bankruptcy long before the members of Congress get off their duffs and begin to make a serious attempt to deal with the profound structural problems plaguing the U.S. economy. Congress can begin by adopting measures that would significantly reduce energy usage. Two important steps would be to adopt higher minimum mileage requirements for all vehicles and to reduce the national speed limit to 55 mph. Reform of the health care and pension systems is also going to have to be addressed at some point, despite the political pain it is going to cause.
Meanwhile, investors can look forward to more leveraged buyouts in 2006. The November 2005 buyout of Georgia-Pacific Corp. by Koch Industries Inc. may be indicative of a new trend of large companies going private to avoid the headaches of being a public company. The announcement of this transaction drove Georgia Pacific's bonds down by 10 points as a result of the higher leverage it will place on the forest products company's balance sheet. This kind of event risk has been a big issue in the European credit markets as well, where investment grade investors have been confronted with the same threat to their bond holdings.
Finally, the equity markets offer more promising opportunities for investors, although it'll remain key to select the right sectors and individual stocks. Many energy stocks are still attractively priced from a price/earnings ratio and book value standpoint; they also pay attractive dividends. Housing stocks may be getting a little long in the tooth, particularly with rising interest rates; but a large sell-off is unlikely as the American consumer's love affair with his home is likely to continue. Health care remains relatively strong, with health care costs rising and the new Medicare drug benefit giving a boost to spending.
Last year was a difficult year for even the most sophisticated investors. Single digit returns were the norm, even for hedge funds that have so captured the attention of the media and regulators. It's fair to expect that 2006 will present similar challenges. The change in the guard at the Federal Reserve is a potentially momentous event. Greenspan was faced with the 1987 stock market crash shortly after he assumed the helm of the Federal Reserve, and he is generally credited with handling that crisis with aplomb. Let's hope that Bernanke is equally well-equipped to handle any crises that may occur if the financial imbalances bequeathed to him by his august predecessor finally come home to roost in 2006.
Quoted in The Wall Street Journal, Nov. 14, 2005, “A Middle Class Made by Detroit Is Now Threatened by Its Slump,” p. A1.