"Kee" Points with Jim Kee, Ph.D.

Greece: So far this year both economies and markets have behaved pretty much as expected at the beginning of the year, with the exception of Greece’s outright refusals to meet creditor demands. In a nutshell, Greece’s government requested an extension of the country’s bailout funds from Eurozone finance ministers on Friday, and they rejected it. This led Greek lawmakers to propose a referendum which basically means that, on July 5th, the Greek people will vote on whether or not to accept bailout conditions set by the “troika” (IMF, ECB, and European Commission). A “yes” vote is a vote to stay in the European Union, while a “no” vote is a step towards exiting the Union. Greek Prime Minister Alexis Tsipras and his Syriza party are very far left, and the vote will reflect whether he’s too far left for the Greek people. In the meantime, and in order to stem bank runs, Greece shut down its banking system today (Monday) for six days and also imposed capital controls to prevent money from being moved out of the country (though a lot of money is allegedly already gone). The positive here is that a week of limited access to funds will no doubt cause the Greek people to rethink their choice in Tsipras. Many feel that Greece’s creditors are basically done trying to negotiate with Tsipras. The negative perhaps is that many Greek people live paycheck-to-paycheck anyway, so they don’t have a lot of money in banks and might not feel particularly invested in the bailout (Jefferies).

 

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Market expectations:  I agree with Jefferies' analyst David Zervos that a “risk off” period in financial markets is a reasonable expectation (and that's certainly what we saw today), but that it will be followed by plenty of reassurances on the part of the troika leaders.  In an interesting series of interviews, former Treasury Secretary Larry Summers has pointed out that, without European support (i.e. a NO vote in the referendum), and with the subsequent bank shut downs and credit problems that would follow, austerity in Greece will be far worse than it is today or would be under the troika’s conditions (pension reform, lower public wages, targeted tax increases/enforcement). I continue to believe that this is the key to anticipating Greece’s future, and I think it predicts a “yes” vote on the referendum. Summers further points out that, while “there are good reasons to think enough foam has been placed on the runway to prevent financial contagion,” it is really not wise to test whether or not we will have another “Lehman” event. I agree (who doesn’t?), and as an aside, we do not own any European bank stocks here at STMM, which would fare worst under ongoing European turmoil.

 

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Puerto Rico is in the news again as the island’s governor warns that it too cannot pay its $72 billion public debt (Associated Press). This isn’t a surprise to markets, as Puerto Rico’s bonds were downgraded to junk status back in January of 2014. Holders of Puerto Rico’s bonds will suffer a substantial loss, and we don’t hold any of those either, but Hutch Bryan, our EVP & Director of Fixed Income, says over half of municipal bond mutual funds do. In fact, the current environment reveals several of the major pitfalls involved with owning bond funds rather than owning individual bonds.  At STMM, we have talked in the past about some of the more opaque risks embedded in bond mutual funds. For example, this week the pitfalls are with funds holding Puerto Rican bonds. Last week it was the fascinating story of how investors have been pulling money out of bond mutual funds like Waddell & Reed, forcing them to sell off their higher quality securities in order to meet the redemptions. This has lowered the overall credit quality of the remaining portfolio (because the best bonds are gone), and it is a great example of how fears of interest rate risk drove investors out of funds, ultimately increasing credit risk! (i.e. the risk of default). By the way, those are the two kinds of risks for bondholders: credit risk, or the risk that the issuer defaults and doesn’t repay lenders (i.e. bond buyers), and interest rate risk, or the risk that interest rates in the economy rise, causing the value of existing bonds (and their prices) to fall. Continuing on with bond fund pitfalls, last year the story was the shake-up at PIMCO (investors pulled a lot of money out) and the pitfalls that come with investing in bond funds with high profile leaders. Prior to that the story was how many of these “bond” mutual funds actually own equities, up to 20%(!). These are just a few of the reasons why STMM has always favored buying individual bonds in separately managed accounts rather than bond funds.