Continued Bad Economic Data sends Investors to Safe Harbors

Posted by PITHOCRATES - June 10th, 2011

Times are Good when the Junk Market is Good

Junk bonds were big in the Eighties.  During the great economic boom courtesy of Ronal Reagan.  Lower tax rates.  Fewer regulations.  It was a time for entrepreneurs to take chances.  And they did.  Some took some really big chances.  They were thinking way outside the box.  In new technologies.  So there weren’t a lot of people lining up to finance their risky ideas.  Because they were too risky for most.  That’s where junk comes in.  A junk bond is a high yield bond.  It pays a high interest rate.  Because there is a very good chance the bond issuer may fail.  Making those bonds worthless.  So to attract capital to fund these risky ideas required a larger return on investment.  And the junk bond market was the place to go.

A lot of things happened that wouldn’t have had it not been for junk.  MCI Communications is a junk bond success story.  The Chrysler bailout in the Eighties was another.  Even Ted Turner owes the success of Turner Broadcasting to junk.  Yes, there were a lot of failures.  But that’s what makes junk so enticing.  You get a high return for that high risk.  A lot of entrepreneurs became millionaires.  And a lot of rich investors got richer.  So when the junk market is doing well, people are taking chances.  Taking risks.  Creating things.  New technologies.  And jobs.  Growing the economy.  But when the junk market isn’t doing well, few are taking risks.  Few are creating jobs.  And the economy isn’t growing.  Or won’t be growing.  For if the economic outlook is bleak, investors look for safe harbors for their cash.  Until a more favorable business/investing climate returns (see Junk bonds hit a speed bump by Ben Rooney posted 6/10/2011 on CNNMoney).

Investors had been flocking to corporate “junk” bonds since the early months of 2009 amid a broad flight to risky assets because of the high yields that come along with that risk. But demand for those bonds has tapered off in the last few weeks following a spate of lousy economic news.

“There’s a lot of uncertainty in market,” said Jody Lurie, corporate credit analyst at Janney Capital Markets. “We’ve had a lot of bad news in the last few weeks and that’s making people hesitant.”

Business owners as well as investors hate uncertainty.  And there’s a lot of that these days.  Suffice it to say the Obama administration is not the most business-friendly administration.  Unless you’re a crony of the administration.  But few small business owners and entrepreneurs can afford what it takes to be a crony capitalist.  Because special favors don’t come cheap.  And there’s that ugly recession that just won’t end.  Few want to invest and create jobs when so many are unemployed and are unable to buy things.

“This market is extremely expensive,” [William Larkin, a bond portfolio manager at Cabot Money Management] said. “I’m afraid that we could get some hot inflation data on top of the prices,” he added. And that could leave bondholders with a negative return.

Inflation is another reason why the junk bond market is losing its appeal.  The value of a bond lies in the difference between your bond interest rate and the prevailing interest rate on the street.  Inflation increases interest rates.  So as inflation increases, that premium you had over the interest rates of ‘safe’ investments decreases.  Making the return on your junk more similar to ‘safe’ investments.  Only you still carry that high risk of your bonds becoming worthless.  If inflation pushes interest rates over your bond interest rate, you lose money.  Because your high-risk bonds pay less than safer investments like government treasury bonds.  So a bad economic outlook and/or inflation worries will make people run away from junk bonds to something safer.

A Six Week Losing Streak

In fact, when bad economic news comes out that says we’ll have more recession before we have any economic recovery, junk bond holders aren’t the only ones looking for safer investments.  Investors also flee the stock market.  Especially when the stock market is setting near-record losing streaks (see At noon: Dow surrenders 12,000 by David Berman posted 6/10/2011 The Globe and Mail).

The Dow was recently spotted at 11,980.78, down about 144 points or 1.2 per cent, marking its lowest level since March amid ongoing concerns about the health of the U.S. economy…

With Friday’s decline, U.S. indexes are well on their way to posting their sixth consecutive losing week – a losing streak noted by Bloomberg as the worst string of down weeks since 2002…

Meanwhile, investors have been diving into the safety of bonds. The yield on the 10-year U.S. Treasury bond recently dipped below 3 per cent as bond prices (which move in the opposite direction to yields) have risen to their highest levels since early December.

And this despite the possibility of a U.S. default after reaching their legal debt limit.  Everyone in the administration is predicting doom and gloom about a U.S. default.  Apparently the investors are more frightened by the horrible economy, high unemployment numbers and a recession that never ends.

Time to call the Recession a Depression?

Of course, this recession will end.  There hasn’t been one that hasn’t yet.  They’re usually over anywhere from 6 months to a year or so.  That’s usually sufficient for the market to correct.  But it may take a little longer this time (see U.S. Will Trail Global Growth for Decade: Fink by Sree Vidya Bhaktavatsalam and Charles Stein posted 6/10/2011 on Bloomberg).

BlackRock Inc. (BLK)’s Laurence D. Fink, chief executive officer of the world’s biggest asset manager, said the U.S. will trail the global economy for much of the next decade.

The U.S. economy will grow 2 percent to 3 percent for the next five to 10 years, lagging behind global growth of 3 percent to 5 percent, Fink said today in a Bloomberg Television interview with Erik Schatzker from the Morningstar conference in Chicago. ..

A series of reports suggests the world’s largest economy is decelerating. Manufacturing grew at its slowest pace in more than a year in May, consumer spending rose less than forecast in April, and the unemployment rate unexpectedly climbed to 9.1 percent in May.

You know, after 10 years I don’t think you call it a recession anymore.  I think you start calling it a depression.

Where’s a Good World War when you Need One?

The last time we had a depression as bad as this there was a Big Government president in the White House.  He spent money like there was no tomorrow.  And none of it helped.  Every New Deal program was a failure.  They didn’t put people back to work in the private sector.  You know what did?  World War II.  It wasn’t FDR that ended the Great Depression.  It was Adolf Hitler.  Because someone had to build all that war material to defeat him.  And that someone was us. 

Things are different today, though.  There is no villain to come to Obama’s rescue.  It will be up to him alone to make his policies more business friendly.  Or his successor in 2012.

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