Over the past two years, as we anticipated the credit cycle downturn, we gradually and methodically worked to reduce credit exposure in our managed portfolios. In light of the dramatic capital markets disruptions and the extreme market illiquidity after the bankruptcy of Lehman Brothers, we temporarily ceased purchases of all non-government guaranteed debt. Additionally, we eliminated indirect credit exposure by moving the liquid portion of our client portfolios into a government money market fund.
Since the spring of 2009, global capital markets have slowly begun to return to normal, as suggested by the plummeting yield spreads of credit investments and a rebounding new issues market. The massive government stimulus package also appears to have worked in stalling the economy’s freefall.
In light of these positive credit developments, we began a gradual and methodical process of layering credit investments in our portfolios since early summer – first in non-financial issuers, then credits of systemically important financial firms, and most recently, moving back into a prime money market fund. Our decision to move back into corporate credits is based on a number of considerations.
Positive Forces at Work
Trajectory of Growth Turns Positive: As we stated in our June 2009 newsletter, our decision to invest in corporate securities must be preceded by credible signs of an economic recovery. We give Fed Chairman Ben Bernanke the credit of correctly identifying the timing of this recovery. After the famous remark of “green shoots” in the economy in early spring, the Chairman declared in September that the “recession is very likely over at this point”. A downward revision to the third quarter GDP still places growth at 2.8%, the first quarterly growth in two years. Elsewhere, GDP growth in Germany and France, two of the largest European economies, also moved into the black. In addition, the improved economic vitality of the Asian economies has been apparent for several quarters.
Although we suspect that growth may be uneven, and that tight credit and tarnished consumer balance sheets may lead to unimpressive rates of growth, we believe the growth trajectory in the U.S. will remain intact. Based on this analysis, we think diversified corporate issuers with strong capital bases and profitability will benefit from the recovery and thus are good candidates for our investment strategies.
Financial Institutions’ Systemic Risk Has Diminished: Thanks to unprecedented government intervention and improved capital markets conditions, the systemic risk of global financial institutions has diminished substantially in recent months. Bank earnings in the second and third quarters of 2009 showed marked pre-provisioning profit improvement. Low interest rates brought in a windfall as net interest revenue improved and more trading and fee income came from the securities business. In addition, although losses and provisions for losses continue to trend higher, early delinquencies are dropping off, suggesting fewer new loans are going bad.
Most of the first nine recipients of the Troubled Asset Relief Program (TARP) investments have repaid the government since last summer, a sign of improved capital strength and a vote of confidence from the regulators. Last month, the Federal Reserve disclosed that nine of the ten largest banks subject to the systemic bank capital stress tests “now have increased their capital sufficiently to meet or exceed their required capital buffers.” In fact, Treasury Secretary Tim Geithner felt strong enough about the strength of the financial system that he is “working to put the TARP out its misery.” Likewise, major banks in the U.K., France, the Netherlands and Germany had similar successes in raising equity capital and repaid government investments.
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