I will start this Sunday’s commentary with an excerpt from an exchange I had with a seasoned Washington insider:
In all prior fiscal cliff debates between 2008 and now, reciting the experience of TARP's initial failure and subsequent passage in 2008 has been enough to convince inexperienced House members to come around and avoid defaulting US debt or a long shutdown. This time, Jim Jordan, one of the few remaining Reps who actually opposed TARP twice, is leading 41 "newbies" that have never experienced a shutdown or fiscal cliff (and 48 other "hard to educate" members) to think it is better to default on US obligations now than to incur any new "debt." For that reason, they prefer to prevent any action on a budget by blocking any speaker election other than Jordan. My sources have said this group is so convinced they are "right" that they refuse to go along even after being told that the course they have chosen will likely cause a worldwide depression and even though they have also been told the ONLY obligation the US debt represents is an obligation to spend/tax wisely over the long-term.
Please note that Republican stalwarts like Karl Rove or, now-presidential candidate, Vice-President Mike Pence have named the few (and they are a minority within the Republican Party) House Members who are disrupting the entire funding and budget process “the Chaos Caucus.”
Market agents don’t like chaos. Market agents don’t like these destroyers of the America that they (Chaos Caucus) purport to represent. Some market agents are not afraid to speak out; I’m one of those. Other market agents avoid the public eye because their firms want them to be “nonpolitical.” Well, I’m not afraid to speak out. In my opinion, spending, budgets, deficits, taxes, laws, rules, and governance are each and all financial inputs; they directly impact markets and economic outcomes.
My professional concern is for the clients of Cumberland who use us for investment advice. My personal and patriotic concern is for my country, which is now paying a price for this Washington rot. Today, I want to show that cost. In the case of this governance failure in the House of Representatives, the two concerns of clients and country mesh into one. I want clients and consultants to see the data below, and then each person can determine for themselves if this is a function of failure in governance. Some may blame these outcomes on the Fed or on the wars in Europe or Middle East. Maybe? But if you look at the calendar (debt ceiling fight, government shutdown fight, House Speaker fight) as you look at the price charts, the coincidence of market reactions to governance failures jumps out at you.
So here goes.
The first chart below is the 10-year credit default swap pricing of the credit insurance on the United States. Please note that it is back to the price at the peak of the McCarthy-Biden standoff in May. I have written about this previously. See “The Cost of Debt Ceiling Crisis,” https://www.cumber.com/market-commentary/cost-debt-ceiling-crisis, and “Gaetz,” https://www.cumber.com/market-commentary/gaetz.
This first chart shows the CDS that trades globally and is denominated in euros. The source is a Bloomberg terminal-based compilation of the data. I personally believe this is the best market-based price indicator of how the global markets perceive the political dysfunction in the US and specifically the destructive dysfunction found in the House of Representatives.
Some readers have asked me about the CDS chart and data that I am using. They point out that since it is in euros, an American investor must face a currency conversion issue between the US dollar and euro. They are correct.
So, we’ll offer a second chart. There is a thin market on the credit default swap on the United States that is denominated in US dollars. Here is the website: https://www.worldgovernmentbonds.com/cds-historical-data/united-states/5-years/. Here is a chart of the recent volatility:
Note that this is a 5-year CDS, not a 10-year CDS. Its pricing reveals a similar conclusion as the 10-year CDS in the first chart. All this nonsense in the US House is costing the United States money and is punishing the US investment community, business community and every investor. Note that this 5-year US dollar-denominated CDS has doubled in price since January.
Some clients have asked how this translates to actual investment policy and management of portfolios. That is the ultimate question for an investment counselor. When all is said and done, it comes down to what do I buy, sell, or hold?
For the stock market investor, we must note that Cumberland’s various investment portfolio styles (not the quant styles) all have cash reserves. The amount varies. In the US Equity ETF portfolio, the cash reserve exceeds 20%. For discussions of cash and the deployment of it, see our weekly YouTube where Matt McAleer describes that cash: https://www.cumber.com/market-commentary/cumberland-advisors-week-review-digest-oct-16-oct-20-2023.
Here’s a chart originating with Bloomberg data that shows the US Treasury short-term yield versus the earnings yield on the S&P 500 Index. Hat tip to Bloomberg columnist John Authers for revealing this chart in his column.
Thus, the old TINA (“there is no alternative”) is now being replaced with “there is an alternative” (TIAA). As the chart above shows, the riskless cash (Treasury funds or T-bills) return is now higher than the earnings yield on stocks. And remember that the earnings reported by a corporation are an accounting-rule description and subject to revisions, while the cash equivalent is paying you cold hard cash. And liquidity in the cash equivalent is instant, so you can change your mind without penalty at any time.
Furthermore, there may be more than one alternative. With this chart, I will offer one for a longer-term investor who is in a high tax bracket. The following chart shows a comparison of a Florida Housing municipal bond, which is tax-free. I compare it with taxable federal agency yields and taxable US Treasury yields. The spreads are also revealed in the chart.
The chart shown above reveals unusual items. The yield on tax-free and on taxable debt of the same high-grade credit quality are about the same. That means the entire US income tax code, which usually provides an arbitrage, has disappeared in the market pricing. There is no rational explanation for this phenomenon, in my opinion. The irrational explanations include (1) that the US is going to default and not pay the debt of its federal agencies or (2) that the entire US income tax code is going to be repealed. In my opinion, neither of these assumptions is rational. Were either to occur, the country would face monumental problems that reasonable people don’t even want to contemplate.
At Cumberland, for individual investors in the highest tax brackets, we are currently buying longer-term tax-free bonds like the one shown in the chart. Write to us if you’re interested and we will have information sent to you: [email protected]
Lastly, I have been asked about banks and the financial sector in general. In the US Equity ETF portfolio, we have not yet repositioned banks. I believe the market price correction in the banking sector is not over. There are forthcoming changes in capital requirements and regulatory impacts that, in my opinion, are not yet fully reflected in the valuation and earnings of the banking sector. In sum, we will probably reposition a bank sector sleeve in the future, but we’re not there yet.
Here’s chart courtesy of Torsten Slok (Tortsen Slok, Jyoti Agarwal, and Rajvi Shah, “Outlook for US regional banks: Credit growth slowing and credit conditions tightening,” Apollo Global Management, October 2023. Email. Data source: FDIC). We thank Torsten for permission to share it with our readers. It shows the unrealized losses in bank portfolios through the first half of 2023. FDIC Q3 data has now confirmed this trend. The machinations in the House of Representatives have only made this circumstance worse.
Let’s sum this up.
The House Members who are the noncompromising, disruptive ones are causing losses for investors, pensioners, foundations, operating businesses, now home buyers, etc. The Chaos Caucus is injuring the capital markets of the United States. Those House Members are mostly too young to remember the TARP moment. Note that Rep. Jordan remembers it. Note that he is known to be a House member who opposed TARP the second time as well as the first time. I believe that is why the designation of “flamethrower” was heaped upon him by his own colleagues and why he repeatedly failed in his attempts to replace Speaker McCarthy. I know of no market agent that supported a vote against the TARP program on the second round of voting.
Let’s leave it to readers to contemplate what that means for a decision-maker who aspires to be our leader.
Also note that Rep. Gaetz was not in the Congress then. Gaetz was a student. He has no personal and experiential knowledge of that history of the events in the prior financial crises. Many of his more mature colleagues want to throw him out of the House. Some of his collaborators, like Boebert or Santos, weren’t old enough to legally buy a beer.
We will have more on Gaetz in a future missive.
Much of this higher credit-risk cost is fixable in my opinion. It requires a congressional resolution and a funding mechanism that would return us from flamethrower politics to functioning government. Imagine if an ironclad law were passed by both chambers and it said that the US will pay what it has appropriated as expenditures and will pay the cost of financing and refinancing. Imagine, no ambiguity, just clarity. In my opinion, the CDS pricing would immediately improve.
Also, imagine if the budget shutdown brinksmanship method were repealed. Again, the improvement in markets and financial conditions would immediately be positive.
Dysfunctional politics have a cost. You can see it the charts above.
If you’d like information about 5% tax-free bonds with the highest quality of credit, we’d love to hear from you: [email protected].
David R. Kotok
Co-Founder & Chief Investment Officer
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