Fund Manager
Eric Dzuba
"There must be some way out of here
Said the joker to the thief
There's too much confusion,
I can't get no relief
Businessmen they drink my wine,
Ploughmen dig my earth.
None of them along the line
Know what any of it is worth."
All Along the Watchtower,
Bob Dylan
Despite the many interpretations of Bob Dylan's lyrics, we're certain he wasn't writing about financial assets. But the lyrics certainly resonate strongly with the third quarter. Looking back at our Q2 2007 comments, we felt that risks to equities would come from the bond market, where potential supply from the Private Equity buying binge and rising administered rates could push yields up. We were right, in part. By the end of the quarter, we found "too much confusion" in that equity markets had recovered smartly from issues that we still feel are unresolved.
Trouble in the fixed-income market—or more accurately, the structured debt (CDO, CLO, etc.) market—spilled over into the equity market causing volatility not seen in almost 5 years. As delinquencies and defaults grew in U.S. sub-prime debt, other debt that contained some portion of these securities began to implode as credit ratings were questioned and liquidity dried up. Then in August, the Asset -Backed Commercial Paper market seized for the same lack of liquidity.
Not only Hedge Funds, but also Pension Funds, traditional Mutual Funds, as well as corporations and individuals bought large quantities of asset-backed paper. As liquidity has dried up and extension options have been exercised, one risk to the system is that "near cash" has been termed out over a year or more. Also, the possibility of default on AAA rated paper exists as liquidity back-stops are not (or can't be) honored: leaving investors with the question "what is it worth?"
In September, the US Federal Reserve lowered its overnight rate 50 bps, causing us "[more] confusion". Although we can appreciate that institution's desire to inject liquidity into the financial system (and July's job figures coupled with the somewhat tepid)we can't ignore rising food and energy prices, an unemployment rate that is just off 5 year lows and a generally strong global economy. Aside from global inflation, our fear was, and continues to be, that a large rate cut would signal that risk is "on" again and perpetuate the asset bubble that was inflated in the early part of this decade. In Canada, the impact was mostly on the dollar, which rose to par with the US dollar for the first time in 30 years.
But the real issue for us as investment managers is the question of "what any of it is worth." Equities rallied during September as pundits declared the credit crisis over. But we note that the TED Spread (difference between the 3-month LIBOR and yield on 3-month US T-bill) is still near mid-Aug levels. This spread is often used as a measure of credit risk. Our issue around structured debt is that a lot of it is not being marked to market: as a result, we still see significant risks to the banks until their exposure becomes more transparent. When coupled with the rate cuts in the U.S., our fears are expressed by 19th century English essayist Walter Bagehot: "if the banks are bad, they will certainly continue to be bad and will probably become worse if the government sustains and encourages them." The ultimate threat of "bad banks" is to global (non-government) liquidity, which has done plenty to fuel the bull market of this decade.
As for the fund, the cash and short positions that minimized volatility through August were a drag on the fund through the month of September. Our REIT holdings began to slowly climb back in September, although the small cap REITs in the portfolio did not participate in this move. We have added back a small amount of capital to REIT names, as well as selectively adding to stocks and trusts that could benefit from earnings growth in the agricultural space. And despite all of the fear and loathing in the CDO space, there are likely opportunities to come as good credits are sold for cents on the dollar.
Eric Dzuba - Q3 2007 Commentary
Date Published
Fund Manager
Despite the many interpretations of Bob Dylan's lyrics, we're certain he wasn't writing about financial assets. But the lyrics certainly resonate strongly with the third quarter. Looking back at our Q2 2007 comments, we felt that risks to equities would come from the bond market, where potential supply from the Private Equity buying binge and rising administered rates could push yields up. We were right, in part. By the end of the quarter, we found "too much confusion" in that equity markets had recovered smartly from issues that we still feel are unresolved.
Trouble in the fixed-income market—or more accurately, the structured debt (CDO, CLO, etc.) market—spilled over into the equity market causing volatility not seen in almost 5 years. As delinquencies and defaults grew in U.S. sub-prime debt, other debt that contained some portion of these securities began to implode as credit ratings were questioned and liquidity dried up. Then in August, the Asset -Backed Commercial Paper market seized for the same lack of liquidity.
Not only Hedge Funds, but also Pension Funds, traditional Mutual Funds, as well as corporations and individuals bought large quantities of asset-backed paper. As liquidity has dried up and extension options have been exercised, one risk to the system is that "near cash" has been termed out over a year or more. Also, the possibility of default on AAA rated paper exists as liquidity back-stops are not (or can't be) honored: leaving investors with the question "what is it worth?"
In September, the US Federal Reserve lowered its overnight rate 50 bps, causing us "[more] confusion". Although we can appreciate that institution's desire to inject liquidity into the financial system (and July's job figures coupled with the somewhat tepid)we can't ignore rising food and energy prices, an unemployment rate that is just off 5 year lows and a generally strong global economy. Aside from global inflation, our fear was, and continues to be, that a large rate cut would signal that risk is "on" again and perpetuate the asset bubble that was inflated in the early part of this decade. In Canada, the impact was mostly on the dollar, which rose to par with the US dollar for the first time in 30 years.
But the real issue for us as investment managers is the question of "what any of it is worth." Equities rallied during September as pundits declared the credit crisis over. But we note that the TED Spread (difference between the 3-month LIBOR and yield on 3-month US T-bill) is still near mid-Aug levels. This spread is often used as a measure of credit risk. Our issue around structured debt is that a lot of it is not being marked to market: as a result, we still see significant risks to the banks until their exposure becomes more transparent. When coupled with the rate cuts in the U.S., our fears are expressed by 19th century English essayist Walter Bagehot: "if the banks are bad, they will certainly continue to be bad and will probably become worse if the government sustains and encourages them." The ultimate threat of "bad banks" is to global (non-government) liquidity, which has done plenty to fuel the bull market of this decade.
As for the fund, the cash and short positions that minimized volatility through August were a drag on the fund through the month of September. Our REIT holdings began to slowly climb back in September, although the small cap REITs in the portfolio did not participate in this move. We have added back a small amount of capital to REIT names, as well as selectively adding to stocks and trusts that could benefit from earnings growth in the agricultural space. And despite all of the fear and loathing in the CDO space, there are likely opportunities to come as good credits are sold for cents on the dollar.