During the first trading session after Standard & Poor’s downgraded its rating of U.S. debt from AAA to AA+, investors got out of stocks and parked their money in...U.S. Treasury bonds.
Was that odd?
"Outside of the fact that the U.S. got downgraded and Treasuries are rallying today?" asked Scott Burns, director of exchange-traded fund analysis at fund monitoring firm Morningstar. “Not really. That's what tells me the selloff has very little to do with the downgrade. That it's really more about recession fears and things” like Congress’ ability to deal with deficits and debt in a cohesive fashion.
Indeed, demand for the U.S.’ bonds drove the price of two-year Treasury notes down to a yield below one-quarter of one-percent per annum.
Which showed that, in the end, there is no substitute – even at AA+ -- for safe keeping of cash other than Treasury bonds.
As a safe haven, “you cannot replace something with nothing,’’ said Mohamed A. El- Erian, co-chief investment officer at Pacific Investment Management Co., which runs the largest mutual fund extant. Its Total Return Fund had $142.5 billion in net assets at the start of July, according to Lipper.
“There is nobody else to pop in and replace the Treasury market as the most liquid and deepest market,’’ El- Erian said in an interview with CNN Money.
Which made demand for Treasuries – particularly with long-term maturities – extremely strong, after the downgrade.
“The Treasury trade is being driven by fear, not love,” said Russ Koesterich, global head of investment strategy for BlackRock’s exchange-traded fund business, iShares.
It’s also being driven by lack of alternatives. "The fact that remains that given the level of uncertainty among market participants, Treasuries have been the flight to safety right now,’’ said Dan Greenhaus, chief global strategies for BTIG, which provides global trading services to mutual funds. ‘As you go further out on the curve, there's incredible demand for longer-dated maturities."
Early in the post-downgrade retreat, the BlackRock iShares Barclays 7-10 Year Treasury Bond Fund and the iShares Treasury Inflation Protected Securities Bond Fund, for instance, were big gainers, Greenhaus noted.
Municipal bonds, he said, were facing “a tough day” as were high-yield bond funds. Among those hit: iShares’ Barclays 1-3 Year Credit Bond Fund, the iBoxx High Yield Corporate Bond Fund and State Street’s SPDR Barclays Capital High Yield Bond Fund.
DWS Investments, a unit of Deutsche Bank Group, however, noted that municipal bonds had defied investor sentiment all year.
Having expected some states to default on their own bonds, investors have been net sellers of municipal bonds for the majority of the year. That while “the muni market was rallying from its January low to post its best second quarter return in 20 years,’’ it said.
“Unlike the federal government, the states are legally required to balance their budgets annually. They’ can’t roll a deficit. They have a history of managing through volatile economic periods,’’ Philip G. Condon, the head of municipal bond portfolio management and bond analysts at DWS said.
The lowest rated states: California and Illinois. Yet, at A- and A+, by the S&P standard, they are “still in solidly investment-grade territory.”
Outside of bonds, mutual funds and exchange-traded funds performed fairly predictably. Exchange-traded funds, in fact, appear to be fast becoming the preferred method of matching or countering directions in world markets. Now, 38 percent of all U.S. trading in equities can be attributed to ETFs, Koesterich said. ETFs now are regarded as “a liquid way to manage risk,’’ he said.
This is the case whether the market down up 624 points, as it did Monday, or up 429 points, as it did Tuesday, or down 520 points, as it went Wednesday, or back up 423 points as on Thursday. That was the fourth straight day of 400-point or bigger swings, a first in the chronicles of the Dow Jones Industrial Average.
Direxion Daily Russia Bear 3x Shares, for instance, gained 22.9 percent in the first two hours of trading Monday. The fund tries to triple the returns generated by the inverse of the DAX Global Russia Index.
But the next day, when the Dow Jones Industrial Average gained back two-thirds of its Monday losses, the Russia Bear 3x Shares lost 12.5 percent of their value.
Other top gainers at the outset of Monday: C-Tracks Citi Volatility Index TR ETN, an exchange-traded note that tries to capture the implied volatility of U.S. stocks with large capitalizations; and, the VelocityShares Daily 2x VIX exchange-traded notes, which try to produce two times the results of the CBOE Standard & Poor’s 500 Volatility Index Short-term Futures Index.
Losers: Funds that tried to triple the returns of the S&P Latin America Index, the MSCI Emerging Markets Index and the DAX Global Russia Index.
For the long haul, the “the least bad place” to put client money, in the minds of Contango Capital Advisors, was (and is) … U.S blue chip stocks.
“What we've seen in the last 10 days or so, is a dawning realization that most of the real economies of the world are slowing down,’’ said chief executive officer George Feiger.
Sovereign debt problems in both the U.S. and Europe are now being understood as chronic, Koesterich said.
But Europe’s financial situation is getting worse and both its banking and currency issues are structural in origin, in Feiger’s estimation.
Emerging markets, from Brazil to India to China, are seeing their growth slow down. And, while 5 percent annual growth in gross domestic product might seem good by Western standards, Western investors have priced assets in these nations as if they would grow at 10 percent per annum.
The governments of these nations are trying to slow down their economies without causing recession. But not all is as rosy as it seems, by the stats.
"Remember, you can't believe Chinese economic statistics in a very literal sense,’’ he said. "They have significant inflation problems. They also have a lot of political problems. They have ethnic minority issues. They have strikes. There is a lot of stuff going on in China, that people don't focus on because they're looking at these numbers which the Chinese produce with a rapidity which would make our statisticians blanch with envy if they believed them."
The U.S. economy, by contrast, is a “mush economy,’’ he says. It will mush along and its best stocks “by that comparison that the U.S. is the least bad place” to put money in.
There’s not unanimity of opinion there. Pacific Investment Management Co., better known as PIMCO and best known as the home of founder Bill Gross, turned bearish on U.S. government bonds, including Treasuries, at the start of the year. Gross and El-Erian dumped all such holdings from the Total Return Fund … in February.
Now, what’s happening is what El- Erian calls a “synchonized global slowdown.” The European debt crisis followed by the downgrade of U.S. debt has dealt “yet another blow to fragile business and household confidence.’’
That is undermining the “animal spirit” that “makes a capitalist system invest and take risk,’’ he said.
Worst is the fractious nature of the leadership of the U.S. government, as called out by Standard & Poor’s in its downgrade.
"Regardless of what the ratings agencies said, you realized this was a ship of fools,’’ Feiger said of the Congressional leaders who could not come up with a coherent and cohesive approach to cutting spending and limiting the amount of debt the nation will carry, by any significant amount.
“These people are willing to do anything for their political advancement, regardless of the impact on the economy. And this is the message the world took from” the debt ceiling dance, Feiger said.
Now the question is whether the country’s leaders will regard this, in El-Erian’s term, as a “Sputnik moment,”’ put the “massive blame game” behind them and “start to claim the future as opposed to arguing about the past.’’
In the meantime, the world financial system will have to reorganize itself. That could be around Treasuries, again, as the safest investment option in times of trouble. Or not.
"So there is a legitimate question out there: Does the system simply renormalize and everything operates again with a double A plus in the middle or do you accelerate a journey toward a multipolar world?,’’ he said.