Waves of Capital

The costs and opportunities of massive government spending

FABIO SAVOLDELLI, CHIEF INVESTMENT OFFICER, OPTIMA FUND MANAGEMENT

To paraphrase Winston Churchill, an exact understanding of the government’s policy toward stimulus is “a riddle wrapped in a mystery inside an enigma”.

Even for skilled observers, it is difficult to see where emergency stimulus ends and the administration’s fundamental economic and political policy begins. Nevertheless, the numbers are breathtaking, even in proportion to GDP, and even when considered versus all major previous declines (see Table 1).

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Yet discussion of these numbers in proportion to GDP fails in most cases: what percentage of citizens even know what the GDP number is, even if we excuse a trillion dollars or two between friends? Equipped with the ever-fascinating facts available from the US Bureau of Engraving and Printing (“the thickness of the paper (for currency) shall be 124 + 7 micrometres” and the bills shall be “6.6294 cm wide and 15.5956 cm long”) one can try another tack, to put it the spending in context:

• The government’s Car Allowance Rebate System (more commonly called “Cash for Clunkers”) has cost the US taxpayer $2.88 billion. In $1 bills this would stretch around the Earth’s circumference almost 11 times, and weigh the same as 2291 Toyota Priuses, about 10% of initial annual production.

• The total amount given to AIG in the bailout stands at $69 billion. This could cover all Hong Kong with a carpet of $100 bills over six bills deep. In $1 bills this could cover Switzerland in a luxurious coat over 17 bills deep.

• The total amount of bailout money that has actually been paid stands at $549.4 billion. In $100 denomination bills the amount could cover every square inch of Switzerland and the Bahamas, or stretch around the world 20 times. In $1 denomination notes, it would weigh the equivalent of 1,445 Boeing 747s, 29 more than have ever been built.

The broad rubric of emergency actions needed for economic recovery has covered the full spectrum: from the near instantaneous purchase of a failing broker-dealers inventory of mortgages (a “justified rescue to prevent a systemic collapse of financial markets”), Cash for Clunkers (needed for “jumpstarting a major sector of the economy”), to a justification of healthcare reform (“a new foundation for future growth”). Some are clearly stimulus, while others lean heavily toward longer term policy.

Among hedge fund investors there are rightly two schools of thought on this, as well as managers with blended approaches. The economist school tends to lean toward classification of government expenditures, broadly divided into those that are infrastructure based, and so can increase potential future GDP, and those that are short term stimulus based, which will effectively increase current expenditure at the expense of future expenditure. This school inherently takes a longer view, and constructs the portfolios on that horizon.

The market school takes a more pragmatic, shorter term, approach: waves of money are being spent and this will reverberate in the economy. To them, the economic rationale, and the longer term effects, are less relevant. What matters to them is the impact, both immediate and in later quarter-on-quarter and year-on-year results. A vivid example of how the government’s actions can be traded upon by both camps can be seen in Cash for Clunkers and its effects.

Cash for Clunkers
The most talked about federal stimulus measure these days is not part of the $789 billion package passed with much fanfare six months ago. Instead, the Cash for Clunkers program launched at the end of July with just a $1 billion initial price tag (now upped to $3 billion) and is being widely credited for increasing vehicle sales. The impact is illustrative of how both the economist school and market school of hedge fund traders will look at the program.

The economist school would note the central argument for the economic stimulus package was creation: building up the economy by improving infrastructure. In contrast, Cash for Clunkers is fundamentally based on destruction. Buyers receive rebates toward new higher-mileage vehicles only if their old vehicles are destroyed. As a result Clunker funding will result in the loss of several hundred thousand road-worthy vehicles. To the economist school this benefits the economy in the way that Hurricane Katrina did: not at all. The damage to New Orleans and that region meant that people would be put to work rebuilding, but the tremendous loss of capital stock made society as a whole much worse off. The rebuilding impacts economic statistics, but the destruction of working infrastructure does not. They are therefore inclined to fade the effect of the program over the longer run. Those managers are looking for extraordinary, but unsustainable, gains in the auto sector. They argue the cars that are selling are occurring at higher profit margins, with a rise in the effective price of cars, with smaller discounts and more richly priced options. Even before Clunkers, vehicle production was set to soar in the second half of 2009. Production of cars generally stays within 1.5 million to 2 million units of (seasonally adjusted) sales. Even as sales fell, production had fallen farther, with a monthly production shortfall of around 3 million units. Production had to increase regardless of the Clunkers program, and current sales come at the expense of futures sales. They will position their portfolios accordingly.

The market school is focused more on profiting from the resultant waves of cash flowing within the broad consumer sector. The cheapest qualifying car costs a net $6,000 (after rebate) and most are selling at a net cost between $10,000 and $25,000. Consumers who owned their clunkers will now have less money to spend on other big-ticket items (the “clunker” dishwasher will have to wait) and sales in non-auto retailers will reflect that. The market school is certainly reconsidering its recession plays in the sector. For example, retailers who specialised in car parts for home mechanics – often used to keep clunkers on the road – performed brilliantly as the economy and markets swooned in the first quarter, but they are fading now as the need to keep clunkers on the road has diminished. This narrowly focused wave of money will continue to impact reported results for a considerable period, and market school managers will continue to ride the wave of cash, and sentiment, across a broad range of stocks.

Too big to fail
The bailout has repercussions across more managers than those focused on the immediate impact of monetary flows:

As the doctrine that certain organisations are too big to fail spreads across sectors, so too will the notion that all these organisations carry an implicit government guarantee. Thus, they can borrow funds more cheaply than competitors, but take the same or even greater risk. This distortion is very real and spreading. While Citibank has been a repeat member of the protected club it now appears that this club includes insurance companies, the finance divisions of domestic auto manufactures and unknown others. This introduces risk, uncertainty and a hindrance to growth. The risk comes from the fact that management at those institutions may, at worse, face substantial benefit from taking risk and, at best, have an unclear objective. In money-losing years, the role of the Federal National Mortgage Association (Fannie Mae) was described by management as being that of a “social institution” to encourage home ownership. In money making years, while handing out bonuses, they were a “successful private sector financial institution”.

The uncertainty of this fuzzy “too big to fail” status is also serious. The membership of the protected club is kept secret, so market participants do not know the effective credit status of the organisations to whom they are lending. We know General Motors Acceptance Corp is protected. Is GE Finance? American Honda Finance Corp? Producing a formal list will be an impossible political fight, but the whisper list existent today is generating uncertainty in the already shaky credit markets. Clarity is as important as regulation in these times.

We are seeing managers react and change to a degree consistent with the volatility we are experiencing. In the equity space, many managers are looking at the world differently, and changing their short book criteria. Old shorts often consisted of companies that needed to access the credit markets. However, solvency is no longer as relevant with the government pumping unlimited liquidity into the system. Other managers have been adding higher beta names to the long book while using liquid and less volatile index hedges on the short side, as lower quality equities have moved up so quickly. One prominent emerging market manager has decided to avoid the risk of stocks in the hedge book melting up by using options, rather then individual names, to protect the investments.

The opportunities created by the havoc in the credit markets are still being captured by investors. One prominent manager has been increasing distressed debt exposure as default rates increase, and continues to add to high quality residential mortgage long exposure. This same manager is also long the debt of finance companies that have government support (TARP, TALF, TLGP) as he believes their default probability is low, and that the depth of government support is not fully discounted in the yield.

The private sector credit market problem is being transferred to governments, and some may be unable to carry the load. One fund is taking a position that some countries’ debt will fall in value as a result, most notably Ireland. Ireland has five million people and has more than doubled its GDP in about 10 years, driven, for the most part, by three engines: 1) a local real estate boom that has rivalled the one in the US; 2) providing tax shelters to eager foreign corporations, with investments similarly doubling in an even shorter time span; and 3) thinly capitalised banks accumulating assets on a global scale, with the highest toxic appetite of all the EU countries and higher risk loans amounting to between three and eight times Irish GDP by different measures.

The flows of funds into the economy are indeed hard to put into perspective, but hedge fund managers have long thrived on inconsistency and non-economic activity. The impact of the waves of government capital will reverberate for years, and afford opportunity to the managers positioned to capture it, both as they come in and as the government inevitably is forced to withdraw the money over time. The same waves will also drag out to sea the managers that ignore them.

Fabio Savoldelli has been leading hedge fund investment teams for over 15 years. Currently he serves as Chief Investment Officer for Optima Fund Management. Mr. Savoldelli received a DBS from the London School of Economics and a BA in Economics from the University of Windsor in Canada. In addition, he is an Adjunct Professor of finance at the Columbia University Business School.