Systematic Relative Strength

Over the course of the last year, the biggest flows have gone into fixed income, including a significant amount of municipal bonds. Now one of the largest state issuers of debt, California, has received another downgrade from Standard & Poor’s and remains on negative creditwatch. (Moody’s and Fitch downgraded the debt even earlier.)

California is facing a $20 billion budget shortfall, but it is far from the only state having fiscal problems. On the face of it, this seems like a very good reason to run for the hills.

However, paradoxically, municipal debt had a pretty good year last year because the funding crisis, although bad, was expected to be even worse. This year could turn out the same way depending on the path various states take to move back toward fiscal balance. If the gap is closed with spending cuts, the market might respond very differently than if the gap is closed by accounting gimmicks and higher taxes. At any rate, investment decisions on municipal debt should be made based on price action and relative performance, not on an emotional reaction to a negative headline.

For a different take on California’s fiscal situation, check out this article in the Wall Street Journal. The author contends that California’s debt is not overly large relative to its economy and that, in fact, California taxpayers have been subsidizing the rest of the country for decades.

The government unveiled a plan to cover the cost of rescuing the financial system which involves charging banks a 15 basis point fee on various covered assets. A relatively healthy commercial bank might make only a 1% return on assets, so 15 basis points could be a substantial levy, depending on exactly what assets are covered and what is excluded. The fee is expected to raise $90 billion dollars over a 10-year period.

Regardless of what you may think of this plan, it illustrates an investment risk not often discussed in finance textbooks: political risk. Usually when we talk about political risk, we are thinking about a coup in Venezuela or a sovereign debt default in Zimbabwe. We don’t necessarily think about how much a domestic industry can be affected by legislation that radically unbalances the status quo. From a fundamental point of view, such a fee could reduce bank earnings by a significant amount for the next decade, leading to lower assumed valuations by spreadsheet jockeys.

From a relative strength point of view, life goes on. If bank stock prices are affected for better or worse, relative strength will change. But actual prices will need to change before anything can be assumed. It may be that some type of fee or punitive operating restrictions were already anticipated by the market—and sometimes when the news is not as bad as expected, the stocks actually rally. Whether it’s political risk or any other exotic risk, price is the final arbiter.