Notes from the Field: CFA Institute Fixed Income Conference 2011

General Tenor: Bearish. Almost all of the speakers at the conference expressed concern about the direction of the global economy. Specifically, bearishness was expressed for:

• The European sovereign debt crisis
• The U.S. Congress’s political gridlock and inability to resolve the U.S. indebtedness problem
• Sagging fortunes of emerging market credit
• The poor performance of the U.S. mortgage market
• Geopolitical tensions
• The uncertainty brought about by sweeping regulatory changes
• Chinese economic problems, including slowing growth and inflationary pressures
• The new world faced, but largely not understood, by the quantitative finance community

Session Highlights:

Paul McCulley

• Paul McCulley offered a simple model for understanding the complexities of geopolitics that is both explanatory and anticipatory. In short, he demonstrated that the three dominate power structures operating in the major economies — democracy, capitalism, and sovereignty — are fundamentally at odds with one another. The combination of the structures creates tension in the international system, which is simultaneously necessary (to provide checks) but also creates complexities (e.g., the European sovereign debt crisis). Additionally, his sense of humor in describing an uncertain environment brought levity to the conference.

• Roberto Rigobon talked about his Billion Prices Project. In particular, he demonstrated that globally inflation is slightly higher than that reported by official agencies. His information technology driven tracking of inflation also seems to anticipate changes in inflation faster than official data.

• Laurie S. Goodman gave a thorough walk-through of the current state of the U.S. mortgage market. She feels that 10 million of 55 million homes are in jeopardy of defaulting on their mortgages. To repair the mortgage market she suggests focusing on both the demand and supply sides. On the demand side she recommends bundling together mortgages in danger of default and selling the bundles to the market simultaneously. A non-simultaneous sale will result in speculators who sit on the sidelines waiting for the bottom of the mortgage market prices before investing. On the supply side Goodman recommended lowering the principal amounts of mortgages as advocated in the Home Affordable Modification Program (HAMP).

• Patrick Brett emphasized that the credit fears that swept through the municipal bond market did not come to fruition. Additionally, he is principally concerned that credit strength lies in the local muni market, rather than at the state level. Last, Brett feels that the oft-advertised pension problems of state and local governments are currently manageable, but that action must be taken soon to minimize the difficulty of implementing solutions in the future.

• Daniel J. Fuss, CFA, outlined a helpful model for evaluating the investment climate: peace, people, politics, and prosperity. In the peace category he highlighted that estimates for a shrinking Department of Defense budget are directionally incorrect. Regarding people, Fuss shared that the proportion of the older population to the younger population is growing; this will create demographic problems that are not properly dealt with in the U.S. Federal budget. In the politics category, Fuss stated that he feels the desire for unity in Europe that dominated the post-World War II period is waning. Last, in the prosperity category, his biggest fear is that on a scale of 1 to 10 liquidity was about a 2. Fuss’s biggest concern is that the combination of factors in the other three Ps will lead to an end of the fourth P, peace.

• Vinay S. Pande spoke about the strength of scenario analysis relative to quantitative methods. With scenario analysis you can anticipate the future, as opposed to predicting it.

• Mark R. Kiesel gave an overview of global markets and where he sees opportunities. Specifically he feels that credit can deliver 6–7% returns going forward, but with one-third of the volatility of equities. He provided nine rules of thumb for the investment process:

1. Invest where the growth is higher.
2. Invest where the debt levels are lower.
3. Always look at the financial flexibility of the company/credit.
4. Always think about who the lender of last resort is.
5. Transparency.
6. Know where, as an investor, you are in the capital structure.
7. Ask whether you have actual asset protection or just covenants.
8. Own hard assets when possible.
9. Try to make it fun.

• Mary J. Miller, CFA, of the U.S. Treasury provided a comprehensive update about the current operations of the U.S. Treasury. She repeatedly emphasized the Treasury’s desire to strike the right balance between economic competitiveness and regulation. Miller also said that it was a stated goal of the U.S. Treasury going forward to increase small businesses’ access to capital. She also stated that the business community does not need to wait for regulators to change the investment landscape. In particular, Miller provided the example of businesses thinking about what mechanism could replace the credit ratings agencies.

• Andrew Gordon, Stephen L. Jen, and John S. Kowalik, CFA, each discussed in an in-depth fashion their areas of expertise. The consensus was that emerging markets are finally starting to see a decline in the attractiveness of their investment prospects. Gordon feels that the talk of another global recession has been overdone. Jen stated that the asset bubbles of the past 15 years in the United States have masked a fundamental reality: that the U.S. is not competitive. Jen also argued that you cannot fix a debt problem using more debt, referring to current events in Europe. Kowalik pointed out that commodities tend to have a right tail skewing in returns because the only way to correct a supply shortage in commodities is for prices to rise.

• Tina Vandersteel, CFA, presented the Mundell-Fleming “Impossible Trinity” model to explain the global flows of capital. The robust model puts inflation target, open capital flows, and exchange-rate targets at the apexes of a triangle. Mundell-Fleming points out that policymakers can control only two of the apexes at any given time, and at the risk of losing control of the third.

• Stephen Blyth spoke about the changed nature of the post-recession world. In particular, he illustrated how certain fundamental assumptions, such as higher interest rates on collateralized debt versus uncollateralized debt, were broken in the financial crisis. His conclusion is that quantitative finance professionals need to expand their universal set of possible outcomes in order to resuscitate the success of their approach to investing.

• James Grant provided historical context for his criticisms of the fiat monetary system and the current regulatory environment. In particular, Grant feels that the amount of manipulation in the marketplace is so great that prices do not have integrity.