Broyhill Letter (Aug-12)

7/31/2019 Broyhill Letter (Aug-12)

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T H E B R O Y H I L L L E T T E R

Executive Summary

Economic andfinancial conditions for the Swiss banking sector have deteriorated since June 2011. The European debt crisis deepened in the

second half of 2011, global economic growth lost momentum, tensions grew in the international banking system, and imbalances in the Swiss

real estate and mortgage markets increased. Early signs of a possible recovery in the euro area, which had emerged at the beginning of 2012,

have vanished again. Even though the SNB expects a gradual improvement of the situation over the next 12 months, the risk of a rapid and

marked deterioration in conditions for the Swiss banking sector remains high.

Swiss National Bank, Financial Stability Report, 2012

Another Bubble in Safety?

We have been steadfastly bullish on bonds since the global deleveraging process began in earnest several years ago. Butwe are not so dogmatic in our philosophy as to be bullish at any price. Price, and price alone, is the primary determinant

of returns. Even a good asset can be a bad investment at too high a price. In fact, even perceived safe havens can behazardous to an investors health under certain circumstances. Those circumstances were apparent in Q4-08 when we

first identified a Bubble in Safety. Following that warning, the iShares Barclays 20+ Year Treasury Bond Fund declinednearly 30% in six months, as white-knuckled investors came to the realization that the sun would still rise post-Lehman,and subsequently rotated out of the comfort of US Treasuries earning next to nothing.

Ironically, next to nothing appears to have been quite a good deal, in hindsight, when faced with less than nothing

in many negative government bond yields today. Intuitively, it would appear wildly irrational to buy a bond with a nega-tive yield, but rationality is not a trait common to the average investor, which works out quite nicely for the governments

of the half a dozen or so countries actually being paid to borrow money today. This fall in bond yields is just one of themany unintended consequences caused by the European debt crisis. While capital initiallyflowed from the periphery tothe core in search for safety, more recently it appears to be leaving the Eurozone all together, as it becomes increasingly

apparent that the center cannot hold. Capital flight is accelerating and investors most basic need for safety has

put immense downward pressure on global government bond yields.

Nowhere is this more apparent than in the tiny, open economy of

Switzerland where even five year government bond yields recentlycrossed into negative territory. In other words, investors are actu-

ally paying for the privilege of lending money to the government.Against this backdrop, prudent allocators of capital have a nearimpossible challenge in front of them choosing between the

least bad expected returns across an overvalued global opportu-

nity set. A catastrophe already appears to be discounted in theprice of Swiss government bondsm, so a few points from ourQ4-08 letter bear repeating: The panic in the financial markets

has driven bond prices to speculative extremes. Unfortunately, un-like the stock market, where hopes and dreams can often sustainspeculative markets for years, it is very difficult to sustain specu-

lative runs in bond prices. The stream of payments for bonds isfixed and known in advance. In Switzerland today, that stream

of payments is reversed.

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Source: PIMCO


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Knives & Cheese

As it turns out, there is much more to the Swiss economy than timeless

watches, perforated cheese and multipurpose army knives. Switzerland ishome to many of the worlds most successful corporations and most rec-

ognized brands including Glencore, Nestl, Novartis, Hoffmann-La Roche,ABB, Adecco, UBS AG, Zurich Financial Services, Credit Suisse, Swiss

Re, and of course, The Swatch Group. Chemicals, pharmaceuticals, preci-sion instruments, musical instruments, real estate, banking, insurance andtourism are all prominent industries in the home of the Alps. The World

Economic Forums Global Competitiveness Report recently ranked Swit-

zerlands economy as the most competitive in the world. The EuropeanUnion ranks it as Europes most innovative country, although surprisinglylittle was said about the surrounding competition. In 2011, it ranked as

the wealthiest country in the world in per capita terms and the 19th largesteconomy by GDP. To this, we can add the $2.1 trillion or so of offshorewealth, attracted by bank secrecy laws entrenched since 1934.

In its May 2012 Country Report, the IMF reports, Switzerland is a very

open, highly productive, innovative economy, with many successful global companies, a highly skilled workforce and anincreasingly open and flexible labor market. Medium-term growth has been good, unemployment is low, there is a track

record of low and stable inflation, the public finances are in better shape than in most advanced countries, and the externalposition is healthy, with a large positive net foreign asset position and current account surplus. Quite a refreshing analysiswhen compared with developed world peers.

Francs & Beans

Switzerland has existed as a state in its present form since the adoption of the Swiss Federal Constitution in 1848, one ofthe oldest constitutions in the world. Its economic and political stability, transparent legal system, sturdy infrastructure,robust capital markets, and low tax rates make Switzerland one of the worlds most competitive economies, home to the

worlds strongest (paper) currency. Fully recognizing that the words strong and currency are rarely found in the samesentence these days, we might highlight the fact that the franc has appreciated over 300% against the buck since the end

of the Bretton Woods era in 1971. Its not a coincidence that Switzerland holds the record as the country with the lowestrate of inflation for both the 19th and 20th century: since 1880 Swiss inflation has on average been a mere 2.2% annually.

That being said, the franc still lost roughly half its value in the century or so leading up to Bretton Woods, and

has lost nearly all of its value - about 95% - against gold, the worlds oldest and strongest currency, since 1900.

Even still, the Swiss National Bank deserves a great deal of credit for accomplishing such a feat, as steward of one of thefew currencies in existence as long as it has been. Founded in 1907, the SNB has the legal status of a corporation, with the

majority of its shares held by cantons, regional banks and public institutions. Private shareholders own shares as well, buthave limited voting rights. SNB shareholders have received an annual dividend consistently for nine decades. Since 1921,

the SNB has never failed to pay this dividend. The SNB is one of just a few central banks with such a holding structureand an even rarer breed in terms of prudence. Or so it was.

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Source: Economist


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Down with the King

The Swiss franc has been on an upward trend since 2008, driven bythe unwinding of carry trades and, more recently, intensified safe

haven capital inflows triggered by the neighboring debt crisis. WithEurozone output more than 20 times greater than Swiss output, itdoesnt take a stretch of the imagination to visualize the consequenc-

es. As Mom is fond of reminding me, imagine squeezing somethingthe size of a watermelon, through something the size of a garden

hose. The CHF/EUR ran from 1.6 in late 2007 to almost parity inearly August 2011 as the crisis intensified, with a cumulative real ef-

fective appreciation of over 30 percent. As a result, after bringing thepolicy rate to zero, the SNB responded in early August last year with amassive liquidity expansion. But as pressures continued, one month

later the bank was forced to announce that it would defend a floor of1.2 Swiss francs per Euro, thus abandoning the floating exchange rate

regime. The new policy has stabilized the nominal exchange rate . . .for now.

As an American of Italian descent, this begs the question, Whats wrong with a strong currency? Some of us, not point-ing anyfingers, might even desire a stable store of value. But for others, particularly of the Swiss descent, a sharp increase

in the value of the franc contributes to deflation by reducing the cost of imports and represents a significant challenge toexport-oriented sectors of the economy. Switzerlands safe currency and open economy makes it particularly vulnerable

in the middle of European turmoil, chiefly because over half of Swiss exports never leave the continent. Its no wonder

then, that the SNB has been bothered by the currency for a very long time. They intervened aggressively on the way downand that cost a lot of money. The acid test will be the Swiss central banks willingness to keep expanding its balance sheet,where foreign exchange holdings have jumped to 365 billion francs, and from a manageable 9% of GDP in 2008 to 64%of GDP today. Recent commentary indicates that, The SNB stands ready to take further measures at any time if the

economic outlook and the risk of deflation so require.

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Source: Economist

Source: IMF


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We are enforcing the minimum exchange rate with all determination because it is the right monetary policy, Swiss Na-

tional Bank President Thomas Jordan recently stated. The Swiss National Bank has to do that to prevent a deflationarydevelopment. Subsequently, the central banks foreign-currency reserves jumped about 20 percent in the five months

through May as policy makers stepped up their defense to fight deflation. Foreign currency reserves increased to 306.1billion francs ($322.4 billion) in May from 247.2 billion francs in the previous month. And in June, the SNB increased its

currency investments by an additional $58 billion, as they did in May, or roughly 11.2% of Swiss GDP. The soon-to-be-extinct-euro accounted for over 60% of foreign currency investments in June, up an additional 10% from May. Expand-ing the SNB balance sheet is just a result of our monetary policy, Jordan added. We have to accept the risks associated

with that. The National Bank is able to bear them. Quite the confidence coming from a man sitting atop a mountain ofpaper money issued by a currency union on the brink of collapse.

The bank said it would enforce thefl

oor through unlimited foreigncurrency buying and indicated it would take further measures ifneeded. Through its purchases of euros, the central bank increasesthe amount of francs available to Switzerlands lenders, raising the

risk of inflation in the medium and long term. History shows

that this is not the first time the SNB has traveled this road.

It charted a similar course in the late 1970s when an exchange

rate floor succeeded in weakening the currency but ultimately

created excessive inflation. Both the economic landscape and thedegree of currency appreciation were similar to current conditionsat the time. However, the SNBs balance sheet was much smaller

then, yet inflation still managed to spike from less than one percentto five percent, and ultimately peaked at around seven percent in

1981. A move of this magnitude in ten-year Swiss interest ratestoday would result in devastating losses for the safe haven du jour.

Experience warns that the normalization of interest rates can oc-cur very quickly once an appropriate spark is provided and both short and long-term rates often significantly overshootfair value during the process.

For as much grief investors give the Fed, the ECB and the BOJ about the size of their balance sheets, they are all

a sideshow when compared to the explosion of central bank assets in the Alps (chart below). Assets had alreadygrown following the interventions in 2009 and 2010, and subsequently ballooned by 50% as a result of last years liquidity

expansion, ultimately reaching the unprecedented level of 70% of GDP last September the largest among developedeconomies. During this time, foreign exchange reserves grew to 80% of assets, the bulk of which were denominated inEuros. The strong appreciation of the Franc has resulted in substantial valuation loss on foreign exchange reserves, ulti-

mately threatening the sustainability of the currencyfloor. The SNB would face even greater losses if it were forced to

abandon its target today. This risk increases as exposure to the Euro rises, making a potential unwind even more devastat-ing. As the Bank of England learned during the ERM crisis in 1992, perceived credit worthiness is just as important as anopen commitment in successfully managing exchange rate policy.

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Source: PIMCO


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Too Big To Fail

Standard & Poors points to Switzerlands highly diversified, high-income, competitive, and flexible economy to sup-port its very low risk assessment in a recent analysis of the Swiss banking industry. The report claims that, The bankingsystems high and stable customer-deposit base contributes to S&Ps very low risk assessment, which is facilitated by

minimal dependence on net external borrowing, and supportive domestic debt capital markets. Furthermore, A very lowcredit growth mitigating a moderate rise in property prices supports S&Ps assessment of very low economic imbalances.

The words optimistic, hopeful, complacent and sanguine come immediately to mind.

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Stepping back to reality for a moment, it is abundantly clear that loose monetary conditions have driven Swiss mortgage

credit and real estate prices to dizzying heights and risk is growing that a bubble may be forming, endangering domesticbanks and insurance companies. The ratio of mortgage credit to GDP has reached an all-time high and property prices

have risen much faster than rents. The SNBs aggressive monetary policy has resulted in very low mortgage rates forseveral quarters now, resulting in house price growth persistently stronger than what can be explained by fundamental fac-

tors. More than one in five owner-occupied properties has a loan-to-value ratio over 80% today, with signs of stretchedaffordability across a significant proportion of new mortgages. As borrowers and banks become more accustomed tothis situation, they may underestimate the risk of sudden interest rate changes. Already, private insolvencies have risen in

recent months. Swiss authorities have taken notice warning, Absent significant shocks or risks to the outlook, the currentexpansionary policy cannot be maintained without compromising price stability in the long term.

The mortgage market constitutes themost significant concentration of risk

for domestic banks, with mortgage

claims making up approximately 70%

of their. The banks loss-absorbing

capital is still below the level needed to

ensure sufficient resilience, since the en-vironment could deteriorate rapidly. Fur-

thermore, regulatory capital indicators areoverestimated due to pro-cyclical effectswhere rising real estate values lead to lower

capital requirements. In other words, thehigher prices rise above levels justified by

fundamentals, the less capital banks arerequired to hold, and the greater magni-

tude of the ensuing price correction andborrower defaults. The issue is that a fallin real estate prices, together with a rise in

defaults, would therefore affect the entirebanking system. In the past, banking crises

triggered by the real estate market have re-peatedly resulted in considerable costs to

the economy. It was not long ago that falling real estate prices and rising mortgage rates triggered a banking crisis in Swit-zerland, ushering in a prolonged stagnation in the Swiss economy during the 1990s.

European Relations

Switzerland voted against membership in the European Economic Area in a referendum in December 1992 and has since

maintained and developed its relationships with the European Union (EU) and European countries through bilateralagreements. In March 2001, the Swiss people shrewdly refused to start accession negotiations with the EU. As a result,

Switzerland is in a unique position - surrounded by countries which use the euro. In fact, the euro was de facto acceptedin many places, especially near borders and in tourist regions. Swiss railways, public phones, vending machines and ticket

machines accepted euro coins. Many shops and smaller businesses customarily accepted euros. And plenty of bank cashmachines issue euros at the traded exchange rate as well as Swiss francs. While we havent spoken to said shops or smallerbusinesses of late, our sense is that they may be regretting this decision today.

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Source: Forbes


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Isnt it incredible how quickly a global debt crisis can change ones perception? Press reports in Switzerland now claim thatcommercial banks are not even able to meet surging demand for safe deposit boxes. Explicably, people are now renting safedeposit boxes in hotels according to a report by Bruce Krasting who claims, This is the weirdest bubble I have seen - a

mad dash for paper money. Like most bubbles, it is a result of manipulative monetary policy and an exchange rate regimethat does not reflect supply and demand. Like all bubbles, it will eventually pop. And like all popped bubbles, that will cause

a great deal of pain for all involved. Well said Bruce.

Switzerlands close ties with the euro zone raise the risk that an intensification of the crisis could trigger an ad-

verse trade shock, and tip the economy into recession. A worsening euro area crisis would also likely accelerate

safe haven capital flows into Switzerland putting the currency under increasing pressure. Under such a scenario,

perhaps hotels will begin renting safe deposit boxes by the hour? Even so, if the floor was abandoned and the exchangerate appreciated, large bank losses would be aggravated by exchange rate movements, as would all those local shops and

hotels. In a tail risk scenario of a severe euro zone crisis, the Swiss economy would likely be dragged into a much moreserious and protracted recession. A possible freeze in global wholesale funding markets, upon which the two large Swiss

banks are heavily reliant, would compound the problem making government support to the financial sector necessary. Webelieve the SNB, faced with such an event, would be unable to protect the peg and would resort to more drastic measuressuch as capital controls or negative interest rates. Unfortunately, the enormous size of the SNBs balance sheet and the

dubious quality of its assets will at some point begin to raise a few eyebrows and ultimately force yields materially higheras demand for bonds shrank.

Bottom Line

The Swiss economy is fundamentally strong, but is facing a number of challenges. Headwinds from the euro area debt crisis and a strong cur-

rency have slowed growth, created deflationary pressures, and forced the central bank to abandon thefloating exchange rate regime. Thefinancial

sector is adapting to the new, more stringent regulatory environment but r emains vulnerable, including to a domestic housing bubble. Thefiscal

position is sound, but pressures from population aging are building.

IMF Country Report, 2012

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Source: Wikipedia


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The Swiss government bond market is said to be a two way between the top Swiss Banks, with the market determined on

the corner caf in Paradeplatz. While this may be somewhat of an exaggeration, it is not too far from reality, as the topSwiss banks aggregate most of the information on execution orders related to the currency. There are just not that many

people making markets in Swiss bonds. In fact, when we began our research on the topic, we were quite surprised by thelack of coverage of such a well-known asset class, which made the work all the more intriguing to us.

Many believe that the introduction of the exchange rate floor was an appropriate policy response to the risk of economiccontraction and deflation. With the economy slowing rapidly, negative inflation, and uncertainty in the euro area spurring

capital inflows and pushing the exchange rate to historic heights, the risk was sizable that further currency appreciationmight lead to entrenched deflation and a recession. Alternative policy options were limited, with interest rates at the zero

bound, fiscal policy governed by the debt brake rule, and quantitative easing constrained by the small size of the domesticbond market.

But defending the floor will require unprecedented monetary expansion with potential negative repercussions (i.e. exces-sive inflation and asset price bubbles). A stronger economy and resurgent inflation might also undermine the credibility of

the commitment to defend the floor. And if growth was to rekindle, pushing inflation toward normal levels, delaying thereturn to a freelyfloating currency would carry the risk of stoking more momentous inflation. Under its baseline scenario,

the IMF projects inflation will return to historical levels by 2013. We are less certain on the precise timing of such a moveand fully expect the situation to get worse before it improves, but the direction is undeniable. Government bond yieldsare headed higher - particularly those with independent central banks with full authority over the modern day printing

press.

Increased risk aversion has shifted investment demand towards perceived safe havens, such as fiscally sound

government bonds and currencies. As a result, fear has driven the prices of these assets to levels that are out of

line with the fundamentals. Investors have quickly forgotten one particular piece of sound advice recently provided byJim Grant, The only real safety in this investing life is that to be found in good assets bought well. Government bonds,particularly of the Swiss variety, may be good assets, but they are certainly not being bought well today. Any indication that

systemic risk is declining or that liquidity is increasing in Europe, should allow rates to normalize. Current rates are un-sustainable. Positive surprises are not necessary to move rates back toward equilibrium. An absence of significant shocks

should do the trick. Hiding your money under a Swiss mattress may prove to be akin to wetting your pants it may feelwarm and comfortable at first, but it soon becomes cold and regrettable.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions

are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice

or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of

any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not

guaranteed.

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Documents

Broyhill Letter (Aug-12)