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Eye on the Market | April 9, 2012
J.P.Morgan

Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain

However, there’s more of an effort at the state/local level to address this issue than at the Federal level. More than 40 states lowered pension benefit liabilities over the last 3 years according to the National Conference of State Legislatures. Measures taken include raising employee contributions (while lowering employer payments), raising minimum retirement ages, cutting post-employment healthcare benefits and in some cases, switching to defined contribution from defined benefit plans.

The good news, to paraphrase Mark Twain, is that reports of municipal bonds’ demise have been greatly exaggerated. From 1970 through to the end of 2011, municipal bonds rated by Moody’s experienced a grand total of 71 defaults among 17,700 issuers (11 of which occurred during 2010 and 2011). General obligation bonds accounted for 5 defaults; 29 were related to housing; 22 for hospitals and healthcare; 3-4 each for education and infrastructure. Utilities and cities registered 2 each, while counties, special districts, and water & sewer and experienced 1 each. The average recovery for defaulted munis was 65%, compared to 49% on corporate senior unsecured bonds. Last comment on municipals: while local tax collections are weak due to the collapse in home prices, state tax collections have been increasing for 7 quarters in a row.

State and local tax revenue
Percent, YoY change of 4-quarter moving average
[Chart showing revenue trends from 2004 to 2011]
Source: US Census.

US mutual fund flows
Billions, USD
[Chart showing Bonds vs Equities flows from 2007 to 2012]
Source: Investment Company Institute.

OK, so the US economy is improving, but is still heavily dependent on monetary and fiscal stimulus to grow; and the only belt-tightening one can find is at the state and local level. Since 2009, after equities collapsed and bond prices rose, how have many investors reacted?
By selling more equities and buying a lot more bonds. See chart above (a global version of this chart looks roughly the same).

Have investors been positioning this way since stocks are expensive?
Not really. Insert a giant martini glass on the chart below from 1998 to 2001 (I hate using simple averages which include periods when the market had lost its collective mind). The current P/E multiple is in the middle of the ex-bubble range of the last 25 years. Some bank stocks look interesting, even after accounting for reliance on shrinking loan loss reserves to drive income, and ongoing regulatory uncertainty. Most US banks are at or close to Basel 3 funding needs, have considerably fewer capital adequacy questions than their European counterparts, and do not rely on wholesale funding to finance loan portfolios.

S&P 500 ex-bubble price to earnings multiple
Price to next twelve months operating EPS
[Chart showing P/E multiple from 1985 to 2012 with a martini glass graphic]
Source: IBES, Standard & Poor's.

US bank price to book ratio
[Chart showing ratio from 1969 to 2010]
Datastream
Morgan Stanley

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