AUGUST 2012

THE BROYHILL LETTER

Executive Summary
Economic and nancial 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. But we 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 be hazardous to an investors health under certain circumstances. Those circumstances were apparent in Q4-08 when we rst identied a Bubble in Safety. Following that warning, the iShares Barclays 20+ Year Treasury Bond Fund declined nearly 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 negative 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 the many unintended consequences caused by the European debt crisis. While capital initially owed from the periphery to the 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 ight 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 ve year government bond yields recently crossed into negative territory. In other words, investors are actually paying for the privilege of lending money to the government. Against this backdrop, prudent allocators of capital have a near impossible challenge in front of them choosing between the least bad expected returns across an overvalued global opportunity set. A catastrophe already appears to be discounted in the price of Swiss government bondsm, so a few points from our Q4-08 letter bear repeating: The panic in the nancial markets has driven bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams can often sustain speculative markets for years, it is very difcult to sustain speculative runs in bond prices. The stream of payments for bonds is xed and known in advance. In Switzerland today, that stream of payments is reversed.

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 is home to many of the worlds most successful corporations and most recognized 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, precision instruments, musical instruments, real estate, banking, insurance and tourism are all prominent industries in the home of the Alps. The World Economic Forums Global Competitiveness Report recently ranked Switzerlands economy as the most competitive in the world. The European Union ranks it as Europes most innovative country, although surprisingly little was said about the surrounding competition. In 2011, it ranked as the wealthiest country in the world in per capita terms and the 19th largest economy by GDP. To this, we can add the $2.1 trillion or so of offshore wealth, attracted by bank secrecy laws entrenched since 1934. In its May 2012 Country Report, the IMF reports, Switzerland is a very Source: Economist open, highly productive, innovative economy, with many successful global companies, a highly skilled workforce and an increasingly open and exible labor market. Medium-term growth has been good, unemployment is low, there is a track record of low and stable ination, the public nances are in better shape than in most advanced countries, and the external position is healthy, with a large positive net foreign asset position and current account surplus. Quite a refreshing analysis when 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 of the 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 same sentence 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 lowest rate of ination for both the 19th and 20th century: since 1880 Swiss ination 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 the few 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, but have 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 structure and an even rarer breed in terms of prudence. Or so it was.

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Down with the King

The Swiss franc has been on an upward trend since 2008, driven by the unwinding of carry trades and, more recently, intensied safe haven capital inows triggered by the neighboring debt crisis. With Eurozone output more than 20 times greater than Swiss output, it doesnt take a stretch of the imagination to visualize the consequences. As Mom is fond of reminding me, imagine squeezing something the 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 in early August 2011 as the crisis intensied, with a cumulative real effective appreciation of over 30 percent. As a result, after bringing the policy rate to zero, the SNB responded in early August last year with massive liquidity expansion. But as pressures continued, one month later the bank was forced to announce that it would defend a oor of 1.2 Swiss francs per Euro, thus abandoning the oating exchange rate regime. The new policy has stabilized the nominal exchange rate . . . for now.

Source: Economist

As an American of Italian descent, this begs the question, Whats wrong with a strong currency? Some of us, not pointing any ngers, 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 deation by reducing the cost of imports and represents a signicant challenge to export-oriented sectors of the economy. Switzerlands safe currency and open economy makes it particularly vulnerable in the middle of European turmoil, chiey 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 down and 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 deation so require.

Source: IMF

AUGUST 2012

We are enforcing the minimum exchange rate with all determination because it is the right monetary policy, Swiss National Bank President Thomas Jordan recently stated. The Swiss National Bank has to do that to prevent a deationary development. Subsequently, the central banks foreign-currency reserves jumped about 20 percent in the ve months through May as policy makers stepped up their defense to ght deation. Foreign currency reserves increased to 306.1 billion 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-beextinct-euro accounted for over 60% of foreign currency investments in June, up an additional 10% from May. Expanding 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 condence coming from a man sitting atop a mountain of paper money issued by a currency union on the brink of collapse. The bank said it would enforce the oor through unlimited foreign currency buying and indicated it would take further measures if needed. Through its purchases of euros, the central bank increases the amount of francs available to Switzerlands lenders, raising the risk of ination in the medium and long term. History shows that this is not the rst time the SNB has traveled this road. It charted a similar course in the late 1970s when an exchange rate oor succeeded in weakening the currency but ultimately created excessive ination. Both the economic landscape and the degree of currency appreciation were similar to current conditions at the time. However, the SNBs balance sheet was much smaller then, yet ination still managed to spike from less than one percent to ve percent, and ultimately peaked at around seven percent in 1981. A move of this magnitude in ten-year Swiss interest rates today would result in devastating losses for the safe haven du jour. Source: PIMCO Experience warns that the normalization of interest rates can occur very quickly once an appropriate spark is provided and both short and long-term rates often signicantly overshoot fair 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 already grown 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 developed economies. During this time, foreign exchange reserves grew to 80% of assets, the bulk of which were denominated in Euros. The strong appreciation of the Franc has resulted in substantial valuation loss on foreign exchange reserves, ultimately threatening the sustainability of the currency oor. 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 devastating. As the Bank of England learned during the ERM crisis in 1992, perceived credit worthiness is just as important as an open commitment in successfully managing exchange rate policy.

AUGUST 2012

Too Big To Fail

Standard & Poors points to Switzerlands highly diversied, high-income, competitive, and exible economy to support its very low risk assessment in a recent analysis of the Swiss banking industry. The report claims that, The banking systems 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 low credit 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.

AUGUST 2012

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 domestic banks 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 for several quarters now, resulting in house price growth persistently stronger than what can be explained by fundamental factors. More than one in ve owner-occupied properties has a loan-to-value ratio over 80% today, with signs of stretched affordability across a signicant proportion of new mortgages. As borrowers and banks become more accustomed to this 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 signicant shocks or risks to the outlook, the current expansionary policy cannot be maintained without compromising price stability in the long term. The mortgage market constitutes the most signicant 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 sufcient resilience, since the environment could deteriorate rapidly. Furthermore, regulatory capital indicators are overestimated due to pro-cyclical effects where rising real estate values lead to lower capital requirements. In other words, the higher prices rise above levels justied by fundamentals, the less capital banks are required to hold, and the greater magnitude of the ensuing price correction and borrower defaults. The issue is that a fall in real estate prices, together with a rise in defaults, would therefore affect the entire banking system. In the past, banking crises triggered by the real estate market have reSource: Forbes 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 Switzerland, 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 bilateral agreements. 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 accepted in 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 cash machines issue euros at the traded exchange rate as well as Swiss francs. While we havent spoken to said shops or smaller businesses of late, our sense is that they may be regretting this decision today.
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AUGUST 2012

Source: Wikipedia

Isnt it incredible how quickly a global debt crisis can change ones perception? Press reports in Switzerland now claim that commercial banks are not even able to meet surging demand for safe deposit boxes. Explicably, people are now renting safe deposit 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 regime that does not reect 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 intensication of the crisis could trigger an adverse trade shock, and tip the economy into recession. A worsening euro area crisis would also likely accelerate safe haven capital ows 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 oor was abandoned and the exchange rate 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 more serious 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 nancial sector necessary. We believe the SNB, faced with such an event, would be unable to protect the peg and would resort to more drastic measures such 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 higher as 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 currency have slowed growth, created deationary pressures, and forced the central bank to abandon the oating exchange rate regime. The nancial sector is adapting to the new, more stringent regulatory environment but remains vulnerable, including to a domestic housing bubble. The scal position is sound, but pressures from population aging are building. IMF Country Report, 2012

AUGUST 2012

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 top Swiss 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 the lack 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 oor was an appropriate policy response to the risk of economic contraction and deation. With the economy slowing rapidly, negative ination, and uncertainty in the euro area spurring capital inows and pushing the exchange rate to historic heights, the risk was sizable that further currency appreciation might lead to entrenched deation and a recession. Alternative policy options were limited, with interest rates at the zero bound, scal policy governed by the debt brake rule, and quantitative easing constrained by the small size of the domestic bond market. But defending the oor will require unprecedented monetary expansion with potential negative repercussions (i.e. excessive ination and asset price bubbles). A stronger economy and resurgent ination might also undermine the credibility of the commitment to defend the oor. And if growth was to rekindle, pushing ination toward normal levels, delaying the return to a freely oating currency would carry the risk of stoking more momentous ination. Under its baseline scenario, the IMF projects ination will return to historical levels by 2013. We are less certain on the precise timing of such a move and fully expect the situation to get worse before it improves, but the direction is undeniable. Government bond yields are 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 scally 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 by Jim 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 unsustainable. Positive surprises are not necessary to move rates back toward equilibrium. An absence of signicant shocks should do the trick. Hiding your money under a Swiss mattress may prove to be akin to wetting your pants it may feel warm and comfortable at rst, 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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