July 2009 - Posts
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This is the last letter of the week (“A View from the Trenches” is
not published on Fridays) and in Canada, next Monday is a civic
holiday. A View from the Trenches will be published again on Tuesday.
With this in mind, I thought it appropriate to summarize the main
thoughts/theses so far, to clarify views and consistently approach the
markets:
-Equities:
I have been sticking to the view first proposed on June 3rd
(www.sibileau.com/martin/2009/06/03 ) that equities will stagnate,
orbiting within a certain range. In the chart below (source:
Bloomberg), we can see that since then, the S&P500 has been trading
in a range of approx. -/+ 5%. Why has it not fallen more? Because the
Fed’s purchases of Treasuries and Agency debt/mortgages have provided
liquidity. Why has the S&P500 not risen higher? Because there is a
lack of growth opportunities and firms’ revenues continue to fall, on
aggregate. Returns do not compensate for the risk taken in Equityland.
On the other hand, without a clear resolution in the housing market,
any hopes of witnessing a Pigou-effect based recovery
(http://en.wikipedia.org/wiki/Pigou_effect ) are put to sleep. Concern
is thus growing around retail/consumer credit losses…
-Corporate Credit:
Given the ample liquidity (LIBOR today set another record, at 48.75bps)
and the poor prospects in Equityland, credit spreads have been
compressing, as we expected at the beginning of June. This trend still
has some more rope. But government intervention here has a more direct
impact, which brings me to the next point,
-Treasuries:
By now, it appears that the Fed and other Central Banks (except in
Canada) can no longer engage in balance sheet expansion, and there may
only be one way for rates to go: Up! As we said on July 22nd
(www.sibileau.com/martin/2009/07/22 ), the Fed has hinted that an
increase in short-term interest rates will be a fundamental aspect of
their exit strategy. My view is that when short-term interest rates are
increased the US Treasury validates these higher rates, regardless of
their level, as it continues to issue debt. The average small firm will
not be able to cope with the higher cost of capital, and many of them
will go bankrupt, increasing concentration. Tax revenue would fall as a
consequence, further boosting the fiscal deficit, in a spiraling
process. Unemployment will remain high, and the Treasury will be forced
to fund more and more fiscal imbalances.
-Gold:
I have not touched on this issue for a while. But I maintain my view,
that the value of gold is negatively correlated to the level of global
coordination in monetary policies. And coordination is high, making
this crisis unique in that respect
(http://sibileau.com/martin/2009/07/27/this-time-is-different/ ).
Coordination also keeps the Canadian dollar under anesthesia. I suspect
the existing coordination will remain, unless the world decisively
repudiates the US fiscal deficits.
Disclaimer:The comments expressed in this publication are my own
personal opinions only and do not necessarily reflect the positions or
opinions of my employer. I prepared and distributed this publication as
an independent activity, outside my regular salaried work. No part of
the compensation I receive from my current employer was, is or will be
directly or indirectly related to any comments or personal views
expressed in this publication. All comments are based upon my current
knowledge. You should conduct independent research to verify the
validity of any statements made in this publication before basing any
decisions upon those statements. The information contained herein is
not necessarily complete and its accuracy is not guaranteed. The comments expressed in this
publication provide general information only. Neither the information
nor any opinion expressed constitutes a solicitation, an offer or an
invitation to make an offer, to buy or sell any securities or other
financial instrument or any derivative related to such securities or
instruments. The comments expressed in this publication are not
intended to provide personal investment advice and they do not take
into account the specific investment objectives, financial situation
and the particular needs of any specific person.
(To subscribe to this daily market letter and receive it by email, in pdf format, please visit : www.sibileau.com/martin )
This is turning out to be a tedious week, with a mix of different
readings on macro data about the housing market, the shape of the (US)
consumer and the validity of the signals we are getting from earnings
releases. But, above all, it is also an interesting week for rates, as
the enormous amount of Treasury bills and coupons test their demand.
Yesterday we had a $42BN issue of 2-yr notes. It appears the demand was
not that enthusiastic about it, and the interest of the market is
piqued.
Everyone is already speculating on when and how violently interest
rates, short-term rates, will increase. My feeling is that it will not
be as violent or as soon as most analysts believe. We live in a global
economy and liquidity will have to reach every corner and raise every
price before it comes back to haunt us with increased consumer prices
and wages.
With this in mind, I want to discuss two investment theses, which are becoming more and more popular:
1. - In structured credit, correlation (of defaults) should be falling, as systemic risk falls
I am not going to deal here on how to play this thesis, which is
currently debated in many forums (shorting equity tranche, equity
steepeners, mezz steepeners, etc.). The point I want to bring up today
is whether the most fundamental assumption underlying this view is
valid: Is it true that systemic risk will fall?
Perhaps what misleads investors here is that systemic risk may not be falling, but evolving,
switching from liquidity risk in its purest form (lack of financing) to
inflation risk (lack of profitability, as costs rise or don’t fall as
quick as revenue and short-term financing becomes more expensive due to
a crowding-out effect created by fiscal deficits). This is consistent
with my view that the equity markets will remain stagnant. Why? Because
with inflation (=distortion in relative prices), there is enough
leverage to avoid asset deflation, but at the same time, there is a
lack of growth opportunities.
Back to my point on correlation, let’s take the structural approach: If
you believe that correlation of defaults are a product of correlation
in equities (in their expected returns) and their respective
volatility, it will be easier to get the picture: If
inflation (distortion in relative prices) and the crowding-out effect
destroy growth opportunities WORLDWIDE, expected returns and volatility
should remain highly correlated. If expected returns and volatility
remain highly correlated, correlation in structured credit should also
remain high (Please, feedback is very welcome on this point).
How do I know there is a global crowding out effect unfolding? I
don’t, but…did you look at the recent action in sovereign credit
default swaps? Do you think this tightening in their credit spreads is
sustainable? (I know we can always argue that this asset class is not
liquid and cannot reveal meaningful information. However, this is a
wide phenomenon affecting ALL sovereigns and their respective public
debt issues, which in turn sets a floor for corporate credit.
Therefore, I don’t think we can afford to ignore its message: Coordinated worldwide currency debasement.)
2. – China’s role in replacing the US as the world’s engine of
growth (for instance, ref. Bank of America’s Situation Report of July
27th, 2009: “Savings substitution”).
This is an increasingly relevant issue and I will be blunt here: China
is merely importing inflation, and this is not sustainable. I also see
the current debate as very “mercantilist”
(http://en.wikipedia.org/wiki/Mercantilism ). Investment demand is not
necessarily financed by the generation of higher savings. Saving
or restraining consumption to have resources available to invest and
increase a nation’s stock of capital is very inefficient. In fact, that was how Stalin conceived the growth path for Russia, for instance. So, what is an alternative and efficient way? Re-assignation
of existing resources! However, how do investors know how to re-assign
resources? How do investors know when their resources are not
efficiently assigned? In theory, when they lose money. But for them to
lose money, the pricing system must be very flexible. Flexibility is
critical.
Back to my point, China will not replace the US until the genuine
driver of capital formation is there: A good, free, pricing system. The
fixed exchange rate regime China has only accentuates the agony for the
world, as it allows the US to keep running their deficits and creates
bubbles in China.
Finally, for the sake of intellectual honesty, I want to refer an
interesting note on this, from a great economist, Ronald McKinnon:
(http://www.stanford.edu/~mckinnon/briefs/policybrief_mar09.pdf ).
Disclaimer:The comments expressed in this publication are my own
personal opinions only and do not necessarily reflect the positions or
opinions of my employer. I prepared and distributed this publication as
an independent activity, outside my regular salaried work. No part of
the compensation I receive from my current employer was, is or will be
directly or indirectly related to any comments or personal views
expressed in this publication. All comments are based upon my current
knowledge. You should conduct independent research to verify the
validity of any statements made in this publication before basing any
decisions upon those statements. The information contained herein is
not necessarily complete and its accuracy is not guaranteed. The comments expressed in this
publication provide general information only. Neither the information
nor any opinion expressed constitutes a solicitation, an offer or an
invitation to make an offer, to buy or sell any securities or other
financial instrument or any derivative related to such securities or
instruments. The comments expressed in this publication are not
intended to provide personal investment advice and they do not take
into account the specific investment objectives, financial situation
and the particular needs of any specific person.
(To subscribe to this daily market letter and receive it by email, in pdf format, please visit : www.sibileau.com/martin )
With the relative normalization trend in place, a lot of different
investment themes start to appear. These themes have a different impact
on the equities, credit, commodities and sovereign markets. Asset
classes (and the respective parts of the capital structure) begin to
regain their own particular dynamics; away from the common driver that
systemic risk was months ago. Diversity represents a challenge to this
daily market letter, where I seek to add value summarizing the main
action drivers in a concise way and relatively plain (non-technical)
language. With this in mind, let’s start the daily exercise of
understanding what happened and what will happen:
Stocks began selling yesterday at 10 am after the New Home Sales
data was released. The number surprised, with 384k vs. 342k expected.
On a month-to-month basis, this represented an 11% increase.
Immediately after, the Dallas Fed Manufacturing Activity was announced.
It showed a 25.5% decline vs. -20.4 expected. At the end of the session
however, stocks managed to end up, with the S&P500 at 982.18pts
(+0.30%). What is the conclusion? In general, investors are concerned
with consumption. The housing market has taken a singular road on its
own. It is a market that by now has been pretty much isolated on the
downside, thanks to the intervention of governments. Therefore, the
upside move here will not be necessarily seen as a recovery signal, in
my view. Consumption, retail sales, is the real thing. Yes,
stabilization in the housing market is needed, but we want to see the
nexus between this market and consumption (For those familiar with the
term, we want to see the “Pigou effect” take place).
Having said that, the trend continues in favor of a general
tightening in credit spreads and steepening of credit curves. The
liquidity is there. The billions of cheques that Central Banks have
been writing on themselves are generating results. Motion creates
motion. The chart below (source: Bloomberg, last two weeks) shows the
trend in the 3-month Libor – Overnight Index swap spread. With Libor
having reached a record at below 50bps, this spread is compressing on a
daily basis. Perhaps, the most impressive effect of this process is the
tightening in sovereign credit default swaps. It is very counter
intuitive. I can understand tighter corporate spreads, because
governments have transferred private risk to the public sphere, with
taxpayers lifting the tab. With a falling tax revenue backdrop and a
huge assumption of public debt, how can we explain tighter sovereign
credit default swaps? I guess the answer is very simple: Currencies are
going to be debased. There is no other explanation. This brings me to
the issue of correlation and specifically, implied correlation. But I
leave it for tomorrow, as it merits extensive discussion…
(To subscribe to this daily market letter and receive it by email, in pdf format, please visit : www.sibileau.com/martin )
We start a week in which $236BN in bills and coupons will be
supplied. Everyone I’ve spoken to in the last days has been a bit
cautious on the signals of the officially introduced weak recovery.
Yet, the markets (all of them) seem to validate the thesis that there
is a change, there is renewed demand for risk.
As I was enjoying a good coffee on Friday in downtown Toronto with a
friend and reader (he knows who he is), I made the comment I felt
optimistic, or let’s say not pessimistic (big difference there), about
the whole situation. My friend brought up the issue of overall Q2
revenues. If revenues don’t pick up, it won’t matter whether companies
manage to swap their debt maturities or reduce costs: Investors will
rush for the exit. I had (and still have) trouble siding with this
categorical statement. However, my friend’s line of reasoning is
flawless and when the logic is perfect, you can only disagree with the
thesis if the axioms are wrong. What are the axioms this time around?
Most analysts seeking to understand what comes next have been busy
of late, running regressions, showing metrics, prices in perspective.
Perhaps the axiom, the main axiom (assumption) here is that we’ve been
in the past through a crisis similar to the one at hand. We compare
metrics vs. 2001, vs. the ‘70s or the ‘30s.
As my friend and I kept walking on Friday, I asked myself what is
different this time. What makes this crisis unique in history? I think
the answer is the improved degree of global coordination of monetary
policy. We have never before seen the “political class” of the world in
union, to save the status quo. Perhaps the most impressive testimony of
this is the intervention in the bankruptcy of General Motors, by the
governments of United States, Canada and Germany. This is just one
example. The coordination between the ECB, the Fed, and the IMF via
currency swaps has also averted a remake of a CreditAnstalt episode of
1931. The conditional commitment by the Bank of Canada to keep the
overnight rate at 25bps until 2010 is another example, because it shuts
one more potential outlet valve to all those (including me) that
believe the USD “should” collapse. If you ask an insider, he or she
will smile at you in disbelief. However, no matter how precarious the
coordination is, from the outside, you can definitely see a global
plan. Furthermore, if you compare this coordination to the sad
political roads taken in the ‘30s (the same ones that led to World War
II and made ), you get a better picture of my point.
Do you think I am exaggerating here? Do you think taking a political
perspective on financial analysis is “soft” and does not explain
reality? Very well then, please allow me to put this in historical
perspective to help you grasp the magnitude of what I am suggesting:
Ask yourself, what would have happened if, instead of letting the
French monarchy die in the revolution that started in 1789, the
monarchies of all Europe would have helped Louis XVI suffocate the
rebellion. More specifically, what if Great Britain, Prussia, Russia,
etc. would have assisted the French treasury with their fiscal
deficits? What if Turgot and Necker would have been supported by a
pan-European mission to establish stand-by facilities and currency
swaps with the British Treasury? Don’t you think that, with the benefit
of hindsight, the western monarchies would have not sought to avoid the
political changes of the nineteenth century? I am absolutely convinced
of that. Every king and queen in Europe would have helped the Ancien
Regime survive. But in 1789, they did not have the benefit of hindsight.
Unlike the monarchies of the 18th century, the political (and
financial) class of the 21st century DOES have the benefit of hindsight
and acts accordingly. They know what happened in the 1930s…Therefore,
the system of central banking, with fiat money, currency debasements
and inflation MUST survive at all cost. Do I think that politicians
consciously think in these terms? No. But they don’t need to either.
All they need is to fear the transition from an overleveraged way of
living towards a more balanced one. Why? Because balance requires a lot
lower public spending and a lot lower taxes; and politicians fear lower
public spending and lower taxes. And also, because without central
banking and currency debasements, the financial class of today would
have to carry their investments on a mark-to-market basis, and that
would be unbearable to say the least.
So, back to my point: Do I feel pessimistic? Not so much, because
the global coordination that we are seeing today has a good chance of
succeeding in delaying or even totally neutralizing the intuitive,
textbook, rebalancing mechanisms that we are familiar with: A
depreciating USD, a lower S&P500, higher REAL interest rates,
flexible capital markets, etc.
In conclusion, it makes sense to think that if fundamentals don’t
improve, we can see a reversal in the recent rally. But at the same
time, I firmly believe coordination among central banks can thwart any
“rebellion”. What is then the result? Tediousness in equities, further
tightening in credit and steady unemployment.
Disclaimer:The comments expressed in this publication are my own
personal opinions only and do not necessarily reflect the positions or
opinions of my employer. I prepared and distributed this publication as
an independent activity, outside my regular salaried work. No part of
the compensation I receive from my current employer was, is or will be
directly or indirectly related to any comments or personal views
expressed in this publication. All comments are based upon my current
knowledge. You should conduct independent research to verify the
validity of any statements made in this publication before basing any
decisions upon those statements. The information contained herein is
not necessarily complete and its accuracy is not guaranteed. The comments expressed in this
publication provide general information only. Neither the information
nor any opinion expressed constitutes a solicitation, an offer or an
invitation to make an offer, to buy or sell any securities or other
financial instrument or any derivative related to such securities or
instruments. The comments expressed in this publication are not
intended to provide personal investment advice and they do not take
into account the specific investment objectives, financial situation
and the particular needs of any specific person.
I don't write on Thursday evenings (i.e. don't post on Fridays), during the sailing season, as I race on an SR21 in Lake Ontario and have no time to write at night. But given the action in the markets yesterday and the fact that the race was canceled due to poor weather conditions, here is a quick summary of thoughts:
-Yesterday, I pointed out that both the USD depreciation and oil crude appreciation were not consistent with what the markets seemed to be expecting: Higher interest rates. I therefore suggested the explanation was that in fact the smart money believes the accommodative policies of the Obama administration are here to stay for longer than most thought...I am now more convinced of this alternative explanation and yesterday, for the 1st time, I think we saw all the stars aligned: Weaker gold, weaker VIX, really tighter credit (CDX IG12 closing at 117bps and catching up with the LCDX12 stellar outperformance), weaker USD, higher crude, higher EUR/Yen cross, etc. etc. On the back of what? On the back of a stronger than expected nascent recovery (shy recovery) in the housing market. Do I think the market went to cover shorts? Not really. I think this was a directional trade this time, fuelled by convexity hedging in mortgages, which brings me to my next point:
-I 've always sustained (as a contrarian to many) that the yield curve was going to remain steep...and steepened it has over the last 3 sessions. You add this to the approx. 30bps Libor-OIS swap spread and the combination gives you a fertil ground for appreciation
-We still need to see investment demand picking up here. We won't see consumption driving us out of the mess, but investment demand. So far, I think we're getting closer and closer to that point, and equities are already discounting the fact.
-Lastly, I really fear the USD will collapse this time. Think of this: If we are really facing the definitive recovery, the starting point is a long-term benchmark rate of 4.5%, with high unemployment and colossal structural fiscal deficits in the US and....with record low fed funds rate. For this latter rate, the sky is the limit, and with 4.5% as a floor in the long end, the crowding-out effect is going to crush a lot of swimmers (= those who are noy on a boat like T-pain!) out there. Barak will feel forced to sustain fiscal expenditures high, to offset the fall in demand by the private sector. This should inevitably lead to a weaker USD. Why did it not happen before? Because the rest of the world was also in a lot of pain. But if countries like Canada and Australia take the lead, the gap will be there, and given their flexible exchange rate regimes, the pressure on the USD will not go.
Have a nice weekend,
Tincho.
(To subscribe to this daily market letter and receive it by email, in pdf format, please visit : www.sibileau.com/martin )
Another boring day of range trading…Equities (S&P500) managed to
stay almost flat at 954.07pts (-.05%). As you can imagine, we start
reading everywhere how overbought the market is, including the CDX IG12
at 124/125bps, for instance. Overbought with respect to which level?
Investors in the developed world, the world that leaves us no time to
think, are so used to inductive reasoning
(http://en.wikipedia.org/wiki/Inductive_reasoning and
http://www.uncg.edu/phi/phi115/induc4.htm ) that they are quick to make
all kinds of statistical inferences referring to past events. How dare
they? When was the last time we had a balance sheet crisis with central
banking coordination, a trillion plus in monetary expansion, emerging
markets with trade surpluses, a credit derivatives market and a
superpower issuing debt on a weekly basis the size of an average
country’s GDP? When? Anyway, it’s of great comfort to know that we
(still) have futures and derivatives markets to hedge the mistakes of
all those experiments in statistical inference.
Overbought or not, there are two things, two flags that in my view call for caution:
1.-The USD is depreciating on the expectation of higher interest
rates (Bernanke is on the record on this one) down the road and the
fact, apparently, that we may already past the bottom of this crisis.
This is not consistent. If you think activity will pick up and monetary
stimulus is going to slowly (very slowly) disappear, the USD should be
(very slowly) appreciating, particularly against the Canadian dollar,
for instance, as the Bank of Canada remains committed to its lowest
overnight rate. Some analysts associate this depreciation to investors’
appetite for risk assets. Why are we supposed to believe for a moment
that risk assets are found outside the US only? Why not inside the US?
Especially in a context of higher interest rates…The only thing that
comes to mind here is that the FX market may be telling us that
activity may not pick up as much as we think, and that defaults are still looming on the horizon…What does this mean? That there is more to accommodative policy on the horizon than it meets the eye.
But Bernanke did not hint at further purchases, on the contrary, he
started to lay out the next steps of the exit strategy. This would make
perfect sense, because it would be telling us that the Fed here is
helpless and Treasuries will need to get a bid from somebody else
(leading to higher defaults in the private sector, financially crushed
by a horrible crowding-out effect). This would tell us that, ceteris
paribus, equities cannot leap further by themselves but, at the same
time, it doesn’t necessarily mean that they are overbought.
2.-Crude oil is appreciating in the face of a widening contango, and without a clearly stronger demand.
Some would say that this is perfectly consistent with the weakening
USD, yet one wonders why would investors put money here, when the
market is bidding for storage. Today’s break over $65/bl was on higher
than 90-day average volume. If the mainstream explanation that the USD
is weaker as the bid for risk assets grows and activity is about to
pick up, we should not be seeing a widening contango. Maybe the USD is
weaker on the omen of stagflation, which would support a higher price
for oil, but I feel it is too early for this, given that, on aggregate,
capital expenditures are down, the official CPI figures are still very
low and the increase in activity is months away.
In my view, these two flags are symptoms of stronger currents under
the surface, and they can be well explaining the agony in equities (and
soon credit too? around 120-130bps?). I leave with an interesting chart
below (source: Bloomberg), on the yield curve, to see where we are,
after 216.7BN in Treasury purchases by the Fed. Any comments?
(To subscribe to this daily market letter and receive it by email, in pdf format, please visit : www.sibileau.com/martin )
Yesterday, we had an “intraday” correction, driven by the earnings
releases for Zions Bancorporation and Regions Financial Corp. The
sell-off in these two names was triggered on the most basic of fears:
Prospective defaults in commercial real estate clients. It didn’t
trigger a huge reaction, but it did bring a bit of perspective, to
which we should pay close attention. At the end, Caterpillar’s results
could take us to 954.58 (+0.36%) on the S&P500… Yes, we are
exploring uncharted waters here…
I read Ben Bernanke’s article on the WSJ, and was deceived to see
that the focus was on the increase in short term rates. Yesterday, I
wrote that for equities to leap higher, I believe we need some sort of
capital markets friendly action. And I defined such action as anything
that allows and encourages a flexible price system. Rates manipulation
doesn’t certainly fall under that category. The Fed does count with
other options, of course, and Bernanke acknowledged this in the
article. But they were not mentioned in detail. As we’ve said many,
many times, the problem with inflation is not that prices rise, but
that they don’t rise simultaneously. Interest rates are prices too, and
when they are manipulated, we are left with price distortion.
One would like to believe that, as the Fed uses short-term rates,
the shape of the yield curve will not change. Note that I am not
worried here about the shape itself, but about changes in the same. If
we are to embark on a recovery path, we will do so on the back of an
impressive amount of “defensive” issuance in 2009. I like this
adjective, which I borrowed from JP Morgan’s Credit Market and Outlook
Strategy report, July 17th, 2009. This report indicates that a
substantial part of 2009 and 2010 corporate maturities have already
been refinanced. Given that such refinancings were not used to fund
projects, capital expenditures, but to minimize refinancing risk,
stability in the term structure of interest rates is crucial once
activity picks up next year.
This is really not a small issue. In September of last year we were
laughed at for suggesting that capitalizing financial institutions the
Paulson way was not going to boost a recovery. We went on record saying
that a real recovery could only take place if governments put a bid on
distressed assets. We were criticized on the basis that injecting
reserves in the system was a much more efficient way to leverage
governments’ capital, assuming the reserves were lent…But they were
not! How could they? One only had to reread Keynes’ liquidity trap
comments made more than 70 years ago to understand this!
By the same token, paying higher interest rates on reserves will
not solve the problem tomorrow. The Fed should SELL ASSETS instead.
There is a very subtle difference here, and it merits elaboration:
My critical assumption (axiom) here is that fiscal deficits will keep steady. Thus, when short-term interest rates are increased, regardless of their level, the US Treasury will continue to issue debt to finance the deficit, validating
the higher rates. Meanwhile, the average small firm will not be able to
cope with the higher cost of capital, and many of them will go
bankrupt, in a process that will increase concentration. Spending with
fiat money is what fuels inflation, and it doesn’t matter whether the
spending is done by private firms or the government! Tax revenue will
fall as a consequence, boosting the fiscal deficit, in a spiraling
process. Given the financial problems firms face, unemployment will
remain high. And the Treasury will be forced to fund more and more
fiscal imbalances. Higher rates, inflation, defaults and unemployment
will live together.
If, on the contrary, the Fed sold assets, it would seek to
restore a previous market for them. In the process, if the Treasury
wanted to keep funding fiscal deficits, Treasuries would have to
compete on a more leveled field with private obligations, given that
there would be an oversupply of both private and public paper. The
clearing interest rates would be therefore, on average, in line with
the issuers’ respective productivity rates and risks. Given the
long-term tenor of the majority of the assets currently owned by the
Fed, one would think that this process would bring about steep credit
and yield curves, forcing the Treasury to look for short-term financing
alternatives, bringing a lot of attention to the problem of fiscal
imbalances. This latter road is the more difficult, expensive, sincere
and productive, which is why it will be the road not taken!
In the meantime, in Canada, the Bank of Canada has left the overnight
rate unchanged, at 25bps. The only worrying issue here is Mr. Carney’s
insistence in making public his concerns about the appreciation of the
Canadian dollar. The commitment (conditional on the inflation outlook)
to keep this rate unchanged until Q2/10 was repeated once more, perhaps
to manage expectations in the FX market (= weaken the CAD).
Intraday yesterday, we saw the CDX IG12 flirting below the 120bps
level. With the correction in equities, it widened back, to end at
123bps. As credit continues to normalize, we will see with more clarity
that the value of good fundamental analysis at the micro level gains
more popularity, vs. the systemic view. However, if the Fed is not able
to contain inflation, the macro and micro analysis will be equally
relevant, as we will need to anticipate the impact of inflation on
individual firms’ margins and liabilities management.
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At 15:06 ET yesterday, Bloomberg was reporting that CIT was
obtaining a $3BN financial rescue from bondholders, temporarily
avoiding bankruptcy ($2BN committed, $1BN needs to be raised within the
next 10 days). The S&P500 touched 950pts (back to Nov/08 levels)
and oil continued to regain lost ground, reaching $64/bl.
It certainly feels like we are about to get to the next act in this
drama. In a few weeks, we have the Federal Open Market Committee
meeting taking place. Given the higher likelihood that we may have seen
the bottom in March, investors are now concentrated in guessing (and
understanding) the Fed’s next steps. It may be too early to force a
definition, but at the same time, the Fed is increasingly pressed to
speak up.
How do we know? Because Mr. Bernanke just published an article on
this issue, in the Wall Street Journal (“The Fed’s Exit Strategy”, July
20, 2009) discussing the issue….Ok, ok, seriously now, how do we know?
Because the USD is selling off, not only against equities, but also
against other currencies. And the latter takes place in the face of
increasing rates expectations.
On July 16th, Bank of America’s Michael Cloherty published a very
interesting note (Situation Room: “How to Tighten (When it’s time)”)
speculating on the different options the Fed has, as well as their
respective impact on markets. In conclusion, Mr. Cloherty expects the
Fed to push a mix of all of the mentioned options (i.e. higher interest
on reserves, reverse repo transactions, Supplementary Financing Program
(SFP) bills issuance, asset sales, and higher reserve requirements).
Such operation would bring cheaper bills, Treasuries and a steeper
curve. Another important effect could be a substantial repo cheapening
(because the Fed would be oversupplying the market with Treasury debt,
to get liquidity out of the system).
In light of this, should we not expect the USD to appreciate? Yes,
absolutely. What could prevent the USD from appreciating? The market’s
belief that the fiscal (federal, state and municipal) deficit is an
ongoing problem, while at the same time, the administration that incurs
in them increases regulation on capital flows. Under such scenario,
capital leaves… Yes, you are right, other nations should promise better
prospects for that capital too, but if there is certainty about hostile
conditions at home, there is a permanent driver for capital to leave.
In the meantime, we are also witnessing a compression in credit
spreads, more debt refinancings taking place and the question now is
whether or not we can get past the 1,000 pts in the S&P500 and
reach 1,200. It’s too early to tell and if you ask me, I don’t think we
can have that leap on good earnings alone. Capital friendly actions
from governments are required. What do I mean by capital friendly
actions? Essentially, anything that allows and encourages a flexible
price system, without distortion in relative prices, and anything that
does that with certainty.
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What do we make of last week’s events? Investors had been
speculating on horrible macro data. A positive (close to 1%) CPI Index,
decreasing jobless claims and increasing housing starts challenged
their view. Personally, given that I could care less about
government-manipulated macro figures, I think the most impressive flags
are:
-Price indexes, regardless of their absolute values, are telling us
that there is no deflation. We’ve witnessed the greatest destruction of
wealth in decades, we are flirting with two digit unemployment rates,
continuing weakness in home prices and yet, we have no deflation…If
prices (and interest rates) are moderately increasing with so many
negatives, how high do you think they will go, when the positives show
up?
-The Libor-OIS spread (i.e. the cost of renting a bank’s balance
sheet to invest in risky assets) has been decreasing in the face of
CIT’s bankruptcy. Is this mere negligence from investors? Analysts are
accordingly quick to recommend “asymmetric” trades, trades that benefit
from the new fact that systemic risk seems to have muted, leaving
losers (to short) and winners (to go long). Decompression trades
between indexes are advertised everywhere. There was an interesting
research note (from Morgan Stanley’s Credit Derivatives team) marketing
the intrinsic option-like nature of index tranches to profit from this
asymmetric view. I wish everyone good luck on these quant trades. It
will be needed in uncharted waters. But if you are an observer seeking
to follow the scientific method, you cannot ignore these events.
-The astonishing recovery in equities and sell-off in Treasuries,
taking us back to where we left things at the end of May. When we first
started publishing “A View from the Trenches” (under the name of
“Tincho’s letter”), we proposed the waterfall chart below
(www.sibileau.com/martin/2009/04/14 ). This chart, updated for July
20th, should be our guide during the inflationary process brewing up
worldwide. I think we are now ahead of stage 3 and in early stage 4.
Why? Because stocks have not only rallied, but they have done so
together with the most dramatic debt maturity swap ever (i.e. companies
have been issuing long-term bonds to repay short-term debt) and
companies are now focused on acquisitions (not necessarily capital
expenditures). In the resource sector, we are seeing a nascent wave of
mergers and acquisitions that will lead to more concentration and
rigidity in commodity prices down the road. These acquisitions are all
about gaining economies of scale and negotiating power. The latter will
be necessary when, in the middle of two-digit interest rates, small
businesses die like flies and big financial institutions put pressure
on survivors. (Yes, you are right: I don’t think you should try your
luck with small cap equity funds. When governments decide who wins and
who dies, it is usually the rich that get richer and the poor that get
poorer…Il n’y a que les pauvres qui partagent!)
-Finally, municipal and state finances are increasingly pressing. I
don’t think California will default, but California is not alone out
there. Nor should we rest comfortably while liquidity keeps flooding
emerging markets.
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Voila! Yesterday equity markets in North America rallied about 3% on average, in the face of high unemployment, a Fed that acknowledges weakness and a market that speculates on upsized purchases (by the Fed), the possible bailout of CIT (at closing, trading on this company had been halted and seems to be heading to bankruptcy) and weak economic data. The rally pushed credit spreads tighter (CDX IG reached 131bps) and of course, triggered the sell-off in Treasuries. Mortgage convexity hedging needs did the usual amplification of the move.
In the land of foreign exchange, the Canadian dollar caught again the winds that seem to push it to parity with the USD. I didn’t feel however, that things are going back to normal, where the Fed pumps liquidity to decrease rates, investors reallocate funds from Treasuries to equities and commodities, and money flows out of the US to safer and more promising bays. The first thing I noticed this morning was that the usual bond issuers of the last two weeks (sovereigns, financials and utilities) were replaced by issuers of other sectors (i.e. gaming), perhaps a coincidence or a conscious decision to take advantage of whichever window of opportunity the market leaves open. Back again to our commentary of June 3rd, where we laid out the investment thesis for these recent weeks (www.sibileau.com/martin/2009/06/03 ) : “…I think that the issuances that we see today, the capital raising initiatives, the maturity swapping we are witnessing are exactly about that: Inventory growth. Why? Because we don’t know what prices will look like tomorrow. Could some firms be buying inventory (liquidity) at a high cost? Absolutely…” Companies are building “stocks of liquidity”. We will see “more cash and less cash flow”, as an analyst recently described the situation.
En fin, one has the feeling that change is breeding since Tuesday. It is not a clean change. It’s full of confusion, anxiety, fear. But it is very healthy. We are discussing how to defuse the next big bomb out there: The municipal and state deficits in the USA. Even another more surprising change is the tone of the debate in monetary policy. For instance, Morgan Stanley’s Global Economics Team put out a note yesterday, suggesting that central banks should switch the policy goal from inflation targeting to price level targeting. As useless as it seems to me, the relevant lesson here is that things maybe changing and changing fast. And that, I believe is healthy.
The municipal and state deficits, to me, are adding pressure to Treasuries and constitute a fundamental underground force behind the late weakness in the USD. The prospect that the Federal government may step in and increase the overwhelming supply of coupons so far this year, creates great concern. Perhaps one bit of good news today was to read that China is continuing to build its USD denominated reserves, which now amount to $2 trillion. This build up in reserves is hugely inflationary and simultaneously supportive of commodities. Year to date, apparently (one can never be too sure about these figures) M2 in China is up 28%!
Meanwhile, what is our beloved Canada doing to take advantage of this excellent opportunity? Nothing, if one excludes the new visa requirement on citizens of one of the countries we have the most important free trade agreements with. We may not need to do anything. After all, the Canada Mortgage and Housing Corp. yesterday offered to buy up to C$4Bn in mortgages to facilitate balance sheet rotation for the country’s big banks, and these barely took more than C$2Bn.
Implementing policies to increase our productivity is critical for a good outcome in this crisis. And the moment is now! As Keynes put it: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…” (The General Theory of Employment, Interest and Money, Ch. 13). If we want to avoid stagnation with inflation when the liquidity being injected today finds its way through the system tomorrow, we need to undertake enormous reforms to make our nation more competitive, more efficient. This letter is not the place to discuss this issue, but I can safely say that hostility with trading partners is certainly not the smart way to go!
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Analysts are striving to understand the action in equities in the
last two days and in credit and Treasuries since yesterday. As I wrote
before, I am not a big fan of statistics, indexes and all the
ammunition mainstream economists use. My dislike for them is based on
the assumptions; the methodologies used to measure, and last but not
least, their respective goals. But this goes beyond the scope of this
letter. Enough is to say that regardless of what was excluded or
included in the calculation of the Producer Price Index released
yesterday, the same was higher than expected and, most importantly,
showed that there is no deflation.
In Canada, another relevant flag is that on July 13th and yesterday,
the Bank of Canada had offered to purchase up to $3BN and C$1BN
respectively, under the Purchase and Resale Agreements (PRAs). These
short term transactions are meant to provide liquidity to the market.
The news is that for the $3BN 84-day offer, only C$2.25BN was sold (for
an average yield of 0.254%), while for the C$1BN 28-day offer, only
C$700MM was sold (for an average yield of 0.50%). This in itself
shouldn’t have caught my attention. What was so special then? Between
July 13th and today, the Canadian dollar appreciated approximately 2.5
US cents. To me, this is bullish of Canadian “stuff”, for not only have
commodities followed the reversal in stocks (S&P500 closed at
905.84pts) this week, but there is also an important amount of Canadian
savings on the sidelines. However, let me be clear here: It is never
wise to take a rally for granted because there is money on the
sidelines!
Finally, let’s recap here what I think is unfolding. I acknowledge I
have been a contrarian since June, but the markets appear to be with me
here. On June 3rd, I said that: “…I expect equities to simply stagnate, orbit within a certain range. The harsh side of this coin will be a high unemployment…” (www.sibileau.com/martin/2009/06/03
). I also maintain that in order for us to see a fire sale in risk
assets, we need some exogenous, political event to trigger it. Therefore,
I might as well be on the wrong side of the bet, because the last two
sessions have ended up based on positive (or better than expected)
data. (I may be right for the wrong reasons) although it is too early
for a final conclusion.
Thus, given the general confusion, let me repeat why I am inclined
to expect agony in the markets, together with high unemployment:
Because of the ongoing inflationary process. To most people, this is
extremely counter intuitive, as they have been educated into the
mainstream theory of inflation, which sees this phenomenon as a one-act
play: A high CPI announcement. For us, educated under the Austrian
school, inflation is the distortion in relative prices. This distortion
can last many, many years, before it translates into a high CPI
reading. This distortion also generates enormous imbalances, obstacles
to firms and uncertainty. The uncertainty is what keeps unemployment
high. What then could get us on a steady growth path? A
reliable fiscal budget in the developed world! Why? It would bring a
reliable benchmark issuance schedule, and demand would consequently
adapt to it.
July 14th 2009, Intraday: S&P500 Index (orange) vs. 30-yr Treasury (white) (Source: Bloomberg)
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Today is the 220th anniversary of the storming of the Bastille prison, in France. On a 14th of July in 1789, an angry crowd liberated what were mainly political prisoners in this fortress-prison, outside of Paris. The anger had brewed during previous years, as Louis XVI ran into massive deficits, which he sought to cover with rising taxes. People back then thought they had seen the worst crowding-out effect ever, by a careless government. But perhaps they were wrong. Perhaps, with yesterday’s announcement of the US 9-month fiscal deficit of $1.1 trillion, those courageous French seeking to end nonsense have been dwarfed by the American taxpayer. In any major crisis, new ideas are born. In the case of the French crisis of the eighteenth century, the new idea was that quantitative analysis could be useful. Yes, quantitative analysis (what follows is my view only; I invite anyone to check if I am right here) was born with the Tableau Economique, of the so-called physiocrats. This analysis sought to make the point that agriculture in France was important and that the government had to develop its potential (as you can see, the United Auto Workers are not original).
Equities rallied today. Maybe because Meredith Whitney was positive on Goldman, maybe because the market sold Treasuries, or Bank of America may not have to pay $4BN in fees to the US government, or perhaps the macroeconomic data is not as bad as it seems. As we have said in recent letters, endogenous factors alone do not guarantee new lows. This does not mean there cannot be new lows. All I have been saying is that, by itself, the macroeconomic fundamental situation should not push a panic sale, because governments have ensured there is liquidity going to the financial system (We will have more to say about this, in the case of Canada). If this flow of liquidity stopped, or if the market believes that it can stop, or if it is challenged by an exogenous effect, then the spiraling asset deflation could indeed be triggered.
How do I know I am right here? I don’t. I can only hope my own Tableau Economique is right. When stocks fell approx. 25% with the Lehman bankruptcy, between Sept. 15th and Oct 10th 2008, the Libor-OIS spread (= 3-mo Libor minus Overnight rate; www.sibileau.com/martin/2009/07/07 ) shot beyond 364bps. Today, the same spread keeps narrowing in the face of all the negative data. It is still above the 2bps pre-crisis, at approx. 31bps. With the chart below in mind (source: Bloomberg), I fail to see why investors should engage in an asset liquidation wave, realizing losses, seeking to preserve that which is currently not lacking. Unless again, exogenous, political, factors show up and break the status quo.
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In the chart below (source: Bloomberg) I show the changes in the
(on-the-run) Treasury yield curve, since June 19th. I wanted to
visualize these changes since the retrenchment in equities and credit
(which started last week) began. The most notable change is in the 7
and 10-year issues, which have appreciated (yield decreased)
substantially. I find it interesting, very telling, to see that both
the short-end and long-end of this curve have not followed the strong
appreciation. This may signal caution, the lack of a strong view from
the market on where and how the situation is unfolding. Should Q2
earnings surprise on the upside, the short end of the curve would
depreciate quickly, driven by the return to a risk friendly mood.
Consistently, given the ongoing monetization of deficits, a risk
friendly environment would only be the other side of asset inflation,
bringing inflation expectations back on stage (together with mortgage
convexity hedging) and driving the long-term yield back again towards
5% (In the meantime, the reverse process in the mortgage world is
taking place).
As Q2 earnings are released, the present danger, therefore, is new,
lower lows in equities. This time, disappointing earnings would signal
a weak consumer (finally higher savings rate) that may or not trigger
more violent defaults, and hence loan losses. In our Thursday letter
(www.sibileau.com/martin/2009/07/09/ ) I suggested that although the
retrenchment is based on endogenous factors, there were still relevant
exogenous ones to keep in mind.
Given the steady decrease in Libor, the narrowing of swap spreads
and the shape of the yield curve, I am now more inclined to believe
that lower lows can only take place as a result of exogenous/political
events. It is a confusing notion, because the problems affecting the
world have not changed; they have merely been transferred from the
previously free, unregulated, marked-to-market balance sheet of the private sector to the political, regulated, amortizing balance sheet of the government.
There are only two possible outcomes, not mutually exclusive, from
this situation: A crowding-out effect (that would do justice to David
Ricardo) or an inflationary process (that would give posthumous fame to
Keynes). Right now, the market is precisely gauging the balance between
the two. When the Fed doesn’t insinuate further action, the market
remembers Ricardo. When the Fed does insinuate it, the market remembers
Keynes. To me, the key here is to remind ourselves that Mr. Obama will
understandably seek reelection, which is years away. Inflation (Keynes)
will be delayed, leaving more chances for the crowding-out effect. In
the times of Ancient Rome, the Senate avoided the crowding-out effect
by sending troops to conquer new countries, confiscating the wheat
harvests of Egypt, the source of savings of the Ancient World. In 2009,
China can certainly not be accounted for something of the sort.
Therefore, the S&P500 could still go lower!
US Treasury yield curve (on the run issues): From June 19th 2009 (green) to July 10th, 2009 (white) (Source: Bloomberg)
Many years ago, when I had to sell my first car to buy a newer one, I was a bit anxious. I could not find buyers. I went to my mechanic’s shop looking for some advice. Perhaps he would be able to place the car with one of his customers. When I told him I was having trouble selling my car, which was in good condition, he plainly replied: “You don’t sell your car because you don’t want to”. “What do you mean?” I asked back. “Well, I will actually buy the car, if you accept $5,000”. That sum was really low and, of course, I put a polite smile, showing I had understood the message.
Today, as I remembered my first big selling experience, I wondered if the same is relevant to stocks. Precisely, I asked myself why stocks are not plunging. Why are equity investors not selling more violently? Is it because they also don’t want to? Are prices already too low? With respect to what? Fundamentals? What fundamentals?
The fundamental story we hear of late goes a bit like this: Upcoming earnings releases may disappoint, showing a lower than expected marginal consumption. The increasing unemployment rate and ongoing energy inventory build up suggest that equity prices may have gotten a bit ahead of themselves.
The obvious question is whether prices should go back to their earlier lows or even lower, based on fundamentals. Did the S&P500 reach 666pts in early March because of liquidity problems or because of weak earnings expectations? If the cause was weak earnings expectations, why did the bond market rally after the Fed’s purchase announcements in mid March? If the cause was liquidity problems and these seem to have eased substantially, why would stocks test the lows again? If the March lows are not going to be tested again, does it mean we are merely witnessing a correction?
Back on June 8th (http://sibileau.com/martin/2009/06/08/the-answer-is-political-exogenous/ ), I proposed the thesis that a sell-off would possibly be triggered due to an exogenous event, namely political. If I had to name one today, I would attribute it to the Fed’s reticence to increase the current Treasuries purchase program. Yes, it is an inflationist policy but it is the only way out of this financial crisis. Will it create growth and produce full employment? No! It will merely redistribute wealth, dictate new winners and losers, but at the end of the day, it will have turned the page to another chapter!
On June 8th, I also wrote that should the sell-off be driven by endogenous causes, commodities would underperform. Commodities are actually underperforming. What makes me think that there may still be some hope? The fact that we are not seeing deflation, the fact that the Libor-OIS spread keeps compressing, that companies are swapping the maturities of their debt, that they are also getting away with negotiating amendments to their bank debt covenants and obviously, that the yield curve remains steepened.
However, there are still possible exogenous factors that in my view may aggravate the picture: a) the structural US federal deficits, b) the insolvency of US states/municipalities that would eventually require federal intervention, and c) the heavy burden of foreign debt to Eastern Europe’s private sector, which would affect Western Europe’s financial sector.
But at the end, what really worries me is that if panic takes place and the sell-off spirals, whatever liquidity we see out there will not be enough, and central banks will find themselves helpless. And as you may have noted, I am not even considering a scenario where in addition to the panic, loan losses effectively increase vs. expectations.
“…It was a serious blunder to believe that the reserve’s task is to provide the means for the redemption of those banknotes the holders of which have lost confidence in the bank. The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence, the rest of them lose it too. No bank issuing fiduciary media and granting circulation credit can fulfill the obligations which it has taken over in issuing money-substitutes if all clients are losing confidence and want to have their banknotes redeemed and their deposits paid back. This is an essential feature or weakness of the business of issuing fiduciary media and granting circulation credit. No system of reserve policy and no reserve requirements as enforced by the laws can remedy it…” L. v. Mises, “Human Action”, 1949.
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The retrenchment in risk assets continues. Yesterday, stocks sold
off again (S&P 500 closed at 881.03 or -1.97%) while Treasuries
gained (30-yr yield ended at 4.304%). The chart below says it all. The
Libor-OIS spread we discussed yesterday continued to compress, with
3-mo Libor now at 53.75bps. It is a trend, certainly, but without the
violence we got so accustomed to see in 2008. It looks like the markets
are under anesthesia, provided by central banks, while everybody waits
for a surgeon to show up and do the dirty job…
I have the feeling that I could safely say that nobody can affirm
with certainty today where markets are headed to (Except of course the
usual bearish voices, the same ones that missed the huge rally of
2009). We cannot blame analysts for their lack of certainty. However,
perhaps, there is value in acknowledging ignorance. What do I mean? I
could argue that today there may be more merit in acknowledging
ignorance than betting on a path. But, if forced, one can always go
back to the comfort of those self evident truths. Whenever I need to
understand something new, I just go back to reading classics. For
instance, let’s rescue Mr. Keynes’ thoughts back from oblivion. If we
want to be consistent, we need to recognize that the goal of every
government’s interventionist policy since 2007 is to increase output
back to a “full employment” level. What should the world look like, if
their efforts are successful? At the end of the 3rd section, Chapter 13
of “The General Theory of Employment, Interest and Money”, Maynard very succinctly told us that: “…when
output has increased and prices have risen, the effect of this on
liquidity-preference will be to increase the quantity of money
necessary to maintain a given rate of interest...” Keynes
could not have been clearer on this. The only possible way out of a
financial crisis is to inflate the way out of it (By the way, that’s
why we have central banks). Anything else is pure hypocrisy and a
painful and unnecessary delay.
In the meantime, the painful and unnecessary delay is caused by
inconsistent intervention that dislocates and segments markets. We
discussed the issue yesterday, in relation to the compression of the
Libor-OIS spread and risk assets dynamics. The intervention is very
harmful, because it affects price relationships. The pricing
system is nothing else than a communications system. In fact, it is not
the only one we have to signal gaps between supply and demand in every
market, but it is also the best one we have within all our
imperfections. Thus, every regulation, every exogenous purchase or sale
of assets done by any government distorts this signaling system and we
end up getting the wrong signals. We then have to hear
mainstream economists say that “equities got a bit ahead of
themselves”. This is nonsense. This school of thought is the same one
that sustains that markets are not rational. See, if you sense a
monster in your room and you run away, you are not irrational, for
escaping monsters is precisely the rational thing to do! What is the
problem then? The problem is that there are no monsters in your room.
You simply had the wrong information. And so do markets today! Who provides it? Governments! The sooner their intervention ends, the sooner we will recover.
Chart 1: 30-yr Treasury (white) vs. S&P 500 Index (orange), intraday (Source: Bloomberg)
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