April 2012 - Posts
If we have to summarize what drove the action last week, we will say it was the speculation over an upcoming (perhaps in June) Growth Pact in the Euro-zone. That was all. That did the trick. There is really nothing, absolutely nothing concrete. And no, we don’t think the market is speculating on a soon-to-come Quantitative Easing Version 3. But from pure intuition, it would seem that the market sees these conditions as necessary to take the any Pact seriously: a) Mario Draghi, President of the European Central Bank, would have to back such pact in a way that would guarantee some sort of deficit monetization, and b) Hollande should win France’s presidential ballotage, next weekend.
Indeed, most news were bearish last week and yet, every single asset class seemed to end on a bullish note. From the Euro zone, we saw a deceiving bond auction by Italy. We also learned that the unemployment rate in Spain (the official rate) averages between 20% and 30%, depending on which region one measures it, and that the United Kingdom is already in a double dip. This only resulted in a stronger Euro and stronger Euro stocks for the week.
Last week too, Moody’s downgraded Ontario’s credit rating to Aa2 with a stable outlook from Aa1 with a negative outlook. How did the market react? The Canadian dollar finished the week stronger. Then came the activity data release for the United States: Jobless claims, housing data, inflation data…all of them were worse than expected and yet….stocks rallied, with the S&P500 reaching again the 1,400pts. And we could say the same about oil and gold…
The lesson here is that a market that will not fall on bearish news is a bullish market. Even if it is a manipulated market, which brings us back to gold. Below is the daily chart (source: Kitco.com) for April 25th, 2012. It shows how upon the start of Bernanke’s press conference an algorithm sold whatever it could precisely at one point in time. Everybody saw it coming. We saw it coming, after what had happened on February 29th, or with the Euro peg announcement by the Swiss National Bank, in 2011. And this time, whoever was behind the move, lost money. We can only hope these moves stop or expect that newer, smarter moves will follow. We think the latter are more likely than the former:
Somehow, the idea of a “Growth Pact” reminds us of the New Deal and Ludwig Von Mises’ comment on the same. Von Mises wisely said:“…The comparatively greater prosperity of the United States is an outcome of the fact that the New Deal did not come in 1900 or 1910, but only in 1933…”. His words, in light of this Growth Pact speculation, sound to us wiser than ever…
We want to leave with this thought: As we have repeated, since the start of the Long-Term Refinancing Operations by the European Central Bank, the savings rate of the world (yes, now is the global savings rate) keeps slowly drifting lower either because of the manipulation of interest rates by central banks, or the fact that income is falling, as in the case of the European Union and the UK, or because of simple financial repression, as in the case of the debt swap between Greece and the European Central Bank, which left holders of sovereign debt suddenly subordinated. This simple observation leads us to think that this crisis will continue to unfold like a painful agony, and that we have many, indeed many more years of it to come.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments 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 (e.g., options, futures, warrants, and contracts for differences). My comments 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.
(Originally posted on April 23, 2012, at www.sibileau.com)
Because simplicity is a virtue, we decided to skip a week and write our comments today. Why? There had really not been any developments during the past two weeks that would have made us change our views. To be certain, even today we think nothing really fundamental has changed.
What has been keeping us awake at night however is the late and blatant manipulation of markets and key prices. The most obscene example is that of gold, where one can almost time the automatic sell-offs that are repeated continuously after 3am or between 10-11am Eastern time. Looking at the charts, the manipulation is so obvious that were it in a particular stock, the SEC would have already acted. But of course, it is gold we’re dealing with here…In general, we think the world is witnessing a phenomenon that Friedrich Von Hayek had already anticipated it could occur in a context like the one we’re living in. Here is an interesting interview on the subject:
http://youtu.be/dV7-2Aua4_4
In Von Hayek’s view, Economics is the study of social cooperation, where markets are an institution and a process for such cooperation. To be more productive and improve their standard of living, individuals specialize and allocate resources farther from the final act of consumption. But if that is the case, and the production process becomes so complex that it is carried out in different geographies by different people…how do all these people know what and how much to produce? Do men count with a signaling system to cooperate and achieve this economic calculation? The answer is fortunately positive: That signal is given by prices. The market signals that a production process is desirable by making the producer profitable and tells the same producer his resources would have been better used somewhere else, by making him unprofitable. Profit and loss therefore are nothing else but key signals needed for social cooperation.
But when men live in a levered world, with fiat currencies, these signals, particularly prices, are completely distorted. This would not be a problem if ultimately, the distortions were corrected. However, they cannot when governments start to repress markets by imposing capital ratios, bands on currencies, caps on commodity prices or manipulate interest rates (i.e. the intertemporal rate of exchange).
Taking this thought to the current context, it is clear to us, that thanks to these interventions, the European Union, to maintain its common currency has destroyed its capital markets, which consist mainly of its banks. There is a lesson to be learned: If you want to keep an overvalued currency with its banking system, you will lose both! But the authorities of the Euro zone are not alone. Back in September 2011, we had warned that the Fed currency swaps would put a floor to the Euro (just like the Swiss National Bank did), enhancing this distortion. We were not wrong here, we think, as the Euro has been able to stay above $1,30. One more thing needs to be said: The Fed swap is not targeting an exchange rate between currencies, but a maximum sovereign yield above which counterparty risk would explode generating a run against the USD financial system. The resulting implicit exchange rate is only a symptom and not the cause. If this is true, as Spain’s sovereign yield approaches key, dangerous levels, it would not be surprising to see a bailout of the Spanish system via swaps. Of course, just like they did in 2011, this time, authorities would also deny any specific bailout.
We are aware that today’s discussion may have sound too theoretical. But we are confident that very practical conclusions may be taken from it. First, this constant intervention and manipulation is going to make any economic/jobs growth unsustainable. As we mentioned in January, companies have been using this window of cheap US dollars, since December 2011, to increase dividends and leverage their operations. Default risk has consequently increased. In this regard, we maintain our bearish view of stocks, regardless of the fact that they have been making higher lows since April 10th. We think that the situation out ofSpain is going to imminently turn things for the worse. Second, and although gold may further be sold by the manipulators to the $1,500s, it will recover its value.
We should finally make some comments on the confiscation of YPF by the Argentine government, from Repsol. But we lack the space and time. Briefly, we are impressed to see how the world has been taken by surprise on this action and fear that it may become a symbol of what is to be expected in the coming years from trade and currency wars.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments 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 (e.g., options, futures, warrants, and contracts for differences). My comments 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.
As Easter approached, we began to see a timid sell off in US stocks (but not so timid in Europe or Canada), in corporate debt, and in Treasuries. Treasuries later in the week rallied, but if you ask, we would see them still in a downtrend. This downtrend began with the implementation of the Fed’s latest currency swaps, at 50bps, in mid December. As we argued against public opinion (refer here), the swap is a bailout that actually coupled the fate of the US with that of Europe, and not the opposite. It makes perfect sense to us because just like now, the US was also coupled to Europe in the 1930s, and ended up having to pardon what it was “owed”. Here is the moment when President Hoover announces the moratorium (ie. pardon) of the debt: http://youtu.be/MFdTISc1KG0
People back then took the matter in their own hands and forced the devaluation that ended in the bank holiday of 1933, with President Roosevelt confiscating gold. Here is the announcement by Mr. Roosevelt. Let’s keep both videos in mind, for future reference, because we have the feeling this crisis will be a horrible déjá vu: http://youtu.be/kTe4paRPEM4
As we have done many times before, we offer this excerpt from Jacques Rueff’s “The Monetary sin of the West”, 1971:
“…On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government’s attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:
There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold exchange standard. Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit….”
We are starting to get dizzy, disappointed, confused by the manipulation of capital markets, which are slowly and steadily losing liquidity.
The manipulation comes first and foremost from central banks, be it in the FX market, rates or gold. And when they intervene, they generate a volatility that is completely foreign to the “natural” changes that “Main street” (i.e. non-financial sector) would expect from a growing economy. It is this volatility that gets everyone dizzy.
Secondly, governments, via regulations and financial repression, distort the subordination points the market had established for different sectors. What do we mean by this? Every business and in aggregate, the whole economic system, has a capitalization structure, consisting, for example, of equity, preferred equity, subordinated debt, sr. unsecured debt and sr. secured debt. Each participant in these “layers” of the capital structure demands a return for the risk taken. That risk consists of two parameters: The probability of default (i.e. losing one’s capital) and what it expects to recover, if there such default takes place. Well, since the beginning of this crisis, with the bailout of the Chrysler and General Motors in the US, the Asset-Backed Commercial Paper scandal in Canada, the bailout of the financial system in the UK and most recently, the debt exchange of Greek debt with the European Central Bank which subordinated private bondholders without triggering default, both parameters (default and recovery) have been insanely disfigured. The natural consequence is a retreat by investors from pouring funds to the “system” at best, or simply reducing the savings rate, at worst. We fear both processes are well underway (last week, we received confirmation of a slight decrease in the savings rate in the US) and it is this repression that disappoints us.
Thirdly, we are confused by the ignorance leaders show. They should by now see that these policies drive people and companies to save less. We discussed this point on March 18th, when we wrote:
“How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt…”
On April 2nd, Zerohedge.com reproduced comments made by David Rosenberg, supporting this view, under the title: “How The Fed’s Visible Hand Is Forcing Corporate Cash Mismanagement” (We generally tend to disagree with mainstream economist David Rosenberg, but it looks like, over the past years, he may have been quietly reading Austrian economic literature).
Under the status quo, investors, globally, are and will continue to shift slowly their savings out of the “system”. On the margin, why would anyone that is not an insider of the financial markets want to keep their savings there? They will be levered/re-hypothecated or invested in cartelized exchange-traded funds or used to pay fees or futures rolls, or face huge bid/ask spreads or finally, if they produce good results… they will be taxed. Why would anyone want this? Why not just keep savings safely invested in farmland, or collectibles, or physical precious metals, or real estate in unique locations? These assets cannot be re-hypothecated, charged with monopolistic fund fees or unreasonable bid/ask differentials. Returns can be influenced by their owners’ commercial activity and taxes can always be minimized. But if these are the alternatives…how will corporations get funding for their projects or even normal capital expenditures? How will governments keep funding their deficits? Of course, …. Ben Bernanke and Mario Draghi assured us last week that their liquidity pumping policies are only transitory…
In the last days again, we have been exposed once more to the rhetoric of the prospective fiscal unification of the European Monetary Union (“EMU”) but based on new, mega bailout funds. We no longer care about the amounts they come up with (they came up with Eur940MM…nobody bought), even if it was true that the EMU members can raise these amounts. The fundamental issue here is that they want to address a “flow” problem (fiscal deficits) with a “stock” solution (bailout funds). It can’t be done. Flow-driven problems must be addressed with flow-based solutions, like a federal tax (If you have never heard of the terms “flow” and “stock” as used in Economics, please, read this explanation).
In particular, the situation out of Spain is rapidly worsening. Most analysts believe it is serious and a good portion of them think that once it spins out of control, the European Central Bank will intervene with plain monetization of Spanish assets. We have our doubts. Unlike other peripheral countries, Spain is a kingdom with a strong and influential king. Unlike other peripheral countries too, the fiscal deficits that hurt Spain are of a regional nature, and the independence of these regions is strong and ferociously defended. Under these circumstances, there is a high risk that the demands imposed upon Spaniards by the Euro Council be harsh enough to be refused and that upon such refusal, the Euro-zone face its final hour. We think that the fact that gold held above $1,600/oz upon the release of the Federal Open Markets Committee’s (“FOMC”) minutes last week, with stocks and the Euro selling off is a signal that this risk is not to be underestimated.
In light of this, having been stopped out of our position in gold with the release of the FOMC minutes, we bought it back on Thursday, at a lower price, but this time, hedged, shorting North American stocks. We are bearish of stocks or, better said, we think that the ratio of gold to stocks is now in gold’s favor, after a serious correction.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments 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 (e.g., options, futures, warrants, and contracts for differences). My comments 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.
Last week we had suggested that the strength of the Euro (by strength, we mean a Euro above $1,30) could be based on the fact that the liquidity lines extended by the European Central Bank were collateralized. As the sovereign risk of Spain,Italy and Portugal had deteriorated, so had the value of their sovereign debt diminished and, as this debt had been used as collateral by the banks of the Eurozone, these banks would be forced to sell assets and buy Euros to post on margin. It was simple and beautiful logic. However, we were wrong and the reason for that left us even more concerned. Someone better informed than us, who shall remain anonymous, wrote us the following (the highlighting is ours):
“…Hi Martin,
I just wanted to chime in on the issue of ECB (European Central Bank) margin calls. I completely agree that in theory the collateralized lending that now dominates can develop into a vicious cycle (as well as a virtuous one of course). However, in practice, a lot of the collateral that is pledged at the ECB is marked to model rather than marked to market. At least that’s what I am inferring from the ECB margin calls. The spikes that you saw relate to Greek collateral coming in and out of the ECB refi ops. Abstracting from those the margin calls themselves tend to be too small in my view to have an impact on the Euro…”
Having proved our axiom wrong (i.e. margin calls triggered by market volatility), our thesis is proved wrong. We had at the beginning of 2012 however warned that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” (“Walking the fine line”, Feb 6th, 2012).
It is time now for us to write a few lines today about Canada and India. Over the past months, we have seen crude oil appreciate. Simultaneously, the Canadian dollar did not (the Canadian dollar is positively correlated with crude oil) and the data coming from activity in Canadahas been disappointing. What makes matters worse is that in light of this, the price of housing has remained strong and even slowly increasing. In discussions with those following this market we noticed that in general, investors tend to see the Canadian context with the same lens used to see that of the USand the UK: They see a bubble in the housing market that would eventually be harmful to the financial system, and which would end in systemic weakness for Canada. This is, after all, what occurred in the USand the UK(We remind readers that at “A View from the Trenches”, we have never seen the EU crisis based on anything else but an institutional problem, rather than a liquidity or solvency problem. Refer: http://sibileau.com/martin/2010/02/10/)
We see the Canadian context differently. We think that it is likely that the barbarians will use the back, rather than the front door. Because Canadians have on average tended to put significant down payments on their houses, only a fraction of the outstanding mortgages have required insurance from the Canadian Housing Mortgage Corp. That fraction can be (but is not necessarily) securitized. The rest remains warehoused by Canadian banks, which unlike US banks, have recourse on their borrowers (if these default on their homes). Our fear then is of a potential contagion from the government. Indeed, rather than expect contagion from the banking system to the government, inCanada, we expect contagion from the government to the banking system. If the fiscal situation deteriorated (led by Ontario), the guarantee of the Canadian Housing Mortgage Corp. and the implicit comfort based on the country’s sovereign AAA rating would immediately affect the banks.
Do we expect this deterioration to be triggered by an endogenous dynamic? No. We fear that Canada may be affected by a foreign development and we can think of many, from the Euro-zone,China, or theUS…which takes us to India.
India has and is embarked in an inflationary process and, like in any other inflationary process, the outstanding amount of money is the taxing base. Following the example set by the Mahatma Gandhi, Indians peacefully protest this taxation by leaving the taxing base, the rupee, in exchange of gold. This has angered the government there which has taken a few repressive measures. It has taxed gold (a tax currently under review), set import duties and even barred gold loan companies (that lend on gold as collateral) from lending against gold bars, coins and bullion. These companies can now only lend against gold jewellery, with a cap on the loan-to value asset ratio and maintaining a minimum Tier 1 capital of 12 per cent. Does anyone think that these measures will favour the development of capital markets in India? Does anyone actually believe that because the competition from the gold loan market falls, savings in rupees will grow and investors will accept the government’s strong hand and lend in rupees? This is another example of the idiocy of bureaucrats that is destroying capital markets across the globe. Not only will savings in rupees not grow, but the overall savings rate will tend to fall, because on the margin, if savings have nowhere to go…why save?
This destruction of capital markets, as we noted, is not only taking place in India. The same is carried away slowly, by breaking the price system, whose signals no longer seem to work. Compared to July 2011, we have more than a trillion of new Euros, we have had Operation Twist, the banks of England and Japan weaken their currencies, sovereign downgrades worldwide, Ben Bernanke announcing low rates until 2014 and yet, gold is below $1,700/oz, courtesy of the interventions (see: http://www.zerohedge.com/news/paul-mylchreest-presents-various-visual-case-studies-gold-price-manipulation) . Even worse, although gold is below $1,700/oz, it is obviously higher than a year ago…but the capitalization of the gold mining sector is lower.
Repression, repression, repression…Interest rates don’t reflect anything these days. If you ask us, we don’t even know what to call capital. The price of crude oil touched $110/bl and yet the capitalization of energy sector in Canada slipped. Only a few dare to short the Euro, in the face of the massive destruction of the financial system in the Euro-zone. How can this be possible?
People wonder and at the same time praise the fact that companies nowadays hoard record amounts of cash, as a sign of strength. We think this is actually a disgrace and it shows how central banks managed to distort the relative prices of the different components of the economy’s capital structure. These companies are not investing that cash but as we mentioned a month ago, they have started to return it via dividends or share buybacks.
The final outcome of these repressive policies can only be a reduction in the savings rate and investments, a fall in productivity, an increase in consumption, if the supply of money continues and the inevitable stagflation.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments 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 (e.g., options, futures, warrants, and contracts for differences). My comments 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.