[private] Friday 11 November – A short break from Euro Zone dominated news likely
First apologies for being off line for so long, it’s quite difficult to put together these reports whilst travelling. However, I suspect the main reason was that I was having far too good a time in the US. Whilst there, I was very kindly invited by Rudy Beutell to the Scarsdale ideas lunches, where you have to come up with sensible investment ideas, as the price for admission. Back now, but have to travel to India next week, though will try and be more diligent.
What an amazing few weeks. Volatility remains extreme, with relatively low volumes in markets, basically, the same old, same old.
In Europe, the pesky Greeks have finally been told to get their act together and I suspect now understand that their normal antics, particularly their propensity to lie, will no longer be tolerated. A Technocrat Unity Government, under the former ECB Deputy, Mr Papademos has been formed, with a mandate to push through much needed structural and austerity measures, which were totally ignored previously. Elections are scheduled for February. However, Greece remains a basket case and further significant Sovereign haircuts are a certainty, much more than the recent 50%.
Banks are writing off larger percentages of Greek debt, but still not enough, French banks recently reported write-offs of 60%, for example. However, when banks do, which I believe will happen, the Euro Zone will get fed up of Greece; it will be able to afford to do so, as long as it ensures that contagion does not spread to other Euro Zone countries. Expect, the Greeks to remain reluctant to comply with the structural and austerity measures, irrespective of the Technocrat Government, as usual but I am getting really fed up of them, as I suspect, most people in Europe are as well.
In Italy, Berlusconi continues to try and remain in power, but his days are numbered. Will Italy follow Greece and appoint a Technocrat Government, led by Mario Monti? Who still has not got a shoe in, but this remains the most likely scenario. However, never underestimate Berlusconi’s attempts to screw this up and interfere, after all if he loses power he will have far less influence to impact the 4, if I recall correctly, criminal charges that he faces.
Good news however, Italy’s Senate has today passed debt reduction measures, more will be needed and, indeed a number of measures will need to be brought forward. That should mean Berlusconi exits imminently, making 2 out of the 3 PM’s to go. The next one to exit will be Zapatero, the Spanish PM, this month. Mr Berlusconi’s description of Mrs Merkel was truly.
The market certainly targeted Italy, with 10 year bond yields rising to 7.4%. However, it is obvious that the ECB has been intervening heavily and 10 year BTP yields are down to 6.60%, down 29bps today and well below the 7.40%+ recently. It was a hairy ride, but my long Italian bond position, which I bought on expectations of ECB intervention, now that Draghi is in place, is looking pretty healthy now. I appreciate that Italy needs to raise E330bn+ next year as do Italian banks, near E70bn according to Bloomberg, but I reiterate the Italian problem is one of liquidity and not solvency.
Yes, debt of E1.9tr to GDP, a dreadful measure but as the market uses it, I have to as well. This is high, approaching 120%, though with an average maturity of 7 years, but Italy remains a rich country by a number of measures greater than virtually all European countries, its GDP is higher than officially reported, due to the huge black economy, perhaps 30%+ of the overall economy, its people are relatively unleveraged, the leverage is really due to Government debt, it has and had a primary surplus and has bumbled along for decades with this level of debt. FYI, last year’s Italian budget deficit was 4.6%, roughly similar to the 4.3% reported by Germany.
Italy’s problem has been a lack of political credibility, no surprise given Berlusconi. Sure, structural reforms are vital, they will be painful and difficult to implement, but Italy will come through this. Competitiveness is also a serious problem, particularly given the far too high Euro, a common problem for the vast majority of Euro Zone countries. However, if they stupidly entered into the Euro, well …
By contrast, I remain of the view that Spain is in a far worse position than Italy. Yes, its debt to GDP of 60% is much lower than Italy’s, but its economy is in much worse shape. Today, Spain announced that its GDP was flat for the 3rd Q. In addition, Spain will not meet its target of 6.0% for its 2011 budget deficit, though I believe it is more likely nearer to 7.0%. Its semi-autonomous regions are in deep trouble; its population is highly leveraged, due to mortgage debt incurred on grossly overvalued housing, which has yet to be written down by Spanish banks. The banks have assumed that the reduction in residential prices is only around 15%. In reality it should be closer to Ireland’s 50%.
However, the Spanish valuation companies are controlled by Spanish banks, need I say more? Its industry is uncompetitive, it has a large current account deficit, unemployment is over 21%, and over 40% for the under 25’s, its banks simply have not accounted for anywhere near the amount of bad loans in the system.
Furthermore, the Spanish Government is not paying its bills to help “reduce” its budget. Mrs Salgado, the Spanish Finance Minister, has been lying through her back teeth. The evidence will be apparent, when the current ruling Socialist party loses the impending elections this month. In my view, Spain will be in recession, quite likely starting in the 4th Q of this year. Currently, 10 year Spanish bonds are trading at 5.80%, over 400 bps over equivalent German bunds at 450 bps, LCH Clearnet will require margin requirements to be increased, based on past history.
Personally I expect yields on Spanish bonds to rise, when the true extent of its fiscal problems surface, following the imminent change of their Government. Confirmation of Spain’s problems are evident, its largest telecommunications company, Telefonica, reported a loss in the last Q, the first for 9 years, in spite of its domestic market being just around a third of its business. It has a significant Latin American business, which has been doing well, though for how much longer?
Euro Zone 2012 GDP continues to be downgraded, even Germany’s numbers have been slashed. Essentially, Europe will be in recession next year, and in my opinion, worse than the “mild recession” forecast by the ECB. This will affect Portugal, whose 2012 GDP forecast lowered further to -3.0% today, and will make its current debt load unsustainable. A haircut of up to 40% is inevitable. Portugal has struggled to produce positive growth, even in good times, what chance do they have now? However, the Portuguese have been trying, unlike the awful Greeks.
Next we have France. Consumption, defence and autos are the major drivers of their economy. France will suffer and yields are rising as compared with equivalent German bunds. French banks are grossly over leveraged. Yesterday’s mistake by S&P relating to a French downgrade was amazing, though it is inevitable that France is downgraded, the only issue is whether it is downgraded before next year’s Presidential elections, in which case Sarkozy is French toast, or after. Clearly he is praying it will be after. Yes, France is implementing further austerity measures, but these measures will not be enough and the French population are liable to take to the streets, even though we are entering winter, the weather will turn cold and nasty.
Belgium, another problem country, though apart from being the HQ of the ghastly EU, is insignificant you could argue. Ok, so what’s the future? It’s clear to me the new ECB President has ramped up ECB purchases of peripheral Euro Zone debt, something that dreadful Trichet should have done. The announcement as to last week’s purchases to Wednesday will be released next Monday. Yes, the German’s and their allies, Austria and Finland, and possibly Holland, though the Dutch are practical and, indeed the only sensible country in the Euro Zone will continue to object. But they remain a minority and will be overruled.
Remember, Germany has only 2 voting members out of the 23 who decide on policy at the ECB. At present, the ECB sterilises its bond purchases though the issue of short term, around 7 days, debt instruments. Will they go the whole hog and implement QE? Still a difficult issue, but inevitable in my view. Finally, it was announced today that Bini Smaghi is to be replaced by a Frenchman at the ECB, who will be voting for QE.
Another inevitability will be the issue of euro bonds, irrespective of German lead opposition. It will require a European debt management agency, as you cannot have Euro Zone countries issuing debt which is jointly and severally guaranteed by all 17 countries unilaterally, combined with strict fiscal measures, which will be verified on a regular basis. Essentially, Germany will control the Euro Zone, without a shot being fired. Whilst out of the Euro Zone, I believe there will be closer cooperation between the UK and Germany, natural allies, in spite of 2 world wars, in due course. And that France’s position will reduce in importance. Indeed, relations between Merkel and Sarkozy remain tense, to say the least. Furthermore, there have been a number of disagreements recently aired publicly.
At present the Germans are including France in the decision making process, to ensure that they are not seen as the sole leader of the Euro Zone, which clearly they are. The German control of the Euro Zone leads me to believe that whilst I am bearish on the Euro Zone in the short term. I’m actually bullish in the medium and, even more so in the longer term. Essentially, the creation of Euro bonds will create a liquid debt capital market, which will rival the US.
Believe you me, there will be huge demand for Euro bonds and at much better rates than people expect, as investors seek to diversify away from the US$. I remain bearish on the US$ in the medium to long term, though the opposite short term. As a result, the Euro will become the second reserve currency. This will result in US interest rates rising in due course, and as a result force the US, at long last, to address its addiction to debt, it will be a painful process.
However, in the short term the EFSF is nonsense, I simply cannot understand how it can possibly work, and in addition the numbers just don’t add up. The other day the EFSF had to raise E3bn for the next tranche of the Irish bail out, at a rate of over 100bps over mid swap rates, bloody expensive money. Thankfully, I have no doubt that the IMF will intervene constructively in Europe. Thank God as the EU cannot sort out this mess, their involvement just makes it worse.
Whilst US commentators continue to criticise the Euro Zone (as I do, though hopefully on the basis that I’m somewhat better informed), Euro Zone aggregate economic data is better than the US, something the market, particularly US based, seems to ignore and/or does not know, this is more likely to the case. With a German controlled fiscal and monetary Union in due course, the only way the Euro will work, as was obvious to all of us at the outset, but not to the goons at the EU, it is dangerous, and in my opinion for the US to gloat over the Euro Zone woes. Particularly a number of very silly and uninformed commentators in the US media and the financial services industry.
All you have to do is to remember how much in efficiency gains, the US companies have extracted from their businesses, in particular recently. Europe has not even started, but they will have to in order to survive, and in addition to gain much needed competitiveness. This suggests to me that profitability in Europe will rise materially in the next few years, for example just look at Germany over the last decade. Furthermore, the current crisis will force structural reforms, which will reduce Europe’s welfare and dependency culture, it is very much necessary.
Reports continue to circulate that Germany will push for changes to the EU Treaty, this is very likely. These changes should improve fiscal disciple by Euro Zone members, and it is very much needed. If I am right, I believe investors in due course will allocate a far greater weighting to Europe than is currently the case, which will be bad news for EM’s and the US. Essentially, never underestimate the German ability to get it right, irrespective of the numerous political, social and other obvious problems that Europe currently faces.
The UK is also of course having its problems. However, we have our own currency, which makes all the difference. In addition we also have a Central Bank, which has learnt from its mistakes in 2008 when it raised interest rates, following a headline rise in inflation, as was the case with the ECB. The difference is that under Trichet, the ECB recently repeated the same mistake earlier this year. The Central Bank is not lead by a moron, as was the case in Trichet’s time with the ECB.
Personally, I believe, that Mr Draghi, whilst being far less communicative is far better, a refreshing and much needed change. I got last week’s ECB 25bps cut right and I’ll stick my neck out further and suggest that a further 25bps cut is on for December. Most importantly Mr Draghi was vice chairman of Goldman’s Europe previously, and is clearly forward looking and most importantly market savvy, something that Trichet could not understand. Finally, I believe there is a good chance that the ECB will cut rates below 1.0%, something they have not done in the past, though I accept there are technical issues involved.
I have no doubt that the BoE will increase the size of its current QE programme, which is currently £275bn, to close to £500bn, the UK economy is struggling and the BoE will act, in spite of a headline inflation rate of 5.0%. Though inflation will decline fast in coming months, even if just due to base effects. This should have and should continue to have a major negative impact on Sterling, though the UK is seen as a flight to safety country. Particularly so as the Swiss are trying to depreciate the Swissy.
The UK’s AAA credit rating must come under pressure; however, the current administration in the UK is by far the best in Europe, particularly from an economic point of view, and I would even argue amongst the best worldwide, particularly given what they inherited from the disastrous policies of the former UK Prime Minister, Mr Gordon Brown. As an aside, having lost my 2 bête noir’s, Brown and Trichet, I really am at a loss, I will have to find some others so I can continue with my rants.
I had a great trip to the US. It is clear that US economic data, in contrast to the Europe, is better than most had expected, including myself I must admit. I accept that some of it is fiscally driven, which changes next year. There will be a net fiscal drag in 2012. The recovery of the US is, in my humble view, finally dependent on the recovery of the US residential market. Here, and I accept it’s anecdotal, I believe there is some positive news.
Indeed, I am playing a recovery in the US residential market, I have bought a significant weighting in 2 building stocks with a large exposure to the US, namely the Irish company CRH (ticker CRH) and Wolseley (ticker WOS). Both have performed well and I believe have a lot further to go. In addition, my friend Toby (one of the best in terms of the European market, he works for Jefferies) has promoted these stocks extensively and, today reminds me that CRH may even get into the UK’s FTSE 100, which will require investors to buy the stock. This would be great news if it happens. I am aware that a number of investors are buying US housing stocks though, for the moment will stick to my way of playing this theme until I complete my research.
A digression for the moment. A gentleman called Sean Egan alleged that Jefferies had a problem relating to Euro Zone Sovereign exposure, in particular that its hedges were illiquid. I accept that there is a real conversation to be had as to the value of Sovereign CDS’s, particularly as the ISDA has deemed that the “voluntary” haircut of 50% on Greek Sovereign debt does not trigger a payment. The unintended impact of this decision and the Euro Zone’s hatred of CDS’s is that investors will be reluctant to buy Sovereign debt as they can’t, in effect, obtain insurance. However, counter party and lack of transparency risk remains in the CDS market, and I for one will not even think about playing this market until this changes.
As Mr Egan’s Jefferies call came shortly after the problems associated with MF Global, which he got right by the way, the market reaction to Jefferies was significant. The stock was down over 20% initially, but recovered rapidly as more sane views prevailed. A few days later, Jefferies closed the vast majority of its exposure to European debt, making the allegation that Jefferies hedges were illiquid, allegedly the CDS’s, which is a complete nonsense.
I have followed Mr Egan, and whilst he is right on some views, he does have an unfortunate habit of sensationalising. Sure, I understand that he is seeking publicity for his credit rating firm and I fully acknowledge that his business model is absolutely right, as he charges investors and not issuers. However, a number of his calls are, how can I put it, somewhat aggressive in my view, which can be dangerous in these markets. Indeed, I would always seek a second opinion.
An American friend of mine Barry Ritholtz who also produces a great daily blog on line, reminded me that US unemployment which is at 9.0%, or around 17% if you look at the U6 data, is focused on unskilled workers to a very large extent. In addition, he also wrote a superb piece on the nonsensical assertion that US regulators were to blame for the US subprime crisis. This is something which a number of crazies are promoting in the US.
Absolute nonsense, as he points out it was the banks that produced this stuff and then some of them shorted it. Furthermore Mr Ritholtz has an endearing and particularly common sense approach, which I find to be very much lacking in most players.
I think another misguided view is of the FED. Bernanke/FED/the US saved the world. If they had not acted, we would all be living in caves. I accept that you can now have a genuine discussion as to whether the FED can and/or should do more, but I for one am not prepared to criticize them. However, further QE next year remains likely.
I spent some time in Washington and as usual I spoke to a number of politicos. It is clear that the Republican strategy is to pray that unemployment remains high and that the US economy does not recover. Furthermore, they are depressed as to the poor quality of their candidates, I can fully understand that. The Democrats, though I did not get any idea as to their strategy as is it could be possible they have none, but it certainly seems like it.
It is all rather alarming, given the US’s position in the global economy. However, it looks as if it is a shootout out at the OK corral, or not so OK as may be the case, between Romney and Obama. Personally I would not write off Obama, as many have, though he really needs to get his act together, and furthermore to have some kind of policy, after all isn’t that what’s it’s all about? For example some kind of energy policy would help, don’t you think?
Focus could well shift to the US and in particular to the Super Committee. Will it agree or will it not? God only knows given the political gridlock in the US. All I can say is that without revenue increases, in addition to spending cuts, this whole exercise is just a complete waste of time.
In the short term I remain bullish, I have not changed. My biggest fear is the Middle East and the Iranian nuclear situation. We all accept that the Iranian leadership are clinically insane. However, it is clear that the Israeli PM is not listening to the US and may well react unilaterally. That will certainly draw in the US, as the Iranians will almost certainly attack US interests. Given the impending US Presidential elections, it is difficult for Obama to constrain Netanyahu. The situation is dangerous and I remain amazed that investors have not focused on it more. I have no doubt that the recent hike in Oil prices is mainly due to the threat in the Middle East.
I met Mr Robert Hardy in the States, he writes an excellent political/Global Macro piece called Geostrat. I found his views particularly informative and indeed essential reading. Most surprisingly, he advised me that demand for his product is mainly ex US. If there’s 1 thing you need to do right now, it’s to follow Global Macro/Political/Policy issues. As you know my theme is that policy/politics will have a significant and increasing influence on market performance.
I am virtually certain of this and I am also certain it will be the case for quite some time to come, way after my retirement date, and hopefully I still have quite a few years to go. However, like Mr Hardy, I am amazed as to the lack of understanding, and indeed knowledge, that the vast majority of both sell side and buy side of US participants have in Macro/policy/political issues. They are completely crazy in my view and a deficiency which will lead to, I have no doubt, under performance.
In Europe, I would argue participants are better clued up, though still way below what is needed. The other issue I found in the States is the propensity of people, who it is abundantly clear are woefully uninformed, to express a view on global matters on the basis that they are experts. Better to shut up, I would have thought.
And finally, China. Interestingly, China is better known by US based participants, though I feel their depth of knowledge is limited. Generally, there is still a love affair with the country, without understanding the politics, economics etc., which is very dangerous. Personally, in the short term, I believe China will ease its tight monetary policy and increase lending. There has been a credit squeeze recently, which has had a severe impact on their economy.
Reserve ratio requirements will be lowered, which should increase the much needed lending. In addition “official” inflation and PPI has declined, which will help to ease tight monetary policy. However, recent data reveals that Chinese exports have declined significantly, especially to it largest trading partner Europe, particularly if you exclude the impact of price rises. There is a hue and cry about the undervalued Yuan in the US.
However, a number of informed analysts argue that the yuan may actually be overvalued. Indeed I am fast becoming a proponent of this view. The key point, as far as I’m concerned is that the rate of Capital Flight from China is accelerating, particularly ahead of the impending major change in leadership. The really alarming issue is that a lot of this capital flight is coming from people “connected” to the senior policy markets. However, in the short term a relaxation of monetary policy will be market positive, good for the A$. But medium/longer term, I remain bearish on basic materials and the A$.
The FT had an interesting article the other day, it reported that European banks were cutting back on lending to Asia, they represented 21% of lending. Asia depends on capital inflows. Whilst US and Japanese banks may cover some of this, they won’t totally, which suggests to me that interest rates in the region will rise.
The deleveraging by European banks, especially as they know they have to meet much tougher capital ratios, is also bad news for Europe. It’s madness to reduce lending when the economy is heading for recession. However, a number of Euro Zone countries cannot afford to recapitalise European banks, which are grossly over leveraged. The ECB is providing a massive amount of liquidity against collateral, which in a number of cases, such as the Greek, is effectively toilet paper.
Given the ECB is thinly capitalised, this issue is going to come back to bite them, though I accept that the ECB can print its way out of their impending problem, which I believe to be very likely. A further problem is that with European banks reducing their Sovereign debt exposure, who will be buyers of subsequent debt issues?
In any event, I’ve droned on for far too long. Markets look health today, this is great news, but I remain convinced that a buy and hold strategy is as dead as a dodo, unless you are looking at a long term play. Personally, I believe that I will be lucky to be able to forecast even one or possibly a few more months ahead. Good luck to those who think they can.
Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]