Please, click here to read this article in pdf format: july-30-2009

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.

Please, click here to read this article in pdf format: july-29-20091

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 ).

Please, click here to read this article in pdf format: july-28-2009

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…

Please, click here to read this article in pdf format: july-27-20091

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.

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 fertile 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.