Archive of April, 2010
Published on April 29th 2010
Please, click here to read this article in pdf format: april-29-2010 What a week! It’s amazing how a few days make a difference these days. We will force ourselves to summarize into a few main points our views: In our previous letter, we wrote: “The ECB has its hands tied and hikes in policy rates [...]
Please, click here to read this article in pdf format: april-29-2010
What a week! It’s amazing how a few days make a difference these days. We will force ourselves to summarize into a few main points our views:
In our previous letter, we wrote: “The ECB has its hands tied and hikes in policy rates cannot happen any time soon. The Euro will continue to be tossed off the proverbial cliff. But the question here is: What will the Euro fall more against, in relative terms? The USD? The CAD? Gold?
In our view, speed here is of the essence. If the Euro devaluation is not carried out in order, global liquidity will be affected. If it is orderly carried out, then the quiet and underlying shift of other central banks’ reserves (i.e. Russia , China ) out of the Euro and into the CAD, the AUD or gold will be more relevant, in relative terms. Hence, it is critical to understand what can cause a “disorderly” devaluation of the Euro and what its corresponding likelihood is. We think that anything that hints towards the dissolution of the monetary union, institutionally, will generate confusion and disorder. Under this scenario, Euros, gold, CAD, AUD and commodities will be sold, while USD and US Treasuries will be bought. Anything else that hints towards a slow and steady debasement of the Euro, will favor gold, CAD, AUD and commodities, at the expense of USD and US Treasuries demand…”
And now, post Greece/Portugal/Spain downgrades, we realize we were half right, or half wrong. The downgrades put the Union in a really tough spot. Commodities, stocks were sold and the USD strengthened. But gold….gold rallied. What happened?
In general, money serves three main purposes: It’s a unit of account, a medium of indirect exchange and a reserve asset. These uses are deeply interconnected. The demand for money is therefore usually conceived as the sum of the demand for liquidity purposes and for saving purposes: Md = Ld + Sd.
What we saw on Tuesday is proof to us that Md (=demand for money) is now STARTING TO BE (the operative word here is “Starting”) at a global level: Md = L (in USD) + S (in Gold). That is, the world may now be starting to use USD for liquidity/funding purposes and gold as a reserve asset. “Starting” again is the operative word. Some people may call this Gresham ‘s law. Gresham ‘s law would be currently at work on the Euro. People toss the Euro for USD and whatever else that is not needed for liquidity, is exchanged for gold.
Since Tuesday, it is evident to us that Europe has only two choices: Either Germany/France guarantee Greece’s debt (and soon Portugal’s) or the European Central Bank lifts the veil and accepts junk sovereign debt as collateral to fund PIGS banks. Which one do you think is politically easier to implement? In our view, it is the latter, which means the Euro will be devalued big time.
Until Tuesday, we considered gold as just another asset. Now, we’ve changed our view, which forces us to pay attention to this detail: Every time a risk position is unwound and a certain percentage is recycled back to USD for liquidity purposes, while another percentage goes to gold, we think that the capital that moves to gold is capital OUT of the system. Who will fill the gap? Will the ECB (i.e. central banks) fill the gap? Has that gap to be filled anyway? Why?
When a central bank tries to fill the gap, we have low inflation morphing into dynamic inflation which, if allowed to blossom, later becomes hyperinflation. At that point, and perhaps we are closer to that point than many of us want to believe, gold becomes “THE” reserve asset. What has to happen for this to materialize? It has to be a global shift in nature. Contagion out of Europe has to spread, it is a necessary condition, in our view.
Under such scenario, would commodities drop in price because Europeans wouldn’t be able to afford them? This is the key question for us in Canada and we think the answer is positive. Therefore, perhaps and only perhaps, we will not see any exit strategies after all. How do we position against this scenario? We want to start buying weakness in gold.
Published on April 26th 2010
Please, click here to read this article in pdf format: april-26-2010 We left our desk on Friday with a smile. Post-Goldman and with the seriousness of the Greece drama, we stuck to our view that nothing fundamentally had changed and that the rally in stocks would continue. And it did, with the S&P500 index closing [...]
Please, click here to read this article in pdf format: april-26-2010
We left our desk on Friday with a smile. Post-Goldman and with the seriousness of the Greece drama, we stuck to our view that nothing fundamentally had changed and that the rally in stocks would continue. And it did, with the S&P500 index closing at 1,217.28pts, the Canadian dollar still not below parity and gold stronger.
We like a quote from a certain Macedonio Fernández (http://en.wikipedia.org/wiki/Macedonio_Fernández ) that we believe has never been more proper to describe market sentiment these days. It goes like this: “We easily accept reality, perhaps because we intuit that nothing is real”. Paraphrasing then Mr. Fernandez: “The markets accept (and rally on) the reality of increased sovereign risk, because they intuit that nothing is real, that deficits shall be monetized and that this too shall pass.”
Today, we would like to write about fundamentals or the latest developments in the credit markets. But unfortunately central banks and governments continue to be the main drivers behind all action these days. On this basis, let’s take a quick bird’s-eye view on the drama.
In Europe, we have a relatively minor government that is technically insolvent and is seeking financial aid from the Union. This aid will come by way of guarantees on their sovereign debt by banks of other Union members (i.e. Kwf Bankengruppe). However, we all know that a Kfw bank can provide that guarantee because at the end of the day, the European Central Bank stands behind. It is the same central bank that will take the guaranteed debt at par and issue Euros in exchange, if liquidity is required by a financial institution holding that sovereign debt. This type of debt monetization is subtle. Herr Schmidt in Hamburg, M. Dupuy in Paris or il signor Michetti in Milano will not notice it. None of them will see their taxes raised. Even if we wanted to explain it to them how their savings are being taxed, the explanation would require a minimum understanding of basic accounting principles. If Herr Schmidt has “ein Sparkonto beim Kfw Bankgruppe” he won’t suspect at all that the collateral supporting his Konto is a mere illusion. When do these people get a hint of what’s going on? Come next winter, when they want book their week-long all-inclusive trip to the Dominican Republic, they will realize their savings are not as good as they were a year ago. Maybe it won’t matter…Maybe they will vacation in a Greek island after all. Why not?
What is the lesson here? The ECB has its hands tied and hikes in policy rates cannot happen any time soon. The Euro will continue to be tossed off the proverbial cliff. But the question here is: What will the Euro fall more against, in relative terms? The USD? The CAD? Gold?
In our view, speed here is of the essence. If the Euro devaluation is not carried out in order, global liquidity will be affected. If it is orderly carried out, then the quiet and underlying shift of other central banks’ reserves (i.e. Russia, China) out of the Euro and into the CAD, the AUD or gold will be more relevant, in relative terms. Hence, it is key to understand what can cause a “disorderly” devaluation of the Euro and what is its corresponding likelihood. We think that anything that hints towards the dissolution of the monetary union, institutionally, will generate confusion and disorder. Under this scenario, Euros, gold, CAD, AUD and commodities will be sold, while USD and US Treasuries will be bought. Anything else that hints towards a slow and steady debasement of the Euro, will favor gold, CAD, AUD and commodities, at the expense of USD and US Treasuries demand.
We believe the underlying theme in this approach cannot be captured by quantitative analysis. Institutional risk would be the so-called tail risk, leaving statistical inference useless (But feedback here is welcome). Therefore, one has to be able to read between the lines, into the messy political game that will unfold before our eyes. One must not underestimate the institutional problem of the European Union. It is not circumscribed to Greece. It involves the future monetization of Portuguese and Spanish deficits as well. It may even involve a bailout of Spanish financial institutions.
Any maneuver by the ECB to gain independence and keep up with an exit strategy, regardless of the fiscal situation of EU members, will open the door for the IMF to play a bigger role and create uncertainty as to which alliance between other EU members (i.e. German-French) will fill the gap. This type of scenarios will favor USD assets. By the same token, any validation by the ECB of sovereign deficits (i.e. extension of emergency liquidity lines for up to BBB+ debt) should push gold, CAD, AUD and commodities higher, at the expense of USD and US Treasuries. One last caveat here: This market thesis assumes things in the US and China remain “stable”.
Published on April 22nd 2010
Please, click here to read this article in pdf format:april-22-2009 Inflation, or asset inflation, seems to be the flavor of the week. It’s in most analysts’ research notes. A month ago, on March 18th, in a letter titled “The winter of our dynamic inflation” (www.sibileau.com/martin/2010/03/18 ), we wrote that: “…the latest action in the markets [...]
Please, click here to read this article in pdf format:april-22-2009
Inflation, or asset inflation, seems to be the flavor of the week. It’s in most analysts’ research notes. A month ago, on March 18th, in a letter titled “The winter of our dynamic inflation” (www.sibileau.com/martin/2010/03/18 ), we wrote that:
“…the latest action in the markets proves that they are dependent on a given rate of money supply …(…)…A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms…Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when exit strategies like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply…Regardless of expectations; the intervention of central banks in the rates markets has a real impact that distorts relative prices…”
The chart below shows Greece’s 5-yr sovereign credit default swap and the S&P500 Index (source: Bloomberg). We thought it would be useful to show two vertical lines, dividing the chart in three periods.
The first period starts in Dec/09 and ends on January 6th. It corresponds to the post-Dubai days and end with the violent shooting of Greece’s sovereign risk. Right after, Greece started to steal headlines. We too wrote a letter on this issue (refer: “Don’t forget Greece”, www.sibileau.com/martin/2010/01/07 ). All markets sold off, while European Union leaders sought to show a unified front in addressing the short-term aspect of the problem: Greece’s upcoming debt refinancings. Of course, the problem remains unsolved. However, during this second period, macroeconomic readings began to surface, signaling that the recovery was not as weak as expected, while at the same time, EU leaders publicly committed to support Greece. This period ended on March 18th, with Greece’s 5-yr sovereign risk touching just below 300bps. It was then when we wrote the comments quoted above, about the upcoming dynamic inflation.
The next period, from March 18th to date shows that the market indeed did well by assuming accommodating policies were going to continue. This is reflected in the markets’ indifference towards sovereign risk, fueled by above-expectations earnings and other macroeconomic metrics that seem to show a steady but slow recovery. You can see that both trends, the rally in stocks and the increase in sovereign risk run in parallel. However, there is no need for stocks to rally or credit to tighten, in light of increasing sovereign default risk. But as we wrote then, investors know and have gotten used to a rate of money supply, which is challenging the measured promises of central bankers regarding inflation control mechanisms. The European Central Bank (also during the last period) announced its intention to extend the emergency contingency lines, which as we showed in our last letter, are nothing else but a mechanism for the indirect monetization of fiscal deficits. Meanwhile, the Fed also made clear that we are still far away from a policy rate hike. On Tuesday, Bloomberg reported Mr. Jörg Asmussen, Staatsekretär im Bundesfinanzministerium, saying Greece would get a loan from the German KfW Bankengruppe (with government guarantee)
Now, why should we write about this today? Why should we all care about this?
Mainstream economists, among which a great majority works for government institutions, are increasingly pointing fingers at the asset bubbles or asset inflation that the world is witnessing in different markets. In China, the case is very obvious. Underneath this observation is the implicit desire to ignore there is a problem. Policy makers find themselves at odds explaining how “asset” prices increase, while unemployment remains high. To us, this is not extraordinary. To us, this is not an aberration, but the perfectly normal results of quantitative easing. In fact, we would be seriously concerned if under monetary expansions, asset prices would not increase. But we do not dictate policy…
A tiresome and wearing battle, on a global scale, is in its infancy. In this battle, governments will seek to regulate every aspect of our lives to delay the unavoidable. Unfortunately, nobody ever wins these battles. Nations, as a whole, end poorer. In the near term and on a relative basis, we continue to like those nations that will delay the less (in our view, Canada), owning stocks and gold.
Published on April 19th 2010
Please, click here to read this article in pdf format: april-19-2010 Indeed, we can’t start the week without referring to the SEC’s securities fraud action vs. Goldman Sachs. We will not comment on the case itself, but on what we think is its macro consequence. For those interested in the case in particular, please, click [...]
Please, click here to read this article in pdf format: april-19-2010
Indeed, we can’t start the week without referring to the SEC’s securities fraud action vs. Goldman Sachs. We will not comment on the case itself, but on what we think is its macro consequence. For those interested in the case in particular, please, click on the link: http://online.wsj.com/public/resources/documents/secgoldman2010-04-16.pdf
We agree with those who see this case as the start of a major move to press financial institutions in the US to accept tougher regulations on lending, derivatives, etc. We are concerned about the rhetoric used by politicians, who continue to blame Wall Street’s greed for all their credit expansion. Frankly, the comments made by certain US senators on Friday were no different than those one can hear from Hugo Chavez on his weekly TV show. But long term, we don’t think this should impact the compression in credit spreads or stocks valuations…The driver of the rally that started in March ‘09 has never been fundamentals, but quantitative easing policies. In Europe, the monetization of deficits is becoming increasingly more explicit. With sovereign risk on the rise, government debt is placed in the banking system, which in turn places it as collateral at the European Central Bank (ECB), to raise liquidity. In summary, the graph below shows the process taking place in Greece:
As you can see, in step 1, governments place debt at banks. Among other sources of funding, Banks use deposits (in Euro) to leverage their capital in this transaction. In step 2, banks may turn to the ECB to exchange the government debt for liquidity, at face value (at par). The final outcome is shown in step 3: Basically, the ECB has bought government bonds, in exchange of fresh money. This is an indirect monetization, which transfers wealth from all the holders of Euro notes to the taxpayers who enjoy the fiscal spending of governments that use the ECB. The size of this transfer equals the fall in purchasing power of the Euro vs. other currencies/commodities, multiplied by the amount of Euros in circulation. It is easy to see that soon, every government will compete to place its debt at the ECB, to win this game.
In the US, monetization is undergoing a change. It has temporarily stopped with the unwinding of the quantitative easing programs, but given the unbalanced nature of the federal, state and municipal budgets, it shall continue. Meanwhile, foreign investors (central banks) and increasingly banks buy US debt. The upcoming financial regulatory framework will be supportive of monetization. Hence, the need to press institutions, as we first glimpsed on Friday. As the issuance of Treasuries and rise in policy rates eventually increase the cost of capital, it will be evident that the sustainability of the recovery/valuations will be more fragile. The government will continue to blame Wall Street for not lending enough to Main Street, while it simultaneously generates a crowding-out effect on corporate credit with the implementation of Basel 3. Under Basel 3, regardless of its final shape, banks will be forced to hold government debt as liquid assets (vs. other corporates) and to issue more equity to raise capital. In countries like Argentina, we have seen this coercion take place already. How was the liquidity shortage circumvented? The government itself became the major lender (i.e. Banco Nación). Would the US not do the same through its Agencies? In our opinion, US financial institutions will be the losers in this game, while gold starts to look like the real winner. Fortunately, on Friday, gold sold off, as investors long financials needed to raise liquidity.
Published on April 15th 2010
Please, click here to read this article in pdf format: april-15-2010 Perhaps the most relevant theme this week is how the market is digesting the announcement of the EUR45BN aid package (some now speculate it can go even further) for Greece. Briefly, credit has tightened, stocks are rallying, while sovereigns are underperforming. On this note, [...]
Please, click here to read this article in pdf format: april-15-2010
Perhaps the most relevant theme this week is how the market is digesting the announcement of the EUR45BN aid package (some now speculate it can go even further) for Greece. Briefly, credit has tightened, stocks are rallying, while sovereigns are underperforming. On this note, we want to go back to our first letter of 2010, titled: “The capital structure game” (www.sibileau.com/martin/2010/01/04 ). Back then, we wrote:
Part 1 (On relative value):
“We think that 2010 will be the year of the capital structure game, because the set of relative prices that will be the most distorted is precisely that of the components of a firm’s capital structure…If we take the simpler view that the spectrum of liabilities of a firm is split into debt and equity, in 2010, it will be very clear that the value of equity is only a function of the value of debt. As central banks reduce their stimulus programs or unwind them and as governments continue to run into fiscal deficits, both of them will significantly affect the markets in which they operate (i.e. Treasuries, Agency debt, mortgage-backed securities, state/provincial and municipal debt)…(…)… In 2010, most companies will have refinanced their short-term debt. However, with central banks unwinding their quantitative easing policies, the decrease in demand for fixed income securities together with the huge issuance of governments’ debt will put pressure on rates. As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity…”
What has happened so far:
We think this game has played out relatively well. Spreads in both investment grade and high yield have compressed, given the strong issuance in Q1/10 (record for High Yield), while sovereign risk has underperformed, given the volatility out of Europe. The issuance has been so strong, that in our view it has been the main factor driving 10-yr swaps into negative territory. Interestingly, the US Treasuries curve, today, is not dramatically different vs. the beginning of 2010. This in our view is due to the central banks’ reserves arbitrage, out of the Euro and into gold and non-US dollars mainly, as well as the same compression in credit spreads, which has forced institutions to reallocate capital out of US corporates and into Treasuries. The clear winner here has been stocks, as we anticipated in January. Below, we show the SP500 index vs. 5-yr generic Inv. Grade Credit Default Swap Index (CDX, source: Bloomberg):
Part 2 (on Foreign Exchange):
“In December, I associated this process with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD).”
What has happened so far:
Our case has been made more than evident here. We were spot on (check the CAD/Brazilian real cross, chart not included). Going forward, we fear this theme will last longer than initially expected. The rise in policy rates from either the USD or Eurozone will take longer than most thought, as the Greece rescue package is demonstrating and as the municipal/state deficits in the US will demonstrate (and the FOMC’s statements make clear). Hence, our late bullish sentiment on gold (refer: www.sibileau.com/martin/2010/04/08 )
Part 3 (On Gold):
“Companies choose to finance their operations or projects with debt or equity for a reason. When their respective markets are distorted, non-efficient decisions are made. That will be the case in 2010, with more companies taking debt for M&A, or share buybacks. Investment banks will love the action and financials and energy should have a good year. Gold should find it hard to outperform, unless some political event breaks the existing “entente” among central banks. I don’t think such a political event would come from either US/Canada, Europe or Japan.”
What has happened so far:
The political event that broke the entente among central banks, we believe, is the Greece situation. (We implicitly thought it would come from China, but it came from Europe). This has caused a revision of central bank reserves allocations, favoring among others the CAD and the sense that coordination is no longer there. The European Central Bank, the Fed, the Bank of Japan, the Bank of Canada, the People’s Bank of China…they all have to attend their own internal problems and will fine tune their respective policies accordingly. It is not chaos, but the indetermination in currency crosses is temporarily paused. The flight out of the Euro put gold as the common price deflator, in our view.
Sovereign risks continue to shadow the overall picture here, but the market does not seem to pay enough attention to it…Well, that could be one of the explanations. In our view, the market is not ignoring it. It simply believes that monetization will be the solution and therefore allocates out of liquidity and into risk, favoring currency zones that will monetize less, relative to others.