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.

Conclusion:
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.

Martin Sibileau