Barron’s Confidence Index Takes a Worrying Turn

Thursday, January 19th, 2012

When reporting on the unfolding of the credit crisis I often referred to the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds.

The difference between the yields is indicative of investor confidence. A rising ratio indicates bond investors are growing more confident, in other words preferring more speculative bonds over high-grade bonds. On the other hand, a declining ratio indicates investors are demanding a lower premium in yield for increased risk. That shows a waning confidence in the economy.

Since hitting an all-time low in December 2008, the Index was almost back to pre-crisis levels in January this year as investors grew increasingly confident. But that was when investors started focusing on sovereigns that were starting to get into trouble.

Since the start of 2011 the Index has given up more than 40% of its gains. This puts us back at levels experienced during mid-2008 – just prior to confidence falling off a cliff. Based purely on this chart, one has to conclude that confidence remains fragile.

Source: Barron’s

Tags: Barron, Bond Investors, Bonds, Confidence Index, Credit Crisis, Crisis Levels, Economy, Investor Confidence, risk, Sovereigns
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It’s An Upside Down World… Or So Much For “Decoupling”

Friday, January 13th, 2012

From Peter Tchir of TF Market Advisors

It’s An Upside Down World… Or So Much For “Decoupling”

Italy has “successful” bond auction and for all intents and purposes, JPM misses earnings.

Stocks failed to respond to a “successful” Italian bond auction.  The market isn’t giving them much credit for placing bonds that mostly mature in the timeframe covered by LTRO.  The auction results are good, but the market is taking a wait and see attitude towards them as everyone is fully aware of how much LTRO money is out there, that Italian banks in particular issued bonds to themselves to get financing and are “indebted” to the government and ECB (in more ways than one).

JPM’s earnings may be enough (or not enough as the case may be) to end the rally in financials.  The numbers were not great and no matter what the official analyst numbers were, everyone was set up for them to beat.  Weak earnings in trading does not bode well for other banks.  It was a decent quarter for the markets (with volumes and volatility far higher than what we have seen so far this year), and JPM is big in the US new issue market, so has a competitive advantage, so their performance is concerning.  DVA give back was about 30% of what they had taken as a gain in Q3.

I think Morgan Stanley in particular is exposed as I doubt they did significantly better than JPM in investment banking, they had a settlement with MBIA that will show up as a big hit (spun as one time, even though the associated earnings were never spun as one time) and they have a much larger DVA give-back.

So as European sovereign debt shows signs of stability (manipulated stability, but stability nonetheless) the US is disappointing on earnings. With the “decoupling” trade so prominent, the US markets are set up to be very weak relative to Europe.  This is second day in a row where the decoupling thesis is taking a beating (yesterday’s economic data was weak).

Tags: Auction Results, Bond Auction, Bonds, Competitive Advantage, Decoupling, Earnings, ECB, Economic Data, Intents And Purposes, Investment Banking, Italian Banks, Jpm, Mbia, Misses, Morgan Stanley, Q3, Sovereign Debt, Timeframe, Upside Down World, Volatility
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Fed’s Failure to Inspire: TrimTabs Shows Where the Real Money is Going

Friday, January 13th, 2012

As volumes this year in stock markets remain significantly below last year’s but high yield bond ETF inflows reach record highs, TrimTabs offers some context for the massive relative flows of real cash into checking and savings accounts versus stock and bond mutual fund and ETFs. Not-Charles-Biderman, otherwise known as David Santschi of the now-infamous Bay Area backdrop, explains the incredible statistic that in the first 11 months of last year investors poured more than eight times more money into checking and savings accounts than into Fed-inspired risk assets in general. Even with rates ultra-low, the Fed’s efforts to drive speculative flows is dwarfed by investors’ aggregate sense of the reality of our tenuous situation as a massive $889bn was poured carefully into mattresses while a measly $109bn went into risk-worthy assets (including bonds). As Santschi concludes, as long as most investors keep hiding most of their money away, the economy is unlikely to get off to the races anytime soon and while we agree from a consumptive demand perspective, any recovery will only be truly sustainable via savings which are being desperately drawn-down by a need to maintain standards of living that are perhaps too much to expect.

Source: TrimTabs, via Youtube, January 12, 2012

Tags: Assets, Backdrop, Bonds, Economy, Eight Times, Failure, High Yield Bond, Investors, Mattresses, Mutual Fund, Perspective, Real Money, Record Highs, risk, Savings Accounts, Statistic, Stock Markets, Trimtabs, Youtube
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A Couple Of Questions To Start The Day (Tchir)

Tuesday, January 10th, 2012

From Peter Tchir of TF Market Advisors

A Couple Of Questions To Start The Day…

On Sunday we had Occupy MetLife Stadium where the 99% happily watched the 1% on the field and in the stands.  Last night we had a decent college football championship and are sure to see several of the players play on Sunday, which leads to the first question.

What is higher, the percentage of NFL starting quarterbacks that attended college, or the percentage of Goldman Sachs partners that attended college?

What are the odds that almost every player in one of the most demanding physical jobs on the planet was smart enough to go to college?  This doesn’t have anything really to do with the markets, other than maybe showing a willingness of the people to perpetuate a myth (that college football isn’t professional) when it suits them.

How many times last year were stocks higher in the morning while Italian bonds were weaker?

Judging by the number of rants I sent last year on the subject, the answer is quite a few.  It was not uncommon for stocks to diverge from the “problem” asset of the moment.  The more important question is how many times were stocks still higher 2 days later?  That, is a far smaller number.

Money continues to come into the market based on “decoupling” and the “muddle through” scenario.  I do not believe that “muddle through” is an option.  The entire system in Europe has become so interconnected that “muddling through” doesn’t seem realistic.  The situation in Italy remains bleak (bond yields are higher again in spite of massive amounts of central bank support).  The situation in Greece is reaching a peak.  A voluntary resolution seems less likely by the day, but that leaves open the ECB’s positions, and also opens up the question of what to do with all the Greek Government Guaranteed Bank Bonds (affectionately known as ponzi bonds) that the ECB is financing to keep Greek banks alive?  The ECB will have to change their rules yet again to let formerly guaranteed debt still be pledged as collateral?   I think that issue is just as important as the CDS settlements and changes in collateral requirements that are likely to result from a Greek default.

So far the liquid hedges are performing well on the back of overnight strength.  It remains to be seen how well it translates into actual corporate bond demand, but with Spanish and Italian 10 year bonds lower on the day, this is likely just another chance to fade the remnants of the start of year rally.

Tags: Bond Yields, Bonds, College Football Championship, Decoupling, ECB, Entire System, Goldman Sachs, Greek Banks, Greek Government, Massive Amounts, Metlife, Muddle, Myth, Nfl Quarterbacks, Nfl Starting Quarterbacks, Odds, Rants, Spite, Stocks, Willingness
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Remember When The Dynamic Duo Was Batman And Robin

Monday, January 9th, 2012

From Peter Tchir of TF Market Advisors

Remember When The Dynamic Duo Was Batman And Robin

The market is essentially frozen ahead of yet another Merkozy press conference.  I have lost count of how many of these press conferences they have had.  I haven’t lost count of how many resulted in anything particularly useful – zero is an easy number to remember.

So what are we going to get?

Renewed commitment to minimal budget deficits?

That was part of the original deal of the Euro.  That was part of the “compact” that was released late last year.  It seems so long ago, but just last year, the Merkozy had a conference and said a lot of good things that they couldn’t get the full summit to agree to.  Maybe they will promise budget surpluses by 2035?  These “budget” solutions are all so far away that they don’t make a difference to the near term solution, or are so unachievable in the near term that they don’t take pressure off either.

Letting the ECB go ahead with quantitative easing?

That is possible, though it appears that the ECB skipped QE and went straight to QGG (Quantitative Gift Giving).  They aren’t buying too much sovereign debt, but they are willing to lend to banks using any collateral they can scrape up.  They are fully encouraging banks to issue bonds to themselves, get a government guarantee, and post it at the ECB for some fresh money.  I think that while many investors have been staring at the SMP (Secondary Market Programme) and whining that full QE isn’t being applied, the ECB has gone beyond that with other programs.  I remain somewhat confused by why the ECB won’t lend to banks directly and are requiring banks to get government guarantees.  Is it to put added pressure on the sovereign not to default, since a sovereign default would drag the banks down with 100% certainty now?  Is it to put pressure on sovereigns to continue to support banks, since now a bank default could drag down a sovereign?   I’m not sure why they are doing it and why these steps are necessary, but it does seem to ensure contagion within a country, rather than preventing it.

Between SMP and all these weird collateralized lending programs, the ECB has been pumping money into the system, and a big portion of their purchases, and lending, is against assets that are highly likely to default!  Quantitative Easing implies some ability to get paid back or to stop easing by selling assets back to the market.  Quantitative Gift Giving is simply throwing money at assets that will never be repaid.  How did Greece come up with €1 billion to buy preferred shares of NBG?

Creating a worse bank?

Maybe the Germans will finally relent and agree to some form of banking license for the EFSF?  If the ECB is now the bad bank (and any quick look at their balance sheet show it is), then this would become the worse bank.  It would be a depository for anything and everything that has no real value?  Maybe something like this is announced.  That would provide the biggest pop to risk assets, which should be immediately sold, since it doesn’t fix any of the problems with EFSF, it just shifts them around.

Time to be chastised?

I think there is a chance that Merkozy come out of this meeting swinging.  They use threats to scare the rest of the Eurozone into doing what they are told.  After months of minimal follow through on any of the Grand Plans maybe they are going to try scare the rest of Europe into playing nice.  No one seems to be expecting this, but it may be the only thing that makes sense.  Maybe it is finally time for Merkozy to point out that Europe needs them as much as they need the rest of Europe.

Tags: Banks, Batman, Batman And Robin, Batman Robin, Bonds, Budget Deficits, Budget Solutions, Budget Surpluses, Collateral, Dynamic Duo, ECB, Government Guarantee, Government Guarantees, Minimal Budget, Press Conferences, Qe, Quantitative Easing, Sovereign Debt, Sovereigns, Term Solution
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Bonds Continue to Break Out

Tuesday, December 20th, 2011

he bond market is having none of this equity market neutral to bullish viewpoints.  We are not far on the 10 year note from areas 10 year yields were when the market was dumping in late September….

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Tags: Bond Market, Bonds, Break, Disclosure Notice, Equity Market, Late September, Mutual Fund, Nbsp, Personal Portfolio, Portfolio Securities, Viewpoints
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Jeremy Grantham: Investment Outlook (Q3 Letter)

Tuesday, December 6th, 2011

Here is the latest quarterly letter (Q3) from GMO’s Jeremy Grantham: The Shortest Quarterly Letter Ever.  One of Grantham’s shorter letters, indeed, and as a usual, a must.

Some excerpts pulled out courtesy of ZeroHedge (without the alarming headline) ;)

• Avoid lower quality U.S. stocks but otherwise have a near normal weight in global equities.
• Tilt, where possible, to safety.
• Try to avoid duration risk in bonds. For the long term they are desperately unattractive. Don’t be too proud (or short-term greedy) to have substantial cash reserves. Admittedly, this is the point where we at GMO try to be clever and do a little better than the minus 1% real from real cash – and, so far, with decent success.
• I like (personally) resources in the ground on a 10-year horizon, but I am nibbling in very slowly because, as per my Quarterly Letter on resources in April 2011, I fear a major short-term decline in commodities based on a combination of less bad weather – which has been bad, but indeed less bad – and economic weakness, especially in China. Prices have declined, often quite substantially, since that letter. However, I believe chances for further price declines in resources are still better than 50/50 as China and the world slow down for a while, and the weather becomes a bit more stable.

Full read here – hit fullscreen for easy reading:

Tags: Bad Weather, Bonds, Cash Reserves, China, Commodities, Decent Success, Decline, Duration, Economic Weakness, Excerpts, Fullscreen, Global Equities, Horizon, Investment Outlook, Jeremy Grantham, Price Declines, Q3, Quarterly Letter, Stocks, Substantial Cash
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What’s up in the Bond Market?

Wednesday, November 23rd, 2011

I do not subscribe to the Lowry onDemand service, but receive the occasional short report from them. The paragraph below is of particular interest.

“The trends of the bond market, as well as the stock market, are the direct result of changes in the forces of supply versus demand. A recent review of the fixed-income ETFs on the Lowry onDemand website reveals a large number of issues reflecting significant negative divergences between their price patterns and our exclusive Power Ratings. Negative divergences occur whenever investor demand for a security weakens substantially while the price pattern is still in a relatively positive trend. Since it is difficult for prices to continue to rise in the face of weak investor demand, well-established negative divergences, as shown in the chart below, are typically followed by important price declines,” said the report.

If Lowry is right on this, it implies a flip to risk on, with better economic prospects, and declining bonds and rising equities.

Source: Lowry onDemand, November 22, 2011.

Tags: Bond Market, Bonds, Economic Prospects, ETFs, Face, Fixed Income, Investor Demand, Lowry, Ondemand, Paragraph, Price Declines, Price Pattern, Price Patterns, Stock Market
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Jim O’Neill: Does Germany Really Still Want the EMU? How About the Rest of Europe?

Sunday, November 20th, 2011

GSAM loss leader Jim O’Neill “Surreal Times” has a very ominous rhetorical question in between all the bullish propaganda: “The ECB doesn’t seem to regard 10-year Italian bonds as a bargain and, of course, it is rather tricky as they need to be sure that Monti will deliver. In turn, this means that what is really important is that Mario gets support from those in the background and, ultimately, the Italian voters. And then there is Spain. And still, of course, the troubling Greek situation. And ultimately, the complex world of Berlin and Frankfurt. As many European newspapers are asking in recent days, does Germany actually really still want the EMU? And, as I shall now provocatively ask, does the Euro Area? All very surreal.” No Jim, all very logical, because for the first time in decades, Europe is finally starting to do the math and realizes it is failing miserably. It is those stuck in a world in which combined total exports are greater than total imports by over $300 blilion: a mathematical lunacy, who think that what is happening is “very surreal.” To everyone else, the right phrase is “very much expected.”

From Goldman’s Jim O’Neill

Surreal Times.

Another fascinating week passes with the European mess understandably dominating the minds of everyone around the world. It is quite surreal. There are no signs of any real collective central leadership, many key players are hardening their positions, other regions of the world are increasingly worrying about it, and markets ended the week with a sort of eerie silence.

As I often have said since the European troubles escalated in August, there is life outside of Europe. That remains the case. But virtually wherever and whoever I talk to or with, people are so focused on the European issues. In the week ahead, I will be participating in a board meeting of BRUEGEL, the European think tank, which will be most interesting. Anyhow, more of this topic and others below.

Good Lord – Gaylord!

My last week started with a brief 2-day trip to Maryland and back. I thought I was going to Washington DC, but, in fact, it was a few miles out in what seemed like a new purpose-built area called National Harbour. I had been invited to participate in a panel at an event for UBS (Paine Webber) at a get together of their most senior nationwide sales team. I had the honour of being on a panel with Alan Greenspan, Otmar Issing and Ken Rogoff to discuss and debate the world.

I think I was there to make the drinks (and offer some perspectives on the so-called emerging world too). The venue was the Gaylord Hotel, which seemed to expand for miles. Think one of those so-called Ghost cities in China or Vegas, but a few miles outside DC. Most surreal. But it was fascinating and thanks to the hosts for inviting me.

I took away two things from this discussion. The first is that everyone wants to talk about Europe, and most people are so negative about it all. I didn’t hear much positive sentiment there myself, but I will repeat what I wrote last weekend. I can’t see how the EMU can survive without Italy, and I can’t see Italy surviving with 6-7 pct 10-year bond yields.

Something has to give, which is actually why it is quite exciting now – even if it is somewhat scary. The second takeaway, and more important one, is that my confidence in the US cyclical recovery picking up momentum is higher than before I joined this panel, not least of which because I heard independent confirmation of the things I notice. I don’t think it is appropriate to mention what others actually said, but it was consistent with my own thoughts. In addition to most actual points of reference supporting this view – another modest decline in job claims this week – I detect more minds coming around to my thinking that we may be close to a turning point in the US housing market.

As I start to think seriously about 2012 and where GDP might be, both absolutely and relatively to consensus, it seems to me that there are notable upside risks to the US outlook. Of course, there are plenty of things that might go wrong, but there are also plenty of things that could go right.

China and the RMB.

As I write this Viewpoint, there are some interesting comments on the wires that imply that Beijing is exploring widening the trading bands of the RMB. This wouldn’t surprise me at all. While many will see this as purely a sign of likely renewed appreciation of the RMB against the Dollar, I am not sure that is the real key. In the reported comments, Premier Wen has said that China will “strengthen the Yuan’s trading flexibility in either direction,” which could suggest that if the US$ were to appreciate significantly, then the RMB might actually decline against the Dollar. This will ultimately be what happens, i.e., the RMB will become more volatile as it becomes more open and less controlled. It will go up as well as down.

What is more clear to me is that such a development is all part of what might be an accelerating path towards opening up the RMB as Beijing moves towards full convertibility. I am now assuming that 2015 is a realistic goal, and if this statement is soon backed up by evidence, happening so soon after the G20 meeting, it is a rather good sign for the world. It is also extremely exciting for anyone involved in the asset management business, as it means  we are likely to see considerable developments in the Chinese bond and equity markets. And, this will all be consistent with the 5- year plan and China moving towards a more domestic consumer-driven economy.

Like many other weeks, I had many interesting conversations with people about China (and the other Growth Markets) this week. On Friday, I had a particularly interesting chat over a sandwich lunch about the big picture with an investor.

This gentleman shares my own optimism, but he had been asked to stress test the rather negative views of his colleagues who couldn’t join us. In particular, they wanted to really delve into who is going to buy all the things that China will produce in the future, implying that they won’t be able to produce much, and that China is heading for a hard landing. I think this is an understandable, but also a weird question. It is understandable because so many Western observers, especially from my generation, simply can’t get their minds around China becoming a significant consumer. It is weird because it is so Western-minded. My best way of answering this beyond repeating all the numbers I have worked on with my colleagues, is to cite 2 anecdotes. One comes from a meeting 12 months ago or so with the CEO of one of the world’s best known retailers who has been expanding considerably in China. He wanted my views on when he should plan to exit, as he thought it was inevitable that China would find a credible domestic competitor at some stage. The second relates to a personal investment I made many years ago in a Chinese luxury company, which continues to grow rather well. It has a number of suitors, including European ones.

As I ended up saying, even in the consumer’s share of total output weren’t to rise above 35 pct of GDP by 2020, China will create at least $3,500 trillion worth of consumption value between now and then – about 10 times the size of Greece.

If it were to rise to 45 pct, at least an additional $5 trillion, or the equivalent of 2½ new Italy’s.

Europe and the Euro Area.

What another remarkable week. We are all fond of saying that Europe doesn’t move very quickly, but look at the events that have occurred in Italy this past fortnight. Berlusconi is gone, Mario Monti is in place, and the country now has a technocratic government led by a collection of reformist-minded individuals and a very pro-European leader. Mario unveiled the broad path of likely initiatives, and from where I sit as someone who has followed the Italian economy closely for 30 years, it looks quite exciting. Not only are there ideas to deal with important deficit and debt challenges, but of greater importance, ideas to boost Italy’s supply side potential, including steps to encourage and help women enter the labour force and to attract the young and brightest from not going overseas to seek opportunity. A significant part of me thinks that 7 pct 10-year bonds for Italy may turn out to be a bargain.

However, there are so many hurdles.

The ECB doesn’t seem to regard 10-year Italian bonds as a bargain and, of course, it is rather tricky as they need to be sure that Monti will deliver. In turn, this means that what is really important is that Mario gets support from those in the background and, ultimately, the Italian voters.

And then there is Spain. And still, of course, the troubling Greek situation. And ultimately, the complex world of Berlin and Frankfurt. As many European newspapers are asking in recent days, does Germany actually really still want the EMU? And, as I shall now provocatively ask, does the Euro Area? All very surreal.

Is it Time for a Referendum?

One of the most interesting things that didn’t get that much press this past week is that German Chancellor Merkel is now openly saying that she believes the Treaty surrounding the EMU should be changed. I think I am right in saying this is the first time she has stated this definitive goal, and may be seen as a signal that Germany thinks it can take Europe, or the Euro Area, or at least those that want and can stay in it, down the path of more fiscal and political union. This, as I have written about many times, is what key German thinkers have believed was ultimately inevitable and should have been agreed before the EMU started in 1999. Beyond all the critical short-term questions, renegotiating the Treaty for more substantive changes is a really big step in my view. It is probably a sensible step to take, as it would allow everyone in Europe a fresh say on what they are really signed up for. As I have also written before, this crisis is not really a sovereign debt crisis, but a crisis of the EMU’s structure and leadership. In this context, I found myself thinking why not actually use this as an opportunity to do something really radical and seek more legitimacy from the European people? As part of a new Treaty, why not allow or encourage all 27 member countries to hold a referendum on what the new Treaty would be and, therefore, seek genuine support from our citizens? In the rather unlikely event that this would happen, it would seem to me that many of the persistent alternative views between different EMU players, including the ECB, would probably disappear.

It seems like a very unlikely thing to happen, but given the remarkable unfolding events across Europe, how can anything be ruled out, especially when it would probably allow the EMU to be strengthened and help the legitimacy of the EU itself.

And Finally, a Brief Note on Japan.

The Economist magazine this week has a most interesting short piece pointing out that Japan showed stronger GDP per capita growth in the past decade than either the US or Europe. That simple, but important, analysis comes at the end of a week when Japan reported 6 pct annualized growth last quarter, not far off BRIC-like standards and way above the US and Europe. I published an op-ed online in the FT about this last week, and pointed out that markets seem pretty disinterested in the Japanese growth numbers. This is especially interesting when Japanese equities are at such a remarkably low valuation compared with certainly any metric. And, at the other extreme, the Yen is so idiotically expensive. Something has to give here also. I suspect what it might end up being is that markets start to realize that the US is not going down the path of Japan, and the Yen begins to reverse, perhaps significantly. It might take more involvement from the monetary authorities to help it along. If this outcome doesn’t happen, then Japan’s relative growth outperformance might end up being even more temporary than many expect, as more big Japanese corporations abandon domestic production. All very interesting, and yet another source of big opportunity going forward. It looks to me that there are so many opportunities for investors as we near the end of 2011 and into 2012. We just have to figure out what side of them to be on!

Jim O’Neill

Chairman, Goldman Sachs Asset Management

Tags: Board Meeting, Bonds, Bruegel, Central Leadership, Decades, ECB, Eerie Silence, Emu, European Newspapers, Frankfurt, Goldman, Gsam, Loss Leader, Lunacy, Mario, Math, O Neill, Propaganda, Regions Of The World, Rhetorical Question
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France, the New Elephant in the Room

Friday, November 11th, 2011

On January 7, long before Italy was in the spotlight of mainstream media attention, I wrote Italy The Invisible Elephant.

It was five or six months before Italy became an uncloaked popular economic topic.

However, “elephant hunting” is now a popular sport and mainstream media has done a better job at spotting the next one (with help of S&P threats to France’s AAA rating of course).

Elephant Spotting Articles

San Francisco Chronicle: France Plans EU7 Billion in Taxes, Cuts to Save AAA Rating

France unveiled tax increases and spending cuts amounting to 7 billion euros ($9.6 billion) for next year to defend its triple-A rating as growth slows and Europe’s debt crisis deepens.

The country will increase some levies on large companies, push up the lower end of its range of value-added taxes and curb welfare spending, Prime Minister Francois Fillon said today.

“French people must roll up their sleeves,” Fillon said at a press conference in Paris. “We have one goal: to protect the French people from the severe difficulties faced by some European countries.”

Los Angeles Times: Eurozone debt jitters creeping into French bonds

The European debt crisis has gone from bad to worse as Italian government bond yields have soared, threatening the solvency of the Eurozone’s third-largest economy.

But things could go from worse to worst if bond yields keep rising in France, the continent’s No. 2 economy after Germany.

The French government knows it can’t afford for the bond market to turn on it. Paris announced a new round of spending cuts last week aimed at ensuring that the country holds on to its coveted AAA credit rating.

Moody’s Investors Service warned last month that it might put a negative outlook on France’s top-rung rating if Paris made too many commitments to back up its banks or other Eurozone states with tax dollars.

But France’s need to protect itself also raises doubts about its ability to extend help to Italy as Rome’s debt nightmare worsens.

Ah yes, how can you save Greece and Italy if your concern is to save yourself?

The answer is you cannot and a quick look at sovereign debt spreads will show the bond market is starting to figure that out.

Sovereign Debt Table France vs. Germany

To help put that spread table into perspective let’s look at today’s action in 10-Year and 2-Year government bonds.

France 2-Year Government Bonds

France 10-Year Government Bonds

Germany 2-Year Government Bonds

Germany 10-Year Government Bonds

The two-day move in French bond yields vs. German is likely a 6-sigma event. Today alone, the 2-year yield rose 27 basis points vs. 2 for Germany.

Unfortunately the chart does not reflect this because Bloomberg charts are hopelessly a day out of sync with the numbers posted left of the chart.

While the equity markets are cheering the Rise of the Borg (and also the ECB stepping into the fray as the buyer of last resort of Italian bonds), a new elephant, completely visible, stepped into the room.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Aaa Credit, Bond Market, Bond Yields, Bonds, Debt Crisis, Economic Topic, Eurozone, Francois Fillon, French People, Government Bond, Investors Service, Italian Government, Jitters, Los Angeles Times, Mainstream Media Attention, Negative Outlook, New Elephant, Outlook, Popular Sport, Prime Minister Francois Fillon, San Francisco Chronicle, Solvency
Posted in Bonds, Brazil, Markets, Outlook | Comments Off

Don’t Play Monopoly with your Portfolio

Thursday, November 10th, 2011

This Week’s Feature: BMO Equal Weight Utilities ETF ( Ticker: ZUT )

Globally equity markets staged an incredible recovery from their October lows. However, Europe’s ongoing troubles ensure that heightened anxiety will remain. Even more reason to keep a careful eye on risk inside your portfolio.

Major equity indices for the United States, Europe and Emerging Markets rallied by 14% to 20% over the last five weeks. The S&P TSX 60 rose 12.5%. Commodities rallied too, with crude oil and copper up about 19%.

Euro-zone relief drove the rally, just as Euro-zone despair drove the drop. Until the Euro-zone begins to resolve its debt issues, every move it makes will agitate markets. When the Greeks decided to put their debt plan before a referendum last Tuesday, European equity markets fell 5%.

In this volatile environment, investors must be more vigilant in managing portfolio risk. One risk often overlooked is counterparty risk. As the exchange-traded market has developed, more, er…esoteric, ETFs have arisen, some of them with counterparty risk.

First, I should stress that most ETFs invest directly in stocks or bonds. These plain vanilla ETFs pose no counterparty risk. Other ETFs use futures contracts: no counterparty risk here either, but they do have other issues such as leverage that I have discussed before.

Then, there are ETFs that use “over-the-counter” (OTC) derivatives contracts. These are the ones that come with counterparty risk. These ETFs do not invest directly. Instead, they pay a fee to a counterparty, say a bank, and in exchange, the bank pays the ETF the return on some index like the S&P 500. All goes well until the day the bank is unable to pay the return.

How can you tell whether your ETFs have counterparty risk? You must read the prospectus. In a past role as a manager of OTC derivatives for a Bay Street fund manager, I was responsible for controlling counterparty risk. Are most investors ready or willing to do that? Unlikely.

In Europe, institutional investors are selling their OTC ETFs in droves and shifting to plain vanilla ones. France’s second largest bank, Société Générale, has seen outflows of Euro 4.4 billion this year from the OTC ETFs managed by its Lyxor division. There is nothing inherently wrong with the ETFs but investors are worried about SocGen’s exposure to Greek debt. SocGen’s stock price has fallen nearly 60% this year.

In recent notes, I discussed sector diversification and lower-risk, higher-dividend sectors like REITs. Another is the utilities sector.

When we play Monopoly, my sons tend to pass on Water Works and Electric Company in favor of Pacific Ave or Boardwalk. Like them, most Canadians pass on utilities for their portfolios.

That’s largely because the S&P TSX Composite passes on utilities. Three sectors dominate the Composite – financials, energy and materials – with nearly 80% of the weight. Utilities account for just 2%, even though their benefits would seem to mesh well with what most investors want.

Utilities are less volatile than energy, materials and even the Index as a whole. They pay better dividends than the Index and every other sector barring telecoms. Best of all, they are not so closely tied to the events in Europe.

There are a couple of Canadian utilities ETFs available: the iShares S&P TSX Capped Utilities (XUT/TSX) and the BMO Equal Weight Utilities (ZUT/TSX). Of the two, BMO ZUT is larger with about $95 million in assets.

iShares XUT is market cap weighted and holds 11 companies, with Fortis, TransAlta, Emera, Canadian Utilities and Atco making up about 70%. XUT pays a dividend of about 2.9%.

BMO ZUT is rebalanced twice a year to equal weights across 15 companies. It pays a dividend of about 5.3%. ZUT also holds one oil pipeline company, Pembina: not strictly a utility but the same idea.

The high yield will attract longer-term investors. In the near term, keep in mind that valuations are rich. The average price-to-earnings ratio for the companies inside ZUT is 23.4 times, with a price-to-book of about 1.93 times. For the Composite, the values are 15.2 times and 1.84 times.

Some of the premium is justified by the benefits. But a price fall in the near term is possible and that would be a good time to enter.

ZUT is less volatile than XIU, the TSX 60 ETF.

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Tags: Bonds, Canadian, Careful Eye, Commodities, Crude Oil, Debt Issues, Debt Plan, Emerging Markets, Equal Weight, Euro Zone, European Equity, Futures Contracts, Greeks, Last Tuesday, Lows, Otc Derivatives, Outlook, Plain Vanilla, Play Monopoly, Portfolio Risk, Prospectus, TSX 60, Volatile Environment, Zut
Posted in Bonds, Brazil, Canadian Market, Commodities, ETFs, Markets, Oil and Gas, Outlook | Comments Off

Italy Update – Collateral Effects (Goldman)

Thursday, November 10th, 2011

What apparently has Goldman confused is how its former employee Mario Draghi has let BTP spreads hit the record and unsustainable levels they did yesterday. To wit: “We were actually quite surprised not to see more forceful intervention by the central bank in secondary markets after the LCH announced it would raise initial margin requirements (and wrong in assuming it would have helped keep the Italy vs. AAA spread close to 450bp – it closed yesterday at 500bp over, but is now back at 450bp).” Here Goldman confirms what we suggested on Monday: that the ECB is now nothing but a policy enactment and dictator overhaul tool: “In this context, Italy still has to comply fully with the ECB’s ‘requests’ dated August 8, while Greece’s commitment to more austerity in exchange for financial support has continued to sway (at the time of writing, news that former ECB no. 2 Papademos would take the helm is encouraging).” Even so, the future to Goldman is quite cloudly :Granted, one positive collateral effect of market tensions has been to precipitate a political shakeup in Italy. But the collateral damage created by the price shock in Italian bonds to the stability of the EMU project (aggravated by explicit talk of countries being expelled from the single currency) is high and quite lasting. It will probably take a leap forward into deeper forms of fiscal risk-sharing (Prof Monti is a long-time proponent of Eurobonds) to get the market properly functioning again.” OTOH, Barclays has done the math, and as we pointed out a few days ago, is not surprised.

Full Goldman Sachs Note

An Update on Italy – Collateral Effects

by Franco Garzarelli, Goldman Sachs

An intensification of pressures on the Italian government bond market, especially after the introduction of higher initial margin requirements on repo by LCH yesterday, appears to have unlocked a stalemate in Italian politics. New fiscal measures (technically, an amendment to the Stability Law), which were scheduled to be voted on in Parliament by the end of next week, will now be discussed expeditiously and most likely rubberstamped by this Saturday. This should then prompt the resignation of PM Berlusconi, who has publicly pledged to step aside after their approval. According to the media, there is now a greater chance that a ‘technocrat’ government including high-calibre personalities such as Prof. Mario Monti and former PM Giuliano Amato may be sworn in by the start of next week. It would seem that Mr. Berlusconi himself has endorsed this solution, as the new Cabinet will likely include members of the PdL party. If confirmed in the coming days, this would represent the most market-friendly outcome at this juncture.

To be sure, the road remains uphill for Italy. The new Italian government will have to pass important and politically controversial economic reforms in the coming months under close scrutiny by the ‘troika’ and markets. Debt roll-over needs also run high (around EUR25bn in December and around EUR114bn in 1Q2012), and some help from either the EFSF or IMF backstop credit lines may be needed along the way. But a strong and reputable government leadership should reduce policy implementation risks (thanks to what we have previously called an ‘initial contracting’ with political parties on the policy programme), allow greater discretion on the sequencing of the individual measures (in recent pronouncements, Monti has emphasised growth-enhancing measures, while Amato has declared himself in favour of a wealth tax) and hopefully mitigate social tensions.

In terms of the bond market, we would expect a reduction of spreads following the appointment of a technocrat government, and a more gradual (and volatile) decline in yields after the successful introduction of new measures over the coming months. As we stated in a recent Global Market Views, we continue to see 350bp over 10-yr Bunds as a credible level around which spreads could settle (currently 530bp). But it will likely linger until a more decisive pan-Eurozone response is finally available (the much-heralded Euro area ‘firewall’ to fend off contagion from Greece is still under construction). In this context, whether the ECB is willing to engage in more pro-active purchases remains to be seen.

We were actually quite surprised not to see more forceful intervention by the central bank in secondary markets after the LCH announced it would raise initial margin requirements (and wrong in assuming it would have helped keep the Italy vs. AAA spread close to 450bp – it closed yesterday at 500bp over, but is now back at 450bp). To be sure, this fits with Mr. Draghi’s pronouncements at his first press conference: the ECB is picking up the slack, not fixing prices. A broader policy of ‘zero tolerance’ towards states reluctant to undertake fiscal action is also taking hold. In this context, Italy still has to comply fully with the ECB’s ‘requests’ dated August 8, while Greece’s commitment to more austerity in exchange for financial support has continued to sway (at the time of writing, news that former ECB no. 2 Papademos would take the helm is encouraging). Granted, one positive collateral effect of market tensions has been to precipitate a political shakeup in Italy. But the collateral damage created by the price shock in Italian bonds to the stability of the EMU project (aggravated by explicit talk of countries being expelled from the single currency) is high and quite lasting. It will probably take a leap forward into deeper forms of fiscal risk-sharing (Prof Monti is a long-time proponent of Eurobonds) to get the market properly functioning again.

Two observations also deserve to be considered:

Italy undoubtedly has large responsibilities for not being ‘ahead of the curve’ in its fiscal strategy, especially after the central bank stepped into the fray in early August. But the sharp widening in Italian BTPs started in mid-June, after the introduction of ‘substantial’ private sector ‘burden sharing’ (PSI) in the restructuring of Greek debt (which had previously been ruled out by policymakers). The ECB itself had cautioned that PSI would lead to contagion in a deeply integrated financial area, and was proven right. Aggravating problems, policymakers have been unwilling to allow sovereign CDS to be triggered, perhaps out of concern of unintended effects. But, on learning that a severe bond restructuring would not be considered a credit event, many investors apparently judged that they had less risk protection than they thought, and reduced bond exposures.

The recent decision by the European Banking Authority (EBA) to oblige EU commercial banks to strengthen capital positions by building up a ‘temporary’ capital buffer against sovereign debt exposures, including those of Italy, has set in motion a perverse chain of events. Banks sold sovereign securities, preferring to park money with the ECB, and have reluctantly participated in the primary market. The resulting decline in prices following these bond sales perversely led to more sales, and a progressive destruction of demand. As a result, 5-yr BTPs, for example, are now 10 points below where they were at end-September, when price marks were recorded for the recapitalization exercise, illustrating the adverse loopback effects that policy decisions have introduced.

As we argued in previous writing, given the inadequate fiscal governance of the Euro area, the ECB has been saddled with quasi-fiscal responsibilities in this crisis and, understandably, is trading off moral hazard risk (i.e., will the Italian government continue to ‘free ride’ bond purchases, and aggravate economic and political tensions among member states) with financial instability. But the price action since June has been amplified by unexpected changes in regulations and private contracts introduced by governments, creating much uncertainty and thus a self-reinforcing price action. Should a more decisive fiscal response be delivered in Italy, as we expect, and markets not take notice, then a more pro-active approach would be warranted. As Dom Wilson writes in this morning’s Global Markets Daily, ‘doing an SNB’ (unlimited purchases at a set price) may be an effective and ultimately cheap way to halt a dangerous slide.

Tags: Austerity, Bonds, Collateral Damage, Collateral Effect, Collateral Effects, Eurobonds, Fiscal Measures, Garzarelli, Gold, Goldman Sachs, Government Bond Market, Initial Margin, Italian Government, Italian Politics, Margin Requirements, Mario Draghi, Political Shakeup, Price Shock, Secondary Markets, Single Currency, Time Proponent, Writing News
Posted in Bonds, Brazil, Gold, Markets | Comments Off

Generation Riskless (Ronalds)

Thursday, November 10th, 2011

Generation Riskless

By Scott Ronalds

I feel for the twentysomething generation. Good jobs are tough to come by, home ownership is out of reach for many (in Vancouver and Toronto, at least), skinny jeans are deemed fashionable for men, and a weekend camping now means pitching a tent downtown.

What’s more, young investors are avoiding risk at an alarming rate. A recent article in the Wall Street Journal (The Young and the Riskless) highlights a survey which showed that 52% of investors in their 20s agreed with the statement: “I will never feel comfortable investing in the stock market.” (only 29% of investors of all ages agreed with the statement)

The piece suggests: “Investors who eschew risk at such a young age might be setting themselves up for disappointment. Without the compounding effects that come with investing in equities for a long time, stock-less investors might find it nearly impossible to accumulate a big enough nest egg to retire at all, let alone in their 60s.”

We’re all aware that the stock market has been turbulent over the past several years, and that the economic headlines aren’t exactly rosy. But investors in their 20s who intend to avoid stocks altogether are making a mistake. A big one. Over a 30-40 year investment horizon, stocks will almost certainly outperform cash and bonds. This is especially true using today as a starting point – stock valuations are attractive on many measures and bond yields are close to historically low levels. Big short-term swings in the market are hard to stomach and can be particularly damaging for older investors, but the twentysomethings should use volatility to their benefit.

Young investors, no doubt traumatized by the events of the past few years, need to step up and take some risk (i.e., invest in stocks) if they want a phat portfolio down the road.

Copyright © Steadyhand Investment Funds

Tags: Alarming Rate, Bond Yields, Bonds, Economic Headlines, Investing In Equities, Investing In The Stock Market, Investment Funds, Investment Horizon, Nest Egg, No Doubt, Older Investors, Pitching A Tent, Point Stock, Recent Article, Skinny Jeans, Stock Valuations, Time Stock, Twentysomething Generation, Twentysomethings, Wall Street Journal, Weekend Camping
Posted in Bonds, Brazil, Markets | Comments Off

Roman Empire Under Pressure: Margin Call of 4-5 Billion Euros as Clearing House Raises Deposit Requirements on Italian Bonds

Wednesday, November 9th, 2011

Roman Empire Under Pressure
Margin Call of 4-5 Billion Euros as Clearing House Raises Deposit Requirements on Italian Bonds

Yields on Italian bonds rose once again on Tuesday as margin requirements on those bonds rose sharply. Bloomberg reports LCH Clearnet Boosts Deposit Required for Trading Italian Government Bonds

The so-called deposit factor charged for Italian bonds due in seven-to-10 years will be raised to 11.65 percent, LCH Clearnet SA said in a document on its website dated yesterday. That compares with a charge of 6.65 percent announced in an Oct. 7 document. The additional charges will be applied from close- of-day positions today, LCH said.

Roman Empire Under Pressure

Steen Jakobsen, chief economist at Saxo Bank, pinged me with these comments.

Major investment banks calculate the “margin call” to be around 4-5 billion EUR as of tomorrow.

The Italian situation is very complicated – on one hand Berlusconi has promised to step down, on the other there are no alternatives to him in the opposition, there is no real hope for majority for “someone else”.

Berlusconi has a long history of comebacks, and being 75 years old he has little to lose. The main issue remains whether Italy truly moves forward with austerity and reforms. One without the other has no value for market and for building a fire-wall around Italy.

The facts are simple: No one but Italy itself can save Italy under present conditions.

ECB intervening is merely delaying the inevitable. Italy needs to move forward.

Only two countries has had lower growth than Italy since 2000 – Haiti and Zimbabwe!

This is the present outlook for 2011 and 2012:

Conclusions

A bureaucrat government in Greece and potentially Italy will not solve anything. What’s needed in both countries are:

• A government elected to deal with crisis
• A plan for creating growth and reforms
• An austerity plan underwritten by politicians, labor unions and employers.

That does not seem likely for now, in either country.

At a bare minimum we will have another month of uncertainty. A concerning trivia remains in place: When a country passes 6.5% in 10 year yield – the call for help from the IMF has only been 14 days behind. Italy is different, but the timeline is running out.

Safe travels,

Steen

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Austerity, Berlusconi, Bloomberg Reports, Bonds, Boosts, Building A Fire, Bureaucrat, Chief Economist, Clearing House, Clearnet, Close Of Day, Fire Wall, Government Bonds, Investment Banks, Italian Government, Italian Situation, Margin Call, Margin Requirements, Oct 7, Outlook, Present Conditions, Roman Empire
Posted in Bonds, Brazil, Markets, Outlook | Comments Off

Goldman Expects Another 10% Margin Hike For Italian Bonds

Wednesday, November 9th, 2011

Goldman’s Francesco Garzarelli has just released a follow up to the “next steps” piece from yesterday (which so far has been woefully wrong in predicting a ceiling to Italian spread). So perhaps this time Goldman will be a little more accurate, which for those who may be buying Italian bunds on the dead cat bounce, will not be a good thing. Here’s why: ” Should Italian BTPs trade above 450bp relative to AAA-rated EMU sovereigns over a period of time, the initial margin would increase by a further 10%. Currently, the initial margin for repo on Italian securities on LCH ranges between around 4% and 20%, increasing along the maturity structure.” The take away from the above – another 10% margin hike is coming. As for those who bought Italian bonds from Goldman yesterday on hope that the bottom is in, better luck next time – as Goldman says “In the meantime, the higher priced Italian government bonds will continue to be sold, as commercial banks raise liquidity buffers as higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB.” Considering the 5s10s is most inverted since 1994, this is not a very controversial call.

Full Goldman Note:

1. Overview

Markets initially took relief from the news of a change of government in Italy, alongside tighter scrutiny by the EC/IMF of the country’s fiscal policy. As we comment below, it may take up to the end of this month to have clarity on what political solution will emerge from the current crisis. In spite of calls for early elections, we continue to assign a low probability to this outcome. Still, pressures on the front-end of the Italian curve will likely persist until political uncertainty clears, with the ECB continuing its secondary market purchases in what we have previously described as ‘passive containment’ mode.

This morning, London Clearing House (LCH) announced a 5% increase in the initial margin applied on Italian collateral. Should Italian BTPs trade above 450bp relative to AAA-rated EMU sovereigns over a period of time, the initial margin would increase by a further 10%. Currently, the initial margin for repo on Italian securities on LCH ranges between around 4% and 20%, increasing along the maturity structure.

A credible commitment to structural reforms in Italy could result in a speedier (and less controversial) financial support from the ECB and the EFSF. IMF backstop credit lines, reportedly turned down by the Italian delegation at the Cannes G-20, could be reconsidered.

Separate from the European sovereign turmoil, and on a more encouraging note for risky assets, Chinese inflation figures for October were market friendly. Specifically, October CPI inflation fell to 5.5%yoy – in line with market expectations – from 6.1%yoy in September. Further high-frequency data reported by the Ministry of Agriculture suggests food prices have continued to moderate, and we continue to expect November CPI inflation to be below 5%. PPI inflation fell to 5%yoy, significantly below market consensus of 5.8%, from 6.5% in September. This moderation in inflationary pressures creates room for a shift to a more accommodative stance by Chinese policymakers. The China Securities Journal reported overnight that credit policy will remain loose in the fourth quarter and suggested that a cut in the reserve requirement ratio could not be ruled out. The prospect of such policy-driven relief for equity markets was a rationale for our long recommendation in Chinese equities, and the HSCEI index is outperforming the region today (+2.2%).

More broadly, the market appears to be increasingly trying to separate developments in Italy, and sovereign Europe more generally, from underlying macro developments, as Kamakshya Trivedi commented in Monday’s Global Markets Daily. In addition to the above mentioned HSCEI vs. SPX position, we are recommending two further macro-informed tactical trades on the back of these dynamics: (i) Long US cyclical sectors vs. defensives through our Wavefront Growth basket; and (ii) short the iTraxx Europe Crossover index. Separate notes by Noah Weisberger, Charlie Himmelberg and their respective teams expand on the rationale behind these views. Our tactical FX recommendation to position long in SGD and MYR, funded out of EUR and USD, also follows this logic.

2. Italy – What Next?

After seeing his parliamentary majority slide further in a routine vote ratifying the 2010 state accounts, last night Italian PM Berlusconi said he would step down as soon as Parliament approves a new set of austerity measures. These should be unveiled in the coming days and passed by the end of next week at the earliest. The measures, which are expected to include the sale of public real estate and the reform of local services, fall short of tackling more politically charged areas such as pensions and labour market reforms.

Meanwhile, the EU Commission has submitted to the Italian Finance Minister a set of questions on fiscal matters, soliciting a reply in writing by 11 November. Although this request may seem intrusive to some, it is completely in the spirit of the greater fiscal coordination and peer review that the EMU countries signed up to earlier this year. In this context, a delegation of the IMF led by David Lipton is expected to arrive in Rome next Tuesday to kick-start a series of quarterly reviews. Such tight oversight by the ‘troika’ on Italy’s economic policy should raise the chances that reforms will eventually go through.

In a note published yesterday, we set out three possible outcomes at this delicate political stage, with different implications for the BTP market and Italian risk premium more broadly. We summarize our views below.

• The most likely scenario is that, in coming weeks, the current centre-right coalition of the Northern League and PdL makes an attempt to rally round another PM candidate who can gain wider acceptance domestically and internationally. In order for this strategy to succeed, the new government will need to win support from smaller centrist parties (and those MPs who have left the PdL in recent weeks). The newly appointed Cabinet would need to prove itself, and reforming the pension system could meet resistance from the Northern League. Still, it would be hard for the ECB and Italy’s EMU peers not to stand by a new Italian government should it genuinely try to pursue reforms. Under this scenario, thanks to the ECB’s interventions, we would expect BTPs to remain capped at around current levels (450bp) over the average of Germany, France and the Netherlands until measures are approved.
• The second most likely scenario is one where the centrist MPs turn down the offer to join a broader coalition. In this case, more MPs from Berlusconi’s PdL party could join forces with formations at the centre of the political spectrum. This could pave the way for a government of national unity of sorts, led by a highly reputable ‘outsider’. From the experience of the early 1990s, the advantage of such ‘technocrat’ solutions lies in the ‘initial contracting’ on the legislative programme (economic reforms agreed with the ‘troika’, better governance through constitutional rules, a smaller public sector, a new electoral law, could all be chapters of such contract), reducing the risks of implementation. We view this as the most market-friendly outcome. The front-end of the sovereign curve would re-price more than intermediate- and long-term maturity bonds, because investors would likely take advantage of the rally to reduce exposure at higher prices. Nevertheless, we would expect 10-yr BTPs to fall to around 350bp over Bunds in fairly short order.
• A third possible scenario involves early elections. These could be held in mid-January at the earliest, although they would most likely be postponed until the Spring amid market turmoil and pressures from EMU peers to strengthen public accounts. This would represent the worst-case scenario for markets, but it is also the least likely in our view. Conscious of the adverse market implications, President Napolitano will probably try to resist dissolving Parliament at this juncture. Also, most centrist parties have openly stated that they want to change the electoral law before a new vote takes place (and a referendum to scrap the existing law is expected to take place next year).

All three scenarios will take some time to play out, a couple of weeks at least. In the meantime, the higher priced Italian government bonds will continue to be sold, as commercial banks raise liquidity buffers as higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB. In conclusion, we are most probably approaching the highs in Italian yields (currently over 500bp over German Bunds in the bellwether 10-yr sector, and 640bp in 2-yr maturities), but a volatile and unsettled market remains our base case until Italy’s sovereign creditors can be reassured that long awaited structural reforms to lift the country’s growth rate will be put in place.

Tags: Better Luck Next Time, Bonds, Bunds, Central Case, Clearing House, Commercial Banks, Dead Cat Bounce, ECB, Fiscal Policy, Garzarelli, Gold, Government Bonds, Government In Italy, Initial Margin, Italian Government, Margin Requirements, Maturity Structure, Political Solution, Political Uncertainty, Repo, S Francesco, Sovereigns
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Art Cashin: “The Spinout May Begin”, And Why Equities Just Got Punk’d By Bonds Once Again

Wednesday, November 9th, 2011

UBS’ Art Cashin, the “Friends of Fermentation” commitee Chairman speaks.

The Spinout May Begin – Overnight Events

Asian stocks followed the New York lead and traded higher. European stocks looked to do the same with Paris and Frankfurt trading up over 1% at 3:30 EST. Italian bonds, however, were having none of it.

The yield on the Italian 10 year pushed well above 7%. More importantly the spread between it and a basket of other
bonds widened enough to prompt some regulators to raise the level of collateral needed for the Italian bonds.

Worse yet, the whole Italian bond yield inverted. The yield on the 2 year and 5 year actually traded higher than the yield on the 10 year.

That spooked markets and Milan was down over 600 points by 6:00 EST.

Things have calmed somewhat since but we need to get some adult supervision soon.

The problem is now clear. Italy is both too big to fail and too big to save. Tomorrow we’ll go through some of the numbers.

And here Art explains why with everyone chasing beta to make up for the October underperformance in which hedge funds only achieved about10-20% of the broader market’s gains, how everyone just got burned. Badly:

Most money market managers have been underperforming the market. There are several ways you can try to make up the difference.

In the old days, you might find the hot new stock in the hot new industry. But given the very heavy correlation among asset classes (everything moves together), that’s not productive.

So now, some managers are trading the swings. You wait for the selling to dry up and as the market begins to turn up; you rush in to buy the high beta stocks (they give you the most bang for the buck). So, by buying the dips in this manner, you add another point or two to your performance.

That strategy may be the cause of another phenomenon noted by Jason Goepfert. It is the apparent crowding into these positive stocks causing some distortion in the arms index.

Here’s a bit of what Jason said:

“This is more directly related to breadth than sentiment, but the Arms Index (better known as the TRIN) is showing that over the past week, traders have poured into positive stocks. There has been roughly 25% more volume flowing into advancing stocks than declining stocks.”

Jason further notes that the prior two times this happened this year, it was at or near a short-term market top. In any case, this morning’s outlook suggests that the bond market is the better interpreter of events Italian.

As always.

Tags: Adult Supervision, Art Cashin, Asian Stocks, Asset Classes, Bonds, Collateral, Commitee Chairman, Correlation, Dips, European Stocks, Hedge Funds, Market Managers, Money Market, Outlook, Overnight Events, Phenomenon, Regulators, Several Ways, Spinout, Swings, Ubs
Posted in Bonds, Brazil, Markets, Outlook | Comments Off

Barclays Says Italy Is Finished: “Mathematically Beyond Point Of No Return”

Wednesday, November 9th, 2011

Euphoria may have returned briefly courtesy of yet another promise for a resignation that will likely not be effectuated for weeks or months, if at all, and already someone has done the math on what the events in the past several days reveal for Italy. That someone is Barcalys, the math is not pretty, and the conclusion is that “Italy is now mathematically beyond point of no return.”

Summary from Barclays Capital inst sales:

1) At this point, it seems Italy is now mathematically beyond point of no return
2) While reforms are necessary, in and of itself not be enough to prevent crisis
3) Reason? Simple math–growth and austerity not enough to offset cost of debt
4) On our ests, yields above 5.5% is inflection point where game is over
5) The danger:high rates reinforce stability concerns, leading to higher rates
6) and deeper conviction of a self sustaining credit event and eventual default
7) We think decisions at eurozone summit is step forward but EFSF not adequate
8) Time has run out–policy reforms not sufficient to break neg mkt dynamics
9) Investors do not have the patience to wait for austerity, growth to work
10) And rate of change in negatives not enuff to offset slow drip of positives
11) Conclusion: We think ECB needs to step up to the plate, print and buy bonds
12) At the moment ECB remains unwilling to be lender last resort on scale needed
13) But frankly will have hand forced by market given massive systemic risk

 

Hint:Not Good.Sell EUR, Buy Gold

The broader referenced report can be found here.

And the associated powerpoint is below:

Tags: Austerity, Barclays, Barclays Capital, Bonds, Briefly, Conviction, Cost Of Debt, ECB, Euphoria, Gold, Inflection Point, Last Resort, Math, Mkt, Nbsp, Patience, Point Of No Return, Policy Reforms, Resignation, Slow Drip, Systemic Risk
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Corporate Bonds: Figuring out a Fair Price (Koesterich)

Tuesday, November 8th, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

Last week we argued that corporate bonds look reasonably priced and appear cheap relative to Treasuries. Now, I want to address the logical follow-up question: How do you know what a fair price is for corporate bonds?

One way to think about corporate bond valuations is to consider the spread. Investors in corporate bonds are assuming credit risk – the risk that the issuer won’t repay the principal or make good on an interest payment. Investors are arguably not subject to that risk with a Treasury bond (for all its troubles, the US government has never defaulted).

As investors are taking on marginally more risk, they should be compensated in the form of a higher return. The spread between the interest on a corporate bond and a Treasury obligation of a similar duration is one way to assess how much investors are being compensated for taking on additional risk.

In general, when the economy is stronger, spreads tend to contract as investors are less worried about companies defaulting. Conversely, when the economy is weaker investors should receive a higher return to compensate for the risk of increased defaults (as you would expect, defaults rise in recessions).

So when it comes to evaluating how wide the spread should be, start with your view on the economy. By comparing your view of the economy to current spreads, you can get at some rough measure of “fair value.”

Today, spreads are wide relative to their historic average – but they also appear wide given the state of the economy.

The spread between an index of Baa corporate bonds and the 10-year US Treasury note is approximately 3.30%, nearly twice the historical average. In other words, investors are sufficiently worried about the state of the economy that they are demanding twice the premium relative to Treasuries they normally receive (another interpretation is that Treasury yields are artificially low because the Fed is buying up a good chunk of existing supply).

But when we compare the current level of spreads to a measure of leading economic indicators (see the chart below), spreads also look too big. Based on this analysis, spreads should be about 1% tighter than they currently are, meaning that either Treasury yields should rise or corporate bond yields should fall.

Either way, corporate bonds look better than Treasury bonds.

Source: Bloomberg

Bonds will decrease in value as interest rates rise.

Copyright © Russ Koesterich, iShares

Tags: Bonds, Chief Investment Strategist, Corporate Bond, Corporate Bonds, Credit Risk, Duration, Economy, Interest Payment, Investors, Obligation, Recessions, Rough Measure, Russ, Treasuries, Treasury Bond, Treasury Note, Treasury Yields, Us Government, Us Treasury, Valuations
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Risks Remain High, But May Be Receding (Doll)

Tuesday, November 8th, 2011

Risks Remain High, But May Be Receding

November 7, 2011

by Bob Doll, Chief Equity Strategist, Blackrock

Volatility Rises Over Greek Surprise

Market action last week was dominated by the early in the week announcement from Greek Prime Minister George Papandreou that he would call for a referendum to allow Greek citizens to vote on whether or not the country would accept the previously announced bailout package in exchange for additional austerity measures. This surprise announcement called into question the stability of the eurozone, renewed risks of a chaotic default of Greek debt and caused risk assets (including stocks) to sink sharply. After it became clear that this decision was politically untenable, the probability of such a referendum faded and markets managed to stage a recovery. For the week as a whole, however, stocks were down, with the Dow Jones Industrial Average falling 2.0% to 11,983, the S&P 500 Index declining 2.5% to 1,253 and the Nasdaq Composite dropping 1.9% to 2,686.

In related European policy news, the European Central Bank (ECB) announced last week that it would lower rates from 1.50% to 1.25%. While we recognize that this is a positive step in terms of promoting a more growth-friendly environment, it only partially unwinds the two ill-timed rate hikes imposed by the ECB earlier in the year.

More Moves From the Fed on the Horizon?

The US Federal Reserve met last week and, as part of its decision to keep rates on hold, also announced that it had lowered its economic growth forecast for the country for the next couple of years. While some viewed this downgrade as a surprise, our view is that the Fed was merely catching up with consensus forecasts that had previously taken a dimmer view of the US economy.

Given the Fed’s comments, it appears the central bank may be paving the way for an additional round of quantitative easing (i.e., a QE3 program). The Fed has been extremely active in recent years and while the central bank’s programs may have prevented a more serious economic disaster, it has failed to deliver the sort of decent economic growth and sharply decreasing unemployment that is typical during the early stages of economic recoveries. To a large extent, this is due to the fact that consumers are still in a deleveraging stage and overall confidence levels remain depressed, which is preventing businesses from hiring.

In any case, we do not think the Fed is quite ready yet to enact QE3, but should we see some sort of combination of further chaos in Europe, inflation levels receding further and economic growth deteriorating, the likelihood would grow. On the economic front, last week saw the release of the October payrolls report. Gains were slightly weaker than expected (up 80,000), but the data also showed that gains in August and September were revised up sharply and that unemployment fell very slightly, from 9.1% to 9.0%.

Market Risks Appear to Be Fading

Notwithstanding last week’s decline, markets have accelerated sharply since early October, and it is worth taking a step back to consider what has changed over the past month. Several weeks ago, investors were facing the dual threats of the inability of European policymakers to solve the debt crisis and what seemed to be a growing likelihood of a double-dip recession in the United States. Given that backdrop, equity risk premiums had moved sharply higher. Today, while the environment can hardly be called great, these risks seem less severe than they previously were, which has allowed the risk premiums to recede somewhat.

In Europe, the odds are growing that policymakers will be able to contain the debt crisis and engineer some sort of stable and organized default of Greek debt. Additionally, the ECB has transitioned to an easing bias, which should provide at least some help for the overall economy. In the United States, risks of a renewed recession have been fading and while growth levels are certainly not robust, the economy does appear to be poised to continue to deliver modestly positive levels of growth. The debt crisis and ongoing economic uncertainty are likely to remain headwinds for stocks for some time, but it does appear to us that markets have moved past the period of greatest risk.

About Bob Doll

Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock^® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.

Copyright © Blackrock

Sources: BlackRock, Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 7, 2011, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock is a registered trademark of BlackRock, Inc. All other trademarks are the property of their respective owners.

Tags: Austerity, Bailout Package, Bob Doll, Bonds, Consensus Forecasts, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Federal Reserve, George Papandreou, Greek Citizens, Greek Prime Minister, Nasdaq Composite, Paving The Way, Policy News, Rate Hikes, Referendum, Strategist, Surprise Announcement, Us Federal Reserve, Volatility
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“Ich bin ein Berliner” (Saut)

Tuesday, November 8th, 2011

“Ich bin ein Berliner”
November 07, 2011

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“Ich bin ein Berliner” was a German phrase used by President John F. Kennedy in his famous Berlin speech where he was emphasizing the U.S. support for West Germany after the Soviet-supported East Germany erected the Berlin Wall as a barrier to prevent movement between East and West Berlin. Last week at the G20, like John Kennedy, President Barack Obama tried to emphasize America’s support for a German bailout plan to prevent a Greek tragedy. The tragedy’s trajectory rose sharply on Tuesday when Greek Prime Minister George Papandreou announced there would be a referendum to decide if the new austerity measures for a second bailout (the first was on July 21, 2011) would be acceptable to the Greek people. That news shocked the world’s equity markets, which was reflected by the Dow’s Dive of some 297 points. I was seeing portfolio managers at the time and told them that in my opinion Papandreou’s prose was telegraphing a Greek withdrawal from the EU. A withdrawal because the Prime Minister knew the Greek people would never vote for such measures and because the vote most likely would not be held until next year. Further, Papandreou knew that given the uncertainty of an austerity vote the IMF would probably hold back its already scheduled disbursement of funds. To be sure, the IMF’s funding conditions require a clear horizon for 12 months, so Greece’s €8-billion tranche, which would come from the IMF, probably would have never showed up.

A Greek withdrawal from the Euro-zone would also be quite messy. Firstly, leaving the euro and returning to the drachma should cause a sharp devaluation in the drachma’s value vis-à-vis other currencies. A good example of this is the monetary breakup of the Austro-Hungarian Monetary Union in 1919. Secondly, the switching of currencies requires changing domestic laws to allow wages and incomes to be paid in the new currency. As well, domestic debt has to be recalibrated for the new currency. Thirdly, Greece’s government would be unable to borrow from the financial markets and thus forced to cut its budget deficit to zero. As The Wall Street Journal notes:

“[Greece’s] debt burden – the weight of government debt as a proportion of economic output – would soar. The economy would shrink as the new national currency depreciated against the euro, but most of the government bonds would still be euro-denominated. If that weren’t enough, many economists argue that the economic benefits of a sharp currency depreciation could quickly be dissipated by wage inflation.”

Then there are things like preparing for capital flight, bank holidays to slow withdrawals, reprogramming cash registers/vending machines/etc., making new notes and coins, well you get the idea. Indeed, it’s all Greek to me … pass the ouzo!

Comes Thursday, however, Papandreou drops his controversial referendum proposal as he faced a “no confidence” vote on Friday. Interestingly, he survived that vote, but surprisingly the DJIA (11983.24) didn’t follow on to Thursday’s Triumph (+208.43). And that, dear reader, raises the question – is the stock market merely reacting to the on/off news from Greece and the EU? – or, has the October rally been more about the better than expected economic news in the U.S.? Our sense is the rally from the “undercut low” of October 4, 2011 has been driven by better than estimated economic reports. Verily, the economy has been doing better than most expected. For example, the recent real GDP report showed an uptick to 2.5%. But, the real GDP, less the change in private inventories, increased by 3.6% (seasonally adjusted annual rate) during 3Q11 versus +1.6% in 2Q11. This suggests companies chose to meet the stronger demand by selling inventories rather than increasing output. This only reinforces our belief that corporate America will have to build inventories, which should add ~1% to this quarter’s GDP report. Then there was the strength in producers’ durable equipment, which jumped 17.4% during 3Q11. Hereto, this plays to our argument that spending on capital equipment (capex) should torque up into year-end, spurred by the ability to expense capex. The fear here is that the 100% expensing feature is slated to expire on December 31, 2011 unless it is extended.

As stated in last Monday’s missive, about three-quarters of October’s economic releases have been coming in better than expected. Unfortunately, that skein was broken last week with seven of the 18 economic releases better than estimates, eight weaker, and three in line. And maybe that, rather than Greece, was the reason for the early week two-day train wreck of down 573.15 points for the senior index. The downside two-step registered back-to-back 90% Downside Days whereby both the declining volume, and the number of downside points, equal or exceed 90% of the total volume and total points traded. Typically, such back-to-back Downside Days tend to temporarily exhaust the sellers, which was the case last week as Wednesday and Thursday’s sessions recorded back-to-back 80% Upside Days. For the past few weeks we have been suggesting some kind of pause/pullback was due, commenting that the McClellan Oscillator was about as overbought as it ever gets. Ditto the percentage of stocks in the S&P 500 (SPX/1253.23) that were above their respective 50-day moving averages (only 4% in early October versus 93.6% as of last Monday morning); and the fact that according to our “day count” sequence, with October 27th being session 17 in the typical 17 – 25 Buying Stampede, the straight up rally was long of tooth.

As for earnings season, earnings continue to track above expectations as with 432 companies in the S&P 500 reporting, earnings are better by 22.2%, with a 12.2% increase in revenues, year over year. The question then arises, “Why are fundamental analysts lowering their forward estimates?” Indeed, there have been noticeable declines in estimates for eight of the S&P’s ten macro sectors. The two sectors where estimates have not been lowered are Healthcare and Utilities. Nevertheless, it has indeed been a great earnings season and we expect more of the same into the Christmas selling season. To that point, there is a high correlation between strength in the stock market and a good Christmas “sell through.” Accordingly, we expect a decent Christmas and suggest investors consider select retailers as investments. As the keen-sighted folks at the Bespoke Investment Group opine:

“In order provide a more detailed look at the performance of retail related groups’ pre and post Thanksgiving, in the table we show the annual returns of the S&P 500, the S&P 500 Retailing group, as well as the various subgroups in the Retail sector from the start of November through Thanksgiving. From 2000 through 2010, the S&P 500 has averaged a gain of 0.9% from 11/1 through Thanksgiving with positive returns nearly three quarters of the time. Retailers, on the other hand, have done even better. From 2000 through 2010, the S&P 500 Retailing group has seen an average gain of 1.6% with positive returns nearly two-thirds of the time. Looking at individual sub-groups shows that Internet retailers (beginning in 2002) have seen the best returns in November with an average gain of 4.8%. After online sales, the next best groups are Apparel (3.1%) and Restaurants (2.8%). If you are looking to generate alpha, both of these groups have outperformed the S&P 500 73% of the time since 2000.”

Some Strong Buy-rated names for Raymond James’ universe of stocks playing to this theme are: Bed Bath & Beyond (BBBY/$62.03); Big Lots (BIG/$41.32); Family Dollar Stores (FDO/$58.97); O’Reilly Automotive (ORLY/$76.90); Red Robin Gourmet Burgers (RRGB/$26.57); Select Comfort (SCSS/$20.77); and Wal-Mart Stores (WMT/$57.50).

The call for this week: Last Monday I wrote, “To us, the real question is – will the SPX get a pullback to the often mentioned pivot point of 1217, or will any pullback be short and shallow? Well, by our work the equity markets still have a lot of internal energy to power their way higher, so our sense is the SPX will keep pushing higher in the months ahead with only shallow pullbacks and sideways pauses along the way.” While falling from 1284.59 to 1218.28 the first two days of last week hardly qualifies as “shallow,” I do find it interesting that on the numerological date of 11/1/11 the S&P 500 closed near the aforementioned pivot point of 1217 and then rallied. Accordingly, we would view a decisive close below that 1217 pivot point as a negative, suggesting a decline back into the 1100s. A more likely outcome, however, is for the SPX to spend some time consolidating before resuming its advance.

P.S. – I am actually here all week …

Click here to enlarge

Copyright © Raymond James

Tags: Austerity Measures, Bailout Plan, Barack Obama, Berlin Speech, Berlin Wall, Bin Ein Berliner, Bonds, Chief Investment Strategist, Clear Horizon, Drachma, Euro Zone, George Papandreou, German Phrase, Greek Prime Minister, Greek Tragedy, Ich Bin Ein Berliner, jeffrey saut, Monetary Union, Portfolio Managers, President John F Kennedy, West Berlin
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