My Diary 692 --- Operation Twist & Euro Area D/Gs; The Crisis of

My Diary 692 --- Operation Twist & Euro Area D/Gs; The Crisis of Incompetency; X-asset Market Strategies

Sunday, September 25, 2011

“Down, Down, Down, But Not Done”--- The rhythm of the latest equity prices is not as beautiful as that of The Proms (or The Henry Wood Promenade Concerts). Founded in 1895, The Proms is an eight-week summer season of daily orchestral classical music concerts and other events held annually, predominantly in the Royal Albert Hall in London. The 2011 Proms season began on 15 July 2011 and ran until 10 September 2011. It saw the first ever 'Comedy Prom' hosted by comedian and pianist Tim Minchin, and featuring a series of other comedians, which reflects the growing relationship between music and comedy. In contrast, the 15.97% YTD drop of MXWO index reflects the growing uncertainty toward politics incompetency and growth outlook.

Before I go into more details of market backdrops, let us have a review over the asset market performance.  On the weekly basis global stocks lost -7.55%, with -6.58% in US; -6.03% in EU; +0.45% in Japan and -6.83% in EMs. In Asia, MXASJ dropped 10.3% and MSCI China tumbled by 11.3%, while A-shares was more resilient with CSI300 -2.4%. MXCN’s valuation is now at the 2008 trough level of 7.5X FWD PE. While equities are now pricing more than 50% chance of recession, worsening fundamentals and the lack of clear triggers justify a defensive stance. Elsewhere, 2yr USTs added 5bp to 0.22% while 10yr declined 21bp to 1.83% and 10yr declined 41bp to 2.90%. Yields jumped across the Euro area periphery. Greek, Irish, and Portuguese 2yr yields all climbed 1337bp, 29bp, and 192bp, respectively. The 3M Euribor-OIS expanded 14bp to 89bp. Brent crude dropped 6.77% to $106.64/bbl. The USD gained 2.1% to 1.3501EUR, but was relative flat at 76.6JPY. CRB dropped 8.4% to 301.87, while Gold price tumbled 8.97% to $1651/oz.

Operation Twist & Euro Area D/Gs

On the policy front, the most important event is that FOMC confirmed that it will extend the duration of its SOMA portfolio by selling USD400bn in short maturity USTs and reinvest the proceeds at the long end of the curve. In addition, it will reinvest principal payments from agency debt and agency MBS back into agency MBS. Although USTs market rallied, risk assets sold off and USD moved higher. Perhaps this reflects the FOMC’s acknowledgment of “significant” downside risks to the economic outlook. Operation twist will remove duration from the bond market and keep downward pressure on UST yields, although the policy was already largely discounted. The resumption of MBS purchases was not as widely anticipated, and it will help to lower borrowing rates for consumers and provide some modest support for the housing market. The selloff in risk assets likely reflects the view that operation twist, on its own, is insufficient to get the economy growing again. Amid risks appear skewed to the downside, I expect that the Fed will not hesitate to take the next step, probably QE3, later this year if the economy continues to languish. The problem is that investors might not have the patience to wait.

Across the ocean, S&P’s one-notch D/G of Italy’s LT and ST sovereign ratings to “A/A-1” is the main development over the week. Given the rating was previously on “Negative Outlook”, an imminent D/G by S&P was probably not fully expected by the market. Such a downgrade was justified from both political and economic assessments. On the political front, S&P thinks that Italy’s fragile governing coalition and policy differences within the parliament will likely continue to limit the government’s ability to respond decisively to the challenging domestic and external macroeconomic headwinds. Politics seem to play a bigger role these days in S&P’s sovereign ratings – the August 5th US downgrade is another recent example of that. Furthermore, S&P do not believe Italy’s projected EUR60bn in fiscal savings will be realized for the following 3 main reasons --- 1) Italy’s economic growth prospects are weakening; 2) nearly 2/3 of the projected budgetary savings in the crucial 2011-2014 period rely on revenue increases; and 3) market interest rates are anticipated to rise. Although Italy has covered 77% of its 2011 debt funding needs, there is still another EUR100bn more to be raised before the end of the year. In reality the ECB will probably need to do more from here. The ECB has been buying around EUR5-10bn in peripheral bonds over the last 5 weeks (c.EU9.8bn settled last week) but that has failed to stop Italian bond yields from rising. With EFSF 2.0 at least a few weeks away from being fully operational let’s hope the ECB is well prepared.

More damage is done by Moody’s as the agency has cut SocGen’s rating to Aa3 from Aa2, of which raised more concerns and speculation over the health of French banking systems. BNP is saying that its exposure to peripheral sovereigns is “manageable” but also announced plans to reduce its risk weighted assets by EU70bn. In addition, I saw news that Chinese state banks have stopped trading with some European banks. According to Reuters, a large Chinese state bank has stopped FX forwards and swaps trading with UBS, Societe Generale, Credit Agricole and BNP Paribas. A second Chinese state bank has stopped Yuan interest rate swaps with some European banks. It is probably a reflection of current sentiment towards the European financial sector but one of the interesting stories came from the FT. The newspaper said that Siemens had withdrawn more than half a billion EUR in cash deposits from a French bank and deposited between EUR4-6bn with the ECB (mostly through one-week deposits). The move was prompted by concerns about the future financial health of the bank and partly to benefit from the higher interest rates paid by the ECB.

As a result, I expect that Euro area banks will need both liquidity support and recapitalization, while the Italian and Spanish sovereigns will likely need support for huge interventions in their primary and secondary government bond markets. The ECB’s balance sheet is likely to expand materially over the coming months. The ECB will also cut its main policy rate, starting with a 50bp ease in early October, and will extend the maturity of the liquidity support that it offers to banks. Meanwhile, I think a coordinated EU aid by the BRICs didn't seem to have the same firepower as market expected. The WSJ said that Brazil is studying an increase in purchases of European debt through reserves. In China, Premier Wen overnight reiterated that China can offer "a helping hand" to Europe though investments but urged DM economies to restore fiscal stability and create jobs.

The Crisis of Incompetency

This 3Q11 has seen global activity pushed and pulled by two forces. Industrial output and consumer demand lifted at the beginning of the quarter as the global economy began to shake off first-half drags from rising commodity prices and the Tohoku earthquake. Gains in June and July look strong enough to return current quarter global GDP growth toward trend. However, growth momentum is slipping again as the quarter ends. This is the message coming from this week’s key activity releases—notably August trade reports from Asia and the September flash PMIs from China (49.4) and the Euro area (48.4). While this slippage partly represents the end of a temporary production bounce as Japan’s supply chain is restored, this turn could be attributed to a perceived “crisis of incompetency.” Concerns that policy institutions are not up to the task of delivering growth and needed fiscal reforms have been building, and have materially depressed risk appetite and consumer confidence.

Going back to Europe, as highlighted in the last diary, the fiscal tightening in the periphery (including Italy) will be a larger drag on growth than we thought. In addition, persistent bank funding stresses are likely to tighten credit conditions, also in parts of the core, while the uncertainties created by the sovereign debt crisis are weighing on business and consumer sentiment. This week’s PMI and consumer confidence (-18.9 from -16.5 in August) reports suggest that these drags, together with softer global demand, have already brought Euro area growth to a halt in September. In addition, I expect a second, harder debt restructuring in Greece sometime next spring, which will weigh on activity even more. As a result, street economists expect the Euro area to slide back into recession, with GDP declining at a 1% yoy from 4Q11 to 2Q12.

In the US, the country is still barreling toward a major fiscal tightening in 2012 with little sign that policymakers are constructively engaging to consider the appropriate fiscal stance for the current cyclical juncture. Incoming data for 3Q11 are generally tracking slightly to the high side of the 1.0% forecast. But incoming data do not yet fully reflect the effects of the decline in equity prices to date on wealth and confidence. The week’s decline in equity prices highlights downside risks to an already subdued growth forecast. Against the backdrop of a Euro area recession and weak US growth, next year’s anticipated fiscal drag of 1.7% could also tip the economy back into recession. For its part, the Fed announced an Operation Twist program on Wednesday, and US LT interest rates have fallen significantly since the meeting. However, it also delivered a statement presenting an outlook with sustained subpar growth and heightened downside risks.

With respect to Ems economy, as DM recession worries continue to dampen investors’ sentiment, and business confidence, we start to saw the slow-down in China, partly due to its previous tightening efforts. Domestically, Sep HSBC China PMI came in at 49.4, marking the third month of sub-50 levels. Investors hoping to see more signs of China policy inflection continued to be disappointed, as focus remains on fighting inflation, and newsflow on weakening property developer balance sheets and SME liquidity woes persisted. In short, a global economy that could lift does not appear like it will as a result of appropriate/ineffective policies that are producing fiscal drag, more cautious behavior, and tighter financial conditions.

X-asset Market Strategies

In terms of investment strategy, I think it is still too soon to reach for the falling sword. Indeed, valuation extremes are cropping up, in terms of most stock markets, government bonds, and now even some currencies and commodities. Valuation measures, however, are not useful as a short-term timing guide. That said, technical indicators argue in favor of a rally in US stocks. Almost all of technical indicators suggest that the S&P500 has reached oversold levels that typically herald a rally. For example, the Composite Technical Indicator has fallen sharply and has reached levels that usually mark the end of major market corrections. The insider sell/buy ratio, which has plunged to levels not far from those seen in late 2008/early 2009, suggests a high level of capitulation among corporate executives. Also, market breadth has collapsed, consistent will a major bottom in a typical cyclical bear market. It is rare to have all key indicators simultaneously flashing signals of massively oversold conditions and reduced risk. When this happens, it can only suggest that selling power has almost been exhausted and the market has absorbed a lot of bad news. However, global financial markets will continue to be troubled by the lack of policy options and inaction coming from the G7 at a time of heightened economic uncertainty and financial system fragility. The risk of systemic events remains high. Thus, though a technical rebound in risk assets is possible, but the broad environment remains unstable and the risk of policy mishaps is still high.

With respect to currency markets I think given the US Congress and European parliaments dither around decisions required to avoid joint recessions, some references to a Lehman moment are becoming increasingly appropriate. Currency markets already reflect these exceptional times, with over 25 pairs posting moves in excess of two STDEV over the past week, mostly through deleveraging in EM locals. As with Lehman, JPY and USD are the world’s strongest currencies in the face of surging volatility, highlighting what determines safe-haven status. It is the low rates which tempt investors to fund in that currency during expansions, thus obliging them to repurchase the same unit during deleveraging. To a lesser degree the same phenomenon has driven EUR’s September rally vs EM and commodity currencies, since it has been used extensively to fund or hedge longs in those currencies. Thus, it looks like that the argument is favor for avoiding EUR as a hedge for the sovereign crisis despite its European epicenter and JPY is a better substitute given its more predictable behavior.

In terms of commodities, the space has been sold off heavily across the board this week, down around 8% with the worst losses coming from base metals (3M Copper -15.4%, Aluminum -7.3%) which fell almost 11%. Given base metals are the commodity most leveraged to global growth, this suggests investors are pricing in a much higher risk of recession than before. Historically,  over the past five US recessions, base metals had fallen an average of 43% from peak to trough. Based on this, and given base metals have fallen around 21% since the recent peak at the end of July, this very simple analysis suggests current prices imply around a 50% chance of a US recession. Expanding the above analysis to other commodities one could find that over the past five recessions precious metals have fallen on average -5%, agriculture -8% and oil -19%. Based on this, if a serious recession were to materialize, I would expect energy and base metals to underperform other commodities.

Good night, my dear friends!