Saturday, December 31, 2011

The road ahead: bull & bear case

As 2011 draws to a close and we 2012 dawns, it's time to consider the bull and bear cases for the stock market and risky assets. I had already outlined my bull case for the market on December 19 (see The bull case for stocks). The bull case consists of:
  • The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
  • In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
  • In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.
Go and read my previous post, there is little more to be said.


The bear case for stocks
From a macro viewpoint, the three regions to watch are Europe, the US and China and the emerging markets. The market was focused on the possibility of a European banking crisis during much of 2011. No, the bear case for stocks in 2012 does not rest with Europe. I believe that market's focus will shift from Europe to the other regions of the world in 2012.


Europe: From heart attack to cancer
The ECB's LTRO program, which offered banks unlimited liquidity for up to three years, has virtually eliminated the possibility of a banking failure. In addition, coordinated central bank intervention that offered unlimited USD liquidity also showed that central bankers around the world are well aware of the risks of a Lehman/Creditanstalt credit event and have taken steps to address the problem. Nevertheless, problems remain and all Draghi & Company has done is bought time for the politicians to address the long term issues.

What is the market saying about Europe? Scott Grannis wrote in his PIIGS Update that conditions in the bond market are normalizing, though far from ideal. The ECB's balance sheet expansion does not appear to be leading the eurozone down the hyperinflation path, but problems remain. In other words, Europe has gone from avoiding the imminent heart attack to a lingering but treatable cancer. We will have to watch and see how the politicians address the longer term problems of the competitiveness disparity between North and South, as well as the debt situation of the PIIGS. No doubt, we will continue to have crises and summits, but the risk of a catastrophe is lower than it was in 2011.


A US recession in 2012?
One thing that investors shouldn't forget that stock prices depend on fundamentals, i.e. earnings, growth outlook, interest rates, etc. An American recession would affect the outlook for earnings and therefore depress stock prices as a result. The question for the bears is, "Will the US experience a recession in 2012?"

Certainly, a recession would not be out of the question here. This post from Pragmatic Capital shows that the US was in recession 18.3% of the time in the 2000-2011 period and a whopping 30% of the time if you consider the 1855-2011 time span. The likes of ECRI and John Hussman have been trumpeting their recession forecasts for the American economy. On the other hand, recent economic releases have largely been coming in ahead of expectations, which point to an economy with subpar growth, but no signs of a slowdown.

Should the US experience a recession, the S+P 500 could easily fall to the 900-1000 level, though it is unlikely to revisit the post-Lehman panic low of 666.


Watch out for China
I believe that the bear case for stocks rests largely with China and the emerging markets. I wrote on December 13 to watch for the China is slowing stories to emerge (see A "China is slowing" scare?). Whether China slows to a hard landing, i.e. sub-5% growth, or not is less relevant to the markets as the scenario of the markets starting to discount the possibility of a Chinese hard landing.

Since I wrote that post, the scare stories are starting to appear. Consider:
I could go on, but you get the idea. More worrying is the fact that other analysts are starting to pile on, not just the China is slowing story, but the prospect of slowing growth in the emerging markets. As an example, Stephen Roach recently penned an article entitled Why India is riskier than China.

I wrote here that the stock indices in India and China are not behaving well. I believe that the biggest risk for the stock markets is a rising level of risk aversion as investors price in the increasing likelihood of a slowing growth from the emerging market economies.


Listen to the markets
In the end, I stand with the bears on the recession, or economic slowdown, call. Commodity prices remain in a downtrend, which is a signal of slowing global demand for raw materials.


The CRB Index is liquidity weighted, which means that it is more energy heavy. As you can see below, oil prices have been behaving relatively well lately.


We can get a even better picture of global commodity demand from the Continuous Commodity Index, which is the CRB Index on an equal weighted basis. The picture of the CCI looks even worse than the CRB as it has undercut its October lows and remains in a well-defined downtrend.


As well, you can tell a lot about short-term direction by the way the market responds to news. In the past couple of weeks, we saw a couple of important signs that much of the good news is priced into stocks. The first occasion occurred when the market sold off in the aftermath of a better than expected LTRO at €489 billion. The second was when it sold off again when Italy sold six-month bills at yields that were roughly half of what they were in November.

When the markets go down on good news, the bulls should be wary. In addition, signs of a global slowdown are on the horizon.

That's why I stand with the bears.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Tuesday, December 27, 2011

A terrible 2011 for hedge funds

I started this blog four years ago and my first post was about how hedge fund returns have been correlated with stock returns. That correlation hasn’t changed.

That’s because hedge funds and stocks are all part of the risk trade. Hedge funds take risks and so do stock investors. In the current environment where the market oscillates between “risk-on” and “risk-off”, it’s not unexpected that hedge funds returns be correlated with stock returns. The chart below shows the returns of the HFRX Global Hedge Fund Index, which is a representative index of all investable hedge funds, compared to the S+P 500.



Even though hedge fund returns were correlated to the S+P 500, the above chart shows that they tended to be less volatile than the S+P 500. What that means is that when stock returns are down, hedge fund returns should be counted on to be down less and beat stock returns. In 2011, the chart below shows that they didn't and lagged the S+P 500 instead.



A funny thing happened in 2011. First of all, hedge funds had a terrible year as they substantially underperformed the S+P 500. On a year-to-date basis to December 16, 2011, the HFRX Global Hedge Fund Index was down -9.0% after fees compared to -1.3% for the S+P 500.

The negative performance occurred across the board. The chart below shows the YTD returns of the various HFRX sub-indices. The Global Index was down 9.0%, but every single category of hedge fund returns underperformed the S&P 500.



The poor performance of hedge funds in all categories is illustrative of the headwinds faced by active managers in 2011. Nothing worked!

Two categories that performed particularly poorly were directional strategies, namely Market Directional and Equity Hedge, which allowed a manager to go long or short. Fundamental Value was the laggard at -23.6% for the year.

The carnage in hedge fund performance can be seen anecdotally from the headlines. John Paulson's Advantage Plus flagship fund's performance through December 16 is down -9% in December and -52% on a YTD basis. Legends like George Soros exited the business of managing money to focus on his own funds. I could go on, but you get the idea.

I am working on a much longer post analyzing why hedge funds performed so poorly in 2011. More on than later.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Thursday, December 22, 2011

The ECB's non-party: What does it mean?

What happened? The ECB throws a party but no one shows up?

The size of ECB's LTRO was far ahead of expectations at €489 billion (see my previous discussion here). That should have been bullish, right? Instead:
  • The EURUSD exchange rate fell
  • Yields for Spanish and Italian debt rose across the yield curve
  • Shares of key troubled banks (SocGen, Credit Agricole, Comerzbank, Intesa and Unicredit) are mostly down on the day
  • European stocks retreat and US stocks retreated but rallied to finish the day roughly flat
Why?

There are a number of plausible explanations for the market reaction, but they could amount to little more than rationalizations. First, the EBA effectively nixed the carry trade by requiring banks to mark-to-market, so much of that €489 billion amounted to liquidity injections into the eurozone banking system. If the banks need that much liquidity, what could they be hiding? Or does this just show that the European banking system is just getting by on ECB life support?

Ambrose Evans-Prichard wrote that the size of yesterday's LTRO wasn't enough:
Roughly €300bn of today’s eagerly awaited LTRO tender is recycled old money from earlier support operations. The new money is €200bn. This alone is not going to shore up the sovereign states of southern Europe as they grind deeper into recession/depression.
He wrote that European banks need to shore up their Tier 1 capital base to the tune of "€2.5 trillion adjustment according to the BIS’s Global Stability Board". In addition, "Eurozone sovereigns must raise €1.6 trillion in 2012, and banks must raise another €700bn."


The LTRO was a liquidity injection operation that took a Lehman-like event off the table. Maybe the markets are now finally focusing on what typically matters, such as earnings, growth, interest rates, etc. and it didn't like what it saw? Indeed, Christine Lagarde of the IMF warned emerging market economies to prepare for a downtrun in Europe.

 
A glass half-full
Putting on my technician's hat, I would say it doesn't matter what the explanation or rationalization is. The market's inability to rally on good news, namely €489 billion in QE from the ECB, has to be interpreted bearishly.

When I look at the one-year charts of most markets, I see the charts mostly forming triangles indicating indecision. The direction of the next break will likely determine the next intermediate term move. This chart of ACWI representing the All-World Index is a typical example.
 
 
Going around the world, a similar pattern can be found in the US stock market:
 
 
..the UK market:
 
 
...and the European market:
 
 
 
A bearish tilt
There are clues of which way the market might break. Much the evidence points to a bearish break. For example, commodities are in a downtrend. If there was a triangle, they experienced a downward break in early or mid December:
 
 
Similarly, the yield on 10-year US Treasury note shows a similar pattern of a downtrend and break downward in early to mid December:
 
 
The commodity sensitive Canadian market is also not behaving well.
 
 
The Chinese market, as represented by the Shanghai Composite, has broken down decisively and is in a well-defined downtrend.
 
 
In sympathy, Hong Kong experienced a downside break in its triangle in the last week.
 
 
India isn't behaving well either.
 
 
The South Korean KOSPI experienced a downside break recently, but that could excused because it could be viewed as a special case of a market reaction to geopolitical tensions.
 
 
Bullish data points are few
To be sure, the picture isn't entirely bearish and there are a couple of bullish data points. The Brazilian market rallied above a downtrend line in October.
 
 
The Australian All-Ords Index is showing a similar pattern of broken downtrend and sideways consolidation.
 
 
Both Australia and Brazil are major supplier of resources to China. So these chart patterns must be regarded as somewhat supportive that a hard landing may not be in the cards for the Middle Kingdom.
 
However, the weight of the evidence suggests that while the trend breaks have not shown up definitively, the bias for the next intermediate term move is to the downside.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Tuesday, December 20, 2011

ECB's LTRO experience a cautionary tale for the Fed

The markets have been anticipating the onset of QE3 by the Federal Reserve. Indeed, Deutsche Bank believes that the market has already discounted $800 billion in QE3 purchases, which is anticipated to be concentrated in Mortgage Backed Securities (MBS).

Recall how the focus on MBS came about. QE2 involved $600 billion in the purchase of Treasuries, which pushed down the Treasury yield curve, flooded the system with liquidity and prompted investors to take more risk. The net effect of QE2 was to push up stock and commodity prices, but didn't do very much for the real economy. In effect, it found that it was pushing on a string. In response, the Fed wanted to concentrated on risk premiums where it mattered, such as mortgage rates, in order to stimulate the housing market. Thus the impetus for QE3 was born. Target MBS, it was said, and you will push down the cost of home ownership and stimulate housing.


Watch out for unintended consequences
The European Central Bank is currently conducting a Great Experiment with its LTRO (Long Term Repo Operation), where it is offering unlimited amounts of three year liquidity to banks, collateralized by paper with credit ratings as low as Single-A.

There was some hope that LTRO would prompt banks to put on the carry trade. Borrow from the ECB at 1%, buy PIIGS debt at 5% or more and earn the carry (see my discussion of LTRO here). The banks repair their balance sheets. The sovereigns get access to loans. Everybody wins!

The program has resulted in some unintended side-effects. Izabella Kaminska at FT Alphaville wrote that LTRO has created a two-tiered market for collateral and the two markets are diverging:
Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.

The crisis changed all of that.Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.


A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.

The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.

The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.

Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning.
Lead a bank to liquidity, but you can't make it lend
In other words, you take your junk lower quality paper to the ECB and you reserve your high quality collateral (e.g. bunds) for the private repo market. The problem is that the private repo market continues to seize up because of a lack of high quality collateral and a rising sense of risk aversion over counterparty risk, i.e. you don't trust that you are going to get paid back so you demand really, really good collateral.

No matter how the ECB steps in to inject liquidity into *ahem* second-tier debt market, Kaminska wrote that the market has lost confidence and there is little the ECB can do [emphasis added]:
Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.

But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.
The ECB's experience with LTRO should be a cautionary tale for the Fed as it considers a QE3 program of purchasing MBS. You can lead a market to liquidity, but you can't make lenders lend and borrowers borrow.

Beware of unintended effects, Mr. Bernanke.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Monday, December 19, 2011

The bull case for stocks

I have been quite bearish in these pages lately. As an antidote and to help me think critically, I outline what could go right for the markets in 2012, along with the risks:
  • The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
  • In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
  • In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.
Global central bankers are worried
The coordinated central bank actions of November 30 to inject liquidity into the global banking system shows that central bankers are worried. No doubt, they learned from 2008. In the short term, liquidity ensures that a major bank failure or Lehman-like failure in the shadow banking systems is off the table and will not bring the global financial system down in a market crash.

Key Risk: The system isn't totally healed. These actions just bought some time for the politicians to act. Indeed, Bloomberg reported that Ben Bernanke, in a closed-door briefing to Republican senators, made it clear that there are limits to Fed policy and it doesn't intend to bail out European banks.

In addition, Bank of Canada head Mark Carney said in an unusually frank speech that the world is in a period of deleveraging. The road ahead is hard and the risks are still high:
The Global Minsky Moment Has Arrived
Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it.

Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full.

While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter.

Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation.

It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage—the situation that got us into this mess in the first place.

The Fed does QE3
Could the Fed still save the equity markets in 2012? Cardiff Garcia of FT Alphaville pointed out this analysis from SocGen showing that the composition of the FOMC is going to turn far more dovish in January 2012.


On that same point, Bloomberg reported on November 29 that vice-chair Janet Yellen that the Fed has the scope for additional asset purchases (read: QE3):
“The Federal Reserve has some scope for action,” Yellen said today. “We are actively considering methods that we could use to provide greater clarity” on the central bank’s pledge to keep rates low through at least mid-2013, and new purchases have the potential to “flatten the yield curve.”
Central banker statements are very measured. Yellen's speech about additional purchases is a definitely signal that QE3 is coming.

Key Risks: We are now in a world of bad news is good news for the markets and good news is bad news. Economic growth has to show that it is indeed deteriorating before the Fed can act. The calls by the likes of ECRI and John Hussman for a recession have to be wrong. The high frequency data is showing the economy is definitely not keeling over. Assuming that ECRI is right, when will the data be convincing for the Fed to act? Would a two month extension of the payroll tax cut for two months just extend the pain?

Moreover, this chart from Scott Grannis shows inflationary expectations are still stubbornly high and rising. The Fed is unlikely to undertake QE3 unless inflationary expectations (and not just inflation) remain elevated.



The Sarko carry trade saves Europe?
Students of market history will recall the policy of forebearance that saved the US banking system during the LDC (Less Developed Country) loan crisis of the early 1980's. After the banks lent to all manner of LDCs that went bust, the authorities pretended that the loans that were on the banks' books remained good for 100 cents on the dollar. At the same time, the Fed began to lower rates in August 1982 and signaled to the banks that they would continue to stay low or continue to fall. Thus, the banks could borrow short and lend long, which repaired their balance sheets over time.
 
The ECB's long term repo operation (LTRO) announced on December 8 did just that. The ECB announced that it would provide unlimited amounts of liquidity via LTRO and relaxed the collateral requirement for LTRO all the way down to anything rated single-A. Nudge-nudge-wink-wink. If you are a troubled bank, you can bring your *cough* junk, borrow from the ECB for up to three years at 1%, put it into Spanish or Italian debt at 5-6% and earn the spread. If you used leverage, it wouldn't take long for you to repair your balance sheet.
 
This prompted Nicolas Sarkozy to say that banks could then finance their own country's debt, which prompted some observers to dub this forebearance trade the "Sarko trade":
French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds. “This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.
The ECB is precluded by mandate from lending directly to sovereigns. LTRO is a backdoor way of doing QE by lending to the banks which then lend to the sovereigns - and the amount is unlimited! It kills two birds with one stone. It repairs banking balance sheets and addresses the solvency problem and it allows sovereigns access to the markets.
 
Key risks: This is another one of those European plans that sound good in theory but the devil is in the details. First of all, Simone Foxman reports that even though the ECB will take single-A paper as collateral for LTRO, it will require a haircut for lower grade paper inasmuch as it will not lend 100 cents on the euro for lower grade debt:
The details of how the ECB means to relax collateral have not yet been released. The Bank currently accepts collateral rated as low as A-, although debtors must pay a penalty based on asset risk. Were even riskier assets allowed to be used as collateral or if the penalty were dropped, this would provide significant incentive for banks to purchase sovereign debt, particularly given currently high yields on bonds. If it worked, it would be the ultimate carry trade—borrowing from the ECB is now a cheap 1%, so banks could see huge returns on sovereign debts with high yields.
Supposing that a bank uses the LTRO facility and puts up Spanish paper as collateral. Soon afterwards, Spain is downgraded by the rating agencies. Under the terms of the facility, the ECB would ask the bank to put up additional collateral as a "margin call" because of the credit downgrade.

Second, one of the legs of the policy of forebearance is to allow banks to carry doubtful debt at book value and market it to market. If they were the required to mark-to-market, then the bank could be deemed insolvent and would either need to be liquidated, merged with a stronger partner or nationalized. The European Banking Authority (EBA) has recently become progressive tougher on European banks in its stress tests and began to raise its standards from a ridiculously low level (recall that Dexia was declared healthy with a Tier 1 capital ratio of 12% just before it imploded).

The EBA stands in the way of this forebearnce trade. Will the EBA play ball? Can Berlin and Paris twist enough arms at the EBA to get them to come onside?

Third, there is the matter of prudence for bank management, a point that Felix Salmon raised when he wrote that it wouldn't work. This is an all-in bet-the-farm trade for any bank who wishes to undertake the carry trade of tapping LTRO to buy sovereign debt. If this works, you make a ton of money and your bank is fine. If it doesn't, your bank is bankrupt. Here are some key quotes from European bankers:
“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.
From my viewpoint, the most important technical consideration for the "Sarko trade" to work is the cooperation of the EBA. It will have to happen in very large scale for it to have an impact. I wrote last week that if you put "all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP." That's a lot of money.

Moreover, the "Sarko trade" will only work if there are no accidents along the way. There are some key elections coming up in 2012, namely Greece, Italy, Finland and France. In particular, will the new governments in Greece and Italy cooperate with the EU? How badly will austerity bite in eurozone? Can they prevent a European bank failure despite their best efforts? If not, would its effects cascade through the banking system? What about China, will it avoid a hard landing?

That's the trouble with the all-in bet-the-farm trade, if it goes wrong (and plenty of things can go wrong), you're dead.


Many moving parts to the bull case
In conclusion, there are many moving parts to the bull case. For stocks to stage a significant rally, I believe that two material things have to happen:
  • The US economy and inflationary expectaions have to weaken sufficiently for the Fed to underatke QE3.
  • The EBA has turn a blind eye and moderate its mark to market rules for bank debt.
Market analysis isn't just about having a single view, but about scenario analysis and the assessment of the probability of those scenarios. How you decide about the likelihood of these events will determine whether you are a bull or a bear.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Friday, December 16, 2011

Are Treasury bonds a crowded long?

How crowded is the long Treasury trade? Anecdotal evidence suggests that the trade is becoming a crowded long. Ed Yardeni recently wrote:
Last week in Kansas City, one of our long-only accounts was especially concerned that the Endgame scenario is upon us. We discussed the best way to preserve capital in such a calamitous environment. The conclusion was to load up on the US dollar and US Treasury bonds, the scenario that seems to be working so far this week.

What does the data show?
Let's go to the data. Global Macro Monitor showed this chart of who is funding the US deficit. While the latest data shows that there are certain a lot of fund flows into US Treasuries from domestic and international investors, levels are similar to levels seen in 1Q 2010 and below the panic levels seen in the 3Q and 4Q of 2008.


What about hedge funds? These charts from Mary Ann Bartels of BoA/Merrill Lynch shows that large speculators, or hedge funds, are nowhere near a crowded long in the long bond.



What about the 10-year note? This chart shows that while large speculators have been buying the 10-year note, they are also nowhere near a crowded long.


This chart below shows the relative performance of the 30-year Treasury ETF against SPY. Again, it shows that while long bond returns are somewhat stretched relative to equities, relative performance levels are similar to the levels seen during the Summer of 2010 and far below the end-of-the-world levels of the Lehman Crisis.


Conclusion: While investors may be rushing into US Treasuries, the safety trade is nowhere near a crowded long, which indicates that risk-off trade has more room run.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Tuesday, December 13, 2011

A "China is slowing" scare?

It's been a while since we've had a "China is slowing" scare, but we may be due for one. The chart of the Shanghai Composite shows that the index violated a key support level last night, which is an indicator of heightened stress.


The chart of the Hang Seng Index also shows that it violated a key support level in September and attempted a failed rally above the support-turned-resistance line. The index is now testing the bottom of a triangle formation, while investors wait for either an upside or downside breakout as an indicator of near-term direction.



China's deflating property bubble
Much of the stress comes from the faltering property market in China. The Los Angeles Times reports that China's housing bubble is losing air:
Home prices nationwide declined in November for the third straight month, according to an index of values in 100 major cities compiled by the China Index Academy, an independent real estate firm. Average prices in the Shanghai area are down about 40% from their peak in mid-2009, to about $176,000 for a 1,000-square-foot home.

Sales have plummeted. In Beijing, nearly two years' worth of inventory is clogging the market, and more than 1,000 real estate agencies have closed this year. Developers who once pre-sold housing projects within hours are growing desperate. A real estate company in the eastern city of Wenzhou is offering to throw in a new BMW with a home purchase.
Patrick Chovanec, professor at Tsinghua University's School of Economics and Management in Beijing, echoed the accounts about deflating housing bubble:
According to the China Real Estate Index, published by Soufun.com, the average primary market housing price across China’s top 100 cities dropped for the third month in a row in November, by 0.3% month-on-month, with prices in 43 cities still rising and 57 cities falling. However, other real estate agencies reported steeper drops in specific locations. Homelink said that in November alone, primary market prices in Beijing dropped 35% month-on-month, and industry sources told the Legal Evening Post they dropped 16.8% week-on-week in the last week of November, down 29% year-on-year. According to Caijing magazine, Beijing home sales volume (by area) in the first 11 months of 2011 was down 27% year-on-year, to a 10-year record low. A similar fall-off was evident in commercial as well as residential real estate. According to the Beijing Morning Post, sales volume for retail and office space in the capital dropped 18% and 7.4% respectively in October, month-on-month. Homelink’s chief Beijing analyst, Zhang Yue, told the paper he saw a growing supply glut developing.

The downturn was not limited to Beijing. Dooioo, another agency, said that primary housing sales volumes in Shanghai are the worst since 2006, while Chinese Business News reported that in Shenzhen, primary prices were down 10.7% and transactions down 11.3% week-on-week in the last week of November. Business China also reported a drastic drop in sales, despite generous discounting.
Chovanec writes that how the market behaves from now on will be a test of Chinese investor confidence in the property market, largely because property purchases are often fully paid for in cash with no leverage and represent a source of savings for individuals [emphasis added]:
How investors in the secondary market will react to the collapse in primary market prices is the biggest question of all. As I’ve mentioned many times, many people in China buy multiple units of housing in order to hold them empty indefinitely, as a form of savings. They do this because they have few attractive alternatives and because they have faith that housing prices will go up. Since many have paid cash, they aren’t under the same immediate pressure to sell as developers. But they do tend to look to rising primary market prices for assurance that their investments are profitable and safe, and now those prices are now plummeting. A great deal depends on whether they hunker down to weather the storm, or join the fire sale.

He does caution, however, that even though many apartments are paid for in cash, there may be other forms of leverage in property purchases. Depending on how pervasive the level of financial leverage, sales could create a cascade of falling Chinese property prices.
Beijing-based blogger Bill Bishop recently related the story of an email he received, which makes equally interesting reading. It came from a real estate agent representing a condo owner in one of the city’s top apartment buildings, in the Central Business District (CBD). Although he had no mortgage, and owned the unit outright, he was desperate to sell in order to raise RMB 20 million for his business. So it’s worth keeping in mind that, while many Chinese investors may not be directly leveraged on their real estate investments, given the credit explosion that has driven the Chinese economy these past few years, they may be highly leveraged in their business or other ways that could turn them into distressed sellers.


Watch for "China is slowing" stories
As the world has focused primarily on Europe and secondarily on the United States, my sense is that the consensus is that China will escape a hard landing. While I am of the belief that China should survive the next economic downturn in relatively good shape, stories like these will serve to heighten investors' sense of emerging market risk. In addition, we are seeing stories about India slowing as well.
Should European or American economies get into serious trouble in the months to come, there may not be any place to hide.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Monday, December 12, 2011

Will S&P downgrade Europe?

Last week, Standard and Poor's warned the 15 EMU sovereigns that they may be downgraded. They expected "review of eurozone sovereign ratings as soon as possible following the EU summit scheduled for Dec. 8 and 9, 2011". They went on to state:
Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.
Now that the EU Summit has come and gone, what now?


The effects of the "fiscal compact"
I did some projections and assumed a number of problems of the latest "fiscal compact" away, such as the difficulties of treaty ratification, specification of enforcement mechanisms, etc. Using this handy tool from the Economist, I projected a probable path for selected eurozone countries. The blue line represents the base case estimates from the IMF and the red line are my revised assumptions. Since the latest "fiscal compact" amounts to nothing less than an austerity club, I made the following rather conservative changes to IMF assumptions to account for the more immediate fiscal tightening effects of austerity programs:
  • Growth slows by 0.5%
  • Inflation slows by 0.5%
  • Primary budget balance is reduced by 0.2%, which is also a side effect of austerity measures
  • Interest rate is the average of the current 5 and 10 year bond yield for that country
The results aren't pretty. Consider Spain, a Club Med country. Debt to GDP is project to spiral upwards, worse than the base case estimate from the IMF (blue=oringal IMF assumptions, red="fiscal compact"):


What about Portugal? The only silver lining is that things don't deteriorate as badly as Spain under these assumptions.


Italy, the biggest Club Med country of all, doesn't fare all that well either as its debt to GDP gets out of control rather quickly. The problem of Italy lays the groundwork for another eurozone crisis in the near future.


What about France? Oh, dear! It looks like Sarkozy is likely to lose his precious AAA credit rating.


The only question at this point is whether it will be one or two notches. This chart below compares the France under my new projections with the United States under IMF's base case projections. At least the French are outperforming the Americans...



The only country that fares reasonably well under these revised assumptions is Germany, whose debt to GDP ratio continues to contract. Even then, its deficit to GDP measure won't be below the magic 60% target, which would suggest further fiscal tightening under the terms of the "fiscal compact".


This analysis indicates that the fiscal balance of major eurozone countries will deteriorate under the terms of the new "fiscal compact", which leads to the conclusion that a wholesale downgrade of many eurozone sovereigns is very likely.


Setting the stage for another debt crisis
The next question for me was, "How much more risk would a credit downgrade introduce to the eurozone?"

Using this data from Jason Voss of the CFA Institute, I constructed a spreadsheet for the likely rollover of debt in 2012 of selected eurozone countries as a measure of the degree of funding stress they may have to undergo. (All amounts are in billions of euros.)

In his article, Voss showed the likely rollover of debt as a percentage of GDP for all eurozone countries. I then went to the IMF website and looked up the projected 2012 GDP by country to calculate the projected rollover figure for 2012. Italy is one of the more problematical as it is scheduled to rollover over €300 billion in 2012 (even this estimate may be low as others have cited a figure of €440 billion). Surprisingly, France will need to come to market with nearly €400 billion and the German rollover comes close to €600 billion.

If you include all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP. Supposing that we assume that Germany will have no trouble rolling its debt and excluded her from 2012 financing needs, then the eurozone debt market will see roughly €1.2 trillion in sovereign debt issues - an astoundingly large number. The PIIGS alone will need to finance about €700 billion next year.

These are very large numbers. Given that European banks are in the process of shrinking their balance sheets, which will reduce their appetite for sovereign paper, where will the money come from? The combination of EFSF and ESM? But the funding for the EFSF and ESM come from the eurozone sovereigns. Can they loan money to themselves?

What about the IMF? There was some discussion that some sovereigns, e.g. Germany, could lend to the IMF, which when then lend it back to troubled European country, e.g. Italy. However, the total amount of that facility amounted to €200 billion.

The size of the ESM, EFSF and new IMF facility is simply not enough. It's like sending out a riot squad of 10 police officers with helmets and batons to face an angry mob of a thousand people. If the mob stampedes, the results won't be pretty.

What about the ECB? Mario Draghi made it clear that the ECB would cap bond purchases to €2 billion a week (when actual recent purchases have amounted to roughly €1 billion a week). The total cap adds to about €1 trillion a year, which could be a big bazooka if it was un-sterilized. However, such intervention would be sterilized, which begs the question of where the money to buy the ECB's sterilized paper would come from.

This analysis tells me to be prepared for more volatility and crisis summits in 2012, if not before.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Sunday, December 11, 2011

Is the eurozone banking system about to collapse?

The Telegraph sounded alarm bells late Friday that the Eurozone banking system [is] on the edge of collapse. Specifically, the problem is related to a lack of acceptable collateral, or "collateral crunch", for overnight and other short-term bank funding [emphasis added]:
Senior analysts and traders warned of impending bank failures as a summit intended to solve the European crisis failed to deliver a solution that eased concerns over bank funding.
 
The European Central Bank admitted it had held meetings about providing emergency funding to the region's struggling banks, however City figures said a "collateral crunch" was looming.

"If anyone thinks things are getting better then they simply don't understand how severe the problems are. I think a major bank could fail within weeks," said one London-based executive at a major global bank.

Many banks, including some French, Italian and Spanish lenders, have already run out of many of the acceptable forms of collateral such as US Treasuries and other liquid securities used to finance short-term loans and have been forced to resort to lending out their gold reserves to maintain access to dollar funding.
The eurozone banking system is paralyzed by counterparty fears risk, where banks would rather park their excess funds with the ECB instead of lending to each other:
Bank deposits with the ECB now stand at their highest level since June 2010 at €905bn (£772bn) as lenders withdraw deposits held with their peers and put them into the central bank. At the same time, banks in major eurozone countries such as France and Italy have become increasingly reliant on central bank funding. This follows the trend seen in smaller countries like Ireland where lenders have effectively becomes taxpayer-funded "zombie" banks.


The Bundesbank is running out of money
Izabella Kaminska at FT Alphaville has was on this story early and she has covered it well. She wrote that the problem is becoming so acute that even the Bundesbank is running out of money. She explains that the ECB isn't a single central bank, but a collection of central banks [emphasis added]:
While policy is decided centrally, actual enforcement and implementation of that policy is conducted on a national central bank (NCB) level.

That means every NCB is in charge of providing liquidity to its own particular market. The Irish NCB’s routine distribution of emergency liquidity assistance (ELAs) on a near enough unilateral basis (there’s only the need to notify central command in Frankfurt) is a good example of how the system works.

All payment surpluses and deficits created as a result of these unilateral NCB processes are then balanced out via the so-called Target2 system (Trans-European Automated Real-time Gross settlement Express Transfer system).

Generally speaking, the system ensures that all NCBs carrying surpluses channel them over to NCBs carrying deficits.

The problem is that since the crisis unfolded, the number of NCBs handling deficits has started to outnumber the number of NCBs holding surpluses. One particular NCB — the Bundesbank — has become the key provider of funds to the whole eurosystem.
She pointed to a blog post at VoxEU which summarized Bundesbank's problem [emphasis added]:
In order to fund these loans, the Bundesbank sold its holdings of German assets. Asshown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion. In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action.
The Bundesbank having to sell its gold to fund banking liquidity??? That will make Merkel sit up and take notice.


An acute collateral crunch
Kaminska explained the collateral crunch problem in ECB as Pawnbroker of Last Resort:
While soaring Libor rates were a key indicator of market stress during the credit crunch, the best indicator of collateral crunch intensity is instead the repo rate. The lower the rate, the greater the crunch.

The wider the spread between Libor and the secured (repo) rate, the greater the general distress in the market. The following chart reveals just how good an indicator of general market stress it is:
 
Also see What the repo markets *want* the ECB to do, specifically the ECB's policy of requiring different levels of haircut for different kinds of collateral:
[W]hile the ECB’s haircut policy might have been seen as prudent at the time, in a single monetary union — where markets are already reflecting preferences for certain types of Eurozone debt — having the ECB treat government collateral differently only intensifes the phenomenon.

The ECB should, by all definitions, treat all government debt the same.
While some of the technical steps the ECB took last week took some pressure of the money markets, they weren't enough. See Nomura on Draghi’s failure to address the collateral problem. Kaminska wrote that bank funding has a greater effect on the perception of the European sovereign solvency [emphasis added]:
[T]here are many reasons to think that the trend towards ‘quality’ collateralised funding is having as much of an impact on the valuation of bonds in both private and central bank funding markets, as the perception that European sovereigns might be insolvent.
This has the makings of a Lehman moment for the European banking system. Here are some of the signs of a imminent bank collapse. First, I would continue to watch for signs of stress in the money market, such as the LIBOR vs. the secured (repo) spread. For investors without access to Bloomberg and other services with money market data, here is a quick and dirty way of watching for signs of rising stress in the banking system.
 
 
The Four Horsemen of the Euro Banking Apocalypse
Watch the stocks of stressed banks. There are four that appear to be under severe stress from a list that I detailed previously here. The first is Commerzbank, which has already undercut its Lehman Crisis 2009 lows and is in the prospect of testing its recent lows as another support level. If that low doesn't hold, then that may be one of the first Signs of the European Banking Apocalypse.
 
 
I would also watch the shares of Credit Agricole, which has also been subject to rumors of severe banking problems.
 
 
Societe Generale, another French bank, has also been the subject of insolvency rumors. In all cases, these banks have undercut their 2009 lows in 2011, but SocGen shares have managed to rally above that level.
 
 
The last one to watch is the shares of Intesa, the Italian bank:
 
 
In all these cases, the shares have fallen below their 2009 Lehman Crisis lows in 2011. In all but one, they are in the process of testing the 2011 lows as the final support - a sort of final trip-wire to a European banking crisis. As many of these stocks trade in ADR form in the US, many of my American may be tempted to monitor the performance of the ADR instead. I would recommend that you watch the euro-denominated price as that is more liquid and I have provided the Yahoo finance link to those prices.
 
There are a number of other troubled bank stocks to watch, but these have not undercut their 2009 lows. In no particular order, these include the Royal Bank of Scotland, KBC, Unicredit, BNP Paribas and Banco Santander.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Thursday, December 8, 2011

Forcing the heart attack victim on the treadmill

In a previous post*, I used the analogy of Europe as a heart attack patient:
Imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.
If the ECB was supposed to be the Emergency Room doctor, then yesterday's decision by Mario Draghi to rule out further bond purchases was like throwing the patient out on the street with instructions of "take an aspirin and call me in the morning."
 
What's more, the patient's family then gathered around to berate him for his bad habits over the years and forced him to get on the treadmill (the latest Grand Plan for greater fiscal integration) in order to lose weight and improve his health.
 
 
Heart attack time?
The markets promptly responded and Italian 10 year yields shot up an astounding 47 bps.
 
 
European stocks took a similar pounding in the wake of the news:
 
Euro STOXX 50
 
 
Fiscal policy does the heavy lifting
Instead of a combination of fiscal and monetary policy to save the eurozone, we now have to rely purely on fiscal policy. Will a new Brussels-on-the-Rhine, even if it were to be ratified by the eurozone governments, be able to do such heavy lifting without plunging Europe and the rest of the world into a deep recession?
 
There is a tool from The Economist that allows a user to specify economic assumptions, i.e. GDP growth, budget balance, interest rates and inflation, for a country's to see what is needed to stabilize national debt-to-GDP ratios. When I played around with it, getting from A to B looks a tough task once you assume the recessionary effects the combination of an austerity program and credit crunch. (If the tool below doesn't work, try this link instead).
 


The markets had been focused on ECB action to buy the eurocrats some time to fix the long-term problems. Now, we have a credit and liquidity squeeze occurring in the European banking system that is technically insolvent. These issues need to get addressed now.

As I write these words late Thursday night, it appears that the latest Grand Plan is already falling apart. Maybe Merkozy and the eurocrats can pull a rabbit out of the hat, but I am not optimistic.
The markets are going to take this very, very badly.




* In the past, I mistakenly referred to the December 9 EU Summit as the Marseilles summit. It is being held in Brussels. I apologize for the error.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.