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.

1 comment:

Tiho said...

This is great post. Now your sounding like you are on the right track.

On top of that, every man and his dog is now betting against the Euro and sitting in Treasuries. They will be flushed out soon enough...

I'm not bullish because the new is good, I am bullish because the news is bad and I have to be a contrarian. That is precisely what you also stated.

I finally agree!