Pensions. Auctions. Banks.

Pensions

Well, well, well. I have given a couple of presentations in Copenhagen and Stockholm about the Euro crisis. One of my points is that the current situation regarding government finances also has a lot to do with the fact that Europe’s baby boomers are retiring in large numbers these years. It has been pre-programmed for years (about 60 years to be specific) but politicians have too short an attention span to focus on it. Now the story has been picked up by Bloomberg. Chapeau!

It goes to confirm that we have a number of different problems occurring at the same time: Debt cycle reversal, cyclical slowdown, badly capitalised banks, inadequate institutional design in Europe, and the pension squeeze. If anybody wants to receive the slides from my presentation, let me know.

Auctions

Tomorrow and Friday Spain and Italy will sell up to 22bn of short and medium term bonds. The yields in that part of the yield curve have dropped sharply since the beginning of December, meaning that the refinancing costs will not increase as dramatically as the markets believed just 3 months ago. In fact, the refinancing costs are far from being bad.

So I cannot understand why the headlines continue to focus so much on the 10-year yields?? They have been volatile but on average moving sideways for three months. Why is it that the headlines need to focus on that as a sign of impending disaster when things are getting better in the auctions? Sensationalism!

I wrote in November that place to watch is exactly the Spanish and Italian bond auctions. As long as those two countries can issue all the bonds they need at reasonable yields, we do not have a real euro-crisis. We may still have a crisis, but it is not one driven by the euro.

If it were to happen that those two countries cannot refinance their debts or that the yields they would pay increased to a point where they cannot stabilise their debt/GDP ratio, we should all head for the hills.

Banks - again

As the pressure is easing on the euro and the sovereigns, it mounts on the European banks. Presumably, The ECB saw the 3-year loans to banks as a way of helping the banks to buy some government bonds from Spain/Italy. It has worked. But now it appears that the banks also want to use that money to refinance some of their own bond issues. It is another sign that the region’s banks prefer to solve their lack of Tier 1 capital by shrinking their balances.

They prefer to shrink their activities instead of raising new capital. UniCredito’s bungled rights issue is certain to scare other banks from trying the same.

It will only undermine Europe’s growth if the current credit shortage continues. At some point in time politicians will have to understand that the banks do not play along as long as it is not in the interest of their management and/or their shareholders. With an essentially insolvent bank sector, I cannot understand that European politicians do not begin to use some muscle. The banks are already dependent on government support in one form or another. This is the moment to seize and to force fundamental changes. The Swedish experience from the ‘90s still beckons as a good example.

The quote “Once You Got Them By The Balls, Their Hearts and Minds Will Follow” is ascribed to Teddy Roosevelt. Barack Obama missed his moment in 2009. Europe, anyone?

Euro growth. US Data. New kind of risk. Euro down

Economic data from the Euro-zone

Rather bad data from the Euro-zone were published on Thursday and Friday. Retail sales fell by 0.8 per cent in November and economic (consumer) sentiment fell half a per cent in December while business sentiment has been picking up. Unemployment rose by 45,000 in November. Even if the numbers are the most recent, they are not up to date, and that is important for understanding them. Inflation continued to fall.

I do not think that those numbers are harbingers of harder times ahead. But they are a confirmation that the Euro-zone stalled sharply in Q4, fully in line with our claim that the maximum downward pressure is just behind us. We will still see bad numbers in Q1 but they will not fall as sharply as in Q4 and a stabilisation will be visible around the turn of Q1-Q2.

It means that I am not in line with those who only now begin to forecast a European recession. They are too late. The recession is a fact. The next game in town is to figure out when the recovery will begin, however anaemic.

While we think of that one, it is worthwhile remembering that the financial markets react to perceived changes in trends and growth. For those who still remember their high school math, it is not the first derivative (growth rates, inflation) that are interesting, it is the second derivative.

Economic data from the US

The US entered the “soft patch” at the end of Q1 2010. In August, when the stock market found out, the economy was about to move on. It stabilised in Q4 and is now in recovery. Even that most unreliable of American indicators, unemployment, is falling (just in time to improve Obama’s possibilities of being re-elected?). It is in line with our forecast from August and so far we see no signs of that recovery faltering.

A new kind of risk

What a joy to work in a profession that is so flexible as to invent new terms when the old ones are not any longer adequate. After having complied with European standards when writing the prospectus for out new fund (Origo Total Return Fund), I thought I knew every kind of risk relevant  to the financial markets. But no. Now there is a new one that has established itself over the past months. It is called “Headline Risk”.

Don’t try to find it on Wikipedia - it is not there (even if Investopedia has an entry). It simply covers the situation that occurs when market participants show up in the office and a headline carries news about a story that the said market participants did not even know existed. How did we manage before we invented Headline Risk?

Euro is falling

Personally I am happy about the “Headline Risk” undermining the Euro. I see that some strategists now predict a collapse to the region of 1.25 against dollar. Wow. Let us get that euro weakened so the Euro-zone can regain some of that growth that went to other regions as the Euro strengthened because the ECB was slower out of the starting blocks than other central banks. 1.00 against USD would be a huge advantage for our exports.

Boring. Economists. Hungary.

Yesterday I found that the US and the European markets were sort of boring. The stories of the impending collapse of the world as we know it are not really having a lot of traction and it tends to reduce volatility quite a bit. There was a French 10-year auction which drew “better-than-feared” demand and the 10-year yield only rose a few basis points. Spanish and Italian bond yields had increased and they fell as the French auction did well. All very normal, and while not headline stuff, quite important. As long as we do not have hiccups we remain on course for a revaluation of risk assets. Origo’s risk indicators continue to improve.

Geopolitical choking point

Do not underestimate the potential trouble brewing in the Strait of Hormuz. 40% the world’s oil (traded) supplies pass through this narrow straight. The place has for years been recognised as a major “choke point” in case of international crisis (the other main choke point is the Strait of Malacca). We are less than one year from the completion of a major pipeline that would dramatically reduce the importance of the Hormuz, since oil tankers would not any longer need to pass there in order to load up with oil.

So now  Iran is trying to use a last chance to threaten the Western world with closing the Hormuz. The purpose is to blackmail USA and Europe into lifting a trade embargo on Iran, imposed because of Iran’s nuclear ambitions. Major preparations for a confrontation is already on its way. Iran will likely try to use “swarming” with small, light vessels that will hard to catch by the US Fifth Fleet, based in Bahrain. Iran may also mine the Strait. The US, on the other hand, is apparently preparing a drone defence. This could accelerate in a very nasty fashion, particularly as both Iran and the USA have serious geopolitical interests at stake.

I will not guess how much oil prices could increase. But it would be enough to slow down growth here.

Economists and money

The American Economic Association has published new ethics guidelines for academic economists. AEA is the association of research economists in the USA and has hosts of foreign members, too.

Now this venerable institution demands that its members disclose their economic interests when writing academic articles. That is good news, since economists have a tendency to pass off their points of view as science, even when they are highly politically charged. About time, one could say, since financial analysts have had to comply with similar rules for years.

Personally, I am more worried that one of the best sites for jokes about economists has been closed. Where will we now go to find wise words like these?:

There are two types of economists:

- those who cannot forecast interest rates, and

- those who do not know that they cannot forecast interest rates.

Hungarian Horntails

Hungary’s conservative government has taken some major steps in a rather worrying direction. Having won a 2/3 majority in parliament, the government has fired the president of the supreme court and announced a constitutional reform that appears to reduce the protection of civil liberties. That kind of stuff is usually not the worry of the financial markets.

But the Hungarian government also wants to reduce the independence of its central bank by granting the government the right to hire and fire the bank’s council almost at will. That has brought the EU Commission and IMF out of their seats. Hungary received emergency loans three years ago and asked for a second bail-out in November 2011. IMF and the EU Commission appear ready to withhold the help unless Hungary guarantees the independence of the central bank.

If this situation ends in a stalemate we may well have a Hungarian government default. Since Hungary is not in the Euro, it should not affect the markets. Unless of course, foreign (ie. EU) banks holding Hungarian debt have not yet made provisions.

Back to Normal. Weaker Euro. Risk Rally

Back to normality?

It's boring out there. And it is perhaps the best piece of news in a long time. After reaching a crescendo in early December, the amount of headlines dealing with the euro crisis is now in a clear decline. I choose to take it as a sign that the ECB's three-year money has stabilised both inter-bank market and the demand for government bonds from Italy and Spain.

More bad news is certainly still possible. As an example, I expect that a major European bank or two will go belly up, as no decisive action is yet taken at a European level to clean up the banking sector. But a collapse or two is probably already built into the soaring risk premiums in financial sector shares. It is more and more urgent to get EFSF and ESM up and running.

A weak euro is a strong euro

I have always wondered a little about the media fixation on the positives of having a strong currency. It smells so badly of Neanderthal nationalist policies (or of man-talk in the locker room), especially when looking at the headlines in recent months. As if it was negative to have a weaker euro!

Since the beginning of the crisis, several countries have profited from a weakening of the currency: USD, GBP, NOK, and especially the SEC. These countries all have central banks and finance ministries able to act quickly. The Euro-zone's institutions were too slow and the result was that the euro strengthened, together with CHF and JPY. This moved growth from the Euro-zone to the countries with weaker currencies. So I can only see it as good news if the EUR / USD were to trade at par. It has been there before, and it was not the end of the world. (My colleague Frank Jensen says: “It will be no surprise if EUR strengthens in the short term as a result of short-covering”. Go figure!)

Back in 1992 we saw the last major crisis in the European Exchange Rate Mechanism, when GBP fell out of the ERM and we had a wave of devaluations against the Deutschmark. Italy devalued by almost 30 percent. That crisis began with a dramatic weakening of the dollar, and it revealed the tensions in Europe. The current euro crisis is similar to the situation at the time - but now we do not have devaluations as a means to remove those tensions. A weakening of the euro will reduce tensions significantly.

Risk Rally

New Year has brought the traditional amount of forecasts for this and that. Obscurity will mercifully descend upon most of them. So let me give my own anti-forecast: If we are moving towards a normalisation of the conditions in Europe, and if risk premiums have finally stabilised, there will be room for a significant shift in the relative prices of the different classes of risk assets. Some will rise dramatically (shares? Bank shares?), while some will fall with a bang (Bunds, T-bonds?). It could conceivably happen in 2012. There are just 241 things that need to be in place first.

Santa is finally coming to town?

ECB and the stock markets

The story I told on Monday appears to be gaining momentum. ECB announced new measures on 7 December and now the stock markets have finally picked it up. The combination of unlimited loans from the ECB and a “guarantee” from EU on government bonds has caused a stampede into short European short-term bonds, including those issued by Spain and Italy.

This is indeed very helpful in covering the short term financing needs of the European countries. And it gives the banks a healthy yield pickup, giving them a stealth, tax-payer financed contribution towards rebuilding their capital base. Wednesday’s opening of the ECB facility will give an important pointer. If the banks take upwards of EUR 250bn, it will be deemed a success and the current Santa rally can continue. Downwards of EUR 100bn will be interpreted as a failure.

I have for some time held the conviction that everything we know about pricing of risk is off the table for the moment. Except of course that bonds with a guarantee should trade at a lower yield than those without a “guarantee”. Go figure.

It is interesting that nobody really noticed ECB’s new initiatives when they were introduced. Instead markets took a great interest in guessing about the imminent Euro-zone breakup.

But heed this warning: If – and it is still a big IF – this re-evaluation of the risk situation continues to gain momentum, we are likely to see a major setback in the two kinds of assets that are the most overvalued or overbought or whatever: US T-bonds and German Bunds.

While gains in the stock market may be fun to look at, the sheer volume of the bond holdings of this world means that you should not take the eye off that ball.

Stocks are for show, but bonds are for dough – as we say on the golf course.

Positive data

Stock markets were helped by positive economic data. German business sentiment data came in strong and a report confirmed that the US construction sector is improving. Last week a rather dubious labour market report also told that the US economy is beginning to add jobs.

That the US economy continues to surprise to the upside is fully in line with Origo’s view that a rebound was due in Q4. The German data are not entirely in line with our rather gloomy view on the European situation. However, in all fairness, we are beginning to see indications that the downturn in Europe may be losing momentum.

US Banks

Somebody stole the punch bowl right under the nose of the US banks, just as a rally in bank stocks was about to take off yesterday. Rumours had it that even the US regulators are serious about demanding higher capital ratios.

Did this really come as a surprise to the markets?? Did market participants really believe that the influence of the banking sector on the politicians is so strong that the US banking sector could avoid completely sensible regulation when the rest of the world is moving that direction.

After 25 years in this business I can still get surprised at the sheer ignorance and credulity of many market participants.

Oil glut. WTF?

Yesterday’s Financial Times carried a story that began with the words “The boom in North American oil production has triggered a race to expand the US’s main oil storage centre, raising concerns among some industry executives of potential glut in capacity”.

Please read it again. It tells that there is a boom in oil production in North America. A couple of years ago an estimated 8bn barrels were found deep under the Mexican Gulf. Shale oil reserves in Colorado and other US states may match the reserves in OPEC. Is this the end of the story of the earth running out of oil.

Maybe oil does not come from dead algae, ferns, and dinosaurs. Maybe oil is formed deep in the mantle of the earth and slowly seeping towards the surface. At least that is a story worth following.

Crisis solved. Didn't you get the memo?

On 8 December ECB announced a new 3-year financing facility. It is UNLIMITED, and with a suitable weakening of the quality of the collateral for the loans, it could end up being a major game changer.

The LTRO will make possible a simple idea to recapitalise European banks: take 3-year loans from the ECB at 1% and place the money in southern European government bonds. EU has promised that banks no longer have to take losses if a European government goes bankrupt. Banks have again been given a "free lunch".

Apparently I am not alone in being able to see this simple idea. Spanish and Italian 2-year yields fell like a stone yesterday. The attached chart could be interpreted as indicating that:

• The market believes that Italy, Spain and Ireland no longer represent a bankruptcy risk.

• Portugal is on the verge but may hold on to dear life

• The conditions of the Greek debt restructuring is still not in place (personally I think that the haircut will end at 80% and not 50%)

ECB begins the new LTRO 3-year loan facility on 21 December. It will be very interesting to see how much this credit facility will be used. Rumours in the market say that banks in each country are buying domestic debt in the two-year segment in some volume, a  sign that demand could exceed expectations. If that happens, the new facility is as close to a Euro-QE as we can come without changing the charter of the ECB.

If we now try to put a positive spin on this development so it could read as follows: the ECB has with its new facilities taken big step towards disarming the liquidity crisis. The EU has with his "paradigm shift" given a guarantee for bonds issued by 16/17th of the euro zone. ESM and EFSF will operate at full volume in about two to three months.

The lower yields at the short end of the curve mean that it becomes easier for the troubled countries to achieve the goals of a budget surplus now that their refunding costs are falling.

Hey presto - euro crisis is solved! Well, maybe we still have a small growth problem here and there ...

This is of course the ultimate positive interpretation of things. However, amid all the end-of-the world headlines, we must also remember to keep an eye on the positive developments. ECB’s initiative is one of them.

Banks

Before we let ourselves be engulfed by a warm and fuzzy Christmas feeling over the Euro-zone’s step in the right direction, let us remember that the crisis is not completely gone. It will just move to where it was always going to end. At the banks.

We have heard more than enough lack of ethics and accountability in certain countries. The next theme will be that the private sector has contributed dramatically to the increase in debt / GDP in the OECD area and the banks have been the willing / necessary instrument in this wave of financial leverage. With Europe’s abysmal growth prospects, the ongoing deleveraging everywhere will continue to mean losses for banks.

Sense and sensitivity

I have been ranting against Germany's ideological crusade and their (lack of) sensitivity to the need for immediate action to disarm the crisis NOW! According to a document leaked from the EU president Van Rompuy’s office, it is clear that at tomorrow's EU summit, a small number of reasonable initiatives will be on the agenda.

I have suggested that one element in getting the crisis to go away is to convert the highly indebted countries' short-term debt to long-term debt instead. If you read the leaked document (attached), it is clear that something is happening on this issue.

EU will discuss to 1) accelerate the process to get EFSF up running with gearing and everything, 2) accelerate the ratification of ESM for this new institution to get started on long-term lending and 3) make "deposits" in the IMF, which can then lend money to European countries with large short-term financing needs.

Importantly, EFSF and the ESM could be allowed to operate in parallel for a while, increasing their lending capacity.

If carried out, it is good news. And should be received by financial markets as such. If not it hurts the poor Germans on their sensitivity.

My checklist to find out if new initiatives are useful to resolve the crisis has the following five elements:

• The ECB to act as a central bank
• The banks to be recapitalised
• Countries with huge short-term debt should have them converted to long term debt - very long term
• Germany and other countries in a good situation stimulate domestic demand and growth
• Structural development in the indebted countries (lend them money to build a bridge between some islands or similar)

This list can serve as a reality check: if new initiatives fit into one of those categories, then it is good news. If not, they are irrelevant or downright dangerous.