Mario. Yields.Economic news. Gross.

Super-Mario II

No, not Mario Monti but Mario Draghi. In a testimony to a committee of the European Parliament he is quoted to have said that “As regulators we should learn to do without ratings. Or at least we should learn to assess creditworthiness in a way in which ratings or credit rating agencies are one of the many components of our information”.

I could not agree more. I have even been quoted for saying so: There is no alternative to doing your homework. Even if it implies that you will have to read up on what creditworthiness means. Or to employ staff that know.

On Monday, I quoted S&P’s musings in their reasoning for the downgrade of France. It was an unashamed judgement of the shortcomings of the European initiatives to shore up the Euro. The fact that I agree with their judgement should not take the attention away from the fact that it revealed one crucial fact. The ratings agencies are as much political players as they are analysts or indeed paid marketing agents. Draghi’s words should be taken to heart and the ratings should be taken as “one of the many components”.

I am happy to see that S&P’s downgrade was largely ignored by the markets.

Yields

French bond yields fell at the auction Monday, a Belgian auction went well, and even Greek bond yields fell Italian and Spanish two year yields have stabilised and 10-year yields declined. I interpret this as a resounding proof that ECB’s 3-year loans are having the desired effect for now. The stock market is picking up the baton.

German bonds (and other “Safe haven” assets) are worrying me. If suddenly bonds from other countries are perceived as being not-so-risky and if even Portugal manages to sell a small amount of 10-year bonds, what will happen to German yields? It does not take a genius to see that one of the world’s most overvalued assets would be in for a rough time if investors drop their obsession with avoiding risk.

If you are ultra-long in these assets despite their ridiculously low yield, take care that you will not suffer the same fate as the (almost) proverbial frog in the water being brought to boil.

The frog story is proven to be a myth. The losses on your bottom line will be real.

World Bank economic forecast

The less thinking part of the financial press will today dedicate too much space to the World Bank’s economic forecast. WB expects global growth of 2.5% in 2012, down from last forecast’s 3.5%. The previous forecast is from June 2011, so most of the downgrade merely reflects the economic development since then. If the European banks break down and the euro-zone enters a deep depression, it will lead to a global recession, according to the WB. That has no news value whatsoever. I notice that the World Bank does not assign a subjective probability to neither the main scenario nor the doom scenario. Do read the report, but take it as a history lesson rather than anything forward-looking.

Good news amid too much gloom

We, Origo, my business partners and I, want to have it on the record that the European recession is a fact here and now, and we are beginning to pull out of it. Some people appear to agree with us (the stock markets, just to mention a few). ZEW’s data for German investor and analyst expectations rose for the second month running. It was the biggest monthly increase in 20 years of data.

Greece

Market rumours now report that the negotiations on Greece’s restructuring will result in a haircut of 68% - it appears to be a good number – for Greece, at least. An anonymous source said that “a lot of brinkmanship is going on”. Sounds about right. Playing this one right may hand a big Ka-Ching to those who blink last. Why else should hedge funds have gotten in there recently?

Gross

Sometimes I wonder what it really takes to have one’s name mentioned in the headlines. I do my best by being mean and sarcastic. PIMCO’s Bill Gross managed to get a headline on Bloomberg for telling the obvious truth that some institutional investors have rules according to which they will be forced to sell bonds that are rated lower than a certain threshold. That may lead to a sell-off. Toe-curling stuff. I promise myself not to quote Bill Gross again until he makes a correct call on US Treasuries.

Downgrade. Euro.

Downgrade

One should always be prepared for a hefty surprise in these markets. Suddenly I find myself agreeing with S&P! In the explanation for the downgrade of France the following gem is hidden:

“The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone's financial problems. (...)  We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone's core and the so-called "periphery." As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.” (My emphasis).

Also very useful to read how S&P are justifying their broad sweep.Somebody have been reading up on their Kindleberger and the history of the crisis in 1929-32.

The only question is: what would S&P have done if France (and Germany) had introduced reforms and tax changes to spur domestic demand and had offered long-term loan programs to Greece and Portugal to help productivity development. Or if Italy had embarked on a long, slow reform program to set free the country from decades of bad management of the laws?

Probably they would have downgraded France and Italy anyway, so in that respect the above quote is just a proof how much of a political institution SP really is. We now wait for the next chapter: The downgrade of Germany. Ultimately it is Germany that has forced a wrong solution upon the rest of the euro 17.

Will it mean anything for France and the 8 other downgraded euro-nations? Too early to tell. But for sure a lot had been priced in already.

More interesting, is this a game-changer? My feeling is that it is not. After all, I cannot remember a rating change that was forward-looking and indicative of any changes that were not already visible to everybody else. But we will be able to see it in the risk appetite in the coming days.

Euro

The euro has fortunately weakened further as a result of the ratings. Good for Europe! However, Colleague Frank points out that the number of short positions betting against the euro is at a historical maximum. But I found a piece on Bloomberg that left me puzzled. Who had understood that the reason for the surprising strength of the euro was that it was propped up by the AUD. Silly me! I thought it was the belated reactions on the part of ECB that had caused the euro to remain stronger than the other main currencies. Never too late to learn something new...

Reuters carry an interesting story – and they appear very keen on telling us that it is well-researched: Hedge funds have apparently bought sufficiently many Greek bonds to actually force a default. That would immediately release the payments of CDS according to ISDA rules.

German growth. Schizophrenia. Banks

Auctions

Italy and Spain sold more short term bonds than expected at lower yields than expected. ECB’s 3-year loans are working their magic. The “euro-collapse” is postponed further.

German growth

Germany has announced a negative growth in Q4 of -0.25%, and newspaper stories have it that the German Federal government will reduce its forecast for economic growth in 2012 to about 0.75%, Negative growth in Q1, zero growth in Q2 and a slow recovery in second half of the year. It is entirely in line with the view I have stated several times before: We are in the middle of a European recession and sometime around March/April we will reach the turning point.

Schizophrenia?

On 19 July last year, Origo made a call that stocks were in for a major correction. We based this forecast on a number of factors. Most important was that on a backdrop of sharply falling growth, stock markets had their Wile E. Coyote moment, while the (high quality) bond markets were right all along.

Again, we have a situation where the stock markets are on average trending upwards, while the (high quality) bond markets stubbornly cling to excessively low yields. But this time it happens as the growth prospects are in fact improving or about to turn the corner. Despite heroic attempts from the London-based financial press to keep the pressure on the euro, the various initiatives to lighten the financing squeeze on Europe’s troubled countries appear effective. The European recession may well end up having an average length (7-9 months) and an average depth (a total output loss of 0.75% to 1%).

Where does that leave us in terms of asset allocation? Well, judge for yourself. One can side with the bond markets and remain depressed. Or decide to see the positive signs and side with the stock markets. As opposed to the turn in March 2009 or August 2011, the signs are not yet all pointing in the same direction. But it appears that the “perma-bears” have a harder time to make their way into the headlines.

Uh-Oh
According to FT, a certain large CSwiss bank is now offering its hedge fund clients a product that allows them to short European banks – even if shorting bank stocks is banned in several countries. I will not discuss the morality of this manoeuvre. Would be akin to discussing something that does not exist. Pure metaphysics!). One thing is, however, clear. Once this particular product is offered to retail investors, the European banking crisis is close to being over. Yet another of my “hillbilly indicators” based on nothing but a long memory.

European Banks
RBS is caving in to demands from Bank of England and the British finance ministry (who owns a not insignificant 83% of the shares in RBS). It will mainly lead to cuts in the investment banking activities. Deutsche Bank wants to sell its asset management division. I am afraid none of it points to a solution to the banking crisis.

The banks trade at depressed prices because nobody can figure out which banks are really rotten. They all mark their assets to fantasy instead of using mark-to-market. They have not yet taken the necessary write-offs on goodwill. If we could finally get a couple of major banks to fold, it would end up being good news for the sector – after the initial shock. As it is now, the entire sector is priced for a meltdown.

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.