Investor protection. Davos. Consensus building

PMI

Yesterday’s January PMI from Germany and the euro-zone confirmed our views – held since September, for those who care – that the European recession is likely to end within a couple of months, and Germany may avoid recession altogether (recession defined as two consecutive quarters of negative growth). Today’s IFO indicator from Germany will show whether we are moving further in that direction.

Help!

In the UK, a new consumer protection watchdog wants to protect “irrational investors” from dangerous financial products, as such investors cannot be relied upon to find out what is in their own interest. Well, given the amount of brainpower the financial sector has poured into making their products completely impenetrable, it would be about time. At the same time the UK government is finally flexing its muscle when it comes to greedy bank chiefs. Equipped with a clearly conservative government, UK is establishing itself as the leader in how to change the ground rules for the financial sector.

PE

Before you shake your head at those poor private investors who now have to be protected from their own ignorance, a fresh study commissioned by Financial Times from Yale and Maastricht universities shows that there is no conclusive evidence that Private Equity creates value for the investors. It is, however, established beyond any doubt that substantial wealth is created for the owners of the Private Equity firms. New compulsory reading for pension fund managers, I guess.

Probably it is with Private Equity as it is with hedge funds. The early movers have earned fabulous returns, primarily because of their ability to fly under the radar and outside of prudential regulation. With huge money to be made, more people and more investors move in, and after a while the average return falls towards market returns. The only thing that proves a remarkably resilience is the ability of the investment managers to shroud themselves in a cloak of invincibility and keep their own remuneration up.

FT reports that US pension funds have had an average 4.5% return on their investments in PE over the past decade. But management fees have been on average 4%. Add all the other fees and received by the PE firms.

Davos

For once, this year’s World Economic Forum in Davos seems to be a place where serious things are discussed. In the running-up to the conference, Lagarde of IMF and even Zoellick of the World bank joined forces with 4 other leaders of international institutions issued a statement about the international economic situation.

Despite the more urbane wording, it was another rebuke to the German belief that austerity-based programmes can save the world in the short term. Zoellick – a man of impeccable conservative credentials, then went on to explain that Germany has to transform herself from a participant in Europe to a political leader. It means to resume responsibility for all of the area, and not, NOT, think of their own domestic situation first. Interesting, and very much in line with former Chancellor Helmut Schmidts insightful comments from 2010.

Consensus

It is equally interesting to see that some of the leading consensus-makers, UBS and Citi, are now joining Origo in pointing out that a risk-on rally is ongoing. Citi even jokes that ECB has created “artificial life”. Whatever! It probably means that they had not seen it coming. I do not care as long as it works. Now we wait for all the other major banks to join.

Risk rally arrives on time

Since November we have been adamant that we were heading into a situation where a tendency to “risk-on” could accelerate into a real risk rally. We are there now. Financial stocks are moving up (phew, they will not go under). Spanish, Italian, Belgian government bond yields are falling quickly (phew, they will not go under). Commodities are about to join in (phew, the world is not going under).

Dollar is (unfortunately for Europe) weakening under a combination of a short-squeeze and a stronger belief that the euro will not fall apart in 2012. HY bonds are doing very well, thank you, as corporate earnings do not really reflect the apocalypse vision of early December. Will this positive sentiment ever end? Of course it will. But just like nobody knew how far the risk-off collapse could take us down in August, nobody knows how far this rally will carry us upwards.

If anybody claims to know, we will question their credentials. But for now, all indications are that we can continue for a while. Until then, enjoy the party. You will be joined by more and more consensus thinkers. UBS and Citi have joined us in the past two days.

The last shoe to drop

Just like we have been keeping tab on the Euro bond auctions, as a sign we are moving away from the pits of the risk-off downdraft, we are now eyeing the T-bonds/Bunds. If the revaluation of risk assets continues, we will eventually see a major calamity in those two types of assets. Once we get there, the risk-on rally will probably on its last legs.

And on the sidelines

We have a lot of rumours going on. Germany and France should be ready to accept a slower implementation of the 9% Tier 1 capital requirement in order not to put too much pressure on the credit market. Germany should be ready to accept “solidarity” with the problem countries and “long term solutions” in order to solve the underlying problems in the euro-zone. Germany suggests to move the ESM forward and let EFSF and ESM operate in parallel for a while. Lagarde from IMF wants more money in order to have bigger reserves if needed. The policy rules in the Euro-17 will be more flexible.

Why am I not surprised about all this? If there is some truth to any of the rumours it appears that a healthy dose of pragmatism is now being brought in. But only after Germany managed to get her way in forcing a deeply destabilising set of long-term upon Europe. Quid pro quo.

Finally it feels as if the ideology is beginning to take back seat to some practical action. There is still a long way to go before anybody can declare “mission accomplished”. But there is no doubt that now is the right time to be pragmatic. It always works best when the market is in a mood to believe that things are heading in the right direction. It seems to be now.

Quotes and time zones

Quotes and time zones

I have been quoted a bit in the press recently and have now joined the club of those “quoted out of context”. It comes with the territory, so I am not going to complain about it. I only want to make a couple of things clear to the readers of this column.

Most importantly, at Origo we try to work in Real Market Time (RMT). It is rather different from Economist’s Hypothetical Time (EHT) or even Newspaper Headline Time (NHT). It is also quite a risky endeavour.

Switching for a moment to EHT, I do not know where the world economy will be in 9 or 12 months from now. There are simply too many unknowns at play. I have an opinion about a lot of them, but those opinions are irrelevant when it comes to today’s practical investment decisions. Those decisions are made in RMT.

The only thing I know is that in RMT, we are right now putting the doom-and-gloom-and collapse scenario of the past four months behind us and that is enough to make the markets react. Another setback may come later, but it is not visible in any economic indicators right now,. We will jump off that bridge when we reach it, i.e. when it becomes relevant in RMT.

Europe is in a crisis, and for several reasons. In EHT, government debt, inadequate institutions, and way too weak banks are central ingredients. But in RMT, a crisis accelerates dramatically if a country or a bank cannot roll over existing debt. The European inter-bank market is pretty much dysfunctional, but ECB has taken over the role as a clearing house. It is certainly not optimal, but it works for now.

The almost weekly auctions over European government bonds is the space to watch (in RMT), when it comes to the government debt situation. As long as the euro-zone countries can refinance themselves at almost normal market conditions, the crisis is not spinning out of control. That is enough for now.

Everywhere the game is to play for time, time to stabilise the economies, and time to revive the economic growth. As opposed to financial markets myths, it is really the only way to solve the problems. There is no quick way out. The best we can hope for is that the train does not run off the track in the meantime.

It is a question of perceived probabilities. Every time the markets perceive a change in the probability that we remain on track, it is good or bad news. And that is exactly what we at Origo try to monitor.

Greece

Despite some last-ditch brinkmanship, the negotiations between the private sector bondholders and the Greek government continue, and now appear to be heading for some kind of resolution. It will mean that the official debt write down is 50% while the real haircut (once the new, longer-dated bonds are issued) will be some 68%. Let us get it in the bag so we can move on.

Speedy solution to EU crisis?

Germany and France now wants to speed up the resolution of the crisis and the final designs of the new EU institutions. It does not make the overall plan more correct. There has been an interesting change in the language. Germany’s foreign minister Westerwelle now talks about solidarity with the countries in trouble. He also talked about long-term solutions. If we could please hear some more about this solidarity, please. Westerwelle also wants to speed up the creation of a European rating agency.

Auctions. Downgrade. Banks. USA. Risk

Auctions

Yes I am a bit OCD about bond auctions these days. It is because that is the place where we have the clearest view from the frontline of the euro-crisis. As long as the euro-zone countries can finance themselves at reasonable costs in the open market, there is no real crisis. At least for the moment.

France and Spain sold a total of eur 15bn worth of government bonds at lower yields than before the S%P downgrade. Spain has now sold close to 20 percent of the planned issuance for 2012. And we are only 20 days into the year.

Has this started a rally in risk assets? No, that one started in late September.

Another downgrade coming

Fitch, the smallest of the three major (i.e. US-chartered, free-speech protected) rating companies is likely to downgrade 6 euro-nations in the coming days. That will be yet  another non-event. Then we will wait for the inevitable downgrade from Moody’s, and we can all move on.

I look forward to see if Fitch will also make an attack on Germany’s plan for the “fiscal compact”. In the good old days, Moody’s was the most openly political of the three. Now they try to reposition themselves, so maybe Moody’s will now drop the political comments.

Commerzbank, MPS

If the euro-crisis is on the backburner for the time being, the European banking crisis is still simmering. Commerzbank is banging the drums that they almost have found all the new capital they need. One of the tricks is that Allianz appears to be willing to convert a holding of non-tier 1 capital into an equity holding. From Italy we hear that the world’s oldest bank, Montepaschi di Siena, is pulling off a similar stunt. It is a beginning. We need far more action on this front.

Good data from the USA

Please do remember that you read it here first (or in my blog back in August): The US growth pause ended in September and growth improves nicely. Initial jobless claims fell in December, housing starts increased and manufacturing output accelerated. At the same time the US budget deficit is shrinking – as it always happens when the economy accelerates.

We know that the fears of a “new” recession is over when the likes of CNBC and Bloomberg TV again begin to interview people who offer “stock tips”. We are on our way. The perpetual bear, the original Mr Doom and Gloom, Marc Faber now assures us that the stock market will not collapse. Time to exhale!

Risk indicator

It will come as no surprise that I am a harsh critic of risk control methods based on “portfolio diversification”. When the things really heat up in the markets, correlation between asset classes increase and the diversification of portfolios lose its effect. 

At Origo we have made an indicator of this, and guess what: it signals that we are moving back towards normal. The risk management departments of this world are soon back where their models again work. I would not be surprised if the message going out from the risk controllers in the banks is “risk is falling, you may take more risk on”. Stock pickers will also feel it is worth going back to work again.

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.