Weekly Commentary on Financial Markets: 19 September 2011
by Jacob H Schmidt
Greece closer to default
News of the week: major central banks coordinating money market intervention; UBS hit by rogue trader losing USD 2.3b; FED’s operation twist
In Europe one group of policy makers continues to be undecided how to proceed here: politicians in Germany, Austria and Finland feel the internal pressure from their electorate and are treading carefully between commitments for the EU and the Euro and growing opposition at home to bail out Greece and other PIIGS without real progress. Last week Austria delayed a vote on a committee on the extension of the EFSF, in Germany chancellor Merkel lost elections in Berlin and Finland wants more collateral for its participation in the Greece PSI (private sector involvement aka restructuring). We observe a divergence between the politicians’ view on Europe and the voters in the respective countries. While many politicians call for more integration, voters seem to want rather a status quo or less. In this scenario right wing parties in Austria, Germany, NL and Scandinavia will benefit from this divergence. A tough call for political leaders. We believe that the likely outcome is delay and short term fixes. My grade: B-
The second group of policy makers the central banks showed their will this week with their coordinated plan to inject USD liquidity to European banks. European banks have been hit hard by USD shortage as they fund part of their activities in USD, but have found it difficult to impossible to borrow USD. For the next three months ample liquidity in USD will be provided by the ECB and other major central banks (via swaps with the FED). This solves the liquidity problem, but not the potential (in)solvency problem in the event of a Greek default and contagion to other PIIGS. The ECB’s book in PIIGS government bonds is growing and the credit quality of these bonds deteriorating; a dangerous development. The ECB wants the EFSF to take over the job, but this is unlikely as any extension of the EFSF would require national approvals. Eurobonds / EU treasuries are also shelved. Conclusion: ECB in short term fix, with huge book in bad credit and no solution in sight; Trichet about to retire and a new head to take over. My Grade: C-
No progress on the Greek debt problem, the PSI still trying to get the 90% approval, but little transparency which banks and what maturities are involved. In Greece the political situation is getting tougher, more strikes, and with more taxes looming, more potential for confrontations. The G7 conference in Poland over the weekend ended – as expected – without decision. The next tranche – much needed Euro 8 b – will not be disbursed before mid October, but Greece might run out of cash by 8 October. Hence yields in Greek GGBs are 150% (1 Y) to high 20% for longer dated maturities – or more meaningful: all bonds trade (price wise) in their 30s. China and the other BRICs have offered help, question is at what price for Greece and Europe. We do not believe that Greece will default in the next two weeks - as chancellor Merkel said: no default before 2013- but the risks of a panic reaction is there. Greek bonds could – and should - trade much lower. My Grade: C-
The other major news was the USD 2.3 b loss at UBS due to a rogue trader in their London Delta One business. While there is little detailed information only one 31 year old director – the member of the Delta One desk – has been arrested. According to reports the losses date back to 2008. We believe that rogue trading – unauthorised transactions, excess risks et al – is more common on Wall Street (the City, in banks in other countries and hedge funds) than generally known, but it is rarely detected and reported. Unauthorised transactions often lead to profits, and are quasi approved afterwards. In the UBS case many important questions remain: what about the risk management, the on-going due diligence, the management’s insight, the role of the auditors, the role of the regulators (FSA, BoE, SNB, et al), the duration (2008 to now) and the size of the loss (USD 2 .3b) and many more. For UBS this revelation will lead to a significant reduction in risk taking and derivatives business activities, for other banks investigations, risk management improvements and more regulation. We cover the questions of excessive risk taking and unauthorised trading in this month’s Due Diligence Monitor. My Grade: C-
In the US rates markets we will watch the FOMC meeting (Tuesday and Wednesday) to hear whether the FED will start QE3 or rather introduce operation twist. Operation twist is a tool developed in 1960s whereby the FED will buy long dated bonds (in cooperation with US Treasury) and Treasury concentrate its issuance in 2 Y (short dated) bonds. It is basically a shortening of maturities in order to flatten the curve. We believe that this is a risky strategy as the US debt is so massive, and any shortening puts them at even bigger risks. While QE is a doubtful instrument, operation twist is definitely too risky. Already anticipated it is another policy to permit dealers and hedge funds to make easy money, but it is not necessarily helping the real economy. My Grade: C-
In South Korea seven banks have been suspended by the regulator due to inadequate capital ratios. While we do not expect similar actions in Europe this should be a warning to investors, savers and counterparties. Many banks in Europe (German banks, some Austrian, some Spanish to name a few countries) could have serious problems in the event of a Greece default – or proper MTM of their books. My Grade: C
In our recent hedge fund research we found that most equity l/s funds have low beta and low gross exposure, but selective alpha. Many fund managers are aware of potential powerful rallies and ready to take of their index hedges to go net long. The extreme volatility, high political and policy risks make it very difficult for low vol funds. Many CTAs have made good money over the last 2-3 weeks (see AHL), CB and other Arb / RV strategies rather disappointing. UCITS III suffered in August, with some funds down 4-5% in August alone. We favour top quality managers in special situations, global macro / trading and l/s equity. Diversified HFoF are alternatives to bonds. Selection is key, investable indices not recommended. My grade: B+
All financial markets remain highly volatile and switch from risk on to risk off within hours or days. After the central banks’ coordinated move equity markets rallied from their oversold levels, bonds and commodities sold off. USD and German Euro rates remain at historic low levels. This week French bank stocks experienced extreme volatility: On Tuesday they moved 10-30% down and within several hours bounced back, to rally for the rest of the week. As expected the DAX outperformed other European markets in the rally from Wednesday to Friday. Corrections rae possible any moment. My grade: C-
Significant risks remain: Greece, US debt problem, inflation due to commodities, policy mistakes, rogue trading revelations. Plus the unknown: what would a Greece default mean to counterparts, firms and Europe. Investors have to weigh between low interest rates in bond markets, volatile FX and commodities, low returns in HF, negative returns in PE and very volatile equity markets. While equity markets are undervalued to fairly valued, the risk is that companies (i.e. equities) might pay the price for the dislocations (2007/8 crisis has moved from banks to sovereigns, sovereigns now at risks, next move back to equities). Hence we recommend hedge exposure, actively managed, in top names. Gold and Silver will be the ultimate hedge in a panic scenario. Asia unlikely to decouple. Investments in Greece to early.
Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Anglo- Austrian, multi-lingual,-cultural, critical thinker. CEO of Schmidt Research Partners Ltd, an investment advisory firm and MD of SFP-International Ltd, a consulting and training company. Available for high quality investment advisory, due diligence and consulting projects.
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