Monday, 26 September 2011

Weekly Commentary on Financial Markets: 26 September 2011: Crunch time for policy makers to avoid another 2008

Weekly Commentary on Financial Markets:  26 September 2011
by Jacob H Schmidt

Crunch time for policy makers to avoid another 2008     

News of the week: UBS CEO resigns; money markets under serious stress; FED’s operation twist leads to sharp sell-off in equities and commodities

Over the last few months we have been discussing the fate of Europe, the EU and the Euro, trying to picture the likely developments. The debt problems in Greece and Latin Europe pose a serious threat to the EU and the Euro. Unfortunately the worst options seem to become reality: the vision of the Eurocrats, that Germany and Northern Europe will bail out Southern Europe, the EU turn into a United States of Europe and Brussels / Strasbourg be running fiscal and monetary policy is in sharp contrast to the reality on the ground: Europe continues to be a continent of nation states where politicians are committed to their electorate.  We believe that the EU will continue as an economic block, but doubt that it can become a political union. On the one hand the interests in the big countries Germany, France, Italy and Spain (as well as the smaller countries) are too different, on the other hand there is no European politician who can demand respect in different countries (a la US president).  My grade: B-

As a result of the developments in Europe, the Euro is – not surprisingly – under stress: the very likely Greek default will pose a problem for the currency and the ECB. While for years many speculated whether the era of the USD as the main reserve currency is over and the Euro could become a serious contender, the current assessment looks very different: some question whether the Euro will survive. We believe that the Euro will split into two blocks, the Northern Euro (main Euro) and the Southern Euro (countries trading at a discount), with certain transfer payments from the richer countries to the poorer ones. We believe that the Southern European countries desperately need a mechanism to become more competitive. The debt problem (Greece foremost, but Latin Europe as well) continues to be the priority number one and last week, the ECB was again a big buyer of Italian bonds. The real question is: what will the ECB do with all its Greek bonds, if Greece defaults? Conclusion: Euro under serious stress with a mid-term solution; in the short term the ECB is the only institution to support the markets. My Grade: C-

Greece is moving even closer to a default: the bond yields suggest a 98% probability of default, and some say that Greece has a 30-40% chance to default before month end. We believe that Germany and France are trying EVERYTHING to avoid a default now, as this would take the German and French banks down. Crunch time is either 8 October or the middle of October, when money is running out and Greece needs the promised Euro 8 b. We believe there is a good chance that they will get the money, the only risk is that Greece might not want it! Greece might decide that a default is preferable over unbearable conditions. In any event we believe that if not before, Greece will default in 2012.  My Grade: D

In the UBS unauthorised trading scandal its CEO Oswald Gruebel resigned over the weekend. This is the first case where a CEO takes full responsibility for a significant loss which is a very positive development, even though Gruebel was an excellent CEO. In the past CEO survived such scandals, e.g. in 2008 at Soc Gen (Jerome Kerviel). We believe that others might have to follow Gruebel, i.e. the risk manager, the head of investment banking and some line managers. The new interims CEO Sergio Ermotti, an experienced banker, has some advantage as a Swiss national from the Ticino. Nevertheless he will be faced with a tough job, as he will have to restructure completely the investment banking and risk taking activities. Because he is only on an interims basis and does not know whether he will be CEO, UBS will be very limited in its activities for many months. My Grade: C-

In the US rates markets the FED announced Operation Twist (buying long dated bonds with money raised by the Treasury auctioning 2 year bonds) on Wednesday leading to a sharp sell-off in the equity and commodity markets. Most commentators and market watchers argued that the weak outlook on the US economy was the trigger for the sell-off, however we believe that the market realised that Operation Twist is an unproven monetary tool (used only once in 1961 with very limited success) and more importantly negative from a debt management point of view. Why would any business man shorten its debt profile if he has a raising financing need?  My Grade: C-

In the South Korea banking scandal (seven banks were suspended by the regulator due to inadequate capital ratios) one CEO committed suicide by jumping from the roof of his bank. In Europe as the recapitalisation debate continues (deadline, amount, sources), the market punishes banks with highest volatilities. My Grade: C-

Hedge Funds:
Big divergence in the performance of hedge funds and hedge funds of funds: while some fixed income and global macro funds continue to shine in September after a strong August (BH Master Fund, Eclectica), L/S, arbitrage and event are having a rather difficult time. On the HFoF level some diversified funds and specialist funds show flat to positive performance (Gottex Constellar up 7% YTD, Gottex MN+ flat), which helps investors in their asset allocation. Other past top performers HFoF struggle: e.g. Liongate Multi-Strategy down 4.4% YTD. One pension fund manager told me recently: They are happy with a flat, uncorrelated performance in hedge funds, as they protect the portfolio in these tough markets. Zero is the new up 10%.      My grade: A-

Extreme volatility, risk-on / risk-off switches every few days make it very difficult even for the discerning investor. Last week’s sell-off in commodities  (Silver down 25%, Gold down 8%, industrial metals et al also down significantly) was brutal, triggered by economic worries and speculators. Currently rather a beta than an alpha play. Interest rates in US (US 10 Y at 1.83%), German 10 Y Bunds at 1.75%) show panic and dislocations, very tough for pension funds and other liability driven investors. My grade: C-
No change in our view: significant risks remain in Europe, the US (debt problem), political risks in Europe, a slowdown in China and the Arab Spring in the Middle East. A Greek default is only a question of time; saving the banks is now the main issue for the European nations.    

While a short term bounce in equities and commodities is possible here (due to oversold levels) the downside risk is significant. We prefer macro and fixed income hedge funds, subject to strictest due diligence. Caution is the eldest child of wisdom (Victor Hugo).     

This commentary is for information only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. It is not an invitation to buy, sell or subscribe and is by way of information only.

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