Weekly Commentary on Financial Markets:
31 October 2011
by Jacob H Schmidt
Eurozone Rescue Plan: Big Headline – Little Details
News of the week: European bail-out plan released with little details and many question marks; account error of Euro 55 b at German HRE bank; markets rally
Europe – Euro
The Eurozone rescue plan as announced last week consisted of a big number, but very little details. The main components of the plan: USD 1.4 trillion via EFSF; bank recapitalisations; Greece PSI with 50% haircut.
Many questions remain: no details were released. The deal via the EFSF is effectively a huge CDO structure with leverage. We see three main problems: the number is not big enough; the funds are not provided yet; the hair cut and CDS implications.
A major issue is the “voluntary hair cut of 50%” for Greece debt by banks. It is the politicians’ plan that the PSI will not trigger a CDS pay out. We believe that some banks and most hedge funds are likely to opt out of the PSI. The USD 1.4 trillion announced by Sarkozy will be provided in part by China but at what cost? Over the weekend Luxembourg’s Junker said no concessions for aid. It is highly unlikely that China will invest into the EFSF without conditions.
France is unhappy about deal because of the China component; Germany is unhappy because of the banks – the FTD compared Merkel’s dealing with the banks with scenes from a “Mafia movie”; in Austria 64% of the population is against bail-out.
Conclusion: as predicted last week, this plan is leaving us with a bad taste (Bazooka chewing gum style) and has significant deal risk.
My Grade: C+
The Greece restructuring (PSI) has no details and should be done within 2-3 months, January 2012 is mentioned as a deadline; the experience from past shows that takes much longer. In Greece anti-German feelings are growing and the suggested write-off is not enough to help Greece and to entice the population to support the plan. The risk that the PSI will not happen and Greece will default and leave the Euro in next 3-6 months is high. We estimate the probability of such a scenario at 50%.
My Grade: D
Due to an accounting error at FMS Wertmanagement, the bad bank set up after Hypo Real Estate’s nationalisation and bailout in 2009, which forgot to book the liability side associated with the assets they took over, Germany is now Euro 55 b (!!) richer, on paper only. Nevertheless the result is an improvement of Germany’s debt to gross domestic product ratio: from 83.7 to 81.1 percent (2.6% points). The number in question is massive (even for Germany) and the subject (transferring of assets and liabilities) relatively straight forward. What is the accounting knowledge of the FMS, of the auditors (PWC) and what about the risk management function of the supervisory bodies and regulators? A fail for any first-year student in finance or economics. If this can happen in Germany, how many black holes are there out there at banks and federal agencies? My Grade: D
We believe that the markets will focus now for a few weeks on the US debt issue. US earnings relatively positive so far, better than the revised low estimates. My Grade: B+
Other geopolitical risks include Syria (tensions rising, over 3000 killed so far, Assad threatening “Afghanistan” like scenario if West gets involved); Egypt (instability after Arab spring, elections soon); US election next year; elections in Italy next year; OWS protests in US and Europe spreading; risks of far right emerging in European / EU countries as a result of many factors: bail-out, decisions taken in Brussels / Strasbourg versus local / national sentiments, bank recap requirement, local factors. My Grade: C+
Earnings in US and Europe relatively positive, but many releases also dressed up (see last week’s banks, e.g. UBS which showed a profit of SFR 1 b despite write off of 2.3b). The earnings release of UBS (using an accounting loophole, FAS 157, marking-to-markets of liabilities) were in particular negative because it seems that the bank showed a profit to be able to pay high boni and compensation, despite the huge trading loss; we believe that the accounting profit was used to justify the payments. According to the Rescue Plan banks will need only Euro 100 b, much less than the IMF number of Euro 200-400 b; and even of Euro 100 b only Euro 20 b in capital increases, the rest in retained earnings and balance sheet reductions. My Grade: B+
Italian spreads widened again after a less successful auction of Italian BTP, where Italy placed only part of the paper. Without the ECB buyers seem rare. The yields are above the symbolic 6% mark (6.05%). German yields also rose (10 y at). Italy needs to roll over Euro 300 b next year. My Grade: C+
Equity markets continued the rally in all sectors, banks benefitted from lower recap number. S&P 500 and other major stock markets are now in positive territory for the year. US Brokerage firm MF Global (the former brokerage arm of Man Group, spin off from Man in 2007) dropped due to 1.20, down 85% in last 12 months. does not pose systematic risk to financial system, most likely to be sold in next few days with shareholders being wiped out. Groupon road show for upcoming IPO started last week, many now critical of business model. We do no like the business model of Groupon and financials. We believe that the IPO might either be pulled or be disaster for investors and lead manager. My Grade: B+
US rates again higher on the long end (2.31% vs. 2.22% at 10 year last week; 3.35% vs. 3.27% at 30 year last week). Rates also much higher now in German bunds (2.19% vs. 2.11%). A lot of pain in the portfolios of investors who went long in the last few weeks. My Grade: C-
Greek bond prices rallied several points after the announcement of the bail out. Italian BTPs fell and other periphery held up. My Grade: C-
In the commodity space base and precious metals also rallied. Silver at 35, Gold at 1740. My Grade: B+
Volatility: VIX down to 24% from 33% last week.
HF performance looking better this month across the board except for CTAs who suffered from the sharp trend reversals. Dow Jones Credit Suisse Core Hedge Fund Index is up 1.55% MTD. Managed Futures / CTA down 3.6% MTD. My Grade: A-
The Christmas rally in equities is likely to run out of steam in the next few weeks as markets want to see details of the bail-out, progress in Greece and implementation of the economic programs in Italy. Because valuations are reasonable, but political and macro risks are hovering over the markets, stock markets will continue with higher than normal volatility. As long as the bailout stands the downside risk is limited. However as we believe that there is a significant deal risk corrections with sharp reversals are highly likely until year end.
With only two months until year end, investors and traders will have to look into 2012 to identify opportunities. Due to the risks ahead of us we believe that sovereign credit will continue to be the focus, equity volatility will prevail and the danger of inflation will be over the rates markets. In our investment strategy we recommend quality companies and quality hedge funds, in our asset allocation we focus on tactical strategy in order to exploit high levels of volatility and to adapt asset allocations as the macro environment changes. Unfortunately we are still in the unfolding of the excesses of the bubble and the market crisis of 2008.
My grade: B+
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