Weekly Commentary on Financial Markets:
14 November 2011
by Jacob H Schmidt
Light at the end of the tunnel
News of the week: Positive Developments in Greece, Italy and the ECB; Bank Shares hit by write offs; Apple shares down on pipeline concerns; Credit Hedge Funds negative on Europe and banks
Europe – Euro
While the European politicians continue to be rather low profile, the ECB under its new president Mario Draghi seems to take up the baton and show leadership by buying Italian BTPs. Last Thursday and Friday yields reached levels of 7.5% for the 10 year BTP and the curve even inverted at one point. We know that the ECB would rather have the EFSF do the job of supporting the bonds, but as they have not yet sorted out the funding, the ECB has been pushed into its natural role of lender of last resort. We have been critical of the bond purchases by the ECB because of its potential consequences in the event of default or disintegration of the Euro. However we believe that there is no real alternative and the ECB has firepower, expertise and standing to stabilise the European bond markets. ECB president Draghi seems an excellent choice to head the ECB at this difficult point.
After the appointment of two new prime ministers we see early stages of a positive development in Europe: a new class of leaders, more experts than politicians who understand European politics, have gained substantial experience at major international institutions and demand the respect of the international community as well as the population. The only risk is that the political parties will spoil the party.
Contrary to perma-bearish Nouriel Roubini, who wrote in several FT blog as of last week’s that Greece should default and leave the Euro and Italy’s days in the Eurozone may be numbered, as well and many other economists and market commentators, who all have adopted a very negative view on Europe, we believe that the situation is more complex and fluent: Greece needs a significant debt write off (probably in the range of 75-80% of total, meaning that either the ECB and Paris Club take a hit or the banks take a larger hit). Italy by contrast is a rich country, full of potential, but mismanaged. Italy can live with a huge stock of debt (a la Japan) as long as finances are under control with economic growth and confidence in the country. The high percentage of Italian holders of BTP is also a positive sign. Analysing the situation one must not forget that there is significant political will to preserve the Eurozone: if the Euro goes so does the EU and Brussels. It is possible that individual smaller countries decide to leave the Euro (temporarily), but the Euro as a currency for the main countries Germany, France, Italy and Spain will not disappear. In the long run the Euro might develop into a two zone currency, but will not disintegrate. In addition to the political aspect Germany benefits too much from a weak Euro and a common currency; she does not want to go separate with a strong currency.
We are cautiously optimistic that this is a turn around and leadership developing from the South and at the ECB. While it is still early days and major hurdles to be taken (Greece debt issue, EFSF role, banking recapitalisation, budget deficits et al) we see the light at the end of the tunnel.
My Grade: B+
The new Prime Minister Papandreou has a huge job, but his reputation, experience and the realisation by the Greek people that there is no more time to lose can lead to a more positive outcome. In the meantime the next tranches of the bail-out will buy time. Nevertheless the debt restructuring will happen, probably later than expected and at worse terms for the banks. The immediate default risk (2011) is relatively low, but any bond after New Year is at risk.
My Grade: C-
In the US the main focus is shifting to next year’s presidential elections. On the debt side we are awaiting comments from the Joint Select Committee on Deficit Reduction aka Super Committee set up in August 2011, but expectations are so low that any positive sign be interpreted as an achievement. My Grade: B+
Bank earnings show the pain of write offs and lower income from investment banking and trading. On the positive side many banks have started looking at the recapitalisation and new capital rules with much higher regulatory capital. Better earnings from corporates. Most major companies have reported and the market will soon focus on 2012. Apple has sold off more than 10% in the last 10 days, on concerns that the pipeline is getting dry and sales in iPads are slowing down. Upside in AAPL limited for the time being. My Grade: B-
Due to the developments last week markets were very volatile, driven by macro factors. We believe that the extreme volatility will decrease somewhat over the next month as the macro worries move to the background and asset allocation and company specific aspects will affect market prices. My Grade: B
As stocks continue their volatile uptrend, the major indices will test important resistance in the coming week. If they can break through – which is unclear - we might see a much larger rally until New Year. My Grade: B+
US rates pretty much unchanged from last week: 2.07% vs 2.06% for 10 year notes (vs last week); also in German bunds (1.89 vs 1.84%). My Grade: C+
Spreads in Italian BTP exploded, now at 6.45% for 10 year bonds (Wednesday 7.5%, last week 6.6%). Greece 10 year at 28.4% (high 20s price level). Austria 10 year 3.37%, France OAT 10 year at 3.39%. My Grade: C-
In the commodity space base and precious metals continue their volatile moves. Silver at 34.7, Gold at 1780. My Grade: B+
Volatility: VIX stable at 30 % from last week.
Last week we spent a lot of time with credit hedge funds. Credit hedge funds take positions in fixed income instruments, anything from sovereign debt to corporate and structured debt (ABS, RMBS, CMBS et al). The majority of these managers focus on idiosyncratic risk and hedge their positions. A small number takes outright long or short positions. We identified a number of interesting commonalities: hardly any fund has produced big numbers, most are plus / minus zero YTD. US RMBS offer good opportunities for specialists in these markets. They preserve capital, with lower volatility, but fail to produce positive returns. Secondly many use the same instruments for hedging: liquid equity markets, namely the S&P500, but also other liquid equity indices. The hedging with S&P futures explains part of the volatility in equities, but also seems suboptimal as these managers are exposed to significant basis risk. Thirdly most hedge funds agree on their extremely negative view on European banks and the PIIGS. The investable Dow Jones Credit Suisse Core Hedge Fund Index is -0.6% to November 9, 2011, YTD -6.24%. CB Arb and Managed Futures are up MTD, but also down for the year. Teh broader non-investable index has much better numbers: Fixed Income and Global Macro 3.6% and 5.8% YTD, Short Bias up 13%. In conclusion a tough year for hedge funds, but security selection (picking great manager) adds significant alpha. My Grade: A-
We are turning positive as some of the political and macro risk decreases and rates remain at lowest levels. The Christmas rally in equities will continue, as hedge funds and other investors are underinvested, but equity indices will have to break through the major resistance levels (S&P500 at 1275, FTSE at 5700). Investors will have to pick excellent hedge fund managers or securities that give enough beta and alpha to benefit from the rally.
We feel that some progress has been made in Europe and the mood has turned positive now. The fixes are still short term and many challenges ahead, but short term into the new year we see a more positive market environment. Hopefully politicians will use this window of opportunity and come up with the bazooka. My grade: A-
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