Weekly Commentary on Financial Markets:
12 December 2011
by Jacob H Schmidt
Slow Progress and Enfant Terrible
News of the week: ECB cuts rates by 25 bp to 1%; UK vetoes EU deal and gets isolated; European banks need Euro 115 b in capital; FSA publishes RBS report
Europe – Euro
Another eventful week, some progress on the European front, but not enough to calm the markets. European politicians seem to have gotten the message as they tried to hammer out a comprehensive solution, not perfect, but certainly in the right direction. Fiscal compacts (i.e. greater fiscal cooperation and coordination), additional 200 b in funds but no bazooka. Because the UK prime minster David Cameron vetoed the deal leading to an isolation of the UK as no other country followed him, the deal is not fully agreed. We believe that Cameron’s move was a serious error of judgement and based on bad advice: the UK cannot afford playing l’enfant terrible as it has important trade relationships with the continent, has London as a global centre of finance and wants to be a leader rather than a niche player like Switzerland. Cameron is in the hands of Tory backbenchers who are working on an EU referendum. This has already put a lot of strain on the coalition government and will upset many global companies who have their headquarters in the UK. Germany and France seem 100% committed to make this work, with or without the UK, but the pace is European style. Many analysts do not understand the continental European way of decision making and negotiations. We believe that the last summit has shown that there is a clear political will to save Europe, the Euro and to move on. However there will be more summits, slow progress and confusing messages out of Europe. But let’s not forget Europe is heterogeneous and still work in progress. Any comparison with the USA is mistaken.
The Euro was very volatile due to the political developments, the ECB rate cut and the press conference by ECB president Draghi on Thursday. Draghi was very clear in his message on policy, the outlook for the economy and the role of the ECB. However we believe that one needs to read his message clearly: when he says that the ECB can’t and won’t take up a bigger role, it means that he will do so when markets get ugly. And it is clear that markets are unsatisfied with the outcome of the summit and the slow pace. Hence they stay volatile, with significant temporary downside risk. The ECB will have to do more to support the periphery markets. As written last week, the solution will be in a two-class Euro, allowing the weaker countries to stay within the Euro, but becoming more competitive. UK papers wrote about preparations at the UK Treasury (finance ministry) as to a potential break-up of the Euro. These news are little helpful, as they are incorrect: of course the Treasury has to foresee any potential outcome, but the likelihood of a Euro breakup is far-fetched. Nevertheless tough times ahead.
My Grade: C+
No real news on Greece, secondary market prices for GGB are now 20 bid for most maturities. Very tough for holders of debt who have it marked at 50 or higher. At 20 Greek GGB start looking interesting: the carry is massive. The risk is that Greek debt will get a 70% discount and long restructuring. In this case the bonds could trade down to the low teens.
My Grade: C-
Austerity program in progress which is good news. While Italian BTP are very volatile (trading between 6% and north of 7%) Italy seems to have secured the refinancing of the Euro 300 b due next year. At 7%+ BTP look attractive, and locals are buying. With the new ECB 2 y loans these bonds are very attractive for banks.
My Grade: B
Again better economic data in the US, but overshadowed by Europe.
My Grade: B+
Company news dominated by news on banking capital: European banks will need to raise Euro 115 b in the next year. For some banks, such as Commerzbank, this might mean a nationalisation and quasi-wipe out for existing shareholders. French banks have massive exposure to Italy and Spain. They will have to address this soon. Their derivatives and other capital intense activities will also have to be cut in view of the higher regulatory capital requirements.
In the UK the long-awaited FSA report on the RBS bail-out was published Monday morning (12 Dec 2011). The FSA explains the failure as a combination of six factors (capital position, ST funding, asset quality, credit trading, ABN Amro acquisition, systematic risk plus number seven RBS management). The FSA claim that under Basle III the ABN Amro acquisition could not happen. Furthermore they say that the FSA was “too focused on conduct regulation at the time” and they ”failed adequately to challenge the judgement and risk assessments of the management of RBS”. They also write that they were understaffed. We do not agree that the ‘light touch’ regulatory regime was the reason for the black out. It is rather the cosy relationship between the agents at the expense of the principal, a classic agency problem. The one answer that remains is why out of several thousand FSA employees nobody realised that RBS ran a massive balance sheet of several trillion on a small equity base, the leverage was massive (between 50 and 70 times at the peak). The information was out there, and many market participants had voiced their negative view. The FSA could have listened to independent market analysts, spoken to hedge funds. It is astonishing that there was no “whistle blower” at the FSA. The language of the report is critical, but unfortunately too general, in the end nobody takes responsibility. Nobody is punished.
The FSA suggests a renewed public discussion on remuneration and more regulation. We believe that in 2008/9 the governments missed a great opportunity to reign in banking activities and corporate behaviour at banks when they saved them from collective collapse. Let’s see what can be done now. We are not against regulation, but doubt very much that more regulation is the solution. What is required is “smart supervision”, where common sense rules, not more regulation. Our conclusion is that the report contributes very little to the burning question of “who”, not “why”.
My Grade: C-
Key dates: Tuesday FOMC meeting announcement. Friday is the important quadruple witching (expiry of stock index futures, stock index options, stock options and single stock futures). PPI Thursday, CPI Friday. Only 15 business days left in US (13 in UK, 14 in Europe) to adjust portfolios.
Markets will continue to be volatile, short term and in a constant risk-on / risk-off mode until next year. My Grade: B+
Rates pretty much unchanged from last week (UST 10 Y at 2.06%, 30Y at 3.11%). German bunds higher, 10 Y yields up 2 bp to 2.15%. We are unimpressed by these levels. My Grade: C-
Spreads continue to be very volatile over the week, Italian and Spanish bonds up and down within hours. Driven by politics and news. Greek bonds are trading now at 20 bid price. My Grade: C+
Gold, Silver and other commodities also very volatile. My Grade: B+
Volatility: VIX at 26%.
Dispersion of performance in all hedge fund styles and also on fund of funds level. The average HF performance of -4% is disappointing and will lead to many reallocations. Only funds and firms with a long track record (positive) and a convincing story will be survivors after 2011. We still see interest for hedge funds exposure from pension funds, but little appetite from leveraged accounts and private clients.
My Grade: A-
Continuous focus on Europe macro development and US data. As per last week for the next 2-3 weeks we remain slightly positive on the stock markets as any good news leads to immediate short covering and investors are under-invested in stocks.
The further developments in Europe will be slow and serious risks remain, but we believe that the political will to save Europe and the Euro is too big to be negative. My grade: B+
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