Weekly Commentary on Financial Markets: 7 November 2011 Towards more instability – waiting for Roosevelt and a European New Deal

Weekly Commentary on Financial Markets:  

7 November 2011

by Jacob H Schmidt

Towards more instability – waiting for Roosevelt and a European New Deal  

News of the week: Papandreou out – coalition government until elections in Feb 2012; Berlusconi out soon as well; European Q3 earnings season in full swing

Europe – Euro

Another round of meetings, this time the G20 in Cannes as of last week ended with little substance, apart from animosities towards Greece. Focus of the G20 meeting was Greece and Italy – whose PM Berlusconi is increasingly isolated in Europe – no mention of the other basket cases Spain, Portugal and Ireland.  The October 26 bail-out has already lost momentum as the Greeks have not accepted the deal, the EFSF is short of money and concerns over the banks dominate the markets. While the media focuses on the Greek drama – Papandreou to resign, a new PM in the person of respected frontrunners Papandreou or Dimas – the reality is that Greece is in a serious political crisis on top of the economic crisis, but Italy is the real problem: 10 year BTP are trading at 6.6% and 30% north of 7%. With Italy facing political turmoil investors are unlikely to pick up BTP at these supposedly attractive rates as these bonds will get even cheaper very soon. The only buyer in town is the ECB, and they have limited resources. The EFSF will be too small to do the heavy lifting. PM Berlusconi might be out of office soon. Out of the three scenarios or Europe

a. no change – continuous instability;

b. reversal of the European project;

c. further integration with a common bond market and fiscal policy

the likelihood of no change with short term fixes is high (70%), and 15% chance of cases a. and c.

My Grade: C-

Greece

In Greece the drama continues, as Papandreou has agreed to resign and the search is for a new prime minister. Both frontrunners have good credentials, but will they be in a position to change anything in Greece? We believe that the interims government will satisfy the formal requirement for the next tranche and buy time. It is not in Europe’s interest that Greece collapses, but the outlook is very grim for Greece. The stability will be very short term. The risk that the new Greek government could go for a default and Euro exit has increased. The immediate default risk (2011) relatively low (2011 bonds trading at prices of 88-90), but any bond after New Year is at risk.  My Grade: D     

US

The WSJ reported last week that 15% of all US citizens rely on food stamps. This is the real tragedy of the recession and the 2008 crisis: official unemployment rate of 9%, unofficial rate of 16%, structurally many are long term out of job and poverty in one of the richest countries of the world. While the US debt is a problem, the increasing poverty in the US is the real failure of the administration. Most European countries do a much better job. The US debt problem will become the focus soon again, when the Joint Select Committee on Deficit Reduction aka Super Committee set up in August 2011 will have to issue a recommendation by November 23, 2011. Nevertheless US debt looks safe versus the less stable European debt markets. US rates to stay at 0% until 2013 at least according to last week’s FOMC. My Grade: B+

Companies

European companies report Q3 earnings, most doing ok, except for the banks, who show heavy write offs due to exposure to Latin Europe and difficult equity markets. BNP Paribas reported a Euro 2.2 b write down on Greek debt (a 60% write off), more French banks to follow this week: Soc Gen, Natixis and Credit Agricole. The focus will be the write off of sovereign debt, the revenues from the business segments and redundancies. The higher capital cost due to Basel III and additional buffers will make banks less profitable. We see more use CoCos (conditional convertibles) to achieve the higher ratios.

In the US Groupon went public with a 30% increase on day 1 (from 20 to 26). While many investors are very critical of the business model and the numbers, the IPO was a first day success due to the controlled size (5%) and probably the role of the syndicate. We believe that Groupon used a small window of opportunity to go public which might close again soon. Linkedin trading at 300 times next year earnings, Groupon at ??. Groupon et al stocks are really for day traders and hedge funds flipping on the first. No serious investor would buy a company with a P/E of 300 or even negative P/E. A lot of OPM buyers.  My Grade: C+

Markets

Continuous high vol in equity markets, FX and bonds which are overshadowed by macro events. Sovereign risk appraisal is en vogue again. My Grade: C+

Stock markets

In the world of economic uncertainty and sovereign risk stocks have been doing reasonably well: Dow is up 3% YTD, SP500 flat, FTSE down 6%, but European and EM stocks down more than 10%. Good, stable companies in liquid markets looking attractive, and the constant sell offs allow investors to pick up great stocks at cheap levels. For traders this creates additional opportunities.  My Grade: B+

Interest Rates

US rates volatile from week to week: 2.04% vs 2.31% for 10 year notes (vs last week); Rates also lower now in German bunds (1.84 vs 2.19%). Too much volatility for large government bond markets.  My Grade: C-

Credit

Wide spreads in Italian BTP, now at 6.6% for 10 year bonds. Greece at default levels. Spain at 5.6%. Irrespective of Berlusconi or a new government, Italy needs to roll over Euro 300 b next year.  My Grade: C-

In the commodity space base and precious metals also volatile. Silver at 34.5, Gold at 1760. My Grade: B+

Volatility: VIX up to 30 % from 24% last week.

Hedge Funds

A tough year for hedge funds, as Dow Jones Credit Suisse Core Hedge Fund Index was up 1.85% in October but down 6.1%. YTD. HFoF doing better, showing that fund selection is key. My Grade: A-

Outlook

Continued political uncertainty, default risk and the fear of a double dip recession guarantee high volatility. For investors the choice is tough as HF and PE flattish at best, most equity markets down and rates low. The Christmas rally in equities has limited upside, investors tempted to take profits where possible.

Conclusion

While European and world leaders disappoint and the naive hope that China would save Europe got dashed, the risks of instability are increasing. According to our analysis there are many parallels to the developments after 1929 when leaders missed the opportunity to reform the process. It took four years until 1933 when President Roosevelt got elected and started the New Deal. Europe is waiting for its Roosevelt (or Roosevelts) and New Deal. My grade: B-

    

Grading: A, A-, B+, B, B-, C+, C- D (adapted from American University Grading / Marking System), higher marks for visibility, clear outlook, little risk, lower marks for little visibility, unclear outlook, high risk.

.

Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Expert Witness. 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.  

Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.

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.

Weekly Commentary on Financial Markets: 31 October 2011 Eurozone Rescue Plan: Big Headline – Little Details

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     

Germany

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

US

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+

Markets

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+

Stock markets

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+

Interest Rates

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-

Credit

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.

Hedge Funds

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-

Outlook

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.

Conclusion

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+

    

Grading: A, A-, B+, B, B-, C+, C- D (adapted from American University Grading / Marking System), higher marks for visibility, clear outlook, little risk, lower marks for little visibility, unclear outlook, high risk.

.

Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Expert Witness. 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.  

Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.

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.

Weekly Commentary on Financial Markets: 24 October 2011: No Bazooka weapon – rather Bazooka chewing gum

Weekly Commentary on Financial Markets:  24 October 2011

by Jacob H Schmidt

No Bazooka weapon – rather Bazooka chewing gum     

News of the week: little progress on European bail-out plan; questions over Chinese slow-down; US earnings season going well

Europe – Euro

We are still waiting for the “bazooka”, but it becomes clear that the package will be much smaller than initially hoped for. Last week’s false news in the Guardian that the European package would be worth north of E 2 t led to more market volatility. Due to much disagreement around the details the deadline for the announcement of the details of the package has been moved to October 26, 2011 when the European ministers will meet again (after this weekend’s meeting). We hear again that other parties such as the BRIC countries should be brought in, but the main idea remains some sort of leverage of the EFSF. We believe that we will see a smaller plan, enough to prevent a market collapse in order to get us to another summit in the next few weeks. In conclusion we seem to get Bazooka chewing gum – remember the funny comic strips and the bad taste the gum leaves in your mouth.  My Grade: C+

The only progress in the Greece PSI is in the much higher haircuts discussed: instead of 21% implied the levels are in the 50-60% range, in line with market levels for Greek debt. Time is running out for Greece and the creditors, but it seems that a default will be avoided at any cost at the moment. Most market participants agree now that Greece has to default and it might be better for Greece to do so sooner rather than later. If they take the pain now, go through one or two years of contraction and restructurings, devalue the currency and regain competiveness, Greece could emerge from the crisis within short period of time – see Mexico 1994, Russia 1998 et al. But it is more likely that the short term fixes continue as politicians believe that the ECB and the European banks would suffer from a default and its contagion.  My Grade: D      

US

US earnings relatively positive so far, better than the revised low estimates. My Grade: B+

Markets

Equity markets continue volatile due to the uncertainty in Europe, but at relatively high levels. US markets are at levels not seen since June, but Europe lagging behind. Company specific news again more relevant. Interesting developments in the miners (Xstrata, Glencore, BHP Billiton), banks (US versus European) and IT (Apple, HP et al). My Grade: B+

Interest Rates

US rates again higher on the long end (2.22% at 10 and 3.27% at 30 year). Market seems to test Fed’s willingness to buy bonds for operation twist and a potential QE3. Bonds still looking pricey here, but if inflation is to drop, Fed intervenes and markets scared due to Europe, they could rally again. Market also knows that PIMCO went long long-dated bonds in massive operation twist speculation. Rates also much higher now in German bunds (2.11%).  My Grade: C-

Commodities continue sideways with high volatility.  My Grade: C+

Hedge Funds

With only three months to go in 2011 and performance across the industry rather weak some hedge funds find themselves in a difficult position: should they add risk here with the potential to turn around for the year (a la PIMCO who has underperformed in long only bonds and has put on his massive long duration tarde), or rather preserve capital. The answer seems to be rather the capital preservation strategy as this is what institutions want and need. We see three developments: a. pension funds and institutions are still interested in hedge funds of funds, but also look at single HF and other structures; b. focus is on low risk, little correlation and capital preservation; c. institutions care for the content, not the wrapper. My Grade: A-

Outlook

The Christmas rally in equities likely to continue for one or two more weeks, selling on the news of a bail-out possible, in particular if high expectations of markets are not met. Investors are confused (term sued by Woody Brocks at Asset Allocation conference last week). Popular view among academics is now that inflation to drop from here (UK headline 5.2%), Greece to default and fiscal policy needed rather than more monetary interventions. At an asset allocation conference I attended last week Nouriel Roubini painted a very dark picture regarding the debt problem in Europe and the US – in line with his reputation as Dr Doom. Other leading economists who grosso modo agreed with him included Woody Brocks – who gave an excellent presentation – as well as the IMF economist for Europe. Investors – both institutional and HNW – have become more tactical in their asset allocation and use many new instruments, tools and techniques, but avoid some products they deem expensive or less useful (e.g. new vol ETF et al).  

Conclusion

Markets have started discounting good news and assume now that the politicians will release a substantial package. The solution will be a short term fix, but good enough to take the fear away for several months, before getting into trouble again. My grade: C-

    

Grading: A, A-, B+, B, B-, C+, C- D (adapted from American University Grading / Marking System), higher marks for visibility, clear outlook, little risk, lower marks for little visibility, unclear outlook, high risk.

.

Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Expert Witness. 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.  

Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.

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.

Weekly Commentary on Financial Markets: 10 October 2011

by Jacob H Schmidt

Bank Bail-out Season, Earnings Season and Year-end Rally      

News of the week: Merkel – Sarkozy meeting ended with promise to recapitalise banks, but without details; Apple Founder Steve Jobs dies age 56; Dexia bailed out again; downgrades of Italy and Spain and banks. 

Europe – Euro

No progress on European front, banks faced downgrades and sovereigns as well. The banking sector is in bad shape, the stress test of 3 months ago not worth the paper written on it. Dexia, one of the largest European banks, was bailed out on Sunday night by Belgium and France (4 b in cash by Belgium, 90 b in guarantees by France and Belgium / Lux, against Euro 700 b in credit exposure), but the other European banks are under immense pressure. This is very bad news for France and Belgium whose public finance is already in bad shape. J-C Trichet is to retire next month and European politicians are working on plans how to save the Euro and Europe, no longer Greece. The problem is: too slow. We believe that it highly likely that the individual nation states will capitalise their banks, as the EFSF might continue to be used to support the Italian and Spanish bond markets. From a European perspective it would be preferable to turn the EFSF into a TARP, i.e. to capitalise all European banks via one source, but as said before, the EFSF is not big enough. No real news from the Merkel – Sarkozy summit on Sunday: they promise to apply common criteria for the capitalisation of the banks, but no further details. This sounds like so many previous meetings: no real progress; no real plan because “the devil is in the details”.  My Grade: C-

Regarding Greece the former taboo – a default by Greece – seems to have become a fact, just waiting to happen. In Germany former chancellor Schroeder presented a plan regarding Europe, including a 50% debt reduction for Greece. Merkel has also shifted her position somewhat, but seems still to target 2013 for a default. Watching events in Greece we believe that they might decide for a default sooner that later. By the way, Greece is running out of money in the next few days....  My Grade: D     

US

Many US data of the last few weeks pointed towards a double dip recession, but last Friday’s better job data has suddenly changed the mood and all eyes are now on the earnings season to start on Tuesday with Alcoa (Dow 30 component). Due to the lower analysts’ forecasts surprises are possible. This could give stocks a boost, and kick off a Christmas rally. Economic situation confusing, Fed still in markets with operation twist, and earnings. My Grade: B+

Markets

Stocks specific news (alpha) as well as market swings (beta) have pushed prices of large companies to the tune of 5-15% per day! As an example Xstrata, a FTSE 100 company with a market cap of GBP 27 b can move + 10% and – 10% (or vice versa) within a day. The early death of Steve Jobs is very sad, as he was one of the great leaders of our times, but for AAPL it is bad news in the mid-term, as we believe that the company will no longer benefit from the genius of its founder. No doubt, the company has a deep infrastructure, a reserve of new ideas and we will continue to buy our Ipods, Iphones and Ipads, but AAPL has seen its best days in terms of stock price and looks fully valued. Bank stocks can be toxic here: any bail-out – recapitalisation due to a Greece default can wipe out current shareholders, see Dexia. UBS fired the two managers in charge of the equity trading business, but apart from UBS CEO Gruebel, no other major reshuffle / changes so far. We believe that UBS will only recover after a proper change in culture and management. On the other hand the next earnings season to start on Tuesday could turn US stock market to “BULL”. The VIX at 36% and interest rates at close to all time low could pull investors in, and the marginal buyers such as hedge funds are currently underinvested. We prefer US and UK stocks over EM and European stocks which are riskier.  My Grade: B+

US interests rates now higher with US 10 Y at 2.08% (vs. 1.9% last week) and German Bunds at 1.94% (vs. 1.6% last week). In the credit markets Greece is trading in the 30s (price wise) with 174% (1Y), 67% (2 Y) and 26% (5Y) and 23.5% (10Y). Italy (5.4% for 10Y) and Spain (5% for 10Y) bearing in mind the ECB purchases. We still believe that Greece is too early and too high to be bought, Italy too expensive and US and Germany yields to low. My Grade: C-

Commodities continue volatile. Gold currently no hedge, but might recover from here after phase of consolidation.  My Grade: C+

Hedge Funds

Many articles report that hedge funds had their worst quarter since 2008, but we also see many funds which have performed well or at least protected capital. Conclusion: first manager, then strategy. Expertise is key, edge essential and small size beautiful. We also see a come-back of hedge funds of funds.   My Grade: A-

Outlook

No change in our outlook from previous weeks. Key data in the next two weeks will be any action by Greece (potential default or similar announcement), bank bail-out in Europe and the earnings season in the US. Investors will also consider positioning for a (or the) Christmas rally.   

Conclusion

Markets driven by more sentiment and robots (high frequency trading, holding positions for seconds only), not by analysis. The next two weeks might be decisive for Greece, Europe, the Euro and the global economy. My grade: C-

    

Grading: A, A-, B+, B, B-, C+, C- D (adapted from American University Grading / Marking System), higher marks for visibility, clear outlook, little risk, lower marks for little visibility, unclear outlook, high risk.

.

Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Expert Witness. 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.  

Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.

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.

Weekly Commentary on Financial Markets: 3 October 2011: Difficult times for investors

Weekly Commentary on Financial Markets:  3 October 2011

by Jacob H Schmidt

Difficult times for investors      

News of the week: EFSF backed by German Bundestag – with constraints; Greek’s next tranche at risk; Buffet in buy back of Berkshire Heathway shares

Europe – Euro

The main concerns of the markets – Euro, EFSF, ECB and the debt problem continue to dominate the markets. Germany’s vote on the EFSF was greeted as a success – only short term though- and is deemed to put pressure on the smaller outstanding countries to conform. The different ideas regarding the EFSF – extending the EFSF from Euro 400 to Euro 2 t; leveraging it by 5 times; using the money to capitalise the banks – floated by politicians, market participants and academics, remind us of 2008 when US Secretary of the Treasury Hank Paulson fought for the TARP in order to support the ABS markets and buy bonds, but changed his mind and saved the banks. Too many ideas, lack of strategy. We believe that an increase in funds for the EFSF is highly unlikely (too difficult to get national support) and the leverage by a factor of 5 risky (its effects not guaranteed). The EFSF will probably take over from the ECB and continue the stabilisation of the Italian, Spanish and other weak government bond markets, until they reach the ceiling and will ask for an increase (and will get a small increase, as part of the muddling through strategy). There is a small chance that the EFSF will become a European TARP, capitalising the banks. The funds would be sufficient and the mission welcomed by most in the markets. Some countries might not like such a development as they would lose the grip on their banks. My Grade: B-

The European Commission’s Barroso gave a big speech on Wednesday to ask for more powers claiming that Brussels (Brussels- Strasbourg) would be better positioned to run fiscal and economic policies than the member nation states. It is not certain that this is really the case, but looking at recent surveys in Germany where 44% in favour of a return of the DM and 75% against more money for a euro rescue fund it seems that the commission is not in sync with the population. My Grade: B-

Greece fighting on all fronts to avoid a default: the PSI (aka reprofiling of the debt) pending, the second tranche – key to avoid a default as Greece will run out of money in the next few days – at risk as the statistical data to be provided by Greece might not be finished and delivered to the TROIKA on time (deadline this Friday). We hear of more demonstrations and real desperation of the Greek population, a dangerous development. It is possible that politicians might consider a default the smaller evil, in the very near future. This is obviously in contrast to the major European states who need to avoid a default to save their banks. We believe that with the second week of October the risk of default is extremely high. While plans are out to tackle this scenario, the reality will be ugly for markets and dislocations dominate for some time. My Grade: C-     

US

While US president Obama suffers from low approval rates due to the bad economic data and risk of a double dip recession, the USA are considered the safe haven in the current global risk environment. China’s slowdown and potential end of the property boom, no decoupling of Asia from a global recession and European debt problem and signs of stress in LATAM make US bonds and equities make look relatively attractive. The political stability and the creativity of the US population are positive factors, but the enormous debt problem, high unemployment and low growth are serious risks which the markets will remember and refocus soon again. We are concerned that in the event of a double dip recession (triggered by a Greece default, the bursting of the China property bubble, or other) the FED will have no tools left: interest rates are already ultra low, the yield curve manipulated via operation twist and QE. My Grade: B

Markets

Equity markets closed down for the week and month. On the one hand have been reporting good earnings and are sounder than in 2008, there are several risks out: earnings disappointments (a la UBS, Man et al), contagion in the event of Greece (banks), risk of a global recession (all stocks), China slowdown – hard landing (miners, China and EM stocks, luxury goods). Man shares sold off 25% in 2 days after reports of big outflows from their hedge fund business. Another rather curious development is Warren Buffet’s announcement that he will now buy back Berkshire Heathway shares (A and B), probably in the range of USD 20 b. This is a strange development as Buffet has been against share buy backs. We believe that he has deviated from his investment approach and engages in transactions which no longer fit his deep value philosophy. The size of the company is definitely too big. The share buy back is a mistake. In general we believe that the next month will be crucial and could be very dangerous, after that some kind of Christmas rally can be expected, even though short lived. My Grade: B

Interests and bond markets look very dear with US 10 Y at 1.9% and German Bunds at 1.6%. In the credit markets we would wait for cheaper levels in Greece (20s/30s rather than current 40s), Italy and Spain expensive. My Grade: C

Commodities suffered one of the worst weeks: all were down, some more than 20% in 2 days, with high volatility. We see commodities in the hands of traders, short term speculators and ETF investors who have very different views that the traditional commercial participants. This trend is likely to continue for the foreseeable future. My Grade: C

Hedge Funds

It is obviously too early to get a proper picture of this month’s performance of the entire industry, but it seems that managed futures and EM were positive while most other strategies were flat to slightly down according to Dow Jones Credit Suisse Core Hedge Fund Index. In any event Q3 and YTD the performance of the indices is negative (YTD -7.3% for the index) which is disappointing. However we see significant divergence in all strategies and also on the HFoF level. In the current markets flexibility, experience and liquidity are key for the success of a manager; manager selection being more important than strategy selection. In addition size is also a factor: smaller AUM easier to manage. Funds on our shortlist are 0-10% up for the year, depending on risk, style and size. My Grade: A-

Outlook

Difficult markets for investors due to political, economic and market uncertainty. While equity markets look more attractive due to the dividend yield / bond yield differential and we see some great bargains, stocks could suffer in a Greece default scenario. We recommend to keep the powder dry and use the high levels of volatility (via options, trading approaches et al). If and when the issues of Greece et al will be addressed markets will react very fast. Investors have to be positioned for this outcome.

Conclusion

The next two weeks might be decisive for Greece, Europe, the Euro and the global economy. My grade: C-

    

Grading: A, A-, B+, B, B-, C+, C- D (adapted from American University Grading / Marking System), higher marks for visibility, clear outlook, little risk, lower marks for little visibility, unclear outlook, high risk.

.

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.  

Schmidt Research Partners are expert providers of advisory services, due diligence, research, consulting and training in financial markets.

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.

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-

Markets:

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-

Outlook:

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.    

Conclusion: 

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.