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Tuesday 17 January 2012

...Something More About Head- and Tail-Winds

Presented here are more provocative and sufficiently joined-up thoughts about market forces from the editor of FPM. Originally written before Christmas, but now posted with editorial screening. Also tempering health warning on the blog: this article published for highlighting prescient factors in the economy as much as for coherency or depth of argumentative analysis. 

While foreseeable indications point to more headwinds for the capital markets and economies in 2012 (as considered below), then by implication potential upside surprises is also augured. As someone who also doesn't like talking in absolutes I hope that makes 'hedged sense'. The below prescient comments makes up the body of the series on investment climate. Commentary continuing from Headwinds and Tailwinds: An Opening Salvo... ,which endorses FPM's wish to see Ron Paul nominated as Republican presidential candidate, and perhaps even President by the general elections.

Markets, Plays and Players

Market bears and shorts are in full parade now, projecting their managed-down realistic expectations about the corporate and economic climate outlook. At the same time globally concerted and unilateral policies are continually being hatched by politicians to restore confidence. Confidence is still fragile after the downturn from housing- and credit bubbles which started four years ago.  Amid the deleveraging cycle, it’s not inconceivable to witness a sudden turnaround in sentiment and subsequent upside extending towards pre-Lehman highs. This low probability optimism stems from belief that policy makers may produce a bold panacea to quicken deleveraging, such as addressing structural issues by say introducing inflation and consequent debt destruction. At FPM, we believe the benchmark S&P 500 moving down to 1,076 is the next support level more likely to be tested on the downside, more so than the 1,255 resistances on the upside. The latter resistance level is evidently the pre-Lehman high set on 15th September 2008.

With such uncertainty capital market investors staying on the sidelines seems prudent. FPM believes there are select asset classes which are recession-proof. In circumstances where the cornerstones of investment performance, being asset allocation and timing trends, becomes trickier than avoiding awkward dating moments, then FPM recommends a select alternative funds exposure (‘SAFE’). Alternative Investment (AI) funds represent an array of multi-assets and myriad strategies, such as actively managed hedged equity strategies and macro funds allocating and timing between assets. Strategies which not only invest in plain vanilla equities and bonds as long-only investments, but potentially extending to commodities, real estate, and private equity and using leverage, derivatives and ability to short. FPM is supported in our general thesis of recommending select alternative funds for the foreseeable investment landscape by a master of hedge fund investing, Julian Robertson. In a recent CNBC interview he stated that the: “the [hedge fund] industry has a lot of legs because it is the best way to run money, the easy times are over."
In light of global banks and other traditional lenders having been choked-off by new reserve capital requirements of Basel III and against a sovereign debt crisis, the shadow banking sector still has firepower and liquidity.By shadow banking system I refer to financial firms that practice global banking activities, which includes hedge funds, private equities, insurance companies, regional banks etcetera. Google plight of American insurance giant AIG, and Spanish & German regional banks in the financial crisis to understand their roles in the new financial services structure. So established asset managers and start-up ones as successful asset gatherers are increasingly taking up the capital-void left by investment banks. For example, hedge funds which are traditionally organised as proprietary trading desks are also making private equity and bank style loans. Remember hedge fund personnel often wear their investment bank experience as a badge of honour, highlighting the offshoot nature between global banks and shadow banking protagonists. See also FT's op-ed on 28th December:"Traditional lenders shiver as shadow banking grows"

FPM believes this defragmentation in the source of investment capital is an important development; a trend multiplied at the turn of the new Millennium.  No longer a core of ‘bulge bracket banks’ and other investment banks bear the risks they raise with lending and investing activities. Notwithstanding the influence of colossal players like Fidelity, Vanguard and Pimco as real cash investors. Risk being raised, sliced and disseminated too widely is at the heart of the financial crisis. The ability to break-down and transfer credit risks in debt / loan transactions via structured products, such as ABS and CDO products, DID MITIGATE WHOLSESALE DAMAGE to the banking system in the current credit crisis. That is, the whole global banking system was brought to its knees due to counterparty solvency and collateral quality concerns like that of Lehman and ABS, respectively. Hence the governments of Europe and US were opening up special liquidity financing window via EFSF and TARP etcetera. Instead of wearing the credit risk intermediaries raised, they were able to spread it via CDOs and the like in the fragmented shadow banking world and causing wider systemic consequences.


 Sovereign Liquidity and Solvency: National debt restructuring speculation is expected to continue to be a fundamental driver in credit markets, and therefore by its significant size and threat of credit event the wider capital markets.

End-November 2011 European sovereign debt auctions reflected severe liquidity strains: Italian and Belgium 10-Year Yields Hit Euro-Era Highs. The sovereign debt burden of the Eurozone is not the only negative newsflow hampering the markets. US woes about Congress and Senate passing bills to extend and manage the national debt ceiling, currently above its constitutionally designated $15 trillion, is also major weighing heavy on investor sentiment. Most investors believe the reserve currency status of the US Dollar will ensure “at-any-cost” policies being enacted, despite the partisan politics and drama in negations.

e.g. Lithuania’s fifth largest bank, Snoras, was nationalised as Lithuanian authorities shut down the bank after it observed irregularities in the bank’s operations.

“…Hungary could become central Europe’s first casualty of euro zone crisis. Growth is poor, debt is high and a credit ratings downgrade to junk is likely. Disquiet over government policy is a problem and risks of deleveraging by Western banks are large. Hungary needs IMF funds.”

“…Cypres  acceded to the Eurozone in 2008, but it's already in a heap of trouble. A recent loan agreement with Russia of €2.5 billion will keep it afloat for a few months into 2012.” [Another Eurozone Country Bites the Dust]

Corporate defaults:  The global corporate default rate is expected  to increase to 2.4% from current 1.8% in 2012, with U.S. media and advertising and European business services companies worst affected, according to Moody’s Investors Service in a December 2011 report. There was a “considerable rise” in defaults in November, with 10 issuers rated by Moody’s missing debt payments. So far, 31 companies have defaulted this year compared with 55 during the same period last year.
Notably, these are not just small start-up failures. For example, MF Global was a $41 bn US broker-dealer who filed for bankruptcy on 31st October 2011, becoming the 8th largest bankruptcy in US history.

Stop Press: Saab declares bankruptcy as GM blocks Chinese deal. FPM is again on the money, focusing on the pertinent issues without blinkered parochial view!
Why does the market concentrate on one story at time?

Currency Wars: The manager of the world’s largest currency hedge fund FX Concepts believes the Euro currency is in “death struggle”. FPM cites this as one of many fundamental macro trends to identify and exploit in this dynamic global economic milieu. The long-term downward trajectory of the US dollar, mitigated by its reserve currency status, is another such trend. Also, the mean-reversion and fundamental re-rating plays in the Euro is inevitable (in its current form or re-structured form). Currently, the Euro at $1.34 is trading above its life-time average of $1.2044 because of debt purchases by the European Central Bank and European financial institutions repatriating funds.

Baltic states and other emerging countries re-aligning their exchange rates to reflect stronger and growing economies is of course another trend.

Radical Fundamentalism Wanted from US Presidential Elections: Unless real political and economic reforms are delivered to address US sovereign debt, yet another painful and steep deleverging cycle is anticipated. Another economic downturn precipitated by destabilising events, such as an unexpected Eurozone sovereign debt defaults / restructure, especially debts of the largest Eurozone sovereign borrower Italy, whose credit-risk premium may peak to unsustainable 7-8% levels.  See FPM’s take on the November 2012 general elections via a look at the Republican presidential nomination candidates, "The man we’re backing for president". With updated headline-value reinforcing demand for new era politics from those most concerned about their futures: Ron Paul Just Nabbed Iowa's Biggest Youth Endorsement

US Recovery Was Made in Washington: It has been hailed that the equity market and economic recovery from the 2007-09 recession was “Made in Washington”; through various quantitative easing and liquidity financing. QEI- and QEII–type liquidity pumping has helped to stabilise capital markets from a state of catharsis. The Fed purchased $2.3 trillion in housing and government debt in two rounds from December 2008 to June 2011. FPM without being cynical asserts that ‘policy smoke and mirrors’ were used repeatedly to support S&P 500 plunging by 20% from highs pumping liquidity to stimulate economic activity thus averting prolonged or double-dip recession (defined technically as a bear market); and by. In the UK recessions are generally defined as two successive quarters of negative growth.

In not precisely addressing the real issues of a major housing slump, financial crisis and now unfolding sovereign insolvency, the Volker-crafted Greenspan-era fixes are only as sustainable as national debt levels are manageable. FPM asserts more decisive ‘real pain policies’ are needed to counteract corporate and consumer profligacy and revolving government administrations passing the buck, in recent business cycles. The buck stops here!

Promptly raising interest rates should encourage profitable lending on the money supply side, and credible borrowing on the demand side by both consumers and corporations. Leading to high-yield seeking capital investment projects, and greater propensity for consumer savings generating much needed capital on the supply-side. Cheap money only means lower investment hurdles characterising prolonged Japan-style deflation and stagnation.

Current economic policy of providing low-cost re-financing via public finances is only assisting those corporate and individual entrepreneurs who borrowed and lent irresponsibly if not greedily. Their irresponsibility is being propped-up. Creditors should eventually be forced to write-down their investment interests in what is materially at the end of the day only inflated paper-money valuations i.e. trillions of currency in aggregated computer systems (data centres) or accounting book entries referencing real / absolute and synthetic / abstract investment returns. Which as the saying goes is not worth the paper its written on! De-leveraging is supposed to result in lower valuations. A cycle that can unfold over an agonisingly long-time like the Great Depression to clear itself, only if dynamic creative-destruction is held-up by status quo preservation. 

Instead of slow implementation of Dodd-Frank measures to give time and relief to debt-burdened entities, those watch-dogs and their over-sight policies with real teeth should be enacted immediately.  At the moment the weak corporations and sovereign countries are being picked-off by vulture-enterprise, bond vigilantes etcetera. If not directly causing a default or restructuring, these shorts-and-bear investors are certainly heightening anxieties among real cash investors. The latter of whom are therefore left perplexed and scratching their heads, at least according to the editor of this article on his meetings with the investment crowd.

P.S. Yet another sign of stalling recovery is that US domestic profits of non-financial corporations increased only $17.4 bn in the 3Q11, compared with an increase of $80.8 bn in the second quarter. Stark!

People Revolution Against Crony Capitalism: In times of national economic strife inter-government politics and indeed between debtors and creditors, and other cosy good-times fostered relationships become fraught.  Mis-allocation of resources from ingenuous economic enterprise should not be financially supported by national governments at the expense of its future generation tax burden. Voters in 2018 can expect to be a heavy taxpaying citizenry. A democracy run by government promotes individual freedom for its citizenry; otherwise rulers and society are organised and designed towards wealth creation for a minority of corporations and its core owners. This evidently is a plutocracy – not really a characteristic of a true and just democratic social organisation of people! This has also resulted in great inequalities in wealth distribution, in many nations and NOT FORGETTING that in a wider global historical perspective too. Witness the recent world-over civilian unrest, especially at the heart of modern capitalism through the nexus of Occupy Wall Street and we are the 99% protest movement. Even in London, United Kingdom, where human tolerance, social welfare and relative socioeconomic-geopolitical are stable there were looting and rioting in major city streets during August.

Wilting Confidence / Sentiment: We all know the importance of confidence and sentiment in economic decisions, and especially for propping up a house of cards. For instance, the Euro crisis causes continuing drop in confidence. Eurozone economic sentiment declined for a ninth month in November 2011 to hit a 2-year low, as heightened sovereign debt crisis coupled with weak global growth took its toll on confidence. The economic sentiment index fell to 93.7 from 94.8 in October, a monthly survey conducted by the European Commission showed. The reading stayed below the expected 93.9 level. There was a broad-based deterioration in sentiment across the sectors.

Caution Over Dotcom-Era Type Hype IPOs: In a light issuance environment for raising equity capital, the supply of issues could be expected to be of high quality and successful. Zynga and Groupon offerings demonstrate renewed difficult business climate following rebound in IPOs in 2010, and company-specific risks in e-commerce business models. For example, in November the three-year old website broker Groupon made headlines after raising $700 mn from its IPO, which valued the company at $12.6 bn. Following a dramatic first day boost (November 4th), to above $31, the stock price at writing is $22.25 (December 12th close). IPO price was $20.
Housing Recession is the Elephant in the Room: Since house prices peaked in mid-2007 the US housing-led credit boom and bust continues to be a drag on its economy, and by implication elsewhere too. A picture speaks a thousand words, as below: 

By understanding how much further residential house prices have to fall for the market to clear itself, FPM seeks to gauge  any turnaround possibilities in the world’s largest economy and its related US$ 11 trillion bond market, that of US mortgage securities. While there are many versions of HPI*** data, and analysis about house price inflation fuelled by reckless lending to facilitate demand from yield hungry mortgage security investors.
Currently there is a slow clearing process in the US housing markets thats about delinquencies and foreclosure practices, while mortgage resets have taken a backseat. The price of housing loans will be relevant in 2012. As unemployment situation and further house price correction takes its toll on mortgages and their securitised products. For example, delinquencies in securitised Alt-A mortgages were seen rising sharply, with Credit Suisse forecasting US$2.4 trillion of Alt-A mortgages in existence at the beginning of 2010. Also that most of these were due for rates reset in 2012. ***An FPM Monitor Situation*** 
Since foreclosure crisis is is expected to shift from subprime mortgages to outside of the housing sector, losses are also expected in the largest US$3.5 trillion commercial real estate.

More than following national price levels FPM Monitoring are watching data on job growth, mortgage purchase applications, housing starts, consumer sentiment and homebuyer traffic pointing to improvements in the housing correction. An asset bubble deflating is in fact the factor auguring protracted low growth economies. Despite the drawn-out and seemingly immense crisis in the Eurozone, this is only a side-show detracting from the US housing-led bubble.

> Data Point: The national foreclosure rate was 3.48% in September 2011 according to California-based business analytics provider CoreLogic

The Unemployment Drag: While official US unemployment exceeds 9%, notwithstanding higher unofficial estimates, policy makers have this aim of crucially reducing it, while juggling with set targets for inflation and keeping the lid on it.

Only Chicago Fed President Charles Evans has publicly supported the idea of allowing consumer-price increases faster than 2 percent annually as a way to lower unemployment. The interest-rate commitment should be contingent on joblessness falling to around 7 percent or 7.5 percent as long as inflation stays below 3 percent in the medium term, Evans said in September. Fed policy makers aim for long-run inflation of about 1.7 percent to 2 percent.

 Unemployment is also a stupendous problem in Eurozone countries, especially those that are at the core of the debt crisis. Spain’s jobless rate jumped to 22.8%. Among 16 to 24-year-olds, it’s a staggering 51.4%, up from 18% in 2008 when Spain’s crisis began with the collapse of its housing bubble. In Greece, youth unemployment reached 46.6%. In Portugal, it’s 30.7%, in Italy 30.1%.


Private sector credit workout moves unabated: Global credit management arm of Blackstone, GSO Capital acquired the   largest manager of leveraged loans in Europe in September 2011.

Orderly Mechanisms of Credit Default Swaps: While recent credit events have convened ISDA’s CDS determination committee there has however been orderly auctions and settlements, despite counterparty credit-risk concerns about contingency payouts.

Converging Traditional and Alternative Asset Management Practices: The expected trend in merging practices of traditional long-only investing firms such as Fidelity and Vanguards with savvy and flexible alternative asset managers, such as hedge funds and private equity is well underway. For example, lower management and performance fees for hedge fund investors, down from the heralded 2/20 fees, is a clear trend. This is inevitable as lower absolute returns of hedge funds, investing in severe market dislocations, makes 2/20 seem onerous. Also, 2/20 didn’t matter so much when annual returns were double-digit, and still irrelevant for hedge fund big-hitters delivering alpha performance, who will be entitled to charge premiums.   Together with other technical reasons like lower yields from low interest rate environment, and increasing supply of hedge funds, means annual performance expectations lowered. Consequently, “after years of poor hedge-fund performance, some pension managers are demanding better terms, including lower fees”.

Emerging Markets Emerge and Frontier Markets Come to the Fore:  Many expect the drivers of global growth to be from BRIC type economies, as consumer deleveraging and subsequent disincentive for corporate capital investment in developed economies stalls global economic recovery. FPM concurs with view that Brazil, Russia, India and China with other smaller emerging economies can continue to grow their undeveloped industries and markets. Even more optimistically, by 2015 i.e. 8 years from onset of crisis, FPM believes the mobilisation of consumer demand from these heavy populous countries will substitute for stymied western consumption.
FPM would also add another large population country to the BRIC acronym, conveniently coined by Goldman Sacs: Indonesia would enhance the acronym to ‘BRIIC’.

CDO / CLO & Other Structured Products: The accruing performance fee feature of ABS- and CDO-like structured products makes them still performing assets, with caveat about underlying asset quality. Not so toxic assets as initially labelled after the deluge of credit downgrades and subsequent fire-sale re-rating of valuations.  As witnessed by the amount of M&A transactions where cash-rich asset managers have been gobbling-up specialist structured credit managers .

Like vultures hovering to feed on the bounty of a large animal carcass, so it is with distressed asset managers circling European leverage loans and sovereign debt sell-off. The vulture analogy is not meant negatively but one to describe utmost practical functionality i.e. scavenging is useful in cleaning up decaying matter efficiently. Similarly, non-performing loans are acquired and serviced by investors in exchange for property or material rights the debt bestows. A vital creative-destruction process in capitalism, maybe an antithesis or corollary to private equity activity of build-and-harvest.

Regulatory Arbitrage From Reforms and Retribution: Incumbent politicians and their regulatory bodies are fighting to keep their nation state from sliding into debt difficulties. Governments have to do battle with creditors who desire to preserve their wealth by keeping debt paper values whole. At the same time alternative investors or shadow banking entities are speculating on the next hand that policy makers’ will play. Their speculation via CDS on bank and sovereign debts is evidently bringing governments and banks to their knees, at least in the theatres of the Eurozone and US credit banking. Witness yield spreads movement on sovereign debt following policy-maker news flow this year.

Citing wider negative consequences to public assets in the form of our pensions and other saving investments there is justifiable reluctance to allow creditors, mainly banks and money managers to go to the wall and voluntarily write-down or write-off sovereign debts or other entirely. Capitalism’s doomsday scenarios arise from systemic consequences of letting strategically important global banking swallow the pain of their irresponsible credit expansion. Notice the perpetual moral hazard and its irony i.e. of being caught between a rock and a hard place.

In today’s headline terms, mainstream media supplied by vocabulary-edited editors (who in turn are dictated to government agencies of propaganda) confusingly inform professionals and public about debt ‘haircuts’ and ‘orderly’ bankruptcies and ‘voluntary’ debt defaults. Language is power and it is wielded like the sword by those who can! We all remember how ABS structured products termed ‘toxic assets’ were euphemistically re-phrased ‘legacy assets’.

Authorities have no wish to see bond and other term financing markets seize-up (like the ABCP market at the onset of US Subprime collapse catalyst). So lead-debtor-nations (LDNs) within fiscal trading blocks or otherwise, and their watchdog multi-lateral agencies such as the EU, ECB, EBA, FED, IMF, World Bank etcetera keep the banking system afloat at the behest of Ben Bernanke by "printing" bank credit. From the same revealing Henry Blodget of BusinessInsider.com article citing Mark Dow of Pharo Management:

“All that printing has made banks' "excess reserves" explode, which means [banks] have a ton of lending capacity if they want it… because the banks themselves need to deleverage: They need to build up their capital levels relative to their asset (loan) levels. And making new loans won't help them do that… In other words, most of the money Ben Bernanke is printing is sitting in bank accounts at the Fed, not finding its way into the economy. And because it's not finding its way into the economy, it's not destroying the value of the dollars that are already in circulation…”.

At FPM we have identified dealer pricing / marks in bond markets as an indicative of banking liquidity, in light of Basel III, Dodd-Frank and Euro-woes. (See video below with Troy Gayeski, senior portfolio manager at SkyBridge Capital).

FPM therefore argues that in the long-run banks cannot be supported by LDNs printing bank credits. As this will lead to and / or exacerbate structural deficits in debtor countries. Structural deficits ARE NOT advocated by Keynesian economists, only that “deficit spending is desirable and necessary as part of countercyclical fiscal policy”.

A sovereign credit default / event like Greece would be a catalyst equivalent to the sequence of events that led to the ABCP markets freezing-up as rating downgrades of structured subprime mortgage securities unfolded in 2007. The obvious difference is the scale of events; which would be a greater seismic event, as opposed to a tremor caused in ABCP short-term funding market, in earthquake parlance.

Whilst threatening liquidity financing problems via interbank 

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