Tuesday, 27 September 2011

Can we fix it? Yes we can!

Europe central bankers have stolen Bob the Builders catchphrase with their latest and greatest proposal to help the struggling european nations.   For those without children, grandchildren or young nieces and nephews - Bob the Builder is a children’s animated cartoon where the main characters catchphrase is “Can we fix it” to this the other characters shout  “yes we can”.  This is a bit like what is happening at the European Central Bank right about now.  
Defaulting on its debt is nothing new for Greece by the way.
According to academic research, Greece was awarded the dubious honour of recording the first ‘default’ back in around 377BC.  Greece has defaulted on its external sovereign debt obligations at least five previous times in the modern era (1826, 1843, 1860, 1894 and 1932). The first episode occurred in the early days of that country's war of independence, and the last default was during the Great Depression in the early 1930s. The combined length of period under which Greece was in default during the modern era totalled 90 years, or approximately 50% of the total period that the country has been independent.
Although many might consider this level of default to be excessive, Greece is nowhere even close to the top of the list. Venezuela and Ecuador, with 10 defaults each, share the (dis)honour of being the greatest serial defaulters of the modern era.
The latest rescue package announcement to hit the wires is for the use of the European Financial Stability Fund (EFSF) which was created by the euro area member states in May 2010 to assist with the debt crisis that was unfolding at that time. 
There are several moving parts in the proposal but essentially it goes like this -  banks would be allowed to exchange their sovereign debt for debt issued by a special purpose vehicle (SPV) created by the European Investment Bank and capitalised with funds from the EFSF.  The creation of the SPV is seen as important to protect the members and ensure that neither the ECB nor EIB are left carry the can should this all turn to custard.
It is important to also understand that prior to this latest announcement the EFSF has already provided emergency funding to Ireland, Portugal and Greece.  The expectation is that a further 100 billion euros in additional funding is needed just for Greece.
Some commentators are speculating that the proposed plan will effectively make the new vehicle a levered fund, which borrows far more than it has in equity capital provided by European governments. After reading this I am left wondering how leveraging the new fund is going to help and wasn’t this kind of how we got into this mess in the first place?  Maybe we never learn from our past mistakes?

Saturday, 24 September 2011

Project Armageddon - UK most indebted nation

Hard to believe the UK is seen as the most indebted nation according to a new study published on www.arabiamoney.net (full article below).  Prince William's recent wedding to Kate Middleton would not have helped reduce this debt pile either.

With so much having been written about Greece and the contagion effect their default would have on the global economy and global are investors ignoring the fact that the UK could default?  

The study released by brokers Tullett Prebon suggests the possibility of the UK defaulting is not being priced in to any of their assets. As investors are we becoming too relaxed around those economies that are perceived to be too big to fail?
UK most indebted nation in the world reveals new study
Posted on 28 August 2011
A new study from brokers Tullett Prebon called ‘Project Armageddon’ has established the true scale of borrowing in Britain which amounts to a truly staggering £5 trillion or $8.3 trillion.
You would hardly think that reading the Sunday papers today that are monumentally self-complacent and seemingly reckon the UK light years away from Europe in terms of financial problems. Yes, they are in a far worse position.
Once pension fund liabilities and PFI contracts are included the total public debt is £2.46 trillion or 167 per cent of GDP. To that you have to add the £1.34 trillion in financial sector bailouts. The total public debt is therefore £3.6 trillion or 244 per cent of GDP or £135,000 per UK household.
Add mortgage debt
Then there is £1.2 trillion in outstanding mortgage debt and £210 billion in unsecured mortgage credit. Together public and private sector debt amounts to £5 trillion, or 340 per cent of GDP.
‘The biggest single debt increment during the period between 2002 and 2009 was mortgage borrowing, which increased £590 billion between those years,’ explains the report. ‘Many borrowers saw this as an investment, a view which was profoundly mistaken even though many policymakers and even bankers managed to delude themselves otherwise.’
Average UK property prices rose by 70 per cent in this period, until the 19 per cent fall between 2007 and 2008. But most of this private borrowing went into consumption and the public sector did exactly the same thing with its borrowing.
‘Equally worryingly, UK external debt is 400 per cent of GDP,’ notes the study. ‘Far higher than countries such as Portugal, Spain or Greece and equates to $143,000 for each man, woman and child in Britain, again far higher than in most other developed countries.’
Bankruptcy possible
The study concludes that there is ‘a very real possibility of national bankruptcy’ but it notes that financial markets are not yet pricing this into UK debt. You have to wonder how long the very low interest rates available to British national debt can persist in view of the quite obvious massive credit risk exposed by this report.
‘Project Armageddon’ is actually pretty thin on predictions as to where this debt mountain will take the UK, apart from flagging up the inadequacies of current government policies, namely that they rely on the resumption of high rates of economic growth that are impossible with 70 per cent of the economy laden with debt.
You are left to draw your own conclusions about the merits of holding sterling-denominated assets with this sword of Damocles hanging over the economy. And the investment conclusion about the UK is surely don’t go there!

Friday, 23 September 2011

Highway to the danger zone

Apologies for the tacky reference to the 1980’s movie ‘Top Gun’.   I could not help it especially after the President of the World Bank Group (Robert B Zoellick) in his press conference at the World Bank and International Monetary Fund (IMF) annual meetings said the ‘world was in a danger zone’.  

His message to the leaders of developed countries was simple - “dangerous times call for courageous people”.  Furthermore, Zoellick stated that “Europe, Japan, and the United States must act to address their big economic problems before they become bigger problems for the rest of the world.  Not to do so is irresponsible”. When pressed on whether he felt the world was heading for a double dip recession, Zoellick did not think so although he hastened to add that his confidence was eroding daily with the constant drip of bad economic news.

Talking of bad news, this  morning we saw the Dow Jones Industrial Index (Dow Jones) down well over 500 points at its peak.  The Dow Jones index did recover somewhat to close down 391 points.  This sell-off was a continuation of the carnage seen yesterday following the announcement of Operation Twist and a rebalancing of large institutional investment portfolios.  The language coming out of the Fed was overtly negative and this has not gone unnoticed.
One of the things that has gone relatively unnoticed is that the previous negative correlation between gold and equities is slowly unravelling.  Gold has up until very recently, been seen as a safe harbour for investors. There is speculation that some of the major corporates and banks in Europe who had been stock piling gold were now selling the precious metal to shore up their balance sheets. 

Another metal that has been sold off today was copper.  On CNBC.com this morning they highlight that the fall in the copper price is possibly an indicator that more stock losses could be ahead.  Copper has traditionally been seen as a predictor for the global economy.  Jeff Hirsh who runs the Stock Traders’s Almanac is quoted as saying that “every bull market has a copper top”. He also notes the top of a stock bull market has previously co-incided with the top in the price of copper.  Hirsch also notes that it could be time to start buying equities as markets have historically bottomed after this type of sell-off. 

The NZ/US dollar cross rate is now below 80 cents (traded down to 78 cents today) which is a six month low.  What we are seeing is a stronger US dollar as investors are bailing out of what are perceived to be more risky currencies (e.g Euro, NZ$, AUS$ etc) and investing it into US cash, treasuries and some equities.  

Tomorrow’s trading in the US should be an interesting affair.    

Thursday, 22 September 2011

Why were US equity markets down heavily after Fed's Operation Twist announcement?

The US Federal Reserve (“the Fed”) announced the employment of Operation Twist today following 2 days of meetings.  So what is Operation Twist?  In plain English – the Fed is selling out of some of its short dated bonds and buying longer dated securities.  The last time this was enacted was in 1961.

The Fed is aiming to keep interest rates in long dated securities low in an attempt to stimulate the economy. By long dated securities we are talking anything with a maturity in excess of 5 years. 
With the Fed trying to stimulate the economy why did equity markets perform so poorly today after what could be conceived as positive news?

There are many convoluted and complicated answers one could give to why markets fell sharply in the last hour of trading. The following points I trust provide investors with a simple explanation.
     1)   The Fed used language such as "significant downside risks" and identified fears about the volatility in global markets.  This sort of language spooks investors.
     2)  The Fed concentrated more on purchasing 30 year treasury securities as opposed to the 7 year & 10 year securities the market was expecting.  This maturity range is generally seen as a sweet spot for businesses.  The market does not like surprises and investors reacted accordingly. 
     3)  As a colleague of mine (Alan Goldman of Goldman Henry) points out, the move by the Fed to focus more on the longer dated bonds is forcing pension funds and other large institutions to rebalance their portfolios to ensure they remain within their investment mandate guidelines. The only way these investors can achieve this rebalancing is to sell equities and top up their holdings in bonds.  By applying the laws of economics when there are more sellers than buyers the price of a commodity or asset falls.

Ratings agency Moody’s added further fuel to the fire when they downgraded Citigroup, Bank of America and Wells Fargo on the basis they did not believe the US government would bail them out if they failed. 

There is a belief amongst some commentators that not all the information has been completely digested.  The traders may be right in saying today’s sell off was nothing more than a knee-jerk reaction.  Time will tell.