Rethinking Risk With Corporate Emerging Market Bond ETFs

Friday, May 18th, 2012

Last month, iShares intro­duced CEMB, which gives investors expo­sure to emerg­ing mar­ket cor­po­rate debt. Since the fund’s launch we’ve fielded some ques­tions from clients won­der­ing why the yield on CEMB is close to the yield on another one of our funds — EMB, which pro­vides access to sov­er­eign emerg­ing mar­ket debt.

As of May 11, CEMB had an aver­age yield to matu­rity of 4.95%, while EMB’s yield was 4.99%. If I’m tak­ing on more risk with CEMB by invest­ing in cor­po­rate vs. sov­er­eign debt, clients have asked, why aren’t I receiv­ing a higher yield in return? The answer is because in this case, the risk asso­ci­ated with cor­po­rate emerg­ing mar­ket bonds might not be as ele­vated as many investors would think.

First, let’s look at the amount of dura­tion, or inter­est rate risk, of these two funds. As mea­sured by its dura­tion of 5.5 years, CEMB has less inter­est rate risk than EMB, which has a dura­tion of 7.42 years as of May 14.

Now, let’s look at the hold­ings of EMB and CEMB. EMB holds secu­ri­ties backed by emerg­ing mar­ket sov­er­eign gov­ern­ments, like Peru, Rus­sia and the Philippines.

CEMB mean­while gives investors access to the cor­po­rate debt of com­pa­nies domi­ciled in emerg­ing mar­ket coun­tries. It holds the debt of big com­pa­nies like Brazil­ian oil com­pany Petro­Bras Inter­na­tional and South African elec­tric­ity pro­ducer, Eskom Hold­ings. Although the issuers in CEMB are based in emerg­ing mar­kets, many have invest­ment grade credit rat­ings, includ­ing a fair num­ber with AA or A rat­ings. As the chart below illus­trates, the com­po­si­tion of CEMB is slightly higher on the credit rat­ing spec­trum than EMB:

Credit Rat­ing Breakdown:

Investors might assume that emerg­ing mar­ket cor­po­rate bond ETFs would con­sist of bonds that have lower credit rat­ings than those in emerg­ing mar­ket sov­er­eign ETFs, mak­ing them riskier hold­ings that pro­vide a higher yield. But this chart illus­trates that is not always the case, and it helps to explains why a fund like CEMB would have a yield sim­i­lar to that of EMB.

How could investors con­sider using CEMB in a portfolio?

1.) Diver­sify away from US cor­po­rate debt: For investors who own a fund like LQD, which holds invest­ment grade US cor­po­rate debt, CEMB offers an oppor­tu­nity to diver­sify away from US cor­po­rate debt while poten­tially pick­ing up addi­tional yield. LQD’s aver­age yield to matu­rity was 3.52% as of May 11. Addi­tion­ally, with low cor­re­la­tions to other fixed income sec­tors and equi­ties, emerg­ing mar­ket cor­po­rate bonds can add diver­si­fi­ca­tion to invest­ment port­fo­lios. Past per­for­mance is no guar­an­tee of future results.

2.) Access the emerg­ing mar­ket con­sumer: As Russ Koes­terich has noted, emerg­ing mar­ket growth con­tin­ues to cre­ate hun­dreds of mil­lions of new middle-class con­sumers. By 2025 China, India and Brazil are respec­tively expected to be the 2nd, 4th, and 9th largest con­sumer mar­kets in the world, accord­ing to McK­in­sey. The emerg­ing mar­ket cor­po­ra­tions whose bonds are held in CEMB are sell­ing their wares to this grow­ing con­sumer base.

3.) Gain access to emerg­ing mar­ket growth with less volatil­ity than emerg­ing mar­ket equi­ties. For the past 10 year, emerg­ing mar­ket cor­po­rate bonds have had total return volatil­ity of 12.5% as com­pared to 24.4% for emerg­ing mar­ket equi­ties, using data from Morn­ingstar and MSCI, as of April 30.

Matt Tucker, CFA is the iShares Head of Fixed Income Strat­egy and a reg­u­lar con­trib­u­tor to the iShares Blog. You can find more of his posts here.

Past per­for­mance is no guar­an­tee of future results. For the stan­dard­ized per­for­mance of these funds, please click here: CEMB, EMB, LQD.

The per­for­mance quoted rep­re­sents past per­for­mance and does not guar­an­tee future results. Invest­ment return and prin­ci­pal value of an invest­ment will fluc­tu­ate so that an investor’s shares, when sold or redeemed, may be worth more or less than the orig­i­nal cost. Cur­rent per­for­mance may be lower or higher than the per­for­mance quoted. Per­for­mance data cur­rent to the most recent month end may be obtained by call­ing toll-free 1–800-iShares (1–800-474‑2737) or by vis­it­ing www.iShares.com.

Hold­ings are sub­ject to change. To view the com­plete list of hold­ings for CEMB, please click here.

In addi­tion to the nor­mal risks asso­ci­ated with invest­ing, inter­na­tional invest­ments may involve risk of cap­i­tal loss from unfa­vor­able fluc­tu­a­tion in cur­rency val­ues, from dif­fer­ences in gen­er­ally accepted account­ing prin­ci­ples or from eco­nomic or polit­i­cal insta­bil­ity in other nations. Emerg­ing mar­kets involve height­ened risks related to the same fac­tors as well as increased volatil­ity and lower trad­ing vol­ume. Bonds and bond funds will decrease in value as inter­est rates rise. Diver­si­fi­ca­tion may not pro­tect against mar­ket risk.

Copy­right © iShares

Tags: Aa, Cemb, Composition, Corporate Bond, Corporate Bonds, Corporate Debt, Credit Rating, Duration, Electricity Producer, Emb, Emerging Market Bonds, Emerging Market Countries, Emerging Markets, Interest Rate Risk, Issuers, Oil Company, Sovereign Debt, Sovereign Governments, Spectrum, Yield To Maturity
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Credit Markets – Transformers vs Decepticons (Tchir)

Wednesday, May 16th, 2012

by Peter Tchir, TF Mar­ket Advisors

In the movies there are these great bat­tles fought out between the trans­form­ers and decep­ti­cons. As cool as the bat­tles are, there must be some inno­cent bystanders won­der­ing what the heck is going on amid all the destruc­tion. That to me is how the credit mar­kets are trad­ing right now.

None of the core sto­ries have changed. Europe is a mess and has got­ten weaker. The U.S. econ­omy is doing okay, and ZIRP is here to stay even if QE3 isn’t immi­nent. Into that already com­plex world we have thrown the JPM trade into the mix. There seems to be a bat­tle between JPM and those against JPM. That bat­tle is caus­ing car­nage across the credit mar­kets. We are see­ing big and weird moves on a reg­u­lar basis. IG gaps out while stocks do noth­ing. MAIN goes wider while XOVER is tighter, only to go back to mov­ing in lock-step. JNK saw its sin­gle biggest share redemp­tion. Both HYG and JNK chug along all day only to have big fades late into the day. MUB has a steep drop only to bounce right back. What­ever bat­tle between the big guys is going on drags every­one else into it. Stop losses are being hit. The price move is caus­ing con­cern that this is just like 2011 again.

It isn’t like 2011 right now for a cou­ple of key rea­sons. The trans­form­ers and decep­ti­cons aren’t bat­tling over the fun­da­men­tals, they are bat­tling over posi­tion­ing. That is real and has con­se­quences, but once that bat­tle is over, the mar­ket will look at the fun­da­men­tals. So that is one key dif­fer­ence, that in addi­tion to the usual fight between the bulls and the bears, this mas­sive unwind, or poten­tially fake unwind, or unwind of the hedge of the alleged unwind, or some­thing, is adding to the volatil­ity and mak­ing the fixed income mar­ket seem more scary than it is.

LTRO is the other big dif­fer­ence. For all the talk about LTRO being a “carry” game to buy sov­er­eign debt, LTRO at its core was designed to ensure that banks have enough money. While the debate rages about what Greece will do, and how bad the sit­u­a­tion in Spain and Italy is, there is vir­tu­ally no talk about banks not being able to fund them­selves. Peo­ple can look at 2 year swap spreads for signs of stress, and they are there, but be care­ful not to over-react. LTRO is there so that we don’t see a “run” on the banks. I doubt another LTRO would be cre­ated merely to try and sup­port sov­er­eign debt, but if there is a need to get money to banks, the ECB will do that. The ECB, with­out a doubt, is lender of last resort to banks, and is happy and able to ful­fill that func­tions, so that is a big dif­fer­ence between now and 2011.

Greece leav­ing the Euro would be a big deal because of what it would do for all the cor­po­rate loans that have been made. That is yet another rea­son that leav­ing the Euro will take more time than peo­ple want to think. Even if it was easy at the sov­er­eign level, which it isn’t, and the cor­po­rate level it has the poten­tial to cause immense con­fu­sion. All of this can be addressed over time, but real plans need to be put in place and solu­tions to prob­lems thought out, and some resources set aside to deal with unex­pected prob­lems. While that prepa­ra­tion is going on, look for the ECB, and the Troika to soften their tone as they decide that they can­not eas­ily deal with the losses they would face on their own Greek exposure.

So, I would be look­ing to add expo­sure to credit, par­tic­u­larly U.S. high yield, and pos­si­bly in IG, as I think the mar­ket has been dri­ven around too much by noise of this alleged unwind (I still think there is a real pos­si­bil­ity that prior to the press con­fer­ence JPM pre­pared them­selves well for the obvi­ous mar­ket reac­tion and is ben­e­fit­ting greatly from the widen­ing and the volatility).

The fact that we tried to rally and then failed yes­ter­day is a sign of how ten­u­ous the over­all mar­ket is, but right now I can’t help but think the same sto­ries will have less of an effect, and that we are close to the point where Europe man­ages to take some steps that at least seem to help the prob­lems, if not resolve them.

Tags: Big Guys, Carnage, Credit Markets, Decepticons, Enough Money, Fades, Fixed Income Market, Great Battles, Hyg, Innocent Bystanders, Jpm, Key Reasons, Mub, Price Move, Sovereign Debt, Steep Drop, Transformers, Volatility, Weird Moves, What The Heck
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The Hidden Rally in Canadian Equities (Lee)

Tuesday, May 15th, 2012

The Hid­den Rally in Cana­dian Equi­ties
Using a Low Beta Strat­egy to Increase Port­fo­lio Efficiency

Alfred Lee, CFA, CMT, DMS, Vice Pres­i­dent & Invest­ment Strate­gist
BMO ETFs & Global Struc­tured Invest­ments
BMO Asset Man­age­ment Inc.
alfred.lee[@]bmo.com

May 15, 2012
Recent Developments:

• Cana­dian equi­ties got off to a strong start this year with the S&P/TSX Com­pos­ite Index (TSX) ral­ly­ing 6.1% on a total return basis in the two months ended Feb­ru­ary 29, 2012. The opti­mism of a global eco­nomic recov­ery has stalled since then and Cana­dian equi­ties have been weak as a result, with the TSX falling 6.6% on a total return basis. U.S. equi­ties, on the other hand, which we have rec­om­mended over­weight­ing over the last 16 months, have been more resilient in the face of the resur­fac­ing of Euro­pean sov­er­eign debt issues. The S&P 500 Com­pos­ite Index (SPX) was down only 0.5%, also out­per­form­ing the MSCI World Index's –3.5% loss since March 1, 2012. (Chart A)
• Tra­di­tional Cana­dian equity bench­marks have shown weak­ness as of late, given the large expo­sure to sec­tors such as energy and mate­ri­als. These com­mod­ity inten­sive areas tend to be highly sen­si­tive to eco­nomic con­di­tions as they are widely used in con­struc­tion and urban­iza­tion projects. With increased polit­i­cal grid­lock, espe­cially in the Euro­zone nations, there may be less clar­ity in the direc­tion of pol­icy that will be imple­mented in address­ing the eco­nomic malaise. As a result, com­mod­ity and commodity-related areas have recently shown both weak­ness and increas­ing volatil­ity, despite the fun­da­men­tals in some sub-groups, such as cop­per, remain­ing favourable. The implied volatil­ity lev­els of the TSX have recently moved above that of the SPX, as indi­cated by the S&P/TSX Implied Volatil­ity Index (VIXC) and the CBOE/S&P 500 Implied Volatil­ity Index (VIX) respec­tively. (Chart B)
• Though the fun­da­men­tals of the TSX remains attrac­tive, with a cur­rent price-to-earnings (P/E) ratio of 13.8x, momen­tum has remained weak over the last sev­eral quar­ters. How­ever, there have been areas within the Cana­dian equity mar­ket that have shown sig­nif­i­cant strength. On a rel­a­tive level, the con­sumer dis­cre­tionary, con­sumer sta­ples, util­ity and health care sec­tors have all gained con­sid­er­ably against the TSX so far this quar­ter, which has largely gone unno­ticed. Low beta sec­tors, or those that are less sen­si­tive to mar­ket move­ments, have been strong year to date (Chart C). These areas, how­ever, tend to be under-represented in major Cana­dian indices and also in the port­fo­lio of many Cana­dian investors. Also, inter­est­ing to note, a com­par­i­son of rel­a­tive strength trends, show that both the energy and mate­r­ial sec­tors under­per­formed the TSX even dur­ing the first quar­ter, when the appetite for risk was strong.

Invest­ment Idea:

• The port­fo­lios of many Cana­dian investors remain highly exposed to com­mod­ity related areas. While we are not sug­gest­ing that investors aban­don com­modi­ties, espe­cially con­sid­er­ing that fur­ther stim­u­lus would cause com­mod­ity prices to rally sharply, we are how­ever rec­om­mend­ing also adding expo­sure to less-cyclical areas to reduce poten­tial volatil­ity that may arise. More­over, given the afore­men­tioned rel­a­tive strength trends, some tra­di­tional mea­sures of Cana­dian beta may strug­gle as com­mod­ity related sec­tors have lagged the TSX. Investors should there­fore have expo­sure to both com­mod­ity and non-commodity related areas to reduce volatil­ity in their Cana­dian equity exposure.
• The BMO Low Volatil­ity Cana­dian Equity ETF (ZLB) is an effi­cient way for investors to diver­sify into less cycli­cal areas and sec­tors under-represented in tra­di­tional market-cap weighted indices. Some of the largest sec­tor weight­ings in ZLB are con­sumer sta­ples (20.9%), con­sumer dis­cre­tionary (12.5%) and util­i­ties (11.0%). There­fore, ZLB may be used as a com­ple­men­tary posi­tion for many investors, giv­ing them expo­sure to a wider range of sectors.
• In addi­tion, given ZLB has a much lower beta than the TSX (0.48 vs. 1.00 respec­tively), it may be used as a com­ple­men­tary posi­tion to reduce equity volatil­ity and poten­tially improve the risk-adjusted returns of an over­all port­fo­lio strategy.

Chart A: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Man­age­ment Inc.

Chart B: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Man­age­ment Inc.

Chart C: Market-Cap Weighted Indices Are Under­weight Sec­tors That Have Outperformed

Source: BMO Asset Man­age­ment Inc.

*All prices as of mar­ket close May 11, 2012 unless oth­er­wise indicated.

Dis­claimer:
Infor­ma­tion, opin­ions and sta­tis­ti­cal data con­tained in this report were obtained or derived from sources deemed to be reli­able, but BMO Asset Man­age­ment Inc. does not rep­re­sent that any such infor­ma­tion, opin­ion or sta­tis­ti­cal data is accu­rate or com­plete and they should not be relied upon as such. Par­tic­u­lar invest­ments and/or trad­ing strate­gies should be eval­u­ated rel­a­tive to each individual's cir­cum­stances. Indi­vid­u­als should seek the advice of pro­fes­sion­als, as appro­pri­ate, regard­ing any par­tic­u­lar investment.

BMO ETFs are man­aged and admin­is­tered by BMO Asset Man­age­ment Inc, an invest­ment fund and port­fo­lio man­ager and sep­a­rate legal entity from the Bank of Mon­tréal. Com­mis­sions, man­age­ment fees and expenses all may be asso­ci­ated with invest­ments in exchange-traded funds. Please read the prospec­tus before invest­ing. The indi­cated rates of return are the his­tor­i­cal annual com­pound total returns includ­ing changes in prices and rein­vest­ment of all dis­tri­b­u­tions and do not take into account com­mis­sion charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guar­an­teed, their value changes fre­quently and past per­for­mance may not be repeated.

Tags: Alfred Lee, Asset Management Inc, BMO, Canadian Equities, Canadian Equity, Cboe, Cmt, Composite Index, Debt Issues, Economic Malaise, Implied Volatility, Intensive Areas, Investment Strategist, Msci World Index, Political Gridlock, Return Basis, Sovereign Debt, Structured Investments, Volatility Index, Volatility Levels
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Draghi Straits — Money for Nothing

Wednesday, May 2nd, 2012

by Peter Tchir, TF Mar­ket Advisors

Eco­nomic data in Europe brought us back to our typ­i­cal real­ity. The eco­nomic con­di­tions are get­ting worse, unem­ploy­ment is break­ing records, and the stocks and banks of the periph­ery are in trou­ble again. The main sup­port for the mar­ket is com­plete faith that Draghi and ECB will unveil some new plan that will make every­thing better.

LTRO was done on Feb­ru­ary 29^th. Just 2 months after the ECB flooded Euro­pean banks with money and encour­aged them to buy sov­er­eign debt we are back in the midst of a cri­sis. How could LTRO fail so quickly? The bet­ter ques­tion is how could LTRO not fail? The premise that banks, already heav­ily exposed to their own sovereign’s debt would buy more, book the carry, and live hap­pily ever after was flawed from the start. Carry takes a long time to work. Carry is a slow, dull, process, but mark to mar­ket and fear of default is fast and painful. Now banks are mas­sively over­ex­posed to the risk of their country’s debt, fund them­selves through a vari­ety of “non-traditional” meth­ods, and face real risk of big losses as restruc­tur­ing becomes the obvi­ous conclusion.

There has been so much talk about growth ver­sus aus­ter­ity lately, that the true goal was lost in the shuf­fle – sus­tain­able debt lev­els. The debt bur­den is too high both in terms of repay­ment, but just as impor­tantly the cost of ser­vic­ing it. Any legit­i­mate plan to res­ur­rect the economies of Spain and Italy will need tar­geted long term cuts, focused short term growth/productivity ori­ented projects, debt restruc­tur­ing, and pos­si­bly a new cur­rency. When every path leads to the same log­i­cal con­clu­sion, it is time to accept the con­clu­sion, and imple­ment it now. As Greece clearly demon­strated, cling­ing to some false notion that default is “dooms­day” and delay­ing true restruc­tur­ing to appease for­eign cred­i­tors (includ­ing the Troika) leads to a much worse col­lapse. Greece needs another round of restruc­tur­ing already because it didn’t truly embrace default the first time. Default /Restructuring is a process. It needs to be planned for and care­fully imple­mented, but it is now inevitable that it will be a part of the Euro­pean “solu­tion” and banks will bear the brunt of the cost.

In the mean­time, the ques­tion for investors is how likely Draghi unleashes some new money and gives the mar­ket another brief relief rally? I’m not sure he is able to do any­thing mean­ing­ful and right now I believe the mar­ket will fade over the course of the day as real­iza­tion sets in that not much can be done. I’m not quite ready to put this trade on, but am look­ing closely at going long Span­ish stocks ver­sus short Ger­man stocks. The belief that Ger­many will be fine while Spain is a dis­as­ter seems too com­mon and priced in. I’m not quite there on that trade, but it is only that am look­ing at very closely.

While Euro­pean PMI was a “clear” indi­ca­tor of how deep the reces­sion is in Europe, the Chi­nese PMI data seems to tell a dif­fer­ent story? Chi­nese Man­u­fac­tur­ing PMI was below 50 for the 6^th straight month. China is largely a man­u­fac­tur­ing based econ­omy, yet GDP growth is still in excess of 8%. Some­how this reminds me of high school physics when you are sup­posed to under­stand that some­times light is a wave, and some­times it is a par­ti­cle, but never both at the same time. That was basi­cally as far as I got in physics, as I just had a lot of dif­fi­culty com­pre­hend­ing that phe­nom­e­non. Sim­i­larly, I can see how PMI can con­tinue to show slow­down, but GDP can be really high, but it is get­ting harder.

Copy­right © TF Mar­ket Advisors

Tags: Austerity, Breaking Records, Debt Burden, Debt Fund, Debt Levels, Debt Restructuring, Doomsday, Draghi, Economic Conditions, Economic Data, European Banks, False Notion, Logical Conclusion, Obvious Conclusion, Oriented Projects, Periphery, Sovereign Debt, Sustainable Debt, Troika, True Goal
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Art Cashin: The Clandestine War Among Central Banks

Wednesday, April 18th, 2012

Noth­ing dra­matic here, but the Chair­man of the fer­men­ta­tion com­mit­tee [Cashin] just has that unique flair for explain­ing things so sim­ply, even an eco­nom­ics Ph.D., a cave­man, or the other kind of 'Chair­man', would understand...

The Not So Clan­des­tine War Among The Cen­tral Banks - Back in Phi­los­o­phy class in the 5th grade, the instruc­tor in Epis­te­mol­ogy used to have an inter­est­ing para­ble on prob­lems of perception.

The the­sis went some­thing like this: Sup­pose you are an alien and have been told about the game of chess. Due to a tech­ni­cal­ity, how­ever, your equip­ment would only allow you to see one square on the board. Over the course of the game any, or all, the pieces might arrive on your square.

You might see a Knight or a Bishop; a Rook or a Queen or a Pawn, but you would never know where it had come from nor where it had gone when it dis­ap­peared. You never got quite enough infor­ma­tion to envi­sion the entire board or the con­cept of the game.

I was reminded of the para­ble as I have watched the actions of some key cen­tral banks over the last few years.

Accord­ing to the finan­cial media, each cen­tral bank is eas­ing aggres­sively to serve a need of the area it serves.

The Fed is eas­ing to help employ­ment and the hous­ing mar­ket in the U.S. The ECB is eas­ing to help it banks, sink­ing under sov­er­eign debt prob­lems. The People’s Bank of China is eas­ing to avoid a hard land­ing. The Bank of Japan is eas­ing to restart an econ­omy that has been dor­mant for two decades.

Those may be the offi­cial lines but cyn­ics think there may be more to the game than is seen through this tele­scope. Cyn­ics think it’s all about the currencies.

The think­ing is that each bank would like to see its cur­rency weaken to make its exports more attrac­tive. It doesn’t stop there. With Europe being China’s biggest trade part­ner, some believe the PBOC is the bid under the Euro at 1:30, keep­ing the Euro strong enough to make Chi­nese goods attractive.

The cur­rency influ­ences of the other cen­tral banks may be a bit more sub­tle but no less effec­tive or intense. No trade war yet but lots of drilling and marching.

Actu­ally that is not true. from Mer­co­press: "US and EU con­sid­er­ing WTO actions against Argen­tine ‘pro­tec­tion­ist practices"

The US and forty coun­tries which for­mal­ized a joint state­ment before the World Trade Orga­ni­za­tion com­plain­ing about Argentina’s trade restric­tions are con­sid­er­ing mov­ing a step fur­ther and begin a “dis­putes set­tle­ment” process which could lead to an open con­dem­na­tion if the admin­is­tra­tion of Pres­i­dent Cristina Kirch­ner does not lift the pro­tec­tion­ist network.

Accord­ing to Buenos Aires daily Clarin quot­ing WTO sources in Geneva, “expec­ta­tions are that it will be the US that presents the “dis­putes set­tle­ment” process since the White House was the main spon­sor of the joint state­ment. The process could end with a for­mal con­dem­na­tion of Argentina open­ing the way for com­mer­cial reprisals”.

In the March joint state­ment pre­sented by the US and forty other lead­ing coun­tries the main com­plaints against Argentina included the non auto­matic licences sys­tem; the pre­vi­ous sworn state­ment reg­istry to obtain the approval of an imports oper­a­tion and the pol­icy forc­ing com­pa­nies to apply the ‘dollar-to-dollar’ mech­a­nism which means they have to export a dol­lar for each dol­lar import.

Once the dis­putes set­tle­ment begins there is a period of con­sul­ta­tions in which in this case Argentina must prove it has not infringed WTO rules, and if no agree­ment is reached a three mem­ber panel is named, cho­sen by the lit­i­gants or WTO Direc­tor Gen­eral Pas­cal Lamy.

Time for some blogger-cum-budding author (which is about 99% of all) to write a cur­rency wars sequel: Trade Wars: The Final Frontier.

Tags: Art Cashin, Bank Of China, Bank Of Japan, Caveman, Central Banks, Chinese Goods, Clandestine War, Cynics, Debt Problems, ECB, Epistemology, Game Of Chess, Parable, Pboc, Philosophy Class, Problems Of Perception, Rook, Sovereign Debt, Technicality, Trade Partner
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Country Default Risk (YTD April 2012)

Saturday, April 14th, 2012

In our prior post we high­lighted year to date coun­try stock mar­ket returns.  Below we high­light the change in sov­er­eign debt default risk for 50 coun­tries.  For each coun­try, we show where its 5-year CDS (credit default swaps) cur­rently stands and where it was at the start of the year.  Prices are in basis points.

As shown, just 3 of the 50 coun­tries have seen default risk increase in 2012 — Por­tu­gal, Greece and Spain.  Spain is the main prob­lem, with default risk now up 32.31% year to date.

Nor­way, Switzer­land, the US and Swe­den have seen huge drops in default risk so far this year.  Nor­way now has the low­est default risk of any coun­try at 22.05 bps, fol­lowed by the US at 29.6 bps.  It's been awhile since US CDS has been below 30.

Tags: April, Basis Points, Bps, CDS, Countries, Country Risk, Country Stock, Credit Default Swaps, Debt Default, Default Risk, Greece, Norway, Portugal, Sovereign Debt, Sovereign Risk, Spain, Stock Market Returns, Sweden, Switzerland
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Volatility is Back! (Tchir)

Saturday, April 14th, 2012

by Peter Tchir, TF Mar­ket Advisors

Volatil­ity is back. The S&P moved more than 1% on 4 of the 5 days, had the biggest down day of the year, and even the least volatile day was a 0.7% move.

Back on April 5th, we saw a warn­ing sign in the credit mar­kets that the bid/offer spread for Euro­pean CDX indices was widen­ing. This has extended into invest­ment grade indices in the US where not every dealer main­tains a ½ bp mar­ket any­more. That lack of liq­uid­ity, which has also been a fac­tor in the sov­er­eign debt mar­ket (espe­cially for Spain) has hit the equity mar­kets as well. We are see­ing big­ger moves on less infor­ma­tion. I believe that this volatil­ity will con­tinue in the short term and that we will see at least one big capit­u­la­tion to the down­side in equi­ties. The Nas­daq seems more sus­cep­ti­ble to such a move since it is still trad­ing above the 50 day mov­ing average.

Euro­pean stocks under­per­formed. That is likely to con­tinue. The prob­lems in Spain and Italy will be directed much more towards Euro­pean insti­tu­tions, and banks in par­tic­u­lar this time around. Gener­i­cally I like being long US finan­cials ver­sus short Euro­pean finan­cials, because although the entire mar­ket will get dragged down by renewed prob­lems in the Euro­zone, the cor­re­la­tion will not be as high as last time.

The Whale

It is hard to talk about trad­ing last week, par­tic­u­larly in the credit mar­kets, and avoid the big JPM CIO trad­ing story. I think that as details come out, the size of the posi­tion has been blown out of pro­por­tion. It will be much smaller than some of the head­line num­bers, and there will be long and short com­po­nents and it will make a lot of sense both from a spe­cific trade stand­point and also from a JPM busi­ness risk stand­point. I con­tinue to believe that it is more in IG9 tranches, with hedges in HY, also pos­si­bly in tranches, and some curve trades.

In any case, the trade is still large and should raise con­cerns for reg­u­la­tors. The too big to fail argu­ment is one obvi­ous ques­tion that needs to be addressed. Is this trade for the “bank” or for the “invest­ment bank”? For those look­ing for a much clearer seg­re­ga­tion of the busi­nesses run by JPM, this trade will be some­thing they can point to. It is com­ing to light in a period of rel­a­tive calm for the mar­ket, unprece­dented sup­port for banks from the Fed, and gen­eral dis­dain of bankers from the pub­lic in an elec­tion year. That could be what is needed to ignite a push towards a return to Glass Stea­gall or some other new legislation.

It may also be the straw that breaks the camel’s back in terms of push­ing deriv­a­tives on to exchanges. This is some­thing that should have been done imme­di­ately after Bear Stearns if not before, but for a vari­ety of rea­sons (bank lob­by­ists) has been avoided up until now. The reg­u­la­tors should exam­ine the whole chain of these trades. Who bought them and what they did with them? How many bil­lions are sit­ting in mark to model books as opposed to hav­ing been traded? How much smaller would the trades been, and how much less would any dis­tor­tion be, if every trade was on an exchange with a stan­dard ini­tial mar­gin require­ment and vari­a­tion margin?

Reg­u­la­tors need to exam­ine the whole series of trades, not just what JPM has on their books, and a renewed effort to develop proper exchange traded CDS needs to be done. None of the argu­ments against this have much cred­i­bil­ity, as mark to model car­ries risk, and if the mar­ket has to shrink to sup­port proper mar­gin require­ment, who really is hurt?

Jobs and Hous­ing

The job­less claims this week were bad, plain and sim­ple. I have seen argu­ments that more peo­ple quit, so it is “good” job­less claims, but since I have never seen a report detail­ing how many peo­ple were laid off but not eli­gi­ble to make claims (which I think is a grow­ing pro­por­tion of the work­force), I will largely ignore that pos­i­tive spin.

Vir­tu­ally every data point sig­nals that the Jan­u­ary and Feb­ru­ary reports over­stated the real long term improve­ment in the econ­omy. The jobs num­ber is impor­tant, but mostly for what it could have meant to hous­ing. Ulti­mately, we need the hous­ing mar­ket to rebound to see the econ­omy as a whole ben­e­fit, and that data lagged the job data all year long. The hopes were that some­how the jobs data was cor­rect and hous­ing would catch up. Now, it seems clear that hous­ing was cor­rect and jobs were over­stated, so we may have a lot longer to wait for that hous­ing recovery.

With­out a hous­ing recov­ery the mar­ket will strug­gle to go up much from here. It is too impor­tant of a sec­tor, so it is hard to be bull­ish at these val­u­a­tions with no real sup­port from housing.

China and Europe

China dis­ap­pointed this week. There is no land­ing yet so it is impos­si­ble to deter­mine whether it will be “hard” or “soft”. I am lean­ing more and more towards hard, as I find it hard to believe the weak data reflects the whole truth, and there seems to be enough real con­cern about infla­tion in China and the state of the banks that more eas­ing may be slow to come, and the pres­sure on the banks and prop­erty may come far faster than any new eas­ing pol­icy can stop.

Spain is in trou­ble. There is no liq­uid­ity for their bonds. Span­ish 5 year and 2 year bonds now trade with higher yields than Italy. That was always the case in CDS, but the LTRO money and much smaller Span­ish bond mar­ket had dis­torted that rela­tion­ship in the cash mar­kets. It is an omi­nous sign that those spreads have moved so much – as it shows that not only is LTRO no longer work­ing for sov­er­eign debt, but that the banks own too much and are bet­ter sell­ers if any­thing. The focus is on the 10 year, and the fact that it looks set to breach 6%, and that is bad, but this rapid nor­mal­iza­tion of the shorter end of the curve is pos­si­bly even more important.

Any fund that pur­chased these bonds lead­ing up to LTRO2 is now fac­ing a sig­nif­i­cant loss, and the lack of liq­uid­ity is scary. I do NOT think the ECB will step up in a mean­ing­ful way this week. The EFSF is sup­posed to take over sec­ondary mar­ket pur­chases, and it is shame­ful that it doesn’t seem set up to do that yet, but there are other rea­sons that the ECB may not buy bonds. It is close to what it viewed as its limit for SMP, which leads to the obvi­ous ques­tion of why didn’t they sell some bonds in the past month when the mar­kets were hot? More impor­tantly, the coun­tries may not want the ECB to buy bonds if they are seri­ously con­sid­er­ing a PSI. The ECB hold­ings were incred­i­bly dis­rup­tive dur­ing the Greek debt nego­ti­a­tions and are the pri­mary rea­son the restruc­tur­ing has been a fail­ure (any restruc­tur­ing where the new bonds trade at 20% of par has to be deemed a fail­ure). So don’t get too excited about pos­si­ble ECB intervention.

There is some talk about Eurobonds (again) and var­i­ous other pos­si­ble pro­grams to unite Europe, but I don’t see that hap­pen­ing any time soon. I think the strangest thing is that Spain agreed to 3% deficit tar­get in the future. I never believed it would hap­pen, but health­care costs aren’t part of the Span­ish deficit. No, in Spain, health­care is largely a “regional” issue. That is why the regions are in such deep trou­ble. It is clear that no coun­try in Europe counts for any­thing in the same way, and any of these “tar­gets” is eas­ily manip­u­lated with some sim­ple changes, and the use of “guar­an­tees” as opposed to debt.

The Span­ish debt load is look­ing like a “black hole”. You start with what seems a man­age­able sov­er­eign debt to GDP ratio, but finally grav­ity is start­ing to pull regional guar­an­tees, bank debt guar­an­tees, off mar­ket swaps, and banks full of unre­al­ized prop­erty losses, into the same spot. That “black hole” is not man­age­able and as real­iza­tion hits, Spain can choose to strug­gle for years and capit­u­late down the road when things are much worse (like Greece did and Por­tu­gal is in the process of doing) or they can stop the non­sense and work out a proper debt restruc­tur­ing plan now. This will hit Euro­pean banks harder than any other sector.

The Out­look

I expect lower equity prices at some point this week. We may open with a bounce based on some IMF announce­ment or some ECB inter­ven­tion, but this is why I think one more downleg:

• Spain in par­tic­u­lar, and Italy to a less degree will weigh on the mar­kets, drag­ging Euro­pean bank shares down, and affect­ing the rest of the market
• Real­iza­tion that the data in the US has been decid­edly weak over the past month will finally over­whelm the mar­ket and those cling­ing to mem­o­ries of Jan­u­ary and Feb­ru­ary NFP
• QE in any of its myr­iad of forms is fur­ther away than the mar­ket cur­rently priced in, the reac­tion to Yellen’s com­ments shows just how crit­i­cal QE is to stock mar­ket val­u­a­tion, but it is NOT crit­i­cal to the econ­omy and those con­cerned that it is actu­ally hin­der­ing the econ­omy are becom­ing more vocal, so QE expec­ta­tions will take another hit
• Credit mar­kets are becom­ing more volatile, less liq­uid, and not just in CDS and for banks, but across the board, this has been a con­sis­tent lead­ing indi­ca­tor of fur­ther weakness
• Weak data glob­ally, and not just in the U.S. has been ignored so that will come into play mak­ing any sell-off that much worse
• AAPL. I have no real rea­son to dis­like AAPL, but lots of “fast money” seems to be sit­ting on big prof­its and could choose to sell, and the price seems to have out­run what is actu­ally being accom­plished, it seems like it is being val­ued on I-Phone 7 sales, I-Pad 5 sales, and other future earn­ings while ignor­ing that every­where I go, noth­ing is sold out or dif­fi­cult to get – like it used to be. For this rea­son, I like Nas­daq to under­per­form. Also, if big com­pa­nies start spend­ing bil­lions of their cash hoard in what might be viewed as a friv­o­lous man­ner, then val­u­a­tions for the entire sec­tor can drop quickly.

As always we will see what the data comes up with, or whether any believ­able polit­i­cal, cen­tral bank, or supra­na­tional insti­tu­tion actions develop to change the view. I don’t expect any­thing dra­matic, but could cer­tainly see the S&P 500 pulling back towards its 100 DMA, now that is has breached the 50.

Copy­right © TF Mar­ket Advisors

Tags: Business Risk, Capitulation, Correlation, Credit Markets, Day Of The Year, Debt Market, Downside, European Stocks, Eurozone, Hedges, Hy, Jpm, liquidity, Questio, Sovereign Debt, Standpoint, Tranches, Volatility, Warning Sign, Whale
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Voldemort, Volcker, and Magic (Tchir)

Friday, April 13th, 2012

by Peter Tchir, TF Mar­ket Advisors

Yesterday’s move seemed almost mag­i­cal. Yellen spoke and the mar­kets lev­i­tated overnight. Job­less claims were a big dis­ap­point­ment. Revi­sions hit the prior week’s num­ber and yesterday’s num­ber was much closer to 400k than to the almost myth­i­cal 350k the mar­ket had become used to expect­ing. The magic of BLS revi­sions have ensured that although num­bers close to 350k were reported for at least 3 weeks, they have all been re-written as 360k or higher.

The mar­kets briefly fell, but then sto­ries of “gnomes” leak­ing China GDP started the mar­kets higher again. That 9% GDP print turned out to be illu­sion­ary, as the real num­ber came in at 8.1%, and since I see no rea­son for China to lie about it to make the data worse than it is, the real growth is prob­a­bly even slower than that.

The weak­ness in sov­er­eign debt over the past week finally made investors look behind the cur­tain of Draghi’s LTRO show, and they are under­whelmed. The fact that LTRO does what it is sup­posed to – ensure banks have access to money – is now a dis­ap­point­ment as too many peo­ple had believed that LTRO could do more than it actu­ally could.

Which leads us to Volde­mort and Vol­cker. How much of JPM’s earn­ings were a direct or indi­rect result of the activ­i­ties of the CIO’s office. We may never know, espe­cially the indi­rect part. I believe the pri­mary trade they have on is long credit via tranches on IG9 vs short HY17 and HY18. The trade makes sense, both as a trade, but for JPM and their busi­ness in par­tic­u­lar. It explains both the price moves in IG9 and the decom­pres­sion of HY CDS in an envi­ron­ment that would nor­mally see com­pres­sion. He is big, but the “prop” trad­ing peo­ple are wor­ried about the wrong things. The Vol­cker rule was meant to limit prop bets on mar­ket mak­ing desks. Banks do need to take risk. Every­one, the Fed included, wants the banks to lend more, but each and every loan is a prop bet, and there is no prof­itable way to run a fully hedged lend­ing book. Let the CIO and trea­sury run the bank.

Cor­re­la­tion desks, includ­ing the one at JPM should be looked at closely. If a desk buys a tranche and sells a cor­re­spond­ing amount of “delta” is that not a “prop” bet? As a mar­ket maker, they haven’t bought and sold some­thing, they bought one thing, and sold another. Vol­cker should be look­ing at those posi­tions and deter­min­ing how much model risk should be allowed. A cor­re­la­tion bet is a bet like any other (just more com­pli­cated). The noise about IG9 is rea­son­able, just misplaced.

As yesterday’s magic dis­si­pates, it is hard to see any­thing in the data that jus­ti­fies the bull­ish­ness. I remain wary of the mar­ket, and cer­tainly feel bet­ter today as being caught too short yes­ter­day was painful. CDS indices are weak across the board. Spi­tal­ian 10 year bonds are both trad­ing down today, and 5 year Spain now yields 16 bps more than 5 year Italy. A clear sign that the manip­u­la­tion has run its course (the size of the Span­ish bond mar­ket makes it far eas­ier for the ECB and banks to con­trol prices – at least for brief peri­ods of time).

I will be look­ing to add HY17 or HY18 risk today. Not as a gen­eral risk on trade, but because if I am cor­rect and they are part of the “whale” trade, they will be left alone by the big buyer and we can see some of that com­pres­sion that should have occurred ear­lier this year. HYG and JNK are both back to “pre­mi­ums” to NAV that seem unsus­tain­able, par­tic­u­larly given the over­all tone of trad­ing so far today.

Tags: Banks, Bet, China Gdp, Curtain, Decompression, Desks, Disappointment, Draghi, Earnings, GDP, Gnomes, Indirect Result, Jobless Claims, Prop Bets, Revisions, Sovereign Debt, Tf, Tranches, Volcker, Voldemort
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Austerity – Mais, non. Spending – Nein. PSI – Tal Vez?

Thursday, March 29th, 2012

by Peter Tchir, TF Mar­ket Advisors

Aus­ter­ity hasn’t worked for coun­tries. So far the aus­ter­ity path has made sit­u­a­tions worse, rather than bet­ter.  With­out stim­u­lus, economies have seen their prob­lems com­pound.  So now vir­tu­ally every­one is against the idea that aus­ter­ity is helpful.

That takes us back to spend­ing.   Maybe it’s just me, but spend­ing is what got us into this mess in the first place. If spend­ing worked so well and was so easy we wouldn’t have a sov­er­eign debt cri­sis in the first place.  Vir­tu­ally every coun­try was spend­ing, yet deficits grew and economies shrank.  Why is there any faith that spend­ing now will work?  Are we so good at tar­get­ing spe­cific things that will really, truly, work?  Not a chance.  Spend­ing will ensure debt grows just as fast, make the prob­lem even big­ger in the end, but will make peo­ple slightly hap­pier in the near term.

So if aus­ter­ity doesn’t work, and spend­ing hasn’t worked, what will?

PSI, or Default, or Restructuring.

Debts have grown so big, that the only way to bring them under con­trol is to default on them in one form or another and wipe some out per­ma­nently.  Doing it sooner than later is key.

Now is the time.  Por­tu­gal 75% hair­cut.  Ire­land 50%.  Spain 40% hair­cut (once they put all the Span­ish guar­an­teed debt on bal­ance sheet, they will need 40%).  Italy 25%.  Greece – just make EU and ECB eat the same dish they served to pub­lic sec­tor.  Only IMF money is sacro­sanct.  The ECB, EFSF, and EU can take losses like the rest of us.  The EU talks about “fire­walls”, well, put up or shut up.  The ECB can print away the losses.

Using cur­rent data, here is the amount of debt at the sov­er­eign level for each coun­try (I think if they are going to do the restruc­tur­ing, they should put on bal­ance sheet a lot of the guar­an­teed debt, so they only have to do this once).

Por­tu­gal:  €171 bil­lion * 75% = €128 billion

Ire­land:    €122 bil­lion * 50% = €61 billion

Spain:       €712 bil­lion * 40% = €285 billion

Italy:      €1,631 bil­lion * 25% = €408 billion

Total write-downs would be €882 billion.

A lot of banks have writ­ten down hold­ings in Por­tu­gal already and taken reserves on other coun­tries.  Greece shows that banks had done a semi decent job reserv­ing against it.  Let’s assume €100 bil­lion of losses have been reserved against or already marked.

That leaves €772 bil­lion of losses.

The ECB has about €175 bil­lion of non Greek bonds on its SMP bal­ance sheet (or a num­ber close to that)?  Assume an aver­age loss of 40% on that (it is a mix of debt from the var­i­ous coun­tries).  That is €70 bil­lion accounted for.  The ECB should just print that money. Call it a one-time exer­cise. With all the default/restructuring, infla­tion isn’t likely to be a concern.

So that leaves €702 bil­lion still that needs to be taken out of the system.

Uni­credit has an equity mar­ket cap of €23 bil­lion.  Intesa is about the same.  Ass­gen (an insur­ance com­pany, where the bond ticker is so much more fun than actual equity ticker) has a mar­ket cap of €19 bil­lion.  BBVA is €30 bil­lion.  DB is €35 billion.

The losses will be a mas­sive hit to the bank­ing and insur­ance indus­try.  But to some extent, so what?  The big “money cen­ter” banks will all sur­vive it.  The DB’s, SocGen’s, BNP’s, HSBC’s of the world will take some seri­ous hits.  US banks will take some hits.  But they have plenty of equity cap­i­tal to sup­port it, and they made bad lend­ing decisions.

The BBVA’s of the world will get hit extremely hard, but they should be able to sur­vive it.  I’m less sure about some of the Ital­ian banks as they seem to have big­ger con­cen­tra­tions, but in the end, there are a lot of banks.

So let the restruc­tur­ings begin and fig­ure out what to do with the banks after.

Many will sur­vive with­out assistance.

Some banks may fail.  If the ECB and EU and EFSF pro­tect senior unse­cured cred­i­tors from losses at the expense of equity and sub debt hold­ers, then the risk of a bank­ing death spi­ral goes away. How much needs to be pro­tected and at what level is unclear.  Some banks that were truly over exposed should see losses to  bond­hold­ers too.  Less losses for the pub­lic to bear and more losses for the bad deci­sion mak­ers to bear.

Pro­vide “War­ren Buf­fet” style equity cap­i­tal to banks that want it or need it.  Why shouldn’t the tax­pay­ers make money like War­ren does?  Stop with the easy money for banks, make them pay the coun­try like they would a pri­vate investor.

There has been ZERO evi­dence that bank share prices influ­ence lend­ing. It doesn’t seem to mat­ter what we cur­rently do to banks, they aren’t lend­ing much.  So let’s not worry about their share price.  So long as they have access to money, they will or won’t lend regard­less of whether their share prices are low.

Banks that are pre­pared and pru­dent will thrive in this environment.

Rather than mak­ing it hard to start new banks, the ECB and Fed should encour­age new banks. There has to be 10’s of bil­lions of Pri­vate Equity money that would start good mid-size banks.  Heck, maybe we could get an i-Bank.  But seri­ously, new money has been crowded out of the space by zom­bie banks and kick the can policies.

Take the hit.  Fig­ure out who excels, who fails, and for those in between, what is the cost of sur­viv­ing.   Open the mar­kets to new equity cap­i­tal and new participants.

Maybe this is too harsh and will never work, but it is a bet­ter path than pur­su­ing the same poli­cies that have failed year after year.

Tags: Austerity, Balance Sheet, Debt Crisis, Debts, Dish, ECB, Efsf, Faith, Greece, Haircut, Hasn, Losses, Nbsp, Psi, Public Sector, Restructuring, Sovereign Debt, Stimulus, Tf, Time Portugal
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Where Are We in the Boom/Bust Liquidity Cycle?

Thursday, March 29th, 2012

Where Are We in the Boom/Bust Liq­uid­ity Cycle?

By Thomas Fahey, Asso­ciate Direc­tor of Macro Strate­gies, Loomis Sayles

March 2012

In an often cyn­i­cal world, stan­dard fi nan­cial and macro­eco­nomic quan­ti­ta­tive mod­els give peo­ple the benefi t of the doubt. Fun­da­men­tal eco­nomic the­ory assumes the best of us, sup­pos­ing that human beings are per­fectly ratio­nal, know all the facts of a given sit­u­a­tion, under­stand the risks, and opti­mize our behav­ior and port­fo­lios accord­ingly. Real­ity, of course, is quite dif­fer­ent. While a sig­nifi cant por­tion of indi­vid­ual and mar­ket behav­ior can be mod­eled rea­son­ably well, the human emo­tions that drive cycles of fear and greed are not pre­dictable and can often defy his­tor­i­cal prece­dent. As a result, quan­ti­ta­tive mod­els some­times fail to antic­i­pate major macro­eco­nomic turn­ing points. The ongo­ing debt cri­sis in Europe is the most recent exam­ple of an extreme event shat­ter­ing his­tor­i­cal norms.

Once an extreme event occurs, stan­dard mod­els offer lim­ited insight as to how the ensu­ing cri­sis could play out and how it should be man­aged, which is why pol­icy responses can seem dis­jointed. The lat­est pol­icy responses to the Euro­pean cri­sis have been no excep­tion. To under­stand and respond to a cri­sis like the one in Europe, per­haps we need to con­sider some new mod­els that include the “human fac­tor.” Eco­nomic his­to­rian Charles Kindle­berger can offer some insight. In his book Manias, Pan­ics, and Crashes, Kindle­berger explores the anatomy of a typ­i­cal fi nan­cial cri­sis and pro­vides a frame­work that con­sid­ers the impact of the pow­er­ful human dynam­ics of fear and greed. Kindleberger’s descrip­tive process of the boom and bust liq­uid­ity cycle can help shed light on the cur­rent Euro­pean sov­er­eign debt saga, and per­haps illu­mi­nate whether we have in fact turned the cor­ner on this fi nan­cial crisis.

KINDLEBERGER AND THE MINSKY MODEL

Kindle­berger ana­lyzed hun­dreds of fi nan­cial crises dat­ing back cen­turies and found them to share a com­mon sequence of events, one that fol­lowed mon­e­tary the­o­rist Hyman Minsky’s model of the insta­bil­ity of a credit sys­tem. Fun­da­men­tally, the more sta­ble and pros­per­ous an eco­nomic struc­ture appears, the more lever­age and spec­u­la­tive fi nanc­ing will build within the sys­tem, even­tu­ally mak­ing it highly vul­ner­a­ble to a sur­pris­ing, extreme col­lapse. Kindle­berger pro­vided the qual­i­ta­tive (as opposed to quan­ti­ta­tive!) descrip­tion of the Min­sky Model, shown below, which is a use­ful snap­shot of the liq­uid­ity cycle. It can be applied to Europe and any poten­tial boom/bust can­di­date, includ­ing Chi­nese real estate, com­mod­ity prices, or investors’ recent love affair with emerg­ing mar­kets. Kindle­berger famously dubbed this sequence a “hardy peren­nial,” prob­a­bly because the gal­va­niz­ing human con­di­tions of fear and greed are more often than not prone to over­shoot fun­da­men­tal val­ues com­pared to the behav­ior of a ratio­nal indi­vid­ual, which exists only in macro­eco­nomic theory.

DISPLACEMENT

The boom typ­i­cally starts with a “dis­place­ment,” a macro­eco­nomic shock (for exam­ple a new tech­nol­ogy, dereg­u­la­tion of an indus­try), that cre­ates new profi t oppor­tu­ni­ties. For Europe, dis­place­ment came in the form of the Eco­nomic and Mon­e­tary Union (EMU) in 1999, which united par­tic­i­pat­ing coun­tries under a sin­gle mon­e­tary pol­icy and cur­rency, the euro. By estab­lish­ing one inter­est rate for EU mem­ber states, EMU enabled all par­tic­i­pat­ing sov­er­eigns to trade as if they pos­sessed Germany’s supe­rior cred­it­wor­thi­ness, regard­less of their fi scal con­di­tion. The oblig­ing mar­ket responded by lend­ing to EU coun­tries indiscriminately.

BANK CREDIT FEEDS THE BOOM

Armed with “AAA credit” bor­rowed from Ger­many, Europe entered the next phase of the cycle: bank credit feeds the boom. As Euro­pean bond yields con­verged to Ger­many under the united cur­rency, it appeared that Europe had entered a new era of exchange rate and inter­est rate sta­bil­ity. How­ever, this con­ver­gence weak­ened mar­ket dis­ci­pline and spurred mount­ing lever­age in Europe’s pub­lic and pri­vate sec­tors. Money was unprece­dent­edly cheap for many sov­er­eign nations and, con­se­quently, the pri­vate sec­tor also saw huge declines in inter­est rates. For exam­ple, neg­a­tive real inter­est rates in Spain and Ire­land fueled real estate booms. Europe ended up with a one-size-fi ts-none mon­e­tary policy.

Impor­tantly, when bank credit feeds the boom, Kindle­berger explains that the fi nan­cial sys­tem often spawns “new” forms of money. This is known as the elas­tic­ity of credit, and it facil­i­tates bor­row­ing and spec­u­la­tion. In Europe, Basel cap­i­tal rules facil­i­tated the elas­tic­ity of credit. Using the assump­tion that devel­oped mar­ket sov­er­eigns would not default, Basel cap­i­tal rules had loop­holes that allowed banks to hold sov­er­eign bonds with­out some off­set­ting charge to risk-based cap­i­tal. As a result, bank appetite for sov­er­eign bonds was endur­ing despite dete­ri­o­rat­ing credit profi les in coun­tries like Greece and Por­tu­gal. With­out any cap­i­tal charge for sov­er­eign bonds, this cre­ated unchecked lever­age on bank bal­ance sheets.

The wave of secu­ri­ti­za­tion and the rise of repur­chase and sale (or “repo”) agree­ments also spawned new forms of money that fed the credit boom. The secu­ri­ti­za­tion and repo mar­kets were the dark cor­ners in which the global fi nan­cial cri­sis man­i­fested itself, because the run on Lehman Broth­ers’ assets occurred in the repo mar­ket, not out­side the broker-dealer’s front door. Sim­i­larly, the Euro­pean bank­ing cri­sis and rush for liq­uid­ity is occur­ring through the inter­bank repo markets.

The repo mar­ket, like bank­ing, is a vehi­cle of liq­uid­ity trans­for­ma­tion. Banks secure fund­ing in short-term liq­uid mar­kets, lend in longer-dated less liq­uid mar­kets and col­lect the inter­est rate spread between the two. Liq­uid­ity trans­for­ma­tion is sus­cep­ti­ble to pan­ics and runs if short-term lenders lose faith and demand imme­di­ate repay­ment. Banks have deposit insur­ance to limit runs, but only up to cer­tain cash lim­its, say €250,0001. In the repo mar­ket, where the sums of money are in the bil­lions, bor­row­ers post col­lat­eral, which serves as insur­ance to let lenders know their money should be safe. This col­lat­eral, usu­ally a pool of loans or bonds, allows banks to secure cru­cial fund­ing liq­uid­ity through short-term loans.

Secu­ri­ti­za­tion and the repo mar­ket expanded the elas­tic­ity of credit that fed the boom. In a cir­cu­lar fash­ion, they also increased the demand for eli­gi­ble col­lat­eral to post as insur­ance in the repo mar­ket. This is where the fi nan­cial engi­neers went to work and helped cre­ate AAA col­lat­eral out of worth­less loans to sub­prime bor­row­ers. By not requir­ing cap­i­tal charges on sov­er­eign bonds, the laissez-faire reg­u­la­tory envi­ron­ment also made sov­er­eign bonds highly val­ued col­lat­eral in repo transactions.

SPECULATION, OVERTRADING & GEARING

As the cycle churned on, the urge to spec­u­late in sov­er­eign bonds, real estate and struc­tured prod­ucts drove prices higher, and the veloc­ity of money (rate at which money changes hands) expanded. This is typ­i­cal of booms—easy credit and the increased wealth that accom­pa­nies soar­ing asset val­u­a­tions feed a sense of eupho­ria and the per­cep­tion that asset val­ues will increase indefi nitely. Greed enters. In Europe, pri­vate and pub­lic investors were rid­ing high. They will­ingly sus­pended their dis­be­lief, seduced into think­ing the music would never stop. Liq­uid­ity trans­for­ma­tion, espe­cially in the repo mar­ket, tends to be very pro-cyclical. As long as prices rise and col­lat­eral val­ues remain sta­ble, there is ample market-based liq­uid­ity to fuel the over­trad­ing and gear­ing (lever­age) of assets. It was cir­cum­stances like these that led Irish banks to lend against ques­tion­able assets six times the size of the nation’s econ­omy with­out being ques­tioned. Accord­ing to Minsky’s fi nan­cial insta­bil­ity hypoth­e­sis, this is the time when the fi nan­cial sys­tem starts becom­ing highly spec­u­la­tive and shaky despite the appear­ance of sta­bil­ity. Just look at how sta­ble Euro­pean bond yields were before the cri­sis, hid­ing deep­rooted credit prob­lems in the periph­eral markets.

INSIDERS TAKE PROFIT AND THE RUSH FOR LIQUIDITY

Finally, the cycle grinds to the point at which insid­ers start to take profi ts, pre­cip­i­tat­ing a rush for liq­uid­ity. Insid­ers are investors who pos­sess an infor­ma­tion advantage—and they rep­re­sent a pow­er­ful real­ity that fl ies in the face of eco­nomic the­ory and mod­el­ing. If insid­ers or lenders begin to worry that the col­lat­eral pool (of sov­er­eign bonds, bank loans, struc­tured prod­ucts) is weak­en­ing, they can demand bet­ter col­lat­eral or a big­ger hair­cut (the dif­fer­ence in value between the actual money lent ver­sus the posted col­lat­eral). These increased require­ments com­pro­mise bor­row­ers’ abil­ity to fund their liq­uid­ity trans­for­ma­tion, fear unseats greed, and the pan­icked rush for liq­uid­ity is on. Bor­row­ers are forced to sell assets and reduce lever­age, caus­ing prices to abruptly reverse.

The fact that trans­ac­tional money (or market-based liq­uid­ity) and credit (like the repo mar­ket) are not fac­tored into tra­di­tional eco­nomic mod­els is a crit­i­cal rea­son why these mod­els failed to iden­tify the sever­ity of the global fi nan­cial cri­sis or its rever­ber­a­tions through­out the inter­con­nected fi nan­cial sys­tem. It was in the repo mar­ket that the insid­ers fi rst began to take profi ts dur­ing the Euro­pean sov­er­eign and bank­ing panic of 2011, just as they had done three years ear­lier when Lehman Broth­ers imploded. As shown in the chart to the right, dur­ing the sum­mer and fall of 2011, the level of repo reported by the Fed­eral Reserve and Euro­pean Cen­tral Bank (ECB) was declin­ing, sig­nal­ing insid­ers’ stress and the rush for liq­uid­ity. Though most tra­di­tional mod­els may have missed the signs of spec­u­la­tive fi nance and grow­ing insta­bil­ity, the Min­sky Model helps high­light these risks, at least fi guratively.

REVULSION, FRAUD, DISCREDIT AND THE LENDER OF LAST RESORT

Once the liq­uid­ity reverses, caus­ing a fi nan­cial crash and cri­sis, the fi nger point­ing begins. Heroes turn to vil­lains as revul­sion, fraud and dis­credit creep in. Banker revul­sion has become an endur­ing issue, the Greek fraud as to the true size of its national debt has been dis­closed, and the notion that a devel­oped mar­ket sov­er­eign could not default was dis­cred­ited. The saga has fol­lowed the typ­i­cal sequenc­ing of a fi nan­cial cri­sis, but a crit­i­cal ques­tion remains: have we moved past revul­sion, fraud, dis­credit and turned the cor­ner toward recovery?

Accord­ing to Kindleberger’s fi gura­tive descrip­tion of Minsky’s liq­uid­ity cycle, we should be turn­ing the cor­ner on the bust phase of the global liq­uid­ity cycle because lenders of last resort have fi nally promised suffi cient liq­uid­ity to restore order—or have they?

In our pre­vi­ous updates on the Euro­pean cri­sis, we were very crit­i­cal of the ECB because it was, in our view, not act­ing like a cred­i­ble lender of last resort. There was a rush for liq­uid­ity when the Euro­pean repo mar­ket plum­meted in the fall of 2011. Widen­ing credit spreads, falling equity prices and tighter bank credit indi­cated the mar­kets were scream­ing for liq­uid­ity. At that time, we believed that the ECB needed to expand its bal­ance sheet much more aggres­sively and meet the ris­ing demand for liq­uid­ity. The ECB has since responded, and its bal­ance sheet is expand­ing rapidly. Most recently, the ECB broke the fever of risk aver­sion with its three-year Long-Term Refi nanc­ing Oper­a­tion (LTRO), which deliv­ered liq­uid­ity to the bank­ing sys­tem and should help avert the devel­op­ment of a severe credit crunch.

While cen­tral bank liq­uid­ity buys time, it does not fi x the fun­da­men­tal sol­vency ques­tion of whether there is enough future income to ser­vice out­stand­ing debts. The say­ing “a rolling loan gath­ers no loss” is a nice thought, but even­tu­ally bad debt has to be rec­og­nized, and some­one has to take a loss. The gear­ing, or lever­age, from the past decade’s credit boom was mas­sive and is tak­ing a long time to resolve. It takes time to reveal which assump­tions on future income, prices and profi tabil­ity lev­els were faulty when lever­age was ris­ing rapidly. Recent infor­ma­tion on some Euro­pean bal­ance sheets, includ­ing the Greek sov­er­eign bal­ance sheet, has revealed such extreme gear­ing that it is unre­al­is­tic to think future incomes and tax rev­enues will be suffi cient to ser­vice the debt. For now, pol­icy mak­ers are try­ing to for­tify bal­ance sheets before rec­og­niz­ing any poten­tial losses to min­i­mize sys­temic risks. In our view, we are not through the process of unwind­ing lever­aged bal­ance sheets; that is why we have had such a hard time reach­ing escape veloc­ity from the fi nan­cial cri­sis despite repeated attempts by cen­tral banks to pro­vide suffi cient liq­uid­ity. The halt­ing eco­nomic recov­ery sug­gests cen­tral banks will have to fi ght any urge to pre­ma­turely reduce their uncon­ven­tional liq­uid­ity provisions.

Nev­er­the­less, the fact that the ECB has laid its cards on the table and is act­ing like a lender of last resort, despite its tough rhetoric, is good news. Other cen­tral banks have also moved to pro­vide more liq­uid­ity: the Fed­eral Reserve, for exam­ple, recently gave guid­ance that inter­est rates will stay very accom­moda­tive until late 2014; the Bank of Japan has imple­mented an infl ation goal of 1.0% and will use quan­ti­ta­tive eas­ing to pur­sue its objec­tive; the People’s Bank of China cut its cap­i­tal reserve require­ments and has been rolling loans to local gov­ern­ments; the Brazil­ians, Aus­tralians, Swedes and Nor­we­gians all cut inter­est rates. Coör­di­nated cen­tral bank actions are help­ing to boost risk appetites glob­ally. These are pos­i­tive signs for reduc­ing major sys­temic tail risks going forward.

So, if cen­tral banks are try­ing to restore order by promis­ing suffi cient liq­uid­ity, should we now focus on iden­ti­fy­ing where bank credit could feed the next boom? Our answer is a resound­ing yes. The next boom always seems to rise from the ashes of the pre­vi­ous bust, just as the global hous­ing bub­ble rose from the easy money poli­cies that fol­lowed the 1990s tech­nol­ogy bust. For now, investors should look around the world and deter­mine which bank­ing sys­tems appear healthy enough to pro­vide that elas­tic­ity of credit. In many devel­oped mar­kets, there are still major head­winds to a tra­di­tional bor­row­ing– and spending-driven recov­ery. The con­sumer and pub­lic sec­tors appear less will­ing or able to lever­age their bal­ance sheets to pro­vide that extra boost to growth. Emerg­ing mar­kets, on the other hand, should still have ample room to grow. How­ever, we sug­gest investors remain vig­i­lant, watch­ing for any sign that boom­ing credit has sown the seeds of Kindleberger’s “hardy perennial.”

Charles P. Kindle­berger (1910–2003) was an Amer­i­can econ­o­mist and eco­nom­ics pro­fes­sor. His noted works include Manias, Pan­ics, and Crashes, A His­tory of Finan­cial Crises, first pub­lished in 1978 (John Wiley & Sons, Inc.).

Hyman P. Min­sky (1919–1996) was an Amer­i­can econ­o­mist and eco­nom­ics pro­fes­sor. His noted works include Sta­bi­liz­ing an Unsta­ble Econ­omy, first pub­lished in 1986 (Yale Uni­ver­sity Press).

Past mar­ket expe­ri­ence is no guar­an­tee of future results.

This arti­cle is pro­vided for infor­ma­tional pur­poses only and should not be con­strued as invest­ment advice. Any opin­ions or fore­casts con­tained herein reflect the sub­jec­tive judg­ments and assump­tions of the authors only and do not nec­es­sar­ily reflect the views of Loomis, Sayles & Com­pany, L.P., or any port­fo­lio man­ager. Invest­ment rec­om­men­da­tions may be incon­sis­tent with these opin­ions. There can be no assur­ance that devel­op­ments will tran­spire as fore­casted and actual results will be dif­fer­ent. Data and analy­sis does not rep­re­sent the actual or expected future per­for­mance of any invest­ment product.

We believe the infor­ma­tion, includ­ing that obtained from out­side sources, to be cor­rect, but we can­not guar­an­tee its accu­racy. The infor­ma­tion is sub­ject to change at  any time with­out notice.

MALR008968 LEGREV122812

Copy­right © Loomis Sayles

Tags: Associate Director, Boom And Bust, Brazil, Charles Kindleberger, Cynical World, Debt Crisis, Economic Historian, Economic Theory, Extreme Event, Greed, Human Dynamics, Human Emotions, liquidity, Loomis Sayles, Market Behavior, Nancial, Panics, Policy Responses, Quantitative Models, Sovereign Debt, Thomas Fahey
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Goldman On Europe: "Risk Of 'Financial Fires' Is Spreading"

Wednesday, March 28th, 2012

Germany's recent 'agree­ment' to expand Europe's fire depart­ment (as Gold­man euphe­mes­ti­cally describes the EFSF/ESM fire­wall) seems to con­firm the pre­vail­ing pol­icy view that big­ger 'fire­walls' would encour­age investors to buy Euro­pean sov­er­eign debt — since the fund­ing back­stop will pre­vent credit shocks spread­ing con­ta­giously. How­ever, as Francesco Garzarelli notes today, given the Euro-area's closed nature (more than 85% of EU sov­er­eign debt is held by its res­i­dents) and the increased 'inter­con­nect­ed­ness' of sov­er­eigns and finan­cials (most debt is now held by the MFIs), the risk of 'finan­cial fires' spread­ing remains high. Due to size lim­i­ta­tions (EFSF/ESM totals would not be sug­gi­cient to cover the larger mar­kets of Italy and Spain let alone any oth­ers), Senior­ity con­straints (as with Greece, the EFSF/ESM will hugely sub­or­di­nate exist­ing bond­hold­ers should action be required, exac­er­bat­ing rather than mit­i­gat­ing the cri­sis), and Gov­er­nance lim­i­ta­tions (the exist­ing infra­struc­ture can­not act pre-emptively and so tim­ing — and admis­sion of cri­sis — could become a lim­it­ing fac­tor), it is unlikely that a more sus­tained realign­ment of rate dif­fer­en­tials (with their macro under­pin­nings) can occur (espe­cially at the longer-end of the curve). The re-appearance of the Redemp­tion Fund idea (akin to Euro-bonds but with­out the paper­work) is likely the next step in coun­ter­ing reality.

Sec­tion 4 below is the most crit­i­cal to under­stand­ing the pit­falls of the con­sen­sus thinking...

1. EFSF Has Helped Con­tain Ten­sions in Periph­eral Hot spots

The EFSF, which became oper­a­tional in August 2010, was the first author­ity empow­ered to redis­trib­ute fis­cal resources to sup­port adjust­ment pro­grams across EMU mem­ber states. The Facil­ity has EUR54.5bn in bonds out­stand­ing (includ­ing EUR30bn as part of the Greek debt exchange) and EUR8.9bn in bills. Ear­lier this month, it was autho­rized to raise a total of EUR241bn. This amount exceeds the aggre­gate com­mit­ted cap­i­tal to the three pro­gram coun­tries by roughly EUR50bn, partly to pro­vide for liq­uid­ity buffers. By com­par­i­son, the amount of bonds out­stand­ing from the Euro­pean Invest­ment Bank—another supra­na­tional issuer—is in the region of EUR405bn.

The EFSF sup­ply replaces the mar­ket fund­ing pro­grams (cov­er­ing amor­ti­za­tions and deficit) for Greece, Por­tu­gal and Ire­land. Thus, from a flow perspective—and tak­ing into account that most EMU coun­tries are reduc­ing their bor­row­ing requirements—the net sup­ply of EUR gov­ern­ment bonds avail­able to pri­vate investors is declining.

The stock of Euro area gov­ern­ment debt has increased sub­stan­tially in the wake of the 2008 finan­cial cri­sis, as has been the case else­where. Reflect­ing a process of ‘mutu­al­iza­tion’ of the debt owed by the smaller issuers through the EFSF, the aver­age qual­ity of the pool of investable Euro area secu­ri­ties is pro­gres­sively being upgraded. The ECB has con­tributed to this dynamic by remov­ing around EUR200bn-worth of debt from pri­vate hands through its Secu­ri­ties Mar­ket Pro­gram (EUR150bn of which are Ital­ian and Span­ish bonds).

The EFSF issuance does not con­sti­tute a ‘Eurobond’, defined as a claim backed jointly and sev­er­ally by the EMU coun­tries. Rather, investors in EFSF secu­ri­ties effec­tively hold a (credit-enhanced) port­fo­lio of Euro area sov­er­eign issuers, exclud­ing those cur­rently under finan­cial assis­tance pro­grams. The coun­try allo­ca­tions of the port­fo­lio map the ECB’s ‘cap­i­tal key’, which roughly cor­re­spond to GDP size. Rel­a­tive to a bond mar­ket cap­i­tal­iza­tion, the cap­i­tal key over-weights Ger­many and under-weights Italy.

The EFSF has no paid-in cap­i­tal, but rather is backed by finan­cial guar­an­tees (amount­ing to EUR726bn) that exceed the max­i­mum lend­ing capac­ity of the facil­ity (EUR440bn, cor­re­spond­ing to the spon­sor­ship of the high­est rated coun­tries). After the down­grade of France, the weighted aver­age rat­ing of the sov­er­eign guar­an­tors is AA minus, and the weak­est con­stituent (Italy) is rated BBB. EFSF long-term bonds are cur­rently rated AA+ by S&P, and have the high­est rat­ing by both Moody’s and Fitch.

The EFSF secu­ri­ties cur­rently span matu­ri­ties rang­ing between 3 months and 20 years. They trade below the Euro-swap curve at the short end, and around 100bp above it at the long end. Bench­mark 10-yr EFSF bonds cur­rently trade around 10-15bp above the cor­re­spond­ing matu­rity gov­ern­ment bond issued by France—the clos­est rated core sov­er­eign issuer. EFSF bonds are also broadly aligned with the weighted aver­age fund­ing cost for the facility’s sov­er­eign back­ers, indi­cat­ing that the ben­e­fits of over-collateralization and the costs of lower liq­uid­ity broadly off­set each other (the Facil­ity lends on to pro­gram coun­tries at fund­ing costs plus oper­a­tional costs, and the recov­ery on loans is assumed to be zero by rat­ing agen­cies). If bond yields move in line with what our val­u­a­tion work sug­gests, EFSF secu­ri­ties should increase in value against the Euro-swap curve, and trade tighter in rela­tion to France.

Demand for EFSF bonds from the first issuances has been split as fol­lows: 46% to the Euro area, 33% to Asia and 10% to the UK. Cen­tral banks and Sov­er­eign Wealth Funds pur­chased 38% of the bonds, with banks buy­ing another 29% (see charts on the next page). The share acquired by Euro area finan­cial insti­tu­tions has pro­gres­sively increased, as investors in the core coun­tries switch away from low-yielding Ger­man Bunds in favor of secu­ri­ties that reflect the sov­er­eign risk syn­di­ca­tion being con­ducted directly through the fis­cal schemes and indi­rectly on the ECB’s bal­ance sheet.

2. Two Ways to Increase Pres­sure in the Fire Hydrants

Pres­sures to increase the EFSF’s endow­ment at the height of the sov­er­eign cri­sis last year even­tu­ally resulted in allow­ing the Facil­ity to lever­age its resources. This has now been crys­tal­lized into two Spe­cial Pur­pose Vehi­cles (SPVs): a Euro­pean Sov­er­eign Bond Pro­tec­tion Facil­ity and a Euro­pean Sov­er­eign Bond Invest­ment Facil­ity. The first scheme aims to pro­vide par­tial risk pro­tec­tion cer­tifi­cates for sov­er­eign bonds (i.e., a ‘first-loss insur­ance’ scheme). The sec­ond is a co-investment fund open to both the pri­vate and pub­lic sec­tor ded­i­cated to EMU area gov­ern­ment bonds.

We assessed the idea of ‘first loss pro­tec­tion’ favor­ably when it was first cir­cu­lated last year. The advan­tages of ‘credit wrap­ping’ new issuance of gov­ern­ment secu­ri­ties are asso­ci­ated with the com­bi­na­tion of a credit risk trans­fer from the guar­an­teed sov­er­eign to its guar­an­tors (the AAA-rated back­ers of the EFSF), which, in turn, ben­e­fit from a decline in sys­temic risk; and the reduc­tion in refi­nanc­ing risk accru­ing to the pre­vi­ous bond hold­ers, which over time mit­i­gates the poten­tial seg­men­ta­tion of the market.

How­ever, faced with the largely unquan­tifi­able risks stem­ming from a poten­tial breakup of the mon­e­tary union, the scheme has become less appeal­ing to investors. The Pro­tec­tion Facil­ity has other short­com­ings too. Based on the rat­ing agen­cies’ pub­lished method­olo­gies, the rat­ing impact of a higher recov­ery assump­tion in the case of Invest­ment Grade secu­ri­ties is small (a 1–2 notch increase at most), hardly chang­ing the posi­tion of coun­tries such as Italy or Spain. Par­tic­u­larly if asso­ci­ated with mul­ti­ple instru­ments, the pro­tec­tion cer­tifi­cate could be treated as a deriv­a­tive instru­ment in bank­ing books, rather than a ‘finan­cial guar­an­tee’. As such, it would fall under mark-to-market rules, with detri­men­tal impacts on demand.

The Sov­er­eign Bond Invest­ment Facil­ity is a more inter­est­ing propo­si­tion, espe­cially if directed at the pri­mary mar­ket. The first loss tranche is remu­ner­ated at the EFSF’s cost of funds. This is to the advan­tage of senior investors, who access a lev­ered return (max­i­mized by the Facility’s man­ager under a set of guide­lines) with lower risk. As an exam­ple, Italy’s main fis­cal prob­lem per­tains to its high debt stock, which needs to be rolled over. The SPV could cover 2 years’-worth of Ital­ian medium-to-long-term matu­rity bond sup­ply (around EUR400bn). The ‘equity’ tranche could amount to 30% (or EUR120bn), the ‘senior tranche’ could be 50% (EUR200bn) and the remain­ing ‘super senior’ tranche 20% (EUR80bn). Assum­ing a recov­ery assump­tion of 50%, the expected risk-weighted returns accru­ing to the senior tranche are attrac­tive. For ref­er­ence, EFSF July 2021 trades at 3.0%, while BTP August 2021 trades at 4.9%, and 10-year EUR Libor at 2.3%. With the cap­i­tal allo­ca­tion used in this exam­ple, the expected return on the senior tranche is around 220bp over the BTP, with a higher recovery.

So far, how­ever, it is not clear who would par­tic­i­pate in this SPV. Sug­ges­tions that sov­er­eign wealth funds and/or the BRIC coun­tries could become poten­tial investors have not led to reported progress and have over­lapped with demands for higher con­tri­bu­tions from the BRICs to the IMF. Senior­ity con­sid­er­a­tions, the legal régime that gov­erns any short­fall and the mech­a­nism for a pos­si­ble trans­fer of the par­tic­i­pa­tion from the EFSF to the ESM would need to be clearly spelled out for the scheme to work.

3. The ESM—The Per­ma­nent ‘Fire Department’

The Euro­pean Sta­bil­ity Mech­a­nism, or ESM, is a per­ma­nent facil­ity that will replace the EFSF from July 2012. The ESM will have an ini­tial lend­ing capac­ity of EUR500bn (reviewed peri­od­i­cally) and a total sub­scribed cap­i­tal of EUR700bn, of which EUR80bn will be in the form of paid-in cap­i­tal to be phased in with a max­i­mum of five installments.

Under cur­rent agree­ments, the con­sol­i­dated lend­ing capac­ity of the EFSF and ESM can­not exceed EUR500bn. But the author­i­ties are actively dis­cussing whether this limit can be increased by com­bin­ing resources, even though it may not be for the entire capac­ity of the two funds (EUR940bn). One pos­si­bil­ity could be that EUR500bn from the ESM will be added to the exist­ing com­mit­ments of the EFSF (EUR17bn for Ire­land, EUR26bn for Por­tu­gal and EUR102bn for the sec­ond Greek pack­age), or to the EUR241bn the EFSF has already been autho­rized to issue. A deci­sion is expected at the Finance Min­is­ters’ meet­ing on March 30.

Increas­ing the total amount of the com­bined EFSF and ESM fund could have pos­i­tive effects on the val­u­a­tion of EFSF bonds, as a greater poten­tial for sov­er­eign credit risk syn­di­ca­tion can lower the yield dif­fer­en­tial between constituents—in prac­tice, Ger­man bonds would lose value, while those of Italy and Spain would increase in value. How­ever, a num­ber of issues that could affect the liq­uid­ity of the EFSF bond mar­ket still need to be addressed. Also, EFSF bonds will be close, but not per­fect, sub­sti­tutes of ESM bonds, because the two facil­i­ties enjoy dif­fer­ent cred­i­tor status.

On the first issue, it is not yet clear what the EFSF’s role will be after July 2012. The EFSF will remain in place until the last bond issued matures. But it has not yet been decided whether new lend­ing pro­grams start­ing after July will come under the ESM, or whether the EFSF will be able to con­tinue issu­ing bonds of exist­ing pro­grams. This deci­sion will affect the depth of the EFSF bond market.

On the sec­ond issue, both EFSF and ESM loans are junior to IMF loans. How­ever, while EFSF loans have the same cred­i­tor sta­tus as other sov­er­eign claims on a coun­try basis (pari passu), ESM loans enjoy pre­ferred cred­i­tor sta­tus over other sov­er­eign claims. This clause does not apply to ESM loans relat­ing to a finan­cial assis­tance pro­gram that came into exis­tence before Feb­ru­ary 2, 2012, when the new ESM treaty was signed. Hence, while in the­ory ESM bonds have a bet­ter credit sta­tus than those issued by the EFSF, in prac­tice this will depend on whether or not lend­ing pro­grams to coun­tries other than Ire­land, Por­tu­gal and Greece will be activated.

4. Too Much Com­bustible Mate­r­ial Still Around

The Euro area is a finan­cially closed region, with more than 85% of sov­er­eign bonds held by res­i­dents of the area. If we add to this the fact that most claims against gov­ern­ments are held by finan­cial insti­tu­tions domi­ciled in the area, the risk of ‘finan­cial fires’ spread­ing is high. The pre­vail­ing pol­icy view that big­ger ‘fire­walls’ would make investors more com­fort­able about pur­chas­ing sov­er­eign bonds of EMU coun­tries. This is pred­i­cated on the idea that the exis­tence of a fund­ing back­stop would pre­vent credit shocks in one of the EMU mem­bers from spread­ing to other issuers. That said, we doubt the cur­rent infra­struc­ture can pro­duce the same effects on mar­kets as the ECB’s long-term liq­uid­ity injec­tions (LTROs). Our view is based on the fol­low­ing considerations.

• Size: Even if we com­bine the full uncom­mit­ted capac­ity of the EFSF and the ESM (EUR700bn), the total would not be suf­fi­cient to back­stop the big­ger mar­kets of Spain and Italy. The former’s bor­row­ing require­ment (amor­ti­za­tion plus deficit) over the next two years is EUR305bn, while the latter’s amounts to EUR525bn.
• Senior­ity: The ESM holds ‘pre­ferred cred­i­tor sta­tus’ over exist­ing bond­hold­ers (art.13 of the Treaty estab­lish­ing the ESM). In prac­tice, this means that if the facil­ity is used to pro­vide an EMU mem­ber coun­try under con­di­tion­al­ity, it would sub­or­di­nate exist­ing bond­hold­ers (twice, if the IMF also par­tic­i­pates in a bailout). Given that investors are aware of this, they would require com­pen­sa­tion to bear such risk. This could exac­er­bate, rather than mit­i­gate, a crisis.
• Gov­er­nance: The exist­ing vehi­cles can­not inter­vene pre-emptively in mar­kets at signs of ten­sion. Rather, they would be acti­vated only after a full cri­sis has erupted. The pro­ce­dure envis­ages that the ECB would ring an alarm bell should ten­sions threaten the sta­bil­ity of the Euro area. The sov­er­eigns expe­ri­enc­ing ten­sions would need to for­mally ask for help, and sign a mem­o­ran­dum of under­stand­ing, before any finan­cial sup­port can pro­vided. Admit­tedly, a ‘fast track’ option is also avail­able, based on ‘light con­di­tion­al­ity’ and allow­ing the EFSF to inter­vene in sec­ondary mar­kets. Still, the fixed size of resources could raise ques­tions on the effec­tive­ness of the operations.

5. What Could Help?

As we have indi­cated in pre­vi­ous research, based on rela­tion­ships with rel­a­tive macro and fis­cal fac­tors pre­vail­ing over the past 20 years, Ital­ian gov­ern­ment bonds should cur­rently trade around 130bp over their Ger­man coun­ter­parts, and Spain at 200bp over Bunds. These spread lev­els are well below the 320-350bp pre­vail­ing at the time of writ­ing. By rein­forc­ing the notion of a ‘con­di­tional mutu­al­iza­tion’ of sov­er­eign EMU debt, the expected increase in the size of the fire­walls could help sta­bi­lize inter-country spreads. But for the rea­sons men­tioned above, we doubt this would lead to a more sus­tained realign­ment of rate dif­fer­en­tials with their macro under­pin­nings, par­tic­u­larly at the long end of the curve where uncer­tain­ties sur­round­ing sub­or­di­na­tion are par­tic­u­larly acute.

We would there­fore advance two ‘nor­ma­tive’ considerations:

• At this junc­ture, Spain remains under close scrutiny because of the inter­play between the recap­i­tal­iza­tion of the non-listed banks (sad­dled with expo­sure to the hous­ing sec­tor, which has dete­ri­o­rated on the back of the increase in unem­ploy­ment) and the chal­leng­ing fis­cal tar­gets that it needs to meet in 2012/2013. On 30 March, the Span­ish gov­ern­ment will announce the 2012 bud­get, which should remove part of the uncer­tainty around the size and qual­ity of the fis­cal mea­sures. But con­cerns about the recap­i­tal­iza­tion of the non-listed banks are unlikely to dimin­ish any time soon. We have long been of the view that an agree­ment between the Span­ish gov­ern­ment and the EFSF to sup­port the recap­i­tal­iza­tion of the bank­ing sec­tor would be a pro­duc­tive use of pooled fis­cal resources. It would avoid an increase in the fund­ing needs and bor­row­ing costs that Spain would face if it had to recap­i­tal­ize banks using funds from the FROB. In this way, Spain could take advan­tage of EFSF funds, avoid­ing the ‘stigma’ of a macro-economic adjust­ment pro­gram, while the planned restructuring/recapitalization would be rein­forced by exter­nal incen­tives and con­trols, and EMU-wide resources would be directed at one of the obvi­ous sources of weak­ness of the com­mon cur­rency area.
• More broadly, we con­tinue to think that a more direct approach to the ‘debt over­hang’ prob­lem affect­ing the Euro area would remove ‘com­bustible mate­r­ial’ and speed up the recov­ery. In this con­text, the pro­posal advanced by the Ger­man Coun­cil of Eco­nomic Advi­sors to set up a Euro area wide Redemp­tion Fund appears to be one of the most promis­ing. We plan to elab­o­rate on this solu­tion in forth­com­ing research, but the out­line is fairly straight­for­ward. The Coun­cil sug­gests cre­at­ing a fund that would be jointly and sev­er­ally guar­an­teed by EMU mem­ber coun­tries, in which each par­tic­i­pant would trans­fer gov­ern­ment debt (ide­ally across the matu­rity struc­ture, and in par­al­lel with ongo­ing mar­ket access) in excess of 60% of GDP. Coun­tries would pledge col­lat­eral to the fund, ear­mark rev­enues of a spe­cific tax, and com­mit to repay­ing their lia­bil­i­ties over a long period (20–25 years). Along­side the fis­cal com­pact and debt brake rules, this ini­tia­tive has the merit of finally estab­lish­ing a liq­uid secu­rity (the expected float is in the region of EUR2.5trn) which would reflect the Euro area’s com­par­a­tively high aggre­gate credit qual­ity and thus rep­re­sent a sound ‘store of value’.

Tags: Backstop, Bondholders, Debt Exchange, Differentials, Efsf, Esm, Fiscal Resources, Garzarelli, Goldman, Hot Spots, Interconnectedness, Limiting Factor, Mfis, Pitfalls, Realignment, Reality Section, Redemption Fund, Seniority, Sovereign Debt, Sovereigns
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Is Needing EU Help a Good Thing? I Really Cannot Remember.

Wednesday, March 28th, 2012

by Peter Tchir, TF Advi­sors

Mar­kets are up a lit­tle this morn­ing, basi­cally get­ting back the late day fade.  S&P Futures up 4.  IG18 is ¾ of a bp tighter.

In Europe, bonds in Spain and Italy are bet­ter after an ini­tial round of weak­ness.  As far as I can tell, they both bounced on rumors that the EU was going to help out the Span­ish banks.  Maybe it’s too early today, but I’m begin­ning to have trou­ble see­ing the logic of ral­ly­ing sov­er­eign debt on a story that the banks need help.  I con­tinue to be a lit­tle sur­prised that Italy is back to mov­ing up and down in lock-step with Spain, as I think Spain is doing a lot to dis­tin­guish itself – and not in a good way.  Ital­ian 5 yr CDS is actu­ally 4 bps wider on the day at 371 while Span­ish 5 yr CDS is 2 tighter at 423.

I will dig into the Span­ish debt issuance and bud­get issues in more detail, but yesterday’s news should scare investors.  The deficit in the first two months of the year was worse than expected, and worse than last year because they trans­ferred money to var­i­ous regions and munic­i­pal­i­ties.  Now they will just guar­an­tee debt of those regions, so no trans­fer, and improved deficit.  All fixed?  Hardly, just account­ing games and another sign that some­how Europe does not under­stand that guar­an­tees count.

Yes­ter­day in fixed income ETF’s, we saw gains across the board, but with trea­sury related assets out­per­form­ing credit assets.  Junk bond ETF’s had the small­est gains, but that was a bit of catch up from the prior day, and the real­ity is that they are run­ning out of room for any sig­nif­i­cant upside, which is why we still like HY17 vs HYG.  HY17 is back to 99 and does seem to be ben­e­fit­ting from the roll.  We are also finally see­ing some “com­pres­sion” as HY out­per­formed IG.  That trade has been hurt­ing peo­ple as the “com­pres­sion” story has been com­pelling, but the mar­ket hasn’t played nice with that trade.  Look­ing at it now, but not yet in it.  IG18 still seems like a rea­son­able short.  Even with creep­ing back into 88.75 this morn­ing, it feels like the mar­ket is under­hedged and even a bit long and it has failed to come back to its tights of 85.5 in spite of a spir­ited stock market.

Durable goods orders have a chance to break the trend of weak data, but that series is so volatile, I’m not sure a pos­i­tive read­ing does much.  My guess is that we miss this num­ber as well, but in this day and age of cen­tral banks dom­i­nat­ing mar­ket moves, that miss might not do much.

VIX and TVIX (trad­ing with almost no pre­mium again) both bounced.  Stocks leaked, but the real­ity is that every­one is still digest­ing Monday’s move and really try­ing to fig­ure out if all that mat­ters is cen­tral bank liq­uid­ity.  I think that has its lim­its, and we have had sell-offs with big cen­tral bank poli­cies in place, but even my faith was shaken on Mon­day as Ben seemed almost single-minded in his pur­suit of more ways to “accom­mo­date” the mar­ket, in spite of our con­cerns that he may be doing more harm than good to the econ­omy, both in the short run and in the long run.

Copy­right © TF Advi­sors

Tags: Accounting, Amp, Assets, Bonds, Bp, Bps, Budget Issues, Debt Issuance, Fixed Income, Futures, Guarantees, Ig, Junk Bond, Logic, Months Of The Year, Municipalities, Sovereign Debt, Spanish Banks, Tf, Treasury
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Gold Market Radar (March 19, 2012)

Saturday, March 17th, 2012

Gold Mar­ket Radar (March 19, 2012)

For the week, spot gold closed at $1,660.00 down $53.65 per ounce, or 3.1 per­cent. Gold stocks, as mea­sured by the NYSE Arca Gold Min­ers Index, fell 6.3 per­cent. The U.S. Trade-Weighted Dol­lar Index slid 0.3 per­cent for the week.

Strengths

• Pre­cious met­als with an indus­trial use have so far fared the best this year. Plat­inum is up just under 20 per­cent and sil­ver is up almost 17 per­cent while gold is up slightly over 6 per­cent. Slightly improv­ing eco­nomic con­di­tions have been the dri­ver for the stronger per­for­mance of plat­inum and sil­ver ver­sus gold as of late.
• China’s Min­istry of Indus­try and Infor­ma­tion Tech­nol­ogy noted in its most recent fig­ures that China cur­rently holds the title of the world’s num­ber one gold miner since 2007. The coun­try has con­tin­ued its dom­i­nance in world gold pro­duc­tion with out­put ris­ing last year by 5.89 per­cent to 360.95 tons. Over­all, world pro­duc­tion of gold is not that dif­fer­ent from where it was 10 years ago, despite the price gains made over the past decade that should have stim­u­lated more production.
• Despite the volatile gold prices we have seen lately and per­ceived pass­ing of the lat­est wave of poten­tial finan­cial col­lapse, there are still many sup­port­ing argu­ments as to why gold will con­tinue to remain a vital cor­ner­stone in a port­fo­lio dur­ing these still highly uncer­tain times. Eco­nomic growth is still weak, sov­er­eign debt is still unsus­tain­able, par­tic­u­larly if inter­est rates go higher, and from emerg­ing mar­kets to China, many coun­tries are engaged in diver­si­fy­ing out of dol­lars and into gold as a means to achieve more sta­ble reserve holdings.

Weak­nesses

• India increased the tax on gold imports for the sec­ond time this year after record pur­chases widened the current-account deficit. Gold imports have grown by almost 50 per­cent over the last three quar­ters in India. Start­ing April 1, the gov­ern­ment will tax gold bars, coins and plat­inum at 4 per­cent, which is up 2 per­cent from the tax set in Jan­u­ary. Sil­ver will incur no change in tax. Gold for imme­di­ate deliv­ery fell on this news.
• In an agree­ment that may set a prece­dent for other foreign-owned min­ing com­pa­nies, Zim­babwe and Impala Plat­inum, the world’s second-largest plat­inum pro­ducer, announced the agree­ment trans­fer of a 51 per­cent stake in the company’s Zim­plats project to black Zim­bab­wean investors, as required by the gov­ern­ment. The joint state­ment said that the 51 per­cent stake would be split with 10 per­cent to the com­mu­nity, 10 per­cent to Zim­plats employ­ees, and 31 per­cent to the state’s National Indi­g­e­niza­tion and Eco­nomic Empow­er­ment Fund.
• Unfor­tu­nately, we saw another agree­ment set­ting a prece­dent for con­fis­ca­tory fis­cal agree­ments between the Ecuado­rian gov­ern­ment and Ecuacorriente’s Mirador project with taxes, roy­al­ties and duties com­bined to encom­pass 52 per­cent of prof­its. Kin­ross has been in the pub­lic eye over con­tracts nego­ti­a­tions for its Fruta Del Norte project along with IAMGOLD for its Quim­sacocha project.

Oppor­tu­ni­ties

• Sin­ga­pore announced that it is plan­ning to boost its share of global gold trade sev­en­fold after scrap­ping taxes on bul­lion, accord­ing to Inter­na­tional Enter­prise Sin­ga­pore, the city state’s exter­nal trade agency. Cur­rently, about 2 per­cent of world gold demand flows through Sin­ga­pore, and the goal is to increase that to 10 to 15 per­cent over the next five to 10 years.
• Last year Venezuela requested the repa­tri­a­tion all of its gold assets in fear of inter­na­tional rul­ings which might have encum­bered the gold due to nation­al­iza­tion steps taken place within the coun­try. This week, an arti­cle high­lighted that there is a con­cern among polit­i­cal lead­ers world­wide who are wor­ried about the where­abouts of their gold, espe­cially any hold­ings held in the U.S. because of the pos­si­bil­ity of a con­fis­ca­tion of for­eign gold reserves by their cus­to­dian, the U.S. government.
• As an exam­ple, this Jan­u­ary, the Dutch gov­ern­ment admit­ted than only 10 per­cent of its 612.5 tons of the tenth-largest offi­cial gold reserve is held in the Nether­lands. When ques­tioned, the Dutch Trea­sury replied that the gold is located in Ottawa, New York, Lon­don and Ams­ter­dam. More alarm­ingly, almost 60 per­cent of Germany’s gold is stored out­side of the coun­try with the major­ity of it being held in the Fed­eral Reserve Bank of New York. The author argued, “What would hap­pen if Ger­many needed to access its gold hold­ings urgently?” It would not be a sur­prise to see more coun­tries take con­trol over the secu­rity of their gold stocks in the future and this will likely raise the pro­file of gold in the public’s eye.

Threats

• South Africa, which used to be the world’s biggest gold pro­ducer, con­tin­ues to see its gold pro­duc­tion plunge. Fol­low­ing an 8.2 per­cent drop in Decem­ber, South Africa saw an 11.3 per­cent fall year-over-year in Jan­u­ary. South Africa was recently over­taken by China, Aus­tralia and the United States as the largest gold pro­duc­ers, and is at risk of being over­taken by Rus­sia as the decline con­tin­ues, accord­ing to Sta­tis­tics SA. Lower ore grades, hav­ing to mine increas­ingly deeper, and declin­ing mine lives have been three of the dri­ving fac­tors behind the decline.
• The Indone­sian gov­ern­ment recently announced that it will be rene­go­ti­at­ing all exist­ing min­ing con­tracts. The country’s new law will require all firms to divest the major­ity of own­er­ship of mines, and applies to all firms with exist­ing “Con­tract of Work” agree­ments signed prior to the new rule. The Indone­sian gov­ern­ment made the announce­ment that the law is aimed at increas­ing the par­tic­i­pa­tion of local investors in mining.
• Gov­ern­ment talks in Peru with ille­gal min­ers fell into dis­ar­ray and turned into a riot which left three peo­ple dead. These wild­cat min­ers gen­er­ally have no for­mal min­ing con­ces­sion or envi­ron­men­tal per­mits to oper­ate nor do they fol­low inter­na­tional stan­dards. The Peru­vian gov­ern­ment is attempt­ing to halt the ille­gal oper­a­tions within the county.

Tags: Current Account Deficit, Dollar Index, Financial Collapse, Gold Bars, Gold Coins, Gold Imports, Gold Market, Gold Miner, Gold Miners, Gold Prices, Gold Production, gold stocks, Market Radar, Nyse Arca, Nyse Index, precious metals, Russia, Sovereign Debt, Spot Gold, Three Quarters, World Gold
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Systemic Risk, Multiple Equilibria and Market Dynamics – What You Need to Know and Why

Thursday, March 15th, 2012

• ​ In assess­ing the pos­si­bil­ity, dura­tion and impact of sys­temic risk fac­tors, we need to ana­lyze the inter­ac­tion of expec­ta­tions with mar­ket (endoge­nous) and pol­icy (exoge­nous) cir­cuit breakers.
• In the cur­rent envi­ron­ment, the preva­lence of some sub­jec­tive bimodal expec­ta­tion dis­tri­b­u­tions (e.g. Europe related) speaks to the mul­ti­ple equi­lib­rium fea­tures of sov­er­eign debt markets.
• Mul­ti­ple equi­lib­ria give rise to a range of sce­nar­ios, each quite dif­fer­ent and each with its own dis­tri­b­u­tion of returns, risks, cor­re­la­tions, and mar­ket functioning.
• In today's global con­text, investors (as well as pol­icy mak­ers, researchers and opin­ion lead­ers) need to sup­ple­ment their analy­ses of fun­da­men­tals, his­toric risk pre­mia, cor­re­la­tions and rel­a­tive value with a clearer delin­eation of the expec­ta­tion for­ma­tion process itself.

​Intro­duc­tion
Finan­cial mar­kets are sub­ject to peri­odic bouts of sys­temic risk that affect their func­tion­ing and sta­bil­ity, as well as invest­ment returns and volatil­ity. Sev­eral ele­ments of invest­ment strat­egy – includ­ing asset allo­ca­tion, liq­uid­ity man­age­ment, risk mit­i­ga­tion and, in cer­tain cases, even the design of bench­marks and guide­lines – can be affected by this real­ity. Accord­ingly, and par­tic­u­larly given the ongo­ing re-alignment of the global econ­omy and mar­kets, it is impor­tant to have a han­dle on the under­ly­ing dynam­ics. To this end, in this paper we ana­lyze those asso­ci­ated with sud­den shifts in expec­ta­tions. It explains how they can morph into par­tic­u­larly dis­rup­tive mul­ti­ple equi­lib­ria dynam­ics, and it points to pos­si­ble impli­ca­tions for mar­ket out­comes, mar­ket equi­lib­ria and pol­icy responses.

The Con­text
Ear­lier work in eco­nom­ics on sig­nal­ing and screen­ing, includ­ing by one of the authors of this arti­cle (Mike Spence), sheds impor­tant light on issues that are of cur­rent inter­est to mar­kets and investors. Specif­i­cally, a sig­nif­i­cant sub­set of mul­ti­ple equi­lib­rium mar­ket struc­tures – the ones that are most rel­e­vant to finan­cial mar­kets and to their inter­ac­tions with the real econ­omy – are those in which expec­ta­tions have two char­ac­ter­is­tics: First, the expec­ta­tions are endoge­nous – i.e., they are deter­mined as part of the process of reach­ing equi­lib­rium out­comes in the mar­ket. Sec­ond, they exert a sub­stan­tial influ­ence on behav­ior and hence on the mar­ket out­comes that are inher­ently linked with the expec­ta­tions themselves.

The inter­ac­tions of these two fac­tors are crit­i­cal. Indeed, if they are mis­un­der­stood, they can eas­ily result in inap­pro­pri­ate analy­ses, invest­ment deci­sions and risk man­age­ment. They also can lead to mis­guided pol­icy reactions.

If just the first char­ac­ter­is­tic is present, mar­kets are in equi­lib­rium when expec­ta­tions are accu­rate. How­ever, if both are present, then expec­ta­tions aren’t best described as accu­rate but rather self-confirming in a ser­ial man­ner; and the sequence of local equi­lib­ria need not lead to a global equi­lib­rium. Con­se­quently, it is this kind of struc­ture that has mul­ti­ple equi­lib­ria and hence the poten­tial sud­den shifts in both expec­ta­tions and equi­lib­rium mar­ket outcomes.

For finan­cial mar­kets, bal­ance sheets and the real econ­omy, the endo­gene­ity of expec­ta­tions is always part of the struc­ture. But shifts in expec­ta­tions and asset val­ues need not always cause pow­er­ful feed­back effects on investor behav­ior and/or the real econ­omy. They do when a slight ini­tial per­tur­ba­tion in expec­ta­tions is ampli­fied into a rapid, non-mean-reverting shift to a very dif­fer­ent set of outcomes.

In assess­ing sys­temic risk, we there­fore need to look for the con­di­tions where there are sub­stan­tial feed­back effects and where mar­ket or pol­icy cir­cuit break­ers are either miss­ing, incom­plete or uncertain.

Sig­nal­ing as an Exam­ple of a Mul­ti­ple Equi­lib­rium Struc­ture
Sig­nal­ing occurs in mar­ket envi­ron­ments in which there are both infor­ma­tional gaps and infor­ma­tional asym­me­tries between the buy­ers and sell­ers. That is, there is some attribute of the prod­uct or ser­vice about which one side knows more than the other.

Asym­met­ri­cal infor­ma­tion con­di­tions are quite com­mon. They occur in labor, finan­cial and insur­ance mar­kets, and in many more places. As an exam­ple, in insur­ance mar­kets, the observ­abil­ity gap is vari­a­tion in risk across the enti­ties seek­ing to buy insur­ance. This phe­nom­e­non is called adverse selec­tion. It leads to sub-optimal out­comes and mar­ket failures.

Incom­plete infor­ma­tion and the inabil­ity to dis­tin­guish cause a loss of prod­uct dif­fer­en­ti­a­tion. Sell­ers try to recover the dif­fer­en­ti­a­tion through sig­nal­ing. For buy­ers, sig­nals are vis­i­ble attrib­utes that sell­ers can acquire at a cost that, in turn, trans­mits infor­ma­tion to buy­ers. Sig­nals that sur­vive and con­tain infor­ma­tion in equi­lib­rium have the prop­erty that their costs are neg­a­tively cor­re­lated with the invis­i­ble, val­ued attribute. If that con­di­tion is absent, the hypo­thet­i­cal sig­nal­ing behav­ior of sell­ers will not be cor­re­lated with the under­ly­ing attribute. Sub­se­quent mar­ket out­comes will reflect that, and the sig­nal then loses its infor­ma­tional con­tent and falls into dis­use and out of the mar­ket equi­lib­rium deter­mi­na­tion mechanisms.

Sig­nal­ing has the two prop­er­ties described above: Expec­ta­tions are endoge­nous; and they exert a pow­er­ful influ­ence on both incen­tives and choices made by sell­ers. Sig­nal­ing mod­els have mul­ti­ple equi­lib­ria, in each of which the expec­ta­tions are self-fulfilling.

In the cur­rent envi­ron­ment of large cor­re­lated global macro risks, we nat­u­rally tend to think mainly of dan­ger­ous equi­lib­rium shifts – away from good ones and toward unfa­vor­able bad ones that are also poten­tially unsta­ble in that one bad equi­lib­rium gives way to even worse ones in a ser­ial fash­ion. But, impor­tantly, it can go the other way too.

Yes, you can get stuck in a “bad” equi­lib­rium. For exam­ple, in the devel­op­ing coun­try con­text in the early stages of devel­op­ment, there is an equi­lib­rium in which there is rel­a­tively lit­tle growth and sub­op­ti­mal invest­ment – a bad equi­lib­rium if you like. Any shock, endoge­nous or exoge­nous, car­ries a high risk of tip­ping the coun­try into an even worse equi­lib­rium. In such cir­cum­stances, the lead­er­ship and reform chal­lenge is to shift the expec­ta­tions and hence the under­ly­ing invest­ment dynam­ics to a dif­fer­ent and much more pos­i­tive equi­lib­rium. And it is here that a series of pos­i­tive equi­lib­ri­ums can impose them­selves, with sig­nif­i­cant impli­ca­tions for invest­ment returns.

Ordi­nary Mar­ket Dynam­ics: Momen­tum and Value Invest­ing
Finan­cial mar­kets have endoge­nous expec­ta­tions. Investors know that expec­ta­tions and prices can drift away from fun­da­men­tals, with a dynamic dri­ven largely by the self-referential nature of the expec­ta­tions. But there are limits.

In “nor­mal” con­di­tions, the feed­back effects of asset price move­ments on the bal­ance sheets of finan­cial and other insti­tu­tions (and of house­holds) are not that large; and the wealth effect on activ­i­ties in the real econ­omy is small as a result. More­over, arbi­trage flows are sub­ject to rel­a­tively low liq­uid­ity and risk premia.

So while a set of investors may base their choices on momen­tum and charts, oth­ers counter by bas­ing their deci­sions more on devi­a­tions of mar­ket prices from some assess­ment of fun­da­men­tal val­ues, either short– or long-term. Trad­ing fre­quency varies, as does the degree of dynamic port­fo­lio real­lo­ca­tions and the pre­mium that can be col­lected for sell­ing volatil­ity in dif­fer­ent mar­ket segments.

Gen­er­ally investors know that at least short term returns are deter­mined in part by other investors’ expec­ta­tions, but longer-term val­u­a­tions will revert to lev­els war­ranted by the under­ly­ing fun­da­men­tals. As cer­tain traders cause mar­kets to move away from fun­da­men­tal val­ues (a mini bub­ble), the devi­a­tions become larger rel­a­tive to the dis­tri­b­u­tion of under­ly­ing value esti­mates. This entices value investors to move against the trends, thus caus­ing a shift in the mar­ket dynam­ics back toward the cen­tral part of the fun­da­men­tal value distribution.

Depend­ing on the size and respon­sive­ness of assets man­aged by each class of investor, the devi­a­tion from fun­da­men­tal val­ues can per­sist for awhile, but it gets pulled back. This can be thought of as a rel­a­tively harm­less form of fluc­tu­at­ing mul­ti­ple equi­lib­rium. And it tends to give rise to attrac­tive pre­mi­ums that investors can cap­ture by sell­ing volatil­ity, either directly in a range of mar­kets (e.g., inter­est rates, credit, equi­ties, com­modi­ties and for­eign exchange) or indi­rectly and less com­pre­hen­sively through cer­tain asset classes (e.g., mort­gages, cor­po­rate bonds, and emerg­ing mar­kets’ local rates, credit and equities).

In this rather com­mon dynamic, the devi­a­tions are gen­er­ally mean revert­ing as expec­ta­tions shifts do not sub­stan­tially affect fun­da­men­tal val­ues. This is not the case when, crit­i­cally, feed­back effects are large and the val­u­a­tion anchor morphs into a mov­ing target.

For exam­ple, in the after­math of the 2008 cri­sis, the real econ­omy headed down a highly cor­re­lated down­ward spi­ral along with the finan­cial mar­kets. Lever­age caused a sub­stan­tial part of the prob­lem, as did pro-cyclical behav­ior on the part of mar­kets and investors. The result was a sig­nif­i­cant, across the board repric­ing of mar­kets, along with “atyp­i­cal” devel­op­ments in mar­ket cor­re­la­tions and the range of risk pre­mia (includ­ing the liq­uid­ity pre­mium). As a result, ini­tial changes in asset val­ues that in an unlever­aged world would not have pro­duced large real econ­omy effects caused sub­stan­tial bal­ance sheet dam­age in the highly lev­ered finan­cial and house­hold sec­tors. This led to large neg­a­tive real-economy feed­back effects and declin­ing fun­da­men­tal val­ues. It wasn’t clear what the anchor was, or if there was one. That kind of struc­ture can implode; and it would have were it not for dra­matic and unprece­dented inter­ven­tion on the part of pol­icy mak­ers who aggres­sively sub­sti­tuted pub­lic bal­ance sheets for rapidly implod­ing pri­vate ones.

The small feed­back con­di­tion that we asso­ciate with nor­mal sta­ble mar­ket con­di­tions was arguably also not what we saw last year in the Euro­pean sov­er­eign debt mar­kets. Then, a yield run up in Italy or Spain threat­ened to shift the trio of mar­ket, polit­i­cal and pol­icy incen­tives in such a way that it would have a major effect on credit qual­ity. This had occurred already in Greece. More on this later.

Bank Runs
Mul­ti­ple equi­lib­rium struc­tures are not new. His­tory is full of exam­ples where, absent effec­tive pol­icy cir­cuit break­ers, mar­ket real­i­ties devi­ated con­sid­er­ably from fun­da­men­tals, and did so in a sequen­tial and increas­ingly dis­or­derly fashion.

Con­sider the case of the bank­ing sec­tor. The nor­mal lev­ered con­fig­u­ra­tion of banks (in a nar­row sense, these are asso­ci­ated pri­mar­ily with their matu­rity trans­for­ma­tion as short term liq­uid lia­bil­i­ties fund longer-term and less liq­uid assets) is key to their role in fund­ing pro­duc­tive invest­ments in an econ­omy. But it also makes them vul­ner­a­ble to losses of con­fi­dence – a sit­u­a­tion that was mas­sively accen­tu­ated in the run up to the global finan­cial cri­sis by prop activ­i­ties and off bal­ance sheet struc­tured invest­ment vehi­cles (SIVs) and other shadow bank­ing activities.

Some­times the change in oper­at­ing par­a­digm is real, in the sense that the assets suf­fer some kind of per­ma­nent impair­ment result­ing in neg­a­tive equity. At some point depos­i­tors and cred­i­tors notice and a race for the exit starts. But as often observed, you do not need such a sol­vency shock to start a bank run. Just the per­cep­tion of such a risk will do. Why? Because it is self-fulfilling absent gov­ern­ment and cen­tral bank inter­ven­tion. In such sit­u­a­tions, sol­vency itself becomes endogenous.

Extreme bank runs are uncom­mon these days because gov­ern­ments guar­an­tee deposits and cen­tral banks can and do move quickly to mon­e­tize the asset side of a sol­vent bank fast enough to keep it in busi­ness, even if the deposit run con­tin­ues for some time, or if short term pri­vate financ­ing in the mar­ket is cut off. Even­tu­ally the deposit run reverses, bor­row­ing capac­ity returns, and the orig­i­nal equi­lib­rium is restored.

The Inter­net Bub­ble of 2000–2001
The inter­net bub­ble of some 10 years ago is an inter­est­ing and slightly dif­fer­ent case. Val­u­a­tions of infor­ma­tional tech­nol­ogy assets (pub­licly traded and not) got dis­con­nected from real­ity, and had some of the char­ac­ter­is­tics of mini-bubbles described above. But the devi­a­tions from fun­da­men­tal value were quite extreme.

The value investor mar­ket cor­rec­tion was delayed by the new­ness of the tech­nolo­gies and the tem­po­rary absence of rel­e­vant data to con­strain the expec­ta­tions. In this data-free envi­ron­ment, nar­ra­tives, uncon­strained by rel­e­vant expe­ri­ence (there wasn’t any), dom­i­nated, usu­ally with a rev­o­lu­tion­ary, dis­rup­tive tech­nol­ogy fla­vor. How­ever, the data-free con­di­tion was not per­ma­nent. Even­tu­ally it became clear that, at least in the short term, fore­casts of growth, rel­e­vance, rev­enues and earn­ings were way too opti­mistic. The mar­kets expe­ri­enced a major down­ward reset, with real econ­omy effects that were large enough to cause a recession.

With hind­sight, it seems fairly clear that the mar­ket dis­tor­tions were not caused by an inac­cu­rate spec­i­fi­ca­tion of the ulti­mate impact of the tech­nol­ogy. Instead, it was the sub­stan­tial over­es­ti­mate of the speed with which these new tech­nolo­gies would affect pro­duc­tiv­ity, soci­ety and the global economy.

There are a vari­ety of ways to describe this. Essen­tially, the value-investing anchor was present but much delayed. There were value and activist investors who were skep­tics but, in the early stages, either they were less numer­ous in terms of con­trol over assets or less cer­tain of their views – hence the delay in responding.

The inter­net bub­ble was suf­fi­ciently large that it did, via the wealth effect, pro­duce a shift in the tra­jec­tory of the real econ­omy. For a while this effect was pos­i­tive and rein­forc­ing. But when expec­ta­tions shifted and val­u­a­tions reset, the reverse occurred and the real econ­omy dipped to the point that the cen­tral bank opted for low inter­est rates to cush­ion the reces­sion­ary effect.

Stand­ing back from these spe­cific two cases for a moment, some­thing is clear. In both, there were mul­ti­ple equi­lib­ria affect­ing mar­ket activ­ity, pol­icy anchors and cir­cuit break­ers; and they ended up oper­at­ing with vary­ing speed and certitude.

Sov­er­eign Debt and the Euro­zone
Olivier Blan­chard, the chief econ­o­mist at the IMF, observed in his 2011 end-of-year remarks: “… post the 2008-09 cri­sis, the world econ­omy is preg­nant with mul­ti­ple equi­lib­ria – self-fulfilling out­comes of pes­simism or opti­mism, with major macro­eco­nomic impli­ca­tions.”

Con­sider the case of Italy last year. In May, Ital­ian bond yields were rel­a­tively sta­ble and well behaved. By August and again in Novem­ber onward, unprece­dented volatil­ity drove them to dan­ger­ously high lev­els – enough to raise legit­i­mate con­cern about the risk of a debt insol­vency sequence.

With yields in the 6% to 7% range and the prospect that they might remain high as matur­ing low cost debt was increas­ingly refi­nanced via high cost debt, there was a mate­r­ial risk of a shift in expec­ta­tions – not just on the mar­ket side, but also on pol­icy incen­tives. The inter­ac­tions of these expec­ta­tions, includ­ing through feed­back mech­a­nisms, trans­lated into mount­ing pres­sures on credit qual­ity, yields, growth and poli­cies. They also had social and polit­i­cal effects. And as the Ital­ian stock mar­ket lost a third of its value, the wealth effect kicked in, help­ing to push Italy’s econ­omy toward neg­a­tive growth and debt defla­tion.

Sov­er­eign debt in this con­text assumes the struc­tural char­ac­ter­is­tics of mul­ti­ple equi­lib­ria. The “credit risk” is endoge­nous. Per­ceived risk affects investor behav­ior, mar­ket prices, the incen­tives of gov­ern­ments and hence credit risk.
What are the cir­cuit break­ers or anchors in a sit­u­a­tion like this? One para­me­ter is the level of sov­er­eign debt. Italy’s pub­lic debt-to-GDP is sec­ond only to Japan among the G-7 economies. That makes the cost of a rise in yields con­sid­er­able.
In the low lever­age case, you could argue that the anchor is the rel­a­tively low cost to the pub­lic finances of a rise in yields, break­ing the feed­back effect on credit risk. In that case, value investors respond to yield increases by increas­ing expo­sures and bring­ing the yields back down. Higher debt flows do the oppo­site: They change the incen­tive struc­ture and amplify the feed­back effect.
Sec­ond, with respect to a sud­den shift in equi­lib­rium, antic­i­pated pol­icy responses mat­ter. In the Ital­ian case, an aggres­sive assault on tax eva­sion, mea­sures to lib­er­al­ize labor mar­kets and lift growth, and to dial back the para­me­ters that deter­mine non-debt pub­lic lia­bil­i­ties like pen­sions, with enough lead­er­ship to over­come the burden-sharing iner­tial forces that are present in any polit­i­cal sys­tem, would clearly reduce (though not elim­i­nate) the risk. By con­trast, prior to the arrival of the tech­no­cratic gov­ern­ment under the lead­er­ship of Prime Min­is­ter Mario Monti, Italy had a gov­ern­ment that was dis­tracted, per­haps not fully aware of the risks, and los­ing pop­u­lar sup­port (as well as that of Euro­pean part­ners). Even if it had attempted the kind of reform pro­gram that would have made a dif­fer­ence, there was height­ened risk that prob­a­bly tipped the mar­kets toward the new equi­lib­rium.
With a change in gov­ern­ment and in pol­icy approach, includ­ing mean­ing­ful sup­port from the ECB via the long-term refi­nanc­ing oper­a­tions (LTROs), Italy had the abil­ity to inter­rupt the neg­a­tive mul­ti­ple equi­lib­rium dynam­ics at the end of 2011/beginning of 2012, thus low­er­ing its bor­row­ing costs. That was not the case for Greece, where the ini­tial eco­nomic and finan­cial con­di­tions were con­sid­er­ably worse, there are legit­i­mate ques­tions about the polit­i­cal will to imple­ment and sus­tain the reform process, and Euro­pean part­ners and the IMF appear much more skep­ti­cal and hes­i­tant.
The gen­eral aware­ness of the seri­ous­ness of the prob­lem has risen sub­stan­tially, but the issue of who across var­i­ous parts of the econ­omy and exter­nally should bear the real costs of restor­ing fis­cal bal­ance and growth momen­tum remains. Even with the recent debt restruc­tur­ing oper­a­tions, or PSI (for pri­vate sec­tor involve­ment), mar­kets are pric­ing remain­ing unal­lo­cated cap­i­tal losses that act as an imped­i­ment to sol­vency, growth and employ­ment. As a result, fresh cap­i­tal is largely refus­ing to engage notwith­stand­ing yields that remain high.
It is impor­tant to stress the com­ple­men­tary poten­tial cir­cuit break­ers formed by the exter­nal pol­icy response – namely, the scale and scope of inter­ven­tion from the ECB, EU and IMF (the “troika”) in the sov­er­eign debt mar­kets expe­ri­enc­ing ris­ing yields that threaten the effec­tive­ness of and com­mit­ment to reform mea­sures.
These enti­ties’ inter­ven­tions can and in some cases have suc­ceeded to sta­bi­lize yields, buy­ing time for the reform process to work. This is the case for the pow­er­ful LTROs.
By pro­vid­ing “unlim­ited liq­uid­ity” to banks on truly excep­tional terms (1%, three-year matu­ri­ties, and relaxed col­lat­eral require­ments), the ECB has been instru­men­tal in eas­ing forced de-leveraging, min­i­miz­ing the risk of dis­or­derly deposit out­flows, and pre­vent­ing highly dis­rup­tive bank runs and pay­ments prob­lems. Some of that inter­ven­tion also spilled over to sov­er­eign debt mar­kets.
But thus far, the ECB and the euro­zone core have been unwill­ing to make uncon­di­tional com­mit­ments to inter­vene directly in the sov­er­eign debt mar­kets of Italy and Spain to sta­bi­lize yields. This reluc­tance is under­stand­able and is prob­a­bly due to con­cern about what might be called polit­i­cal or pol­icy moral haz­ard: The con­cern is that such a com­mit­ment, while reduc­ing the like­li­hood of the unat­trac­tive equi­lib­rium, other things equal, might also reduce the incen­tive for reform by politi­cians and cit­i­zens. Since such reform is acknowl­edged to be essen­tial to restor­ing sta­bil­ity in the euro­zone, depend­ing on which effect is larger, the inter­ven­tion could be self-defeating.
Many knowl­edge­able observers believe that the inten­tion in the euro­zone core is to inter­vene, pro­vided the reform process is seri­ous and mak­ing head­way, but not to announce this inten­tion in order to mit­i­gate the moral haz­ard prob­lem. The prob­lem then becomes the bal­ance between proac­tive and reac­tive mea­sures, as well as the abil­ity to crowd in the pri­vate sec­tor.
A sim­i­lar kind of polit­i­cal moral haz­ard may have moti­vated Ger­man Chan­cel­lor Angela Merkel’s deci­sion to insist on a par­al­lel process of fis­cal reform, in spite of the fact that such a process bur­dens a polit­i­cal con­struct that is already chal­lenged by the process of restor­ing order in the periph­ery. The the­ory being that, in the sequen­tial ver­sion, if and when things are sta­bi­lized, the incen­tive to do the insti­tu­tional reform declines among politi­cians and elec­torates. It is a com­plex situation.

The USA and Japan
If this analy­sis is cor­rect, then as the U.S. runs up its sov­er­eign debt over time, there will be a grad­ual increase in the risk of a sud­den shift in sentiment/expectations. Down the road, this could lead to an increase in yields and hence reduce fis­cal space and pol­icy flex­i­bil­ity. Polit­i­cal grid­lock adds to this risk by low­er­ing the per­ceived capac­ity to engage in cor­rec­tive medium-term action on a timely basis, or to cred­i­bly com­mit to a multi-year term plan for fis­cal sta­bi­liza­tion and growth.
If expec­ta­tions start to dete­ri­o­rate on U.S. sov­er­eign debt, there is no plau­si­ble exter­nal cir­cuit breaker. It has to come from within the coun­try. And the only plau­si­ble anchor to pull it back would be strong, dis­ci­plined, multi-year pol­icy response that tar­gets, impor­tantly, both lower debt and higher growth. The longer it is delayed, the more expen­sive and riskier it becomes. While the lever­age is prob­a­bly not yet high enough to make the cur­rent equi­lib­rium unsta­ble, the return of the threat of a tech­ni­cal default in late 2012 or early 2013 could move the risks for­ward in time.
The U.S. Econ­omy in the Decade Prior to the Cri­sis of 2008
The U.S. econ­omy prior to the cri­sis was run­ning with excess con­sump­tion, defi­cient pub­lic sec­tor invest­ment, gov­ern­ment dis-saving, and a cur­rent account deficit reflect­ing a short­fall of sav­ing rel­a­tive to gross invest­ment. In short, the econ­omy was invest­ing too lit­tle to sus­tain growth and sav­ing even less.
Unlike other major devel­oped economies, the U.S. ran a bilat­eral cur­rent account deficit with respect to almost every major coun­try. Income and wealth dis­tri­b­u­tion con­tin­ued to dete­ri­o­rate, and net employ­ment cre­ation in the trad­able side was neg­a­tive with espe­cially large declines for the middle-income groups. The non-tradable side of the econ­omy absorbed the incre­men­tal labor force with big increases in gov­ern­ment and health care and a boost from excess con­sump­tion, espe­cially in the labor inten­sive sec­tors, retail­ing, hos­pi­tal­ity and con­struc­tion.
Both the struc­tural imbal­ances and the accu­mu­la­tion of pub­lic and pri­vate debt should have raised ques­tions among pol­icy mak­ers and investors about the sus­tain­abil­ity of the growth pat­tern over the medium-term, espe­cially in the non-tradable sec­tor, as well as about the polit­i­cal econ­omy and dis­tri­b­u­tional effects. But all of this is with the ben­e­fit of hind­sight. Too many were insuf­fi­ciently atten­tive to the pow­er­ful sec­u­lar tech­no­log­i­cal and global eco­nomic forces oper­at­ing on the econ­omy, overly san­guine about the sus­tain­abil­ity of the growth pat­tern, and unable to accu­rately assess the ris­ing sys­temic risks. As a result, on a rather large scale, the mar­ket and pol­icy cir­cuit break­ers failed to oper­ate, and even­tu­ally the equi­lib­rium shifted sud­denly and vio­lently.
The cri­sis of 2008 wasn’t so much a 100 year storm but rather an acci­dent wait­ing to hap­pen. It is true that fail­ures of reg­u­la­tion and risk assess­ment played impor­tant enabling roles. But the under­ly­ing prob­lem was in large part a sys­tem­atic pat­tern of unsus­tain­able intertem­po­ral choices, reflected in lever­age, debt and a sense of unlim­ited credit enti­tle­ment. This led to a dynamic in both the real econ­omy and the mar­kets that con­sti­tuted an increas­ingly unsta­ble equi­lib­rium. It broke in 2008, and we are in the some­what lengthy process of shift­ing to a dif­fer­ent equi­lib­rium, what PIMCO labeled back in May 2009 the bumpy jour­ney to a new des­ti­na­tion (or a “new nor­mal”).
Assess­ing non-cyclical macro sys­temic risk is com­plex: Accu­rately gaug­ing the like­li­hood of an equi­lib­rium shift is hard, and as a result, the anchors that pre­vent major devi­a­tions from real­is­tic sus­tain­able long run value cre­ation are not nec­es­sar­ily present. But one les­son for pol­icy mak­ers and investors seems clear: It is unwise to assume sta­bil­ity and sus­tain­abil­ity when under­ly­ing fun­da­men­tals are weak­en­ing.
Tip­ping Points
It is not enough for investors and pol­i­cy­mak­ers to rec­og­nize the fuel for mul­ti­ple equi­lib­ria dynam­ics. There is also the ques­tion of the spark, or what is known as tip­ping points.
Tip­ping points are shifts in the equi­lib­rium when either fun­da­men­tals or expec­ta­tions change course and then are legit­imized by sub­se­quent devel­op­ments. Often they occur quite sud­denly, with accel­er­a­tions com­ing from tech­ni­cal fac­tors. The exact tim­ing is noto­ri­ously dif­fi­cult to pre­dict, rais­ing the chal­lenges for how mar­kets, investors and poli­cies should react and internalize/price this non-linearity.
From recent expe­ri­ence, ques­tion marks or chang­ing views about pol­icy responses increase the like­li­hood of an equi­lib­rium shift by oper­at­ing directly on the expec­ta­tions. New data can have the same effect. Also, obser­va­tion of mar­ket dynam­ics sug­gest that there are nar­ra­tives and sto­ries that affect investor behav­ior, and that when these nar­ra­tives change, expec­ta­tions and pric­ing dynam­ics can shift too.
But even for con­trar­i­ans who detect the struc­tural con­di­tions early, pre­dict­ing the tim­ing has proved elu­sive, and the dura­tion of the con­trar­ian bet can be uncom­fort­ably long. Gen­er­ally, most schol­ars and ana­lysts have con­cluded that it is impos­si­ble to pre­dict the tim­ing of an equi­lib­rium shift even when the ingre­di­ents that cre­ate the ris­ing poten­tial insta­bil­ity and the pos­si­bil­ity of mul­ti­ple equi­lib­ria are present. The ana­logue in the sci­ences are sys­tems that are called “crit­i­cal states” whose move­ments behave accord­ing to fat-tailed power law dis­tri­b­u­tions.
Bimodal Dis­tri­b­u­tions, Mul­ti­ple Equi­lib­ria and Invest­ment Strat­egy
In the cur­rent envi­ron­ment, the preva­lence of some sub­jec­tive bimodal dis­tri­b­u­tions on the part of investors can be viewed as a reflec­tion of the mul­ti­ple equi­lib­rium fea­tures of a num­ber of sov­er­eign debt mar­kets. This is espe­cially the case in Europe where investors are torn between the prospects for frag­men­ta­tion (reflect­ing both default and exit risks asso­ci­ated with the weak­est euro­zone periph­er­als) and recov­ery (dri­ven by the core’s com­mit­ment to “refound­ing” the euro­zone and the periphery’s adjust­ment efforts). Here the ram­i­fi­ca­tions of a sud­den equi­lib­rium shift, good or bad, go well beyond the sov­er­eign debt mar­kets them­selves, radi­at­ing out to the entire global econ­omy.
Mul­ti­ple equi­lib­ria give rise to two or more sce­nar­ios, each quite dif­fer­ent and each with its own dis­tri­b­u­tion of out­comes, cor­re­la­tions, mar­ket func­tion­ing and returns. Investors – and espe­cially long-term investors in both finan­cial and phys­i­cal assets – are faced with the need to assess the rel­a­tive like­li­hood of the sce­nar­ios, and then take a weighted aver­age of usu­ally two rather more nor­mal look­ing dis­tri­b­u­tions to end up with the bi-modal one. Whether it is in fact bimodal or not depends on the weights. Extreme opti­mism or pes­simism will elim­i­nate the bimodal fea­ture.
This sug­gests that the tip­ping point can be crossed when the rel­a­tive weight given to the non-status quo sce­nario starts to rise for a sub­set of investors. There is some emerg­ing evi­dence that the short-term cor­re­la­tions, across and within asset classes, start to rise before a pos­si­ble equi­lib­rium shift. But that does not imply that the shift will occur. And when the cor­re­la­tions rise, the cost of the tail risk hedges also tends to rise.
Boldly bet­ting on one or the other of the sce­nar­ios – i.e., either an extreme risk-off or risk-on pos­ture – requires a very high level of con­vic­tion and foun­da­tion in an inher­ently “unusu­ally uncer­tain” con­text. Sim­i­larly, posi­tion­ing for the aver­age of the two modes means that investors end up in the mud­dled mid­dle – a “carry-laden” port­fo­lio posi­tion­ing that pays off only if the unsus­tain­able is sus­tained.
A bet­ter approach revolves around the early detec­tion of the struc­tural bases for mul­ti­ple equi­lib­ria accom­pa­nied by rel­a­tive low cost tail-risk hedges. Absent that, for many investors, sit­ting on the side­lines and accept­ing low cash returns (and, in today’s policy-induced finan­cial repres­sion envi­ron­ment, neg­a­tive real rates) until the bimodal fea­tures are resolved is under­stand­able. How to do that used to be via a bas­ket of “risk-free” assets; but with sov­er­eign debt risk in the major economies on the rise, the menu of “risk-free” assets is being reduced, and yields on what remains have con­verged to very low nom­i­nal lev­els.
Con­clu­sions
With too many advanced economies con­fronting the twin dilemma of too much debt and too lit­tle growth, and with sys­tem­i­cally impor­tant emerg­ing coun­tries nav­i­gat­ing the tricky middle-income devel­op­men­tal tran­si­tion, today’s global econ­omy poses unusual chal­lenges for tra­di­tional con­cepts of asset allo­ca­tion and risk man­age­ment. It is also slowly influ­enc­ing the way that cer­tain investors are think­ing about cor­re­la­tions, volatil­ity, guide­lines and bench­marks.
These changes can be par­tic­u­larly pro­nounced in sit­u­a­tions where mar­kets tran­si­tion from a mean-reverting par­a­digm to one of mul­ti­ple equi­lib­ria and path depen­dency. This is the world in which expec­ta­tions can and do play a major role in eco­nomic and mar­ket out­comes.
On the neg­a­tive side, the global econ­omy saw this dra­mat­i­cally back in 2008-09, and Europe has been expe­ri­enc­ing it more recently. More­over, it fea­tured in many of the his­toric bub­bles and bank runs that are still the sub­ject of analy­sis and fas­ci­na­tion. On the pos­i­tive end, it has char­ac­ter­ized the ben­e­fi­cial break­out phase in sev­eral emerg­ing economies. We also saw it in the reac­tions of mar­kets to cir­cuit break­ers imposed by deci­sive pol­icy actions on the part of sev­eral coun­tries in 2009.
In such cases, suc­cess­ful investors (as well as pol­icy mak­ers, researchers and opin­ion lead­ers) have to extend well beyond their under­stand­ing of fun­da­men­tals, his­toric risk pre­mia, cor­re­la­tions and rel­a­tive value. They have no alter­na­tive but to also try to under­stand the expec­ta­tion for­ma­tion process itself, includ­ing agent sig­nal­ing and feed­back loops incor­po­rat­ing eco­nomic out­comes and incen­tive struc­tures. With­out such under­stand­ing, it becomes even harder to con­tin­u­ously suc­ceed in meet­ing objec­tives – espe­cially in a world that will con­tinue to de-lever and where pol­icy mak­ers are still in full exper­i­men­ta­tion mode.
Both the­ory and the expe­ri­ence of the last few years sug­gest that investors must also enhance their analy­sis of pol­icy mak­ers’ reac­tion func­tion. Indeed, this is an impor­tant input into assess­ments of cor­re­la­tions, volatil­ity, returns and risk.
For pol­icy, this points to a need for a bet­ter design and use of ex ante and ex post cir­cuit break­ers. The for­mer pre­vent the evo­lu­tion of struc­tures that amplify the feed­back loops. The lat­ter are designed to break the ser­ial con­t­a­m­i­na­tion of expec­ta­tions, the real econ­omy and mar­ket link­ages, thereby inter­rupt­ing the often dis­rup­tive dynamic that leads to a sequence of bad equilibria.

A "risk free" asset refers to an asset which in the­ory has a cer­tain future return. U.S. Trea­suries are typ­i­cally per­ceived to be the "risk free" asset because they are backed by the U.S. gov­ern­ment. All invest­ments con­tain risk and may lose value.
Invest­ing in the bond mar­ket is sub­ject to cer­tain risks includ­ing mar­ket, interest-rate, issuer, credit, and infla­tion risk. Equi­ties may decline in value due to both real and per­ceived gen­eral mar­ket, eco­nomic, and indus­try con­di­tions. Invest­ing in for­eign denom­i­nated and/or domi­ciled secu­ri­ties may involve height­ened risk due to cur­rency fluc­tu­a­tions, and eco­nomic and polit­i­cal risks, which may be enhanced in emerg­ing mar­kets. Sov­er­eign secu­ri­ties are gen­er­ally backed by the issu­ing gov­ern­ment, oblig­a­tions of U.S. Gov­ern­ment agen­cies and author­i­ties are sup­ported by vary­ing degrees but are gen­er­ally not backed by the full faith of the U.S. Gov­ern­ment; port­fo­lios that invest in such secu­ri­ties are not guar­an­teed and will fluc­tu­ate in value. Mort­gage and asset-backed secu­ri­ties may be sen­si­tive to changes in inter­est rates, sub­ject to early repay­ment risk, and while gen­er­ally sup­ported by a gov­ern­ment, government-agency or pri­vate guar­an­tor there is no assur­ance that the guar­an­tor will meet its oblig­a­tions. Tail risk hedg­ing may involve enter­ing into finan­cial deriv­a­tives that are expected to increase in value dur­ing the occur­rence of tail events. Invest­ing in a tail event instru­ment could lose all or a por­tion of its value even in a period of severe mar­ket stress. A tail event is unpre­dictable; there­fore, invest­ments in instru­ments tied to the occur­rence of a tail event are spec­u­la­tive. Deriv­a­tives may involve cer­tain costs and risks such as liq­uid­ity, inter­est rate, mar­ket, credit, man­age­ment and the risk that a posi­tion could not be closed when most advan­ta­geous. Invest­ing in deriv­a­tives could lose more than the amount invested.
This mate­r­ial con­tains the opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this mate­r­ial may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion. ©2012, PIMCO.

Tags: Asset Allocation, Circuit Breakers, Debt Markets, Delineation, Global Context, Global Economy, Investment Returns, Liquidity Management, Management Risk, Market Dynamics, Market Equilibria, Market Outcomes, Mike Spence, Periodic Bouts, Policy Responses, Relative Value, Risk Mitigation, Risk Premia, Sovereign Debt, Sudden Shifts
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Is Risk in Emerging Economies Less Than Developed Economies?

Monday, March 12th, 2012

To get an over­all view of the health of emerging-market economies I devel­oped a GDP-weighted man­u­fac­tur­ing PMI as well as a GDP-weighted non-manufacturing/services PMI index using 2010’s GDP con­verted to U.S. dollars.

Fol­low­ing a double-dip in Sep­tem­ber and Novem­ber last year, growth in man­u­fac­tur­ing is steadily increas­ing, with the man­u­fac­tur­ing PMI in Feb­ru­ary ris­ing to 52.0. The PMI is still sig­nif­i­cantly below the recent peak of 54.3 in Jan­u­ary last year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

In the first half of last year growth in the man­u­fac­tur­ing sec­tor of emerg­ing economies was sig­nif­i­cantly slower than that of the major devel­oped economies. The sov­er­eign debt cri­sis in the Euro­zone lev­eled the score in the sec­ond half, though.

Sources: Markit; HSBC; CFLP; Kag­iso; ISM; Plexus Asset Management.

With a weight of 51.9% China’s man­u­fac­tur­ing sec­tor has a major bear­ing on the emerg­ing economies’ man­u­fac­tur­ing PMI. Nowa­days it is pop­u­lar to say that when China sneezes the other the emerging-market economies catch a cold – yes, the same adage used for the U.S. in the past. My analy­sis indi­cates it is devoid of any truth. It is evi­dent that the trend of my cycli­cally adjusted China CFLP Man­u­fac­tur­ing PMI is out of sync with the GDP-weighted Man­u­fac­tur­ing PMI of the emerg­ing economies exclud­ing China. The grad­ual weak­en­ing of China’s PMI from Octo­ber 2010 to Feb­ru­ary 2011 had no effect on the rest of the emerg­ing economies as the latter’s PMI con­tin­ued to rise until Japan’s ter­ri­ble twin dis­as­ters in March. The Man­u­fac­tur­ing PMI (exclud­ing China) bot­tomed in Sep­tem­ber last year while China’s PMI only bot­tomed in Novem­ber, but the two series are now ris­ing in unison.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

The GDP-weighted PMI (exclud­ing China) is highly cor­re­lated with the GDP-weighted Man­u­fac­tur­ing PMI that I cal­cu­late for the major devel­oped economies.

Sources: Markit; HSBC; CFLP; Kag­iso; ISM; Plexus Asset Management.

Due to lim­ited data, I was forced to focus on the BRIC coun­tries when cal­cu­lat­ing the non-manufacturing/services PMI for emerg­ing economies. Con­trary to the man­u­fac­tur­ing PMI the non-manufacturing/services PMI of the BRICs remained well above 50 at the height of the Euro­zone cri­sis and in Feb­ru­ary regained pre-crisis levels.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

It is note­wor­thy that while the ser­vices sec­tor in the devel­oped economies col­lec­tively was severely affected by Japan’s twin dis­as­ters the ser­vices sec­tor in the BRIC zone was largely unaf­fected. It was only when the Euro­zone cri­sis deep­ened that sig­nif­i­cant weak­ness appeared in the BRIC ser­vices sec­tor. This sec­tor also led the recov­ery as the cri­sis started to dissipate.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

China’s non-manufacturing sec­tor that com­prises 44.7% of the BRIC zone’s non-manufacturing/services PMI ini­tially held up extremely well rel­a­tive to the other BRIC economies when the Euro­zone cri­sis hit the head­lines, but in the end suc­cumbed when the cri­sis deep­ened. The drop in China’s PMI in Feb­ru­ary last year can be ascribed to the later than nor­mal Chi­nese Lunar New Year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

It is also inter­est­ing to note that growth in the ser­vices sec­tor of the BRIC zone is very steady com­pared to that of the devel­oped economies – even with the stal­wart China excluded.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management

Although the country’s weight is only 3.4%, I included South Africa in the cal­cu­la­tion of a GDP-weighted com­pos­ite PMI (man­u­fac­tur­ing and ser­vices com­bined) for emerg­ing economies as rep­re­sented by the BRICS zone (BRIC plus South Africa).

The BRICS Com­pos­ite PMI recov­ered sharply to 55.5 in Feb­ru­ary after nearly stalling in Novem­ber last year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

The com­pos­ite PMI of BRICS remained rel­a­tively steady in the after­math of Japan’s twin dis­as­ters but even­tu­ally gave way as the Euro­zone cri­sis deepened.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

Again China’s dom­i­nance in the com­pos­ite PMI had a major impact as it is note­wor­thy that the BRICS Com­pos­ite PMI exclud­ing China bot­tomed in Sep­tem­ber while China’s PMI only bot­tomed two months later.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

I asked myself whether rel­a­tive strength in the BRICS com­pos­ite PMI rel­a­tive to devel­oped economies mat­ters in the rel­a­tive per­for­mance of the emerging-market equity indices against mature-market equity indices.

There is clear evi­dence that China’s stock market’s per­for­mance rel­a­tive to the MSCI World Index in terms of U.S. dol­lar is in fact heav­ily influ­enced by the per­for­mance of the under­ly­ing econ­omy rel­a­tive to the global econ­omy as mea­sured by rel­a­tive com­pos­ite PMIs. The der­at­ing of China’s stock mar­ket rel­a­tive to global stock mar­kets in the sec­ond quar­ter of last year stands out. Over the past three months the Chi­nese mar­ket has made up some lost ground but sig­nif­i­cant rel­a­tive upside poten­tial remains.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

My research indi­cates that the under­ly­ing econ­omy of India as mea­sured by the com­pos­ite PMI has no bear­ing on the rel­a­tive per­for­mance of the Indian stock mar­ket. The rel­a­tive per­for­mance of China’s econ­omy has a huge impact, though.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

As in the case of India the under­ly­ing econ­omy of Brazil as mea­sured by the com­pos­ite PMI has no bear­ing on the rel­a­tive per­for­mance of the Indian stock mar­ket. What I found is that the Brazil­ian stock market’s per­for­mance rel­a­tive to global stock mar­kets is highly cor­re­lated to the GDP-weighted Emerg­ing Economies’ man­u­fac­tur­ing PMI.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

In Russia’s case the rel­a­tive per­for­mance of the stock mar­ket is pri­mar­ily influ­enced by oil prices and not the state of the under­ly­ing econ­omy as mea­sured by the com­pos­ite PMI rel­a­tive to the global economy.

Sources: I-Net Bridge; Plexus Asset Management.

The rel­a­tive per­for­mance of the South Africa’s econ­omy also has no bear­ing on the stock market’s per­for­mance. Metal prices are the main determinants.

Sources: I-Net Bridge; Plexus Asset Management.

In con­clu­sion, the emerg­ing economies are not as depen­dent on China as many would like to believe. In light of the steadi­ness of espe­cially the non-manufacturing/services com­pos­ite PMI of BRICs rel­a­tive to that of the JP Mor­gan Global Ser­vices PMI I am of the opin­ion the eco­nomic risk in emerg­ing economies is less than that of devel­oped economies. Do emerg­ing mar­kets then not deserve bet­ter rat­ings and more expo­sure in global diver­si­fied port­fo­lios? It is clear to me that dif­fer­ent fac­tors influ­ence the rel­a­tive per­for­mance of the indi­vid­ual emerg­ing mar­kets and they are there­fore not a homoge­nous group.

Tags: Adage, Asset Management, Bearing, China, Debt Crisis, Disasters, Double Dip, Emerging Economies, Emerging Market Economies, Eurozone, GDP, Ism, Manufacturing Sector, Manufacturing Services, Pmi, Russia, Score, Second Half, Sovereign Debt, Sync, Unison
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Silver Surges 4.5% To Over $37/Oz On "Massive Fund Buying"

Wednesday, February 29th, 2012

From Gold­Core

Sil­ver Surges 4.5% To Over $37/Oz On "Mas­sive Fund Buy­ing"

Gold’s Lon­don AM fix this morn­ing was USD 1,788.00, EUR 1,329.96, and GBP 1,120.79 per ounce..

Yesterday's AM fix was USD 1,774.75, EUR 1,321.48, and GBP 1,120.42 per ounce.

Cross Cur­rency Table – (Bloomberg)

Gold rose 1% in New York yes­ter­day and closed at $1,783.90/oz. Gold rose in Asia to a high of $1,790.16 it’s high­est since mid Novem­ber then edged down.  Europe this morn­ing saw side­ways trad­ing until unusu­ally volatile trad­ing around the Lon­don AM fix saw gold rise from $1785.oz to over $1790/oz at 1030 GMT and then fall quickly to $1783/oz.

Spot sil­ver has gained another 0.5% to $37.05 an ounce, after surg­ing 4.5% yes­ter­day once it rose above resis­tance at $35.50/oz. Sil­ver reached a 5 month high of $37.21 but remains more than 30% below its nom­i­nal high in of April last year of $48.44.

Sil­ver Spot $/oz – (Bloomberg)

Over 800 Euro­pean banks have taken €529.5 bil­lion from the ECB today after tak­ing €489 bil­lion euros at the first ten­der in Decem­ber. The ECB’s 3 year lend­ing is now near 1 tril­lion euros ($1.35 tril­lion) and the ECB’s bal­ance sheet looks increas­ingly precarious.

Although the flood of paper has been cred­ited with fuelling a rally on Europe’s dis­traught bond mar­kets and safe­guard­ing the region’s banks, it is another exer­cise in kick­ing the beer keg down the road as it fails to address the fun­da­men­tal issue which is the insol­vency of many Euro­pean banks and many Euro­pean nations and the obvi­ous risk of con­ta­gion from that.

The con­tin­u­a­tion of ultra loose mon­e­tary poli­cies increases the risk of infla­tion which will ben­e­fit gold which is an excel­lent infla­tion hedge. Extremely low yields on deposits and “risk free” sov­er­eign debt means the oppor­tu­nity cost of car­ry­ing non yield­ing bul­lion remains very low.

Spot sil­ver gained 0.4% to $37.05 an ounce, after surg­ing 4% and hit­ting a 5 month high of $37.21 in the pre­vi­ous session.

Sil­ver as ever out­per­formed gold yes­ter­day and traders attrib­uted the surge to “mas­sive fund buy­ing” and to “panic” short cov­er­ing. Some of the bul­lion banks with large con­cen­trated short posi­tions cov­ered short posi­tions after the tech­ni­cal level of $35.50/oz was breached easily.

Mas­sive liq­uid­ity injec­tions and ultra loose mon­e­tary poli­cies make sil­ver increas­ingly attrac­tive for hedge funds, insti­tu­tions and investors.

This time last year (Feb­ru­ary 28th 2011) sil­ver was at $36.67/oz. Two months later on April 28th it had risen to $48.44/oz for a gain of 32% in 2 months.

There then came a very sharp cor­rec­tion and a period of con­sol­i­da­tion in recent months. Silver’s fun­da­men­tals remain as bull­ish as ever and the tech­ni­cals look increas­ingly bull­ish with strong gains seen in Jan­u­ary and February.

Very bull­ish is the fact that sil­ver also remains more than 30% below its record nom­i­nal high 32 years ago in 1980 and more than 75% below its infla­tion adjusted high of $140/oz in 1980.

The gold-silver ratio dropped to its low­est level in 5 months, after sil­ver rose more than 12% so far this month and an enor­mous 34% this year, out­per­form­ing other pre­cious metals.

Ris­ing hold­ings of silver-backed ETF’s also indi­cated grow­ing investor inter­est in the metal. The over­all sil­ver Exchange Traded Funds hold­ings rose to 491.079 mil­lion ounces, the high­est since last May.

Spot plat­inum gained nearly 0.5% to $1,722.24, as investors await the lat­est in Impala Platinum's deal­ing with an ille­gal strike that has dis­rupted pro­duc­tion at Rusten­burg, the world's largest plat­inum mine.

For break­ing news and com­men­tary on finan­cial mar­kets and gold, fol­low us on Twit­ter.

OTHER NEWS
(AP) — Sil­ver Prices Jump, Play­ing Catch-up to Gold
Sil­ver prices shot up 4.5 per­cent Tues­day, play­ing catch-up to gold.

Sil­ver is both a pre­cious and an indus­trial metal. Traders can buy it to hedge against a volatile stock mar­ket, as they do with gold. But it can also be used to make prod­ucts like com­puter chips, mean­ing prices can rise when traders expect demand from man­u­fac­tur­ers to go up.

In March con­tracts, sil­ver rose $1.616 to $37.14 per ounce. It's up roughly 10 per­cent from where it was a year ago. Ster­ling Smith, senior mar­ket ana­lyst at Coun­try Hedg­ing in St. Paul, Minn., said part of the rea­son sil­ver is surg­ing is that traders believe it's under­val­ued com­pared to gold. Gold closed at $1,788.40 an ounce, up $13.50 for the day. It's up about 26 per­cent com­pared to a year ago.

Cop­per rose 3.15 cents to $3.912 per pound, and plat­inum rose $9.20 to $1,723.50.

Energy con­tracts fell, partly because investors were pulling back after price gains last week. Oil prices remain close to nine-month highs because of con­cerns that Iran could cut ship­ments of crude to Europe and inter­fere with sup­plies else­where. The Euro­pean Union and the U.S. are using sanc­tions against Iran because they fear the coun­try is devel­op­ing a nuclear weapon.

Bench­mark oil fell $2.01 to fin­ish at $106.55 per bar­rel on the New York Mer­can­tile Exchange. Nat­ural gas prices fell 8.5 cents to end at $2.627 per 1,000 cubic feet. Heat­ing oil fell 6.28 cents to $3.2201 per gallon.

Smith said grains and other agri­cul­tural prod­ucts have been enjoy­ing a "win­ning streak" for the past week. Those move­ments are espe­cially impor­tant now as farm­ers decide what to plant this year.

Soy­bean prices on Mon­day topped $13 a bushel for the first time in five months. That's because traders think there will be greater demand for U.S. exports of the protein-rich beans because smaller har­vests from South Amer­ica are expected.

On Tues­day, soy­beans for March deliv­ery rose less than 1 per­cent, to $13.125 per bushel from $13.025. March wheat rose 15.5 cents to fin­ish at $6.6825 per bushel. Corn ended up 8.75 cents to $6.5725 per bushel.

The price of orange juice also rose. Cocoa and sugar fell.

(Bloomberg) – Gold-Oil Cor­re­la­tion Rises to Eight-Month High
Gold’s strength­en­ing cor­re­la­tion with oil means more gains for the metal as Brent near a nine– month high spurs demand for an infla­tion hedge, UBS AG said.

The CHART OF THE DAY shows Brent prices reached $125.55 a bar­rel in Lon­don on Feb. 24, the high­est since early May, and are up 15 per­cent this year. Bul­lion has gained 14 per­cent in the period and reached $1,787.55 an ounce last week, the high­est since Nov. 14. The 30-week cor­re­la­tion coef­fi­cient between the com­modi­ties rose to 0.61 today, the most since June. A fig­ure of 1 means the two always move in the same direction.

Gold’s “rolling cor­re­la­tion with oil is slowly inch­ing higher and we think this sig­nals that some catch­ing up lies ahead,” Edel Tully, an ana­lyst at UBS in Lon­don, wrote today in a report. “To the extent that ris­ing oil prices feed into higher infla­tion expec­ta­tions, gold is bound to reap benefits.”

Some investors buy gold to hedge against accel­er­at­ing con­sumer prices and as a pro­tec­tion from slow­ing growth and geopo­lit­i­cal risk. The metal, which gen­er­ally earns hold­ers returns only through price gains, ral­lied for an 11th year in 2011 as cen­tral banks in Europe and the U.S. kept inter­est rates near record lows. Oil advanced this year on con­cern the west’s dis­pute with Iran over the Islamic republic’s nuclear pro­gram may lead to a dis­rup­tion in exports from the Mid­dle East.

Investors are hold­ing a record 2,398.2 met­ric tons of gold in exchange-traded prod­ucts backed by the metal, val­ued at about $137.1 bil­lion, accord­ing to data com­piled by Bloomberg. The ton­nage exceeds the hold­ings of all but four cen­tral banks, which are expand­ing reserves for the first time in a generation.

The Islamic repub­lic has threat­ened to close the Strait of Hor­muz, a tran­sit point for about 20 per­cent of glob­ally traded crude oil, if its exports are banned in sanc­tions. While UBS fore­casts Brent at $110 a bar­rel in the sec­ond quar­ter, “any Iran-related head­lines, mil­i­tary threats or small inci­dents in the Per­sian Gulf are likely to push oil prices sharply higher and poten­tially boost gold in turn,” Tully said.

(Bloomberg) – Oil Set for Best Month Since Octo­ber on Recov­ery Signs, Iran
Oil rose, head­ing for its best month since Octo­ber in New York, amid signs of eco­nomic recov­ery and con­cern that ten­sion with Iran threat­ens global crude supplies.

West Texas Inter­me­di­ate futures climbed as much as 0.6 per­cent after slid­ing yes­ter­day the most in five weeks. Indus­trial out­put in Japan and South Korea beat esti­mates and U.S. con­sumer con­fi­dence rose to the high­est level in a year. Oil has advanced 8.8 per­cent in Feb­ru­ary, its first monthly gain in three, as sanc­tions tighten against Iran, OPEC’s sec­ond– biggest producer.

(Bloomberg) – Impala Says Strike Halts 2 Bil­lion Rand of Plat­inum Out­put
Impala Plat­inum Hold­ings Ltd. said 100,000 ounces of out­put, equiv­a­lent to sales of 2 bil­lion rand ($265 mil­lion), was halted by a strike at its Rusten­burg mine.

The com­pany, based in Johan­nes­burg, is work­ing to resume out­put at the world’s biggest plat­inum mine after bring­ing back 9,800 of 17,200 staff fired dur­ing the ille­gal strike, Impala said today in a state­ment. About 15,800 didn’t join the strike.

“It is depen­dent on oper­a­tional turnout of staff,” Impala said. Fired work­ers have until tomor­row to return on their prior terms after the walk­out, which has entered a sixth week.

SILVER
Sil­ver is trad­ing at $37.14/oz, €27.64/oz and £23.30/oz.

PLATINUM GROUP METALS
Plat­inum is trad­ing at $1,723.00/oz, pal­la­dium at $710.00/oz and rhodium at $1,475/oz.

NEWS

(Reuters)
Gold edges up ahead of ECB loan offer‎

(Reuters)
Sil­ver up 4 per­cent, gold races toward $1800 on ECB

(Reuters)
Iran to accept pay­ment in gold from trad­ing partners

(The Finan­cial Times)
Tehran con­sid­ers trade pay­ments in gold

COMMENTARY

(The Globe and Mail)
Don Coxe on Why Buf­fett Has Gold All Wrong

(Mar­ket­Watch)
Buf­fett rebuffs gold, but infla­tion says 'buy'‎

(Chatham House)
Gold and the Inter­na­tional Mon­e­tary System

(The Wash­ing­ton Post)
UBS's Hick­son Expects Gold Will Rise to $2025 in 2012‎

(Zero Hedge)
Sil­ver Explodes As DJIA Closes Above 13,000

Tags: agricultural, Balance Sheet, Beer Keg, Bloomberg, Bond Markets, Bullion, Contagion, Currency Table, ECB, Eur 1, European Banks, Fundamental Issue, Gbp, Insolvency, Monetary Policies, Opportunity Cost, Ounce, Silver Spot, Sovereign Debt, Spot Silver, Trillion
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Hedge Fund Managers Thrilled to Death?

Thursday, February 9th, 2012

Mia Lamar of the WSJ reports, Hedge Funds Added Small Gains in Jan­u­ary:

Hedge-fund per­for­mance perked up in Jan­u­ary, although con­tin­ued to lag the major stock indexes, accord­ing to indus­try adviser Hen­nessee Group.

Hennessee's hedge fund index rose 2.5% for the month of Jan­u­ary, less than the Stan­dard & Poor's 500 and Dow Jones Indus­trial Aver­age, which posted gains of 4.4% and 3.4%, respec­tively. The Nas­daq Com­pos­ite Index climbed 8% last month.

Still, the advance­ment in Jan­u­ary comes after a dis­mal 2011 for the hedge indus­try, which has been bat­tered by swiftly chang­ing sen­ti­ment on Europe's sovereign-debt cri­sis and other macro con­cerns around the world. Hennessee's hedge fund Index fell 4.27% in 2011, mark­ing the worst year for hedge funds since 2008.

"It is encour­ag­ing to see a respectable gain even with man­agers con­ser­v­a­tively posi­tioned," said Lee Hen­nessee, man­ag­ing prin­ci­pal of Hen­nessee Group.

Equity long/short strate­gies were among the best-performing strate­gies last month, as the Hen­nessee Long/Short Equity Index advanced 2.47%. Stocks pushed higher in Jan­u­ary, led by tech­nol­ogy and finan­cials, as U.S. eco­nomic data con­tin­ued to show signs of improvement.

It's hardly sur­pris­ing to see Equity long/short funds posted the best returns as stock mar­kets rock­eted up in Jan­u­ary. In other words, once more, it's all about beta stupid!

There is how­ever more good news for hed­gies. Har­riet Agnew of Finan­cial news reports, Long/short hedge funds to gain from cor­re­la­tion decline:

Stock cor­re­la­tion within sec­tors has dropped sig­nif­i­cantly this year as mar­kets have ral­lied, pro­vid­ing a boon for long/short equi­ties man­agers who buy and sell com­pa­nies based on fun­da­men­tal analy­sis of their indi­vid­ual mer­its.

Giles Wor­thing­ton, a port­fo­lio man­ager at River­Crest Cap­i­tal, said: "Cor­re­la­tions are falling with quite a pow­er­ful force and diver­sity in stock returns is ris­ing. This is good news for stock-pickers as once again investors are con­sid­er­ing the dif­fer­ence between a high-quality and a low-quality company.”

The attached chart, pub­lished yes­ter­day on Busi­ness Insider, illus­trates the 21-day stock cor­re­la­tion within the Rus­sell 1000 Index. It shows that cor­re­la­tion has fallen from a peak of about 0.75 in Sep­tem­ber to about 0.2.

Wor­thing­ton said that the key short-term dri­ver of this has been the Euro­pean Bank's three-year pro­vi­sion of liq­uid­ity through its Long Term Refi­nance Oper­a­tion that was announced in December.

He said: "The LTRO has sig­nif­i­cantly reduced the tail risk in the mar­kets. The huge risk of finan­cial implo­sion has gone away for the time being. Last year the mar­kets were dic­tated by macro calls and now they are focus­ing on stocks."

For many man­agers, the drop in cor­re­la­tion is a wel­come respite from the high cor­re­la­tions dri­ven by macro­eco­nomic news­flow that char­ac­terised the mar­kets for much of last year.

Look­ing at val­u­a­tions alone would have cre­ated the wrong idea: defen­sive growth stocks trad­ing at high mul­ti­ples per­formed well, while cheap cycli­cal stocks per­ceived as value invest­ments suf­fered losses.

At times com­pany share prices moved not on indi­vid­ual val­u­a­tions but on the per­ceived coun­try risk or cur­rency risk of the issuer. Late last year, for exam­ple as investors became more con­cerned about France's triple-a rat­ing poten­tially being down­graded, French stocks were sold off indis­crim­i­nately, in line with the market's per­cep­tion of an inher­ent risk of invest­ing in France.

Accord­ing to data provider Hedge Fund Research, the aver­age hedge fund gained 2.63% in Jan­u­ary, with equity strate­gies lead­ing the way, up 3.84%.

Among long/short equity man­agers, many of last year's biggest losers rebounded strongly in Jan­u­ary. Crispin Odey's Odey Euro­pean fund is up dou­ble dig­its this year, while Lans­downe Part­ners' UK fund gained 5.7% in Jan­u­ary, investors said.

Wor­thing­ton said that although stock selec­tion detracted from his fund's per­for­mance in Decem­ber, by Jan­u­ary it accounted for 60% of the returns.

How­ever, he also sounded a note of cau­tion. He said: "The mar­ket always starts the year quite buoy­ant as com­pa­nies invari­ably come out with good expec­ta­tions and they have a full year to disappoint.

"There's been bit of a 'dash for trash' too — in the US, for exam­ple, the top-performing stocks this year under­per­formed by 40% on aver­age in 2011. A lot of the highly-leveraged, high-cyclical com­pa­nies have bounced as port­fo­lio man­agers have rotated out of more defen­sive names."

Accord­ing to Credit Suisse strate­gists, the rota­tion ratio in Jan­u­ary was 76%. This means that around three quar­ters of sec­tors either out­per­formed in Jan­u­ary 2012 after under­per­form­ing in 2011 or vice versa, the high­est level of rota­tion since 2001. Banks are the most strik­ing exam­ple of this, they said.

The chart was first reported by Busi­ness Insider blog.

In other news, Final­ter­na­tives reports that Gold­man Sachs' for­mer spe­cial sit­u­a­tions chief will launch his new firm's maiden hedge fund next quar­ter along with another Gold­man and Tudor vet:

Richard Ruzika, global head of spe­cial sit­u­a­tions at Gold­man between 2007 and last year, founded Dublin Hill Cap­i­tal in Con­necti­cut with Lance Bakrow and Joe How­ley. The Connecticut-based firm will unveil its Global Macro Fund in an effort to take advan­tage of the strategy's cur­rent pop­u­lar­ity, HFMWeek reports.

Ruzika was co-head of global macro trad­ing and global head of com­modi­ties at points dur­ing his 29-year career at Goldman.

Bakrow, another Gold­man Sachs vet­eran, is a founder of Green­wich Energy Part­ners. How­ley, a Tudor Invest­ment Corp. vet­eran, was man­ag­ing direc­tor of nat­ural gas trad­ing at Sem­pra Energy.

When­ever you read vet­er­ans from Gold­man and Tudor are get­ting together to start a global macro fund, it's worth meet­ing them and dis­cussing their new fund. Ask them lots of tough ques­tions but this is the type of new fund I like invest­ing in.

I've been tough on hed­gies lately. Some­one accused me of "wag­ing war against them". Noth­ing can be fur­ther from the truth. While I've seen many "malakies" in the hedge fund indus­try, includ­ing non­sense within pen­sion funds invest­ing in hedge funds, I still believe that excel­lent hedge funds are worth invest­ing with.

Do I believe in pay­ing 2 & 20? A lot less than I used to. Why? Because most hedge funds are mediocre and the large ones are mostly asset gath­er­ers. More­over, insti­tu­tions can repli­cate a lot of hedge funds strate­gies inter­nally and if you're a large pen­sion fund like ATP, you got a large enough bal­ance sheet to beat them at their own game at a frac­tion of the cost. It's stu­pid to get eaten alive by hedge fund fees, mak­ing them rich for gath­er­ing assets.

Tonight I had din­ner with some for­mer col­leagues. We all worked in hedge funds before. We were dis­cussing how stu­pid it is for large pub­lic pen­sion funds to pay mil­lions in fees to hedge funds instead of devel­op­ing alpha inter­nally. These guys are sharp money man­agers and know all about hedge funds. One of the guys can slice and dice any hedge fund strat­egy and reverse engi­neer it. The other is a credit spe­cial­ist who has done his share of due dili­gence on hedge funds and knows all about alpha and man­ag­ing money.

We all feel that too many insti­tu­tions are wast­ing their money on hedge funds. Save your money, develop alpha tal­ent inter­nally and don't waste your time and resources chas­ing hedge funds. And if you are going to ven­ture into hedge funds, seed some alpha man­agers who are per­for­mance dri­ven but don't take an equity stake!!!

All these insti­tu­tions invest­ing in hedge funds, includ­ing the Caisse and Ontario Teach­ers', should pub­licly dis­close how much they've dis­bursed in fees since incep­tion of their hedge fund pro­grams. My guess is hun­dreds of mil­lions. Sure, they've invested in some great funds, made money, but also got clob­bered in oth­ers which you'll never hear about. The point is would they have been bet­ter off tak­ing the ATP approach, invest­ing in inter­nal hedge funds? Results speak for them­selves.

Below, Ann Pet­ti­for, George Kapopou­los and Matina Ste­vis dis­cuss the prospect of a Greek default on Al-Jazeera. Debt dis­cus­sions in Greece have stalled on pen­sion dis­pute. If Greece defaults, you'll see macro news take over again, and cor­re­la­tions rise across all asset classes (except bonds).

If all hell breaks loose, hedge funds will suf­fer. If a deal is struck, watch out, a mas­sive liq­uid­ity rally could mean many hedge funds will under­per­form. Both sce­nar­ios would be bad for hedge funds, espe­cially the for­mer one. At the end of the day, most hedge funds are a lot more like mutual funds and pen­sion funds in that they des­per­ately need the big beta boost to make money.

Tags: Debt Crisis, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Equity Index, Fundamental Analysis, Group Equity, Hedge Fund Index, Hedge Fund Performance, Hedgies, Lee Hennessee, Long Short Equity, Major Stock Indexes, Nasdaq Composite Index, Respectable Gain, Short Hedge, Sovereign Debt, Stock Pickers, Stock Returns, Wsj Reports
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Country Default Risk (Bespoke)

Tuesday, February 7th, 2012

Feb­ru­ary 6, 2012

Below we high­light the cur­rent sov­er­eign debt credit default swap (CDS) prices for 39 coun­tries around the world, as well as their year to date changes.

As shown, every coun­try except one (Por­tu­gal) has seen its default risk decline in 2012.  Euro­pean coun­tries have mostly seen the biggest drops in default risk, with Bel­gium lead­ing the way with a drop of 31.6%.  Greece – while it still has by far the high­est default risk – has seen its default risk fall the third most in 2012 with a decline of 25.5%.  (France ranks sec­ond at –25.7%.)  The US cur­rently has the low­est default risk out of all the coun­tries shown by a wide margin.

Tags: Belgium, Countries Around The World, Country Risk, Credit Default Swap, Debt Credit, Decline, Default Risk, European Countries, Greece, Leading The Way, Portugal, Sovereign Debt, Swap Cds, Wide Margin, Year To Date
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U.S. Equity Market Radar (February 6, 2012)

Sunday, February 5th, 2012

U.S. Equity Mar­ket Radar (Feb­ru­ary 6, 2012)

The domes­tic stock mar­ket as mea­sured by the S&P 500 Index rose by more than 2 per­cent for the week. The finan­cial and tech­nol­ogy sec­tors led the way, with both ris­ing by more than 3 percent.

Strengths

• The S&P 500 Finan­cials had a very strong week, ris­ing by more than 4 per­cent as this sec­tor con­tin­ues to respond to pos­i­tive eco­nomic and gov­ern­ment pol­icy developments.
• The S&P 500 Tech­nol­ogy sec­tor also had a strong week, led by strong results from Mas­ter­card, a bounce back from the prior week for Corn­ing and ris­ing expec­ta­tions for NetApp in front of earnings.
• Indi­vid­ual stocks that per­formed well this week include Whirlpool Corp., Marathon Petro­leum, and Gen­worth Finan­cial, all three stocks rose by at least 16 per­cent this week.

Weak­nesses

• Defen­sive, non­cycli­cal sec­tors under­per­formed as util­i­ties, con­sumer sta­ples and health­care all lagged the mar­ket this week.

• The con­sumer & elec­tron­ics retail indus­try group was among the worst per­form­ers as both Best Buy and GameStop fell for the week as Radio Shack reported dis­ap­point­ing pre­lim­i­nary results.

• Aber­crom­bie & Fitch Co. was the worst per­former in the S&P 500 after giv­ing weak pre­lim­i­nary results and 2012 guidance.

Oppor­tu­ni­ties

• Earn­ing results have been encour­ag­ing so far and the mar­ket has responded. We have another heavy week of earn­ings announce­ments next week.

Threats

• An esca­la­tion in con­cerns over sov­er­eign debt oblig­a­tions in Europe would be neg­a­tive for stocks.

Tags: Best Buy, Consumer Staples, Debt Obligations, Domestic Stock Market, Earnings Announcements, Gamestop, Genworth, Genworth Financial, Industry Group, Market Radar, Netapp, Policy Developments, Preliminary Results, Radio Shack, Retail Industry, Rising Expectations, Sovereign Debt, Technology Sector, Technology Sectors, Whirlpool Corp
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Global Economic 'Mojo' Still Lacking

Tuesday, January 24th, 2012

As of Q3 2011, the cit­i­zens of less than 20% of the coun­tries involved in Nielsen's Global Con­sumer Con­fi­dence, Con­cerns, and Spend­ing Inten­tions Sur­vey were on aver­age con­fi­dent in their future eco­nomic con­fi­dence. Not sur­pris­ingly, Nic Colas of Con­vergEx points out, six were in Asia, the least con­fi­dent were in East­ern and Periph­eral Euro­pean nations, and fur­ther­more over­all global con­sumer con­fi­dence remains 9.3% below 2H 2006 (and 6.4% below Q4 2010) read­ings as the global econ­omy still has a long way to get its 'mojo' back. Colas points to the fact that 'con­fi­dence is an essen­tial lubri­cant of any capitalist-based sys­tem' and one of the key chal­lenges that worst hit Europe (and other regions and nations) face is cap­i­tal mar­kets that are assess­ing the long shadow of the Finan­cial Cri­sis of 2007–2008 and the ongo­ing Euro­pean sov­er­eign debt cri­sis impact on the world's Con­sumer Confidence.

Nic Colas, Con­vergEx Group: Con­fi­dence Games around the World

Sum­mary:

Today we review the Nielsen Global Con­sumer Con­fi­dence, Con­cerns and Spend­ing Inten­tions Sur­vey with an eye to com­par­ing the most recent read­ings of country-specific and regional sen­ti­ment to the 2010 data as well as that prior to the finan­cial cri­sis. While the Street doesn’t often focus on this par­tic­u­lar dataset, its com­bi­na­tion of breadth (50+ coun­tries) and depth (+28,000 online con­sumers) makes it uniquely use­ful in gaug­ing global lev­els of con­sumer con­fi­dence. The upshot is that as of Q3 2011, only 11 of the 56 coun­tries sur­veyed had cit­i­zens that were, on aver­age, con­fi­dent in their future eco­nomic prospects. Not sur­pris­ingly, six were in Asia. Ver­sus both pre-crisis lev­els and those of 2010, the most recent mea­sured lev­els of con­fi­dence dur­ing Q3 2011 were 9.3% below 2H 2006 read­ings and 6.4% those of Q4 2010. In short, most of the global econ­omy still has a long way to go in get­ting its “Mojo” back.

For such a seem­ingly sim­ple crime, the ‘Con­fi­dence Game’ is a rel­a­tively mod­ern inven­tion. And no sur­prise to the denizens of the Big Apple, it was invented (or at least made famous) right here in New York City. On July 8th, 1849 the New York Her­ald ran an item in its crime sec­tion not­ing the arrest of one William Thomp­son. His scam was breath­tak­ingly simple:

• Dress like a wealthy man of leisure
• Walk up to another man of leisure in the street
• Strike up a con­ver­sa­tion that gives the impres­sion that the two of you are acquainted
• Ask for the gentleman's watch in the fol­low­ing way: "Have you con­fi­dence in me to trust me with your watch until tomorrow?"
• Take the watch and walk away, laugh­ing as if the whole thing is lit­tle joke between two friends, never to be seen again

The only prob­lem Mr. Thomp­son encoun­tered was when he relied too much on the city’s large pop­u­la­tion to pre­vent his marks from ever spot­ting him a sec­ond time. Sure enough, some­one who had given him a watch val­ued at $2,800 in today’s money (think of a nice used Rolex) pointed him out on the streets to police and he was arrested after a brawl with the arrest­ing offi­cer. One of his for­mer cell­mates from Sing Sing iden­ti­fied him at the sta­tion­house. The case made the front page dur­ing the sub­se­quent trial, since the accused could rightly say that he had been given the watches will­ingly rather than by force. How could it be theft?

There is a great quote from David Mamet’s movie House of Games, spo­ken by a vet­eran con man, which neatly sum­ma­rizes why such scams work: “It’s called a con­fi­dence game. Why? Because you give me your con­fi­dence? No. Because I give you mine.” If you’ve ever been the tar­get of a scam, you know this is true. The first “tell” of some­one run­ning a game on you is that they appear TOO famil­iar, TOO friendly. They are try­ing to make you feel like they have total trust in you.

But in this lit­tle seed of a crim­i­nal idea is a greater and more impor­tant truth: con­fi­dence is some­thing that is shared by two or more peo­ple. It can grow or shrink, quickly or slowly, and has its roots in the social wiring most human beings share. And from an eco­nomic stand­point, con­fi­dence is an essen­tial lubri­cant of any cap­i­tal­ist based sys­tem. You need con­fi­dence in the legal sys­tem, the market’s abil­ity to set prices fairly, and in your fel­low cit­i­zen to hold up their end of a bar­gain, just to name a few struc­tural neces­si­ties. And you need con­fi­dence that the under­ly­ing econ­omy is sound, that you will con­tinue to have a job, that inter­est rates will remain sta­ble, that infla­tion is under con­trol, and so forth, before you will spend freely.

One of the key dif­fi­cul­ties cap­i­tal mar­kets face at the moment is the chal­lenge of assess­ing the long shadow of the Finan­cial Cri­sis of 2007–2008 and the ongo­ing Euro­pean sov­er­eign debt cri­sis on the world’s Con­sumer Con­fi­dence. While many coun­tries have local sur­veys of their pop­u­la­tions, no two mea­sure­ments are done exactly the same. This makes it hard to com­pare results around the world and over time. We recently came across the Nielsen Global Online Con­sumer Con­fi­dence, Con­cerns and Spend­ing Inten­tions sur­vey, which is a large scale (+28,000 peo­ple) multi­na­tional (+50 coun­tries) and at least a few years span of time (2005 to the present). While it is likely that short-ish con­ti­nu­ity that keeps this dataset from wider use on Wall Street, it is long enough to encom­pass the period before and after the Finan­cial Crisis.

We’ve included sev­eral tables from the Nielsen data, and here are our key takeaways:

As of the most recent read­ings in Q3 2011, the world is not a very con­fi­dent place. A score of 100 is the water­shed between con­fi­dent and dour con­sumers. Only 11 of 56 coun­tries man­age to break above this line – Brazil, China, Hong Kong (mea­sured sep­a­rately), Indone­sia, Malaysia, Philip­pines, Thai­land, India, Saudi Ara­bia, U.A.E, and Nor­way. The clear trends are that Asian coun­tries and exporters of raw mate­ri­als rule the global con­fi­dence roost at the moment.

The world’s least con­fi­dent con­sumers reside in Hun­gary (last score 37), Por­tu­gal (40) Croa­tia (49) and Roma­nia (also 49). Greece had a score of 51 in Q3 2011, and Italy came in at 52.

In terms of com­par­isons to how con­fi­dent the var­i­ous coun­tries’ con­sumer felt before the Finan­cial Cri­sis, back in 2H 2006, very few coun­tries have been able to bounce back com­pletely. On aver­age, the world’s major devel­oped and devel­op­ing economies poll at 9.3% lower con­fi­dence than pre-crisis lev­els. The ones that have been able to set a new and mean­ing­ful fast lap for con­sumer con­fi­dence: Aus­tria, Egypt, Saudi Ara­bia, Turkey, Philip­pines, Tai­wan, and Thailand.

By region, Europe has actu­ally been much harder hit in terms of con­sumer con­fi­dence from the peak than any other area of the world. Across both east­ern and west­ern Europe, con­fi­dence is 23–24% lower than 2H 2006, ver­sus an 11% decline in the Amer­i­cas and 8% reduc­tion in Asia. The U.S. is 28% lower, to be sure, but other parts of the region are only down 14% (Canada) to 21% (Mex­ico). Brazil, as men­tioned ear­lier, is actu­ally up 18% since 2006.

Over the last year (mean­ing later 2011 ver­sus 2010), west­ern Europe is a clear lag­gard as well. Ital­ian con­sumer con­fi­dence took an unsur­pris­ing hit last year, down 27%, with almost all other coun­tries in the region down double-digit per­cent­age terms as well. The big win­ners were in the Mid­dle East (Egypt and Saudi Ara­bia), rather than Asia. The notable excep­tion here was China/Hong Kong at +4/5%.

There’s very much a “Half empty/half full” debate when it comes to any kind of con­sumer con­fi­dence mea­sure­ment as a Buy/Sell sig­nal, of course. In gen­eral, it pays to buy risk assets when things look dread­ful and sell them when skies clear. But the cur­rent pic­ture of global con­sumer con­fi­dence from the Nielsen sur­vey looks very much like one of those sketches of an ice­berg in a children’s text­book. A lot of the mass is below the sur­face, with only a tiny bit pok­ing up out of the water. It pays to con­sider the pos­si­bil­ity that global con­sumer con­fi­dence has gone through a semi-permanent shift to some­thing below the water­line, invis­i­ble to pro­duc­ers of goods and mar­kets alike. If true, this would mean that con­sumers will only slowly begin to reap­pear, essen­tially as the ice­berg melts.

Tags: Colas, Confidence Game, Confidence Games, Consumer Confidence, Crisis Levels, Dataset, Debt Crisis, Economic Confidence, Economic Prospects, Games Around The World, Global Consumer, Global Economy, Global Levels, Group Confidence, Key Challenges, Long Shadow, Lubricant, Mojo, Sovereign Debt, Upshot
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