Our view on Egypt is that it is currently experiencing a “soft” coup. The center of power in Egypt is the military, from which Hosni Mubarak gained power. Many view the appointment of Omar Suleiman to the Vice President post as a sign that he will be the next leader of Egypt. In our view, the more likely candidate is the newly appointed Prime Minister Ahmed Shafiq. Mr. Suleiman is 75 years old and is not viewed by the military as a long term successor. On the other hand, Ahmed Shafiq is younger and was the Commander of the Air Force, until recently when he became Minister of Civil Aviation in 2002.
Under Egyptian law any person running for President must have at least one year of government experience, therefore, Mr. Shafiq’s Civil Aviation experience qualifies him to run as President. We view the likely succession to involve Hosni Mubarak stepping down within the week, paving the way for Omar Suleiman to ascend to power and announce new elections. The military supports Ahmed Shafiq and thus he is the natural candidate to succeed Mr. Suleiman at the new elections.
By staging this “soft” coup, the military exerts its power in Egypt, by ousting Murbarak and restoring calm. At the same time, the newly announced elections will satisfy the international community that is calling for democracy. The danger lies not in Egypt, as the military still appears to be in total control, the danger lies in contagion. Already protests have occurred in Saudi Arabia and there is talk of Thursday being a “day of rage” in Yemen.However, barring a global uprising we expect the Egyptian violence to cease when Mubarak leaves the country. And when the steady stream of protest videos cease there non stop loop, we expect the financial markets to rally in relief. It is this relief rally that we anticipate using as an opportunity to sell short the financial markets.
There is Something Happening Here
In our view the entire economic recovery has been based on the ability of governments to borrow and spend toward prosperity. The plan (hope) has been that this pump priming would allow the global economy to reach escape velocity and begin the self sustaining growth phase. However, what has happened is the liquidity has fueled inflationary pressures which are causing many countries to withdraw the very liquidity that is needed to fuel escape velocity. Our concern is that as this liquidity dries up, the recovery will stall and we are already beginning to see signs of this occurring.
In China, attempts to cool inflationary pressures do not appear to be working as the growth rate of M2 has continued to climb.
Chinese M2 Growth YOY % Change
However, despite the growth in the supply of money, the demand for money is so great that it has caused the benchmark 3 Month SHIBOR Rate to rise to the highest level in 2 years.
The bullish case is that heading into the Chinese New Year, banks are short of cash and this rise in rates will subside after the holiday. We question this line of thinking since the rise has been steady for the last year. We would not be surprised by a rate hike during the New Year Holiday.
Not to be outdone, the European Central Bank has also started to slow the growth of money supply.
EU Money Supply YOY% Change
In our view, money supply needs to grow in Europe to sustain the recovery, however Jean Claude Trichet appears to be more concerned with price stability. The markets have not ignored the latest drop in the supply of money, as 3 month Euribor is at the highest level since July 2009.
3 Month Euribor
Those less concerned about the rise in short rates will point to the bank maintenance period currently underway in Europe. Once again we would point to the steady rise in Euribor over the last 6 months as evidence that this is more than just a short term cash crunch.
A Few More Market Based Liquidity Indicators...
The Australian Dollar v. Japanese Yen currency pair (AUDJPY) has been the poster child for the carry trade, and it has tracked the S&P 500 since the March 2009 low. The carry trade has been a source of funds for many global investors, which have then redeployed the borrowed funds into the equity markets. However, the new high in the S&P 500 has not been confirmed by a new high in the AUDJPY, suggesting the carry trade may no longer be fuel for a stock market rally.
Even the oil market has experienced potential liquidity issues. The Bent-WTI spread has hit record highs, the last time this occurred was after the collapse of Lehman Brothers when credit was non existent.
Typically a spread this wide would result in arbitrageurs buying WTI crude and shipping it to Brent delivery points, this action would cause the spread to compress. During the 2008 crisis the spread did not compress because arbitrageurs could not get the financing to execute the trade. The market may be signalling that this is happening again.
Beyond Liquidity There is a Fundamental Reason to Sell
One of the hallmarks of market peaks is excessive enthusiasm, investors tend to extrapolate the current conditions far into the future. We are beginning to see signs of this happening once again. In the early part of 2008, analyst drastically increased earnings estimates on the S&P 500 from $90 to $100.
The exact same scenario has taken place this year. What’s more, gross margins are falling, just as they did in the beginning of 2008.
S&P 500 Gross Margin
In our view, it is the decline gross margins that is the reason for the sell-off in equities. Whether this sell-off is simply a correction or the beginning of a bear market depends heavily on the ability of central banks to control inflation. For now we shall be playing any sell-off as a trade-able correction, which means we intend to use any relief rally to move toward a short bias for our client portfolios.