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Suneet Chandvani
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Suneet analyzes distressed credits and has experience in performing extensive analysis on companies, municipalities and their capital structures, from senior secured loans to subordinated unsecured debt and equity. He takes a long term view and employs a private equity based approach to... More
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10thquantum
  • Accuracy in prediction and the next safe haven (follow-up to my previous article)
    Accuracy in prediction:
    On 14th July 2011 I wrote an article highlighting that the S&P is at its high and there is disconnect between the fundamental economy and the market. From 14th July 2011 until today, 9 September 2011, S&P is down 11.8%. If you had a put option on S&P, depending on the option maturity and the strike price, you could have made anywhere between 30% to 200% in approx two months. The volatility and price, both would have acted in favor of that option.
     
    All we heard in the market two months back was low P/E’s and attractive valuations. People were talking about 1500 on S&P (GS had a target of 1450 on S&P). When everybody was bullish, I was bearish and pointed out disconnects in my previous article, by analyzing risks within the economy and globally. I specifically mentioned that the US economy may enter recession soon and there might be another leg down. I have understood one thing: street is in the business of making predictions based on the last quarterly and/or monthly and/or weekly data. Few people look at trends and analyze different sets of data as a whole.
     
    President Obama’s job plan:
    The new plan proposed by the President on 8 September 2011 reduces Social Security taxes and extends the tax cut for one more year.  According to the plan, the Social Security taxes would be reduced to 3.1% for 2012 from 4.2% for 2011. The plan also proposes to extend the tax cut to businesses on the first USD 5m of their payroll. As per the plan, extending and reducing these taxes would cost government approx USD 240bn. The reason to implement this plan is to reduce taxes and hence increase the personal disposable income, which would then boost spending. Increased spending would then result in more revenue collection via taxes.
    In December 2010, Congress passed a similar plan reducing Social Security tax by 2%, from 6.2% to 4.2% for 2011. Even after reduction of tax GDP growth in 1Q11 and 2Q11 were very timid at 0.4% and 1% respectively. The question is if reduction in Social Security taxes by 2% in 2011 did not improve the economy why another 1.1% would make any difference. As of June 2011 total compensation of all employees (private and government) in the US was approx USD 8.235tr. A 1.1% reducing in Social Security tax would increase the personal disposable income by USD 90bn (1.1%*8235). Also, not all of that increased personal disposable income would be spent. Of the 2008 President Bush tax rebates, only 17% were spent and 83% was either saved or used to pay down debt. On a very optimistic scenario, even if 60% of that is spent it would give a one-time boost to the economy of less than 0.4%.
    The main long term problem is the difference between contribution for government social insurance (revenues collected by government from Social Security, Medicare, taxes) and government social benefits (money spent by government on Social security, Medicare, etc). This differencehas grown exponentially by 245% in last 10 years from USD – 406bn in 2Q01 to USD -1.4tr in 2Q11. Further Social Security tax cuts could have a significant impact on the already exponentially increasing difference. A decline in Social Security taxes to 3.1% from 4.2% would mean reducing Social Security tax revenues by approx 26%. Another potential problem with tax cuts is that once implemented, even though temporary, they usually end up being permanent. Rarely politicians let those tax cuts expire as then they are less preferred by the general public.
    The plan also includes additional USD 62bn to pay people who aren’t employed for 99 or more weeks. This is just extending unemployment. Also, according to the plan USD 100bn is anticipated to be spent on infrastructure, which is unlikely to be approved by the Republicans.
     
    Understanding the US economy:
    The US consumer:
    Consumer in the US is still weak and is still deleveraging from the massive increase in credit. Along with the deleveraging process the population of the US is aging at a significant pace as compared to the working population. As per Census, the age group between 20-64 will grow by 5.4% from 2010 to 2020 and 4% from 2020 to 2030, while the population aged 65 and older will grow by 36% and 32% during same years.
     
    Housing market:
    In addition, as of July 2011, foreclosures are increasing at approx 3 times than houses in foreclosures are being sold. Total inventory of 90+ days delinquent loans and loans in foreclosure is 58 times of monthly foreclosure sales. This ratio will increase as more foreclosures are added to the inventory than they are sold. Weekly mortgage applications for new purchases are weakening further and low interest rate hasn’t helped. Besides, 30% of current loans that are making payments on time are at risk as they have negative equity due to falling house prices.
     
    Deficit reduction plan:
    To reduce the massive debt government has already started cutting spending which would have a negative impact on the economy. The deficit reduction plan is to be rolled out in two steps. Phase 1 of the plan would reduce approx USD 915m in government spending in 10 years. A special committee is appointed for Phase 2 of the plan. The committee has to come up with deficit reduction plan of at least USD 1.2tr. Failure to approve the deficit reduction plan by the special committee would result in automatic cuts worth USD 1.2tr for next 10 years.
     
    Job market:
    To cut spending government is already reducing its workforce. From start of the year until August 2011 government had already downsized its work force by 290,000 (124% of what it did in the entire year of 2010). This figure is expected to go up to approx 400,000 by the end of the year. Also, we have recently seen banks cutting jobs in anticipation of the Euro debt problems and the US recession. Banks are most sensitive to these issues and are the first to downsize. UBS is expected to cut 3,500 jobs while GS has been reducing its workforce quietly. Bank of America is expected to cut approx 30,000 jobs and close 10% of its branches nation-wide over next several years to reduce its expenses by approx USD 5bn annually. Additionally productivity has declined for straight two quarters. To maintain margins we might see some lay-offs. If President’s plan is implemented the increase in disposable income due to decrease in taxes would be offset by reduction in workforce.
     
    GDP:
    GDP growth rate for 1Q11 was revised from 1.4% to 0.4%. There is a possibility that the 1% increase in GDP for 2Q11 might be revised lower again. This is because personal savings (as a percentage of personal disposable income) increased by 0.4% to 5.4% in June 2011. A 0.4% increase in savings rate can have a 1.2% decline in personal consumption, which in turn can have a 0.8% decline in the GDP. This is for a month, so approx 0.2% decline for the quarter. I won’t be surprised if the 1% GDP growth for 2Q11 would be revised to 0.8% or lower.
     
    All the above data and risks were analyzed in detail in my previous article. Programs like Cash for Clunkers, First Time Homebuyers Tax Credit along with inventory adjustments (refilling), and enormous stimulus (QE1 and QE2) didn’t help. All these programs have now ended. If that didn’t do much now we have spending cuts which will only make things worse.  In 1996, Japan’s GDP growth was approx 4.4%. This was mainly due to government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, Japanese economy experienced five consecutive quarters of negative growth. The recent fiscal stimulus in the US and UK was approx 10% of GDP.
    The US is going through a slow growth and not liquidity or solvency crisis like peripheral Europe. Every country has its cycle. From 1980’s until 2000, the US had a strong growth and main reasons were right demographics, credit expansion, and hence increase in asset prices. All these factors have reversed and now we have excessive debt, high fiscal deficit, deleveraging by consumers, aging population and declining asset prices. The US situation is not out of hand and the fiscal deficit is solvable with right policies, cuts in spending and entitlements, and increase in taxes. The best thing would be to de-lever and let it go through its cycle. This might result in slow growth in years to come. That said, deleveraging and innovation, which always leads to new cycles, would make the country stronger again.
    One has to understand that nothing has changed with ratings downgrade. In fact treasury yields have moved even lower. Peoples’ thinking has changed, which is good, that the US can never be downgraded irrespective of its fiscal situation and debt.
     
    Is everything priced in:
    Market overeats to data. As previously mentioned, the data out of the US in the coming months would be depressing and markets might overreact to that as it would confirm their belief that the US is heading towards a recession.
    Market is cautious about the European debt crisis and has priced in a default/haircut on Greece debt. What it hasn’t priced in is the effect of Greek default on European banking system and its spill over in the US. Quantifying that is very difficult. If Greece defaults we could see a massive selloff.
    So far markets have seen companies beating expectation. If that turns, even for a quarter, markets will panic and start selling assuming that the economy is now affecting the bottom line of companies.
    It is very important to keep in mind that the mutual funds are all invested. With mutual fund cash levels at 3.4% as of June 2011, historically the lowest, if they start selling we can see a huge sell off.
     
    Understanding Europe:
    Understanding Europe is not difficult if you just look at the numbers. As per EuroStat (debt and GDP growth rates are on a Y-o-Y basis as of 31 March 2011)
    Greece’s debt to GDP was 150%, its debt is still growing at approx 10% and GDP is declining by approx 2.8%.
    Italy’s debt to GDP was 120%, its debt is growing by approx 4% and GDP by approx 2.5%.
    Ireland’s debt to GDP was 103%, its debt is growing by a whopping 28% and GDP is declining by approx 2%.
    Portugal’s debt to GDP was 94%, its debt is growing by approx 14% and GDP by approx 1.8%.
    Spain’s debt to GDP was 64%, its debt is growing by approx 17.5% and GDP by approx 1.7%.
    France’s debt to GDP was 84%, its debt is growing by approx 7% and GDP by approx 2.8%.
    Germany’s debt to GDP was 83%, recently its debt has grown by approx 17% (due to support extended to Greece) and GDP by approx 4.6%.
    Are these numbers sustainable?
    Source: Eurostat
     
    Would there be a default / haircut or can it be avoided? What about Euro Bonds?
    With funds in EFSF and ECB’s commitment, we have seen some buying of Spanish and Italian bonds. That said, they can’t do it for too long as the total consolidated debt of Ireland, Greece, Spain, Italy, and Portugal is approx Eur 3.2tr (71% of Germany and France’s GDP combined, excluding their own debt). The amount is too big for anyone to bail these countries out. Also, as mentioned above, debt of these countries is still growing at a significant pace. Its politically and financially not feasible for Germany and France to backstop all this debt as that would not only affect their financial health but can also cause social unrest in these countries. In last 2 quarters, 4Q10 and 1Q11, Germany’s debt has grown by 18% and 17% on a Y-o-Y basis, respectively, due to support extended to Greece.
    The haircut on Greece is inevitable. Debt/GDP ratio of Greece is already at 150%. As of 31 March 2011, even with all those austerity measures, debt is increasing at 10% on a Y-o-Y basis. Austerity would only reduce country’s revenues and growth which is evident in the GDP growth of negative 2.8%, as of 31 March 2011 on a Y-o-Y basis. Growing debt and negative GDP can never solve a country’s problem irrespective of austerity measures taken. A simple math shows that the debt to GDP ratio will only increase. The problem of debt can’t be cured with more debt, be it public or private. Companies have tried it and even countries have tried it (example Japan). None of them have been successful in doing it. Japan now has a debt to GDP of 200% and still growing, declining population, almost no immigration, increasing aging population, and declining tax revenues. At least Japan has the ability to print its own money and issue its own debt and sell 95% of that in its own country. Greece can’t do that.
    What about the idea of Euro bonds? Can that be done? That would be the biggest mistake. EU itself is a mistake as the countries in EU can’t print money and there is no mechanism for ensuring fiscal discipline. The basis of different currencies is its ability to get weaker or stronger depending on that country’s productivity, competitiveness and growth. That entire basis was removed with the formation of the EU. Having a Euro bond would further take away liberty from countries in EU to issue debt, if and when they needed. Also, if you allow all countries in the Euro zone to get access to cheap capital at the expense of the strong EU countries by issuing Euro bonds you basically give the weaker countries a free ride and they wouldn’t adhere to the austerity measures. Euro bond would be like a mortgage backed security (MBS) which is pool of good and bad loans. Only in this case it would be a pool of debt of good and bad countries. Every time a financially unstable country has a problem the financially stable country would bail it out. That way the financially stable country not only has to use its money to bail them out but also has to pay higher interest rate on its debt (now there is just one Euro bond, so all countries in EU pay the same interest rate) due to mistakes made by financially unstable country. I don’t know how long would that continue. A haircut is necessary, inevitable and healthy. If they avoid it they would just delay the consequences.
    Pushing Greece out of the EU could also be an option. This would solve the current problem of EU and would be a lesson to the other EU countries that fudging data, reporting wrong data (that’s how it all started), having huge deficit and fiscal imbalances could have serious consequences. That said, Greece being removed out of EU would also mean a default. Where would the Greek Euro denominated debt that banks/financial institutions/central banks hold go?
     
    Understanding the consequences of haircut on the market
    We are talking about USD 493bn of total Greek debt. Debt to GDP of Greece is approx 155%. To bring it down to even 100% levels Greece would need a hair cut of approx 50%. Even if we consider a hair cut of just 20% we could see a hit of approx USD 99bn (493 *20% = 98.7) in the system. People are expecting a 50% haircut which could be approx USD 245bn of losses in the system. Lehman was just USD 70bn.
    This is just the hair cut. A more important concern appears to be the threat of short-term liquidity as a result of the hair-cut. The biggest European banks receive an average of approx USD 64bn funding through the US money market. This flow would be the first to dry up in case of any crisis faced by the European banks, reducing the liquidity and fueling the crisis.
    Also, stronger banks in EU would cut back their lending to the weaker banks further exacerbating the process. Not to forget, this could lead to breach in covenants resulting in acceleration of debt and/or additional capital/collateral requirements. Banks in general are highly levered entities. The leverage could be anywhere between 20x to 50x. A 1%-2% reduction in their assets values could have a significant impact on their equity.
    The overall effect could be large and the big banks would feel the pain but would be able to handle it as they have trillions of dollars of assets. Also Greek debt is pretty well diversified and not one bank holds a lot. The maximum amount of exposure that a non Greek bank holds is Eur 6bn. Here is the list of estimated top 40 holders of Greek government debt. http://www.zerohedge.com/sites/default/files/images/user5/imageroot/draghi/Barclays%20Top%20Holders.jpg . It is the small banks having direct or indirect exposure to Greek debt that might be in serious trouble.
    Though this would be good for the system as it would be a clean-up of excessive debt, markets as usual would overreact and fall significantly. As mentioned, the repercussions would range from losses on balance sheets of European banks, CDS’s being triggered, breach of covenants, fall in global stock markets , drying up of liquidity and banks being conservative and hence reduction in lending resulting in slower growth. If one thing triggers the other follows and there is massive selling. Besides, they all use the same risk metrics and hence they all sell at the same time when the risk goes up. Short term traders and computer trading makes it worse.
     
    Understanding the long term macro picture and spotting areas for long term investments
    That would be the time to buy. Think about it, there is so much more money in the system now than it was a few years ago. Once there is a selloff, which would be global as the markets are interconnected (with globalization the correlation of world equity markets is north of 80%), it would be an opportunity of the decade to buy. This would hold true especially for the emerging markets. In some of these markets, some stocks are extremely cheap and market in general is trading at its 52 week low (I have been following Indian market on a very regular basis). The fall would further bring down the prices making them super attractive. If you logically think from a 3 to 5 year perspective, you would be investing in i) fundamentally good and less levered economies ii) growing at a good pace with strong and growing middle class population iii) with cheap valuations due to the fall in the global markets.
    Once investors realize that the growth in the US and the Euro zone is stagnant or very timid, a lot of that money will start flowing to emerging economies driving up asset prices in those places. This is what exactly happened in Japan. After the Japanese crash, a lot of Japanese money moved to the US markets for a decade. This was because of low growth and ample liquidity; the same conditions which are now in the US. Japan's stock of FDI since 2001 has nearly tripled, from ¥6 trillion to over ¥18 trillion. (Source: www.state.gov/p/eap/rls/reports/2009/125... ). That’s a compounded annual growth rate of approx 15% for 10 years. I think these are the kind of growth rates at which we will see money flowing to the emerging economies. Cheap valuations, good fundamentals, strong growth, and increase in inflow of money are simple ingredients to great returns on a long term basis.
     
    Understanding the macro economy globally to understand the direction of the market, and then picking markets and securities (stock, bonds, derivatives, commodities, etc) would be the best way to play in these times.
     
    Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.


    Disclosure: Investments in Indian markets


    -Suneet Chandvani


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: Long Indian stocks
    Sep 13 12:27 AM | Link | Comment!
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