I'm back after a 2-month hiatus. So much has happened but the markets haven't moved much. Yes, day to day volatility and the implicit price of volatility has been high but something tells me that the markets have been immensely opaque recently. Fundamental developments (or the lack thereof) haven't been priced in (or should I say inaccurately reflected). I wanted to dissect the edifice of my thoughts into a few distinct groups: 1) Europe; 2) America & China; 3) Financial markets in general and the macro opportunities that may ensue.
Everything about Europe has gone nuts. It seems Mario Draghi has thrown a monkey wrench into the pit: Southern European sovereign credit; Equities and the Euro itself have gone haywire. Posterior to Thursday's ECB announcement of its new SMP ver.2 (outright monetary transactions - OMT), Southern European sovereign credit had already started rallying (looking at the 10 year part of the curves since anything shorter would be heavily distorted). Bunds were falling steadily, OATs were rallying, GGBs were rallying... basically concentric European risk was on and funds were flowing out of the safe havens.
Nothing has changed in Europe. Fundamentally, insolvent governments need cash to cover borrowing costs (interest payments) and thus had to issue more debt to cover existing debt. Financial contagion, private sector leverage, new capital adequacy requirements remained the main factors to the great operational impasse. These economies were stagnant in terms of productivity and innovation from the start of their individual cycles; current unemployment rates are rising, GDP growth is negative, real wages are falling, social unrest is reaching fever pitch. Countries like Greece, Ireland, Portugal have lost their competitive advantages of labor and technological innovation, the two distinct dimensions of output growth. Spain and Italy are entering this abysmal zone.
Politically, no one was and is willing to lend these troubled nations. The money has to come from somewhere but Germany, the last powerhouse of Europe knows best that whatever money that it lends the Southern Nations will likely vanish in the supermassive black hole. Losses have to be borne regardless of the jawboning and the baton passing. Absent an orderly restructuring, the only two outcomes of solving Europe's sugar high are deleveraging (a protracted depression/deflationary spiral) and hyper inflation (debasing the currency and hence the value of debt; at the same time boosting growth of nominal GDP). Germany's constitutional court is set to vote on the legislation of the European Stability Mechanism this coming Wednesday but expectations are pessimistic. Germany's Bundesbank, the largest and most influential member of the ECB has consistently opposed to unconventional monetary policy (money printing, financing SPVs that gobble up bad sovereign debt et al).
Angela Merkel, the chancellor of Germany still believes in a European Union and a fiscal pact where by there is a single set of rules that govern fiscal prudence per each member country. Although austerity is a widely abused and misused term, it remains the only legitimate way of resolving Europe's current enigma. Europe's version of austerity involves promising to slash the size of deficits by reducing government expenditures and raising taxes. What isn't told is that these promises will always be broken and new promises will almost always subjugate them. Austerity is a promise to break promises. However, troubled nations like Spain and Greece receive previously negotiated bailout money conditional on these promises. Moral hazard is real and alive in Europe.
The newswires reported that the fourth wealthiest man in the world, the CEO of LVMH holdings based in France has decided to take up a Belgium citizenship and is filing a request to the French immigration for approval. Why? A few months ago, France's new president François Hollande proposed a new law that would tax the 1% of its citizenry (those with annual personal incomes above 1mn Euros) 75% of their incomes. Backfire, next story please...
Also crucial to note is the massive fund outflows from the Spanish banking sector. Retail depositors and clients have been withdrawing funds at a staggering rate. I don't have the exact numbers but total YTD fund outflows amounted to roughly 15%-20% of total bank assets. Ring a bell? Yes, it's an orderly bankrun. Funds are flowing into safehavens and are being converted into anything but the Euro. Redenomination of European assets into other currencies like the Greek Drachma or the Italian Lira in the unlikely event of a EMU breakup would mean massive unrecoverable losses on assets, deposits and life savings. Better safe than sorry I guess.
Enough of the past. The present isn't much different. The political chasm hasn't been bridged and we know the Euro was an invention motivated by political incentives. Let's talk about the OMT for one moment. The market expect Spain to request for a "bailout" in a few weeks due to scheduled principal repayments on its debt. Spain is currently on the verge of being cash-less and doesn't have access to the credit market. The only ways Spain manages to repay maturing liabilities is through fund transfers (target 2) and issuing new debt at prevailing market yields (which have fallen a great deal). The OMT is conditional on a nation requesting help from the ESM and will hence have to meet prerequisites of deficit reductions under the ESM legislation. Once under the ESM bond buying program, the OMT facility will monetize the nation's bond issuances, effectively lending money to that sovereign. Operationally, the ECB would credit the ESM with money and then would arrange reverse repurchase agreements with the various NCBs (Bundesbank, Banc de France et al) so as to "sterilize" the entire process (ie: no new money has actually been created as existing money offsets the ECB transfers to the ESM).
If we short circuited the entire process of the OMT, it would inexorably boil down to NCBs (read Germany) funding the purchases of sovereign debt, be it new issuances or secondary market purchases. Yes, mark to market risk will be reduced to mark to model risk on the ESM's balance sheet but as I've tautologically hemorrhaged on, the credit bases hasn't expanded one single bit. Without credit growth, Europe (actually all economies) can forget about growth. Basically, pray and hope that the OMT lowers the effective borrowing rate for these sovereigns and stems any form of black swan event involving a blow up of these nations an the Euro. We all know the quagmire Europe is currently in but the more optimistic point is that if no bad events occur from now till things improve, things will stabilize and markets will adopt to the new standard of a depression. This is basically the ultimate aim of can kicking, to postpone once imminent problems until the market's threshold has advanced to an extent that it is able to absorb those negative shocks without sparking a major crash.
The Euro's suffering from some schizophrenia: Sov yields lower but Euro's lower
QE & End of China's Exuburance?
The foremost reason for US equity's reluctance to fall may well be the persistent hope for the NewQETM . Just to recap, the FED extended its Operation Twist (Maturity Extension Program) a few months back to continue selling at the short end of the curve (3 years and under) and buying at the longer end (7 years, 10-30 years) to the tune of roughly $40bn/month. There is an apparent problem as highlighted by the quants over at Zerohedge: The FED has nearly run out of short term paper to sell and will have to include longer term debt (probably up to 5 years) if it was to continue with Twist. The primary goal of Twist was to flatten the yield curve to try boost the housing (refinance market) market. So far so bad, Twist hasn't done anything but to increase the FED's DV01 (duration risk) by ever so slightly. There's one other thing Twist might have succeeded in doing: pump priming the stock market to current exorbitant heights. Twist might have been QE3 (after the $600bn QE2 program). Yes, Twist was sterilized and is a flow program (ie: reinvesting proceeds from maturing and liquidated paper). But as the market's have pointed out, it is the flow and not the stock that motivates risk appetite. There comes a time when the flow gets huge enough to be considered new stock. If Twist was indeed QE3, the market is either expecting a stock program (something around the lines of $500bn of MBS purchases) or an increase in the monthly purchases under Twist (say from $40bn to $60bn).
Zerohedge recently brought to light a limitation of what the FED can actually do when it comes to unconventional monetary policy. At the current rate of bond buying, the FED is effectively monetizing all of the Treasury's long bond issuance. Remember that the presidential elections are just round the corner and the fiscal cliff will soon ensue Washington. Possible implications may include a reduction in long term debt issuance (10-20 years). The FED may be forced to monetize other assets besides treasuries; and this might be why the entire TSY curve has shifted higher in the past week or so. Is this a case where the FED through the many years of gargantuan purchases grown bigger than the treasury market itself?
The above chart provides a simple linear-scale visualization of the SPX. We are technically quite extended and according to the venerable Elliot Wave Theory, SPX is threading on Wave 5 (the last impulse before corrective A-B-C). The FED might be the harbinger of its self-destruction; besides, I was always of the opinion that policy makers were near or at their wit's ends.
Across the Pacific, the once furnace-hot Chinese growth has waned to a much more manageable level of 7.4% YoY for Q2'12. As tempting as lowering RRR and repo rates might be, the PBoC knows if it continues with loose policy, inflation will supersede any gains of growth. Inflation for the low income Chinese means alot because around 30% of their monthly income goes into food and staples. As premier Hu Jintao's 10-year term draws nigh, an angry population is one of the last thing he needs when the Chinese political system gets a shakeup towards year's end. Inflation is the greater of the evils in China. A YoY7.4% growth is still immensely impressive considering how the other developing economies are coping.
Delving beyond the superficial, some analysts are already cutting corporate outlooks due to increasing margins due to sticky energy costs and rising employee wages, and weakening exports to Europe and the West. Such downward revisions to corporate outlooks are general associated to slowdowns. Chinese firms have quite a bit of inventory to clear because of the over supply of certain raw commodities like steel and copper. Many Chinese steel makers have been suffering losses for the past few quarters but still continue to operate. The reason for such is that municipal governments have been offering incentives and strong oppose to laying off workers, something that is inevitable when production is halted.
Iron ore prices have been an accurate barometer of global infrastructure development and that translates to GDP growth. Prices have risen north of tenfold over the past decade but have probably peaked early this year. The Baltic Dry Index (BDI) is another useful indicator of global maritime trade; although it has bottomed out somewhere late last year, current levels are unindicative of progression (the index is basically flat as shipping prices remain suppressed and stagnant). As previously stated, global growth is a novelty without credit creation and money velocity. The consumers of exports (America, EU) from labor and commodity rich economies such as China, India and Brazil have been stunned by falling real wages and high unemployment. Aggregate demand hasn't recovered when adjusted for government stimuli.
In order for China to achieve that proverbial soft-landing everyone is hopping for, it needs to moderate growth, hence exports and trade surpluses will fall/turn negative. I wouldn't be surprised if the government enacted new laws that impede personal saving habits and induce spending/consumerism, in a bid to transition from a foreign investment to a domestically fueled economy. Such forces might quell fears of a vacuum once capital flees China's property markets.
Some FX Charts:
Yen: Shorting the Yen will probably be the investments of the decade... but everything about those returns is contingent on your timing
Aussie: FX carry risk hasn't been as ebullient as European sov risk and US equity risk. Clearly, not every market is buying into the ECB bazooka scheme...
Swiss: The Yen, Dollar and the Franc are probably the only currencies that are considered safe-havens due to their market depth amongst other reasons. Recent Swiss strength against the Greenback contradicts general risk-on ramp fest
Gold: If anything should excite it would be Gold. Implied volatility on Gold exchange traded options spiked 9%+ on Friday. Current price action strong hints of a successful breakout and continuation of the secular trend. Strategically, market would be expecting some form of money printing or systemic black-swan type of tail event if Gold were to surpass the indicated supply areas