Weekly Newsletter – Party Like its 1999

The past week saw a massive return to risk markets, with volatility getting crushed as well as short sellers running for the hills.  In particular, Thursday was a spectacular day, with the US dollar plunging as the euro, Australian dollar and Swiss franc skyrocketed.  We continue to believe that the situation in Europe will spark problems down the line, and view the current rally as an ideal time to enter bearish trades.

The following chart shows the CRB Raw Industrials as well as the GSCI Total Return index.

While the CRB RIND has been fairly correlated to the S&P 500, the fact that stocks are within 7% of the year-to-date highs while the CRB RIND fails to show any lasting change in trend is an alarming sign for bulls.  The story appears to be the same: aggregate demand across the global economy is falling.

On the other hand, speculators have been jumping for joy in the past 3 weeks, with the GSCI index rallying over 15% from October 4th to today.  This disconnect between speculators’ whims and industrial demand is yet another sign that we are not out of the woods just yet.

While we have multiple anecdotal points to prove this (Apple missing earnings for the first time since 1997, Amazon badly missing earnings estimates, borderline riots at Chinese real estate developers), equity and risk markets have taken it upon themselves to carry the torch of a new economic expansion and completely forget about all that ails us.  It is our opinion that given due time, the equity markets will have shown to be completely false in their hopes, and will be shot down as fundamental factors take hold.  Of course, the most important factor for the foreseeable future is Europe.

Europe: All is Well that Ends Well?

The headline movements of markets in the past week saw investors buying hand over fist (or more likely short-covering) as Sarkozy announced the EFSF would be expanded to 1 trillion euros and the fund would be 4-5 times leveraged.  No other details of how any of this would be accomplished were provided.

At face value, this seems like quite an impressive feat.  1 trillion euros is enough to cover the flow of refinancing PIIGS debt for the next 15 months.  However, how exactly did the EFSF go from a remaining 250-330 billion euros to 1 trillion euros without any ECB borrowing or increased contributions from Germany?  We have never seen a more euphoric market that was ready to burst to the upside, because buyers simply did not care for the details, as they got the numbers they were looking for, and the now seemingly daily task of “buy first, ask questions later” took hold.

Judging from these simple statements by Sarkozy, it appears that the EFSF has not received a dime in extra contributions yet.  While Sarkozy is going hat in hand to China to beg them to bail Europe out, it remains to be seen if this will be possible.  As we commented in recent articles, China’s ability to write blank checks is not without bounds.  With their own debt problem from spiraling bad loans made to real estate developers and a huge shadow debt system, even if China were to come to Europe’s rescue at this time, that would most likely bode even more poorly for the future of the global economy.  While China is the world’s largest creditor nation, their actual debt level most likely stands at around 100% of GDP when factoring in all of the state and municipal level liabilities.  These are appropriate to add to the federal debt in China because much of China’s real estate debt is taken on at these levels in the form of real estate development loans, and China as recently as April had to take on about $830 billion worth of state level debts onto the federal balance sheet.

Without any “new” money for the EFSF and/or ECB leverage (ideas that the Germans have vehemently rejected numerous times), the only possible explanation for this “4-5 times leverage” of the fund is that the Europeans intend to use the EFSF as insurance on new sovereign debt issued by the PIIGS.  Leverage of 4-5 times implies that the EFSF will take anywhere from 20-25% of initial losses on new PIIGS debt issued.  It is the EU’s hope that this insurance will calm market fears over the sovereign debt and restore Italian and Spanish sovereign debt to riskless status.

However, even a superficial examination of this proves its woeful inadequacy.  The Europeans have literally just negotiated a 50% writedown on Greek debt because the Greeks became too indebted.  How exactly can they convince the market that the losses on Italian and Spanish debt will only be 25% in a worst-case scenario?  While the equity market has cheered this development, it is very clear that the fixed-income market is not a believer in the slightest.  Posted below is a chart of Italian 10 year yields.

Italy

The most important part of this chart is to note that the Italian 10 year currently stands above a 6% yield.  This is a truly horrific number for the Italians, especially considering that they were paying less than 4% for their borrowing just 1 year ago.  Even more interesting to note is that Italian yields climbed all of October even as risk assets rallied.  Considering that the US investment-grade index yields less than 4.5%, if investors really thought that the risk from Italian bonds had been diminished, there is no way Italian debt would yield 150 basis points more.

Also, another less commented on point is that Merkel had to give the opposition party a few carrots in order to pass the latest EFSF expansion bill.  One of these was the insistence that the ECB stop “unconditional debt buying” (http://www.businessweek.com/news/2011-10-25/ecb-bond-buying-should-end-with-new-efsf-german-motion-says.html).  This is a terrible development, as it was ECB bond buying that caused Italian yields to fall from their August highs to the September lows.  Without that check, Italian yields may, and probably will, rise to new records.  With the 3rd largest debt in the world, this would be debilitating for Europe and the world economy, as Italian debt begins to trade like a high-yield bond.

In case you were wondering about the EU’s insistence that Italy come up with a credible deficit reduction plan, after a marathon parliament session which featured fistfights between politicians (http://www.ifaonline.co.uk/ifaonline/news/2120480/italian-mps-fisticuffs-pension-cut-plans), the Italians were able to hammer out a historic deal.  Hopefully our sarcasm has been picked up upon, as the deal Italy cut was little more than a joke.  The Italian deal was for the government to raise 5 billion euros annually from asset sales and raise the Italian retirement age by 2 years beginning in 2026 (http://www.bloomberg.com/news/2011-10-28/focus-swings-to-italy-debt-as-greece-wins-reprieve.html).  5 billion euros over 3 years for a country that already has 1.9 trillion euros in debt AND is running a 4.6% budget deficit is not even a drop in the bucket, it is a complete sham.  Italy is running at 0.8% GDP growth and falling, and is running large budget deficits.  Without a devalued euro, there is literally no hope for the Italian economy to grow its way out of this mess.

To top it all off, at this point, the sovereign debt problem is actually one of the easier concerns for Europe to deal with.  The European banking sector is teetering on the edge of collapse.

European Banks

Posted below is a table of metrics for large European and American banks.

The table is sorted by debt to equity, a fairly no-nonsense metric of how leveraged these companies are, and therefore how apt they are to failure.  Legitimizing this view is that Dexia is/was easily the most leveraged, at an astonishing 3408% debt to equity, and Dexia failed a few weeks ago, requiring a French and Belgian bailout.  A quick glance shows us that the European dream team of banking (Soc Gen, BNP, Credit Agricole, Commerzbank) are all in the top 7.  Important to note is that the American triumvirate (JP Morgan, Bank of America, and Citi) are all vastly less leveraged than their European counterparts on a debt to equity basis.

However, the other metrics we have presented tell an even more alarming story.  The European Banking Authority has stated  that the entire European banking sector will require only 106 billion euros to recapitalize (http://www.eba.europa.eu/News–Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx).  Supposedly, this figure will bring all their banks to the stated goal of a 9% tier 1 capital ratio.

Looking at the table above, a tier 1 capital ratio of 9% does nothing to help a bank’s solvency.  At the time of bankruptcy, Dexia had an 11.4% tier 1 capital ratio.  Indeed, at the time of Lehman’s bankruptcy, Lehman was running an 11% tier 1 capital ratio, a supposedly conservative figure by European estimation.

A much better picture of a bank’s health is provided by their tangible common equity ratio.  This measure strips out intangible assets such as goodwill, patents, trademarks, etc. that can frankly be easily manipulated.  As can be seen, Dexia had a tangible common equity ratio of less than 1%!  This means that just a 1% loss in asset value would/did make Dexia insolvent due to their massive overleverage.  Other European heavyweights are not far behind, with Credit Agricole at 1.5% and Deutsche Bank at 1.61%.  One can also see that the American banks, while not exactly pictures of health, are relatively worlds better off than their European counterparts.

Lastly, the short-term borrowings of European banks are an absolute trainwreck.  Take Soc Gen as an example: Soc Gen has 598 billion euros of short-term borrowings on its balance sheet, comprising more than 50% of its total liabilities, yet its market cap is only 18.5b euros.  Comparing to JP Morgan, JPM has a market cap more than 5 times higher, yet has short-term liabilities of less than half that of Soc Gen.  This is an important concept because short-term debt must be rolled forward frequently, and are subject to the market’s whims as far as interest rates, whereas long-term debt locks in financing rates for a longer period of time.

European banks must raise between 800b to 1 trillion euros of debt in the next 15 months (http://www.bloomberg.com/news/2011-10-25/europe-banks-must-find-900-billion-in-2012-creditsights-says.html).  Even if the EFSF somehow succeeds in convincing investors to buy up PIIGS debt, there will not be a single cent left over for European bank bond guarantees.  The only other way the banks can fill this funding shortfall is by selling assets.  Considering that almost all of European banks’ assets are private loans, there is no ready market for these assets, and a great deal of subjectivity regarding their true worth.  Many commenters have agreed that 1 trillion euros of European banking assets hitting the market nearly simultaneously would be catastrophic, yet under current conditions, this appears to be exactly the scenario we are entering.  Moreover, selling assets would essentially require European banks to revalue their assets at market value instead of book value, possibly causing insolvency in and of itself.  European banks could also attempt to raise equity on the open market, but diluting their equity base by this much would be catastrophic to their share price and market confidence.

The final option, which will most likely see fruition at some point, is bank guarantees on a national level.  This is the point that Germany has hammered home over the past month, and it is the most bearish of them all.  Germany has insisted that bank recapitalizations be handled on the national level, and then only through the EFSF if absolutely necessary.  This would mean that France would be on the hook for guaranteeing their banks’ debt if the market does not turn rosy in a hurry.  With Soc Gen’s short-term debt at 598 billion euros, and the entirety of French federal debt at 1.6 trillion euros, even a small, partial guarantee of bank debts would cause the French implied government debt level to skyrocket as a percentage of GDP.  This would invariably trigger French ratings downgrades, as S&P and Moody’s both made clear last week.  Once French debt is downgraded, we will be past the point of no return, and the consequences to the global economy will be severe.

The market has already begun to sense this impending situation.  Posted below is a chart of French 10 year yields relative to German.

As can be seen, the market has been losing confidence in France relative to Germany at an astonishing pace so far this year.  The bulk of the spread widening actually occurred in October, yet another sign that fixed-income markets are rejecting the current cheers from equity investors.  While the spread has contracted a bit in the last couple days, a 100 basis point spread indicates a major division in terms of perceived credit quality.  We expect this spread to continue to widen as it becomes more and more clear that France must take on a mountain of new debt to support their massively overleveraged banking system.

Currencies and Precious Metals

On the day, Thursday saw the euro rally by over 2%, the Australian dollar rally by over 3% and the Swiss franc rally 2.5%.  These are gargantuan moves for currency, and while the media claims it is mainly short covering, experience and data dictate otherwise.

Currency and indeed all risk assets moves recently appear to suggest that renewed quantitative easing is imminent.  As economic data has largely surprised to the upside, and the S&P 500 stands 6% above where it was during the Fed’s last meeting, we continue to be amazed at the market’s ignorance.  With 3 dissenters and a heavy political backlash against further monetary and fiscal stimulus, there is extremely little chance that Bernanke and Co. will announce QE3 this Wednesday.

We do believe that QE3 in the US and a European TARP are inevitable, however, they are months away at the least.  As long as the Europeans, and therefore the Americans, can delude themselves into thinking that everything is going great in the world economy, there will be no political support for radical monetary policy.

For this reason, we continue to be highly bullish on the US dollar and bearish on precious metals.  While the prevailing view is that the developed world will print money in perpetuity, the Fed has quietly restrained itself for the past 4 months while every other developed central bank has gone on a spending spree.  The following chart shows the Fed balance sheet in white, the ECB balance sheet in orange, the Bank of Japan balance sheet in green and the Bank of England balance sheet in purple.

As can be seen, the Fed balance sheet has actually slightly contracted over the past 4 months, whilt eh ECB balance sheet has ballooned almost 19% higher.  With the resumption of 12 month loans to Eurozone area banks, this figure should continue to increase at an aggressive rate.

We believe the FOMC statement on Wednesday could be a major catalyst to the upside for the US dollar and to the downside for precious metals, just as it was after September’s meeting.   Since the end of September, silver has risen 16% and gold has risen 8% in anticipation of further monetary stimulus.  If the market does not receive their wish, downside on the order of magnitude of what occurred after the September Fed meeting is not nearly out of the question (35% loss on silver in 5 days and 16% loss for gold).

Similarly, we believe risk currencies such as the Australian dollar and the euro could also have significant downside, with both witnessing their own positive negative catalysts in addition to the FOMC statement.  The Reserve Bank of Australia releases their interest rate target on Monday, while the ECB meets to set interest rates on Thursday.  At this point, a status quo of rate decisions appears to be priced in to the market on both the euro and the Australian dollar, with both trading at levels not seen since late July before the market chaos began.  This presents a low-risk, high possible reward scenario in that if rates are not cut, the market should take it as a non-event, but if rates are cut, the market should react sharply negatively.