Government

Investors are calling this risk “Lehman Squared”

As Eurozone turmoil resurfaces, Gemma Godfrey takes you through the under the radar risks and how to trade them.

The risk of Greece leaving the Euro is looming large over markets as a ‘snap’ election nears on Jan 25th. Threatening to reverse the austerity measures (spending cuts etc) required for bailout funds and remaining in the Eurozone, Syriza looks likely to lead any coalition government, if it does not win outright.

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Why Europe Is Doing The ‘Ice Bucket Challenge’ With A Glass Of Water

‘Grand’ gestures with minimal effects, Europe is doing the ‘Ice Bucket Challenge’ with a glass of water. Measures won’t measure up to much. Little movement in interest rates, not enough assets to buy and ultimately – you can put out as many cream cakes as you’d like, but if people aren’t hungry, they aren’t going to eat. The pressure is rising and more is needed. Europe has become a ‘binary trade’, and it is important to invest in those set to benefit regardless.

(Click on the image below for a quick video clip summary)

cnbc FMHR Sept 2014

2 Measures That Won’t Measure Up To Much… (more…)

5 Ways To Check You’re Not Late To The Stock Market Party

The room’s getting crowded, the party’s been going on a while but more people could arrive. Just beware fair weather friends and a sign it could be time to think about leaving…

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Banks: Why We Can’t Use a Sledge Hammer to Correct a House of Cards

Watch this as a 1 minute clip on Newsnight

 

While banks need to earn back our respect, moves to strengthen the system should be handled sensitively.

The challenge is that a low level of regulation hasn’t worked while too heavy handed regulation could be just as damaging. Elevated regulation costs could be passed on to the consumer in terms of higher borrow costs and lower credit availability. The ‘man on the street’ may be the ultimate victim as a tougher environment leads to job losses as companies struggle to finance themselves.

The misunderstanding is that it is not as binary as ‘retail good’, ‘investment banking bad’. Ringfencing and protecting one part of the industry from its perceived higher risk other half is a flawed strategy. Good assets can go bad, as we’ve seen in Europe as certain government bonds have become less and less credit worthy, with the likelihood of default increasing. Retail banks have gone bankrupt, far from worthy of their halos. Furthermore there’s the issue of funding. Retail banks are subsidised by investment bank revenues. Therefore again, those with a high street bank account could be hit with fees to have a deposit account. Although it may be argued this cost is preferable to the possibility of greater losses from instability. Nevertheless, instead of a focus only on separation, the issues to tackle run deeper.

It’s about mitigating the risk not just moving it about. We need interests to be brought back inline & not incentivise  excessive risk taking. Nonetheless, while banks remain fragile, complex & different to each other, the situation needs to be handled carefully.

‘Operation Twist’ – What is it? How could it help? But why will it not?

As the US launches $400bn ‘Operation Twist’ in a desperate attempt to kick-start the economy, concerns arise over how effective this will be. It’s true that something needs to be done and inflation restricts the options open to the Fed but the strategy has a poor track record in terms of effectiveness. We will be in a lower growth environment for longer and should prepare accordingly.

 

The Economy Struggles: Something needs to be done

The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds. Unemployment is stuck at 9% and even more worrying are the ‘under-employment’ figures which include those that have been forced to cut their working week rise as far as 18.5% of the population. In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.

But inflation restricts options

So what can they do? When conventional monetary policy has become ineffective, since short term interest rates are already low, that’s where quantitative easing steps in.  With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%. Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to and you get less ‘bang for you buck’. Things seem more expensive and inflation has been boosted.

Operation Twist to the rescue?

There is hope. One form of quantitative easing avoids the problem of inflation – Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short term bonds. This avoids flooding the market with cash which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extending of the maturity of Fed’s bond portfolio. Buying these long dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer term rate makes for example mortgages (long term borrowing) more affordable which would hopefully encourage spending.

A Poor Track Record

History teaches that Operation Twist may be of limited use.  When it was applied back in 1961, it only reduced rates by 15bps! This would not be enough to encourage spending, hiring and boost the economy sufficiently.

What can you do?

Prepare for a lower growth environment for longer. Pay attention to the type of customer a company in which you’re interested in investing services. A strong balance sheet, pricing power and protected demand will serve firms well.

Europe – Lacking a Long-Term Solution

Over the last few days we have seen a tremendous amount of volatility in the markets, epitomising the lack of clarity with which many investors have struggled. The contagion continues to spread as we hear rumours of a possible downgrade of French government debt although it is far more likely to occur for Italy first. Fundamentally, there is a lack of a long-term solution and the knee-jerk reaction by some EU countries to ban short selling not only misses the point, it may negatively impact the very stocks it is trying to protect. So as we see movement to safe havens, we also see room for opportunistic buying – as long as you invest with those with strong balance sheets unlikely to be hit in future earnings downgrades and have a long enough time horizon to withstand the volatility.

Italy and France to be downgraded? The Contagion Continues to Spread

The markets are already betting for the ratings agencies to downgrade France’s debt with credit default swap spreads widening to double their level at the beginning of July. A rising expense to insure against default implies the market believes it to be more likely. However, Italy is the more likely downgrade candidate in the short-term. The reasons given behind Portugal’s downgrade a few months back apply equally to Italy – an unsustainable debt burden (Italy has the third largest in the word at €1.8tn) and a low likelihood of being able to repay these obligations (as it dips back into recession). The European Financial Stability Fund is losing its credibility since even its increase to €440bn is not enough to cover future potential bailouts and would need to amount to at least €2tn. The crux of the problem, as I’ve iterated before, is that you can’t solve the problem of debt with debt and austerity does not foster growth. Instead debt burdens are increasing at a faster rate than GDP growth in many western economies so the situation is only getting worse.

Outlook for banks: Headwinds for banks remain

European banks remain highly correlated to the future of the periphery. German banks, for example, have exposure to the PIIGS (Portugal, Ireland, Italy and Spain) amounting to more than 18% of German GDP. Commerzbank revealed that a €760m write-down for Greek debt holdings wiped out their entire Q2 earnings. That’s before we look at France who have an even higher exposure and here in the UK, our banks have nearly £100bn exposed to struggling economies. Furthermore, these banks need to refinance maturing debt (at a rate of €5.4tn over the next 24 months) at higher rates and with demand shrinking.

Will the ban on short-selling help? No, it misses the point

The markets are concerned with government fiscal credibility not its regulatory might. Instead, the ban could increase volatility and negatively impact the very stocks it is trying to protect. ‘Shorting’ was acknowledged by the Committee for European Securities Regulators as beneficial for “price discovery, liquidity and risk management” just last year, so we may well see higher volatility than we would have without. Secondly, it limits fund ability to bet on financials going up. Hedge funds use shorts to remove market risk, buying shares in one bank and borrowing and selling shares in another. If they are forced to close these ‘borrowed’ positions, they will have to sell the other bank shares they have bought outright, causing further selling pressure and price falls. Most interesting was the timing of the implementation, just before an announcement was made that the Greek economy shrank by 7% in Q2 – fuelling fears the ban was needed since there’s more bad news to come.

How to trade these markets: Movement to safe haven offering opportunities

So how can you invest in these markets? A possible support to the stock markets is the ‘search for yield’. Sitting on cash can’t be satisfying for long, with rates as low as they are, and the dividend yield on the Eurostoxx is now double the 10 year German ‘bund’ yield. This means that even if markets go sideways, the return generated from holding European stocks could be more attractive than either if the other options. In addition, valuations are looking reasonable, at a near 8x forward earnings. Therefore we may see flows returning to the markets. However, be warned, we are starting to see earnings downgrades and volatility may remain. Therefore invest in companies with strong balance sheets and maintain a medium to longer-term time horizon.

The US Debt Ceiling: The How, Why and What Could Happen?

The deadline for delivering a deal to allow the US to continue to borrow and spend, August 2nd, is approaching. Mirroring issues in the EU, a problem of debt cannot be solved by yet more debt. With the threat of a downgrade looming, any rise in interest rates could make the situation worse, hitting the tax payer and US exporters. Moreover, an increase in this ‘benchmark’ rate could impact the UK and hurt our property market, and a weaker dollar could result in job losses in our export sector. Further afield, with China the largest holder of US debt, the concern could spread globally towards countries relied upon to drive future growth. But failing to raise the ceiling isn’t an option and may cause an eventual default further down the line. Therefore, a deal will be struck and a balance found between demands for more spending cuts and aspirations for tax increases.

The US has ‘maxed out its credit card’

The US debt ‘ceiling’ is the maximum amount of bonds the US can issue, i.e. the maximum amount the US can borrow to finance its spending. The limit is currently set at $14.3tn but with the country spending approximately $120bn more than it takes in terms of revenue each month, after funding its participation in 2 world wars, rescuing the financial system post-Lehmans and pumping the economy with new capital to boost economic growth, the debt limit was reached on May 16. Put another way, the US has maxed out its credit card.

The issue echoes EU troubles: Debt cannot solve the problem of debt

Instigated in 1917, the debt ceiling has in fact been raised 74 times since 1962 alone. It should be noted; raising the limit does not increase fiscal spending but merely allows current obligations to be met and annual deficits to be financed. Nevertheless, in the current environment, with sovereign debt crises in Europe, investors and rating agencies are becoming acutely aware that cannot solve a problem of debt with more debt and the extent to which the ceiling would have to be expanded is troublesome. Obama’s proposed budget will require a ~$2.2tn hike just to meet next year’s obligations.

A lose-lose situation could hit tax payers and US exporters

Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA’ status and ‘stable’ outlook’, any downgrade would threaten its role as the safest place to store savings. To retain their position, the US needs to address how it will not only plug this short-term gap, but also meet longer-term challenges. A hit to confidence would increase the rate of interest demanded by investors to compensate for a higher perceived risk of loss. This would increase borrowing costs for the US, worsening their debt burden and further limiting the amount of new debt they would be able to issue. It has been estimated that even an increase of 25 basis points could cost tax payers $500m more per month. With less demand for US treasuries, there would be less demand for the dollar to fund these transactions, making the products the country exports more expensive abroad and again hitting their balance sheet.

The issue could hit the East and future global growth

In its extreme, uncertainty could spark another financial crisis as well as put the dollar’s status as the world reserve currency at risk. (Interestingly, a McKinsey investigation reported less than 20% of business executives expect its dominance to continue to 2025). For this isn’t an isolated incidence. Dollar-denominated US debt is held world-wide (especially $1.1tn by China), spreading the problem towards the very countries many are lauding as growth drivers of the future.

UK jobs, home prices and recovery could be hit

There could be dire consequences felt even in the UK. The US is our largest export partner, spending $50bn for our products last year alone. A weaker dollar would damage American buying power, making these products more expensive and damaging demand. This would cause companies producing these goods to suffer and jobs would be lost. Furthermore, if fears over the ability of the US government to repay its debts led to investors demanding more to lend to the UK government, mortgage rates would become more onerous and it could be harder for buyers to purchase a property. With less investors able to buy and therefore lower demand, sellers may be forced to lower asking prices to get a sale.

Failing to raise the ceiling wouldn’t cause an immediate but an eventual default

In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits. Furthermore, some of their debt could be rolled over so long as the overall amount of treasuries outstanding didn’t rise. However, this is unsustainable in the medium to longer-term and would lead to an eventual default.

With too much at stake a deal is likely to be reached

The issue is currently being used as a negotiating chip by Republicans to get deeper cuts and long-term reforms whilst refusing to raise taxes, versus the White House aiming to cap tax exemptions and reduce ‘inequalities’ benefitting big business. Nevertheless, with such serious ramifications possible, it is unlikely a deal will not be struck.

Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.

Our Macroeconomic thoughts… Something has to give…


Tzanetatos Capital Management LLC

The US Equity market in less than two years, as measured by the S&P500, has doubled from its post crisis March 2009 low. Volatility has sunk. US Unemployment remains high. The Fed is fueling a speculative boom with the riches accumulating to the few. US Labor struggling to get back to a decent or any work and the geopolitics paint a complete opposite picture to the market euphoria. All the while clouds in the global geopolitical sphere continue to gather pace. While in the west we measure progress many times by the rise or fall of the markets alone on a daily basis – For the people of Egypt the long struggle for jobs, social justice has only begun. On Feb 13th, the military council abolished the constitution… timetable to nowhere is all we can see… as the military positions to further consolidate its stranglehold on the people. Unrest potential is building in the Arab world. From the lands north of Sahara- Northern Africa. From the Nile to the Euphrates. From the Mediterranean to Mesopotamia. The two ‘I’s, Israel-Iran, eyeing each other and global players are taking positions. China has a new world status and it could test its newly found powers, all the while weaknesses are building into its own economic system that risk world destabilization. Change in the status quo in the middle east and elsewhere where pressures have been building for some time now can have seismic implications for growth of the world economy. Rather growth stalling at best with uncertainty keeping long term investment plans at bay and hungry jobless populations or democratically starved plutocratic nations citizens pressuring for reforms. Global aggregate demand on the government side is pressured to collapse as spending at current intervals is unsustainable. The pace of implementation of structural reforms is slow and major structural reforms measures are still to be taken. Will the Fed stimulus policies continue to keep the economy from faltering? We take the view that the higher you are the greater the fall and the highs we are now are not compatible with the struggle to put bread on the table for most families. Even in the most affluent of Nations. Ours. The Baltic index has closed at near quarter century lows. Ship oversupply? Yes. Australia flood impact? Yes. Trade used to be the life blood of world economy. Now it is finance. Speculative flows of money looking for a quick domicile for short term gain. Capital has always ruled the world but money movements of such intensity is a relatively new phenomenon that our econometric models do not have much historic data to go by. All is so synchronized now around the world. The supply of funding for excess speculative building abundant from the central authorities. Yet Trade the heart pulse of human global endevours and interactions since time in antiquity- trade- global trade- is telling us otherwise. Something is happening. Something big. The amount of trade is clearly going down as things look up in government, central banks and brokerage house reports. The Greek ships have been taking much to China but lately they come back many times empty. Yet the forward looking equity markets of our Western World…measures of progress in the eyes of many.. vain quests of financial engineering yet once more.. have been marching higher. Fundamental and technical traders follow the same momentum of a rising tide on stimulative action not structural reform. This is not healthy. The system has yet to cleanse itself. Something has to give…..

TZANETATOS CAPITAL MANAGEMENT LLC
CHICAGO
Past performance is not indicative of futures results.

http://www.TzanetatosCapital.com
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