IMF

The EU ‘Rescue Fund’ – Part of The Problem Not The Solution

There is still much to be decided before EU leaders can claim to have provided a comprehensive and credible plan to end the sovereign debt crisis. The rescue fund itself has met with significant obstacles, with demand in doubt and delays to capital raising leading to question marks over its ability to borrow on behalf of those that can’t. Instead of improving sentiment, it may cause it to deteriorate. Details, commitment, growth, structural reforms and greater consolidation of governance, fiscal policy and politics are needed. This has become a global issue.

Deutsche Bank, Germany’s biggest bank, and Credit Agricole, the largest retail banking group in France, rallied more than 19% over the last week in October after certain ‘positive’ news was announced at EU Summit. Measures included the leveraging of the rescue fund to €1tn, a voluntary default of Greek debt and bank recapitalisation. However, this may involve a dangerous derivative structure with insurance coverage not guaranteed and demands not going far enough.

Delays could hit sentiment, deadline looming

The European Financial Stability Fund (a.k.a. the ‘rescue fund’) was created to borrow on behalf of those countries that found themselves unable to borrow (read Greece, Ireland, Portugal etc). However, Wednesday’s attempt to raise capital met a substantial obstacle – limited demand, leaving the fund itself unable to borrow. The €3bn 10-year bond offering had to be postponed, in the hope conditions would improve but a ‘red flag’ has been raised. If this fund is already having issues, at its current size with a lending capacity of €440bn, how will it manage with demands up to €1tn? Inadequate demand could cause sentiment to deteriorate, worsening the very situation it was meant to improve.

Demand from the East now in doubt

Plans to leverage the current fund to enable this €1tn of firepower seem to be heavily reliant on demand from the likes of China and Japan. This makes their apparent lack of interest in this recent bond offering most worrying. Investors have maintained the situation is too opaque and the risk/reward potential too skewed to the downside.

Dangerous derivative structure

The ‘Special Purpose Investment Vehicle’ which would allow this leveraging to occur has been likened to a CDO – collateralised debt obligation and the instrument that was at the heart of the subprime crisis, by insuring investors against loss. The bonds act as collateral so investors effectively buy junk sovereign debt with a certain level of guarantee from the fund.

The Greek ‘haircut’ has highlighted some of the risks. The ‘writedown’ of debt was structured as ‘voluntary’. It was agreed that private bond holders should offer to write off half of the amount Greece owed them versus a formal, official, enforced default. The latter would be classified as a credit event and trigger any insurers to pay up. However, the former doesn’t. Therefore investors who insured against losses paid a premium for cover but won’t get paid out to offset the losses suffered. The risk of a debt ‘default’ may not always be mitigated.

 Doesn’t cover all that is needed

More details are needed to understand how bailout facilities will be implemented and hopes for the first signs of commitment from the IMF, China and Japan were dashed at the G20 Meeting last Thursday and Friday. Moreover, the recapitalisation of the banks, which was set at €140bn will need to be increased dramatically. The IMF already put the level at €200bn, with analysts advising a number nearer €275bn.

Finally, the fund does not compensate for what the EU really needs: growth, structural reforms and greater consolidation of governance, fiscal policy and politics. The EU’s jobless figures are the highest they’ve been since the launch of the euro. Draghi may have put the focus back on growth by cutting interest rates, in a move that surprised the markets, from 1.5% to 1.25% but admitted growth forecasts are likely to be downgraded so the EU economy will remain fragile for some time. Accounting for approximately 24% of global GDP and with lower demand hitting export-oriented Asian countries, as for example Taiwan expands at its slowest rate for 2 years.

This is a global issue.

Stagflation risk and what this means for stocks

As the outlook for growth continues to deteriorate, whilst the price for goods and services remain stubbornly high, the risk of stagflation returns. This would be a tough scenario, where policy options tackling one of these issues would only worsen the other. This creates substantial downside risk for stock valuations based on bullish growth forecasts, whilst making it more prudent to invest in price makers able to pass on rising input costs.

Lower growth outlook

The outlook for growth is bleak. The IMF has reduced their forecasted expansion of Europe from 2% to 1.6% and Goldman Sachs swiftly followed suit predicting France and Germany will fall into recession next year, with the EU stagnating. The data looks supportive of this view. German retail sales disappointed expectations, with a contraction of -4.3% in July vs. -0.5% expected. With Europe still our largest trading partner, the effect on the UK could be severe.

Outside the EU, countries aren’t immune. China’s Purchasing Managers Index has fallen below the 50 mark, the line separating expansion from contraction and GDP growth came in at 9.1%, falling from 9.5% and below expectations.

QE increases stagflation fears

In an effort to boost the economy, the Bank of England surprised many commentators by increasing their purchases of UK government bonds, from £200bn to £275bn.  However, this is not without its risks. It is not a guaranteed strategy to boost growth and crucially create jobs. Instead, it is more likely to increase inflation.

Taking bonds out of the market and pumping cash in their place only reduces the value and purchasing power of the currency, making goods and services more expensive. Inflation is already above the 2% target set for price stability, hitting a rate of 5.2% at the latest measure this week. In the EU the value jumped to 3% in September, the fastest increase in 3 years and potentially a reason behind their Central Bank’s decision not to cut rates.

Unemployment in stagnating economies is an issue and highlights the threat. Spain is struggling with 1 in every 5 of their people without a job, increasing to 45% of the youth population, and Portugal’s jobless level has reached highs not seen for over two decades. The US’s September figures are stuck at 9.1%, although CPI came in below expectations. Here in the UK the level might ‘only’ be 7.9% but this is still high and stubbornly so, with inflation surprising on the upside.

The stagflation quandary (where stagnation and inflation meet) is that to tackle unemployment and boost growth, interest rates would be cut, however not only are they already low, but that would boost inflation even further. Likewise, to tackle inflation, interest rates might be increased but this would only hurt growth and employment.

A lose-lose situation.

Risk of Stock Downgrades

So what has this meant for stocks? Firstly, there is downside risk to stock valuations. With many valuations based on forecasted growth, downgrades could negatively impact and seem more expensive. Analysts are 10 times more bullish on the growth outlook than economists. Although, always more optimistic, that is twice the historical average.

Secondly, it may be more prudent to invest with those that are price makers not price takers, as well as with a protected demand base, in order to be able to pass on rising costs.

The Greek Tragedy: Could a ‘Haircut’ Help?

Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets? 

Background to the Problem

Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.

What’s Going On?

Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.

Attempted Solutions

Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.

What are the Complications?

Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.

Could a Good ‘Haircut’ Help?

With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.

Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.

So, What Are the Options?

As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.

How are the financial Markets Reacting?

Risk aversion is back on the rise. Investors are worried and, understandably, demanding higher premiums to lend to Greece. That’s not all. Other markets are suffering. “All sophisticated indicators of systemic risk, cross correlations of CDS and yield spreads show a high sensitivity to restructuring moves and are at levels higher than in September 2008”.

The Investment Insight: What Can You Do?

This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.

Russian Investment Opportunities: The Drivers and the Hidden Gems

From the world’s best performing index in the first three months of this year, to a laggard this quarter, the Russian index has offered dramatic returns as well as downside risk. What has driven investor sentiment and what are many investors missing?

The World Leader Slips to World Laggard

Russia’s RTS Index was the world’s best performing index in the first three months of this year but has now fallen by around 11% in value so far this quarter (Source: Bloomberg). Moves in this market are often attributed to sentiment over the oil price due to the significant revenues generated by the country exporting this commodity. Therefore speculation over economic growth (read: oil demand) is highly influential. This year has been no different. Turmoil in the Middle East can be attributed as one of the main drivers of a strong rally in oil in the first quarter and concerns over economic growth has caused a reversal since that time. However, is this too simplistic a view and aren’t there other factors to which an investor in Russia should be paying attention?

Source: Bloomberg. Russian RTS Index (white) vs. MSCI World Index (orange) - all $.

Beyond Oil

It is clear to see why investors play so much emphasis on the oil price as a dictator of Russia’s financial health. Supplying some 11.4% of the world’s oil supply last year, Russia is the “biggest single source outside the opec cartel”. Although official figures calculate its contribution to Russia’s GDP at 9%, it is important to be aware that speculation over tax avoidance suggests the value may be nearer to 25%. Nevertheless, what is often overlooked is the specific oil price factored into their budget. For this year, a price above $75/barrel will produce a deficit reduction. With Brent currently standing at $115/barrel, a fall in the Russian Index in reaction to a fall in the oil price to anything above $75/barrel may be missing the point.

Boosting Ties with Iraq

With Russian oil fields maturing and production growth resting heavily on foreign investment, the country is looking externally for new sources. Iraq offers potential opportunities and TNK-BP, Russia’s 3rd largest oil producer and BP Plc’s 50-50 joint venture, isn’t holding back. The relationship between the two countries dates back many years and in 2008 Russia wrote off most of their $12.9bn debt mainly generated pre-gulf war from the Saddam Hussein government purchases of Soviet weapons. Interestingly, last October the Russian President, Dmitry Medvedev announced his country was ready to strengthen co-operation with Iraq, the same month TNK-BP gained the right to bid for 3 natural gas areas in the region.

Mediating the Exit of Qaddafi

Within the political arena, Russia has been just as active. In addition to fighting for a stronger developing market influence at the IMF, Russia has offered its services to facilitate the exit of Qaddafi from rule in Libya. This is the first time it has shown support for the NATO-led military campaign after abstaining from UN Security council vote in March which authorised the intervention and accusing NATO of violating the resolution by backing anti-Qaddafi rebels and causing civilian casualties from air raids. Due to the belief that Qaddafi has “forfeited legitimacy”, they are willing to negotiate his fate with members of his entourage. Evidence of the country’s powerful network, the value of their political clout has been highlighted.

Driving the Agriculture Market

Back to commodities but from a different angle, the Russian weather is an influencer to watch for investing in the agriculture markets. Fine weather has prompted an upward revision of Russian grain production with the Federal Hydrometerological Center reporting the warmer weather has improved the prospect for crops. This has led to speculation that Russia’s ban on grain exports may be lifted on 1 July. Wheat future prices saw double digit losses.

The Chinese Buyer

One particular potential buyer of Russia’s resources is China, state media reported last Monday. China Investment Corp (CIC), the country’s $300bn sovereign wealth fund, was set up in 2007 to invest some of the country’s massive foreign exchange reserves. With the world’s largest foreign capital resource, at $3.0tn, they are keen to find better sources of return and commodities to fuel their rapid economic growth.

G-8 Bullishness Boosting Appetite for Risk

Despite these many factors which may influence Russia’s outlook, financially, economically and politically; its index continues to exhibit a strong correlation to the oil price. This week we’ve seen oil (and Russian equities) respond positively to the declaration by the Group of Eight that the global recovery is strengthening.

Investment Insight

Nevertheless, to differentiate between short-term over-reaction and more logical fundamental moves, being aware of all the issues will equip you with the insight to navigate this volatile but potentially profitable market.

IMF Revelations: The End of European Dominance & The Rise of Emerging Markets?

As “super-injunctions” are labelled “pointless” by the rise of ‘new’ social media sites, the world seems a smaller place for those wanting to hide potential transgressions.  Indeed, such accusations can have broad ramifications as the head of the International Monetary Fund this week steps down from his leadership position. Could this trigger the end of European dominance at the IMF and even pave the way for Emerging Market leaders to acquire a more appropriate size of the power pie?

Jurisdiction Arbitrage: The Super-Injunction Flaw

Last week, an anonymous twitter user exploited a ‘jurisdiction arbitrage’ to name celebrities whose identities are being protected by a series of ‘gagging-orders’. The Twitter site is based in the US and therefore “outside the jurisdiction of the British courts”. Furthermore, not only would the user himself be “difficult to trace” but the number of other users who forwarded on the names and could be charged represented a “mass defiance” and “unlikely” any of them would be pursued. Therefore potential wrong-doers can, for the moment at least, be named and shamed in some form of media. Just how dangerous can these revelations be?

Revelations at The IMF

This week legalities are once again in the headlines as Dominique Strauss-Kahn, (now the former) head of the International Monetary Fund, stands accused of politically damaging indiscretions. Regardless of the outcome of the case, the political impact has been made and focus is on identifying his potential successor.

The European Bias

Historically the IMF Managing Director has been European and the World Bank President American but nowhere in the “Articles of Agreement’ is this mentioned. So where did this bias come from? It dates back to the Bretton Woods conference, where the fund was formed and this informal agreement struck. In the aftermath of World War II, European economic stability played a large part in the health of the world’s economy and voting power reflected the balance of power. The US has a 16.7% share, Germany 5.9% and the UK & France 4.9% each; leaving the ‘door open’ for ‘behind the scenes’ negotiations. Unsurprisingly, since this time, there have been 10 Managing Directors, all of them European.

Flaws of a European Successor

Proponents of a continuation of European dominance point to the IMF’s crucial role in stemming the European Sovereign Debt crisis. A German government spokesman, Christoph Steegmans, maintains that the leader needs to understand “Europe’s particularities”. Interesting then that there has been no talk of electing an official from the Middle East as Egypt requests a $4bn loan to ‘fill its budget gap’. With all the turmoil, doesn’t a leader need to understand the ‘particularities’ of this region too? Instead, focus is on German candidates (including Axel Weber, the former head of the Central Bank who recently withdrew from the race to succeed Trichet as head of the ECB). A favourite amongst pundits is French finance Minister Christine Lagarde. Bank of Canada Governor, Mark Carney has even been given odds of 10-to-1 by a British bookmaker. Gordon Brown’s name has even been thrown into the ring but was quickly opposed by our PM Cameron due to the record budget deficit which continued to build during his tenure. Here lies the crux of the issue, since the EU and ECB have yet to solve the debt crisis, is it time for someone else to have a go?

Opportunity for Developing Markets

The economic balance of power is changing. China has overtaken Japan as the second largest economy and it has been argued that it will surpass the US’s share of global GDP in a decade. Back in 1973, the developing nations asserted more of their power as a group led by Indonesia and Iran vetoed the nomination of a Dutch candidate (seen as too closely aligned to the interests of wealthy nations). With this in mind, candidates from South Africa, Turkey, Singapore, Indonesia, Mexico and a Chinese official who advises the IMF already have been mentioned in the press. Brazil too has contributed to the discussion, as their Finance Minister argues for a “new criteria”. Indeed changes to IMF governance were decided in 2008 and last year, shifting 5.3% of the voting share to emerging markets. Although nothing has yet taken effect. However, with the increased contribution of funding coming from these regions and the negativity within these countries expressed against too much focus on the developed world, change is warranted.

Investment Conclusion

As ever, economic issues can often lie opposed to equity market movement. But changes (or continuation) of dominance could affect short-term sentiment for various country’s financial markets. Exploit any over-reaction in the short-term whilst remaining focused on quality in the longer-term. The shift of economic power is well underway, let’s see if the political powers play catch up….

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.

European “Financial Mechanisms” – Can they solve the EU’s problems? And how can I make money from the concern?

World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr  (American , b.1968)

There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”.  Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches!  This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….

Source: Bloomberg. The premium investors demand for investing in Irish government bonds over German bunds remains elevated (indicating a perceived heightened risk)

Why won’t the EU bailouts solve everything?

1. FLAWED LOGIC: attempting to solve the problem of debt with more debt

2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013,  if Debt/GDP has not reduced significantly then bond holders start sharing the pain

3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!

The key discrepancy –

What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)

What EU country economies need: COMPETITIVENESS AND GROWTH

Market Impacts

  • YIELDS may have fallen sharply for some periphery debt but as the chart before shows, they remain at elevated levels.
  • FORCED SELLING – Pension funds, insurance cos and ETFs which are focused on matching the liabilities to their assets may have to sell certain debt when its credit rating is cut

How can you exploit this?

“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister

  1. Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure and demand for their products from the east etc) making it a sound investment choice, may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up cheaply.
  2. In addition, a downgrade in a country’s government debt may trigger a wave of forced sellers (the pension funds etc. mentioned above) that are restricted in holding this level of debt. If this is just an automatic trade, these distressed sellers may be exploited with the purchasing power in your hands