Tuesday, 28 April 2009

Chaos theory: a pig flaps its wings in Mexico...

Swine flu is a sideshow, blown out of proportion by the media. Having rallied over 25%, equity markets were vulnerable and looking for an excuse to go lower even before the outbreak.

To date, and tragically, swine flu has accounted for 149 deaths in Mexico, a country of 111 million people. This represents 0.0001% of the population.

So, if swine flu is no more of a serious and lasting issue to world health than SARS or bird flu were, there are bargains to be had in those sectors particularly hit by pandemic hysteria.

Airlines, in particular, come to mind, as do other travel sectors such as hotels. However, these sectors were already struggling in the face of the global slowdown, and companies with stressed balance sheets may be at risk.

Friday, 24 April 2009

Reassessing Gilts: don't panic Mr Mainwaring!

In light of the 30-35 basis point back-up in the 10 year Gilt yield, pushing it above 3.5%, it is time to reassess the investment case for Gilts.

A tumultuous week for Gilts started with Alastair Darling's pre-budget speech, in which he announced the Government will borrow £220 billion this fiscal year, increasing the public debt:GDP ratio from 45% to 76.2% by 2013. This was followed by a Moody's report, How safe are safe havens?, which sent yields higher and Sterling lower, on concerns over the UK's credit rating. Finally, Q1 UK GDP came in worse than expected at -4.1% year-on-year, the worst since 1979.

So, which, if any, of these facts warrant higher Gilts yields?

Increased Gilt issuance
Economic s 1.01 says that, increased supply of a good results in a lower price unless there is a similar rise in demand. However, as the chart below demonstrates, there is little or no relationship between Gilt issuance and Gilt returns. Indeed, the 2008/ 09 financial year saw record gross Gilt issuance of £146.4 billion and the third highest Gilt 12 month total return of 6.8%.

Further proof that bond issuance and returns are not related comes from Japan, where a sustained increase in public debt has been accompanied with a fall in JGB yields.

Moreover, the supply-demand dynamic has shifted in favour of Gilts due the Bank of England's QE programme. The full £100 billion authorised by HMT for Gilt purchases represents 18% of the overall £543.9 billion Gilt market and 45% of the gross issuance this financial year.

These percentages are not small. Indeed, at the end of Q1 2009, the Bank of England had 'only' spent £12.9 billion on Gilts, out of a possible £75 billion. Mervyn King has plenty of firepower left at his disposal with which to mop up new issuance and force yields lower. Thus, to some extent, what the Chancellor giveth, the Bank of England taketh away.

Moody's report
Next, the Moody's report. For all the hysteria it generated, the essence of the report was not as bearish as the market reaction. The conclusion is summarised below:

"Moody's believes that Aaa governments' unconventional policies are defensive responses that are – at best – ratings-neutral if they succeed in kick-starting economic activity. However, if they lead to massive increases in public net debt and a permanent deterioration of debt affordability without tangible growth effects, Moody's cautions that they will be ratings-negative. In extremis, since confidence is not a linear process, these policies could potentially increase 'tail risk', and therefore also the (currently small) risk of sharp rating migration."

Indeed, a spokesman for Moody's confirmed, "the [UK] rating has not changed, and it's not under review for a downgrade. The outlook is stable."

GDP and Gilt returns have a negative correlation, meaning that as GDP falls Gilt returns increase. The chart below demonstrates this by comparing year on year GDP against the 12 month total returns of Gilts.

So, why then was worse than expected GDP cited as a negative for Gilts? The answer could lie in the relative position of the UK versus other developed nations. IMF forecasts for developed nations' GDP are as follows:

The economic outlook for the UK may not be good, but it is no worse than in others countries, indeed, with the exception of the US, it is the best of a bad bunch.

Therefore, it appears that, on balance, nothing has changed the medium term term outlook for Gilts. Yes, inflation is a risk for the longer term, but as the above evidence suggests, none of the developments last week appear to warrant higher Gilt yields.

So, in the immortal words of Corporal Jones, "don't panic Mr Mainwaring!".

Tuesday, 21 April 2009

George Soros interview with Bloomberg

The following are excerpts taken from a transcript of Bloomberg interview with George Soros on 6th April 2009...

The effect of the Western financial crisis on 'periphery' countries
After the bankruptcy of Lehman, the countries - the United States and the European countries - felt obliged to effectively guarantee their banking systems. And saying no other financially significant company will be allowed to go into bankruptcy. But countries at the periphery were not in a position to provide similarly convincing guarantees. And there was a flight of capital from the periphery to the centre. And that is what precipitated the crisis in Eastern Europe; and of course, in Brazil as well. So that was the unintended side effect of this artificial life support. And now that some support is extended by empowering the IMF, and also coordinating better the banking regulations.

China is now also simulating domestic growth. They have a pretty big stimulus package. And it is not enough. They are going to use more because not being a democracy, they know - the leadership knows - that their very survival, the avoidance of social unrest, requires them to generate growth. So they will - that’s for them the top priority. And they are in a position to do it. And so China is going to be coming out of their recession before the end of the year. And they will also try to maintain exports by providing credit to other countries. After all, they provided a lot of credit to us. Now they just made a swap agreement with Argentina. And they will similarly do the same with other countries in Africa, Latin America. And so they will actually restart their export industry, too.

I think Brazil is another country that’s relatively well-situated. It was doing very well until the Lehman bankruptcy and the sudden collapse. And then you had a crash in Brazil. It did a certain amount of damage. But I think Brazil will also be a country that’s coming - will come out of the recession relatively soon. They have a big deal with China, I think invested something in the neighbourhood of $10 billion to develop the new oilfields there. China will be an avid buyer of Brazil’s soybeans and so on. And eventually will again buy their iron ore. So I think Brazil, actually - together with China, will be among the recovering countries. I don’t know about rapidly recovering, but I think the outlook for Brazil is better than for most other countries.

It’s very much a question of when does the economy recovery. Because when the world economy recovers, the price of oil will recover. And since the world economy suddenly collapsed, the price of oil collapsed. It hit a low below $40 from $140. And now it’s slowly climbing up. But the longer-term future deliveries never fell that far. And in fact now oil is about $50. And it will probably recover perhaps to $70 or so because the marginal cost of developing new oilfields is around $70. Maybe that will fall if prices fall. So it may be lower. But $50 to $70, somewhere in there.

You see, this is a clear example where you have that conflict between the short term and the long term. Because in the long term, there is no question that first of all, the cost of discovering oil is getting bigger and bigger. And the really large oilfields are getting exhausted. There hasn’t been that much new very large discoveries, except, let’s say, in Brazil in very, very deep and very far out waters. And as the Arctic ice melts, then under the Arctic Ocean, we will find oil. But that’s going to be quite expensive. So long term, price of oil has to rise. And we do have this very serious problem of global warming, which really requires us to develop alternative forms of energy, which are also initially, more expensive than the existing sources. The big difference between the new - the alternative sources that with time, their costs may decline. So right now, let’s say solar energy, is more expensive than natural gas. However, as you develop the technology, those prices may rise. So we have no alternative but to develop those. But the collapse in prices short term has really pulled the rug out from under all these alternative sources of energy. And that is directly counter to what we need in the long term. So here’s another example where the short term is directly contradictory to our long-term interests.

Banks & financial system
The banks are functioning. But they are weighed down by a lot of bad assets, which are still declining in value. So the banking system as a whole is seriously under water. The amount is difficult to estimate. But I think it’s in the region of maybe $1.5 trillion.

I am afraid that we are basically setting ourselves up on a route which will lead to preserving the banking system, preventing it from collapsing, but not recapitalizing them, but allowing them to earn their way out of the hole. And that is going to weigh on our economy for a considerable length of time and set - instead of providing new energy in terms of new loans, it will actually sap our energies by the banks charging heavy fees and restricting credit in order to improve their own earnings, in order to first of all survive so they don’t have to put themselves into hands of the government; and if possible, to buy themselves out by repaying the loans that they have got.

HSBC just raised $18.5 billion and I also subscribed.

On when to cut losses
If it isn’t working, I re-examine it. And it depends on the re-examination. It may be that I find nothing wrong and I can explain why its not working the way it’s supposed to. And I might actually increase my position. Or, I discover something that I left out of account,
and then I cut my loss. So - and I don’t cut my losses automatically. And sometimes, actually, I greatly increase my positions because the - I find the situation more attractive.

INTERVIEWER: So you still do your analysis and just - even if it’s going against you for a while, if the argument that got you there still working, you stick with it?

SOROS: Yes, yes.

Has the rally got legs?
I think it’s a bear market rally because we have not yet turned the economy around. What people don’t seem to understand, that something quite profound has happened. It doesn’t happen very often that the financial system actually collapses. So this is not a financial crisis like all the other financial crises that we have experienced in our lifetime.

The US Dollar's role as reserve currency
To some extent it has already been replaced because it’s not the sole reserve currency anymore. The euro is an important alternative. But there aren’t other alternatives. And the special drawing rights, which I think is a very good thing to use for other reasons, is not an alternative currency. Those are merely bookkeeping entries at the IMF. They can’t be used to buy goods. You know, to use them that way, you have to convert them into useable currency.

US fiscal deficit
You are not going to have a widening U.S. deficit, because there isn’t any more the desire to finance those deficits. And we are not in a – the households are not in a position to use the appreciating house values to savings. And so the savings rate of U.S. households will increase substantially. So the deficit is already falling, and it will continue to fall. So we will actually get back into closer to balance than we were. That’s not a very optimistic view because it’s very painful because it means that we are - economy will not grow that much.

Friday, 17 April 2009

The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).

In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.

Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.

Calling half time in the UK house price crash

According to Nationwide, UK house prices have fallen 19% from their October 2007 peak and are now equivalent to 4.1x average earnings. Given that wages are unlikely to rise due to falling inflation and rising unemployment, house prices will have to fall a further 20% in order to reach a multiple of 3.3x earnings, in line with their long term average.

However, it could be argued that UK house prices can sustain a higher multiple due to lower interest rates (UK base rates averaged 11.7% in the 1980's, 7.8% in the 1990's and 4.6% since 2000 according to the Bank of England) and increased availability of mortgage finance, notwithstanding the current credit crunch. Therefore, assuming a higher P/E ratio of 3.5x, UK house prices would have to fall a further -15% in order to reach equilibrium, which means we're only half way through the crash!

Tuesday, 14 April 2009

Little Wing Macro: March review

March was a successful first month as the portfolio was up 4.6% net of 2% p.a. costs. However, intra-month gains were running at over +15% and these were lost towards the end of the month, although they have thus far been recuperated in April.

Large gains were made on Chinese & UK equity index call options, up 65% and 10% respectively, as they captured the rally in equity markets. Profits were taken in FTSE puts before the rally started however, following a 10-20% rally in equities from March lows, FTSE puts have been added back into the portfolio as insurance against a reversal in risk appetite. Given their continued gains in April and the subsequent extent of the profits (+50-150%) made in long equity investments, the decision was taken in April to lock in part of these gains and keep the proceeds in cash.

Having got off to a good start following the announcement and implementation of QE, the portfolio's Gilt positions sold off towards the end of the month as save haven assets in general lost their appeal. Nonetheless, the BoE's commitment to buy Gilts is greater than any other market force and will therefore push yields inexorably lower. Gilts also remain an effective hedge against deflation or another round of economic deterioration.

Gold contributed negatively to performance, with the physical price falling -3% over the month and the portfolio's call option position falling -37%. However, implied volatility remains high and the rationale for holding gold remains intact since longer term inflation risks have not gone away.

In FX, the short USD versus GBP June forward added 9%, whilst the short JPY versus USD warrants lost -5.4% as USDJPY retreated below 100 on profit taking. Longer term, the risk to the US dollar is to the downside and it may make sense to take profits on short USD versus GBP in order to express this view verus a wider currency basket, such as the DXY index. During the month, the Norweigan Krone (NOK) knocked the USD of its perch to become the safe haven currency du jour, backed by strong public finances and oil revenues that are poised to benefit from a turn in the oil price.

The portfolio's cash allocation remained fairly constant at c. 50% and portfolio volatility declined from c. 60% to sub 50% by the month end.

Interesting FT story on Germany's perspective on the possible economic aftermath

Germany warns on 'crisis after crisis'
By Bertrand Benoit in Berlin, 12 Apr 2009 10:57pm

The world could face high inflation and a "crisis after the crisis" when the global economy recovers, Peer Steinbrück, German finance minister, has warned.

The comments, in a weekend interview, are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments.

"I am concerned that the countermeasures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis," Mr Steinbrück told Bild, a tabloid daily.

"So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.

Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery.

German officials fear the liquidity being injected into financial markets could prove difficult to reabsorb, creating long-term inflationary pressure and, possibly, new asset price bubbles. "We do not have a short-term inflation problem," Mr Steinbrück said. "But in the medium term we must start thinking about how to pull the billions we are pumping into our economies out of the system again. This will be a special challenge for the central banks, including for the European Central Bank."

Because of its strong reliance on exports, the German economy has been one of the worst affected in Europe by the global economic downturn. It is set to shrink by 4.5-7 per cent this year and statistics published last week showed Germany had its lowest inflation in 11 years.

Peter Bofinger, one of the five top academics who advise the government on economic policy and, like Mr Steinbrück, a member of the Social Democratic party, said that Berlin's concerns about inflation were unwarranted. "Germany faces no risk of inflation for the foreseeable future. On the contrary, I see a clear danger of deflation," he told the Handelsblatt.com website.

Rising unemployment in the coming months would put wages under pressure, said Prof Bofinger, creating a potential downward spiral in wages and prices. Asked about how to fight the crisis, Mr Steinbrück conceded that there were "no intelligent alternatives" to higher public investments programmes. Unlike in the US, he said, there were no signs yet the German economy had turned the corner. "We are not through yet. Nobody can say if the worst is behind us."

China, what credit crunch?

Chinese data released over the weekend showed that banks had continued to lend for new investment projects with record new loans of $277bn in March. China's latest trade numbers revealed signs of stabilisation for both exports and imports over the past year to March. The news, together with the record surge in bank lending and money supply last month, fuelled hopes of an early economic recovery in the country and boosted Chinese equities. The Shanghai Composite gained 2.8 per cent to reach its highest level in eight months as turnover ballooned to Rmb187.3bn, the highest for nearly a year.

Tuesday, 7 April 2009

Why QE will push Gilt yields lower

The fat lady hasn't sung yet and the Old Lady of Threadneedle Street can go on buying Gilts indefinitely until it has the desired effect...

Fortune favours the patient

The rally in risk assets over the last couple of weeks amounts to nothing more than a short squeeze. Fundamentals have not changed, indeed some measures such as the recent Non Farm Payrolls and today's -13% YoY UK industrial production number continue to worsen.

However, it is important to distinguish between absolute and relative risk/reward ratios and between trading and investing. Trading, a more 'sexy' name for market timing, is either for the fortunate or the brave, whilst investing, based on sound analysis of long term risk/reward prospects, is for the patient.

The longer the world's economic problems go on unresolved, the longer the recovery will be delayed, causing the price of risk assets to grind ever lower. So, should the investor sit tight in cash and invest only at the inflection point? Of course not. Not only is it impossible to consistently time the market, but also the opportunity cost of holding cash or government bonds is low given their current yields. Thus, make steady investment into risk assets, locking in attractive risk premiums by buying from impatient market timers, disillusioned that the world has not infact recovered overnight.

Fortune favours those with the patience and tenacity required for a long term investment horizon, just ask Warren Buffett!