Charles Gave on Jackson Hole

“The natural rate is going down because we are moving into period of secular stagnation.” This reminds me of Dr Diafoirus in Moliere’s play The Hypochondriac, who declared that opium puts people to sleep because “it possesses a soporific power which induces sleep”.

Mario Draghi on Eurozone banks

You’re right, banks are important, especially important for the euro zone, which is basically a bank-based economy where the credit intermediation goes mostly through the bank lending channel. Bank equities in the aftermath of the Brexit were especially hit. And especially in the euro zone, and especially those banks with a high share of NPLs, or non-performing loans.

Equity prices, bank equity prices are also significant for policymakers, because when if they drop in the way they did one would assume this is to stay cost of capital would increase, and therefore the net return on lending would decrease, that would suggest on the banking side a more conservative lending behavior. That’s why we do care about bank equity prices for the transmission of our monetary policy…

On the solvency side, our banks are better if not much better than they were before… So what is the problem? The problem now that we have to address is the weak profitability, not a problem of solvency.

Morgan Stanley US Equity Analysts lose it

Are we on a cube-shaped planet? Should “Us do opposite of all Earthly things?” Everything seems backwards. Sell winners, buy losers, own staples in both up and down markets. Just do the opposite of what makes sense. Bizzaro World.

Martin Marietta reported last week, and they and a couple of other materials companies have blamed their poor quarters on the rain. Even Milli Vanilli’s success with this line turned out to be fake. The rain? Oh, the stock went up a lot that day. Bizarro World. The credit card companies are discounting a consumer recession. The banks are discounting an industrials recession. But, Visa said volumes were good in January, and jobs, housing, delinquencies, confidence,and other metrics appear to belie the market price action. Bizarro World. Companies with good results are being hammered. Companies with bad results have stopped going down, with freight, WMT ,and other prior losers outperforming. Bizarro World.

Our portfolio advice has been pretty horrendous lately. As my 90-year old Latin teacher used to tell the class in 1985, “son,you are in left field, without a glove, with the sun in your eyes”.

For those who follow our portfolio, we did quite well over the five years from 2011-2015. But, our portfolio just had its worst month in 61 months in January, and things have not improved in February. The market is down more than we thought it would be. Our biggest sector bet has been financials (particularly credit cards). As an investor recently said to us at a conference, “I am doing a lot of things, just nothing with confidence”. Doing the opposite of what we recommended would have been better. Bizarro World. Or at least hopefully not the real world.

What’s the bull case? The positives are this: no one is articulating a bull case for US equities with conviction. Earnings expectations are potentially low. There is some fiscal stimulus this year (vs. drag previous years).The Presidential candidates don’t appear to be multiple expanders now, but they will get more centrist and the riffraff will be removed in a few more weeks. Sentiment is low (two weeks ago an investor on a panel we moderated said “It is a multi-variable world and every variable is negative”.) The US probably looks relatively better than other parts of the world. So maybe, the bull case is just that no one can articulate a bull case.

Martin Wolf On The GFC

So the basic idea is that, stripped down, there were some very large shifts in the world economy in the late 1990s and early 2000s. At the end of which ­­ just to mention, the most important of which were the Asian financial crises and the rise of China, and the policies pursued by China ­­ the emerging world became essentially a huge capital exporter in aggregate, and pursued policies for a long time designed to reinforce those capital exports. Huge reserve accumulations, deliberate undervaluation in real terms of their currencies relative to what I think would have happened under floating rates. And they started to accumulate huge surpluses. 

There were a number of other developed countries ­­ Germany and Japan in different ways ­­ pursuing quite similar policies, to some extent accidentally as a result of ageing, or as a result of collapses in the desire for investment in their corporate sector, which also generated huge excess savings. And this is something that I develop more in my current book rather than in that earlier book: I have become more aware of the shifts in income distribution within our countries and the effects they have had. But the net effect of this was huge capital exports and a huge shift in the balance between savings and investment, shown in the real interest rate from the late 1990s onwards. 

Now, the world economy has to balance. Demand and supply must balance, demand must equal supply. The question is at what level of activity. My argument is that in the world system that we actually have ­­ this is slightly simplified ­­ the Federal Reserve acts as the global balancer. It effectively balances demand and supply, because when there is ever a huge net export of capital from the rest of the world, it almost automatically takes the form of excess demand for US liabilities ­­ or US assets if you like, or claims on the US to be most precise. Because it's the safest place. It's got the biggest capital markets, where everybody wants to put their money looking for decent, safe returns.

Krishna Guha on Scottish independence

The onset of divorce negotiations would lay bare that Scotland faces an impossible trinity: full independence, financial stability and deep economic integration with the UK. It can have any two of these but not all three.

The declared objective of the pro-independence campaign is to unwind the British political and fiscal union while retaining a common currency. But the eurozone crisis demonstrated that monetary unions without deep integration are debt intolerant: they become unstable at relatively low levels of debt and deficits, particularly absent banking union.

The FT on George Saravelos on NIRP

"Second, the effect on FX once the zero bound is crossed will likely be non-linear. On the one hand, it will be the first time a major central bank “pays” investors to short the currency. Swiss money market rates briefly turned negative in the crisis but the SNB never charged banks for deposits. Denmark also has negative rates but this is to defend a fixed exchange rate. If the euro becomes the first major funder with NIRP (negative rate policy) rather than ZIRP status, portfolio shifts are likely to be larger than usual.

"Third, negative rates will open up market pricing for QE. The ECB can’t take rates too negative, because at some point the opportunity cost of depositing at the ECB will be high enough to encourage physical cash hoarding and financial disintermediation. Once rates go negative, the next step is for the market to start pricing quantitative easing, and rightly so in our opinion – real rates in Europe remain higher than in the US.

On private equity

Most big companies naturally belong in liquid public markets. This is because investors value shares they can sell easily more highly than shares they cannot freely trade. It should not be easy for private equity firms to find big, undervalued targets. If investors think listed shares are cheap, they can buy them without paying a private equity firm to do the job for them. Alternatively, undervalued companies can be taken over by other listed companies able to extract synergies from merging their operations. Private equity firms have no synergies to offer. Small companies may not be valued correctly because there is not enough public information about their prospects. The same could be true of emerging markets. The problem here is that in markets with weak regulation and corporate governance, private equity firms may not enjoy full information either. They tend to go for bigger, not smaller, companies

The FT on why Buffett was successful

One of the reasons why the bets have worked, and why Berkshire has since stopped making them, is that it was able to agree very large derivative contracts where it received all the premium up-front, and then did not have to post collateral. Any payment only comes due when the contracts are unwound or expire.

Simply stated, Berkshire appears to have enjoyed tremendous, and perhaps unique, advantages when it came to selling the derivatives from which the float (and thus the edge’s foundation) comes. Without those advantages in place, the whole thing may not have been possible to begin with. And the true key is that those advantages may be reserved for Buffett and, maybe, just a handful of other people. Enjoying those advantages , in other words, can lead to vast competitive benefits.

Those three key factors that may not have been available to all market players are:

(1) very soft collateral requirements,

(2) utter disregard for quarterly earnings volatility, and

(3) the ability to find buyers of sizable and often heterodox contracts.

Other players may have faced much more stringent collateral requirements. Other players may care much more about cont inuous earnings turbulence. Other players may not be able to sell such contracts. Buffett is very clear about it: If he had to face “normal” collateral rules, he would not have entered into the trades.

Robert Buckland says equities are the new bonds

Buckland has a suspicion that QE is doing the exact opposite of what polcymakers intended. It’s destroying jobs, rather than creating them. Theory: QE is forcing bond investors out of fixed income into equities, where they are demanding income rather than capital growth. This, in turn, is pressing corporates into boosting dividends and share buybacks. Example: Pfizer closed its Viagra lab in the UK, sacked more than 2000 white-coat workers, announced a buyback and watched its share price spike 7 per cent.

Is the RMB overvalued?

If the Chinese continue with their efforts to open up the capital account — which increasingly suits them if these pressures are indeed boiling over — there is a growing risk that the capital flight might accelerate, triggering a major financial crisis. Not only that, those foreign investors and trading counterparties who have bought into the idea that settling in RMB is a good idea, could find themselves holding a much less valuable currency than they originally expected.

When the Chinese themselves are putting their money in anything but RMB — London, Canadian property, gold, luxury, commodities, equities — you have to wonder does it really make sense to buy into the hype about RMB settlement. 

Is it really the hot new currency that will change global settlements, or are the Chinese perchance looking for as many ways as possible to recycle RMB into currencies that will genuinely protect purchasing power?

On which note, the following comment from Euromoney is worth a read.

As they note, while speculating that the renminbi could be overvalued by as much as 30 per cent.:

The evidence that RMB is overvalued is the deflationary effect it is exerting – seen in exporters cutting prices to compete, causing a profits squeeze, which in turn impacts investment. The transition requires careful management because if export- and investment-led growth fall away before domestic consumption is sufficient to fill the void, economic growth could fall sharply. The trade surplus bottomed out at 2.1% of GDP in 2011 rebounding to 2.8% last year, according to official figures. It has continued to widen this year, hitting $20.4 billion in May – not so much because exports are surging but because hoped for growth in imports has faltered, in line with a slowdown in consumption growth.

And the most important views of all may be those by Lombard Street’s Hong-Kong based economist Freya Beamish. As Euromoney reports:

Lombard Street Research’s Hong Kong-based economist Freya Beamish believes the exchange rate is a smokescreen and that RMB could be overvalued by as much as 30%. “Because China hasn’t been willing to allow the currency to appreciate nominally, it’s happened through a back-door way of inflation and that has persisted for a number of years, driving up the RMB,” she says. “Overvaluation of the RMB is now exerting a deflationary force on the economy and that’s causing a profits squeeze, which is the main factor curtailing growth.

“The symptoms are the product price deflation that China’s facing. If you look back to mid-2011, product prices went from inflation of about 7% annually to deflation of about 2% to 3% and that situation has persisted for the six intervening quarters, which strongly suggests there is some kind of overvaluation force from the RMB.”

Beamish adds: “So you have hefty product price deflation and it also makes sense from the macro story because adjusted unit labour costs of productivity have been inflating at about 11% in dollar terms since 2005 but that’s not the case for the major trading partners that China faces. “If a currency can’t appreciate in nominal terms, it will appreciate in real terms. So either you’ll have nominal appreciation of the RMB, or you’ll have prices in China inflating at a far greater rate than in, say, the United States, which is what we’ve seen. RMB has appreciated much more in real terms than in nominal terms.”

Julian D. A. Wiseman on IR Swaps in a Euro Break Up

In 1998, new swaps were being transacted against LIBOR in any of ECU, DEM, FRF, ITL, ESP, NLG, and PTE (LIBOR is the London Inter-Bank Offered Rate, and is computed by the British Bankers’ Association). New swaps were also being transacted against FIBOR (the cost of borrowing DEM in Frankfurt, computed by the German Bankers’ Association), PIBOR (FRF in Paris), RIBOR (ITL in Rome), MIBOR (ESP in Madrid), AIBOR (NLG in Amsterdam),BIBOR (BEF in Belgium), HELIBOR (FIM in Helsinki), VIBOR (ATS in Vienna), DIBOR (IEP in Dublin), and others.

EMU brought on a simplification. There are no longer separate London ‘fixings’ of ECU, DEM, FRF, ITL, ESP, NLG, and PTE: there is one fixing of the cost of EUR money in London, and this is copied across for the other currencies. On the continent, the European Banking Federation has created a eurozone fixing called Euribor. And (for example), the German Bankers’ Association no longer fixes the cost of borrowing DEM in Frankfurt; instead it has specified that the FIBOR fixing shall be equal to the Euribor fixing.

For the most part, this has worked smoothly. (The one exception is that the French Bankers’ Association messed up the transition from FRF PIBOR to Euribor*3.)

Consider the position of two parties who have traded a BIBOR swap (the former Belgium-franc fixing), using German-law documentation. This swap is, well, whatever German law says it is. And it settles against, well, whatever the Belgium Banking Association says it does. Of course, for now and the foreseeable future, each jurisdiction’s law says that swaps are properly enforceable, and the various eurozone national banking associations say that their national IBORs have been properly succeeded by Euribor (with a modest exception for the French mess-up). But if either of these countries leave EMU, legal uncertainty would surely increase.
Conclusion

1. The old national currencies are irrecoverable. For good or for ill, Germany cannot recover the old Deutschmark — it has been too stirred up with the other national currencies.

2. A nation can leave EMU, by introducing a new currency. In doing so, it can leave euro obligations to be paid in euro, or it can cause varying degrees of trouble by doing something different.

3. Because governments have a lot of power over their legal jurisdictions, and over the legal definition of their own currency, both past and present, and over the definition of their former national ‘IBOR’, a government that wanted to cause trouble could cause a lot of it.

*3 PIBOR used to settle T+1. So if money was borrowed today for three months, the money would arrive on the business day after the trade date, and be repaid three months after receiving it. Euribor is T+2: money arrives the two business days after trading. The logical thing would have been for the French Bankers’ Association to say that a day’s PIBOR fixing is equal to the previous business day’s Euribor fixing, so that the old PIBOR fixing and the new Euribor fixing always span the same period of time. However, for ‘simplicity’, the French decided that today’s PIBOR fixing is to be today’s Euribor fixing. So, if you had traded a swap that was to fix against 3-month PIBOR on 29 September 1999, you might have thought that you were trading the cost of borrowing money from 30 September 1999 to 30 December 1999. But the rules by which PIBOR rolled into Euribor changed this to the cost of borrowing money from 01 October 1999 to 04 January 2000; changing the fixing from one that didn’t cover the turn-of-the-century weekend, to one that did. That made a big difference, and it seems that the whole sorry business is to end in court. (This problem was predicted in advance by William Porter of LEDR.)

Gavekal on China

The dynamism of China's industrialization process is such that it is easy to both exaggerate the upsides ("a billion customers") as well as the downsides ("ghost cities abound!"). As we see it, it seems the downsides are currently being exaggerated. This is not overly surprising, because China's policymakers have indeed been fighting the dragon of excessive liquidity creation since 2009, and this has been neither easy nor pretty. But while there are undoubtedly very real financial risks, with some companies and individuals facing very real stress, investors should put the situation in context. Indeed, we refer readers to Joyce's ad hoc published yesterday, The Shadow Knows-Exploring China's Hidden Financial System, which highlights that:

* The unofficial funding channels which have evaded official credit restrictions in the past year, and thus made it harder for Beijing to control inflation, have always existed. Moreover, these unofficial channels are actually a long-term positive: in the state controlled financing sector, credit is not only irrationally (cheaply) priced, but it is often allotted to favored parties (such as state-owned companies). In "shadow financing" activities, we are now witnessing market pricing of both deposits and loans-which is the exact structural direction in which China's financial system needs to move. In the long run, this is a good thing.

* No doubt, however, shadow financing activities have gotten out of hand recently, and have complicated Beijing's effort to fight inflation. We estimate that shadow financing activities made up about 16% of total outstanding credit in the past decade; however credit extended through channels other than the formal bank loans and the bond market reached about RMB17 trillion by mid-2011, or about 25% of the total. Moreover, shadow financing accounted for more than 40% of new credit creation in 2010 and 1H11.

....Our view is that China is likely to continue to tighten shadow financing, but will, in small, quiet ways, such as through open market operations, start to loosen official liquidity conditions.

John Stuart Mill

"Panics do not destroy capital. They merely reveal the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works." 

Charles Gave on market intervention

Such distortions reverberate throughout the system, affecting every asset class from commodities to real estate. They also create a domino effect of spreading interventions, wack-a-mole style. So to summarize, after ten years of "smart" interventions by astute policymakers we are now left without any proper market pricing mechanism for:

1) US interest rates and exchange rates - both manipulated by the Fed

2) Oil prices - which are manipulated on a second order by the undervalued Dollar

3) The Euro exchange rate - manipulated by the ECB and China

4) Sovereign yields in Europe - manipulated by the ECB and the PBOC

5) The Swiss France and the Yen - now both manipulated by the local central banks.

It is no wonder international liquidity is vulnerable to a squeeze and markets are nervous. Why anybody is surprised that we have been in bear markets for the better part of the last ten years is beyond me. Never in my 40 year career have I seen such a combination of incompetence and intellectual arrogance in the ruling class.

Merrill Lynch on Eurobond spreads from the FT

The argument goes that with a joint and severally guaranteed Eurobond, the low refinancing cost of Germany would be exported to the periphery, at marginal cost to Germany. The cost would be a function of Germany’s refinancing cost today, relative to the weighted average spread of Eurozone sovereigns either today, or at some arbitrary point in the past.

We find this argument fundamentally flawed: if a Eurobond just mutualises debt issuance, the default probability of a Eurobond is the default probability of the largest country that cannot be bailed out by the core. This is because Germany and other AAA countries alone cannot credibly guarantee the debt of the entire Eurozone. This is the fundamental difference between a Federation, such as the US or Germany, and a Union of sovereign member states, such as EMU.

Sir Martin Jacomb on Greece in the FT

The euro gave the peripheral countries a standard of living above their earning power and, at the same time, took away their ability to correct this by devaluation. It is the same process which led to the permanent impoverishment of southern Italy, when the lira became the national currency after Italy was united under the Risorgimento 150 years ago. At the turn of the 19th century Naples was the largest city in Italy and the region was relatively sophisticated. But its economy declined relative to the north. Although it had started to build railways in the 1830s, before any other part of Italy, the effort was soon discontinued. Moreover, railways were unable to reach the length of the country because Pope Gregory XVI forbade their construction in the Papal States. He called them “chemins d’enfer”. The economies of north and south thus became progressively divergent. Southern Italy’s economic decline continued but, with the introduction of the lira, it lost its ability to correct its uncompetitive position. Able and enterprising people moved to the north or emigrated, and the situation became permanent, as it remains today. This tragedy endures.

On the Greek fiscal crisis

Letter from David Riley of Fitch to the FT: "it is surprising and unfortunate that so much effort appears to have been invested in circumventing a particular rating outcome. By far the most important and beneficial outcome for Greece and its creditors is securing a credible solution to the current crisis. In light of the market focus on a rating outcome...Fitch is guided by the spirit as well as the letter of the criteria. If it looks like a default we will rate it as a default."

GaveKal on the weak US$

The markets have clearly started to signal that further weakness in the US$ is no longer a positive development for the macro-environment (see A Roadmap for the Coming Changes in Fed Policy). After all, with the US trade deficit being almost entirely made up by China and oil, a weaker US$ from here probably means a deteriorating trade balance for the US' non-China/non energy trade partners (a theme we will explore further in an upcoming ad-hoc). Simultaneously, a weaker US$ accentuates inflationary pressures around the world, eating into margins and forcing other central banks (e.g., Poland's surprise rate hike yesterday) to adopt tighter monetary policies...

However, the real reason most of the clients we have talked to lately seem to be so uncomfortable is the growing perception that, with QE2, the "weights and measures" of our financial system have been tinkered with and who knows what consequences this will have? Indeed, investing is all about "value"-figuring out where the value is and why "values" move over time. To measure this we use money-even if it is very hard to explain why money itself has any "value," since, in our world of fiat money the marginal cost of producing money is zero. So the investment business has two sides. The easy side is trying to understand how the values are going to move versus one another (i.e., equities vs bonds, or Japan vs China...), making in the meantime the assumption that the value of money will not. The difficult side is trying to understand whether the value of money itself is about to change.

Now money has two prices: a domestic price (interest rates), and an international price (the exchange rate). Thus, the only way for a fiat monetary system to work is if the different monies, each corresponding to different economic and political systems, can compete freely against one another. Which is why things are so tricky today: there are three major economic blocks (US, EMU, China...) which now account for more than half of global GDP. But their currencies are completely out of whack and heavily manipulated by governments and central banks. This leaves investors without a proper "weight and measure" system to establish how to invest-and the feeling that this status quo cannot last. No wonder the level of discomfort is high.

David Beckwith on why rising USTs aren't a sign that QE2 has failed

If QE2 is successful, then we would expect treasury yields to rise! A successful QE will first raise inflation expectations. This alone will put upward pressure on nominal yields. However, expectations of higher inflation are in effect expectations of higher nominal spending. And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth. The expected real economic growth should in turn increase the real yields. It is that simple.

Buiter on MCM

He may be the chief economist of Citigroup but that doesn’t mean he can’t speak his mind as his latest essay for the bank’s clients proves. In it, Buiter claims Ireland is insolvent, Portugal is quietly insolvent, Greece is de facto insolvent and Spain will be insolvent once the problems in its banking sector are recognised. At which point things get really interesting. Buiter predicts the ECB could be forced to buy Spanish government paper and fund its banking system by purchasing the debt from the European Financial Stability Facility if things get really bad.

From Buiter’s Sovereign Debt Crisis Update

Portugal and Greece:

After an Irish agreement with the EU/IMF, the market’s attention is likely to turn to Portugal’s sovereign, which at current levels of interest rates and growth rates, is less dramatically, but quietly, insolvent, in our view. We consider it likely that it will need to access the EFSF soon.

Greece is de facto insolvent, in our view, all the more so after the recent debt and deficit revisions. As long as Greece remains sufficiently compliant with the conditionality of its EU/IMF program, sovereign debt restructuring is likely to be postponed at least until mid-2013, when its EU/IMF programme expires. At that point, it likely will be transferred to the EFSF or its successor. Whether its debt will be restructured at that stage, including haircuts, will depend on factors beyond the sustainability of its debt.

Spain:

For now, the markets have put Spain in Italy’s sovereign risk class when, in our view, it should be closer to Portugal and Ireland once its banking sector problems are recognised. We argued before that the EFSF should be much larger (€2trn). Should Spain need assistance, it will stretch the resources of the EFSF, perhaps beyond its current limits. There may be some room to expand the size of the EFSF. But, in our view, once Spain needs assistance, the support of the ECB will be critical (by purchasing Spanish sovereign debt through its Securities Markets Program — SMP — and funding Spanish banks using Spanish sovereign debt or sovereign-guaranteed financial instruments as collateral or by making loans to or purchasing the debt of the EFSF, legally a limited liability company that could even be made an eligible counterparty of the Eurosystem for this purpose).

In the longer term, there may be a need for large-scale restructuring of the debt of the Spanish banking sector and possibly the sovereign. At longer horizons, high debt levels and political instability in Italy and Belgium may yet give rise to fundamentally warranted sovereign debt crises, while self-justifying crises are possible even in the near term, despite roughly balanced structural primary budgets.

And if you thought that the EU/IMF bailout marked the end of Ireland’s troubles, think again says Buiter:

Accessing external sources of funds will not mark the end of Ireland’s troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is de facto insolvent. The Irish sovereign cannot from its own resources ‘bail out’ the banks and make its own creditors whole. In addition, a fully-fledged bailout (permanent fiscal transfer) from EA partners or the ECB is most unlikely. Therefore, either the unsecured non-guaranteed creditors of the banks, and/or the creditors of the sovereign may eventually have to accept a restructuring with an NPV haircut, even if it is not a condition for accessing the EFSF or the EFSM at present.