March 26, 2012
March 15, 2012
From early last October to the end of last month, the S&P 500 rose 25%; amazing for an economy that is struggling to stay out of recession. Then again, the equity markets are hooked on the liquidity drug.
When Federal Reserve Chairman Ben Bernanke, in his recent semi-annual testimony before Congress, did not hint that QE3 was just around the corner, the market sold off. When the European Central Bank broke its traditional role as lender of last resort and morphed into a gift giver to its member banks (to the tune of more than a trillion dollars), much like our Fed, the equity markets soared.
Money printing can’t go on forever, can it?
In every historical context, whenever the equity markets have a run up not based on economic fundamentals, eventually, they return to what those fundamentals dictate. And here are some of the underlying economics:
- There is no doubt that American manufacturing is undergoing a renaissance. Labor costs in Asia are on a steep rise while wages here have been stagnant for several years. Shipping costs, quality control and culture are other factors. But, manufacturing represents less than 12% of GDP. It, alone, cannot drive significant economic growth.
- Gasoline prices are up more than $.60/gallon year to date with talk of $4.50 gas by summer. That cost/gallon is already here in some markets. Every penny increase drains $1.5 billion annually from other consumer discretionary spending. That’s about $90 billion so far for 2012. And what happens to gas prices if the Middle East flares up again?
- While the first quarter is far from over, early data suggest a much softer than expected GDP. Retail sales have been soft except for automobiles (pent-up demand or just a rush to buy fuel efficient vehicles ?). Consumers (70% of GDP) have shown no real income growth for many quarters, and incomes are tumbling in Europe. Inventories appear to be on the high side given the level of demand. So additional production won’t be forthcoming.
- Despite a reinstitution of 100% depreciation for capital equipment, much of that demand was pulled into 2011, as the business community was uncertain as to whether or not the tax break was going to be reinstated in 2012. The state and local government sector is still in contraction, and, given the slowdown evident in the rest of the world, exports aren’t likely to add to GDP. Of course, the market may like the softer side of GDP, as it likely ensures another dose of the liquidity drug from the money czar, Bernanke, the king of money printing.
- Europe is sicker than the markets have priced in. The hoopla around the Greek bailout is just another can kicking. Because the Greek populace hasn’t accepted the idea that they have lived beyond their means for the past decade, austerity won’t be successful. Politicians who promise to end the austerity are likely to be elected. Eventually, Greece will need to have their own currency which can fluctuate in value vis a vis other currencies with commensurate interest rate levels.
- It is rare that all of Europe is in recession at the same time. The current market expectation is that Europe’s recession will be mild. But, don’t forget, Germany’s biggest export clients are other European countries. In fact, as a general rule, all of Europe’s economies export heavily to each other. Being in recession together is going to have a large impact on those exports. In addition, if the Euro remains at its current lofty level (above $1.30), it will be more difficult to export to non-EU countries.
- The determination by the ISDA (International Swaps and Derivatives Association) that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns (Portugal, Spain, Italy, Ireland) because it assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with Credit Default Swaps (CDS) and a Greek style default occurs, they will be paid at or near par value. If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
- This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain (debt > $1 trillion) and/or Italy (debt> $2 trillion) default. In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults. After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
- But even ignoring Greece for the short term, the ECB’s LTRO 1 and 2 appear to make Europe’s banks even more vulnerable. Unlike the Fed, which purchased questionable assets from bank balance sheets and put them on its own, the ECB has not followed suit. In fact, it stepped in and, by force majeure, inserted itself as senior to other bondholders holding the exact same Greek bonds, thus avoiding any losses in its own portfolio. That makes losses for the private sector even greater. Worse, it sours potential investors in European sovereign debt, seeing that they cannot easily quantify their risks as they can’t know how much of the same sovereign debt they own may be owned by the ECB. This partially reverses the positive impact that the triggering of the CDS default will have on the European sovereign debt market.
- Finally, the LTROs may make European banks even more insolvent than they are now, as they have been encouraged to take the cheap ECB funding and purchase European sovereigns for the interest spread (by Basle II and III rules, the debt of the European sovereigns is “riskless” and requires no capital backing on a bank’s balance sheet)! Further sovereign debt crises, e.g., Portugal, Spain, or Italy, will eat away at already scarce European bank capital. Contagion could very well result.
Looking at the GDP of Europe relative to China, if one includes all of the European Union countries and those closely related, Europe’s economy is about twice the size of China. If China’s GDP growth went from 9% to 3%, the equity markets would certainly have a huge sell off. But, it is likely that Europe’s GDP will fall from about 1.5% in 2011 to -1.5% in 2012, maybe even more than that. Do the math! This is equivalent to a Chinese hard landing. As the European recession unfolds, the equity markets are likely to wake up.
Speaking of China, a slowdown is clearly developing. They actually ran a trade deficit for the first two months of 2012 signaling a real slowdown in exports. Retail sales have been softer than expected and the real estate bubble there appears to be in the process of popping as property sales and prices are plunging. No wonder the government recently lowered its official growth forecast from 8% to 7.5%. This is not to say that China, itself, is entering a recession, but a slower growth rate there (2nd largest economy) in combination with growth issues in the US (largest economy), Japan (3rd largest), and a significant recession in Europe bodes ill for worldwide growth and will eventually play out in the equity markets.
The profit implications for multinational corporations of the severe recession in Europe, and a slowdown in China and elsewhere are significant. Analysts have continued to forecast rapid earnings growth and high profit margins even in the face of rising energy and food costs and stagnant U.S. and falling European incomes. Using such rosy profit forecasts makes the market look undervalued. However, a 15% – 20% profit decline is normal for a recessionary world. If you plug that in, the equity markets look overvalued today.
Wasn’t it somewhere around this time last year that the equity markets were also priced for perfection? Didn’t we hear that the economy had achieved “escape” velocity and that the recovery was about to accelerate? And, didn’t the market sink when the economy fizzled and needed the QE2 liquidity drug injection? In fact, the S&P 500 ended 2011 at exactly the point where it began, with a lot of volatility in between. So far, 2012 appears to be following 2011′s path.
Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.
Robert Barone (Ph.D., Economics, GeorgetownUniversity) is a Principal of Universal Value Advisors (UVA),Reno,NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at:9222 Prototype Dr.,Reno,NV 89521. Ph: (775) 284-7778.
March 13, 2012
NEW YORK (TheStreet) — The determination by the International Swaps and Derivatives Association that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns like Portugal, Spain, Italy and Ireland.
The ISDA determination assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with credit default swaps and a Greek style default occurs, they will be paid at or near par value.
If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
According to the ISDA, about $3.16 billion of Greek debt is covered by the CDS (4,323 swap contracts). On March 19, an auction will be held which will set the “recovery” value on the Greek bonds. The difference between that recovery value and par will be the payout of the CDS.
For example, if the auction results in a recovery value of 20%, then the CDS payment will be 80%, or about $2.5 billion. This is not a large amount in the context of world markets, and it would be a surprise if any viable CDS issuer will be greatly impacted, although it does appear that Austria’s KA Finanz, the “bad” bank that was created in 2008 when Kommunalkredit Austria AG was nationalized and given all of the “distressed” assets, will be stuck with CDS losses in excess of $550 billion which will require the Austrian government to step up with a significant capital injection.
The “non-eventness” of the CDS payouts is a result of the fact that there has been a long lead time for the issuers to adjust their risk portfolios to deal with the likelihood of a Greek default. Over the past year, the amount of Greek debt covered by the CDS has halved. Compare this to the Lehman default of $5.2 billion where there was almost no lead time between the emergence of the Lehman issue and its bankruptcy filing.
It was the lack of such a lead time that caught CDS issuers, like American International Group(AIG), with no time to adjust their risk portfolios, and required government intervention to prevent a domino default effect. With Greece, no such domino effect is expected although there is always the possibility (albeit low) of a surprise. We will know that soon after the March 19 auction when settlement must occur.
This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain, with a debt of about $1 trillion and/or Italy with a debt of about $2 trillion default.
In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.
After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
March 9, 2012