The Semantics of Central Banking

Lately a lot of financial journalists have been speculating on whether or not the ECB will become the "lender of last resort" to European governments. Some of these journalists even have the gall to quote the central bankers' Bible - Bagehot's "Lombard Street" - as evidence of the historical precedent for such action (for example - here).

Unfortunately these journalists are just plain wrong in their interpretation of what Bagehot's text. When he said that central banks should act as lenders of last resort, he was referring to extending credit to private banks during liquidity squeezes. For the conspiracy theorists out there, I should further clarify that Bagehot advocated lending to solvent banks during liquidity squeezes, charging a punitive interest rate and demanding high-quality collateral.

Thankfully I am not the only one taking these simpletons to task. Mervyn King - the governor of the Bank of England - has also chimed in on the matter (here):

This phrase 'lender of last resort' has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That's what lender of last resort means.

Couldn't have said it better myself.

Paulson Takes it on the Chin

John Paulson is probably the most celebrated hedge fund manager in the world. For those of you who have been living under a rock for the past few years, he rose to prominence after one of his funds returned just under 600% in 2007 after taking long positions in CDOs which tracked MBS backed by sub-prime mortgages. This trade has been the inspiration for two books: Gregory Zuckerman's "The Greatest Trade Ever" and Michael Lewis' "The Big Short", and the basis for a record-setting settlement in an SEC case filed against Goldman Sachs.

Although he was not the only one to see through the mess of subprime mortgage securitization, he certainly profited the most handsomely. He followed up this bet with short positions in select financial firms in 2008 and reversed this position in time to catch the epic rally in bank stocks from the March 2009 lows.

Lately however, he has been giving his profits back. His largest fund is down 46% year to date (here), representing approximately $9 billion in losses. In response, Paulson is reportedly scaling back risk, which will make it awfully effectively impossible for him to reclaim his high water. Presumably massive redemption requests are in the mail.

Personally, I have always thought that Paulson was a considerably over-hyped. Before his subprime bet, he was an also-ran in the merger arbitrage space. Yes, he made one fantastic call but if he was a mediocre merger-arb manager, how does one call make him a savant? His bets on a vigorous economic recovery have made it quite clear that he (and his analysts) do not understand what a post credit-bubble economy looks like. The fact that he held somewhere around $1B of Sino-Forest stock speaks volumes to his due diligence practices.

Paulson's investment attributes aside though, he may be suffering from a very common problem in the hedge fund world - size begetting poor performance. FTAlphaville recently posted an article summarizing a comprehensive report of hedge fund returns (here):

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%... The dollar-weighted number is a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number.

It is a common refrain that the best returns are earned when a fund is in its infancy, but it is nice to see someone actually run the numbers to confirm it. Combine that fact with the astronomical growth in Paulson & Co's assets under management (and a manager with dubious global macro credentials), and the -50% annualized return becomes much less of a surprise.

I would not be surprised if Paulson & Co shuts up shop sometime in 2012.

Political Paralysis

Mohammed El-Erian recently provided readers with a very sobering wake-up call by comparing America's present political paralysis to that in Japan during their lost decade, and the implications of continued paralysis in Washington (here). El-Erian recalls that

there was a time when America looked down on Japan for the latter’s inability to deal with its economic problems. No more. Like Japan, America is now realizing how difficult a post bubble economy can be. The fear is that it will also find out that that it lacks some of Japan’s attributes needed to cope with long years of economic stagnation.

The attributes he is referring to are a higher level of social cohesion (and the concomitant social safety net), and Japan's net creditor status (ie the sectors of the economy are savers in aggregate). El-Erian figures that these attributes made Japan more capable of dealing with a prolonged period of stagnant economic growth and that as a result urgent action from American policy makers is necessary in order to prevent an adjustment even more painful than that experienced in Japan.

However, El-Erian did not discuss the likelihood of the urgent policy he is calling for being enacted. I consdier the probability of anything substantive being passed before the presidential elections to be effectively nil. The Republicans are convinced that they will win both houses in 2012 and are content to torpedo anything the Democrats table until then. Whether this is on purely ideological grounds (as they proclaim) or a tactic to weaken the economy in the hopes of improving their chances of winning the White House is not entirely clear, but it is of no real consequence. The Democrats for their part are refusing to let the GOP dictate the agenda, and why should they? They have a majority in the Senate and control the White House.

So then what do I expect in 2012? I think the Dems are closer to the mark in terms of economic policy (my views are very much in line with Cullen Roche at the Pragmatic Capitalist - here) than the Republicans, so a Democratic majority in both houses would be my preferred outcome, but I do not consider this particularly likely. A Republican majority in both houses would be a nightmare - too much austerity at precisely the wrong time. Thankfully I consider this quite unlikely as well, as the Tea Party simply scares too many independents (and rightfully so). My base case is for another stalemate in Washington, with split houses and a Democrat in the White House (because the Republicans won't field a candidate with mass appeal). Hopefully at that point, the Republicans will be in more of a compromising mood. I for one am not holding my breath.

Good Reads

When it comes to links, I believe in quality over quantity. Here's some of the best of what I read this week:

Reuters reports on the major commodity trading houses (here). Seems like their volume would really move markets. Given that a lot of these firms are traders as well as producers, it is possible that are classified as "commercial hedgers" in the CFTC commitment of traders data. Maybe this is why Peter L. Brandt pays so much attention to this classification?

FT Alphaville brings a unique take on deleveraging (here).

The London Stock Exchange is padding their bottom line by lending to Italian banks in need of liquidity (here). While the way the have structured the lending (as a depositor rather than a creditor, thereby placing their claims higher in the capital structure) is prudent, regulators must hate this as it is another possible channel for contagion.

The Economist considers the challenges facing Mario Draghi, the new head of the ECB (here). A little dated, but well worth the read.

Boeing delivers 32,000 pound, $15.7 million bunker-busting bombs to the U.S. Air Force (here). Given all the recent rhetoric surrounding the IAEA report on Iran's nuclear weapons program and the possibility of an Israeli air strike, the timing of this release is interesting. Granted, the first of the bombs were delivered relatively recently.

Forecast Fails

As a user of the (excellent) Bloomberg data terminals at work, I am by default a recipient of the (generally crappy) Bloomberg Markets magazine. I usually keep them on hand for when I have been thinking too hard and need to read something inane while my brain reboots.

This month’s edition had an article titled “The World’s Best Financial Stock Pickers” which detailed the sell-side analysts – complete with awkward, contrived photographs – who had the best record calling financial stocks since January 2009.

The best team was Citigroup, who “made 26 accurate calls on the 43 financial stocks they follow”. 60 percent. That was the best of 212 firms - not very impressive. Despite having a section on “How We Crunched the Numbers”, the authors were not clear on what constituted a correct call in their methodology. This is unfortunate because it does not allow us to determine whether flipping a coin is more accurate than all that analysis. That being said, this gem implies that maybe the Citi team was better than the 60% implies: “on average, the 212 firms ... got 1.3 stock recommendations correct out of every 16”. I don’t know if that’s a typo, but it sure makes me sceptical of the next bounce I see off of an analyst upgrade.


Note: As an aside, there a few members of my organization who consider Bloomberg Markets to be more insightful than much higher-quality publications such as The Economist. Such a conviction is generally an excellent indicator of the intellectual capacity of its possessor.

Long Groupon

Yup I said it. To my knowledge, I am the only person out there who has said it - the coverage of GRPN in the blogosphere is universally bearish.

Not only that, but all of the available supply of securities have been sold short at very high lease rates (here - technically in order to go short you have to locate someone who is long and pay them an annual return for the privilege of shorting their stock).

Additionally, I hate this stock. They are spending way too much to add customers, their business model is easily replicable (which means that margins will inevitably shrink), and their valuation bakes in growth rates which I consider an impossibility.

So how do I end up recommending a long position? For one, assuming that no other investors are willing to lend out their shares, there will be no more selling pressure from the shorts (as well as a non-negligible risk of a short squeeze). Two, I don't think there will be immediate clarity on the strength of the bearish arguments - it will take a couple of quarters of reporting for the market to reach a consensus. In this period, I expect significant volatility in the stock's price.

Finally, the nature of my long position is important. I purchased a very small amount (1% of capital) of July 2012 $30 calls this Monday for $1.10 apiece (mid-price is currently $1.70). The skew in pricing between puts and calls was pretty outrageous - at the time similarly out-of-the-money puts were trading for about 4.5X the price, tilting the odds in my favour. This position exposes me to asymmetric payoffs: a small loss if the stock falls (the most likely scenario) and a large profit if the stock defies gravity and rises.

In sum, my thinking here is that this stock will experience considerable volatility over the next few months (look at LinkedIn's price history for a guide). As a result, there is a considerable probability that Groupon could appreciate from here. Even if this move is only short-lived, my options will move in a similar direction. Timing the exit from this trade will be difficult, and there is a considerable probability that I end up holding the options as they expire worthless. However, due to the asymmetrical payoffs of this trade, I consider this a positive expected value situation.

Disclosure: I am long July 2012 $30 calls. I also went short AMZN via Jan 2012 $200 put options after they failed the retest of resistance at $220 yesterday - see previous post here.

EZPW Beats Earnings

In my last post, I laid out a synopsis of the bull case for EZCorp. It didn't take long for my views to be validated - EZCorp posted Q4 earnings of 72 cents last night, beating expectations by two cents. International growth was strong (especially in Mexico) and is poised to be a driver of considerable earnings growth moving forward. They also guided for $3.05 to $3.10 in earnings for 2012, mildly above analysts' expectations of $3.00.

The stock is up 2.5% today outperforming the market by 6%. So far so good on this call.

Disclosure: I remain long EZPW

Warren Would be Proud

In this environment, there are a lot of good buys on the market. EZCorp is my favorite of them. EZCorp is a pawn shop operator with operations concentrated in the United States, and aggressive growth internationally, particularly in Canada and Mexico.

In fact, they do quite a bit more than pawning, but all of their operations are focused on providing financial services to the "under-banked" lower class. Due to the paucity of competition in this sector, they enjoy enormous margins and are growing quickly - if they come in-line with guidance on 8 November (they rarely miss), EPS will have grown at a compounded rate of 30% over the last 4 years! Even if you halve this growth rate moving forward, with a P/E of 12, you get a PEG of .80 - great value.

This company is also run very prudently: conservative accounting, no debt. Their expansion and acquisitions have been financed entirely by internal cash flow. Since they are reinvesting so much cash into their business, Price/FCF is not a good valuation metric, but their CFO over the last 12 months is $337M, yielding a Price/CFO of 4.15. I know, kind of an odd metric, but the bottom line is that they are generating a ton of cash.

This stock has been killed over the last few months. It sold off hard after missing revenue expectations by one cent last quarter (they met earnings). Combine that with a broad sell off in global equity markets and an analyst downgrade, and you have a stock trading at nearly a 40% discount to where it was in July.

What are the catches? The biggest one is that the publicly-traded class B shares are non-voting. This means a substantial discount (maybe 25%?) must be applied to valuations of comparable firms. This also necessitates closer monitoring for signs of agency problems between voting and non-voting equity holders. There have also been concerns of regulators cracking down on some of EZPW's business lines. However, with the current deadlock in Washington, I do not foresee the realization of any regulatory risk events until sometime in 2013 when next administration begins implementing their agenda.

Bottom line is that this is a big-time growth stock trading close at a value stock valuation - huge upside. Applying a 15X multiple (very reasonable for a company experiencing as much growth as they are) to next year's earnings of $3 gives you a conservative price target of $45. I would not be surprised to see this stock trade at or near this level over the next 12 months, as multiples expand and earnings continue to impress. Over an even longer time horizon, as EZPW's market cap and volume increases, it will meet the investment standards of the larger institutional investors, and multiples should expand further, making this stock a great long-term play.

Disclosure: I am long EZPW

BAA II

Bad Asset Allocation: more tech.

Amazon is one of the few original dot-com companies that actually became a viable business. That being said, this stock is massively overvalued. Trading at 112X trailing earnings, this stock is priced like a small cap hyper-growth stock. The only problem is at this size, it can't grow like a hyper-growth stock, leaving it with a PEG of 7.While I do love Amazon (I buy pretty much all of my books there), this valuation cannot last. They have less than $1B earnings propping up a $100B market cap - absurd, and their forecast for Q4 earnings is -$200M to $250M.

Historically, shorts in this stock have been crused. I am still unsure when to put on my short, but am looking for a good entry point. I will let you know when I find one.

Disclosure: I am not presently short AMZN, but may initiate a position in the next 72 hours.

On Greek CDS

I am quite a strong advocate of the most recent European bailout package. However, there is one aspect of it which I cannot countenance: European policy makers' pathological obsession with avoiding triggering Greek CDS.

By keeping the 50% writedown of privately held Greek debt strictly voluntary, it appears that this absurd fixation will be satisfied - the ISDA has indicated that they will not consider this a credit event. Beyond 'punishing the evil speculators', I am struggling to figure out why this issue is a focus of the Eurocrats.

I have detailed DTCC's numbers for the net notional exposures outstanding to various European countries (here), and they have fallen further (to $3.67 billion) since that post. Compared to the size of the 'voluntary writedowns', this is peanuts, so these exposures are not the motivation. I suppose it is a possibility that there is a huge over-the-counter exposure (ie not accounted for in DTCC's figures) held by some sort of European AIG, but I cannot imagine this is the case, as who would purchase non-standardized contracts if they had the choice of their centrally cleared counterparts?

The hushed-up incident of the suppressed European Commission policy paper which indicated that CDS provided liquidity to sovereign debt markets (here) erased any credibility policy makers had, leaving me to assume that it is in fact as simple as 'punishing the evil speculators'.  That is insane. What about the (presumably stupid) speculators who took the long side of these contracts when Greece was clearly bankrupt? Shouldn't they be punished? Or, what if the long side recognized Greece's insolvency but placed a bet that any bailout package would not include a CDS trigger - for some reason I find that deeply unsettling.

More important than the motivation are the ramifications, and with some guidance from Macro Man (here) and FTAlphaville (here), I have isolated what I consider to be the three most significant implications:

1. This will spell the end of the sovereign CDS market. When a 50% haircut doesn't trigger payout, then who will trust these credit products moving forward? Macro Man has suggested long-term bond futures as a viable alternative to CDS for hedging purposes.
2. If sovereign CDS cannot be trusted as a hedge, any holders of peripheral sovereign debt who had hedged via CDS will now be second-guessing the safety of their positions and will be incented to sell their remaining peripheral sovereign debt holdings, thereby pressuring funding costs for these countries.
3. What will this mean for the capital positions of banks which have hedged positions via CDS? Basel II gave relief on capital requirements positions hedged with CDS, but if the hedges are now (arbitrarily) bunk, this becomes a serious question. 

And that is only what immediately comes to mind; there may be more (as yet invisible) implications. The bottom line is that this policy is both populist and reactionary. Those three words in a sentence make me shudder. The thought of financially-illiterate European policy makers attempting to fine-tune financial markets should be reserved for my nightmares.

All the King's Horses and all the King's Men

Appear to have put the EMU back together again.

I outlined in a previous post (here) what I thought would be necessary to put a (medium-term) end to the European sovereign debt/banking crisis. Overnight announcements out of Europe present a rough draft of what I was looking for: a considerable "voluntary" write-down of Greek debt, plans to recapitalize Europe's banks, and an expanded EFSF. The details are sketchy and need fleshing out, but all of the requisite pieces are there. While this package does nothing to address the longer-term structural issues in the EMU (see previous post here), it seems to be sufficient to give that can a good punt down the road.

Markets appear to agree with my analysis. Credit spreads dropped, and equities rallied fiercely - the Eurostoxx index was up 6%! The marginal moves in short-term European bank funding costs were somewhat unsettling (sorry no imbedded charts, but you can see the one-year EUR-USD basis swap here, couldn't find a chart of the 3-month Euribor-OIS spread), but I expect these to tighten as the mechanics of the bank recapitalizations emerge and are implemented.

Smooth sailing for now. Let's forget the pending European recession and the childish partisan politics being played on the American deficit super-commission - those are concerns for another day.

The Semantics of Feedback Loops

People who know me well know that I can be a stickler for proper English.

Recently one particularly egregious journalistic oversight has re-emerged. I can remember reading about "negative feedback loops" between the real economy and financial markets back in 2008 (examples here and here) whereby bad economic data were leading to sell-offs in financial markets, which were in turn undermining confidence, and thereby negatively impacting the real economy. Today's "negative feedback loops" are generally between sovereign debt yields and sovereign solvency (here and here).

However, this mechanism, whereby one event causes a second event which in turns reinforces the original event is actually known as a positive feedback loop (here). A system is described as a negative feedback loop when an initial shock is mitigated by its secondary effects - such as the pancreas secreting more insulin in response to elevated glucose levels in the blood.

Journalist, bloggers, and arm-chair philosophers take note.

A Few Good Articles

Some of the articles I have read lately that I deem worthy of further consideration.

NY Fed: perhaps we don't need the all-encompassing solution to Europe's soveriegn debt crisis. Lessons from the resolution of the speculative attack on the European exchange rate mechanism in the early 1990s - here.

John Kay weighs in on the state of economics. Probably the most lucid piece I have read on the topic yet. Here.

Some throwback Michael Pettis on the what the PBoC can and can't do with their reserves. Here.

Inflation vs Austerity

When facing unsustainable sovereign debt dynamics, a country which is a currency printer* may response with any of the following three approaches (ranked from most to least common): fiscal austerity, a period of heightened inflation, and default. The conventional wisdom is that default is so devastating that it should be avoided at all costs, and while this may not necessarily be reflective of reality (see Iceland, among others) I do not intend to challenge that assumption here.

I would like to debate inflation versus fiscal austerity as approaches to unsustainable sovereign debt. Once again, conventional wisdom (which weighs in overwhelmingly on the side of austerity) appears to have stifled any real discussion in this direction. I suspect that this is due to policymakers’ memories of the stagflation era, and the extraordinary efforts of Volcker et al required to get inflation under control. This has led to a “don’t let that rabbit out of the hat again” mentality, effectively removing a period of heightened inflation from  policymakers’ toolkits.

Not being old enough to remember the aforementioned era removes leaves me more suited to engage in a measured assessment of inflation as a sovereign debt policy tool. The way I see it, the fear of inflation becoming ingrained is misplaced. I am a subscriber of the balance-sheet recession theory (is there really any debate left here?) which posits that the private-sector deleveraging we are witnessing causes considerable deflationary pressures in the economy. In such an economy, if monetary authorities generate elevated inflation, inflation may be brought back into target ranges simply by scaling down or reversing the inflation-stimulating policy.

Sticking to more conventional economics, concerns over ingrained inflation are still misplaced. Inflation-indexed wages negotiated by unions have been identified as a major driver of the persistence of inflation in the 1970s. Due to the sustained downtrend in union density in developed economies, this simply would not be a factor this time around, implying much less inflation "staying power."

A final argument against persistent inflation is the credibility that policy makers have attained in 15 to 20 years of largely successful inflation targeting. If policy makers were to explicitly target a given level of inflation until government debt fell to a predetermined level (or for a pre-specified period of time), and commit to a reversion to more traditional policy thereafter, I suspect that such commitments would be viewed as credible by the private economy.

Having established the reversibility of heightened inflation in today’s context, let’s consider its effects. With the exception of inflation-linked notes, all debt is denominated in nominal currency units, which means that inflation of say 5% is a very effective method of reducing the national debt burden. Who suffers from such a policy? Two demographics: (1) creditors (ie the rich), who have the real value of their savings eroded, and (2) the poor, who feel the most acute pressure from rising price levels. The middle class also feels the squeeze of rising prices, but not to the same extent as the poor. While no solution to unsustainable government debt is pleasant, these consequences are arguably more efficient than those of austerity.

In the case of austerity, the brunt of the pain is borne by the lower and middle classes. This is because, when compared with the rich, this area of the income curve is more reliant on government programs than the rich. Naturally, the poor again are the hardest hit, as they are the most reliant on government programs. Given that they are not as reliant on government spending the rich are left relatively unscathed. Additionally, fiscal austerity tends to lead to sustained periods of below-trend growth (or more usually, widens and sustains an existing gap between trend and realized growth), which has serious ramifications across the income spectrum.

Furthermore, taking the cynical view, inflation is also arguably more efficient from a social unrest perspective. While inflation leads to a slow burn of discontent (via slow, steady increases in price levels), government austerity has much more recognizable, tangible effects, such as the cutting of wages in the public sector, or a reduction in welfare benefits. Such identifiable consequences may come to represent rallying points for social unrest.

The reasoning above leads me to conclude that elevated inflation should at least enter the policy arena, although admittedly it would have to be precluded by an integration of monetary and fiscal policy, similar to  that advocated by Cullen Roche at The Pragmatic Capitalist (here).

*Currency printers (ie the US and UK) differ from currency users (any member of the EMU) in that they determine their own monetary policy, and therefore inflation.

The High-Yield Freeze

Recently there have been a number of comparisons between financial conditions today and those of Q4 2008. A lot of these parallel that have been drawn are tenuous, but one I do think is relevant is the high-yield primary market.

High yield issuance has been going gangbusters over the last couple of years, setting records in 2009, 2010, and was recently on pace for another record in 2011. However, the latest bout of financial instability has left investors unwilling to allocate fresh money to this sector, reducing the flood of high-yield issuance to a tiny trickle over the last 10 weeks.

Assuming the pace that was observed from January through the end July of this year were sustained, there is approximately $65B in 'missing' issuance. Making the further assumption that high-yield corporations have a marginal propensity to spend which approaches 1, this 'missing' issuance represents as much as .5% of annual GDP. With government expenditure set to contract in 2012, any marginal reduction in private investment is not a welcome sign for the economic recovery. Let's hope this market thaws sooner rather than later.

A Europlan that Works

Winston Churchill once remarked that "American can always be counted on to do the right thing... after they have exhausted all other possibilities." While the veracity of this statement is certainly up for debate, it seems  to apply to European policymakers in today's context.

Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.

The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:

1. A forced Greek default, with a haircut of 40-50%.
2. A commitment that no other countries will be allowed to default (this will require either a larger EFSF or more bond purchases by the ECB to be credible).
3. Bank recapitalizations. There is to be a new round of stress tests including a much harsher set of assumptions surrounding sovereign debt valuations. Where the estimated 200 billion euros necessary to get all European banks to the targeted 9% tier 1 capital under the stressed scenario will come from is to be determined, but it seems that there are enough good credits in Europe to raise the money.

The current expectation is for the final details to be ironed out by the end of the meeting of the G20 on November 3-4. Should the plan emerge as a credible version of the points above, I would consider it sufficient to contain the European sovereign (banking) crisis for a considerable period of time.

It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).

Chalk One Up for the Good Guys

Raj Rajaratnam (of Galleon Group fame) got what he had coming today.

11 years in federal prison - the longest sentence for insider trading in history. Plus a $10 million fine to boot; pile that on top of his lawyer fees.

He deserves it. He operated a huge network of executives and analysts who routintely exploited insider information for profit. Not that I consider insider trading particularly out of the ordinary, but I like to believe that most shops haven't made it as large a part of their day-to-day business practice as Galleon did.

This is important. The investigation that led to this trial was the first time that wiretaps were used in an insider trading case. Talk about a game changer. The possibility Big Brother listening in on your phone calls will make networks such as Raj's considerably harder to operate moving forward. And that's the really determined people. There will be a lot of others who will simply stop trading on tips for fear of prosecution. This will lead to fairer markets going forward.

Kudos to the investigators and the prosecutors.

Why the Euro Doesn't Work

Currently there are two existential problems in the euro area. The first is a relatively recent development and must be dealt with immediately, while the second has been building for about a decade and requires longer-term solutions:

1. The positive feedback loop between insolvency in the European periphery and stresses in the European banking sector.
2. The long-term structural divide between unit labour costs in the north and the south of Europe.

Let’s start at the beginning – ironically the second problem above. Before anyone gets pedantic, I realize that what follows quite a stylized story (ie short on details) but I am simplifying for the sake of clarity.

Before the nations now known rather pejoratively as the European periphery joined the euro area, their workers were kept competitive with those industrious Germans through a regime of flexible exchange rates. For example, if the Portuguese were not innovating as quickly as the Germans, the Portuguese escudo would depreciate against the German mark, making Portuguese products relatively cheaper (all else equal) and thereby allowing the Portuguese to compete with the Germans in international trade.

When the euro was introduced, this mechanism disappeared and the European periphery rapidly lost competitiveness with the core.

Seems like a raw deal right? Well not entirely. The upside for these chronically uncompetitive countries was that, despite all of structural differences between the economies, the bond markets began treating debt issued by any European government as essentially the same credit (assuming an implicit mutual guarantee). This allowed these countries to fill the gap created by the erosion of their domestic private sector with government spending financed by cheap debt issuance.

This was all good until it wasn't. Once people woke up to state of the sovereign finances in these countries (initially just Greece), they rushed for the exits. With European policymakers refusing to take bold action to resolve the crisis, it spread and evolved to the point where we stand now - uncomfortably close to the abyss.

The next post will describe in more detail why policy fixes introduced have been insufficient, and detail the policy prescription necessary for Europe to extricate themselves from the mess they have found themselves in.

Note: I have not included Ireland in this discussion because I consider both its path to fiscal ruin and the steps to recovery be considerably different from the nations detailed above.

Bad Asset Allocation (BAA) I

I have been critical of the valuations attached to the .com 2.0 firms since Groupon turned down $6 billion from Google. I said it then, and I’ll say it again Groupon/Google will prove to be the next Yahoo/Microsoft.

 Let’s have a look at the biggest name to IPO before markets crashed in August.

This clearly isn’t pets.com (there are real earnings there) but I can’t countenance that P/E. They’re priced for better than perfection.

I’ve heard all of the bull cases:

• They’re going to grow exponentially forever! 
• Investors are willing to pay a premium for high-growth companies in low-growth environments!
• They are revolutionizing the head-hunting industry!
• Think of all the advertising dollars they can rake in!

Sorry, not interested. Not at that valuation. If you’re willing to consider though, I have a bridge to sell you.

The Future of the Renminbi

If there has been one sure bet in financial markets over the last few years, it has been on an appreciation of the Chinese renminbi against the U.S. dollar.

The appreciation has been slow but steady. After a few years of managed appreciation, the renminbi was repegged during the 2008 crisis. In response to considerable pressure from the United States, the peg was removed  and the currency was re-'floated' in June 2010. However, the Chinese authorities continue to set the daily closing value and the renminbi has appreciated less than 7% against the U.S. dollar since then. Reputable estimates of the size of the undervaluation are as high as 70% (here), but my read of the 'main-stream' estimate has been about 20-30%.

 

This intervention has caused considerable furor in the United States. It seems like every six months (or is it a year?) there is a bout of political grandstanding surrounding whether the Treasury will be forced by the Senate to include China on their list of currency manipulators, which would pave the way for the U.S. government to impose trade sanctions. Of course, due to the symbiotic nature of the trade relationship between China and the United States, this never ends up happening, but the posturing appears to have started again (here).

The market however, sees things quite differently. The renminbi forwards market is currently pricing a depreciation of the currency against the U.S. dollar over the coming months.

In other words...

The best explanation I can come up with is that the market consensus is waking up to the Jim Chanos version of the Chinese growth story - economic expansion fueled by unsustainable credit growth which is financing enormous investment in overcapacity (here, starting at the 7 minute mark). While the renminbi forwards have moved in a manner consistent with the recent sell-off in Chinese equities and commodities, I was still quite surprised to see this pricing in the forward markets. Any divergence between these asset classes should be closely monitored moving forward.

Rececssion Ahoy!

On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.

Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.

Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).

Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates,  the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.

Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.

I do not have any strong feelings on net exports and feel that it is probably a wash.

Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.

I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.

European Blow-Up Risk - Hedge Edition

If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?

Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink

Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?

QE3 Q&A

Seeing as tomorrow is the Fed's big day, I figured I'd briefly give my thoughts on QE3.

What will happen?
The market is expecting 'Operation Twist', whereby the Fed reinvests the maturing portion of their portfolio of short-term Treasuries (and MBS) into the long end of the curve, thereby lowering long term interest rates without altering the size of the Fed's balance sheet. Given their commitment to low-for-long the last time around (which guarantees that the short-end will remain flat), Operation Twist strikes me as the most reasonable policy expectation for this FOMC.

Will it happen?
I see this as about 50/50. While the Fed is looking to do more to stimulate the economy, the 5x5 year inflation expectations (the Fed's favorite measure of inflation) are much higher than they were at the initiation of QE1 and QE2. This gives them less cover when the politicians inevitably start harping on about currency debasement and the inflation that will follow (I personally do not see this as a likely consequence). It is important to remember the backlash from both sides of the aisle in response to QE2, which at the margin will make Bernanke more reluctant to act. On the other hand, unemployment - the other half of the Fed's dual mandate - remains unacceptably high.

Will it be effective?
With 10-year U.S. Treasuries trading at their lowest yields in 60 years, it is hard to imagine that Operation Twist, if implemented, will have a meaningful impact on the long end of the curve (25 or 50 bps at most). I am of the mind that the problem the United States is facing is a shortage of demand for credit, rather than supply (as Fed policy assumes). Therefore, I do not expect Operation Twist to have a measurable impact on the economy.

What will be the impact on asset markets?
This is a tougher question to answer, but it strikes me that Operation Twist is largely priced into asset markets. I suspect that commodity bulls will try to sell the QE1 and QE2 redux story - ie higher commodity prices, but since there is no net liquidity going into the system, I think the market will see through this. Selling the news is also a possibility here (but carries a considerably lower probability than the 'little marginal impact' outcome). Finally, given market pricing, should the Fed not implement Operation Twist, I foresee a significant sell-off in risk markets and the inevitable concomitant flight to quality. However, this flight to quality will be balanced by the sell-off in the long end, as people have bought in anticipation of Operation Twist. Therefore, I would expect the yield curve to steepen significantly.

RIMM: BP 2010 Redux?

Totally different industries, headquarters an ocean apart, and stocks plagued by completely opposed idiosyncratic factors.  So what, pray you, do these stocks have in common?

I don't blame you for asking yourself this question after reading the title of this entry, but bear with me - it may well be worth your while. As I am sure you all remember, BP's Macondo well blew out in late April 2010 and leaked uncontrolled throughout the summer, in what turned out to be the largest oil spill in history. To no one's surprise, BP's stock was pummelled as a result. However, its price performance over the course of the disaster was somewhat surprising in that it levitated in early Q3, even as the disaster dragged on without a solution in sight - see chart.

So what happened here? I recall quite clearly that there was no news justifying a 30% appreciation during the month of July. Therefore, it appears to me that institutional investors dumped this stock ahead of quarter-end, anticipating having to present fund holding to investors and not wanting to have to defend holding this environment-trampling dog of a firm. As we transitioned into Q3, the sellers were exhausted and investors who had done their homework and did not face the same transparency requirements (read: hedge funds) stepped in and began snapping up this stock, which proceeded to return 30% over the next month.

Now let's have a look at RIMM's chart: 

So now it's my turn to pose a question: Who's will be left to sell heading into Q3? With a forward CFO yield of nearly 25% (based on the firm's reduced guidance), it appears that there is upside potential here (admittedly not as large as in the case of BP).  Therefore, a long position with a tight stop strikes me as a trade with an attractive risk-reward ratio.

Clearly there are very important differences between BP in 2010 and RIMM today. The former was a company with a strong core business which had a massive NPV-negative event, while the latter's massive NPV-negative event was weakness forecast in its core business.  I am not here to claim that RIMM is a strong long-term investment - that depends on whether Mr. Balsillie & Co. manage to right the ship. However, I do think that there is a good short term trading opportunity here for a10-20% upside.

Disclosure: I went long RIMM today.

Working Assumptions and Predictions

Well at long last, it is time to get this blog started up again.  Third time the charm?

I suppose the best (and easiest) way to go about this is to articulate the assumptions which impact my worldview and expectations of how the global economy will evolve moving forward:

1) Greece and Ireland are insolvent. The only way out of their current situation will be debt restructuring. The current policy is quite clearly to roll maturing privately-held debt onto the books of the solvent core EU members, in anticipation of a restructuring at a later date. It is unfortunate that the precarious state of the European banking sector does not allow policy makers to force a restructuring of privately held debt (and let the cards fall where they may) but that is the status quo, and the current policy strikes me as the least-bad of policy makers' options. Domestic politics in both the core and periphery nations are the biggest threat to the current policy prescription, but I am guardedly optimistic that it will be sustained until a restructuring is a containable event. I think it is incredibly unfair that German taxpayers will have to shoulder a considerable amount of this burden, but it is a necessary evil.

Once the EU emerges from the slow burn of the peripheral debt crisis (if it does at all), there will have to be a dramatic move towards fiscal union in order for the common currency to be tenable. However, I fear that the electorate in member countries will be unwilling to accept this and therefore am not confident in the long-term sustainability of the Euro as a currency. That being said, I do understand the significant benefits of regional integration and expect regional currencies to be a more common phenomenon moving forward (say on a 50-year time frame)

2) The emergence of the Tea Party in the United States has made a responsible discussion of the U.S. budget deficit a near-impossibility before the next presidential election. Any Republican presidential hopeful must pander to the hard right's overzealous anything-but-tax-to-fix-the-deficit dogmatism and cannot be seen as cooperating with Obama on anything if they are to succeed in the Republican primaries. Diddo for any Republican who will be seeking re-election in the near term. Fortunately, I don't see this as cataclysmic for the Treasury market.  Perhaps some risk premium will be priced in (and rightly so), but I do not foresee a Greece-like spike in yields anytime soon (sorry Gross et al).

3) I don't believe the hype about China. Yes they have grown 10% annually for 30 odd years. No, it cannot be sustained for the next 30. Anyone who tells you otherwise is either a fool, or has an ulterior motive for doing so.  Over the last 3 years, there has been an unprecedented surge in lending without enough/any analysis of borrowers' credit worthiness. The result has been massive investment in what will turn out to be overcapacity and totally unproductive infrastructure. We are already witnessing the first ramifications of this in the form of spiking non-performing loan ratios, and it is going to get much worse before it gets better.
That being said, I am a long-term China bull - a chart of fixed capital per capita in China vs the West is all I need - but there are going to be some pretty nasty surprises in the short term, which will shift long-term output projections downward.  Trend growth will also prove to be closer to 7% than 10%.


4) There has been an accelerating shift over the last 150 years from a world where capital was very scarce and real interest rates were high, to a world where capital is abundant and real interest rates on high quality investments are much lower.  This is the necessary by-product of enormous gains in economic efficiency, which has lead to higher aggregate savings as an ever-expanding proportion of the population produces more than they consume and are thereby able to save for the future. While the implications of this shift are surely enormous, they are also not immediately apparent to me. If financial markets manage to allocate this capital more efficiently, it should allow for more entrepreneurial ventures and positively impact total factor productivity. Holding inflation constant, this will allow for more leverage across the economy, from the consumer through to the government, as the cost of debt service declines. This final dynamic strikes me as one of the most under appreciated dynamics at play in the global economy and warrants significant analysis by both private and public decision makers.

5) Finally, over the long term, as there is a transition to a more multi-polar world, I expect a re-emergence of realpolitik and a shift to the right across the Western world as a number of liberal ideals which (while both admirable and generally desirable) will lose priority in a more adversarial global community.