Prometheus

Over the last couple of weeks we have seen news coming thick and fast, which should have been ideal for the new blog format, but such has been the import of the news flow that time has been dedicated to our key responsibility of thinking about how this may impact our client’s investments. One thing seems clear, the horizon grows darker.

Storm clouds gather

If you take nothing else from this note it is that we should see navigating financial markets as being akin to sailing the oceans in the days of sail. We can use our experience to read the winds, the waves and the sky but the horizon limits how much we can see. We went through a truly horrendous storm following Lehman Brothers collapse, but worryingly in the calm that followed many seemed so relieved they stopped looking at the signs, only being able to see hope in the odd single ray of sunshine that occasionally breaks through.

Well from our point of view the sea has started to get choppy and dark clouds are massing in several places ahead. The weather may blow past us and we may again bathe in sunshine but it seems increasingly unlikely, it is perhaps more a question of how rough things get. Anyone of a bearish disposition really should be battening down the hatches. Even those natural bulls should make sure they know where all the hatches are, just in case.

These menacing signs include:

• Monetary tightening in China
• A spike in volatility as risk markets fell
• The dollar breaking up out of its trading range (remember the carry trade we discussed a few weeks ago)
• US growth apparently came in strong but this was based mainly inventory rebuild, while other indicators are now pointing to a further dip in output and confidence
• The UK regained growth: by 0.1% (or a rounding error)
• The eurozone disappointed with the same anaemic figure, while a number of nations returned to recession and the allegedly mighty Germany surprised some losing its recent upward momentum (which we suspect is likely to remain lost)
• QE was put on hold, even though global money supply remains week and we have seen a record decline of 8.1% in bank lending to UK businesses
• Inflation has just come in above 3% for both CPI and RPI
• Withdrawal of a number of new debt and equity issues as market appetite wanes, removing lifelines for many struggling companies
• The UK running its first January budget deficit since records began (1993), undershooting market expectations by a whopping £5.3 Bln
• The US Federal Reserve has raised its discount rate even though US money supply figures are cratering (as they are across much of the globe)

We could go on and there is still plenty of fodder for future missives; however for the moment let us look at one potential game changer:

Beware Greeks bearing gilts

Let’s be honest Greek government bonds aren’t called gilts (and frankly should never have been considered gilt edged as their past pricing inferred) but you get the point. This story has garnered quite a few headlines, column inches and tube time recently but few have really grasped that we are witnessing an irrevocable interruption in the narrative of European Union.   

Greece already had a dreadful fiscal position when it was “discovered” that the previous government had fudged the books (or committed fraud on an international scale) to gain euro entry. Worse still most of Greece’s debt is relatively short term which means in addition to new issuance it is having to role over billions in existing loans (incidentally the fact that UK debt has the longest date to maturity among major economies, 14 years instead of 6 to 7 years, is why our position, although dreadful is not yet calamitous).

Now the Greek government could collect more tax. This is a country where apparently only 6 people declare an income of over €1 Mln and where many self employed doctors, accountants and lawyers declare an income under the tax threshold of €12,000. However correcting this problem will take time, which is in short supply.

The EU has talked about a bail-out, but few concrete steps have been taken, other than stripping Greece of its EU voting rights. Furthermore any support can only be short term as the ongoing expense would be ruinous and increasingly divisive. IMF support (a route favoured by the UK and US) will not be countenanced as this would be seen to undermine the euro’s credibility. If either of these routes is taken it can only be temporary and in the end Greece will still have to make swinging cuts that may lead to years of depression.

According to Otmar Issing (a German economist and former ECB Board member) writing in the FT this week “financial aid from other EU countries or institutions that amounted, directly or indirectly, to a bail-out would violate EU treaties and undermine the foundations of the euro.” In Otmar’s world Greece is forced (by the Germans, that would go down well) to do what it’s told and take the pain, not apparently worrying that without control over its currency or monetary policy this may lead to a deflationary death spiral. Without the EU being allowed to override Greek domestic policy then this is unlikely to work.

As a result one or two Europhiles are seeing this as an opportunity to push forward their European dream. In today’s FT another former ECB board member writes: those who argued….”there can be no monetary union without political union” are precisely those who should welcome political union now that it finally knocks at the door claiming its rights. No, no and thrice again NO.

What this honorable muppe….sorry, gentleman is suggesting is that when an inappropriate single currency is foisted on a populous who are not equipped to understand the consequences (past it makes going on holiday easier) and things become shaped like a pear (which always was and for the foreseeable will remain inevitable) it is used as an excuse to create a supra-national super state. This will not stand.

Sorry, rant over but really, how did people not see that something like this was bound to happen. It makes me want to weep. Anyway whether there is a short-term fudge or not, without being able to devalue the outlook is bleak for Greece and default may become inevitable and its Euro position untenable so it may simply leave before this occurs. The impact would be severe on financial markets, as a new drachma would devalue sharply, reducing the value of sovereign debt even if default was avoided. But at least if this happens Greece could rebuild and start again. Is this likely or will Greece toe the line and suffer the consequences?

Prometheus is prepared to stick his neck out here. Whether there is a short term fudge that lasts a month or three years the Euro will not look the same at the end of this decade. The problem is in the meantime the risks attached to the European and global financial systems by any kind of failure within the Eurozone are deeply worrying. However this missive has gone on long enough and we will look at some of the hard figures another day.

And finally……

The Sensitive Man

A woman meets a man in a bar. 
They talk; they connect; they end up leaving together.

They get back to his place and as he shows her around his apartment.
She notices that one wall of his bedroom is completely filled with soft, sweet, cuddly teddy bears.

There are three shelves in the bedroom, with hundreds and hundreds of cute, cuddly teddy bears carefully placed in rows, covering the entire wall!

It was obvious that he had taken quite some time to lovingly arrange them and she was immediately touched by the amount of thought he had put into organizing the display.  

There were small bears all along the bottom shelf, medium-sized bears covering the length of the middle shelf, and huge, enormous bears running all the way along the top shelf.  

She found it strange for an obviously masculine guy to have such a large collection of Teddy Bears,

She is quite impressed by his sensitive side but doesn't mention this to him.

They share a bottle of wine and continue talking and, after awhile, she finds herself thinking, 'Oh my God! Maybe, this guy could be the one!

Maybe he could be the future father of my children?'

She turns to him and kisses him lightly on the lips
 He responds warmly.

They continue to kiss, the passion builds, and he romantically lifts her in his arms and carries her into his bedroom where they rip off each other's clothes and make hot, steamy love.

After an intense, explosive night of raw passion with this sensitive guy, they are lying there together in the afterglow.
The woman rolls over, gently strokes his chest and asks coyly,

'Well, how was it?'

The guy gently smiles at her, strokes her cheek, looks deeply into her eyes, and says:

“Help yourself to any prize from the middle shelf “

Given the rise in equity markets since the nadir of the economic crisis at the end of 2008, it seems counter-intuitive that Gold has actually risen strongly since then as if anything, one might have expected it to rise steeply in 2008 and fallen since as the immediate risk to the global economic system receded in the face of concerted action from Central Banks.  Is this telling us anything and are Volcker (and Paulson's) recent comments likely to relate to current affairs, not history?

Prometheus

Out of Recession……Just         

What a let down for all the financial market writers this mornings Q4 GDP figures were, as their clearly pre-penned articles discussed the good news for the government as we finally left recession behind. Well that’s optimism for you when the rebound from the sharpest annual economic contraction on record (4.8%) and the longest since 1955, is just a measly 0.1%.  While this may get revised this still represents a real disappointment and supports our base case that it will take time for us to recover to where we were at the start of 2008, let alone move forward.

We will revisit this following the US GDP figures that are released at the end of the week. In the meantime let us look at the recent Obama announcement and why the issue is somewhat more complicated than the headlines indicate. This is a little longer than normal but we hope worth the extra two or three minutes for some of the views you are unlikely to find in the financial press and a fresh insight on the workings of a leading hedge fund.

Volcker Rules, OK?

Much has been written in the press since the new Volcker Plan was announced in an effort to reign in the excesses of Wall Street. While there is merit in such a move we should first point out that investment bankers, while very guilty, have become a scapegoat for a decade of financial illiteracy where politicians, central bankers, regulators, TV property pundits and of course the debt ridden consumer all have their share of culpability.

More to the point such is the complex nature of modern investment banking and financial markets the early sketch looks too simplistic and what we discuss below demonstrates the need for greater regulation and knowledge on the part of regulators and governments. First, as some commentators correctly point out Lehman Brothers was not a high street bank and did not take deposits so the new rules would not have prevented the global financial crisis. But is this true?

Well yes. But no

Ignoring the fact that the now shrunken investment bank world operates like a state backed, rent seeking oligopoly (we are being kind) some of the innovations of this sector spread like a disease that infected the banking system, to the point where almost every major name was at systemic risk. Indeed once you understood this (and regardless of very justifiable concerns over moral hazard) it seemed clear that no major name would be allowed to go bust due to the inevitable calamity that would follow. Indeed following the saving and takeover of Bear Stearns we wrote in April 2008:

“Armageddon is off the table.” This sounds melodramatic, but it isn’t. It is truly scary how close we have come to the possible meltdown of the Western banking system (this is an issue we will address in the near future), however the decisive intervention by the Fed to support Bear Stearns and to open funding to a wider range of financial institutions has signalled that it will do whatever is necessary to avert catastrophe.

Re-reading these words two things spring out, firstly that we didn’t actually delve into the details of why a meltdown was possible, in large part because that seemed no longer a risk in light of our second assumption; that the authorities “got it” and wouldn’t allow catastrophe to happen. Yep, have to hold our hands up there; we didn’t see Lehman’s coming.

In light of this let’s go back and address why the banking meltdown was inevitable if a major player got taken out. In simple terms the modern inter-bank market is monumental in size and largely unregulated. Perhaps the poster boy for these markets with regard to Lehman’s and crucially the concurrent collapse of AIG, is the market for Credit Default Swaps, more commonly known as the CDS market.

Now I know many will be stifling a yawn at this point but bear with us and we will try to make the boring bit as succinct as possible and then use a real life hedge fund trade to highlight the risks still involved in this market.

CDS basics

As the name implies the CDS was originally developed as insurance to protect a bond (credit) holder from a default on corporate and government bonds they held. Effectively the Swap part of the term is the swapping of risk between an investor and a specialist in financial insurance.

From small beginnings the market grew as investors could trade with others, changing their risk profile in many varied ways. With this flexibility came more and more trading and investing ideas that could be uniquely tailored to suit a specific view or strategy, most of which didn’t have anything to do with simple insurance. The hedge fund trade we highlight at the end clearly illustrates this.

By the beginning of 2008 it was estimated that the total value of outstanding CDS contracts stood at around $60 Trillion (yes, Trillion, roughly the same as global GDP). The view of the market at the time was that this posed little risk as traders would offset their positions (often wrong and basically naïve about traders) and that at least risk was broadly spread across markets, which of course it was, but on a vast scale. Now maybe it’s just us but in a $60 Trillion market if only a small percentage of deals have problems you rapidly begin to talk about a lot of money. And so it came to pass in autumn 2008…

Financial Weapons of Mass Destruction

Is what Warren Buffet called financial derivatives in 2003 and that they posed “mega-catastrophic risk”. Smart bloke that Warren Buffett. Probably worth a bob or two.

Now the CDS market is unregulated and has no central counterparty, so most of these contracts were written by a few key investment banks, including Bear Stearns and Lehman Brothers, who traded with each other (and third parties) directly. Now if one of those bank counter-parties goes bust a black hole, potentially worth hundreds of billions of dollars appears in the banking system (we won’t know the full extent of the losses for years as it will take that long to sort out Lehmans trading books). In a world full of banks struggling with the impact of US mortgage debacle, and the seizing up of the inter-bank deposit market, this was too much.

So you see it didn’t matter that Lehman’s wasn’t a high street clearer, the fact is many others in this inter-connected world were, such is the nature of systemic risk

But worse was yet to come

Just as the banks were reeling from Lehman’s an even worse problem was unravelling at insurer AIG all because of the humble CDS. As concerns about the US housing market began to surface in 2006/7 some investors in Mortgage backed CDOs (Collateralised Debt Obligations) wanted protection from possible risks and the result was the CPDO (Constant Proportion Debt Obligation, we thought you might want to know) which effectively protected the CDO capital value, income, or both and the cost was only a small drop in the yield. But how was this possible, well the humble CDS was doing something it was designed for, insuring a bond. But who would write protection on a bunch of overvalued, opaque and often geared products with exposure to the unfolding disaster of US housing that would ultimately result in over $100 bln losses.

Surely not the company who underwrote and insured much of the global banking network, not conservative, dull AIG. Unfortunately without a proper market place and regulatory oversight nobody knew. You really couldn’t make it up.

AIG was saved. It really had to be because although it wasn’t a bank many have argued that the banking system it underwrote (and we include banks with absolutely no investment banking interest) could not have survived. All hail the humble CDS.  Lets be clear the Volcker rule wouldn’t have stopped AIG.

Clever CDS trade

And just to prove that the CDS continues to be used for things other than insurance take a recent trade by a highly regarded hedge funds manager (lets call him Harry Hedge, or HH for short).

Now HH knows a company in the Far East. It is heavily indebted, in a market with excess capacity, has a higher cost base than its competitors and HH has good reason to think it is about to loose its biggest customer. He reckons they have a very good chance of going bust, say 50/50.

But he doesn’t bet against the shares in the market, that’s too messy, unpredictable, costly, fraught with regulatory oversight, and frankly unprofitable compared to what he has done. Instead he buys a CDS to provide default protection on £10m worth of the company’s bonds. Now he doesn’t own any bonds; he just wants the insurance payout if the company goes bust, which after some recovery of assets he reckons will be 95% of the sum insured. So if he gets his 50/50 bet right he gets £9.5m for a £50,000 stake. That’s a 190 times uplift for the same odds as flipping a coin.

That’s great if you are him or an investor in his hedge fund but what of the bank where a trader looking at his standard risk models, little macro or fundamental analysis and with little imagination has effectively done the equivalent of insuring a driver who has a 50/50 chance of totalling his £20k car for just £100. With those odds HH has a fair margin for error but if you have an interest in the bank you should worry about risk management.

And finally

Sorry no joke today. Writing about this tends to remove your sense of humour. The sad simple truth is that this is about much more than just splitting up the banks and the authorities need to get a grip with this underlying reality but they aren’t. We’re not sure they get it even now. Vast amounts of money have been pumped into the markets but the banks have largely kept it to themselves, while credit supply to the real economy craters and the imbalances begin to grow all over again. If they don’t get a grip soon….well lets just hope they do

The legions of the discouraged

 The first Friday of every month the latest Non-Farm payroll figures are announced at 8:30 Eastern Standard Time (so usually 13:30 for us) which informs the world about the state of US employment. A few weeks ago we highlighted an oddity about the key US jobs data set, known as the non-farm payrolls, which throws a shocking light on the latest figures.

On Friday 8^th January the markets had been expecting a figure that was more or less flat, hopefully ending the string of bad news that has seen unemployment grow from around 5% to an unprecedented (for the US at least) 10%. With this in mind is was thought that a strong deviation either way would hurt the markets, with a poor figure bursting the bubble of the V-shaped recovery crowd, while a very positive figure would spook the markets that interest rates may go up sooner than expected.

The actual figure published showed a decline of 85,000 jobs, well below expectations and raised concerns about a negative market reaction; however in the event markets seemed pretty nonplussed by the news and the Dow actually rallied sharply towards the end of trading. The explanation of this was partly the figure diminished the chance of a near term hike in interest rates, while the figures were much better than those from early 09 and  the increase in temporary jobs may herald a real turnaround. Such bullish thoughts are highlighted in the BCA chart below:

The not so hidden awful news

This is all well and good but having trawled the figures in the US Bureau of Labor Statistics (BLS) website (yes, I know, need to get out more often) we need to return to the anomaly we highlighted late last year, which is the removal of discouraged workers from the list of the unemployed. To clarify this is what the BLS has to say:

About 2.5 million persons were marginally attached to the labor force in December, an increase of 578,000 from a year earlier. (The data are not seasonally adjusted.) These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

Among the marginally attached, there were 929,000 (emphasis added) discouraged workers in December, up from 642,000 a year earlier. (The data are not seasonally adjusted.) Discouraged workers are persons not currently looking for work because they believe no jobs are available for them.

Sorry! That’s nearly a million unemployed removed from the unemployed figures in one month even though they are unemployed. ???? And these are people who want to work, not the long term indolent. If this makes sense to anyone answers on a postcard please.

How this will play out as we move forward is unclear but it seems the data is being cherry picked and what is most worrying is that those doing the most selective picking are those who were most bullish prior to our recent economic train wreck and still they don’t seem to have got the message.

We all want things to get better and get better soon but just as Gordon Brown is discovering you can’t bury your head in the sand indefinitely.

And finally….

The Frog and Golf

A man goes out golfing.
He is on the second hole when he notices a frog sitting next to the green.
He thinks nothing of it and is about to shoot when he hears, "Ribbit 9 Iron."
The man looks around and doesn't see anyone.
Again, he hears, "Ribbit 9 Iron."
He looks at the frog and decides to prove the frog wrong, puts the club away, and grabs a 9 iron and Bang! He hits it 10 inches from the hole.
He is shocked. He says to the frog, "Wow that's amazing, you must be a lucky frog?"

The frog replies, "Ribbit Lucky frog."

The man decides to take the frog with him to the next hole.
"What do you think frog?" the man asks.
"Ribbit 3 wood."
The guy takes out a 3 wood and Bang! Hole in one.
The man is befuddled and doesn't know what to say.
By the end of the day, the man golfed the best game of golf in his life and asks the frog, "OK where to next?" The frog replies, "Ribbit, Las Vegas ."

They go to  Las Vegas and the guy says, "OK frog, now what?"
The frog says, "Ribbit Roulette."
Upon approaching the roulette table the man asks, "What do you think I should bet?"
The frog replies, "Ribbit $3000, black 6."
Now, this is a slim shot to win, but after the golf game the man figures why not.
Bang!  Tons of cash comes sliding back across the table.

The man takes his winnings and buys the best room in the hotel and sits the frog down and says, "Frog, I don't know how to repay you.You've won me all this money and I am forever grateful."
The frog replies, "Ribbit Kiss Me."
He figures why not, since after all, the frog did for him, he deserves it and with a kiss and Bang! The frog turns into a gorgeous girl.

"And that is how the she ended up in my room Elin. So help me or my name is
not Tiger Woods."

After what has been another, ahem, interesting year we lead up to the Christmas break with a flurry of last minute data. As this may help set the scene for the New Year a brief overview is probably appropriate.

UK

GDP data for the third quarter (Q3) was revised up to -0.2%, having been officially measured at -0.4%. It would not have been surprising to see this figure flat or even slightly positive and in light of news this quarter it seems likely that the UK economy will have emerged from recession in Q4.

After years of increasing debt and reducing savings the UK consumers savings rate jumped up to 8.6% in Q3, indicating the consumer is sensibly trying to repair balance sheets. This is good news and hopefully points to a more stable economic environment in at least one area.

Inflation has started to tick up and as the latest Bank of England minutes (released this morning) discuss this will have much to do with fuel prices. Combined with the VAT hike on January 1^st inflation may be a big cause for concern early next year, although at the moment we anticipate these fears will prove misplaced as growth remains subdued.

Internationally

In the US the strong Q3 figures have been revised down further, starting at 3.5% the figure now stands at 2.2%, annualised. Breaking down the figures as we did before it looks like 2.3% of this growth came from areas supported by government spending and stimulus.

Chicago Fed figures indicate that some sectors of the US economy have been mired at recessionary levels over Q4 and the possibility that the worlds largest economy’s rebound may be grinding to a halt seems to be growing.

On the positive side there are indications that the US housing market may have stabilised and affordability levels are now good (particularly compared to the UK where prices still stand at a frightening 6 times average wage) while there are indications that unemployment may not be getting any worse. We do however need to see several months’ worth of data to fully buy into this latter story.

Thankfully Emerging Market growth remains robust and it appears that the Chinese stimulus package is still working well. While there continue to be fears about market distortions and bubbles as a result the Chinese government has proved remarkably adept at tweaking things and there seems to be no obvious reason why this growth will grind to a halt. In the short term we do remain wary about individual equity markets but the longer term growth potential remains intact.

Indicators

The Dollar is showing some signs of recovery, particularly against the Euro, with the DXY index (discussed last time) breaking out of its downtrend. On a macro level this makes sense because despite doubts about the speed of its recovery the US recession has been shallower than Europe and the long term growth prospects are better.

The big question is, will the strengthening dollar break the carry trade and send markets backwards? So far this has not happened and the hope is we will see an orderly unwinding of the trade if the dollar gets stronger but with stock market volumes incredibly light for the end of year holidays it is difficult to read anything into this at the moment.

Yesterday the VIX volatility index briefly dropped to its lowest point for the year, indeed its lowest point since pre-Lehman’s. This reflects a more relaxed mood in the markets, although to many commentators this is now seen as a high level of complacency. Without trying to spoil Christmas this is perhaps the most worrying indicator because with the macro outlook still so unclear and therefore corporate earnings so uncertain, we would think there should be more caution in the market.

Conclusion

Never before have we experienced a time like the last 16 months and the legacy of this period, and the boom that led us here, will linger for many years.

As a consequence of this remarkable period we have encountered so many divergent views on markets and economies from so many accomplished people, extrapolating out all different kinds of outcome but one thing has remained constant, those that most accurately predicted the fall have remained steadfastly measured in their outlook.

Morgan Stanley’s expectations of a BBB recovery among the larger nations: Bumpy, Below-par and Boring may be as good as we should expect.

One conclusion however remains clear. Now is not a time to be too clever or brave but to gather around yourself what is truly important at this time of year and count your blessings as we look towards a New Year, with optimism and hope but also a strong sense of caution.

Merry Christmas and a Happy New Year

And finally (having tried very hard to find a decent Christmas joke, and failed miserably, after such a year our politicians deserve a brief mention)………

It’s tough being a politician. Half your reputation is ruined by lies the other half is ruined by the truth.

With so much commentary having been already written about Alistair Darling’s disappointing Pre Budget Report lets look at something which may have a real impact on the global economy and markets.

In recent issues we have looked at the dichotomy between positive market behaviour and the problems in key economies. Put simply markets seem to be discounting an outcome that seems improbable.

So if the market is not reflecting the economic reality what is it doing? We are increasingly of the view that in addition to the massive liquidity that has been injected into financial markets there has been one key story behind stock market strength and that is the dollar carry trade.

This is selling (effectively borrowing in) the dollar, which is cheap as the US base rate is basically at zero, while buying higher yielding riskier assets with the proceeds. This trade has enjoyed an additional benefit in that the selling pressure forces the dollar lower while the buying drives risk assets higher. This enhances the profit on both sides of the trade. The net effect of this can be shown on the chart below which compares the DXY index (which reflects the dollars level against a basket of six currencies, dominated by the Euro) with the S&P 500 US share index over the last two years.

The top line shows the strength of the dollar and you can see a significant inverse correlation to the strength of the stock market shown below. The weaker the dollar the stronger the stock market and vice versa.

Odd isn’t it, the weaker dollar should signify worries about economic disappointment, while the strong equity markets should indicate belief in recovery. So it seems that stock markets may have been going up, not because investors truly believe the economic environment has improved, but because it is the trade that has had all the momentum. But what happens when reality reasserts itself? Well that may be happening now.

Over recent days we have seen the Dubai crisis blow up, we have seen Greek government debt downgraded, while the Irish government has passed an unprecedented austerity budget to maintain confidence among bond investors. Furthermore Moody’s is now the second credit rating agency to suggest that UK debt will be downgraded, while Japan’s stellar third quarter growth recovery of 4.8% was adjusted to just 1.3% (annualised).  In this environment the US doesn’t look so bad, the dollar is looking oversold and the chart below shows how it appears to be breaking out of its trend.

If this breakout continues (despite Ben Bernanke desperately trying to talk down US prospects to keep the dollar weak) it will rapidly begin to undermine the logic of the carry trade as currency gains will be eroded, leading traders to take profits in risk assets, raising funds to close down (repay) their dollar positions. This could lead to some rapid corrections and although stock markets have shown mixed results a number of key commodities have shown sharp reversals in recent days.

If this scenario seems a little tenuous then the final chart, comparing the dollar/Yen exchange rate against the S&P 500, my help explain the concern. Until the middle of 2007 the Yen carry trade was the big news, with Japanese interest rates already pinned to around zero, compared to 4%-6% elsewhere. Hence traders borrowed in Yen to buy risk assets, in this case US stocks. Again the borrowed currency fell so again investors benefitted from both asset price appreciation and favourable currency movement. Once the carry trade came off in the summer of 2007 and the Yen began to appreciate traders scrambled to unwind their positions and the correlation to S&P 500 is clear.

As the credit crunch began around this time there was more at work than just this one trade but it was one of a number of key imbalances that helped destabilise markets as the edifice of unsustainable excess began to collapse.

The current hope for the markets is that we have begun to see the needed rotation into higher quality stocks in recent weeks. If this heralds the return of longer term investors there is a chance markets can survive a flight of short term punters (sorry traders) but the risks remain high.

And finally…..

Software Development Cycle

Software doesn't just appear on the shelves by magic. That program shrink-wrapped inside the box along with the indecipherable manual and 12-paragraph disclaimer notice actually came to you by way of an elaborate path, through the most rigid quality control on the planet. Here, shared for the first time with the general public, are the inside details of the program development cycle.

1. Programmer produces code he believes is bug-free.
2. Product is tested. 20 bugs are found.
3. Programmer fixes 10 of the bugs and explains to the testing department that the other 10 aren't really bugs.
4. Testing department finds that five of the fixes didn't work and discovers 15 new bugs.
5. See 3.
6. See 4.
7. See 5.
8. See 6.
9. See 7.
10. See 8.
11. Due to marketing pressure and an extremely premature product announcement based on an overly optimistic programming schedule, the product is released.
12. Users find 137 new bugs.
13. Original programmer, having cashed his royalty check, is nowhere to be found.
14. Newly-assembled programming team fixes almost all of the 137 bugs, but introduces 456 new ones.
15. Original programmer sends underpaid testing department a postcard from Fiji. Entire testing department quits.
16. Company is bought in a hostile takeover by competitor using profits from their latest release, which had 783 bugs.
17. New CEO is brought in by board of directors. He hires programmer to redo program from scratch.
18. Programmer produces code he believes is bug-free.

(It should be noted that there is absolutely no correlation between the use of this joke and a recent major software release. None whatsoever)

The Bald Eagle belly flops?

The Dubai debt crisis has clearly garnering the attention of investors around the world but in reality the sums involved are small compared to those in the initial stages of the financial crisis and, in all likelihood, the surprises that still await us. More to the point is that the market reaction shows how nervous investors are at heart, with rapid economic recovery far from certain, particularly in the US.

While China is undoubtedly the star of the moment (although with serious concerns attached) the sustainability of its current rate of growth still ultimately relies upon its ability to export and the worlds biggest consumer continues to be the American public,  who make up 70% of what is still the world’s largest economy by some margin. As a result the US consumer remains the single largest contributor to world trade and is central to any global recovery. Indeed unless the US picks up strongly global growth will remain anemic at best and increasingly vulnerable to shock.

Strong Growth ?

However on the 29^th October the world received a much needed economic boost with news that the US economy had grown during the third quarter by 3.5% after declining for over a year. This has subsequently been revised down to 2.8% although of course this figure is annualised so the gain over the quarter was under 0.7%. We would humbly suggest though that those of an optimistic bent don’t spend too much time drilling down through the figures (made available in detail on the website of the Bureau of Economic Analysis – BEA – website. It’s laugh a minute).

Of the 2.8% it seems that 1.17% came from vehicles and recreational vehicles (cash for clunkers), 0.45% from residential investment (up to $8,000 tax breaks for first time buyers), 0.87% from inventory rebuilding (an expected and necessary rebound from the massive write downs in previous quarters) and finally an increase in Federal Government expenditure (by a government which is, oh so deeply indebted) of 0.65%.

That is 3.14% growth (so 112% of the total) largely on the back of unsustainable government spending, short term stimulus, promoting more consumer debt and by a rebound in inventories which was inevitable unless we were facing the mother of all depressions. There seems a fair chance that as stimulus is removed (which it must be, such is the parlous state of the governments finances) growth will fall away dramatically, if not back into outright recession.

Unemployment, Less Bad Apparently

The November US non-farm payrolls were well taken with the headline figures beating expectations and certainly far better than those seen earlier in the year. Unfortunately markets are so busy looking at the monthly numbers the key fact seemed to be missed by many and that was the total percentage of the workforce unemployed jumped to 10.2%. One of the problems with US unemployment figures is that if you stop looking for work for four weeks you are removed from the statistics. You are officially no longer unemployed. No, really.

It is thought likely that with a slight increase in optimism at the end of summer more people started looking for work and were then re-registered as unemployed. If those who are underemployed (those who want to work full time but have accepted part time hours) are also included it is estimated the true unemployment figure is over 17%

But US Retail Sales are pretty good!

Headline sales figures for October were slightly ahead of expectations, with same store sales up by 5% year on year, which followed on from good September figures, prompting some headlines to declare US consumer spending was on the up. Unfortunately sales volumes and money spent are two different things, a point made recently by the excellent Texan analyst John Mauldin (whose regular commentaries can be found at www.2000wave.com). As he points out, one way to really see how much is being spent is to look at sales tax figures as these are based upon actual receipts and many states posted significant double digit declines in tax received during October.

Overall sales volumes may be up but the amount being spent has clearly fallen. Furthermore combined with falling income tax receipts this is rapidly leading into another problem, apparently overlooked by many.

Fiscal Stimulus falters faster than anticipated

With sales tax receipts slumping and growing unemployment slashing income tax revenues some individual US states are facing huge budgetary problems. We all know that California is flirting with bankruptcy, delaying inevitable hard choices but other states face difficult decisions, with budgetary cuts of up to 20% expected in low profile Michigan for instance. Apparently some of the budgetary shortfall has been met by utilising federal aid for infrastructure projects, which in turn will dull the stimulatory impact of these measures.

Record numbers late on US loans

A headline in the FT on 20^th November, reported on how one-in-seven US mortgages are either in arrears or in foreclosure. The highest level since records began in 1972. Enough said?

Well not quiet, home sales have picked up lately (on the back of the first time buyers tax break) but prices are still falling in many states, which is likely to continue if foreclosed homes are pushed back into the market.

 US Insider selling

A slightly alarming figure we have recently encountered indicating that the ratio of corporate insider selling shares (legally and visibly) against buying stock in the market is now at 18-to-1. This hardly inspires us with confidence.

Strong third quarter results

The bulls are keen to point out how strong the Q3 reporting season in the US has been, although as we have mentioned before when forecasts have been slashed to the bone beating them shouldn’t be too difficult. Nonetheless across the US overall profits (in aggregate) surged by $123 Bln, or 13.4% which is pretty impressive. However if you drill down through the figures you find that $97 Bln of that (79%) of that came from the financial sector (which makes up about 25% of the market) which is in receipt of the massive stimulus injected into the markets and benefitting from nearly zero interest rates.

Average profits from non-financials were up 0.6%, which is pretty poor from depressed recessionary lows.

The end is not nigh

As we have stressed repeatedly; we are not all doomed, but the continued refusal of certain mainstream commentators (who did not foresee the trouble we have blundered into) and major investment banks (who had a large role in creating the hole we are in) to even examine the detail of our current position is alarming. The thought that we can simply take the massive government and central bank largesse as being normal, with no concurrent consequences, stores up likely future disappointments

How and when reality reasserts itself remains uncertain but perhaps our worst fear is that sufficient momentum will continue to generate superficial strength for sometime, all the while allowing the underlying problems to grow larger while simultaneously blowing new bubbles. Then when reality again bites there will be no ammunition left in the bag to respond.

This is not our base case but the risks grow the longer markets ignore them.

And finally……

Deep within a forest a little turtle began to climb a tree.

After hours of effort he reached the top, jumped into the air waving his front legs and crashed to the ground.

After recovering, he slowly climbed the tree again, jumped, and fell to the ground.

The turtle tried again and again while a couple of birds sitting on a branch watched his sad efforts.

Finally, the female bird turned to her mate.
"Dear," she chirped, "I think it's time to tell him he's adopted."

“The markets can remain irrational far longer than you or I can remain solvent”

John Maynard Keynes.

This was the reflection of the great economist after his initial foray into market speculation nearly left him bankrupt. As an economist after the First World War he believed that the outlook for the dollar was good, expecting it to strengthen against struggling European currencies. Initially he made good money shorting (selling) currencies like the deutschemark, while going long (buying) the dollar. As his confidence grew he amplified the bets by borrowing, or in modern parlance employing leverage, to increase his exposure. So when the dollar fell and the deutschemark enjoyed a three month rally against the fundamental trend he (correctly) he was wiped out.

So why is this lesson still so important today? Well put simply when we look at the economic fundamentals we see a very weak outlook, with massive uncertainties, yet equity markets are partying like it’s 1999 (well ’97 & ’98 to be more accurate with the FTSE around 5350). So the question we pose is; are we missing something fundamentally positive or is the collective wisdom of the markets wrong.

Well in one respect it seems easy to justify the exuberance, reflecting on the fact that we are currently at market levels first reached over a decade ago. Looking at current valuations market bulls will tell you that the recent earnings season has proved positive with many upside surprise; however when expectations have been cut to the bone it is easy to beat them. Furthermore a headline PE ratio of around 18 for the FTSE 100 is not cheap by historical standards

Alternatively you might like to believe the following fan chart on expected GDP growth, taken from the latest Bank of England quarterly inflation report.

This predicts a rapid return to robust, above trend, economic growth as early as next year and aligns with the views of the optimists, like Fidelity’s Trevor Greetham writing in the FT today. He sees the extraordinary stimulus reigniting the economy in a traditional v-shaped recovery. Having discussed these views with him recently and with all due respect to Trevor, who is both very pleasant and very bright, I think the only comparable periods historically are the 1930’s generally and Japan in the 1990’s. While the extraordinary stimulus has stopped the worst of either of these scenarios repeating themselves the chart above looks delusional. After all growth above the rate we experienced in the debt fuelled property bubble madness of the last few years. Erm…………. clearly that isn’t going to happen.

Unemployment is growing (although the pace has recently slowed – briefly we anticipate), bankruptcies are increasing and we have a broken banking system, which among other things, has not yet admitted to around £300 Bln worth of dodgy loans to UK commercial property which are being rolled over because they dare not foreclose. Oh and I didn’t mention a national debt spiraling out of control, which will either require massive government cuts, destroying jobs and risking fragile growth. Or worse if we don’t cut we risk a bond market rebellion which will force interest rates higher, increasing the woes of the debt burden, which mixed with a falling currency will force up inflation, again risking fragile growth.

To be fair the BoE is hobbled in its outlook by using market interest rate predictions (based upon the view from sell side investment banks with massive vested interests) and by the assumed impact of QE (which is in fact not filtering through to the real economy) and more importantly on the budgetary assumptions of a government living in denial about slow growth and ballooning deficits. It is probable that the BoE’s real view was more accurately represented by the very low key performance of Mervyn King at the press conference last week (yes, I watched and yes, it was dull), who repeatedly emphasised the risks to growth.

Interestingly the minutes from the bank’s monthly interest rates meeting released this morning point to a mix of views, perhaps the most surprising that the Chief Economist, Spencer Dale, opposed an extension to Quantitative Easing. This was in part due to inflation risk but more pointedly to the “risk that further substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify”.

And perhaps here we see it dawning on the BoE that markets are getting ahead of themselves, not on the back of realistic valuations but on the wall of liquidity that QE has unleashed on the financial sector. With money supply to the real economy still suppressed we are seeing a growing disconnect between markets and fundamentals. True we still see terrific value available in certain companies but fear that even these may suffer if the market undergoes another sharp correction.

Our best hope in the short term is that markets find some stability and we can see a steady rotation in sectors allowing high quality value to rally, while the geared cyclical stocks can deflate gently to more realistic (and rational) levels. Hopefully markets will be kind, although unfortunately that has not been the common experience in recent years.

And finally…..

Not a joke this time but a note to inform you that we will try to produce shorter notes more frequently. There are an increasing number of good journalists’ blogs out there which can rapidly cut to the chase but in these febrile times we see the financial news as it happens, flashed up onto our screens, and have access to some of the sharpest commentators in the financial world. So it makes sense to speed up delivery of the important ideas you might not see elsewhere from the perspective of those immersed in markets and economics.

This also helps the author who in writing these notes tries to edit down masses of ideas to a reasonably succinct, broad outlook. This can take time and sometimes the spontaneity and relevance is lost resulting in unsent issues.

This note will shortly be followed by some commentary on the US economy and why the recent data releases on GDP and jobs, which have been interpreted with some good cheer, were actually rather difficult.

That piece will include a much needed joke.

The Shipping Forecast

Markets have continued to perform well and the mood has turned increasingly bullish. At times like these it can feel odd to be holding up a hand and asking for a little calm.

Just as we tried not to be drawn into the despondency that followed the banking crisis, we now try to avoid being swept along by the euphoria, blind to the underlying problems which, almost without exception, are worse than before Lehman Brothers broke.

It was expected that there would be a bounce following the catastrophic retreats of the winter, simply because if there wasn’t then GDP would soon have fallen by Great Depression levels. However as we have stressed many times in even the worst recession most people keep their jobs and will still buy things, even if the pace is reduced dramatically, so in the Western world there is a clear inventory rebuild taking place

In China there has been massive stimulus with the government deploying some of its massive reserves in huge support package. This has then driven global commodity prices upwards, adding to the confidence in global markets further justifying the rise in other risk assets. But…

The real world intrudes

Ignoring sentiment there has been one reliable indicator of global trade (largely because it reflects real economic demand) and that is the Baltic Dry Index. This measures the price being paid for the rental of large bulk carrying ships; hence it represents real economic demand and expectations.

During the global boom this index rose rapidly, its steep trajectory matching those of the commodities being shipped, such as copper or iron ore. Post the Lehman Brothers failure the index crashed to earth; as trade credit disappeared. Once liquidity started to flow and trade picked up the index bounced back rapidly, although only into the trading range it had enjoyed earlier in the decade. What is really interesting is that over the last few months the index has plunged southwards, even while commodity and stock markets have enjoyed strong bull runs. This is clearly reflected on the chart below, which shows the index has moved sharply down through both its 20 and 200 day moving averages, not a good sign for those interested in chart (technical) analysis.

So what does this tell us? As we pointed out above this market is a reflection on shipping prices so sharp fall is not bullish for global growth. By comparison commodity markets are much more exposed to speculative flows of funds, just as stock markets are. This may indicate that the massive flows of capital being pumped into the worlds economies by central banks is finding its way into financial markets, rather than the real economy, where it is desperately needed. If this is the case it would indicate central banks may now be repeating the mistakes that created the bubbles that nearly destroyed the global economy in the first place.

While we think that this is a real risk and that many markets have got ahead of themselves if we look at shipping fundamentals it is important to recognise also that a significant number of Capesize vessels (very large bulk carriers, unable to traverse the Panama and Suez canal, hence having to travel round the Southern Cape’s) ordered at the peak of the boom will be delivered over the next couple of years, adding to shipping stock and helping drive down prices on a supply and demand basis. However new supply alone is not enough to explain the extent of the fall in the index, nor, more importantly its larger underperformance against the commodities that ships carry.

While this makes it difficult to draw a definitive conclusion it is important to maintain a balanced view on fundamentals, particularly in these confusing times, even if this means we are forced to accept that there may still be more rough weather ahead.

And finally……..

A city lawyer and a Yorkshire man are sitting next to each
other on a flight to Leeds. The lawyer is thinking that
Yorkshire men are all 'cloth cap and clogs' and that he can fool them
easily...
So the lawyer asks if the Yorkshire man would like to play a fun game. The Yorkshire man is tired and just wants to take a nap, so he politely declines and tries to catch a few winks.

The lawyer persists and says that the game is a lot of fun.
'I ask you a question, and if you don't know the answer, you pay me only £5; you ask me one, and if I don't know the answer, I will pay you £500.'
As may be expected, this catches the Yorkshire man's attention and to keep the lawyer quiet, he agrees to play the game.
The lawyer asks the first question. 'What's the distance from The Earth to the moon?'
The Yorkshire man doesn't say a word, reaches in his pocket, pulls out a five-pound note and hands it to the lawyer.
Now, it's the Yorkshire man's turn. He asks the lawyer, 'What goes up a hill with three legs, and comes down with four?'
The lawyer uses his laptop, searches all the references he knows. He uses the air-phone; he searches the Net and even the British Library. He sends e-mails to all the smart friends he knows, all to no avail. After a long search, he finally gives up.

He wakes up the Yorkshire man and hands him £500, which he pockets and goes straight back to sleep.
The lawyer is going crazy not knowing the answer. He wakes the Yorkshire man up and asks, 'Well! What goes up a hill with three legs and comes down with four?'
The Yorkshire man reaches in his pocket, hands the lawyer £5
and goes back to sleep.

Don't mess with Yorkshire men; they only talk different!

Land of confusion

In July we witnessed one of the most positive and long lived rallies in stock market history, with the FTSE 100 breaking out off its trading range between 4000 and 4500, reaching (briefly) 4700 on Monday 3rd August. Over a month this was a rise of around 13% and in increase of 33% from the lows reached in early March.

In the meantime an increasing number of commentators are hailing the emergence of positive economic news. Yet perversely the Bank of England has just announced a £50 Billion extension the Asset Purchase Scheme (otherwise known as QE, or Printing Money) accompanied by a distinctly cautious statement.

So what is going on? And while we wish the economy a speedy recovery it is wise to maintain a cautious position.

First, the optimistic notion of a few months ago that we might see a return to growth in the UK in the second quarter of 2009 was comprehensively rebuffed by the actual figures. These indicated a further fall of 0.8%, resulting in a total decline in GDP of 5.7% over five quarters. However there have been strong signals that we could see positive numbers for the third quarter with industrial production showing the largest monthly gain in over two years and the service sector also showing signs of improvement.

The Bank of England however remain cautious, balancing the good news with a realistic appreciation of the issues we confront, as can be seen from the following extracts from the latest rate decision statement:

“The world economy remains in recession, though there have been increasing signs that output in the U.K.'s main export markets is stabilising. Financial market strains have eased and banks' funding conditions have improved a little, although financial conditions remain fragile. Household and business confidence has picked up, albeit from the very low levels experienced in the wake of the financial crisis last autumn.

In the U.K., the recession appears to have been deeper than previously thought. Gross Domestic Product fell further in the second quarter of 2009. But the pace of contraction has moderated and business surveys suggest that the trough in output is close at hand.

Underlying broad money growth has picked up since the end of last year but remains weak. And though there are signs that credit conditions may have started to ease, lending to business has fallen and spreads on bank loans remain elevated.”

 And “The margin of spare capacity in the economy increased further and pay growth remained weak. The future evolution of output and inflation will be determined by the balance of two sets of forces.

On the one hand, there is a considerable stimulus still working through from the easing in monetary and fiscal policy and the past depreciation of sterling. On the other hand, the need for banks to continue repairing their balance sheets is likely to restrict the availability of credit, and past falls in asset prices and high levels of debt may weigh on spending.”

And on this crucial latter point we agree. The official figures tell us that banks aren’t increasing lending, despite protestations to the contrary. This is highlighted by the latest figures from Lloyds Group, which indicate that business lending to non-financial companies has actually fallen as have loans to private customers. Furthermore the bank is planning to shrink credit available over the coming years.

The reality is that any recovery in economic fortunes is likely to be anemic at best. Unemployment, traditionally a lagging factor, will continue to grow while the country’s collective debt burden continues to weigh on us. So by all means let us celebrate that the worst of the declines are behind us but agree that the outlook remains uncertain

And finally……

Three men married wives from different countries.

The first man married a woman from China. He told her that she was to do their dishes and house cleaning. It took a couple of days, but on the third day, he came home to see a clean house and dishes washed and put away.

The second man married a woman from Italy. He gave his wife orders that she was to do all the cleaning, dishes and the cooking. The first day he didn't see any results, but the next day he saw it was better. By the third day, he saw his house was clean, the dishes were done and there was a huge dinner on the table.

The third man married a girl from England. He ordered her to keep the house cleaned, dishes washed, lawn mowed, laundry washed, and hot meals on the table for every meal. He said the first day he didn't see anything, the second day he didn't see anything but by the third day, some of the swelling had gone down and he could see a little out of his left eye, and his arm was healed enough that he could fix himself a sandwich and load the dishwasher.