While the Greek debt crisis continues to garner some headlines there appears to be a growing complacency among commentators (and more worryingly the markets) that all will be right in the end and life can go on as normal.

Well sorry to upset the applecart but that view is utter balderdash as it is becoming increasingly clear that this is a game-changer and whether the ultimate denouement is postponed by fudge for a few years, or comes crashing upon us over the coming weeks, it will not be pleasant and throws a harsh light on our own current situation.

The recent EU-IMF rescue that was heralded by EU politicians is clearly nothing of the sort. At German insistence it only provides funding for Greece at market rates. Well those rates have blown up to between 7% & 8%and if Greece actually reaches the point where it can't get market funding the rates are likely to have gone higher still. Bearing in mind Greece faces deflation to get its fiscal house in order, this could lead to crippling real rates of 10% or more, on debt that is already out of control. Hardly a rescue.

However the alternative to a rescue is inevitable default as not only does Greece have to issue plenty of fresh debt it has a significant amount of existing debt rolling over before the end of May. Some optimists have been saying that at current yields the new dollar issue of between $5-$10 Bln that the Greek Government is hawking across the US will whet the appetite of Emerging Market Debt (EMD) investors. Well although some may step up to the plate (with BCA Research recently suggesting Greek debt looked attractive at those yields) it is hard to see why when you look closely.

Speaking as an actual investor in the asset class one of the key attractions of EMD is not just its high income yield it is the fact that the underlying finances of many of these economies are very strong, completely unlike Greece. To highlight the point lets look at some debt to GDP predictions for 2011 (figures from the OECD and IMF): Japan 204%, Italy 130%, Greece 130%, Ireland 93%, Portugal 97%UK 94%, US 100%, France 88% and just so they don't feel too smug, Germany 85%. Compare these figures to the following regional averages: Asia 41%, Central Europe 29% and Latin America 35% (no really, and that is with Argentina in risk of default again, showing how strong the finances of other nations are). Why would you want Greek debt?

Intervention this weekend?

With things so difficult one UBS analyst says "external intervention may be unavoidable and could happen very soon as the situation is untenable. We think an intervention over the weekend is a distinct possibility". But at what rate and what terms? In an effort to save the Eurozone Germany may bow to pressure and allow financing at 4-4.5% and stave off collapse (ignoring the legal action some Germans are preparing to stop any such move) but this will only delay the inevitable as Greece will not do an Ireland and make the necessary cuts (We would take the just announced 40% deficit cut for the first quarter with a handful of salt. This is the nation that massaged its GDP figures by including the economic impact of money-laundering and prostitution to help gain entry to the Euro). What is more Greek banks are already facing massive difficulties as their rich have withdrawn up to €10Bln since the start of the year (remember this is a country where only 6 people admit to earning €1m+ per annum) and are already receiving government support.

In the short term it is probable that a further fudge will be found but recent talk from Trichet that "default is not an issue for Greece" sounds like talk we heard before the sub-prime collapse, Bear Stearns, Lehman Brothers, AIG, RBS, HBOS and others. Talk is cheap, the fundamentals look horrid and the risks massive, although we will perhaps delve further into the specifics another time.

The stock market? It's up again.

With relentless determination time has brought us to the end of another quarter and as I write the sun is finally making an impression outside and the world feels an alright place to be and with the equity markets continuing on at a positive pace perhaps that feeling is right.

Except there is a gnawing feeling in my head (no not a hangover, it was herbal tea last night) that just will not buy into the spring like mood, so as we move forward into the second quarter let us have a very brief look at the evidence that confronts us (and news of one worried hedge fund manager).

Positives

Growth has returned, UK Q4 GDP figures have been revised up (although at some expense to earlier quarters), while the US put in useful growth in both Q3 and Q4. The Eurozone was mixed and largely flat after a positive Q3, although final revisions to are out next week.

Growth has rebounded strongly in Emerging economies, with China continuing to surprise on the upside.

Manufacturing indicators in the Western world are generally moving into positive territory and there are signs that unemployment may be flattening out.

On the back of this risk markets have been strong, with equities regaining ground to pre-crisis levels, corporate bond spreads normalising and commodity prices are generally up.

Negatives

In light of the extent of the retracement the re-bound in growth and manufacturing is hardly stellar (and weaker than previous upturns) and may be largely inventory re-build. If the consumer (and indicators are mixed here) does not come back strongly this may reverse.

Market valuations are no longer cheap and vulnerable to disappointments.

There appear to be growing macro risks, from Greek debt (the recent EU/IMF solution was yet another massive fudge, leaving even the FT’s very pro-European Wolfgang Munchau very worried) while growing protectionism from a newly emboldened Democratic party in the US looks problematic.

Reining in fiscal deficits poses a real risk of double dip recessions, with a natural knock on to asset valuations, while surprisingly strong recovery would lead to monetary tightening with similar possible consequences.

Conclusion

It all looks finely balanced and we suggest that we all maintain that as a mantra. There are reasons to take risk and reasons to keep the powder dry.

One worrying news titbit is the Jupiter’s Phillip Gibbs (who famously had no financials and high cash in his “Financials Fund”, just prior to Lehman Brothers) has moved the cash position in his hedge fund to over 50% as he fears the markets are underestimating the sovereign debt risks. He is not always right and his performance is volatile but it is a point worthy of note.

Finally we hope everyone has a good break over the next few days and again we remind ourselves of the value of the important things in life.

And finally, finally...

After every flight, Qantas pilots fill out a form, called a "gripe sheet," which tells mechanics about problems with the aircraft. 

The  mechanics correct the problems, document their repairs on the form, and 
then  pilots review the gripe sheets before the next flight... 

Never let it be  said that ground crews lack a sense of humour. Here are some actual maintenance complaints submitted by Qantas' pilots (marked with a P)   and the solutions recorded (marked with an S) by maintenance engineers.

P: Left inside main tire almost needs replacement.  
S: Almost replaced left inside main tire.

P: Test flight OK, except auto-land very rough.  
S: Auto-land not installed on this aircraft. 

P: Something loose in cockpit.  
S: Something tightened in cockpit. 

P: Dead bugs on windshield. 
S: Live bugs on back-order.   

P: Autopilot in altitude-hold mode produces a 200 feet per minute descent.
S: Cannot reproduce problem on ground. 

P: Evidence of leak on right main landing gear. 
S: Evidence removed.   

P: DME volume unbelievably loud. 
S: DME volume set to more believable level.   

P: Friction locks cause throttle levers to stick.  
S: That's what friction locks are for.   

P: IFF inoperative in OFF mode.  
S: IFF always inoperative in OFF mode.   

P: Suspected crack in windshield. 
S: Suspect you're right.   

P: Number 3 engine missing. 
S: Engine found on right wing after brief search.   

P: Aircraft handles funny. 
S: Aircraft warned to straighten up, fly right, and be serious.   

P: Target radar hums. 
S: Reprogrammed target radar with lyrics. 

P: Mouse in cockpit.  
S: Cat installed. 

P: Noise coming from under instrument panel. Sounds like a midget pounding on something with a hammer. 
S: Took hammer away from midget.

The budget has given us a perfect opportunity to re-launch the blog after some discussion and a few changes, which include a new look for our e-mail version and the ability of all visitors to our website to view the blog without having to be logged on to the site. This we hope will encourage our busier visitors to dip in when it most suits them. 

Any rumours that part of the delay in this re-launch may also have been caused by the author's receipt of a new wunder-operating system from those chaps and chapesses in Seattle should be completely disregarded!

Anyway, to the budget. Well as usual a lot of hot air and blather with most of the concrete details bypassed but in fairness there are some interesting points immediately worth highlighting.

The first point is that the chancellors plan for reducing the deficit looks reasonable and would leave our debt to GDP at 75% by the end of the next Parliament. This would leave us in a position similar to other G8 countries. Not bad. Oh..... that depends upon growth of 3-3.5% next year (reduced from a target of 3.5-4%) and onwards. Well that is very optimistic. No economists who had a clear idea of the problems we were approaching gives figures like these any credence. It will be nice if Darling is correct but it seems unlikely; however as David Cameron points out these plans to reduce the deficit fall well short of what is wanted from the OECD, IMF or CBI.

At least we did see a reduction in the estimate for the current year's deficit by a whopping £11Bln. Reducing the total figure to a tiny £167 Bln. Now I read that again that still looks b****y awful to me

In fairness Darling did commit to make savings of around £20 Bln in coming years from the civil service, although the details of how this will be done will apparently not come until after the election. That's a surprise.

At least one upside form these optimistic predictions is that we have seen no changes to VAT, Income Tax, National Insurance or Capital Gains Tax which is good news for most of us and for that we can perhaps thank the proximity of a general election. However IHT limits have been frozen (so in inflation adjusted terms reduced), while alcohol and tobacco taxes have gone up. Expected increases in fuel duty will be staggered.

One real positive step, if it ever really comes to fruition is the targeted support for SMEs which make up the foundation of our economy. The chancellor announced new measures to increase targeted lending from the state owned banks, with a figure of £94Bln being quoted, although how this will work with divisional managers in these institutions clearly scared of their own shadow will be interesting to see.

Additionally there will be a Growth Capital fund to target funding for this sector, funded by both banks and Government, while state organisations will be directed to do business with SMEs where possible and there is a commitment that bills will be paid rapidly, a key point for businesses under cash-flow pressure.

An additional help for the sector is the news that businesses will be able to depreciate £100k of new investment in one year.

There will be much more detail fleshed out as analysts dig through the small print, which as usual makes listening to the politically driven blather of limited value (perhaps apart from those who want to sell me blood pressure pills), however this budget could have done some real instant harm and at least that has been avoided, with financial markets decidedly non-plussed.

If we see anything interesting dug up after the details are sifted over the coming days we will report.

And finally....

For all of us who feel only the deepest love and affection for the way
computers have enhanced our lives, read on.

At a recent computer expo (COMDEX), Bill Gates reportedly compared the
computer industry with the auto industry and stated,  'If GM had kept up
with technology like the computer industry has, we would all be driving $25
cars that got 1,000 miles to the gallon..'

In  response to Bill's comments, General Motors issued a press  release
stating:

If  GM had developed technology like Microsoft, we would all be driving cars
with the following characteristics:

1. For no reason whatsoever, your car would crash.........twice a day.

2. Every time they repainted the lines in the road, you would have to buy a
new car.

3. Occasionally your car would die on the freeway for no reason.  You would
have to pull to the side of the road, close all of the windows, shut off the
car, restart it and reopen the windows before you could continue.  For some
reason you would simply accept this.

4. Occasionally, executing a manoeuvre such as a left turn would cause your
car to shut down and refuse to restart, in which case you would have to
reinstall the engine.

5. Macintosh would make a car that was powered by the sun, was reliable,
five times as fast and twice as easy to drive - but would run on only five
per cent of the roads.

6. The oil, water temperature, and alternator warning lights would all be
replaced by a single 'This car has performed an illegal operation' warning
light.

7. The airbag system would ask, 'Are you sure?' before deploying.

8. Occasionally, for no reason whatsoever, your car would lock you out and
refuse to let you in until you simultaneously lifted the door handle, turned
the key and grabbed hold of the radio antenna.

9. Every time a new car was introduced car buyers would have to learn how to
drive all over again because none of the controls would operate in the same
manner as the old car.

10. You'd have to press the  'Start' button to turn the engine off (ok, let's be fair that's how you do it in an Aston Martin or Range Rover!).

PS - I 'd like to add that when all else fails, you could call ' customer
service ' in some foreign country and be instructed in how to fix your car yourself!!!!

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."