“I am a contrarian in the sense of being willing to take on perceived risk as opposed to actual risk, because the market pays you for taking perceived risk. You may or may not get paid for taking actual risk.”
- Wilbur Ross
Wilbur Ross’s quote above gets to the heart of the question facing markets today. Is the risk in the market actual or only perceived? Well, consider some of the following data points.
Bank of America 5-year credit default swaps traded at 402 bps on Thursday of last week, a new all-time high (then dropped slightly to 382 bps yesterday). Morgan Stanley’s credit default swaps closed Friday at 440 bps. 21 of the 40 largest European banks now have their swaps trading over 300 bps, 13 of which are trading over 400 bps and 10 of which are trading over 700 bps. A default swap at 300 bps implies approximately a 20% probability of default, 400 bps equates to a default probability around 25%, and 700 bps of annual premium works out to around a 40% default probability.
At the end of the second quarter 2011, Bank of America had $74.8 trillion of gross notional derivatives outstanding, second largest among US banks (JPMorgan leads the pack). Of that $74.8 trillion, $4.1 trillion represents OTC credit derivatives. Morgan Stanley has $56.4 trillion in notional derivatives outstanding, $5.7 trillion of which are OTC credit derivatives. Of course, the vast majority of these notional derivatives are offset positions that should be effectively hedged (assuming no single large counterparty defaults).
So what does all this mean? Notional derivatives show the size of a bank's counterparty risk, and cds shows the likelihood a bank will default (according to the market). Together, they give us an idea of the problem we have on our hands. The market is currently saying that BAC – a bank with $76 trillion of gross derivatives exposure – has roughly a 25% chance of default. Today, the majority of the systemic risk to the system is coming out of Europe and is likely to be addressed head-on on Thursday at the German Bundestag vote. The market rallied yesterday amid speculation that the EFSF can lever the 440 billion Euro fund up to 2 trillion Euros. However, the German courts may not allow the facility to use leverage without first getting additional approvals from the Bundestag. Stay tuned.
Looking beyond the systemic risk posed by Europe and large bank counterparty exposure, fundamentally, the problems of the US Financials have been on three fronts thus far this year:
- First, there’s been the ongoing issue of mortgage putbacks and great uncertainty on the part of investors around what the true liabilities are for companies with large mortgage exposures like Bank of America. This explains why tangible book value offers no support to the stock. BAC is currently trading at approximately 50% of tangible book value.
- Second, systemically important financial institutions (SIFIs) were hit this summer with an aggressively punitive capital surcharge under Basel 3 of 2.5%. This is in addition to existing Tier 1 common requirements of 7.0%. The largest US banks (JPM, BAC, C, WFC) will all be hit by this. This is one of the factors calling into question whether Bank of America needs to raise common equity. For reference, BAC has approximately $115 billion in tier 1 common capital under Basel 3 but needs $171 billion to be fully compliant (a shortfall of roughly $56 billion), though, importantly, they are not required to reach this level of capital until January 1, 2019, which is obviously a long time from now.
- Third, falling revenues and deteriorating fundamentals are putting the squeeze on the banks’ ability to navigate through these challenges. The newest problem facing the sector is that of declining margins (revenue) hitting simultaneously with rising credit and operating costs. Take Bank of America as an example. In 2Q, the company reported roughly $2 billion in non-cash pre-tax earnings from releasing credit card loan loss reserves through the income statement. For several quarters now, these non-cash pre-tax earnings have been used to offset cash expenses associated with higher mortgage servicing related costs and mortgage putback expenses. The catch is that those credit card reserve release non-cash earnings are about to come to an end for all six of the largest US card issuers (BAC, JPM, C, COF, DFS & AXP). This will occur at the same time that the Fed’s Operation Twist will really start putting the squeeze on bank net interest margins. Earth to the Fed: flattening the long end when banks have no more room to take down funding costs is not going to help bank margins.
None of these issues are going away – or are they? On Friday there was an interesting story out of Bloomberg talking about the upcoming Basel meeting this week (Tuesday & Wednesday). The Basel Committee on Banking Supervision – the same folks who gave us the 250 bps SIFI surcharge this summer – is now considering the need for changes to those surcharges. Not surprisingly, large lenders in the crosshairs of these new rules feel they’re unfair and would like to see them changed. This is a matter of politics, and we have no real edge on the outcome, but we would point out that a substantial chunk of the 34% downside in the XLF since February 21 of this year can be traced back to SIFI surcharge pronouncements this summer. While it’s hard to precisely deconvolve how much of the selloff is attributable to each of the three factors we itemized earlier, an announcement of capital relief by Basel would trigger a material rally in the Financials. Keep your antennae tuned to this potentially important development.
Finally, on a completely unrelated note, take a look at NYSE margin debt. Margin debt hit its post-2007 peak in April of this year at $320.7 billion. Let’s put things in context. The chart below shows the S&P 500 overlaid against NYSE margin debt going back to 1997. In this chart both the S&P 500 and margin debt have been inflation adjusted (back to 1990 dollar levels), and we’re showing margin debt levels in standard deviations relative to the mean covering the period 1. While this may sound complicated, the message is really quite simple. There are two important takeaways. First, when margin debt gets to 1.5 standard deviations or greater, as it did this past April, that has historically been a signal of extreme risk in the equity market - the last two times it did this the equity market lost half its value in the ensuing period). We flagged this for the first time back in May of this year.
The second point is that margin debt trends tend to exhibit high degrees of autocorrelation. For those unfamiliar, autocorrelation is simply a statistical term that means that trends tend to continue. In other words, the last few month’s change in margin debt is the best predictor of the change we’ll see in the next few months. This is important because it means that margin debt, which has retraced back to +0.64 standard deviations as of August, still has a long way to go. We would need to see it approach -0.5 to -1.0 standard deviations before the trend reversed. We’ve dropped 230 S&P handles in getting from +1.5 standard deviations to +0.64 standard deviations. Bear in mind there’s plenty of room for short/intermediate term reversals within this broader secular move. That said, this setup represents a material headwind for the market.
Josh Steiner, CFA
THE HEDGEYE DAILY OUTLOOK
TODAY’S S&P 500 SET-UP - September 27, 2011
Another short squeeze into month-end; fancy that. As we look at today’s set up for the S&P 500, the range is 56 points or -3.78% downside to 1119 and 1.04% upside to 1175.
SECTOR AND GLOBAL PERFORMANCE
Some central planners would hope that a day like yesterday would solve all of the world’s problems. Hope, unfortunately, is not a risk management process. The Top 3 Sectors in the US equity market today were the 3 that still look the worse from their closing prices (Financials, Basic Materials, and Energy).
In the end, Strong Dollar = Strong America, because it Deflates The Inflation. And you are starting to see that in the daily divergences with Consumer Discretionary and Technology looking 2nd and 3rd best, respectively, next to Utilities (the only Sector that’s bullish TRADE and TREND).
The other 6 of 9 Sectors remain bearish on both TRADE and TREND durations. We shorted Consumer Staples (XLP) yesterday as it broke last week and the international companies in the ETF are going to face FX headwinds in the coming quarters if we continue to be right on the Strong Dollar position (USD).
- ADVANCE/DECLINE LINE: 1401 (+601)
- VOLUME: NYSE 1157.38 (-5.89%)
- VIX: 39.02 -5.41% YTD PERFORMANCE: +119.83%
- SPX PUT/CALL RATIO: 1.86 from 1.31 (+41.91%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 35.77
- 3-MONTH T-BILL YIELD: 0.02% +0.01%
- 10-Year: 1.91 from 1.84
- YIELD CURVE: 1.66 from 1.61
MACRO DATA POINTS (Bloomberg Estimates):
- 7:45 a.m./8:55 a.m.: Weekly retail sales from ICSC/Redbook
- 9 a.m.: S&P Case-Shiller, July, est. M/m 0.1%, prior -0.06%
- 10 a.m.: Consumer Confidence, Sept., est. 46.0, prior 44.5
- 10 a.m.: Richmond Fed Manufact. Index, Sept., est. -11, prior -10
- 11:30 a.m.: U.S. to sell 4-week bills
- 12:30 p.m.: Fed’s Lockhart speaks on economy in Jacksonville, Fla.
- 1 p.m.: U.S. to sell $35b 2-yr notes
- 1:20 p.m.: Fed’s Fisher speaks in Dallas, Texas
- 4:30 p.m.: API inventories
WHAT TO WATCH:
- Treasury Secretary Geithner predicts European governments will step up response to debt crisis after chiding from counterparts around the world, in comments on ABC last night
- Goldman Sachs said to consider deepening cost-cutting, may lead to additional job losses: NYT
- Google+ U.S. visits up 13-fold last week after site opened to the general public: Experian Hitwise
- Oracle may make more deals to buy industry-specific software makers, CEO says
- Liberty Media wants to buy Spain’s Telecable, Expansion reported; other bidders said to include CVC Capital, Ono, Carlyle Group
- Blackstone tops list of most active private-equity firms, with deals valued at $20.3b, according to data compiled by Bloomberg, followed by Avista Capital at $14.2b
- Oneok Partners (OKS) sees net income $740m-$800m in 2012, up from forecast 2011 earnings of $630m-$660m
- Priceline.com (PCLN) appointed former Microsoft executive Darren Huston as CEO of its Booking.com unit
- Watson Pharmaceuticals (WPI) introduced generic version of Warner Chilcott’s (WCRX) Femcon female contraception tablets
It felt like an investor in Gold yesterday (a trader who was underwater from his Friday Gold purchase), but I’m smart again today! With an +8% rally “off the lows” in Gold (a +22% move in Silver!) is just another day at Bernanke’s price stability casino. Copper and Oil both seeing their dead cat bounces this morning but TRADE lines of resistance for both are well established overhead at $84.98 and $3.68, respectively.
MOST POPULAR COMMODITY HEADLINES FROM BLOOMBERG:
- JPMorgan Differs With JPMorgan on Apple IPad Order Research
- VW Soups Up Golf for Twice the Price After Phaeton Flop: Cars
- Galvin Brothers Garner U.K. Chefs’ Award for City Restaurant
- Starbucks Sevenfold Gain Over S&P 500 Fuels Put Buying: Options
- Cavalli Chief Sees Luxury-Goods Slowdown as Debt Crisis Deepens
- Family Dollar Investors Bet on Sale as Shorts Flee: Real M&A
- Li & Fung Advances After Billionaire William Fung Buys Shares
- German Consumer Confidence Will Hold Steady in October, GfK Says
- Universal Entertainment to Invest $2.3 Billion in Manila Casino
- China Yurun Food Advances by Most in Three Weeks in Hong Kong
- Goodman Fielder to Raise A$259 Million With Entitlement Offer
- MillerCoors Claims New England Patriots Broke Sponsorship Deal
- Netflix Gets 57% Cheaper for Amazon-to-Google Acquirer: Real M&A
- Tesco Cutting Price Gap With Asda, Not Starting Price War: BofA
- Nestle Borrows at 4-Year Low as KitKat Maker Favored in Crisis
- Porsche at $213,000 Belies Singapore Slowdown: Chart of the Day
- Lego Prepares for Global Economic Decline, Borsen Reports
- Yurun Plunges Most in Six Years After Saying Profit May Fall
- Kodak Declines After Drawing $160 Million From Credit Line
- Clorox Drops After Carl Icahn Withdraws Slate of Directors
GERMANY – day 3 of a +6-7% short squeeze in German stocks from their YTD lows (after crashing -33% since May), but if the DAX can hold its head above 5441, it will have conquered its immediate-term TRADE line of resistance. That would be bullish (on the margin) and that’s why I don’t have any European shorts on right now (currency or equities). Wait and watch here as the CAC’s TRADE line is 3042; Greece up small.
ASIA – huge squeeze in the Asian equity markets that literally went down in a straight line last week (KOSPI +5%, Indonesia +4.8%, HK +4.2%, etc), but all of these markets remain in Bearish Formations with KOSPI and HK TRADE lines of resistance = 1799 and 19476, respectively.
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Recent moves in Latin American financial and capital markets are signaling a very bearish outlook indeed for the regional economy.
Latin American equity markets got completely tagged last week, closing down -7.2% wk/wk on a median basis. The cap-weighted MSCI EM Latin America Index (Brazil, Chile, Colombia, Mexico, and Peru) actually closed down -13.6% wk/wk as the Flight to Liquidity trade continues to roil emerging market assets worldwide. This was confirmed in the FX market as well, with the region’s currencies depreciating nearly a full four percent wk/wk vs. the USD on a median basis.
Latin American sovereign debt markets sang a similar tune, with yields generally backing up across the curve throughout the region. Brazil’s 2yr sovereign debt yields posted a noteworthy negative divergence on expectations of more dovish monetary policy, as indicated by the -20bps wk/wk decline in the country’s 1yr on-shore interest rate swap. From a credit quality perspective, Latin American 5yr CDS widened fairly dramatically wk/wk, with Brazil, Chile, Colombia, Mexico, and Peru all posting percentage gains north of +30%. With the exception of Chile – the region’s highest rated sovereign credit – 5yr CDS quotes for these countries have nearly doubled in the YTD.
Brazil: The key developments out of Brazil in the past week largely centered on the real’s plunge vs. the USD (down -15.3% over the past two months, making it the 2nd-worst performing currency in the world over that time period). The declines were met with central bank action, as the bank stepped into the market to mitigate declines by auctioning currency swap contracts (112,290 in total with maturities between Nov and Jan). This effort, which is equivalent to selling dollars in the futures market, reverses a 28-month-old trend of implementing policy designed to limit real appreciation. With renewed speculation of a Greek default swirling about the financial media, Brazilian policymakers were quick to act in support of their currency.
The real, which declined -32.3% in the five months through Dec 31, 2008, is a major source of worry for Brazilian officials – which explains the hard line stance of defense provided by the central bank (per monetary policy director Aldo Mendes’ recent commentary). Aside from exacerbating the external debt burdens of the sovereign and Brazilian corporations alike, the real’s rapid depreciation also threatens to continue undermining Brazilian capital markets and make the cost of financing business ventures prohibitive for Brazilian corporations. For example, the cost of short-term trade financing for Brazilian investment grade companies has more than doubled this month (1yr credit line export contracts now cost 2.85% vs. 1.35% 1mo ago) and is fueling speculation that the central bank will have to step in to support this market as they did back in ’08.
All told, the real’s global underperformance vs. the USD of late is largely a function of a series of Big Government Intervention designed to limit real appreciation – inconveniently at the top of the global economic cycle. The cumulative effect of the measures, which included a tax on foreign currency derivatives transactions, caused foreign wagers for real appreciation (vs. the USD) to fall -85% from July’s record high of $25.6 billion in futures and dollar spread contracts. Now, Brazil is backpedaling as its currency suffers the most as a result of these capital controls:
“We established regulatory measures exactly for that, to add and take away. The IOF is one of those; we introduced it, then we can take it away when it’s no longer needed. We are always looking at all the possibilities, but there is no decision.”
-Finance Minister Guido Mantega (9/23)
Mexico: The Mexican peso, which just snapped its longest losing streak on record last Friday is in a similar boat as Brazil – though largely for a different reason (Indefinitely Dovish monetary policy as opposed to Big Government Intervention). The peso, which is down over -14% vs. the USD over the past two months is facilitating foreign liquidation across Mexican financial markets, headlined by the -13.2% loss for peso-denominated sovereign debt in the month-to-date (vs. +2.5% for U.S. Treasuries and an -8.2% average across all emerging markets). Central bank governor Augustin Carstens believes that peso weakness is “transitory” and expects it to “resume its upward trend” along with other Latin American currencies.
Clearly Carstens is modeling in a near-term inflection point in the global economic cycle – an outcome not being priced into any of the macro markets we monitor globally. This view is likely to leave the Mexican central bank on the sidelines for now as it relates to meaningfully supporting the peso in the FX market – potentially paving the way for further declines. As interest rates continue to back up and increase the cost of capital for Mexican corporations and consumers, we expect growth south of the border to continue slowing – just as we called out in early 2Q when we first went negative on the Mexican economy and its stock and currency markets.
Colombia: The key callout out of Colombia last week is undoubtedly the government’s decision to scrap a $240 million bond issue for the rest of year, citing “global financial turmoil”. The key takeaway here is that if the Colombian government is finding it hard to raise debt capital, we don’t think many Colombian corporations are able to do so either. Growth tends to slow when capital markets dry up.
Elsewhere in the Colombian economy, Finance Minister Juan Carlos Echeverry, who put his own job on the line if the Colombian unemployment rate doesn’t improve to single digits by year end (11.3% currently), did reiterate his forecast for Colombia to grow 5% next year. We interpret this as they’ll be quick to quick to fire the stimulus gun to help achieve this goal should Colombian economic data start to come in negative on the margin. He is also keen on maintaining national confidence so that financial intermediation can continue to support growth. This may prove to be a tall order, given the global economic backdrop.
Argentina: Continuing with the theme of capital flight, which is currently on pace for the largest yearly amount on record, new data does indeed confirm that Argentina is likely to run out of money to defend its currency, the peso, in 2012. Based on a law that FX reserves are not allowed to fall below the monetary base (put in place for this exact reason – to protect against capital flight), we can now see that Argentina has only a $3.4 billion buffer before FX reserves hit this dreaded level. To complicate matters, President Cristina Fernandez’s 2012 budget includes a $5.7 billion provision of FX reserves for international debt service. Moreover, Argentina’s inability to access international debt capital markets (especially in times of global stress) all but guarantees this payment is made – perhaps alongside other FX reserve-financed social spending in the event of an economic downturn (which we’d argue is already happening given that Argentina systematically underreports inflation by 10-15% – artificially boosting GDP growth on a real-adjusted basis).
Argentina’s FX reserves, which have declined by -5.8% YTD to $49.1 billion, are largely a function of trade revenue from agricultural commodities (over 50% of exports per Bloomberg). With our call for Deflating the Inflation to continue, over the intermediate term, we think the market will continue to price in a peso devaluation at some point over the next year to get reserves to a comfortable level when compared to the monetary base. This is what the FX market has been sniffing out and is largely the reason why the blue-chip exchange rate (a market that intensifies during bouts of capital flight) is trading at a -10.4% discount to the spot market rate (vs. the USD). The capital flight ahead of a perceived currency devaluation has pushed up yields on Argentine peso-denominated bonds due in 2033 +361bps YTD to 10.51% vs. an increase of “only” +283bps on Argentine dollar bonds. All told, we are bearish on the Argentine peso (and Argentinean assets in general from a USD perspective) until the FX reserve issue is adequately addressed – a resolution we don’t see taking place anytime soon.
Little to nothing came of this weekend’s G20/IMF/Worldbank meetings in Washington in terms of a policy response to the Euro/Greek “crisis”. The loudest voices of the Germans, and those that we’re taking our cues from, portend willingness to further aid Greece despite strong winds against such actions from the German populace. Germany’s Bundestag vote on the terms on the facility (originally issued on June 21) comes this Thursday and remains in our minds the lynchpin for the decisions of the other 16 Eurozone parliaments (loosely scheduled in the next weeks, with Slovenia tomorrow and Finland Wednesday) as well as the conciliatory approval of remainder of the EU-27 states outside the Eurozone.
European equity markets rallied today on the belief that the Europeans will throw some sort of bazooka at its fiscal problems, both on the sovereign and banking sides, yet question marks remain on the size, scope, or timing of such a decision. There’s talk that from a calendar perspective, a new framework could be reached at an EU finance ministers meeting on November 4 in Cannes. Regardless, expect the microscope to remain on Europe along with expectations of a near-term solution. We’d expect significant volatility (and greater downside risk) into year-end as investors wrestle with and anticipate additional policy measures that may include a larger EFSF (2-3x its current size of €750B), directed funds to better recapitalize European banks, and stronger fiscal contingency plans for Greece and further down the road for the entire monetary union.
Last week major European equity indices were down -5 to -8%, with the EUR-USD pair falling -2.2%. We’d caution that today’s bounce (European equity indices closed up +2 to 3% and the EUR-USD was mixed) may be short lived. The EUR-USD is in a bearish formation, meaning it’s currently trading below its short term TRADE, intermediate term TREND, and long term TAIL lines. We’d short the EUR-USD on any bounce up to around $1.37 - 1.39 and see immediate term TRADE support (to buy) at $1.34 (see chart).
Risk signals continue to suggest that premiums across the periphery especially (but also in the core – DAX down -28% in last two months) will continue to blow out over the intermediate term TREND, as Eurocrats are likely to continue to attach band-aides to the wounds, yet any new grand policy measures will likely take many months to be pushed through, if they come at all. Again, the market waits for no one.
This weekend German Chancellor Angela Merkel said that Eurozone leaders must erect a firewall around Greece to avert a cascade of market attacks on other European states that would risk breaking up the currency area and German finance minister Wolfgang Schaeuble called for the permanent stability fund, the European Stability Mechanism (ESM), to be possibly issued a bit earlier than its present date of 2013. In any case, both leaders, without giving any details away, lean towards aiding Greece, and therefore have minimized the prospect of Greece leaving the Union anytime soon – which may boost sentiment on the news but may not arrest the slide across capital markets.
It’s the risk signals that continue to worry us: CDS spreads for Belgium, France, and Germany are at or near all-time highs in the last two days. And spreads across the periphery, and despite improvements in Ireland, maintain their direction “up-and-to-the-right” (see charts below). Sovereign yields tell a similar story, with Italy and Spain the main points of interest: both have government 19YR yields inside of 6%, a critical break-out level, yet there’s little confidence that Italy and Spain couldn’t overcome the line, especially should the ECB’s secondary sovereign bond purchasing (SMP) wane in the coming weeks (third chart below).
On the banking side, our Financials MD Josh Steiner has astutely noted that between December 31, 2010 and March 31, 2011 the French banking system increased its exposure to PIIGS by $25 billion; while the German banking system decreased its exposure by almost $11 billion, almost all of which came from reductions in Greek sovereign debt holdings; and Italian and Spanish banks both increased their exposure by $3 and $9 billion, respectively, according to the newest report publish by the Bank of International Settlements.
In short, European banking risks have yet to be addressed concisely by Eurocrats, which adds significant fuel to the fire as sovereign exposures are highly linked across the European banks. Our weekly European Financials CDS Monitor showed that bank swaps mostly widened in Europe last week. 39 of the 40 reference entities were wider week over week. The average widening was 11.3%, or 56 basis points, and the median widening was 23.4%
Expect more volatility into and out of tomorrow as Merkel hosts talks with Greek PM Papandreou and the Greek Parliament votes on property tax as one measure of its austerity program. And expect strikes and rioting in Greece beginning today and possibly lasting throughout the week as Troika inspects “the books” and the Greek state thirsts for its next €8 Billion loan tranche!
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