“The readiness is all.”
You have to give it to William Shakespeare, he had a way with words. Just as Canadian hockey players have a way with understatement. When it comes to the daily global macro market grind, Shakespeare’s quote above about says it all. You are either ready; or you are not ready. It is really that simple.
I’ve recently been reading, “How Markets Fail”, by John Cassidy. I wouldn’t say I agree with all of Cassidy’s observations in the book, but he does offer some interesting anecdotes regarding markets and prevailing wisdom. Near the end of the book, Cassidy takes a break from analyzing markets and describes the origin and construction of the Millennium Bridge in London.
As background, in 1996, the London Borough of Soutwark, the Royal Institute of British Architects, and the Financial Times newspaper held a competition to build a new footbridge from the Tate Modern Art Gallery to St. Paul’s Cathedral, which, of course, would cross the Thames. The winning bid ultimately came from sculptor Sir Anthony Caro, architect Sir Norman Foster, and the engineering firm of Ove Arup.
The winning entry was a spectacular design “with steel balustrades projecting out at obtuse angles from a narrow aluminum roadway.” The designers insisted that the unique looking bridge could support at least five thousand pedestrians. So, on June 10, 2000, just in time for the Millennial, the bridge was opened up by Queen Elizabeth II with much fanfare and thousands of pedestrians started to walk across the bridge.
The bridge began to immediately sway causing pedestrians to cling to the sides of the bridge and created what has been described as a sea sick feeling amongst those who traversed it. Two days later, London authorities quickly shut the bridge down for an indefinite period, concerned about the stability of the bridge and safety of pedestrians utilizing it.
After studying the issue, the engineers at Ove Arup concluded that the issue was with the pedestrians and not due to the actual design of the bridge. In part, the engineers were correct. The bridge had been designed to gently swing to and fro, but what the designers didn’t account for was that pedestrians would exaggerate these movements in unison as they walked across the bridge. Arguably, the engineers’ design was not ready.
The natural movement of walking produces a slight sideways force. Thus as hundreds, even thousands of pedestrians walked across the bridge, they unwittingly created a unified sideways force that amplified the movement of the bridge. In effect, the natural wobble of the bridge became self-reinforcing and fed on itself. The savvy engineers at Ove Arup even came up for a name for this action, called “synchronous lateral excitation”.
In preparing you for the market action in the coming quarter, one of our Q4 themes will be related to this idea of “synchronous lateral excitation”. In global markets, currently, this concept is increasingly related to heightening correlations across asset classes. In some instances, this heightened correlation applies to even seemingly unrelated asset classes. Simply put, investors are increasingly acting in unison, which is amplifying price movements across markets and amplifying future risk. We’ve termed this, the “Correlation Risk” in previous notes.
Interestingly, though, even as cross-asset correlations are heightening globally, there are seemingly outlier markets that remain less correlated. According to recent report from Bloomberg:
“The 30-day correlation coefficient between the S&P 500 Financials Index and the banking group in the Stoxx Europe 600 Index has averaged 0.65 in 2011, according to data compiled by Bloomberg. The figure for European banks and Japan's Topix Banks Index is 0.25.”
Yes, you read that correctly. Japanese banks are becoming a global safe haven. Were you ready for that?
My colleague, and Hedgeye Asian analyst, Darius Dale recently updated his thoughts on Japan in a presentation. A key takeaway is that in the last three years U.S. policy makers have been much more Japanese than the Japanese in terms of monetary policy. In fact, not only did Chairman Bernanke and his associates cut rates more aggressively from the outset of the financial crisis, they have also leaned more heavily on the balance sheet of the central bank than their Japanese counterparts.
Interestingly, and related to the topic of global banking risk, this morning credit default swaps on Morgan Stanley reached a new cycle high of 455 basis points from 275 basis points at the end of August. In effect, Morgan Stanley is now seen to be as risky a credit as the Italian banks. Are you ready for that?
Part of increasing correlation between global markets is and has been the advent of increasing economic globalization and integration. In 2011, it is truly a global economy. This morning, the Chinese HSBC manufacturing PMI came in at 49.9, which is sub 50 for the third straight month. The immediate reaction to this tepid manufacturing number from China can be seen in European equities off 1.5 – 3.0% across the board. The German Dax is leading the way to the downside as a German lawmaker spoke out against an expanded EFSF.
The Hedgeye team has certainly tried to do our best to alert our subscribers as to the dismal outlook for equities this year and this quarter. To that point, with the last trading day for Q3 2011 today, the SP500 is down -12.1% quarter-to-date. Based on the performance of the SP500 and some broad hedge fund return numbers we have seen, there is another risk to be ready for: fund redemptions. Redemptions are never fun to talk about, but they are an unfortunate reality in this business that can impact asset prices.
Hopefully this note isn’t too somber heading into the weekend, but as Shakespeare also said:
“Better three hours too soon than a minute too late.”
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
THE HEDGEYE DAILY OUTLOOK
TODAY’S S&P 500 SET-UP - September 30, 2011
As we look at today’s set up for the S&P 500, the range is 64 points or -3.83% downside to 1116 and 1.60% upside to 1179.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: 1295 (+3374)
- VOLUME: NYSE 1120.96 (+6.86%)
- VIX: 38.84 -5.45% YTD PERFORMANCE: +118.82%
- SPX PUT/CALL RATIO: 2.20 from 2.45 (-10.19%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 36.70
- 3-MONTH T-BILL YIELD: 0.02%
- 10-Year: 1.99 from 2.03
- YIELD CURVE: 1.72 from 1.76
MACRO DATA POINTS (Bloomberg Estimates):
- 8:30 a.m.: USDA Quarterly
- 8:30 a.m.: Personal income, est. 0.1%, prior 0.3%
- 8:30 a.m.: Personal spending, est. 0.2%, prior 0.8%
- 9:45 a.m.: Chicago Purchasing, est. 55.0, prior 56.5
- 9:55 a.m.: UMich Confidence, Sept. F, est. 57.8, prior 57.8
- 10 a.m.: NAPM-Milwaukee, est. 57.2, est. 58.3
- 11 a.m.: Fed’s Bullard to speak in San Diego
- 1 p.m.: Baker Hughes rig count
WHAT TO WATCH:
- Italy softens blow of falling government bond prices for insurers - FT
- Alderney Gambling Control Commission pulls Full Tilt Poker's gambling license - WSJ
- Strategic bidders look like current favorites in EMI auction - Billboard
- FAA to propose higher minimum-experience standard for co-pilots - WSJ
- Workers at Chrysler's Global Engine Manufacturing Alliance plant approve joining with UAW contract - WSJ
- Global investors say Operation Twist will fail to reduce unemployment as the U.S. economy slows: Bloomberg poll
- September quarter ends: Watch for portfolio shuffling as fund managers adjust holdings
- Strategic bidders look like current favorites in EMI auction - Billboard
- Invesco, Square Mile Capital, Canyon combine to acquire $880M loan portfolio from BAC
MOST POPULAR COMMODITY HEADLINES FROM BLOOMBERG:
- Copper Rout Outpaces Analysts Focused on Shortages: Commodities
- Gold Gains as Rout Spurs Purchases, Central Banks Boost Reserves
- Korea Shipyards’ LNG Skill Beats China Bulk Focus: Freight
- Diesel Rally on Shell Fire Set to End on Formosa: Energy Markets
- Oil Gains in New York; Set for Biggest Quarterly Drop Since 2008
- Copper Gains, Paring Biggest Quarterly Decline Since 2008
- Commodities Pare Quarterly Drop on German Vote, U.S. Outlook
- Zinc Output May Rise in Japan to Meet Post-Quake Demand
- Rare Earths Fall as Toyota Develops Alternatives: Commodities
- Thailand, Bolivia, Tajikistan Boost Gold Reserves in August
- SGX, LSE in Joint Bid for London Metal Exchange, Reuters Says
- Oil Heads for Biggest Quarterly Decline in New York Since 2008
- Fifty-Year Drop in Asian Monsoons Linked to Fossil-Fuel Use
- Farm Subsidies May Face Supercommittee Cuts Amid Record Profits
- Gold May Gain as Price-Rout Spurs Physical Demand, Survey Shows
- Sugar May Decline on Large Crops in Europe, Asia, Survey Shows
- Crude Oil Rises on U.S. Economy, German Passage of Bailout Bill
- Chaoda Chairman, Fidelity Manager Accused of Insider Trading
- Eurozone August unemployment +10.0% vs consensus +10.0% and prior +10.0%
- Eurozone Sep CPI +3.0% y/y vs consensus +2.5% and prior +2.5%
- Germany August retail sales -2.9% MoM; +2.2% y/y vs consensus (0.6%) and prior revised to (1.8%) from (1.6%)
- France August consumer spending +0.2% m/m vs consensus +0.3% and prior (1.60%)
- France July producer prices +0.5% m/m vs consensus +0.3% and prior (0.3%)
- Japan August core CPI +0.2% y/y vs cons +0.1%. Jobless rate 4.3% vs cons 4.7%.
- Preliminary industrial output +0.8% m/m vs cons +1.5%.
- September manufacturing PMI 49.3 vs 51.9 seq.
- Tokyo September core CPI (0.1%) y/y, matching expectations.
- HSBC China September PMI 49.9 vs preliminary 49.4, month-ago 49.9.
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“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 1997-2011. 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
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