The Hedgeye Macro team Friday hosted a conference call with Peter Tchir (@TFMkts), founder of TF Market Advisors, an independent provider of macro research and market information. Peter’s expertise in global credit markets has made him a valued advisor to hedge funds, money managers and asset allocation firms. Peter looks at global markets from a Macro perspective, watching trends in fixed income as they signal upcoming events in other markets, including currencies and equities.
In the near term, Peter sees more risk than upside in the US equities market.
He believes the emerging awareness of risks from Europe, combined with a bottomless well of QE will soon have investors seeing stock valuations as overextended. There are high hopes for an LBO boom, which he believes will not materialize, and risk contagion will also spread from weakness in emerging economies, all of which should leave the S&P vulnerable for a pullback to the 1,500 level.
Peter believes Spain and Italy will ultimately become buying opportunities for investors who trade global ETFs. But not until there is a perception that the ECB has the ability to make something happen in recalcitrant economies.
At some point, the Fed will end its QE program. They will not signal it ahead of time, but it will be important to recognize when it does occur.
Among other effects, Peter believes investors will reassess the position of the banks, which he says will do much better under Dodd Frank than most people predict. Meanwhile the US market, which he sees as mildly overvalued, should retrench, giving patient buyers an opportunity to bargain hunt.
Peter sees a number of major market segments where investor perception is at odds with reality. “When perception catches up with reality,” he says, “those are always the most interesting moves.”
Follow the Money: US Equity Markets and the Fed
Peter says, don’t listen to what the Fed says – look at what the Fed owns.
Bernanke says the Fed will not sell bonds. Peter says the Fed can’t sell bonds. They have such a massive position that, should they sell a bond, the market will rush to place enormous pressure on Treasurys.
The Fed owns 40% of all Treasury bonds with maturities in the 5-20 year range, and nearly as much in the 20-30 year. The Fed no longer participates in this market. They have become the market. As we are hearing in this morning’s JP MorganChase senate testimony, when you get too big in a market, you become its prisoner. Fed Chairman Bernanke is “The Washington Whale.”
The Fed wants to maintain momentum in housing. Since mortgage rates are tied to the 10-year Treasury, this is all the more reason why, says Peter, the Fed not only won’t sell bonds – they can’t sell.
This continues to create a bind in the economy. The Fed is both buying mortgages, and controlling rates, squeezing others out of the mortgage market. meanwhile, banks continue buying far more Treasurys than mortgages, meaning they are financing the government instead of the economy.
JPMorgan recently laid off a large number of employees in its mortgage unit – a sign of widespread concern that a true private market for mortgages may never reappear. Peter says we need to return to the normal scenario of Banks lending money to People and to Businesses. There will almost certainly be a volatility hiccup on the way, but once the Fed finally steps back from its Quantitative Easing (QE) program, the economy will emerge much stronger.
How does this work its way into the stock market?
The Fed’s recent stress test scenarios all assumed 10 year rates at around 2%, but they were able to achieve a projected result, in at least one case, of stock prices doubling, coupled with 4% GDP growth. On the way to a double, stock first declined substantially, but the Fed looks at the positive part of the analysis. This means the Fed believes they can remain in the driver’s seat for a long time, though it is still not clear what policy measures they foresee in the event their rosy scenario comes true. After all, even the greatest bull market only lasts until it doesn’t. QE has taken the bounce out of the economy.
Recent gains in employment are not resonating through the equities markets the way they normally would, housing prices are rising, retail activity is picking up, but Peter’s work indicates none of those factors will have the strength they normally would to take equity prices higher. You can’t fight the Fed, as they say.
What About All Those Equity Deals?
There have been a couple of substantial equity deals lately. Two prominent deals – Dell and Heinz – have investors salivating over a new wave of buyout activity. Peter cautions that these transactions had unique owners and participants, and that in both cases the owners sought large pieces of secured debt – not your normal private equity of investment bank-led equity deal. Peter says it is unclear whether there is enough unrealized value for a real LBO wave to take off. And he points out that credit is not yet exuberant enough to provide the levels of leverage needed for a consistent flow of transactions.
Another theme that has equity investors living in hope is the Great Rotation, the notion that investors will dump their bonds and buy stocks. Peter says this correlation has broken down, largely thanks to the Fed’s relentless buying of $85 billion worth of bonds and mortgages every month.
Europe and the ECB
Italy and Spain remain key risks in Europe. While they are no longer cited as major concerns by most commentators, Peter says the risks have definitely not gone away, noting that yields in both countries’ sovereign debt rose in the past week. Italy’s election has not been resolved – the front runners are Beppe Grillo, a former clown who may be prevented from assuming office because of a 1980 manslaughter conviction; and former Prime Minister Silvio Berlusconi, recently sentenced to one year in jail over a wiretap scandal.
Italy’s political disarray is ominous, Peter says, because their economy is big enough to go it alone. Italy’s continued refusal to cooperate in the ECB’s credit program puts significant pressure on the rest of the ECB system.
Spain, while not so colorful, continues to have its share of economic woes, similarly compounded by an ongoing corruption investigation of its own Premier Rajoy.
France, largely viewed as part of the core of the “good Europe,” may be showing signs of a new brewing crisis as analysts dig deeper.
To manage all this, the ECB instituted the Outright Monetary Transaction program (OMT), where the ECB will buy bonds of countries that enter into a program under conditions established and negotiated by the IMF. Says Peter, the ECB is not the Fed – it can make recommendations, but without a European central fiscal authority, the OMT relies on the voluntary cooperation of member states.
It also relies on the continued willingness of strong members – particularly Germany – to backstop weaker members’ bond issuance, a willingness that is dwindling by the hour.
Italy and Spain have rejected the IMF conditions, possibly because they are holding out for a better deal, and possibly because they believe the pain of going it alone would not be worse than the pain of submitting to the OMT requirements. If either country gets in fiscal trouble, there is no mechanism to stop the bleeding. And with no government in place, Italy doesn’t have anyone to negotiate with the IMF, much less the ability to reach a consensus to reach out to the OMT. Peter says the risks posed by Italy are not priced into the European credit markets, creating the possibility of a severe bump in an already rocky road.