This note was originally published
at 8am on March 08, 2013 for Hedgeye subscribers.
“The dramatic modernization of the Asian economies ranks alongside the Renaissance and the Industrial revolution as one of the most important developments in economic history.”
Candidly, over time I have found myself disagreeing with a lot of what Larry Summers has said publicly. That said, the above quote definitely resonates with me. As I touched on earlier this week, the story of development in Asia over the last twenty years, and in particular in China, is really unprecedented in economic history.
In North America over the last few decades the Renaissance Men, for lack of a better word, have been the private equity firms and hedge funds partners that have generated outsized returns and been paid handsomely. Like any Renaissance, though, this one too will end. This end is evidenced by some recent studies that highlight hedge funds returns are correlated to the SP500 with a more than 0.9 r-squared. If true, this renaissance may be ending sooner than many expect.
With such a tight R-squared, an emerging risk is actually how much each hedge fund owns of a particular stock. Many quantitative managers have actually gone on to categorize this as “hedge fund risk”. In effect, this equates to the amount of stock outstanding that is in the hands of a series of hedge fund managers. So if a lot of the stock is held with hedge fund managers, then the hedge fund risk is high.
So speaking of Renaissance men, Hedgeye has a few, but perhaps the most legitimate one is our own Matt Hedrick, who covers European equities. Matt hits our internal team with an update on Europe every morning and today his key points were limited. This is actually positive because what it means is there is a not a lot going on in European and her sovereign debt crisis.
In fact, in the Chart of the Day we highlight this by showing Spanish 2 and 10 year yields over the last year. The fact is that credit risk in Europe has been steadily declining. As the chart shows, Spanish yields are well of their peak, but not only that, they are also below the levels of a year ago. The key take-away from this is that while Europe sill matters, it only matters to a point as European credit risk, broadly, has improved.
With peripheral yields improving, we are also seeing an improvement in capital flowing back to certain countries.
Specifically, in Italy private sector deposits were up 7.7% year-over-year in the last month. While this is not a number that is going gangbusters per se, what it does show is that capital is coming back to the certain at-risk sovereigns in the Euro-zone. This ultimately is a positive for broader credit risk in the EU.
On the flip side, some of the European data was less than positive night-over-night. For instance, German industrial production declined -1.5% from last year. This is an acceleration from December, which declined -0.5%. Are these freak out type numbers? No, but they are indicative of a European economy that continues to struggle in its recovery.
I often quote my colleague and Hedgeye Financials Sector Head Josh Steiner in the Early Look. Once again I want to highlight a big call he made yesterday in a note titled, “BAC, C, MS - LONG THE BIG CAP BETA RENORMALIZATION TRADE”. As Josh wrote:
“There’s a paradox in global U.S. banks right now, and that is that they hold more capital today than they’ve held in a very long time. We show this in a chart below, which looks at Bank of America. The red line shows BofA’s tangible equity ratio going back ten years. You can see on the right hand y-axis that capital fell steadily from the high fives in 2003 to a low of 3% in the belly of the crisis and has since risen to around 7%. Capital ratios are much higher on a regulatory basis, but we like tangible equity for its simplicity – in other words, unlike risk-weighted capital measures, it’s more difficult for banks to manipulate this ratio in their favor. The point is that capital levels are very high today and, in fact, are still headed still higher for the foreseeable future (we'll know how much more after the close). The second line on this chart shows Bank of America’s rolling one year beta going back ten years. The takeaway here is that it has risen from its tight range around 0.8 from 2003 through 2007 to around 2 today (1.93 as of this morning). Capital is the inverse of leverage, and leverage is risk. High capital equates to low risk. Now let’s use beta as our proxy for cost of capital, and by the transitive property we find that the the market is charging the highest cost of capital at a time when the risk is, in fact, lowest. This is clearly paradoxical, and a dynamic we don’t think will last.”
So to summarize: capital ratios for large U.S. banks are improving and these stocks are poised to continue to lead the U.S. equity rally. While I enjoy having a few drinks with my colleague Josh, I’m not sure he (or me for that matter) is a Renaissance man, but what he is definitely is very accurate in terms of his view of the U.S. banking system. If you’d like more of his thoughts, please email firstname.lastname@example.org.
As you all head into the weekend, I wanted to leave you with one last quote, which is related to a quote from the Early Look earlier this week:
“Marxism is like a classical building that followed the Renaissance; beautiful in its way, but incapable of growth.”
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1559-1585, $109.07-111.73, $81.98-82.54, 92.11-95.81, 1.94-2.04%, 11.67-14.91, and 1519-1558, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research