At Hedgeye, we firmly believe risk is always “on”. Latin American financial markets would certainly attest to this contrarian mantra.
Last week was a rough week for Latin American equity investors, with the region’s indices closing down -2.5% wk/wk on average and falling -3% wk/wk on a median basis. Argentina led the way to the downside, plunging -4.1% wk/wk, while Colombia’s -0.3% wk/wk decline outperformed amid a sea of red.
Falling expectations for further monetary tightening and outright speculation for monetary loosening continues to weigh on Latin American FX markets, with our least favorite – the Mexican peso – leading the way to downside (-2.2% wk/wk vs. the USD). Interest rates across Latin America’s sovereign debt markets continued their recent trend of declines – particularly on the short end of the curve, where monetary policy tends to have a more forceful impact. Interestingly, rates on the long-end of Mexico’s sovereign debt curve backed up fairly meaningfully wk/wk. The -3.8% wk/wk decline in Mexico’s IPC Index and the central bank’s own bearish commentary do not suggest that this widening of Mexico’s yield curve should be interpreted as heightened growth expectations, however.
Latin American sovereign CDS broadly widened wk/wk, with Colombia and Peru leading the way on a percentage basis (up +12.9% and +11.4%, respectively). The recent broad-based trend of higher-highs and higher-lows remains intact.
Brazil: Brazilian economic data remains flat-out terrible and has been for much of the last 3-4 quarters, yet Brazilian financial markets continue to signal there is more bad data to come (equities, currency, bond yields – all down wk/wk). The most recent spate of Sticky Stagflation on a reported basis came in the form of slowing real GDP growth (+3.1% YoY in 2Q vs. +4.2% prior) and accelerating CPI (+7.2% YoY in Aug – a six year high – vs. +6.9% prior). Even Brazil’s oft-bandied about domestic demand is slowing, with the Aug services PMI reading ticking down to 52.2 (vs. 53.7 prior).
Obviously with the recent rate cut, combating slowing growth remains atop Brazilian policymakers’ collective agenda. In fact, Finance Minister Guido Mantega said that Brazil has a “great deal of room to maneuver” in both monetary and fiscal policy (though he did confirm that officials would prefer not to use the fiscal stimulus – a much-needed sign of fiscal conservatism). Absent a material unwinding of the European banking system, we continue to believe that much of Brazil’s stimulus efforts will come in the form of interest rate cuts, due to mounting political pressure to lower the country’s real interest rate/debt service burden, as well as the simple fact that the Rousseff administration has shown that it has its hands full with containing nominal expenditure growth in the upcoming federal budget.
An interesting callout that we wanted to flag was the rate of DPGE debt being issued by mid-sized Brazilian banks (R$8.5B YTD vs. R$6.3B in all of ’10). The bonds, which are backed by the country’s depoisit insurance fund, have essentially become a source of last-resort funding for Brazilian lenders after the Banco Panamericano scandal all but evaporated the loan portfolio market. Obviously, we’re a long way away from a crisis, but the risk that mid-sized banks in Brazil face heightened liquidity risk in 2012 is an important one to flag, as government incentives for larger banks to buy bonds or loan books from smaller banks get phased out.
Mexico: Mexican economic data continues to support our bearish intermediate-term view of the Mexican peso and Mexican equities: consumer confidence ticked down in Aug to 93.4 (vs. 95.5 prior); manufacturing PMI ticked down in Aug to 51.5 (vs. 50.1 prior); services PMI ticked down in Aug to 52 (vs. 52.5 prior); and CPI slowed in Aug to +3.6% YoY (vs. +3.6% prior) – which is negative for expectations for tighter monetary policy (MXN-bearish). In fact, of the 47 currencies we track, the Mexican peso’s -9.2% decline vs. the USD over the last two months is only bested by the Polish zloty’s -9.5% decline.
Chile: Sticky Stagflation continues to dominate both headlines and headline economic data in Chile. From a headline perspective, the central bank lowered the top end of its 2011 real GDP growth forecast -75bps to +6.25% YoY. Currently growing at an +8.2% pace YTD, their outlook clearly implies a meaningful drop-off in Chilean economic activity in 2H – which is in line with what our models were signaling much earlier in the year and continue to signal. On the inflation front, CPI accelerated in August, supportive of the central bank’s recent statement that it was “too early to cut interest rates”. Elevated rates of reported inflation are likely to continue to keep many central banks in a box and prevent them from easing monetary policy in a proactive manner and Chile is no exception in this regard.
Colombia: Political pressure on Colombia’s central bank to cut interest rates continues to grow and a marginally dovish inflation reading for Aug only amplified those claims (CPI slowed to +3.3% YoY vs. +3.4% prior). President Juan Manuel Santos blatantly asked the central bank to refrain from raising interest rates early last week and subsequently tweeted, “There is no reason to raise rates.” Moreover, he publically stated that he “remains concerned about the strength of the [Colombian] peso” (COP). While Colombia’s 2yr sovereign debt yields have fallen -66bps over the last three months, they remain a regional outlier from a YTD perspective (up +57bps) and this tug-of-war should eventually culminate with the central bank giving in to the President’s demands (our models have Colombian GDP growth slowing in 2H11).
EUR/USD breaks TREND and TAIL as Greek Concerns Flair
If we were to relate the European Sovereign Debt contagion to a boxing match, Germany (represented as the long-standing heavyweight champion) would be facing-off against numerous competitors in a league that includes the countries of France and the PIIGS, the latter of which collectively belong to the featherweight and welterweight divisions. The obvious mismatch would see Germany handily defeat the PIIGS—blood would spray deep into the 10th row and the sea of German fans would cheer!
Yet now consider that while Germany would happily throw the knock-out punch to see at least its featherweight competition never rise to its feet again (call them Greece, Ireland, and Portugal), Germany has ulterior motives, influence both by its fan club (the German populous and Merkel’s reelection efforts) and the Boxing Commission (think: ECB and Eurocrats from Brussels).
Firstly, Germany intuitively understands that it’s happy to beat up on its competition, but ultimately if it wants to fill the seats (think: export markets) it needs competition week in and week out. Secondly, Germany is being pressured by the Boxing Commission that so long as it doesn’t “finish off” its competition, the Commission will help split the PIIGS’ medical bills (think: bailout packages; SMP bond purchases; and EFSF) to ensure there are future rounds to fight.
Germany, however, soon realizes that the competition is so mismatched that its weakest competition can hardly stand up straight, let alone see straight to protect (help) itself, and upset with the rising medical costs to “fix” its competition, the share of which is increasingly rising. Further, the game is so mismatched, that Germany fears it will lose not only its fan base who cannot justify the ticket price for such a match, but also that its poor competition will drag down its championship form (GDP).
Germany, the Boxing Commission, and the badly injured adversaries are at an impasse--what should be done? German fans aren’t returning (Merkel’s popularity tanking); Greece, Ireland, and Portugal are in the ICU; and Spain and Italy need extra doses of morphine to deal with the pain. The Boxing Commission and Germany are at odds. Germany’s only other competition, France, has caught a nasty cold with whispers of pneumonia. While Germany isn’t willing to let the league disintegrate, it’s also not in the position to continue to pay the lion’s share of the medical bills to fight another week. And so far Boxing Commissioner (Trichet) has yet to indicate that he’s willing to cover the rising medical bills should Germany skirt the bill.
On the 29th of September the German team will hold a vote to see if they want to continue to pay the medical bills to insure future matches. Heading into the vote, many of the team’s strong voices feel that paying the bills accomplishes little: even with a healthy Greece, Ireland, and Portugal, there’s no competition for Germany. Further, fears percolate that should France be down and out for a long period and Italy and Spain require care, Germany will not be able to fit the bill. The larger question before the team remains: is it a larger risk for Germany to let the league disintegrate and lose its championship form, or continue to support its competition at a heavy cost so it at least has a body to throw punches at in the ring? The fans seem unwilling to let this decision linger.
The “boxing tale” above presents some of the larger issues regarding European sovereign debt contagion and Germany’s leading position in the issue, all of which have heightened since the German government considered the impact of a Greek sovereign default on its banks over the weekend. While there are numerous moving parts in crafting “solutions” to this contagion issue, including political conflicts and solving for known unknowns on the sovereign and banking sides, what’s clear is that Germany’s vote on the 29th, a change in the ECB’s willingness or unwillingness to provide more fiscal support, and/or market forces may all have significant impact on the direction of this contagion.
We’re not currently invested in Europe via our Hedgeye Portfolio and don’t expect a quick fix to European debt and banking contagion risks and expect to see more downside in European capital markets from here as:
- Eurocrats refuse to accept default of member countries
- The EU Constitution does not account for measures to let a member country leave the Eurozone
- Stronger nations will likely vote against Eurobonds
- Countries (like Finland) will demand collateral for funds posted to the EFSF which will pinch the Greek state which doesn’t have the assets to cover the EFSF
- There’s no European-wide banking plan to recapitalize/write down peripheral exposure, or simply to let banks fail
Obviously the region’s common currency hangs in the balance. Our immediate term TRADE levels on the EUR-USD cross are $1.36 to $1.39. As Keith has stated recently, from “The Correlation Risk perspective, this cross remains the most important relationship in all of Global Macro. We like to say, “get the EUR/USD pair right and you’ll get a lot of other things right.” Both the TAIL ($1.39) and TREND ($1.43) for the Euro have broken expeditiously here in September.”
As we show in the 3 year chart below, we don’t see any longer term support in the EUR-USD until $1.20. From a calendar perspective, the Germany’s EFSF vote at the end of the month remains a critical catalyst, as does Troika’s report on Greece’s fiscal consolidation measures, the report of which is expected to come out at the end of the month and the findings of which will determine if Greece receives its next tranche of funding of 8B EUR, monies it’s desperately relying on to pay its bills.
European equity indices, especially banking stocks took it on the chin in August and are off to a bad start in September. The heavy weight German DAX is down a full -33% since its early May highs! The point here is that no country is immune despite how impressive its right hand (balance sheet) is.
Below we include the Weekly Risk Monitor report from our Financials sector head Josh Steiner. It shows in particular the rising risk premium, reflected by CDS spreads, across the sovereigns and banks of Europe. Directly below we refresh our chart of 10YR yields of the periphery. In particular, Italy has move back to 5.50%, and therefore is flirting closer to the 6% breakout level. Italy’s 54.5B EUR austerity program, which could pass the lower house as soon as this week, is weighing on this yield—both that the package gets passed and the terms are bold enough to arrest the country’s severe debt levels. Whether or not the Chinese come to Europe or Italy's aid (FT rumors today), we’re sure there are no short term fixes to Europe's debt "crisis", especially if Eurocrats have their way.
European Financials CDS Monitor – Banks swaps also widened in Europe last week. 35 of the 39 swaps were wider and 4 tightened. The average widening was 5.9%, or 25 bps, and the median widening was 21.3%. Tightening was concentrated in the Greek banks, where swaps are already trading well over 1,000 bps.
European Sovereign CDS – European sovereign swaps went parabolic last week. All the countries we track, with the exception of Ireland, hit a new high as of this morning. Greek swaps are up 56% WoW as of this morning, rocketing to 3500 bps. French CDS rose 23% WoW to a new high of 191 bps.
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Looking at Greece and the Other Dominoes
With the market now saying a Greek default is upon us, we're revisiting a post we first published on July 18 of this year called "European Debt: Where the Bodies are Buried". In that post we reverse engineered the EU stress tests and published the precise sovereign holdings and loan exposure by EU bank across each PIIGS country. We broke this out in a series of tables, which we are republishing below. Bear in mind that a limitation here is that we're looking at holdings as of year-end 2010.
By way of example, one area of market concern this morning is French bank downgrade risk. As the table below shows, both Soc Gen and BNP held approximately 10% of their Tier 1 Capital in Greek Sovereign Exposure as of YE2010, while Credit Agricole holds around 1%. Other highly exposed non-Greek EU banks as of YE10 were Banco Comercial Portugues (Portugal: 60 billion euros RWA) with 21% of its capital directly exposed to Greek sovereign debt, Dexia (Belgium: 140 billion euros RWA) with 20% of its capital directly exposed to Greek sovereign debt, and Commerzbank (Germany: 268 billion euros RWA) with 11% of its capital exposed.
Investors can consider these tables a reasonable starting point in assessing interconnected risk across the EU banking landscape.
Summary Conclusions: 13 of the Top 40 EU Banks Hold Over 200% of their Capital in PIIGS Exposure
We find that there are numerous European banks with over 100% of their Core Tier 1 Capital committed to either PIIGS commercial loans or PIIGS sovereign debt holdings. For example, we found that 18 of the 40 largest European banks held 100% or more of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans. In 14 of these cases, the banks held more than 200% of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans.
As a general rule we found that the Nordic banks are the least exposed to PIIGS debt, typically holding less than 20% of their Core Tier 1 Capital, putting them at considerably less risk than the group as a whole.
Joshua Steiner, CFA
POSITION: Long Utilities (XLU), Long Healthcare (XLV)
This morning’s rally “off the lows” didn’t surprise us. Neither did the selloff from the intraday highs. Bottoms, like tops, are processes - not points. And this one looks to be finally establishing a manageable immediate-term TRADE range at higher-lows (versus the YTD closing low of 1119).
To review the lines/levels that matter most across our risk management durations:
- TAIL (long-term) resistance remains up at 1265
- TRADE (immediate-term) resistance is now 1173
- TRADE support = 1135
In other words, trade the 1135-1173 range.
Interestingly, but not surprisingly, pre-market open downside support signaled a line of 1126 and now my immediate-term TRADE line of support is 9 points higher than that at 1135. So even when I really tighten up the duration, volatility, and standard deviation scenarios in my model, I’m coming to the same conclusion.
This is a Short Covering Opportunity, much like the one we called on August 8th, 2011.
Keith R. McCullough
Chief Executive Officer
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