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Archive for the ‘Greece’ Category

Looking beyond Greece

We don’t know whether the Eurozone agreement on Greece will hold – let alone for how long. My guess is not for long. In any case, for investors this long-awaited deal looks like a classic case of buy on the story, sell on the news. Financial markets have run up so strongly in anticipation of such an outcome that equities now look massively overbought, implying that the short-term reaction is more likely to be negative than positive. Longer term it is still impoosible to know for certain how this great drama reaches its endgame.

My view remains, as it has done for some time, that the best outcome now, as Bill Emmott was saying in The Times yesterday, is for a managed default (and probable exit) by Greece at some point in the course of this year, as it becomes apparent that the country cannot meet the demands which have now been placed on it. I suspect that this is the outcome which the Germans have been after for quite a while now, without of course being able to say so in so many words. It is also in the best interests of the Greeks themselves over time.

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Written by Jonathan Davis

February 21, 2012 at 9:45 AM

New Year hopes

My suspicions back in the autumn that a market rally was on the way have, I am happy to say, been borne our by events. Not for the first time, the peak of rhetorical despair – this time about the dire outlook for the world economy should the Eurozone crisis not be resolved – has turned out to be the moment to turn bullish. The rally since the failure of the Cannes summit has been impressive.

The MSCI world index is up by more than 20 per cent since its October low and has risen for seven straight weeks in a row, something that has not happened since the spring of 2009, according to the equity strategists at Societe Generale. Equity markets have made an even stronger start in 2012, with January producing one of its best monthly returns for many years. Contrarian sentiment indicators, such as the venerable Investors Intelligence survey of investment advisors in the United States, once again proved invaluable in identifying a turning point back in the autumn.

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Views on Europe

Back from a two-day trip to Paris, it is no surprise to find that the markets are still obsessing about Europe. In the absence of elections political change is rarely a straightforward business, as this week’s tortuous attempts to form new governments in Italy and Greece are demonstrating. The markets remain volatile, but as yet nothing has happened to change my view that we are moving towards an endgame that will ultimately prove beneficial, howver messy it becomes in the short term.

What is noticeable is how opinion is at last slowly shifting away from arguing over how the eurozone in its present form can be saved towards the (more sensible) view that the eurozone cannot continue exactly as it is, whether or not it survives the immediate crisis.. See for example an excellent piece by Lord Owen, the former Foreign Secretary, writing in The Guardian on Monday which begins:

A eurozone may survive, but it will not be the present 17 member state eurozone. What will emerge, if it is to survive, will be smaller and more focused around German financial and monetary disciplines

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Written by Jonathan Davis

November 10, 2011 at 3:02 PM

Bye bye, Berlusconi

The word now is that Berlusconi is on his way out in Italy, as I predicted on this blog a week ago. Assuming that happens, as I am sure it will, it means that we have lost two credibility-shorn prime ministers in the troubled countries of the Eurozone in just 24 hours. In this long and tortuous process, nothing is certain, but I can’t help thinking that this is good news for the markets, as indeed in time the failure of the Cannes summit will also turn out to be.

Why? Becuase it means that the Eurozone is finally getting ready to deal with ugly reality, rather than utopian and impractical dreams. The one premise that has only rarely been challenged throughout this whole drawn out charade has been the belief that the Eurozone could not survive unless it continued exactly as it is now, with all its members on board and Greece and others facing permanent but unsustainable austerity.

That was – and is – a pipedream. What we are seeing now is a process by which failed incumbent political leaders are having to face the consequences of their past errors, not least clinging to such a dogmatic and unproven assumption, which has never been put to the popular vote. Having done more than anyone to talk the Eurozone into recession, with his doom-laden warnings about the consequences of a Greek default, M.Sarkozy faces his own rendezvous with the voters next May. Mrs Merkel, now calling the shots in Europe, probably has until the following year to face the electors.

Whether the new Governments in Greece and Italy can do any better than their predecessors remains to be seen, but the markets are driving the Eurozone to a less worse outcome than wasting all its firepower on saving a bankrupt country, uncertain and potentially disruptive though the consequences may be in the short term.

Written by Jonathan Davis

November 7, 2011 at 12:56 PM

Posted in Eurozone, Greece

Those damned voters…

Did I say there was a need to take these markets one step at a time yesterday? Make that one day at a time. The unexpected decision yesterday by the Greek Prime Minister to call for a referendum on the eurozone package clearly introduces a whole new element of uncertainty into the outlook for financial assets. It almost certainly brings forward the date when Greece defaults and leaves the euro (as eventually it must).

It has never been obvious to me that staying in the euro is the best option for the Greek people, and that may well turn out to be what they think too.  They may opt to take the Icelandic route and vote for the devil they don’t know in preference to the one they do, which has little obvious to commend it.  The decision of the Eurozone to go all out for monetary union without waiting to establish the necessary fiscal  and political regime that was needed to make it workable has always been its most serious flaw, but sadly not the only one.

A consistent failure to consult or carry public opinion has been another hallmark of the whole EU project, and one that may now prove very costly to its architects. Markets hate uncertainty, but if the prospect of a referendum in Greece now forces the Eurozone leadership to start planning properly for the consequences of at least a partial breakup of the single currency, instead of trying to do everything to avoid even thinking about such an outcome, it will be no bad thing. Look out next for the departure of Berlusconi.

Written by Jonathan Davis

November 1, 2011 at 10:31 AM

A $100 billion dollar warning

There is an interesting profile in the latest issue of the New Yorker about Ray Dalio, the founder of Bridgewater Associates, one of the world most successful macro hedge fund businesses, in the tradition of George Soros and Julian Robertson. Mr Soros has meanwhile just announced that he is closing his Quantum Endowment Fund to outside investors, ostensibly because of the impact of new regulations, and will in future run it solely as a family office.

Bridgewater Associates has around $100 billion under mangement and both anticipated and weathered the credit crisis with some success. Unlike the Quantum Fund, which until it changed its objective in 2000 from aggressive return-sekking to wealth preservation was famous for its big concentrated bets, the firm’s Pure Alpha fund is up around 10% this year while most hedge funds have struggled to make any money at all. Its style is to make a wide range of bets, many of them paired – buying platinum or selling silver, for example – in an effort to do what hedge funds were originally designed to do, which is to reduce correlation to the market’s overall movement. Dalio’s speciality is making calls on bond and currency markets.

While a lot of the New Yorker article is devoted to the unusual way in which Bridgewater Associates is run, it also contains Dalio’s judgment on current market conditions. “We are still in a deleveraging period” he says, and “we will be in a deleveraging period for ten years or more”. The article continues:

Dalio believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets. “There hasn’t been a case in history where they haven’t eventually printed money and devalued their currency,” he said.

Other developed countries, particularly those tied to the euro and thus to the European Central Bank, don’t have the option of printing money and are destined to undergo “classic depressions,” Dalio said. The recent deal to avoid an immediate debt default by Greece didn’t alter his pessimistic view. “People concentrate on the particular thing of the moment, and they forget the larger underlying forces,” he said. “That’s what got us into the debt crisis. It’s just today, today.”‘

But he also makes the obvious point that timing is the key to getting these big calls right. “I think late 2012 or early 2013 is going to be another very difficult period” is his reported view. That has always been my expectation too, but recent events – the muted response to the latest Greek bailout plan and the ongoing stalemate over the US debt ceiling (which Soros dismissed last week as “theatre”) -  may of course be bringing the point of crisis nearer.

That may of course also be one reason why the Quantum Fund is currently reported to be sitting with 75% of its assets in cash. However if the debt deal is done, which still looks the more likely outcome, there could be a decent rally in risk assets over the last few months of the year.

Written by Jonathan Davis

July 28, 2011 at 12:31 PM

Economists and banks

Some observations on economists from veteran US investor Laslzo Birinyi, writing in the Financial Times.

In my experience, economists are not equipped by training or discipline to provide insight and guidance on stocks. As manifest by an number of cliches, the bond market is about here and now, while stocks are always looking ahead. Hence economists, almost by definition, “lead from the rear”.

Their recent concern regarding the banks and the implication for the financial system may indeed be correct, but I would note that the recent weakness of the traditional banks is actually the norm. In the nine bull markets back to 1962, 48 per cent of banks’s ultimate gains was made in the first two months of the rally. In the last two bull markets, after the first two months, banks not only underperformed, they were actually down the rest of the rally.

US bank shares certainly have been going nowhere for some time.

Meanwhile, as the market has been indicating since the weekend, the narrow Greek vote in favour of the austerity programme – although it does nothing but defer the country’s inevitable sovereign debt default  - looks likely to be the trigger for a reversal of the straight line fall in equities and bond yields which has been such a striking feature of the last two months in the markets.

Written by Jonathan Davis

June 30, 2011 at 6:41 AM

May Can Be The Cruellest Month Too

MAY TURNED OUT to be one of the worst months on record for world equity markets, reports Andrew Lapthorne, the head number-cruncher and quant in Soc Gen Asset Management’s award-winning strategy team. The MSCI World Index dropped almost 10% in dollar terms, making it the worst May for this index since it began in 1970, and the worst monthly performance since February 2009, which turned out to be the final death throes of the great credit crisis bear market, the darkest hour before the dawn.

The worst country casualties, unsurprisingly, included the Eurozone countries whose debt problems have been so much in the headlines; Greece down 19%, Ireland 13% and Spain 11% in local currency terms. It turns out however that the falls in Asia were much greater: China’s Shanghai B market was down 16% and the Nikkei 225 down over 11%. The best performing markets year to date, as at the start of the month, more surprisingly, are mid and small cap stocks. Both the Russell 2000 and the FTSE 250 are still ahead year to date.

What is easily overlooked, of course, as with any short term data set, is that the recent falls in equity markets followed an exceptionally long and sustained period of market gains from February to April, with the S&P 500 rising for something like ten consecutive weeks, a most unusual trend. To use the jargon of the technical analysts, markets had become highly oversold. To that extent May’s falls were no more than a necessary and overdue correction.

However it seems clear that, just as Anthony Bolton predicted six months ago, equities are likely to be pushing against headwinds for some weeks yet. News will continue to be dominated by crises of one sort or another. The earnings upgrades that have helped to drive the markets higher are petering out. Valuations appear to have priced in a lot of future recovery already, with the MSCI World index trading on a p/e of 13 and a dividend yield of 2.7%.

Nevertheless the scale and strength economic recovery around the world continues to impress seasoned market-watchers. Few fund managers have navigated the crisis of the last three years better than Jonathan Ruffer and his team at Ruffer Investment Management. To quote a recent note of theirs: “One of the by-products of the tumultuous events and the private sector bail-outs of the last two years has been a massive transfer of risk from the private to the public sectors”.

“In part it is precisely this factor which has enabled equity markets over the past year to display a raffish insouciance in the face of so many outstanding problems and risks; with risk being largely socialized and a negligible cost of money, the measures that the corporate sector has taken in terms of inventory liquidation, labour shedding and capital spending cuts means that its present rude financial health stands in stark contrast to the groaning public sector deficits on view across the globe”.

They go on: “While we never try to time markets, it does not seem outlandish to say that the next few months will see risk assets move into the departure lounge from the ‘sweet spot’. Improving economic conditions, which we fully expect, will bring into sharper relief the need for ‘exit strategies’, with a likely reduction in liquidity available for investment in financial assets”.

“Further sovereign bond crises, accompanied by default risk, may erode the valuation basis for equities. Meanwhile, even if the UK is an acute case, inflation is regularly outpacing forecasts and will prove indeed to be part of the solution. After the relative ease of the last twelve months, protecting capital and generating real returns is about to start getting more difficult again”. We shall see.

A LOT of headlines have been generated by the European School of Management’s report into hedge funds.  The main findings are that hedge fund investors chase recent past performance and merrily buy into investment styles that have been working well recently regardless of the huge differentials in risk that different styles entail. 

The researcher, assistant professor Guillermo Baquero, concludes: “These results raise serious concerns about investors’ ability to make the right allocation choices and suggest that increasing investor protection and curbing unnecessary risks and speculative activity of hedge funds should be a priority for regulators”. 

I am not so interested in the regulatory issues. It has always been my view that hedge funds are not appropriate for retail investors, and should remain what they once were, namely largely unregulated vehicles for professionals and consenting wealthy adults. There is plenty of evidence to suggest that a small minority of hedge funds, if you are lucky enough to find the ones with real talent, are proven and consistent wealth-generators.

The majority, however, charge too much for what they in practice deliver, and their risk profile is skewed far too heavily in favour of the managers to make them prudent investments for most investors. Illiquidity too can be a problem, as became all too evident during the credit crisis. It is no real surprise that there has been a lot of pushback on the level of fees since the crisis. To blame them for causing the crisis is quite wrong however.

What these new research findings do show clearly, as many of us have long suspected, is that hedge fund investors are really no different from investors in general. They may be richer, and more sophisticated in other ways, but at heart they make just the same old mistakes – too greedy for results, too short term, too hyper-active, too blind to risk.

A SURVEY by the Association of Investment Companies names the top 20 investment trusts of the last decade, as measured (a) by their absolute returns and (b) by the consistency of their performance. Top of the list on both scores, gratifyingly, comes a trust that I own, Blackrock World Mining, which has returned an impressive 811% over the past decade and outperformed the average investment trust in eight of those ten years.

It is followed in the rankings by Fidelity European Values (once run by Anthony Bolton, but for most of the period in question by his successor Tim McCarron) and HgCapital, the private equity fund that spun out of Mercury Asset Management some years ago. (This is another fund which I happen to own, having bought some shares last year). The table of supporting data is worth looking at, although purists would argue that it suffers from taking no account of risk, gearing or volatility. A table of risk-adjusted returns would show some significant differences, as indeed would a table constructed on the same basis 12 months ago.

As a long term investor in investment trusts, the main message that I take from the survey is that identifying the big long term themes in the investment world and letting them run their course through a shrewdly managed, low cost vehicle is a much easier way to make money than furiously trying to pick winners over shorter periods of time.  Blackrock World Mining is a play on the commodity cycle. A good number of the other trusts on the list are essentially beneficiaries of emerging markets in one form or another, which has been the other big story of the past decade.  In a decade when the equity markets have produced little return overall, it is also noticeable how well some smaller company funds have continued to do.

AT A ROUND TABLE discussion I chaired for Spectator Business magazine last week, to be published shortly, a key theme on which all the participants agreed was the need for the new coalition government not to make a mess of the recovery by bungling the proposed Capital Gains Tax changes. As it happens, there is a powerful blast on the subject in this week’s Spectator from Art Laffer, inventor of the notorious Laffer curve. Economists may not be able to agree whether or not the Laffer curve is valid, but the general conclusion seems compelling to me. The way that the government crafts its CGT proposals is going to be a critical test of how far the new Government is hampered by the need to make concessions on tax to its own coalition partners.

THE THOUGHTS of Canadian investment strategist and commodity bull Don Coxe on the markets (from a recent conference call with clients): “No new bear market — we are going to have a correction here, but the global economy is still growing, but not as fast as the optimists would have hoped, and I don’t believe we can have a true bear market as long as liquidity is being supplied by the central banks at virtually zero cost. So much of that liquidity was misallocated before, but gradually as the economy grows it will be able to absorb it in actually productive activity”. I hope Don is right. Marc Faber dug out this apt quote from the US founding father Thomas Jefferson for his most recent monthly market commentary: “I predict future happiness for Americans if they can prevent the government from wasting the labours of the people under the pretext of taking care of them”.

Written by Jonathan Davis

June 7, 2010 at 8:31 AM

Market Review: 18 May 2010

Andrew Dalton, formerly of Mercury Asset Management, now running his own successful fund management firm boutique, provides Independent Investor with regular weekly market reviews. This is his take on last week’s market action in Europe, which has once again called the resilience of the euro project into question, and highlighted the dangers of policymaking errors.

Last week investment attention remained firmly fixed on the problems in Europe. Chancellor Merkel suffered a significant defeat last weekend, which highlighted the lack of support from German voters for a Greek bail out. There were various dissenting voices behind what has hitherto been determined official support for the euro. One German law maker suggested that Trichet should step down because the ECB had bought Greek debt. President Sarkozy threatened at one point to pull out of the euro zone.

Deutsche Bank suggests that Greece might not be able to repay its debts and Paul Volker, in London, suggested that the euro zone might disintegrate. There were riots in Greece and Ireland and strikes are now scheduled in Spain. The unemployment rate in Greece in May will probably be around 13% and over 20% in Spain – and that is before the proposed fiscal drag is applied. Both Spain and Portugal announced cuts in public expenditure.

The €750 billion EU/IMF rescue package a week ago was intended as a once-and-for-all method to solve the EU crisis. It was designed to prevent bond market defaults within the EU and dampen the massive interest rate risk spreads that had opened up for Mediterranean government bonds over recent months. The problem, of course, is that the rescue package, although necessary in the short term, does not address the bigger, long term structural problems.

Over the course of the last week, markets focussed on these longer-term structural problems. The truth is that there has been massive divergence between EU budget deficits, unit labour costs, current account deficits, etc. The EU took only a first small step towards addressing those deeper fundamental problems last week when Spain and Portugal proposed 5% pay cuts for public sector workers.

The establishment of the euro zone in 1999 presupposed that the various countries linked together in monetary union would experience roughly similar fundamental trends. However, that has not been the case. In the last 11 years, fundamentals among EU member nations have diverged significantly, creating the pressures now apparent among the laggard deficit countries of Greece, Portugal and Spain.

The divergence can be seen between Germany at one end of the EU spectrum with its stronger unit labour cost trends, resulting in large current account surpluses, much of which is from rest of the EU. While at the other end of the spectrum, the Mediterranean economies have had weaker unit labour cost trends and much larger budget and current account deficits than Germany.

With 11 years of divergence, Mediterranean governments have backed themselves into unfinanceable deficits and are now forced into belated action. Benefits and wages may have to be cut as much as 30% over the next few years. The bailout out packages can only prevent default in the near term but in the longer run these countries require smaller budget and current account deficits. They need to become more like Germany.

Private capital is now unwilling to fund those on-going Mediterranean budget deficits, and those economies, therefore, are faced with the necessity of bringing wages and benefits down swiftly in nominal terms, since they are unable in practice to raise their productivity sufficiently quickly to close the gap with Germany. Perversely, of course, German industrialists have been the great beneficiaries of the euro. Their southern European competition has become increasingly unable to compete with them, because they have not been able to benefit from regular, if disguised, devaluations against the Deutschemark. Germany has been running an increasingly large trade surplus with the rest of Europe.

Much of Europe now risks having to go through a second recession to right the imbalances. It is difficult to avoid the conclusion that the rest of Europe either has to compete with Germany within the euro or still go through similar austerity measures even if they leave the euro – truly an unattractive choice. Northern European members of the Euro zone, of course, have concomitant obligation to pick up an enormous bill to maintain the euro and, meanwhile, allow the ‘quality’ of the ECB’s balance sheet to deteriorate. In recent months, that fact has caused the euro exchange rate to trade more like a Greek euro than a German one. A European recession would be a major negative for the world economy and trade cycle.

If this were all, the situation indeed would be gloomy. The correct response, of course, is to stimulate growth not foster depression. The ECB will remain under pressure to ease monetary policy both by cutting rates and increasing the size of its balance sheet – quantitative easing. Germany should grow faster. Indeed, it should be noted that the Euro zone economy has been recovering, interest rates in Europe are close to zero and are likely to remain so. The euro has declined almost -20% in the last quarter and global growth is strong.

The world is growing elsewhere. The US continues to grow as is much of the rest of the emerging world. Indian imports in the year to date are up at an annualised rate of 79%. French industrial production is up by 7.8% and ISI’s Truckers survey of commercial traffic in the US has risen a remarkable 39.9% from its recession low. There are steady and incipient signs that US employment is in an up trend. ISI’s Permanent Employment Companies survey increased again last week by 0.8% to 42.9%. This is versus its recession low of 16.1%. And the ISI Temporary Employment Companies survey remained at a strong 61.6%.

We have assumed that the tighter fiscal policy is, the looser monetary policy needs to be. A policy mix of “tight fiscal and loose monetary” is generally positive for asset prices. On a net basis, we have had nothing in Continental European equities for some weeks. For US dollar based accounts, we have wholly hedged any non US dollar positions back into the US dollar. For sterling based and euro based accounts, we have increased our exposure to the US dollar. We have raised our cash levels but we have not yet abandoned the view that a primary trend in equities is intact. However, we have to acknowledge the risk of political disruption and administrative incompetence. Nowhere are these two possibilities more on show than in Europe.

Europe will have to resolve its problems. Ultimately, we expect a fiscal union and possibly a two tier Euro zone. Europe has never addressed the lack of a fiscal union effectively. Without fiscal union, the core EMU countries are effectively giving a credit card to the weaker countries that lack discipline and are too eager for growth at any cost.

Ultimately some countries will have to take a leave from monetary union. Without the option of devaluing their “own” currency, there is no other option than outright default. Therefore, an option that allows devaluation, combined possibly with austerity policies, may be a more realistic option. From the perspective of bond holders, this is just default in disguise. You lend people euros and get back something less.

The likely outcome is that the euro will survive but the fixing process will take time, which will also mean that relative to the US dollar and other regions of the world, Europe will be weak, which is what the market is reflecting.

Written by Jonathan Davis

May 19, 2010 at 5:42 PM

Andrew Dalton’s Market Review

Equity markets rose last week until Friday, when they fell sharply with the announcement of the SEC’s suit against Goldman Sachs.  The picture that emerges from the suit is nasty, plausible but, probably, difficult to prove.  Goldman Sachs was not alone in manufacturing these types of synthetic transactions.  Nonetheless, it appears that the SEC intends to follow the profile of the particular Goldman Sachs transaction known as Abacus 2007 – AC1. 

 Andrew Dalton 2 If the case is eventually proven, the path for compensation for those who lost money would be much easier.  The timing of the SEC’s case is important politically, because regulation of the investment banking community is under active discussion in the US Congress.  It is important, however, to realise that much of what is in contention is already history and the impact on world equity markets, therefore, is likely to be short-lived. 

Of more importance has been the progress of first quarter earnings reports from the United States, which has been good.  As of April 16th, 38 companies in the S&P 500 have reported, representing 12% of total market capitalisation.  The upside surprise ratio stands at 78.9%.  The earnings growth of companies reporting thus far is up 31.8% year-on-year.  The reported earnings growth rate excluding financial sector is 41%.

Elsewhere the Greek situation rumbles on.  The latest IMF/EU delegation expected in Athens today has been delayed by a week because of volcanic ash that prevents flights.  However, it now appears likely that the Greeks will seek to draw down official pledges of assistance from other European Union countries.  This had the effect, at the end of last week, of pushing German government bond yields higher and Greek government bond yields higher still.

In the United Kingdom, the Liberal Democrat leader, Nick Clegg, appeared to do well in the three way debate on UK television between himself and the two other party leaders last Thursday.  The most recent opinion poll even suggests that the Liberal Democratic party has more electoral support than any other party in the UK general election, which is to be held on 6 May.  Even that level of support, though, would be insufficient to give the Liberal Democratic party a majority of seats in the UK House of Commons, although it could double the number of seats they currently hold, making a ‘hung’ parliament more likely.  Sterling weakened.

Part of the difficulty on Friday was that Goldman Sachs did not issue its rebuttal until this morning.  In that rebuttal, Goldman was anxious to ensure that attention should be focussed on this one transaction, which involved two professional institutional investors, IKB and ACA Capital Management.  They pointed out that this particular transaction has been the subject of SEC examination and review for over 18 months and that, based on all that Goldman itself had learned from this examination, the firm’s actions were entirely appropriate. 

Goldman further pointed out that the institutions were very experienced in the CDO market, extensive disclosure was made in respect of each of the securities in the reference portfolio, similar in detail and scale to those disclosures required by the SEC in public transactions and that the offering documents provided all the information needed to understand and evaluate the portfolio.  In essence, the transactions at issue involved a static portfolio of securities, which was marketed solely to sophisticated financial institutions. 

IKB, a large German bank and leading CDO market participant and ACA, the two investors knew about the associated risks.  Goldman pointed out that they were among the most sophisticated mortgage investors in the world, they understood that a synthetic CDO transaction requires a short interest for every corresponding long position.  Goldman Sachs insisted that it never represented to ACA that Paulson was going to be a long investor.  As normal business practice, they asserted, market makers do not disclose the identities of a buyer to a seller and vice versa.  Clearly, Goldman is going to fight it all the way and suits against major broker dealers have been difficult to win.

More generally, the US economy has clearly ended the first quarter on a stronger note than originally anticipated and the second quarter has started even more strongly.  The April manufacturing PMI probably increased to 61.5% and ISI’s company surveys last week were at 46.7 versus 45.4 in March.  Strength in the Empire manufacturing employment index, published on Friday, fits with an improving picture for household employment, which has risen by almost 1.4 million over the past three months.  Credit markets are improving.  ABX prices (ie housing related securities) have surged in the past few weeks from 35.5 to 44.0 and CMBX prices (ie commercial real estate related securities) have risen from roughly 86.0 to 91.5.  Junk bond yields declined last week to 8.05%.

The range of investors’ views is, though, extraordinarily wide. ISI last week tested the views of their clients in a survey and the range of views was wider than at any stage that they can recall.  The expectations for real US GDP growth in 2011 range from 0% to +6%, the range for house prices from -10% to +15% and the level of the S&P index at the year end from 950 to 1450.

One way or another these views will eventually converge.  To our mind, sharply rising corporate profits, strong growth in emerging markets and rapidly recovering world trade argue for higher business spending, still further rises in commodity prices and equity market strength.  It may be that some of this strength has made some investors even more nervous.  Over the last 301 days, the GSCI measure of commodity prices has risen 80.4% – the most ever in an economic recovery. 

Even the most deadbeat areas of economic activity in the United States seem to be catching the mood.  California’s manufacturing PMI for the second quarter increased to 61.7, which is an outstanding figure, and Californian employment data reported last Friday showed that Californian employment over the last three months was actually up 35,000.  New York was up 43,000.

Technically, markets may have been rather overbought in the middle of last week with rises in each of the last seven weeks.  Friday’s action helps to correct that situation but, in our view at least, does not affect the primary uptrend.

Andrew Dalton is the Founder and Chief Investment Officer of the Dalton Strategic Partnership, and previously spent 30 years at Mercury Asset Management in a variety of senior investment positions. His market review will appear weekly in Independent Investor’s newsletter.

Written by Jonathan Davis

April 20, 2010 at 6:22 PM

The Need For Skin In The Game

One of the most powerful ideas to emerge out of the post-crisis reviews of the global financial system is the need for tradeable derivatives such as credit default swaps to incorporate in future an “insurable interest”, to make sure that we never again allow hedge funds and other short term traders to take free shots at their targets (today Greece, yesterday banks and mortgages) without having any “skin in the game”.

The point was well made in an article in the Financial Times by the former general counsel of Long Term Capital Management on Friday – an insight made all the more convincing by the fact that LTCM was itself a hedge fund whose over-geared trading almost brought the financial system to a crashing halt in 1998 before being rescued (nothing like a sinner who repents to talk sense!).

Here is an extract:

Wall Street loves a piñata party – singling out a company or country, making it the piñata, grabbing their sticks and banging it until it breaks. As in the child’s game, the piñata is left in shreds. Unlike the child’s game, in the Wall Street version the piñata is stuffed with money for the bankers to scoop up with both hands, instead of sweets. We see this game being played today, with Greece as the piñata.

Investors trying to understand why their portfolios have begun to melt down for the second time in five years are becoming experts in the fiscal policy of Greece. A look at the piñata party might make things clearer.

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

Comment: Mr Rickards goes on to make clear that he is not disputing that public finance in Greece is a mess, which it clearly is. The folly of allowing countries into the eurozone when they deliberately falsify statistics in order to meet the entry requirements is becoming all too apparent. Unlike the Irish, who have responded to the debt crisis with commendable determination, it is difficult to have much faith in the ability of the Greeks to put their own house in order.

Mr Rickards’  point is not that Greek fiscal extravagance does not need fixing, but that it should be dealt with in an orderly fashion by governments without the incendiary assistance of footloose traders. The argument against this line of thinking is that governments only get round to solving problems when it is too late and the damage has already been done (think of the UK and the Exchange Rate Mechanism in 1992). Even if you accept this argument, however, it is clear that financial market discipline would be more responsibly exercised if it was firmly rooted in an ownership interest.

Written by Jonathan Davis

February 15, 2010 at 11:37 AM

Posted in Commentary, Greece