(Oct. 8, 2009 - Erwan Mahe) As I write these lines, I am increasingly uncomfortable because wherever I look, I see the symptoms of the debt deflation process which has formed the core of our macroeconomic scenario since the death of securitisation in May 2007.
As much as this analysis proved itself useful during the entirety of the credit crisis, enabling us to point out the attractiveness of fixed rate debt instrument markets when some people were going delirious over the supposed return of hyperinflation, it also served to paralyse us during the second part of the huge stock market rally between April and September!
In times like these I appreciate all the more the difficulty of our clients who are obliged to follow these movements, even when it conflicts with their own analyses.
Since I’m on the subject, I would like to thank those clients who warned me about the liquidity avalanche which would inevitably end up in equity assets, given the already impressive movement toward credit paper. This warning enabled us to avoid a lot of accidents on our advised option positions, by favouring small deltas and time-value attractive positions.
After many hours of reflexion, I have come to the following conclusion.
I have taken a mischievous pleasure in citing the now famous quote of Mervyn King, “It’s the levels, Stupid”, to illustrate the point that we need to stop focusing on percentage changes in economic indicators, whose rises only look impressive when viewed against their previous steep declines. These variations mask the fact that the concerned indicators are still well below the nominal levels of 2007, as highlighted by the fact that the Bundesbank itself doesn’t not expect Germany’s GDP to return to its previous high before …2013.
I must also admit that the term stupid may also apply to me in that this analysis also refers to stock indices!
Indeed, just how significant is it that the Eurostoxx has rebounded 65% since its low point in March, when at 2900, it is still well below its peak of 4550 in 2007?!
However, this does not signify a capitulation in the midst of the battle, since the structural fault line in the capitalist system, which has appeared since the death of securitisation, cannot be remedied solely by asset appreciation, although it helps.
It just seems impossible to gauge the point of equilibrium, within less than a 30% range, at which stock indices should settle.
This is probably why, when the historical volatility of the Eurostoxx (20 trading days) stuck just above 15% for the entire late summer, the implied 1-year option volatility never declined to below 26%, while it was worth 18% on a same configuration basis in 2007!
Conclusion: we need to try and guess the flows and the state of final portfolios suffocated by 0% interest rates (TC 29-09: The absolute power of 0% interest rates!) to be able to navigate correctly in these treacherous waters.
All we need now is for Mr Trichet to announce in the coming minutes an upcoming tightening of the ECB’s monetary policy to poke a hole in our pro-fixed rate bias. If that happens, I would do just as well take some of those numerous holiday days accumulated in the past two years!
Enough of the chatter, it’s time for drivel, with the return of …Debt Deflation.
• First, just a small point about securitisation, the cornerstone of modern “credit”: It represented 60% of credit in the United States in 2007. US authorities have been desperately trying to resuscitate it with the TALF, PPIF and other assorted acronyms, which amounts to putting public funds into areas in which private capital refuses to trespass without backing.
The Fed has thus bought $1 trillion in MBS since it launched its quantitative easing, but bear in mind that these security issues totalled $744bn in 2005, whereas total issues in the first six months of 2009 amounted to just $89bn!
And that’s leaving aside the CMBS of which there has not been a single issue in the past two years, as huge payment dates come to term.
• The debt restructuring plans for CIT, the US lender to SMBs, seems to be taking on water, with the recently announced withdrawal of PIMCO and Baupost for the Bondholder Steering Committee. The 5-year CDS price climbed 2% yesterday, with 40% upfront.
• Energy Futures Holding Corp, Former TXU group, acquired by KKR and TPG for $43bn in October 2007 (what timing!), is demanding a drastic renegotiation of its LBO debt by offering to exchange its 25-year debt against a new 10-year issue, but at 46.5 cents on the dollar!
The firm must also pay off $22.4bn of its $44.5bn in total debt in 2014.
• In Spain, we are closely watching the situation at banks which clearly abused debt-to-equity swaps with their real estate sector clients.
Banesto has just announced a 30% contraction in earnings, after having to hike its provision ratio on doubtful loans to 2.6%.
Bear in mind that the average ratio for banks in the country is 4.7%, and Banesto now admits to being the happy owner of a residential real estate portfolio appraised (?) at … €1.3bn.
In the meantime, in its core business of lending to the economy, outstanding loans retreated 2.60% on an annual basis.
• As for Germany, we have been noting day in and day out the reality of the credit crunch (denied by the venerable Mr Stark and Mr Weber), and today brings us a particularly sad example of it as reported in the FT: the bankruptcy of the 37-employee high precision machine tool manufacturer led by Mr Haux (the pride of German industry).
Just as the company received a huge order, saving this company inactive for the past 10 months, one of its traditional banks refused to lend it the needed cash advance and even threatened to cut existing credit lines, thus, scaring off two of its other two longstanding banks.
The Austrians will undoubtedly celebrate this fine example of Schumpeterian destructive creation.
With the ripping of the domestic banking fabric and the upcoming bankruptcy cases in 2010, based on the hardly attractive 2009 earnings figures of German SMBs, the situation is likely to grow ever more complicated.
• One of our favourite indicators, US consumer consumption published yesterday evening, contracted by an extra $12bn in August (-5.8% on an annual basis).
As we have had occasion to repeat far too often in these lines, the demand for credit is collapsing as much as its availability (confirmed by Mr Trichet at his press conference just a few seconds ago)!
This is the seventh monthly decline in a row, the first time since 1991, and I am willing to bet that the September figures will show a new contraction, making the string of monthly declines the longest since this statistic began publication in …1946.
After all, just consider what these figures will look like minus the Cash for Clunkers effect.
Check out these two revealing links relating to inflation and monetary policy, below:
• Following Wal-Mart, it is now retail chain Target’s turn to launch Christmas holiday sales starting this week, with 50% discounts on the Barbie and other dolls
• Dell has announced that it is cutting 905 jobs (1% of total staff) by January, one more proof that the inflation in financial stocks (Dell announced in late September the acquisition of Perot Systems for $3.9bn) has little relation with macroeconomic reality.
Mr Provopoulos, the boss of the Greek Central Bank, said this morning that he did not foresee a real rebound in economic activity for another two or three years. Maybe that will serve as a guide for the ECB’s exit strategy.
Mr Trichet gave no direct answers to any of the questions asked of him, and interest rate markets logically paid: “we will do what is needed for the stability of prices and credibility”.
No change in our investment focus: positive bias toward government debt instruments, especially, on the eurozone 5-10 year segment, which benefits from the ECB's credibility.
With each market rebound, we can see the might of end buyers, who feel suffocated by 0% interest rates, and who will therefore continue to prop up stock indices for a while longer whenever they shows signs of weakness.