David Einhorn - the manager of Greenlight Capital, recently wrote an OpEd piece for the NYT (it was a reproduction of his speech at the Ira Sohn conference). It is worth a read. Really makes me question the investment merits of TIPS and reinforces my interest in natural resources like Timber and Gold. Without further ado, here is the article:
"Are you worried that we are passing our debt on to future generations? Well, you need not worry.
Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.
According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government-guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.
A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.
Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.
The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?
•
The recent United States credit crisis was attributable in large measure to capital requirements and risk models that incorrectly assumed AAA-rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behavior of borrowers and lenders becomes distorted.
It was once unthinkable that “risk-free” institutions could fail — so unthinkable that the chief executives of the companies that recently did fail probably didn’t realize when they crossed the line from highly creditworthy to eventually insolvent. Surely, had they seen the line, they would, to a man, have stopped on the solvent side.
Our government leaders are faced with the same risk today. At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?
I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.
He went on to say that the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. It’s a valid point, but an insufficient excuse for holding off on addressing the long-term structural deficit. If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.
Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and bond buyers have told Congress they want to continue the current system.
As William Gross, the managing director of the bond management company Pimco, put it in his last newsletter, “Firms such as Pimco with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.”
Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the status quo.
It would be better to have each investor individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be determined by a couple of rating agency committees.
Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grâce.
The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero-risk weighting, which means zero capital requirements. As a result, European banks stocked up on Greek debt, and sold sovereign credit default swaps, and now need to be bailed out to avoid another banking crisis.
As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.
We should have learned by now that each credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA-rated collateral debt obligations, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.
•
I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.
Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.
That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.
Government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. According to the Web site Shadow Government Statistics, using the pre-1980 method, the Consumer Price Index would be over 9 percent, compared with about 2 percent in the official statistics today.
While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)
Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.
Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.
Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)
Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.
While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.
EASY money has negative consequences in addition to the risk of inflation and devaluing the dollar. It can also feed asset bubbles. In recent years, we have gone from one bubble and bailout to the next. Each bailout has rewarded those who acted imprudently. This has encouraged additional risky behavior, feeding the creation of new, larger bubbles.
The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury-financed bailout started a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of Long-Term Capital Management’s counterparties spurred the Internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt, despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble bursting.
Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.
David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article."
Friday, May 28, 2010
Tuesday, May 18, 2010
Regency Affiliates, Inc.
Regency Affiliates, Inc. (RAFI) is a publicly traded, they are the parent company of several subsidiary business operations. This play on this name is a take private that has already been approved by shareholders and the board and is currently awaiting comments (if any) from the SEC. The deal is as follows:
They will be doing a 1-for-100 reverse stock split immediately followed by a 100-for-1 forward stock split. The purpose of the split / re-split is to reduce the shareholder count below 300. Under SEC rules, a company with a class of securities registered under the Securities Exchange Act of 1934 may choose to terminate its registration if certain conditions are met - one such condition is if the securities have fewer than 300 record holders. By de-registering they will be able to avoid costly SEC listing requirements. Stockholders owning fewer than 100 shares of common stock immediately before the reverse stock split will no longer own such shares after the effective time and, in lieu thereof, will receive from RAFI $6.00 in cash, without interest, for each of such shares of common stock.
Based on this and today's closing price, investors can make a quick 43% return (non-annualized and excluding trading fees). Based on my discussions with the GC and with a couple of corporate lawyers the only risk is if the SEC comments on the transaction, thus stalling the process. The transaction was submitted to the SEC when they filed their proxy on March 1, 2010. The SEC than has (again according to the GC and confirmed by others) 60 days to review the transaction and if no comment is made the stock will split and repurchase will commence.
It almost doesn't matter what RAFI does but for those who care:
RAFI is more than 50 years old. It was reorganized in 1987 to be the successor to Transcontinental Oil Corporation, which existed since 1947. RAFI owns a partnership interest in the Security Land and Development Company Limited Partnership. The Partnership owns a two story office building and a connected six story office tower occupied by the United States Social Security Administration Office of Disability and International Operations under a fifteen year lease, expiring in 2018. On April 30, 2004, RAFI, through a newly-formed, wholly-owned subsidiary called Regency Power Corporation, acquired a 50% membership interest in MESC Capital, LLC, from DTE Mobile, LLC. MESC Capital was formed to acquire all of the membership interests in Mobile Energy Services Company, LLC. Mobile Energy owns an on-site energy facility that supplies steam and electricity to a Kimberly-Clark tissue mill in Mobile, Alabama. RAFI owns, through it 75% owned subsidiary, 80% of National Resource Development Corporation which has as its principal asset approximately 70 million + short tons of previously quarried and stockpiled rock located at the site of the Groveland Mine in Dickinson County, Michigan.
As of the most recent 10-Q (9/30/09) RAFI has approximately $7m in cash and marketable securities vs. $0 in debt.
So to reiterate the simplicity of this thesis - buy 99 shares (use limit orders so you don't get bad pricing due to the illiquidity) then sit and wait and receive $6 per share or approx 43% return in less than a month or so (annualize if you want but the number is satisfactory enough in its un-annualized state). Assuming you can get closing pricing your profit potential is ~ $180 before commissions so around $170 ex commissions. It is true you won't profit greatly from this trade, but at least its enough of a profit to go out to eat....maybe there is such a thing as a free lunch...
Target: $6.00 Current Price: $4.19
They will be doing a 1-for-100 reverse stock split immediately followed by a 100-for-1 forward stock split. The purpose of the split / re-split is to reduce the shareholder count below 300. Under SEC rules, a company with a class of securities registered under the Securities Exchange Act of 1934 may choose to terminate its registration if certain conditions are met - one such condition is if the securities have fewer than 300 record holders. By de-registering they will be able to avoid costly SEC listing requirements. Stockholders owning fewer than 100 shares of common stock immediately before the reverse stock split will no longer own such shares after the effective time and, in lieu thereof, will receive from RAFI $6.00 in cash, without interest, for each of such shares of common stock.
Based on this and today's closing price, investors can make a quick 43% return (non-annualized and excluding trading fees). Based on my discussions with the GC and with a couple of corporate lawyers the only risk is if the SEC comments on the transaction, thus stalling the process. The transaction was submitted to the SEC when they filed their proxy on March 1, 2010. The SEC than has (again according to the GC and confirmed by others) 60 days to review the transaction and if no comment is made the stock will split and repurchase will commence.
It almost doesn't matter what RAFI does but for those who care:
RAFI is more than 50 years old. It was reorganized in 1987 to be the successor to Transcontinental Oil Corporation, which existed since 1947. RAFI owns a partnership interest in the Security Land and Development Company Limited Partnership. The Partnership owns a two story office building and a connected six story office tower occupied by the United States Social Security Administration Office of Disability and International Operations under a fifteen year lease, expiring in 2018. On April 30, 2004, RAFI, through a newly-formed, wholly-owned subsidiary called Regency Power Corporation, acquired a 50% membership interest in MESC Capital, LLC, from DTE Mobile, LLC. MESC Capital was formed to acquire all of the membership interests in Mobile Energy Services Company, LLC. Mobile Energy owns an on-site energy facility that supplies steam and electricity to a Kimberly-Clark tissue mill in Mobile, Alabama. RAFI owns, through it 75% owned subsidiary, 80% of National Resource Development Corporation which has as its principal asset approximately 70 million + short tons of previously quarried and stockpiled rock located at the site of the Groveland Mine in Dickinson County, Michigan.
As of the most recent 10-Q (9/30/09) RAFI has approximately $7m in cash and marketable securities vs. $0 in debt.
So to reiterate the simplicity of this thesis - buy 99 shares (use limit orders so you don't get bad pricing due to the illiquidity) then sit and wait and receive $6 per share or approx 43% return in less than a month or so (annualize if you want but the number is satisfactory enough in its un-annualized state). Assuming you can get closing pricing your profit potential is ~ $180 before commissions so around $170 ex commissions. It is true you won't profit greatly from this trade, but at least its enough of a profit to go out to eat....maybe there is such a thing as a free lunch...
Target: $6.00 Current Price: $4.19
Great Northern Iron Ore Properties
reat Northern Iron Ore Properties (the "Trust") is a conventional nonvoting trust organized in 1906 by James J. Hill. He was the CEO of the Great Northern Railway and was a railroad tycoon back in the late 1800s and due to the size of the size of this region and the economic dominance exerted by his lines, Hill became known during his lifetime as The Empire Builder. Hill set up a trust to provide income for his youngest heirs. The beneficiaries were 18 children who at the inception of the trust were less than six years old.
The terms of the Great Northern Iron Ore Properties Trust Agreement, created December 7, 1906, state that the Trust shall continue for twenty years after the death of the last survivor of eighteen persons named in the Trust Agreement. The last survivor of these eighteen persons died on April 6, 1995. Accordingly, the Trust terminates twenty years from April 6, 1995, that being April 6, 2015.
The Trust owns interests in fee, both mineral and non-mineral lands, on the Mesabi Iron Range in northeastern Minnesota. The Trust's properties, which span two counties (St. Louis and Itasca) in northeastern Minnesota, extend from Hoyt Lakes on the east end of the Mesabi Iron Range to Grand Rapids on the west end of the Mesabi Iron Range. Many of these properties are leased to steel and mining companies that mine the mineral lands for taconite iron ore. The Trust has no subsidiaries.
The primary purposes of the Trust are to lease its mineral interests on the Mesabi Iron Range in northeastern Minnesota to the major steel and taconite producers, collect royalties from the extraction of taconite ore by the producers, and provide a return to the shareholders, while at the same time balancing the interests of the certificate holders with those of the reversioner -- Glacier Park Company, a wholly owned subsidiary of ConocoPhillips.
Deriving its royalty income from Taconite, as one would expect the Trust's distributions are highly correlated to the price of steel. Seeing how the trust has been operating for over 100 years it seems logical that additional discovers of Taconite are highly unlikely.
At the end of the Trust, the shares in the Trust will cease to trade on the New York Stock Exchange and thereafter will represent only the right to receive certain distributions payable to the certificate holders of record at the time of the termination of the Trust. Upon termination, the Trust is obligated to distribute ratably to shareholders the net monies remaining in the hands of the Trustees (after paying and providing for all expenses and obligations of the Trust), plus the balance in the Principal Charges account (the balance in this account consists of attorneys’ fees and expenses of counsel for adverse parties pursuant to the Court Order in connection with litigation commenced in 1972 relating to the Trustees’ powers and duties under the Trust Agreement and the costs of homes and surface lands acquired in accordance with provisions of a lease with U.S. Steel Corporation, net of an allowance to amortize the cost of the land based on actual shipments of taconite and net of a credit for disposition of tangible assets). All other Trust property (most notably the Trust’s mineral properties and the active leases) must be conveyed and transferred to the Glacier Park Company, a wholly owned subsidiary of Conoco Phillips.
This termination payment is currently (as of 12/31/09 which is the last estimate) at $8.53/share (for frame of reference it was: $8.20 in 2008, $8.78 in 2007, $8.80 in 2006, and $10.53 in 2005).
Over the past 12 months the company has declared $8.20 in annual dividends (with the last dividend being paid on April 30, 2010) which makes for some intimidating - an 8.8% trailing dividend yield.
The bet quite simply is that the Trust's accumulated dividends from here until April 6, 2015 plus the termination payment will total less than the current stock price.
Without going into great detail (which I highly recommend readers build out their own models as they can see how sensitive the Trust is to steel prices), lets assume that steel prices are back to the wild days of 2008 and the Trust's payments rise accordingly to their 2008 highs - which was $11.70/share. If we take this and multiple it by 20 payments (20 quarters to April 6, 2015 - assuming the April 30, 2015 dividend is paid on April 6, 2015) it results in total distributions of $58.5/share. We then add in the termination payment which should be around $9. This results in total payments to shareholders of $67.5/share. So in the absolute worst case (assuming steel at prices 50% higher than today) you can still expect a 9.2% IRR, if steel prices remain in a more normalized range it is a fairly attractive high double digit IRR, which could be accelerated should the shares trade closer to intrinsic value more rapidly than I am assuming.
Only negative is the cost the short - this is one reason why it may be worth sitting on the sidelines and selling into the rallies. Overall it is a fairly simple idea that should produce adequate returns.
Variant View:
There is no variant opinion, this stock has zero coverage. But the real keys to focus on in my mind are:
Higher steel prices leading to larger distributions
Some additional discovery of Taconite that can meaningfully increase their royalty stream (highly unlikely as described above)
Something funky that makes the distribution from the Principal Charges Account meaningfully higher (not even sure if this is possible).
Target: $67.50 by expiration, current price: $91.42
The terms of the Great Northern Iron Ore Properties Trust Agreement, created December 7, 1906, state that the Trust shall continue for twenty years after the death of the last survivor of eighteen persons named in the Trust Agreement. The last survivor of these eighteen persons died on April 6, 1995. Accordingly, the Trust terminates twenty years from April 6, 1995, that being April 6, 2015.
The Trust owns interests in fee, both mineral and non-mineral lands, on the Mesabi Iron Range in northeastern Minnesota. The Trust's properties, which span two counties (St. Louis and Itasca) in northeastern Minnesota, extend from Hoyt Lakes on the east end of the Mesabi Iron Range to Grand Rapids on the west end of the Mesabi Iron Range. Many of these properties are leased to steel and mining companies that mine the mineral lands for taconite iron ore. The Trust has no subsidiaries.
The primary purposes of the Trust are to lease its mineral interests on the Mesabi Iron Range in northeastern Minnesota to the major steel and taconite producers, collect royalties from the extraction of taconite ore by the producers, and provide a return to the shareholders, while at the same time balancing the interests of the certificate holders with those of the reversioner -- Glacier Park Company, a wholly owned subsidiary of ConocoPhillips.
Deriving its royalty income from Taconite, as one would expect the Trust's distributions are highly correlated to the price of steel. Seeing how the trust has been operating for over 100 years it seems logical that additional discovers of Taconite are highly unlikely.
At the end of the Trust, the shares in the Trust will cease to trade on the New York Stock Exchange and thereafter will represent only the right to receive certain distributions payable to the certificate holders of record at the time of the termination of the Trust. Upon termination, the Trust is obligated to distribute ratably to shareholders the net monies remaining in the hands of the Trustees (after paying and providing for all expenses and obligations of the Trust), plus the balance in the Principal Charges account (the balance in this account consists of attorneys’ fees and expenses of counsel for adverse parties pursuant to the Court Order in connection with litigation commenced in 1972 relating to the Trustees’ powers and duties under the Trust Agreement and the costs of homes and surface lands acquired in accordance with provisions of a lease with U.S. Steel Corporation, net of an allowance to amortize the cost of the land based on actual shipments of taconite and net of a credit for disposition of tangible assets). All other Trust property (most notably the Trust’s mineral properties and the active leases) must be conveyed and transferred to the Glacier Park Company, a wholly owned subsidiary of Conoco Phillips.
This termination payment is currently (as of 12/31/09 which is the last estimate) at $8.53/share (for frame of reference it was: $8.20 in 2008, $8.78 in 2007, $8.80 in 2006, and $10.53 in 2005).
Over the past 12 months the company has declared $8.20 in annual dividends (with the last dividend being paid on April 30, 2010) which makes for some intimidating - an 8.8% trailing dividend yield.
The bet quite simply is that the Trust's accumulated dividends from here until April 6, 2015 plus the termination payment will total less than the current stock price.
Without going into great detail (which I highly recommend readers build out their own models as they can see how sensitive the Trust is to steel prices), lets assume that steel prices are back to the wild days of 2008 and the Trust's payments rise accordingly to their 2008 highs - which was $11.70/share. If we take this and multiple it by 20 payments (20 quarters to April 6, 2015 - assuming the April 30, 2015 dividend is paid on April 6, 2015) it results in total distributions of $58.5/share. We then add in the termination payment which should be around $9. This results in total payments to shareholders of $67.5/share. So in the absolute worst case (assuming steel at prices 50% higher than today) you can still expect a 9.2% IRR, if steel prices remain in a more normalized range it is a fairly attractive high double digit IRR, which could be accelerated should the shares trade closer to intrinsic value more rapidly than I am assuming.
Only negative is the cost the short - this is one reason why it may be worth sitting on the sidelines and selling into the rallies. Overall it is a fairly simple idea that should produce adequate returns.
Variant View:
There is no variant opinion, this stock has zero coverage. But the real keys to focus on in my mind are:
Higher steel prices leading to larger distributions
Some additional discovery of Taconite that can meaningfully increase their royalty stream (highly unlikely as described above)
Something funky that makes the distribution from the Principal Charges Account meaningfully higher (not even sure if this is possible).
Target: $67.50 by expiration, current price: $91.42
Updates - New Directions
Much has happened since my last post. In an effort to better align this forum with my current interests I will be shifting the format from Global Macro calls to more classical stock picking. User feedback will be greatly appreciated so if you have any thoughts or suggestions please let me know. Thanks.
Wednesday, December 31, 2008
Hussman Article
Below is an exerpt from John P. Hussman's article "The Dollar Crisis Begins." I have been sharing this view for some time. Either the dollar will fall or the yield on the long-bond will rise. The retail way to play this is through TBT and UDN. I am currently working on an options strategy to best play this theme. Hopefully I will post shortly with my findings.
"On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”
Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.
And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.
In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.
As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”
I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely."
Source: http://hussmanfunds.com/wmc/wmc081222.htm
"On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”
Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.
And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.
In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.
As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”
I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely."
Source: http://hussmanfunds.com/wmc/wmc081222.htm
Sunday, December 14, 2008
Untitled
We are now at a very interesting point in time. This upcoming week should provide some fantastic data. Not only do we have some interesting earnings being reported (GS, MS, NKE, FDX, etc.) but we also get to see the FOMC decision and the CPI data. Plus who knows what news will come out of Washington with regards to the auto bail out or any other stimulus plans. This week will likely set the tone until inauguration. I read an interesting stat lately that I felt was worth sharing, in the past 12 months the Fed’s assets grew by 146% the ECB by 58%, the Swiss National Bank’s by 74%, and the BoE by 158%. I find it somewhat funny that we are solving the problem of excessive leverage by leveraging. One can’t help but wonder when long-term rates will raise and inflation will once again be a fear (I guess it is just a function of how talented the Fed has become at putting its collective feet on and off of the accelerator).
Goldman Sachs recently came out with their top trades of 2009. I have pasted a brief overview below, enjoy.
TRADE #1: Long Chinese A-shares at 2,079, target 2,600 Despite the uncertainties in the global equity picture, the scope for a sharp increase in China’s A-share market this year, which is down 70% from its peaks in October 2007, is quite real. While the Chinese economy is heading towards its worst slowdown in many years, the policy response, both on the fiscal and monetary fronts, is also set to be aggressive. Broader quantitative easing and the kind of renewed USD weakness that our FX forecasts show would probably also help this Dollar-linked market.
TRADE #2: Long/Short EM FX Differentiation Basket at 100, target 106 in spot (plus carry) This basket, with 20% long EUR/PLN, 30% long EUR/CZK, 15% long EUR/TRY, 20% short US$/MXN, 15% short US$/BRL, seeks to take advantage of valuation differentials in EM currencies as well as different degrees of vulnerability to further deleveraging. At this stage, we view Eastern European currencies as most vulnerable. LATAM currencies, on the other hand, have seen disproportionate depreciation moves lately and the economies seem less exposed to ongoing tensions in the credit markets based on various metrics of leverage and banking system health.
TRADE #3: Short Dec-11 crude oil futures at US$67.97 target US$ 60 The global recession has put sharp pressure on oil prices, which will likely extend to long-dated oil contracts, as typically occurs during cyclical downturns. With long-dated oil at very significant premiums to front-month crude, there is substantial positive carry and plenty of evidence that this dynamic has not yet fully taken hold. One consequence is that integrated energy stocks (and the broad energy sector) may see renewed relative and absolute pressure.
TRADE #4: Long US 30-yr current coupon Fannie-Mae MBS, target 4.0% As ‘unconventional’ monetary policy measures in the US, and perhaps elsewhere, begin to kick into gear, the mortgage borrowing rate is likely to become a more explicit focus of any new policy measures. With this in mind, we recommend buying current coupon Fannie Mae 30-yr MBS. The 5% coupon trades at a yield of 4.7% on current pre-payment speed assumptions. This corresponds to a spread of over 300bp over the 5-yr Treasury yield (roughly comparable duration on current prepayment assumptions). Our target is 4%. An alternative is to enter Dollar ’Rolls’ at an implied repo of 2%.
TRADE #5: Sell credit protection on Sweden through 5-yr CDS at 148bp, target 60bp
As investors have become more concerned about Sweden’s banking sector’s exposure to the Baltic countries, and Eastern Europe more broadly, the 5-yr Swedish sovereign CDS has gone from 13bp (or flat to Germany’s) at the end of September to 148bp currently
(Or 100bp over). Even accounting for the sharp slowdown in economic activity and our banking team’s estimates that banking losses from exposure to Eastern Europe could reach 3.0% of GDP over the next few years, Sweden’s credit fundamentals are solid. The government is expected to run close to a balanced budget position, after a string of surpluses; gross public debt is a meager 30% of GDP, less than half the Eurozone average. The current account position is a healthy surplus (in excess of 7% of GDP) and external liabilities are tiny.
TRADE #6: Long the Wavefront housing basket at 58.97 for a target of 70
Our Housing basket is a relative trade, pitting homebuilders and other housing related areas of the US equity market (appliances, furnishings, house wares, autos, electronics) against a broader set of cyclical areas of the market. We expect to see residential investment growth bottom in Q4 2008, and, with the Fed focused on quantitative easing in the mortgage and agency space, we think stabilization and sequential improvement in the data (even if not outright strength) will prove supportive for this relative equity trade, even if the broad cyclical picture remains weak.
TRADE #7: Long Cable (For those wondering Cable is the exchange rate between the U.S. dollar and the British pound sterling. The origins of this term are attributed to the fact that in the 1800s, the dollar/pound sterling exchange rate was transmitted via transatlantic cable.), at 1.48, for an initial target of 1.65 a large part of recent Dollar strength has been the result of forced deleveraging flows. As these flows abate, the Dollar should weaken on the back of continued large current account deficits. And if the US administration continues towards more aggressive quantitative easing policies and succeeds in raising inflation expectations, that too could be Dollar-weakening. Alongside this, we are of the view that much of the weakness of the UK economy and banking system is now priced. Moreover, the exceptional easing of financial conditions due to fast
BoE rate cuts and unprecedented trade-weighted Sterling weakness create upside risks to the UK economy.
I am particularly inclined to believe in trade #7 as I think the dollar is grossly overvalued purely due to the fear in the market place. Once people realize the world is all equally hurt and it is not ending, they will trade out of the dollar (and dollar debt) until yields rise to an appropriate rate commensurate to the risks associated with the US Government and economy.
One interesting stock that I think could make an intriguing trade should it fall from its current levels is De La Rue plc. They are a UK based printer of banknotes. I believe this is one of the more interesting equity based ways to profit off of all the balance-sheet growth currently occurring in the world. De La Rue, traces its roots back to 1813 and was originally listed on the LSE in 1947. De La Rue specializes in the supply of cash-related printing and systems services to both central and commercial banks. The Security Printing & Paper division prints currencies, passports and other documents requiring security features. It has 50% of the outsourced banknote printing market (10-20%). It is also the largest independent producer of banknote paper (30% market share). The cash systems division supplies cash counting, sorting and dispensing equipment for the banking industry. It has a 27% stake in Camelot, which has the license to run the National Lottery until February 2009. So this company should benefit from a few trends: global balance sheet expansion, lottery participation (which increases in tough times), and the need for consistent and increased global ID protection/management services. Over the past five years the company has extensively restructured. It has returned more than $1+Bn to shareholders. They even sold a commercial cash systems business to The Carlyle Group for about $600m. Analysts currently expect the company to earn around $100m of net profit for 2009 which equates to a forward P/E of around 11x (this by the way is well below its historical average in the high 20s). On an underlying basis (excluding legacy central costs not disposed with Cash Systems), De La Rue trades on around 10x EV/EBIT and 13x PE for Mar 09E. Unfortunately the stock has held up fairly well YTD, should this name come down substantially from its current 850 pence price I suggest investors take a serious look.
Goldman Sachs recently came out with their top trades of 2009. I have pasted a brief overview below, enjoy.
TRADE #1: Long Chinese A-shares at 2,079, target 2,600 Despite the uncertainties in the global equity picture, the scope for a sharp increase in China’s A-share market this year, which is down 70% from its peaks in October 2007, is quite real. While the Chinese economy is heading towards its worst slowdown in many years, the policy response, both on the fiscal and monetary fronts, is also set to be aggressive. Broader quantitative easing and the kind of renewed USD weakness that our FX forecasts show would probably also help this Dollar-linked market.
TRADE #2: Long/Short EM FX Differentiation Basket at 100, target 106 in spot (plus carry) This basket, with 20% long EUR/PLN, 30% long EUR/CZK, 15% long EUR/TRY, 20% short US$/MXN, 15% short US$/BRL, seeks to take advantage of valuation differentials in EM currencies as well as different degrees of vulnerability to further deleveraging. At this stage, we view Eastern European currencies as most vulnerable. LATAM currencies, on the other hand, have seen disproportionate depreciation moves lately and the economies seem less exposed to ongoing tensions in the credit markets based on various metrics of leverage and banking system health.
TRADE #3: Short Dec-11 crude oil futures at US$67.97 target US$ 60 The global recession has put sharp pressure on oil prices, which will likely extend to long-dated oil contracts, as typically occurs during cyclical downturns. With long-dated oil at very significant premiums to front-month crude, there is substantial positive carry and plenty of evidence that this dynamic has not yet fully taken hold. One consequence is that integrated energy stocks (and the broad energy sector) may see renewed relative and absolute pressure.
TRADE #4: Long US 30-yr current coupon Fannie-Mae MBS, target 4.0% As ‘unconventional’ monetary policy measures in the US, and perhaps elsewhere, begin to kick into gear, the mortgage borrowing rate is likely to become a more explicit focus of any new policy measures. With this in mind, we recommend buying current coupon Fannie Mae 30-yr MBS. The 5% coupon trades at a yield of 4.7% on current pre-payment speed assumptions. This corresponds to a spread of over 300bp over the 5-yr Treasury yield (roughly comparable duration on current prepayment assumptions). Our target is 4%. An alternative is to enter Dollar ’Rolls’ at an implied repo of 2%.
TRADE #5: Sell credit protection on Sweden through 5-yr CDS at 148bp, target 60bp
As investors have become more concerned about Sweden’s banking sector’s exposure to the Baltic countries, and Eastern Europe more broadly, the 5-yr Swedish sovereign CDS has gone from 13bp (or flat to Germany’s) at the end of September to 148bp currently
(Or 100bp over). Even accounting for the sharp slowdown in economic activity and our banking team’s estimates that banking losses from exposure to Eastern Europe could reach 3.0% of GDP over the next few years, Sweden’s credit fundamentals are solid. The government is expected to run close to a balanced budget position, after a string of surpluses; gross public debt is a meager 30% of GDP, less than half the Eurozone average. The current account position is a healthy surplus (in excess of 7% of GDP) and external liabilities are tiny.
TRADE #6: Long the Wavefront housing basket at 58.97 for a target of 70
Our Housing basket is a relative trade, pitting homebuilders and other housing related areas of the US equity market (appliances, furnishings, house wares, autos, electronics) against a broader set of cyclical areas of the market. We expect to see residential investment growth bottom in Q4 2008, and, with the Fed focused on quantitative easing in the mortgage and agency space, we think stabilization and sequential improvement in the data (even if not outright strength) will prove supportive for this relative equity trade, even if the broad cyclical picture remains weak.
TRADE #7: Long Cable (For those wondering Cable is the exchange rate between the U.S. dollar and the British pound sterling. The origins of this term are attributed to the fact that in the 1800s, the dollar/pound sterling exchange rate was transmitted via transatlantic cable.), at 1.48, for an initial target of 1.65 a large part of recent Dollar strength has been the result of forced deleveraging flows. As these flows abate, the Dollar should weaken on the back of continued large current account deficits. And if the US administration continues towards more aggressive quantitative easing policies and succeeds in raising inflation expectations, that too could be Dollar-weakening. Alongside this, we are of the view that much of the weakness of the UK economy and banking system is now priced. Moreover, the exceptional easing of financial conditions due to fast
BoE rate cuts and unprecedented trade-weighted Sterling weakness create upside risks to the UK economy.
I am particularly inclined to believe in trade #7 as I think the dollar is grossly overvalued purely due to the fear in the market place. Once people realize the world is all equally hurt and it is not ending, they will trade out of the dollar (and dollar debt) until yields rise to an appropriate rate commensurate to the risks associated with the US Government and economy.
One interesting stock that I think could make an intriguing trade should it fall from its current levels is De La Rue plc. They are a UK based printer of banknotes. I believe this is one of the more interesting equity based ways to profit off of all the balance-sheet growth currently occurring in the world. De La Rue, traces its roots back to 1813 and was originally listed on the LSE in 1947. De La Rue specializes in the supply of cash-related printing and systems services to both central and commercial banks. The Security Printing & Paper division prints currencies, passports and other documents requiring security features. It has 50% of the outsourced banknote printing market (10-20%). It is also the largest independent producer of banknote paper (30% market share). The cash systems division supplies cash counting, sorting and dispensing equipment for the banking industry. It has a 27% stake in Camelot, which has the license to run the National Lottery until February 2009. So this company should benefit from a few trends: global balance sheet expansion, lottery participation (which increases in tough times), and the need for consistent and increased global ID protection/management services. Over the past five years the company has extensively restructured. It has returned more than $1+Bn to shareholders. They even sold a commercial cash systems business to The Carlyle Group for about $600m. Analysts currently expect the company to earn around $100m of net profit for 2009 which equates to a forward P/E of around 11x (this by the way is well below its historical average in the high 20s). On an underlying basis (excluding legacy central costs not disposed with Cash Systems), De La Rue trades on around 10x EV/EBIT and 13x PE for Mar 09E. Unfortunately the stock has held up fairly well YTD, should this name come down substantially from its current 850 pence price I suggest investors take a serious look.
Sunday, December 7, 2008
Quick posting
Looking back at my previous recommendations the one thing that I have gotten wrong more often than not is my unfortunate bullishness on emerging markets. I thought now if ever was a good time to revisit this position.
Thus far various EM economies have taken quite varied approaches towards the crisis. Historically, emerging markets have reacted to crises by jacking up short-term interest rates, tightening fiscal budgets, and either rigidly trying to defend their exchange rates or, when that proves impossible, permitting large devaluations. However, during the current episode, as Friday’s surprise 100bp cut in Thailand illustrates, most EMs have opted to lower interest rates. Moreover, many are easing fiscal policy, and have taken the middle ground with respect to exchange rate management by letting their currencies depreciate gradually. In other words, EMs are trying to react to the global economic slowdown in the same way that most developed economies are reacting. But will the new medicine work any better than the old?
The reality is that countercyclical fiscal and monetary policy is a luxury that not every EM can afford, not every EM economy has the resilience associated with more developed economies. The good news for EMs is that, as a group, they have become a lot more resilient over the past decade. Total EM external debt to exports has declined from 152% in 1998 to 66% in 2008. Meanwhile, the overall EM current account balance has moved from a deficit a decade ago to a surplus of about 2.6% of GDP in 2008. The bad news is that in an environment in which advanced economies are likely to experience a nasty recession –GDP in advanced economies are expected to contract 1% in 2009 – the traditional reliance of many EMs on export demand will prove to be a handicap. Furthermore, the resilience to economic shocks varies significantly across EMs. For example, between 2000 and 2008, the ratio of external debt to GDP declined from 36.7% to 20.4% in Latin America, and from 28.2% to 16.5% in Emerging Asia, but increased from 45.3% to 50.5% in Central and Eastern Europe. Thus, we need to differentiate between countries such as China that are really part of the solution, in terms of their capacity to ease both fiscal and monetary policy, and countries where the fundamentals are shakier. This latter group of countries is at risk of experiencing significant balance of payments pressures if the global financial crisis were to worsen.
Russia looks vulnerable. Interest rates are negative in real terms, credit growth – at least until recently – has been very high, and the country has a weak inflation track record, marked by periodic bouts of extremely high inflation. Furthermore, the sharp deterioration in Russia’s terms of trade since the summer has left it with a currency that is overvalued. While debt payments (both private and public) due in 2009 are a manageable 9% of external reserves and 10% of exports and foreign income receipts, there is concern that a move by Russians to shift their deposits from Rubles to Dollars and Euros could put a strain on reserves, which have already fallen by $150 billion (25%) since August. The CBR has reacted by allowing the Ruble to weaken by 1% on three successive occasions over the past three weeks. These glacial moves stand in stark contrast to the forwards, which are now pricing a 27% depreciation against the Dollar over the next 12 months. As such, a large one-time devaluation would be appropriate, as it would help the CBR conserve reserves and give a competitive boost to the Russian export sector. On the fiscal side, Russia is expected to run a small fiscal surplus in 2009 and government debt to remain low at 8% of GDP, the high CDS spread on Russia’s sovereign obligations suggests that investors have become more concerned about solvency risk.
In Latin America, CDS spreads are pricing in significant default risk in Argentina and Venezuela. Sovereign spreads are moderate in Colombia, Brazil and Mexico, and relatively low in Chile. Real rates are quite high in Brazil and Mexico, and there is scope for both countries to ease monetary policy as inflation concerns begin to subside. However, while Brazil’s fundamentals have improved markedly over the past 5 years to the point that it has become one of the most resilient EMs, given the country’s history of hyperinflation, as well as its large negative net foreign asset position (43% of GDP) and somewhat overvalued currency, policymakers will need to stay vigilant in the event that the global financial crisis worsens and capital outflows intensify. Likewise, in Mexico, while the Peso is undervalued on a trade-weighted basis, a high ratio of scheduled debt service in 2009 (36% of reserves) may complicate the conduct of monetary policy.
Among the major EM regions, emerging Asia seems the most resilient, although even here, the Philippines and Indonesia look quite vulnerable. China in particular appears very resilient. While the Renminbi is now about 8% overvalued on a trade-weighted basis, total debt service in 2009 is projected to be only 1% of exports and foreign income receipts, and 1% of external reserves, while net foreign assets stand at a healthy 31% of GDP. Real interest rates are also positive (real deposit rates are about 3%), which gives the PBoC further scope to lower deposit and lending rates. Moreover, the country has no recent history of hyperinflation, and hence has more monetary credibility than many other EMs. The fiscal position is also strong. While the government balance is expected to shift to a deficit of 1.8% next year, government debt is low (18% of GDP), and CDS spreads indicate that the market is not overly concerned about solvency risk. China also has the fastest long-term growth rate of any EM, with an estimated GDP growth rate of 10.1% between 2010 and 2025.
In thinking about the market implications of this analysis, it is important to juxtapose the risks described above with how the market is pricing them. In a number of EMs, the market is pricing in significant tightening of monetary policy. Brazil is one market that comes to mind where this is obviously already priced in. I am still bullish on the long-term stories of select EMs, I would just be careful in selection. I will reiterate what I have been saying for some time, now is the time to be writing OTM puts on select securities that you would be interested in otherwise purchasing. It is just like putting in a limit order and getting paid to wait. With implied volatility near all time highs and the VIX at the highest 3 month realized levels since the Great Depression the premiums on some names are absolutely fantastic. For example, last week I wrote some Dec 35 GS Puts and received $1.60 up front! Those are fantastic annualized returns. The key to this strategy is you have to want to take delivery on the underlying security should it fall to your level.
While it is tempting to believe that a New Year will bring an entirely different set of market prospects – a new slate – the reality is often different. The start of 2009 is unlikely to bring a change in the dynamic of growth and the unlocking of credit that is required for risky assets to re-rate. While I do expect an inflection point in economic activity and the pricing of equities and credit markets sometime in 2009 it is likely to be from lower levels and later in the year. From a trading perspective (aka I am going off my gut, there is no real deep research backing me up) I would expect the current rally to continue (although at a more moderated tone) through the beginning of next year. After our new president is inaugurated and we start to see some ugly Q4 data, people will bid the markets further down. I would expect a bottom sometime in Mid-summer when I hope we might begin to anticipate the affects of Obama’s plan to save the American consumer. Fears of debt deflation are probably overdone – the mistakes of the 1930s, and Japan in the 1990s, are unlikely to be repeated as government action becomes increasingly aggressive, coordinated and unorthodox. But we live in an age where the unexpected happens – regularly. Investors are assuming the worst before they are proved wrong. Governments are likely to be seen as guilty until proven innocent, and so deflation, while unlikely, is likely priced as a growing probability in the near term. It is still too early in the process of growth deterioration and falls in profits for the market to start pricing in the next recovery. The credit markets need to right themselves before I can put any faith in this recent bear rally.
With all these speak of need for further government intervention I am amazed at how little structure the government plan has thus far. Apart from the still uncertain size of the stimulus package, there is even greater uncertainty regarding its composition. Infrastructure has been the top theme in the debate, but there appears to be limit to how much infrastructure spending can be carried out in the two-year timeframe lawmakers are considering and especially in 2009. Other options include state fiscal assistance, which is more or less limited to the amount of state fiscal shortfalls, and tax provisions. Ultimately, the first two options appear likely to have a higher multiplier than the last, but the last is by far the easiest to implement in large amounts and also has quicker effects. Near term projects do exist, but there is a limit. The Congressional Budget Office estimates that $18 billion in transportation related
projects are “shovel ready” and could begin within 120 days. The American Association of State Highway and Transportation Officials (AASHTO) puts this number at $32 billion. Meanwhile, the National Governor’s Association (NGA) has estimated that $136 billion in infrastructure projects – including not only transportation projects but other areas as well—are planned and ready to be started within the next year. It will be interesting to see where the final dollars go. My hope is that it will be spent useful i.e. not building bridges to nowhere in Alaska.
Going forward I think this market will turn into a truly fantastic time for hard core value stock pickers. One recent move that I hope everyone was smart enough to participate in was when Berkshire Hathaway fell below $80,000 (those are the A shares for those of us who are less fortunate I recommend investing in the B shares which are usually 1/30th the price). Berkshire fell due to fears of derivative contracts that expire in 10+ years. For more on this read the Barron’s article written two weeks ago or just look under Yahoo! Finance, I am sure there is a story on it. The CDS for a short period shot up on Berkshire to 5%, I would have loved to traded in those. The key to winning in volatile times likes these is being ever vigilante to take advantage of those sweet opportunities. I know I am watching both the equities, options, and convertibles market like a hawk for the once in a decade opportunity. If any readers see anything or would like to discuss some please feel free to post a question which we can discuss in greater detail. Thanks.
Thus far various EM economies have taken quite varied approaches towards the crisis. Historically, emerging markets have reacted to crises by jacking up short-term interest rates, tightening fiscal budgets, and either rigidly trying to defend their exchange rates or, when that proves impossible, permitting large devaluations. However, during the current episode, as Friday’s surprise 100bp cut in Thailand illustrates, most EMs have opted to lower interest rates. Moreover, many are easing fiscal policy, and have taken the middle ground with respect to exchange rate management by letting their currencies depreciate gradually. In other words, EMs are trying to react to the global economic slowdown in the same way that most developed economies are reacting. But will the new medicine work any better than the old?
The reality is that countercyclical fiscal and monetary policy is a luxury that not every EM can afford, not every EM economy has the resilience associated with more developed economies. The good news for EMs is that, as a group, they have become a lot more resilient over the past decade. Total EM external debt to exports has declined from 152% in 1998 to 66% in 2008. Meanwhile, the overall EM current account balance has moved from a deficit a decade ago to a surplus of about 2.6% of GDP in 2008. The bad news is that in an environment in which advanced economies are likely to experience a nasty recession –GDP in advanced economies are expected to contract 1% in 2009 – the traditional reliance of many EMs on export demand will prove to be a handicap. Furthermore, the resilience to economic shocks varies significantly across EMs. For example, between 2000 and 2008, the ratio of external debt to GDP declined from 36.7% to 20.4% in Latin America, and from 28.2% to 16.5% in Emerging Asia, but increased from 45.3% to 50.5% in Central and Eastern Europe. Thus, we need to differentiate between countries such as China that are really part of the solution, in terms of their capacity to ease both fiscal and monetary policy, and countries where the fundamentals are shakier. This latter group of countries is at risk of experiencing significant balance of payments pressures if the global financial crisis were to worsen.
Russia looks vulnerable. Interest rates are negative in real terms, credit growth – at least until recently – has been very high, and the country has a weak inflation track record, marked by periodic bouts of extremely high inflation. Furthermore, the sharp deterioration in Russia’s terms of trade since the summer has left it with a currency that is overvalued. While debt payments (both private and public) due in 2009 are a manageable 9% of external reserves and 10% of exports and foreign income receipts, there is concern that a move by Russians to shift their deposits from Rubles to Dollars and Euros could put a strain on reserves, which have already fallen by $150 billion (25%) since August. The CBR has reacted by allowing the Ruble to weaken by 1% on three successive occasions over the past three weeks. These glacial moves stand in stark contrast to the forwards, which are now pricing a 27% depreciation against the Dollar over the next 12 months. As such, a large one-time devaluation would be appropriate, as it would help the CBR conserve reserves and give a competitive boost to the Russian export sector. On the fiscal side, Russia is expected to run a small fiscal surplus in 2009 and government debt to remain low at 8% of GDP, the high CDS spread on Russia’s sovereign obligations suggests that investors have become more concerned about solvency risk.
In Latin America, CDS spreads are pricing in significant default risk in Argentina and Venezuela. Sovereign spreads are moderate in Colombia, Brazil and Mexico, and relatively low in Chile. Real rates are quite high in Brazil and Mexico, and there is scope for both countries to ease monetary policy as inflation concerns begin to subside. However, while Brazil’s fundamentals have improved markedly over the past 5 years to the point that it has become one of the most resilient EMs, given the country’s history of hyperinflation, as well as its large negative net foreign asset position (43% of GDP) and somewhat overvalued currency, policymakers will need to stay vigilant in the event that the global financial crisis worsens and capital outflows intensify. Likewise, in Mexico, while the Peso is undervalued on a trade-weighted basis, a high ratio of scheduled debt service in 2009 (36% of reserves) may complicate the conduct of monetary policy.
Among the major EM regions, emerging Asia seems the most resilient, although even here, the Philippines and Indonesia look quite vulnerable. China in particular appears very resilient. While the Renminbi is now about 8% overvalued on a trade-weighted basis, total debt service in 2009 is projected to be only 1% of exports and foreign income receipts, and 1% of external reserves, while net foreign assets stand at a healthy 31% of GDP. Real interest rates are also positive (real deposit rates are about 3%), which gives the PBoC further scope to lower deposit and lending rates. Moreover, the country has no recent history of hyperinflation, and hence has more monetary credibility than many other EMs. The fiscal position is also strong. While the government balance is expected to shift to a deficit of 1.8% next year, government debt is low (18% of GDP), and CDS spreads indicate that the market is not overly concerned about solvency risk. China also has the fastest long-term growth rate of any EM, with an estimated GDP growth rate of 10.1% between 2010 and 2025.
In thinking about the market implications of this analysis, it is important to juxtapose the risks described above with how the market is pricing them. In a number of EMs, the market is pricing in significant tightening of monetary policy. Brazil is one market that comes to mind where this is obviously already priced in. I am still bullish on the long-term stories of select EMs, I would just be careful in selection. I will reiterate what I have been saying for some time, now is the time to be writing OTM puts on select securities that you would be interested in otherwise purchasing. It is just like putting in a limit order and getting paid to wait. With implied volatility near all time highs and the VIX at the highest 3 month realized levels since the Great Depression the premiums on some names are absolutely fantastic. For example, last week I wrote some Dec 35 GS Puts and received $1.60 up front! Those are fantastic annualized returns. The key to this strategy is you have to want to take delivery on the underlying security should it fall to your level.
While it is tempting to believe that a New Year will bring an entirely different set of market prospects – a new slate – the reality is often different. The start of 2009 is unlikely to bring a change in the dynamic of growth and the unlocking of credit that is required for risky assets to re-rate. While I do expect an inflection point in economic activity and the pricing of equities and credit markets sometime in 2009 it is likely to be from lower levels and later in the year. From a trading perspective (aka I am going off my gut, there is no real deep research backing me up) I would expect the current rally to continue (although at a more moderated tone) through the beginning of next year. After our new president is inaugurated and we start to see some ugly Q4 data, people will bid the markets further down. I would expect a bottom sometime in Mid-summer when I hope we might begin to anticipate the affects of Obama’s plan to save the American consumer. Fears of debt deflation are probably overdone – the mistakes of the 1930s, and Japan in the 1990s, are unlikely to be repeated as government action becomes increasingly aggressive, coordinated and unorthodox. But we live in an age where the unexpected happens – regularly. Investors are assuming the worst before they are proved wrong. Governments are likely to be seen as guilty until proven innocent, and so deflation, while unlikely, is likely priced as a growing probability in the near term. It is still too early in the process of growth deterioration and falls in profits for the market to start pricing in the next recovery. The credit markets need to right themselves before I can put any faith in this recent bear rally.
With all these speak of need for further government intervention I am amazed at how little structure the government plan has thus far. Apart from the still uncertain size of the stimulus package, there is even greater uncertainty regarding its composition. Infrastructure has been the top theme in the debate, but there appears to be limit to how much infrastructure spending can be carried out in the two-year timeframe lawmakers are considering and especially in 2009. Other options include state fiscal assistance, which is more or less limited to the amount of state fiscal shortfalls, and tax provisions. Ultimately, the first two options appear likely to have a higher multiplier than the last, but the last is by far the easiest to implement in large amounts and also has quicker effects. Near term projects do exist, but there is a limit. The Congressional Budget Office estimates that $18 billion in transportation related
projects are “shovel ready” and could begin within 120 days. The American Association of State Highway and Transportation Officials (AASHTO) puts this number at $32 billion. Meanwhile, the National Governor’s Association (NGA) has estimated that $136 billion in infrastructure projects – including not only transportation projects but other areas as well—are planned and ready to be started within the next year. It will be interesting to see where the final dollars go. My hope is that it will be spent useful i.e. not building bridges to nowhere in Alaska.
Going forward I think this market will turn into a truly fantastic time for hard core value stock pickers. One recent move that I hope everyone was smart enough to participate in was when Berkshire Hathaway fell below $80,000 (those are the A shares for those of us who are less fortunate I recommend investing in the B shares which are usually 1/30th the price). Berkshire fell due to fears of derivative contracts that expire in 10+ years. For more on this read the Barron’s article written two weeks ago or just look under Yahoo! Finance, I am sure there is a story on it. The CDS for a short period shot up on Berkshire to 5%, I would have loved to traded in those. The key to winning in volatile times likes these is being ever vigilante to take advantage of those sweet opportunities. I know I am watching both the equities, options, and convertibles market like a hawk for the once in a decade opportunity. If any readers see anything or would like to discuss some please feel free to post a question which we can discuss in greater detail. Thanks.
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