Recap 10-5-11

Main Items:

· ADP Employment improved 91k vs 75k exp and 91k

· ISM Non-Mfg ISM declined to 53 in Sept vs 52.8 exp and 53.3 prev

· Dexia plans to allocate EUR 180bn of troubled assets into a bad bank, which will be guaranteed by France and Belgium. Dexia is also expected to sell off its asset management business and DenizBank, its fast growing retail bank in Turkey. The Paris based public finance arm, Dexia Municipal Agency, will most likely be sold to the French savings banks Caisse des Depots or CDC according to Reuters / WSJ


· Italian PMI declined to 45.8 vs 47 exp and 48.4 prev

· UK PMI improved to 52.9 vs 50.5 exp vs 51.1


The ECB looks likely to do 1yr LTRO’s tomorrow, but not a refi rate cut. But whether it cuts the refi rate or not is almost beside the point. It will cut at some point over the next few months, and even if it doesn’t, markets will expect front loaded cuts in 1Q12. As a result, I think ERZ1 remains too cheap.
Looking at later maturities, the market appears to believe that Euribor is unlikely to set below 1%, as 99.05 has been a pretty solid ceiling for white Euribor contracts since early August. This is probably because the ECB never cut refi rates below 1% in the last recession. This assumption may be incorrect. Leading indicators suggest that the upcoming EU recession will be longer than the last one, although potentially not as deep. A particular difference is that the EU fiscal stimulus in 2009 will instead be fiscal headwinds in 2012. In 2009, pan Eurozone fiscal deficit was 6.3% of GDP, and in 2010, it was 6%. In 2012, fiscal stimulus is projected fall to 3.5%, a swing of 2.5%. In comparison, Eurozone GDP has averaged just 1.6% over the past 6 quarters, and the UE rate has remain stuck near the highs at 10% compared to just 7.5% in 2007.
This ‘paradox of thrift’ in an environment of high unemployment is likely to have a particularly large impact in keeping the UE rate high as well as lowering both inflation as well as expectations. I think EZ core CPI will fall below 1% on a sustained basis and this will eventually allow the ECB to cut rates below 1%, or at least let Euribor settle below 1% again. .

Finally, model based outputs suggests that current Eonia rates of ~50bps is ‘fair value,’ which suggests that it is also the target for Euribor settings.

A Hypothesis on Mis-valuations:
I postulate that the global economy is speculative capital heavy as a result of tax policies and demographics. Tax policy has lead to increased wealth inequality, which increases speculative capital. In addition, the mercantilist policies in EM as well as the global demographic profile means there has been an excess of savers vs spenders in the past few decades.
The additional speculative capital means that asset prices are more likely to deviate from ‘fair value.’ I don’t have any direct proof for this, although I note that we saw both a stock market as well as housing bubble in the past 15 years.
This is relevant because, as others have pointed out, many asset prices suggest a macro economic situation that is much worse than what the data is reflecting. Given the increased speculative capital, which I postulate are caused by secular, long term drivers, this environment is likely to persist (possibly for an extended period) until the data gets better. Therefore, strategies that buy only based on valuation are likely to show low sharpe ratios. To some extent, this has been reflected by recent performance at various Graham/Dodd type hedge fund and insurance companies.
As macro managers, this means we should put increased focus on positioning, sentiment, and catalysts. It also means that because mis-valuations are larger, cyclical swings in asset prices are also likely to be larger.


4 thoughts on “Recap 10-5-11

  1. Your hypothesis is interesting, but a bit oversimplified IMO. In 2003-2007 we had a nice and quiet low-volatility bull market – under exactly the same overflowing liquidity conditions, with bubbles being blown all over the world in that period. I think catalysts for high volatility lie less with the speculative capital and more with structural macro-risks we’re currently facing – mainly, from EZ and China. Besides, we’ve had three major shocks excluding those two this year – the Arab Spring oil jump, the Japanese earthquake and the US debt limit rampage. Can’t blame the markets for being spooked, really.

    So, as I see it, the situation is more complicated, but this liquidity abundance is obviously a major factor – perhaps, long-term (maybe even secular?) and structural. I’ll have to think about it, the implications can be pretty big.

    1. Yes, the political and event uncertainties could certainly explain price action over the past year. But IMO the bubbles we saw over the past decade suggest that larger secular forces are afoot.

      The abundance of liquidity has been helpful in the past, when leverage were not at worrisome levels. Without enough equity, even zero borrowing rates will not entice additional credit expansion. That seems to be the problem today.

      1. Well, the consumer in most important deficit countries is tapped out, no doubt that. In some places, even in balance sheet recession/liquidity trap. But let’s not forget about the imbalances – while there was overconsumption and undersaving (=underinvestment) in the deficit countries, there was and still is underconsumption and overinvestment in the surplus countries: mainly, Germany and China. In theory, these two can cancel out and we can continue with normal trend growth. Though I doubt this can happen in practice in a painless way.

        1. I think that’s correct. Over the short run the problem is that the consumption share of GDP in the surplus countries are already so low. In China, it is an unheard of 35%. As a result, private consumption needs to growth 50% more than capital investment to generate the same GDP growth in China.

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