As always, comments & thoughts are welcome. In the interests of keeping this brief, I didn’t include detailed data behind some of the ideas, but I may discuss them in future updates.
The current bout of deleveraging is likely to continue. The tightening in credit over the past few months will accelerate the contraction we are already seeing in the Eurozone, and will likely last at least through 1H 2012.
Also accelerating this process is likely further downgrades of sovereign EU debt, which will increase the amount of capital that has to be held against them. Finally, the upcoming EU recession will cause EU budget deficits to be worse than forecast as the ‘automatic stabilizers’ like unemployment benefits kick in. The additional issuance of debt will also exacerbate the deleveraging process. However, I do not think the EMU will break up in a disorderly way, barring a revolution in Greece. I think the societal and legal constraints are much stronger than some market participants think.
In the US, the situation looks better, but only on a relative basis, thanks to super easy monetary policy and a resilient consumer. However, the US is now the only major country which is growing more than expected, and the big question is how long the US can remain decoupled. Forward looking items that are growth negative include:
· likely fiscal contraction, if not much near term at the federal level then a continuation at the state and local level
· low savings rates, which suggests there isn’t much room left for increasing consumption. This is the key factor since consumer spending remains 2/3rds of GDP. Note that historically, declines in the savings rate (white) has proceeded declines in retail sales (orange) and recessions.
· the US economic surprise index is near all time highs, which suggests that this recent series of positive data surprises may be ending soon. Historically, these episodes have coincided with short term tops in US equities as well.
I expect US growth, as reflected by ISM prints, to peak in the next few months before grinding lower. The likely slowdown in the US will probably induce another round of QE.
This suggests that the market environment over the next quarter will continue be choppy and challenging. As a result, I am putting out some ideas for all of 2012 rather than just 1Q.
Buy Short Term USD SIFI US Bank debt
- Recent Fed stress tests suggest that the Fed is very concerned about solvency. They do not want to let any of the SIFI banks go under again. Worst case scenario is probably the GSE conservatorship model, whereby equity holders get wiped.
- Short term yields on senior unsecured obligations are consistent with super junk levels. For example, a Merrill Aug 2012 issue is trading at a yield to maturity of 5%.
- US banks are in good shape from a liquidity perspective. There is almost no use of the Fed’s discount window, suggesting that liquidity remains plentiful. This is important because ultimately, it is a liquidity problem that causes large banks to go under.
Buy an ATMF 3y1y USD Receiver
- The US is going to slowdown, and headline Inflation is likely to peak soon
- Fed will do more QE. Implicitly this pushes back expectations for the date of the first hike.
- K = 1.72%, 2y1y = 1.03%. If vol and fwd curves are unchanged in 1yr, you’re up 50% on the premium.
- Real rates globally are likely to remain low for an extended period. The Fed is likely to embark on another round of QE. Almost every major CB in the world is easing policy. Most developed market currencies have negative real rates
- Stockpiles of crude oil and grains are at very low levels, increasing the likelihood of a supply shock
- The biggest risk is a disorderly deleveraging of the EU banking system. However, given recent ECB actions, arguably this risk has been sharply reduced.
Long Brent Crude
- OECD supplies are very tight. The lesson from 2008 is that tight supplies can induce rallies despite an upcoming recession
- Futures strip is very backwardated as a result of tight supplies, which has historically been very positive for returns.
- An EU recession is less damaging for Oil demand than a US recession due to lower elasticity of demand. Meanwhile, US vehicle sales have been surprising on the upside
- The Swedish current account is actually broadly uncorrelated to EURSEK levels. Historically, the swing factor has been portfolio flows. As a result of the EU crisis, this should continue to support SEK.
- Historically, Swedish banks have had large EUR liabilities. This contributed to the massive move in EURSEK following Lehman. However, since then much of the exposure has been reduced, meaning the currency is less exposed to EU contractions
- Carry is 2% annualized, for now
- Recent Swiss data has been horrible. Mfg PMI has declined to 44.8. CPI is now at -0.5% YoY. The SNB is likely to react by resetting the EURCHF floor higher, since it is the only tool left.
Long Nasdaq 100 vs Dow Jones Industrials Avg
- Relative valuation is very skewed. There is a large amount of flight to quality premium priced into the DJIA which is likely to unwind either via a stabilization of the stress in the EU or over time via Nasdaq’s higher earnings growth
- In a slow or no growth environment, growth stocks are likely to outperform
Long S&P 500 vs Eurostoxx50, FX hedged
- US growth will exceed EU growth relative to expectations. Specifically, consensus expectations have not adjusted sufficiently for the upcoming EU recession.
Short Consumer Discretionary vs Consumer Staples
- US slowdown + low savings rate => discretionary spending will fall.
Buy agency REITS like NLY or AGNC
- 15% dividend yield is sustainable given current low levels of leverage due to the wide spread between current coupon and swaps
- An MBS focused QE program will yield a sharp improvement in book value
- NLY currently trading at just 1x book. Over the past decade, this is the bottom end of the valuation range. Buying at 1x book has been good entry points.