Trader’s Review of the Week; 5 June 2011

[private] Sunday 5th Global economic slowdown?

Any second Greek bail out plan will have to be approved by the other 16 Eurozone countries (including countries such as Portugal and Ireland who have their own fiscal problems, but will be expected to contribute) – no easy task. We all know that the Finns are becoming more and more belligerent, as are the Dutch, the Austrians and the Germans (though the Germans recently seem to be backing off).

The Troika (comprising the EU, ECB and the IMF) will impose additional austerity measures and Greece has agreed to set up an independent body to supervise the privatisation of State assets. Great, but the assets to be privatised will not raise the E50bn projected (indeed, more likely a mere fraction of this amount).

The E50bn is a number plucked out of the air by Greek politicians. Unions will be (indeed are) on the war path and opposition within the Greek Government will make the proposed privatisation programme a complete farce – believe you me. I have been involved in privatisation for over 20 years across developed and emerging markets.

Even more serious is public opinion in Greece and in the other Euro Zone countries. In Greece, expect the incidents of civil disorder/public strikes etc to continue to increase in intensity and outside of Greece and the other peripherals, expect politicians who criticise such bail outs to gain more and more political support. I totally accept that the EU can keep this whole ludicrous scheme going on for longer than most people (including myself) believe is possible, but it will crack, it’s only a matter of time.

With limited funds, the EU/ECB should address the fundamental issue – restructure the debts of country’s to more manageable levels i.e. to no more than say 60% of GDP (the EU target), as opposed to the 150% which will be the case for Greece this year.

By buying/exchanging existing debt for say EFSF bonds (at a large discount), place strict future fiscal constraints on these countries, with significant automatic penalties for non compliance and recapitalise the banks, which will become insolvent, following a debt restructuring. There is enough money to do this.

However, if good money is thrown after bad, the available resources will be less when this current plan fails, as surely it will, which will mean that the subsequent pain will be far, far greater. A recent BarCap report that a haircut of Greek debt could amount to 75%, forget the 50% talked about recently.

The argument that time will reduce the problem with the peripheral Euro Zone countries does not stand up. Particularly in a slowing global economy and, much more importantly, an ongoing recession in these peripheral countries – which need growth, and not a contraction of their economies. Delays will reduce the funds available for an eventual rescue and make the problem bigger, with much more serious consequences in the future.

I have spent decades dealing with politicians, diplomats and bureaucrats. In my experience, they will always dither around, but if they feel their own position threatened, they will U-turn fast, normally with disastrous consequences.

As you know, I have been bearish and I believe that recent economic data supports my view. Oil (Brent) still is above US$115. I simply do not believe analysts who suggest that this does not matter.

If Brent was in the US$80s I would be more comfortable, but at current prices, discretionary spending in the developed world will reduce, as a larger part of disposable income is used to pay for the essentials. This will have a knock on impact on emerging economies.

The best news would be a swift resolution of the Libyan situation and a flow of 1.5mn barrels per day, resulting in a sharp drop in the oil price. This is a strong possibility, which is good news, though there is very little information on the state of the oil producing infrastructure in Libya.

However, oil has remained at elevated levels for a long time – what is needed is a long and sustained low $80s oil price. Based on past history, this may well appear optimistic. Until, at least, the oil price declines significantly, I will continue to be bearish.

Sunday 5th (pm) Right leaning parties expected to gain a majority in the Portuguese Parliament following today’s general election poll

Chinese international Yuan deposits (CNH) are a small part of China’s deposit base – approx 0.6% or 2.0% of China’s demand deposits. These deposits are as a result of China’s policy to allow more domestic companies to conduct cross border trade.

However, they represent 7.6% of Hong Kong’s deposit base and 15.5% of its foreign deposits. RBS estimates that it would take just over 1 year for it to reach 50% of Hong Kong’s deposit base, given the current rate of growth. The question then arises as to how Hong Kong maintains its peg to the US$.

In addition, where has all this CNH liquidity gone? Either re-deposited back into China, or swapped into HK$ and/or other currencies or lent. Lending seems to be the name of the game at present. The excess liquidity will force up inflation in Hong Kong.

However, another impact – the Chinese Central Bank will lose some of its powers and current capital controls will be difficult to maintain, something the Chinese authorities are unlikely to welcome.

The FT adds that the Chinese may add Singapore to offshore CNH centres and, subsequently, London. Logistical and regulatory issues stand in the way at present, but, China could well be a significant source of global liquidity in the future.

The right leaning Social Democrats (PSD) and the smaller conservative Popular Party (CDS-PP) look set to achieve victory in the Portuguese general elections and to form a majority Government. The defeat of Mr Socrates socialist government leaves only Spain, Greece, Austria, Slovenia and Cyprus with socialist Governments in the 27 countries that form the EU. The incoming PSD party has agreed to implement the austerity measures, agreed with the EU/ECB/IMF as part of the bail out plan.

As part of the deal with the EU/ECB/IMF, Greek PM, Mr Papandreou is promising spending cuts of E6.4bn this year, another E22bn up to 2015 and E50bn in privatisation proceeds – well PIGS do indeed fly!

In return Mr Jean Claude Junker has stated that Greece will obtain “additional funding…under strict conditionality”. A E12bn tranche of the bail out payment is expected to be paid in July by the EU’s stability fund (EFSF) and the IMF.

Under the original bail out plan, Greece was supposed to tap capital markets for E27bn in 2012 – clearly impossible. As a result the EU/IMF will have to increase their support. The plan for a voluntary roll over of maturing Greek debt is expected to be agreed by some 55% of bondholders – the ECB, Greek institutions/banks etc. Others will collect their cash and wipe the sweat off their brow.

Thousands of Greeks protested today against the additional austerity measures. A campaign – the “indignant citizens”, first started in Spain in reaction to the austerity measures is spreading across Europe. Expect these protests to continue and, indeed, increase in intensity.

Groupon’s S-1 filing reports that they measure their business using several metrics. However, their key metrics are Gross profit, adjusted consolidated segment operating income (adjusted CSOI) and free cash flow.

Adjusted CSOI, what’s that you may ask – adjusted CSOI does not include interest payments, forex fluctuations, significant cash investments that they are making to acquire new subscribers, management and employee shares issued and taxes i.e. most of the company’s expenses.

On an adjusted CSOI basis, Groupon’s 2010 operating income was a healthy US$60.6, but on a GAAP basis, a LOSS of US$413.3mn (source FT). Maybe the Chinese accounting firms, who are being investigated by US authorities in respect of Chinese companies listed in the US, should learn this trick – I bet you they will.

The FED is considering the need for US banks to sharply increase their capital requirements – in a recent speech, FED Governor Mr Daniel Tarullo suggested that systemically important banks hold capital ranging from 8.0% – 14% of assets (the recent Basel proposal was for capital to be 7.0%).

It is clear that a deal between the US and Europe needs to be agreed, but the pressure to raise capital levels continues. These proposals will be strongly resisted by US and European banks as they are under capitalised and, in addition, profitability will decline.

My view is that there will be relentless pressure to increase capital, particularly for systemically important banks, which is why I don’t like the sector, in spite of appearing cheap.

The recent statement by Moody’s to put a number of US banks (BoA, Citi, Wells Fargo) under review for a possible downgrade, follows S&P’s warning that these banks may lose their A1 rating – the consequence – these banks paper may be ineligible to be held by money market funds.

This is also an issue for European banks, who rely on money market funds for short term US$ financing. Basically, at best the funding costs of these banks will rise or, at worst, they will have to access other funding sources – yet another reason why I don’t like the sector.  In 2008, losses at money market funds shut down the US commercial paper market!

Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland.