Trader’s Review of the Week; 7 August 2011

[private] Sunday 7th August – That was the week that was

What a week both in the US and Europe and, indeed, global markets. In the US, S&P decided to downgrade US long term sovereign debt from AAA by 1 notch to AA+, outlook negative and, furthermore, could lower the US long term rating to AA within the next 2 years.

Amongst the reasons cited by S&P, was their view that “the fiscal consolidation plans that Congress and the Administration recently agreed on fall short of what would be necessary to stabilize the governments’ medium term debt dynamics”. S&P adds “More broadly, the downgrade reflects (S&P’s) view that the effectiveness, stability, and predictability of American policy making and political challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18th 2011”.

Moody’s and Fitch have retained their AAA rating, which given their previous comments this should have been expected. This S&P move, will still come as a huge shock and, more importantly, reduce US consumer confidence even further as spending is only growing at the slowest pace outside recessionary periods. This is bad news for the consumer dependent and US economy.

S&P decided to go ahead with the downgrade, in spite of admitting errors in their calculation, more than a little embarrassing I would have thought. The impact on the US is expected to be marginal, some investors could reduce their investments in bond funds, though in interest rate terms, in the short term yields are unlikely to rise by any meaningful amount.

The very important repo market could be affected, which, in turn, could result in higher interest rates But once again the impact is likely to be minimal, particularly given the risk aversion globally currently prevailing. Retail investor reactions will be interesting to watch. Overall, I really see no pick up in the US economy, if anything, current economic and earnings forecasts still remain optimistic.

In Europe, the ECB has agreed to intervene in the markets and buy Spanish and Italian bonds, of course yields of Spanish and Italian bonds were lower on Friday ahead of the ECB announcement. This really should have been a very strong signal that something was up, particularly given the weak markets at that time.

In exchange Italy will bring forward measures to liberalise their economy and, importantly, introduce a balanced budget amendment to reduce the budget deficit to zero in 2013, 1 year ahead of the previous plan. Also they would also introduce legislation which would force “closed professions” to liberalise their services, speed up welfare reforms and other structural reforms, and most importantly into their constitution.

All of these (long overdue) measures are to be welcomed and should help the Italian economy, in the medium term, to boost its stagnant economy. In real terms the Italian economy has grown by much less than 1.0% over the last decade. The Italian Parliament will be recalled and the necessary legislation will be enacted in August, though not without the usual Latin theatrics I’m sure.

Spain is to introduce other structural reforms and presumably further austerity measures. Late next week, the Spanish authorities announce 2nd Q GDP, which is expected to be around +0.2%, hardly inspiring. Remember, that both Italy and Spain are on credit watch for a possible downgrade.

The big problem with Europe is that the EFSF, the temporary bail out fund for the Euro Zone, is to remain at E440bn. That’s enough to deal with Greece, Portugal and Ireland, but also dealing with Italy and Spain will be impossible. For example, Italy has funding requirements of E400bn+ pa for years and with current rates (over 6.0% for the 10 year, as is the case for Spain), will pose a significant burden, given its excessively high debt to GDP (approaching 120%).

However, the German’s are reluctant to increase the size of the EFSF as this is an impossible situation. The bottom line is that these measures are insufficient. Sorry, but I just can not see it any other way.

As usual the telecoms companies are benefiting as there have been and will be numerous telephone calls between various G7/G20 politicians over the weekend. But unfortunately apart from platitudes, I strongly suspect, they will achieve very little. The global economy is slowing, even economists have finally come to this conclusion.

What you need is growth. In the US (as is the case in Europe), the Tea party talks about anti growth measures austerity (though according to them it is measures for growth). Though this is needed, it will simply reduce growth. I have to say I am fed up of listening to, in particular, members of the Tea party in the US, they clearly have the IQ of an amoeba – collectively!

When I hear people like Cantor and Bachmann, I feel that I want to hit the delete button. The scary thing is that it looks as if a number of people in the US take them seriously, as they did Sarah Palin! Case proven, I believe.

An American couple stayed with me over the last few days, they described the Tea Party as a party for the disenfranchised – not a bad description at all. Just say no, seems to be their motto. The Democrats just cannot get away from their excessive spending habits. However, markets will constrain this ludicrous habit.

Many years ago, during the latter part of Mrs Thatcher’s and then John Major’s Governments, the UK equivalent of the Tea Party carried significant political sway. The result was the election of the Labour Party for over 15 years and the collapse of the Tory (Conservative) Party, who have only just got in this time and only in coalition with the Liberals.

Furthermore, one of my real ‘bête noir’ is, Gordon Brown became PM – unelected, I hasten to add. He virtually brought the country to its knees, through reckless spending, and he claimed he was the “Iron Chancellor” and many in the financial community believed so, as well.

The moral of this story is that extreme right wing nutcases (read the Tea Party) is bad for Conservatives, believe you me. For years, the UK has followed the US in virtually every aspect. However, it may be that this time, the US should learn from the UK experience.

In the UK, the coalition Government (personally, I don’t believe that coalitions work, but it does appear to be working in the UK, so far) have introduced savage spending cuts, accompanied by revenue increases – that does mean tax increases by the way. If the US think that spending cuts, most of them illusory, will suffice, then good luck to them. Every sensible person will say this, but the denial by those US political loonies is just breathe taking.

As you know, my major theme has and continues to be that “Political and policy actions will have a greater impact on market performance”. Clearly financial and economic issues are hugely important, but they have to be considered together with political and policy issues, in my opinion.

I suspect, most of us in Europe understand this, but unsurprisingly, most in the US do not, I guess after all, business has had a relatively political or policy free life. Great, as it should be, but that’s not what is going to happen, as all can see right now. The problem is that most believe they can understand politicians etc. I’m afraid it simply is not the case.

When I was at Rothschild’s, we were the No1 rated investment bank in privatisations, probably globally, for virtually ever. Indeed, I did not believe that we really had any competition, but the important issue was that we were involved in most of the significant privatisation transactions, globally.

The reason was not because we were geniuses, but because we understood how to play the political game, whilst designing politically acceptable solutions which were also acceptable to the financial markets. No easy task, I assure you. Indeed my team comprised of 2 political and financial people, both of whom are serious players in UK politics right now.

Subsequently, following my stint with the UK Government, advising countries in Central and Eastern Europe on privatisations, I joined the Canadian corporate and investment bank. Even at CIBC (who had virtually zero track record in privatisation) we won virtually every privatisation mandate we went for – once again the reason was virtually zero competition.

However, playing this political game is not easy, but it is and will continue to be necessary. Indeed, I am amused (most times) by the political and policy analysis by most market commentators. For example, virtually every investment decision I have taken recently has reflected my views on the prevalent political and policy issue. Both are on the long and short side, in addition to the important financial and economic background.

The other issue is that most market participants concentrate mainly on financial matters and don’t spend enough time on economic issues. It’s the combination that is critical in my view.

I am amazed when investors play Emerging Markets. EM’s are all about politics, the financial and economic issues are secondary considerations quite frankly. The political situation and actions in these countries have the best predictive power for market performance, yet 99%+ of investors totally ignore it. Amazing.

I must remind you of S&P’s statement “we [S&P] have changed our views of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilises the governments debt dynamics any time soon”, read Politics/Policy Matters.

The markets next week clearly fear prevails. No point being brave, I will watch for a bit at the open, though I may well be tempted to buy some energy stocks, particularly if they decline further, as they really have been beaten up.

Financials have taken a real beating and, in Europe there may be an initial rally following the announcement that the ECB would buy Italian and Spanish bonds. However, I remain bearish about the sector. In spite of the numerous protestations from bankers, politicians globally will press for banks to raise their capital levels far faster than the market believes.  Having witnessed the problems that could and have occurred, this is a no brainier.

The problem is that a number of financials will seek to raise capital, and all at the same time. I covered all my European financial shorts on Friday, as you know in anticipating of a policy change in Europe. The situation clearly was untenable and the ECB statement that they would buy Italian and Spanish bonds after European markets closed, bore this out. I will leave the sector for the moment, but may well revisit in due course.

A number of equity analysts suggest playing the EM’s – good luck to them. The view that EM’s are no longer dependent (indeed decoupled), on DM’s is so ludicrous, and I find to be totally laughable. I had a long conversation with a very good friend re China over the weekend. He is a major bull of the country, I remain sceptical at present.

It’s not that China is not important and that it’s importance will not increase in years, as I certainly do believe it is and will be. However, it’s just that China will have to follow developments, rather than lead them at present. Particularly as China does basically follow the US monetary policy.

I am Sure that will change in due course and when it does, we will have some real fun, but for the moment, China is not a player in the current game. Furthermore, history, I believe, proves that Command economies do not work, other than in the short, and possibly, medium term. However, trying to introduce democracy quickly in places such as China is fraught with its own economic and political problems, as I have experienced in other EM’s.

The Chinese authorities have a tough task ahead. By the way, the best person who really knows China is Stephen Roach (far, far better than me, by miles). In addition, it is also clear (though he does not admit) he has superb political connections in the country. Stephen is a bull on China.

There are a number of politically and policy driven issues I am working on at the moment, particularly as the current status quo is impossible as is. The likely course should become evident, even later this year, maybe around autumn.

The biggest issue is that most Governments, particularly in DM’s, are tapped out financially. A few years ago, they could relax fiscal policy; however, they can not afford it now. I truly did wish it was different, but like a boring record, stuck in the same old groove, I remain bearish.

Finally, given the S&P announcement re the US, I repeat, I am close to certain that France will lose its AAA rating. Another other country that is susceptible to this is Belgium, the home of the EU – that will be highly amusing. The UK it is marginal, but I believe the ratings agencies will give the UK the benefit of the doubt, for the moment, given the corrective action that the Government is taking, but if the economy deteriorates, time will tell.

The SNB’s and the BOJ’s actions to halt the rise in their currencies will not work, in my view. I will keep my Swiss longs, against the US$ and Euro also long Sing$, against the A$.

The good news is that volatility will continue. No point living in a boring world. One of the good bits of news around is that investors and institutions are pretty cashed up, I suspect. The other is that inflation should weaken, as a result there will be significant rallies on good news.

 

 

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. [/private]