If you focus on the downside risk, the upside return will take care of itself




Thursday 21 July 2011

Direct and indirect exposure to European peripherals is huge!

It is assumed that banks that hold Greek debt will have write downs.

But what if they bought CDS's? Who wrote the CDS will suffer the lose from a restructuring! It is hard to know who wrote the CDS, so libor rates will increase due to the mystery!

Majority of the debt is from retail/commercial loans (75%). Then interbank lending and soveriegn debt.

Insurance companies only really have exposure to the sovereign debt side. Hence are less at risk then the banks - unless they were the ones that wrote the CDS's!

What is a safe haven currency? A country that has favourable macroeconomic features in difficult times. But Switzerland has a banking sector considerably larger than its total GDP. Hence, though Swiss bank exposure to peripherals is small, it is over 100% of GDP to other European sovereign. Do you think German banks would be immune from restructuring of debt in Spain or Italy? There will be blood! And even a 10% haircut for Swiss banks would be huge in absolute terms.

Is the NOK safer? What is there pension fund invested in? How would oil react in such circumstances? The advantage is that there is likely to be slightly less damage to the Norweigian banking system. But there would be little money moving around if oil is not increasing! There are bad, and more bad! Gold would see a chunk of money momve towards it I suppose?

Commodities, bonds and equities

History suggests that commodity prices and the multiple on equities are inversely correlated to each other over many years. There period of evolution also seems to be similar, suggesting one may affect the other directly.

When commodities are going through a decade of increasing prices, history would suggest in that decade the price/earnings ratio for stocks would decline.

There is some sense to this. Many companies have raw material and transportation costs that make up a significant portion of total costs.

However, the operating margin does not follow the commodity cycle! (debt cycle has more influence)

During 2002 - 2007 margins increased whilst commodities also increased in price - no doubt both fueled by the increase in credit in the system. It is the multiple, hence the markets perception of what a future stream of cash flows are worth, that has a strong relation to the price of commodities. Hence it may well be the FEAR of inflation in the future that reduces the multiple on equities. The fear that interest rates will be higher, and a dollar will be worth less.

Debt cycle is longer than the commodity and equity multiple cycle.

Credit is what makes booms and busts according to Ray Dalio. They are what makes GDP growth vary around the increase of productivity. Population growth is the second source of GDP growth. If GDP/capita is constant and the population doubles over time, so will the GDP. Population growth is also what determines the population structure in an economy, i.e. number of 25 to 50 year olds in a society. This will determine the liabilities of a society that has a develope economy, i.e. a welfare system. Productivity needs resources - if it is not funded because capital allocation becomes worse, the GDP growth rate can change?

Credit determines the demand in an economy. Hence can provide purchasing power to companies (support margins) and keep consumers spending. The authorities artifically prop up debt markets, is that why they last longer? Does inflation follow the credit cycle? It seems to. We assume that inflation follows the credit cycle (or is it vice versa).

The margin cycle seems simply to be a function of the business cycle. We note that the 1980 peak was the same as the 1995 peak. The three bottoms between 1980 - 2010 in 86, 01, 09 were all similar. The big difference were the peaks in 06 and 10, which were much larger than any point in the last 30 years. Credit led initially and then cost cutting led? During the first few years of the strong bull market in the 1980s the margin was actually decreasing, reaching its bottom in 1986. Prices were so cheap by that time that multiple expansion was the primary source of equity market returns. Can you imagine the newspapers then, margins are following, beware of stocks! When there is margin pressure you need multiples to be low to make money, when margins are increasing, a high multiple can be mitigated by stronger earnings growth.

So where are we today?

Debt: cost of debt has been falling for 30 years. History suggests it should start increasing. Led by need to attract capital to an economy as short of capital (rather than authorities increasing rates to decrease speed of a recovery in the business cycle. Short of capital as there will be capital destruction and a run for cash, but there is not enough cash). Due to less demand for there currency and their assets because of (1) Lower growth than in the past (paradigm shift in the way the country is perceived. If dollar pegging decreases, less demand for USD. Need to attract it back with a higher interest rate, not with the title of being the reserve currency of the world. FX foreign reserves will decrease in USD etc), or (2) Risk spread increases as fear of default increases? Risk assets will have a headwind as a result, decreasing in price as there yield must increase. Need to buy at low multiples

Equities: Almost 2/3 through a multiple decline process. On a normalised basis (Shiller P/E) equities are trading at an above average multiple. Again, focus on buying low multiples. Very careful with cyclicals whose multiple may look low to very high profits created during a boom time difficult to replicate in the next decade. Opportunities exist in high quality where earnings are more stable and where normalised P/E are relatively attractive: yields are between 7.5 - 10%. We would suggest a buy should have a minimum earnings yield of 2% above equity markets average return: 8.5%. Less, sell - unless you feel very stable and visible earnings.

Margins: Seem to be too high. Again, as a result, caution on assessing earnings in the last five years when credit growth was strong and recent cost cutting was very swift. Demand a higher yield if buying on potential cash flow. With regards to asset plays, need to consider the potential of weak growth, hence a catalyst is required or the physical assets may decrease in value.

Commodities. Developed market money printing has not increasing lending (but is another solution to dilute the value of the currency and provide more cash for a country that has too many assets and not enough cash generation). No dubt because the lenders have poor balance sheets, but also because they fear that their currency in the future will be worth less, hence may make a real negative return. This money has gone to inflation hedge assets - primariy equities and commodities. Excess liquidty has pushed up commodity prices, which will put pressure on equity multiples. This cash is also going to regions where countries are growing faster. Many of these countries currently have USD pegs - hence extremely loose monetory policy whilst plenty of cash is coming there way and their GDP growth is strong. If this continues, the USD peg will not be sustainable as it will lead to a dangerous inflation (In EM, not in the US! What a strategy to force the Chinese to de peg. But this will reduce further USD demand making potentially the USD weaker. Hence more exports for the US, less imports, reduce trade deficit, help bring the economy back on track, but the USD will fall. As a result households will reduce quality of life as cant import as many goods as before, but they will start getting more manufacturing jobs. BUY US EXPORTERS WHILST SHORTING THE USD WITH A FORWARD CONTRACT. The US stock market can do well, but the household will have less purchasing power. Need to supplement that with investing in their corporations who will be doing well selling and investing in other countries as well as in the USA!

The USD weakening is a central part of the world economy clearing itself up. It is the fountain that will led to change as EM de peg and start losing their export competitiveness - a major source of the imbalance. They will consume more, leading to more imports hence creating more jobs for others! But can China survive this change? The USD policy as the reserve currency is what is holding many imbalances back from being rectified? Reminscent of an old system that now does not exist. There are different engines in the global economy and they need to be set loose, not tied to the USD.

THE PROBLEM IN A SENTENCE IS A LACK OF GLOBAL AGGREGATE DEMAND! THOSE WHO HAD ACCESS TO CREDIT TO CREATE DEMAND ARE TAPPED OUT. THOSE WHO NEED TO TAKE OVER DONT REALLY HAVE ACCESS TO CREDIT AND DONT EVEN HAVE THEIR OWN FREELY FLOATED CURRENCY. HENCE THE OLD SYSTEM NEEDS TO MAKE CHANGE FOR THE NEW WHERE THESE IMBALANCES CAN BE CLEANED UP. Buy developed market banks that can lend to EM, who have experience of those markets and the cutting edge knowledge of having worked in DM for many decades, like standard chartered, HSBC.

A weakening currency in developed countries will not only help them export more hence create jobs and GDP growth, it will reduce the burden of their debts as they are de valued away! This alongside capital destruction will do a good job of clearing up the mess!

I see the problem primarily from the point of view of europe, as I live there. However, it is a global problem. What seems like a lack of change and finding solutions in Europe, is a consequence of also lack of change globally. The old system continues - it needs to be changed. It is slowly being down as we see the USD weaken, the Chinese consume more. But the EUR getting stronger? There is a tension between these currencies as there is a lack of alternatives. The strength of the EURO seems to be a consequence of living in a new world with the old system. The euro is the punching bag due to it having weak political strength. Indeed, history suggests the market likes it when the politicians are weak, because they cannot decide anything! Hence they cannot commit to surprise policies which the market does not like! Such as money printing! How convenient! So the euro strength is a consequence of having poorer options, not because it is the best. There is a consensus that the USD weakening is the most dominant theme in making the world clean up the imbalances we have..

Last thing to do is reduce their rights to the good things which has made us lazy and feel we deserve (have the right) to a good life and most of the basic things to enjoy life. NO! Take away healthy pensions, only enough to survive. Watch how people will work!

Reduce government liabilities by reducing pension benefits, increase the work ethic of the population

Kill the USD reserve currency, float EM currencies openly. Less demand for DM currencies. Then interest rates increase (force default, or govt print money to reduce further value of money)

DM currency decrease from less demand from more alternatives and money printing. This will make them more competitive in exporting. Create jobs and foreigners attracted to their assets. Improve the current account by reducing the trade deficit. BUT TOO WEAK A CURRENCY WILL CREATE A PROBLEM WITH BUYING ENERGY/OIL! HENCE NEED TO BE MORE ENERGY INDEPENDENT BEFORE FOLLOW THIS STRATEGY. IN THE US HAVE FOUND LOTS OF GAS! HENCE CAN FOLLOW THIS IDEA! More of a problem for Europe, hence the greater focus on renewables, energy emissions to force the issue, etc. UNLESS RUSSIA USES THE EURO, THEN CAN BUY ENERGY IN EUROS AND NOT A PROBLEM TO DEVALUE THE CURRENCY TO GENERATE GROWTH!

Weakening DM currency will reduce burden of debt, as many companies will be paid in the newly floated currencies. Build up reserves and debt burdens decrease

If China de pegged - then in theory they would not need to print as much money to keep the currency weak. Hence less money printing for them. Investors that bought gold can buy the YUAN. Hence GOLD COULD FALL IF CHINA DE PEGS. US WOULD ALSO NOT NEED TO PRINT AS MUCH MONEY TO WEAKEN ITS CURRENCY, THERE WILL BE A MORE NATURAL ROUTE! HENCE GOLD IS USED AS THE SAFE HAVEN DURING THE MID WAY POINT - AS WE MAKE THE TRANSITION. BUT WHEN WILL THE TRANSITION BE MADE!? UNTIL THEN HOLD GOLD? THE CHINESE WANT GOLD TO BACK THEIR CURRENCY UP AS WELL?

The reason the EUR is strong is a similar reason to why gold is strong. Gold has a historic reference as a store of value due to its physical properties and historical use, and the fact that GOVERNMENTS CANNOT PRINT IT! THE EUR HAS THE SIMILAR PERCEIVED STABILITY, AT THE MOMENT, AS ITS POLITICIANS ARE SO WEAK TOGETHER THEY CANNOT AGREE ABOUT ANYTHING. IT IS THEREFORE PERCEIVED IT IS UNLIKELY THEY WILL PRINT MONEY! HENCE THE EUR MAINTAINS ITS VALUE VERSUS THE USD. LIKELY VERSUS GOLD IT HAS NOT DONE MUCH AT ALL! AND ALSO WEAKENED VERSUS THE CHF

(To understand why incentive for authorities to print money - need to appreciate the difference between CREDIT & MONEY. The debt burden that has been created is phenomenal, and unprecendented. When people want access to money by liquidating assets - need to appreciate in the US there is 2 trillion in cash, and 50 trillion in financial assets. There is simply not enough cash for everyone without printing money or having defaults/write downs etc). Credit appears, and can as easily diseappear...! If it is backed by future promised earnings that cannot be met (ie buying expensive assets with debt) then write downs must be made. This reduces the stock of capital (assets) in the world - this is exactly what is required as too much money should simply not have been created! Leading to spreads for returns becoming too small. This needs to expand so new capital can come in and start the cycle anew. Capital destruction is required - or money printing. The latter is viewed as being more politically savvy in gaining votes)

THE CHF TAKES THE ROLE OF THE DEUTSCHEMARK FOR MANY EUROPEANS, as that currency is deeply hidden within the Euro. It is seen as safe haven, but will a strong enough currency erode its economy to self correct those self haven characteristics it has, ie less exports, more imports, hence trade deficit etc. SHORT CHF at what level?

If you want to gain the most by doing the least, you should move to Singapore over the next 50 years.

It is considerably harder to know what will happen tomorrow, which depends on sentiment, then what happens in 10 years, which depends on reason.

(why do cycles exist? Part of human nature, the system. Also, when something exists, it is hard to get rid of. It becomes part of us, how we perceive the world. It is an unconscious reference that affects the behaviour of all of us)