Tuesday, May 31, 2011

European Debt Galaxy

With heartfelt apologies to Monty Python's "Galaxy Song" (from "Meaning of Life")

The Euro Debt Galaxy Song

Just remember that you're standing on a debt that's just evolving
And revolving at 3 trillion euros a year
That's interest of 5k a second, so it's reckoned
A sum that is the drain of all our power
That sum and you and me, and all the money that we can see
Is sucked out at 400 mill a day
In an outer spiral arm, at 440 bp
Down the plughole we call the ECB

Our debt itself contains 100 million billion loans
It's 100,000 light-years side to side
It bulges in the middle, duration three to seven
But out by us it's just one year wide
We're 30,000 light-years from repayment's final point
As we roll it forward 200 million years
And our debt is only one of millions of billions
In this quantitatively easing universe

The periphery debt keeps on expanding and expanding
In all of the directions it can whiz
As fast as it can go, at the speed of light you know
Twelve billion trillion a minute and that's the fastest print there is
So remember, when you're feeling very small and insecure
How unlikely your money you will ever see
And pray that there's intelligent life somewhere in the world
Because there's bugger all at the ECB

Wednesday, May 25, 2011

Germany catching a cold

Well, the choppiness across markets continues, with Asia selling off on the back of potential US bank lawsuits and rumours of a Spanish and/or Greek snap election, only for Europe to reverse most of the overnight move. Or then again, like yesterday it could just be a case of "fill the gap" and then roll-over again. TMM still sense that punters are trying to hold onto long risky asset positions, or at least still attempting to follow the JBTFD strategy and it doesn't seem to us that there has yet been a capitulatory "baby with the bathwater" moment as of yet.

It is particularly striking that the PhD community has only just begun to downgrade their 2Q11 GDP forecasts, with JPM overnight lowering theirs from 3% to 2.5%. While TMM's survey-based GDP proxy underperformed the official GDP figures in early-2010 (largely, we believe, due to the impact of the fiscal stimulus), since then it has re-converged, and after implying a brief growth spurt in Q1, it has come off sharply, and is now consistent with 1.5% annualised rates of growth. Now TMM completely accept the idea that this is downwardly biased by seasonal issues related to the timing of Easter, but even if we generously add 0.7% to that figure, we still sit at 2.2% while consensus are at 3.3%. TMM reckon the PhD community have some capitulation to do, and with them, erstwhile risky asset longs.

The other argument TMM have heard is that "it's all just the Japanese supply chain effect". Sure, some of it is - the obvious stuff like Toyota etc - but if this were really the driver of the slowdown, then it would show up in inventory/sales ratios... and the below chart of ISM Orders/Inventories shows a clear downtrend.

Continuing along the lines of TMM's belief that global growth has rolled over and is moving into a soft patch and, ultimately, growth scare, we decided to take a closer look at the post-crisis powerhouse that is Germany. Yesterday's IFO survey seemed to point to continued vigorous growth, but TMM are sceptical given that Germany is leveraged to China and the rest of Europe, and still has shown itself unable to sufficiently produce its own domestic demand. So, along these lines of thinking, TMM decided to construct a set of FCI-like models for IFO, the Manufacturing PMI and, most importantly, GDP. The logic behind using the components of an FCI is that it can provide a basis for the conditions of domestically-generated growth.

So, first off, the IFO (see chart below: IFO - blue line, model - red line). The model fit here has been OK, but not brilliant, and despite financial conditions having flattened out over the past year, the IFO has gone on to hit highs not seen since 2006. TMM are aware that the construction of the IFO survey has changed recently, so that may be behind some of the divergence, and possibly, the strong cash position of small-medium German corporates (who make up the bulk of the survey responses) may well be reason here, with less need for financing.

Next up, the Manufacturing PMI (see chart below - blue line, red line - model). As this is primarily made up of larger companies, it is more reflective of global demand growth and, given their funding nature, more sensitive to financial conditions. The fit is much better here, and shows the PMI falling to around 55, so still decent growth but not at the exceptionally strong rates seen over the past year or so. Given the tightening path the ECB is on, it is likely that this will continue to drift lower.

Finally, GDP (see chart below - blue line, model - red line). Q1 2011 saw a very strong print from Germany, that is flattered by a high rate of Government Spending (+1.3% vs. expectations of just 0.2%), something that TMM reckon will revert in the next print. Indeed, apart from that, the model does a pretty good job of predicting German GDP, and the direction is clear: sub-trend growth.

To summarise, it seems that while German SMEs aren't doing too shabbily, outperforming what one might expect given financial conditions, that is yet to show up as significant domestic demand (Q1's was just 1.1%, following on from -0.2% the previous quarter). The more important large corporates look set to experience the squeeze in financial conditions as the ECB moves to hike rates and worries regarding collateral damage from the PIGS widen credit spreads. It seems clear to TMM that German growth is also moving into a mid-cycle slowdown along with the rest of the world and that is the last thing Europe needs.

However, with Schatz yields 20bps lower (see chart below) in just a week (see chart below) it's hard to get too long of the front end here. TMM are still holding their September 107.40 calls, though, which given the slow motion train crash occurring in Greece (which could be particularly disastrous should the proposed austerity referendum fail), look like a good bottom drawer trade for what they expect to be a choppy month of trading as markets try and make sense of where we are in the global cycle.

And TMM didn't even mention Marmite.

Monday, May 23, 2011

Dam Breach!

And we are off! The roll-over that TMM has been waiting for in their JSTFR plan has arrived. We are fully aware of the TMM Non-Predictions re: Spain over Germany and EUR/CHF but we have plenty of time for all of that. For the moment, however, we are in a rerun of 2010. In fact, looking at the price action you could almost say that nearly to the day "EUR/USD May 2011 = EUR/USD May 2010 + 0.1800". Today's fuel for the fire have been the Spanish elections (following on from Catalonia's revelations last week, debt skeletons are expected to tumble out of regional closets), S+P putting Italy on credit watch negative, European PMIs (yes even you, Germany) and just to keep the risk globally balanced let's chuck in a weak Chinese PMI too. So for Europe, in the words of Queen, "Is this the real life, or is this just fantasy, caught in a landslide, no escape from reality"?

The perceived wisdom (and TMM's view) for the past 6 months or so has been that Spain was fine and de-coupled from the basket cases of Greece, Portugal and Ireland, as the Caja recapitalisation plans were progressing well, growth had returned and the stress tests for Spain were virtually the only ones with any credibility last year. However, this view was predicated on the condition that nothing else went wrong. And, with the combination of hidden debts (bringing back bad memories of Greece), more widespread social unrest and an electoral backlash, all of a sudden this isn't looking quite as clear cut as it was a couple of months ago. Indeed, S&P's weekend downgrade of Italy to Negative Watch underlines the fact that Spain and Italy are breaking out of the trading ranges they have essentially held since last year's bailout (exception a brief period in late November-early January) on the back of real domestic news-flow, rather than on the back of speculator-driven contagion. To TMM, this is an exceptionally important distinction, as it demonstrates that the dam around Spain & Italy is breaching.

TMM fear that all things Euroblx are in the process of becoming systemic once again, as it is clear that the politicians have decided that there will be some form of Greek restructuring imminently, the ECB are panicking at this prospect, and Spain and Italy no longer seem immune. The below chart shows the rolling average correlations of Spain's 10yr Bund spread with the rest of the PIGS (red line), Italy with the rest of the PIGS (blue line), the average PIGS cross-correlation (orange line), and periods of average PIGS spread widening denoted by the green line (TMM's Excel skills are wanting!) during 2010's episode. As can be seen, in the run up to Stress Tests in June 2010, periods of spread widening were accompanied by high or rising correlations between the PIGS, and it was only after that dispersion rose as systemic fears died down.

Looking at a more recent history, in spread widening periods, the cross-correlations tended to fall during spread widening periods as Spain & Italy had been judged to have decoupled from the rest of the pack. However, since mid-April, the opposite appears to have been happening, with spread-widening episodes being accompanied by rising correlations. This argues that the crisis is once again morphing into a systemic one.

So in summary, TMM think we are seeing a general dam breach in some of the levees that the Eurocrats had built and been pinning their hopes on. Acceleration is picking up in the downward S curve in prices in general to move TMM's stance from JSTFR to JFSI.

Friday, May 20, 2011

South Africa: Township of the Damned

You might get the impression from some of TMM’s comments about emerging markets that we love them all, from the BRICs to the frontier markets of Indonesia, Mongolia and Vietnam. Au contraire, TMM are very price sensitive and in a few cases we just “don’t get it” when it comes to certain markets which we see as stories of structural and perhaps quite violent decline. It is in that category that we place South Africa.

Much of the touting of South Africa by MENA analysts out there sounds like Vicky Pollard:
Q: Seriously, what percentage of people are HIV positive?
A: “Yeah but – no but – itsgotayoungpopulationlotsoflaborandisntJapandyingfaster, innit?”

TMM are not convinced, and not because of the obvious headline grabbing stuff like, say, having a ridiculously high rate of HIV and political leaders who apparently still don’t know how to avoid getting it (though, according to the NY Post, the IMF is no better). Or, for that matter, out of control crime rates and poor levels of educational attainment. Don’t get us wrong, that’s all awful, but it has been the case for quite some time and since the early 2000s the carry on the currency and South African equities have done quite well. FX carry below has hardly been all that bad:

Similarly, equities in USD terms are no Japan:

So, for a country which has been known to have weak leadership, a health crisis and security issues it hasn’t done halfway bad. To TMM the problems with South Africa are more prosaic – high tide for terms of trade, poor fiscal management and incredibly dysfunctional labor markets.

As with most big commodity exporters it is worth looking at what drives the trade balance as per below:

As for merchandise exports and gold, TMM lumped them together as the “stuff” category and went to the DMR website to work out just what the breakout was of shiny stuff (gold and platinum) vs lumpy stuff (coal and iron ore). As can be seen below, of those merchandise exports about 10% is platinum, 9% is gold and coal and iron ore are about 5% a piece.

TMM don’t rep to Citi’s terms of trade indices, but they do seem to capture the fact that ZAR should be partying as hard as AUD and BRL and likely running a big trade surplus too:

Au contraire... Much like the other two South Africa runs a current account deficit but it seems to be getting worse over time rather than better, despite terms of trade being utterly off the chart.

Now this could just be due to a strong currency causing manufacturing to decline, but then you would also think that South Africa would have low unemployment since wages for driving trucks would be approaching those of radiologists like in Australia. That does not seem to be the case – SA unemployment is high and has stayed high. Despite high unemployment and the fact that most mining jobs are unskilled or semi-skilled, comparing wages for mine workers to domestic wage inflation YoY makes it pretty clear that something is up with the mining sector.

Then looking at CPI components it’s clear that the big divergences are driven by communications on the downside (like everywhere else), but a ridiculous ramp in utilities.

Then if you look at actual numbers for a lot of commodities South Africa produces, the increase in output is pretty weak, especially for gold and platinum. So to summarize, you have a labor market with excess supply and pockets of rapid wage inflation and your most profitable and export-friendly sector cannot seem to increase production to capture that increased demand as much as they should. What’s up?


TMM are far from a bunch of union-busting robber barons, but there is a point at which the interests of a union become utterly conflicted with those of the population at large, a rubicon that South Africa crossed some time ago. It doesn’t help a country’s ability to encourage investment when major trade union groups are vocal advocates of nationalization of mineral resources and your nearby neighbor, Zimbabwe, recently went a long way towards that. Not to mention when your unions go past basic striking to outright vandalism as was recently the case for Eastern Platinum. With unions so firmly entrenched in the ruling ANC party TMM find it hard to see them learning to behave or think of the bigger picture any time soon.

As a result of this, TMM do not see SA’s exports picking up that much in volume terms, especially if further indigenization or nationalization occurs – just ask Venezuelans how their oil exports have performed post nationalization. In addition when a lot of your exports are Platinum, something that has limited use in an age of electric cars, and Gold, something that is sitting an awfully long way above cash costs, you have to start looking at what the financial account line items are that are balancing out flows in the FX market and providing financing to the government’s deficits, projected to be 5.3% of GDP in 2010. The financial inflows are awfully portfolio flow heavy ...and the FDI is mostly mining.

There is an awful lot of pontificating about who is vulnerable in a terms of trade shock. To TMM the Rand looks as bad as it gets, given likely political catalysts (nationalization/indigenization, more mining labor problems), a structurally poor picture for the economy and labor force, and the likely slow grind down in merchandise exports as car engines get smaller or go electric. As for gold, TMM are not convinced - and when it comes down to it, the South African mines are some of the oldest and highest-cost around. If prices drop, SA won't only lose out on price, volumes will be cut quickly too... Add to that an external balance that requires portfolio flows into, well, mining companies amongst others and government debt that is approaching 40% of GDP by end of 2011, in an unequivocally good period for the country. All of a sudden the longer-term prospects for the country look very precarious.

As to the long term, if South Africa's poltics really do converge with Zimbabwe why not have a currency union? With recent performance of the Zimbabwe dollar and what TMM thinks the country has in store for the Rand, the Southern African Whoonga (SAW) might not be a bad name for the new unit of account (we look forward to seeing the Argentine cross appearing on our screens). In the interim TMM are wondering how to be short ZAR/ZIM without having to visit Harare with suitcases.

Wednesday, May 18, 2011

I Spy More Pain (ISM Pain)

Yesterday's bounce in many markets led to surprise in the TMM camp. Not surprise over the bounce occurring (the Soothsayer signals in many USD crosses signaled an end to the run yesterday) but we were more surprised at the amount of pain and woe being expressed by many on the street, as it wasn’t THAT big a bounce. To TMM the corpses of some overexcited new uberbears is good news as it leaves the market more balanced, yet still pretty close to recent lows. This is supportive of our thesis that yesterday's move was just the "R" of our JSTFR play of the past couple of weeks. Hopefully we can get back to the basics now that the panic noise has diminished.

TMM's basics, as expressed here recently, are that both Global and US growth are slowing and still like the idea of JSTFR in Equities while continuing to favour the bull flattener in USTs. But today, we thought they'd take a closer look at the inputs to their ISM model, why it appears to have diverged from the actual numbers over the past year and the outlook moving into the summer. The below chart shows ISM (red line) vs. TMM's ISM model (blue line). Over the past year, this overshot to the downside during last summer's double-dip scare, something TMM believe to be the result of the very large shifts in the global inventory cycle (something we will take a closer look at below), but directionally - if not in actual level terms - the model is clearly pointing to another drop off in industrial production.

The two main variables in TMM's ISM model aim to describe short term inventory cycle-driven factors (see chart below, blue line) and proxy "true" end demand (red line) in terms of raw materials needed for investment in infrastructure. As TMM noted above, the inventory cycle has been very volatile over the past few years, making it very difficult to see the wood for the trees in terms of how the recovery has been progressing, which is why TMM are particularly interested that the end demand variable in their model. And this component has largely settled around sub-trend growth levels, seen either during recessions or mid-cycle slowdowns (c.f. - 1995/96, 2004/5). Now TMM are not anticipating a recession, because a lot of things need to go wrong for such an outturn, but it seems increasingly likely that that growth will slow further over the coming months and that consensus economist expectations for Q2 and Q3 GDP of 3.3% annualised rates have some way to fall...

...which in the context of historic equity performance when the model is these levels (see chart below, SPX YoY% - red line), suggests to TMM that Spooz continue to look vulnerable over the next couple of months, especially given the scarred memories of this time last year for many a trader.

In TMM's experience, growth slowdowns usually morph into growth scares (in recent years morphing further into deflation scares) so we think the curve is likely to continue bull-flattening, with 10yr notes headed to 2.9%. TMM's mates at Nomura rightly point out that given specs are positioned in steepeners and primary dealers are short the belly of the curve that a nasty position squeeze could develop here.

Oh yeah, and Bill is still short.

Monday, May 16, 2011

Songs For Europe

Yes - Azerbaijan just won the Eurovision song contest. It didn't really surprise TMM on the musical front because along with Hungary and Ukraine they had a blonde female singer that of course can bang out musical ditties that make any normal Euromale grab the phone and dial her number. However TMM were a little surprised to find that far from being a principality in Italy along the lines of San Marino, Azerbaijan is actually a fully fledged Asian nation of its own a little further west than China. But not much, its western border being more easterly than that of Iran's. European expansion east really is a good idea if they are to look for new contributors to the bail out funds and you could do worse than choosing a nation sitting on that much hydrocarbon. TMM look forward to Singapore, China, Australia, India and Brazil all appearing in the next year's competition.

As for Greece's entry, its first airing had TMM exclaiming that obviously songwriting was the only profession to have felt the effects of their austerity measures. So we were fairly gobsmacked to see the votes coming pouring in for them, (did Germany gave them douze points or another 110billion Euro). TMM themselves, sitting in London, stayed impartial and didn't cast a single vote, but have wondered why they just been presented with a very large phone bill. Their Moldovan Au Pair has no explanation either.

But of course the most shocking news of the weekend is the lengths Gordon Brown will go to to secure himself the post of Chairman of the IMF. Please someone, tell us the New York chambermaid didn't have a wonky eye and a Scottish accent. For the bigger picture TMM find it hard to believe that a global rescue service as important as the IMF can really allow itself such key man risk. Strauss-Kahn's arrest may have have allowed the broadsheets to behave like tabloids but in effect he's more or less irrelevant as the executive Board makes decisions. He's the Chairman, but he doesn't vote, he just sets the agenda and In his absence Lipsky or one of the other two Deputies will do it. And of course the most important pointer to the irrelevance of his role is the fact that they would consider letting Gordon Brown have a go at it.

As for markets we stand firm on our JSTFR positioning. TMM know there is trouble brewing when real money starts throwing in the towel, something that we are seeing in the typically slow moving world of credit, particularly in Asia. High beta Chinese property has been on the move for a week now but when investment grade gets moving you know that the bedrock of dip buyers is stepping back.

Today is going to be pretty busy for TMM so we will leave you with a couple of Eurovision song's that were sadly axed from Saturday's show.

David Bowie performing a remix of "Heroes":

I will be King,
And you,
You will be Bean,
Though nothing will,
Drive inflation away,
We can't beat it,
Just for one day,
We can't be Heroes,
Even for one day.

And you,
You can be Merkel,
And I will be Greece,
I'll drink all the time,
'Cause we're lovers,
And that is a fact,
Yes we're lovers,
And that is that.

Though nothing,
Will keep us together,
We could steal time,
Just for one day,
For we cant buy Euro's,
For ever and ever,
What d'you say,

I wish you could lend,
Like the countries before you,
Like those countries could lend,
Though nothing,
Will keep us together,
We can't beat them,
For ever and ever,
Oh we just can't buy Euro's,
Even for one day.

We can't buy Euros,
We can't buy Euros,
We can't buy Euros,
Even for one day,
We can't buy Euros,
They're nothing,
And nothing can help us,
Maybe Juncker's lying,
Then we'd better say,
That we'd be safer,
Shorting that play.

And Greece's new entry - to the tune of "Roll out the barrel":

There's a Greek garden, what a garden,
Only happy faces bloom there,
And there's never any room there,
For a worry or a gloom there.
Oh there's music and there's dancing,
And a lot of sweet romancing
When they pluck bouzouki
They all get in the swing

Every time they hear their Papa ,
Borrow more for a new car,
They want to spend their cares away,
Never, ever have to repay
Then they hear a rumble on the floor, the floor,
It's the big bailout they're waiting for
Eurocrats then form a ring,
For miles around you'll hear them sing...

Roll out and borrow, so the default will never quite come
Roll out and borrow, now the EU's on the run.
Extend and pretend, redemption is nowhere near.
Now's the time to roll out and borrow, for the debts still here!

Thursday, May 12, 2011

Commodities are Rubbish

Rubbish is seen by recyclers as commodities. TMM just think that Commodities are rubbish.
TMM’s lack of interest to participate in the upswing in commodities and particularly inenergy has proven to be well timed. Carnage continues in all things commodities and does not appear to be abating. The first leg down, as we suggested last week, was predominantly CTA driven leaving the market thinking that such moves can happily be faded as they are just “to be expected” adjustments within a macro trend, which normally plays out as long as the real money investors don’t start to liquidate as well. But whilst many in the market are scrutinizing for signs of real money joining the selling TMM think there is another major force at work that hasn’t really been noticed or discussed - The great China warehouse financing unwind.

The Chinese warehouse financing goes something like this -

Now, to TMM’s eyes there are a few problems here. First, this is fraud for the simple reason your use of proceeds isn’t what you stated. That isn’t good. Second, the entire creditworthiness of this exercise moves from being copper that should be delivered within a month, to 6 months of murky real estate/whatever you name it risk. Third, this says a lot about Chinese bank credit risk management – it’s awful.

TMM note that this commodity unwind appears to have been very closely correlated with Chinese administrative measures in property and particularly declining property sale volumes (not values). It’s easy to see why: if these guys can’t sell their dirt quickly the loan game is up and the developer has a problem. What’s more, the copper is not something the developer actually needs and what he is holding has now depreciated. So he finds himself long of dirt, long of copper at the wrong price and with a lot of short term liabilities. What’s the easiest solution? You Sell the copper and sell the dirt ASAP and try to get alternative funding. Is it  just a coincidence that the Asian high yield market is bursting with supply from all manner of corporates that need dollar funding? Admittedly going from L+70 Letter of Credit funding to L+800 high yield is a tough unwind but there isn’t a lot of choice out there. Additionally, for those not big enough to do bond deals this may go some way to explaining Chinese loan growth still being laughably high – extend and pretend is a good option for these guys while they try to work out all these dirt loans they made to dirt bags.  Sounds positively European re periphery debt doesn’t it?

And yes, if you are wondering “maybe Jim Chanos is right and China is a massive Ponzi scheme built upon property prices and infrastructure spending that is not NPV positive” TMM thinks you are probably right, though no doubt the government will turn on the credit taps in case of emergency and run the Hang Seng up in our faces one more time yet. So, what does this mean for metals? First, with the great China warehouse financing unwind has come a pretty brutal liquidation of hedge fund positions – and it wasn’t just CTAs. Our friends and associates in the macro space appear to have been very long and wrong in this stuff and stories of who dropped how many hundreds of basis points over the last month are a seemingly daily occurrence.

In the short term, this dip is really hard to buy – just like China base metal demand made no sense for a long time and ran metals way higher than anyone thought possible it is similarly likely to prove a long and ugly unwind. Add to that the risk of a China rate rise or one-off reval which would blow up more warehousing deals and a bad outlook elsehere (Eurostriches, bad ISMs etc) it is very hard to love base metals at anywhere near current levels.

As for precious, TMM are of the opinion that silver is a pretty good indication of how likely QE3 is, and how that changes fair values for things without a coupon.

Wednesday, May 11, 2011

Pass the methadone please, darling

Since our post yesterday there's been a catalogue of rumours and headlines concerning Greek packages. Together with a bounce in commodities that has yet to have its feline qualities tested, the market has calmed down. TMM actually think that today is make or break for the construction of the next big move, but first let's have a look at the Greeks' package.

As we discussed yesterday, it looks as though the Eurostriches are pulling their heads out of the sand and accepting that "something must be done". But what? Unfortunately, judging by comments out overnight, nettle grasping is still considered a last option. Lagarde's comments are particularly head-buryingly worrying.

"Lagarde said that no decision had been taken on the possible amount or form of any supplementary aid for Greece, but a debt restructuring was out of the question because it would mean higher interest rates for all euro zone members and losses for the ECB on its Greek debt portfolio"

Europe has a simple tradeoff to ponder over:
- Increase in the cost of borrowing for the EU in general if Greece defaults times size of EU debt over a the guessed period of how long it all takes to stabilise, versus
- The cost of funding periphery nations' debt until they sort it out for themselves.
It would appear that Lagarde has chosen the policy of passing more methadone to the addict, having decided that the path of federalizing periphery debt is the way forward. As to where to stick the debt, pushing it deeper under the carpet of an "EU" label (either ECB, EFSF or ESM) may not fool anyone who has noted the exploding size of the ECB's balance sheet (now around 1.9 trillion Euro). However, to the general populaces of France and Germany it is not yet visible as their problem.

TMM therefore look forward to a headline along the lines of


In seriousness, we think this is a very dangerous game on two fronts:
1) The bulge under the ECB carpet is so large that even Herr Hans Publik (as well as his more suave conterpart, Monsieur Jean-Jacques Publique) will spot it, releasing pent up political problems.
2) The ransom equation may come down in favour of supporting Greece or Portugal, but it won't be that easy if Spain should find themselves in similar need. However, once the commitment to federalise has been made, it cannot be unmade. This once again will leave the market watching and testing the membrane of Spain that separates the good guys from the not so good ones.

But back to market reactions. A relief rally in practically everything so far leaves TMM thinking that it's decision time for the next make or break move. Voldermort et al may well be back in the fray but the first signs from our DNA tests are pointing towards a feline heterozygote. As such so TMM stay firmly in the JSTFR camp in all the main dumpage candidates of last week and especially the Euro.

Tuesday, May 10, 2011

We smell smoke

First, before we go any further please cast your minds back to this blog exactly a year ago and we ask you to reread THIS posted on 10th May 2010.

It was to the day that the markets were responding positively to announcements of European rescue packages designed to support the ailing periphery whilst they implemented austerity measures designed to cut their internal debts to levels that made it serviceable in the long run. And to wit, MM commented at the time:

As always in the Eurozone, conditionality and enforcement are paramount issues that will be tricky to solve. No doubt Portugal, Spain, et al. will say the right things and appear to toe the line...but what happens when growth undershoots and so do fiscal revenues? Which will give way...living standards for civil servants, or fiscal rectitude? (This, as an aside, is the primary argument for IMF involvement: so the German's won't have to play "bad cop").

Now we have always known that it has been a tightrope for the peripheral Governments to walk. Not enough talk of implementing austerity and the desperately needed emergency funding will not be forthcoming... No actual austerity and there will be no improvement in debt burden and no long term solution. Against which, too much austerity will see a public backlash which could kick out the Government and result in economic mob rule (as has happened in Iceland where public referenda are used to decide whether international debt should be repaid; result is Ms Dottirdottir saying "Nei").

For the past year the Greek government has been playing the population off against the European creditors. But just as a teenager will promise his mum he has stopped smoking in order to collect the $100 promised for doing so, while just sucking on mints to cover the smell, Greece hasn't stopped the rot at all and the wafts of peppermint no longer shroud the stink of smoke from the utterly horrendous data out recently from Greece (Nominal GDP -2.1% vs 5%+ financing rates, Real GDP -6%). TMM's suspicions and concerns from last August in their "Postcard from Greece" now appear fully justified.

So the European debt collectors have started knocking on the door but have arrived to be greeted by a debtor threatening to trigger the suicide belt of leaving the Euro, causing collateral damage that threatens the very foudantions of the building. Recent comments have TMM's nostrils twitching to the smoke coming from a bushfire:

  1. (The above mentioned Greek data is utterly horrendous.
  2. Bini-Smaghi and Nowotny suddenly are not sounding like central bankers anymore, very odd - almost "panicked".
  3. The Friday meetings was with the big guys alone, and were vehemently denied even as they happened - seems like desperation.
  4. Continued dialogue from respected economists and politicians about how such austerity has never been unaccompanied by debt forgiveness.
  5. Discussions by ratings agencies and bank economics departments that maturity extension alone is insufficient to regain fiscal solvency.

TMM have thought hard about the current strategy of increasing aid and extending maturities and now think there is an increasing probability that the Eurostriches are finally recognising we are on the following path that ends with "Lions".

  1. EU institutions keep rolling over Greek loans and extending maturities.
  2. Private debt stock gets gradually paid down.
  3. EU institutions end up holding a very large amount of outstanding Greek debt stock.
  4. Greece is unable to get any or all of (i) enough Growth, (ii) enough tax collection, (iii) enough spending cuts etc.
  5. EU institutions are forced to take a large haircut on the debt stock.
  6. Political crisis of the EU when it becomes clear that the EU has to take a hit of EUR150-200bn (to put this into perspective, the EU budget is EUR133bn...).

That doesn’t only threaten the existence of the EMU, it could ignite the EU. TMM are seriously worried that the Eurocrats have moved into the depression stage of grief over the loss of their investments, both financial and political, in their Euro project and it will not take long to move from the depression stage of grief to the "acceptance" stage. We - like many now - feel that a new Greek package that includes an agreement on private participation is coming soon as it will be easier, politically (not just domestically, but also in terms of "The European Project"), for France and Germany to justify bailing out their own banks directly (blaming Greece) rather than justify bailing out Greece directly again for another year.

Monday, May 09, 2011

Oil, Greece and Slippery Politics

Well Friday afternoon certainly saw the resurgence of Greece to No.1 in the markets pop charts with talk of them leaving the Eurozone and sailing off into the sunset across of sea of un-fundable debt. Since then it would appear that every Eurocrat and even the Greek's themselves have been instructed, in small boy and dyke style, to plug every possible thought leak that Greece could ever, ever, ever leave the Euro zone. Now we can't decide if this could possibly be because, from the Greek's point of view that, if they were to leave, their funding would be so right royally stuffed they wouldn't even be able to borrow the time in a clock shop or whether its because the German's are so absolutely terrified of the Greek debt time bombs in their bank's vaults, or perhaps it's just that Greece is really so absolutely wonderful there is no reason to ever think that such a beautiful friendship should ever end (cue clip of Mafia boss reassuring proven snitch as he gets into mob car for a "little ride").

TMM think this is all just part of the predictable path to a restructuring that has long been due and is part of the brinkmanship involved. But having landed in a market that was looking for something to hang a falling EUR/USD on, it has resulted in the Euro-cupboards being emptied of the Eurowoes that were being filed away as they weren't fitting with the recent rally.

As far as the recent general sell offs go, TMM think the moves over the last 4 days are something bigger than a short term correction, with remaining trapped longs that need to get out in all the recent hyperbolic assets. We are JSTFR rather than JBTFD.

Now, TMM ask their readers forgive them for covering an issue that is probably not of particular interest to many, but in light of TMM's Non-Prediction that the UK's Alternative Vote referendum would NOT pass, but the coalition would also NOT collapse, they thought they would take a more detailed look at the implications of Friday's election results.

Whilst we would like to think that these instructions, spotted by a friend of ours, contributed to the LibDem whitewash we really ought to delve a little deeper:

TMM reckon the council election results are quite significant in several respects: (i) a Scottish independence referendum is now certain, (ii) the Liberal Democratic vote collapsed, (iii) the Conservative vote held up very well with 53% of the English vote, and (iv) the combined Conservative and Labour vote share hit 80%, which is the highest for many years.

Delving a little deeper, Scotland voted for independence as Labour, the Conservatives and the Liberal Democrats all lost seats in a dramatic swing to the SNP. According to TMM's models, were the Scottish election carried out under the First Past The Post (FPTP) system as per the General Election, that Labour would have been all but wiped out, only holding a couple of constituencies. Scottish First Minister Alex Salmond has already been making demands in the media, and it appears that David Cameron will acquiesce to some of these, particularly in the case of allowing Scotland to raise its own debt. Alex Salmond is a shrewd political operator, and is not unaware of his ability to extract concessions from Westminster while delaying an eventual referendum on Scottish independence. Now, TMM are pretty sceptical of Scotland's ability to survive as an independent nation within the Euro given that it shares many structural problems with the PIGS (low productivity growth, high dependence upon fiscal transfers etc). A discussion of how independence mechanically would work is far beyond the scope of your humble bloggers, but it is clear that the division of oil revenues, Gilt stock and the cost of bailing out RBS and HBOS will play centrally. But intricacies aside, TMM reckon the Labour Party will be especially worried about how things play out.

Onto England... TMM reckon the UK council election results are particularly surprising, as based upon national polling, the swing from 2007 (the last time many of these constituencies were asked to vote) suggested that Labour should pick up around 1300 council seats, but instead only picked up 800 seats. That is a disappointing performance, especially in the context of the Conservatives *winning* 81 seats, something none of TMM's Westminster mates were expecting. What appears to have happened is that the Liberal Democratic vote has collapsed, but also, minor parties and independents have been squeezed too, moving England back towards polarised two party politics and reversing the trend of the past 30years. The seat shares for England were CON (53%), LAB (27%), LIB (12%) and OTHERS (8%). Professors Rallings & Thrasher's electoral models reckon the overall results put the national equivalent vote shares at CON (38%), LAB (37%), LIB (16%) and OTHERS (9%). That would equate to the first time the Tories have led Labour in the polls since last Autumn. Aside from Liberal Democrat infighting, TMM expect Cameron and the Tories will be reenergised by these results as they show a clear building of momentum on the national polls. The fact is, for such a stage in the economic and political cycle, Labour should be further ahead.

But this also raises a further question: how much more momentum do the Tories need to gain in order for there to be a snap election?

The coalition document is key in its agreement of the next election date being 2015, something the Liberal Democrats wanted in order to stop the governing part from calling snap elections. However, the key Tory electoral reform proposal - the boundary review - has been passed into law (in the same bill as the AV referendum), but the fixed term parliament legislation has not. TMM reckon that the Lords may try and remove the fixed term parliament clause from the Bill, allowing the Tories to call a snap election should the right circumstances arise, as Labour do not currently have the momentum (or the money) to win a national campaign should an election be called shortly. It is worth remembering here that polls always narrow in favour of the incumbent as an election date approaches and currently, Labour do not have enough momentum (or cash) to fight an election. The Tory aim now should be to try and appear "above" the squabbling going on within the LibDem camp, and quietly refuse to enact anything that is not within the coalition document. Given public anger with the LibDems, the MPs will either wear it and grit their teeth for fear of losing their seats in an election, or else out of "principle" or whatever else, they will force a breakup of the coalition. TMM genuinely don't think Cameron has an agenda either way, in this respect, however they would expect others in the party will be plotting behind the scenes. The key is to appear reasonable and attempt to drag things out for another 6-9months. TMM will explain why below...

Obviously, one of the most famous political quotes ever is "It's the economy, stupid". Nothing is more important in TMM's opinion, and we think things are about to get interesting...Firstly, the below chart shows a model of UK Consumer confidence based upon various lagged economic variables. The fit is not perfect in recent years, something TMM believe to be the result of the volatility in the RICS survey (one of the model inputs) over the past four years, as well as base effects that we couldn't be bothered to adjust for properly, but you get the idea - consumer confidence is largely a function of the economy. Several of the inputs to this model have begun to turn over the past couple of months, and after last week's oil collapse, the petrol price component should do too, soon...

The next thing to look at is how Consumer Confidence behaved in the context of similar economic conditions (the early-1980s). Getting data back to the late-1970s is not easy, so the data is not as granular as TMM would like, but you should be able to see what we're trying to illustrate. The below chart shows consumer confidence (red line, left axis) vs. the Conservative vote share in polling data (blue line, right axis). The 1981-83 period is covered in a bit more detail below, so we'll just say that you can see that from 1979-80, confidence rebounded with the new government and the end of the Winter of Discontent, but then stalled until around mid-1981. It then began to rebound sharply as the economy exited recession, and dragged the Conservative polling share higher (more on this and the Falklands below). As economic restructuring in the North continued into the mid 1980s, both confidence and the Conservative vote share fell. At the height of Thatcher's battle with the unions, the unpopularity of Thatcher became widespread and their share collapsed, though as the economy rallied into 1987 with the Lawson boom, confidence led the vote share higher... And then subsequently lower as the economy slid into the 1989-90 recession, bottomed and rebounded back into 1992, before collapsing after Black Wednesday. That was the point at which economic credibility was lost and the Tories descended into infighting, detaching from confidence.

Zooming into 1981, it is possible to put paid to the common belief that the 1983 election was only won as a result of the Falklands War. As can be seen from the below chart, Consumer confidence had been moving higher for a while and the Tory vote share bottomed in August 1981, before rebounding sharply with the economy to around 40% just prior to the Argentinean invasion. That was only a couple of percentage points away from the level needed to win a majority, and would inevitably have been built up once an election was called (remember the poll narrowing point).

So how is this relevant now? Well, there are several similarities. Firstly, the Royal Wedding saw a large bump in consumer confidence in 1981 from -28 to -17. With a 2bn global audience and excitement all around, it is easy to see how many will have been cheered by the event. Secondly, the recession here ended a while back and the recovery is currently tracking the 1981 experience reasonably well. TMM are not convinced that the blip in the UK data is anything more than an Easter/bank holiday effect - certainly that is the impression that a few other metrics they look at are giving (notably, housing, mortgage approvals, Lloyds business barometer, consumption etc). Thirdly, the weather has been fantastic, aiding the High Street (see Next's recent statement). TMM reckon that the outlook for consumer confidence is beginning to turn positive.

It is clear that the hurdle for the Conservatives is no longer that high given their essential level-pegging with Labour in the polls and their electoral performance. Clearly, the momentum is likely to energise the party and should economic conditions improve over the next 6-9months then it seems to TMM that an early election is suddenly significantly more likely. It's worth remembering that there are large numbers of both LIB-CON marginal constituencies that just turned a "virtual" blue and several more three-way marginals. An encouraging development for the Tories is the squeeze on "Others" and "Independents", implying that UKIP voters (of which a mere 1500 cost them a majority last year) are coming back into the fold. The key barrier to an early election is the current constituency boundaries are stacked against the Tories, and won't be set under the new legislation until 2013. Of course, should polling thresholds be met, TMM do not doubt that Tory High Command may take a gamble.

As far as the LibDems go, they now are - in electoral terms - reduced to their SDP/Liberal "rump" as Labour defectors have already moved back and students (who are too lazy to vote anyway) move into Labour's arms. The Clegg resignation calls were inevitable, and Chris Huhne has clearly been positioning himself as the left's candidate, but he is a clown... and his ex-wife has threatened to embarrass him by releasing potentially damaging information on him. TMM's gut says Clegg will stay in control, but anger will simmer more broadly within the party, something which the Conservatives may try and take advantage of in coming months should their polling position improve. As above, the key for them is for the LibDems to blow themselves to pieces such that the government falls as a result of the LibDems. This is clearly a risky proposition...

...but one thing is certain, the probability of an early election has risen and, with it, TMM's Non-Prediction (the first half of which they got right) is looking slightly more vulnerable.

Friday, May 06, 2011

Too Big to Succeed, Too Greedy to Turn Down Investors

We woke up this morning to find various confused people crying over the corpses of their sacred cows.

- First the BBC, who can't seem to understand how the Tories could have done so well in the UK local elections. More importantly, they appear to be struggling to get to grips with the fact that outside Luvvie Land quite a few people do actually support government spending cuts. In Scotland, Labour’s support has all but evaporated, as the political fault line running underneath Hadrian’s Wall starts to creak. Which all together makes TMM want to nip down to the bookies to put a friendly fiver on the Conservatives calling a snap UK election, though autumn would be more likely.

Second, the commodity inflationistas. Depending on how you’ve been positioned recently, commodities have either been one hell of a party or, well, hell. TMM have been noting the weirdly consistent trending behavior in commodities for some time and the absolutely insane price action in things like cotton and silver. A price squeeze is a price squeeze, but many of these materials are not in short supply in spot markets and have been running incredibly hard.

TMM have been of the opinion that much of this has been driven by the commodity trading advisor (CTA)/managed futures/evil robot juggernaut part of the investing community cashing in on trend lines and public hysteria, rather than being purely dominated by the supply and demand end user arguments. As one comment yesterday said “So do you think Gasoline prices have fallen 7% in a day because 7% of car drivers decided not to drive all of a sudden?”. Nope. The spec is alive and well and the strategy’s participation in the recent run up supports that view.

Judging by the recent strong performance put in by the industry’s monster, Man AHL, during the parabolic move in silver and their recent slowdown we're getting more and more convinced that the CTA community has a lot to answer for recent unhinged price actions (gold, silver, Euro, you name it).

TMM have been thinking a lot about this recently because one the sad facts of investing is that it is more or less impossible to generate the same performance in the same strategy when your AUM increases materially. One of the doyens of fixed income, Antti Ilmanen, devotes a whole chapter of his new book to endogeneity risks in markets – aka being too damn big to make money in a particular product or strategy. In some things like small caps and distressed debt the performance diminishes rapidly with size, but this can happen even when your core products are FX and futures. This is especially so when your returns depend on being nimble and able to move quickly – something that is awfully hard to do when your position in a product is a week’s volume.

The question is why would anyone invest in a strategy that is known to underperform past a certain size? The short answer is that fund of funds are idiots, the longer answer is that asset allocators at endowments and the like chase performance just like CTAs. It’s easy to add more money to a strategy and then pin it on the manager when it all blows up.

To that end TMM think that we will see flows out of CTAs and with that comes the reminder of the rewards of doing one’s research and understanding where fair non-financial use sits for commodities (*cough* lead). TMM are happy to have closed out on the highs for copper and are looking for more pain in industrial metals as there are few dip buyers on the hedge fund side (some of TMM think that with price moves like this, someone has to have gone out of business) and the energy sector appears to be moving back to fundamentals – ie, the $100 WTI we had as a price target at the start of the year. Yesterday’s game changing US data reinforces these feelings.

Much of this, of course, comes down to the timing and severity of the US slowdown (see yesterday's post) and whether there is further QE, not to mention resolution of China’s inflation problem that might allow commodities demand to pick up. TMM are not feeling bullish but are expecting the downward momentum to fade so have switched their puts to cash shorts until the fog clears.

Thursday, May 05, 2011

Was that the "Gong"?

TMM "Note to self": USD/JPY will remain difficult. DO NOT TOUCH. We are out of that one as the mood turned "carry off" in general. The EUR/GBP we will hang on to.

TMM must admit that, as optimists on the US economy and having taken a constructive view of equities this year, they have found today's post very difficult to write. This is because after a pretty good earnings season (where revenues posted their largest upside surprise since Q4 2004) equities still look pretty cheap on their valuation models and have been remarkably resilient in the face of several idiosyncratic shocks this year. While Q1 growth data disappointed to the downside, certain survey and supply side data were suggesting a reacceleration to around 3.6% annualised GDP going into H2. Indeed, today's post was - until yesterday - going to be about how TMM were coming around to the view that the bond market was overpricing the risks to growth (based upon a combination of arithmetic and forward real rates) and that they were getting to close to pulling the trigger and going short Treasuries. But yesterday's Non-Manufacturing ISM data have them wondering if the "Gong" has just been rung...

In an eerily similar manner to 2010, the US data has begun to roll over, with Non-Manufacturing ISM adding to the list of Philly Fed, the Global PMI and Jobless Claims. As above, TMM's GDP model (see chart below, white line vs. actual GDP - pink line) had been, until recently, pointing to growth in the 3.6-3.7% annualised region. However, the most recent survey data have led to a dramatic reversal, with the model now consistent with annualised growth of just 1.6%. Now, the model not even close to perfect (it does not include household or government consumption inputs, for simplicity), and certainly, it is possible to argue that the most recent data may be the product of statistical factors related to a late Easter, but it is hard to ignore the fact that a trend in the data has emerged and it is increasingly looking like the US is once again growing sub-trend, widening the output gap further.

Regular readers will be familiar with the below chart of Economist 2011 GDP consensus expectations lagged two weeks (white line) vs. the 5y5y forward real rate (orange). Obviously, both have been moving lower over the past month, with the bond market seemingly settling at just below 2.8%, while analysts have settled on 2.9%. Plugging in 1.8% for Q1, that would suggest in order to match the economists' yearly 2.9% figure, that GDP would need to be growing at an annualised 3.2% for the rest of year and a mere 3% under the bond market's pricing of growth. Until yesterday, TMM thought that was not a big hurdle and that the time to short Treasuries was near. However, if the model prediction of 1.6% is plugged in, that would require H2 annualised growth of around 4% (or 3.9% under the bond market metric), which is a significantly higher hurdle. TMM are increasingly concerned that markets may be sleepwalking into a growth scare...

...particularly ahead of tomorrow's Payroll report, about which TMM's model (see chart below, orange line) reckons economists are overly optimistic in looking for a 200k private jobs increase vs. 110k on our model.

The trouble for markets, and growth expectations, is that real rates have fallen a great deal in past couple of months, such that the 5y5y forward real rate is now plumbing levels usually seen prior to a Fed easing. Under this prism, it is hard for nominal yields to fall much further unless either inflation breakevens fall and/or the Fed eases further...

Oh dear... we said it... could this be the time that the "Gong" rang for QE3?

Or rather, the time the "Bell Tolled" for Equities and risk assets more broadly?

The below chart shows 10yr yields (white line), 5y5y breakevens (orange line) and 5y5y real rates (yellow line). In 2010, real rates initially fell in response to slowing data but then gradually dragged breakevens lower as well to the point that a growth scare morphed into a deflation scare. Sure, real rates can go a little lower, but TMM suspect that with commodities being given the short shrift that it will be breakevens that take leadership.

In short, TMM have found this a very difficult post to write upon the backdrop of their, up to now, optimistic views of growth. However, given positioning in EMFX and equities, a demonstrable turn in the macro data and little room for the bond market to cushion these growth downgrades that we are at an important inflexion point. TMM believe that either the data has to rebound sharpish, or else talk of QE3 is likely to intensify in the coming months. TMM are struggling to believe that they are writing these words...

It is a shame, as we had hoped that the US would tough it through to the point where they became competitive enough to re-compete against the new world, which is all the more frustrating as that cavalry may well be coming to the rescue in the shape of the stories in the FT today on US competitiveness re: China and Siemens' concerns re: Brazil hint that that structurally the way companies think may be changing. But will they be in time to make it a Waterloo rather than an Alamo.

Wednesday, May 04, 2011

Lost in FX space

To be completely honest TMM are dashing around playing catch up after time-out over the UK bank holidayfest.  Wasn’t the Wedding lovely?  The UK's weather has been absolutely stunning over the last 2 weeks and we have to say that, if it were to be predictably that glorious, there would be little need to holiday abroad.  What a shame we all had to return to work!  Of course, our Big Country cousins in the US have been working diligently throughout (TMM have wondered if there is any real correlation between number of holidays and real productivity), but that diligence seems to have done little for the state of the US dollar.

We have come in to find that the world has changed little.  Chopping the head off the Hydra of Al-Qaeda is not a global market mover, though it has been a field day for the Armchair Special Forces experts and those who play video games with names like "Call of Duty - Abbottabad".  However, TMM assume that Bin Laden isn't really dead until Donald Trump has seen the death certificate.  Is "Donald Trump for President" part of the "Gordon Brown for Head of IMF" joke?

But we are interested in what has started to happen to some of the normal USD indicators.  We had a flash crash in gold 2 days ago and silver puts have gone "Pippa Middleton" (no one had bothered with the little sister of Gold Puts until after last Friday, when they went monster bid).  Silver's collapse may be blamed on it "Bunker Hunt"ing itself again with an increase in margin requirements bursting the specs' bubble, but its demise should still be a worry to the dollar bears

For the past 2 days we have seen the interesting spectacle of Asia time zone buying USD, but Europe and the US reversing it.  The same with equities.  So why is Asia selling risk and carry, while the West is buying it? Shouldn’t we be listening more to Asian sentiment as they are the ones who are driving the flows these days? Through all this the Euro is riding rampant, up against even the mighty AUD.

So what of Europe?  The "vinaigrette" currency is riding a wave of ECB policy and the resultant impact on the curve (EUR 10yr yields are now higher than USD) and, of course, the world's favorite creditor is still stuffing the periphery scaremongers.  Has the premium for pork in China led them to buy European PIGS? But what they give with one hand in buying the debt they take away with the other by forcing the currency against the weaker economies.  TMM wonders if the European economies can recover enough before the ECB rate rise program takes them back to the stone age.  Germany's figures today may be the first sign.

The UK data is looking crap and TMM are most concerned that yesterday's UK figures looked leaked again.  If the SFA were doing their job properly you would see their squad cars screaming around the city and snatch squads smashing in doors at addresses in Cardiff and London.  Instead they are just doing the equivalent of handing out speeding tickets.  Together with EUR's rampage EURGBP is now flirting with 0.9000.  Another reason, apart from the weather, to stay at home this summer.

So put that lot togther and we would like to say that the USD's run down is showing signs of abating in some assets, but we are torn.  Whilst, as is pretty clear from the above ramble, we are pretty lost in FX space, we think we should try and grab ahold of something -  so we are going to don the kevlar gloves and buy some USDJPY and sell some EURGBP.