For the week, spot gold closed at $1,134.65 per ounce up $17.05 or 1.53 percent. Gold equities, as measured by the XAU Gold & Silver Index rose 5.84 percent for the week. The U.S. Trade-Weighted Dollar Index nudged at bit higher, gaining 0.12 percent.
Strengths
Despite a slightly stronger U.S. dollar, gold, silver and platinum group metals all made good gains this week.
The gold stocks also followed through with many stocks posting returns twice what the commodity gained.
Copper prices were also very strong, rising 4.31 percent.
Weaknesses
The S&P 500 closed the week at 1138.7, posting a gain of 3.10 percent.
Some investors question why they need gold exposure if broader equity markets seem to be showing strength. Historically, the S&P 500 and the price of gold have traded at a ratio of one-to-one over the long-term. Gold currently is at 1,134.65.
The credit crises of the private banking sector is now a sovereign debt problem which may not disappear in the near term unless spending is cut or taxes are raised substantially, The most stealth solution would be a program of inflation.
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Opportunities
Record demand for U.S. Mint silver coins shows no signs of abating. For the first two months of the year, sales are up 40 percent over the prior year.
Gold coin sales fell almost 18 percent for the same timeframe. However, there have been some constraints on meeting consumer demand on the part of the U.S. Mint for gold coins.
Threats
South Africa is expected to have enough power generation capacity in 2010, but lingering electric power issues should mean a tighter market in 2011.
Seasonally we should expect a correction in gold, but this has not materialized.
For most of the past 2000 years, China was the biggest economy in the world; for the last 200 years, though, it has lagged because the country didn’t pursue the path of industrialization. That has changed and models that are U.S.-centric just may not matter anymore.
British companies paid out £10bn less in dividends in 2009 compared with the previous year leaving pension and other investment funds dangerously dependent on carbon-heavy oil groups, BP and Shell, for a quarter of all such income, new research shows.
A total of £57bn was handed out to shareholders last year, 15% less than in the previous 12-month period, with 202 firms cutting their dividends and 74 paying nothing at all, according to Capita Registrars Research.
The data shows the financial crisis led to a £6bn fall in dividends from the banks, leaving drug, tobacco and oil companies to fill some of the gap.
“The recession has hit dividends particularly hard because companies have not only had to cope with falling profits, but also massive pressure on their ability to finance themselves. Preserving cash has been a top priority,” said Paul Taylor, head of dividends at Capita Registrars, who used data provided by the financial information specialists Exchange Data International to prepare the report.
“Much of the banking sector is either in state or foreign hands, while the ability of the remaining independents to pay dividends is severely constrained by the need to rebuild their balance sheets… Among retailers, only the supermarkets have managed to keep the dividends flowing,” he added.
Capita points out that investors are now “heavily dependent” on just five companies – BP, Shell, HSBC, Vodafone and GlaxoSmithKline – for 47% of all dividends, giving those businesses enormous clout in the investment markets and around government.
Yet Shell faces demands from its own shareholders to move away from its controversial tar sands investments in Canada, while the Co-op’s investment arm will today unveil plans to oppose BP’s involvement in this area.
“The increasing dominance of the oil companies has left investors highly dependent on a few big stocks to provide them with an income,” said Taylor. “Oil has fuelled the engine of UK dividends in the last two years. Lower oil prices, tighter refining margins, slower production growth and unfavourable currency trends have put profitability under pressure at the big oil companies and will make it tougher for them to increase their payouts to shareholders. Indeed, the latest news from the oil sector may even mean our forecast for 2010 is optimistic.”
Shell reported last week a 75% downturn in profits during 2009. It said there would be no further increase in the first quarter of 2010 as the future looked difficult. BP also gave a downbeat assessment of future trading opportunities.
Capita believes dividend payments from UK companies should recover with the economy over the next year, reaching an estimated £60bn, 5% up on 2009.
Meanwhile, UK companies raised a record £73bn from new equity as banks and other businesses fought to rebuild their balance sheets. “There has been an unprecedented flow of capital from investors to companies,” said Taylor.
Pension funds and other institutional investors committed the most money to the UK commercial property sector on record last quarter, in spite of continued fears of a further drop in values this year.
Institutional property funds raised more than £3.2bn last quarter, dwarfing the previous peak of £1.7bn collected in the boom of the market in 2006. This is the highest since records began in 1998.
Official numbers from the Association of Real Estate Funds show that UK unlisted pooled property funds attracted £2.9bn in the fourth quarter on a net basis, much higher than the £400m raised in the third quarter.
The sudden influx of new capital from institutional investors reflects the wider shift in sentiment towards UK commercial property, which has seen a bounce in pricing since last summer after almost halving in value. Retail investment funds have also recently seen record amounts raised to invest in commercial property.
John Cartwright, AREF chief executive, said: “Last year was a volatile year, but it ended on a positive note with record new money coming in to the funds, as well as the final quarter showing extraordinary growth in returns.
“This marks the second quarter of positive net sales, signalling the resurgence in popularity for property funds. Interestingly, while retail investors remain active, we have also seen significant new money from institutional investors who tend to have longer-term investment horizons.”
However, the speed of the recovery - which has seen capital values grow by 10 per cent in six months - has led to fears that there will be a second dip in values. These fears have been exacerbated by weak fundamental reasons to invest in real estate, with rents under pressure.
Analysts said these reasons, in addition to pressure from the end of the Bank of England’s quantitative easing scheme, may have meant that the “easy money” from the bounce could have been made.
Fund managers, however, say they are investing for the longer term, typically for more than five years, meaning a further dip would not be a disaster.
AREF said the net asset value of the sector had reached £25.2bn by the end of last year, down from £26.2bn the year before.
Gross sales for 2009 were £4.5bn, up from £567.3m in 2008, while net inflows were £3.2bn, a reversal of funds, given net outflows in 2008 of £224.2m.
The UK property market stands to gain the most from all this influx of pension assets looking to scoop up commercial property at attractive prices. Will this be a great long-term investment? That depends on a lot of factors, chief among them, will the world avoid a protracted deflationary episode?
If it does, then it may make sense to pile into UK and US commercial real estate now. If it doesn’t then pensions will be waiting a long time before they see any meaningful price appreciation on these investments. The same goes for those incredibly shrinking dividends.
We originally published the main body of this story in mid-June this year, and are reprising it now as the chart below from Credit Suisse’s chart is making the rounds again, given there is talk that the monetary authorities are considering halting quantitative easing operations (i.e. printing money). We may have gotten through the last 6 months, thanks largely to the Fed’s QE induced liquidity, which fuelled a very strong rally off the March lows. The question is, “Has it worked?”
The equity market seems to indicate “yes,” and now it remains to be seen in the next two quarters if it has indeed worked.
The passing of a hurricane is quite an event, and a strong one can wreak havoc. In the eye of a hurricane, there is an eerie calm, and quiet, and the sun often shines brightly. The bigger the hurricane, the bigger the eye. This is then usually followed by a secondary lashing as the back end of the hurricane passes. Is this what’s in store for the mortgage and credit market over the next 2 years as the banking system faces its next round of resets?
Have the banks hoarded cash for this reason? Is it enough?
According to statistics provided by Credit Suisse, we are in the midst of a mortgage-paper-resets lull (the space between the two humps), as seen by the chart below. Doug Short (dshort.com) has kindly added the S&P500 chart to the one produced by CS. In a nutshell, banks (and the credit market) have gotten a much needed break from the enormous pressure of having to ensure that the liquid assets are available for the re-financings that are in the works.
Given the size of the Option-ARM (Adjustable Rate Mortgages) portion of the scheduled resets, there is much cause for concern, especially for the banking sector, and the credit market in general. This picture of the mortgage reset histogram is reminiscent of the passing of a hurricane. The tail end of the hurricane this time includes not only the Option ARMs but also the Alt-A (better than subprime) mortgages.
The S&P 500 is up nearly 36% from its bear market low on March 9th. Sentiment is somewhat less negative on several fronts. Credit crisis indicators, the ADP employment report, bank stress test leaks, and the market rally itself have all encouraged optimism that the worst is over.
According to Wall Street, the market is forward looking. But has the market really discounted the future impact of continuing mortgage resets? Here’s a widely circulated Credit Suisse histogram of resets to which I’ve added a thumbnail of the S&P 500 matching the timeline from October 2007 to the present. There are a lot more resets ahead — option-adjustable, prime and alt-A — over the next 2 1/2 years.
Canada is on the cusp of something big. A boom in commodities means Canada will outperform the US over the next decade. Our recovery and upward trajectory is tied to global demand coming from China and India, and the rest of the developing world. And with attractive risk/reward fundamentals, sound fiscal position, and strong banking sector, Canada is destined to become a darling of global investors. At this time, Canada resides in a sweet spot of long term investing opportunity, but not for the one reason - inflation - that gets cited most often. Not yet anyway.
Mark Carney says Canada’s economic recovery is merely a ‘consequence’ of unconventional measures. And, his report cites that prices are still falling in Canada.
This flies in the face of all the hoopla surrounding the inflation-motivated theme of investing in commodities and/or commodities producers. Investing in commodities producers is by no means a bad idea; its the rationale for doing so, by way of inflation, that may be flawed. Investing in commodities falls under the aegis of inflation protection, because if indeed we find ourselves in inflationary times again, we will be happy to own real things, such as commodities and real estate.
In the U.S. however, is it really a big surprise that the G20 meeting is yielding a “strong dollar” consensus? China, and other dollar reservists, Brazil, Russia and India, have been squawking about the faltering greenback, threatening to take measures to reduce its appetite/dependency on the US dollar since before the crisis began. If you listen to the Michael Pettis interview regarding China, you’ll get the idea very clearly that China is in no position to undo its marriage to the US. At least not anytime soon. Un-pegging from the greenback would have destabilizing consequences for China, not too mention the global economy, if not because of its effect on China, then due to its effect on the US economy. The US/China relationship is a symbiotic one. In the meantime, we will watch the U.S./China economic ballet continue.
Therefore, as the G20 has reached a strong dollar consensus, the Canadian, Aussie and NZ dollars have all pulled back. It preserves balance for the dollar, yen and euro economies, and more importantly it keeps everyone happy politically. As for the Canadian dollar rising in value, it’s not a good development for the Canadian economy, but rather a by-product of the demand for what we produce. Its terrible for our non-commodity exports. So, balance works for us too, in the long run.
Kathy Lien: The Canadian Dollar tumbled against the greenback as investors took profits ahead of G20 meeting. Oil prices also fell more than 4 percent while gold prices closed below $1000, providing no support for the commodity currencies. The Canadian government returned to easier monetary policy after Canadian Finance Minister Jim Flaherty proposed an expansion of mortgage buy-backs to C$125 Billion or $116.4 Billion. The proposal comes on the midst of yesterday’s comments by Governor Mark Carney who claims the recovery is not “self-sustainable” and is a mere consequence of unconventional measures. If they proceed further with this, we could see a turnaround in the Canadian dollar.
In What is Gold to China?, we discussed the idea that gold is a safer long term bet as a result of the “Beijing put,” the notion that whenever gold falls to lower levels, the Chinese come in as strong buyers, bidding gold back up, as they are continually out to diversify their reserves into other currencies. Its all part of a symphony of intervention that is choreographed between the US, Europe, the IMF, Japan, and China to keep the dollar in a fundamentally stable range. Having said that, this too, benefits Canada as one of the world’s biggest gold producers, despite the fact the price of gold is subject to the manipulation of central bankers.
In that vein, Canada, as important as it is in today’s world, is along for the ride. Our recovery will depend upon a stable global recovery determined by steady interest rate policy and coordinated currency balancing.
Herein lies the opportunity; we just need to recognize it, and get our (long-term) peas lined up.
Canada has what the world needs (resources), a sound fiscal position, and a strong banking system - So why haven’t the dollar reservists chosen to invest in Canada bonds, as an ultra-safe alternative to US Treasuries? Simple.
Canada has so much of what the reservists (BRICs and other emerging economies) need and want in order to build out their own economies, that investing in our debt would raise the price of the very things they want to buy from us, such as wheat, oil and gas, metals, and minerals. They are not just interested in importing commodities from us; more important, they have their eyes on buying the companies that produce the commodities, as well. Despite this, Canada’s bond market may perform well in the near term, as a by-product of today’s continued price weaknesses. And, the time will come, though not in the near future, when foreign investors will alternatively opt to buy Canada bonds.
Among the great inefficiencies that have plagued Canada is our conservatism (or rather the reluctance among Canadians to invest risk capital in the most strategic areas of our economy), and our complacency. Canadian companies have historically faced shortages of domestic investor capital, and that issue has forced them to look first to the US, and now globally for substantial sources of capital. This has meant that Canadians have foregone the ownership of our homegrown companies to foreign interests. Its this inefficiency that makes the opportunity to invest in our own commodities producers, and other companies so attractive.
By the way, every time something creative comes along to make it easy to raise money in Canada, for example, income trusts, someone in government comes along and shuts it down. There’s no doubt that there was some abuse and stretching of the rules which led to the legislation shutting them down, but then again, it was also one of the most successful equity financing periods in Canada’s capital markets history. At times it feels as though the Canadian government would rather help foreign investors take over our industries, rather than police the tax incentives that make raising capital easier, more fairly. Then again, this too, is part of our conservatism as a society, isn’t it?
Foreign investors are more interested in our companies than we are. As a country and as investors we need to realize that our assets are worth far more to foreigners right now than they are to us. We take our greatest assets, our natural resources, water, oil and gas for granted, because we have always lived in a state of surplus and exported most of what we produce, mainly to the US.
Now that the balance of demand is coming increasingly from the large emerging economies who face massive future shortfalls of materials, water, food, and energy we need to prepare for the geometric growth of demand coming in the next several decades. We sincerely owe it to ourselves to exercise our right to own and nurture these precious assets, before they pass into the hands of foreign corporate interests.
David Rosenberg states in his latest report, out today, that Canada is in the sweetest of spots because we are in the midst of a secular commodities boom. He cites Chindia as the key driver of demand over the next decade, but initially 2009 and 2010, where it is shown that China and India will lead the world in GDP growth, and currently command 21.4% share of Global GDP. This is no big surprise to anyone following commodities, but rather, more confirmation.
We believe that commodities are in a secular bull market, and this is where Canadian outperformance relative to the United States comes into play - nearly 45% of the TSX composite index is in resources; almost triple the share in the U.S. Almost 60% of Canada’s exports are linked to the commodity sector, roughly double the U.S. exposure. This explains how it is that the Canadian equity market has managed to outperform the S&P 500 this year by a cool 2,000 basis points (in this sense, Canada is basically a low-beta way to play the emerging markets via commodity exposure).
This by no means indicates that the US and the Western consumer will cease to be the world’s top consumer, but rather that we will have to line up with the new consumers from the developing world, to buy the same stuff. That is ultimately inflationary, but not for some time.
Rosenberg points out very nicely that commodities prices bottomed last year at the highest recession levels ever.
And, that prices bottomed at levels above historical peak prices.
This last chart is remarkable, because it illustrates how strong demand has gotten during the last ten years with the rise of China and India. Even after last year’s blow-off, prices are fundamentally higher because of the surge coming from the developing world’ growing appetite for food, shelter and commerce.
Forget about inflation, at least for now, as a reason to buy commodities. There are two overriding themes, that should be front and centre:
1) demand for commodities - Foreign interests wish to lock up supply which means the commodities themselves will be bid up.
2) demand for producing companies - Foreign interests, particularly China and its rapidly developing and mutually rich peers have their eyes squarely focused on our businesses and our natural resources. Mergers acquisitions and hostile takeovers will bid up the prices of Canada’s most desirable commodities producers, and it won’t be only China which comes knocking, though they will likely turn out to be the most aggressive. The onslaught of foreign-sourced capital markets activity is likely to come well in advance of peak prices for the commodities themselves.
What do policymakers think of, in the now wealthier, fastest growing countries of the world, whose nations are facing shortages of materials, oil, water, and food that would be devastating to their economic progress? “What will we need, and what do we have to do to get it?”
Let’s come back to the notion of complacency. Canadian complacency. We have taken our most valuable assets for granted, because they are abundantly available in our backyard. Also, the last year’s turmoil has also made it more difficult for investors to commit long term capital out of fear.
In the period ahead, it is not so much inflation, but rather pure and simple demand for the future supply of commodities that will take centre stage. Inflation, when it re-appears will be the icing. Canadian investors should view any market corrections as opportunities to accumulate meaningful overweight positions in their portfolios in the commodities complex in some combination of commodities and commodities producers.
This period represents Canada’s big chance to get out in front of foreign interests in our own backyard. We have the right to participate in the growth that will come Canada’s way as a result of the massive global economic transformation that is underway or we can choose to be bystanders.
We will continue to write and drill deeper into this subject in the coming weeks and months.
The Lehman Bros. bust, one year ago this week, was a watershed moment and event that many would like to erase from memory, given that the consequences were disastrous, wiping out trillions of dollars in wealth and destroying the financial plans of so many in the Western World. But, there is a silver lining, in particular, for Canadians. While we were not spared the pain, Canada is now uniquely positioned against the rest of the struggling western world, and it is Canadians who should grab the advantage.
First, we have no inflation - interest rates will remain low for some time - perhaps one to two years.
Canada has experienced the steepest fall in consumer prices in more than 50 years. That is remarkable.
Consumer prices overall fell by 0.8 percent in August from a year earlier, the second-largest 12-month drop since 1953, Statscan said. In July, consumer prices slid 0.9 percent at an annual rate, which was the sharpest drop since 1953 when the CPI fell 1.4 percent.
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Statistics Canada also said on Thursday that the composite leading indicator rose by a sharper-than-expected 1.1 percent in August, the latest sign the economy is pulling out of deep recession.
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“We haven’t seen the end to the downsides on core consumer prices going forward,” said Derek Holt, vice-president at Scotia Capital Economics.
“If we are right and the Canadian dollar goes to parity (with the U.S. dollar) then inflation is going to be parked as a side issue for a good couple of years,” he said.
Yesterday we wrote that the US dollar had fallen to its lowest levels in a year, this due to investors ditching risk-free assets such as cash and cash instruments in favour of higher yielding assets and … gold. Hence, the price of gold doubly has been fueled by the exit from cash and the bidding up of gold itself.
Price deflation, however, in Canada has been due to the rising value of the loonie. Thankfully, Canadian consumers’, banks’ and the country’s balance sheets are not overlevered. And that has placed Canada in an advantageous position, vis-a-vis our neighbours to the south.
Second, Canadian banks are strong and in an enviable financial position
Canadian banks are eyeing opportunties to expand south further into the US banking sector - prices are depressed and the Canadian dollar is strong …
Canadian banks may step up acquisitions and investments in the U.S. as troubled lenders falter amid the economic slump.
“Significant opportunities” exist outside Canada in the next two to five years as banks restructure, Royal Bank of Canada President and Chief Executive Officer Gordon Nixon said today during a conference in Toronto sponsored by Scotia Capital. Other Canadian bank executives agreed, and Bank of Montreal President and CEO William Downe called this a “once in decades growth opportunity”.
It’s reminiscent of the days when Canadian moguls snapped up cheap Manhattan real estate in the mid 70s crisis. This period of opportunity for Canadian banks rhymes with those partaken by firms like historic components of Brookfield Asset Management (Edper, Brascan, Trizec) and the once great Olympia and York, in the period following economic crises in 1973-74 and during the 90s. Brookfield is today the largest single landlord in Manhattan.
In Canada: There’s No Place Like Home we discussed the idea that Canada was in a uniquely advantageous position on three fronts - fiscal soundness, healthy and strong banking sector, and a resilient consumer. Let’s discuss investing in Canada - its time Canadian investors realize the grass is greener on our side of the fence, and if so, to act on that belief and position ahead of interested foreign acquirers of our key resource and commodities companies. I say this, because although many Canadians would say “duh!,” how do we explain that for years we have been letting our companies be acquired by dragons in return for adequate levels of capital funding for our expansions. Why aren’t we sponsoring our own businesses to the degree that they can remain in Canadian hands.
We are taking our advantage for granted - Foreign investors see greater value in our key assets than we do.
“If you’ve been in the [poker] game for 30 minutes and you don’t know who the patsy is,” said Warren Buffett, “you’re the patsy”.
Why, for instance, was Research in Motion denied the opportunity to acquire some Nortel’s key telecom patents and assets, and in essence, keep them Canadian. Instead, they were awarded to Ericsson, and a subsequent sale of additional key intellectual properties and technologies were sold to Avaya. Why? It’s madness that one of our own homegrown, and financially willing and able corporate darlings lost this chance, and subsequently, that Siemens bid to re-invigorate Nortel into Canadian-headquartered $5-billion-a-year tech giant failed because of a lack of support for it from Ottawa.
A year-long drive by a German company to create a Canadian-headquartered, $5-billion-a-year telecom equipment maker from the remnants of Nortel Networks Corp. ended in failure because of a lack of support from Ottawa, according to people close to the situation.
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But the landscape in Ottawa changed in late July, after RIM co-CEO Jim Balsillie publicly attacked the planned sale of Nortel’s wireless unit, claiming RIM had been shut out of the process. EDC arranged a $300-million loan to one of the bidders, Nokia Siemens Networks, and the business was eventually bought by Sweden’s Ericsson.
While RIM did not take part in the auction, Mr. Balsillie framed the issue as one of foreigners being favoured over a home-grown tech play.
Now it also appears Chinese interests are visiting Canada in order to investigate Canadian financing options for what would be the acquisition of Canadian companies in the resource sector. The Chinese want to secure as much of their future natural resource requirements as they can - but they want to see if we can help them to finance their acquisition of Canadian companies. If we are selling our companies to the Chinese and other foreign investors now, in return for making sure our projects are adequately funded and viable in the long run, like the oil sands, then how do we justify this when some parties are willing to discuss funding the acquisitions for them, as in the example of Macquarie. Is this an extension of our risk aversion - we would rather fund the obligations and collect the interest, than take the developmental risks ourselves on resource projects and maintain Canadian interests?
China Petroleum & Chemical Corp.’s finance subsidiary said it held talks with Macquarie Group Ltd.’s Canadian unit as part of efforts to raise funds for the refiner’s operations.
“We’ve had discussions over what kind of cooperation we can have in the area of financial services,” said Song Guoming, a Sinopec Finance Co. Ltd. manager who held talks with Australia’s biggest investment bank yesterday in Toronto. “We’re studying their methods of raising funds.”
Canada has universal appeal as an investment destination, finally
As Canadians we should take a larger interest in maintaining and making financially viable what we already have, rather than helping foreigners help themselves to it. This is quite possibly the time to do it, given that Canada now has what appears to be real global and universal appeal as a destination for investment.
“In our opinion, Canadian assets (bonds and equities) punch well above their weight and, as we believe Canadian equities remain underweight in global portfolios, global investors should heighten their focus north of the U.S. border,” he said. “We would also point out that Canadian domestic investors should temper their international endeavours and stick to a higher domestic bias in their portfolios.” - Vincent Delisle, Scotia Capital
Meredith Whitney says economic and banking fundamentals in the US have not changed in the last year. Whitney sounds less optimistic now than when she upgraded Goldman a few months ago.
Click play to view:
Part 1:
Part 2:
Whitney made the following points:
“No bank underwrote a loan with 10 percent unemployment on the horizon”.
“I think there is no doubt that home prices will go down dramatically from here, it’s just a question of when.”
She said local governments and states are chronically under-funded and “most states are under water,” adding to the problem of low private consumption.
“If you look at the drivers for unemployment I don’t see that reversing very soon,” Whitney said.
If consumers were to decide to spend, “that would be a game-changer,” but it would be an unnatural thing to do in a recession, she said.
“A lot of themes are constant, which is the US consumer and the small business doesn’t have any credit, credit is still contracting.” Whitney said.
Consumer debt and consumer credit have dropped according to the latest figures which also show that people have been spending more from their debit cards than from their credit cards.
“Obviously that doesn’t bode well for spending,” Whitney said.
Whitney maintains only one buy rating - GS - Goldman Sachs still has a lot of “gas in the tank” and it is taking up a lot of what Lehman left on the table.
“Banks are taking advantage of what the government is doing by artificially inflating asset prices so they can ride a steep yield curve and they’re going to have a third quarter that reflects that.”
The buy rating on GS is a reminder that PIMCO’s advice to “shake hands with the government,” and the ‘new normal,” remain significant themes in this market.
The passing of a hurricane is quite an event, and a strong one can wreak havoc. In the eye of a hurricane, there is an eerie calm, and quiet, and the sun often shines brightly. The bigger the hurricane, the bigger the eye. This is then usually followed by a secondary lashing as the back end of the hurricane passes. Is this what’s in store for the mortgage and credit market over the next 2 years as the banking system faces its next round of resets?
Have the banks hoarded cash for this reason? Is it enough?
According to statistics provided by Credit Suisse, we are in the midst of a mortgage-paper-resets lull (the space between the two humps), as seen by the chart below. Doug Short (dshort.com) has kindly added the S&P500 chart to the one produced by CS. In a nutshell, banks (and the credit market) have gotten a much needed break from the enormous pressure of having to ensure that the liquid assets are available for the re-financings that are in the works.
Given the size of the Option-ARM (Adjustable Rate Mortgages) portion of the scheduled resets, there is much cause for concern, especially for the banking sector, and the credit market in general. This picture of the mortgage reset histogram is reminiscent of the passing of a hurricane. The tail end of the hurricane this time includes not only the Option ARMs but also the Alt-A (better than subprime) mortgages.
The S&P 500 is up nearly 36% from its bear market low on March 9th. Sentiment is somewhat less negative on several fronts. Credit crisis indicators, the ADP employment report, bank stress test leaks, and the market rally itself have all encouraged optimism that the worst is over.
According to Wall Street, the market is forward looking. But has the market really discounted the future impact of continuing mortgage resets? Here’s a widely circulated Credit Suisse histogram of resets to which I’ve added a thumbnail of the S&P 500 matching the timeline from October 2007 to the present. There are a lot more resets ahead — option-adjustable, prime and alt-A — over the next 2 1/2 years.
According to preliminary results leaked to the New York Times, all 19 banks with assets above $100 billion that are subject to the Treasury’s “stress test” are bound to pass the test. The official results are due by the end of April but the upbeat mood in the banking sector was already reflected in the 30% stock price rally in the run up to the Q1 earnings season.
The major three commercial banks had already noted that they were profitable in the first two months of the year, and Wells Fargo announced that it expects to post a record net income of $3 billion when it reports results on April 22 (with combined net charge-offs of $3.3 billion for both Wells and Wachovia from $6.1 billion in the fourth quarter). Meanwhile, Goldman Sachs reported larger than expected Q1 earnings (ex December loss due to earnings calendar move) while at the same time raising fresh capital through a $5 billion stock sale in order to pay back the $10 billion in TARP money received last year.
A look below the surface reveals some caveats to this positive picture. As Nouriel Roubini points out in a recent writing: “In brief, banks are benefitting from close to zero borrowing costs and fewer competitors; they are benefitting from a massive transfer of wealth from savers to borrowers given a dozen different government bailout and subsidy programs for the financial system; they are not properly provisioning/reserving for massive future loan losses; they are not properly marking down current losses from loans in delinquency; they are using the recent mark-to-market accounting changes by FASB to inflate the value of many assets; they are using a number of accounting tricks to minimize reported losses and maximize reported earnings; the Treasury is using a stress scenario for the stress tests that is not a true stress scenario as actual data are already running worse than the worst case scenario.”
Other commentators also point to the fact that many of these banks were among the main recipients of AIG bailout funds in previous months, e.g. Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion), according to New York Times data. The firms involved dismiss this factor as immaterial for Q1 earnings. Nevertheless, the US Government Accountability Office (GAO) noted in a report at the end of March that Treasury should require that AIG seek additional concessions from employees and existing derivatives counterparties.
Meanwhile, in the real economy credit growth to the private sector has continued to slow at a fast pace in the US as well as in Europe, while US credit card charge-offs rose to an all-time high in February at 8.82%. Moody’s predicts the charge-off rate index will peak at about 10.5 percent in the first half of 2010, assuming a coincident unemployment rate peak at 10 percent. In turn, Fitch warns that credit card delinquencies point to record defaults ahead. Keep also in mind that global high-yield defaults are expected to reach 15% by the end of 2009 and that the commercial real estate market has just turned.
According to recent press reports, in a report next week the IMF plans to raise its global loan and securities loss estimate to $4 trillion by the end of 2010, including about $3.1 trillion in US originated losses (up from $2.2 trillion estimate as of January) and $900bn in European and Asian originated losses. Compare these numbers with US originated loan and securities losses of $3.6 trillion as estimated by RGE Monitor in a January report. As outlined in our report, $1.8 trillion are expected to fall on US banks alone.
Eurozone banks are also exposed to the US downturn, especially through expected losses on securities holdings. Adding the expected losses on Central and Eastern European exposures, as well as domestic originated loans and securities losses, a first back of the envelope calculation suggests combined losses of about 11% to 15% of GDP compared to the 12.6% of GDP calculated for the US.
How are eurozone governments responding to their toxic asset overhang? Both the ECB and the European Commission were reported to be working on consistent draft guidelines for “bad bank” while leaving each country its own strategy.
The rapidly worsening situation in Ireland - the Economist defines it as a depression - for banks, despite liability guarantees, forced the government on April 8 to introduce its nationwide “bad bank” scheme. In particular, the Irish solution envisions the government buying certain toxic loans at a discount from banks’ balance sheets in return for government bonds. Importantly, the assets will be transferred at an appropriate discount, thus forcing the current stakeholders to take a haircut. Moreover, the government requires the banking sector to cover any losses the toxic asset management company incurs at the end of its mission. While RGE thinks this is an efficient approach, the necessary upfront outlays to capitalize the investment fund weigh further on the country’s strained public finances and funding costs.
The German proposition, on the other hand, aims to distinguish between temporarily illiquid as opposed to toxic assets. According to press reports, the idea is to guarantee the illiquid assets in separate but still bank-affiliated vehicles with EUR200 billion in government funds. Press reports point to a far more radical solution in the making for problem banks, such as Hypo Real Estate (HRE), some state banks, as well as Commerzbank. A final decision is expected by April 21.
Hugh Hendry, the outspoken CIO and co-founder of Eclectica, one of the UK’s most successful hedge funds during the last 4 years, and in particular the last 2 years, appears in a full length interview, speaking on a variety of issues, including his thoughts on contrarianism, quantitative easing, deflation vs. inflation, his outlook for the market, and future of the hedge fund industry.
As usual, Hendry is both enlightening, and controversial, and his remarkable accuracy about the nature of the market and course during the last year make him worth listening to. Click play to view:
Part 1: The Eclectica co-founder explains why he is sticking to his guns despite having ‘my tail between my legs’ after the recent banking sector rally, and why the dollar could approach parity with the euro.
Part 2 : The outspoken hedge fund manager argues that the majority of his peers ‘have no future’, and explains his fear that tighter financial regulation will mean two decades of deflation in the second of a two part series.
Here is a complete transcript of the interview:
We have had an unprecedented period, unprecedented. Its never happened before. It’s never been the case that the stock market has gone up almost 30 times in just one movement. What I’m saying to you is that the Dow Jones in 1975 was around 590 points, and in 2007, we got to around 14,200 points. I round down, you know. That’s never ever happened. That is unprecedented prosperity. And the people who gained the most from that, are the fund managers, like me. Except, I’m aware of it. A lot of people are just not aware of it, to be lucky to be in the right place at the right time. But as you know, equity markets have done nothing for the past ten years, and if you look at the example of Japan, you’re stretching 25 years, and you’re seeing lows that we recorded in the 1980s. And I think that’s coming, that’s encroaching on our path.
When I go the major cities of the world, I say, hey, “Where do the fund managers live?” “Where do they work?” I want to short people like me; I’m very fearful about my profession’s career. So to lay it off, I want to short these guys. “Who has the biggest portfolio of assets?” ’cause all assets are coming down, coming down. So, you’re going to go from being the luckiest and the chosen, to being the unluckiest and the reviled. So, fund management franchises, insurance companies; I don’t care if you’re composite or if you’re life. I worry about the opacity of it. The ability to see in and the ability to test the value of their portfolio. I worry about what’s this mark-to-market. The banks have had the discipline of it, and we’ve seen what that’s done to their share price. The insurance companies haven’t. That’s my premise, the same thing applies with General Electric, GE, GE Capital. That’s a huge investment manager: $660-billion in assets and they’re coming down, but they’ve only marked 2% of the assets to market. To my mind, if you gave that business an appropriate hair cut, it would suggest that that business is insolvent, and yet its deemed to be one of the most credit worthy companies in the world today. Nothing makes sense today.
Will the Dollar Maintain its Strength?
Whatever I say now, no one will understand, so with that caveat, I don’t say that as a conceited man, I’m not talking down to anyone, its just a difficult theory, nevertheless its a theory postulated by one of the great economists of the twentieth century, Irving Fisher, and its [the kind] along the lines of paradox of thrift. And what’s happening is that, or what’s happened again in America is that like everyone else we took on too much debt, and at its peak we had $53-trillion, think about that, that’s a lot of zeroes, $53-trillion of debt outstanding. People went crazy, they had these liabilities and they hoped that on [the other] this side, they had $53-trillion of assets, and indeed, three years ago, they probably had $80-trillion of assets, and they were looking kind of funky.
The problem is the assets, house prices have fallen 25% in the US, that’s a big haircut, equity prices, they’ve fallen 50-60%, that’s a huge haircut. Commodity prices, they’re down 30%-40%-45%, that’s a huge haircut. Suddenly, you’re finding that as you come to create dollars [convert assets in to cash], because you own things and you sell things, you’re getting less dollars. So what I want to tell you is that there is a scarcity of cash, there is a scarcity of dollars, and that sounds absurd, because here we are today, and they’re announcing they’re bank bailout scheme, and they’re talking about $50-100-billion of government money and leveraging it, they can’t break the link with the past, they want to leverage it up to half a trillion dollars. That’s why I want to say to you…if you think about all of the government’s announcements in the US…its small change out of $53-trillion of debt. That’s why I say to you, the economy will weaken, because they’re not being heroic enough, actually they believe the consensus that if you print enough money you create inflation.
Every one believes in Friedman, everyone is being slow to deal with the fact that there’s this legacy of $53-trillion and its like a heavy object, just pressing the life out of the entrepreneurial spirit, and therefore keeping the economy down. Look, that’s my presumption, and under that presumption, the dollar should be strong, and the dollar has been strong. Its been a frustration to the many people, the strength of the dollar. Now in the last two weeks with the quantitative easing announcement, the dollar has weakened, but I think in the process of the next month or two, you will see the dollar bottom and then go on, and I wouldn’t be surprised if we got close to parity vis-a-vis the Euro within the months and years to come.
The Paradox of Contrarianism
Expert after expert lines up to tell you that the future’s inflationary and you should be selling conventional government bonds. Government bonds have been in an uptrend, so that is an intellectual conceit which is not supported by the price trend, and therefore I am invested in government bonds, I’m trend following, but I’m contrarian. The dollar over the course of the last 3 years has risen. Every investment counsellor will advise you to sell dollars. I will advise you to buy. I pursuing the trend, yet I’m being contrarian. You see how it works out? So first principals are 1) identifying the idea, the opportunity, and then 2) testing it against the market. I got a computer screen on the wall and I say to my kids, Mirror, Mirror on the wall, who’s the prettiest of them all? When I’m stuck, I ask the market. And if the market’s trending higher, then it says I should be trying to buy them, and if its trending down, I should be trying to avoid it.
What people forget is that a successful contrarian is only contrarian 20% of the time. Less than 20% of the time do you ever dare to go against the trend. So most of the time we are pursuing trend. And yet, being contrarian.
A Bear Market Rally - A Test of Faith?
Last March, my hedge fund, we lost 16% percent. That’s a hefty decline. The preceding two months, we made 25% and then we lost 16%, then we lost money in April and May, and June. I have to say, I was quite suicidal, but remember, for the year we made 32%.
So, I tell you, we could sum it up, the stock market was captured by the biblical story. It was St. Peter or St. Paul, but he was the most fervent believer. He’s seen the almightiest Jesus Christ, he’s there in the garden, and he says’s “You’re the man!” And Jesus says, “What are you talking about?” Before the cock crows three times you’ll have rejected me not once, but three times. And he says “Impossible!”
That’s what stock markets are all about. Here I am with my deflationary notions of what might happen. Here I am believing that there’s no intrinsic value in banking stocks, and the cock’s crowing and its kind of “Have I changed my mind?” I haven’t. Have I changed my mind? Markets are set up to take you away from the purity and the sanctity of sensible thinking. And because of that I spend my time talking to you. I spend my time; I’m just back from China, I hug trees, I do anything but sit in my office and watch the portfolio go like that [he makes a fluttering motion].
People claim that I get very cocky. I read some of the correspondence that goes on when they’ve seen me on television and they were saying after my last appearance, I really was a bit cocky, so you know what? Yeah, I get my head handed to me by these people. I sober up, you’re quite right, It’s a lesson that has to be relearnt over and over again, that no one person is bigger than the market, that no one person has a divine right to be right. There, I hear you, I hear you [motioning hand to ear to God].
The hedge fund industry in its construction, as we know it from like, a year ago or 18 months ago is finished. Its finished, I think, yeah. And it was a disfiguration of the spirit of hedge funds. Hedge funds in the 1970s, there weren’t many, they were kind of kooky, kind of maverick, eclectic people. The kind of thing that I’ve tried to emulate, probably with less success. And because of all those characteristics, you can never give them much mind. That’s why they’re alternative. You kind of respected them, but it was just too much, they were just too mad. And then you spent of the rest of your life wishing you’d given them more money. I think we go back to that environment. There are too many hedge fund managers, and not enough kooky brave independent thinking spirits out there like them. I think the mechanism that will take us there, is all these non-kooky individuals losing money. The average hedge fund lost money last year.
The average hedge fund has imposed gates and locked their clients in. They’re finished. They’re finished. There are hedge funds out there and they have gated, what I mean is they’re denying their clients withdrawing their money. They’re writing to their clients, the good news, is that we’ve made money in January, and February, we’re making money in March. Absolute tripe! Okay, you have not made a penny, when you’re denying the clients their money. So these are people who have no future, who are walking around pretending that they have a future. That time will catch up with them. Lastly, the point I want to make to you is that the common thread of these funds like Madoff, which have failed, and the example of one unveiled last week in London, this Global Macro fund, the commonality is the very low volatility. These are funds that made money in a reasonable consistent manner; it was almost linear, linear, linear, year after year after year. I never believe in linear progression.
I believe in volatility and the craziness of life as we search for the uncertain future. My returns are volatile. Our only thing is from a calendar year of risk, we never lose much money. One year, we lost 3% and it still gobbles me that we lost 3%., not 33%. On a month-by-month basis it can be crazy. So what we found, we found a conceit in that as a society, we have abolished the business cycle so rather than going up and down with the economy. Gordon Brown told us he had abolished boom bust so that we have a linear progression. Bernie Madoff was a linear progression. We could make money without doubts, hence we elevated the hedge fund community into the premier division. That was all a mistake. And, cyclicality is re-imposing itself, and I’m just warning you that cyclicality, once unleashed, isn’t necessarily 2-3 years, it’s 20-30 years in its formation.
Can the Regulators Save Us?
This is a big fear, I think its a legitimate fear. The fear is that there’s now an open outcry, by society at large as to the remuneration, and the risk taking that was necessary over the last few years by the financial sector. And, because society has been called in to rescue the financial sector is demanding its pound of flesh. And I don’t take issue with that, I accept that as the natural course of events. But, there is also this law of unintended consequences, so we look at say the British property market, and it now seems crazy. One could get up to 5 times your salary to purchase your house. And now we might impose a low amount of leverage of 2-3 times. The problem with that is that even with the decline in housing prices, no one could afford a house price if you bring down the… so that the credit leverage was only a function of asset prices being very high, and therefore you had to overarch in order to gain a competitive return as a speculator or just get on the housing matter as a regular person. The commonality between those two transaction is asset prices. They were too high.
So the regulator’s coming in and trying to bring down leverage in the market, and they are after hedge funds. I don’t know why… I do know why - They are rich and successful. Fair game - bring down their leverage and bring down the leverage of home buyers, prospective house buyers. The problem with that is it bakes in the notion that house prices and assets will spend the next 20 years deflating, under this more sober and conservative environment.
The Hedge Fund as Investment Laboratory
The last two weeks, nothing has been fun, because all the portfolios, they all go the same way. There’s no product diversification, so one fund’s doing well another one’s not doing well. I don’t understand that word, supermarket, and the difficult thing right now is we have no confirmation for our ideas, we’re taking a pasting. Three weeks ago, we were 11 or 12 points ahead of the index and today, that’s probably now 3 or 4. At the same time, we were up 10-11 points in absolute terms in the hedge fund and that’s come down to 4. So everywhere I look now, my tail’s between my legs. But my message is the same. All my money’s in my hedge fund. The hedge fund, I believe, is as superior product, and if you’ve got that minimal market, those pounds, euros, and dollars, I, we’ve placed within the hedge fund; we use the hedge fund as a laboratory, a test pad. We incubate ideas and once they take root and they gain legitimacy, and once we start to make money on the blasted things, we can then take little transplants and put in to our long [term] holdings. Its a better way, I hope its harmonious and they can live together, one benefits from the other.
What is Eclectica’s Investment Process?
We are very much free thinkers at the macro level. We, through our collective efforts in travel, in terms of information sources, in the way we look at things - you know we’re trading currencies, we’re trading commodity futures, we’re trading government bonds, we’ve got fingers in the all of the pies, so when we come to look at an equity portfolio, we drill down all that wealth of experience, to try and determine the most likely path of the economy and the stocks that benefit from it. Our portfolios have undergone a dramatic change. Up until July of last year, we had up to three quarters of the portfolios invested in commodities, and the majority of that was agricultural commodities. But then, something happened. This deflation shock struck, and it hit, our crisis, and after three or four more months it hit the two year trend, and our portfolio changed. And today our portfolio is defensive. Tobacco, health care, utilities, staples. In the last three weeks that’s come under enormous downside pressure. But as I say to you its three weeks and we need monthly observations. Now if that downside pressure were to continue, our portfolio would change again.
My ideological preference is that that won’t happen, but I have to remain intellectually robust to change my portfolio if it does need to. As I say to you, it’s not a process of three weeks or four weeks, we’re not high intensity traders. New world, new price. New trend, new portfolio. That’s our mantra, but today, we’re still from the view that the economy is under duress and therefore we’re still sticking to the low end of these trends, close to trends in the defensive stocks. Time will tell if we have to change them.
Fund Management Without Conviction
Conviction has got no role in my operation. There are concerns about Eclectica, or about, me… The concern is that you see me everywhere, you see me on CNBC, I do Bloomberg in the US, I’m on the BBC - heavens, I made a documentary for Channel Four last year, and its all high falutin stuff and it all gives the impression that there’s all of this conceit and arrogance - Hey, you’re taking on, I am Hugh Hendry taking on the market, but its actually driven by the reverse. I actually very fearful of having ideas that I can articulate and gain your conviction. I’m very fearful of that, and so those first principals that we built up, what we call portfolio management principles. - we developed a series of rules which are there to constrain what I can do. So I can only get involved in the portfolios as I said to you when we have the legitimacy of a positive trend. Without a postive trend, you can take my conviction and you can throw it away. You can discard it. Conviction has to married with discipline, and we’ve always done that, but of course, when you see the odd soundbyte, and I’m going on and pontificating about something, you forget that if the trend changes, we change the portfolio.
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WSJ What's News Late Edition, March 15, 2010by The Wall Street Journal 15 Mar 2010 at 5:54pm
Blue chips edge higher in a nervous market; Boston Scientific recalls its implantable defirbrillators; and Continental to charge for food in coach.
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