Against Risk Parity, Redux (Aleph Blog)

Thursday, February 9th, 2012

by David J. Merkel, Aleph Blog

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.  For additional support consider my article Risks, Not Risk.  Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.  There are many risks.  Interest rate risk and credit risk are different topics.   There are bonds that have interest rate risk but not credit risk — long Treasuries.  There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.  For fixed income, I described those in the two articles linked in the last paragraph.  During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.  But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.  The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.  The second moves in line with 5-year Treasury yields, and short senior bank spreads.  The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.  But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.  History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That’s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

“It’s called risk parity,” Gundlach says. “There’s only two investors who seem to understand it—me and Ray Dalio,” the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.  I’ve run the regression of Treasuries vs junk bond index yields many times.  It’s barely significant for BBs, and insignificant thereafter.  Second, look at stock market indexes of industries that lever up and issue junk debt.  Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.  With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.  Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.  Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.  Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.  Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.  Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.  You can’t be certain that you will be able to ride through the storm.  The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.  But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.  If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.  I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.   First in the hands of the master, last in the hands of a sorcerer’s apprentice.  Be careful.

PS — I have respect for the skills of Gundlach and Dalio.  I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.  And, here is a nice little piece about Bridgewater and its strategies.

Tags: Bank Trust, Bond Manager, Corporate Bond, Credit Risk, David J, First Moves, First Security, Fixed Income, Har, Interest Rate Risk, Investment Results, Libor, Merkel, Noncallable Bond, Parity, Preferred Security, Price Volatility, Risk Manager, Treasuries, Treasury Yields, Trust Preferred Securities
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Goldman Explains Why The Market Has Gotten Ahead Of Itself In Its European Optimism Again

Wednesday, February 8th, 2012

While hardly new to anyone who actually has been reading between the lines, and/or Zero Hedge, in the past few months, the Greek endspiel is here, and as a note by Goldman’s Themistoklis Fiotakis overnight, the Greek timeline, or what little is left of it, “allows little room for error.” Furthermore, “Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage).” Once again – nothing new, and merely proof that despite headlines from the IIF, the true news will come in 2-3 weeks when the exchange offer is formally closed, only for the world to find that 20-40% of bondholders have declined the deal and killed the transaction! But of course, by then the idiot market, which apparently has never opened a Restructuring 101 textbook will take the EURUSD to 1.5000, only for it to plunge to sub-parity after. More importantly, with Greek bonds set to define a 15 cent real cash recovery, one can see why absent the ECB’s buying, Portugese bonds would be trading in their 30s: “Portugal will be crucial in determining the market’s view on the probability of default outside Greece… Given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.” Don’t for a second assume Europe is fixed. The fun is only just beginning…

From Goldman Sachs – Market Uncertainty Ahead from Euro Area Sources

Overview

News reports over potential progress in Greece’s PSI talks and the possible involvement of the ECB/EFSF in the restructuring deal have once again boosted the performance of risky assets, with S&P futures trading stronger and the dollar weaker. Peripheral Euro area bonds are trading flat-ish. Today is a quiet day in terms of data releases and markets are likely to start focusing on tomorrow’s ECB and BOE meetings…. In today’s note we discuss the reasons for managing our recommendations more cautiously, linked to Euro area sovereign uncertainties and the likely balance of risks around the ECB’s policy stance vs. market expectations.

A Tight Timeline For Greece Allows Little Room For Error

Greece remains an important source of risk to watch. As we have argued in the past, markets have interpreted the case of the Greek Private Sector Involvement as a precedent for restructuring within the Euro area. Over the last eight months of PSI discussions and preparations, the deterioration in Greek debt dynamics has been accompanied by a gradual deterioration in the terms of the deal for the existing bondholders (in an effort to achieve debt sustainability). In the end, the revealed preference of policymakers in the Greek case has been to pass a significant part of the cost of restructuring Greek debt to the private sector. Fundamentals in Greece may be much worse than in other countries, but the market has extrapolated the policymakers’ reaction function to the other peripheral countries with better fundamentals, thus pushing risk premia higher.

The next few weeks will be no exception. There are important issues to be resolved and further important precedents to be set thereby. To better grasp the complications at hand it is important to discuss the timeline of events ahead. The agreement between the Greek government and the creditors represented by the IIF is likely to be reached in parallel with an agreement between the IMF and the Greek government on the new austerity measures. Then the new austerity measures (including reductions in minimum wages and further reductions in pensions), which are likely to prove unpopular domestically, will need to be approved by the Greek parliament. All this needs to take place about 3-4 weeks ahead of the March 20th bond redemption, so that there is enough time for the IMF to sign off on the new loan package, for the offer to be extended across bondholders and for maximum participation to be pursued.

As we have discussed in previous pieces on the subject, outside official lenders, Greek bond holders and Euro-area banks, there are about EUR70bn of bonds scattered across different institutions. Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage). One way of staging such an involuntary restructuring operation for the holdouts would be the retroactive imposition of collective action clauses and their invocation following the conclusion of the voluntary restructuring operation. The introduction of such clauses would likely happen before the PSI exchange offer goes live – in order to further discourage investors from holding out.

The good news is that after a successful restructuring operation, Greece’s systemic importance as a source of risk declines meaningfully due to the limited refinancing needs, the meaningful reduction in debt servicing costs and the low levels of residual market exposure to Greek bonds post PSI.

Portugal’s Significance to Rise Post-Greece

Greece has created a market concern to do with low recovery rates in the event of a restructuring episode in the Euro area, which has been reflected across sovereign risk premia in peripheral Euro area bond markets. However, Portugal will be crucial in determining the market’s view on the probability of default outside Greece. This is because Euro area policymakers have gone out of their way to signal that Greece is a unique case, addressed with a one-off operation. Therefore it will be important that this commitment is maintained.

As Silvia Ardagna and Andrew Benito discussed in a recent Viewpoint, it is likely that Portugal may need an increase in assistance funds. The progress that Portugal has made in its adjustment programme and the reasonably limited resources that need to be put to work make it likely that a “top-up” of official funds to fully cover Portugal’s needs may ultimately be the preferred policy option.

But given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.

Tags: Bondholders, Broad Market, Bullish Signal, ECB, Eurusd, Goldman, Greek Bonds, Greek Timeline, Holdouts, Market Volatility, Npv, Optimism, Parity, Policy Statements, Preferential Treatment, Probability, Psi, Reading Between The Lines, Restructuring, True News
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Are Emerging Markets Ready to Lead the Global Economy?

Friday, July 29th, 2011

by Lupin Rahman, PIMCO

• We forecast emerging economies will expand at a faster pace than advanced economies over the secular horizon.
• The challenge for emerging market central bankers is to remain ahead of inflation expectations and retain credibility on inflation targeting. We feel they are well positioned for this.
• We believe global investors remain significantly underweight emerging market assets. We expect this underallocation to decrease, providing multiyear support for the asset class.

Emerging markets are increasingly important drivers of growth for the global economy, though they face challenges to reaching parity with, or even surpassing, today’s developed nations.

In the final of a series of Q&A articles accompanying the recent release of PIMCO’s Secular Outlook, portfolio manager Lupin Rahman discusses growth dynamics, inflation and structural change in emerging markets (EM) as well as what all of this means for the global economy.

Q. Could you discuss growth dynamics in emerging markets and their share of the global economy?

Rahman: We forecast emerging markets to outperform advanced economies over the secular horizon (next three to five years) with growth averaging 6% vs. 2% in advanced economies. Significant transitions already underway in the global economy underpin this trend. Essentially we are seeing a shift from a unipolar world anchored by advanced economies toward a multipolar world with large emerging economies playing an increasingly larger role in the global economy.

Within EM we expect to see differentiation across economies. In Latin America and emerging Asia we forecast growth in the 6% to 7% range to be anchored by low leverage, strong structural demand for commodities and a soft landing in China. Meanwhile, countries in emerging Europe, and in particular those economies with high levels of leverage, are likely to experience a period of modest growth in the 4% range.

The relevance of this increasing importance of EM for investors lies in the remarkable divergence between current investor positioning and the economic realities of the postcrisis world. Specifically, we believe global investors remain significantly underweight emerging market assets in relation to both their current and future share of the world economy, as well as in relation to the trends in their relative credit fundamentals. We believe that as markets reorient to our New Normal view of the world this underallocation to EM will decrease, providing multiyear support for the asset class.

Q. How does the middle class in emerging markets compare to the developed world? And what are
current and anticipated domestic consumption patterns in EM?

Rahman: The growth of the emerging middle class is an important aspect of the EM growth story, particularly in the context of a deleveraging consumer base in advanced economies. If we take the World Bank’s definition, the global middle class is forecast to triple from 400 million in 2000 to 1.2 billion in 2030, with China and India accounting for most of this expansion, according to a December 2006 report. To put this into perspective, this means that by 2030 a significant majority of the global middle class will be from EM.

In addition to important strides in po verty reduction, this shift represents tremendous opportunities in new global consumer markets as EM consumption expands beyond food and shelter and towards consumer durables and services. In fact we are already seeing this trend with spending on automobiles, refrigerators and entertainment showing robust growth. We expect this to continue in the next decade and be underpinned by gains in real EM consumption growth which we estimate will increase by 50% in real terms.

Q. Shifting gears, could inflation cloud the outlook for emerging markets?

Rahman: There have been two important shifts in EM inflation dynamics over the past decade underpinned by more independent central banks, a reduction of fiscal dominance and a reduction in wage indexation. First, the levels of inflation in emerging markets have dropped from double-digit increases being the norm to headline inflation decreasing to the mid-single digits. Second, inflation volatility has decreased as a result of more anchored inflation expectations.

Looking ahead, the current 2 to 3 percentage point differential between emerging market and advanced
economy inflation will likely persist given our forecast of robust EM growth and debt deleveraging in advanced
economies. But importantly, we do not see a sharp secular increase in this differential. Of course there are risks to this baseline view from potential spikes in commodity prices and asset-market bubbles, but the fundamental shifts in inflation expectations mentioned before provide EM policymakers room to maneuver in tackling these shocks.

Q. What are central bankers in those countries doing to contain inflation, and what are the implications of
their policies?

Tags: asset class, Brazil, Commodities, Credibility, Differentiation, Emerging Asia, Emerging Economies, Emerging Europe, Emerging Market, Emerging Markets, Global Economy, Global Investors, Growth Dynamics, India, Inflation Expectations, Latin America, Leverage, Market Assets, Multipolar World, Parity, Portfolio Manager, Unipolar World
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Hungary Meltdown – Euro Contagion Spreading

Friday, June 4th, 2010

Euro-contagion has spread to Hungary. Parity for the euro may come sooner than anyone expected. Here are notes and analysis from a variety of sources on the unfolding euro/Hungarian meltdown, Round 2:

To all those who listened to Hugh Hendry’s recommendation to panic a week ago, congratulations- you are well ahead of the market today. Hungary CDS is now offerless as investors are shocked, shocked, that the country (and continent) is actually really bankrupt, as opposed to just make believe. IMF’s comments yesterday that it does not have the funds to rescue all of Europe are not helping. Hungary CDS is now essentially bidless last seen 120 bps wider, around 430/460 with the bid/ask spread at 30bps, and only dealers daring to take on any risk exposure as the risk off brigade has kicked the optimists out of the building. The one thing up today so far? Gold. NFP better be north of 100 million or else the stick save today will be a tad problematic.

Europe Tremors Resume: Spain Bund Spreads At All Time Wides, China Exporters Ditch Euro As CHF Surges, from ZeroHedge.com.

Another horrendous day shaping up for Europe. Spanish Bund spreads have surged to all time highs just south of 200 bps, Hungary confirms that it was not exaggerating comments about chances of (not) avoiding Greek situation, pushing its CDS even wider, the EURCHF has dropped to under 1.40 and the SNB has not intervened yet, while the EURUSD is down to 4 year lows below 1.21. The nail in the euro coffin is a report by Reuters that a growing number of Chinese exporters turn down euro payment, flatly refuting anything SAFE may be saying officially.

Chinese exporters who made a big push only a year ago to bill in euros are increasingly turning their backs on the wounded European currency and demanding dollars instead.

By contrst, Beijing last week said a report it was reviewing the euro portion in its mountain of foreign exchange reserves was groundless and it calmed markets by saying that Europe remained a key investment market.

But Chinese exporters and the local governments that oversee them are less confident. They are trying to keep a wider berth from the euro, at least for now.

Oh, and now the French PM is quoted as saying that he only sees good news in parity between the dollar and the euro. Too bad none of his bank share the sentimentm realizing all too well none of them will exist in that situation.

Add Hungary to the PIIGs List, from Big Picture.

The market needs a new acronym to replace PIIGS to include Hungary as a spokesman for the PM of Hungary said their economy is “in a grave economic situation” and the possibility of default is “not an exaggeration.” Markets rolled over after the comments and the euro fell to a new 4 year low vs the US$. Hungary 5 yr CDS is higher by 15 bps to 323 bps, the highest since July ‘09. Hungarian stocks are lower by almost 4% and European banks are all lower. With respect to the US jobs data, it’s not the headline number that will matter but what’s under the hood as census workers may add 500k+ to the figure. The private sector is expected to add 180k jobs and that is the only thing that matters as the census workers will be off the gov’t rolls by Sept. The birth/death model will also contribute as 186k jobs were added in May ‘09. The unemployment rate is expected to tick lower by .1% to 9.8%.

Now it’s Hungary’s Turn, from TraderMark.

Well this one came out of the blue. Looks like they pulled a Greece in their statistics department. Hmm, governments worldwide fudging the numbers to create an alternate sense of reality? Whodda thunk!

• Hungary’s is in a “grave situation” because the previous government “manipulated” figures and “lied” about the state of the economy, said Peter Szijjarto, spokesman for Prime Minister Viktor Orban. The forint fell for a second day, dropping as much as 2.1 percent against the euro.
• A fact-finding panel will probably present preliminary figures on the state of the economy this weekend, Szijjarto said today at a news conference in Budapest. The government will publish an action plan within 72 hours after the committee reports its findings, he said.
• “It’s clear that the economy is in a very grave situation,” Szijjarto said. “We need a clean slate to formulate our economic action plan, and the fact-finding committee will provide just that.”
• “It’s no exaggeration” to talk about a default, Szijjarto said today.
• Hungary needed a 20 billion-euro ($24 billion) international bailout to avert a default in 2008. Orban, who took over May 29 after winning elections by pledging to cut taxes and stimulate the economy, yesterday failed to get European Union approval for looser fiscal policy.
• “Investors are losing their patience,” Gyorgy Barta, a Budapest-based economist at Intesa Sanpaolo SpA, said in a phone interview. “This is part of a communications strategy that wants to tell voters one thing and the markets another. It’s getting too complicated, and the government now needs to come clean and present a convincing plan of fiscal consolidation.”

Oh well, nothing a hundred or two billion euro won’t fix. Get to work US taxpayer… err IMF.

Biggest Hungarian Commercial Bank Trading Halted On Budapest Stock Exchange, from ZeroHedge.com.

All trading in shares of OTP Bank, Hungary’s largest commercial bank, has been halted on the Budapest stock exchange after a plunge greater than 10%. Nothing to see here, go back to reading Goldman’s spin on things, and why everything all of this really should be priced in already.

Austria Next On The Implosion Radar; German, France CDS Blow Out, from ZeroHedge.com.

Austria, the country most exposed to weakness in Central and Eastern Europe, is back on the radar. After having avoided skeptical investor scrutiny even as the bulk of Europe was collapsing all around it, the country is today’s top CDS widener, yet still stunningly trades inside of France and Belgium. Look for this spread to blow out over the next week. Then again, the biggest CDS wideners are precisely the countries formerly seen safe: Austria, France, Germany and Belgium are all the top movers in CDS. So much for the whole North vs South division in Europe.

Goldman Sachs’ Desperate Attempt at Hungary Damage Control, courtesy of ZeroHedge.com.

Goldman Sachs to save the day…

Hungary – Greek-like crisis has already happened; Fidesz tries to free itself from campaign promises

Yesterday’s comments by Fidesz vice-president Kósa alleged that Hungary stands on a brink of a sovereign default due to its very precarious budget situation and continuously appearing ‘skeletons’ in the fiscal accounts while Michaly Varga, a deputy PM, claimed again that the ‘true’ 2010 budget deficit is closer to 7%-7.5% of GDP rather than the 3.8% assumed in the IMF-led program or 4.3%-4.5% forecasted by the NBH. Given the seriousness of the situation, Kósa declared that within a week the new government will announce a two-year crisis management plan that would include deep constitutional and structural reforms. Nevertheless, Kósa did not withdraw the plans to lower taxes which was one of the key election promises. He also declared that countries that were successful at crisis management ‘rejected the requirements of the World Bank and the IMF’ and expected the European Union to foot the bill for a potential external rescue of Hungary.

On the same day, European Commission President Barroso urged the new Hungarian government to speed up fiscal consolidation and implement structural reforms that would help maintain long-term fiscal sustainability and support economic recovery.

The Hungarian PM, Victor Orban, followed with declarations that the new government is committed to restoring fiscal stability and that the new economic plan, to be published within 72 hours after revealing the budget report, will include structural measures to boost growth and competitiveness as well as significant tax cuts.

IMF mission chief is due to arrive in Budapest for informal talks with the government. His visit is not a part of a formal review mission, which was postponed because of the parliamentary elections.

COMMENT: We believe that yesterday’s dramatic comments were intended for domestic consumption and were used to build a dramatic backdrop that would let Fidesz backtrack on a large share of its campaign promises and broadly continue with the fiscal policies of the previous government, as well as preparing the ground for another round of IMF talks. Exaggerating the state of public finances left by the previous government, pretty common as it is (the incoming UK government used very similar tactics), supports the arguments against fiscal expansion and, in the future, will back up the claims that the crisis management plan was successful in reducing public deficit. The party faces local elections in October and not following up on the election promises risks alienating the voters, while blaming the ‘imminent crisis’ and ‘fiscal skeletons’ helps it save its face. At the same time, inflating the deficit forecast gives it space for negotiations with the international lenders and increases the chances that the potential new program will allow for some fiscal loosening in 2010 and 2011.

The claim that the country is on a brink of sovereign default and risks following the Greek path does not hold up against the facts. Hungary has already faced a crisis and asked for IMF and EU assistance in late-2008. In this context, Hungary is some 18 months ahead of Greece. Next, Hungary is not an EMU member and by having its own currency and domestic and external debt benefits from having a captive investor base. Finally, Hungary still has access to the undisbursed tranches of the IMF/EU loans. Our analysis (New Markets Analyst 10/04) shows that under the current policies debt stock is stable and that the country will be able to rollover its maturing debt without a problem.

It seems that Fidesz has taken a major decision on the path of macroeconomic policy and is now preparing the stage for its announcement – first, by revealing the ‘true’ size of the deficit and, second, by following up with the two-year plan. We believe that the ‘good scenario’ is more likely, namely a new agreement with the IMF and the EU and broad continuity of the fiscal consolidation plans, although with some loosening due to the cost of the yet to be announced structural reforms and to accommodate some of the election promises. We continue to believe that a stabilization program is the most likely outcome, which should significantly reduce the perception of the Hungarian sovereign risk (for more information, please see New Markets Analyst 10/05).

The risk here is that the new government attempts to follow the Ukrainian and Romanian examples, leading to protracted and rocky discussions. The other risk is that the new government is too confident in its ability to influence the Forint (in earlier comments, Fidesz said that weaker currency will support Hungary’s competitiveness) and may be careless in its communications (as shown by yesterday’s comments from Kósa). The punishment from the market may come quickly and weakening of the currency beyond the pain level of banks and households (about EURHUF of 300) – which hold significant amounts of FX debt – would serve as a warning to the new government. Our research shows that among CE3 countries, Hungary is most exposed to risk sentiment and the widening of risk premia would hurt Hungary’s growth.

The ‘negative scenario’ in which the new government abandons the IMF program and lets the fiscal situation get out of control would actually help fulfil the claims that the country is indeed unable to access financing; we find that unlikely, though.

The news that the IMF mission chief will hold informal talks with the new government is neutral. Such a visit had to happen regardless of the course of Fidesz’s macroeconomic plans. IMF needs to learn more about these plans and both sides need to decide how they want to proceed. This should clarify the situation and help us know whether the next program is going to happen. We expect some follow-up news within the next couple of days.

Tags: All Time Highs, Bps, China, China Exporters, Chinese Exporters, Coffin, Contagion, Ditch, ETF, Eurchf, Eurusd, Gold, Hugh Hendry, Imf, Lows, Meltdown, Optimists, Parity, Reuters, Risk Exposure, Snb, Surges, Tremors
Posted in ETFs, Gold, Markets | 1 Comment »

Canada Moral Hazard Corporation?

Monday, February 15th, 2010

As the world’s spotlight turns to the Vancouver Olympics, all eyes will be on Canada. Our nation suffered comparatively less than other G7 economies during the last recession, and our banking system has received praises for being good and boring (read the Sceptical Market Observer’s comment on this).

To be sure, our economy is adding jobs, our stock market has rallied sharply, our currency is close to reaching parity with the USD, commodity exports are up, everything looks great. A buddy of mine even told me that our currency is being bought by central banks around the world. Canada seems to be on a tear.

But things are far from perfect. For one, there is a housing bubble in the making that could last a lot longer than people think. Stephen Jarislowsky, one of Canada’s best known investors, says he believes government measures aimed at juicing the housing market has put the sector in a bubble:

“I am convinced there is a housing bubble in Canada,” Mr. Jarislowsky told Bloomberg News. “… I conclude that the prices of housing today in the U.S. are cheaper than they should be, and that the prices in Canada are far more expensive than they should be.”

Mr. Jarislowsky is not alone. Other economists have also fretted about a bubble given the stunning rebound in real estate after the slump, and projections for record sales and prices this year. Ottawa is now considering tightening some rules. Said Mr. Jarislowsky: “They have basically encouraged people to buy houses based on cheap mortgages. That has created the opposite effect of what was desirable.”

Then, there is what Peter Foster of the National Post calls the Canada Moral Hazard Corporation:

There has been much official chest swelling over Canada’s relatively strong performance during the financial crisis, but perhaps Canadians shouldn’t — if you’ll excuse the mixing of metaphors — be counting their chickens until they are sure that there are no black swans present. And in fact there does seem to be one dark, plump, bird looming around the back of economic barnyard: the Canada Mortgage and Housing Corporation. Or is that a turkey that should be renamed the Canada Moral Hazard Corporation?

The CMHC was never given a cutesy acronym like its U.S. equivalents, Fannie Mae and Freddie Mac. But why not “Morrie Haz,” acknowledging that it has always been an instrument of moral hazard, the situation where insurance makes the insured-against event more likely?

As we know, Fannie and Freddie — which were privately-owned but “government-sponsored,” which meant they inevitably got bailed out — were front and centre in the U.S. housing market meltdown, which in turn precipitated the global financial crisis.

There are increasing concerns that the Canadian housing market is headed the same way as that of the U.S., stoked by the same factors: artificially low central bank interest rates, and the government insurance/promotion of risky mortgages.

This policy double whammy explains the growing calls for somebody — banks? CMHC? Carney? Flaherty? Anybody else? — to tighten mortgage regulations. These requests appear puzzling until we realize the role of the CMHC in encouraging perverse behaviour.

In a free market, if banks felt a housing bubble building, they would simply tighten standards themselves, either by demanding higher credit qualifications, hoisting rates, or shortening amortization periods. Hoisting rates is out of the question, since rock bottom mortgage rates are now considered by the Bank of Canada to be essential to national economic recovery and protection of our export industries. That leaves Morrie Haz waiting there to insure mortgages, and gives the banks every incentive to hand out any loan that can get insurance. However, they obviously grasp that such cosmic policy fecklessness will ultimately come back to haunt them.

A couple of weeks ago, Peter Routledge of credit analyst Moody’s pointed out that the overheating of the housing market was goosing an unsustainable increase in household borrowing more generally. “As witnessed in the United States,” he wrote, “this movie does not end well.” Specifically, once the punchbowl of low interest rates disappears, households find themselves in trouble, and so do their bankers.

Mr. Routledge noted that Canadian banks likely wouldn’t wind up in the same depths as their U.S. counterparts, but that is only because their riskiest mortgages are backstopped by CMHC. But this makes the systemic threat to the Canadian economy greater.

The U.S. crisis was massive but did not fall entirely on Fannie and Freddie. It was shared with other financial institutions. Nevertheless Fannie and Freddie both failed and had to be taken into government “conservatorship.” Mr. Routledge suggests that the situation is more “secure” in Canada, but as a recent report from the Fraser Institute points out, what this really means that the Canadian system features “massive taxpayer exposure.”

Mr. Routledge suggested that CMHC should tighten its insurance criteria, and this week he was seconded by former Governor of the Bank of Canada David Dodge.

The Fraser study, by Neil Mohindra, confirms that the taxpayer risk from a housing collapse is greater in Canada than elsewhere. He notes that a stunning 90% of all insured residential mortgages in Canada are covered by the CMHC. This amounts to an estimated $480-billion for which Canadian taxpayers would be on the hook if the housing market tanked (although any loss would obviously only be a fraction of this amount).

The study suggests that the CMHC’s activities should be privatized, but that possibility appears a long way down the road, both for practical and political reasons. The biggest problem is that nobody is going to want to privatize a property which harbours a potential time bomb.

The whole thrust of CMHC insurance is to encourage banks to make riskier loans. Normal insurance provisions are based on actuarial principles. CMHC insurance is based — like the activities of Fannie and Freddie — on promoting home ownership. Mixing social and economic objectives usually ends in taxpayer tears.

There is no indication that the Canadian mortgage market has been subject to the lunacies of the U.S., where — for a while — anybody with a pulse could get a home loan. Still, high ratio mortgages — that is, ones with down payments as low as 5% — inevitably carry a hefty risk of default when a bubble bursts. That default then becomes the CMHC’s problem.

As such, notes Mr. Mohindra, Canada is not a model for anybody. Morrie Haz has always been an accident waiting to happen.

According to Moody’s Mr. Routledge, “If policymakers deploy the appropriate tools early rather than late in this period of household credit expansion, perhaps the Canadian movie will end differently.”

But Finance Minister Jim Flaherty knows that ending the party is not going to be popular, which is where inevitable political self-interest compounds those practical problems. Meanwhile CMHC isn’t just a provider of potentially reckless insurance and the depository of last resort for mortgage assets the banks don’t want. Yesterday a representative of Diane Finley, Minister of Human Resources and Skills Development, who is also responsible for CMHC (go figure), was in Montreal handing out stimulus slush under Canada’s Economic Action Plan.

Mr. Flaherty doesn’t want to see a bubble, much less a bomb. But when it comes to which movie we’re coming to the end of, maybe he should check out The Hurt Locker. Just in case.

Of course, lenders like ING, oppose any clampdown to rein in mortgage borrowing. Sound familiar? I agree with Stephen Jarislowsky and I also fear that this movie isn’t going to end well. Enjoy the Vancouver games, because I feel a post-Olympics winter chill headed our way.

Tags: Banking System, Black Swans, Canadian Market, Central Banks, Cheap Mortgages, Chickens, Commodity Exports, Financial Crisis, Government Measures, Housing Bubble, Housing Market, Jarislowsky, Metaphors, Moral Hazard, Parity, Praises, Recession, Record Sales, Slump, Swans, World Canada
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Why China Can’t Divorce the Dollar

Friday, October 16th, 2009

Yesterday, we discussed the hype about the imminent death of the US dollar that is bubbling up these days, that is sending the Canadian dollar to parity, stocks and gold to new highs, and lifting commodity prices in general. In his FT.com column, Martin Wolf contends that it is the success of American economic policy that is sinking the dollar, and on the subject of China says:

Relevant policy is made by the Federal Reserve, which has no mandate to preserve the dollar’s external value. The only way China’s policymakers can preserve the domestic value of external holdings is to support the dollar without limit, which compromises China’s domestic monetary stability and will prove self-defeating in the end.

Wolf’s thesis is that the zeroing out of interest rates and re-liquidification of the US economy in the face of the credit crisis has crowded investors, both domestic and foreign, out of money market instruments and short term treasuries, into risk assets for yield or growth. It is the crowding out that has proven to be a success for the market and, as consequence, the devaluation of the greenback.

This presents short-term problems for China and its export recovery, but it is not yet time for China to deal with the advent of divorce from the US dollar as a reserve currency.

Mark Gimien, says China is not about to stop propping up the dollar, because in the meantime, the value of the RMB is rising, making its exports more expensive.

The dollar-renminbi trade is a perfect case study in being careful what you wish for. Though American exporters complain about an undervalued renminbi, China’s currency management turns out to have some enormous advantages for the American economy. China’s voracious demand for dollars—and the Treasury bonds to sink those dollars into—is a key reason why the U.S. government can borrow cheaply and keep U.S. interest rates low.

…

For a while now, economists have wondered when China will tire of lending cheaply to the U.S. government. The longer the process continues, the more China stands to lose over the long run; China is effectively propping up the dollar, and, thanks to its enormous holdings of Treasury bonds, gets left holding the proverbial bag when the dollar falls in value—as it already has in relation to the euro. Eventually, the thinking among economists goes, China will tire of getting rock-bottom interest on U.S. Treasuries while watching the value of its dollar-hoard shrink. This is why people like Ferguson and New York University economist Nouriel Roubini—one of the more prescient (and pessimistic) observers of the meltdown—are predicting an economic divorce between the two massive trading partners.

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So should we be worried? In the long run, yes—but we probably won’t see a massive and sudden catastrophe. China does want to disentangle itself from its reliance on the dollar. To do that, though, it also has to decrease its reliance on exports to the United States. That won’t happen overnight. As bad as the financial meltdown has been for the United States, it has been even worse for much of the rest of the world. The United States is the world’s consumer of last (and, well, first, too) resort, so the irony of American economic problems is that, as an oft-repeated adage has it, a U.S. sneeze tends to cause pneumonia in its trade partners.

One of the key economic memes of the past years has been the emergence of a robust Chinese consumer middle class. It is absolutely true that China’s middle class and its domestic consumption have both grown dramatically. Even in this economic climate, Chinese retail sales are up by double digit percentages. China remains, however, an export-led economy.

Another question to ponder from the domestic China perspective is one of confidence. How confident would the Chinese be in their own currency if it were not pegged to the US dollar?

When you cut through all of the noise surrounding the fate of the dollar, and look at the economic probabilities, the conclusion you can make is that China and the world for that matter have got far more incentive at the hinge of our economic crisis to do their respective parts to defend balance, not as a favour or whim, but as a matter of economic continuity. China’s best move is a smoother and longer term transition to independence from its symbiotic co-existence with the US dollar economy.

A US/China divorce is many years away, a long term proposition at worst. The more important issues in the present still rest on how monetary authorities will rebalance currency valuations, and that ultimately will slow or reverse the flow of liquidity out of the dollar. A reversal in the dollar’s decline would be negative for equity markets and other risk assets in the short term.

Tags: American Economic Policy, American Economy, American Exporters, Canadian Dollar, Canadian Market, China, China Currency, Commodities, Commodity Prices, Credit Crisis, Currency Management, Devaluation, Economist Nouriel Roubini, Economy China, Emerging Markets, Enormous Advantages, Export Recovery, Federal Reserve, Gold, Greenback, Hype, Imminent Death, Mandate, Martin Wolf, Meltdown, Monetary Stability, Money Market Instruments, New Highs, New York University, Parity, Policymakers, Relevant Policy, Reserve Currency, RMB, Rock Bottom, Treasuries, Treasury Bonds
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Canada’s Universal Appeal and Advantage

Thursday, September 17th, 2009

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.

Canada prices fall, recovery signals brighten, Reuters, September 17, 2009

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.

…

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.

…

“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 See Takeover ‘Opportunities’ in U.S., Bloomberg, September 16, 2009

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.

How a Made-in-Canada Nortel solution died, Andrew Willis, The Globe and Mail, Sept. 17, 2009

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.

…

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?

Sinopec, China Firms Seek Canadian Financing, Resource, Bloomberg, September 15, 2009

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

Sources: Reuters | Bloomberg | Globe and Mail | Scotia Capital (via G&M Market Blog)

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“Loonie a Thoughtful Choice” (WSJ.com)

Monday, June 22nd, 2009

The Wall Street Journal suggests that Americans should think about investing in Canadian assets to take advantage of the recent interim weakness in the Loonie, as Canada’s economic outlook hinges on China and emerging markets’ demand for oil and commodities.

WSJ: While the loonie might bounce around in the next few weeks, the expected long-term trend is for Canadian vigor. Economists at TD Bank Financial Group forecast the U.S. and Canadian dollars will reach parity by year’s end, thanks to general U.S. dollar weakness and Canada’s stronger fiscal position. Canada, the world’s 10th-largest economy, has avoided bank bailouts and central-bank interventions.

The retail sales figures aren’t expected to reflect the recent rise in commodity prices that will likely buoy Canadian spending in the second half of the year. The U.S.’s neighbor to the north has long been tightly linked to the U.S., its biggest trading partner.

But the rise of the commodity demand from Asia is giving Canadians something else to watch.

Benjamin Tal, economist at CIBC World Markets, likens Canada’s exposure to the U.S.’s woes as like a secondhand smoker. Bad but not a direct hit.

And with China scooping up oil and metals that Canada produces, China is taking a bigger role in Canada’s fortunes.

Source: WSJ.com, June 19, 2009

Tags: Bank Financial Group, Canadian Assets, Canadian Dollars, Canadian Market, CIBC, CIBC World Markets, Commodities, Commodity Prices, Direct Hit, Dollar Weakness, Economic Outlook, Emerging Markets, Fiscal Position, Fortunes, Hinges, oil, Parity, Retail Sales Figures, Td Bank Financial Group, Term Trend, Vigor, Wall Street Journal, Woes, Wsj
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Hugh Hendry: Citywire Interview

Saturday, April 11th, 2009

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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Rio Tinto/BHP Billiton at parity

Friday, December 19th, 2008

Yep, the share prices of the two mining giants have crossed. After suffering another sickening fall on Thursday, Rio shares (down 10 per cent) are now trading at £10.40, about 4p lower than BHP’s.

This is seriously embarrassing for Rio. After all, BHP’s abandoned bid was pitched at a ratio of 3.4:1.

Of course, the reason Rio is being dragged lower is debt. And Rio has a lot of it – $40bn to be precise, against a market value of $27bn.

The company says it will be able to meet its debt repayments ($8.9bn is due next September) and does not need a rights issue.

But the market doesn’t believe Rio, and the result is a sinking share price.

Since BHP walked away last week, Rio shares have fallen 58 per cent.

Related links:
No respite for Rio - FT Alphaville

Source

Tags: Alphaville, Bhp Billiton, Bid, Debt Repayments, Ft Alphaville, Gbp, Giants, Lot, Parity, pence, Reason, Respite, Rio 10, Rio Tinto, Share Price, Share Prices, Shares, usd
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