On 14th July 2011 I wrote an article highlighting that the S&P is at its high and there is disconnect between the fundamental economy and the market. From 14th July 2011 until today, 23 August 2011, S&P is down 12.6%. If you had a put option on S&P, depending on the option maturity and the strike price, you could have made anywhere between 30% to 200% in a month or less. The implied volatility and price, both would have acted in favor of that option.
People were talking about 1500 on S&P (GS had a target of 1450 on S&P for the year end 2011). When everybody was bullish, I was bearish and pointed out disconnects in my previous article, by analyzing in-depth risks within the economy and globally. When people were talking about low P/E’s and attractive valuations, I wrote in my article that the US economy may enter recession soon and there might be another leg down. I have understood one thing; the street is in the business of making predictions based on the last quarterly and/or monthly and/or weekly data. Few people look at the trends and analyze different sets of data as a whole.
Situation in the US
Consumer in the US is still weak and is still deleveraging from the massive increase in credit (below is the chart). Along with the deleveraging process the population of the US is aging at a significant pace as compared to the working population. As per Census, the age group between 20-64 will grow by 5.4% from 2010 to 2020 and 4% from 2020 to 2030, while the population aged 65 and older will grow by 36% and 32% in the same years, respectively. Not to forget, to get the fiscal debt in place, government has already started cutting spending which would definitely have a negative impact on the economy. In addition, foreclosures are increasing at 2.5x than houses in foreclosures are being sold and the total inventory of 90+ days delinquent loans and loans in foreclosure, is 51.9x of monthly foreclosure sales. This ratio will increase, as more foreclosures are added to the inventory than they are sold. The super low interest rate hasn’t helped. Besides, still 30% of current loans that are making payments on time are at risk, as they have negative equity due to falling house prices. All this data was as of May 2011. These risks were analyzed in detail in my previous article.
All these factors have a negative impact on the economy slowing the growth. Programs like Cash for Clunkers, First Time Homebuyers Tax Credit along with inventory adjustments (refilling), and enormous stimulus (QE1 and QE2) didn’t help. All these programs have now ended. Imagine, if that didn’t do much, now we have spending cuts which will only make things worse.
I think, we will see depressing numbers on the job front in the coming months due to following reasons:
i) To cut spending, government is reducing its workforce. In 2011, until May, government has already downsized its work force by 188k, approx 80% of what it did in the entire calendar year of 2010. This figure is expected to go up to 400k by the end of the year.
ii)We have recently seen banks cutting jobs. BOA and UBS plan to cut jobs by 3500 each. GS has been reducing its workforce quietly. In the anticipation of the Euro debt problems and the US recession, the banks, which are most sensitive to these issues, would cut jobs even more.
iii) With the overall worries in the economy, small businesses, which create most of the jobs in the US, would also be skeptical in hiring and would again, face the same issue of tightened lending standards from banks with banks turning more cautious.
iv) Productivity has declined for straight two quarters. To maintain margins we might see some lay offs.
In addition, personal savings, as a percentage of personal disposable income, increased by 0.4% to 5.4% in June 2011. A 0.4% increase in savings rate can have a 1.2% decline in personal consumption. There is a possibility that the 1.3% increase in GDP for 2Q11 might be revised lower. Besides, weekly mortgage applications for new purchases are weakening further and the much anticipated Philly Fed survey dropped to -30.7, which is extremely bearish. Not to forget, the Europe contagion is spreading.
In 1996, Japan’s GDP growth was approx 4.4%. This was mainly due to government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, Japanese economy experienced five consecutive quarters of negative growth. The recent fiscal stimulus in the US and UK was approx 10% of GDP.
The US is going through a slow growth and not liquidity or solvency crisis like peripheral Europe. Every country has its cycle. From 1980’s until 2000, the US had a strong growth and main reasons were right demographics, credit expansion, and hence increase in asset prices. All these factors have reversed and now we have excessive debt, high fiscal deficit, deleveraging by consumers, aging population and declining asset prices. The US situation is not out of hand and the fiscal deficit is solvable with right policies, cuts in spending and entitlements, and increase in taxes. The best thing would be to de-lever and let it go through its cycle. This might result in slow growth in years to come. That said, deleveraging and innovation, which always leads to new cycles, would make the country stronger again. (http://www.ted.com/talks/geoffrey_west_the_surprising_math_of_cities_and_corporations.html)
One has to understand that with ratings downgrade nothing has changed. In fact, treasury yields have moved even lower. Peoples’ thinking has changed, which is good, that the US can never be downgraded irrespective of its fiscal situation and debt.
Is everything priced in?
1) Market overeats to data. As previously mentioned, the data out of the US in the coming months might be depressing and markets might overreact to that, as that would confirm their belief that the US is heading towards a recession.
2) Markets are expecting some kind of QE3, if that doesn’t happen we might see a sell off.
3) Market is cautious about the European debt crisis but definitely hasn’t priced in a default/haircut. If that happens we could see a massive selloff.
4) So far markets have seen companies beating expectation. If that turns, even for a quarter, markets will panic and start selling assuming that the economy is now affecting the bottom line of companies.
5) It is very important to keep in mind that the mutual funds are all invested. With mutual fund cash levels at 3.4% as of June 2011, historically the lowest, if they start selling we can see a huge sell off.
Understanding Europe:
Understanding Europe is not difficult if you just look at the numbers. As per Eurostat, as of 31 March 2011: (debt and GDP growth rates are on a Y-o-Y basis as of 31 March 2011)
Greece’s debt to GDP was 150%, its debt is still growing at approx 10% and GDP is declining by approx 2.8%.
Italy’s debt to GDP was 120%, its debt is growing by approx 4% and GDP by approx 2.5%.
Ireland’s debt to GDP was 103%, its debt is growing by a whooping 28% and GDP is declining by approx 2%.
Portugal’s debt to GDP was 94%, its debt is growing by approx 14% and GDP by approx 1.8%.
Spain’s debt to GDP was 64%, its debt is growing by approx 17.5% and GDP by approx 1.7%.
France’s debt to GDP was 84%, its debt is growing by approx 7% and GDP by approx 2.8%.
Germany’s debt to GDP was 83%, recently its debt has grown by approx 17% (due to support extended to Greece) and GDP by approx 4.6%.
Are these numbers sustainable? Below is the table
Would there be a default / haircut or can it be avoided? What about Euro Bonds?
With funds in EFSF and ECB’s commitment, we have seen some buying of Spanish and Italian bonds. That said, they can’t do it for too long as the total consolidated debt of Ireland, Greece, Spain, Italy, and Portugal is approx Eur 3.2tr (71% of Germany and France’s GDP combined, excluding their own debt), as of 31 March 2011. The amount is too big for anyone to bail these countries out. Also, as mentioned above, debt of these countries is still growing at a significant pace. Its politically and financially not feasible for Germany and France to backstop all this debt as that would not only affect their financial health but can also cause social unrest in these countries. In last two quarters, 4Q10 and 1Q11, Germany’s debt has grown by 18% and 17% on a Y-o-Y basis, respectively, due to support extended to Greece.
The haircut on Greece is inevitable. Debt/GDP ratio of Greece is already at 150%. As of 31 March 2011, even with all those austerity measures, debt is increasing at 10% on a Y-o-Y basis. Austerity would only reduce country’s revenues and growth, which is evident in the GDP growth of negative 2.8%, as of 31 March 2011 on a Y-o-Y basis. Growing debt and negative GDP can never solve a country’s problem, irrespective of austerity measures taken. A simple math shows that the debt to GDP ratio will only increase. The problem of debt can’t be cured with more debt, be it public or private. Companies have tried it and even countries have tried it (example Japan). None of them have been successful in doing it. Japan now has a debt to GDP of 200% and still growing, declining population, almost no immigration, increasing aging population, and declining tax revenues. At least Japan has the ability to print its own money and issue its own debt and sell 95% of that in its own country. Greece can’t do that.
What about the idea of Euro bonds? Can that be done? That would be the biggest mistake. EU itself is a mistake as the countries in EU can’t print money and there is no mechanism for ensuring fiscal discipline. The basis of different currencies is its ability to get weaker or stronger depending on that country’s productivity, competitiveness and growth. That entire basis was removed with the formation of the EU. Imagine having a Euro bond. That would take away further liberty from countries in EU to issue debt, if and when they needed. Also, if you allow all countries in the Euro zone to get access to cheap capital at the expense of the strong EU countries by issuing Euro bonds, you basically give the weaker countries a free ride and they wouldn’t adhere to the austerity measures. Euro bond would be like a mortgage backed security (MBS), wich is pool of good and bad loans. Only in this case it would be a pool of good and bad countries. Every time a financially unstable country has a problem the financially stable country would bail it out. That way the financially stable country not only has to use its money to bail them out but also has to pay higher interest rate on its debt (now there is just one Euro bond, so all countries in EU pay the same interest rate) due to mistakes made by financially unstable country. I don’t know how long would that continue. A haircut is necessary, inevitable and healthy. If they avoid it, they would just delay the consequences.
Pushing Greece out of the EU could also be an option. This would solve the current problem of EU and would be a lesson to the other EU countries that fudging data, reporting wrong data (that’s how it all started), having huge deficit and fiscal imbalances could have serious consequences. That said, Greece being removed out of EU would also mean a default. Where would the Greek Euro denominated debt that banks/financial institutions/central banks hold go?
Understanding the consequences of haircut on the market
Approx USD 135bn of Greece debt matures between now and the end of 2013 and an additional USD 82 bn in 2014. They are planning to roll over this maturing debt held by banks and ECB. That would be considered as default or selective default by the credit rating agencies. If the credit agencies consider it as a default, the ECB and banks can’t hold them anymore. Even if they provide an exception to this rule, the ECB and banks can’t use the Greek debt as collateral. Also, if rating agencies consider it as a default, the banks and ECB have to write down that debt on their balance sheet.
We are talking about USD 493bn of total Greek debt. As per Eurostat, Debt to GDP of Greece as of 31 March 2011 was approx 150%. To bring it down to even 100% levels, Greece would need a hair cut of approx 50%. Even if we consider a hair cut of just 20%, we could see a hit of approx USD 99bn (493 *20% = 98.7) in the system. This is just the hair cut. A more important concern appears to be the threat of short-term liquidity as a result of the hair-cut. The biggest European banks receive an average of USD 64bn funding through the US money market. This flow would be the first to dry up in case of any crisis faced by the European banks, reducing the liquidity and fueling the crisis.
Also, the stronger banks in EU would cut back their lending to the weaker banks further exacerbating the process. Not to forget, this could lead to breach in covenants resulting in acceleration of debt and/or additional capital/collateral requirements.
The overall effect could be large and the big banks would feel the pain but would be able to handle it as they have trillions of dollars of assets. Also Greek debt is pretty well diversified and not one bank holds a lot. The maximum amount of exposure that a non Greek bank holds is Eur 6bn. Here is the list of estimated top 40 holders of Greek government debt. http://www.zerohedge.com/sites/default/files/images/user5/imageroot/draghi/Barclays%20Top%20Holders.jpg. It is the small banks having direct or indirect exposure to Greek debt, which might be in serious trouble.
Though this would be good for the system as it would be a clean-up of excessive debt, markets, as usual, would overreact and fall significantly. As mentioned, the repercussions would range from losses on balance sheets of European banks, CDS’s being triggered, breach of covenants, fall in global stock markets , drying up of liquidity and banks being conservative and hence reduction in lending resulting in slower growth. Also, market always overreacts due to short term traders and computer trading. If one thing triggers, the other follows and there is massive selling. Besides, they all use the same risk metrics and hence they all sell at the same time when the risk goes up.
Understanding the long term macro picture and spotting areas for long term investments
That would be the time to buy. Think about it, there is so much more money in the system now than it was a few years ago. Once there is a selloff, which would be global as the markets are interconnected, it would be an opportunity of the decade to buy, especially in the emerging markets. In some of these markets, some stocks are extremely cheap and market in general is trading at its 52 week low (I have been following Indian market on a very regular basis). The fall would further bring down the prices making them super attractive. If you logically think from a 3 to 5 year perspective, you would be investing in i) fundamentally good and less levered economies ii) growing at a good pace with strong and growing middle class population iii) with cheap valuations due to the fall in the global markets.
Once investors realize that the growth in the US and the Euro zone is stagnant or very timid, a lot of that money will start flowing to emerging economies driving up asset prices in those places. This is what exactly happened in Japan. After the Japanese crash, a lot of Japanese money moved to the US markets for a decade. This was because of low growth and ample liquidity; the same conditions which we are now seeing in the US. Japan’s stock of FDI since 2001 has nearly tripled, from ¥6 trillion to over ¥18 trillion. (Source: http://www.state.gov/p/eap/rls/reports/2009/125605.htm#fdinus ). That’s a compounded annual growth rate of approx 15% for 10 years. I think, these are the growth rates at which we will see money flowing to the emerging economies. Cheap valuations, good fundamentals, strong growth, and increase in inflow of money are simple ingredients to great returns, on a long term basis.
Safe investments with good returns (making a low risk 10% return)
The best thing would be to keep money on the sidelines and wait for the right opportunity. A very small amount can still be invested in some carefully analyzed, not overvalued, put options on the market. The downside would be small, as a small amount is invested, but if the market falls, the returns could be huge. To play safe one can buy emerging market government bonds and still get a good yields. 5 year Indian government bonds yield 8.3%. If you lever up 20% here and invest there you can easily get a yield of approx 10%. Lock-in period is approx 3 years. You can enter into a FX swap to hedge the currency risk. It is a pretty safe investment as Indian government is extremely conservative and will not default on its bond as that would collapse the entire economy. Nobody is talking about this, but I guess soon investors will. I don’t know about other emerging market government bonds as the only emerging market I follow is India.
The central banks efforts of trying to push up asset prices by artificial stimulus and quantitative easing have failed. Now they are using the same methods to protect financial institutions from losses. We will see how far they succeed in that.
Understanding the macro economy globally to understand the direction of the market, and then picking markets and securities (stock, bonds, derivatives, commodities, etc) would be the best way to play in these times.
Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.
Disclosure: Investments in Indian markets
-Suneet Chandvani
Suneet Chandvani
