Download - Atwel - Global Macro 7/2011
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As with other investment-driven economic miracles Germany in the 1930, the Soviet Union in the
1950s and 1960s, and Japan in the 1970s and 1980s you started seeing this unsustainable build up in
debt, Pettis said. In the early stagesbuilding the first road is profitable, but what happens when youve
Current edition contains:
1CONSEQUENCES OF A BUDGET IMPASSE
US Dollar looks like the short-term winner in every case.
2IF YOU CANNOT SHORT OATs, SHORT FRENCH BANKS INSTEAD
Shorting French banks is both a good hedge and structural story.
3GLOBAL PMIs
A look at global economy.
4IS THE IRISH DEBT ATTRACTIVE?
Given where it trades on implied-loss basis, we think it is.
MONTHLY INVESTMENT NEWSLETTER
Global Macro Strategy:July 2011
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1) CONSEQUENCES OF A BUDGET IMPASSEWithout any exaggeration, the current dispute between Democrats and Republicans in the US is threatening the very
essence of market stability. That is why we have been suggesting over the past month to either stay out of market
completely or hedge positions accordingly. As we are drawing nearer to the August 2nd
, we have stood a witness to
the rise in volatility as more and more market participants have been net buyers of protection in their fear of a
complete meltdown.
We are fully aware that abrupt changes in negotiations can occur at any date / minute which may make this piece
irrelevant. But for sure one should be ready for such occurrence or at least wary of a possibility that resolution may
not happen in the very last moment (if at all) as both parties will be trying to get the best deal.
First, let us write shortly what we think about the whole situation and whether we lean towards the reasoning of
Republicans or Democrats. To those of you, who are not interested in our poor Machiavellian thoughts, we advise to
skip the first section completely and devote your attention to the second one, where we scrutinize the most
probable outcome of this whole impasse.
a) Where do we lean
Firstly, if one looks at the development of budget deficit from the revenue and outlays perspective, it is pretty clear
that todays budget deficit is a result of roughly a 50% drop in revenues and 50% rise in spending. Hence, the refusal
of Republicans to increase revenue seems a bit off. The truth is that Republican Boehner agreed to close some
loopholes but strongly antagonized raising two highest marginal tax rates. Any statutory changes in tax rates were
the main reason why the debate failed. Republicans are rightly worried that while statutory taxes will remain in
place, spending would slowly creep back in over time.
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The US budget is also deeply pro-cyclical and we think in case US came back to full employment (result of necessary
macro and microeconomic adjustments), than we would be left only with the structural budget deficit in the vicinity
of 3% (and going forward, result primary of too high and too inefficient healthcare spending US spends about 8% of
GDP on healthcare more than everyone else with worse results).
Naturally, if Obama could choose, he would simply sweep the whole thing off the table and start looking for a
solution once his second presidential term is secured. But that is exactly what Republicans do not want to lethappen. They want Obama involved and they want him to be the icon of budget cuts. The fact is either Obama will
address cuts now or he will be forced to decide after August 2nd
which spending he will prioritize and which will go
down the drain anyways.
b) How to position your portfolio.
As we mentioned above, there is a growing probability that US will experience a significant amount of cuts in
spending. What would the impacts of such move be? As the US economy is known to have a rather small marginal
propensity of imports (estimates range from 0.2-.0.5), any 1% reduction in aggregate demand would be
accompanied by 0.2 - 0.5% decrease in imports and current account balance. Besides, we believe lower aggregate
demand in US would translate into lower world aggregate demand and a marginal fall in oil prices, thus alleviating
additional burden from the current account.
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NX = net exports, NS = net savings, Y1 = new equilibrium in case of a country with low marginal propensity to imports, Y2 = new equilibrium in
case of a country with high marginal propensity to imports
That would be structurally great for US Dollar and bad for commodities. Secondly, as US would decrease its current
account deficit and would thus keep sending less dollars abroad, we would not be surprised to see US Dollar liquidity
abroad dry up. Watch the TED spread as our favorite tool for judging whether there is a lack of dollars abroad (USD
Lending rates in Britain less yield on 3M T-Bills).
If the budget deficit reining occurs in an orderly way and both parties find a solution without defaulting nor putting
foreign lenders at an increased risk, we think it is a long-term positive for stocks as US will stand on a much firmer
fiscal trajectory. Should nothing happen and US go into default, stocks would tank and bonds could move either way.
We would favor staying in US Dollar as budget cutting under any circumstance looks like the most likely outcome.
NX
NS
Y
NX2
NX1
NS
NS1
NS2
Y1 Y2
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2) IF YOU CANNOT SHORT OATS, SHORT FRENCH BANKSShorting European bonds is an art of its own. On one hand, you are squeezed by politicians trying to outlaw anything
to do with shorting, on the other, futures market or specific ETF products in government bonds of particular country
are grossly underdeveloped. As our broker does not even allow us to short bonds, we had to figure out a way around
that and find the best proxy that gives us short exposure to French bonds.
In order to arrive at a result, we ran a correlation test between monthly percentage change in stock prices regressed
against monthly percentage change in French CDS (we wanted to regress it against the credit risk actually, not the
growth part of the bond yield). It was not really a surprise that highest correlation was found among French banks
and financial institutions (after all, they hold a lot of this paper, dont they?). Still, it is always good to have a
statistical confirmation of your thought.
The reason why we chose France as a scapegoat is due to its problems with current account (and growing
requirement for outside funding), reflecting its issues with socialist policies and balancing the budget as well as due
to other signs of deterioration in competitiveness such as a loss of market share in world exports.
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The broadest indicator of competitiveness, the current account, has been deteriorating since 2002. Over past 10
years, it has worsened by more than 4% and we think it will continue to do so as PIGS will be hard pressed by
markets to reform its labor and product markets and Germany will be a tough competitor to beat. In all bluntness,
we perceive France as a socialist relict that will converge with PIGS over time.
Also, we believe the main reason why readings out of French economy have been strong lately is due to domestic
credit expansion, which can be observed especially in housing (while total credit to households grew at 7.54% y/y,
mortgages grew by over 9% y/y compare it with M3 actually falling y/y in Italy).
-16%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
Current Account Deficit as % GDP%
I taly CA deficit (annualized) / GDP Spain CA def icit (annualized) / GDP Port ugal CA def icit (annualized) / GDP
Greece CA deficit (annualized) / GDP France CA deficit (annualized) / GDP
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The Economist has recently published updated housing indicators, clearly showing that France, unlike other Western
countries, escaped the house-price adjustment spiral after the 2008 bust and the real estate market has actually
reached new highs in absolute terms just recently. On a price to rent basis, France remains grossly overvalued
leaving banks holding dangerous assets.
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Looking at the spread and correlations between Bunds and OATs, it increasingly looks like market has started
distinguishing between these two. It seems to us that market is growing increasingly wary of quality of French debt
as it has ceased trading like a German equivalent.
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We believe that despite recent correction, going short a basket of French banks does not have to be such a bad idea
after all. A basket of 4 major French financial institutions is a well-diversified, yet compact opportunity, to bet not
only on problems in European banking sector, but on a country with deteriorating competitiveness
Basket: (2 * BNP FP Equity + 3 * GLE FP Equity + 7 * CS FP Equity + 11 * ACA FP Equity) /4
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3) GLOBAL PMIs
In the last Global Macro Monthly, we have introduced our 4 quadrant model that looks at a composite reading of
several growth and inflation leading indicators. Underneath, we are presenting our latest results for the end of June.
The conclusion is that we are still located in an inflation and growth enabling environment (yet with an increased
political risk of deflationary bust if debt ceiling is not lifted).
20%
30%
40%
50%
60%
70%
80%
90%
20% 30% 40% 50% 60% 70% 80% 90%
Leading indicators, each point represents 1 month
x axis - inflationary environment = >50; y axis - economic growth environment =>50
T T-1 History
Inflationary boom
Inflationary bust
Deflationary boom
Deflationary bust
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During last month, we have created another decision-making tool, which is based on co-incident PMIs. So while not
having great predictive power, it is giving us a good hint and a convenient overview of where global economies are
located right now.
It is interesting to point out, that manufacturing PMIs are well below 50 in Spain, Italy, Ireland, Greece (though
improving from worse levels) and surprisingly even in Brazil.
y = 0,8791x + 1,5574
R = 0,7303
185%
190%
195%
200%
205%
210%
215%
220%
225%
230%
235%
45% 50% 55% 60% 65% 70% 75% 80% 85%
Leading indicators vs. P/B value of S&P 500
x axis - pro-growth economic environment = >50; y axis - Price to book
Historie T T-7 Linern (Historie)
S&P levn vi
pedbhajcm indiktorm
S&P drah vi
pedbhajcm indiktorm
Japan UK
US
Germany
France
Italy
Spain
Ireland
Greece
Czech Rep.
Poland
Korea
Australia
China
IndiaBrazil
Russia
Eurozone
Global
-6
-4
-2
0
2
4
6
-6 -4 -2 0 2 4 6
World, PMI Manufacturing
June 2011
PMI - deviation from neutral 50
Decelerating boom
Accelerating boom
Worsening bust
Improving bust
m/m
absolutechangeinPMI
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If we look at biggest moves in manufacturing PMIs over past month, major economies experienced weakening in
activity. US looks positive on the headline number, yet as most analysts point out, the gains in PMI were realized on
the back of inventory buildup, while new orders were weak.
It is unfortunate that we do not have access to all detailed PMI reports and thus can not make an analysison the leading PMI subindices such as new orders or hiring plans.
Japan
Italy
Germany
Australia
US
-8
-6
-4
-2
0
2
4
6
8
-8 -6 -4 -2 0 2 4 6 8
World, PMI Manufacturing
Biggest changes May - June 2011
PMI - deviation from neutral (50)
Decelerating boom
Accelerating boom
Worsening bust
Improving bust
m/m
absolutechangeinPMI
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On the charts below, we are presenting same set of data based on GDP-weighted composite PMIs.
Japan
UKUS
France
Italy
Spain
Ireland
China
BrazilRussia
Hong Kong
Eurozone
Global
-6
-4
-2
0
2
4
6
-6 -4 -2 0 2 4 6
World, PMI Composite
June 2011
PMI - deviation from neutral 50
Decelerating boom
Accelerating boom
Worsening bust
Improving bust
m/m
absolutechangeinPMI
Japan
Italy China
France
-8
-6
-4
-2
0
2
4
6
8
10
12
-8 -6 -4 -2 0 2 4 6 8 10 12
World, PMI Composite
Biggest changes May - June 2011
PMI - deviation from neutral (50)
Decelerating boom
Accelerating boom
Worsening bust
Improving bust
m/
m
absolutechangeinPMI
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4) IS THE IRISH DEBT ATTRACTIVE?
According to a Bloomberg article, Sandor Steverink, the Europes best-performing sovereign debt fund manager over
the last decade, asserted that when the Irish debt gets downgraded to junk, it is time to become a buyer. Steverink
said he prefers Irish bonds to Portuguese ones as the countrys debt burden was caused by the banks and the
country doesnt have the structural problems of southern Europes economies. Above all, Ireland also has more
potential to export its way out of trouble. We very much agree with such assessment and believe that once Ireland
gets downgraded to junk, forced sellers will create a wonderful opportunity to buy.
Let us provide you for some facts and explanation, why we think Irish bonds at todays prices are already a good
deal. And in case debt gets downgraded further, the deal will be so much sweeter. As of today, Irish 10Y government
bonds are yielding in excess of 12% p.a. and trade at 60% of par value. Let us look at what is actually priced in?
Going back into history as far as 1997, before Ireland's accession to EMU, Irish public debt traded with roughly
100bps premium to German Bunds. So if Ireland goes through a default of sufficient size so that its debt trajectory ison sound foundation, we believe spreads should compress back to 100bps or possibly even lower. Remember that
Germany is currently bearing public debt worth of 89% of GDP and faces a possibility of having to bail out certain
Landesbanken in the not so distant future.
In 2012, Irish debt will rise to 120% of GDP on the back of further banking sector recapitalization and a budget deficit
reflecting the huge output gap. According to Goldman Sachs report from the end of last year, additional capital
required for Irish banks may reach as much as 35bn over next 5 years, which is roughly 23% of GDP.
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If we assume some modest GDP growth of roughly 2-3% in current prices, gradual improvement in the budget deficit
(Ireland is actually on schedule with the IMF budget deficit reduction plan) and NAMA turning into modest profit,
than Irish public debt should end up no higher than 130% of GDP in the 2013/2014 period. Afterwards, it should start
gradually declining on the back of GDP growth led by exports as Ireland has already regained a lot of lost
competitiveness thanks to brutal deflation in wages (the current account is already in surplus and trade surplus is
growing by the day).
Therefore if Ireland were to default in 2013/2014, which marks a confluence of periods when Ireland reaches a
primary surplus (a precondition for successful default as the country will not have to tap debt markets) and runs out
of money, we see roughly two possible outcomes:
a) haircut of 40% while reaching public debt of 80% of GDP 100 bps spread to German Bundsb) haircut of 55% while reaching public debt of 60% of GDP 0 bps spread to German Bunds
We have built a map where Irish debt should be trading given the assumption of haircut and number of years to
default.
Current pricing is more favorable than our assumption of 40% haircut in 2013/2014 and 100 bps spread to Bunds
(currently priced @ 223bps over Bunds). If Ireland got more stringent with is creditors and decided for a 55% haircut,
than current loss-adjusted implied spread over Bunds stands at negative 135 bps, which is still positive yield in
absolute terms, but not truly attractive, as it is 135 bps below our prediction where clean Irish bond should trade. In
order to get our predicted attractive yield, we would wait for the price of Irish 4.5% coupon 2020 bond to fall to
levels around 54-55, or yields equal to 13.50% p.a.
02
468
-30%
-26%
-22%
-18%
-14%
-10%
-6%
-2%
2%
6%
10%
5% 10% 15% 20% 25% 30%35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% Y
ear
stod
efault
Bund
Sp
read
Haircut
Haircut adjusted Implied Bund Spread on Irish 10Y Government Bond%
6%-10% 2%-6% -2%-2% -6%--2% -10%--6%
-14%--10% -18%--14% -22%--18% -26%--22% -30%--26%
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Years to default
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43%
Haircut
5% 8,62% 8,65% 8,68% 8,71% 8,73% 8,76% 8,78% 8,81% 8,85% 8,88%
10% 7,73% 7,80% 7,86% 7,93% 7,98% 8,05% 8,09% 8,17% 8,25% 8,33%
15% 6,78% 6,89% 6,99% 7,11% 7,19% 7,28% 7,35% 7,48% 7,62% 7,75%
20% 5,80% 5,95% 6,09% 6,25% 6,36% 6,49% 6,57% 6,77% 6,96% 7,16%
25% 4,80% 4,99% 5,16% 5,37% 5,51% 5,69% 5,79% 6,04% 6,30% 6,55%
30% 3,77% 4,01% 4,22% 4,47% 4,65% 4,87% 5,01% 5,31% 5,61% 5,91%
35% 2,72% 2,99% 3,25% 3,53% 3,76% 4,03% 4,24% 4,57% 4,91% 5,24%
40% 1,63% 1,93% 2,23% 2,53% 2,84% 3,17% 3,46% 3,82% 4,17% 4,53%
45% 0,47% 0,80% 1,15% 1,46% 1,86% 2,25% 2,65% 3,02% 3,39% 3,76%
50% -0,79% -0,43% -0,03% 0,28% 0,78% 1,24% 1,78% 2,16% 2,55% 2,93%
55% -2,19% -1,81% -1,35% -1,04% -0,43% 0,11% 0,79% 1,20% 1,61% 2,02%
60% -3,78% -3,37% -2,86% -2,56% -1,83% -1,18% -0,36% 0,10% 0,56% 1,03%
65% -5,62% -5,19% -4,61% -4,33% -3,47% -2,71% -1,75% -1,19% -0,64% -0,08%70% -7,77% -7,31% -6,68% -6,41% -5,42% -4,53% -3,45% -2,74% -2,02% -1,31%
75% -10,31% -9,83% -9,14% -8,87% -7,76% -6,71% -5,56% -4,60% -3,64% -2,69%
80% -13,33% -12,81% -12,07% -11,78% -10,58% -9,34% -8,18% -6,86% -5,54% -4,23%
85% -16,92% -16,35% -15,56% -15,23% -13,96% -12,50% -11,42% -9,60% -7,78% -5,96%
90% -21,18% -20,56% -19,71% -19,31% -18,01% -16,31% -15,40% -12,90% -10,40% -7,90%
95% -26,22% -25,52% -24,63% -24,12% -22,84% -20,85% -20,28% -16,88% -13,47% -10,07%
We also feel that Irish bond has an embedded option in the form of Ireland actually not defaulting on its sovereign
bond, but letting the bank senior bondholders feel the pain and thus avoiding any further bank recapitalization. Net
interest payments will reach 4% of GDP by the end of next year, which is a lot, but not yet self-fulfilling sign of doom.
The best what Europe could do is to refinance Ireland through ESM as it would throw good money after good money.
0,0 1,0 2,0 3,0 4,0 5,0 6,0
Spain
Germany
France
Euro area
United Kingdom
Israel
Hungary
Belgium
Iceland
Ireland
Italy
Portugal
Greece
Net interest payments on general government net debt, 2012% GDP
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Unfortunately as is the case with every other trade, there are some risks associated as well. We would keep us
awake at night is the downside risk that European authorities decide to somehow subordinate private investors in
the future.
We know from official statements that unlike the IMF loan, loans under the EFSM (and the EFSF) rankpari passu with
private creditors; that is, in the event of default, payment of EFSM loans does not take particular precedence over
payment of other holders of sovereign debt. The rationale for this is that too many creditors with preferred status(like the IMF) can crowd out private investors wishing to purchase sovereign debt. The presence of preferred IMF
loan ( 22,5bn or roughly 10% of Irish debt outstanding) does not change computations by much, in case of debt
reduction to 60% of GDP, haircut would have to stand at 60%, in case of targeting 80% debt to GDP, haircut would
have to be increased to 43%.
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Disclaimer
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