Global Financial Market Review


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VIEWS ON THE PAST, PRESENT AND FUTURE. To understand the future, it is necessary to understand the past. This report looks at was has happened, what may be about to happen and what to do about it.

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Global Financial Market Review

  1. 1. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice DIVINE COMEDY James Vinall – Senior Investment Officer To understand the future, it is necessary to understand the past. The seeds of the current crisis can be found in the Western world’s response to the collapse of Communism. Socialism was a nice ideal, but could not get past inherent human selfishness (especially the greed of their leaders) and the premise of even distribution of existing assets failed. Left leaning political parties (like the US Democrats and UK’s Labour) needed to find another way. Bill Clinton noticed how true wealth was created for the average American after WWII through consumer credit and hire purchase. This was the first time the general population was able to borrow and invest and the resulting growth made the USA the superpower it is today. After many years of “greed is good” excess at the hands of the Republicans and UK’s Conservatives, Clinton and Blair stumbled on the laudable idea of social democracy, which promotes extensive credit to the poor to make themselves rich. This created the asset boom of the late 1990’s, which had a hiccup in 2000 with the “Tech Wreck” caused by massive corporate overinvestment. In 2001, George Bush and the Republicans took over and restoring corporate growth was their priority to fuel economic expansion. To rescue the deeply indebted “USA Inc”, Greenspan took US interest rates quickly down to 1% to transfer debt from companies to individuals and zealously encouraged exuberant spending on borrowing. The resultant cheap money fuelled the greatest worldwide asset boom ever seen. Bush got US corporate profits into record territory and Blair saw that “things could only get better” for the average man. The banks were regulated, accounting tightened and risk management systems deployed to guard against “Saving & Loans”, LTCM, Barings, Enron and Worldcom ever happening again. Unfortunately, AIG et al found a whacky wheeze of insuring banks all over the world against loan default which meant they could lend to anyone as they would not carry the can if the debt was not serviced. These credit default swaps and collateralised debt obligations increased money supply by 30% beyond what was normally available using debt provisioning. The US government even used FannieMae and FreddieMac as state sponsored lenders of last resort to people whose credit was so bad, even the banks wouldn’t lend to them. Debt piled high and the social democrats celebrated engineering the greatest mass creation of wealth in the history of the world. The mistake was that bank regulators in the US, UK and Europe did not require banks to provision for bad debt if that loan was being covered by some form of insurance. Politicians and central bankers basked in the warm glow of never ending prosperity having banished the boom and bust cycle to annals of economic history. THIS IS A MARKETING COMMUNICATION Intended for information only and should not be construed as an invitation or offer to buy or sell any investment vehicle or instrument. This note has not been prepared in accordance with legal requirements designed to promote the independence of investment research; and is not subject to any prohibition on dealing ahead of the dissemination of this marketing note. EquityBell Securities will provide extra detail on data or graphs used in this note upon requested.
  2. 2. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice This was until, individuals and companies had borrowed so much money that inter-bank risk was unsustainable causing a systemic failure starting with Bear Stearns th mortgage hedge fund collapse on 5 August 2007. This was followed by NorthernRock in the UK in Feb 2008, Bear Stearns in March, and then FannieMae/FreddieMac, Lehman, Merrill, AIG, Washington Mutual, Wachovia and Fortis in September 2008. Credit for all is a great idea, but, Greenspan, Bush, Brown and Blair took it too far and it will take more than a generation to pay back this “irrational exuberance”. Wide sections of the population who have sampled the delights of comparative wealth are not going to return to fiscal purgatory quietly. Source: Adam Zyglis In the last week of February 2009, investors looked into the various stimulus packages and saw Dante’s version of hell in the Divine Comedy and abandoned all hope as almost every asset class was sold in the rush for cash (including gold). Funds need to meet redemptions and individuals have margin calls and the resulting selling is throwing the babies out with the bath water. This brings us to where we are now. Politicians have a choice to borrow and print unimaginably large sums to spend their way out of deflation or throw companies and individuals to the wolves and let the phoenix rise from the ashes. Having given consumer nirvana to the mass population in the great social democracy experiment, politicians have no choice but to bail out the economy with stimulus packages, that will probably need to be three times greater than those already announced with the subsequent effect on bond prices and currencies. We believe the European banking system is on the brink of collapse, insurers are in free fall and will need a rescue package in the following weeks. China has been acting like a global department store credit card by lending money to Western consumers to borrow and spend on their goods. China has the world largest current account surplus and foreign currency reserves. However, both China and Japan are highly leveraged to the Western Consumer and their economies have significantly collapsed because of belt tightening. Japan has spent the last 19 years trying to stimulate domestic demand and the government now owes US$132,300 for every worker (in a rapidly aging population) which will take more than a generation to pay back. Japan’s economic future is very bleak as their export market has evaporated, corporate earnings are disappearing and it has little ammunition left to develop their domestic market. The Nikkei 225 is currently at 7,086 which is down 82% from the ultimate peak of 38,915 on the 29th December 1989. By contrast, China to said to own 10% of the US public debt and can use those funds to adjust from an exporter nation to domestic growth. The overriding concern of the Chinese Communist Party and the seven-member Politburo Standing Committee is to retain control over their vast and diverse population. China is very good at learning from other people’s mistakes and successes. The fall of Communism in Russia taught them to closely manage regional nationalism and avoid separatist escalation. China followed the Japanese export success model by keeping their currency low by lending to the buyers of their goods and printing money at home. In November, Premier Wen Jiabao announced a CNY4 trillion (US$586 billion) stimulus package which is probably just the start as the 8% GDP growth target for this year was reaffirmed last month. In cultural sea-change, Chinese Banks have embarked on a country wide consumer credit initiative to encourage the population to borrow and spend, fuelling an asset price boom and driving up domestic demand. China is very aware of letting
  3. 3. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice China is now in the ascendant and is making the adjustment to a domestic led economy and buying valuable distressed assets and companies at fire sale prices all over the world. China is not going to let America climb back to the top of the fiscal pile using their money. th On 11 February 2009, Luo Ping, a director-general at the China Banking Regulatory Commission, said China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world. As we all know, things change and the key moment for the US$ will be when the Chinese government decide to stop buying US Treasury bonds in order to stimulate their own economy. That will signal the start of Asian dominance of global economics for the rest of this century, as the US, UK and Europe take a generation to pay off their current debt. Middle Eastern Sovereign Wealth Funds have already halted major purchases of US Treasuries as they cannot see how the US$ can survive the economic measures required to put the economy back on track. We have never had a financial crisis where every country in the world is profoundly affected at the same time. This is the first global depression and it will take decades to fully recover. Currencies We have previously covered the debt levels of the leading economies and the extraordinarily high level of UK external debt, which is now to have been largely deleveraged by hedge funds and banks. Public Sector Public Debt per External Debt per External Debt as a Country GDP External Debt Net Debt Worker Worker % of GDP $8.45 tril $287,957 412% UK $987 bil $33,616 $2.05 tril USA $10.6 tril $73,611 $14.58 tril $13.63 tril $94,444 93% $8.4 tril $132,300 Japan $6.0 tril $2.32 tril $36,825 39% France $1.35 tril $48,300 $2.1 tril $4.58 tril $163,889 218% Germany $1.86 tril $45,588 $3.65 tril $4.85 tril $118,978 133% Source: BoE, ONS, US Fed, BdF, Bundesbank and MoF Britain’s relatively low level of public sector net debt per worker at US$33.6k (compared to Japan @ US$132k) suggests that UK government has a vast amount of room to borrow and print more money to stimulate the UK economy which will not be good for sterling. Our greatest current concern is the Euro and the scale of bank lending. Peripheral Europe (Ireland, Portugal, Spain, Italy, Greece, Austria and the former Soviet states) have vast lending and fading economies. France and Germany do not have the political will to effectively help, even if they did have the cash (which they don’t) and the ECB has no established rescue mechanism. Current prospects for the EUR look worse than the USD and GBP. America and the UK are currently losing the battle of hearts and minds that they have conquered deflation and every asset class is being sold in a flight to cash. We recently discussed how governments fighting deflation need to throw irresponsibly large amounts of money at a failing economy to make saving worthless to have credible expectations to force people to borrow and spend. The US and UK have started printing money via quantitative easing to make money so cheap, it will eventually create inflation. The US and UK need much bigger and faster stimulus packages to inject “real” cash to create the perception of inflation coming soon. The heavily indebted Japanese government cannot borrow much more to stimulate domestic demand which should be good for the JPY against the US$ and GBP in the longer term.
  4. 4. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice The CHF is likely to be weaker as UBS have made a precedent of revealing 250 tax avoiding account holders to the USA IRS (previously it had to be criminal activity) with the DoJ saying another 17,000 need to be investigated. Switzerland’s safe haven status in now under threat (although where else can the money go?). Also 60% of all recent Polish mortgages are in CHF which has appreciated 50% against the Zloty in recent months and the chances of getting this money back anytime soon is slim. Another concern is that Swiss bank liabilities (that may require a bailout) significantly dwarf the Swiss National Bank reserves. Factor in the tacit connection to the EUR and Switzerland is not in a good place. We are currently seeing a large amount of asset sales and cash repatriation, especially from sterling. Short term the GBP, US$ and EUR pairs are likely to be volatile as it will be difficult to determine which currency will be perceived as weaker than the other at any given moment. The UK is a small country and if consumers significantly slow buying, the currency will become less important to exporters. The USD is the world’s reserve currency with a massive scale economy that will always be important. Longer term, regardless of the amount irresponsible fiscal stimulus from both sides of the pond, the US$ should outperform the GBP with exchange rates settling into a lower range between 1.1000 and 1.3000. In August 2005, China revealed the Renminbi currency (CNY) is fixed against a basket of world currencies that comprise the US$, the Euro, the Japanese ¥en, and the South Korean Won, with smaller weightings of UK Sterling, Thai Baht, Russian Ruble and the Canadian, Australian and Singaporean dollars. The weightings of the components within the basket are undisclosed, but analysis reveals the Japanese ¥en, Euro and Korean Won have a greater influence than the US$ . China’s CNY will probably continue its longer term appreciation against the US$, which supports holding Chinese domestic assets. Chart of US$/CNY since 2004 showing Aug 2005 start of the currency basket. FX Recap Short term – stronger US$, and GBP and weaker CHF, EUR and JPY Longer term – stronger JPY, with US$ probably better than EUR, while CHF will be weaker and GBP weakest of all. Source: Saxo Bank Commodities Gold has rallied strongly from a low of US$682 per ounce on 24 Oct 2008 to th 1,006 on Friday 20 Feb 2009 (up 47%). Since then Gold has fallen dramatically with a low of US$900.1 on th the 4 March 2009 before rallying to th US$945 on the 6 March 2009 and is currently @ US$912. The selling is coming from Hedge funds meeting redemptions, individuals meeting margin calls in falling equity markets and general need for quick cash.
  5. 5. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice Western Central banks printing money to finance ever increasing stimulus packages to fight deflation, mistrust of fiat (paper) money and financial irregularities/fraud should see gold appreciate significantly in the longer term. We believe Gold will rally past US$1,000 later this year and our model portfolio is already long @ US$934, with a further buying target @ US$893 per ounce. Another way to play gold is through the gold producing companies. The American stock exchange Gold Bugs Index comprises 15 gold mining companies that do not hedge their production past 18 months forward. That assumes that they are best exposed to movements in the gold price. See The Market Vectors Gold Miners Exchange Traded Fund (ETF), code GDX listed on the NYSE, comprises 32 gold mining companies of which the 15 components of the Gold Bugs Index comprise 79.73% of the ETF. See The correlation is very close. The graph below shows the relationship between Gold (in black) and the Gold Bugs Index (in blue - divided by 10 to make comparison easier) and the GDX ETF (in red). Gold stocks started collapsing in the end of September 2008 as funds sold any liquid issue to meet redemptions. This broke the long standing relationship between Gold and Gold producers which is slowly recovering. As we have covered in the FX section, a large portion of leveraged fund redemptions have taken place and Gold producers are climbing back to their long run relationship with Gold. The Gold producers were hit very hard by the price collapse from late September 2008 and have recovered considerably, but are still lagging 50% behind the previous relationship. th Gold bottomed at US$682 per ounce on the 24 October 2008 and has since rallied 33% to US$912. The Gold Bugs Index bottomed on 20th Nov 2008 at 159.28 and is now up 72% at 275 and the GDX ETF bottomed on the same day at US$17.59 and is up 79% at US$31.55. AMEX Gold Bugs Index / 10 GDX ETF Gold 60 1200 50 1000 40 800 30 600 20 400 10 200 0 0 Data Source: Yahoo Finance The chart (above) shows that the Gold Bugs Index and the GDX used to trade above the Gold price and is now significantly below, despite recent appreciation. If the Gold producing stocks return to their previous relationship (if indiscriminate fund selling of equities subsides), the GDX should be at US$46 (up 45% from here) with Gold at US$912. If Gold rallies to 1,000 (up 9% from here) and the GDX ETF returns to parity, the implied price is in the order of US$50 (up 58% from here). The risk is this is an empirical, not implicit relationship and subject to macro money flows in equities rather than actual corporate value. Investors need to balance the downside risk in Gold producing stocks compared to Gold with the potential gain if the relation is re-established.
  6. 6. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice Demand destruction in oil, lower industrial production and the desperate need of foreign capital by all of the oil producers should conspire to keep crude low for a while, despite platitudes of production cuts. Fixed Income Bond markets are dogged by Central Bank quantitative easing and the deleveraging of the 30% extra money supply created by default insurance lent out in good times by the banks that now needs traditional provisioning. The charts below show the US and UK central bank overnight rate and the yield of the 10 year government bonds revealing how low rates have been driven in the fight to provide liquidity. 10 yr UK Gilt yield 10 yr UST yield From 1998 to now From 1998 to now BOE Base Rate Fed Funds 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Data Source: St Louis Federal Reserve Bank Data Source: Bank of England 10 year US Treasury yields bottomed at 2% on year end buying and still slightly higher, showing that investors who have been throwing in the towel and going to cash do not want to buy bonds in the face of quantitative easing. Government sponsored stimulus packages will fail in the long run unless they generate sufficient individual capital and savings to drive the economy forward. Governments are likely to follow the Robert Rubin’s (Clinton’s Treasury Secretary) path of taking new government borrowing under three years into the short end of the curve. Demand for longer term money from corporates is likely to push 10 year rates significantly higher as cash holders will demand extra compensation to discount quantitative easing, resulting in a steep yield curve. 10 year UK Gilt yield is 3.11%. The Euronext Long Gilt futures contract has a nominal coupon of 6% and a maturity between 8 years, 9 months and 13 years and the front month contract is trading @ 125.54%. If 10 year Gilt rates rise to 6% as we believe, the implied price of the front month Long Gilt futures contract should be in the region of 60% to 70%. 10 year US Treasury Note yield is 2.95%. The CBOT US Treasury Note futures contract also has a nominal coupon of 6% and a maturity between 6 years, 6 months to 10 years and the front month contract is trading @ 122.75%. If 10 year US Treasury Note rates rise to 6% as we believe, the implied price of the front month US Treasury Note futures contract should also be in the region of 60% to 70%. At some point in the near future, when governments and corporates are issuing bonds and traditional buyers are less conspicuous, we would suggest shorting long bond futures as a strategic position.
  7. 7. CLEAR AS A BELL LEAR ELL VIEWS ON THE PAST, PRESENT AND FUTURE IEWS UTURE 10th March 2009 Sound Advice Equities Equity markets look awful as investors are capitulating and getting out. The chart below shows the performance of the major indices since the 9th October 2007 when the S&P 500 had its ultimate peak at 1,565. S&P500 down 57% IBEX35 down 55% FTSE100 down 48% DAX down 55% CAC40 58% Nikkei225 down 59% FTSE/Xinhua China 25 down 62% Shanghai Comp down 64% 120.00% 100.00% 80.00% 60.00% 40.00% 20.00% 0.00% Data Source: Yahoo Finance The FTSE is the best performing market as it is ONLY down 48%. China is the worst performer being down 64%. Below is a chart of equity index performance each day past the ultimate peak of the market during a financial crisis caused by overburdening debt. We can directly compare how Wall Street 1929, Japan 1989, NASDAQ compare 2000 and the S&P500 2007 pan out over the subsequent days as Governments struggle to reflate economies. overnments Data Source: Yahoo Finance
  8. 8. CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE 10th March 2009 Sound Advice Major equity indices look good value when compared to 2008 actual earnings. However corporate earnings are collapsing fast and no one really knows how bad the figures will be, although everyone agrees that analyst estimates are probably behind the curve. The FTSE is currently trading at 7 times 2008 earnings, estimates for 2009 earnings suggest the price earnings ratio (P/E) could be 22 and likely to get worse, which is not good value. The world is in crisis. The primary trend of equity indices is lower and if the markets follow the Dow Jones Industrial from 1929, technical support for the S&P500 is 400 and the FTSE100 at 2,000 over the next year. We are helping some trading clients to define buying targets for the expected countertrend rally in equity indices, but the scale and duration of such a rally is an unknown risk. We are also identifying “babies” that have been thrown out with the bath water for rapid recovery to fair value like Carrefour who have a 6% dividend yield at €23.90 per share and results out on Thursday 12th March that are likely to be good. Given our longer term view that equity markets still have further to fall, we would suggest taking a strategic short position on equity indices at a suitable point in the near future to benefit from the long, grinding slide lower over the next year. Conclusion This financial crisis is taking us all through a Divine Comedy as investors have currently abandoned all hope within the Inferno; when we hit bottom we’ll be in Purgatory for quite a while before finally climbing back to Paradise many years from now. 16 months into this crisis, if we look at previous market disruptions, we are a long way from sorting out the mess and heading to recovery. We first saw “abandon all hope” selling in November and then again in the past week. We will probably see another round of final capitulation later this year as the stimulus packages fail to bring on inflation as fast as politicians, companies and individuals would like. We are helping traders to play the short term movements, but our longer term primary trends are strong Gold, weak equities, weak long term bond prices and a stronger JPY. EquityBell Securities Quay House, 2 Admirals Way, Canary Wharf, London E14 9XG Tel: +44 (0) 20 3189 2108 Risk Warning Notice: Equity Bell Securities is a trading name of Equity Bell Limited (registered office: Talbot House, 8 – 9 Talbot Court, London EC3V 0BP. Registered in England and Wales No. 6725781) is an Appointed Representative of London Islamic Investment Bank Limited, which is authorized and regulated by the Financial Services Authority. Whilst every attempt is made to ensure the accuracy of the information provided, no responsibility can be accepted for any inaccuracy. The information provided cannot be relied upon as constituting a recommendation, nor construed as any offer to sell, or any solicitation of any offer to buy investments. No liability is accepted for any loss whether direct or indirect, incidental or consequential, arising out of any of the information being untrue and / or inaccurate, except caused by the wilful default or gross negligence of EquityBell Securities, its employees, or which arises under the Financial Services and Markets Act 2000.