Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. Storm Insurance: Imagine for a moment that you own a property in South Florida and the usual hurricane is brewing off the coast. Fortunately, you are insured.
As the storm makes landfall this year, you are hit particularly hard. The old oak in your front yard makes an unwelcome entry into your living and dining rooms, crashing through the roof and reminding you that “stick built” really means, “toothpick built.” Not to worry, you bought insurance.
Then comes the bad news. You were insured from the storm, but not the tree. The insurance adjuster determines that the tree’s maturity and an infestation of termites in the trunk are the casual factors – not the wind and rain you assumed to be the material influences.
Now, travel in your mind to Southern Europe. When this Greek ordeal is settled, there will be winners and losers. As we are seeing with greater frequency, the winners and losers are not chosen freely by the market, but by politicians and special committees. When the International Swaps and Derivatives Association (ISDA) determines that the 50% haircut is “voluntary,” and thus not a default, there will be disappointment among institutions and investors that held insurance against such a decline in value resulting from default.
This is an example of how the term “free market” is being redefined in terms of a new global command economy. The holder of Credit Default Swaps paid insurance premiums to be covered from catastrophic loss, and yet due to the recategorization of the event as a non-default, they will have to deal with the tree in the living room, and the costs to repair the roof, on their own.
It is understandable for the ISDA to try to create a firebreak around Greek debt and derivative obligations. However, the way it did so fundamentally alters an investor’s expectation of what a true hedge is. Are you insured or are you not? The contract is less important than the nuance of interpretation being offered by the ISDA.
2. Is the Problem Greek or Italian? We don’t know what side of the trade John Corzine took for MF Global trading accounts, but over $6 billion in dodgy European sovereign exposure left the firm vulnerable. This week’s failure represented the 8th largest bankruptcy in US history.
Corzine, an ex-Goldman Chief, thinking like an aggressive trader and all too familiar with the implicit guarantee of Agency paper, might have assumed that sovereign paper tied to the core of the eurozone was by definition “risk free.” Did he buy European paper as a sure bet, selling at a distressed price and offering a handsome reward to the calm, cool, and collected company looking beyond the panic level valuations of the day? Did he believe that, as of September 2, two-year Greek debt trading with a yield of 46.84% already priced in the worst news possible? Only two months later, on November 3rd, the yield has exceeded 100%. (John, remember one of the first rules of trading: Never catch a falling knife.) The assumption that anything with a government stamp is “riskless” is coming into question, as a Financial Times article entitled “Subprime moment looms for ‘risk-free’ sovereign debt” documented yesterday.
Alternatively, did Corzine consider exposure to the credit default swap market a safe play? Many observers thought that collecting the payout on European default was going to be as easy as leaning over and picking up Benjamins. Of course Greece would go broke. Of course a default would occur. Of course the fracturing of the Euro would spell profits for those with good hedges – and for those with speculative shorts, as well.
In both cases, the unexpected occurred. The long investor (buyer of bonds) lost a lot of money; the short investor (short seller or purchaser of CDSs) lost a lot of money. The only participant that appears to have made out like a bandit is Greece, with a much-reduced debt burden – assuming the bailout deal goes through and is not derailed by a referendum vote. Perhaps the riddle of the decade is how to bet on political outcomes. This game is getting more complicated all the time.
We hope that Mario Draghi, newly appointed chief of the ECB and former Goldman Sachs International director, has a healthier appreciation of risk than former Goldman CEO Corzine. Unfortunately, there is no evidence of this so far. Within days of taking the ECB helm, he lowered rates to 1.25% and emphatically stated that inflation is a non-issue and should drop in 2012.
Already he looks and sounds a bit like a Bernanke clone. Joining the Central Bank chorus identifying liquidity as the issue, he’s sounding the wrong note, in our view. He’s ignoring structural issues of solvency brewing not only in Greece but in his own back yard – Italy. Perhaps we can safely say that the European problems of 2012 will be Italian sourced (Draghi instead of Papandreou).
3. Stocks Running on Fumes: In case you weren’t paying attention to the score, even as the economies of the PIIGS deteriorate, no checks have been written and no loans have been made – at least not yet. Let’s face it, lending to anyone who is virtually bankrupt and who also lacks the necessary fiscal reform would be a colossal mistake, to say the least.
This may be oversimplifying the situation, but it appears that, with the recent ECB rate cut, combined with FOMC remarks, solutions based on loan restructuring are once again being abandoned in favor of money printing. When commodities indexes were running strong six months ago, QE would not have been the first choice. But with markets off their highs, inflation appears to be benign, giving central banks the orchestrated green light they need to print without objection. How effective these easing efforts may be this time around remains to be seen. For starters, markets are in very rich territory already and inflation really isn’t that tame.
It may take more than a rate cut and/or jawboning by central bank powers to keep stocks in rally mode. “Buy the rumor and sell the news” may be in effect. Stocks have rallied since the beginning of October (adding $7 trillion in global market cap) on the anticipation of more QE. Following the central bank announcements, momentum in stocks faded quickly, finishing the week with a loss while bonds rallied (see the box scores). The best that stock operators may then hope for is sideways motion in the major indexes until the Fed and ECB up the ante.
Bulls looked to the US jobs report to keep stocks alive this week, but the numbers still didn’t add up. 80,000 non-farm jobs were created, and the unemployment rate fell to 9.0% (from 9.1) in October. Seasonal factors pertaining to construction jobs appeared to be the drag on the data. However, this was offset by hedonic adjustments made in the birth/death component of the BLS model, which added 102,000 (fictitious) jobs to the mix. We have noted here before that job creation needs to be over 200,000 a month at a minimum to validate the acclaimed “recovery.” How this was not the case even as unemployment managed to decline is mind boggling.
As an aside, there are a few articles that appeared during the week that I thought were worth mentioning. Even though the Fed and the ECB continue to espouse price stability and low inflation, in our opinion to excuse or condone the use of QE, this flies in the face of what other countries outside the circle of trust are saying and doing.
If you have a Financial Times subscription, you’ll want to read “Rates dilemma for frontier markets” (emerging markets are raising rates) and “The dollar looks even shakier than the euro.” Bloomberg had an important article entitled “Heating Fuel at Record as European Diesel Surges.”
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