A View from the Trenches, March 11th, 2010: "Out of the woods?"
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In the past days, the world seems to have embarked on to another leg of a
rally, with equities trying to set the stage for higher highs. Volume
is reduced though and you may ask yourselves why we are not as bullish
as we were last year, after all the evidence in favor of a nascent
recovery. Is it because the recovery is weak? Is it because unemployment
remains high? Is it because consumer spending looks low? No, no, no…We
wrote before anyone, back at the beginning of 2009, that we expected
unemployment to be high and that we did not expect any growth, but
agony.
The main reason we were bullish then was that the stimulus programs, the
quantitative easing was well underway. That is no longer the case. Is
that all? Should we no longer be bullish just because stimulus programs
are unwound? No, there is another element to it. The same countries that
claim to be unwinding these programs are running unsustainable fiscal
deficits and absolutely no serious and credible action is taken. That,
to us, is enough to worry. Are we short the markets? No, we were stopped
weeks ago, because we can no longer take the pain of even a 1.5% loss…
Consistent with this sentiment, some analysts deem the credit (not
yield) curve in investment grade space (CDX IG13 index) to currently be
to steep in the front end, suggesting that the implicit default rate is
too high. What is the analysis based on? Simple, descriptive statistics,
going back to 1970. We wonder what period in history, back to 1970, was
ever similar to the outlook we’re facing? When was there monetary
coordination? When did the world fall since 1970 into a liquidity crisis
with stimulus programs of the size and geographic reach seen today?
Furthermore, we ask ourselves how is it that so much research is
currently being done on the defaults outlook, without anyone taking a
closer look at the maturities concentration the world faces in high
yield, between 2013 and 2015? When did a scenario of so close a maturity
front together with increasing interest rates not demand a steep credit
curve? Hence our not so bullish stance here, as discussed above.
On another topic, we are finally seeing some long overdue concern of
politicians on sovereign credit default swaps. Particularly in Europe.
As we wrote on March 1st (refer: www.sibileau.com/martin/2010/03/01 ): “…politicians
focus on the greedy side of those who trade these swaps, which is
really idiotic, because these derivatives represent a huge boost to
systemic risk, even if they were traded for the most morally justifiable
reasons…”. Regulators are wrong in seeking to prohibit these
instruments, blaming them for their problems to issue debt. By the same
token, regulators are ignoring the true problem of these contracts,
which is the fact that any counterparty selling them does so on
leverage. If a sovereign in Europe or the US was to fall, the implicit
guarantees that these institutions selling sovereign credit default
swaps have would be worthless and they would be undercapitalized, at
exactly the same time everyone rushes to the liquidity door.
Finally, we refer to our previous letter, where we challenged the
notion of Canadian markets strength based on commodities performance or
even growth expectations. As you can see in the charts below (source:
Bloomberg), the exodus to Canada is a process that started long before
Parliament discussed the 2010 budget last week. It began in November,
and took off in earnest with the Dubai credit event. The Canadian
“thesis” worked against the Australian dollar, a commodity currency
which has increased policy rates (below left) and extremely steadily vs.
the Euro (below right). The foreign exchange market never lies.
Martin Sibileau
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