Piling On!

Location Date: 
November 24, 2011

Happy Thanksgiving again to all our American friends!  Canadians celebrate this holiday in October – we front- run the turkey market!  I was hoping to find some silver linings in markets to say all is not bad in this post.  Unfortunately, no such luck.

Yesterday’s news was a good example.  In pro wrestling terms, it looks a lot like “piling on” or even better, like the Undertaker doing his famous pile driver move over and over. 

In Europe, the news just keeps getting worse.  Despite positive political changes in Spain and Italy, yields on their sovereign debt continues to rise to unsustainable levels.  Germany had a very poor 10 year auction as market participants are becoming more wary of the need for Germany to toss a life rope to the rest of Euroland – and 1.9% yields don’t compensate for heightened risk.  The Dexia bailout is hitting a snag with the Belgian government (now there is an oxymoron!) wanting France to pick up a bigger part of “deal” – they can’t pay and France can’t afford to see its AAA status fall.  With French 10-year yields now +161 bps over bunds, maybe it is too late anyways.  It certainly appears that the race for liquidity is “game on” in Europe.  Add a 'pile on' with a Euro PMI number that implies negative Q4 GDP in Europe and the outlook is not bright.  The new ECB head Mario Draghi is caught in the political vortex – the Germans don’t want the ECB to outright buy more periphery debt and the EFSF is in no position to help with Spain or Italy.  He is not mandated to do much else than watch for now.  Our best guess is that QE and a money- printing bonanza is not far off for Europe once the gun is to the head of the political elites.  The elastic band is stretched just about as far as it can go.  Germany will have to acquiesce – today’s 10 year spreads on bunds versus UST’s hit 30bps!  Who is the better credit risk now?  Add to this, the growing understanding that German banks are very highly levered and exposed, and we may see the “snap” within 3 months.

The news in the U.S. is a bit more positive – at least economically – on the surface.  While jobless claims falling below 400,000 is a good sign, the continued deleveraging of households is keeping GDP at levels below what is required to get a “virtuous cycle” underway.  The so-called “stall speed” often quoted by economists is the reality today.  Attention has surrounded the failure of the Super Committee to even agree on a miniscule $1.2 trillion in deficit cutting (most of which is in defence already), leading many businesses to simply continue to sit on their hands.  No news on payroll taxes or any pending government policy is actually far worse than the political theatre and brinksmanship in Washington.

With risks so high, why have U.S. equity and bond markets been so durable?  The easy answer is that the U.S. dollar and securities markets remain the safe haven trade.  But for how long?  The big change out of Europe is a growing view that sovereign debt needs to be repaid at some point.  Without changes to the governance model in Europe and a coordinated effort, this is problematic.  It will be very important to watch CDS spreads in Germany, France and the EIB for the continuation of this shift in market consensus.  As a corollary, I am not certain how long the U.S. and the UK will be able to have 10-year rates at or below Germany once you compare aggregate European indebtedness to GDP versus these two countries.  These bond markets (and currencies) are also quite vulnerable in 2012.  As a result, I am short sterling as a hedge in our overlays.  As for Japan, they are the biggest basket case but it is a very difficult trade.

China is often looked to as the saviour – they will fund Europe with their massive reserves. With domestic inflation easing somewhat, they may start to loosen monetary policy and kick-start their economy.  However, the HSBC China Flash Manufacturing PMI hit 48 Tuesday night – the lowest reading since March 2009.  There is no question the slowdown is in full force now, so all eyes are focused on whether a soft landing can be achieved.  China’s Vice Premier and head of finance even declared this week, “the only thing we can be certain of is that the world economic recession caused by the international crisis will last a long time.”  Not encouraging words.  As to whether China will come to Europe’s rescue – I doubt it, not without ECB/German support.

The above situation reinforces our view that any rallies in risk assets are good opportunities to reduce exposure and wait for better entry points.  It appears inevitable that a recession is in the cards for Europe.  The U.S. is stalling badly with little in the way of policy changes in the medium term.  And China remains a wild card but it, too, is clearly in sick bay.

All in all not such great news.  Trading around these situations however should prove very profitable.