Tag Archives: Banks

article 3 months old

The Overnight Report: No We Can’t

By Greg Peel

The Dow closed down 3 points while the S&P was flat at 1223 and the Nasdaq gained 0.1%.

President Obama is clearly a man caught between a rock and a hard place. Having declared over and over that the US budget could simply not afford the loss of income implied by extending the Bush tax cuts to all brackets, including to the top 2% mega-earners, he was forced into compromise by the Democratic drubbing at the mid-terms. As anticipated by Wall Street, the Bush tax cuts will now be extended in full for two more years.

Obama nevertheless was able to win concessions on other policies, including extending benefits for the long term unemployed and providing tax breaks for parents putting their children through college, and Wall Street was surprised to find that despite the addition of the top 2% cut there were also payroll tax cuts within the package. Yet while the Republicans are still obviously opposed to Obama Administration policies, liberal Democrats are also unhappy. They see their president as a sell-out.

And so it was an ordinary press conference held this morning (Sydney time) in the wake of the tax policy announcement morphed into an impassioned speech from the president – unintended – with disillusioned Democrats clearly the target. In short, Obama made it clear that while he had been forced to compromise on the top 2%, his opposition to such a move remained steadfast. Indeed, his own concession is that the extension lasts only two years. At that time, of course, America can vote on the issue, but the president remained resolute in believing the deficit will only suffer in the meantime as a result. Compromise has been a necessary part of American history, the president entreated to a now silent room. If not, he himself would not have been “allowed to walk in through the front door”. There ended the press conference.

And there ended the rally. While largely anticipated, confirmation of the top 2% compromise had the Dow up 90 points on the open. It wavered through the session and was up only 50 ahead of the press conference, but as the conference began in typical fashion the average moved up to be about 75 points higher. Then came the unscripted speech, and then the Dow dropped like a stone. Perhaps Wall Street was not happy that Obama was still vehemently opposed in principle to the top 2% compromise and that he had no intention of extending it past two years. 

Or perhaps the real impetus, exogenous to fiscal policy, was an unqualified Reuters wire that hit trading desks at the time suggesting US authorities were stepping up the level of their insider trading probes. Or with stocks having run up strongly the past few days on anticipation of the Obama compromise, perhaps it was just a good opportunity to sell the fact and book some profits.

Nevertheless, if the US stock market is now heartened by fiscal policy, the US bond market is not. If ever one might be able to pinpoint exactly when the US bond “bubble” burst it was last night.

Having toyed with the 3% yield level recently even as the Fed has been buying, with a lot more buying to come, last night the benchmark ten-year yield exploded through 3% and jumped an extraordinary 22 basis points to 3.15%. The bulk of the move came long before the president's press conference. The two-year added 11bps to 0.54% and the thirty-year – upon which mortgage rates are set – jumped 15bps to 4.19%. These were still not highs for the day. As the press conference played out, Wall Street sold stocks and bought back some bonds.

Is it simply finally time for US investors to switch out of bonds and into stocks? Well it's easy to make the case. The Fed is determined to see stock prices higher and that's what QE2's all about. QE2 devalues the US dollar and offers longer dated inflation risk, and now the tax compromise is in place the deficit is also compromised. If the US is unable to reel in its massive deficit over time then lending the government more money does not seem like a sensible investment strategy.

Despite the US bonds suffering a big sell-off last night, the US dollar index actually finished higher. There is anxiety once more stemming from Ireland where the new austerity package legislation is being put to parliament. The package must be passed before the EU-IMF will hand over its E85bn in aid.

The financial markets really were all over the shop last night. Bonds were sold despite a stronger dollar in at least partial fear of inflation pressures and that should also be an impetus for gold, but having run very hard in the last couple of sessions gold saw some hefty profit-taking last night, falling US$23.40 to US$1401.60/oz. One presumes, as is always the case at “big figures”, that gold needs to do a bit more work around the US$1400 mark.

Commodities were mixed. Oil fell US83c to US$88.56/bbl while copper continued its relentless rise, gaining another 1%. 

In terms of stock market turnover, it was a big session last night. However a solid half of the volume was ascribed to Citigroup shares alone. While Citi is almost always the most highly traded stock, last night the US government sold down the last of its TARP-related ordinary share holdings. While investors are now more keen on an investment in Citi (and the end of TARP means dividends can now be paid once more), the truth is Standard & Poors will now rebalance the S&P 500 to re-include the previous government tranche in open market calculations. Citi's market cap ratio thus increases accordingly, and as such index funds had to buy Citi shares over the session and on the bell to maintain correct weightings.

At the time the detractors suggested the US government should not use taxpayer funds to bail out Citigroup and its peers. But at the end of the day the US taxpayer has done very nicely.

The SPI Overnight was up 2 points.

Today in Australia sees the monthly housing and investment lending data.

A reminder that Rudi will appear on Sky Business's Lunch Money program tomorrow at noon, and I will be appearing on Business View at 2pm on Friday.

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

Europe The Unknown Factor

By Greg Peel

While immediate problems in Europe seem to have settled down somewhat in the wake of the Irish bail-out, concerns have persisted that were a bigger economy to hit the skids the existing EU-IMF bail-out fund of around E750bn would not be enough to prevent defaults. Already Portugal is looking at market-imposed credit spreads that would make bond rollovers to a higher interest cost untenable, and fear lingers of the domino effect into Spain and even Italy.

To recap, there are 27 nations in the European Union but only sixteen of them have adopted the common currency of the euro. Notable exceptions are the large economies of the UK and Sweden. Of those nations within the eurozone there is a fairly distinctive split between the northern economic powerhouses of Germany, France and their smaller neighbours and the southern economic basket cases of Greece, Portugal and Spain in particular. Any strength in the euro can be attributed to the north – and in particular the hard-working and frugal Germans – allowing the less productive southern states to ride on the north's coat tails and abuse and exploit the strength of their common currency.

The south includes Greece, where it has been revealed, for example, that tax avoidance is the national pass time, and Spain, which has suffered a catastrophic property bubble-and-bust, but also Italy, which despite being the world's seventh largest economy has managed to be overly profligate in its euro exploitation. Then of course there's Ireland, which has also seen a property bubble-and-bust but has suffered from shying away in the 21st century from traditional industries and trying to become a European banking centre instead.

One of the biggest problems of the eurozone structure is that while there is a common currency there is no common bond. In the US, for example, there is one currency and one bond and a QE program which involves printing currency to buy those bonds. In the eurozone there is one currency but sixteen individual sovereign bonds. While PIIGS bond yields blow out money rushes into the safety of German bonds causing an imbalance which cannot be reflected by exchange rate movements given the single currency. The end result is Germany has to feed taxpayer funds back into the PIIGS to prevent the collapse of the euro – much to the chagrin of frugal Germans.

Were there never a euro created and instead the EU existed with each member retaining its original and individual currency, then exchange rate movements would reflect the respective size and strength of each economy. Southern Europe would find itself with much less spending power and opportunity to live the high life. Germany's currency would be the strongest.

While it may seem an obvious solution to simply ditch the euro as a nice idea proven unworkable, so much European finance is tied up in the common currency the fall-out of attempts to unravel the web would still be itself catastrophic, according to analysts. But it must also be noted that while Germany might bitch and moan about its profligate co-members, its own export economy has received a considerable boost from the euro's value reflecting the smaller economies in the mix as well as the larger – even before the debt problems began to surface.

There is a lot of outcry about China's “artificial” currency but in truth, Germany is also benefiting from something “artificial”.

Since the Greek crisis early this year the European Central Bank has been forced to extend cheap emergency loans to European banks and to buy up the distressed bonds of the PIIGS. As the crisis had appeared to abate in the wake of the Greek bail-out and the establishment of the E750bn EU-IMF general emergency fund, the ECB had begun quietly reversing those measures. Since Ireland blew up however, the ECB's back at it again.

So not only are Germany and others contributing taxpayer money to EU emergency bail-out funds, they are by default contributors to ECB funding as well which is currently being used to buy distressed PIIGS debt. It's no wonder that in its death throes, the Brown government initially rejected any idea of a UK contribution to a eurozone fund. The pound had its own problems.

So the eurozone is stuck with the euro for now and all rhetoric suggests that's the way the EU members want to keep it. This is despite Germany making moves to reintroduce trading in the Deutschmark alongside the euro. What is said in back rooms is clearly different to that said in public. But as Ireland becomes the next member threatening to start of the domino effect of default into Portugal, Spain and maybe even Italy there is now fear that the E750bn bail-out fund simply may not be enough.

To that end the eurozone finance minsters have been meeting this morning (Sydney time) to discuss the issue. The head of the IMF has suggested that the emergency fund needs to be increased in size. That's one option to consider.

Another option, as put forward by Italy's finance minister along with the prime minister of Luxembourg, is for a common eurozone bond to be created as well as the common currency to deliver a “strong and systematic response to the crisis”.

At present, money is flowing out of the sovereign bonds of the PIIGS members and into German bonds in particular, creating the imbalance a single currency can't adjust for. European debt has become the plaything of global traders and the blow-outs in yields on PIIGS bonds potentially mean that no matter what levels of budgetary austerity are imposed, the cost of rolling over debt when its due will be so much higher as to render it unpayable anyway. Default should surely follow.

The theory is that a common bond would address this imbalance. But Germany has already voiced its complete disapproval ahead of the meeting – both for the common bond idea and for the IMF's suggestion of more emergency funds. Mind you, Germany was always dead against the original emergency fund from the outset but finally capitulated once the Merkel government had assured support from its Opposition.

The other rumour that went around markets last week was that the Fed would step into the fray and indirectly contribute to the eurozone emergency fund by providing more funds to the IMF. The US is already the IMF's biggest contributor and maintains a strong control over the “global” body. We know that the Fed can create funds out of thin air, given that's exactly what QE2's all about (and QE1, and probably QE3).

Why would the US want to help Europe? Well because of the flow-on effect of a European collapse to all global financial markets. Just as the GFC threatened to bring down America and thus the rest of the world in the process. Of course, the idea of the US helping Europe raises the hackles of the ignorant, jingoistic and self-serving members of US Congress who can't get past “America the superpower” because they still don't understand the GFC nor the reasons it occurred.

Another solution to the crisis, expressed back when Greece was the centre of attention, is to simply allow members to default on their debt just as Russia did in the late nineties. Russia is now back stronger than ever. The problem here is that those holding PIIGS bond do not just include US hedge funds but mostly many banks across Europe which would be driven insolvent by their resultant losses.

Okay – how about PIIGS bondholders simply take a “haircut” on their investments? This means that instead of receiving 100 cents in the dollar on maturity to agree to take a lesser amount. This would effectively reduce borrowing costs for the PIIGS and if implemented carefully would dilute the fall-out and maintain the solvency of European banks. Indeed, there are plenty in the market now assuming haircuts are inevitable.

But such a move would, in reality, mean the euro experiment has been a failure. The structure of the eurozone would not have held together as intended and the euro itself would be seen as pretender rather than a legitimate alternative to the US dollar as global reserve currency. At least in public, EU members do not want this to happen.

So what's the upshot of all of the above? Uncertainty. And financial markets fear uncertainty over everything else, including an obvious bear market. At least you know where you're going in a bear market and can make investment decisions accordingly. If you have no idea what might happen next, you simply stay out of it. Or buy gold.

Realistically there are three main macro factors driving and worrying global financial markets at present. One is the strength or lack thereof of the US economy, but that is supposedly now covered by QE2. Another is the potential for further Chinese monetary policy tightening measures, but realistically Beijing only tightens when China's economy threatens to run too hard.

And the third is Europe, which quite simply is an unknown.

article 3 months old

The Monday Report

By Greg Peel

Having entered December with a fresh breeze of economic optimism following some better than expected data, Wall Street was assuming the same for the November jobs report, particularly given the earlier ADP private sector report was positive. It thus came as a bit of a shock that having expected 155,000 new jobs to have been created, the result was only 39,000.

To some it seemed incongruous, and for once Wall Street pointed to the volatility of jobs data to provide some hope. At each release earlier months' numbers are revised – sometimes considerably – and Wall Street could not figure out why the retail sector, as noted in the break-down, could have lost jobs in November when every other year Christmas hirings dominate.

As it was the Dow fell 40 points from the bell on the news, which was not a lot under the circumstances. From there it was a bumpy road of recovery before ending the session higher. With the official unemployment rate having risen from 9.6% to 9.8%, Wall Street could relax in the knowledge the Fed would simply have to increase its QE2 efforts were unemployment to remain stubbornly high. We're back to the model of good news being good news and bad news being good news as well – assuming no more shocks out of Europe, China or the Koreas.

The Dow closed up 19 points or 0.2% while the S&P added 0.3% to 1224.

To support the “bad news is good news” model, CBS revealed on Friday that in an interview with Ben Bernanke, which aired on Sunday night, the Fed chairman did not rule out expanding QE2 if necessary. If you like – QE3. With Europe more settled, the US dollar did what it should do under threat of additional money supply and fell 1.3% to 79.17 on its index. More definitively, gold soared US$30.40 to US$1413.80/oz.

The flipside of pouring Monopoly money into the market to artificially boost stock prices is the threat of inflation down the track, although supporters of QE suggest there is no inflation threat in merely fighting deflation.

Only a couple of sessions ago the Aussie was staring 95 in the face, but on Friday it jumped 1.7 cents on the weaker greenback to US$0.9924. Oil jumped US$1.19 to US$89.19/bbl but after a strong week there was some profit-taking on the LME, with all metals slightly softer.

There's little in the way of economic data releases in the US this week. Tuesday sees consumer credit and Thursday wholesale trade before Friday brings the trade balance, Treasury budget and the first Michigan Uni consumer confidence survey for December – one which will provide a guide to Christmas shopping intentions.

It's nevertheless a busy week in Australia on the economic front. Today sees the release of the November construction PMI, along with the ANZ job ads series and the TD Securities monthly inflation gauge. On Tuesday the RBA meets but Stevens has already signalled no rate hike again till next year at least. It will nevertheless be interesting to read the commentary given everything that's happened since the November hike which has made that hike look premature.

Wednesday brings home loan and investment finance data and then on Thursday its our own unemployment report for November. Having ticked up to 5.4% in October from 5.1% the expectation is for a drop back to 5.2%.

Canada also makes a rate decision on Tuesday and this week sees monthly trade balance releases from Germany, Japan, the UK and US, along with China on the Friday.

The Australian AGM rush is now over although there are still a handful of meetings to be held in December. This week's highlight will be the first of the big bank AGMs but not before Bank of Queensland ((BOQ)) meets on Thursday. Thursday also sees a battle of the wallets as the bizarre new Network Ten ((TEN)) board faces off for the first time.

Rudi will be the guest on Sky Business channel's Lunch Money on Thursday at noon.

For further global economic release dates and local company events please refer to the FNArena Calendar.

article 3 months old

The Overnight Report: The Bulls Are Snorting

By Greg Peel

The Dow rose 106 points or 1.0% while the S&P corrected its underperformance on Wednesday by rising 1.3% to 1221 and the Nasdaq added 1.2%.

All eyes were on Europe last night for the scheduled European Central Bank monetary policy update and all ears on president Jean-Claude Trichet at his traditional press conference (a commitment the Fed is now considering emulating). With apologies to Annabel Crabb, “People Skills” Trichet was at his stubborn best.

The ECB left its cash rate unchanged at 1% which came as no surprise. The central bank has not moved below this number at any time since the GFC but has instead implemented what are mostly known as “extraordinary measures” that equate to the ECB's version of quantitative easing. This involves offering short-term fixed-rate loans at low rates to eurozone banks and also buying the sovereign bonds of those members in distress.

Once the EU-IMF had bailed out Greece earlier this year and put in place the emergency fund in an attempt to stem fears of contagion, an improving euro and ebbing credit spreads allowed the ECB to begin withdrawing those QE measures. The balance of QE reduction in Europe and QE2 speculation in the US sent the euro soaring back to pre-crisis levels, right up until the time Ireland sparked a whole new round of fear. With PIIGS bond yields blowing out once more – to unserviceable levels in some cases – it has become incumbent upon the ECB to act.

The best Trichet could come up with was to confirm that emergency loans would continue to be made available to all banks in need and that the purchase of distressed sovereign debt would be “ongoing”. Trichet would not be pressed on the size of the bond buying commitment and deflected questions as to whether the ECB was actually boosting this commitment. In short, Trichet provided the bare minimum of assurance, failing to fully assuage heightened fears.

The euro stumbled initially, but turned around and ran hard on news that ECB literally was in the market buying sovereign bonds last night. The sun had also risen over New York, and economic data releases proved to be fuel for a genuine reinstatement of the risk rally. This means selling US dollars.

The same-store sales index for the major US retail chains rose 6% in November when economists had forecast 3.6%. A successful Black Friday was touted as the driver given the jump in shopper numbers and the slight rise in sales values over last year. Initially there was concern that despite the rise in traffic shoppers didn't really spend a lot, but that concern seems to have faded now, particularly after last night's number which had the consumer discretionary index soaring.

But the big shock was October pending home sales, which jumped 10.4% to mark the strongest month since records began being kept in 2001. This result is at odds with other recent housing data, and in a couple of months should translate through to actual home sales numbers to provide another burst of excitement.

There was likely still short-covering in last night's rally but it looked more like a rally than did Wednesday's step-jump gain. The Dow opened up about 40 points and then mostly kept rising. Suddenly there's a fresh round of parochial optimism to draw attention away from Europe. US economic data are quietly improving, but we won't say “green shoots” this time as that didn't really work last time.

Weekly new jobless claims incidentally rose a worse than expected 26,000, but Wall Street let that one go through to the keeper. Tonight is the November jobs report.

There has been no more talk of the Fed providing a funding injection to the IMF to help with the European situation, but now that the idea has been raised Wall Street has probably assumed Fed-ECB coordination is a likelihood were the situation to deteriorate. There has been some anger in Congress from the small-minded who can't understand why the US of A would consider bailing out a bunch of socialists, but those who appreciate that if you throw the Monopoly money around it's better not to be a crossed purposes are excited to think there is a big, global safety net in place and a central bank desire to see higher stock prices.

November seemed like a pretty weak month, although it did begin with a breach of the old April high. So with the S&P 500 closing at 1221 last night there's actually only 0.5% to go to breach that November high. A decent jobs number tonight and we might just be back in post-GFC “blue sky” (notwithstanding it will be a long road to reclaim historical blue sky). December has begun as if with a clean slate, and talk of a Santa Rally is in the air.

[Note: strictly a “Santa Rally” occurs in the week after Christmas but the expression seems to have now stretched to include a rally up to Christmas.]

I will note, just playing Devil's advocate for a moment, that Beijing is fond of announcing policy changes on a Saturday and the Korean peninsula has gone eerily quiet. Despite November's stock market weakness, various commodities have continued to push higher – particularly the agriculturals. Copper is running on inventory tightness and oil is pushing closer to reclaiming the US$90/bbl mark on stronger economic data and cold weather in the northern hemisphere. US gasoline futures are up 9% in a week. Beijing will be growing increasingly uneasy about its burgeoning inflation problem.

The US dollar index fell 0.6% last night to 80.20 reflecting a 0.6% gain in the euro as well as returning risk sentiment. We are still in this strange post-GFC world in which positive economic data means you sell the dollar and invest the funds elsewhere, and global fear means you bail into the reserve currency despite America having more debt than anyone else. Maybe one day that relationship will “normalise”.

The Aussie gained another 0.8 of a cent to US$0.9754 but gold is still betwixt and between, torn between easing debt fears, US dollar movements and inflation expectations. It was off US$3.60 to US$1383.40/oz last night. On the latter point, the US ten-year bond yield closed up 3 basis points to the psychological 3.0% mark.

Oil rose US$1.25 to US$88.00/bbl while lead, tin and zinc were up 2-3% and copper another 0.8%.

The SPI Overnight was up 45 points or 1.0%.

An interesting point to note is that last night Goldman Sachs issued a report in which it upgraded its rating for US banks to Overweight. While brokers shift around ratings all the time, the news provided a big boost for bank stocks given (a) when Goldmans talks you listen and (b) it is the first time since the GFC Goldmans has made such an upgrade to the banks. Stronger economic growth, higher equity prices and a supportive interest rate environment (steep positive yield curve) were cited as the catalysts.

It was global manufacturing PMI day on Wednesday and today it's global services PMI day. Wall Street gets all excited about manufacturing but services actually represent about 80% of US output. And it's jobs night tonight. 

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

The Overnight Report: Europe Continues To Founder

By Greg Peel

The Dow closed down 46 points or 0.4% while the S&P lost 0.6% to 1180 and the Nasdaq fell 1%.

The eurozone continued on its slippery slope last night. A meeting of EU finance ministers attempted to water down Germany's insistence on bondholder haircuts after 2013 and in so doing simply introduced further uncertainty. The bail-out fund is looking increasingly inadequate.

We recall that the US Treasury and Fed saved Bear Stearns in 2008 but decided Lehman was one step too far, given Merrill Lynch, Morgan Stanley and ultimately Goldman Sachs were lining up behind it. This proved a mistake, and the TARP was rapidly brought in after the fact.

The EU-IMF have now saved Greece and Ireland and told Portugal it should accept a bail-out before it's too late. But in these three, we're talking small economies. It's a big jump up to Spain, and then a much bigger jump again to Italy. We recall that the G7 is the group of largest industrialised economies. Italy is a member.

The Spanish ten-year bond yield continued to blow-out last night to 5.63%, to be more than 3% above the equivalent German bund (2.68%). Greek and Portuguese (7.15%) bonds are already well above this level. Italian bonds blew out to 4.77% in a worrying sign and even Belgian bonds – Belgium has to date been roped in with Germany and France as a “safe” eurozone economy – have reached 3.97%.

At 4% over German bunds, it is considered the point of no return has been passed. Refinancing of existing budget deficits at that price is so costly that a nation can only continue to go backwards, no matter what austerity measures are put in place. Either a bail-out is required, or bondholders have to take haircuts. The EU seems determined that no defaults or even restructuring will occur, but then the Treasury-Fed had thought it had saved the world by saving Bear Stearns. Once you're on the slippery slope, it's very hard to get off. Only the bravest of the brave would hold eurozone debt in a contrarian risk-trade. It was tried in Russia in 1998, and failed.

How far can EU-IMF bail-outs stretch? And the next question is: how many of the European banks which hold the bulk of eurozone sovereign debt are themselves sufficiently solvent to cope with serious haircuts on their investments, were they to transpire?

In the meantime, Wall Street is quietly beginning to have more faith in gradually improving economic data, albeit what was 2009's “green shoots” looks a bit like 2010's “clutching at straws”. For starters, Wall Street has decided to call Black Friday a “win” on shopper numbers despite the fact actual spending growth was tepid.

Yet last night's Conference Board consumer confidence survey showed a rise to 54.1 from 50.2 in October when 53 was expected. This was seen as great news, despite the fact a truly “confident” result would be in the 90s on this measure. The Chicago purchasing managers' index (PMI) rose to 62.5 from 60.6 in October when 59 was expected. This makes it four out of five wins for the major regional manufacturing indices, suggesting a good result on tonight's national manufacturing PMI.

These positive data releases were nevertheless tempered by the release of the Case-Shiller 20-city house price index, which fell by 0.7% in September. Year-on-year this index is still in the positive, but the September annual rate has slipped to 0.6% from August's 1.7%. The annual index is threatening to slip into the negative. When will Obama reintroduce first home buyer tax credit stimulus?

The supposedly positive data allowed Wall Street to recover from a Europe-led opening, in which the Dow was down 110 points, to a slightly positive Dow movement by lunch time. But as the afternoon wore on, the sellers returned. It was the last day of the month so close-outs may have been a factor.

Another day, another 1% drop in the euro which has now slipped to under US$1.30. The US dollar index rose by 0.6% to 81.31 in response. The Aussie lost another 0.4 of a cent to US$0.9595.

Gold has been a little quiet of late, but it has followed a familiar pattern. Having run hard up to US$1400/oz in a speculative frenzy, the euro-related bounce in the US dollar saw the weak longs bail out in a hurry. This is when true gold believers stand aside, and so we had a rather violent sell-off. Now that that dust has cleared, European concerns are sending the buyers back in despite the strength in the greenback. Gold was up US$18.40 last night to US$1384.80/oz. Silver jumped 3.4%.

For once, the base metal market is trading along true demand-supply lines rather than simple commodity fund speculation. Despite Europe's woes, and despite the stronger US dollar, copper jumped 2% last night as December inventories threaten to be very tight. The other metals rallied in sympathy. Expectations of a solid US manufacturing PMI also helped.

But there are also concerns as to what the equivalent Chinese PMI might be when it's released today. A solid number might be positive, but it also increases the likelihood of another Chinese rate rise. To me this would be a zero-sum net result, but to markets any concept of a Chinese rate rise seems to spark irrational fear.

Lord only knows what's going on in oil at the moment. After Monday's counter-market jump, oil fell US$1.62 to US$84.11/bbl last night.

The US ten-year bond also continues to tick down in yield as money flows out of Europe and into the ironic safe haven, albeit moves have only been modest. The yield fell 2 basis points to 2.81%.

No doubt looking to commodity price increases, the SPI Overnight fell only 2 points.

It's a big day for Australia today with the release of the September quarter GDP. As at yesterday economist consensus had the forecast at 0.4% growth. But there is a bit of a spread.

The Australian manufacturing PMI is also released today, before China, the UK, EU and US follow suit as the earth turns. The other highlight tonight in the US will be the ADP private sector unemployment number for November ahead of Friday's official unemployment data.

Well whaddya know – it's December already.

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

The Overnight Report: Europe De-Rates

By Greg Peel

The Dow closed down 39 points or 0.4% while the S&P fell 0.1% to 1187 and the Nasdaq lost 0.4%.

Disappointment over weaker than expected Black Friday sales in the US gave way to relief when it was revealed internet sales were very robust. These numbers are released on the Monday after the Thanksgiving weekend which is thus known as Cyber Monday. Shares in Amazon, for example, were strong last night, as were shares in Amazon's carrier FedEx.

There was also further good news on the regional manufacturing front, with the Dallas Fed index rising to 16.2 in November from 2.6 in October. We have had strong results from all of Philadelphia, Richmond and Dallas this month with only one shocker in the form of New York State.

Such news meant little on the open of Wall Street, however, when the Dow plunged 162 points. Wall Street was following the European bourses, which saw falls of around 2.5% in each of the UK, France and Germany, and following the flow of funds out of the euro and into the US dollar. More de-risking.

When Greece was saved with an individual EU-IMF bail-out earlier in the year the relief was temporary, but when the EU-IMF subsequently set up an emergency fund of around US$1 trillion to ease concerns of contagion the markets finally managed to recover and retrace to April highs. The intention of the fund was to ensure that no peripheral European country could ever default, albeit the fund's intention was more psychological than practical. The assumption was it would never have to be used because knowing it was there, bond traders would stop selling Euro-debt and allow the struggling PIIGS to refinance at cheaper levels.

Therein lies the problem. It's all well and good for the PIIGS and others (ie UK) to introduce strict austerity measures, budget cuts, tax hikes and so forth, but the reality is each nation still has to roll over its bonds used to finance its budget deficit before such time as that deficit can be reduced to more comfortable levels. If the cost of those bonds rises (credit spreads rise) then the cost of financing the budget becomes prohibitive anyway. A point of no return is passed. (The rule of thumb is a 4% spread over the German bund is that point of no return).

The euro may have rallied strongly in the interim but the reality is the Euro-debt problem never really went away. And so it is that Ireland has now had to be bailed out to the tune of E85bn. One might have thought that the Irish bail-out would once again relieve the markets, but then attention turned to the Iberian peninsula, as Portugal and Spain became again the next ducks to be lined up by the bond markets. We know the EU-IMF emergency fund is still there. What's the problem?

Well for starters, it was hoped the emergency fund would never have to be used but now it has been. And thus the question arises as to whether the fund could go as far as saving the big economy of Spain having bailed out Portugal on the way, with Italy lining up as the next down the track, and the UK hardly out of the woods yet. But the real problem is that Germany has since changed the rules on the fund.

Originally the intention was that the fund would mean, emphatically, that no European country would have to default on its debt. The markets were not so easily convinced by what was effectively spin however, and so bond yields did not return to more comfortable levels. The assumption was that at least someone would need to restructure its debt. And with Germany being the biggest contributor to the fund, meaning effectively the hardworking German taxpayer was bailing out the profligate, tax-avoiding Mediterraneans, Angel Merkel saw the potential for political suicide. And so Merkel has insisted that Germany will play the game until 2013. Thereafter, the bondholders of any European sovereign which is still technically insolvent will simply have to take a “haircut”, as would happen in the commercial world. (Instead of retrieving 100 cents in the dollar on maturity, holders would only see, say, 90 cents or less).

Investment is all about discounted cash flows and risk premiums. Bondholders will not be sitting back with fingers crossed hoping they get past 2013 without incident. They will immediately apply a risk premium to their sovereign bond valuations and thus reduce the value of those bonds on their books. They will de-rate those bonds. The biggest holders of Euro-debt are Euro-banks and insurance companies. They also represent large proportions of stock indices.

So there you have it – Europe is being de-rated. Is this a calamity? Well some people are up in arms – Germans are never popular at the best of times – but realistically one would have to think the end result is a good one – orderly re-pricing with plenty of time to respond. At the end of the day, investing in Euro-debt was not a good decision. Investors who make bad decisions lose money. That's the way the capitalist system works. As long as sudden announcements don't send markets crashing, longer term planning means orderly re-pricing of risk.

What the haircuts mean is that were, say, Portugal to hit 2014 with a big rollover required and a bond spread that would send it broke, it simply rolls to a “cheaper” cost of debt by not paying out all of the 100 cents in the dollar owed. And no one can whinge if it's been coming for three years.

It does not nevertheless detract from the fact that the PIIGS are rolling over debt right now. Last night Italy received lacklustre support for a sovereign auction and Portugal and Spain both have auctions this week. The euro fell another 1.2% last night to just over US$1.31, sending the US dollar index up 0.5% to 80.80. The dollar index was higher earlier, and indeed the Dow recovered from its steep loss to be down only 39 points on the close.

The Aussie was looking at a 95 “handle” as they say, but is back to where it was on Friday night at US$0.9632. Gold was little moved at US$1366.40/oz and base metals were steady enough, albeit lead fell 4% and zinc 2%.

Oil, on the other hand, is currently ignoring the dollar and de-risking and doing its own thing. It jumped US$1.97 to US$85.73/bbl last night on what traders described as technical trading.

The SPI Overnight was up 5 points.

Today in Australia sees private sector credit data, building approvals and a house price index. Once upon a time all of these numbers would have been closely watched by a “finely balanced” RBA – the same RBA that two months ago suggested it couldn't wait forever to see if Europe was going to blow up again. The numbers are now academic as we're unlikely to see another RBA rate rise until perhaps the second half of next year. Tomorrow's third quarter GDP could well be negative. Glenn Stevens is no doubt looking for a big hole he can crawl into.

There are certain truisms in life such as, for example, one should never have that last drink and one should never have just one more run down a ski slope. Another is that a central bank will always make one policy move too far.

Today also sees interim earnings results from Metcash ((MTS)) and Campbell Bros ((CPB)).

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

Little Upside And Mostly Downside For Australian Banks

By Greg Peel

The timing of National Bank's ((NAB)) payment system corruption, the fallout from which is still continuing, could not have come at a worse time. It's hard to imagine a public even more angry at Australia's banks than they already are. But such anger only serves to highlight the dichotomy of opinion in this country between the view of an ignorant (in the true sense of the word) public and the political frenzy being whipped up by ignorant (take that as you see it) politicians in order to leverage off such anger for political gain, and the opinion of those who actually do have an understanding of how commercial banks work. The latter group includes bank analysts, the governor of the Reserve Bank, bank competitor John Symond, and anyone else not beholden to misguided herd mentality.

The political strategy is simple. The only people in Australia now served by the federal government are those in swinging seats, which just so happen to contain a concentration of struggling mortgage holders, and whose views are articulated by small focus groups and interpreted by spin doctors. The rest of the population can pretty much go and get stuffed.

The rest of the population includes anyone with a non-resource-sector related business who is suffering from the RBA's rate rises and government disinterest. It includes the growing number of Australians who rely on investment in bank deposits – the other side of the ledger – who benefit from rate rises and also from aggressive bank competition in this space. A great number of this group are self-funded retirees who are saving the government pension costs as Australia's population ages. And it also includes bank shareholders. And bank shareholders include everyone with a superannuation scheme, that is, most of Australia.

RBA governor Glenn Stevens alluded to the latter group in his regular testimony to the House of Representatives committee last week when he suggested that one “need be careful not to forget the capital that is invested in these institutions”. Stevens came out in defence of bank profits, which he suggested were a much safer proposition than lack of bank profits. He also stated the obvious on the competition issue in suggesting “Competition that pushes down lending standards, ends up lending money to people who really shouldn't get it, that's not a good thing”.

John Symond founded Aussie Home Loans in the nineties with the specific agenda of offering competition to the entrenched “four pillars” on mortgage rates. He should thus be a champion of the current bank bashing and competition drive, yet on Sky Business last week he defended the banks' out-of-cycle rate rises.

There is a current obsession with what is perceived as collusion from the banks on mortgage pricing, thus suggesting a lack of competition. Yet one of the biggest problems facing the banks over the past year and into next year is the aggressive level of competition between each which has pushed up deposit rates and thus pushed down margins at a time when offshore funding costs are still on the rise. There is also anger over a perceived exploitation by the banks of the government's deposit guarantees, to the point of which the cost to banks of such guarantees is now under review.

As misguided as the likes of Wayne Swan, Joe Hockey and Bob Brown (the Greens shadow minister for everything) are on the role of publicly-listed commercial banks in a capitalist society, the bottom line is any reviews and resultant regulatory changes are certainly not going to be to the banks favour.

And then there's the potential for some mandated increase in competition, perhaps with some form of subsidy. Competition is indeed healthy in any market – that's why we have four major banks and a plethora of smaller institutions while the government endorses a supermarket duopoly and protects a single international carrier, among other inconsistencies of policy. But while some competition is healthy, too much unfettered and subsidised competition is dangerous, as Stevens has pointed out. To support this argument I need only say the words “US subprime crisis”.

JP Morgan's bank analysts currently see the Big Four as “stumbling along a corridor of uncertainty”, which is constrained by ongoing tightness in funding, regulatory uncertainty surrounding how APRA will interpret the Basel III liquidity requirements, and “political risk in the shape of the federal government considering the deployment of 'social capital'”. The “corridor” manifests itself as a relatively tight share price trading range between yield support at the bottom end and lack of earnings growth potential at the top end.

To the disappointment of the banks, another government institution in the form of the Australian Prudential Regulatory Authority is threatening to throw a spanner in the works in an ill-conceived policy move. Australian banks are all comfortably capitalised under the new Basel III international requirements, but Basel III also requires newly tightened liquidity ratios. Capital may bolster a bank against a financial market crisis, but when backs are against the wall only the rapid conversion of liquid investments into necessary daily funding can prevent an insolvency crisis, particularly when counterparties run away in fear as was the case in the GFC.

The preferred “liquid” asset is government bonds, so realistically Basel III is saying that all banks must hold certain level of government bonds on their balance sheets. This is okay for banks in those countries which are so heavily in debt there are vast amounts of government bonds on issue, such as the US and Europe, but problematic for banks in a country where a comparative lack of debt means a lack of government bonds. Ironic really.

Yet Basel III is not inflexible, such that concessions can be made under such circumstances. The RBA is fully supportive of certain exemptions to be made for Australia's banks. Yet APRA is not. APRA wants to “harmonise” Australia's liquidity rules with those of the rest of the world – the rest of the effectively bankrupt world. This can only suggest some new cost Australia's banks will have to bear.

It's probably a good time to remember that people who work at government bodies related to financial markets are usually those who weren't smart enough to be accepted for positions at private sector financial institutions.

JP Morgan notes that the recent out-of-cycle rate rises from banks have at least restored the potential for a recovery in banks' return on equity, which would otherwise still be negative had such increases not been implemented. But that potential is somewhat snuffed out by a lack of earnings upside.

Deutsche Bank's analysts are happy to declare the Australian banking sector as “competitive” despite government attacks. Competition for deposits and the recent removal of a number of fee categories drives such a view. Deutsche agrees with JP Morgan that government interference is likely to impact on future bank earnings. BA-Merrill Lynch is concerned the banks will be unable to accommodate lower revenue growth ahead, and “threats from disintermediation [corporates looking to issue bonds to the investment market rather than borrow from banks], Basel III [or APRA], foreign banks [competition] and government interference”. Merrills warns bank earnings multiples could de-rate further despite Australia's listed banks being “not expensive” at this time.

Macquarie has thrown another consideration into the mix, that of the government's deposit guarantees, or deposit insurance scheme as it is known. Were this to be overhauled into a bank-funded, risk-adjusted scheme it would “represent another 'hit' to bank earnings,” Macquarie notes.

With all of the above going on, one would be forgiven for assuming Australia's banks are so rich in profits and their prospects so assured for even greater profits in a booming Australian economy that it makes sense a government would wish to review the means by which those banks are making so, so much money. Unfortunately, all the Australian public and their political representatives have been able to latch onto are the big jumps in percentage terms in bank profits in FY10 from FY09, and the thus “offensive” mortgage rate hikes which followed.

Never mind that the percentage gains were in comparison to the depths of the GFC within FY09, and that much of the reported profit has come from bringing back provisions against bad loans rather than from raping and pillaging an Australian public. Indeed, nothing could be further from the truth.

Morgan Stanley's bank analysts don't expect FY11 to look any better for the banks than FY10. The second half of FY10 featured slowing home loan growth, margins still in decline despite asset re-pricing due to increasing funding cost, a reduction in bank treasury department profits now that markets have quietened down since the volatile GFC period, reduced fees due to public outcry, and increasing business expenses which include ongoing technology overhauls.

Not specifically mentioned is credit demand in the business sector. The rate of decline is such demand may now be slowing, but the reality is business credit demand is still in decline despite the GFC now being over two years old and Australia's economy never officially falling into recession. Bank analysts have been continually forced to push out the timing of the expected eventual recovery in such demand.

And such a recovery rather hinges on Australia's supposedly “booming” economy. It is at this point one is reminded that Australian banks have little business dealings with the risky mining sector.

The only offset to earnings weakness ahead in FY11, other than the mortgage rate rises, is the potential to continue to bring back earlier bad debt provisions into the earnings line. But even that source of earnings is now struggling.

In short, the bulk of the true “emergency” provisions, or provisions against whatever calamitous disaster may still be around the corner for the global financial markets, is now back on balance sheets. What is left is largely the sort of provisions against bad debts a bank would normally hold anyway. And returning to the reality of still-falling business credit demand, it's no stretch of logic to assume Australian businesses are not growing earnings either on a net basis. And that means greater risk of loan default.

In other words, as the RBA hikes rates while the non-resource sectors of the economy struggle in the face of falling revenues, bad debts are at risk of growing from here, not reducing further.

Morgan Stanley expects no more than “flat” earnings growth for the banks in FY11 outside of whatever happens to provisions.

Last week the banks underperformed in a weak stock market, or outperformed on the downside of you will. Driving bank underperformance at present is not simply all of the above, but more immediately the ongoing blow-out in European sovereign debt spreads which flow through to the funding costs of every bank on the planet. In the current global situation, all these Australian domestic and government-related problems may yet prove to be no more than background noise.

There is at least some flipside. With Australia's big banks offering earnings risk, Macquarie believes Bank of Queensland ((BOQ)) is in a good position to benefit from any government pro-competition initiatives and has thus promoted the stock to its list of “marquee ideas”, which is a list of those stocks with “conviction” Outperform ratings.

article 3 months old

The Monday Report

By Greg Peel

Americans crammed the stores on Black Friday for the day-after-Thanksgiving Christmas shopping frenzy. Retailers reported sizeable crowds and there was hope in the air. But when the tills were counted at the end of the day it was clear shoppers were discerning and reluctant to overspend. Crowd figures saw a 2.2% increase but sales figures came in at only a 0.3% increase on the same day last year. In the abbreviated Wall Street session on Friday however, only the positive crowd figures were available.

While Americans shopped, the EU nations worked on the deal which ultimately saw an Irish bail-out figure of E85 billion agreed upon. The rate of 5.8% is well below what Ireland would have to pay under current market pricing and E35bn of the figure will be directed towards propping up Ireland's failed banks. The other E50bn will be kept on hand for public finances, but will be supplemented by the austerity contribution of the Irish people to the tune of E5,000 each via taxes and other measures. The mood on the streets of Dublin is one of extreme anger and bitterness.

The rest of the world has turned its attention back to the continent now that Ireland's bail-out is bedded down. News came through on Friday that while the EU was meeting to work out the Irish solution, the suggestion was made to Portugal that it, too, should accept a hand-out now rather than wait until its debt situation deteriorates. The bond market has been hammering Portuguese debt, meaning refinancing at such levels is a death warrant anyway. But the market has also been hammering Spanish debt, and that is the real concern. Spain's economy is much, much bigger than those of Ireland, Portugal or Greece. Unfortunately the Spanish prime minister fell into the same old foolish trap on Friday and suggested there was “absolutely no chance” Spain would need to seek an EU bail-out. Such comments usually signal the final step towards bail-out, as the Irish prime minister would attest.

The European goings on were enough to further spook Wall Street on Friday at a time when it looked like Black Friday might be a success. Further artillery fire from North Korea only added to the stress. South Koreans are angry at its government's discretion in response, outside of the potentially provocative war games being played with the US military, and as such South Korea's defence minister has resigned. That's not helpful at a time of extreme tension. Seoul sits right up near the Korean border.

By the early NYSE close of 1pm, the Dow had fallen 95 points or 0.9% while the S&P lost 0.8% to 1189.

Money continues to flow out of the euro and into the US dollar, and risk trades are also being unwound to send funds back to the reserve currency. The US dollar index rose 0.9% to 80.38 and the Aussie fell close to another two cents to US$0.9633. The US ten-year bond yield fell 4 basis points to 2.87%.

The strength of risk trade unwinding was evident in another fall in gold, by US$10.90 to US$1364.20/oz, at a time when one might expect gold to be well supported. It is simply a crowded trade.

Commodities were also trimmed on the US dollar's rise, with base metals falling around 1% (zinc 3%) and oil dropping US10c to US$83.76/bbl in light trade.

The SPI Overnight fell 21 points or 0.5%.

It's a solid week this week for US economic data beginning with the Dallas Fed manufacturing index tonight. Tuesday sees the Chicago purchasing managers' index, the Conference Board consumer confidence survey and the Case-Shiller house price index, and Wednesday construction spending, vehicle sales, and productivity. The Fed will also release its Beige Book on Wednesday and the ADP private sector unemployment data for November will be released, along with the November manufacturing PMI as part of global PMI day.

Thursday is pending home sales and same-store sales while Friday is global services PMI day along with factory orders and the November non-farm payrolls data.

All Of Australia, China, the UK, EU and US report manufacturing PMIs on Wednesday and service sector PMIs on Friday.

It's an important week for Australia, the highlight of which will be the third quarter GDP release on Wednesday. Economists trimmed their GDP forecasts last week on the back of third quarter construction and capex data, and today we see third quarter corporate profits and inventories data. Consensus at present is sitting around the 0.2% growth mark, but watch this space.

Today also brings new home sales, Tuesday building approvals, private sector credit (very important for the RBA) and the RP Data-Rismark house price index, and Wednesday the manufacturing PMI. Thursday it's retail sales and the trade balance, and Friday the services PMI.

Today and tomorrow are the last two big days of the AGM season before December all but shuts the door, although there are a couple of pesky stragglers who meet in December.

The local market already has a weak lead for today but fortunes won't be helped by yet another Qantas ((QAN)) aircraft technical problem on the weekend and the lingering transaction problems for National Bank ((NAB)) which sounds like it might prove rather costly.

Rudi's Lunch Money appearance on Sky Business this week will be on the Thursday at 12 noon.

For further global economic release dates and local company events please refer to the FNArena Calendar.

article 3 months old

All This And QE2

By Greg Peel

Last week legendary US investor Warren Buffett wrote an op-ed piece published in the New York Times which took the form of a letter, beginning “Dear Uncle Sam...”.

In it Buffett ostensibly declared his support for “Uncle Sam” in the form of the unmentioned two GFC-stricken administrations and the US Federal Reserve and their actions in coping with the crisis both then and now. It concludes:

“So...Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through – and the world would look far different now if you had not.”

It was signed “your grateful nephew, Warren”. Clearly it was timed to rebuff growing criticism of Ben Bernanke and QE2. Bernanke himself had already written his own published piece in which he explained to a doubtful public just what the intentions of QE2 were and why the policy was necessary.

The letter has since meant the loss of Buffett's reputation and guru status in the eyes of many once fawning Wall Street observers. Aside from the financial advantages Buffett gleaned from the TARP and QE1, including protection of the big stake he took, pre-bail-out, in Goldman Sachs and the significant positions he held in Wells Fargo and Moody's, many critics are fuming at the implicit support of governments and Fed boards past and present. They see it very differently, and one Barry Ritholtz penned in response what he suggested was the same letter Buffett might have written had he first been given truth serum. It begins, “Dear Uncle Sucker...”.

The letter goes on to list all the events in the lead-up period which all were contributors to what became an inevitable GFC.

In 1999 there was the repeal of the Glass-Steagall Act, that which had ensured separation of commercial and investment banking and prevented the '87 Crash impacting on Main Street. From 1997 the credit agencies were allowed to change their business model from “investor pays” to “underwriter pays” which led to AAA ratings being for sale. In 2000 an act was passed to allow an over-the-counter derivatives market to develop outside CFTC jurisdiction, which ultimately gave us unlisted CDOs and CDSs.

Following 2001, then Fed chairman Alan Greenspan dropped the funds rate to 1% which ensured a housing bubble. In the decade to 2007, the Fed ignored its monitoring powers of mortgage credit-worthiness. And in 2004, the SEC waived the earlier twelve-to-one leverage limit on investment banks and allowed ratios of up to forty-to-one.

Ritholtz calls it ironic that the last amendment was actually called “the Bear Stearns exemption”. Perhaps equally ironic was that the staunchest lobbyist for the change was then Goldman Sachs CEO Hank Paulson, who has admitted that four years later saw him reduced to praying for guidance on the weekend of the Lehman collapse in his new role as Treasury Secretary.

Ritholtz suggests that Bernanke had the opportunity to right the regulatory wrongs and commensurately punish those executives who had brought their once great institutions to bankruptcy, but instead he saved the institutions and secured the offensive bonuses of said executives. And now here he is, effectively doing it all again.

An oft asked question asked among those less close to the action is: if QE1 hasn't made any difference to housing and unemployment and economic growth, why would QE2? The answer, according to many bloggers, is that QE has nothing to do with inflation mandates and employment targets and the like, but everything to do with what the Fed's role really is, and always has been, that of supporting the US banks.

Writing for Forbes, Richard Lehmann suggests that the Fed – which is a private company and not some independent government legislated body - “is owned by the banks and is run, first and foremost, in their interest”. It was the Administration which introduced the TARP to prevent immediate financial collapse, but it was the Fed who provided the longer term solution, which was to rebuild the banks' capital bases and provide earnings opportunities to offset the unrealised losses on mortgage securities.

By dropping the Fed funds rate to zero, Bernanke ensured that the banks could borrow for nothing and invest in longer-dated Treasuries at 3-4% which, when leveraged several times, could mean a risk-free 20-30% rate of return. The problem for Bernanke in his supposed role of keeper of the wider economy is that the banks chose only to profit from these “carry trades” and did not on-lend any money into the corporate sector where jobs could be created.

Zero interest rates were not enough, and by March last year the only possible solution the Fed had up its sleeve was to effectively drop rates into the negative by printing money, which became the couple of trillion dollars worth of QE1.

Yet still the banks would not lend to corporates, despite the recovery of their share prices in the rally of 2009 which allowed them to raise fresh capital. Given the rally basically began with QE1, that fresh capital could be construed as indirectly representing a hand-out from the Fed.

It was expected that the unemployment problem would still take a while to peak given its lagging nature but with the help of fiscal stimulus, the housing market soon appeared to be dragging itself out of the depths. However, the expiry of that stimulus earlier this year showed the policy up to be no more than smoke and mirrors. Recent data suggest the US property market is once again facing a downward spiral. If that is the case, the hope the US banks might have had that their “toxic” assets could still come good at maturity will evaporate and we still haven't seen the much feared commercial property collapse that most had assumed was a given post-GFC.

The Wall Street Journal's Andy Kessler made note in an article last week of the significance of the recent “take-under” of construction loan purveyor Wilmington Trust. “Take-under” is just a mocked-up expression used when a company is taken over in the usual sense but at a discount to its share price value rather than a premium as is usually the case. A standard takeover requires a 30% control premium as a rule, but Wilmington was sold at a 40% discount. The agreed price suggests that those inside the firm had a much graver view of the world than the stock market.

Bank analysts, including those in Australia, have been forced to look more closely at “book value” as a measure of listed bank valuation since the GFC than the typical measures of PE multiples and total shareholder return projections. Book value ascribes no sentiment factor or even earnings projections but is simply the market value of a bank's assets minus the market value of its liabilities. Bank of America's balance sheet has most recently claimed a book value of US$230m yet its current stock price (as at last week) implies a value for the business of only US$118m, notes Andy Kessler.

Who's right? The suggestion here is that the market believes BofA, and the same is true for the others, is denying the true market value of the assets on its books just as all US institutions still had toxic CDOs on their balance sheets at 70c in the dollar in 2008 when they were realistically devoid of any buyer.

Were the US property market to truly enter another downward spiral, Kessler suggests, then down would go the banks once more as well. With QE2, Bernanke might be claiming that “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” as he said in his own op-ed piece in the Washington Post, but Kessler believes that with QE2 Bernanke is simply buying the banks more time.

“In 2009,” notes Kessler, “even with TARP money injected directly into their balance sheets, banks faced a [US]$75bn capital shortfall. Mr Bernanke orchestrated a stock market rally so they could sell equity for much needed capital”.

Bernanke must nevertheless know that the Japanese have been trying to influence their own stock market for 20 years with little effect on the economy, says Kessler, and that QE tactics cannot be about forcing a dollar devaluation, as many claim, given history has shown such ploys have tended to destroy more jobs than they create.

It is this perceived US dollar devaluation, otherwise known as currency manipulation, that has the rest of the world in a lather. Japan is only one nation among many which has had to intervene to prevent the destructive revaluation of its own currency as the inverse of dollar weakness. There is only one collective import market on the planet and the exporter with the greatest currency advantage will be the winner. Every time one nation shifts on the see-saw through artificial policy, those on the other side of the see-saw have to shift the other way to prevent a tumble.

The US has been desperately trying to focus world attention on China as the villain. But the US has almost ingenuously found this policy to have backfired. Sure – China needs to revalue its own currency sooner rather than later to restore a global balance, but to arrogantly introduce yet another round of money printing on the one hand and then make heated accusations on the other that China is indeed the “manipulator” is sheer folly. The rest of the world is simply not that stupid and while not necessarily flag-wavers for Communist China, the rest of the world is pretty sick and tired of America and its arrogance in the face of a financial crisis which it clearly started. (Not that all else are blameless).

And so we now have a Currency War, despite the concept being nervously laughed off by Western leaders. Last week The Fundamental View picked up on a memo to clients from Mark Lapolla, global investment strategist at US-based Knight Capital. Knight Capital, notes TFV, executes more trades than any other US firm. The core of Lapolla's argument is simple, TFV suggests: “The world is done playing fair with each other. Government policy, economic security and resources, the tents of global trade, are all in a fragile state.

Lapolla wrote:

“The game is over…We expect a shockingly powerful rally in the dollar, broad-based weakness across the commodity sector, a dramatic widening of emerging market credit spreads, and what could prove to be a stampede of hot fund flows out of the emerging markets.

“We believe the data and government actions out of China, the back-up in US interest rates, the Fed’s emphatic commitment to QE2, intensifying pressures across the EU, broadly rising commodity prices, government efforts to control hot money flows, have finally pushed the global terms of trade to their tipping point.

“We appreciate both the gravity and the brevity of this note; but then again, the story is simple.”

It is little wonder that, aside from the new Troubles in Ireland and ongoing angst over Chinese interest rates, arguments over QE2 are currently making Wall Street and thus the world a lot more nervous than they are meant to be given QE2's direct intention.

All the while, nevertheless, in contemplating the “moral hazard” of TARPs and QE policies and emergency bail-outs, many still ponder what might have otherwise been had the free market been left to take its natural course. Maybe we're still yet to find out.

article 3 months old

‘No Problem’

By Tim Price

"..Brian Lenihan, Ireland's finance minister, told Irish radio early on Wednesday the banks had "no funding difficulties."
- The Financial Times, November 18 2010.

The rule of thumb during a banking crisis: trust no-one, least of all the politicians. Peripheral Europe's banks and its governments are now caught like Macbeth's "two spent swimmers that do cling together / And choke their art". Ireland's banking system and its sovereign creditworthiness are now effectively one and the same fragile thing. A comparison with US banks and their Latin American debt adventuring in 1982 is instructive. As Nassim Taleb put it in "The Black Swan":

"In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking – everything."

Richard Koo, the Chief Economist of the Nomura Research Institute and author of "The Holy Grail of Macroeconomics: lessons from Japan's Great Recession" tells it with extraordinary candour at the Centre for Strategic & International Studies website. The presentation gets particularly fruity after roughly 31 minutes. Koo recounts his experience as a syndicated loan desk officer at the New York Fed. Late on a Friday afternoon in August 1982, his job and that of his colleagues was to try and convince the rest of the world, and notably other central banks, that the US banking system was solvent when it was not.

The following is taken verbatim from this presentation:

"That was about the worst possible banking crisis in modern US history. [Plus ça change..] Our conclusion was that seven out of eight US money centre banks were actually underwater.. It was so bad because everyone down from Mexico to the southern tip of Chile went bankrupt [or defaulted].. Paul Volcker, the chairman of the Fed, called central banks and ministries of finance all around the world on that critical Friday in August 1982.. Later a Bank of Japan official who took that telephone call from Paul Volcker told me the exact words he used. He said:

"You better give me Governor Maekawa right away. If you don't give me Governor Maekawa there might not be any US banks left on Monday."

"What we at the New York Fed had to do was arrange for all the foreign banks to keep credit lines open to the American banks, knowing fully well that all these American banks were actually bankrupt. And we also could not tell the outside world about the situation because if you go out and say "American banks are bankrupt" – the next day they will be bankrupt. And so we had to come up with these stories that "well, there are some Latin American problems, but they're all good debt, not bad debt," and we had to lengthen the clean-up process; it was a very difficult period for US central bankers and bank regulators in general.. So by keeping this myth going, that everything is fine.. we had to do that for a very long time.. the whole process took about 13 years.."

The credit bubble was a long time inflating, so it will doubtless take a long time to properly deflate. Meanwhile we get the surreal experience of one of the most indebted countries in the world – the UK – considering lending billions of pounds to help its heavily indebted Irish neighbour. Hinde Capital shows the extent of our own folly, with the UK suffering from a debt problem "much worse than the US'. We are the most leveraged country in the world per capita":

Since we're deploying graphics, the following table (Morgan Stanley via FT Alphaville) shows the ugly "secret" behind whatever bailout Ireland will ultimately get – in that it will actually constitute a stealth loan designed to keep imprudent lenders like France's Credit Agricole, Belgium's Dexia and, with tiresome inevitability, the UK's RBS afloat.

In a narrow sense we are living through a protracted banking crisis. But in a much broader sense the crisis is political – not least as any nominal distinctions between central banks and national treasuries are fast eroding, and because at this scale, banks that are too-big-to-fail now represent what is effectively sovereign – because sovereign underwritten – risk. The crisis is also political because the workings of a free market have been trampled by political actors desperate to keep the show on the road; it's not their money they're casually recycling through an insolvent system.

Ignoring for a moment any value judgment as to whether perhaps a sizeable number of the "have-nots" got that way through their own greed and stupidity, in the words of WH Hutt in "Politically Impossible" (hat-tip to Sean Corrigan and Jonathan Escott):

"The efforts at power-acquisition by politicians who promise exploitation of the "haves" are facilitated by the patent sincerity of a mass of disinterested supporters. But their campaigns are universally accompanied by grotesque factual distortion, reliance on the ignorance and indoctrination of those led and (in the USA, at least) the deliberate engendering of envy and violent feelings. Their appeals are basically effective, however, because, in the short run, it is obviously possible for some "have-nots" to benefit through expropriation of the "haves" via income transfers. And relatively few among the classes believed to benefit are much concerned with the long run, while the consequences are not apparent to the generous-hearted acquiescent citizens who are not beneficiaries. Under universal suffrage, if the improvident are in the majority, or if they constitute a determining "swing vote", they are in the position ultimately to pauperize a nation as long as politicians can rise to wealth and power through outbidding one another in generosity at the taxpayers' expense."

We get no particular pleasure from discussing politics when we could otherwise be profitably discussing "pure" investment. But the investment problems of today are precisely political ones, which is one reason why they've become so intractable. One could plausibly argue that democracy sows the seeds of its own destruction when it allows swathes of the electorate to vote for their own enrichment, leading politicians to indulge in a race to the bottom, in fiscal terms, that can ultimately only lead to ever-increasing monetary inflation and currency debauchery en route to sovereign bankruptcy. In both asset and currency terms, the only practical solution to the current mass insanity and denial on the part of western politicians is to entrust one's monies to those regimes and territories that still practice some form of fiscal discipline. Gold and silver, of course, as the ultimate expression of the stateless asset, are beholden to no politician or arbitrary law.

Tim Price
Director of Investment
PFP Wealth Management
22nd November 2010.

Email: tim.price@pfpg.co.uk Weblog: http://thepriceofeverything.typepad.com
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The views expressed are the author's, not FNArena's (see our disclaimer).

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