Written on May 27, 2010
Here is Michael Cembalest's latest Eye on the Market.
Hope you find it useful.
Leon
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Eye on the Market, May 25, 2010 (the attached PDF of this email is easier to read)
Topics: Portfolios, gold, the Euro, financial sector reform, Odds and Ends, and New York's fouled nest
As described last week, 3 forces have thrown global equity markets into reverse: withdrawal of Chinese monetary stimulus, US and Euro-zone financial sector reform, and austerity brought on by the unraveling of the EMU periphery.
We entered 2010 with the view that the easy returns of 2009 were a thing of the past, and that portfolios would need to be positioned for a lot more uncertainty in a post-stimulus world. With global equity markets down 8% this year (MSCI World), I wanted to review some decisions taken in our Balanced Portfolios in late 2009 that we believe may help navigate through some of this. Time will tell if the steps described below prove to be sufficiently effective in doing so.
* Despite multi-decade highs in manufacturing, earnings, margins and positive earnings revisions coming into 2010, we kept our equity weights in check, from 35%-40% of portfolio assets. We have no plans to change these levels, given our regional preference for the U.S., where recent data suggest that the recovery is still broadly on track, highlighted by today's durable goods report
* The regional overweight to U.S. large and mid cap is offset by underweight positions in Europe. We also trimmed positions in Asia last year given our concerns about inflation risks and skyrocketing property prices. It looks like China is succeeding in cooling things down; property sales may fall by 50%, and prices are off by 25% in some areas of Beijing.
* Subsets of our equity positions, particularly in European markets, include some downside protection and hedge away exposure to the Euro. Our active equity managers are generally underweight Europe vs. the rest of the world, over-weight Germany within Europe, and underweight European financials. US equities have outperformed Europe by 15% YTD.
* We have a large allocation to hedge funds (17%-22%, depending on region). As of late May, while global equities are in negative territory, we estimate that our aggregate hedge fund exposures have generated modest positive returns. Compared to equities, we use HF to reduce rather than add risk; most of our equity long-short funds have net exposure between 0% and 40%.
* Credit continues to benefit portfolios; our allocations to high yield, leveraged loans and highly-rated commercial / residential real estate securities have generated positive returns this year
* Missed opportunities this year: not enough gold or long-duration Treasuries. As for the latter, our concern about deficits and potential changes in Chinese demand kept us from moving too far out the yield curve. As for the former, the G3 appears to be suffering more from deflation than inflation, and deflation is usually not a great backdrop for gold. Gold enthusiasts point to the ratio of the value of US gold relative to the US monetary base (~15%) as being close to its lowest level in 40 years, despite gold at ~$1200/oz. So the gold outlook from here depends on whether the Fed decides to inflate away the public debt.
Might the U.S. opt to inflate away its public debt? It won’t be easy. In the post-war era (1946), inflation was low and debt was high (108% of GDP). After a decade of 4.4% inflation, US debt/GDP fell to 58%. But…the average maturity of the public debt was longer then (9 yrs vs. 4.3 yrs today), and held 100% domestically (a). The economic and geopolitical consequences of such a strategy today are scarier to contemplate (see comments below on North Korea). We expect the Fed to rein the monetary base back in when the time comes to do so; Federal Reserve Bank of St. Louis President Bullard stated yesterday that the Fed’s balance sheet could take around 5 years to get back to normal. We recommend selling gold at modestly higher values than today’s.
EURashomon: what is the “right” value for the Euro?
It depends upon whose vantage point you are looking from (b). Using data on regional and external trade, current account deficits and sensitivity to changing FX rates, we derived the following: at what level of the Euro could each country’s external imbalances be resolved without having to resort to deflation? (c) The good news for Italy and France: not that far from where the Euro is already. But for Spain, Greece and Portugal, it’s a long way before a weaker Euro could carry the burden (for Spain, the Euro would have to fall to $0.60/EUR). German inflation concerns would render such Euro levels implausible; note that the ECB may have already intervened to support the Euro (not for economic reasons, but for confidence/political ones). While this is a stylized and assumption-heavy analysis, the results reinforce our concern that austerity will have to carry the load in many countries, even should the Euro fall to parity with the US$. For a region with high levels of sovereign, household and corporate debt, austerity is a difficult policy prescription.
In former EU Commission President Prodi’s May 20 article in the FT, he concedes that designers of the Euro knew there would be a crisis (confirmed by the chart on divergent current accounts), and that this should be seized upon: “Elections in North Rhine-Westphalia delayed the realization that the Greek crisis presented an opportunity to take the inevitable steps towards economic governance that were not possible when the euro was created.” He then raises the stakes: “The only alternative to greater co-ordination of economic policies is dissolution of the euro”.
Statements like these convey the risks involved with a crisis-prompted move towards Federalism. While it may work, it is not good for risk-taking while it’s happening. One measure of European capital markets and merger activity is down 17% YTD, and up elsewhere (US +53%, Asia +68%). Europe’s Revolution from Above may fail; asset prices will have to get cheaper for us to shift back to Europe.
On reason and reform
The financial reform bills are in part a consequence of the extraordinary levels of support that the banking sector received from the Treasury and the Federal Reserve. Our Chairman has stated repeatedly that the era of bailouts must end, and that a reform bill should accomplish (among other things) the following as soon as possible:
* end the concept of “too big to fail”
* create a systemic regulator to oversee risks in both banks and non-banks which create and extend credit
* ensure that originators and distributors of securitized products have some skin in the game
* provide greater oversight of derivatives
These EoTM Notes have detailed some of the misdeeds, misjudgments and mismanagement of the financial sector for 5+ years. But on regulation and reform, how far is too far? I read that former Fed Chair Paul Volcker is against Section 716 (d), which could force dealers to move swaps activity from the bank level (e.g., under the supervision of bank regulators) into a holding company or other subsidiary. Volcker believes it should remain at the bank level, and that it would be counter-productive to change that; opponents disagree with him. Regardless of the merits of the arguments in play, there’s an interesting subtext here: one of the voices that stoked the fires of reform is finding that it’s not that easy to put out (just ask Georges Danton). In addition to the 1,500 page bill passed by the Senate, the reform agenda has taken root at the state level as well. In the New York State legislature (see "Das Eigene Nest Beschmutzen", below), there are no fewer than 94 bills that tax, restrict, penalize or regulate the financial sector. There is a point of diminishing economic returns to regulation, but it is unclear who would volunteer to define it.
During Congressional discussions, little mention was made about the tumbling estimated costs of the TARP, that the Fed’s Maiden Lane facilities are in the black (even with AIG and Bear Stearns factored in), or that Fed credit facilities have been almost entirely repaid (see charts below). It could be that it was not politically expedient to do so. For comparison’s sake, I included estimates on possible losses from the GSEs (Fannie Mae and Freddie Mac), which have prompted much less Congressional debate and introspection, and which have not declined much over time.
DAS EIGENE NEST BESCHMUTZEN
The Public Policy Institute of New York released a paper entitled "Derailing New York's Economic Engine: How Albany Punishes New York's Largest Industry". They could’ve used the German saying above as its title as well; it means “To Soil One’s Own Nest”. Their findings:
* Senators, Governors, Congressmen and State Legislators in states dominated by auto, oil, agriculture, agri-fuel and technology sectors vigorously protect their largest industries; in this regard, New York’s politicians are the exception
* There are 94 bills before the New York State Legislature that add punitive taxes, restrict business operations or are otherwise designed to curtail financial services; the total cost could be as high as $12 bn per year on the industry
* Using BEA multipliers, the financial services sector accounts for $187 bn of New York's $318 bn economy
* Using the same multipliers, 39% of wage income in New York is derived from financial services; this is similar to the 40% of personal income taxes paid by financial sector employees, as per the New York Assembly Ways and Means Committee
* This is taking place at a time of rapid technological advances in networking and telecommuting which reduces the need for the industry to be as geographically concentrated as it has been
* Adverse impacts on the financial services industry will make it harder for New York to reconcile its spending binge, which has left it only behind New Jersey as the state with the highest per capita state debt. From 1999-2010, New York spending grew 20% faster than personal income and 30% faster than inflation (driven in part by rising public sector employment/wage growth)
Odds and Ends
* S&P’s apparent go-slow approach in response to the Financial Sector Reform Bill reduces some of the risks to money markets and the triparty repo system of potential downgrades to firms like Citi, Bank of America and Wells Fargo
* There was some excitement yesterday that the Fed might consider lowering the cost of dollars it lends to European banks via the ECB, to prevent Libor from rising. But what fragile a world it must be for the markets to consider the Fed’s rate of 1.22% “too expensive” (roughly Libor + 70 bps), particularly since the supply of funds at that rate is unlimited. The WSJ reported today that BBVA has been unable to renew $1bn in commercial paper; perhaps they will be next in line at the Fed.
* Korea now trades at a forward P/E multiple below 10x. Assuming conflict is avoided, it may be an attractive entry point.
* At what point might China’s holdings of $800 bn in Treasuries impact the way the US handles the situation in North Korea? Major Generals at China's National Defense University and Academy of Military Sciences have recommended that China use this lever in the furtherance of its broader policy objectives. This is the face of geopolitics in the 21st century.
Michael Cembalest
Chief Investment Officer
J.P. Morgan Private Banking
Notes:
(a) Post-war data from “Using Inflation to Erode the Public Debt”, November 2009, Aizenmann and Marion, Dartmouth & UCSC.
(b) Rashomon, a film by Akiro Kurosawa in which a violent crime is re-enacted from the vantage points of four different witnesses.
(c) Computations using December 2009 data, and applying the methodology found in: “Adjustment in EMU and German Inflation”, Banque AIG Market Research, August 2008.
(d) As per a May 6, 2010 letter to Senator Chris Dodd, with cc to Secretary Geithner and Senators Shelby, Merkley, Levin and Lincoln.
On TARP, GSE and Fed Credit Facility computations
* TARP costs shown excludes $16.7 bn in offsetting gains related to the Capital Purchase Program, Targeted Investment Program and Asset Guarantee Program. Not all GSE losses will require Treasury contributions of capital: some GSE losses will be absorbed by "putbacks" of defective loans to private sector banks, mortgage insurers such as PMI and Radian, and ongoing GSE fee income and loan loss reserves
* Peter Wallison is a former Treasury official and current fellow at the American Enterprise Institute on banking and securities, the co-Chair of the Financial Reform Task Force, and a member of the Financial Crisis Inquiry Commission and the Shadow Financial Regulatory Committee. Laurie Goodman is a former senior economist at the Federal Reserve Bank of New York, author of "The Mortgage Strategist", and current head of research and risk management at Amherst Securities.
* Fed Maiden Lane portfolio holdings are marked by Black Rock on a quarterly basis. Gains in excess of loan principal are derived from net interest payments and revaluations of assets acquired in September 2009. Some gains may be payable to other parties, subject to ultimate recovery levels. Source: Federal Reserve, Haver
* A March 2010 Federal Reserve report indicated that all loans under the TSLF, PDCF, CPFF and AMLF have been repaid in full with interest at no loss to the Federal Reserve. At the time of this report, the Fed did not anticipate any losses under the TALF program.
ECB European Central Bank
EMU European Monetary Union
BEA Bureau of Economic Analysis
TARP Troubled Asset Relief Program
GSE Government Sponsored Enterprise
HAMP Home Affordable Modification Program
CBO Congressional Budget Office
TALF Term Asset Backed Securities Loan Facility
TSLF Term Securities Lending Facility
PDCF Primary Dealer Credit Facility
CPFF Commercial Paper Funding Facility
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