Thursday, August 23, 2012

A Full Circle for the S&P500

The S&P500 has made a full circle since its April 2, 2012 peak. The index closed at 1,419 on that day, but then steadily lost steam as Q1 earnings poured in. Disappointing earnings pressured the index, and by the end of the earnings season, the S&P500 had lost ~10%. The standout performers during downtrun were Telecom Services, Utilities, and Food and Staples Retailing. Not a surprise there.

The S&P500 troughed on June 1, 2012 at 1,278. It was the day May non-farm payroll surprised to the downside by a big chunk (+69K vs +150K consensus and downward revision for the prior months). The S&P500 traded lower the next day but snapped back above the 200-day moving average the day after. Thereafter it grinded higher on combination of favorable comments from the Fed and the ECB members, and on better than expected US macro data. The start of the Q2 earnings season on July 9th meant that investor focus shifted to corporate news from macro headlines. From June 1 to August 21, when the S&P500 touched 4-year high on the intra-day basis (1,426), it gained ~10%. Energy and Tech led the rallies but their outperformance was relatively muted. Telecom Services and Pharma lagged but only slightly.

The bottom line is that the defensive sectors (Telecom Services, Pharma, Food & Staples Retailing and Software and Services) have acted much better both in the downturn as well as the upturn. Cyclical sectors (Autos, Semis and Consumer Durables and Apparel) have fared the worst.

The S&P500 is hitting against important resistance levels. If it were to make a next leg up, I would bet that the cyclicals will have to do the heavy lifting. That means, if you are bullish, buy Semis, Materials, Diversified Financials and Tech Hardware.

Wednesday, August 08, 2012

Fun Stuff - Shhhhh

Earl Long, the colorful late former Governor of Louisiana once offered this advice on Louisiana politics: "Don't write anything you can phone. Don't phone anything you can talk. Don't talk anything you can whisper. Don't whisper anything you can smile. Don't smile anything you can nod. Don't nod anything you can wink."
That advice is equally applicable to Wall Street but with a caveat "Don't e-mail anything, you can write on paper. Don't write anything on paper, you can phone....."  Smile

Source: hereisthecity.com

1. 'You f.cking Americans. Who are you to tell us, the rest of the world, that we’re not going to deal with Iranians'.
In October 2006, the head of the Standard Chartered’s American operations allegedly sent a panicked message to a Group Executive Director in London, saying that the bank’s handling of Iranian clients could cause 'catastrophic reputational damage'. The above is said to be the reply the American got for his troubles.

2. 'Dude. I owe you big time! Come over one day after work and I'm opening a bottle of Bollinger'.
External trader to a Barclays trader who allegedly asked for a low LIBOR submission.

3. 'Just made it to the country of your favourite clients (Belgians)!!! I have managed to sell a few Abacus bonds to widows and orphans that I ran into at the airport, apparently these Belgians love synthetic ABS CDO2!!!!'.
Fabrice Tourre, an Executive Director in Goldman's Structured Products, Group Trading unit, messaging a girlfriend.

4. Many of the 'e-mails they'd like you to forget' were sent by equity analysts. Here are some other gems which appeared in the press a few years back:

'If I so much as hear one more f.....g peep out of them, we will put the proper rating...on the stock'. (Citigroup)

'If you can't say something positive, don't say anything at all'. (CSFB)

'Question 'What's so interesting about GoTo except investment banking fees ?' Answer - 'Nothin'' (Merrill Lynch)

'Triangle is a very important client. We could not go out with a big research call trashing their lead product'. (UBS)

'For the record, I have attempted to downgrade RSL THREE times over the last year but have been held off for banking reasons each time'. (Lehman)

'I can't believe what a POS that thing is. Shame on me/us for giving them any benefit of the doubt'. (Merrill)

While on the subject of stock analysts, it would be remiss not to mention former Citigroup man Jack Grubman. Former New York State Attorney General Eliot Spitzer released 'report cards' on Grubman. These were compiled by some of Citigroup's own brokers and investment bankers.
Here's a selection of what Grubman's colleagues allegedly said about him:

'Not all four letter words are bad ones. Perhaps some of the analysts, like Grubman, should consider this one: SELL'.

'A monkey could pick better stocks than he could'.

'Please do not fire Jack. He is my No.1 indicator - I do exactly what he says not to'.

5. 'Ratings agencies continue to create an even bigger monster - the CDO market. Let's hope we are all retired by the time this house of cards falters'.

'Screwing with criteria to 'get the deal' is putting the entire S&P franchise at risk - it's a bad idea'.

6. Bear hedge fund manager Matthew Tannin sent the e-mail below to his boss, Ralph Cioffi, in April 2007- months before two Bear hedge funds collapsed. Prosecutors used it to bolster their case that the two men had committed fraud.

'The supbrime market looks pretty damn ugly ... If we believe the (report) is ANYWHERE CLOSE to accurate I think we should close the funds now....the reason for this is that if (the report) is correct then the entire subprime market is toast'.

The matter ended up in court, and all over the front pages. In the end, and after a lot of aggro, both fund managers were found not guilty by a New York jury.

Monday, August 06, 2012

Bond King versus Stock Guru

In his monthly Investment Outlook, Mr. Bill Gross, the Bond King had not so nice things to say about Mr. Jeremy Siegel, the Stock Guru. Basically, Gross said Siegel's argument that "Stocks are for the Long Run" does not make economic sense. Both are clearly the leaders in their respective fields and their fiesty debate on CNBC is an interesting side-show.

Cult Figures
  • ​The long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return since 1912. 
  • The legitimate question that market analysts, government forecasters and pension consultants should answer is how that return can be duplicated in the future.
  • Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades.

​The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well. I “tweeted” last month that the souring attitude might be a generational thing: “Boomers can’t take risk. Gen X and Y believe in Facebook but not its stock. Gen Z has no money.” True enough, but my tweetering 95-character message still didn’t answer the question as to where the love or the aspen-like green went, and why it seemed to disappear so quickly. Several generations were weaned and in fact grew wealthier believing that pieces of paper representing “shares” of future profits were something more than a conditional IOU that came with risk. Hadn’t history confirmed it? Jeremy Siegel’s rather ill-timed book affirming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives. Now in 2012, however, an investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously “safer” investment than a diversified portfolio of equities. In turn it would show that higher risk is usually, but not always, rewarded with excess return >>>




Sunday, August 05, 2012

The Story from July Employment Report

Last Friday's July employment report surprised to the upside. The upside came from a robust growth in private payroll. There was some hint of such outcome earlier in the week in the form of the ADP report. But be as it may, markets rallied on the back of this report.

While the report was better than what could have been, some economists raised the issue of"seasonality". July is a tough month for calculating seasonal factor because teachers are off for the summer break and auto workers stay home as plants stay idle. Even ignoring this issue, the report was not great.

Private payroll peaked in January 2008 at 138 million and troughed in February 2010 at 129 million. The latest release showed 133 million workers suggesting 130K a month job growth since the bottom. At this growth rate, job level will not reach January 2008 peak until early 2015.  
We calculate monthly job growth required to get unemployment rate back to 6% by January 2015 on different population growth and participation rate assumptions. The bottom-line is that 160K is the minimum required.
From January 2008 to February 2010, 8.7 million jobs were lost. Since February 2010, 4 million jobs have been re-gained, meaning there are still 4.7 million jobs missing. Those 4.7 million jobs still missing are in manufacturing, construction and retail trade.

Other interesting facts from the report,
(1) since February 2010, 230K teachers have lost their jobs
(2) manufacturing renaissance is a myth. Only 500K jobs have been re-gained since February 2010, while job loss between January 2008 and February 2010 was 2.2 million, meaning a net loss of 1.7 million jobs since the recession.

Thursday, August 02, 2012

A Picture's Worth Thousand Words


Mario Draghi "Overpromised on July 26 and under-delivered on August 2". Markets reacted accordingly. With the earnings season in the US tapering off, macro factors, more specifically around euro survivability, will start to dominate again. Expect volatility to trend higher.

On July 26, Draghi said, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough". Investors were caught off-guard by such unexpected comments. That caused an instant rally in the euro, the Spanish 10-year, Dax and the S&P500 future.

On August 2, Draghi could not even deliver a rate cut (benchmark rate stayed at 0.75%) let alone convince policymakers at the ECB and the wider Europe to pursue aggressive policies like Securities Market Purchase, ECM banking license etc. Not surprisingly, all the asset classes fell in unison as soon as Draghi opened his mouth at the bi-weekly post-ECB meeting press conference.

The charts on the left (click on it to enlarge) show the schizophrenic reaction of different asset classes to Draghi's comments.

Wednesday, August 01, 2012

Forget the Fed, Focus on ISM

Stock markets were pretty sanguine today despite being hit by trifecta of major economic data, the ADP employment pre-market, the ISM during the early morning trade and the FOMC decision before the close. The most significant and the most waited of all was the 2:15PM EST Fed announcement. Investors were anxiously waiting for Bernanke’s team to give hints of QE3. Surprisingly, they didn’t although there was a slight change in the language. Equity investors shrugged off the “bad” news. May be they are expecting “Super Mario to Save the Market” tomorrow.

From the economic standpoint, the more relevant data was July ISM. It missed economists’ estimates and was the second consecutive month of sub-50 reading. More ominously, the gap between New Orders and Inventory indices was negative for the first time since September last year. A negative reading is usually a precursor for a downturn in ISM. Last year’s negative readings (July and August) were exception mainly because the Fed embarked on QE2. Everyone is expecting the Fed to do again (QE3) in September. Bernanke may prep the market in his Jackson Hole speech like last year. If the Fed does not do QE3, for whatever reason, or even if it does but is ineffective, then the downward momentum in ISM may be unstoppable.

Tuesday, July 31, 2012

Corn Climaxes

Corn futures have jumped massively in recent weeks. It made fresh new high today.

A record high price for corn is caused by fears of supply shock owing to (1) harsh weather condition and (2) very low inventory.

The USDA tracks the weather condition during the growing season on a weekly basis. According to the USDA, "excellent condition" has plunged to the lowest level ever.

Inventory has been plunging since 2009, thanks to a jump in usage of corn to make ethanol. In 2002, 10% of domestic corn production was used to make ethanol. In 2011, it has reached 40%, and it the amount was more than used for feedstock.

Monday, July 30, 2012

Much Ado About GDP Revision

The annual revision to GDP last Friday was a non-event. The annual revision, which goes back 3 years (from 2009-Q1 through 2012-Q1), the BEA revised the growth profile marginally (2009 +0.4%, 2010 -0.6%, 2011 +0.1). The net result was that real GDP level in 2012-Q1 was 0.1% higher than before the revision.

Last year, the BEA revised down the growth profile massively (2008 -0.3%, 2009 -0.9%, 2010 +0.1%. The net result was that real GDP level in 2011-Q1 was lower by a whopping 1.6% versus before the revision.

Following the “out of the left field” annual revision last year, market started to price in QE. It eventually got one when Chairman Bernanke give hints of QE2 in a speech at the Jackson Hole Meeting. Looks like market was expecting, or more appropriately, protecting against a similar surprise.

When the annual revision came in as a “non-event”, treasuries sold-off. Last Friday, yield on treasury rose from 1.40% to 1.60% before settling at 1.55% - 20bp move in 10Y treasury is a huge move.

Thursday, July 26, 2012

Mario (Draghi) Saves the Market

European equities rallied, euro/$ rate jumped over a percent and Spanish 10-year fell by 45bp. All thanks to comments by Draghi at a pre-Olyimpics Global Investment Conference in London this morning.

What did Draghi say? Two things, (1) “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” and (2) “To the extent that the size of the sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate”.

While the timing of Draghi’s comments came as a surprise, the fact that he talked about euro and sovereign premia did not. In fact, investors were expecting it to come imminently. The simple reason is that every time Spanish yield rose above 6%, there had been some form of reaction from European policymaker, verbally or otherwise, to push the yield back to below 6%. The only difference has been that the pain threshold leading to the reaction has steadily increased over time.

The first time Spanish yield rose over 6% was in July 2011, just a year ago. It rose steadily going into the European Banking Authority (EBA) stress tests results on July 15, 2011. When the results came in, only 8 banks failed and a mere €2.5bn of new capital was required. That along with positive comments on Greece rescue plans ahead of the July 21st EU Summit started to push Spanish yield lower. As such, the auction of Spain’s 18-month T-bill on July 19th was over-subscribed. The EU Summit confirmed investors’ expectations. At the Summit the leaders attempted to prevent Greek contagion from spreading to other peripheral European countries by providing additional help to Greece (extending the maturity of new EFSF loans and significantly lowering interest rates) and allowing the EFSF to buy bonds in secondary markets.

The second time Spanish yield rose over 6% was in November 2011. Again, concerns over the European project rose and reached a peak when the German bond  auction was under-subscribed on November 23rd. Again, policymakers started to make noise going into the December 9th EU Summit, which helped push Spanish yield lower. Essentially, the debate started to move towards a fiscal union.  The summit confirmed the rumors. They agreed on principal on a fiscal union but did not flush out the details.

This time Spanish bond yield jumped over 7% on concerns that regional governments are seeking financial aid from the central government. On July 22, Bloomberg reported that, “Catalonia May Follow Valencia in Bailout Request. As the pressure kept building on Spanish bond, the market was waiting for some form of reaction from policymakers and they got one today.

The rally in risky assets is likely to be short-lived because it is short-covering.

Tuesday, April 24, 2012

S&P500 Breaking the Trend Since Oct 4, 2011

S&P500 has broken couple of key technical levels, (1) up-trend since October 4, 2011 low and (2) 50-day moving average.

Looks like it is in the process of forming a head-and-shoulder pattern with the neck around 1,042 level, which also happens to be the 76.4% retracement from October low (1,074) to April high (1,422).

1,040 is a very key technical level. Should it break, then the index is heading to 1,290-1,300 very quickly. Apple earnings after the close today might sent the tone for the short-term move in the S&P500. Personally, I think the set-up for Apple earnings is bullish especially given that the stock has already moved lower heading into the print - it's down again pre-open following results from AT&T. We'll see what happens, we'll just have to wait.

Saturday, April 21, 2012

What Hedge Funds were upto in Q1 2012?

Given that Hedge Funds underperformed the S&P500 in Q1 2012 because they didn't want to repeat the mistake of last year, i.e. they ramped up risk in Q1 but got creamed by market downturn in Q2 and Q3, means if markets survive the treacherous Q2 and Q3, then we're set up for the "mother of all rallies" in Q4 (you read it here first :).

Friday, April 20, 2012

Interesting Charts: IMF Global Financial Stability Report (April 2012)

Global Financial Stability Report
[Full Link]

There are lot interesting charts in the latest edition of IMF's Global Stability report. Given the focus of investors on the European sovereign crisis, here are the 4 notable ones.

The ECB has been the most aggressive among the world's central banks in providing liquidity. It seems the Fed is the most conservative, relative to the size of the US economy.
Given the ECB's aggressive stance, credit contraction has been less pronounced there than during other financial crisis. Even in the "worst case scenario", credit cruch will be nowhere as severe as in the US during the 2008-09 crisis.
The IMF estimates that European banks need to shed $1.5 trillion assets during the next year-and-half to bring Tier 1 ratio to the target level. The question is who's going to be the buyers of the assets? The ECB again? The Fed?
Europe's impact on the US banks is something to watch out for given the banks' exposure through their derivatives business. If the crisis spreads to France then the problems will get bigger. If Germany and the UK become victims, then all bets are off.  

Monday, April 16, 2012

Book Excerpt: Breakout Nations

Book Excerpt: Breakout Nations
Ruchir Sharma

As playwright Arthur Miller once observed, "An era can be said to end when its basic illusions are exhausted." Most of the illusions that defined the last decade -- the notion that global growth had moved to a permanently higher plane, the hope that the Fed (or any central bank) could iron out the highs and lows of the business cycle -- are indeed spent. Yet one idea still has the power to capture the imagination of the markets: that the inexorable rise of China and other big developing economies will continue to drive a "commodity supercycle," a prolonged upward rise in the prices of commodities ranging from oil to copper and silver, to textiles, to corn and soybeans. This conviction is the main reason for the optimism about the prospects of the many countries that live off commodity exports, from Brazil to Argentina, and Australia to Canada.

I call this illusion commodity.com, for it is strikingly similar in some ways to the mania for technology stocks that gripped the world in the late 1990s. At the height of the dotcom era, tech stocks comprised 30 percent of all the money invested in global markets. When the bubble finally burst, commodity stocks -- energy and materials -- rose to replace tech stocks as the investment of choice, and by early 2011 they accounted for 30 percent of the global stock markets. No bubble is a good bubble, and all leave some level of misery in their wakes. But the commodity.com era has had a larger and more negative impact on the global economy than the tech boom did.

The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments. Copper is piling up in bonded warehouses not because the owners plan to use it to make wire, but because speculators are sitting on it, like gold, figuring that they can sell it one day for a huge profit. Daily trading in oil now dwarfs daily consumption of oil, running up prices. While rising prices for stocks--tech ones included--generally boost the economy, high prices for staples like oil impose unavoidable costs on businesses and consumers and act as a profound drag on the economy.

That is how average citizens experience commodity.com, as an anchor weighing down their every move, not the exciting froth of the hot new thing. The dotcom sensation broke the bounds of the financial world and seized the popular imagination, attracting thrilled media hype around the world and enticing cubicle jockeys to become day traders. There was the dream of great riches, yes, but also a boundless optimism and faith in human progress, a sense that the innovations flowing out of Silicon Valley would soon reshape the world for the better.

Tech CEOs became rock stars because they promised a life of rising productivity, falling prices, and high salaries for generating ideas in the hip office pods of the knowledge economy, or for trading tech stocks from a laptop in the living room. It was impossible in those days to get investors interested in anything that did not involve technology and the United States, so some of us started talking up emerging markets as "e-merging markets," while analysts spent a lot of time searching for the new Silicon Valley, which they dutifully but often implausibly discovered hiding in loft offices everywhere from Prague to Kuala Lumpur.

A decade later the chatter was all about the big emerging markets and oil, but with a darker mood. Commodity.com is driven by fear and a total lack of faith in human progress: fear of a rising phalanx of emerging nations with an insatiable demand led by China, of predictions that the world is running out of oil and farmland, coupled with a lack of faith in the human capacity to devise answers, to find alternatives to oil or ways to make agricultural land more productive. It's a Malthusian vision of struggle and scarcity: of prices driven up by failing supplies and wages pushed down by foreign competition.

Excitement about rising commodity prices exists only among the investors, financiers, and speculators who can gain from it. Commodity.com has inspired many an Indian and Chinese entrepreneur to go trekking across Africa in search of coal mines, yet it has no positive manifestation in the public mind at all. At the height of the tech bubble millions of American high school students aspired to become Stanford MBAs bound for Silicon Valley; today the growing number of oil, gas, and energy-management programs represents a small niche inside the MBA world. The only popular manifestations of commodity.com are complaints about rising gasoline prices and outbreaks of unrest over rising food prices in emerging markets.

It is well-justified unrest. If anything, the negative impact of sky-high commodity prices on the larger economy is underestimated. The price of oil rose sharply before ten of the eleven postwar recessions in the United States, including a spike of nearly 60 percent in the twelve months before the Great Recession of 2008 and more than 60 percent before the economy lost momentum in mid-2011. When the price of oil trips up the United States, it takes emerging markets down with it. In 2008 and 2009 the average economic growth rate dropped by 8 percentage points in both the developed and the emerging world, from its peak pace to the recession trough.

The strongest common thread connecting the dotcom and commodity.com eras is the fundamental driver of all manias: the invention of "new paradigms" to justify irrationally high prices. We heard all sorts of exotic rationales at the height of the dotcom boom, when analysts offered gushy explanations for why a company with no profits, a sketchy business plan, and a cute name should trade at astronomical prices. It was all about the future, about understanding why prices in a digitally networked economy "want to be free," while the "monetization" problem (how to make money on the Internet) would solve itself down the line. The dotcom mania, while it lasted, was powerful enough to make Bill Clinton -- who campaigned as the first U.S. president to fully embrace the "new economy" -- a living emblem of American revival, just as the commodity price boom played a role in making Vladimir Putin a symbol of Russian resurgence and Inácio Lula da Silva the face of a Brazilian recovery. When the rapture is over, the nations and companies that have been living high off commodities will also share the sinking feeling that followed the dotcom boom.






Friday, April 13, 2012

Interesting Charts: Low Wage Workers in the US

Low-wage Lessons
By John Schmitt
Center for Economic and Policy Research
[Full Link]

The economics of "economic distribution" is not only relevant to politics but also to investment. Given that the US has a such a large share of low-wage earners and the share of that has been trending up for 20 years, it is good news for companies cater to that segment of the demographics like the Wal-Mart and Dollar stores of the world.






















According to the OECD, in 2009, about one-fourth of U.S. workers were in low-wage jobs, defined as earning less than two-thirds of the national median hourly wage.

Not only has the U.S. the highest share of low-wage workers in the OECD countries, the incidence of low-wage work has been rising for at least three decades, from just over 20 percent in 1979 to just under 30 percent in 2010.

The minimum wage in the U.S. has been set at a level that is well below the threshold for low-wage work. As a result, it has had little or no impact on the share of the workforce experiencing low pay by the standard definition.

The Federal program, the Earned Income Tax Credit (EITC) which reimburses low-income earners (27 million families, $60 billion in 2009 with complicated eligibility rules (max benefit 4.8K and max earnings 39K) may have exacerbated the low-wage problem in the U.S. because it increased the supply of low wage workers who then do not become eligible for the EITC or get the EITC that is too small.


Thursday, April 12, 2012

"The Paradox of Low-Risk Stocks"

The Paradox of Low-Risk Stocks
By Kent Hargis and Chris Marx
[Full Link]

A white-paper by Kent Hargis and Chris Marx, portfolio managers at AllianceBernstein argues that the best stock investment strategy for the long-run is "low-volatility, high-quality".

That begs the question, why low-vol portfolio outperform in the long run? The simple answer is "compounding". A more volatile stock does outperform in upturns but also underperforms significantly during downturns. And following downturns, they take long longer to get to break-even point.

The second question is why does this "anomoly" persist? The authors cite two reasons (1) behavorial biases and (2) agency issues.

From portfolio standpoint low-vol stocks provide additional benefit because they do not share many characteristics with "growth" or "value" stocks. That means their inclusion in a portfolio will enchance the portfolio's efficient frontier.

The third question is, there must be a catch! Yes there is, and that is investors must have "long horizon". So it is ideal for pension fund managers especially given new pension-accounting and insurance-solvency regulations.

Wednesday, April 11, 2012

Today's Reads

Today's Reads
Interesting readings from today

Edward J. DeMarco, the acting director of the FHFA gave a speech at the Brookings Institute and talked in details about the US Treasury's programs to help struggling mortgage borrowers. DeMarco said that 11 million homeowners are under-water and raised issues over principal reduction.

Goldman Sachs has developed a "House Price Index" that estimates the percentage of zip-codes with year/year increase in house price. Like the Case-Shiller index, it is bouncing at the bottom. What is not exactly clear is how many zip-codes GS analyzes to create the index but I think it is certainly less than 43,000 zip-codes (43,191 to be precise) in the US.

There seems to be lot going in the Money Market Funds (MMFs). The SEC proposed a rule late last year to let NAV of MMFs fluctuate and to require them to impose higher reserves and restrictions on withdrawals. The SEC has been tightening rules over MMFs since 2008 crisis. In October 2008, Reserve Primary Fund, the oldest MMF "broke the buck" because it held $785 million in Lehman debt out of $64.8 billion in total assets. In May 2010, a SEC rule shortened the average maturity of assets held from 90 to 60 days, required that 10% of a fund be in cash or securities that mature in one day and that 30% of a fund must mature within 60 days. But looks like the SEC's new proposal is dead on arrival owing to push-back from powerful industry players.

Thursday, January 26, 2012

Today's Reads

Today's Reads
Interesting readings from today

The Fed surprised the market by promising to keep the rates low "at least through late 2014". Chairman Bernanke gave subtle hint that it may initiate QE3 at the post-FOMC press conference although there is disagreement among economists on whether the Fed will actually go for it. The reason for the Fed becoming more dovish was a reduction in their outlook for growth and inflation (but no unemployment rate) for 2012-13.

The painstaking negotiation between Greece and the bondholders continues. It was supposed to be over before last weekend ahead of the EuroFin meeting but that didn't happen (surprise?). Looks like there is broad agreement on the outline but disagreement over the details particularly how much "average" interest should be paid on the new debt - Greece wants 3.50% while bondholders want 4% but they might split the difference at 3.75%. It will be interesting to find out the final outcome, hopefully in the next few days. There pretty cool references on this top including,
(1) From BBC, Pretty nifty graphics on debt by major countries
(2) From FT, An Interative Timeline of Greek debt crisis
(3) From HSBC Global Research, "FAQ on Greek Debt Swap" published back in August 2011.

In his, State of the Union address, President Obama proposed relief to homeowners through mortgage refinancing but the likelihood this proposal becoming a law is minimal. This looks errily like HARP, which allows homeowners with negative equity to refinance without paying mortgage insurance but goes one step further, which is that it allows Non-Agency mortagage borrowers to refinance also without penalty. This could be bad for mortgage REITs but it is offset by the Fed's commitment to keep the rates low and possibly initiate QE3, which will likely focus on Agency MBS securities. The President's proposal could also bring relief on loan-level price adjustment (LLPAs) that Fannie Mae charges.

Notwithstanding today's worse than expected weekly jobless claims, the trend has been heading south. But it has not improved fast enough to dent the poverty rate in the country. According to the USDA that administers the Supplemental Nutrition Assistance Program (SNAP) aka Food Stamp, 44 million American receive that aid amounting to $134/month on average. Companies like SBUX, SVU, FDO and of course WMT are positioning themselves to get the most of $71.8 billion Food Stamp money - they already get 85% share.

Thursday, January 19, 2012

McKinsey Global Institute: Debt and Deleveraging

Debt and Deleveraging: Uneven progress on the path to growth
McKinsey Global Institute, Jan 2012
[Full Link]
[Full Report in PDF]


Safely reducing debt and clearing the way for economic growth in the aftermath of the global credit bubble will take many years and involve difficult choices, as MGI’s 2010 report showed.

Two years later, major economies have only just begun deleveraging. In only three of the largest mature economies—the United States, Australia, and South Korea—has the ratio of total debt relative to GDP fallen. The private sector leads in debt reduction, and government debt has continued to rise, due to recession. However, history shows that, under the right conditions, private-sector deleveraging leads to renewed economic growth and then public-sector debt reduction.

These are the principal findings of MGI’s latest perspective on deleveraging, which revisits the world’s ten largest mature economies to see where they stand in the process of reducing debt ratios (United States, Japan, Germany, France, United Kingdom, Italy, Canada, Spain, Australia, and South Korea). It focuses in particular on the experience and outlook for the United States, United Kingdom, and Spain—three countries covering a range of deleveraging and growth challenges. It also examines the relevant lessons from history about how governments can support economic recovery amid deleveraging, and identifies six key markers business leaders can look for to monitor progress of specific countries.

Highlights of the research include:

* The deleveraging process has only just begun in most countries. Based on data up to Q2 2011, total debt has actually grown across the world’s ten largest mature economies since the 2008–09 financial crisis, due mainly to rising government debt. Only three countries in the sample—the United States, Australia, and South Korea—have seen the ratio of total debt to GDP decline.

* The deleveraging processes in Sweden and Finland in the 1990s offer relevant lessons today. Both endured credit bubbles and collapses, followed by recession, debt reduction, and eventually a return to robust economic growth. Their experiences and other historical examples show two distinct phases of deleveraging. In the first phase, lasting several years, households, corporations, and financial institutions reduce debt significantly. While this happens, economic growth is negative or minimal and government debt rises. In the second phase of deleveraging, GDP growth rebounds and then government debt is gradually reduced over many years.

* The historic deleveraging episodes reveal six critical markers of progress: the financial sector is stabilized and lending is rising; structural reforms unleash private-sector growth; credible medium-term public deficit reduction plans are in place; exports are growing; private investment has resumed; and the housing market is stabilized and residential construction revives.

* As of January 2012, the United States is most closely following the Nordic path towards deleveraging. Debt in the financial sector has fallen back to levels last seen in 2000, before the credit bubble, and the ratio of corporate debt relative to GDP has also fallen. US households have made more progress in debt reduction than other countries, and may have roughly two more years before returning to sustainable levels of debt. Deleveraging in the United Kingdom and Spain is proceeding more slowly, and these countries could face many years of gradual debt reduction ahead.

* Understanding the course of deleveraging will be of critical importance both to business leaders, who will need to take a granular approach to strategy, and to governments. The report examines implications for business strategy and suggests that current macroeconomic models do not fully capture the impact of deleveraging on demand—so companies must develop their own views of how deleveraging is proceeding to find pockets of opportunity in the near term. Overall growth in the time of deleveraging is likely to be restrained, but the pace of debt reduction varies across nations and sectors and from place to place within nations. No single country has all the conditions in place to revive growth.

Wednesday, January 18, 2012

Today's Reads

Today's Reads
Interesting readings from today

The World Bank lowered its 2012 growth forecast to 2.5% (down from 3.6% forecast in June). Developing countries should expect 5.4% growth (from 6.2%) and developed countries 1.4% (from 2.7%). Euro Area will be in a recession with -0.3% (from +1.8%) growth and China's growth will be at a "dismal" 8.4%.

The IEA is also lowering its global demand forecast for oil for 2012 to 1.1 MBD (from 1.3 MBD). Growth in emerging markets (+3.2%) will offset decline (-0.7%) in developed countries bringing the aggregate growth to 1.2%. China's growth is cut to 4.3% (from 5.2%) but still accounts for 40% global increase.

The FDIC now requires 37 banks with more than $50 billion assets (total $4.14 trillion) to provide "living will" for dismantling them if they collapse. Banks with excess of $10 billion are required to conduct regular "stress test".

The National Science Board released a new report where it outlines trends in U.S. global competitiveness in Science and Technology (S&T). The interesting takeaway is that between 1999 and 2009, the U.S. share of global R&D dropped to 31% (from 38%), whereas Asian share grew to 35% (from 24%). China's R&A grew 28% just in one yar (2008 to 2009) to propell it to the 2nd position behind the US.

Among the bizarre news, imagine travelling on BA Flight 206 from Miami to London, and 3 hours into the flight, you hear the announcement, "This is an emergency. We will shortly be making an emergency landing on water". The good news was that it was a pre-recorded message that activated in error.

Tuesday, January 17, 2012

Today's Reads

Today's Reads
Interesting readings from today

US markets ripped higher in the morning on reports of better than expected China GDP growth, up 8.9% vs 89.7% consensus. The funny thing is that I have not been able to get hold of the expenditure breakdown of the Chinese GDP i.e. C+I+X-M+G. And there is plenty of skepticism about the trustworthiness or the quality of Chinese economic figures. In any case, the market seems to be shrugging off bad news, and the FT tries to make a point that it could just be short covering.

In "Time to stop fearing the Greek CDS bogeyman" Sober Look gives 4 reasons why a trigger of the Greeck CDS is not as big a deal as the ECB is making it to be, (1) they're already marked to market (2) protections are written long time ago (3) worst case scenario priced in because CDS spreads have narrowed vs 1 month ago, and (4) CDS is already pricing in a 70% probability of a default.

CNBC has an interesting explanation of "Credit Event for CDS and Bond Payouts".

An interesting interview with the CEO of Athenahealth (ATHN), a Healthcare Tech Company, by Fortune Magazine. Couple of interesting tidbits (1) 1/3 of healthcare is consumed by 5% of population that dies each year, another 1/3 by 5% with chronic diseases, and the rest by 90%, (2) VC invested $410 million in Healthcare IT in 2011 vs $30 billion in tech including social media, and (3) only ~1% of doctors are using closed loop Healthcare IT system because it is illegal for a pharmacy or a testing lab to pay a doctor for sending information electronically - it's considered a kickback.

An interesting chart of oil price going back to 1861 from page# 15 of BP Statistical Review of World Energy (June 2011)

Thursday, January 05, 2012

Raising the Ante on Last Year’s Big Global Macro Bets

Raising the Ante on Last Year’s Big Global Macro Bets
Institutional Investor, 5-Jan-12
James Shinn

Some traders ruefully describe 2011 as “shockingly volatile,” even as others are pricing new Ferraris in sleek showrooms on Park Avenue and in Mayfair. What combination of asset volatility and fast-car returns is in store for 2012?

In the June 2011 issue of Institutional Investor, I described a reference scenario of the events that global macro traders believed to be moving markets last year, based on a two-day conference at Ditchley Park in Oxfordshire, England. According to this scenario, global macro hedge funds were focused, laserlike, on just four key events: the Federal Reserve Board’s monetary stance, a Chinese hard or soft landing in terms of GDP growth, euro zone stresses and that perennial favorite, oil prices. As I explained in my previous article, “with four big events, there are 16 possible outcomes (two to the fourth power) in the reference scenario ‘decision tree.’?”

With the benefit of hindsight, how did these scenario events actually play out, and how skillfully did our traders predict the four outcomes? Are the same cyclical and secular drivers of these events still at work? Looking forward, will these be the four key variables in 2012? And as the accountants tally up hedge funds’ year-end winners and losers, what is the reference scenario for 2012 — and with what odds?

The Fed’s Stance: Loose or Looser

The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the Federal Reserve Open Market Committee’s decisions will drive asset markets around the world, for good or for ill.

One branch leading from this decision is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit. In this branch continued dis-saving by Washington is matched by household savings and the purchase of Treasury debt by foreigners and Ben Bernanke’s Fed, and this is what powers GDP recovery — at least for a while.

The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The former branch might be described as “business as usual,” the latter as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.

Original Prediction: Painful Adjustment

Traders in our poll overwhelmingly bet on the “malaise/painful adjustment” outcome, 68 percent to 32 percent (with a standard deviation of 17 percent). The individual arguments supporting this view reflected global macro traders’ conviction that long-term adjustment is crucial — “This party just can’t go on forever,” one trader explained. The traders were also confident, in some cases adamant, that financial markets would force a fiscal deficit reduction in Washington: “If Moody’s gives the Treasury a downgrade, even Congress will have to pay attention,” was a popular comment. Most traders have a visceral dislike of quantitative expansion in any form — “QE is just a central bank’s monetization of government debt, any way you look at it,” observed one trader.

I should add that all quotes in this article are guaranteed genuine, but some of our traders’ firms have blanket policies forbidding their employees from being quoted in the financial press.

Actual Outcome: Business as Usual, Plus ‘Twist and Shout’

Contrary to the traders’ average prediction, we are still heading up the “business as usual” branch at the start of 2012, with no real deal on the U.S. fiscal deficit and with another shot of QE via September’s Operation Twist, although, unlike QE1, the Twist was balance-sheet neutral for the Fed.

The U.S. federal deficit in fiscal 2011 was -8.6 percent of GDP, barely down from 2010’s -9 percent. According to International Monetary Fund forecasts, the U.S. fiscal deficit will shrink only slowly, stubbornly sticking above 6 percent five years out. Consensus forecasts for U.S. economic growth are 1.8 percent for 2011 and 2 percent for 2012, with unemployment running at 9 percent and 8.7 percent, respectively. Even as government debt continues to climb, households will deleverage very slowly, and the external trade deficit will keep running at the 3 percent–of-GDP level more or less indefinitely.

The benefits of QE may still be a dangerous illusion in the minds of many financial professionals and has encountered a groundswell of political opposition in the Republican Party. But all indications are that the dominant dove faction on the Federal Reserve Board is keeping this option open. “Public political criticism of the Fed is nothing new and won’t have more than a marginal impact on its policy actions — maybe just on how it communicates them,” says Thomas McGlade, a Greenwich, Connecticut–based portfolio manager and director of U.S. operations for London-based hedge fund firm Prologue Capital.

Drivers: Deflation and Unemployment Fears Trump Deleveraging

As an example of the communication style described by McGlade, in a November 15, 2011, speech at the Council on Foreign Relations in New York City, Chicago Fed president Charles Evans made the case that inflation was essentially under control, displaying slides showing that the FOMC “central tendency” forecasts have core inflation running well under 2 percent for several years while unemployment slowly creeps down from the 9 percent level, still hovering in the 8 to 9 percent range a year hence and not going below 7 percent until 2014. If Evans’s view indeed reflects the central tendency of the Fed, the cyclic driver of slow U.S. recovery and sideways unemployment will wash the urgency out of deleveraging.

The persistence of secular leveraging was called rather rudely to the Fed’s attention by the now-famous paper on “the real effects of debt” by Brandeis University finance professor Stephen Cecchetti and his colleagues, presented at the Fed’s August 2011 Jackson Hole meeting; it later appeared as the Bank for International Settlements’ BIS Working Papers 352. I have seen copies of the graphs from this paper (see graph below, left) taped to traders’ screens and pinned to the corkboard over a trading floor’s espresso machine.

According to the BIS team’s calculations, total nonfinancial debt in 18 OECD countries grew from 167 percent of GDP to 314 percent between 1980 and 2010, an increase of almost 5 percent of GDP per year for three decades, as shown in the graphs. This trend has brought us to the point in many of these countries where debt levels are stifling GDP growth, according to economists Carmen Reinhart and Kenneth Rogoff. This implies that households and then governments must go through a sustained and painful deleveraging process.

Says Paul Brodsky, co–managing member of New York–based hedge fund firm QB Asset Management: “The issue across the board in developed economies is solvency — not discrete liquidity flare-ups among sovereigns, banks or households. Nor is a lack of confidence among consumers the issue. It all comes down to the extraordinary gap separating systemic debt from existing base money. The world needs to deleverage.”

The FOMC may think that deleveraging and adjustment are necessary someday, but putting more of the 25 million unemployed or involuntarily part-time employed Americans back to work appears to be more pressing — the central banker’s version of Saint Augustine of Hippo’s famous prayer, “O Lord, grant me chastity and continence, but not yet.”

Prediction for 2012: The Fed Will Make It Too Dangerous to Hold Bonds

Looking forward into 2012, our sample of traders believes the important choice is no longer between business as usual and adjustment, but between more quantitative easing or not, and the vast majority believe the Fed will engage in QE3. The average bet is 70-30 in favor of QE3, with a standard deviation of 22 percent.

There is broad consensus among traders that U.S. growth and employment are sliding sideways in an L-shaped, “slow and fragile” recovery through 2012, and the real question at this point is when and how much the doves at the Fed will resort to QE3. “How many bullets does the Fed really have left in its gun at this point?” asks Prologue’s McGlade. “From now on, the only remaining impactful policy option is additional QE, which could be balance-sheet neutral or expansive. And sometime in the first half of 2012, provided that the data continues to undershoot the hurdles of the dual mandate, I think we will see additional QE involving balance-sheet expansion rather than another balance-sheet-neutral move like Twist, and most likely involving mortgages this time.”

There is disagreement over what the transmission mechanisms from QE3 back into the real economy are — if any. “By pressing rates so low, the Fed is just making it too dangerous to hold cash and bonds,” concludes a skeptical global macro trader. “If you need yield, you are being forced up into equities and other real assets — not a comfortable position to be in.”

China: Hard or Soft Landing?

Will Beijing keep real Chinese GNP growing somewhere around its current target of 7.5 percent for the next year? Or will inflation fears cause the leadership to dampen demand levels back down toward 5 percent? There is a history of Beijing throttling the economy back and forth rather radically. As Arvind Sanger, founder of New York–based hedge fund firm GeoSphere Capital Management, says, “The Chinese authorities have only two economic management tools at their disposal — one is a flamethrower, and the other is a fire extinguisher.”

One possible outcome from the China event is real growth in the 8 to 10 percent range, with increasing inflation above 5 percent, sustained feverish levels of capital and infrastructure investment, and some reduction in net exports (which together add to 70 percent of GDP) — not quite the flamethrower mode but still pretty hot, and consistent with a “business as usual” view of the world. The other possible outcome is a hard landing: growth around 5 percent, with persistent inflation and expansion of net exports.

Original Prediction: Soft Landing

On average, the traders assigned a 57 percent probability to the soft-landing path and 43 percent to a hard landing, with a standard deviation of 19 percent. The dominant view argued that the leaders in Beijing had a lot of tools at their disposal to drive the economy in the direction they wanted it to land, including ownership of the banking system and a cushion of several trillion dollars in foreign exchange reserves.

Actual Outcome: Headed for Hard Landing but Changed Course

The traders were on the money, on average. We are still in soft-landing territory, with Chinese real growth expected to hit 9.2 percent on an annual basis in 2011, according to Xinhua News Agency. This growth was achieved by sustained high levels of domestic investment and by net exports, although the ratio of net exports to GDP declined from 3.1 percent in 2010 to 2.4 percent in 2011.

“They [Beijing] were tightening at the beginning of 2011, tightening real estate lending and raising some tax rates, but then they changed in October, with a minor monetary ease, some tax cuts for business and a shift toward easier monetary and fiscal policy, suggesting that the Chinese leadership is more concerned about the risk of a “hard landing,” says Laurence Zuriff, managing partner of Granite Capital International Group, a New York–based investment firm.

There is considerable uncertainty about the real rate of inflation, given doubts about the accuracy of reported consumer price index figures: Official 2011 inflation is running at somewhere between 5 and 6 percent (6.1 percent in September and 5.5 percent in October). Some believe this number has been engineered by the government statistics office — for example, by lowering the weights of food in the CPI basket.

Drivers: Rebalance, but Not Yet

Cyclically, the Chinese face the same trade-offs noted in my last article. The Politburo, which charts the basic guidelines for macro policy, fears the twin miseries of unemployment and inflation. If real growth falls below 7 percent or so, China cannot absorb annual increases in the workforce; if inflation rises much above 5 percent, the population gets restive.

Secularly, the members of the Politburo know they need to rebalance the components of GNP sooner or later — probably sooner — because the large weight and high growth rates of fixed investment and net exports can’t continue indefinitely and will have to be replaced with high personal consumption. All the official speeches acknowledge this. But no one in Beijing appears to be in any hurry to accelerate adjustment at the risk of domestic instability.

According to Ben Simpfendorfer, a Hong Kong–based economist for New York–based financial advisory boutique Global Strategic Associates and editor of the “China Insider” newsletter: “China has some of the world’s best economic planners, but the scale of the challenges are daunting, especially in the midst of a political transition. Beijing’s biggest challenge is weaning itself off state-owned heavy industry and revitalizing the private sector. The economy was, ironically, better balanced in 2008, or shortly before the crisis.”

Chinese officials think the shrinkage of net exports will continue, although some in Beijing are already raising alarms about a possible sharp swing down. According to Zhang Yansheng, director of the Beijing-based Institute for International Economics Research, under the National Development and Reform Commission, “What we’re facing now is a grave situation for exports, and slowdown is inevitable in the third and fourth quarters.”

So a soft landing is still the target, though what constitutes “soft” appears to be somewhat slower nominal growth — say, 8 percent rather than 9 percent — and the danger zone of hard-landing growth is a bit higher: say, 6 percent rather than 5 percent.

Prediction for 2012: China Needs Reform, Not More Easing

Looking forward, the traders believe that China’s glide path toward lower growth is still one of the big four events that will move financial markets in 2012. The average prediction continues to see a soft landing, but the odds fell from 57 percent in June to 53 percent looking forward into 2012.

“China has the firepower to prevent a hard landing in 2012, but the economy needs more reform, not more policy easing,” says Simpfendorfer. “Flushing the system with more credit will only worsen imbalances. China’s middle-income trap is approaching fast unless productivity gains start replacing labor and capital as the main drivers of growth. Policy easing can only delay, not avert, the challenges.”

Granite’s Zuriff agrees that 2012 will be a tougher growth environment for Beijing’s leaders. “Global demand will likely be lower, and their wage inflation is reducing their competitive advantage in a lot of export sectors,” he says. “And there have been a series of frauds and corporate governance issues, like Sino-Forest and Alipay, that are undermining inward foreign investment. The housing sector is overbuilt and vulnerable to a big price correction, and the Communist Party leadership itself is going through a big transition in the second half of the year. When trying to determine if we will see a hard landing in 2012, we have to ask if the party leaders will try to buy growth to buy stability in front of the leadership transition — and if they’ll succeed.”

Of course, the 53-47 split of our poll indicates average confusion more than anything else, as the standard deviation of the forecast widened from 20 percent to 23 percent. “We can’t understand economic policymaking in Brussels or Washington anymore, much less in Beijing,” complains one trader. “Plus, if the Chinese don’t make their growth or inflation targets, they can just make it up. But at the end of the day, the Chinese can have a soft landing because they can afford it — they have the resources needed to carry them through a transition period.”

Euro Zone: Extend or Breakup?

Will the EU peripheral states force bondholders to take a haircut on their debt? Or will the EU, the European Central Bank and Germany somehow manage to bail them all out in a way that doesn’t force big write-downs?

All macro traders believe the question isn’t whether the periphery writes down its sovereign debt, but rather how it does so. One branch of the European debt limb of the decision tree is what one trader describes as “extend and pretend,” with some kind of government bailout that keeps holders of Irish, Greek and Portuguese sovereign debt from taking big write-offs, thereby averting contagion to the European banking system. This is business as usual in the euro zone. The other branch is an ugly adjustment that reveals the scale of the exposure of French and German banks to peripheral sovereign debt and threatens to spread to Italy and Spain.

Original Prediction: Extend and Pretend

The average probability estimate for “extend and pretend” was 53 percent, versus a 47 percent prediction of an ugly default, with a standard deviation of 25 percent, a wide distribution around the mean.

The average prediction gave the euro authorities almost even odds between going up the “extend and pretend” path with a bailout that didn’t result in a haircut for the holders of euro zone periphery sovereign debt and an ugly default on the periphery, which would rapidly spread to Italy and Spain as well as threaten the credibility of the European banking system, including the core French and German banks. The big standard deviation suggests a fairly wide dispersion around the mean by individual traders. Some believed the Europeans could trudge toward a solution and eventually muddle through. Others insisted that markets wouldn’t wait that long.

Actual Outcome: Ugly Adjustment

The funding crisis of European banks and sovereigns alike is driving them both pell-mell into the reluctant embrace of the ECB. This surely constitutes evidence that we are going down the ugly-adjustment pathway.

In the last half of 2011, French banks’ dependency on the ECB for liquidity exploded, from €10 billion to €100 billion ($13 billion to $130 billion). The FTSE index of French and German banks dropped from 100 to 60. Moody’s Investors Service downgraded the credit ratings for BNP Paribas, Crédit Agricole and Société Générale, while Fitch Ratings downgraded the long-term ratings of Barclays, Credit Suisse and Deutsche Bank.

Euro zone authorities are still pretending that the monetary union part of the “European project” is on track, but this could fall apart any day now. They are also pretending that there has been no default event for the holders of European sovereign debt, even while twisting their collective arm to take a big haircut — a truly surreal juxtaposition. In the meantime, Greek debt is trading at a deep discount to par, which is surely a write-down in the real world. Beyond the Continent everyone is watching the circus of euro negotiations with a combination of anxiety and disbelief. “Demographics have caught up with the European social welfare state, and European governments made promises they can’t keep, so what we’re seeing is the bursting of the entitlements bubble,” says one Connecticut-based global macro trader. “These last weeks have been a fiasco for European authorities. The EFSF [European Financial Stability Facility] is hamstrung, the outlook for the euro is bleak, and any chance of a year-end rally is gone. The banking crisis will deepen, sovereign bond yields will continue to increase, and we traders are facing grindingly volatile markets with a downward trend.”

Drivers: The Sovereign Debt Danger Zone

The cyclic and secular drivers of euro zone survival going into 2012 are the same as in mid-2011. The euro zone is sliding into a second recession, and the long-term problems of center-periphery price adjustment (or lack thereof) and sovereign debt remain unresolved. The sheer scale of the political compromises and subsequent approvals required to alter the euro zone agreement — particularly in Germany — is dragging out the adjustment process and amplifying the cyclical crisis.

The basic math on the sustainability of sovereign debt is still in place: Once sovereign yields climb above the likely GDP growth rate, the debt burden will climb and sooner or later crush the state. By this measure, all of the so-called PIIGS — Portugal, Ireland, Italy, Greece and Spain — are already above the sovereign yield danger zone.

Prediction for 2012: Either Way, It’s Game Over in 2012

Our traders remain almost equally split on the euro zone trajectory — 53 to 47 — with an average forecast that Brussels and the European authorities can somehow pull off an extend-and-pretend bailout of the periphery and the core through 2012, but the standard deviation of the forecasts narrowed from 25 percent to 19 percent. The overall tone, however, is increasingly skeptical as traders and other market participants watch the European authorities dither through endless summits, deadlines and “senior consultations.”

“With some help from other wealthy European states and ECB repo operations, Germany has the money to do a wholesale credit wrap of euro-area bank and sovereign debt,” says Prologue’s McGlade. “But there are stringent conditions from the Germans for that wrap. Plus, the political and nationalist constraints in the other states that have to accept those German conditions are uncertain and volatile. The scale of funding needs in the first quarter at the sovereign, banking and corporate level in Europe is absolutely huge, and that means some sort of climax is imminent.”

From his market soundings, McGlade believes he is not alone in this view. “The ECB is dancing as fast as it can to preserve the European banking system, and the market is sniffing this,” he explains. “[ECB president Mario] Draghi’s hawkish refusal to allow the ECB to expand the bond purchase program has begun a new, dangerous chapter in the euro crisis. The global pool of capital will not fund those debt rollovers unless it is at a steep discount, and at such a discount the debt-service load becomes untenable and the government business models unsustainable.”

Another Greenwich-based macro trader is equally pessimistic. “The euro is destined to be a weak currency in 2012,” he says. “Rates are going to zero or just 25 basis points, Brussels’ interventions will remain haphazard, and the ECB will continue to disappoint those calling for full-force monetization of struggling sovereign debt. Greece and Italy will both default in 2012, and the ‘core’ European banks are going to have to get recapitalized. We are on the precipice of a nasty election cycle globally, and there is going to be a lot of tearing of social fabric.”

Not all observers are so bleak about the euro zone’s prospects, though they agree that 2012 is a year of decision. “The political obligation on the part of the Germans to avoid the disintegration of Europe is so great that ultimately they will choose the lesser of two evils and decide to take the hit and guarantee debt. The Greeks and Italians will write rules, and the Germans will sign the checks,” predicts a senior investment banker. “Either way, it’s game over within 2012. Either Germany concedes or the euro zone dies.”

Oil: Medium or Expensive?

The final big event is oil prices. Every day since the Arab Spring broke out in December in Tunisia, traders have been running and rerunning the odds that chaos in the dusty streets of Middle Eastern and North African capitals will result in fewer oil tankers passing the Strait of Hormuz. Since it is well established that there is very little swing capacity in the oil market with which Saudi Arabia could maintain stability in oil prices (even if it wanted to), a minor disruption in oil exports from the Gulf could result in big price increases. One possible outcome is expensive oil, $125 or more a barrel; the other is medium to expensive oil at about $100 a barrel.

Original Prediction: Medium Oil

The majority view of the macro traders was the second outcome, toward medium to expensive oil, but only narrowly so, with an average 52 percent probability and a large standard deviation of 21 percent. Traders were more concerned about possible supply shocks caused by the Arab Spring rippling more widely through the oil-supplying countries of the Middle East and less concerned about variations in demand, especially from China and India.

Actual Outcome: Medium Oil as Libya Is Off-Line and Then On-Line

The prediction was right — we are down the path of $100 to $110 oil. “Oil in 2011 was all about Libya,” says one macro trader, who spent a decade as an energy specialist. “Libya went off-line in February and came back on-line in the fall. Before the war they were pumping 1.6 million barrels per day, which then dropped to zero. That’s the chief reason Brent got up to $130 per barrel. But Libya has exceeded expectations recently and is back pumping between 800,000 and 900,000 barrels per day.”

Drivers: Finely Balanced Supply and Demand

The same cyclic and secular drivers are likely to be propelling oil prices in 2012. Emerging-markets demand has absorbed the small incremental pumping capacity that softened developed market demand is freeing up. On the supply side there is still political instability in several major suppliers: Iran, Libya, Nigeria and Venezuela.

In terms of secular drivers, the Arab Spring has resulted in massive injections of funds back into those nations’ societies by nervous sheiks and kings. This puts some pressure on them and OPEC to pump more. On the other hand, it also gives them an incentive to cut back on supply so they can raise prices. For example, because of enhanced fiscal commitments, the price of oil that Saudi Arabia needs to balance its budget — the so-called budget break-even point — went up to $80 a barrel and may climb to $115 a barrel in a year or so at current production rates.

The secular drivers increasing supply or substitutes outside of politically dicey areas in the Middle East and Africa through oil shale, deepwater drilling and fracking are steady but will take time. In the meantime, conventional oil capacity is increasing only about 1 percent per year on a net basis, which, combined with slim marginal capacity, could produce quite a bit of volatility in 2012.

Prediction for 2012: It’s All about Geopolitical Risk

Traders seem to have changed their minds about oil prices more decisively than about the other events. The average forecast is 59 percent that oil will stick at $100 or below throughout 2012, with a standard deviation of 18 percent.

“We are entering 2012 with low oil inventories but with overall demand flat because of recession here and in Europe, and with OPEC pumping at high levels, inventories will build in the early parts of the year, which will knock prices down,” says the energy-specialist-turned-macro-trader. “If Libya holds together, the balances for the second half of 2012 are very bearish. Prices should go flat to down through the year. So we’re really looking at geopolitical risk here. If one more big supplier goes off-line for whatever reason, these prices must go up again to ration demand.”

The Arab Spring continues to reverberate in traders’ minds. “For whatever reason, the capital markets have simply turned a blind eye to the situation or have gotten comfortably numb with all that has transpired in the Mideast, beginning with the immolation of that Tunisian vegetable vendor that sparked the Arab Spring,” says Stevyn Schutzman, chief macro strategist at RBC Capital Markets. “But these situations in the Mideast are all interconnected. The ripple effects that U.S. withdrawal from Iraq may have on the capital markets could be enormous — not just on the oil price but more broadly into energy policy and even defense spending.”

One Extreme or Another?

Some traders insist that oil prices could also move upward in response to higher inflation expectations generated by several central banks engaging in quantitative easing throughout 2012 — a wall of money pumped into the world economy by the Fed, the Bank of England, the Bank of Japan and the ECB. “The financialization of money over the last generation demands the monetization of finance now,” says QB Asset Management’s Brodsky. “The value of goods, services, assets and labor must be reconciled in real terms with our global currencies, both for takers and providers of them. So I expect inflation because of central bank money manufacturing that forces the general price level higher.”

This is an uncomfortable reminder for all forecasters — in academia or trading — that the big events that will move markets in 2012 are not the truly independent variables so prized by the runners of regressions but rather covariant in complex ways.

When smart traders are equally split on the odds while the markets are getting both volatile and increasingly cross-correlated, one strategy is to simply bet on both ends. According to Alen Mattich in his Wall Street Journal blog: “The hope may be for a muddle through when it comes to the euro crisis, but investors are increasingly betting on one extreme or another. Take a look at the oil market . . . [with] very heavy activity in out-of-the-money options on oil prices — at either end of the spectrum. Although prices are currently hovering at around $100 a barrel, investors are betting that prices either collapse by half or surge by 50 percent. But it’s not just oil. Everywhere you look, asset prices seem unstable.”

Concludes Brendan Dornan, principal of New York–based Dornan Capital Management: “The best strategy for this is to sell at-the-money puts and calls, and use the proceeds to fund purchases of many more out-of-the-money puts and calls. This is the ‘barbell strategy’ advocated by Nassim Taleb.”

So what do you need to sleep easily through the new year with your barbell bets? Probably a lot more information than you have. Peter Bernstein, the preeminent academic historian of risk-taking, described the trader’s dilemma, likely to be as true throughout 2012 as it was in 2011:

* The information you have is not the information you want.
* The information you want is not the information you need.
* The information you need is not the information you can obtain.
* The information you can obtain costs more than you want to pay.

James Shinn (jshinn@princeton.edu) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He serves on the advisory boards of GSA, Oxford Analytica and CQS, a London-based hedge fund.