Thursday, December 17, 2009

Under Construction

This post will be a working post with additions made as the fog of the equity rally and US government "recovery talk" misdirection clears. The are still major threats to financial markets lurking in the shadows, unresolved issues from the GFC and a relatively permanent change to US consumer trends.

The threats to financial markets include the status of sovereign balance sheets - the PIIGS mostly, the reflated commodity bubbles, and commercial real estate (and other debt bombs with 2010 and beyond maturities). The recent events in Dubai remind us all that these slow burning fuses with ignite the plastique eventually.

In the event of Dubai, they have Abu Dhabi. Abu Dhabi seems certain to rescue Dubai, albeit at some discount. The bulk of the debt isn't technically sovereign so there is some wiggle room for Abu Dhabi to get a haircut on the debt support (they likely were buying Nakheel bonds, front running their own decision to support).

Does Greece have Germany? Does Ireland have France? What about the Baltics and maybe Spain? These countries have such battered balance sheets and overstated asset values that insolvency is a fair question. How will these issues be resolved? How will the Euro behave?

There are major piles of money chasing assets, speculating and in need of discipline. Never before have we had such piles of money in need of investing discipline: several trillion dollars of sovereign wealth built up over the past decade, with limited leadership and inexperienced managers, driven by politicians. Certainly more mistakes and poorly thought out decisions are ahead. Add to this the money controlled by hedge funds - again new in the past decade - and you have financial markets with new players and uncertain behavior.

Commercial real estate in the US and Europe is still in free fall and a huge chunk of the underlying debt on the past few years' of transactions is coming due through 2012. Values are still overstated and balance sheets will get hit at banks and investment funds. This clean up is still ahead.

Among the unresolved issues, the story of the US housing crisis hasn't changed much, the imbalance caused by the linking of chinese and US currencies hasn't changed, and governments still provide active credit support to the worldwide banking system. While not likely to cause additional crises, these issues are certainly a solid pair of cement shoes.

Owners are still walking away from homes, prices are still bouncing along the bottom and REO on bank balance sheets is still growing. Much work remains, particularly on the part of banks who must speed this process up. The imbalances caused by the linking of the two biggest economies' currencies have not been resolved. I'm am still working on this one - a nice note was put together by Niall Ferguson that should explain it all.

The US government is still the active guarantor of the banking system and the economy. While the TARP may be winding up, few mortgages are underwritten without the support of the government. Home purchase incentives have been extended and low rates appear to be around for a few more months. Bank lending has not rebounded and monetary velocity is still in decline. Jobs are not coming back soon and as a reminder, the US needs a net 100,000 new jobs per month just to maintain an even employment rate.

Our final issue may turn out to be the most important. It seems clear to me 10,000 miles from home that consumer behavior has changed for a generation. Savings rates are going up and will stay up, and the US economy has further adjustments to make (as does the world) to this new behavior.

We are reversing 30 years of democratising access to capital, increasing levels of leverage and monetisation of assets. This is a balance sheet recession where it takes years to reset balance sheet health. Simply walking away from your upside down mortgage doesnt change the fact that you have no money in the bank, little set aside for retirement and lifestyle expectations that you cant afford.

What is the right valuation for the US equity market in this unfinished correction? I'm not sure, but from a trading perspective, the bounce from awful corporate reports to improved cost-cutting reports looks to be over, the return of the consumer will not happen. The bounce has been mighty and may have more to go; as long as Ben keeps the rates at zero, there may not be a major correction. But once he puts out the signal to begin normalizing credit access, look out below. It will happen in 2010. Not in the fist quarter and maybe not in the second...

I like the coming quarterly reporting period for a bounce to the high 10's and into the elevens and then I get off the bus. I start to look at the short bond side, wait for better commodity prices triggered by tightening worldwide central bank behavior. Again, this is a work in progress, more later.

- The recent analysis of Chinese GDP growth suggests that 95% comes from infrastructure/government spending; Fitch is out saying the Chinese banks are accumulating massive bad debts, again. Argument here is the Chinese balance sheet, supported by $2t of Fx reserves, is being deployed in a less than sensible/sustainable way. The questions are, how long can they spend until their export/consumer numbers pick up and how bad is the coming banking balance sheet problem? How does this impact the US? Will US consumer spending pick up soon enough to help partially rebalance China's economy? If China does run into problems in '10, clearly bad for the US stock market and maybe it means a faster liquidation of their US treasury holdings?
- 10 year yields are on the way back up. TIPS are at a spread suggesting inflation is around the corner. Comments from pundits suggest that investors have no more than six months to get their bond durations low to avoid the eventual rate rises and bond sell off. Having said that, there is still no lending and velocity is still in decline. Is it that when we see velocity start to climb, we'll be too late to get to the short end of the curve?
- The recent moves in the TIPS and the 10 year are supporting the move up in the US$, which rallies in response to any sentiment that rates are coming up. How much total assets are owned in leveraged US$ trades? Will there be a larger commodity sell off in the a US$ sustained rally? IS this a sustained rally? Only if the private sector growth numbers in the US show a recovery; so far they havent. So the T selloff and and the $ rally are just guesses for the moment...