Europe healing?


Author Cam Hui

Posted: 28 May 2013

Sometimes things are so bad it can’t get any worse. That seems to be case in the eurozone, which is mired in deep recession and possibly a multi-year depression.

Yet I am seeing signs of improvement. Mario Draghi’s ECB has moved to take tail risk off the table. What’s more, the periphery is starting to turn around. Walter Kurtz of Sober Look noted last week that peripheral Europe is starting to improve:

Today we got the latest PMI numbers from the Eurozone (see figure 2). France is clearly struggling and Germany’s growth has been slower than many had hoped – due primarily to global economic weakness. But take a look at the rest of the Eurozone. While still in contraction mode, it shows an improving trend.

Spain printed a trade surplus last month (surprising some commentators), which may be a signal to rethink how valid some of these forecasts really are. Nobody is suggesting we will see Spain or Portugal all of a sudden begin to grow at 5%. But given the extremely pessimistic sentiment of many economists (a contrarian indicator), it is highly possible we are at or near the bottom of the cycle. People should not be surprised if we start seeing some positive growth indicators – especially in the periphery nations – in the next few quarters.

Indeed, bond yields in the periphery have been showing a trend of steady improvement and “normalization”. As an example, look at Italy:

Here is Spain:

Here is the real clincher. Greek 10-year yields have fallen from over 30% to under 10% today:

As a sign of how the bond markets have normalized and how risk appetite has returned to Europe, consider this account of what happened with Slovenia early this month. Slovenia was doing a bond financing, then Moody’s downgraded them two notches to junk:

After several days of roadshowing, the troubled Slovenia decided to open books for 5 and 10y bonds on Tuesday (30 April). Given that in the previous weeks peripheral bond markets rallied like mad, it wasn’t too heroic to assume that the book-building would be quite quick. Indeed, in the early afternoon books exceeded USD10bn (I guess Slovenia wanted to sell something around 2-3bn) and then reached a quarter of what Apple managed to get in its book building. If I were to take a cheap shot I would say that Slovenia’s GDP is almost 10 times smaller than Apple’s market capitalisation* but I won’t.

And then the lightning struck. Moody’s informed the government of an impending downgrade, which has led to a subsequent suspension of the whole issuance process. I honesty can’t recall the last time a rating agency would do such a thing after the roadshow and during book-building but that’s beside the point. That evening, Moody’s (which already was the most bearish agency on Slovenia) downgraded the country by two notches to junk AND maintained the negative outlook. This created a whopping four-notch difference between them and both Fitch and S&P (A-). The justification of the decision was appalling. Particularly the point about “uncertain funding prospects”. I actually do understand why Moody’s did what it did – they must have assumed that the Dijsselbloem Rule (a.k.a. The Template) means that Slovenia will fall down at the first stumbling point. But they weren’t brave enough to put that in writing and instead chose a set of phony arguments.

Did the bond financing get pulled or re-priced? Did bond investors run for the hills and scream that Slovenia is the next Cyprus? Not a chance. In fact, the issue sold out and traded above par despite the downgrade:

Then the big day came – books reopened, bids were even stronger than during the first attempt and Slovenia sold 3.5bn worth of 5 and 10y bonds. On Friday, the new Sloven23s traded up by more than 4 points, which means yield fell by more than 50bp from the 6% the government paid. A fairy tale ending.

Key risk: France
From a longer term perspective, the elephant in the room continues to be France (see my previous post Short France?). French economic performance continues to negatively diverge with Germany. This isn’t Greece or Ireland, whose troubles could be papered over. France is the at the heart of Europe and the Franco-German relationship is the political raison d’etre for the European Union. France cannot be saved. It can only save itself. 

Despite these dark clouds, the markets are relatively calm over France. The CAC 30 is actually outperforming the Euro STOXX 50:

From a global perspective, European stocks are also showing a turnaround against the All-Country World Index (ACWI):

I am watching this carefully. European stocks could turn out to be the new emerging leadership and the source of outperformance.

Full disclosure: Long FEZ

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.  

More of the usual Eurocrisis drama


Author Cam Hui

Posted: 22 Mar 2013

So the Cypriot parliament has rejected the terms of the Troika’s rescue deal. Their finance minister is in Moscow and there were stories floating about that the quid pro quo for a Russian rescue of Cyprus would be a Russian naval base (via Business Insider). Should the EU and NATO be concerned?

I don’t think so. The Russians had a chance to expand their geopolitical footprint in November but they passed. Here is what I wrote back then (see Europe dodges another bullet (Not the Catalan election)) [emphasis added]:

The wild card that I had been watching for is for Greece to turn to Russia instead of the Troika for financing. What if the Greeks got tired of the pain and turned to Putin for relief? Moscow has long had a historical desires for the warm waters of the Mediterranean for centuries. A financing deal could have shook up NATO and significantly shifted the geopolitical balance in the Eastern Med.

The test case was Cyprus. Russian nationals have a large presence on that island. As its banks got into trouble because they were stuffed full of Greek debt, the Cyprus economy was in peril. As the New York Times reported in June:

The Russian government last year gave Cyprus a three-year loan of 2.5 billion euros, or $3.1 billion at the current exchange rate, at a below-market rate of 4.5 percent to help it service its debt. Cyprus now needs at least 1.8 billion euros, or $2.3 billion, by the end of this month to buttress its ailing banking sector.

Instead of turning to the EU, they turned to Russia [emphasis added]:

Now many on this tiny island nation, whose banks and government are facing economic insolvency, are hoping for financial salvation from Russia rather than Germany and the European Union.

“I would much rather be saved by Moscow,” said Elena Tsolia, 30, an attendant at the department store Debenhams, where Russian shoppers snap up bottles of Dior and Chanel perfume. “We are a small island and we don’t want to be owned by Germany.”

I speculated that Russia could have not only rescued Cyprus, but Greece in return for naval basing rights:

Cyprus would have been the test case of Russia flexing its financial and geopolitical muscle in the Eastern Med.

Today Nicosia, tomorrow Athens? Can you say “Russian Black Sea fleet base in Athens, or Crete”?

So what happened? Cyprus turned back to the Troika instead of Moscow:

A little noticed announcement came across my desk. The headline was CYPRUS Government – Troika reach agreement:

The Government of the Republic of Cyprus informed on the 25th of June 2012 the appropriate European Authorities of its decision to submit to euro area Member States a request of financial assistance from the EFSF/ESM.

Any talk of a rescue from Moscow is likely just that – talk. The Russians demonstrated their lack of interest in November when they had the chance.

Cypriot crisis tripwires
Here is what I am watching for as signs that the markets believe that the Cyprus crisis is getting out of hand. The chart below shows the relative return of the ETF of Greek stocks (GREK) against large cap eurozone stocks (FEZ). The GREK/FEZ ratio has declined and it is testing a relative support zone. Should it break support, then it’s time to get more cautious.

I use this ratio for two reasons. Cypriot banks are highly exposed to Greek debt. As well, the Greek stock market is the high beta “canary in the coalmine” of risk in the eurozone.

Looking at a similar ratio of the Athens Index to the Euro STOXX 50, it gives me further comfort that the market isn’t overly concerned about the Cyprus situation. This ratio isn’t even testing the relative support level yet:

So take a deep breath and relax. The headlines represent the usual European negotiation drama in a crisis, with one or both sides leaking stories of catastrophe should there be no agreement.

On the other hand, the message from the markets is that this crisis will be resolve in a relatively benign manner. Listen to the markets. Calm down.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Don’t lose sight of the medium term


Author Cam Hui

Posted: 18 June 2012

Rather than focus on Greece this weekend, I thought that I would write about the medium term path for equities and the global economy. I came upon this BIS paper entitled Characterising the financial cycle: don’t lose sight of the medium term! The BIS researchers break economic cycles into two components, a shorter business cycle and a longer financial cycle. Here is the abstract:

We characterise empirically the financial cycle using two approaches: analysis of turning points and frequency-based filters. We identify the financial cycle with the medium-term component in the joint fluctuations of credit and property prices; equity prices do not fit this picture well. We show that financial cycle peaks are very closely associated with financial crises and that the length and amplitude of the financial cycle have increased markedly since the mid-1980s. We argue that this reflects, in particular, financial liberalisation and changes in monetary policy frameworks. So defined, the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the “unfinished recession” phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road.

The financial cycle is turning down. Ray Dalio of Bridgewater explained the financial cycle using the Monopoly® game as an analogy in this note.

If you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

Now imagine Monopoly® with financial leverage and you understand what is happening with the financial cycle:

Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash.

What happened with Lehman in 2008 and in Greece, Spain and the other eurozone peripheral countries today are symptoms of the downturn in the financial cycle.

The business cycle turns down
There is no doubt that the financial cycle has been turning down since 2008. What about the business cycle? It’s turning down as well. Regular readers know that I use commodity prices as the “canaries in the coalmine” of global growth and inflationary expectations. Consider this chart of the negative divergence between US equities and commodities prices.

The market is also telling a similar story of an economic slowdown. Here is the relative performance of the Morgan Stanley Cyclicals Index against the market. It’s in a relative downtrend, indicating cyclical weakness.

Globally, air cargo traffic represents an important real-time indicator of the strength of the global economy (h/t Macronomics). This chart from Nomura shows the correlation of air cargo growth with global industrial production growth. Air cargo growth is headed south as well.

I have written about the Axis of Growth, namely the US, Europe and China and at least two of the three are slowing. Hale Stewart at The Bonddad Blog went around the world and explained why the global economy is slowing:

[T]here are no areas of the world economy that are demonstrating a pure growth environment; everybody is dealing with a fairly serious negative environment. Let’s break the world down into geographic blocks:

1.) China is located at the center of Asian economic activity. Recently, they lowered their lending rate largely as result of weakening internal numbers. While these numbers still appear strong to a western observer (growth just over 8%), remember that China is trying to help over a billion people become middle class. To accomplish that goal, the economy needs to have a strong growth rate. Also consider that the news out of India has become darker over the last few months as well. A recent set of articles in the Economist highlighted the issues: a political system that is more or less unable to lead, thereby preventing the action on structural roadblocks to growth. The fact that two of the Asian tigers are slowing is rippling into other regions of the world, which leads to point number 2.

2.) The countries that supply the raw materials to these regions are now slowing. Australia recently lowered its interest rate by 25 BP in response to the slowing in Asia. A contributing factor to Brazil’s slowdown is the decrease in exports to China. Other Asian economies that have a trade relationship with China are all experiencing a degree of slowdown, but not recession. Some of these countries (such as Brazil) were also experiencing strong price increases. The price increases are are starting to slow, but they are still above comfort levels.

3.) Russia has dropped off the news map of late. However, it emerged from the recession in far worse shape; it’s annual growth rate for the duration of the recovery has been between 3.8% and 5%, which is a full 3% below its growth rate preceding the recession. This slower rate of growth makes Russia a far less impressive member of the BRIC list.

4.) The entire European continent is caught up in the debt story — underneath which we’re seeing some terrible economic numbers emerge. PMIs are now in recession territory, unemployment is increasing and interest rates for less than credit-worthy borrowers are rising. And, the overall credit situation is casting a pall over the continent, freezing expansion plans.

5.) The US economy has experienced 2-3 months of declining numbers. While we’re not in recession territory yet, we are clearly in a slowdown with growth probably hovering around the 0% mark.

In addition, I have documented warning signs of rising tail risk in China (see Focus on China, Not Europe, Ominous signs from China and The ultimate contrarian sell signal for China?)In last week’s analysis, John Hussman said that the US is in recession now and blamed it on the financial cycle:

By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago.

Regardless of the outcome of the Greek election, my inner investor tells me that the fundamentals of the economic outlook is negative. When the financial cycle and the business cycle both turning down in unison, that’s bad news.

As for how much of the negative news has been discounted by the markets, I don’t know. What can change the trajectory of the outlook in the next few months is intervention, either by the central banks (which was rumored late last week), an announcement of more QE by the FOMC, or the news of some deal cooked up by the European governments, IMF, etc.

My inner trader tells me that fundamentals don’t matter and the markets will react to short term headline news.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Time for the Draghi and Bernanke Puts?


Author Cam Hui

Posted: 05 June 2012

This week is an important week for investors who are watching for central bank action in the wake of market angst over Europe and the American economy. On Wednesday, the ECB will announce its interest rate decision and Mario Draghi will hold the customary press conference afterwards. On Thursday, Ben Bernanke will be testifying before Congress.

What will they say?

Don’t expect too much
While I do expect that the ECB and Federal Reserve will intervene eventually, I do think that the markets may be getting ahead of themselves in anticipating another round of LTRO from the ECB or QE from the Fed. After all, Mario Draghi said last week that the ECB was reaching the limits of what it could do and it’s now up to the politicians:

Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.

The ECB is likely to reduce interest rates in the face of economic weakness in the eurozone, but don’t expect too much more. If Draghi were to reverse course from last week and announce some extraordinary measure like another round of LTRO, it would not only erode the ECB’s credibility, but could paradoxically have a negative effect on the markets as it asks, “What looming disaster does the ECB know about that we aren’t aware of?”

QE3 in June?
Across the Atlantic, there is a lot of expectation built up that we are due for another round of QE at the June FOMC meeting in the wake of last week’s ugly NFP report. Veteran Fed watcher Tim Duy disagrees  [emphasis added]:

Bottom Line: At this point, the direction of US data, the pathetic state of Europe, and the evolving slowdown across the rest of the world all point toward additional action by the Federal Reserve. Assuming this continues, it is an issue of timing and tools. My baseline is steady policy at the June meeting (depending, of course, on the usual financial turmoil disclaimer), with a possibility of an extension of Operation Twist. The latter option is something of a tough sell for me; it is cheap, but will prove to be ineffective. If the Fed needs to move, they need to reverse course back into quantitative easing. They need time to build internal support for such a move, which argues for action later in the summer or early fall, much as we have seen in the past two years. I just don’t think they have enough to shift policy at this juncture.

Don’t forget that Bernanke and the Bernanke Fed is made up largely of conservative academics, who tend to wait for definitive evidence of a slowdown before acting. As I wrote before about the difference between the Bernanke and Greenspan Fed (see Yes to QE3, but not yet), both the Greenspan Put and Bernanke Put exist, the difference is in reaction time:

[P]ut yourself in Bernanke’s head. His academic reputation was built on the study of central bank action during the Great Depression. This is probably a little voice in his head telling over and over again, “Don’t let another Great Depression happen on your watch.” As a result, we have the Bernanke Put.

Greenspan had a long career on the Street as a forecasting economist and tended to be more proactive:

Greenspan’s approach as Fed Chairman was to stimulate whenever he saw signs of weakness – and he was far more market savvy than Bernanke. Therefore the Greenspan Fed tended to be more proactive and tended to get ahead of events. The Great Moderation was the result of the Greenspan Put – and those policies worked well, until they went overboard with the stimulus (and we are still paying the price for those policies).

My guess is that investors looking for hints of another round of QE from the Fed on Thursday are likely to be disappointed.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

2012 = 1998?

Posted: 04 Jun 2012 12:16 AM PDT

Weekends are a good time to think and reflect. After last week’s carnage in the stock market, some thinking and reflection was more than overdue. The question I had was, “What is the market headed?”

When I consider the different dimensions by which investors evaluate equities, they present a mixed picture that is, while bearish, does not point to disaster:

  • Sentiment: bullish
  • Valuation: neutral to slightly bearish
  • Momentum: bearish
  • Macro: bearish, but subject to policy-induced whipsaw

Sentiment models are screaming “buy”!
Let’s go through each of these one at a time. Martin T. over at Macronomics noted that Wall Street strategists are off the charts bearish, which is contrarian bullish.

As well, US 10yr yields are trading 3 standard deviations from the 30+ year downtrend, which indicates a crowded long in the Treasury safe haven trade.

Scott Grannis has noted the same level of exuberance when he asked “What record-low Treasury yields tell us“. His take:

If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today’s record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects.

Valuation: Neh!
Typically, when sentiment is this bearish, Value investors are all crawling out of the woodwork and shouting, “I can’t believe that there are so many bargains!”

While I have heard that comment directed at a number of European companies, i.e. these are real world-class companies trading at bargain prices (see one example at the FT article While all around ar panicking…buy), the same couldn’t really be said of most markets. The Value investors just aren’t there.

Consider, for example, this Barron’s interview with Jeremy Grantham, who is known to have a value bias, on February 25, 2012 when the SPX was about 1360, which is about 6% above Friday’s close of 1278.

We do a seven-year forecast every month. On a seven-year forecast, global equities outside the U.S. are boring. They’ve been so nervous the last year that they mostly reflect the right degree of fear about European problems. Emerging markets and developed markets outside the U.S. are within nickels and dimes of fair value. This is very unusual. We are in the asset-allocation business, and we like to see horrific roller coasters: It gives us something to get our teeth into. What could be more boring than global equity markets at fair value?
About a quarter of the U.S. equity market—the high-quality, boring, great companies—is about fair price, too. The other three quarters are overpriced, and based on our numbers have a slight negative imputed return.

While Grantham doesn’t represent the final word in stock market valuation, he is a good bellwether for what Value investors think. As of the end of February, he believed that non-US equities were roughly at fair valuation. US equities are overpriced, with only a quarter, i.e. high quality stocks, at fair value.

His comments were not a stunning endorsement for the stock market.

A Dow Theory sell signal
The Dow Theory is one of the original trend following models, which is based on price momentum and looks for confirmations from different sectors of the market: industrials, transportation and utilities. Long-term market analyst and Dow Theorist Richard Russell recently flashed a major sell signal for stocks [emphasis added]:

IMPORTANT — Dow Theory — The D-J industrial Average recorded a high of 13,279.32 on May 1, 2012.  This Dow high was not confirmed by the Transports.  The two averages then turned down and broke below their April lows.  This action confirmed that a primary bear market is in progress — it was a textbook bear signal.

Could you be a little more clear, Richard?

Macro picture gets worse
Last week, the news flow from Europe continued to deteriorate. The latest Greek tracking polls have SYRIZA on top again:

Not only that, the markets are now getting concerned about Spain – a country that’s too big to fail. In the meantime, ECB head Mario Draghi stood aside last week and said that the ECB can’t do much more. It’s all up to the politicians:

Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.

Last week, I wrote that investors should focus on China, not Europe. The news out of China is headed south. The latest PMIs are signaling a global slowdown, not just in China but in Europe as well. I raised the issue of when investors might focus on the question of capital flight out of China, when Tim Duy picked up on the same story. Should the market start to price in the tail-risk of capital flight, look out below!

Then we have the ugly US Non-Farm Payroll Friday. The only good news is that more data points of economic weakness will give the Fed political cover to act and unveil another round of QE. Despite what the central bankers say, don’t forget that when things get bad enough, there will a policy response. As an example of the anticipated response, Mark Dow at Behavioral Macro believes that the IMF is putting on the face paint for a rescue of Spain. While the response may not fully solve the problem, it will kick the can down the road and spark a stock market rally.

A repeat of 1998 in 2012?
Putting it all together, what does it all mean? The market is supported by washed out investor sentiment, but not by valuation. The macro backdrop and momentum looks ugly. Is this the start of another cyclical bear?

Probably not. Valuations don’t look excessively stretched, but they aren’t screaming “buy” either. Major bear markets generally don’t start with these kinds of valuation metrics.

My best wild-eyed-guess is that we will see a major air pocket like 1997 (Asian Crisis) or 1998 (Russia/LTCM Crisis) in which some macro event sparks a major selloff, but turns around based on policy response. There are plenty of macro triggers out there. Greece, Spain, China, etc.

Market analogues have limited uses, but look at the chart of the stock market in 1998. The market had an initial dislocation (Greece), stabilized and rallied (as we did a couple weeks ago) and started selling off again. At the nadir of the Russia Crisis that threatened to sink Long-Term Capital Management, the Fed came in and knocked some heads together to save the system.

Now look at the chart of the market this year and last year. See any parallels?

Don’t misunderstand me. This is not a forecast that stocks are going to plunge this week. Analogues are analogies and they are imperfect. Markets are extremely oversold on a short-term basis and I don’t think that we’ve actually seen the macro trigger for a waterfall decline yet, though there are lots of potential triggers.

Not enough pain
Nevertheless, were this scenario were to play out, it suggests that we haven’t quite seen enough pain and we need one more capitulation down leg to equities. For now, my Asset Inflation-Deflation Trend Model remains at a deflation reading, indicating that the model portfolio should be primarily positioned in the US Treasury market. I will be primarily using that model and some short-term timing tools to try to spot the turn. Here is what I am watching. The chart below of the Euro STOXX 50 is falling, but not quite at the lows delineated by the 2009 and 2011 lows. Wait until the index approaches that zone and watch for signs of a “margin clerk” liquidation forced selling in the panic.

Here in Canada, I am also watching the ratio of the junior TSX Venture Index to the more senior and established TSX Composite. While there is a lot of pain, utter and blind panic hasn’t quite set in yet.

When the blood starts to run in the streets, official intervention will be all but inevitable. At that time, that will be the opportunity to buy the pain in Spain.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The NFP coin tossWhat’s the risk of capital flight in China?


Author Cam Hui

Posted: June 3 2012

I wrote before that the likely negative surprise was going to come from China and not Europe (see Focus on China, not Europe). Yes, I am worried about China, but my concerns are longer term oriented.

No, I am not as concerned about the possibility of a slowdown in China, as per Marc Faber on CNBC:

“As an observer of markets – whenever everyone focuses on one thing – like Greece and Europe – maybe they miss issues that are far more important – such as a meaningful slowdown in India and China.”

No, I am not as concerned about the disappointment over the size of the announced stimulus program. The market rallied initially when the news of the stimulus program hit the tape and official media announced that it was RMB 1 trillion [emphasis added]:

In the context of complicated and changed economic situations, the Chinese government has vowed to make some tailored changes to its established macroeconomic policy. At an earlier State Council meeting, a consensus was reached that China will accelerate the approval of some infrastructure projects, promote consumption of energy-saving home appliances and increase tax cuts on enterprises in a bid to ensure steady growth. China’s central bank also announced a 50-basis-point cut for banks’ reserve requirements on May 12, the second such cut this year and a third since December, which will release more liquidity. The stimulus packages are expected to reach 1 trillion yuan ($158 billion).

The markets then sold off the next day when it realized that the size of the program is only one-quarter of the size of the 2008 RMB 4 trillion program. What did you expect? They announced that it would by RMB 1 trillion!

Is China’s business elite losing confidence in China?
Here’s what I am worried about: There are signs that the Chinese business elite is losing confidence in China, which could result in a disastrous run on the RMB.

To set the stage, FT Alphaville highlighted a paper by Victor Shih of Northwestern University that illustrates the vulnerability of China’s vaunted foreign exchange reserves:

And on that note, we found some of the points raised in this 2011 paper by Victor Shih from Northwestern University extremely insightful.

For one thing, did you know that China’s wealthiest 1 per cent could determine everything?

Consider the following points (emphasis ours):

China in fact faces three major structural causes of capital flight.

First, the empirical portion of this paper will conduct three calculations to show that the wealthiest 1% households in China commands wealth that is at least as large as 2/3 of the foreign exchange reserve and possibly as high as nearly twice its size.

Thus, if the top 2.1 million households in a nation of 1.3 billion people decide to move even 30% of their wealth overseas, the foreign exchange reserve will reduce by a trillion dollars or more.

Second, despite official foreign exchange control, numerous channels, especially those through China’s current account, exist to move capital in and out of China.

Third, households, which are net savers, face a negative 3 plus percent in real return from bank deposits and Chinese treasury bonds, forcing them to constantly look for higher returns than inflation rates.

These three conditions combine to create extremely fragile conditions for China’s foreign exchange reserve, which is the backbone of the entire financial system of China.

If the foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector (Walter and Howie 2011; Shih 2004).

In other words, the Shih paper says that China’s foreign exchange are highly vulnerable to a loss of confidence by its business elite.

So what? That’s just like saying that a banking system, any banking system, is vulnerable to a loss of confidence. What if all the depositors all rushed to get their money out of the banks at the same time? If you had been predicting doom in the banking system in the last 50 years based on this premise, you would still be waiting for the collapse to occur.

What you need is a catalyst, a loss of confidence, for a catastrophe to occur. There are signs that a loss of confidence by China’s business elite seems to be happening. I wrote on Monday that:

FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China in 20 years

Capital flight?

OK – so they are starting to lose confidence in China’s long-term growth outlook. What are they doing about it?

Look at this chart from Bianco Research of China’s net purchase of Treasuries. They went NEGATIVE a few months ago and ticked back to positive, but net purchases are still net negative on a rolling 12 month basis.

When I added two and two together, this story of a USD shortage in China now makes sense:

We noted last week that there was a rising tussle over dollars in China, spurred by capital outflows and RMB-denominated selling on signs that the world’s key economic powerhouse may be slowing. A situation which was arguably thrusting China into a dollar short position.

While that might seem counterintuitive given China’s substantial longer-duration dollar assets, it is possible because of China’s substantial short-term dollar liabilities. Essentially, we’re talking about a dollar-denominated duration mismatch on the mainland at a time when China is running one of its largest outstanding external debt positions for 27 years.

When I worked with our emerging market investment team, the team head told me that one of the buy signals for a country is when the locals start to repatriate funds from abroad (and he was referring to Latin America at the time). What we have in China are signs of a loss of confidence, followed by indications of capital flight – all very bad news.

To be sure, I may have just misinterpreted the data and wrongly concluded that capital flight is occurring. Another explanation is that this episode of capital flight is just a momentary flash of panic, created by the uncertainty that accompanies a change in leadership.

Let me make myself clear: A collapse in China’s foreign exchange account is not my base case scenario. Such a loss of confidence would not just mean a hard landing involving sub-par economic growth, but a crash landing involving negative GDP growth, which would totally freak out the markets. Nevertheless, the probability of such an event is small, but non-zero – and definitely not discounted by the markets at all. What worries me is that the markets start to get a whiff of this story and starts to price in this kind of tail risk. That’s when the trouble begins.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Poor starving children in China…


Author Cam Hui

Posted: 28 May 2012

It is said that American parents used to admonish their children to eat their dinner because “there are poor starving children in China.”* In a recent interview with the Guardian, IMF chief Christine Lagarde invoked the poor starving children metaphor when speaking about Greece [emphasis added]:

So when she studies the Greek balance sheet and demands measures she knows may mean women won’t have access to a midwife when they give birth, and patients won’t get life-saving drugs, and the elderly will die alone for lack of care – does she block all of that out and just look at the sums?

“No, I think more of the little kids from a school in a little village in Niger who get teaching two hours a day, sharing one chair for three of them, and who are very keen to get an education. I have them in my mind all the time. Because I think they need even more help than the people in Athens.” She breaks off for a pointedly meaningful pause, before leaning forward.

“Do you know what? As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time. All these people in Greece who are trying to escape tax.”

Even more than she thinks about all those now struggling to survive without jobs or public services? “I think of them equally. And I think they should also help themselves collectively.” How? “By all paying their tax. Yeah.”

In summary, Lagarde is admonishing the Greeks to get on with eating their vegetables. This seems to be a clever piece of negotiating on her part as a way of pushing two parties towards a middle ground, becuase last week, the WSJ reported that she was pushing Germany to accept eurobonds:

International Monetary Fund head Christine Lagarde Tuesday called on euro-zone governments to accept more common liability for each other’s debts, saying that the region urgently needs to take further steps to contain the crisis.

“We consider that more needs to be done, particularly by way of fiscal liability-sharing, and there are multiple ways to do that,” Lagarde told a press conference in London to mark the completion of a regular review of U.K. finances.

I wrote last week (see A Canadian’s roadmap to Greek struggles) that to expect Europe to show both a carrot and a stick to the Greeks. Lagarde offered them a carrot last week in the form of tacit support for eurobonds. Now she is showing them a stick.

* I can still recall the Doonesbury cartoon from the 1970’s of the Chinese parent admonishing his son to eat his jellied duck web because there are poor starving children in West Virginia.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Draghi, the last domino falls


Author Cam Hui

Posted: 25 May 2012

As expected, the Latin quarter of the eurozone ganged up on Germany on the issue of eurobonds, but Angela Merkel stood fast. But Germany is becoming increasingly isolated. The WSJ report that Christine Lagarde of the IMF came out in support of the concept of eurobonds:

International Monetary Fund head Christine Lagarde Tuesday called on euro-zone governments to accept more common liability for each other’s debts, saying that the region urgently needs to take further steps to contain the crisis.

“We consider that more needs to be done, particularly by way of fiscal liability-sharing, and there are multiple ways to do that,” Lagarde told a press conference in London to mark the completion of a regular review of U.K. finances.

So did the OECD:

Her comments came an hour after the Organization for Economic Cooperation and Development had, for the first time, endorsed joint bond issuance in its latest Economic Outlook

Angela Merkel’s staunchest ally has been Mario Draghi of the European Central Bank. Up until now, Draghi had been relatively silent on the Greek crisis. He spoke yesterday at at the Sapienza University in Rome and addressed the latest eurozone crisis in an unusually frank manner [emphasis added]:

We are living at a critical juncture in the history of the Union. The sovereign debt crisis has exposed serious weaknesses in the institutional framework; in this context, the difficulties in finding common solutions are having a negative impact on market valuations. The extraordinary measures taken by the ECB have gained us time; they have preserved the functioning of monetary policy.

But we have now reached a point where European integration, in order to survive, needs a bold leap of political imagination. It is in this sense that I have referred to the need for a “growth compact” alongside the well-known “fiscal compact”.

He went on to explain what he meant by a “growth compact”, namely closer economic integration:

A growth compact rests on three pillars and the most important one, from a structural viewpoint, is political: the economic and financial crisis has challenged the myopic belief that monetary union could remain just that, and not evolve into something closer, more binding, into an arrangement whereby national sovereignty on economic policy is replaced by the Community ruling. If the governments of the Member States of the euro define jointly and irrevocably their vision of what the political and economic construct that supports the single currency will be and what the conditions to reach that goal together should be. This is the most effective answer to the question everyone is asking: “Where will the euro be in ten years’ time?”.

Hmm, sounds sort of like an endorsement of eurobonds to me.

He went on to talk about “structural reforms”, which I wrote about extensively in the past (see Mario Draghi reveals the Grand Plan). It means, in effect, structural reforms at the micro-economic level so that it’s easier to fire people. It also means internal devaluation by the peripheral countries:

The second pillar is that of structural reforms, especially, but not only, in the product and labour markets. The completion of the single market and the strengthening of competition are crucial for growth and employment. Labour market reforms that combine flexibility and mobility with a sense of fairness and social inclusion are essential.

Growth and fairness are closely connected: without growth, and the events of recent months also reflect this, the temptation to “circle our wagons” gains strength, and solidarity weakens. Without fairness, the economy breaks up into multiple interest groups, no common good emerges as a result of social and economic interaction, and there are negative effects on the capacity to grow. Recent Italian history has no shortage of examples.

By fairness, he refers partly to the high level of youth unemployment compared to the entrenched older generation with their job security and gold-plated pension plans:

In the European Union, between 2007 and 2011 the unemployment rate rose by 5.8 percentage points among the 15-24 year olds, by 3.5 points among the 25-34 year olds and by 1.8 points in the 35-64 age range. Qualitatively, the profile is similar almost everywhere; the clear exception is Germany, where the unemployment rate among 15 to 24 year olds in the first quarter of 2012 was 8%; in Italy it was 34.2%, in Spain 50.7% and the euro area average was 21.9%. These trends reflect a fundamental question: they confirm the particular vulnerability of this essential part of our workforce. The unequal sharing of the “cost of flexibility”, only affecting young people, an eternal flexibility with no hope of stabilisation, leads among other things to companies not investing in young people, whose skills and talents often decline in jobs with low added value. The underuse of their resources reduces growth in various ways: it makes the creation of start-ups less likely – and they are on average more innovative than others – it causes a decline in skills in the long run, slowing down the assimilation of new technology and acting as a brake on efficient production processes. In addition to undermining society’s sense of fairness, it is a waste that we cannot afford.

In addition, Draghi endorsed the idea of pan-European infrastructure bonds:

The third pillar is the revival of public investment: the use of public resources to push forward investment in infrastructure and human capital, research and innovation at national and European levels. (The proposed strengthening of the EIB and the reprogramming of Union structural funds in favour of less-developed areas go in this direction).

An endorsement of closer economic integration? A advocate for pan-European infrastructure bonds, which is the first step in the slippery slope to eurobonds?

It sounds like Merkel is losing her last ally in Mario Draghi. Expect the Germans to bend sooner than later.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A Canadian’s roadmap for Greek struggles


Author Cam Hui

Posted: 22 May 2012

A small state within a federation of states believe it’s getting a raw deal. A charismatic leader emerges who tells the population of the small state that he has a solution that relieves them of the burden, but get the benefits of the federation at the same time.

Greece? Well, sort of. In Canada, we went through a similar experience with the Quebec sovereigntist movements, culminating in the referendum of 1980 and a second one in 1995. If that is a road map for the political struggles that we see in Greece today, then consider what happened in the Canadian experience.

In the Quebec case, the sovereigntist message was, “We can have our own country, our own culture and at the same time have the economic benefits of Canada as well.” The reasoning went something like this. If Quebec were to separate, Canada would have no choice but to enter into some sort of economic association with Quebec, as the economies are so intricately connected with each other. Quebec would even use the Canadian Dollar as its currency (a bad idea given the eurozone experience of not having control of your own monetary policy, but they didn’t know that then). Canada has always allowed dual citizenship, so Quebec citizens could retain their Canadian citizenship, so what’s the big deal?

It was a seductive message, just as Syriza’s message is today to Greeks. Default, but stay within the euro. What can they do to us?

Expect a carrot and stick
Here’s what to expect. From the Canadian federalist (anti-separation) side, there were two messages, one offering a carrot and the other a stick. There was the tough talk about the dire consequences of what happens if Quebec were to leave. You’re either in or out. Don’t expect a sweet deal, or any deal on economic association if you were to leave. For example, there was some dispute of how much of Canada’s national debt Quebec were to assume if it were to become a separate country. I can recall that Diane Francis of the conservative National Post suggesting that Canada should unilaterally separate Government of Canada bonds and notes by a set amount and declare a portion to be Quebec’s obligation.

Already, we are seeing signs of this tough talk of a stark choice as Angela Merkel appears to be suggesting that Greece hold a referendum on euro membership, which most Greeks are in favor. Johann Rupert, the head of the Swiss-based luxury goods maker Richemont, chimed in on how Greeks should adjust their expectations:

You cannot work 35 hours a week, want to retire by 50 with full pension, have eight weeks of holiday and expect to be bailed out by people who work their butts off either in northern Europe or in China. Life does not work like that.

Michalis Chrysohoidis, the minister of Citizen Proection in the former Greek government, warned of civil war should Greece exit the euro:

An outgoing Greek minister warned that the country could descend into “civil war” amid the chaos of a euro exit. “If Greece cannot meet its obligations and serve its debt the pain will be great,” Michalis Chrysohoidis was quoted as telling a local radio station. “What will prevail are armed gangs with Kalashnikovs and which one has the greatest number of Kalashnikovs will count … we will end up in civil war.”

On the other hand, you will have a group with a soothing message of what you would get if you were to remain with the federation. You have Merkel-Hollande sounding conciliatory to Greece in their first meeting [emphasis added]:

German Chancellor Angela Merkel and French President Francois Hollande said they would consider measures to spur economic growth in Greece as long as voters there committed to the austerity demanded to stay in the euro.

Requests for measures to bolster growth will be “considered” and the European Union may also “approach Greece with proposals,” Merkel said late yesterday at a joint press conference with Hollande during his first official visit to Berlin. “Greece can stay in the euro area,” and “Greek citizens will be voting on exactly that.”

Notice the carrot and stick in their statements.

Even the hardline Germans appear to be bending a bit, both on inflation, which indicate easier monetary policy, and higher wages in Germany, which boost German demand and lessens the burden to take all of the the adjustments through austerity programs:

The Bundesbank, the most hawkish of central banks, has signalled it would accept higher inflation in Germany as part of an economic rebalancing in the eurozone that would boost the international competitiveness of countries worst-hit by the region’s debt crisis.

A future German inflation rate above the eurozone average could be part of a natural adjustment process as crisis-hit countries pulled themselves out of recession, the Bundesbank argued in evidence to German parliamentarians submitted on Wednesday.

It followed comments at the weekend by Wolfgang Schäuble, German finance minister, backing stronger wage increases, which would boost domestic demand – benefiting other European countries exporting goods and services to Germany – but could drive German inflation rates higher.

Despite the Bundesbank’s conciliatory stance on inflation, German policy makers have been among the toughest in insisting that Greece sticks to its agreed reform programme underpinning its bailout in the aftermath of Sunday’s Greek election in which most voters rejected the plan. Speaking in Brussels, Mr Schäuble said that changing the bailout terms would unleash ‘’catastrophic uncertainty’’ in financial markets.

How will all this play out?
In Canada, both Quebec referendums on sovereignty were defeated. The first by a fairly wide margin and the second narrowly by less than 1%. Guessing the likely outcome of the Greek elections is trickier.

Bruce Krasting wrote that he has a source in Athens and recounted their recent conversation:

Athens – The results of the May election are in conflict with the people’s desire to stay with the Euro.

The people voted in anger. They voted against those they had voted for in the past. Now they see whom they have elected.

Every day on TV the extreme right is interviewed. They are Nazi’s. People are frightened by this.

On the left you have Alexis Tsipras (Syriza). This man is an uneducated thug. The people understand that. They don’t want this man to be their leader.

When the next election comes, Greeks will not vote in anger and they will not vote for the idiots on the fringes. The centrist parties will rebound. A National Salvation Government will be formed.

BK – There are polls in the US press that say that Syriza will win a majority. (link)

Athens – I don’t think those polls are accurate. To me, things look much brighter today than a few weeks ago.

BK – But does it matter who wins? Can Greece be saved?

Athens – This up to Germany. Most of the debt is now with Germany and France. France’s Hollande would agree in one minute to reset the interest on the debt to zero for the next five years. If Germany agrees to do the same, there is a chance. The IMF would support Greece under these conditions. The restructured bank debt would get paid interest.

BK – Do you really believe that Greece can achieve a long-term recovery with this?

Athens – Not a chance. Everything will blow up again in less than one year.

Already, the latest polls show that New Democracy regaining the lead against Syriza:

After recent polls put Syriza in the lead, a survey Friday showed the race narrowing, giving New Democracy 23.1 percent of the vote, up from the 18.85 percent it won on May 6, with Syriza on 21 percent, up from 16.8 percent.

The Germans are becoming more conciliatory. The pro-European Greek parties are starting to gain ground. Going forward, events will be fluid and volatile, but don’t get short and bet on the catastrophic scenario of a Greek exit or even default. Chances are, Europe kicks the can down the road one more time.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The “Merde” rally?


Author Cam Hui

Posted: 10 May 2012

There is a silver lining in most dark clouds. When the stock market and other risky assets got clobbered over anxieties about Greece today, the silver lining is that a short-term bottom may be forming.

The chart below of SPY is just a bellwether whose analysis could be extrapolated to many other risky assets. The ETF formed a reversal day by selling off but rallying near the end of the day to a level where it roughly opened, and the action occurred on relatively high volume. Moreover, the selloff successfully tested a key short-term support level. For technicians, this action is, at a minimum, an indication of market indecision in the face of bad news – a positive sign. It could be more bullishly interpreted as capitulation selling.

An overreaction to Europe and Greece
As for Greece, things aren’t necessarily as bad as it sounds. Foreign Policy wrote that the surprise showing by SYRIZA, the leftist party that polled in second place in the election, doesn’t necessarily mean that the scenario of a catastrophic Greek exit from the eurozone is necessarily around the corner [emphasis added]:

Even if SYRIZA earns the mandate and manages to somehow seize the reins of power, the changes in Greek policy will hardly be “radical,” as the Coalition of the Radical Left’s name misleadingly implies. The party’s young, charismatic leader, Alexis Tsipras, has made it clear that he has no intentions of withdrawing Greece from the eurozone, let alone the European Union. Instead, we should expect a more nuanced approach to economic revitalization, which would likely include an aggressive renegotiation of the bailout terms currently in place between Greece and the “troika” composed of the EU, the European Central Bank, and the IMF, as well as a demand for more public investment in lieu of loans.

If I were to stretch the point a little further, even Foreign Policy‘s new term to replace “Merkozy” as a characterization of the new Franco-German partnership could also be interpreted bullishly as a contrarian magazine cover indicator:

A short-term Merde bottom?
I previously posted that a short-term bottom may be forming for gold and gold stocks, which is another high beta risky asset:

These readings are suggestive of a tradable short-term bottom in gold and gold stocks is coming up, but a long or even intermediate term bottom may have to wait. Given that gold prices are deflating in the wake of the French and Greek elections, that short-term bottom may be fast approaching.

We may be seeing that short-term trading bottom now. My inner trader wants to buy risk in anticipation of an oversold rally. My inner investor tells me to watch the market action in likely ensuing rally to gauge the strength of the bulls as this is just another phase in the choppy up-and-down market action that we have been witnessing in the past few weeks.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Europe takes one step back?


Author Cam Hui

Posted: 29 Mar 2012

The story of Europe has been the story of two steps forward and one step back. Here are the two steps forward/

Since the eurozone crisis, the ECB has taken steps with its LTRO programs to stabilize the banking and financial system. Moreover, I wrote that Mario Draghi, on behalf of the eurocrats, outlined the Grand Plan as a way to fix the long-term problems within the eurozone. The Grand Plan consisted of two steps, which sound like pages taken from the Maggie Thatcher playbook:

  • Austerity in the form of “good austerity”, defined as lower taxes and less government spending; and
  • Structural reform, which is the European version of the China taking steps to smash the iron rice bowl, which translates to union busting and going after all of the entrenched interests of the old with their lifetime jobs and gold-plated pensions at the expense of the young jobless.

The one step back happens when Europe dilutes these grandiose object. In the wake of the German and Dutch failure to hit austerity targets, a step backward is inevitable.

Time for Grand Plan 2.0
Most recently, the OECD warned that the eurozone debt crisis is far from over. The organization indicated more work needed to be done, i.e. Grand Plan, and market confidence is fragile. At about the same time, Willem Buiter at Citigroup issued a warning on Spain:

Spain is likely, in our view, to be pushed into a troika (EC, ECB, IMF) programme of some kind during 2012, possibly by losing access to market funding on affordable terms, but more likely by the ECB making a programme for the Spanish sovereign a condition for continued willingness to fund the Spanish banks, which are currently the main buyers of newly issued Spanish sovereign debt. The existing and likely near future EFSF/ESM and IMF financial facilities are unlikely to be sufficient to both fund the Spanish sovereign fully and leave enough financial ammunition in reserve to deal with possible sovereign financial emergencies in Italy or in the ‘soft-core’ of the euro area. The Spanish sovereign would therefore likely continue to fund itself at least partly in the markets even if it comes under a programme. To ensure market access by the Spanish sovereign, the same combination of cheap ECB funding for periphery banks and financial repression of periphery banks by their national authorities that has been effective in lowering sovereign yields since the first LTRO is likely to be required.

Buiter did concede that the government is taking steps to implement structural reforms:

It did use this period to pass several important pieces of structural reform legislation. Among these were labour market reforms aimed at reducing severance pay in the long-term contract sector (while introducing or raising it in the flexible contract sector); reforms aimed at reducing the scope and incidence of industry-wide collective bargaining and replacing it with something closer to firm-level or establishment-level contracting; the imposition of an additional €50bn provisioning requirement on the banks; and laws aimed at strengthening central government control over the finances of the lower-tier authorities (autonomous regions and municipalities).

…though he was uncertain as to their implementation:

Passing legislation and implementing it are not the same thing, however, as we know from the Greek experience. In addition, both structural reform and a medium-term programme of fiscal austerity based on a politically acceptable formula for fiscal burden sharing look necessary to restore Spain to fiscal sustainability. The new government’s decision to wait 100 days to introduce its first budget, in the pursuit of electoral gain, did little to boost Spain’s standing in global markets.

Spain is a too-big-to-fail country within the eurozone. Market angst is starting to rise over the willingness of the Spanish government and the Spanish people to bear the pain of austerity.

Will Spain fall and bring down the eurozone in another crisis? I doubt it. This is the back-and-forth of the Theatre of Europe, but some form of Grand Plan 2.0 compromise will likely emerge. I agree with Gayle Allard at the IE Business School in Madrid who says to not count Spain out in a crisis:

[Allard] said Spain’s biggest problem is investors’ lack of faith in the population’s willingness to withstand austerity. “They don’t see the Spanish people in that way, they don’t understand how a country can put up with it,” she said.

“Having watched Spain through previous crisis, they are a pretty surprising country. They get behind things, hard things,” Allard said. “I don’t think this is ever going to look like Greece and that’s something the markets don’t understand.”

Italy does structural reform
Over in Italy, FT recently reported that Mario Monti clashed with the unions over structural reforms “that would give companies more flexibility to fire workers for economic reasons” and he is winning because of weakened opposition:

[W]ith the [labor union] CGIL considerably weaker than a decade ago and with the main political parties in no position to offer a coherent alternative to the present government, political commentators doubt Mr Monti’s technocrats risk being driven from office.

Opinion polls indicate strong public support for Mr Monti in general, although a majority of Italians opposes changing Article 18 which protects workers in the courts from wrongful dismissals for economic reasons. Under the proposed changes, employees would receive compensation but not reintegration back into their workplace.

Monti is also following the Grand Plan script of structural reforms which pit the young unemployed against their elders, who have secure jobs:

With nearly a third of young people unemployed, Mr Monti also wants to end Italy’s two-tier labour market that protects older workers on indefinite contracts but provides little or no security for mostly new hires on short-term contracts.

The politicians are indeed following through with painful structural reforms. In the meantime, there is doubt from the markets that they can implement them even if the legislation is passed. In a typical EU-style compromise, some of the legislation will get watered down, but I believe that the pendulum is swinging back and the momentum toward structural reform is inevitable.

For now, the message for investors is be prepared for some downside volatility out of Europe. But also know that it is likely a temporary hiccup out of which Grand Plan 2.0 will emerge.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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