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CROSSASSETMONTHLY
TheMoreThingsChange...BytheRGEMarketStrategyTeam
June2011
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CROSS ASSET MONTHLY 2
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The Here and Now: Groundhog Day?
By Arnab Das
A bit more than a year after the U.S. deceleration, the original high point of the eurozone (EZ) PIGS debt crisis
and the equity bloodbath that combined to prompt new bailouts and QE2, we’re back in the same rut. In the film
Groundhog Day , the eponymous rodent poked his head above ground to check if winter were yielding to spring,
but the ill-fated protagonist saw this repeated daily, stuck in permanent winter. Here and now, the West can’t
achieve escape velocity and the emerging market (EM) world must restrain itself, as signaled repeatedly by
balance-sheet constraints.
Weighing up the structural, fiscal and external adjustment prospects, we worry that not much can be done quickly
to bail out the recovery, though we are ultimately unlikely to be allowed to slip into a new, full-blown crisis. It’s
now clear we’re in no position to engineer a V-shaped recovery, but that’s no reason to expect the powers that be
to let us slip into a severe W either. The U-shaped rut prevails. Let’s step through the looking glass into the U.S., EZ
and EM economies.
The U.S. has thrown a cumulative 40% of GDP at real and financial activity to stoke the recovery, across three
bouts of fiscal easing (FE), bailouts and backstops, Fed emergency liquidity measures and QE1 and 2. With all
this, it achieved a 5-6% GDP lift, yet activity data are sliding toward signaling red once again, just as at this time
last year. One may dispute the inclusion of QE1 (aka, credit easing), and early Fed balance-sheet expansions such
as TALF and the ensuing alphabet soup of emergency measures, but they did help to contain financial and
economic collapse. The scale of demand and capital destruction would have been far greater without them. It
follows that eventual recovery would have been from a lower base to a lower level of output and growth rate, all
with a sustained impact on potential GDP and growth. Thus, despite being prelapsarian history, these programs
still affect the here and now. Since then, FE1-3, as well as automatic stabilizers and backstops, have added some
30%+ of GDP to the truly gross public debt.
The next chapter of this screenplay might be different to last year’s edition. QE3 and FE4 are quite unlikely from
the current perspective; they cannot be ruled out, but they’re only going to be likely if the risk of a double dip rises
sharply. It may require the U.S. economy to be close to or even in a stall to really scare the pants off Washington—
far worse activity data and a far sharper fall in equity prices, as we had early last summer, to generate fear and
loathing in D.C. The political gridlock of the day is a dogfight over deficits; with repeated rejections of the looming
debt ceiling, things may need to be very bad indeed.
We expect the debt ceiling to be lifted, but early fiscal compromise is unlikely before the next presidential term—
so there is every reason to think this one will go right down to the wire. The brinksmanship could scare bond and
risky-asset markets, another reason to be risk light. In this context, the only good way to expend yet more stimulus
to stoke recovery without incurring the wrath of bond market vigilantes —design and implement an economically
credible, politically and legally binding technology to ease now and tighten later, once a durable recovery is
established—is easier said than done.
EZ crisis management and reform leaves much be desired and little to heave a sigh of relief over, though now
hope may be reignited by ECB President Jean-Claude Trichet’s proposal for an EZ Finance Ministry. We feel the
need to reiterate a few basics. Monetary unions have not survived without fiscal unions, which in turn require
political union; and the closer a monetary union is to an optimal currency union the better. The EZ remains the sole
extant and largest example of a multi-state, multi-nation currency union, yet suffers from many of the afflictions of
the ghosts of attempted monetary unions past. Trichet’s idea would on the face of it help cement the fisca l
apparatus, but as conceived, would only federalize spending constraints and veto power. It would not federalize
tax or spending authority, or debt.
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CROSS ASSET MONTHLY 3
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© Roubini Global Economics 2011 – All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
As a halfway house, it could be a major step forward, if pan-EZ fiscal vetoes were binding. But will member states
cede spending authority, though EZ integration entailed limited transfers of sovereignty? Political obstacles apply
as much to creditor as to debtor countries; EZ paymasters, Germany and France, and the PIIGS violated Maastricht
Criteria en route to, and Stability/Growth Pact fiscal criteria once in, EMU. What about the underlying issues of
which excessive intra-EZ imbalances are mere symptoms: the lack of mobility in labor and corporate controlregardless of paper rules, reflecting the EZ’s multi-state nature?
Turning to the immediate debt crisis options for Greece, the choices boil down to further official lending,
perhaps but not immediately extending to full-blown bailout or inadequate debt relief. Any specific plans under
these two broad choices will, given the policy debate, remain hostage to the political dichotomy of willingness “to
do whatever it takes to save the euro,” but ability to do the bare minimum if that. Even if Greece’s or the other
PIGS’ destiny is a full-blown bailout, not just a drip feed of lending and re-profiling to keep the ship of the EZ
relatively steady, it would not be pre-announced, but happen over time. Plus, the ECB has stepped into politics and
the fiscal arena, pushing the rest of the “Troika” (the IMF and EU) to l end more to Greece, by threatening to
disqualify rescheduled bonds as repo collateral.
This unprecedented action would amount to a total EZ hijacking of the IMF. Full-blown debt relief would require
either an actual default by Greece, as in almost all other cases of significant face-value write-downs, or arecapitalization of the EZ banking system—and that seems unlikely in the extreme given the policy signals. Greece
may well remain close to the brink, in turn keeping the other PIGS dangling, and the EZ lurching from crisis to crisis.
The fat tails then would continue to wag the dog, another reason to remain light on risky assets, expecting
investors to seek liquidity and safety in U.S. Treasurys.
EM inflation: It is increasingly clear, as we have long argued, that EMs face an overheating problem, arising from
an inappropriate FX/monetary policy mix. Monetary policies are being tightened, but FX appreciation is still
generally being curbed, and vendor financing by dramatic FX reserve accumulation continues, stoking global
imbalances. Our macro views call for very limited rate hikes across the West. U.S. and EZ macro performance, PIIGS
developments, plus UK stagnation in response to premature fiscal adjustment all point to tight limits to monetary
policy normalization. We expect the ECB to hike in line with its pronouncements, but for rate hikes to peter out
soon, given weak growth. The Bank of England will continue to wait it out for a few more quarters, but even if it
then decides to hike, it’s hard to see it going very far either.
Led by China, EM countries are quite likely to respond to the continued weakness of DM aggregate demand by
resisting further significant deterioration in their terms of trade via FX revaluation. If China continues to shadow
the dollar as global economic deceleration continues to gather pace, other countries will continue to shadow China
lest they lose further competitiveness. The cycle of carry trades betting on capital gains in assets and in currencies
would continue, in due course, unleashing more EM inflation pressures. So we remain cautious about EM assets
despite the current respite in inflation, since we’ve seen this part of the movie before too, and expect it to repeat
as well…
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CROSS ASSET MONTHLY 4
June 6, 2011
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LONDON - 174-177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | [email protected] | [email protected]
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Page
Commodities: Regulation vs. Intervention—When
Governments Take Action
By Shelley Goldberg
Governments are becoming increasingly involved in the global trade of commodities, both physical
and financial, motivated by economic, environmental and geopolitical forces.
We continue to hold a neutral weighting in commodities from a sector standpoint; however, in light
of greater government involvement and therefore potential trading constraints, advise increasing
diversification both by commodity and instruments.
Expectations for continued government action lead us to suggest longs in corn, soybeans, ethanol,
potash and natural gas, as well as farmland, water and agri-businesses, with shorts in palm oil.
Dodd-Frank and Swaps, Not the Best of Friends
Commodity trading, for years perceived as the “dark” market, is demanding increasingly high levels of
transparency. The Dodd Frank Act of 2008 gave the CFTC power to set trading limits in commodities after critics
blamed a spike in oil prices on speculators. The act overhauls measures intended to bring more OTC derivatives,
particularly swaps, onto regulated exchanges, and to prevent speculators amassing excessively large positions,
distorting market prices. In addition to margin requirements, trading curbs can take the form of position limits and,
indirectly, through heightened CFTC surveillance, which can increase company back-office costs and potentially
curb trading. The CFTC recently filed its second oil manipulation case after launching a “nationwide crude oil
investigation” three years ago. Such policy calls for increased diversification of commodities in a portfolio.
Silver Margins—Up, Up and Away
Figure 1: Margin Effects on Price & Volatility Figure 2: Margin Effects on Open Interest & Volume
Source: RGE and Bloomberg
We look at recent activity in silver as an example. Maintenance margins have increased 12 times, by over 176%,
since April 2010, as the price of silver has risen, including seven hikes in 2011 (Figures 1 and 2). Increased margins
have reduced the price of silver (30% in one week alone), yet they have also had the effect of reducing both trade
volume, and open interest, and thus, liquidity, and at the same time increasing volatility. Less liquidity and higher
volatility have negative implications for hedgers, while the lower price helps consumer hedgers but not producer
hedgers. In the first week in May, silver ETP holdings slid the most in three years. The overarching problem with
Dodd-Frank is one cannot simply divide the world into pure hedgers and speculators, as many hedgers also
speculate for profit.
10203040506070
8000
10000
12000
14000
16000
18000
Maint Margin (LHS) 30-Day Volatility % (RHS)
Price US$/oz. (RHS)
-2000
8000
18000
50000
150000
250000
350000
Maint Margin (RHS) Open Interest (LHS)
Volume (LHS)
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CROSS ASSET MONTHLY 6
June 6, 2011
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LONDON - 174-177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | [email protected] | [email protected]
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Page | Currencies: Hiccup or Reversal?
By Michael Hart
We shifted our recommendations into a pronounced “risk off” mode in mid-May, looking for the EUR,
GBP and risk-correlated currencies to decline. With the fundametal backdrop deteriorating and event
risk rising we maintain our stance, the recent cleaning out of over-stretched positions and market
recovery notwithstanding.
Market Performance: Going Full Circle
With the beginning of the market selloff in early May, we recalibrated our trade recommendations with a view to
position for a rise in risk aversion and a weakening of the EUR and GBP. We rotated out of our relative value
recommendations and the trades benefited from a 4.4% rally in the DXY from trough to peak during May. As
stretched positions have been pared back (Figure 1), markets have recently recovered somewhat, our trade
recommendations have given back some of their gains and our short EURUSD position has moved into the red
(while the DXY has dropped 2.4% from the May peak).
We nevertheless maintain our recommendations as evidence of a global deceleration beyond previous
expectations is beginning to take hold (economic surprise indices marked a further sharp deceleration this month).
Renewed weakness in the labor market is adding to persistently poor U.S. housing data, taking the U.S. economy
close to stall-speed. The eurozone (EZ) crisis is once again reaching boiling point (see below) with June marked by
several important milestones. Beyond the G10, Chinese growth is chipping away at the global growth picture as it
is showing signs of deceleration, whereas Brazil appears to be overheating, suggesting the likelihood of harsh
policy tightening eventually. In addition, the gradual phasing out of QE2 provides a less supportive backdrop for
risk-correlated trades. The caveat is that a very sharp deceleration in the U.S. could provide fodder for renewed
monetary accommodation, which would eventually be supportive of equities and risk in general. Indeed, the
recent drop in U.S. 10y rates to the 3% mark suggests that the market has begun to price in the possibility of QE3.
Figure 1: CFTC Net Positions (Z-score over five years) Figure 2: Spain vs. PIG Spread-to-Bunds (ratio)
Source: Bloomberg, RGE Source: Bloomberg, RGE
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
EU R JPY GBP AU D CHF CA D N ZD Gold Tr es S&P
0.000
0.100
0.200
0.300
0.400
0.500
0.600
0.700
-8.000
-7.000
-6.000
-5.000
-4.000
-3.000
-2.000
-1.000
0.000
Jan-1 0 Apr-1 0 Jul-1 0 O ct -1 0 Jan-1 1 Apr-1 1
Spain - PIG, bps
(LHS)
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CROSS ASSET MONTHLY 7
Page |
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LONDON - 174-177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | [email protected] | [email protected]
© Roubini Global Economics 2011 – All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.
Eurozone: Going M.A.D.
With Greece having demonstrably gone “off track” in its adjustment program and the chance of renewed market
access in 2012 having receded, the release of the next IMF tranche has been put in doubt. This leads to an
increasingly binary set of outcomes, implying either an earlier-than-anticipated credit event or a continuation of official support which would eventually need to morph from loans into grants, creating the “mother of all moral
hazards.”
Spooked by the former, the ECB has activated the financial equivalent of a M.A.D. (mutually assured destruction)
strategy, threatening not to accept sovereign Greek bonds as collateral should they in any way be impaired.
Ultimately, this threat is likely to be inconsequential as either the ECB would not be able to follow through for fear
of a financial meltdown in the Greek and perhaps other banking systems or else national central banks could take
over the role of lender of last resort via the emergency liquidity assistance mechanism. Nevertheless, it has turned
the ECB into an essential hold-out investor (rather than a constructive participant in a resolution attempt) and
shifted the terms of the debate.
In the past, trouble in the EZ has not been able to spill over into global risk sentiment or even affect EURUSD in a
sustained or drastic manner (its June 2010 low of 1.19 remained a far cry from the historical 0.82 low). But on the
other hand, an EZ credit event, and the potential for EZ contagion, had never seemed as likely. What is more, the
(delayed) release of the EZ bank stress tests and the meeting of the EZ finance ministers on June 20 represent
critical milestones for the EUR. In a world still dominated by near-zero interest rates and little prospect of an
aggressive exit in major economies, the ECB’s rate hikes increasingly look like an insurance policy against a sharp
EUR selloff should a credit event materialize. The ongoing “muddle through” approach is unsustainable and
destined to unravel eventually, but for markets it means lurching from crisis to crisis with rebounds in between.
Yet, on the back of rising event risk and the difficulty of predicting when these events will be, we choose to
maintain a defensive stance on the EUR.
Figure 3: FX Trade Recommendations
Note: Trades opened/closed this month in bold.
Short Long Entry Entry Exit Exit Current P & L
date level date level level
EUR CHF 01 November 2010 1.378 03 June 2011 1.21396 1.21396 11.9%
AUD USD 04 May 2011 1.08 1.0613 1.7%
EUR USD 12 May 2011 1.4232 1.448 -1.7%
GBP USD 12 May 2011 1.6291 1.6193 0.6%
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CROSS ASSET MONTHLY 8
June 6, 2011
www.roubini.com
NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | [email protected]
LONDON - 174-177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | [email protected] | [email protected]
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Page | 8
Government Bonds/Rates: Repression Reality
By David Nowakowski
Global economic data have weakened in the past several weeks, causing rates to plummet across the
board. Markets are now realistically appraising a long period of low rates as central banks punish savers.
Credit and inflation risks are being rightly ignored for now by markets for most G10 countries; in fact,
long rates continue to underestimate the “Japan scenario” of stagnation and deleveraging.
Greece is back in the spotlight: A failure to ring-fence core banks or the periphery heightens the
contagion risks of a disorderly outcome; this raises risk aversion and depresses yields.
Soft Patch Softens Yields
In the past two months, short-end yields in the eurozone (EZ) and the U.S. have pulled in 40 bps and 50 bps,
respectively. Part of this is the realization that QE2 is not ending in June—it will only “end” when the Fed shrinks its
balance sheet and/or raises rates; this is over a year away, in RGE’s estimation. While the ECB has begun tightening,
it is now clear that, in both markets, optimists have yet again been too quick to celebrate a recovery, while
inflation hawks are still a minority on both central banks’ rate-setting boards.
In the last Cross Asset Monthly, we found that the two-to-three-year sectors in both the U.S. and EZ were
attractive; following the recent rally, we no longer think so, as the rate hikes now priced in are more in line with
our economic forecasts. Where we now find inconsistency is with the large discrepancy between the two, with
two-year swap rates in the EZ 150 bps above U.S. two-year swaps (Figure 1). We would receive the former and pay
the latter, at these levels, as the current large divergence in U.S. and EZ policy rates, exceeded only in 2008, is
unlikely to persist for such a long time.
Figure 1: How Far Can Euro Rates Diverge? Figure 2: Forwards Are Too Close to ‘Normal’
Source: Bloomberg, RGE
We have previously cited the uncomfortable reality of a de-facto “financial repression,” as policy makers—where
they can—transfer wealth from savers to banks and debtors via low rates and moderate inflation. This was once
thought to occur in command-and-control economies like Argentina or China, but it is now seemingly occurring in
the U.S., UK and EZ. While some bondholders may call for revolution, RGE thinks that it is unlikely that policy
makers will feel any pity. Rather than “fight the Fed,” or the ECB or Bank of England, we would take as our base
case that the G4 economies will remain in a deep hole for a long while yet and so will long bond yields. Private
sector deleveraging lasted for two decades in Japan, but is only just underway in the West. Fiscal consolidation in
all developed markets will be a long and arduous task and has barely begun; when it properly gets underway,
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monetary stimulus will likely need to be maintained. But as Figure 2 shows, forward rates are still at levels that
assume we’ll be “back to normal” in five years’ time. We wouldn’t be short long-ends until sentiment pushes these
into well below-average territory, even if our base case is not for a double dip.
Euro Periphery: Will Policy Makers Heed RGE’s Advice? What if They Don’t?
Worries continue to plague the EZ, and this is unfortunately justified as denial, bailouts, equivocation and recent
official talk of bail-ins, euro-ejection and default have unsurprisingly failed to restore confidence. Russia and
Argentina followed this pattern as well; yet, even though Greece is insolvent, and Ireland and Portugal are likely
headed that way, these three don’t need to follow in the steps of the worst emerging market debacles. RGE has
argued that an orderly restructuring, in which bondholders incur severe 30-50% haircuts or net present value
(NPV) losses through long maturity extension and coupon reductions, is already largely priced into Greek debt and
should be attempted to avoid utter failure and worse contagion later on. Portugal and Ireland may still face
pressure, but with yields in those markets in double digits, the most compelling peripheral short is still Spain,
based on risks from Greece as well as its own precarious debt sustainability.
Greek and European policy makers have time and again failed to fully face up to the problems, so we must also
consider the alternatives:Muddle through: Continued loans and recession-inducing adjustment, short maturity extension
without principal or coupon reduction. This would cause continued uncertainty for Ireland and
Portugal, but would be a reprieve for risk assets and cause swap and bund yields to rise, until the next
round of crisis. Because of political constraints, RGE views this rather perilous and unfortunate
outcome as the most likely, as RGE’s economic team discussed in “EZ Policy Makers Will Avoid Tough
Decisions and Continue to Muddle Through for Now.”
Total bail-in: The mother of all moral hazards would be superb for risky assets, as Greek bondholders
would be paid out at par; other PIIGS spreads would also bull steepen. However, the risk-on combined
with the realization that costs of a Spanish bailout would fall on Germany would lead to Euro swaps
bear steepening, with 10y rates approaching 4%.
Disorderly default: A Lehman redux in the EZ could be more severe than the 2008-09 crisis, as banksand sovereigns suffered from a renewed credit crunch. The ECB would reverse its hikes and flight-to-
safety would benefit bunds and Treasurys. RGE’s EZ Endgame Scenarios could also come into play, as
the future of the common currency area comes into question.
Duration Curve
U . S .
Neutral. U.S. yields look low, but the fact of monetary
repression and balance-sheet deleveraging may last a
decade, which means fair value is far lower than precrisis.
Some flattening is possible as Treasurys properly price in the
current slowdown. Hard to see 2s-10s going below 200 bps
unless the Fed tightens, which we see only in late 2012.
E Z
In the past month, Euribor futures have removed two hikes
from the December 2012 path. Unlike last month, where we
flagged this discrepancy, this is closer to fair value.
Front-end has gone from attractive to fair, but long-end is
rallying on fears of global slowdown and PIIGS risk-aversion.
This is warranted, but will be temporary. Expect steepening.
U K
Weak economic readings have strengthened the hands of the doves on the MPC, but CPI has jumped back despite
that. But there is not much room for yields to go lower.
The expected curve flattening has occurred, but longer-termbreakeven inflation rates are still attractive.
J PNeutral. Economic weakness, as LSAP will likely cause JGBs
to perform well, despite massive fiscal deficits and issuance.
We would be cautious on the long-end, as signs of recovery
or rebuilding that spurs inflation would end the deep freeze.
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June 6, 2011
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LONDON - 174-177 High Holborn, 7th Floor, London WC1V 7AA | TEL: 44 207 420 2800 | FAX: 44 207 836 5362 | [email protected] | [email protected]
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Page | 1Emerging Markets: Walking a Tightrope
By Natalia Gurushina
Fat-tail risks cloud the near-term outlook for EM FX despite reasonably strong fundamentals. We
recommend relative-value trades in line with our ROSI framework—long Asia FX (THB, KRW, INR,
TWD, IDR)/short commodity FX (RUB, COP, CHF, AUD, NOK), long USD/CLP, long USD/ZAR, short
RUB/INR and short RUB/MYR.
We start gradual rebalancing of our interest rates recommendations to reflect weaker inflation
pressures in LatAm and emerging Asia in H2 2011 and H1 2012 and stronger inflation pressures in
EMEA. We close a July 2011-January 2017 Pre-DI flattener in Brazil and now recommend a January
2012-January 2017 Pre-DI steepener. We open a two-year cross-currency swap payer in Turkey.
We recommend maintaining long exposure to inflation-linked debt in Poland and Turkey, but start re-
evaluating our “overweight” position in global EM inflation-linkers as we think further upside might
be limited. We maintain a small “underweight” in EM local currency debt.
EM FX: Relative Value Trades Within Commodity Framework
The near-term outlook for EM FX remains clouded due to several factors. The first and most obvious one is the end
of QE2, with related concerns about additional global liquidity inflows, the sustainability of the global recovery and
its impact on emerging markets (EMs) through export channels and the narrowing interest rate differentials
between EMs and developed markets (DMs). The second factor is the ongoing debt crisis in the eurozone, which
could affect most liquid regional EM currencies, such as PLN (despite the supportive interest rate outlook). Finally,
there is a possibility of further correction in commodity prices, which will likely benefit Asian currencies, but
weaken traditional “commodity” FX.
On a tactical level, we remain comfortable recommending relative value trades that are in line with RGE’s current
“neutral” stance on commodities and the ROSI oil sensitivity framework. In particular, we like being long a basket
of Asian currencies that are most vulnerable to high oil prices (THB, KRW, INR, TWD, IDR) and short a basket of
currencies that benefit the most from high oil prices (RUB, COP, CHF, AUD, NOK). As regards individual currency
pairs, the following recommendations with “commodity roots” still make a lot of sense to us—long USD/CLP (our
estimates suggest that CLP is still too strong relative to copper prices), short RUB/INR and short RUB/MYR. This
month, we also introduce a new relative value trade—long USD/ZAR. The key supporting reasons include the
growth slowdown in South Africa, the downside risks for global growth and commodity prices and the fact South
Africa is lagging behind other EMs in policy rate normalization, with the first hike expected only toward the end of
2011 (November). Finally, our estimates suggest that ZAR is about 3.5% stronger than its “fair value” implied by
the flow of capital approach.
EM Rates: Walking a Tightrope
We are starting to gradually rebalance our interest rate recommendations to reflect weaker inflation pressures in
some EMs in H2 2011 and H1 2012 and stronger inflation pressures in others. In particular, we expect moderating
output growth, the impact of FX appreciation earlier this year, the lagged impact of past rate hikes and a positive
base effect from food and commodity prices to help ease inflation pressures in most of LatAm and Asia ex-Japan.
This should either slow the pace of monetary tightening or bring the current tightening cycles to an end.
We therefore believe that further curve flattening in LatAm—especially in Brazil, Chile and Mexico—is likely to be
limited. The only exception to that is Peru, where inflation pressures and a likely continuation of rate hikes will
continue to flatten the local nominal curve in the coming months. In Asia, Taiwan, Malaysia and especially China
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Page | 1
Credit: Boom Times Amid Slowdown
By David Nowakowski
As investors recoil from negative real yields on hazardous “risk-free” government debt, the demand for riskier
but higher-yielding spread products will continue to surge, supporting markets across the credit spectrum.
We stick to our long investment-grade (IG) call (preferring triple Bs), hedging rate risk.
Short European credit (main, crossover and financials) outright and versus U.S. IG and high yield (HY). With
Greece on the brink and other PIIGS vulnerable, contagion to banks and to corporates via the credit channel,
taxes and austerity remains a risk.
Fundamentals versus macro: Strong earnings will power credit through a soft patch, but the PIIGS crisis and
risk aversion will put pressure on high-beta junk bonds and emerging markets (EM) corporates. Aside from
construction and financials, most sectors can shrug off a temporary slowdown and endemic unemployment.
Outlook: The Gilded and the Left Behind
After another month of almost continuous worse-than-expected economic readings, worries about the pace and
sustainability of the U.S. recovery were enough to stop the positive market momentum. However, the sell-off in
equities has been relatively minor, and spread widening miniscule as well, particularly in light of Citi’s Economic
Surprise Index for the U.S. hitting -90 and the extremely sharp 65bps rally in the U.S. 10-year over the past two
months. IG and HY spreads in the U.S. widened only 8bps and 29bps respectively, and European corporates
performed similarly.
The tone in the markets can still be described as amazingly positive, with issuance of high-quality long-term debt
as busy as ever, and junk bonds setting a new monthly record with US$45 billion-worth of deals. Chief financial
officers are evidently making the most of the low-yield environment caused by monetary policy and a degree of
risk aversion, while investor demand is being herded by Bernanke and company out of Treasurys into riskier assets
in a stretch for yield: Exactly as QE2 was advertised. Low rates, low taxes, a weak dollar: All this stimulus aids
returns on capital directly. Labor, small business, consumption and investment will have to wait for the trickle-down, but given the atmosphere in Washington and Brussels, and the decades-long trends favoring capital at the
expense of labor, one should expect banks and corporations to do far better than the rest of the economy at large.
Investors in credit can do well even as economies sputter.
Figure 1: Anemic U-Shaped Non-Recovery
Source: Calculated Risk
Figure 2: Dramatic V-Shaped Complete Recovery
Source: Bureau of Economic Analysis, Bloomberg, RGE
400
600
800
1,000
1,200
1,400
1,600
1,800
D e c - 9 9
J u l - 0 0
F e b - 0 1
S e p - 0 1
A p r - 0 2
N o v - 0 2
J u n - 0 3
J a n - 0 4
A u g - 0 4
M a r - 0 5
O c t - 0 5
M a y - 0 6
D e c - 0 6
J u l - 0 7
F e b - 0 8
S e p - 0 8
A p r - 0 9
N o v - 0 9
J u n - 1 0
J a n - 1 1
U.S. Corporate Profits (Total)
U.S. Corporate Profits (Domestic)
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The outlook for the U.S. and European economies is far from positive, however. Things will continue to be painful
for overleveraged homeowners, consumers and governments, and financial institutions will also have to clean up
their toxic waste accumulated in the bubble years. Even with the growth we’ve been getting recently, assuming no
slow patches, policy mistakes or external setbacks—it won’t be until 2016 before the U.S. is back to normal (see
Figure 1). Post-crisis EM experience proves that countries with severe structural problems and high unemploymentcan be great investments and have long bull runs. As the U.S. economy only gradually climbs out of its deep hole,
CEOs and shareholders are basking in sunshine, with earnings above previous highs and still growing robustly as
U.S. and European multinationals plug themselves into the healthy parts of the global economy (see Figure 2).
Earnings season in the U.S. hammered this point home, and even European earnings continue to expand at mid-
teen rates.
Notable recent examples of how companies are making hay:
Caterpillar borrowed US$1.25 billion for 30 years at 5.2%.
Hewlett-Packard issued a colossal US$5 billion in a five-tranche deal, including coupons as low as 0.53%
and 10-year debt paying investors all of 4.3%.
B2-rated Chrysler Group, which came out of bankruptcy in June 2009, managed to raise over US$3 billion,
at spreads just over +500 bps: “High” yielding coupons of 8.00% and 8.25% for eight and 10 years.
CCC-Caesars continues to gamble on the future, trying to push out loans after swapping debt for equity
and flunking a planned IPO late last year; Apollo and TPG paid up US$30 billion in 2008 for the money-
losing casino group and geared it up to an eye-popping 16-to-one debt-to-equity; 10y CDS is a bit better
than Greece at +1030.
Future bankruptcy candidate Freescale Semi (still consistently losing money even before interest
expenses) did manage an IPO, raising around US$740 million for debt reduction after i-banks and its
private equity owners took their cuts. Its bonds were among the best performing in the HY universe.
Along with current and expected earnings, the current environment allows firms to lock in extremely low funding
costs far into the future. Eventually, rebalancing may hurt corporate profits (especially as fiscal tightening cuts
subsidies and loopholes, and raises taxes), but despite the anemic recovery and longer-term structural problems in
the U.S. and Europe, micro trumps macro: The present and the near-term outlook support our overweight of IG
and neutral HY. However, our concerns about a disorderly outcome in Greece, which would cause contagion to
remaining periphery and core alike, force us to remain underweight European credit.
In May, CEMBI underperformed EMBIG, as we recommended, and we continue to hold this view. Its HY
component was the main drag, with China and India being notable negatives, leading corporate EM spreads to
widen 25 bps while sovereigns widened just 10 bps.
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Page |
E n e r g y
M a t e r i a l s
I n d u s t r i a l s
C o n s u m e r
D i s c r e t i o n a r y
C o n s u m e r S t a p l e s
H e a l t h C a r e
F i n a n c i a l s
I n f o r m a t i o n
T e c h n o l o g y
T e l e c o m m u n i c a t i o n
S e r v i c e s
U t i l i t i e s
United Kingdom 1.07 1.71 0.95 1.01 0.79 0.81 1.22 1.04 1.02 0.85
France 1.21 1.31 1.27 1.17 1.00 1.05 1.61 1.24 1.03 1.15
Germany -- 1.31 1.30 1.40 0.97 1.02 1.25 1.03 1.03 1.09
Swi tzer la nd 1.67 1.04 0.99 1.23 0.83 0.71 1.10 1.09 0.72 0.76
Sweden 1.90 1.43 1.50 1.29 1.05 1.22 1.47 1.47 1.24 1.92
Spain 1.35 1.13 1.24 1.29 0.87 1.23 1.76 1.08 1.19 1.23
Italy 1.20 1.36 1.12 1.29 1.05 0.95 1.58 1.50 1.31 1.01
Netherl ands 1.27 1.17 1.28 0.94 0.86 0.87 1.81 1.22 0.91 --
Finland 1.41 1.42 1.30 1.17 1.10 1.03 1.20 1.70 1.15 1.11
Norway 1.49 1.82 1.38 1.64 1.53 1.96 1.66 1.52 1.60 1.20
Belgium 1.40 1.35 1.44 1.20 1.02 1.12 1.52 1.31 0.89 0.80
Denmark 2.03 1.28 1.39 1.35 1.23 1.00 1.33 1.21 1.07 --
Austria 1.50 1.55 1.17 -- 1.30 2.52 1.58 1.56 1.30 1.32
Ireland 1.83 1.90 1.12 1.24 1.04 1.15 3.49 -- -- --
Portugal 1.39 1.23 1.28 1.32 1.42 -- 1.43 1.29 1.38 1.09
Greece 1.25 1.83 1.32 1.53 1.55 2 .3 5 2.42 2 .58 1 .78 1 .67
Figure 1: Beware of Beta Risks in Europe
Global Equity: A Tale of Fat-Tail Risk in Europe
By Gina Sanchez and Ibrahim Gassambe
We continue to recommend U.S. vs. Europe.
We continue to recommend emerging market (EM) equity vs. developed market (DM) equity as
inflation and growth expectations become favorable.
We continue to prefer Canada, Norway and Switzerland to Portugal and Spain.
On a sector basis, we are overweight energy versus financials, but would recommend moving to a
more defensive stance through consumer staples and health care.
Swinging to Extremes
We have argued since the start of the year that global growth pricing would have to be de-rated and the latest
inflows of macro data have confirmed this, both globally and within Europe. The effects on demand of higher oilprices and the Japanese earthquake further emphasize the recovery’s fundamental weakness. Until recently,
markets have been fairly buoyant on earnings expectations and global equity markets have shared in the rally,
although not to the extent that the U.S. equity markets have experienced it. However, worrying macro data from
the U.S. and other parts of the world, including China, are starting to spook the markets. A slowdown in the U.S.
represents a near-term fat-tail risk that has started to take hold of the markets acutely in the past week,
particularly in light of the very disappointing jobs number on June 3. The markets are braced for a continuation of
historically high profit margins and buoyant earnings, but will likely not be able to hold up against the top-line
disappointment that could come when fiscal spending winds down in 2012 as we expect. The storm clouds in the
distance that we have called attention to in past CAMs are certainly gathering quickly.
All the while, equity markets in Europe have been
plagued by the ever-present fat tail of a Greek
restructuring that may or may not herald a contagion
effect that could paralyze lending across Europe. Not
surprisingly, the south has traded cheap with relief
rallies that have shaken even the highest conviction
players out of their positions from time to time. With
Spain coming under scrutiny, we have to consider the
various scenarios for policy responses and the likely
outcomes for equities. We have six general scenarios,
but for the purposes of simplicity, we are lumping the
various restructuring/default scenarios (outrightdefault, reprofiling, restructuring, Vienna Initiative-
style restructuring and expulsion) into one scenario.
Scenario 1: Bailouts Continue, Just in Time
In this status quo scenario, markets will continue to swing from optimism to pessimism and vice versa as policy
makers talk, muddle, ponder, posture and manage to continue to bailout sovereign after insolvent sovereign,
paving the way to disaster through fiscally unsustainable bailouts. With the current approach, where policy
Source: Factset
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Figure 2: Normalized Debt to Equity vs. Normalized EBIT/Interest
T o t a l C o u n t r y
F i n a n c i a l s
C o n s u m e r D i s c r e t i o n a r y
C o n s u m e r S t a p l e s
I n d u s t r i a l s
E n e r g y
M a t e r i a l s
T e c h n o l o g y
H e a l t h C a r e
T e l e c o m
U t i l i t i e s
Germany 0.35 2.24 0.27 0.49 0.45 -- 0.88 1.94 0.60 1.22 0.48
Denmark 0.43 2.54 7.63 0.47 0.59 -1.81 0.89 -5.18 0.62 0.57 --
France 0.46 0.28 0.31 0.89 0.46 0.28 0.70 0.65 2.16 -0.28 0.98
Switzerland 0.47 -3.11 0.13 0.30 0.10 0.76 0.51 0.31 3.12 1.24 0.13
Italy 0.54 0.06 0.35 0.32 0.48 4.47 1.51 0.33 0.29 0.13 0.90
Sweden 0.58 0.47 0.47 2.31 0.52 1.02 0.46 0.24 0.59 0.08 --
Finland 0.79 -- 1.61 0.30 0.46 4.35 0.38 5.29 5.26 0.71 0.82
Norway 0.82 -- 1.21 0.40 0.27 0.76 0.26 1.28 0.66 0.38 1.52
Spain 0.97 0.12 0.66 0.46 3.87 2.35 1.71 2.34 1.38 0.93 0.93
Netherlands 1.02 -- 1.11 0.59 0.99 0.61 0.69 0.17 1.39 1.77 --
Portugal 1.33 -- 3.11 -0.68 4.23 -0.15 1.00 -0.23 -- 2.93 1.27
Belgium 1.50 0.10 0.36 0.80 0.17 1.92 0.67 0.50 5.36 1.84 0.94
Ireland 1.51 -- 0.55 0.31 1.20 -- 1.35 -- 2.08 -- --
Greece 2.31 -9.00 1.36 2. 12 3.59 3.76 3.60 -2.91 -2.13 23.92 0.30 W o r s t ( n e g . o r h i g h )
< - - - - - - - - > B e s t ( n e a r 0 )
proposals (reprofiling with its execution risks, a Vienna Part II) are short of our proposed resolution plan (Plan B),
we expect the market to trade sideways, as EZ banks’ solvency/capital adequacy and sovereign debt sustainability
remain issues until 2013 at least, when we could potentially have a full-blown crisis with equity markets selling off
steeply. Here, beta risk matters as the higher-volatility markets will introduce significantly more risk to the
portfolio during scares and relief rallies (Figure 1).
Scenario 2: Various Restructuring Scenarios
There are two potential outcomes in this combined scenario: Market buy in and no contagion; or the opposite.
Assuming no contagion, a soft restructuring could be carried out as a net present value (NPV)-neutral event within
the limit of 0% to -10% of the pre-restructuring NPV, while avoiding triggering a CDS event. In this event, bank
capital is minimally impacted. However, in the event of default, expulsion and outright restructuring, there would
be real contagion risk and so we see two potential transmission channels to the equity markets. The first is through
sentiment, which would cause a severe risky asset sell off of high beta markets. We envisage that this would be
fairly limited to the financial sector, but some high beta sectors could be hurt as well (Figure 1).
The second and more concerning
transmission channel is through a
tightening of financial conditions that
affects market access and borrowing
costs for corporations. Sales will also be
affected through deterioration in
consumer and business sentiment. We
have evaluated country equity markets
through normalized debt-to-equity and
EBIT-to-interest expense ratios to assess
their relative vulnerability to the likely
deterioration in financial conditions in
the EZ and elsewhere in Europe. In both
cases, we have evaluated how the
current ratios compare with long-term
averages. The higher the normalized
interest coverage, which shows the
ability of a company to withstand a spike in borrowing costs, and the lower the normalized debt-to-equity ratio,
the better positioned companies are to withstand a deterioration in financial conditions. Figure 2 shows that
Greece is the worst-performing country, with three of the 10 sectors recording negative earnings and seven of the
10 sectors having debt-to-equity ratios significantly above long-term averages. While certain countries, i.e.
Germany and France, are relatively economically healthy, the vulnerability of their banking systems to a Greek
restructuring is certainly an Achilles heel. Nevertheless, the health of their economies may limit the impact of a full
blown contagion on their equity markets. On the whole, though, the Nordics perform very well on this metric.
Overall, despite the slowdown in growth in the U.S., we still favor U.S. equity over European equity and continue
to favor EM equity over DM equity on growth and moderating inflation. Flows have bottomed out and look
supportive of the position. We are also turning more defensive in the positioning of the DM portfolio, with
consumer staples and health care becoming important parts of the equity weighting. Finally, we continue to stay
overweight Canada, Norway and Switzerland versus Portugal and Spain.
Source: Factset
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Page |
Financials: The Persistent Allure of Bailouts
By Jennifer Kapila
U.S. bank valuations face a triple whammy through macro growth downgrades, the end of QE2 and
continued deleveraging of bank and household balance sheets.
European banks are more variegated; EMU bank valuations teeter on options with divergent payoffs
as the EU backs away from restructuring, while non-EMU bank regulators push for more stringent
regulation. The UK banks are firmly in the middle of these two extremes.
We go neutral U.S. banks relative to European banks across credit and equity.
Credit: Remain overweight LT2 bullets. Regionally, remain overweight Swiss but downgrade U.S. risk
to neutral. Upgrade Italian risk to neutral, but remain underweight on Spain. We overweight Italian
risk relative to French risk.
Equity: Take profits and upgrade Spanish risk to neutral. Upgrade Italian risk to overweight and
downgrade U.S. risk to neutral. Remain underweight on Portuguese risk and overweight Swiss risk.
Figure 1: Tangible Common Equity Ratios and Exposure to PIG Sovereigns of European Banks
Note: TCE data as of 2010, adjusted for 2011 and capital raisings under way. The TCE ratio is not a regulatory capital ratio.
Dexia’s exposure is 100% of TCE. Irish sovereign exposure does not include banks. Source: Bloomberg, CEBS, RGE estimates
U.S. Banks: Where Exactly Is the Upside?
Slowing growth, the ebbing of the QE2 “accelerator” and a potential renewal of house price declines can only be
negative for asset quality in U.S. banks. Extend-and-pretend is likely to extend far into the future under the quiet
assent of regulators, but it means that credit growth will remain flat at best, meaning no volume growth and also
no margin growth since rates are on perma-hold until household balance sheets are repaired. While there is, of
course, significant event risk in the eurozone (EZ), which could drive temporary outperformance in U.S. banks, we
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throw in the towel on our “lesser of two evils” approach and move to neutralize our long U.S. short Europe trade
vis-à-vis banks.
EZ Banks: Lack of Options Favor Broadly Neutral Position
Recent history is difficult to ignore. Although financial regulation has moved toward eliminating the implicit public
sector subsidy benefiting banks, recent financial crisis in developed markets has followed a pattern: A lengthy
period of denial, bursts of volatility, panic and then the calm ocean of liquidity (through debt, equity, or both).
Given this recent pattern, the array of options laid at the feet of EU officials, the unique issues facing a single-
currency block and current valuations (particularly in equity), we prefer a positioning that can retain some level of
market neutrality while holding the potential for upside moves.
RGE has recommended a reprofiling of debt to soften the refinancing risk facing Greece and minimize the potential
impact on bank capital. However, given the ECB’s staunch opposition and doubts about the long-term viability of
such an approach, it seems the EU is limited ultimately to persistent bailouts, which could lead to deeper
integration or default. This does not, however, preclude debt reprofilings or restructurings in the interim, though
we fear the half-hearted approach taken to the EZ crisis thus far will carry over to such efforts.
A bailout that leads to deeper integration (or indications thereof)—a first step perhaps in the form of an EU
Finance Ministry—would favor the periphery banks, with the strongest gains accruing to issuers in the PIG, as well
as in Spain, Italy and Belgium. French bank equity would likely experience significant uplift. However, barring a
reversal of ECB policy and language, a default or hard restructuring in Greece has the potential to cause significant,
if temporary, contagion and a tightening of financial conditions as investors re-examine default risk in the EZ. The
winners of a bailout would likely be losers in a default scenario, with core banks coming under greater scrutiny.
The capital hit to core banks would be broadly manageable—either through the banks’ own reserves or in the form
of a capital call to the public sector. In some cases, these losses may already be apparent in common equity if
exposures are held in the available-for-sale book. And although German banks operate under a restructuringregime, the historical ties and effective public ownership of these entities muddies the execution waters. But the
potential read-across of a Greek default or restructuring paints a less comforting picture, which is why we find it
very difficult to believe that the ECB would stand idly by at a moment of peak contagion, particularly if core
sovereigns refuse to recapitalize their banks (a possible quid pro quo here). Otherwise, funding costs across the EZ
would rise to unsustainable levels and French officials may have to face the reality of “contaminating” the
relatively leveraged public balance sheet with extensive liquidity support for French and Belgian banks.
Non-EU European Banks: Pseudo ‘Safe Havens’
Outside of the EZ, there is a bag of pseudo “safe-haven” banks—Nordics, Swiss, UK Asians—and a sizeable group in
terms of total assets—UK domestics—that is exposed to waning revenue growth, Irish risk and Spanish contagion
(via Santander’s Abbey operation). Banks in the former group retain limited upside in both equity and credit during
risk-on phases, while banks of the latter are fairly priced given the macro and asset quality risks weighing on future
earnings potential.
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-0.01%
0.00%
0.00%
0.00%
0.00%
0.06%
-0.02%
-0.06%
-0.03%
0.02%
-0.10% 0.00% 0.10%
Total
Interaction
Barclays EM Inf lation Li nked
ML World GovInflation Linked
S&P GSCI
ML 3 Month T Bill
S&P Europe Leve raged Loan
S&P US Leveraged Loan
JPM GBI EM Global
JPM EMBI Global
JPM ELMI+
JPM CEMBI Broad
ML Global High Yield
ML Global Co llateralized
ML Global Broad Mkt Corp
ML Munic ipal Master
ML Global Gov Bond
S&P Emerging BMI
S&P Developed BMI
Figure 3: May 2011 Contribution to Performance
Source: RGE, Bloomberg
The quality bias of our portfolio is still expressed through
credit and equity recommendations. With corporate
sectors continuing to sit on cash mountains and
government debt offering negative real yields, investors
must seek carry elsewhere. IG credit still looks attractive on
a risk-adjusted basis—though we remain cautious on
eurozone credit and prefer U.S. BBBs—so we continue to
overweight IG credit funded by government bonds.
Regarding equities, inflation and growth dynamics are
skewed in favor of EMs, while DM buoyancy has begun to
deflate on concerns over cooling growth and a string of
macro data releases that surprised on the downside.
Therefore, we remain overweight EM equity relative to DM
equity. Of course, country outlooks are far from
homogenous and, thus, we continue to limit exposure to
vulnerable European countries (Portugal, Spain) versus
Norway, Switzerland and Canada and, overall, favor U.S.
equity to European markets. As inflation dynamics shift
across most EMs we begin to adjust our tactical inflation-
themed trades. We hold small underweight in local EM
yield curves with proceeds funding ELMI+ and EMBIG, pro-
rata, as we believe the amalgam of risk aversion and the
end of QE2 could result in a drying-up of capital
inflows/increase in capital outflows of local EM bonds,
which could cause local EM bonds to underperform. With
inflation pressures easing in most of LatAm, we see limited
upside in EM inflation linked indexes as they are largely
LatAm oriented and move to a neutral stance. Finally, EM
corporate credit (CEMBI) underperformed sovereigns
(EMBIG), as risk aversion put pressure on CEMBI spreads in
May. We hold this position going forward.
Market Review and Cross Asset Model Portfolio Review
Despite an end-of-the month rally, the majority of indexes suffered losses in May, signaling that markets were no
longer ignoring the growing list of downside risks to the global recovery. Economic reports continued to surprise
on the downside with disappointing numbers on manufacturing, home prices and job creation adding to the list of
concerning data. Equity markets retreated across the board. The S&P 500 fell 1.4%, while the DJIA dropped 1.9%.The Treasury market remained well bid amid the equity sell-off, thus pushing 10y yields to their lowest—3.038%—
this year before ending the month at 3.06%.
Updates to RGE Model Portfolio
We remove our overweight to EM inflation linkers. This brings our position on global inflation linkers to neutral to
the benchmark.