The State of the (European) Union...and Deleveraging in focus

The state of the (European) Union is quite terrible.

Europe, and the Euro, continues to unravel. Ireland did its thing on an Eu/IMF rescue package and the market gave it about a 15-minute welcome before hammering it, taking Potugal, Spain, Italy alongside. Many major commentators continue to spew venom at the ongoing tale of privatizing leverage and profits, while socializing losses and risk. Banks are not the most beloved institutions anywhere in the world, and the idea that banks and bondholders are being kept as pain-free as possible in this hastily-cobbled deal does have no chance of any popular support: there is no certainty at all that the Irish Budget will pass on Dec 7 or that the government will remain anything but lame duck. That has left Euro leaders notably Ms Merkel of Germany and Mr. Sarkozy of France scrambling to defend the currency union.

Aditya Rana quotes from Gary Shilling’s The Age of Deleveraging: Investment Strategies for a decade of slow growth and deflation and calls it a must read for serious students of markets and investing, starting off with saying that after four decades of leveraging up by the financial and household sectors, deleveraging is underway which is likely to take a decade or more. He says further crises lie ahead: another sovereign debt crisis in Europe with Ireland being the focus, a further 20% drop in US house prices due to the excess inventories and foreclosure delays which could push the number of underwater homeowners from 23% to 40% of mortgagors causing a sharp fall in consumer spending , a crisis in US commercial real estate which could exceed the housing crisis, a hard landing in China and a slow-motion train in Japan due to lower demand for its exports and an ageing population.

In terms of the current market, I continue to believe that long-dated US Treasuries offer exceptional value from a 6-month horizon with current yields at 4.30% - the ETF ZROZ, which invests in long-dated zeros, is currently trading at 73 (after having gone down to 69 last week) and has the potential to move towards 100 over the course of 2011. The US$ has, as expected, commenced its appreciation versus the Euro and is likely to continue to do so into the early part of 2011. Expectations of further QE programs are likely to cause sharp reversals in the US$, followed by periods of steady appreciation. Select EM equity markets are likely to be the main beneficiaries of QE programs, while grappling with high domestic inflation and real (and some nominal) currency appreciation.

Contagious Times

"Contagion" is the new key word in markets. And risk aversion is a natural consequence. Hence the flight to the US Dollar, and Gold

The Europeans are struggling to keep their act (and their currency) together, even as Ireland stutters through the economics and politics of trying to get a basic bank rescue fund in place, and the IMF (as well as the rating agencies) even marginally satisfied. Irish, Portugese, Spanish, and Greek bonds are trading at life-time high yields. Markets are quick to focus on Spain (and the other peripheral European dalliance partners) even if they scent an Ireland rescue coming together (if the Irish Government that negotiated this rescue even lasts to be able to see it through!). Meanwhile, in a finalist slot for understatement of the year, the Irish central bank governor Honohan says that “confidence in the banks and government is well below what is justified”.

Germany’s Merkel says the Euro is in an "exceptionally serious situation, there is no alternative to German budget austerity"; she sees at best 'decent' German GDP growth soon. Merkelisms otherwise focus on the post-2013 Euro rescue system (while markets worry about how we will even get there in one piece) as she pontificates that it “must involve investors but politicians need 'primacy' over markets”. German Finance Minister Schaeuble weighs in with “Germany is not swimming in money but drowning in debt; the future of the joint currency is at stake”. Even as I write this, that currency (the Euro) is as close to bid-less today as it can possibly get.

Otherwise, things are okay. To paraphrase various literary pieces today "The Koreans are back in ‘explosive mode” throwing loud things around, the FBI is serving hot warrants around the Street, and everywhere you look you see a sea of joblessness, a housing market that remains very soft, absolute records in deficits, two open-ended wars that have got off the front pages for a bit, an im/exploding mortgage-backed securitization problem of gargantuan intensity, the Federal Reserve continuing to print money as its predominant tool of considered monetary policy, many US States and municipalities in doomsday-level financial peril...."

Not much fun out there folks, even as we head to a Thanksgiving break. If anything the Thanks may just be due for the break !

Jaidev

QEII

Aditya Rana writes....

Criticisms of QE2 have centered around its inability to increase growth and reduce unemployment while stoking inflationary pressures in the economy through an increase in money supply. As pointed out in last week’s newsletter, the impact of quantitative easing on the economy is likely to be muted while its impact on increasing asset prices can be significant. However, it is unlikely to have any impact on inflation in the developed world due to prevailing excess capacity and lack of credit growth. But, most importantly, it does have a significant impact on increasing asset prices and inflation in emerging markets as argued by two star managers at the well known hedge GLG in the FT last week.

Read more on the Aditya Rana page in this Blog Post......

Jaidev

Risk Appetite ....is back, at least in the soul-search!

There is new market-wide focus on the creation, adoption and implementation of appropriate Risk Appetite statements for financial firms. The key challenges in this include but are not restricted to: How to define it (top-down, generically and at level of portfolio/marginal risk), How to dimension and communicate it, How to monitor it (reporting issues, common metrics, creation and artistry of a “risk dashboard”), How to test it (potential loss and limits architecture and monitoring, scenario analysis including non-quantitative “what-if” tests), How to reconcile business strategy with it (including acquisitions and divestitures) and not least How to align incentives with it (compensation issues).

Many companies are currently working on detailed statements of Risk Appetite. Boards have begun to insist that they see one and actively discuss the same with the CEO, CFO and CRO. The process includes Dimensioning Risk Appetite, formulating a Statement/s of Risk Appetite, Communicating this all the way along and down the organization.

Risk Appetite dimensions of a firm typically should include a Quantitative and a Qualitative component/s. Quantitative Risk Appetite is articulated at the level of the firm overall, and usually also at one or more subsidiary levels such as key businesses, regions, products, and risk-types as well. Dimensions include

- Economic and Regulatory Risk Capital
- Value-at-Risk, Earnings at Risk, and the requirement that these be related to both the Risk Appetite overall and to the subsidiary structure of product and risk level Limits
- Scenario Analysis & Stress-Testing Results at portfolio and transactional levels.

Some leading banks have operational-ized the Risk Appetite statement - at a portfolio/transaction level, risk-takers and risk-managers must justify, approve, monitor, and report on Stress Returns, and Returns on Capital i.e. RAROC, RORAC, RORC, NIACC etc..

Qualitative Risk Appetite includes some range of acceptable risks and boundaries across
- Businesses that the firm will do and How
- Unusual, Unintended, and Unacceptable risks
- Approach to Legal and Regulatory grey areas
- Ethics and Conflict of Interest Policies/statements
- Loud clarity on unacceptable behavior (articulating policies on, say, sexual harassment and discrimination are relatively easy as they belong in the zero-tolerance zone. Firms seem to find things so-very-difficult once you go beyond these simple examples)


Will be back with more on this as also on Risk Principles, Policies, processes....

Jaidev