Investment Grade

The conflict between labor and capital is a long and illustrious one, and one in which ideology and politics have played a far greater role than simple economics and math. And while labor enjoyed a brief period of growth in the the past 100 years first due to the anti-trust and anti-monopoly, and pro-union laws and regulations taking place in the early 20th century US, and subsequently due to the era of "Great Moderation"-driven "trickling down" abnormal growth in the developed world, it is precisely the unwind of this latest period of prosperity, loosely known as "The New Normal", and in which economic growth will persist at well sub-optimal (<2%) rates for the foreseeable future, that is pushing the precarious balance between labor and capital costs - in their purest economic sense, and stripped of all ethics and ideology - to a point in which labor will likely find itself at a persistent disadvantage, leading to the same social upheaval that ushered in pure Marxist ideology in the late 19th century. Only this time there will be a peculiar twist, because while in relative terms labor costs as a percentage of all operating expenses are declining around the world, when accounting for benefits, and entitlement funding, labor costs are rising in absolute terms if at uneven rates and are now at record highs. Which sets the stage for what may probably be the biggest push-pull tension of the 21st century for the simple worker: declining relative wages, which however are increasing in absolute terms when factoring in the self-funded components paid into an insolvent welfare system. But the rub comes when one considers the biggest disequilibrium creator of all: central bank predicated cost of capital "planning", whereby Fed policies may be the most insidious and stealth destroyer of all of labor's hard won gains over the past century. 

Austerity is coming our way, it's just a matter in what manner and by how much, and whether it becomes an orderly or disorderly process. The fiscal cliff is really a bit of a ruse in that respect, but the key here is that years of fiscal profligacy is coming to an end and the Fed at this point, having used its bazookas, is now down to firecrackers. The economic outlook as such is completely muddled and along with that the prospect for any turnaround in corporate earnings... Once we get past the Fiscal Cliff we will confront the inherent inability of the Democrats and the GOP to embark on any grand bargain to blaze the trail for true fiscal reforms. The U.S. has not had a rewrite of its tax code since 1986, which was the year Microsoft went public and a decade prior to Al Gore's invention of the Internet. The tax system is massively inefficient and leads to a gross misallocation of resources that impedes economic progress — rewarding conspicuous consumption at the expense of savings and investment. It is the lingering uncertainty over the road to meaningful fiscal reform that is really the mot cause of the angst — the fiscal cliff is really a side show because who doesn't know that we are going to have a Khrushchev moment?

As we head into the last of this year and we confront various cliffs; fiscal and European, the threat of rising taxes for individuals and perhaps corporations should not be minimized. My best advice of today is to stop and look at your portfolios and take some profits and re-invest the proceeds or take profits and keep cash to be re-invested after the first of the year when we have either bumbled our way out of our predicament or behaved badly and find ourselves in a morass with all of the markets rolling about on their backside. It makes no difference as to your viewpoint and it takes no socially charged adjectives to reach a correct opinion; our President wants more and increased social programs and he wants those with the money to pay for them. Now you have one and one-half months to make preparations.

Stocks tend to experience very long periods (5-20 years) of either anemic or exceptional returns, which UBS calls Investment Regimes. Somewhat surprisingly (to some), they note that returns during these periods are not driven by divergences in economic or earnings growth. Rather, Investment Regimes are defined by secular multiple expansion or contraction - and it is critical to understand this dynamic as over the past 40 years (and four regimes) investors have tended to focus on only one dynamic at a time. From the 'Disco' regime to the 'Hangover II', UBS explains in a few simple charts why all eyes should be focused on high-yield credit - as we have noted time and again. Inflation signals are gone, the 'Fed model' is broken, and investment grade credit is too repressed to matter (until it does!)...

Life imitates math.

European stocks popped at the open and then generally trod water for the rest of the day. The initial liquid-driven surge had no follow through and in fact European sovereigns bled wider most of the day - with Greek govvies now down almost 10% (in price) in the last week.  Credit markets re-racked along with stocks - with XOver outperforming and Main (investment grade) underperforming (along with financials). The story of the day was yet another 100pip-or-so rampapalooza in EURUSD - the 3rd in 5 days - as we noted earlier, when everything else is shut, EUR is simplest lever to drive markets higher given the correlations (and no Treasury police to keep things under control). Despite today's push, Spain's IBEX remains -0.5% on the week (as its peers are all up around 0.5%) and Italy and Spain bond spreads are up around 15bps on the week. So with EUR up around 0.22% vs USD on the week and fulcrum securities from Spain down, take your pick on where risk is being flushed.

With all the hope slooshing around the world, it is likely no surprise that some risk-reward connections have 'broken' or become misaligned. In an effort to simplify the view of asset class risk and return, we present Morgan Stanley's Yield vs Volatility chart. It seems relatively plain to see that the Russell 2000 (and European stocks SX5E) are dramatically over-priced (under-'yielded') relative to their risk, while Asian and European High Yield credit (and to a lesser extent Asian and European Investment Grade Credit) are trading notably cheap relative to their volatility. So for all those performance chasing asset-allocators who remain fundamental bulls, buying European High Yield credit seems the best bang for your buck - instead of piling into more Russell 2000 beta...interestingly the S&P 500 appears 'fair' compared to risky sovereigns, global stocks, and global credits from a risk-reward perspective.

Fear the truth, it shall set fundamental market forces free!

Over the weekend there appears to have been more confusion about pretty much everything finance related by aspiring CTRL-V majors-cum-'market experts.' In this specific case, the correlation between the soaring US deficit is magically supposed to imply the causation of surging corporate profits. Standalone this would be wonderful, because in a socialist utopia thought experiment, where one could hit infinite deficits funded by some magic MMT money tree, corporation would make, well, an infinite amount of profits, and would be an incentive for the government to spend itself to oblivion. And everyone would be happy right: infinite corporate profits means at least some trickle down wealth, and infinity even minus a big number is still infinity, meaning full employment for everyone. Hence utopia. Idiocy of this conclusion aside, the bigger problem with making the biggest rookie mistake in finance (and statistics), namely confusing correlation with causation, is that it is, as usual, 100% wrong when presented with one counterfactual. And when it comes to counterfactuals of soaring deficits, one always goes to the place that has "been there and done all of that" before. Japan.

Today Europe awakes to yet another Eurozone summit, one at which such topics as Greece, Spain, the banking union project or a economic/budgetary union will have to gain further traction, if not resolution. In fact Greece could hardly wait and has already launched it latest 24 hour strike against austerity. The same Greece which demands a 2 year, €30 billion extension from Europe to comply with reform, a move which Europe has/has not agreed to as while the core have said yes to more time, all have refused to fund Greece with any more money. Alas the two are synonymous. As SocGen predicts unless there is some credible progress today, all the progress since the September ECB meeting, which has seen SPGB 10 Year yields decline from 690 bps to sub 550 bps, may simply drift away. And as everyone knows, there is never any progress at these meetings, except for lots of headlines, lots of promises (the Eurozone June summit's conclusions have yet to be implemented) and lots of bottom line profits by Belgian caterers. Elsewhere, Spain sold 3, 4 and 10 year bonds at declining yields on residual optimism from the pro forma bailed out country's paradoxical Investment Grade rating. In non-hopium based news, Spanish bad loans rose to a record 10.5% in August from 10.1% previously while the oldest bank in the world, Italy's Banka Monte dei Paschi was cut to junk status. All this is irrelevant though, as no negative news will ever matter again in a centrally-planned world. Finally the only real good news (at least until it is revised)came out of the UK, where retail sales posted a 0.4% increase on expectations of a 0.2% rise from -0.2%.

While we have largely resumed ignoring the non-newsflow out of Europe, as it has reverted back to one made up on the fly lie after another, or just simple rumor and political talking point innuendo in the most recent attempt to get hedge funds starved for yield (and chasing year end performance) to pursue every and any piece of Italian and Spanish debt (at least the until euphoria ends and the selling on fundamentals resumes) the latest development from the FT bears noting as it has major implications for Europe's make it up as you go along "recovery." According to the FT: "A plan to create a single eurozone banking supervisor is illegal, according to a secret legal opinion for EU finance ministers that deals a further blow to a reform deemed vital to solving the bloc’s debt crisis. A paper from the EU Council’s top legal adviser, obtained by the Financial Times, argues the plan goes “beyond the powers” permitted under law to change governance rules at the European Central Bank." The punchline: "The legal service concludes that without altering EU treaties it would be impossible to give a bank supervision board within the ECB any formal decision-making powers as suggested in the blueprint drawn up by the European Commission."

Back in January, Zero Hedge proposed a pair trade, which to date has returned well over 100% on a blended basis, namely the shorting of local law peripheral European bonds, while going long English law (or strong covenant) bonds (a relationship best arbed in Greece, when various foreign-law issues were tendered for at par to avoid a bankruptcy, even as the local law bond population saw a massive cram down a few months later as part of the second Greek "bailout"). In big part, this proposal stemmed from the work of Cleary Gottlieb's Lee Buccheit, who has been the quiet brain behind the real time restructuring of Europe's insolvent states. In fact, one can say that what is happening in Europe was predicted to a large extent in his "How to Restructure Greek Debt" and "Greek Debt; The Endgame Scenarios." Which is why we read his latest white paper: "The Eurozone Debt Crisis - The Options Now", because it presents, in clear, practical terms, just what the flowchart for Europe looks like, unimpeded by the ceaseless chatter and noise of clueless politicians and career bureaucrats who have never heard the term pro forma or fresh start. In brief, Buccheit, unlike all European politicians, is hardly optimistic.

• Obama takes offensive against Romney in debate rematch (Reuters)
• Obama Says Romney Words Aren’t ‘True’ in Second Debate (Bloomberg)
• Obama takes Romney head-on in debate (FT)
• And another joins the club: Thailand Unexpectedly Cuts Rate as Global Outlook Worsens (Bloomberg)
• PBOC Injects Less Cash (WSJ)
• Japan to Hold Special Cabinet Meeting After Economy Downgraded (Bloomberg)
• Greek Coalition Duo Reject Labour Moves Proposed by Troika (WSJ)
• Opposition wanes to Spanish aid request (FT)
• RBS to Exit U.K. Asset Protection Plan After $4 Billion Fees (Bloomberg)
• Spain Retains Investment Grade Credit Rating From Moody’s (Bloomberg)
• US diplomat asks Japan, ROK to resolve islands spat (China Daily)
• Stagnation not due to austerity, says OBR (FT)

"Liquidity trap" was a term coined by John Maynard Keynes in the aftermath of the Great Depression. He argued that when yields are low enough, expanding money supply won't stimulate growth because bonds and cash are already near-equivalents when bonds pay (almost) no interest. Some, like Citi's credit strategy team, would say that it is a pretty apt description of the state of play these days. To their minds (and ours), there is very little doubt that central banks have played an absolutely crucial role in propping up asset prices in recent years, Why have markets responded so resolutely when growth hasn't? The answer, we think, is that in their attempts to free markets from the liquidity trap, central banks are ensnaring markets in what we'll call a "liquidity lure". That lure is three pronged... but tail risks are bound to re-appear and from this position, there is no painless escape.

Dimon: "So, we were asked to buy Bear Stearns.  Some said the Fed did us a favor...No, no, we did them a favor.  Let's get this one exactly right.  We were asked to do it."