Capital Markets

Moments ago, the San Fran Fed, best known for spending taxpayer money to conduct such indepth analyses on topics including whether water is wet, and whether the Fed creates bubbles, has just released its most recent 'FedViews' economic outlook in which we read that "we expect growth to steadily accelerate in 2013 as the economy bounces back from harsh weather conditions and as the underlying expansion of consumer spending reemerges. We expect growth to register 1.7% in 2012 and 2.6% in 2013." This would be great if only a two minute Google search did not expose some of the San Fran Fed's previous attempts at forecasting the future, such as this one from October 14, 2010, in which the crack experts said that "we currently project that real GDP will  expand around 2½% in 2010, below its potential of about 3% annually. We expect the recovery to gain momentum over the course of next year and that real GDP growth for 2011 will reach about 3½%." Final 2011 GDP growth: 2.4%.... or this one from June 9, 2011, in which we learned that "growth should rebound in the third quarter. We expect GDP to expand at an annualized 3½% rate in the second half of the year and to continue to strengthen throughout 2012." Final 2012 GDP growth: 1.8%. Or just 50% off. Applying the same undershoot error rate to the Fed's 2013 forecast means that real economic growth next year will be at best 1.3%. And that's with a fresh $1 trillion in monetary injections from the Fed.

By now everyone should know what is at stake in the Fiscal Cliff, which unless resolved in precisely under two weeks, will introduce America to something disastrous, horrifying, unbearable and simply ghastly: living within its means. And in case there is still any residual confusion, here is yet another infographic, this time from Saxo Capital Markets, to simplify it so well even an economist will get it.

Instead of uttering one more word in a long, seemingly endless tirade that stretches all the way to April 2009, we will this time let such dignified members of the credible, veritable status quo as Credit Suisse, who have released a two part primer on everything HFT related, with an emphasis on the broken market left in the wake of the "high freaks", which is so simple even a member of congress will understand (we would say a member of the SEC, but even at this level of simplicity its comprehension by the rank and file of the SEC is arguable). As Credit Suisse conveniently points out "market manipulation is already banned", but that doesn't mean that there are numerous loophole that HFT can manifest themselves in negative strategies that have virtually the same impact on a two-tiered market (those that have access to HFT and those that do not) as manipulation. Among such strategies are:

• Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
• Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
• Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
• Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

Today is probably the first day in a while in which minute-by-minute rumors on the Fiscal Cliff will not be on the frontburner (with yet another late day rumor yesterday of an imminent deal turning out to be a dud, when it was reported that Obama's latest grand compromise was to lower his initial tax hike demand from $1.6 to $1.4 trillion, or still $600 billion more than last summer's negotiated number), with Ben Bernanke and QE4 taking center stage instead. By now it is a foregone conclusion that Ben will proceed with extending Twist as first predicted here, into an unsterilized bond buying operation, in effect confirming that there has been zero improvement in the economy, as another $1 trillion is about to be injected until the end of 2013, and more trillions after that. The good thing is that all pretense that the Fed cares about anything but the market is now gone. The bad thing is that the Fed will continue to take over the capital markets until it and the other central banks are the only traders remaining. The only question is whether the market, now well into massively overbought territory, will fizzle and snap back after Bernanke's news announcement, and will QE4EVA (as we believe QE3+1, aka QEternity-er, should be called) have been fully priced in by the time it was announced?

The man who singlehandedly fought the administration over the idea of converting Fannie and Freddie into the latest taxpayer-funded handout machine, FHFA head Ed DeMarco, and refused to write down Fannie and Freddie home loans in yet another Geithner-conceived debt forgiveness scheme, whose cost like any other non-free lunch will simply end being footed again by yet more taxpayers (what little is left of them), appears to have lost the war, and with the second coming of Obama appears set to be replaced as head of the FHFA. The WSJ reports that "The White House has begun preparations to nominate a new director to lead the agency that oversees Fannie Mae and Freddie Mac as soon as early next year, according to people familiar with the discussions. This would pave the way for President Barack Obama to fill what has become one of the most important economic policy positions in Washington." And so the impetus for as many as possible to default on their mortgage in a wholesale scramble to obtain debt forgiveness, will soon take the nation by storm, while the contingent liability will be transferred to those who still believe that taking out debt should be a prudent activity and one that takes into account future cash flows. In other words, the solvent middle class - those who were prudent stupid enough to save when they should have simply be doing what the government does and spend like a drunken sailor, preferably on credit, will soon be punished once more. And like it. Because according to the new broke normal "it's only fair."

As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet.... And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency.

The markets are holding up on hopes of additional stimulus from the Central Banks. Some bulls are even calling for QE 4 at the upcoming Fed meeting, despite the fact that QE 3 was launched a mere three months ago and was open-ended (meaning it would not end until the Fed deemed it time).

In what is the day's most overhyped piece of non-news, we go to Italy to learn what many already knew on Thursday, namely that with the loss of support of Berlusconi's PDL party, Mario Monti's technocratic government, which correctly "feels" it lost its parliamentary support, is coming to an end and after a two hour meeting between the former Goldman advisor and Italian president Napolitano, Monti announced he "intends to resign after checking to see if parliament can pass next year's budget law, President Giorgio Napolitano's office said on Saturday... If the budget law can be passed "quickly", Monti said he would immediately confirm his resignation. Monti's announcement came after a two-hour meeting with Napolitano, who has the power to dissolve parliament." The reason this is non-news is that Monti government's tenure is ending in a few months anyway, and general elections are coming in Q1 regardless. In other words, it may take weeks or months for the budget law to pass, or not, at which point it will be time for new elections anyway.

The market continues to track the same pattern it performed going into the failed debt ceiling talks of July 2011. As you’ll recall, then as is the case now, US politicians failed to reach a credible solution to the US’s debt problems. What followed was a credit rating downgrade and a market collapse.

By now there can be no doubt that due to Bernanke et al's endless intervention in any and all capital markets, the "market" is no longer a mechanism that discounts the future in any way. In fact, instead of predicting the future, all the market has become is a backward looking race in which collocated algos respond to historical data - flashing red headlines - and attempt to out run each other in who can buy or sell more free for all, knowing full well at least one other greater fool will be behind them to pick up the pieces. Sadly, fundamentals as a driver to valuaton no longer exist. But such is life under central planning.  Yet there is one thing that the market responds to - it is politicians and the uncertainty that political risk brings with it. This certainly includes that most political of organizations, the Federal Reserve, whose stimulative intervention into capital markets two months before the presidential elections was without precedent. Yet even here, the market has managed to decouple from reality, and is trading at level far greater than what political uncertainty risk implies. As the chart below from Citi's Matt King shows, a correlation between BBB spreads and a broader proprietary uncertainty index, there is currently a roughly 50% political risk premium that is not being priced into stocks.

• MSM discovers window dressing: Fund Managers Lift Results With Timely Trading Sprees (WSJ)
• White House Unyielding on Debt Limit (WSJ)
• Obama, Boehner talk; Geithner prepared to go off "cliff" (Reuters)
• Republicans urged to resist tax rises (FT)
• China looms large over Japanese poll (FT)
• As predicted here two months ago, Greek Bond Buyback Leads S&P to Cut to Selective Default (BBG)
• Japan opposition LDP set to win solid election majority – polls (BBG), but...
• Japan Opposition LDP’s Main Ally Cautions Abe on BOJ Pressure (BBG)
• U.S. and Europe Tackle Russia Trade (WSJ)
• King Seen Maintaining QE as Osborne Extends Fiscal Squeeze (BBG)
• Syria pound fall suggests currency crisis (FT)
• Irish budget seeks extra €3.5bn (FT)
• U.K. Extends Cuts Due to Poor Outlook (WSJ)
• ECB Seen Refraining From Rate Cuts as Yields Sink on Bond Plan (BBG)

Sluggish global economic growth means many public companies will have to rely on mergers and acquisitions to generate earnings growth in 2013 and beyond (FCX aside that is).  ConvergEx's Nick Colas notes that the academic discussion of whether such a strategy adds “Real” value to shareholders has shifted in recent years.  From an unequivocal “No, never…” to a more qualified, “It really depends,” this discussion will grow more critical as industries from financial services to manufacturing to commodity producers evaluate their long term prospects.  The key to this question, at least to Colas' thinking, is in the analysis of barriers to entry/exit and true economies of scale.  The right answer to the “Does M&A add value” question is much more about business strategy and competitive analysis than any blanket statement about the merits of buying or selling assets. In summary, M&A is now simply much more important to corporate strategy than at any point in the last 30 years; over the next 5-10 years M&A activity will be increasingly necessary to keep the tailwind of growth in almost every sector of the economy and capital markets. There’s just no other way to grow (though shareholders increasingly want that 'cash' in dividends or buybacks - and not growth!)

Citi's Robert Buckland explains: If policymakers really do want to encourage stronger economic growth (and especially higher employment) then we would suggest that they take a closer look at the equity market's part in driving corporate behaviour. Despite high profitability, strong balance sheets and ultra-low interest rates, any stock market observer can see daily evidence of why the listed sector is unlikely to kick-start a meaningful acceleration in the global economy. A recent Reuters headline says it all: "P&G Plans to Cut More Jobs, Repurchasing More Shares". If anything, low interest rates are increasingly part of the problem rather than the solution. Perversely, they may be turning the world's largest companies into capital distributors rather than investors.