Global Market Update From Damien Cleusix

To everyone needing a big picture refresh of all that is happening in the world, and to focus on the forest behind the trees of endless headlines, here is Damien Cleusix' latest macro markets update.

Dear All,

We will start with some rumblings on the financial sector in general and banks in particular. For those only interested in the financial market calls they are at the end... THE KEY for the future of the system has we know it will be the decision which will be made in the weeks/months to come with regard to banks. If politicians screw this once more we are afraid that this will be remembered as the final trigger toward a radical change on how our financial system work. This won't happen overnight but be sure that the system you will be living in in 5 years will be RADICALLY different than today's. While the "Occupy Wall Street" movement remains marginal, be sure that it will grow exponentially if politicians make the bad choices. It will grow so much that it might ultimately dictate the political (regulator) agenda. Far fetched? Probably but we have done some far fetched prediction in the past 10 years and they have come to pass to why not try our luck once more.

How could politicians and regulators screw it once more?

Simply by not letting the losses fall upon those who made the wrong bets. Did they learn from the 2008-2009 mistake? We don't think so and so there is a very high probability that they will screw it again (we apologize for the choice of word but this is really what they are doing, they are paving the way for a whole generation toward insecurity, poverty and despair).

So what need to be done with banks.

They should be recapitalized. Up to here we mostly agree.


We believe that banks should be recapitalized toward, at least Basel III requirements after taking into account an adverse 2012-2013 scenario, and even more. Take those Deferred tax assets out of tier 1 capital ratio, stop the 0 risk weighting of highly rated sovereign debt,... Up to now we have only heard of a move toward 9% Basel 2.5 tier 1 capital ratio without adverse scenario. The latter would require between EUR 90-150 bio. The former would probably require EUR 750- much much more bio. The former would imply that the current shareholders would be wiped out almost entirely. We would also require bond holders to bear some of the losses. By doing so tax payers money is likely to earn some money, otherwise it won't. If the current discussion about the 9% Basel 2.5 ratio come to pass, be sure that banks will need more money in a not so distant future.

The recent Dexia recap was exactly the opposite of what we want to see. How can guaranteeing some assets be profitable for tax payers? You only have the downside for god sake.

Banks have successfully  convinced that a shareholder wipe-out (and bondholders hair cut) is not possible as it would lead to Armageddon. They are using the Lehman specter ad nauseam. THIS IS SIMPLY NOT TRUE. Did Washington Mutual failure have any impact? We are pretty sure that most of its clients wouldn't even notice it if they had not heard it  in the media. Lehman failure brought a lot of ill because it was not orderly. The banks stopped functioning from one day to the other. Clients did not know what would happen to the assets held directly or indirectly by Lehman. All of this happened because the FDIC was not able (regulation did not permit it) to take Lehman into receivership. Receivership is the secret. Under receivership the bank can continue to operate as if nothing has happened. Under receivership, past shareholders and bondholders take their losses and balance sheet are restructured. Then the banks can be sold to new holders. Clients and counter-parties do not have to notice a thing.

So European banks, when they lose access to the private capital markets and are in desperate needs of money, should be taken in receivership. If politicians/regulators do it, then the system as we know it might have a chance to survive.

John Hussman told this better than us so...

We are headed toward a new recession because our policy makers never addressed the underlying problem in the first place, which was, and remains, the need for debt restructuring. This is an issue that I suspect will re-emerge to the forefront of public debate in the next year. Hopefully, the response of our policymakers will be at different.


Think of restructuring this way. U.S. stocks just lost $2.5 trillion last quarter. Why should the public bail out the bondholders of financial institutions when the assets of these companies are far beyond what is needed to cover their liabilities to depositors and customers? The problem for banks, of course, is that they are leveraged, so even a drop of a few percent in their assets wipes out much of their own capital and threatens to make them insolvent. That should be a major concern for the lenders who have allowed the managements of those banks to leverage their bets with increasing lack of transparency (thanks to the FASB). But "failing" institutions can be restructured without any loss to depositors or counterparties. When banks become insolvent, my view is that receivership and restructuring is exactly what should happen, and swiftly.


Look at Bank of America's balance sheet, for example. Reported assets are $2.261 trillion. Against that, liabilities to depositors amount to less than half that, at $1.038 trillion. Add in $239 billion for securities that they are obligated to repurchase, $129 billion in trading account and derivative liabilities, and $155 billion for accrued expenses. Now you've covered counterparties, as well as vendors or others who might have invoices outstanding. Even then, and you're still only up to $1.561 trillion of the liabilities. The remaining 31% of Bank of America's liabilities represent obligations to its own bondholders and equity of its own shareholders. This is well beyond what is sufficient to buffer any loss that the company might take on its assets, while still leaving customers and counterparties completely whole. To say that Bank of America can't be allowed to "fail" is really simply to say that Bank of America's bondholders can't be allowed to experience a loss.


What "failure" really means is that bondholders lose money, and the operating part of the institution is taken into receivership, sold for the difference between assets and non-bondholder liabilities, and recapitalized under different ownership. Often the only thing that customers and depositors notice is that there is a new logo on top of their statements.


Now take a look at Citigroup's balance sheet. Reported assets are $1.956 trillion. Against that, liabilities to depositors again amount to less than half of that, at $866 billion. Add in $204 billion in repurchase obligations, $209 billion in trading and brokerage liabilities, and $73 billion in other liabilities, and you're still only up to $1.352 trillion. The remaining 31% of Citigroup's liabilities, again, represent obligations to its own bondholders and equity of its own shareholders. And again, to say that Citigroup can't be allowed to "fail" is really simply to say that Citigroup's bondholders can't be allowed to experience a loss.


You can do the same calculations for nearly every major financial institution in the world. The amount of bondholders and equity coverage varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions. Make no mistake - that choice is what the oncoming crisis is going to be about


But who are those bondholders? They include corporate investors, pension funds, endowments, mutual funds and ordinary investors. And all of them willingly take a risk in order to reach for return. As do stock market investors. And if the risk doesn't work out, none of them should look to the government to fire teachers, lay off social workers, underfund the National Institutes of Health, cut Medicaid, and print money (because until the Fed sells its Treasury and GSE holdings, it has indeed printed money), just because they take their risk in a different type of security.


My impression is that the scare-mongering of self-serving financial "experts" on Wall Street is shortly about to become deafening. It would be catastrophe, utter catastrophe, no, Armageddon, to let the global financial system collapse - collapse! - because the world as we know it will indeed collapse, as day follows night, if bondholders, who knowingly and voluntarily take risk and invest at a spread, are actually allowed to lose anything! We cannot, in a thinking society, allow losses to befall risk-takers who make reckless loans and bad investments. We must, must at all costs, divert money away from health, education, and welfare, in order to save these companies from failure, because neither health, nor education, nor welfare are even possible unless we save the financial system from unthinkable meltdown. We have no choice. No choice at all. They are too big to fail, and we cannot hesitate - they must be saved, for the sake of our children, for our children's children, for our freedom, for the flag, and to honor the legacy of our forefathers, so that these Champions of Disfigured Capitalism can continue to do their vital work with impunity, unbound by any of the incentives or consequences that actually allow capitalism to work in practice.


To reiterate the observations of Sheila Bair, the outgoing head of the FDIC, in her discussion of the 2008-2009 crisis: "'We were rarely consulted. They would bring me in after they'd made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.' If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.' No analysis, no meaningful discussion. It was very frustrating.' ... As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management's risk-taking."

I feel it is important to emphasize - as we move toward recession - that we shouldn't blame what is happening here on capitalism or free markets. We really have only a caricature of those here. We have a system that is constantly eager to abandon the proper role of government in the markets - which is effective regulation of risk - and to substitute it with the worst role of government in the markets - which is absorbing losses for those whose losses should not be absorbed, and pursuing policies tilted toward the constant creation of speculative bubbles and the avoidance of required economic adjustments, rather than the productive allocation of capital.


Free markets work - provided that they operate within a framework of government policy that enforces property rights, provides reasonable regulation, coordinates objectives that cannot be achieved privately (e.g. certain infrastructure, insurance coverage for pre-existing conditions - which otherwise creates an adverse selection problem even for companies that would like to offer it), and maintains reasonable consumer protection (because there is a huge "information problem" in requiring each consumer to have all of the requisite facts to avoid abusive practices). To blame our economic problems on the free market is an insult to what has proved for centuries to be the most effective economic system for creating prosperity and raising living standards. We would be wise to stomp out the incessant policy of bailouts and monetary distortions if we hope for that to continue."

Now European banks have  announced that they plan to shrink their balance sheet by approximately EUR 775 Bio. during the next 2 years to lower their dependence on short-term wholesale financing and their leverage. They plan to do it by selling assets and reducing lending. What would this imply?

A gigantic credit crunch which would transform the current recession to a quasi depression. The negative domino effects would cause more harms than goods to bank as bankruptcies would increase, housing market would correct massively (yes the housing markets in Europe have yet to correct  and they will... and mortgage in not a non-recourse liability for its holder  here as it is in many states in the US...). It is already almost impossible for an Italian SME to borrow money now so...

This would have consequence globally too (not only indirectly). As we have been saying for quite some time, European banks have been the biggest provider of loans to emerging markets.

If they are allowed to shrink their balance sheet as quickly as they are saying, Eastern Europe will go belly up, Brazil would move from boom to bust and Asia will suffer.

As an aside we have updated a spreadsheet we sent back at the end of 2007 looking at US banks most at risk. 8 of our top 10 "failure list" ultimately failed or were acquired.

So here comes Europe...

As a final point on banks equity coverage, we warmly recommend an excellent read on the subject can be found here: (ROE will have to fall back to historical level and we won't live much longer in a world of a third to half of the profits are made by the financial sector).


On Europe macro picture, we have not much positive to say. We have been extremely bearish on its macro prospects and we see not reason to change our view. Austerity through internal devaluation of high indebted countries is not a solution. It won't work as Greece is clearly showing (for those citing the Baltic State as an example we just want to say: Let's see what will happen in the near future, people suffered but their competitiveness was not restored, they did OK while the rest of the world was growing in 2010-2011, they won't now and they will ultimately devalue their currencies). The problem is that the countries who would need a booming export sector to make the transition easier can not as they are not competitive enough. Germany has been a great benefactor when those countries were booming (do you remember the time when Spain was consuming almost 70% of the cement in Europe) and now can not help them. We understand why they do not want to bail them out and the only solution would be for the German relative exchange rate to rise (which will ultimately happen). We have been particularly bearish on France and Belgium and depending on the bank recap scheme chosen bad will become worse.

In the US while macro data has surprised positively (and if you read the ISM reports in details you will see that it was a false positive report...) their trend is still down. The other positive surprises have come from lagging (or at best coincided indicators). We see no reason to alter our recession call made this summer. The US will be in recession at the latest during Q1 2012. The fact that the ECRI also made a recession call is encouraging.

Japan will continue to suffer. We are still scratching our head wondering why they are not tackling the Yen problem more actively. We understand their encouragement toward domestic companies to buy foreign assets (and some acquisition have been announced recently) Japan will have to finance part of its deficit from outside of Japan as some of the biggest domestic buyers (pension funds) have started to see their asset base shrink. Why would one buy an asset with a 1% coupon in an overvalued currencies in a country with severe structural headwinds? We see no reason. What should Japan do? They should (and we think they will) do a "SNBs". They should peg the Yen against the USD (or a basket of currencies which would be more politically feasible but less interesting economically as they would have to buy less undervalued currencies such as the Euro,...). They should first peg it a 82-85 and hope to become a large buyer of USD. In so doing they would buy a lot of an undervalued currency which will become very handy in the future. The BOJ should let its balance sheet swell and use a nominal growth target for partial normalization. A share of the international reserve accumulated should be parked into a new sovereign wealth fund whose mandate should be to invest domestically along the government into long-term productivity enhancing projects and internationally when assets are cheap and investors panicking. The peg should be raised with time. Investors long the Yen or willing to take a long position should have a Damocles Sword upon their head. Japan could also play the brinkmanship game where they would, once they have amassed significant amounts of foreign currencies. This would lead to a rapidly plunging Yen toward extremely undervalued levels (what about a Yen at 175-200). The US has almost been doing this in the past few years (and it accumulated a lot of foreign assets but not enough when the USD was overvalued back in 1998-2001). With a low Yen it would not be a problem for Japan to finance itself (and it could pocket some of its reserve gain to pay back its debt to domestic actors,...). Hope spring eternal...

On emerging markets do not forget their dependence on foreign capital in general and European banks in particulars, exports toward the US, Europe and Japan and commodity prices. It feels like a perfect storm is in the making... This will be a bump in the road toward higher standard of living but what look like a small bumb on a 100 years graph can be pretty unpleasant to go through. We maintain our call on a recession in Brazil, India and most of Eastern Europe. With regard to China we do not really know. We know it is a gigantic bubble which will ultimately have to burst (not implying that the Chinese economy won't be much bigger than today in 20 years, it will but it is a young economy which experienced a gigantic capital formation boom and down cycles can not be suppressed indefinitely). The domestic shadow financial system seems to be felling some strains but has grow exponentially and inflation is stickier than the government hoped so they won't be able to play the same playbook as in 2008-2009 with a huge fiscal stimulus (money will be needed to recapitalize banks instead).



On the valuation side, markets are expensive in the US.  Europe is relatively undervalued in Europe but  at best fairly valued if you remove financial companies. They are cheap in Japan with small caps extremely cheap. They are not yet cheap in emerging markets but are approaching fair value. Remember that markets valuation tend to move in cycle. You have the structural valuation cycle (which is a generational cycle influenced by both psychology and demographic shifts), lasting 30-40 years where the markets move to extremely undervalued to extremely overvalued and back to extremely undervalued and you have the shorter-term cycle (would call it the cyclical cycle but...) which last 3-5 years where markets valuation move from one extreme of the structural cycle channel to the other.

Developed markets (ex Japan) are since 1998 (or 2007??) in the downside phase of the structural valuation cycle and this cycle will end at valuation levels which usually make people laugh when we name them. They reached the top of the falling structural channel this year and have now started a new decent toward the lower section of this channel (30-50% below current levels.

Japan should be soon (after the current cyclical down phase) into a new structural up phase while emerging markets entered such a phase in 2003. Japan downside for here is 15-25% while emerging market downside is 30-50%.

We have written extensively on the demographic cycle influence on the valuation cycle (see our past quarterlies with detailed graphs for many countries). The San Francisco Fed recently published a research note on the same subject. You can find it here

Our cyclical models are negative as they have been since mid-July and we are thus in sell the rallies mode.

On a short-term basis, we have seen early signs of panic in early October (short interest ratio, high put call ratios, plunging investor bullishness in various surveys, huge outflows in equity mutual funds and some bearish covers). We have experienced a multitude of breadth thrusts  since which are bullish signs for the medium-term (at least they have been bullish in the past 70 years). The most likely scenario is for the markets  to be 4-5% higher (S&P 500 proxy so higher beta market swill rise more) sometime between the beginning of next week and 1 month for now. We had a lot of studies pointing toward a correction to 1150-1170 in the short-term (2-5 days) and we still have some but the markets have refused to correct. Now a move toward 1180 would be a strong warning for those who wants (not us) to play the few % upside potential. We strongly doubt that the S&P 500 will be able to move significantly higher than 1270 and we will start to take a net short position on a move above 1250 (or a failure below 1180).

The main reason why we did not lift our market risk hedges during the recent panic is that we feel the rally can be crushed at any time by politicians and we do not want to be exposed to this risk (especially when the main actors are Eurocrats). Remember that sometimes it is preferable to do nothing and to preserve capital. If we are wrong here we won't loose anything, just an opportunity and they will be hundreds others in the year to come so...

 We maintain that the S&P 500 will move below 800 (and we see a move below the 2009 lows as a distinct possibility) in the next 12-18 months. As always, we will respect our cyclical models signal and if they were to turn positive again well so be it.


We are again seller of the Euro at current levels. The 3 months risk reversal is not confirming the strength of the past few days and we believe that a fair share of the big speculators net short future position held 2 weeks ago has now been covered. With regard to the potential repatriation of capital of European banks before the soon to be announced recap plan, we do not have hard data to confirm it but it seems plausible.

EUR 3M Risk Reversal

The Central Banks 12 months discounter spread is again pointing toward a lower Euro as are the 2 years government bond and swaps yields spreads. The large increase of the French-German 10 years spread has also been associated with Euro weakness in the past.

EUR and ECB-Fed 12M discounter

The Euro is expected to fall below 1.25 in a non too distant future and without a break up the 2000 lows will be retested in the next year or two.

We are also selling the Yen which offer a fantastic risk reward ratio. It can be frustrating to wait but we promise it will be worth it.

We are seller of the commodity currencies on strength and would start to build short position at current levels on the AUD.

We are out of emerging market currencies which could suffer some nasty decline. We will be buyer again (as we where between 2003-2007 and very briefly (too briefly...) at the end of 2008, on a decline 10-15% below our fair value models.


Nothing has changed on commodities, while they will move up along with equities they are in cyclical bear markets with much lower price to come (copper will be halved before it set a real bottom,...)

The exception might be grains which could be supported by the apparent emergence another La Nina and gold.

With regard to gold, the main risk is one of liquidation and reversal of the emerging market demand boom.

Gold has followed our script in the past few months and one would need a move above 1700 for the up move to resume. In the meantime a correction toward 1425-1500 would not be too surprising. A move to 1250-1300 could unfold if equity markets experience a water fall decline but we will be heavy buyers at those levels. Gold producers stocks are likely to fall like stones if this happen and we would buy them aggressively it they do. AGGRESSIVELY.

Fixed Income

We have mostly recommended relative CDS or cash pair trade in the past few months as one could find fantastic risk reward ratio trade. They behaved as expected.

Now on plain vanilla government bonds we are currently neutral but might start to buy again some treasuries on a move toward 2.35-40 on the 10 years. We avoid Europe as the plague and we are completely out of emerging market bonds.

On corporate bonds we are also not exposed but we would will to build position on distressed name in Europe during the next down wave. Elsewhere spreads have to widen further before picking our interest.