Mark Grant On The Dangerous Road Ahead

From Mark J. Grant, author of Out of the Box

The Dangerous Road Ahead

“The last time Quantitative Easing was stopped the equity markets dropped precipitously. There is no reason to think that will not occur again though the severity may be less. Today's FOMC minutes are quite significant in my view. They also said, for the first time, that the pledge to hold short rates at near zero was "conditional." This is another very meaningful statement. I would be taking money off the table now in both equities and bonds as the stock market will probably head lower and yields will begin to rise in fixed coupon securities.”
                                                                                      -MJG, April 3, 2012, 2:16 pm

This was the note that I put out to the readers of “Out of the Box” sixteen minutes after the Fed released their monthly report. That was as fast as my fingers could type what was going on in my mind. I thought it was good advice to the 5,000+ institutions that receive my commentary and I have become more positive about it as the days have rolled along as the Dow Jones Index has dropped 350 points since I typed my musings. In fact, we are just at the beginning of a great divergence where credit assets, risk assets, decline in value and where Treasuries head in a quite separate direction as driven by U.S. data in part but, more significantly, by the travails in Europe. The CDS for Spain reached an all-time high on Friday reflecting the financial issues in Spain as the Spanish bond yields creep higher held back, in part, by the threat of intervention from one of Europe’s stabilization funds.

We have just been presented with one very red flag signaling the seriousness of the issues in both Italy and Spain. Spain just announced that its banks borrowed $415 billion from the LTRO funding while net borrowing stood at almost $300 billion and accounted for 63% of the net borrowing at the ECB. For Italy the number is $354 billion in LTRO borrowing and they are not that far behind Spain in needing aid. The actual debt to GDP ratio, which I detailed on March 29, is 133.8% for Spain, not the official 79% number, and is getting worse as their economy shrinks and as the country guarantees ever more bank debt to be used as collateral. It is not much better in Italy as the combined national debt and their share of the debts at the ECB and the EU peg Italy’s actual debt to GDP ratio right at 200% and while Italy’s ability to self-fund is appreciably better than Spain; their funding needs are becoming appreciably larger as the country sinks into recession.

For the moment both the Fed and the ECB are not engaged in Monetary or Quantitative Easing. This has been the driving force for both equities and for bonds for the last four years. Yields have been lowered, spreads have compressed but I think we are now in the early stages of a massive reversal where stocks decline and where yields rise and a widening takes place between Treasuries and every other asset class. In my view, during the next several months, the situation will continue to deteriorate and so I continue to advise taking profits in both equities and bonds and re-deploying the money. I would stick with various structures that float or step-up and I would avoid bullets as losses will accumulate both from the absolute rise in yields but also from the widening in spreads.

The one other area I am becoming quite concerned about are the banks; in particular the European Banks. Of the twenty-five largest banks in the world there is only one that does not need to raise additional capital to de-lever to a 20x leverage and a 5% of Tangible Capital Ratio and that is Citigroup which has a current leverage of just 13 times and I also point out that Wells Fargo with a 14 times leverage needs a minor amount of capital to accomplish these goals. At the far other end of this scale is Deutsche Bank which is levered 62 times and would need a massive amount of new capital and tremendous shrinkage to accomplish these goals. The assets of DB are also equivalent to the entire GDP of Germany so that the bank could devour the country if Deutsche Bank were to hit the wall. Then the most leverage can be found at Credit Agricole at 66 times which would also swamp France, given its size, if asset values continue to decline or if Spain or Italy need to be bailed out and the contagion worsens.

“It is in the uncompromisingness with which dogma is held and not in the dogma or want of dogma that the danger lies.”

                                             -Samuel Butler
                                                                                                             -Mark J. Grant