Published on February 26, 2009
LONGER TERM THEMES A GUIDE FOR ASSET APPRECIATION 26th February 2009 Sound Advice FIGHTING DEFLATION James Vinall – Senior Investment Officer Premise This is a guide to the emerging themes EquityBell is pursuing. This report does not attempt to define the exact timing for entry into or exit from an investment, but explores the basis for considering proactive longer term asset switching. Dominant Theme For economies to pull out of a recession, individuals need to have confidence to spend and the ability to borrow. In the 1930’s, banks did not extend much credit to the working man, which is why the recovery took so long. Until last year, modern banking extended credit to almost everyone. Governments around the world are working very hard to get banks lending again with the sole purpose of fighting deflation. The financial crisis hit as equity markets started looking at the poor economic prospects over the following 6 to 9 months. Major equity indices fell substantially from October 2007 to November 2008 with most having recovered a small amount. Individuals are not trading equities, but institutions are looking at the economic prospects a year or eighteen months from now and deciding whether governments will have restored the ability of banks to lend and avoid “Japanese style” deflation. This battle is being fought on our TV screens right now and this is a critical juncture. Currencies Much has been made of levels of public sector net debt verses external debt levels. Commentators got very worried that 3Q08 UK external debt was reported by the UK Office of National Statistics at £5.97 trillion, where GDP was £1.4 trillion and public sector net debt at £697 billion. Country Public Sector Public Debt per GDP External Debt External Debt per External Debt as a Net Debt Worker Worker % of GDP $8.45 tril $287,957 412% UK $987 bil $33,616 $2.05 tril USA $10.6 tril $73,611 $14.58 tril $13.63 tril $94,444 93% $8.4 tril $132,300 Japan $6.0 tril $2.32 tril $36,825 39% France $1.35 tril $48,300 $2.1 tril $4.58 tril $163,889 218% Germany $1.86 tril $45,588 $3.65 tril $4.85 tril $118,978 133% Source: BoE, ONS, US Fed, BdF, Bundesbank and MoF THIS IS A MARKETING COMMUNICATION Intended for information only and should not be construed as an invitation or offer to buy or sell any investment vehicle or instrument. This note has not been prepared in accordance with legal requirements designed to promote the independence of investment research; and is not subject to any prohibition on dealing ahead of the dissemination of this marketing note. EquityBell Securities will provide extra detail on data or graphs used in this note upon requested.
LONGER TERM THEMES A GUIDE FOR ASSET APPRECIATION 26th February 2009 Sound Advice The extraordinarily high level of UK external debt was explained as hedge fund and bank investment leverage, particularly on the JPY carry trade (where JPY is borrowed at low rate and converted into another currency to trade). As hedge funds met redemptions and trading books reduced risk, large portions of this borrowing has been retired. This huge JPY buying and USD and GBP deleverage selling has seen the JPY rally while depressing GBP and USD. As the lion’s share of the unwind has happened, the JPY can now weaken from being overbought and USD and GBP strengthen from being oversold. Britain’s relatively low level of public sector net debt per worker (compared to Japan) suggests that UK government has a vast amount of room to borrow and print more money to stimulate the UK economy which will not be good for GBP. Our greatest current concern is the EUR and the scale of bank lending. Peripheral Europe (Ireland, Portugal, Spain, Italy, Greece, Austria and the former Soviet states) have vast lending and fading economies. France and Germany do not have the political will to effectively help, even if they did have the cash (which they don’t) and the ECB has no established rescue mechanism. Current prospects for the EUR look worse than the USD and GBP. America and the UK are currently losing the battle of hearts and minds that they have conquered deflation. Have a look at http://www.safehaven.com/article-12665.htm, where they discuss how governments fighting deflation need to act irresponsibly by throwing money at a failing economy to make saving worthless to have credible expectations to force people to spend and borrow. The US and UK look likely to borrow via bonds and print money via quantitative easing to make money so cheap, it will eventually create inflation. The US and UK need much bigger and faster stimulus packages to inject “real” cash to create the perception of inflation coming soon. Longer term is not good for the USD and GBP against the JPY as the heavily indebted Japanese government can do little more. The CHF is likely to be weaker as UBS have made a precedent of revealing tax avoiding account holders to the USA IRS (previously it had to be criminal activity) and Switzerland is losing it’s safe haven status (although where else can the money go?). Also 60% of all recent Polish mortgages are in CHF which has appreciated 50% against the Zloty in recent months and the chances of getting this money back anytime soon is slim. Another concern is that Swiss bank liabilities (that may require a bailout) significantly dwarf the Swiss National Bank reserves. Factor in the tacit connection to the EUR and Switzerland is not in a good place. Short term the GBP against US$ is likely to be volatile as it will be difficult to determine which currency will be perceived as weaker than the other at any given moment. The UK is a small country and if consumers significantly slow buying, the currency will become less important to exporters. The USD is the world’s reserve currency with a massive scale economy that will always be important. Longer term, regardless of the amount irresponsible fiscal stimulus from both sides of the pond, the US$ should outperform the GBP with rates settling into a lower range between 1.1000 and 1.3000. China and Japan have the highest current account surpluses in the world, but are highly leveraged to the Western consumer and have been hit hardest by the belt tightening. Asia needs to use its cash to adjust from an export led economy to domestic stimulus economy, to survive the inability of their traditional consumer base to buy their goods. The key moment for the US$ will be when the Chinese government stop buying US Treasury bonds, in order to stimulate their own economy. That will signal the start of Asian dominance of global economics for the rest of this century, as China will not allow the USA to climb back to the top of the global fiscal pile using their money. FX Recap Short term – stronger US$, and GBP and weaker CHF, EUR and JPY Longer term – stronger JPY, with US$ probably better than EUR, while CHF will be weaker and GBP weakest of all.
LONGER TERM THEMES A GUIDE FOR ASSET APPRECIATION 26th February 2009 Sound Advice Commodities Source: Saxo Bank Gold has rallied strongly from a low of US$682 per ounce on 24 Oct 2008 to 1,006 on th Friday 20 Feb 2009 (up 47%). Gold remains a long term favourite as a hedge against fiat currency quantitative easing and mistrust of the financial system, but appears overbought at present. Given that this financial crisis is truly global for the first time ever and gold is the currency of fear, we see long term gains for gold beyond US$1,000 per ounce and suggest a buying level of US$934. Another way to play gold is through the gold producing companies. The American stock exchange Gold Bugs Index comprises 15 gold mining companies that do not hedge their production past 18 months forward. That assumes that they are best exposed to movements in the gold price. See http://www.amex.com/othProd/prodInf/OpPiIndComp.jsp?Product_Symbol=HUI The Market Vectors Gold Miners Exchange Traded Fund (ETF), code GDX listed on the NYSE, comprises 32 gold mining companies of which the 15 components of the Gold Bugs Index comprise 79.73% of the ETF. See http://www.vaneck.com/index.cfm?cat=3192&cGroup=ETF&tkr=GDX&LN=3_02&rfl=/gdx. The correlation is very close. The graph below shows the relationship between Gold (in black) and the Gold Bugs Index (divided by 10 to make comparison easier) and the GDX ETF. Gold stocks started collapsing in the end of September 2008 as funds sold any liquid issue to meet redemptions. This broke the long standing relationship between Gold and Gold producers which is slowly recovering. As we have covered in the FX section, a large portion of leveraged fund redemptions have taken place and Gold producers are climbing back to AMEX Gold Bugs Index / 10 GDX ETF Gold their long run relationship with 60 1200 Gold. The Gold producers were hit very hard by the price collapse from late September 2008 and 50 1000 have recovered considerably, but are still lagging 50% behind the 40 800 previous relationship. Gold bottomed at US$682 per 30 600 ounce on the 24th October 2008 and has since rallied 38% to 20 400 US$945. The Gold Bugs Index bottomed on 20th Nov 2008 at 10 200 159.28 and is now up 72% at 275 and the GDX ETF bottomed on the same day at US$17.59 and is up 0 0 80% at US$31.75. Data Source: Yahoo Finance
LONGER TERM THEMES A GUIDE FOR ASSET APPRECIATION 26th February 2009 Sound Advice The chart shows that the Gold Bugs Index and the GDX used to trade above the Gold price and is now significantly below, despite recent appreciation. If the Gold producing stocks return to their previous relationship (if indiscriminate fund selling of equities subsides), the GDX should be at US$48 (up 51% from here) with Gold at US$945. If Gold rallies to 1,000 (up 5.5% from here) and the GDX ETF returns to parity, the implied price is in the order of US$50.5 (up 59% from here). The risk is this is an empirical, not implicit relationship and subject to macro money flows in equities rather than actual corporate value. Investors need to balance the downside risk in Gold producing stocks compared to Gold with the potential gain if the relation is re-established. Demand destruction in oil, lower industrial production and the desperate need of foreign capital by all of the oil producers should conspire to keep crude low for a while, despite platitudes of production cuts. Fixed Income The global bond market is double the size of the equity markets and is the key indicator of investor sentiment. The charts below shows 10 year US Treasury note yield since 1962 and also from August 2008, revealing just how low current rates are. 10 yr US Treasury Note yield currently very low 10 yr US Treasury Note yield currently very @ 2.83% low @ 2.83% 16 4.5 4 14 3.5 12 3 2.5 10 2 8 1.5 6 1 0.5 4 0 2 0 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 Data Source: Yahoo Finance Yields bottomed at 2% on year end buying and have since risen, despite the decline in the equity markets. If fear drives investors into bonds at these appalling yields because there is nothing better to buy, the stock market is in deep trouble. In the longer term, the US, UK and European governments and corporates will need to raise irresponsibly vast amounts of money to credibly fight deflation which will eventually push up long end rates in a steep yield curve. That may not happen until the green shoots of recovery are showing and that could be a while. The bond markets are the key confidence indicator. Watch the US Treasury 10 and 30 year yields and the UK Gilt yields for investors throwing in the towel and settling for very low returns as better than nothing or risking a loss on equities. It is very interesting to note the June 30 year US Treasury futures are trading over one point below the March futures (when they normally trade at a slight premium), implying that the market expects bond prices to be lower and yields higher in three months (which is a good sign). The 10 year US Treasury Note benchmark yield recently held above 2.70%, but any breach of 2.5% is a very bad signal for confidence. Conversely, any advance beyond the recent high of 3.05% is a good sign. The jury is out on the avoidance of deflation while we listen to Obama’s fine words of reassurance. It appears likely that we will need a despair rally in bonds, to kick-start extra fiscal packages to induce spending and investment.
LONGER TERM THEMES ONGER HEMES AG GUIDE FOR ASSET APPRECIATION 26th February 2009 Sound Advice Short term look for yields to retest the 2% levels on the UST 10 year bonds at the end of last year, before demand for money to finance the Obama’s future “bet the farm” reflation packages sees long end yields rise while Fed funds package are virtually zero. Longer term, shorting bonds futures when the fiscal floodgates open could be very profitable. ould Equities We are at a critical juncture in equity markets with the Obama /Bernanke rhetoric fighting deflation and a possible lation European banking crisis. Markets never go down in a straight line and we have been expecting a bear market rally to take the S&P500 back to 1,050 and the FTSE back to 4,500. We are struggling to find any basis in reason to tempt investors back into equities except hope that the stimulus packages will work (which we don’t think they are packages nearly big enough to inspire confidence yet). Below is a chart of equity index performance following the ultimate peak of the market during a financial crisis caused by overburdening debt. We can directly compare how Wall Street 1929, Japan 1989, NASDAQ 2000 and the S&P500 pan out over the days as governments struggle to reflate economies. The consolidation has taken a while and we are at a critical juncture to see if this countertrend rally emerges as we onsolidation first highlighted in our 8th Dec 2008 “Clear as a Bell” report and we see the probability as fast diminishing. Clear Bell Data Source: Yahoo Finance The world is in crisis. The primary trend of equity markets is lower and we have long term targets of S&P500 at 400 S& and the FTSE100 at 2,000 over the next 18 months. With P/E ratios having not collapsed (and analysts still behind the curve), it is difficult for us recommend model portfolio positions to participate in a bear market rally based on little more than hope (even if they might run for 27%). It is always darkest before the dawn and news is bleak and sentiment about as bad as it gets, but equities remain above support (for now). EquityBell Securities Quay House, 2 Admirals Way, Canary Wharf, London E14 9XG Tel: +44 (0) 20 3189 2105 www.equitybell.com Risk Warning Notice: Equity Bell Securities is a trading name of Equity Bell Limited (registered office: Talbot House, 8 – 9 Talbot Court, London EC3V 0BP. Registered in England and Wales No. 6725781 is an Appointed Representative of London Islamic Investment Bank Limited, which 6725781) is authorized and regulated by the Financial Services Authority. Whilst every attempt is made to ensure the accuracy of the information egulated provided, no responsibility can be accepted for any inaccuracy. The information provided cannot be relied upon as constituti constituting a recommendation, nor construed as any offer to sell, or any solicitation of any offer to buy investments. No liability is accepted for any loss dation, whether direct or indirect, incidental or consequential, arising out of any of the information being untrue and / or inac inaccurate, except caused by the wilful default or gross negligence of EquityBell Securities, its employees, or which arises under the Financial Services and Markets Act 2000.
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