Friday, May 14, 2010

Understanding European Weekend Package...

Very often during crisis we get weekend solutions. That is the time when markets are closde and there is enough time to figure out some kind of deal. The US$1T package came a few hours before the Asian markets opened and was initially treated with some skepticism before euphoria overran the markets on Monday. That was followed by doubts on Tuesday. More euphoria on Wednesday and more doubts on Thursday. In other words, there was some confusion over whether the package is big enough, how they will get the money and whether it will work and so on.

The trillion dollar package sets up a fund for the ECB to purchase govt debt in particular debt of PIIG countries. This money comes from contributions from IMF and EU govts. So how does it work? Whether it works or not depends on what problems you're looking at. The EU problems are divided into the short term and long term. Remember the long term debt problems have been there for years long before this crisis. The short term problems were triggered by accounting fraud in Greece discovered at the end of last year. Quickly it became very clear that Greece's debts are too big and the country is probably insolvent. Financial markets had been pretty calm and optimistic prior to that. All these factors made it very profitable for hedge funds and speculators to attempt to launch attacks on the Euro, govt debt, etc. The result was a 2-3 week panic culminating in tremendous intense fear and uncertainty of last week. The problem was these speculative attacks were driving up interest rates on govt debt of Portugal and Spain to something like 8% making it hard for these countries to raise cash to service their debt and because of fear that these govt will default the banking system in Europe was freezing up because banks were afraid of lending to each other and that could end the global economic recovery.

The package is already working for the short term problem by bringing down the interest on govt debt and the cost of protecting them. So while we still see some volatility, the panic has largely ended (I hope). There is a lot of confusing commentary that the package is not enough and so on....the package was never intended to solve the long term multi-trillion debt problem of Europe - those were around 5 years ago and will be around 5 years from now. There are not too many ways to solve it - monetise the debt and risk inflation, cut the budget deficits to slow the growth of debt. Both involve undermining the living standards in many parts Europe so the ordinary people will not be too happy. In the absence of financial panic, these problems can be amortised over longer periods..... entitlement cuts, welfare reduction, i.e. falling living standards.

I think the question on investor's minds is what will happen in the markets? While there is some silver lining from this - Federal Reserve will have to postpone rate hikes until next year and China too will probably lessen its tightening, the stock markets may a little harder to fathom in the coming days. Earlier I had forecasted a peak in May 2010 (best estimate 12 May) but the peak came several weeks earlier when the European problems erupted. I came out with the May date looking at the average time it takes for carry trades to build up and get disrupted/unwound. The carry trade is the use of a low interest currency to buy risky assets in another currency. The use of the carry trade is associated with benign currency movements i.e. stable or slowly weakening of US$ and the Yen...and is characterised by the overwhelming number of up-days (vs down days) on the stock markets. Because the carry trade feeds on itself - carry trade begets more carry trade, it tends to build euphoria in the markets. In the past, once every few months the carry trade get disrupted by speculators attacking the US$/Yen rate leading to sharp stock market corrections lasting 2-3 weeks....many investors panic and get shaken out of the markets by these sharp selloffs. Because they tend to occur when markets are in a semi-euphoric state, many small time stock investors get burnt. The events of the past 3 weeks cause the massive unwinding of carry trades - the very sharp one associated with the 1000pts drop in the DOW. 15 minutes before that huge drop, the Yen fell by 2%....such a huge drop probably triggered high speed trading 'robots' to sell equities ahead of carry trades unwind for profits.

How do we know that some kind of an intermediate bottom is formed in the markets? We will know when most of the most leverage carry trades are unwound and stock market movement decorrelated with currency movements or when currencies stabilise. As long as we have extremely low interest rates and thesis that the global economy is recovering is still believed, the carry trade will come back. Yesterday night the DOW fell by 100+ points in the last hour of trading and if you look at the US$ chart, the US$ moved up sharply by 0.5% against the Euro during that period so there is this clear correlation between currencies and stocks. The devaluation of the Euro perhaps another piece of the puzzle in getting Europe out of its rut - remember when Greece imploded, they said one of the problems is Greece does not have its own currency which it can devalue competitively when in trouble. The Euro has fallen by 15% in the past few months - the Italian marble you're thinking of using for your home is 15% cheaper, if not for the COE + crazy taxes in Singapore, Mercs and BMWs will be 15% cheaper. Many people are thinking of going to Europe for their next holiday. For Germany which is a major exporter, it benefits from the devalued Euro and sharp investors already know that - despite being part of the trouble EU and caught in this turmoil, the German stock index is only 1-2% from its 52 week high which is quite amazing given the turmoil we have seen.

The carry trade has always been involved in worsening market volatility when trouble occurs. Be it the subprime crisis or the Greek contagion, the carry trade become part of the transmission mechanism that disrupts markets. A number have come to warn that the carry trade will lead to next crisis (article : Currency carry trade could be next global crisis) whatever the underlying triggers (subprime debt, sovereign debt) are. The thing about the carry trade is it has to build up, bring euphoria and happiness to investors before it tumbles down like a house of cards. Speculators and hedge funds time their currency attacks to maximise the disruption in the markets with an element of surprise to create the shock and fear effects. Once you're passed the point of maximum fear as we saw last week, they will slowly back off to plot the next round of attacks. They were so ferocious and deceptive, the EU leaders called them 'wolfpacks'.

While the Greek contagion disrupted the carry trade a little earlier than I thought would happen. I also predicted that there will be a double top in a previous post. Why did I conclude that there will be another peak coming and why did I think that would be the final one? The next time the market goes up and come down, it may not be so easy to recover because we might be in an rising interest rate environment and inflation may so rear its ugly head forcing govts to tighten quickly...when that happens risky assets will decline no matter how sustainable the economy looks. For now, I still believe we will have another peak (I hope) and my advice is think seriously about getting out.


Michael said...

Hi LT,

This blog is prolly the most ineffective post ever. I couldn't understand many of the technical terms you wrote such as "monetise debt leads to inflation"

Could I suggest something to better capture the sensitivity of the knowledge structures of your readers? Could you provide a link to a list of financial jargons that you use so that present ad futre readers can click to that link each time they have problems understanding the term? It is likely that you'll be using more of the same terms and concepts in your future posts. I look forward to it. Cheers

Michael said...

Anonymous said...

I think for the stocks, for the short and immediate term not so much as final peaks or troughs but more like a saw. That is many peaks and troughs on the way up or down.

Only in the long term (10 or 20 years) can you clearly see the trend of real peak and real trough.

Also only in the long term will you really see whether PAP will be voted out, if they continue the way they did.

In the short term, only a revolution can throw PAP out but that is totally out of the quesion.
Can't even get more than 20 people for an illegal protest, let alone a revolution!

Lucky Tan said...


Sorry I read through my own post and found it is less readable than usual. But for those who have been investing for sometime, I hope they can understand most of it.

Lim Leng Hiong said...

Genting S'pore Q1 loss widens; Sentosa EBITDA S$109 mln


"Genting Singapore, a unit of Malaysia's Genting Bhd (GENT.KL), reported late on Thursday a net loss of S$396 million ($286.5 million) for the first quarter, widening from S$32 million a year ago.

Resorts World at Sentosa, its $4.8 billion Singapore casino resort which opened on Feb. 14, achieved earnings before interest, tax, depreciation and amortisation (EBITDA) of S$109 million."

That would be approx. S$1.2 million daily.

Lucky Tan said...

Lim Leong Heng,

I think the lost from UK operations while Sentosa is cashflow positive. The only interest I have in RWS is they don't addict Singaporeans with their gambling operations.

Unfortunately, those losses are not going to shut them down.They will be around for some time.

Never say never said...

There is a sense of impending doom in all your posts regarding stocks and investing in general.
I agree that in any market, vegetable markets or stock markets, there will be corrections. How big, how small, how long, how short is anyone's guess.

One thing for sure is that there will be a market, even for junk, subprime loans.. the issue is always the price.
And as you say, that interest rates will go up: I doubt it will go up enough to move the markets..
returns on investing in shares is currently superior to leaving it in the bank.

Interest rates moving up will shake the lenders buying properties.. and these are the ones that will sweat the most, even then, their numbers will not create defaults to be of any concern ( singapore )

In fact, I prefer a higher interest rate enviroment.. it helps to define who can and who cannot. At this time, everyone seems to be able to buy,spend on anything their heart desires. Its great, but can they pay for it?
If not,we may have to provide the crutches.. in an oblique way.

As with USA,Greece,Citibank etc, we cannot allow them to fail.. so more bail outs will come. When will it all end?.. who knows. but I disagree it will come with a bang... its slow suffocation.

Meanwhile, sip a nice glass of Sauvignon Blanc and enjoy the taste of fresh Tasman crab and dance with the stars...

Anonymous said...

So Lucky, what will all these lead to for the average Joe? Are we heading to a period of hyper-inflation and very high interest rate? If yes, what are the asset class to hold or invest in - Property? Stocks? Gold? or Cash?

skeptic said...

I don't know whether you are aware of this but there is a trend among some EU based companies that are delisting from the NYSE. I am not talking about penny stocks but blue chip companies.

They are still available for purchase as OTC ADRs though.