Understanding the Credit Crunch

Monday, February 4, 2013

Why the Big Mac Index is an Inefficient Predictor of Forex Valuations

By Grant de Graf

The Economist has once again posted its Big Mac Index, a measure of the strength of foreign exchange rates, based on the purchasing-power parity (PPP) of a McDonald burger. The Big Mac uses a single point of reference (the Mac) to calculate the over or under valuation of a currency , the theory being that prices and exchange rates should adjust over the long run, so that identical baskets of tradable goods cost the same across countries.

Using the PPP of the Mac for measuring the strength of a currency as opposed to a basket of goods does have distinct advantages, in that the noise and deflections which may exist in selecting a broad spectrum of goods, is removed. However, there is another factor which will intrinsically effect PPP.

The PPP of a currency, will always reflect the fundamental political and economic attributes of a region, which serve to skew it's value. For example in Switzerland, the Swiss franc is used by investors as a safe haven. Consequently, it is priced in at a premium. Conversely, South Africa is considered an economically and politically high risk region, hence the discount at which the rand trades.

Similarly, currencies of other emerging markets or volatile regions also tend to trade at a discount, with the exception of Brazil 's real. Brazil's price enigma can be attributed to the capital controls which the country maintains and to the fact that many traders use the Brazilian real, as a point of reference and security to price in other currencies in the region.

A similar pattern can be observed with the pricing of options. When implied volatility of specific equities experience a spike, relative to their historical volatility, thus reflecting an apparent overvaluation, some traders view this as an opportunity to sell the option and profit from the anomaly. Invariably, the incongruousness is a function of weakness within the equity or the underlying company. Without the appropriate hedge, many a trader has been wrong-footed.

The Mac Index is a good exercise to measure currency valuations, but to trade on the apparent anomaly, can be dangerous.

Top 15 Factors Governing Financial Risk in 2013

The following variables will play a critical role in governing financial risk in 2013:

Sovereign debt
Political instability
Regulation
Environment
Social
Technology
Infrastructure
Economics
Environment
Energy
Global workforce
Natural resources
Currencies
Market volatility
Austerity

Other variables that should also be on the radar screen:

Litigation
Health
Natural disasters (event risk)
Climate
Education
Copyright protection

Reality of Euro Crisis Comes to Light

Uri Dadush, senior associate and director of the International Economics Program of the Carnegie Endowment for International Peace,in an opinion for the Wall Street Journal, expresses disbelief with the suggestion the Euro Crisis is over, in his article, "Who Says the Euro Crisis Is Over?"

His points are well foundered and can be summarized as follows:

18 million people still remain unemployed in the euro zone.
Markets incorrectly believe that European Central Bank President Mario Draghi's emphatic promise that the ECB will buy the bonds of troubled countries has all but eliminated the risk of a collapse.
The risk of relapses triggered by domestic rifts or an external economic shocks will remain high.
The euro zone can fail even if the single currency survives.
Application of "boiling frog" allegory: If you put a frog in scalding water, he said, it will jump out. But if you place it in cold water and slowly raise the heat, it will stay put, eventually being boiled to death.
Instead of a region of shared and uniform prosperity, the euro zone has become a study in internal divergence.
Unemployment is at 26.8% in Greece, 26.6% in Spain, 16.3% in Portugal, 14.6% in Ireland, 11.1% in Italy—and joblessness is still rising in all of these countries. Meanwhile, the unemployment rate is 5.4% in Germany and 7.8% in the U.S.
Italy's gross domestic product has fallen by 6% since the pre-crisis peak in 2007, whereas Germany's is up 8%. In the U.S., where the world financial crisis began, GDP has surpassed its pre-crisis peak by 7%. By comparison, Europe's GDP is only 2% above its pre-crisis level.
The fiscal stance in Europe remains contractionary, reflecting the inexistence of a large central government, the inability of the periphery countries to borrow, and a fiscally conservative government in Germany, where the effect of the crisis has been felt much less.
The limited monetary-policy response, which is now changing belatedly, was also the result of a conservative approach by the core, especially Germany.
Falling interest-rate spreads and improving financial markets are not enough to reignite growth and competitiveness.
In Brussels, plans for a banking union are advancing, but at a snail's pace. Proposals for forgiving official-sector debt holdings are dead on arrival. Fiscal union is not on the table.

EURO ZONE UNEMPLOYMENT

Creativity vs. Execution

Merissa Meyer, Yahoo's new CEO makes an interesting observation in conversation, with Bloomberg's Erik Schatzker, at the World Economic Forum in Davos. (See video below for shortened version, key points of the discussion.)

Meyer depicts creativity within a company, in a novel and interesting light.

"One would think that the opposite of creativity is stagnation," she argues. "But there is a school of thought, which suggests that on the opposite side of creativity is execution." In other words, if a company is focused on creativity, many aspects of execution (in respect to growth, may be compromised) or visa versa.

Ostensibly, Yahoo is in execution mode, which means that the company will focus on taking the platform (spawned from creativity) to optimizing the experience and making functionality more accessible to users.

Jan. 25 (Bloomberg) -- Highlights from Yahoo CEO Marissa Mayer's conversation with Bloomberg's Erik Schatzker at the World Economic Forum in Davos.

Thursday, January 31, 2013

Are U.S. Markets Acting Inefficiently?

By Grant de Graf

CNN Money reports:

U.S. stocks are flirting with all-time highs, climbing to levels not seen since before the financial crisis. The Dow Jones industrial average is hovering just below 14,000. The S&P 500 recently broke above 1,500 and is inching closer to a new record. Both indexes have risen to their highest levels since October 2007.

Low bond yields and protracted QE by the Fed are some of the reasons why the U.S. market continues to rocket to new highs.

Stocks in the S&P 500 are trading at roughly 14 times expected earnings for this year, which is reasonable.

However, there are significant risks. U.S. growth for 2013 is unlikely to be robust, the challenge of the fiscal cliff has to be resolved and a potential fallout in the European Debt Crisis could significantly dent any progress, which Americans are likely to achieve. Global social political risks remains high, the Iran card has to be played out and North Korea continues to beat the drum.

Historically, the market tends to lag in its response to event risk, hence the difficulty of being able to accurately predict market moves. The gap between market response and actual risk is dynamic and consequently, market inefficiency will always dog traders.

Contributing to the equation of inefficiency, is the fact that investors are being challenged to find a suitable home for their funds. Interest rate yields are at all time lows and real estate fails to impress, especially with the absence of optimism for a strong recovery. This means that investors may be all dressed up, but they have no where to go.

Alternatively, portfolio managers will continue to be content to maintain their percentage allocation to stocks, because on a risk-adjusted basis, stocks will still trump other lower return, lower risk, investment options.

SOURCE: REALTICK

Can QE Ignite Prospects For Growth?

By Grant de Graf

Federal Reserve Chairman Ben S. Bernanke has signaled that he will not ease up on the $85 billion in monthly bond purchases, aimed to spur a stalled economy and bring down 7.8 percent unemployment.

The Federal Open Market Committee said in a statement yesterday that growth, while slowed by “transitory factors,” faces “downside risks” even after strains in global financial markets have eased. The expansion will pick up and unemployment will fall in response to “appropriate policy accommodation,” Fed officials said in a statement after a two-day meeting.

The Feds decision to continue with its program of QE is appropriate, given the constrained prospects of growth and the low levels of inflation which prevail. This will help create the appropriate economic climate to improve investor confidence and allow business to expand more rapidly.

However, monetary policy on it own, will not provide the U.S. economy with a solution that will fast track the economy. To achieve this, the country needs a program, which will result in the investment of billions of dollars in an initiative, of which the nation can be part. Additionally, government investment (not expenditure) in the infrastructure, should be tendered out to the private sector, thus providing business with the opportunity to participate in economic expansion.

The Second World War provided the U.S. economy with a catalyst to exit the Great Depression. The allocation of funds in infrastructure facilitated a spin-off effect, which benefited business as a whole.

It is folly to suggest that in today's economic environment, increased spending in military can improve the economy. During the Second World War, the manufacturing sector was underdeveloped and the allocation of public funds to private sector initiatives, helped develop industry and secure a term of protracted growth. Today the manufacturing sector is at a very different stage, than it was 70 years ago.

However, a program which will benefit the nation and provide fiscal stimulus is still required. Investment funding needs to be distinguished from expenditure funding, in view of the constraints that exist with the pending fiscal cliff.

Monetary policy on its own, cannot be expected to expedite growth in the U.S., without a national investment program that will catapult the U.S. economy to recovery.

Jan. 30 (Bloomberg) -- Michael Feroli, chief U.S. economist at JPMorgan Chase & Co., talks about the Federal Reserve's decision today to keep purchasing securities at the rate of $85 billion a month, and the outlook for Fed policy and the U.S. economy. Feroli speaks with Adam Johnson and Alix Steel on Bloomberg Television's "Street Smart." (Source: Bloomberg)

The Firmer Euros KO Blow

The WSJ reports:

The euro, once on death's door, is on a months long tear, rising Wednesday to its highest level since November 2011.

But even some investors who helped propel the currency above $1.3560 Wednesday say it can't fly much further. Europe's economy is still in the doldrums, they say, and a stronger euro could make the situation worse.

Concern is rising that the stronger Euro will impact Europe's ability to export goods at competitively attractive prices. While the Euro was in free fall mode, exports rallied. As the duration of the Euro spike is unpredictable, that celebration may well be short lived.

Irrespective, the segments of the EU who are feeling the pinch the most, are the weaker countries, notably PIIGS, who have to compete with their stronger partners, Germany and France, to capture market share of the lucrative export industry.

The sudden upward adjustment in the Euro for most of the weaker members, is an uppercut to the jaw, which may well leave these smaller nations, sprawled out on the canvas.

German Unemployment Number Pulls Wool Over Eyes

German unemployment unexpectedly declined in January for the first time in 10 months.

The number of people out of work fell a seasonally adjusted 16,000 to 2.92 million, the Nuremberg-based Federal Labor Agency said today. The adjusted jobless rate dropped to 6.8 percent, matching a two- decade low.

Although this is good news for political leaders, as it will give them ammunition to persuade the electorate that they are leading the country in the right direction, popping champagne corks and bring out the wurst, is premature.

Bloomberg reports:

Today’s decline in unemployment may not yet be a turning point, said Frank-Juergen Weise, President of the Federal Labor Agency. “There’s a chance the cold weather in the second half of January may bring an increase in unemployment in February,” he said.

The truth is that the German economic growth slowed to 0.7 percent in 2012 from 3 percent in 2011 and the Bundesbank predicts economic expansion will decelerate further to 0.4 percent this year. That compares to a contraction of 0.3 percent in the euro area, the country’s biggest export market.

Additionally, most of German's trade is conducted within the Euro zone and consequently it is advantaged by the comparative advantage it enjoys over weaker EU countries.

Wednesday, January 30, 2013

Italy's Economy Needs Soprano

By Grant de Graf

Italy continues to wrestle with its own set of economic woes, a victim of one of the latter casualties of the European economic crisis. Lackluster business performance, a build up of government debt and a deepening recession are leading to alarm bells that would jump start any troop of Rockettes at Radio City Music Hall in Manhattan, New York City.

The only thing is that we are in Italy and we need a performance that will raise eyebrows, but will not have everyone jumping out their seat.

Austerity, as with the rest of Europe, has not worked well for Italy. It has resulted in slower growth, a further increase in debt and business activity is grinding to a halt.

A lower influx of tax income has prompted Uncle Giuseppe (Italy's version of Uncle Sam) to peruse a tax hunt for businessmen who have sought to evade their respective tax burden. As if that would help. Uncle Giuseppe misses the point. If every Italian citizen had to pay their full liability in tax, it is unlikely to make a dent on the economic tragedy which has struck home. This is because the essence of the problem lies in the European blueprint for the Euro Zone, which has been imposed on Italy.

To start with, it is unrealistic to control monetary policy centrally, at the EU level and then expect fiscal policy to be implemented locally, by Italian politicians. The two instruments have very different agendas and an instruction from either source (monetary or fiscal) is likely to be heard by the other.

Add to that the yoke of the Euro currency and Italy's inability to export goods at competitive prices, which it could do under the system of the Italian lira, I would say things are about to get hot.

Imposed austerity has only aggravated Italy's cause (as with so many other member nations of the EU) and indeed it is less likely that the street will stomach another round of austerity measures. If the future path for Italy's politicians is at stake, which it is, politics may well be the catalyst which throws off the yoke of austerity and prompts the country's leaders to inform EU officials, with true local fanfare, to go fly their kites.

This may not be such a bad thing. Seemingly, it will prompt Europe into recognizing that it is time to make make some adjustments.

Further Evidence that the EU is in Denial

By Grant de Graf

Further proof that the crisis in the EU is deteriorating and the the recession is deepening, is found in an article in the Economist's Free Exchange, "Tracking the euro-zone economy in real time."

The article reports:

"As of the third quarter of 2012, the euro zone economy is officially in recession. GDP in the euro area shrank 0.1% in the three months to September after contracting 0.2% in the second quarter. That marks four consecutive quarters of flat of falling growth. Output fell sharply in peripheral economies like Spain and Italy but also tumbled in core countries like Austria and the Netherlands.

Conditions look like getting worse. An analysis of recent data points by Now-Casting, which publishes "real-time" economic forecasts, points toward deeper contraction in the fourth quarter of 2012. And on the current pace, the euro zone's recession will continue through at least the first three months of 2013."

The unfortunate truth, is that you can wrap the injury in as many bandages as you like, but when you take the x-ray, the illness, a function of an economic blueprint which has clear failings, will still rare its ugly head.

Instead of dousing the wound with morphine, the infection has to be removed, before a long term recovery can begin. In short, the solution is hampered by the lack of politicians who are imbued with the skill to throw aside misplaced ideals. They are ideals which have become the baggage of the architects who helped father their blueprint, the function of which is leading to Europe's collapse. Absent are leaders who need to do what is necessary, to bring together common interests and fight for a cause that will be beneficial for Europe as a whole.

Euro Zone Weekly GDP in Real Time (Provided by now-casting.com)

U.S. Economic Contraction Hits Economy

By Grant de Graf

The contraction of the U.S. economy in the last quarter of 2012 comes as little surprise.

The nation's gross domestic product shrank for the first time in 3 1/2 years during the fourth quarter, declining at an annual rate of 0.1% between October and December, the Commerce Department said Wednesday.

Although one can expect GDP to adopt a more positive track, growth is bound to be constrained. Additionally, the possibility of a European fallout remains possible and there no evidence of any initiative which may spur growth in the U.S.

At best, it will remain lackluster and while there is always room for a surprise, no one is buying tickets for the show.

Real estate could always make a comeback, but there still needs to be an improvement in core economic growth for any sustained solid recovery.

To realize solid growth and to circumvent the dangers which face the economy in respect to the fiscal cliff debate, the U.S. needs a national blueprint, supported by both Democrats and Republicans, which will facilitate the high levels of business expansion which the economy needs.

Economist John Mauldin joins WSJ's Markets Hub with an outlook on the U.S. economy, and his take on the Federal Reserve's effect on the stock market. Photo: Getty Images.

European Economic Performance Suffers Blow

Grant de Graf

In yet another blow to the European Debt Crisis, the latest economic statistics underscore the severity of the recession and the absence of a recovery, despite higher levels of confidence and optimism in the EU.

Spanish gross domestic product fell 0.7% from the third quarter and 1.8% from the same period a year earlier, Spain's National Statistics Institute, or INE, said in a preliminary reading. It said output for the whole of 2012 fell 1.4% from 2011.

The statistics once again show the futility of the austerity measures (vs stimulus) which are being propagated in the EU as a source of hope for economic recovery. Although the reduction of government spending in certain unproductive sectors are necessary, optimizing public expenditure towards projects that will stimulate economic growth are paramount.

While the example of stimulus in the United States has proven to be a more effective means in circumvented a deep recession (than austerity), the lack of a clear and focused stimulus plan, will impede a strong and sustained recovery, and strengthen many a critic's view that officials are simply "kicking the can" and that a "pick-up point" will be necessary at some point on the road.

Europe will need to learn from the example and mistakes of the U.S. Additionally, Spain will need to exist the Euro if it and Europe wish to avoid the same fate as the Dodo. The quicker European officials can come to their senses and realize that that they need to formulate a new EU blueprint that will allow for the exit of the Euro for weaker countries, the sooner Europe can start to focus on achieving real economic growth and regaining its position as formidable powerhouse on the globe.

Dow Jones's Paul Hannon looks at the continued divergence in euro-zone economies despite the slight improvement so far this year. With the euro also rising, he questions the strength of a future recovery.

EU Regulatory Challenges Highlighted

The WSJ reports in an article "In EU a Test of Wills" the realization by EU officials that the challenges related to increased banking regulation could constrain growth in the EU and delay or short circuit an economic recovery.

At odds are the restrictions which are being applied by regulators to banks and which effectively eradicate the benefits of a single market for financial services, unimpeded by national boundaries. This includes the prevention of moving funds across national borders, together with several other restrictions.

At least officials are aware of the hazards that could impact a recovery, but whether EU officials have the political muscle and will, to prevent regulatory obstacles taking their course, remain questionable.

Dichotomy of Stock Performance With GDP

By Grant de Graf

In an interview with the WSJ, hedge fund manager, Oscar Schaffer, describes the unusual correlation between stock performance and GDP. (See "Stock Performance Enigma") Greece and China (among many other countries) are examples where the performance of stocks are inversely correlated to GDP. Although GDP in Greece disappointed, stocks experienced all time highs. Conversely, China which displayed an expanding GDP, incurred a retraction in stock trends.

Schaeffer defines stock performance being correlated to other factor like earnings and the inflow of funds. He anticipates that when bond yields start to increase, there will a long term outflow of capital from (long term) bonds into stocks, as investors are likely to be concerned about capital losses in the bond market.

However, the equation is not so simple and linear. The performance of stocks will ultimately depend on many other economic factors and should the risks in stock investment increase and the impact of a European fallout weigh against the U.S., investors may well direct capital towards short-term income yielding bonds and reduce their exposure in stocks.

Stock Performance Enigma

Hedge fund manager Oscar Schaefer explains that GDP growth doesn't always correlate with stock returns. And he tells us why Hertz shares will zoom higher.

Sunday, January 27, 2013

The Case For Not Exiting The Euro

By Grant de Graf

Professor Klaus Schwab's arguments for not exiting the Euro was published in the Huffington Post on January 19, 2013 "The Re-emergence of Europe: Why Exiting the Euro is a Bad Idea".

His arguments for not exiting the Euro can be summarized as follows:

Jettisoning the euro altogether and opting for national devaluation may eradicate a country's current account balance in the short term, but it will not lead to longer term growth.
Even though a devalued currency may make exports cheaper and therefore more attractive to foreign buyers, imports would become more expensive and cause a decrease in real incomes.
An overwhelming number of economists, international civil servants and policy-makers argue that a fragmentation of the Eurozone would cause a new depression and massive wealth destruction around the world.
It would end the period of economic integration that has characterized world politics since the end of the Cold War. The important founding notion of solidarity would be broken. Old rivalries could be reignited.
There is a high risk of financial chaos, as a country would have to quickly revert to its new currency.
Lack of clarity as to who would set the exchange rate for the new currency.
High probability of debt default, bank collapse and lack of access to international capital markets.
There is no legal frame work for a member country to re-establish its own currency.

This is why the arguments are without foundation:

The goal for exiting the euro was never to balance a current account deficit, but rather to provide a country with a viable framework to export its goods at competitive prices and consequently drive up local production and the economy.
The higher cost of imported goods would swing demand towards local production and if anything result in higher levels of disposal income.
Predicting the future is a dangerous game. What is the basis of the estimates which forecast further recession and wealth destruction? Is this scenario a consequence of higher administration costs or lower expected GDP? Clearly, the forecasts are not founded on sound economic principle or pragmatism.
Economic fragmentation and political rivalry does not have to be the result of a country's exit from the euro. An exit from the euro needs to be effected with deliberation, planning and the full co-operation of the EU, regarded not as a rogue act of self-interest, but rather as a measure which is beneficial for all parties (which it is).
The changes necessary to invoke the euro did not result in chaos and pandemonium. Similarly, if a country were to exit the euro, there is no reason to assume that with the correct planning, this would be any different. History provides us with a long record of successful instances, when nations took on new currencies.
There is no more efficient setter of the exchange rate, than the market.
Defaulting on debt and exiting the euro are two different things, with one having nothing to do with the other. In fact, an exit from the euro makes the case for default less likely. The higher prospects for economic recovery (following an exit) make access to capital markets more compelling.
The lack of a legal basis for a country to exist the euro is unfortunate and possibly demonstrates the lack of planning that went into the creation of a single currency union. Irrespective, if exiting the euro is indeed the optimal route for a country and the EU to follow, there's little doubt that European leaders will devise a blueprint which will accommodate such an initiative.

Saturday, January 26, 2013

Davos 2013: Irish PM says UK exit would be bad for EU

HEADLINE NEWS * MARKET NEWS * SENTIMENT * TRENDING * BONDS * FOREX

The Euro in Perspective

I'm commenting about the interview in Davos with the Blackstone Group's John Studzinki, by Reuter's Alex Smith (January 26, 2013) on future prospects of the Euro, which deserves clarity. See "Real Estate in Europe Ripe for Plucking".

Studzinki is correct in his assessment that Europe is calmer. Certainly, there is a greater sense of ease and patently absent is the rush from the madding notion that the Euro will collapse. However, the prospect of the Euro collapsing, of Germany and France being wiped into economic oblivion and of investors in the Euro having to take a bath, was never on the agenda. What is relevant, is whether the Euro will continue to exist in its current form or not.

Although some investors take comfort in the fact that governments are not caught in their regular fox hunt, seeking debt restructuring and assuring investors that the ECB has sufficient funds for a bail out (if the rabbit cannot be found), it's not over until it's over, and the likelihood of PIIGS vacating the Euro still remains high.

Is this a danger to the Euro currency or to European unity per se? No, it doesn't have to be that way, contrary to some opinion that makes its rounds in the coffee houses of some institutions located in the public service or to those who feel that their jobs, financial interests and vested future lies in the Euro, in its current state.

However, a Euro with PIIGS out of the way (although still very much part of the EU) will make for a stronger currency and a quicker resurgence of growth in Europe, which is currently sadly lacking.

Blackstone's Studzinki Declares Real Estate in Europe Ripe for Plucking

In an interview with Reuter's Alex Smith, John Studzinki from the Blackstone Group declared that Europe is much calmer (See Author's "Future of Euro's Sustainability is Vulnerable"), that the concern of a collapse of the Euro had been removed and consequently, U.S. companies that were flush with cash, would possibly consider European opportunities as a target for investment. This was particularly true as a result of low yields in the U.S. as business continues to generate cash in an "all dressed up, no where to go" mode.

Although Mr. Studzinki is remaining mum on whether Blackstone will be making further investment in Europe, he did concede that institutions' willingness to shed their real estate portfolios in Europe is lagging, and that the possibility of further activity in this arena is probable.

Asked whether banks would become a source for M&A, Studzinki believed that given the regulatory restructuring that was taking place, it was unlikely that banks themselves would present themselves as attractive investment opportunities.