Slightly More Fertile Land

The term "green shoots", which has been adopted as a synonym for signs of recovery, is misleading in that it implies growth when really we haven't seen any growth yet. Financial markets, the soil that breeds green shoots, have improved as credit spreads have tightened, commodities have recovered, and equities have rallied. For that reason, the economic landscape is better descriped as "greater arable land" than "green shoots." We won't have green shoots until we have profits.

I wrote a few weeks ago asset prices would reinflate until we came to a reversal of the expectations cycle. The expectations cycle is the product of constant forecasting by economists and Wall Street. In early 2009 we had worse than expected economic data which pushed asset prices to their trough in early March. This worse than expected data brought about more pessimistic forecasts. The "green shoots" of the last two months have come from these overly pessimistic forecasts. I think we have now reached the next turning point in the expectations cycle.

Whether this is occuring or not will be evident in the next few weeks' economic data. For a start, it will be interesting to look at the consumption data coming out later this week. So far retail data has been more negative than expected. If this week's consumer spending data is negative it indicates the American consumer has increased its rate of deleveraging. The end of 2Q is also coming up soon. 1Q earnings were better than expected, especially for banks. Now that expectations have been revised upwards, it is very likely we will see a significant fall in stocks after earnings announcements.

Lastly, I'd like to recommend an article in today's FT by Martin Wolf. Martin Wolf has written repeatedly that "too big to fail" is a fundamental problem and needs to be corrected because once a firm gets to this point, it is no longer a true market participant as its downside is limited. One suggestion of his in the past was to have these firms pay regular fees to regulators for a "bail-out fund" or something of that sort. I think this peice is his magnum opus on moral hazard and the regulatory overhaul, and you can find it here.

Protests: Better than a Victory

Sometimes, you have to lose in order to win. A few examples come to mind. Obi-Wan Kenobi in Star Wars. Gandalf in the Lord of the Rings. And after this week's events: Iran’s progressive youth.

Many people around the world viewed the victory of Ahmadinejad as a defeat in the war against Islamic extremism. Under that same thinking, supreme leader Khameini’s suppression of protests today is another defeat. But this is far from the truth. It is a defeat for Mousavi and Rafsanjani, but a win in the war against extremism. For Ahmadinejad, it is not a “definitive victory,” as Grand Ayatollah Khameini described it this morning. In fact, the election results and subsequent protests are even better than if Mousavi had won.

Obama was right when he said there would probably have been little difference between Ahmadinejad and Mousavi. Western media have portrayed Mousavi as a progressive artist that came back to politics after seclusion to right what went wrong in his country (not unlike Obi-Wan). But we must not forget, Mousavi, Rafsanjani, and other allies are members of the Islamic establishment. They might call themselves “reformist,” but compared to Western standards, they are probably to the right even of Rush Limbaugh. (Mousavi and Ahmadinejad have been called the Obama and Bush of Iran, respectively. This may be a valid comparison, but this does not imply change. Compare how US foreign policy has changed from Obama to Bush—rhetoric is different but the same policies remain.)

Much better than a slightly less extreme government, is a movement among young people for real change. Young people (under 30) make up 70% of the Iranian population. If this movement of protest continues to spread among the youth (with the help of the web), it could create a new revolution in Iran that would bring lasting change to the region. There is a powerful and intense energy that can engulf and unite young people. Consider the following passage from Hunter S. Thompson’s Fear and Loathing in Las Vegas (a reflection on the counterculture of the 60s):

“San Francisco in the middle sixties was a very special time and place to be a part of. Maybe it meant something…History is hard to know, because of all the hired bullshit, but even without being sure of “history” it seems entirely reasonable to think that every now and then the energy of a whole generation comes to a head in a long fine flash, for reasons that nobody really understands at the time — and which never explain, in retrospect, what actually happened…There was a fantastic universal sense that whatever we were doing was right, that we were winning…And that, I think, was the handle—that sense of inevitable victory over the forces of Old and Evil. Not in any mean or military sense; we didn’t need that. Our energy would simply prevail. There was no point in fighting — on our side or theirs. We had all the momentum; we were riding the crest of a high and beautiful wave.”

By striking down Mousavi, Ahmadinejad and Khameini have made the Iranian progressive movement more powerful than they could ever imagine.

BRIC Finds Its Voice

After World War II, one of the US’ most successful strategies was the use of international organizations to consolidate allies and project influence. To combat communism, the US created a network of defense and economic treaties that encircled the Soviet Union. The beauty in this was communism could never threaten western financial institutions, meaning the Soviet Union could never match the US by creating an alternative to the dollar. In the end, it was capitalism that defeated communism.

But now, the communist foes of old are capitalist “frenemies,” as Stephen Colbert calls them. These countries now have the ability to provide an alternative to western institutions, and therefore, at some point, an alternative to the dollar. Increased engagement internationally between these countries indicates the extent to which this is occurring. In particular, this means increased cooperation among emerging economies within their own institutions.

This is evident in the greater role of the Shanghai Cooperation Organization, meeting today. It is also evident in Russia’s withdrawn application to the WTO in favor for a trade bloc with Belarus and Kazakhstan. Perhaps the most interesting example is the first full-fledged meeting of BRIC (Brazil, India, Russia, China) this week.

The BRIC countries are unique emerging economies, not only because they are the largest with the most potential, but they each have individual strengths and interests. They account for 40% of the world’s population and 25% of its land, and Goldman Sachs expects their economies to eclipse the G8 by 2050. Their meeting is significant because it adds a geopolitical aspect to their economic potential. BRIC was a creation of Goldman Sachs’ Jim O’Neil in 2001 to describe the future economic landscape. The fact that this has evolved to a new organization is a tectonic shift. It is a sign of the increased self-confidence of emerging economies after the western financial crisis.

So now that the BRIC countries have found their voice, what will they say? Early on, a large part of their rhetoric will be about economic and political development. Though this may sound unsubstantial, this “development” has real implications. The power of a currency is derived from how widely it is used. As BRIC economies grow and interact among themselves, more trade will be denominated in other currencies. Using the dollar isn’t voluntary, it is a necessity because of its liquidity. BRIC countries cannot stop using the dollar, as much as they might want to. This was evident recently in trade negotiations between Brazil and China. These talks concluded with Brazil promising oil in exchange for financing from China. Before these talks started, Brazil’s president, Lula da Silva, suggested using domestic currencies for trade between the two countries as China had surpassed the US as Brazil’s biggest trading partner. Da Silva said afterward on the failure to accomplish this, “It is not a political issue, it’s much more of a technical issue.”

In the near term, BRIC is unlikely to accomplish anything significant. But eventually BRIC will announce currency swaps and new trade partnerships, reducing the technical issues of not using the dollar. And from then on, it will seem as if every time BRIC makes a new announcement, it weakens the dollar as the global reserve currency.

High Yield Rally Likely to Level Off

The high yield market has been an active participant in the recent back-to-normalcy trend, also called “reinflation”, where asset prices revert back to familiar, pre-financial Armageddon levels (though not bubble-era levels). The high yield market can serve as a measure of investor risk appetite since it is one of the riskiest asset classes during a credit bust. This is reflected in the steep discounts high yield bonds traded at during 4Q 2008 and 1Q 2009. Buying high-yield bonds two months ago would easily have provided a 30% return.

This rally coincides with a tremendous increase in supply. New issuance last week alone was $5bn. The total for April and May was $10bn and $25bn, respectively. These are huge numbers considering that from July 08 to March 09 there were only $2.2bn new issues a month ($20bn total). This supply has been met with 12 straight weeks of a positive retail funds flow totaling $8.12bn. This sustained flow into junk bonds underscores investors’ new risk appetite.

This is also evident in the tightening of spreads between all high yield credit and high yield utilities. Since traditionally utilities are seen as a low-risk sector, they can be used to measure risk appetite in a manner similar to treasuries. High risk appetite during the credit bubble tightened spreads between treasuries and corporate bonds. Likewise, rising risk appetite is now tightening spreads between high yield credit and high yield utilities.

The question is, how long can this rally continue? There has been a lot of optimism in the high-yield market, as debt for many highly leveraged companies went from trading at 40 cents on the dollar to 70 cents on the dollar. These gains obviously can’t continue for long. As you can see in the chart below, yields are now around the level they were during the 2001-2003 recession, which was much milder, especially for credit markets. The default rate this year is expected to be 13.6%. The highest default rate during the early 2000s recession was 12.8%. The expected default rate for leveraged loans is 9.0% for 2009, which in the early 2000s reached a peak of only 6.6%.

I would argue the tightening of the spread between high yield utilities and other high yield credit indicates a leveling out of risk appetite and, therefore, yields. We can expect the high yield market to move like other asset classes that have hit their reinflation zenith (like US equities)—sideways.

Elections Reveal Nationalist Sentiment

The majority party usually loses votes during a recession. The recent European Parliament elections defy this trend as the center-right remained strong and the center-left lost 6% of their seats. This is especially strange considering the center-right is usually associated with laissez-faire capitalism. Here are some of the winners and losers across Europe:

United Kingdom
Winners: Conservative, UK Indepedence Party (anti-EU), British National Party (anti-immigrants)
Losers: Labour Party
France
Winners: UMP (Sarkozy), Green Party (doubled representation)
Losers: Socialists
Germany
Winners: CDU, FDP
Losers: SPD
Italy
Winners: Party of Freedom (or, as much of a winner as you can be after your 72 year-old leader (Berlusconi) is revealed to be having an affair with a teenage model)
Austria
Winners: Austria's Freedom Party (anit-immigrant)
Denmark
Winners: People's Party
Netherland
Winners: Freedom Party
Sweden
Winners: Pirate Party (pro-piracy)
Hungaria
Winners: Jobbik (anti-Roma)
Romania
Winners: Greater Romania Party (anti-minority)

As you can see, many of the winning parties have names that contain the word "freedom." Ironically, freedom in this case rarely signifies free markets (with the exception of the FDP) but anti-immigration. So, what is the cause for the rise in anti-immigration sentiment in Europe? And, more importantly, what does this mean going forward?

It's difficult to determine a single cause, but my guess is it is a reaction to globalization. In many ways, the 2008 financial crisis was a crisis of globalization. Global capital imbalances and financial innovation were key causes of the crisis. The subprime mess might have started in the US, but it would never have gotten as bad without the rest of the world. In the face of the devastation caused by the crisis, many Europeans now find themselves taking another look at how integrated they want to be with the rest of the world. The intellectual response to the financial crisis is to shun the laissez-faire, center-right policies that enabled it; however, the emotional response is to turn to nationalist parties like the Danish People's Party or the Austrian Freedom Party.

As for the future, I doubt nationalist sentiments will endure for long, but they might endure just long enough. I see three direct applications:

1. Threat to the EU. The EU is in a vulnerable position right now as Ireland, Poland, and the Czech Republic still need to ratify the Lisbon treaty and conservative parties are generally more euro-skeptic. This is especially true in the UK, where leader of the opposing conservative party David Cameron said he would hold a referendum on the Lisbon treaty. Therefore, timing is an issue. If Ireland fails to ratify the treaty before Gordon Brown is toppled, it could be very bad news for the EU considering the gains of euro-skeptics in the UK. Therefore, the people of Europe are losing faith in the EU right when it needs to hold together. How will the EU ever fix its banks if every country has a nationalist government?

2. Bad news for Turkey. Turkey desparately wants to join the EU, which is now almost impossible. This could also have ramifications for US-EU relations, as the US is dependent on Turkey and supports its EU bid.

3. Protectionism. The outcome of the elections is another example of rising nationalism, which is usually accompanied with protectionism. We have already seen numerous examples of protectionism in the last year, and as nationalism begins to permeate through officeholders we are likely to see more.

Impact of Margin Requirements on OTC Derivatives

One of Geithner's six measures to contain systemic risk and prevent financial crisis is to process OTC derivatives through clearinghouses and to move a large portion of OTC derivatives onto exchanges. This change could have the following effects:

1. Exchanges' volume (and profit) will increase. (Considering the recent gains of the CME group and Deutsche Boerse, it seems the market agrees.) More importantly, their operations will evolve. Derivatives are an emerging technology with powerful risk managment applications. Like other new technologies, they still need time before users figure out how to use them safely. The dangerous application of derivatives for risk management was most evident in the role of AIG during the credit crisis. Many financial institutions hedged their exposure to bad credit with credit default swaps from AIG. Hence, it would appear that derivatives adequately distributed risk, when really they just concentrated all the risk in one counterparty. These CDS were also used to bypass capital requirements. Geithner's plan takes strong steps to prevent this misuse in the future by limiting counterparty risk.

2. But limiting counterparty risk also has negative side effects. Geithner's plan includes "robust margin requirements," to prevent firms like AIG from making hundreds of bets without any money down. While margin requirements discourage excessive speculation and go-for-broke strategies, it is also a drain of liquidity. Assets held on margin cannot be productive assets necessary for business operations. They must be passive assets that are not used by the company.

On an aggregate level, this represents a significant loss of liquidity in the financial system as it slows the velocity of money. Instead of sitting in idly, these funds could be used for capital expenditures that grow the economy. The margin requirements will have an especially strong effect on distressed or highly levered companies who do not have easy access to capital. Having to pay a margin for a simple, unrisky derivative like an interest rate swap makes these instruments significantly more expensive since liquidity holds an especially large premium for these companies. If it becomes impossible to make interest rate swaps without posting margin, many of these already vulnerable companies will simply take the risk. One company I was recently looking at has 8bn of floating debt and would have needed 400m margin in order to hedge the interest rate risk associated with this debt.

3. I predict interst rate swaps will still be available OTC, though I expect the fees will be higher to compensate for a lack of margin requirements. This will essentially be a liquidity premium. If the market develops in this way, it would actually benefit the banks by keeping OTC volume. Banks make very high profits off OTC derivatives from their ability to shave off a few basis points here and there. (JPM had 5bn in profits from OTC derivatives in 2008.) The profits from OTC derivatives could also be more evenly spread out among banks. Geithner's plan includes margin requirements for OTC dealers as they have greater systemic risk. This means the large dealers like JPMorgan might have to decrease their volume. Naturally, the extent to which this occurs depends on the exact margin rules and the degree to which OTC derivatives are moved to exchanges.

LIBOIS Indicates Banks Are Lending Again

Everything seems to be returning to normal. I expect this to continue until there is a reversal of the expectations cycle. Though asset prices are rising, I think most market participants are expecting a W, especially considering a recent survey in the Lex column showed most investors think the current equity market upswing is a bear market rally.

I thought I would share this interesting chart. The Libor-OIS spread is the premium banks charge each other for three-month interbank loans. A downward trend indicates a decrease in bank lending. As you can see, the index has almost returned to pre-subprime levels.

Bevin's Dilemma and Obama's Soft Power

If Zionists had a list of the most evil people in history, the British Foreign Secretary after WWII, Ernest Bevin, would be close to the top of the list, right under Hitler. The reason for this is that Bevin oppossed Jewish emigration to Palestine after WWII. Furthermore, he opposed the creation of a Jewish state. One has to agree denying Jews a home after the Holocaust isn't a praiseworthy act.

But, there is a different perspective. Bevin and the (flailing) British Empire had a strong interest in keeping Palestine peaceful. The Middle East was seen as the new future for the Empire, especially with mounting nationalism in India. Not only did Palestine have a crucial geopolitical position right by the Suez Canal, but relations with Arabs were key to maintaining British power over Kuwait, Qatar, Iraq, Iran, Bahrain, and Aden (Yemen). Keeping even levels of population was a necessity for stability in Palestine, much like it is in Lebanon today. In general, when one looks back on the Arab-Israeli conflict, much of it stems from population differences. For example, in the 80s there was relative peace in Israel. Peace lasted until the fall of the Soviet Union brought a huge wave of Jewish immigrants to the region.

When one considers the enormous pressure on Bevin to maintain a crumbling empire and the negative implications of Jewish immigration for British interests, Bevin's position becomes more understandable. We can at least empathize that Bevin was in a very difficult position.Bevin's side of the story has been forgotten for too long. But, it seems Obama understands Bevin's dilemma. In fact, Obama might have found the perfect middle way between supporting Israel and pleasing the Arabs. Geopolitically, Obama's position is similar to Bevin's. Obama faces significant pressure to cede to Israel's demands; though like Bevin, giving in to these demands would mean a weaker position among Arabs. Also, much like Bevin, Obama has a much greater stake in being friends with the Middle East than previous presidents—a result of high oil prices and terrorism.

Giddeon Rachman wrote in the FT today that Obama is "a soft power president. But the world keeps asking him hard power questions." That may be true for cases like Afghanistan and North Korea, but the Israeli-Palestine conflict is a pure soft power play. I wrote in an earlier post that Obama's soft power efforts would yet bear dividends and I think that moment is near in the Middle East. With his highly anticipated speech in Cairo tomorrow (as well as his order to Netranyahu to stop settlements), Obama will set the course to achieve what Bevin could not: a balance of Arab pride and Israeli ambitions. Historians' most potent criticism of Bevin is not that he was anti-semetic, just very undiplomatic—what a difference soft power makes.