Can the Bluff be Called?

From October 2013;

There are many clichés which go around — chief among them is a game of two halves, a year of two halves and the like. Last year (2012), was a year of two clear, distinct halves — the kind which would make a cliché happy.

Till the Bumblebee address by Mario Draghi, the year 2012 was a culmination of, not just the profligacy of the previous decade, but a failed system and a failed bailout. Spain couldn’t borrow at a cost which they could afford to repay and the Greeks were perilously close to debt repudiation — an idea I put forth to a European Central Bank executive during my visit in February 2012 and it was never really answered. His answer, which I believe is the German answer, was that you have to pay back what you borrowed — a full 100 cents on the Euro to the E.C.B. if not to anyone else. When you can’t control your own monetary policy, it is a tough ask — more on that later.

World equities and in particular European equities were facing a grim battle in H1'12. Companies, unlike countries, cannot spend their way out of trouble — they have accounts to maintain. China was all set for a hard landing — something which would not only put the skids on any hope of a recovery, but lead to a crash in the markets of most of its’ trading partners. China was the driving force behind the commodity boom of the previous decade and it had grown “too big to slow”. The Chinese leadership made it clear that steering the world out of an economic slowdown wasn’t something they were willing to do — so much for their world leading aspirations. USA, not even a year on from a downgrade by S&P, couldn’t come to terms with a new debt ceiling and companies exposed to Government budgets couldn’t decide whether the sectors they were exposed to would be sequestered — an automatic spending cut triggered in case of a budget impasse (happened yesterday,9/30/13).

India showed itself to be an exemplar at policy inaction. A progressive Prime Minister couldn’t rally the cabinet, the allies and the opposition behind some of the reforms he proposed. He wore the look of a defeated man. That an emerging economy can’t accept limits of 50% FDI in, operationally and logistically, poorly run sectors like Airlines and Retail is ludicrous. The irony was that India was grappling with inflation — supply side inflation — something a Central Bank cannot control by cutting rates. Cutting rates inflames supply side inflation and ever the hawk, The Reserve Bank of India, could, at best, only hold interest rates.

Enter — Mario Draghi

“Whatever it takes” is not open to interpretation, it reads and speaks like it is written. The minutes of the meeting after which Mr. Draghi said this phrase aren’t yet known, but the message was loud and clear — The Euro will live — along with all its constituent members. Period. Italian and Spanish borrowing costs came down heavily. A seemingly “Risk on” year morphed into a “Risk off” second half. Italian stocks rallied as the yields came down, the Spanish thought the best way to capture this rally would be to ban short selling. After all, it was the vulture like hedge funds which hammer down equities and it is those very same hedge funds who spike their borrowing costs and to top it all off — they never ever even own these assets, they either bought insurance against a credit event — a Credit Default Swap, or simply bought “puts” on the equities — situations wherein you profit when the underlying asset goes down in value.

It was as if, suddenly, a tail-risk had been taken away — stocks started soaring. There was slight encouraging data coming out of all the countries — growth was picking up and consumer confidence was robust (easier comps obviously start showing up sometime!). Mr. Draghi had altered the course of history. A year going nowhere, a year full of headwinds and tail-risks turned into a year of celebration. A celebration of a stubborn government and stubborn central banking authorities who wouldn’t simply bow down to market pressures — who wouldn’t simply succumb to conventional knowledge. These were men and women who were willing to use nuclear power against an impending economic Armageddon.

“Whatever it takes” meant buying more bonds and then some more to help bring down the borrowing costs for the countries’ troubled by already high debt levels. Of course, they would insist on austerity measures, but when you give someone a drug and ask them to behave — you rear an ugly/unruly animal. You don’t just stop administering the drug one fine day — once you get in, you stay in. Greece, Spain and Italy have a gun held to Germany’s head and Germany just has to keep paying.

Competitive Devaluation

If the entire Euro-Zone was one country, of course they could devalue the currency — it would help both exports and tourists, but the tragedy is they can’t. Greece, not only has to live with a high unemployment, it also has to live with the fact that there will be even higher unemployment because they cannot devalue to spur their economy. Shock therapy, as advocated by the economist Jeffery Sachs to the South American economies was a brutal remedy — things get worse before they get better. You have to contend with raging inflation as controls are suddenly lifted, but goods soon start reappearing on the marketplace almost magically, after a while. Let’s be clear, EU cannot do this because Germany cannot be treated the same way as the so called profligate idiots of Southern Europe.

Another tenured Harvard economist, Gita Gopinath, suggests a lower payroll tax and a higher Value Added Tax to alleviate the pain. After all, it isn’t the action of devaluing a currency which is most important — it is the aftereffects which cure the economy — a cheaper currency which allows you to export more and makes imports costlier. This, she argues, can very well be stimulated by a lower payroll tax, which effectively makes you pay less and a higher VAT — which effectively makes imports costlier. Monsieur Hollande has apparently picked up on this and is running with the idea.

High level endorsements notwithstanding, this idea is poised to fail as well. One key cause, in a nutshell, the E.U. When your largest trading partners are within the Eurozone you cannot levy taxes on imports from those countries and you cannot pay drastically less than you pay workers in other Euro zone countries — a level of parity must be maintained. Competitive advantages built over decades cannot be erased in a few years — engineering and precision will continue to be Germany’s forte and Luxury France’s- those are near sacrosanct in today’s Euro zone.

Enter — Hedge Funds

The Great Recession wasn’t all bad for hedge funds — there were funds which were right and there were funds which were wrong. Suffice to say, the cream survive today.

Hedge funds, across asset classes, work on a few simple principles, chief among them — Convergence. When spreads open up between similar assets and companies — these funds bet aggressively that the divergence will soon end and convergence will set in. The reverse also holds true — when two assets with widely varying underlying fundamentals trade in the same range — these funds bet that massive spreads will open up.

As I have already pointed out, not all these trades happen by owning the underlying asset — these funds simply buy insurance against an event. Many argue that this adds volatility to the markets and distorts asset prices. My argument is that, these funds contrive to buy and sell the options and Credit Default Swaps in a manner which results in a price which can then act as a barometer of the health of a security. Make no mistake, these are no punts placed on assets, these are highly studied and well researched directional bets. This was the industry which started betting aggressively against Greece — which heralded the Euro Zone crisis. Good or bad, I’ll let you decide. I’ll just present some facts.

Till the financial crisis Greece’s sovereign debt was trading within 10 basis points (1 basis point = 0.01%) of Germany’s sovereign debt and the hedge funds took the gospel bet — divergence. Greece’s economic condition was far worse than what they were actually willing to project and these guys knew it. So they bet aggressively against Greece’s debt. These trades alone don’t always generate high returns, but these trades can double (or better) your returns when paired. So the simplest trade that popped up was — buy German debt and sell Greek debt. If you believed, back then, that Greece would see the bad days it is seeing now then you could generate $700,000 by just putting in $1000. Those were the kind of returns you could have made. Obviously, these are asymmetrical hedges. As a corollary, if you wanted to hedge $700,000 worth of Greek exposure you may have had — through debt or equities, all you had to do was put up $1000 in insurance — because the probability of Greece failing was so low (yeah, right!).

The aforementioned returns stayed in place, obviously, for a very short while. Trends don’t last too long in today’s electronic marketplace.

Other investors, probably looked at the spreads that the hedge funds were demanding to hold Greek debt and decided to either exit Greek debt or demand a higher yield (yield = Interest payment/Market price of the bond). Something must definitely be wrong if these guys were hammering down the bond prices. This caused an unraveling of a scale most of us haven’t seen before. The Greeks admitted to worrying levels of public spending, lower tax receipts and even fudging their GDP. Now, the yields really spiked.

The role of hedge funds as price makers was thus bought into question. It is probably not the prerogative of hedge funds to set asset prices through lead indicators like CDS spreads, but also, can you hate a mirror because you are ugly?

The Bluff?

If you didn’t notice thus far, the divergence bet is essentially calling a bluff. It says simply, I don’t think the cards you hold are winning you this table.

The next pack of cards to fall, logically, should be Japan. An aging population — which represents the worst demographics of any society in the world, the most xenophobic developed society and the highest on balance sheet debt in the word — all point to an unsustainable deficit.

Yet, the biggest factor which the markets, and mostly the hedge funds, didn’t consider in the past two years was the Governments and Central Bankers were really willing to fight impending doom with all they have and that Central Banks would become the de facto Governments. The way most risky holes were backstopped by the Central Bankers has been unprecedented.

Convergence trades, which start working, say, within a few months went on for a few years. An EasyJet which really had no reason to outperform Ryanair substantially did just that, simply because it wasn’t at constant loggerheads with the regulators. Spreads between Colgate and P&G stayed at levels which were never seen before. The markets seemed to be moving into an age of extremely “risk-off” trades. Balance sheet strength was rewarded over market positioning and the trades never converged. What went up continued to go up and the fringe names, just like the Euro zone, lagged.

In the past two years you could’ve called a bluff or two, but the majority of them would have gone wrong — for no fundamental reason underlying the asset price, but simply because the Central Bankers wouldn’t let anything fail. Big or small, failure would hit them just as hard. Contagion had become a fab word, and everyone seemed to run with it. Even letting a small firm fail was unthinkable these past two years and now the market is buying into the rosy story again.

Things definitely aren’t as bad as they were two years ago. Data from across the world is routinely better, but the bets are still out there marking their time. Deepak Narula, the best performing hedge fund manager last year, had to close down his first hedge fund in 2005 because he made astronomical losses betting against the housing market. His research and view were spot on, but his timing was wrong. It wouldn’t have been until 2007 that those bets would’ve turned profitable. 
Similarly, would you bet again the Yen today or two years down the line? Or would you bet at all?

Next in the series: Has the bluff been called? (October — 2014)

Since I first wrote this, the Yen has been devalued and artificial stimuli continue to be the MO of all central banks.

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