(Beta) News Rem

News Rem
Agenda

European Sovereign Crisis The Chinese Landing Hard or Soft? Relative outperformance of Asian economies Operation Twist US Subprime Crisis Currency Markets Yen & CHF Appreciation Commodities
8/11/2011
Beta Series on Finance
European Sovereign Crisis
Reaction to Sovereign risk gained credence with Dubai World- An investment company managing the portfolio for the Dubai Govt Efforts to tide over the crisis has been reactionary at best Markets have historically lead in pre-determining the culprits before the ECB
8/11/2011 Beta Series on Finance 3
Currency union enabled low borrowing rates across countries Maastricht treaty Countries pledged to keep spending in check Greece & other countries through derivatives were able to mask their deficits A squeeze in credit, coupled with a fall in asset prices accelerated the recession in these countries Market focus on PIIGS France too has entered the fray
8/11/2011 Beta Series on Finance
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High level of public spending External Debt/GDP : 182% GDP ~ $320bn
Main economic drivers: Tourism & Shipping Highly cyclical both declined during recession (18% unemployment)
European Sovereign Crisis Greece
Political turmoil has increased uncertainty New unity govt post referendum drama
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Economic drivers: Real Estate (20% of GDP), Tourism (12%)
Low industrial production growth & high levels of leverage
European Sovereign Crisis Spain
Political uncertainty due to harsh austerity measures

8/11/2011
Unemployment rate ~ 20% Lack of labor reforms such as collective bargaining by unions, high severance pay etc
External Debt ~ 180%, GDP: $1.37 trillion

Beta Series on Finance 7
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8/11/2011
Issues
Single Monetary Union vs Different Fiscal Unions Labor Mobility
Transfer mechanisms
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Y = C + I + G + NX In the euro zone, Governments find it hard to increase NX (depreciating currency) or G (austerity measures!), I (dependent on interest rate set by the ECB), C (dependent on interest rates as well)
One will not see the unemployed from Spain making a run for Germany
Bailout Mechanisms restricted to a block of power outside your nation

10
EFSF (European Financial Stability Facility)

Recent capital raises
A fund created by 17 Euro member states in 2010
EFSF essentially raises debts in the capital markets to help distressed countries EFSF mandated to lend to countries in financial difficulties Issued EUR 3 billion bonds yesterday to help Ireland Issued EUR 3 bn bonds in June to aid Portugal
Member states guarantee up to EUR 780 billion of this debt; European Commission funds another EUR 60 bn; IMF another EUR 250 bn
EFSF can also finance recapitalization of banks through loans to govts.
ESM (European Stability Mechanism)

8/11/2011
This is a permanent funding program to succeed the temporary EFSF

8/11/2011
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Chinese Economy Growth Vs Inflation
A devalued currency has typically a role to play in inflation Inflation data of China should be taken with a pinch of salt
PBOC is allowing Yuan to appreciate with respect to dollar
Chinas central bank has raised interest rates fives times since October, 2010; reserve requirement have been increased 9 times (currently at 21.5%)
Inflation 6.1%, mainly due to food inflation of 13.4%
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Chinese Economy Real Estate

Real Estate prices in China are finally stabilizing or is the cycle about to turn ?
Government is determined to control the price increase in Real Estate price

S&P has turned its outlook on Chinese Economy on downturn
Steps such as high interest on mortgage payments, other credit controls has been taken Banks in China & Hong Kong have huge exposures to the Real Estate in China
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Activities linked to Real Estate account for ~25% of the total GDP of China
Real Estate Price Index in China
Question is whether it will be soft or hard landing ?
8/11/2011
Chinese Economy Issues?
Maintaining Competitive Edge while stimulating growth

Increasing cost structure hurts export competitiveness Currency devaluation has implications for inflation Proposed currency Bill in US Increasing inflation has an impact on the cost structure Chinas growth is export oriented low cost base Phillips curve Unemployment Vs Inflation
Any economy has to make a trade-off between inflation and growth
Currency devaluation helps in increasing competitiveness in global markets Countries such as US are coming harder on currency controls
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China Other points to notice

Interested in buying debt Looking for a market
Pushing for Yuan as an international currency Role in Euro zone
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Relative outperformance of Asian economies
Future outlook: Greater uncertainty implies that Asian central banks are likely to pause monetary tightening Capital flows could re-emerge as a policy challenge for some Asian central banks, especially if they are reluctant to allow their currencies to appreciate on a trade-weighted basis Continuing search for yield by global investors will attract them to invest in Asian markets
Reasons for Asias outperformance: Reducing public debt levels Strengthening currency reserves Applying discipline to fiscal deficits Government packages for strengthening infrastructure etc.
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8/11/2011
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What is Operation Twist?
8/11/2011
US Fed targets inflation as well as unemployment Ten year Treasuries as low as 1.95% but Unemployment 9%, Inflation 2% (but inflationary pressures rising - CPI) Sell medium term bonds ($400B) due in the next few years and buy 6-10y chiefly10y Treasuries (long term) Major interest rates (e.g. Mortgage rates, corporate bonds, long term bank loans) tied to the 10y Treasury rate Tried once before in 60s pushed down rates by 0.15% and mortgage rates by even less so it really effective? Also, treasury issuing long term securities at an even faster rate. So supply matching demand.
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Monetary easing (QE) with treasury curve steepening

10y @1.95%
Source US Treasury website
8/11/2011
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Effects of Operation Twist
BUT - 30 yr yields fell by 17bp on announcement and 2s/10s curve flattened sharply, correcting to10bp flatter May have been caused due to other effects weakening European economy, cut in IMF world growth forecast from 4.5%-4% (risk off sentiment) Support in favor of above equities/commodities fell (should have risen on announcement of a new stimulus) Fed is not printing money to fuel the risk appetite to buy risky assets and fund carry trades so no fall in dollar Dollar rose against major currencies (risk off sentiment, higher short term yields attracting short term investors)
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Risk off sentiment takes hold
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Risk off sentiment takes hole
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Effects of Operation Twist
Fed running out of options liquidity trap. Fiscal policy out of Feds control high deficits, no stimulus Flatter yield curve reduces incentives for banks to lend fall in Net Interest Margins Bank stocks tanked Argument in support of Operation Twist Monetary Disequilibrium theory easing demand for money But yield rise on T-bills is capped by banks arbitraging between excess reserves and T-bills Expectations - Should Fed commit to a nominal income and price level target? Investment alternatives Treasuries? Gold? Stock?
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Where to invest?
8/11/2011
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The Subprime Credit Crisis

The business of banking
Short Term Liabilities (Deposits)
Bank
Long Term Assets (Loans, mortgages)
Anatomy of a bank run

Panic: People think bank assets are falling in value; they panic and start withdrawing money In other words the short term financing is not renewed Fire sales: Bank sells assets to repay depositors Assets fall in value because of massive sales
8/11/2011
Vicious cycle appears
A bank run: From the movie Its a wonderful life
27

And this market is not insured!
In response, U.S. govt. introduced deposit insurance in 1934 which finally ended such bank runs A new form of depository banking emerged the repo market So who are these new depositors?
Institutional investors like pension funds and non-financial companies like Coke also need to have some accounts where they can park money But deposit insurance is limited and does not cover these huge amounts So they go to the Repo market!
Example: Fidelity has $ 500 million which it wants to keep in a safe place for a short duration say overnight
Fidelity
$ 500 mm $ 500 mm collateral Next morning, Bear repays $ 500 mm in exchange for collateral
Bear Stearns
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How does Bear Stearns earn income? So what happened in the crisis?
The asset which it gives as collateral earns a higher interest than the interest it gives to Fidelity on the $ 500 mm loan Investors like Fidelity want safe collateral, but Treasuries and AAA corporate bonds were not sufficient for this collateral demand in comes Asset Backed Securities
The 21st century bank run

Around Aug 2007, when subprime bonds started deteriorating, the new depositors panicked Bear Stearns starts selling assets asset prices fall across all categories Such prices are due to forced sales (called fire sales) and do not reflect fundamentals
8/11/2011
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AAA corporate bond spreads went above those of AA corporate bonds!! Most relevant points
Subprime by itself was $ 1.2 trillion (which is not large enough compared to size of the shadow banking system which is $ 20 tn) All asset classes (e.g. student loans, auto loans) were not fundamentally bad it is forced sales which led to all assets tanking
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Currency Markets Yen Appreciation

Earthquake
Swiss bank intervention BoJ Intervenes
8/11/2011
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Currency Markets - Yen Appreciation
Yen recently recorded post World War-II high of 75.31 against US$ (83 at start of 2011) This is hurting Japans exporters as appreciating Yen makes their goods expensive to foreign buyers What is driving the Yen up? Two theories to explain this.
First theory: Repatriation of foreign assets
Market doesnt think so inflows were not significant & secondly

March earthquake caused destruction of life and property and therefore insurance claims Insurance companies sold assets held abroad to bring proceeds to Japan for repaying claims People who were devastated sold their foreign assets as well Did these inflows caused the Yen to rise?
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Second theory: Negative real yields in U.S.
The real interest rates in the U.S. have gone negative! The Japanese real rates though low are still positive With Yen & US $ being the safe haven currencies investors flock to them at the sight of distress signals in global economy With Yen now offering higher real yields, it is the preferred choice
8/11/2011
Yen Appreciation
View
Short-term: Likely to strengthen given the positive real rates Risk in short-term posed by the Bank of Japan intervening to get the Yen to depreciate Medium term: Likely to weaken as the U.S. economy recovers and the real interest rates rise
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Currency Markets CHF Appreciation
Swiss bank intervention
8/11/2011
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Commodity Market Overview

Types of commodities
Oil and Energy Agri-Based Metals
Usage Metals Precious Metals Gold!!!
What are the commodity based economies

Australia China Canada/New Zealand
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Commodity Market Linkages

Commodity Market drivers
Behavior common to all commodities Peculiarities of recent moves

8/11/2011
Real world Demand Supply Inflation and Price rises in other commodities Currency Linked moves: Especially Oil and Gold Tendency to high volatility Highest Cyclicity among other commodities Extremely high volatility Gold as single global currency
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Commodity Markets:Gold
The history: Traditional measure of value Gold Valuation: Foreign Exchange reserves Inflation Hedge
8/11/2011
Demand supply for use is small percent of total trade Links to tulips story: Is there anything intrinsic? Asian economy demands very high Tendency to high volatility
Trends: Rise and recent correction

39
Exchange reserves and Gold reserves

Rank Country
Gold's share
Gold
tonnes
of national forex reserves(%) 74.70% 71.70% 71.40% 66.10% 1.70% 16.40% 7.10% 6.70% 3.00% 59.40% 8.10%
Rank 1 2 2 4 5 6 7 8 9 10
Country People's Republic of China Japan Eurosystem Russia Saudi Arabia Republic of China (Taiwan) Brazil India Republic of Korea Switzerland
Reserves 31,97,000 11,37,809 8,86,355 5,16,800 4,56,200 4,00,770 3,50,000 3,11,516 3,05,084 2,88,590
1 2 3 4 5 6 7 8 9 10 11 USA Germany Italy France China
8,133.50 3,401.00 2,451.80 2,435.40 1,054.10
Switzerland 1,040.10 Qatar Russia Japan Netherlands India 950.3 775.2 765.2 615.5 614.8
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Gold as currency backing
8/11/2011
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Gold Price trends
8/11/2011
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Thanks & All The Best!
8/11/2011
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News Rem

Beta Series on Finance

European Sovereign Crisis

European Sovereign Crisis

European Sovereign Crisis

Beta Series on Finance

High level of public spending External Debt/GDP : 182% GDP ~ $320bn

European Sovereign Crisis Greece

Beta Series on Finance

Economic drivers: Real Estate (20% of GDP), Tourism (12%)

Low industrial production growth & high levels of leverage

European Sovereign Crisis Spain

Political uncertainty due to harsh austerity measures

External Debt ~ 180%, GDP: $1.37 trillion

European Sovereign Crisis

Beta Series on Finance

European Sovereign Crisis

Beta Series on Finance

Single Monetary Union vs Different Fiscal Unions Labor Mobility

Bailout Mechanisms restricted to a block of power outside your nation

EFSF (European Financial Stability Facility)

A fund created by 17 Euro member states in 2010

EFSF can also finance recapitalization of banks through loans to govts.

ESM (European Stability Mechanism)

This is a permanent funding program to succeed the temporary EFSF

European Sovereign Crisis

Beta Series on Finance

Chinese Economy Growth Vs Inflation

Inflation 6.1%, mainly due to food inflation of 13.4%

Beta Series on Finance

Chinese Economy Real Estate

Government is determined to control the price increase in Real Estate price

Real Estate Price Index in China

Question is whether it will be soft or hard landing ?

Beta Series on Finance

Chinese Economy Issues?

Maintaining Competitive Edge while stimulating growth

Any economy has to make a trade-off between inflation and growth

China Other points to notice

Pushing for Yuan as an international currency Role in Euro zone

Beta Series on Finance

Relative outperformance of Asian economies

Relative outperformance of Asian economies

Beta Series on Finance

Relative outperformance of Asian economies

Beta Series on Finance

What is Operation Twist?

Monetary easing (QE) with treasury curve steepening

Source US Treasury website

Beta Series on Finance

Effects of Operation Twist

Risk off sentiment takes hold

Beta Series on Finance

Risk off sentiment takes hole

Beta Series on Finance

Effects of Operation Twist

Beta Series on Finance

The Subprime Credit Crisis

Long Term Assets (Loans, mortgages)

Anatomy of a bank run

Vicious cycle appears

A bank run: From the movie Its a wonderful life