Posts Tagged ‘ECB’

Looming Black Swan that can bring the market back into panic

Thursday, August 6th, 2009

The Panic of 2008 ended in March 2009, when the S&P 500 fell to a low of 666 points. After that, the stock market, emboldened by optimism of “green shoots” of recovery, embarked on a powerful rally that was briefly interrupted by a small correction in June.

Today, the stock market is in an extremely technically overbought level. In lay-person’s speak, the stock market has arrived at a very bubbly level. This implies that the market is overdue for a trend reversal. But that does not necessary mean it is imminent because we have respect for this market rally.

For investors, what should they do?

If you have substantial long positions in the market, we believe this is the time to put on your hedges (e.g. long put options, short deep-in-the-money call options, stop losses, guaranteed stop losses, short CFDs on long positions, take some chips off the table, etc). For those who missed out on the March-June rally, Marc Faber advised at his latest market commentary that they should wait for a correction before entering the market.

What can possibly trigger a major correction? We looked high and low and found one possible Black Swan in one corner of the earth- Lithuania. In fact, this Black Swan may even trigger more than a correction- it can trigger another panic though it is hard to quantify how great that panic will be, given the propensity of the Fed to print money. As this news article reported,

Lithuania?s new president has admitted that her country could be forced to seek help from the International Monetary Fund if it fails in efforts to raise more money from foreign capital markets to prop up its teetering economy.

The fate of the Baltic economies is being watched across Europe amid fears that they could trigger devaluations and defaults in eastern and central Europe.

Sweden and other Nordic countries are especially sensitive because their banks expanded aggressively in the region and now face a rising tide of bad loans.

As the RBA’s most recent statement on yesterday’s interest rate decision said,

There is tentative evidence that the US economy is approaching a turning point, but conditions in Europe are still weakening.

The “green-shoots” can hardly be found in Eastern Europe (more generally, the “emerging” economies). Many European banks are highly leveraged to Eastern Europe.The following is the list of emerging market debt exposures of European nations:

Austria – 85% of GDP (Central & Eastern Europe)
Switzerland – 50% of GDP
Sweden – 25% of GDP
UK – 24% of GDP (mainly Asia)
Spain – 23% of GDP (mainly Latin America)

In contrast, the US amounted to only 4% of GDP.

Richard Karn wrote in his soon to be released book, Credit and Credibility,

Today, although the situation has improved in step with global equity markets, Western European bank exposure to Central and Eastern Europe alone exceeds $1.6 trillion.

The recent news of Lithuania can be a portent of more Black Swan contagion in Europe.

The following is the list of Central European refinancing needs in 2009 as a percentage of foreign exchange reserves:

Estonia – 346%
Latvia – 341%
Lithuania – 204%
Poland – 141%
Croatia – 136%
Bulgaria – 132%
Romania – 127%
Ukraine – 117%
Turkey – 110%
Hungary – 101%
Czech Republic – 89%
Kazakhstan – 82%
Russia – 34%

As Richard Karn continued,

Because the European central bank has not embraced quantitative easing and Western European banks have written down so little debt, especially compared with their US counterparts, a number of commentators contend the banking crisis has yet to fully hit Europe. Essentially, because European banks employed more leverage, they have less freedom to mark down debt, which makes them vulnerable in these conditions. In addition to the situation in Central and Eastern Europe, Western European banks face substantial US property losses they have yet to recognize, and are exposed to euro zone corporate debt to the tune of $11 trillion, equaling 95% of the combined economy, compared with US exposure of roughly 50%. If this were not enough, a significant portion of the Russian banking industry is under considerable stress, with $280 billion of a total $400 billion in debt to European banks being due in the next four years, and the issues regarding repayment and threats of non-payment that rattled markets regularly earlier in the year have yet to be resolved.

A contagion from Europe can easily trigger another global panic. That’s the reason why Kevin Rudd is not ready to declare “Mission Accomplished” for Australia with regards to the global recession (unlike the sheeps in the financial markets).

Watch this space.

Is this a bear market rally or a turning point?

Sunday, May 17th, 2009

The global stock market has been rallying for the past couple of months already. There have been talks of “green shoots” of economic recovery. There are hopes that China’s stimulus spending will bring out renewed demand for Australian commodities. Already, there are reports of record Chinese demand for commodities (see China on buying spree).

We heard of many retail investors piling into the stock market, not wanting to miss out in the turning point. Since the stock market tends to be a leading indicator of future economic activity, many are seduced by the idea that this rally is predicting a turning point in the global economy. Unfortunately, as with many cliché ideas, this is only half-true. This is an example of a mental pitfall called lazy induction (see Mental pitfall: Lazy Induction).

To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery. A very good example will be the number of bear market rallies in the chart of the Dow Jones from 1929 at Bear market rally on the works?.

Now, let’s take a read at what Marc Faber says about this rally in his latest market commentrary:

The economic news in the world is hardly getting any better, but the rate of economic contraction has slowed down somewhat as the  governments? stimulus packages begin to have some impact and as some replacement demand is starting to support consumption. However, to talk  already now about a sustainable economic recovery seems premature because whereas some sectors (autos) and regions may be stabilizing, others are still in a steep decline.

The global economy are declining, but the speed of decline is not as fast as the second half of 2008. Therefore, this stock market rally is anticipating that this reduction in speed is a turning point.

The next question to ask is this: will the stock market be lower or higher in 2010? Even Marc Faber admitted not knowing the answer to this question. Indeed, it is certainly possible to see another bout of breathtaking crash that can rival the panic of 2008. There can be many possible triggers for that, including:

  1. Collapse of a major European bank. Many big European banks lent so much money to Eastern Europe that their asset books are even bigger in size than the GDP of some European nations! Meanwhile, many Eastern European economies are in serious trouble, which means there will be many gigantic bad debts floating around. The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask. Therefore, if a banking crisis is to hit Europe, the political deadlock can result in another panic in financial markets.
  2. Swine flu
  3. Collapse of Pakistan

At the same time, governments are already embarking in massive money printing (quantitative easing), stimulus and bailouts spree. As we said before in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

… while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see ?Bernankeism and hyper-inflation?), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts.

If government pumps so much money into the financial system, it is only a matter of time before asset prices rise again, not because of improving economic outlook but because of the sheer weight of money. The problem will be massive consumer price inflation once the Global Financial Crisis (GFC) is over, which is a problem for the next generation to solve. The outcome will be what we wrote in Zimbabwe: Best Performing Stock Market in 2007?.

In any case, no matter what happens, the peak of economic boom in 2006/2007 is over and will not be back soon. Investors who are expecting that will be disappointed.

Prepare for asset repricing, warns Trichet

Wednesday, January 31st, 2007

In this news article, Trichet, the president of the European Union central bank warned that that instability of global financial markets can lead to ?re-pricing? of assets. He said that:

There is now such creativity of new and very sophisticated financial instruments . . . that we don’t know fully where the risks are located… We are trying to understand what is going on?but it is a big, big challenge.

As we mentioned in Spectre of deflation, the majority of global liquidity is made up of derivatives which is estimated to be valued at US$450 trillion. However, world GDP is estimated to be only US$46.66 trillion?only one-tenth the size of the value of derivatives!

With such massive quantity of derivatives sloshing around the global financial market, there is very little wonder that no one, not even governments or central banks can fully understand what is going on. Thus, opinions on derivatives are highly polarized?some think they are beneficial because they reduce risks by spreading it, whereas others see that they are currently too dangerous because they encouraged too much leverage and risk taking behaviour. Whichever the truth is, we believe that with all these absurdities in the financial world, it is more likely that risks are underestimated than overestimated.

Now is the time to reduce both debt and leverage. Start hedging.