10 December 2010


After number of dedicated requests (thank you for your messages) we decided to resume our market commentary.  It is nice to know that they are actually influential for some of you.
As we are in the final steps of concluding our agreement on having a reputable external provider of financial research, the commentaries going forward will have a more of the informal format (do not like the word blog).

Global Economy - the structure
In summary the current state of the economy, the new normal which was evident in the last two months, only reconfirms us in our view that the only way for the governments to solve the current problems is to keep and even intensify quantitative easing, what in turn will inflate the asset levels, revalue the salaries, pensions and social benefits, as well as the debt levels for those highly in debt (mainly the governments), devalue the strength of the "developed currencies" vs the "emerging currencies" and commodities.  Of course "controlled inflation" as a policy would be hardly popular amongst vast majority of economists, banks and even governments themselves, but having a choice of Japan like twenty years of zero growth with prevailing inefficiencies, or a "shock theraphy" I would advocate the second. 
My only concern is that the current stagnation and delay of major changes, will infact make any forthcoming "shock therapy" only more difficult to implement, and as quantitative easing (or printing and debt buy back) is not happening fast enough the markets will start to prepare for it making its effectiveness much lower.  From the governments down to individual people, we are all getting used to the New Normal, and once it appears that this in fact will need to be also revoked there will be more unhappiness . The Governments are also happy, first to outline the success, and fearing taking bold decisions like that of inflating the economy. The classical economics approach, with pure rational greed, prevails, and not many economicsts, bankers would support the claim that quantitative easing is needed to ensure the objectives listed in the previous paragraph are met.  As the result, we will now struggle from crisis to crisis, from Greece, to Ireland, to Spain, Portugal, to Italy, France and UK, and even California and whole USA itself, injecting cash at the times of needed bail-outs (see Commercial Real Estate).  To see how good things are just look at the extension of the tax cuts for the middle class in the US.  At some point someone will need to pay for these cuts.
Global Economy - the fundamentals
While we think that the structure of the economy including mispricing of assets, the skeletons in the closet like accrual accounting in financial markets, like house stocks, like pension deficits, state deficits, off balance sheet financing, all remain, it is undeniable that the overall prospects for the global growth are very strong.
We never had so much capital ready for investment, both financial and human.  The efficiencies of technology, internet, telecommunications are more and more apparent.  It reminds me of the Econ100 course, where basically GDP is set by AS and AD, where AS is fixed and capped.  This cap is constantly risen, and as more people are able to access the benefits of the last twenty years of technology, so does the AS increases.
Naturally there are regions and sectors that are better positioned.  Emerging Markets remains a key driver of growth.  Commoddities will remain strong, as its supply is scarce and demands are ever greater.   Technology, internet, even media (although media will be more volatile due to its advertising dependent business model and natural fear of piracy and oversupply).  The major winners are already emerging.  I remember writting about Facebook few months ago, when it was rumoured to be valued at USD35bn.  The latest reports show its value at USD50bn and Mark Zuckenberg says that Facebook is only at the start of its journey.  Though early days, we remain in the view that Facebook will be the worlds first trillion dollar company.  Its unique market setup, a first global internet natural monopoly is undisputable.  Also watch out for Chrome OS, another major change on the horizon, no more viruses, rebooting, hard drive fatal errors.
Alert:  Commercial Real Estate
Today is Friday and FT reminds me of the boom years, once again thick and full of advertising.  Only a year ago I was worried that FT will soon come as a newsletter. Of course the problem with thick FT is that it is diffucult find information that is actually important.  To me this informatino wasa small article on the "Business Property Loans Decline", an article by Daniel Thomas.
While the article shows that for a first time in the decade the outstanding level of commercial real estate loans declined, the real interest is in the following data:
 - total outstanding loan stock is GBP 216bn
 - total debt in breach or in default is at GBP42.8bn  (vast majority in breach)
 - GBP 1bn of equity positions taken by banks
 - most property remained on books to avoid selling into depressed market
What this article outlines is that the closet hiding one of the most major skeletons is increasingly difficult to keep shut.  A lot of people know that there is more commercial real estate than it ever made sense to build, with rents implying the yields that are below the cost of building, a serious anormality and a sign of singnificant oversupply over the last years (decade).  Banks know this, but to admit would be a karahiri like that of Ireland, which despite having a reasonable budged condition (at least if compared to the likes of Italy or UK), it has admitted the problems with its toxic assets, requiring it to have a "one off" deficit.  This is hardly a problem of Greece, and it hardly insentivises the other countries and banks to come clean with the problem.
It is hence most profitable for banks to hold on to the real estate commercial stocks at artificially inflated prices waiting for another crisis, or a policy aimed at reinflating the asset values (including that of the commercial real estate).
Now this state of the affairs is shared by residential real estate, where various banks lend out 30 year money at Bank of England or Libor rate (while they are themselves financing at rates 2% higher), or direct bank loans (where the syndicated loans are simply extended or at worst swapped into equity at the artificially high equity book values).  These skeletons however are perfectly happy in their closets, or respective SPVs.  Commercial Real Estate is different as there is a vast overhang of CMBS (Commercial Mortgage Backed Securities), which upon maturity will unwillingly trigger the defaults of other loans, including bankrupcy proceedings and forced asset sales.  This skeleton is hence increasingly hard to keep under control, and it will require a significant bail out (via toxic asset scheme).
Euro Eurobond
I started with stating that there is a choice of quantitative easing or twenty years of deflation (which will end in inflation anyway, only many years down the line).  The twenty years of deflation however will require money to pay for all the bail outs that we are seeing, not only EUR85bn for Ireland, but possibly tenfold of this for other countries too.  This will require additional financing, which will not come from IMF but will need to be financed by Frankfurt (either by printing or by borrowing). 
It is undeniable that if one is serious about the EURO, the common currency, the idea of common debt is not that unreasonable.  Indeed EURO being a collective union should enjoy much lower cost of financing (in theory it is a FTD of many countries,  hence even assuming the correlation of default of 1, it shoud at least offer the rate as low as the best of the credits in the basket, namely Germany).  Of course like any borrower it must have some "assets", which can be either
  - state guarantees of all member states (FTD - first to default concept), OR
  - some form of cash flow from government member contributions or common tax
Now, lets look at the numbers.  If each country obliges itself to pay say 1% of its GDP for EU, than technically assuming no other expenditures by EU, it would mean income of some EUR 140 bn a year, or ability to repay the debt on some EUR3tn.  This is not a bad solution, especially as the only cost will be a reduced financial independence of the current EUR states, what will largely come unnoticed.  In adition this EUR3tn could at worst be used not only to bail out many banks, but to inject this into the banks balance sheets, effectively improving the entire economy.  If you follow this logic, than Euro Eurodebt seems like a great idea to keep the monopoly game going.

So on that note, if ECB calls Vision Finance for advice, we would definitely say that the Euro Eurobond is indeed a good and very sensible idea, especially if it is structured right, long term.  After all there is also an even more Machiavellian approach, that after all all this debt would be devalued anyway once the quantitative easing starts.