Altair June Commentary

The End of QE2 and the Probability (Possibility) of QE3

 

During the run of QE2, the end of which is rapidly approaching, we discovered an interesting phenomenon.  There would be days when the stock market would open lower, only to begin a major bounce-back around 10 a.m.  This was occurring with such frequency that “buy the dip” became the mantra of many traders.  What we noticed, while visiting the homepage of the NY Fed on these days, was that Permanent Open Market Operations were being conducted at the same time the markets were finding their bottom – with regularity.  The point being…  QE2 arguably added artificial price stability to equities (and to other risk assets) and its ending in June should remove some of this stability.  I emphasize the word “should, ” because the normalization of the market’s pricing mechanism will be largely dependent on whether there is a QE3 or some form of a stealth extension of QE2.

 

The idea of a potential QE3 moved to the front over the past few weeks with declining ISM numbers, weak Non-Farm Payroll numbers, dismal housing numbers, and faltering consumer confidence.  Additionally, by falling for the past 5 consecutive weeks and 5 consecutive sessions, the stock market returns seem to be “suggesting” to the Fed that additional QE might be desired.

 

While it’s doubtful that the American people have an appetite for an overt QE3, we believe that the Fed will, for the foreseeable future, maintain the size of its balance sheet by reinvesting the proceeds as bonds “roll-off” its balance sheet.  In this way, they can “keep interest rates exceptionally low for an extended period, ” as has been the Fed’s repeatedly quoted position.  And while cheap money is unquestionably a stimulant for the stock market, the fact that the economy remains so weak that a Zero Interest Rate Policy must be perpetuated should give everybody a reason to pause.

 

We are likely nearing an inflection point as QE2 winds down, so we are keeping our betas to a minimum.

 

The European Bailout and Long-Term Viability of the Euro

 

Here are a few headlines from the past few days (in no particular order):

 

  • Greek Government Faces Revolt Over Second Wave of Austerity Measures
  • Seven Years for Ireland to Fully Recover, Warns Banker
  • S&P warns EU over Greek Debt
  • Obama Says European Debt Crisis Must Not Endanger Recovery
  • Riots in Greece Over IMF-imposed Setbacks to Workers

 

In our analysis, Greece has no choice but to default – either via debt restructuring, technical default, or outright failure to pay.  A recent Moody’s downgrade places the likelihood of a Greek default at 50%.  While many pundits argue that Greece, and Ireland for that matter, are too small to matter, we would argue that the impact on the Eurozone as a whole and the Euro as a currency could be severe.  The fact that Trichet recently began pushing for a European fiscal union to pair up with the existing monetary union would support our point.  It was the lack of a fiscal union that allowed Greece to spend into oblivion while more fiscally conservative countries, like Germany, were left holding the bailout bag.  Now, the citizens of each country have little appetite for what needs done to correct this deficiency (assuming to can be corrected).  The May 5 riots in Greece that resulted in the deaths of 3 bank employees present an ominous example of the friction between workers and their government.  There is a real chance that it may be too late for the fiscal union idea to be of any use in this crisis.

 

We continue to be short European banks in Hedged Equity as a hedge against what we believe to be an upcoming elevation in the crisis.

 

Housing in Double Dip

 

In May, the Case-Shiller Home Price Index fell below its April 2009 low to officially enter the area of “double-dip.”   For the month ending March 31, 2011, 19 out of the 20 cities in the index saw price declines.  Washington D.C. was the only market to post a gain on both a monthly and an annual basis – Washington is growing while the rest of the nations is shrinking…is anybody shocked?   Minneapolis saw a 10% decline for the year, indicating that the housing crisis is being felt hard in the Midwest.  The quarterly annualized decline for the overall index was 5.1%.

 

As home prices continue to decline and the pace of foreclosures hastens, we expect the real estate market to remain soft for the foreseeable future.  Such softness would be a bad thing for consumer confidence and consumption, as well as the financial sector as a whole.

 

We believe there is a silver-lining to housing issue that should show itself in the next 2 or 3 years.  The excess supply of homes is shrinking – currently at about 1.3 million units down from 1.8 million only 6 months ago.  Factoring in new home construction, 2011 should come up roughly 1.25 million homes built short of what should be needed to keep up with population growth.  That trend is unsustainable.  Additionally, the laws of supply and demand are becoming a factor.  As more people seek to be renters, the cost of rent is rising.  There will be a cross-over point somewhere in the not-so-far-in-the-future-to-care, where the price of rent will make homeownership an economical venture once again.  The convergence of reduced housing supply with increased rental costs could provide a significant tail opportunity in the coming years.

 

China May Be In Trouble

 

Stealth Bailout in Progress

Earlier in the week I read an article from Societe Generale’s Dylan Grice about a Reuters’ report regarding China’s Local Government Financing Vehicles (LGFV).  It was reported that China’s central government was “taking on responsibility” for up to $463 billion of bad loans made to LGFV to fund various infrastructure and development projects as a part of the stimulus package. Basically, this amounts to a stealth bailout.  It’s not clear yet how this will be done, but if it is handled in a fashion similar to that used during the recapitalizations of Chinese banks, asset management companies will buy up the bad assets, which they will pay for with non-tradable government-guaranteed bonds.  These bonds do not show up in the official measures of government debt.  Since the bonds are off the official records, it’s like the bailout never happened.  But the problem hasn’t gone away. As Grice noted, a bail-out of $463 billion is half the size of the TARP for an economy which is only one-third the size of the US’.  So adjusted for GDP, China has enacted a bailout equal to one and a half TARPs.  If we calibrate the magnitude of the economic crisis with the size of the bail-out, one and a half TARPs implies a financial crisis one and half times the order of magnitude of 2008.  With China quietly buying up its own bonds, there is a real possibility that their demand for US bonds may wane – causing US interest rates to rise.  One more reason we are short US Treasuries.

Says Grice: “The critical issue in both cases is the artificial suppression of volatility in the name of stability. We know that the longer volatility is artificially suppressed, the more emphatic will be its release when it does come.”

 

Energy and Food Inflation

With energy and food prices rising at a heady pace, China has had no choice but to restrain credit and money growth.  Protests such as the recent truckers strike indicate this is not going to be an easy sell to the population. Chinese consumer expectations have been plummeting, and are now at their lowest level since late 2008.  Car sales, which were exploding during the massive stimulus injections, are now growing at low single digit annual rates.  And finally, housing starts are running at +40% year-over-year, but sales are falling at a -5% annual rate. There is a lot of faith being priced into the market that the Chinese authorities will be able to engineer a soft landing for the economy, but given the extraordinary imbalances that have built up, that will be increasingly difficult.