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A. Tavazzi, Pictet & Cie
July 12th
2011Geneva
Advisory Salon:
Unintended Consequences
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2Salon Advisory: Unintended ConsequencesPictet
Recent events
Two weeks ago, it became clear that Greek debt had to berestructured. France took the leadership of the negotiations,proposing a very complicated structure.
The French plan was to roll 30bil of existing debt (up to 2014maturities) to 30 years maturity. Investors would get 30%repayment and 70% would be split 40% in EFSF bonds and 30%effectively going to Greece. Interest rates on the new debt woulddepend on the countrys growth rate or inflation. This rollover wouldbe limited to 50% of outstanding bonds. As complicated as it looks,
the scheme was designed to help bond holders and avoid a CDSpayment on Greek debt.
The Scheme therefore was designed to help Greek debt holders, butnothing was done to solve the initial issue: growth.
S&P was quick to announce that it would constitute a selectivedefault. Private bond holders have been meeting with authoritiessince, but no solution has been found yet.
A constantly moving
environment
And rating agencies that look
through complicated structures
(at last).
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What went wrong since
On July 4th, Moodys downgraded Portuguese debt to belowinvestment grade.
As the Greek example shows, CDS do not protect debt holdersanymore and the market sold off, sending 3Y bond yields from 14%to 20% currently.
Then, Italian Services PMI went below the 50, making it clear thatthe economy has started to slow down.
Consequently, market attention shifted to a pan-European issueabout the ability of these countries to grow (and eventually paybond holders).
European banks declined by 9% in 6 sessions.
To respond to the crisis, European Council President Herman VanRompuy has called an emergency meeting of top officials dealingwith the euro zone debt crisis for Monday morning, reflecting
concern that the crisis could spread to Italy, the regions thirdlargest economy.
It is now clear that markets demand a comprehensivesolution to the debt stock and measures to generategrowth.
The crisis has spread
Italys debt market is larger
that Spain, Greece, Portugal
and Ireland combined. With
$2.2Tril, it is the 3rd largest
debt market in the world.
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Bond markets reacted immediately
Portuguese and Italian 3 Y government bond yieldsThe market reaction after
Moodys downgrade was
immediate: Portuguese 3 years
yields rose from 14% to 18%
in one day.
They closed at 20% yesterday.
Italian yields rose from 3.5%
to 4.7%.
Investors feel that the CDS
protection is not valid anymore
as seen from the Greek rollover
proposal.
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CDS
European Sovereign CDSThe Portuguese CDS quickly
joined the Irish one.
The Italian CDS reacted
quickly in the last 2 weeks,
rising from 171bps to 294bps.
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An extreme situation ?
German 2Y rates are below the ECB refinance rateGerman 2 years rates are now
below the ECB 2 weeks
refinance rates.
There is a huge premium paid
in Europe for the highest
quality asset.
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Portugal and Italys debt distribution
Insert Chart titleItalys debt structure is very
different from Portugals one
as it is more evenly spread
over next years.
The issue thus is less pressing
for a quick solution.
The pressure on policymakers
nevertheless is intense as the
size of Italys bond market is
very big.
Peripherals have not really
recovered the lost economic
activity from the crisis.
Italy has recovered only 21%
of its lost GDP.
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Why the contagion to US markets ?
Share of US money market fund assets in bank paperAccording the the latest BIS
report, more than 40% of the
US money market funds are
invested in European bank
papers.
European banks are heavy $
short-term paper issuers to
fund their overseas operations.
US banks have been less
active since the Fed bought
their MBS abd replaced them
with cash. US banks excess
reserves currently amount to
$1.5 tril.
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Intermediary Conclusion
Markets reaction has been rational
If policymakers try to avoid a CDS payment, why hold theunderlying bonds ?
As growth slows and no measures are taken to correct thissituation, the ability of the countries to pay debt holders is putin question.
As growth slows, equity valuations tend to be compressed.
When it comes to investment though, one can still find some
transactions to propose. Maybe to protect ones portfolio, or tocapture opportunities given by markets.
We believe it would be a mistake to try to compensate a badperformance by taking huge bets.
Market performances are very close and all assets tend to move
in a synchronous way.
We believe the Summer environment will remain one ofdisappointing growth. News and decisions will dominate.
The unintended consequence
of the Greek plan.
Markets performances are
close to each other.
Diversification is less effective
and top-down factors
dominate.
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Small Dispertion
Difference between the best and worst MSCI regional indices quarterly performanceThe difficulty is compounded
by the small difference in
performances.
An underperformance in one
side of the portfolio cannot be
easily compensated by gains
elsewhere, or
by taking very big risks.
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Downward Pressure on yields until the end of the Summer
Us Treasuries Leading Pressure IndicatorThe downward pressure on
rates should stay intense until
the end of the summer.
The risk on / risk off type of
market behaviour will remain
in place for the coming
months.
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And Growth Worries
Citi Economic Surprise indexEconomic data have been
disappointing not only in the
US, but European and
emerging countries data have
disappointed too.
Growth worried are at the heart
of the current market
behaviour.
PER Expansion will be
difficult.
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S&P 500 (SPX)
S&P 500S&P 500 remains ranging for
the moment between its
resistance at 1351 and the
major support at 1286 given
by the 200 days SMA and the
50 % Fibonacci Extension.
The intermediary support holds
at 1316, defined by the 100
days SMA.
We advised to our clients to
hedge their positions by
shorting S&P futures only if
supports are broken.
By the same token, we would
place stop los orders when
resistances are crossed.
Major Resistance :1351
Major Support : 1285
Source: Pictet Ngoce
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EURO BUND (RX1)
EURO BUND FUTURE
Major Resistance :129
Major Support : 127.32
The Euro Bund is testing its
Major resistance at 129, given
by the 64.8% Fibonacci
Retracement. On the other
hand the major support is now
holding at 127.32.
Source: Pictet Ngoce
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Equities: some
Relative Performance of Gold Mining to Gold priceGold miners relative
performance to gold is now at
a multi-year low leel.
Historically, this has proven to
be a good buying opportunity.
Investors looking for
opportunities in the equity
area
can purchase the GDX US
tracker.
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Gold Miners Tracker Members
GDX CompositionDuring the April correction,
Barrick lost more than 18%.
It currently trades at 10x
earnings.
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Bund : the only risk free asset ?
Bund Futures Contracts and Trading Envelopes 2 STDEVThe bonds' collateral value ofdowngraded countries can be
seriously put in question by
investors.
German government bonds
quickly become the ultimate
financial collateral.
For Advisory clients, we
decided to take profits on our
Bund futures yesterday.
The technical situation is
really stretched, but the
environment remain
supportive.
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The same movement in Treasuries
10Y treasuries futures and Trading Envelopes 2 STDEVOne can see the samemovement in Treasury Futures.
the Technical situation is less
stretched though than in Bund
Futures.
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Currencies
Euro dollar 2 years interest rates spreadThe euro is losing a keysupport: its interest rate
differential against the USD.
The market is realizing that
higher interest rates cannot be
sustained in the Eurozone.
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Euro / USD
Euro/USD and Trading Envelopes 2 STDEVVersus the USD, the Europeancurrency is not yet at the low
end of its range.
To be really oversold, it would
have to go to 1.375
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The Swiss Franc
Swiss Franc Real Effective Exchange RateAt +4 stdev, the Swiss francsituation is extremely
stretched.
But this is also a reflexion of
its trading partners situation.
At the current level we would
not
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DCI opportunities
DCI conditions 2 weeks maturities (July 12th)Investors willing to capture thevery low euro level can find
attractive DCI levels.
Given the oversold level,
remaining reasonable withcoupons gives a safety margin.
Investors looking for a longer-
term currency allocation can
purchase bonds in structurallystable currencies.
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CAD Bonds
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SGD Bonds
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SEK Bonds
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Conclusion
Financial markets reactions remain decision-driven. The ability of governments to generate growth in front of a huge
stock of debt is at the heart of investors worries.
This environment will stay with us until the end of the summer.From that time, the disruptions coming from the Japaneseearthquake should be corrected and the decline in oil prices willhelp US consumption.
Until then, the news flow will dominate markets and we expectmany mini-cycles of risk-on / risk off behaviour.
We believe the right investment attitude is to multiply smalldecisions in attractively-valued assets until conditions improve.
This is not the time for big bets in either direction as liquidityremains tight and prices movements wide.
News will dominate
And price swings will continue.
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