As a halfway house, it could be a major step forward, if pan-EZ fiscal vetoes were binding. But will member states
cede spending authority, though EZ integration entailed limited transfers of sovereignty? Political obstacles apply
as much to creditor as to debtor countries; EZ paymasters, Germany and France, and the PIIGS violated Maastricht
Criteria en route to, and Stability/Growth Pact fiscal criteria once in, EMU. What about the underlying issues of
which excessive intra-EZ imbalances are mere symptoms: the lack of mobility in labor and corporate controlregardless of paper rules, reflecting the EZ’s multi-state nature?
Turning to the immediate debt crisis options for Greece, the choices boil down to further official lending,
perhaps but not immediately extending to full-blown bailout or inadequate debt relief. Any specific plans under
these two broad choices will, given the policy debate, remain hostage to the political dichotomy of willingness “to
do whatever it takes to save the euro,” but ability to do the bare minimum if that. Even if Greece’s or the other
PIGS’ destiny is a full-blown bailout, not just a drip feed of lending and re-profiling to keep the ship of the EZ
relatively steady, it would not be pre-announced, but happen over time. Plus, the ECB has stepped into politics and
the fiscal arena, pushing the rest of the “Troika” (the IMF and EU) to l end more to Greece, by threatening to
disqualify rescheduled bonds as repo collateral.
This unprecedented action would amount to a total EZ hijacking of the IMF. Full-blown debt relief would require
either an actual default by Greece, as in almost all other cases of significant face-value write-downs, or arecapitalization of the EZ banking system—and that seems unlikely in the extreme given the policy signals. Greece
may well remain close to the brink, in turn keeping the other PIGS dangling, and the EZ lurching from crisis to crisis.
The fat tails then would continue to wag the dog, another reason to remain light on risky assets, expecting
investors to seek liquidity and safety in U.S. Treasurys.
EM inflation: It is increasingly clear, as we have long argued, that EMs face an overheating problem, arising from
an inappropriate FX/monetary policy mix. Monetary policies are being tightened, but FX appreciation is still
generally being curbed, and vendor financing by dramatic FX reserve accumulation continues, stoking global
imbalances. Our macro views call for very limited rate hikes across the West. U.S. and EZ macro performance, PIIGS
developments, plus UK stagnation in response to premature fiscal adjustment all point to tight limits to monetary
policy normalization. We expect the ECB to hike in line with its pronouncements, but for rate hikes to peter out
soon, given weak growth. The Bank of England will continue to wait it out for a few more quarters, but even if it
then decides to hike, it’s hard to see it going very far either.
Led by China, EM countries are quite likely to respond to the continued weakness of DM aggregate demand by
resisting further significant deterioration in their terms of trade via FX revaluation. If China continues to shadow
the dollar as global economic deceleration continues to gather pace, other countries will continue to shadow China
lest they lose further competitiveness. The cycle of carry trades betting on capital gains in assets and in currencies
would continue, in due course, unleashing more EM inflation pressures. So we remain cautious about EM assets
despite the current respite in inflation, since we’ve seen this part of the movie before too, and expect it to repeat
as well…
8/6/2019 Cross Asset Monthly - The More Things Change - June 2011
With Greece having demonstrably gone “off track” in its adjustment program and the chance of renewed market
access in 2012 having receded, the release of the next IMF tranche has been put in doubt. This leads to an
increasingly binary set of outcomes, implying either an earlier-than-anticipated credit event or a continuation of official support which would eventually need to morph from loans into grants, creating the “mother of all moral
hazards.”
Spooked by the former, the ECB has activated the financial equivalent of a M.A.D. (mutually assured destruction)
strategy, threatening not to accept sovereign Greek bonds as collateral should they in any way be impaired.
Ultimately, this threat is likely to be inconsequential as either the ECB would not be able to follow through for fear
of a financial meltdown in the Greek and perhaps other banking systems or else national central banks could take
over the role of lender of last resort via the emergency liquidity assistance mechanism. Nevertheless, it has turned
the ECB into an essential hold-out investor (rather than a constructive participant in a resolution attempt) and
shifted the terms of the debate.
In the past, trouble in the EZ has not been able to spill over into global risk sentiment or even affect EURUSD in a
sustained or drastic manner (its June 2010 low of 1.19 remained a far cry from the historical 0.82 low). But on the
other hand, an EZ credit event, and the potential for EZ contagion, had never seemed as likely. What is more, the
(delayed) release of the EZ bank stress tests and the meeting of the EZ finance ministers on June 20 represent
critical milestones for the EUR. In a world still dominated by near-zero interest rates and little prospect of an
aggressive exit in major economies, the ECB’s rate hikes increasingly look like an insurance policy against a sharp
EUR selloff should a credit event materialize. The ongoing “muddle through” approach is unsustainable and
destined to unravel eventually, but for markets it means lurching from crisis to crisis with rebounds in between.
Yet, on the back of rising event risk and the difficulty of predicting when these events will be, we choose to
maintain a defensive stance on the EUR.
Figure 3: FX Trade Recommendations
Note: Trades opened/closed this month in bold.
Short Long Entry Entry Exit Exit Current P & L
date level date level level
EUR CHF 01 November 2010 1.378 03 June 2011 1.21396 1.21396 11.9%
AUD USD 04 May 2011 1.08 1.0613 1.7%
EUR USD 12 May 2011 1.4232 1.448 -1.7%
GBP USD 12 May 2011 1.6291 1.6193 0.6%
8/6/2019 Cross Asset Monthly - The More Things Change - June 2011
monetary stimulus will likely need to be maintained. But as Figure 2 shows, forward rates are still at levels that
assume we’ll be “back to normal” in five years’ time. We wouldn’t be short long-ends until sentiment pushes these
into well below-average territory, even if our base case is not for a double dip.
Euro Periphery: Will Policy Makers Heed RGE’s Advice? What if They Don’t?
Worries continue to plague the EZ, and this is unfortunately justified as denial, bailouts, equivocation and recent
official talk of bail-ins, euro-ejection and default have unsurprisingly failed to restore confidence. Russia and
Argentina followed this pattern as well; yet, even though Greece is insolvent, and Ireland and Portugal are likely
headed that way, these three don’t need to follow in the steps of the worst emerging market debacles. RGE has
argued that an orderly restructuring, in which bondholders incur severe 30-50% haircuts or net present value
(NPV) losses through long maturity extension and coupon reductions, is already largely priced into Greek debt and
should be attempted to avoid utter failure and worse contagion later on. Portugal and Ireland may still face
pressure, but with yields in those markets in double digits, the most compelling peripheral short is still Spain,
based on risks from Greece as well as its own precarious debt sustainability.
Greek and European policy makers have time and again failed to fully face up to the problems, so we must also
consider the alternatives:Muddle through: Continued loans and recession-inducing adjustment, short maturity extension
without principal or coupon reduction. This would cause continued uncertainty for Ireland and
Portugal, but would be a reprieve for risk assets and cause swap and bund yields to rise, until the next
round of crisis. Because of political constraints, RGE views this rather perilous and unfortunate
outcome as the most likely, as RGE’s economic team discussed in “EZ Policy Makers Will Avoid Tough
Decisions and Continue to Muddle Through for Now.”
Total bail-in: The mother of all moral hazards would be superb for risky assets, as Greek bondholders
would be paid out at par; other PIIGS spreads would also bull steepen. However, the risk-on combined
with the realization that costs of a Spanish bailout would fall on Germany would lead to Euro swaps
bear steepening, with 10y rates approaching 4%.
Disorderly default: A Lehman redux in the EZ could be more severe than the 2008-09 crisis, as banksand sovereigns suffered from a renewed credit crunch. The ECB would reverse its hikes and flight-to-
safety would benefit bunds and Treasurys. RGE’s EZ Endgame Scenarios could also come into play, as
the future of the common currency area comes into question.
Duration Curve
U . S .
Neutral. U.S. yields look low, but the fact of monetary
repression and balance-sheet deleveraging may last a
decade, which means fair value is far lower than precrisis.
Some flattening is possible as Treasurys properly price in the
current slowdown. Hard to see 2s-10s going below 200 bps
unless the Fed tightens, which we see only in late 2012.
E Z
In the past month, Euribor futures have removed two hikes
from the December 2012 path. Unlike last month, where we
flagged this discrepancy, this is closer to fair value.
Front-end has gone from attractive to fair, but long-end is
rallying on fears of global slowdown and PIIGS risk-aversion.
This is warranted, but will be temporary. Expect steepening.
U K
Weak economic readings have strengthened the hands of the doves on the MPC, but CPI has jumped back despite
that. But there is not much room for yields to go lower.
The expected curve flattening has occurred, but longer-termbreakeven inflation rates are still attractive.
J PNeutral. Economic weakness, as LSAP will likely cause JGBs
to perform well, despite massive fiscal deficits and issuance.
We would be cautious on the long-end, as signs of recovery
or rebuilding that spurs inflation would end the deep freeze.
As investors recoil from negative real yields on hazardous “risk-free” government debt, the demand for riskier
but higher-yielding spread products will continue to surge, supporting markets across the credit spectrum.
We stick to our long investment-grade (IG) call (preferring triple Bs), hedging rate risk.
Short European credit (main, crossover and financials) outright and versus U.S. IG and high yield (HY). With
Greece on the brink and other PIIGS vulnerable, contagion to banks and to corporates via the credit channel,
taxes and austerity remains a risk.
Fundamentals versus macro: Strong earnings will power credit through a soft patch, but the PIIGS crisis and
risk aversion will put pressure on high-beta junk bonds and emerging markets (EM) corporates. Aside from
construction and financials, most sectors can shrug off a temporary slowdown and endemic unemployment.
Outlook: The Gilded and the Left Behind
After another month of almost continuous worse-than-expected economic readings, worries about the pace and
sustainability of the U.S. recovery were enough to stop the positive market momentum. However, the sell-off in
equities has been relatively minor, and spread widening miniscule as well, particularly in light of Citi’s Economic
Surprise Index for the U.S. hitting -90 and the extremely sharp 65bps rally in the U.S. 10-year over the past two
months. IG and HY spreads in the U.S. widened only 8bps and 29bps respectively, and European corporates
performed similarly.
The tone in the markets can still be described as amazingly positive, with issuance of high-quality long-term debt
as busy as ever, and junk bonds setting a new monthly record with US$45 billion-worth of deals. Chief financial
officers are evidently making the most of the low-yield environment caused by monetary policy and a degree of
risk aversion, while investor demand is being herded by Bernanke and company out of Treasurys into riskier assets
in a stretch for yield: Exactly as QE2 was advertised. Low rates, low taxes, a weak dollar: All this stimulus aids
returns on capital directly. Labor, small business, consumption and investment will have to wait for the trickle-down, but given the atmosphere in Washington and Brussels, and the decades-long trends favoring capital at the
expense of labor, one should expect banks and corporations to do far better than the rest of the economy at large.
Investors in credit can do well even as economies sputter.
Figure 1: Anemic U-Shaped Non-Recovery
Source: Calculated Risk
Figure 2: Dramatic V-Shaped Complete Recovery
Source: Bureau of Economic Analysis, Bloomberg, RGE
The outlook for the U.S. and European economies is far from positive, however. Things will continue to be painful
for overleveraged homeowners, consumers and governments, and financial institutions will also have to clean up
their toxic waste accumulated in the bubble years. Even with the growth we’ve been getting recently, assuming no
slow patches, policy mistakes or external setbacks—it won’t be until 2016 before the U.S. is back to normal (see
Figure 1). Post-crisis EM experience proves that countries with severe structural problems and high unemploymentcan be great investments and have long bull runs. As the U.S. economy only gradually climbs out of its deep hole,
CEOs and shareholders are basking in sunshine, with earnings above previous highs and still growing robustly as
U.S. and European multinationals plug themselves into the healthy parts of the global economy (see Figure 2).
Earnings season in the U.S. hammered this point home, and even European earnings continue to expand at mid-
teen rates.
Notable recent examples of how companies are making hay:
Caterpillar borrowed US$1.25 billion for 30 years at 5.2%.
Hewlett-Packard issued a colossal US$5 billion in a five-tranche deal, including coupons as low as 0.53%
and 10-year debt paying investors all of 4.3%.
B2-rated Chrysler Group, which came out of bankruptcy in June 2009, managed to raise over US$3 billion,
at spreads just over +500 bps: “High” yielding coupons of 8.00% and 8.25% for eight and 10 years.
CCC-Caesars continues to gamble on the future, trying to push out loans after swapping debt for equity
and flunking a planned IPO late last year; Apollo and TPG paid up US$30 billion in 2008 for the money-
losing casino group and geared it up to an eye-popping 16-to-one debt-to-equity; 10y CDS is a bit better
than Greece at +1030.
Future bankruptcy candidate Freescale Semi (still consistently losing money even before interest
expenses) did manage an IPO, raising around US$740 million for debt reduction after i-banks and its
private equity owners took their cuts. Its bonds were among the best performing in the HY universe.
Along with current and expected earnings, the current environment allows firms to lock in extremely low funding
costs far into the future. Eventually, rebalancing may hurt corporate profits (especially as fiscal tightening cuts
subsidies and loopholes, and raises taxes), but despite the anemic recovery and longer-term structural problems in
the U.S. and Europe, micro trumps macro: The present and the near-term outlook support our overweight of IG
and neutral HY. However, our concerns about a disorderly outcome in Greece, which would cause contagion to
remaining periphery and core alike, force us to remain underweight European credit.
In May, CEMBI underperformed EMBIG, as we recommended, and we continue to hold this view. Its HY
component was the main drag, with China and India being notable negatives, leading corporate EM spreads to
widen 25 bps while sovereigns widened just 10 bps.
We continue to recommend emerging market (EM) equity vs. developed market (DM) equity as
inflation and growth expectations become favorable.
We continue to prefer Canada, Norway and Switzerland to Portugal and Spain.
On a sector basis, we are overweight energy versus financials, but would recommend moving to a
more defensive stance through consumer staples and health care.
Swinging to Extremes
We have argued since the start of the year that global growth pricing would have to be de-rated and the latest
inflows of macro data have confirmed this, both globally and within Europe. The effects on demand of higher oilprices and the Japanese earthquake further emphasize the recovery’s fundamental weakness. Until recently,
markets have been fairly buoyant on earnings expectations and global equity markets have shared in the rally,
although not to the extent that the U.S. equity markets have experienced it. However, worrying macro data from
the U.S. and other parts of the world, including China, are starting to spook the markets. A slowdown in the U.S.
represents a near-term fat-tail risk that has started to take hold of the markets acutely in the past week,
particularly in light of the very disappointing jobs number on June 3. The markets are braced for a continuation of
historically high profit margins and buoyant earnings, but will likely not be able to hold up against the top-line
disappointment that could come when fiscal spending winds down in 2012 as we expect. The storm clouds in the
distance that we have called attention to in past CAMs are certainly gathering quickly.
All the while, equity markets in Europe have been
plagued by the ever-present fat tail of a Greek
restructuring that may or may not herald a contagion
effect that could paralyze lending across Europe. Not
surprisingly, the south has traded cheap with relief
rallies that have shaken even the highest conviction
players out of their positions from time to time. With
Spain coming under scrutiny, we have to consider the
various scenarios for policy responses and the likely
outcomes for equities. We have six general scenarios,
but for the purposes of simplicity, we are lumping the
various restructuring/default scenarios (outrightdefault, reprofiling, restructuring, Vienna Initiative-
style restructuring and expulsion) into one scenario.
Scenario 1: Bailouts Continue, Just in Time
In this status quo scenario, markets will continue to swing from optimism to pessimism and vice versa as policy
makers talk, muddle, ponder, posture and manage to continue to bailout sovereign after insolvent sovereign,
paving the way to disaster through fiscally unsustainable bailouts. With the current approach, where policy
throw in the towel on our “lesser of two evils” approach and move to neutralize our long U.S. short Europe trade
vis-à-vis banks.
EZ Banks: Lack of Options Favor Broadly Neutral Position
Recent history is difficult to ignore. Although financial regulation has moved toward eliminating the implicit public
sector subsidy benefiting banks, recent financial crisis in developed markets has followed a pattern: A lengthy
period of denial, bursts of volatility, panic and then the calm ocean of liquidity (through debt, equity, or both).
Given this recent pattern, the array of options laid at the feet of EU officials, the unique issues facing a single-
currency block and current valuations (particularly in equity), we prefer a positioning that can retain some level of
market neutrality while holding the potential for upside moves.
RGE has recommended a reprofiling of debt to soften the refinancing risk facing Greece and minimize the potential
impact on bank capital. However, given the ECB’s staunch opposition and doubts about the long-term viability of
such an approach, it seems the EU is limited ultimately to persistent bailouts, which could lead to deeper
integration or default. This does not, however, preclude debt reprofilings or restructurings in the interim, though
we fear the half-hearted approach taken to the EZ crisis thus far will carry over to such efforts.
A bailout that leads to deeper integration (or indications thereof)—a first step perhaps in the form of an EU
Finance Ministry—would favor the periphery banks, with the strongest gains accruing to issuers in the PIG, as well
as in Spain, Italy and Belgium. French bank equity would likely experience significant uplift. However, barring a
reversal of ECB policy and language, a default or hard restructuring in Greece has the potential to cause significant,
if temporary, contagion and a tightening of financial conditions as investors re-examine default risk in the EZ. The
winners of a bailout would likely be losers in a default scenario, with core banks coming under greater scrutiny.
The capital hit to core banks would be broadly manageable—either through the banks’ own reserves or in the form
of a capital call to the public sector. In some cases, these losses may already be apparent in common equity if
exposures are held in the available-for-sale book. And although German banks operate under a restructuringregime, the historical ties and effective public ownership of these entities muddies the execution waters. But the
potential read-across of a Greek default or restructuring paints a less comforting picture, which is why we find it
very difficult to believe that the ECB would stand idly by at a moment of peak contagion, particularly if core
sovereigns refuse to recapitalize their banks (a possible quid pro quo here). Otherwise, funding costs across the EZ
would rise to unsustainable levels and French officials may have to face the reality of “contaminating” the
relatively leveraged public balance sheet with extensive liquidity support for French and Belgian banks.
Non-EU European Banks: Pseudo ‘Safe Havens’
Outside of the EZ, there is a bag of pseudo “safe-haven” banks—Nordics, Swiss, UK Asians—and a sizeable group in
terms of total assets—UK domestics—that is exposed to waning revenue growth, Irish risk and Spanish contagion
(via Santander’s Abbey operation). Banks in the former group retain limited upside in both equity and credit during
risk-on phases, while banks of the latter are fairly priced given the macro and asset quality risks weighing on future
(EMBIG), as risk aversion put pressure on CEMBI spreads in
May. We hold this position going forward.
Market Review and Cross Asset Model Portfolio Review
Despite an end-of-the month rally, the majority of indexes suffered losses in May, signaling that markets were no
longer ignoring the growing list of downside risks to the global recovery. Economic reports continued to surprise
on the downside with disappointing numbers on manufacturing, home prices and job creation adding to the list of
concerning data. Equity markets retreated across the board. The S&P 500 fell 1.4%, while the DJIA dropped 1.9%.The Treasury market remained well bid amid the equity sell-off, thus pushing 10y yields to their lowest—3.038%—
this year before ending the month at 3.06%.
Updates to RGE Model Portfolio
We remove our overweight to EM inflation linkers. This brings our position on global inflation linkers to neutral to
