(Published in Spain in Cotizalia on 14th August 2011)

Beware of those that see the fall in the stock market this August as an unjustified anomaly and the rise in the past days as “a return to normal”.

We have heard all sorts of explanations for the decline in stocks except one that is coincidentally the most important and most painful:

Between the 1st and the 11th of August, according to Merrill Lynch and Goldman Sachs, we saw a systematic sale of $25 billion in stocks. Of that total, $16.5 billion were not evil hedge funds, or robotic machines or high frequency traders, but pension funds and institutions: the ‘Long Onlys’, the long-term guys. Goodbye.

Now our beloved regulators decide to ban short selling. Congratulations. Let’s put the blame for the bad restaurant food on the customer . We do not learn. We are repeating 2008 step by step. That year Europe also banned short-selling, and after a rise of 7%, it led to a collapse of 30%. Because that is when sales really start. Hedge Funds provide liquidity and short-selling is for many market participants the only way of adjusting risk on their long positions. So long positions are not added when investors cannot mitigate the risks with shorts. Simple.

If the fundamentals of the economy are not sound governments can do what they want, but intervention cannot prevent the stock market from falling. Since they can’t ban investors from selling their stocks, they look for “other measures” to generate calm, measures that create greater panic later.

The interventionist measures, from mass-buying Italian or Spanish bonds, to QE1-2, to the release of IEA crude inventories or banning short-selling, cause the same effect as shooting heroin to a drug addict. A temporary high followed by a bigger fall.

Governments are obsessed with controlling the movement of the market, either through intervention on bonds, stock markets, laws or taxes. And governments desperately want to see asset appreciation. Why? Because a huge part of private debt comes at risk if the listed securities fall by 30-40% and this would generate a new problem in the balance of “non performing loans” of financial institutions. The same institutions that governments desperately need to refinance their debt snowball.

But the effect of these injections of more debt in the economy are diminishing because the real problem, the system’s debt and low growth, increases and no government is interested in implementing measures to encourage enterprise creation and growth, because they are too long-term, while short term spending programs are more effective when one has the forthcoming elections as the only horizon. 

In a sick economy, solutions like these that are just giving alcohol to the drunk do not help, but also the immediate rush effect is dissipated faster and faster because cirrhosis is getting worse.

The future is not what it used to be, as the great composer Jim Steinman said. That’s the problem. What we have been saying in this column for two years. The forecasts of GDP in the U.S., and the Eurozone in particular, are inflated.

France published a zero GDP growth in the second quarter, Germany +0.1% (vs +0.5% expected), Greece a contraction of no less than 6.9%, Netherlands flat, Spain is on the path to ‘zero growth’, Italy as well, and the list goes on. Several banks have had to revise their estimates of GDP growth for the Euro-zone in the second half of 2011 to +0.1% (from +0.4% previously).

It is a slow but inexorable drain that leads to a conclusion that is very difficult to explain politically after an increase in debt and public spending “to reactivate the economy” of 6-7% annually, 14% annually in the U.S.. Zero growth and stagflation.

It is surprising that for 2012 we still expect GDP growth in the Euro area of +1.1% to +1.6%. And this is impossible in an environment in which the rising debt is choking the economy and in which governments have to impose much more aggressive cost cutting measures and austerity plans.

How do we repay the debt without growth?

As the Italian opposition leader, Bersani, told Berlusconi when the latter blamed speculators for the stock market nosedive: “It is not speculation. Investors are asking something completely legitimate: how will we repay our debt if this country is unable to grow? “

The problem of constant negative revisions of growth estimates would not be such if countries had not wasted so much money injecting useless stimulus funds into the economy to create more debt and no improvement in GDP. This is the Debt Saturation Model.

When the economy is sick, it is wise to invest selectively and appropriately in areas of high productivity to generate a positive GDP effect, but this effect decreases rapidly as countries abuse of the formula. And boy has it been abused. According to Roubini, 78% of money spent on the so-called stimulus packages implemented in Europe has not produced any improvement in GDP. More importantly, the vast majority of that money has been wasted in low productivity areas, ghost airports, unused infrastructures, subsidising the automotive, construction and cinema industries, let alone to rescue bankrupt countries. Like a heavily geared company that invests its meagre cash flows in low ROIC businesses, the debt hole grows.

Countries in Europe have created an enormous debt burden with no GDP boost to help pay for it, so the solvency of the system suffers because it does not generate revenue for the state or growth.

And here’s why the stock market nosedives. If GDP is stagnant, debt cannot be repaid, leverage goes up, and austerity measures will be more severe, which in turn delays the recovery even further. And stocks values ​​fall because the equity risk premium rises.

Intervention doesn’t work. Didn’t work. And will not work. But for those still tempted to do it again, this time, unlike in 2007, the weapons of States to “intervene” markets are fewer and weaker. Then, interest rates were 5% (now close to zero), the economy was still growing (not anymore) and the debt was much lower (Spain, France, Italy were in surplus).

European governments have ignored the effect of government debt on the real economy

While the European Union was struggling to extinguish the fire of Greek bankruptcy and the debt crisis of the peripheral countries, the multiplying effect of risk was in motion . In fact, by troubleshooting debt with more debt (heroin to the addict) and convincing themselves that their debt to GDP was not as high as the U.S. one, governments have accelerated the evaporation of liquidity available for the real economy in the banking system . That is, while the cake of GDP was reduced and the burden of debt grew, Europe went from a solvency problem to a possible liquidity problem. By focusing on State debt and feeding the credit monster, governments have virtually wiped-out small businesses and mid sized enterprises.

If we also note that European banks have in most cases more than 100% of their core capital in sovereign debt, then the risk in the balance sheet of banks is that, unless countries take urgent measures to reduce absolute total debt, banks will have to take more provisions for sovereign risk and liquidity available to the system and the real economy will be even lower.

This multiplying effect of sovereign risk is passed to companies, their financing costs and therefore, stock market valuation, because the average cost of capital (WACC) rises.

Does anyone remember that between November 2008 and March 2009 some very solid single A rated and large companies had to refinance their debt at 320-360 basis points above mid-swaps due to the lack of liquidity in the system caused by the huge ball of sovereign debt?

If 100% of Societe Generale’s “core capital” is sovereign debt and for any reason there was a new State problem of liquidity, it would have an immediate impact on the real economy (“shrink lending”) and the financing of French companies. In Italy, UniCredit has 121%, in Intesa 121% in Spain between 76% and 120% … and that’s assuming that all urgent refinancing needs are covered. European states have in excess of €250 billion short to medium term maturities.

So the cake of GDP is shrinking, the snowball of debt is rising and the financial system is draining its liquidity. Add lack of confidence and the cocktail is explosive. European banks have deposited €120bn in the ECB this month,  the interbank market is drying up and that could be a sign that banks don’t trust each other.


(Data: Boombust.org)

We must curtail the spiral of debt

In addition, the European Central Bank checkbook is not as wide and in any case, such checks are going to be paid by the real economy in cuts and taxes. In July, the Spanish banks increased the use of credit lines of the ECB by 10% to € 52 billion, the Italian banking increased by 95% to € 80 billion, France followed suit in € 2.3 billion. The cake is reduced and the ability to stop fires is diminishing.

We can blame whoever we want for the stock market reactions, but to the recent comments blaming speculators I would say:

– Who is more of a speculator than a government which provides estimates of GDP and deficit that are not going to be achieved?

– Who is more of a speculator than a government that wastes the future revenues of an entire generation on short-term-no-growth spending?. As an example, every new child in Spain, Portugal or Greece is born with €30,000 (average) of debt.

– Who can demand long term investment commitment when all policy decisions taken are for the short term?

– How will governments solve the snowball of debt in Europe when many political parties, unions and social agents claim that more spending is needed, and therefore more debt?

A year ago I commented a few points that I think are worth remembering today, because they are relevant again:

“The market is wary of the macroeconomic environment, following continuous downward revisions of growth forecasts and increases of the deficit of the Euro-zone countries, yet without a clear environment that promotes economic growth. On the other hand, the market does not trust the estimates of earnings and balance sheet structure of companies, however big or strong they are. ”

In Europe, in the second quarter, over 48% of companies have published in-line or lower results than expected, but more important is that the majority (80%) has revised down or avoided to comment on future prospects. 35% have cut dividends. And the worst, 86% of companies that have reported have not improved their debt using free cash. Only through divestments. So if the problem of sovereign debt spreads on banks, companies can suffer another black winter of liquidity as in 2008.

The current market is “a bad investment and a good bet” . Investors have very little visibility for long-term investment decisions . And that increases the volatility and equity risk premium.

Further read:

Euro Crisis, CDS, The Market Doesn’t Attack. It Defends Itself.

http://energyandmoney.blogspot.com/2011/08/euro-crisis-credit-default-swaps-market.html

Graph above shows Italian 5 yr CDS.

I look forward to the day when I hear “risk premium rises because institutions can no longer absorb more debt than they already have”.

As in 2008, the blame now is placed among hedge funds . And wait, soon we will see European governments or the ECB making interventionist decisions. Ban Credit Default Swaps. Or ignore rating agencies. Kill the dog to get rid of the flees. Blame the customer for the restaurant food. Does anyone remember what happened in 2008 when Europe banned short positions? The market plummeted another 30%. Because that is when selling REALLY starts. So far it’s only protection seeking. Trust me.

96% of the market for sovereign CDS (credit default swaps or the cost of insurance against a default) is absorbed by the European largest institutions, most of them country “flagships” or semi-state-owned entities, who are flooded with  €250 billion of European sovereign bonds in their books. These entities, from DB to SocGen, the Spaniards or the Italians, seek protection and can not sell because of low liquidity, there are no buyers, and in any case they will receive the call to participate in the the next auction of debt. With a problem. The purchasing power is reduced by saturation, but also due to the increasingly stringent requirements of core reserves… While at the same time refinancing needs of indebted states are increasing. According to JP Morgan, Italy will have liquidity problems in September, and Spain in March 2012.Hedge funds don’t attack. We would be happy to invest against the rise of the risk premium if it were not justified . But that is not the case. The trend is clear and normal. It is re-evaluating sovereign risk. A sovereign debt that for decades we have been told had no risk. As the swindle of “house prices never go down.”The sovereign debt crisis has many similarities with the housing bubble. An “over-priced” asset (in this case sovereign debt, regarded as an unwarranted risk-free asset), a brutal increase in inventory (all countries issuing, using pension funds, domestic banks and social security to buy more debt) and a bubble burst, when borrowing capacity is maximized. At the same time, the pool of capital allowed to invest in sovereign debt evaporates as the CDS rises and the cost of borrow rockets, because most fixed income investors cannot take the risk and volatility implied by the high yield sovereigns.

The end in this case, as in the sub-prime crisis (read “The Big Short”) is the same. A devaluation of the underlying asset (sovereign debt) and an appreciation of its risk factor according to real actual demand and true likelihood of repayment. 

Countries and institutions thought the CDS market, $60 trillion, was more than enough to ensure credit risk. Why? Because they only thought there was risk in corporate bonds and, therefore, the sovereign debt market would not need large default insurance contracts. That was OK until countries started to issue debt like crazy, creating a huge bubble of bonds that are almost impossible to insure, while at the same time GDP growth stalled and unemployment rose. And who takes the risk to insure this debt while state banks and credit institutions are struggling to remove themselves of their debt hole?

For those who blame the wicked capitalists, do not forget that over 50% of the Spanish financial system is public, the saving banks, and in Italy, Portugal and Greece the percentage is also in the region of 50%.But let us review the elements that make the snowball grow, despite the “messages” to calm the market, because actions, I must say, few. In Spain, Italy and the peripheral economies they have not implemented many of the measures announced with great fanfare.1) The precedent of “stress tests” in which banks have taken significant haircuts in the valuation of their assets, has proven to be self-indulgent and inadequate, but also has shown to the eyes of the public the very low core capital of the institutions, particularly the semi-state-owned ones.

2) The rating downgrades, which no one in any government expected, are a reality. The agencies have taken two years to reflect on their “ratings” what the market already knew. The economic fragility of the indebted countries. And its is not the “evil doings of Anglo-Saxon agencies attacking the poor European countries with imperialist tactics” as some politicians say. It is rather the opposite. Rating agencies have been monstrously generous in the past.

3) The successive bailouts of Greece and Ireland have left the financial system without “gunpowder” to address similar risks in other countries, but also these bailouts have weakened the balance sheets of the entities that hold the bonds.

4) The optimistic estimates of growth and deficit reduction . Each month we see new revised estimates of GDP in 2012. And they are too optimistic. The IMF indicates that Spain, Portugal, Italy and Greece will not meet the government forecasts of deficit for 2014. Spain will be at -3.9%, versus a target of -2.14%, as growth will probably be very low. If GDP is not growing, unemployment rises, funding costs rocket and debt goes up.But what is more important, without measures to incentivize  job creation and support entrepeneurs, government revenues will be eaten by interest charges and costs that do not generate any return (GDP). Some call these costs “social” but they are just borrowing from our children’s future income.

While governments gave themselves pats on the back on the success of the last auction of sovereign debt, no one wrote the headline “the latest debt auctions have only been covered by domestic institutions.” Foreign entities were flying away from peripheral sovereign debt (see graph above, sorry it’s in Spanish). And while Southern European leaders took advantage of their last months in office before an election debacle to sink the economy of their regions by increasing the debt by 43% amid economic pre-stagnation, the states were dangerously close to a level of risk country that is not acceptable for any investor. Today, the premium  that Spanish ten year bonds have to offer for investors to buy them instead of German bonds is up to 6.2%. Italian one is 5.8%. If Spain or Italy reach the 7% level, many institutions simply will not be able to buy them for being too risky. The pie of available capital for investment is not only smaller and with more countries stalking it, but some countries will simply be unable to access a part of it.

The warning signs have been there since 2008 . Many of us have said this in writing. Meanwhile, the system has continued to sink into debt at a more expensive interest rate each time, while no one cared that almost 60% of peripheral countries’ state revenues are used to pay interest expenses. This year, the cash deficit reached by Spain will be 14.5 billion euros. The balance of income over expenditure is negative before paying interests.

And now governments demand cheaper and more credit when they are borrowing money to cover interests only. No capital. The result is that after the cuts already announced, peripheral countries will need a spending reduction of 30% to cover the cash deficit and interest. “Blame it on the wicked investors” who have the fastidious desire to recover their investment and request an interest that is appropriate to the risk. Outrageous.

The market, that evil entity that causes so much hatred among interventionists, reacts because it has been lied to. And reacts by selling equities and seeking protection on bonds.

Do the interventionist European States want to get rid of the alleged “dictatorship of the markets” that they claim is the problem? Perfect. Do not allow leaders to borrow again like crazy. No more deficit and they will not have to worry whether the blame is of hedge funds , Merkel, Fitch or the new U2 tour.

PS: Pier Luigi Bersani, Italy’s opposition leader said to Berlusconi on Wednesday: “it’s not speculation, it’s about investors and our creditors that don’t trust us any longer”. “Investors are asking a legitimate question… how can these guys pay their debt if they don’t grow”

Further read:

European crisis, falling demand more debt

http://energyandmoney.blogspot.com/2011/07/european-crisis-falling-demand-and.html

I write to you this week from Oman. Impressive country, producing 900 thousand barrels of oil a day, and 9% of GDP from oil revenues, which finances amazing investments in infrastructure and civil works from Musqat to Salalah and other cities that are downright impressive.

As a country, it’s an example of how different the countries of the area are, despite the Western media efforts to put them all in the same basket of so-called risk of Egyptian contagion.

Another week and now that the Egyptian crisis has been solved, the market continues to focus on that country and the risk involved in the Suez Canal for crude supplies. And there is no real risk. The importance of the Suez Canal for the transportation of crude oil has fallen sharply in recent decades. During the 60s and 70s, almost 10% of global oil traffic passed through the canal. Today, it’s less than 1%. Moreover, as the three largest companies working in the channel say, the traffic is roughly balanced, with 55% of oil on ships heading north (992 thousand barrels/day) and 45% (about 850 thousand barrels/day) due south. Any problem in the Canal is, first, negligible for the transit of oil and, second, very easy to re-route around the Horn of Africa, an increase of transit time of less than 15 days.

For those who care about Egypt and the Sumed pipeline, just remind them that it only moves 1.1 million barrels per day despite having a capacity of 2.4 million barrels per day. And as a good friend of EGPC told me, there are few safer places than this pipeline, where the army has more troops than any city in the country except Cairo.

And in this environment we find the Brent and WTI spread at historical highs. Two clear effects: first the inflationary impact on Brent added to the deflationary impact on WTI to create the largest differential between the two ever seen: $14.5/bbl. Also very wide differential relative to other crude, Bonny Light (Nigeria), in particular, and Asian Tapis.

Let’s start by explaining what justifies the weakness of WTI:

Inventories at Cushing (at Oklahoma) are at historically high levels. 50% higher than the average for the past five years (25022). The problem is that the WTI weakness shows the growing isolation of the North American market and infrastructure problems to evacuate excess oil.

WTI crude trades on the basis of inventories at Cushing, in the middle of the American continent, and it is hard to move oil out of the area (called PAD II) or the large refineries on the Gulf.

1) There is enough transport capacity to carry crude from the Gulf to the center of the continent, but not vice versa. The fact that the Enbridge pipeline has had problems has increased the glut of crude in Cushing.

2) There has been an increase in exports of crude oil (oil sands) from Canada to the U.S., which increases the overcapacity in Cushing. Transcanada launched the second phase of its Keystone pipeline, which attracts even more crude to Cushing bottleneck.

3) The increase in U.S. domestic production, including Bakken, is also filling the stores in Cushing. The over-production in the U.S. is partly because the gas companies take advantage of high oil prices to produce more natural gas liquids, whose price is close to oil, in order to fund production of natural gas which today at $4/mmbtu, is not giving the best economics, actually very poor returns. Therefore they compensate for the low profitability of the gas with the price of associated liquids.

Add the fact that three refineries have been closed for maintenance, and we have the perfect storm. Excess production of high oil prices, withdrawal of the American system because of lack of infrastructure, and reduced refinery demand .

Meanwhile, Brent is affected some powerful inflationary forces:

1) The decline of production from Norway and North Sea, that previously functioned as a cushion against price increases, and does not produce that effect anymore.

2) The increase in OPEC oil transit to Asia, and rising domestic demand in exporting countries have reduced the oil for export. Saudi Arabia expects to increase its exports by 1 million barrels per day, but, for now, demand does not justify it.

3) The perception of geopolitical risk and the effect that we mentioned of transport cost increase. The market assumes that the cost of transport must rise. We are already seeing freight day rates recover, particularly in the VLCC segment, as I commented with Oman Oil. Having seen the Baltic Dry Index tumble to record lows due to excess spare capacity of ships, we could start to envision a horizon of recovery. Very gradual, and certainly not to be bullish, because overcapacity still exists (especially in the Capesize and Panamax segments.) And if freight costs rise, the chance to evacuate American crude to Europe is reduced.

As I mentioned two years ago on the differential between gas (Henry Hub) and oil, it is very dangerous to play against a very clear structural effect of isolation of a market, the American, in which the administration has no intention of promoting improvements in the system, and as a result, crude oil and domestic gas (WTI and Henry Hub) at lows is a clear boost from the country’s competitiveness.

Further read:

http://energyandmoney.blogspot.com/2010/01/revolution-of-shale-gas.html

http://energyandmoney.blogspot.com/2011/06/iea-releasing-strategic-reserves.html