20110712 Unintended Consequences 12[1].07

8/6/2019 20110712 Unintended Consequences 12[1].07

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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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20110712 Unintended Consequences 12[1].07