Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Default Gambling: Markit Launches New Sovereign CDS Indices as Government Debt Levels Surge in 2009

Montreal, Canada

The explosion of global sovereign debt issuance since last year combined with a marked deterioration of public finances has fueled a new market for betting against governments bonds. And that’s great news for aggressive investors because before this credit unwinding is over several nations will default on their sovereign debt obligations.

The enormous weight of this financial crisis has caused severe damage to balance sheets in many regions but most notably in the United States, Western Europe and especially in the emerging markets of the Baltic Republics, the Balkans and Central Europe. The odds are high that one or more of these emerging market sovereign issuers will default over the next 12-18 months. Unlike the West these countries simply don’t have the capacity to spend their way out of economic misery.

The International Monetary Fund or IMF has already bailed-out several countries – Ukraine and Hungary among them – but it’s highly unlikely the lending agency can forestall every default once a major issuer in a region triggers a chain panic reaction. I’m convinced we’ll see a credit default in Central Europe before this credit unwinding is over.

Sophisticated investors can now place bets buying credit default swap indices (CDS) that speculate on sovereign government defaults in major and emerging markets following the creation of the first tradable indices tracking the risks of countries defaulting. Credit default swaps – chastised by George Soros – are used as insurance against a bond defaulting.

Markit, the service-provider, is launching four CDS indices today including the iTraxx SovX Western Europe Index and the Markit iTraxx CEE-MEA Index. The latter looks especially appealing because it includes Central European and Middle East countries – both regions that are vulnerable as debt financing bleeds them dry. The other two indices are based on a group of industrialized countries (G-7) and a diversified basket of credit default swaps speculating against issuers in Europe, Asia, Latin America, the Middle East, Africa and North America.

Another sector that extremely vulnerable to refinancing is the U.S. junk bond market. This asset class is now in a “bubble” following a 35% rally since March and a crash in credit spreads. The default rate, currently at 7% through May, is probably going to double before it bottoms in this economic cycle; I highly doubt investors have discounted a 14% or 15% default rate ahead of $950 billion dollars of refinancing coming due from now until 2014 for high-yield bonds.

In the next issue of The Sovereign Individual I’ll be betting against junk bonds with a fury.

This is not a normal economic cycle and credit deflation remains a central theme over the next few years as governments, companies and consumers alike struggle to raise capital.

Surging U.S. Savings Rate a Bad Omen for Stocks

On Friday, data confirmed the rising trend among Americans since Q4 2008.

For the first time in almost two decades, Americans are saving again and becoming frugal following a decade of reckless spending, massive debt accumulation and mortgage speculation.

The U.S. national savings rate as a percentage of disposable income rose to 6.9% in May compared to 5.6% in April and almost zero percent just 12 months ago. Though consumer sentiment has improved since March when fears of Great Depression II were becoming a possibility amid a market freefall, confidence remains well below its all-time high in January 2007.

Compared to other major economies in Europe, however, America’s savings rate is low.

In Germany, savings as a percentage of disposable income is at 11%. In Canada, America’s largest trading partner, the savings rate has risen to 12% recently. Clearly, the trend among consumers in the world’s largest economies is to sock away savings following a brutal decline in personal assets since 2007. And that’s bad news for domestic consumption and corporate earnings.

Historically, the relationship between a rising savings rate in the United States and corporate earnings has been poor. The last bout of rising consumer savings in the 1970s resulted in the second worst bear market for stocks (1973-1974) followed by volatile equity markets that basically ended the decade where they began; adjusted for soaring inflation, stocks finished the decade much lower.

The big difference between the boost in consumer savings since late 2008 and the 1970s is the monumental shift in interest rate deposits. Thirty years ago, a consumer could stash away cash at 12% or more; today, interest rates remain at their lowest levels since the 1950s prompting many savers to consider lunging after riskier strategies that yield more than just 0.5% or less in staid savings accounts. That’s what the market wants – more liquidity tired of earning near-zero percent interest.

Low rates will continue to attract more money from savings to riskier investments. But the trend is likely to be much more subdued compared to 2002, 1994, 1990 and 1982 when previous bear markets resulted in typical recoveries for financial markets. This is not a “typical” recovery; the unemployment rate is still rising (9.4%), housing markets have not stabilized and consumption is now largely in the hands of the government through fiscal spending. Finally, the expansion of bank credit in this cycle won’t be similar to previous post-WW II expansions. Banks are not lending.

With Americans finally turning thrifty again it’ll be interesting to see how meaningful corporate earnings can recover over the next six months. If consumers aren’t spending then it’s a pretty good bet that earnings expectations are too way optimistic.

Curious about China’s Dollar Sabre-Rattling

Montreal, Canada

In the absence of a major stock market decline or another financial institution blow-up this summer it’s probably a safe bet to start nibbling at foreign currencies again.

The U.S. Dollar Index (see enclosed chart) broke important support levels last month but is now oversold on a short-term basis. Any dollar rally at this stage of the economic cycle should be tepid at best. The economy is stuck in a de-leveraging process that will take a few years to unwind coupled by scant bank lending in an environment of cash hoarding. This is not a macro environment that will boost U.S. short-term interest rates any time soon.

The United States and probably China, to some extent, desire a weak American dollar to boost domestic inflation. U.S. CPI is still contracting and in May declined for the third straight month to its lowest level since 1955. A lower dollar helps to grow inflation – a desperate commodity right now.

This morning, China launched another currency salvo claiming the world should look “for alternatives to the U.S. dollar.” Such utterances won’t boost the buck but instead likely help facilitate a decline. Interesting how China would slam the dollar when she holds about 35% of all Treasury bonds in circulation.

On Tuesday, I began buying small positions for my managed accounts in Canadian dollars and Norwegian kroner. Gold remains 5% of my portfolio for now.

Though I remain cautious about commodities this summer, including oil and gold, I like the CAD and NOK currencies because of their relatively stronger balance sheets; Norway, in particular, smarts a 10.5% budget surplus-to-GDP ratio – the highest among industrialized nations. This compares to rapidly rising or skyrocketing budget deficits across the major economies since late 2007. And Canada, though now in budget deficit, sports a small deficit compared to its overall economy.

What about the euro? The single European currency is probably better than the dollar but not by much. I prefer gold, NOK and CAD.

Several peripheral euro-zone economies are now in deflation and major trading partners to the East are in desperate need of bank capital. I’m still predicting some sort of blow-up in the Baltic Republics or the Balkans this year. Any macroeconomic collapse in these regions will hit the euro and the emerging markets new “bubble” hard.

The precious metals should rally if the dollar continues to weaken. But, like I said earlier, I’m just “nibbling” at foreign currencies here to build fresh positions that are part of a long-term accumulation strategy for my dollar-based accounts. Any sell-off in risk-based assets this summer – highly likely ahead of earnings guidance and a 40% post-March rally – will drive the dollar higher. That’s when I’ll add to my existing foreign currency holdings.

Gold and silver, however, remains hostage to traditional summer weakness in the commodities complex; gold is especially vulnerable near-term because jewelry demand has collapsed and any outflows from gold-related ETFs will drive the price sharply lower. I’m looking to re-enter gold around $875 to $850 and silver around $14.

It strikes me as fascinating that China is denouncing the dollar again. Something is cooking in Beijing and Washington whereby policymakers probably welcome a weaker dollar.

This should be another very exciting summer marked by renewed volatility, especially in the currency markets, which have been largely range-bound for the last four weeks.

Have a good weekend. See you on Monday.

Next Chapter of Banking Crisis Unfolds as Credit Card Securitization Threatens to Unravel

Montreal, Canada

Credit card securitization is the new dirty phrase in mid-2009 as banks face an avalanche of bad loans tied to consumer loans that were aggressively sold to investors as individual securities prior to the credit crash almost 24 months ago.

Major U.S. banks are now coming to the rescue of their off-balance sheet vehicles tied to credit card securitization or investment products linked to consumer loans. This marks the next chapter of the ongoing financial crisis tied to the explosion of credit that started in August 2007.

Though the worst of the financial crisis appears to be behind us since March, the real economy remains mired in the worst contraction in GDP output since the 1930s. We’re still in the midst of a severe downturn marked by the lack of credit expansion, tepid consumer borrowing, rising unemployment, a housing bear market and a plunge in domestic consumption. Now the credit card world is starting to rip apart at the seams.

According to Moody’s Credit Card Index, losses on U.S. credit cards rose beyond 10% of total loans outstanding in May – a new high in the 20-year history of the benchmark and the sixth consecutive monthly decline. Banks, however, are not obliged to support these structured pools that are sold to investors; but in order to keep the market funded and creditworthy banks continue to pump the necessary capital into what appears to be a wave of growing losses.

Amazingly, like the Fed, which has purchased Treasury bonds and mortgage-backed securities since last November to keep rates down, some banks are buying back their own debt to maintain liquidity and transparency. This form of monetization or buying back bank-issued credit card securitization products can’t persist indefinitely if the market deteriorates further; the Fed can print money – banks can’t.

Since hitting a multi-decade low in early March the bank stocks have more than doubled. But since mid-June the sector is starting to waffle again as it breaches its 200-day and 50-day moving averages (see enclosed chart). Meanwhile, senior bank debt continues to rally over the last three months with credit spreads tightening markedly since May. This price action is not indicative of bank balance sheet stress or fears of renewed losses tied to credit card securitization; it does, however, imply that perhaps the market has already discounted a fresh wave of losses tied to credit card securities since banks have been warning about these impending losses for months.

Still, the market might have incorrectly discounted a modest level of credit card securitization defaults. The trend in this market in getting much worse as losses begin to exceed analysts’ expectations; the bank stocks, in my book, should be viewed like the stock market as one big trading opportunity whereby investors sell the higher end of the ranges and buy the steep declines. Bank balance sheets are still battered.

Maersk Warning Sheds Bearish Signal on Global Shipping

Denmark’s AP Moller-Maersk, the world’s largest bulk cargo shipping company, provided some important insight on the future direction of trade-flows on Tuesday. The news sheds bearish light on the absurd rally in the Baltic Dry Index and other industrial metals, including crude oil.

The Baltic Dry Index is a daily average of prices to ship raw materials. It represents the cost paid by an end customer or user to have a shipping company transport raw materials via ocean-crossing on the Baltic Exchange -- the global marketplace for brokering shipping contracts.

Maersk’s CEO said cargo volumes would drop by as much as 10% this year and will show no signs of growth in 2010. That statement defies the spectacular rise of the Baltic Dry Index since last winter following a stunning 97% crash last year.

Since hitting a multi-year low in December, the Baltic Dry Index has surged 484%; but since hitting its highest levels in 2009 earlier in June the index has declined 20%.

If Maerk’s CEO is warning of flat or zero volume growth over the next 18 months then it would seem logical to conclude that most commodities and other cyclical sectors of the marketplace have largely overextended their post-March rally. I could argue some commodities like copper and oil, for example, are in a mini-bubble.

Companies won’t be aggressively rebuilding inventories this year; the market has discounted any inventory accumulation and much more at this stage of the economic recovery, which will be extremely sluggish because of the enormous debt overhang still plaguing the world’s largest economy – the United States.

As for China and her great economic rebound, it would seem misguided to argue that she alone can salvage the world economy in 2009. The Chinese don’t aggressively accumulate commodity inventories amid high prices; rather, China builds her raw materials stockpiles when prices crash or decline.

The Baltic Dry Index appears to be forming another top. And judging my Maersk’s comments last night in Copenhagen, this rally is about to roll over.

Cashing in on Conventional Wisdom, Part II

From a credit perspective, the emerging market bond sector is the most compelling short speculation over the next few years. And Brazil, the largest debt issuer in the sector is now not only rated investment grade but also widely believed to be the next super economy this century as resource revenues continue to fatten its foreign exchange reserves and drive massive foreign direct inflows into Latin America’s largest economy.

Brazilian debt isn’t alone in “bubble” territory. Other credits in the region are expensive and many others in Eastern and Central Europe will probably default before the deepest economic recession in more than 75 years leaves them in ruins.

Is Brazil invulnerable economically? How about China, India or Russia?

It’s incredible to find credit spreads for emerging market bonds at just 430 basis points or 4.3% above Treasury bonds; prior to the big collapse in late 2007, the J.P. Morgan Emerging Market Bond Index saw its spreads collapse to barely 200 basis points over Treasury bonds before widening amid a credit crash in 2008.

About twenty years ago former U.S. Treasury Secretary, Nicholas Brady, launched a series of dollar denominated debt to help Latin America out of its economic malaise. Dubbed “Brady Bonds,” these instruments helped Brazil, Mexico and other countries out of the economic abyss. Can the same event repeat itself? Inflation went out of control in Latin America in the 1980s resulting in defaults, devaluations – you name it.

Now everything with an emerging markets bias is skyrocketing again – just like in 2006. This is especially true in South America – the best performing emerging market index since 2000 and up a stunning 43% in 2009.

Brazilian credit spreads have tumbled to 290 basis points (2.90%). Other regional economies have also seen spreads tighten, including Peru (260 basis points), Mexico (227 basis points) and Colombia (319 basis points). Argentina, which remains an economic pariah, is the lone black sheep with spreads at a whopping 36.9% above T-bonds.

I find it hard to believe that Brazil, yet alone Colombia and Peru deserve spreads under 400 basis points above Treasury bonds. It’s almost ridiculous. Basically, investors now believe that emerging market bonds are almost the same credit risk as Treasury debt or even German bunds.

At some point, eventually, emerging market bonds will witness an unprecedented crash. Whether this collapse lasts months or years is hard to forecast; but it does seem plausible that if commodities prices head sharply lower again or if China’s seemingly amazing economic rebound falters that spreads will surge overnight. Perhaps a sovereign debt default in Eastern Europe might spell the end of the boom. Herein lies the Black Swan.

If an asset class is invincible and almost impossible to bet against then the odds of making big bucks from a sudden reversal in the primary trend are spectacular. It’s only a matter of time until conventional wisdom is defeated in the emerging market bond sector. When that happens, I’ll be there.

Learn more in the upcoming issues of The Sovereign Individual and how to profit from one of the greatest speculations since the Great American real estate crash two years ago.

Cashing in on Conventional Wisdom (Part I)

How many investors shorted technology stocks in the late 1990s ahead of the bust in March 2000? Alternatively, how many speculators bet against bank stocks in 2007 ahead of the historical crash in financial services companies? And how many investors wagered residential real estate prices would collapse ahead of the peak in the summer of 2006?

Betting against conventional wisdom is a risky proposition. After all, investors generally feel more comfortable in a crowd buying the same assets that are appreciating; we’re conditioned to buy en masse and naturally feel comforted by a rising trend that enriches our bank account. Then the Piper comes calling like he always does when a speculative “bubble” finally draws to an ugly end.

As we shortly conclude the half-way mark in 2009 I’m asking myself where can an investor make money betting against conventional wisdom? In other words, which sectors are seemingly in a speculative “bubble” and absolutely accepted by the masses?

Since the market low on March 9 it’s almost like investors have completely forgotten about the financial crisis. Did it ever exist? Judging by market benchmark performance, mutual fund inflows and investor consensus, the good ole’ days are back.

One sector has gone “punch drunk” since March and deserves a closer look.

My favorite by far is betting against emerging market debt – the best performing fixed-income sector since 1992. Though it might be too early to wager against this booming asset class the payback will be spectacular once a Black Swan, or an unknown event, finally debases this formidable trend.

Over the last three years a host of emerging market economies have been the beneficiaries of credit rating upgrades by Moody’s, Fitch Ratings and Standard & Poor’s.

Only a decade ago many of these same countries were a basket case – including Russia, which defaulted on its foreign debt in 1998.

Driven by the bull market in raw materials this decade the emerging markets are now the flavor of the year as over 50% of stock market revenues in this sector are derived from natural resource exports – namely oil. Soaring commodities prices since 2002 have catapulted this asset class to the Big Leagues; this undeniable trend is confirmed by the famous acronym developed by Goldman Sachs earlier this decade – the BRICs or Brazil, Russia, India and China.

It almost takes an unlimited pool of capital or a lack of scruples to wager against the BRICs in 2009 – yet this Black Swan has a big payout should it materialize.

Stick to Income, Cash amid Rising Euphoria

Don’t feel compelled to buy stocks now.

Though the economic news lately has been “less bad” compared to just several months ago, the economy remains badly fractured and still heavily reliant on government life support. Several important credit markets are still largely dysfunctional and the entire yield curve on Treasury securities has surged since May making the prospect of recovery more uncertain.

The government is also in the process of revamping financial regulations and securities laws – similar to what occurred during the 1930s. This effort is laced with great uncertainty because nobody really knows how policy will affect the banking sector and the future of profitability.

Earlier this week, Dow Theory flashed a warning signal as the Dow Jones Transportation Average failed to confirm the Dow Jones Industrials Average – meaning, a major divergence has occurred in this market rally since March 9. Both averages must confirm each other if this is truly a new bull market.

I’ve argued all along that although March did represent a good opportunity to buy battered stocks, it wasn’t the bottom of this economic cycle. I remain adamant that the United States won’t muster a typical post-WW II expansion because of tight credit, tepid domestic consumption and rising unemployment. These trends have not improved over the last twelve weeks and challenge conventional wisdom surrounding “green shoots.” Basically, the government can’t act as the consumer of last resort through fiscal spending indefinitely; organic domestic consumption will remain impaired for years.

The markets gravely underestimate the effects of a severe credit-inflicted bear market with participants bullish on the economy and earnings without understanding the consequences of credit expansion or in this case, the lack of credit growth. Bank lending remains anemic and if it doesn’t grow soon the Federal Reserve will probably have to make loans directly to cash-starved companies and even consumers. That’s not the ideal macro scenario for a sustainable rally in risky assets.

Ahead of corporate earnings guidance later this summer, it’s hard to envision a swift earnings recovery. Investors have re-embraced risk all too quickly since March with emerging market stocks skyrocketing on the heels of a commodity recovery and the dollar heading sharply lower since May. Let’s not forget that companies will once again find $70 oil and possibly, $80 oil a major headwind to earnings growth.

Junk bonds, in the midst of a “bubble” ahead of almost $1 trillion dollars of refinancing coming due over the next five years are severely overbought considering where we stand in the credit cycle. Also, credit spreads for most emerging market bonds are ridiculously narrow --- barely 400 basis points above Treasury bonds. Some countries, like Brazil, are clearly in a “bubble” with everything Brazilian surging over the last seven years, including the real currency, bonds and the BOVESPA.

Markets are now obsessed with inflation – a monetary phenomenon that’s inevitable as a result of unprecedented fiscal spending and bank bailouts in the United States and Europe. True, inflation will make a violent comeback over the next 36-48 months as the United States attempts to print its way back to prosperity.

But there’s a problem believing inflation will rear its ugly head soon.

Several important indicators are NOT flashing inflation.

Of these, TIPS or Treasury Inflation-Protected Securities have declined over the last few weeks – a sign investors aren’t paying for inflation protection. Also, gold prices have declined about $60 off their best levels last month while wages are on the verge of turning negative. Finally, the Dow Transports should be hitting new multi-month highs if inflation and pricing power was truly making a recovery since this index is a leading economic barometer of cyclical expansion.

I’m sticking to convertible bonds, investment-grade bonds, TIPS, Canadian investment-grade debt and increasingly looking to add bear market indexes tied to junk bonds, emerging market bonds, stocks and the VIX. I hold little or no equities, except the biggest food and beverage companies, some renewable energy and gold stocks.

We’ve come a log way since March but investors have underestimated the economic environment – still heavily impaired by a lack of bank credit growth and poor loan demand. Inflation won’t grow under these circumstances and corporate earnings have little or no pricing power to justify current multiples, which by the way are not cheap after a 50% rally for the MSCI World Index since March 9.

Have a good weekend. See you on Monday.

Accelerating Deflation Handcuffs Ireland

Deflation or an environment of falling prices has not only hit Ireland but threatens to morph into runaway deflation following the latest report on consumer prices.

Ireland’s consumer price index fell 4.7% in May from a year ago – the sharpest contraction across Europe and the worst in Ireland since 1933. Though not as chronic as Ireland, consumer prices have indeed turned negative in other Euro-zone countries since March.

In the United States, consumer prices turned negative in March for the first time since 1955. In May, CPI actually gained but remains down 1.3% over the last twelve months.

Deflation is now attacking a handful of industrialized economies in the West as a combination of soaring job losses and declining wages put pressure on consumer price data. Since late 2007, a blitzkrieg has walloped consumer balance sheets, including plunging stocks and real estate – the largest assets defining personal wealth.

Ireland has been a model for low corporate taxes, high productivity and a booming financial services hub for years until the property bull market collapsed about eighteen months ago. There’s no doubt that Irish real estate prices went overboard over the last decade and were long overdue for a correction or worse. In May, Irish mortgage-interest costs fell 42.4% on the year.

Economists expect unemployment to reach 17% by the end of 2010 while the country’s budget deficit is skyrocketing – a consequence of financing a bailout of the Irish banking sector last fall. On a per capita GDP basis, no other country has greater bank liabilities than Ireland.

Along with the Italian, Greek and Portuguese economies, Ireland is now a drag on the euro. Credit spreads for weaker euro-zone members have indeed compressed since March but remain historically elevated since the creation of the euro in 1999.

Though it’s highly unlikely Ireland will exit the euro-zone, that strategy might be the quickest avenue to recovery because of its inflationary consequences. That’s what the United Kingdom and Italy did back in September 1992 when they quit the ERM or the European Exchange Rate Mechanism – the euro’s predecessor. Yet the cost of financing Ireland’s enormous fiscal spending packages would also surge and that would not help the country.

Deflation, not inflation, remains a primary threat to global markets. It’s still premature to be concerned with inflation. The destruction of credit lingers in the West as most banks continue to hoard cash. Deflation still rules the landscape.

“Gold to Go” Vending Machines Hit Germany

Germans will soon be able to buy gold in vending machines across the country the same way most people purchase a chocolate bar or a soda. That’s not the sort of bullish development that’s conducive to new highs for the gold market – at least not for now.

Germans, however, don’t trust paper money and have a long-term relationship with gold stemming from the collapse of the economy under the Weimar Republic in the 1920s. During that decade, hyper-inflation crippled the German economy – compounded by expensive and unrealistic war reparations dictated by the Treaty of Versailles.

In addition to plunging jewelry demand since last fall in India, the latest news out of Germany to install “Gold to Go” vending machines casts a dark cloud on the short-term trend for the yellow metal. Though I remain an unfettered bull, too many people are coming aboard for the ride lately as inflation fears rise, government’s struggle to auction their debt financing and gold stocks skyrocket since October.

When too many investors join the same trade then the cliff isn’t far away. That’s exactly what’s happening now in the gold market as investors obsess with inflation fears.

The transition from a protracted cycle of debt destruction (since late 2007) to a period of rapidly rising inflation won’t happen overnight; deflation has already engulfed the economy with most companies reducing pricing, cutting employment and domestic consumption still tepid at best. The big picture remains a banking system that’s largely insolvent and still unwilling to lend amid a glut of toxic assets still sitting on their balance sheets. It’s a big mistake to believe deflation has left town this quickly.

In Germany, “Gold to Go” is a new project whereby vending machines will be installed across 500 locations, including train stations. Investors can purchase small increments of gold the same way they purchase a CD or an iPod. In Frankfurt airport, a dispenser now sells 1 gram gold wafers starting at EUR 30 ($42). I’ll be traveling through Frankfurt in two weeks and plan on buying a few grams along with my favorite German Ritter chocolate bar. Talk about convenient!

Gold, like most commodities, has already posted big gains since early March. Consequently, the dollar has been blasted and is now oversold. Combined with the traditional summer doldrums for commodities the odds favor a correction for raw materials, including gold. This view is consistent with deflation fears returning this summer following a big stock market rally off the March 9 lows and a bludgeoned Treasury bond market.

A decline in gold prices should be viewed as another opportunity to accumulate the metal. This bull market is soon entering its final phase whereby the gains will be enormous – probably north of $2,000 an ounce. But for now, gold is too popular and needs to correct lower. When entrepreneurs are selling gold in vending machines, it’s time for a pause.