The Ex Ante Factor: 2008 - A Zero Sum Game
This was sent to members on 12/29/07
It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another. ~ Gordon Gekko - Wall Street
With 2007 in the books we wanted to focus on what the events of 2008 will offer traders and investors in the various asset markets. Readers know we have been looking for the dollar to bottom, bond yields to fall to new lows, equity prices to violently chop big ranges and for commodity prices to ease. For most of coming months the media pundits and short-sighted analysts will be focusing on the proposition of a US recession, the effect on the job market and the subsequent course of Federal Reserve policy. If we are to see an "official" recession, by the time we are told it happened the market will already have discounted the outcome. Sitting around waiting on the data is of little use.
Whether or not we have a recession will not be the big story of 2008 in our opinion. The orderly or disorderly liquidation of assets and collateral by banks and other financial institutions such as dealers and hedge funds will be the most important event. We are witnessing a gigantic transfer of assets ownership from weak hands to strong hands. Whether the process and final result causes an "official" recession or not, we don't care, we just want to be on the right side of the trade. How the market discounts the outcome will show up in the behavior of asset prices long before it hits the cover of the WSJ. In order to gauge the economic impact of this transformation, we will want to look for clues and answers to the following questions:
Currencies - Can the dollar finally put in a bottom v the euro?
Interest Rates - Where does the 10YR yield trade and how does it get there via the slope of the yield curve?
Equities - Will emerging markets continue to outperform and where do financials bottom?
Commodities - What happens to crude and the crack spread and specifically who wins the tug of war, producers or consumers?
We will be measuring the progress and success of the great asset exchange by monitoring the following developments:
During a credit crunch cash is king. Those with liquidity are able to take advantage of the losses by those who are raising equity and/or liquidating collateral at discounts. Sovereign wealth funds, petro exporters and Berkshire Hathaway who have all put capital to work in distressed assets in late 2007 share one thing in common. Loads of cash dollars. We expect these dollars will continue to find attractive opportunity at the expense of sellers. These cash infusions are occurring at discounts, be it MER, C, or TXU leveraged loans. Issuers and lenders are selling capitalization at a loss and the cash kings are buying at a discount. This shrinking of leveraged balance sheets putting a premium on cash is the principal thesis behind our bullish USD stance and if it were to find support we think the attractiveness will feed on itself as foreigners look to invest more into distressed US assets.
Forget residential housing, whether the commercial real estate market can weather the credit crunch will have more important implications for financial company balance sheets, collateral values and credit availability. The upcoming $9b Hilton Hotel CMBS offering by private equity firm, Blackstone Group, will be an important gauge of risk appetite by the lenders of commercial real estate. It would be the largest CMBS deal ever issued and if it can get done at a reasonable price the market would be indicating some freeing up of risk capital which would also alleviate the balance sheet strain were the banks forced to eat the paper. Failing to sell the deal would be indicative of a lending market continuing to shy away from credit and real estate collateral. Thus far massive amounts of LBO debt sit for sale on major bank balance sheets so this offering could add insult to injury. However considering the size of recent equity infusions by foreign investors, it's possible they get it done. We suspect the sheiks may be interested in some hotel assets.
The spread between LIBOR and risk-free rates has widened to levels not seen since the 1987 stock market crash. The elevated risk premium banks are charging each other for funds is indicative of strain in the banking sector and this has been well documented. We are anticipating the spread to narrow from these historical levels but remain elevated. The VIX index has a high correlation to risk premiums and if we are entering a new cycle of rising volatility premiums we should also assume risk premiums will stay high. This higher risk premium will have an adverse affect on asset price multiples as the cost of capital rises. This adjustment process will likely continue to be choppy with thin liquidity creating an unpleasant trading environment for investors as the risk/reward ratio remains inverted.
Emerging market and commodity based equities such as materials and energy have been star performers and there is much debate as to whether they can continue to rally if the US consumer shrinks demand. Emerging markets have traditionally been correlated with commodity prices and we see no reason why that won't continue in 2008. We are monitoring various markets and leaders such as X, BHP and the Australian All Ords index for indications that the commodity led emerging market rally will continue. Getting a dollar rally and a top in commodities would in theory be bearish for emerging markets and commodity related equities so we must keep an eye on all three. We have a hunch that the narrow crack spread with crude at all time highs is indicative of weak end market demand and what this relationship does next year will go a long way in answering the inflation/deflation question. The ability of the Federal Reserve and other foreign central banks to sufficiently lubricate the financial system will show up in this performance of these markets.
Most analysts who are looking for a slowdown or recession are anticipating a quick rebound similar to 2002. We disagree on the grounds that this bubble was a function of credit availability and the collateral values that supported the credit. The tech bubble was essentially a 1 year event as liquidity pumped after LTCM coupled with Y2K fears drove speculative capital into these shares which soared and collapsed within a relatively short time frame. The credit bubble is a different story in that by nature the transactions were highly leveraged (some over 100% of already inflated collateral) and can take up to 3-6 months to complete. We currently have a record +9 months supply of housing inventory on the market so banks are selling into a very soft market. The unwinding of this bubble will likely take a much longer time as banks find it difficult to liquidate their assets and collateral.
The 10YR could be the big unrecognized story of 2008. The long term channel has turned the yield lower and is painting a grim scenario if on its way below the 2003 low. The 10YR yield in the low 4% area is clearly discounting a deceleration of growth and since we expect prices to make new highs (yields make new lows) we think there is more work to the downside in banking stocks throughout 2008. The 10YR yield will likely bottom before financial stocks. We are looking for banks to trade closer to their book value which is not yet known. When 10YR yields start to lift it is indicative that demand for money is rising and banks are freeing up capital. If we can get a higher 10YR yield and steeper curve it would be a positive indication that the system is normalizing and banks are comfortable their balance sheets can take on risk.
We can't be sure how these developments unfold. There is a lot of pain in the system and a lot of desire to avoid pain. The one thing we do expect is that 2008 will continue to see the strong hands shaking out and taking advantage of the weak hands. In a credit crunch induced collateral liquidation, somebody wins and somebody loses. We suspect this particular one shall be quite an emotional transfer of perception.
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