Market as clear as mud: Atlantic

Arno Lawrenz of Atlantic Asset Management writes that the market outlook remains clear as mud with even the post MPC statement clearly depicting an organisation not 100% sure of itself. The fact that from a global perspective we continue to see the smallest signs of stabilisation, but locally, (despite no real change for the worse since the November MPC meeting), some panel members now feel that a further interest rate cut may not be such a bad idea, just again highlights the extreme level of uncertainty we are experiencing at the end of this current interest rate cutting cycle.

Something we have then clearly witnessed since the release of the MPC statement, the yield curve (2v10 swap) normalising (i.e. steepening) a further 15bp, with many now revising their targets on this spread to at least 165bp, where previously no one even considered the potential for it to move beyond 150bp.

It remains a concern, however, that the SARB continues to be presented with a slightly-less-than-even playing field when it comes to the decision-making process. Not only did Gill Marcus have to face questions regarding their concerns over the Eskom tariff increase, but also about the independence of the Reserve Bank.

Interesting though, markets seem to have taken the latest 'brainburb' from the ANC in its stride. (Over the weekend, ANC Secretary General, Gwede Mantashe, raised the topic of potential nationalisation of the SARB). In seclusion, again, this is probably something that can be ignored, but signs are clearly on the increase that the ANC is busy consolidating control of key (independent) decision-making processes (the judiciary, broadcasting/media etc).

Of critical importance though, is that while we as a nation are hard on ourselves and what we expect from authorities, many other countries face political dilemmas of their own. It is thus crucial to appreciate that the average "switched on" foreign investor will take a more global, holistic approach when looking at the local political landscape . (Taking into consideration that these investors have to contend with the following elsewhere:

Greece - after fudging its books twice in ten years - sees its EUR5bn bond issue oversubscribed to the extent where it decided to issue EUR8bn at 6.11% (260bp below SA yields) and in the process manage to place just about what SA expects to raise in the entire upcoming fiscal year from nominal government bonds! (Has no one learnt anything about sovereign risks from the past 18 months?!)

And if that is not rich enough for you, in Argentina, yes that stunning country with arguably the best red meat on the planet (reason enough to want to go and 'test' the theory!) and some would say the best looking female population on the planet (an even better reason for those red meat lovers!), it's president saw it fit to fire the central bank chief.

Why you ask?

Oh, just because he opposed her idea of using the country's reserves to service maturing debt obligations this year.

Silly him...

SA's political woes are much worse than elsewhere.

Or is it?

As one of my offshore friends (running one of the largest EM funds in the world) put it so eloquently yesterday when pressed why someone would want to pay almost 300bp through SA levels to buy Greece: "This world is made up of boxes, people thinking inside those boxes, rules and regulations. Common sense is no longer that common…"

Therefore, from an investment perspective the status quo stands for now. But we are faced with some key investment risks over 2010, none more pressing that what lies ahead at the 17 February National Budget. The risk that a change in the SARB mandate could lead to a second round of cuts (helped along further by political pressure on Nersa to grant Eskom a maximum of 25% tariff increase) is non-negligible. As we so clearly pointed out last week, this will be the year where we all will have to be open-minded... (and not be scared to change our minds when the facts change!)

Fixed Income

Today I take a different approach in this section, bringing to you a summary from Tradition Financial Services on the topic of global demand for Emerging Market Fixed Income. Earlier in the week the Financial Times also ran with a very similar topic, followed by very strong positive support for the argument by probably one of the leading authorities on EM debt, Jerome Booth from Ashmore Asset Management.

• One of the major themes for 2010 (which is really a spillover theme from 2H09) is that of sovereign asset allocation within a yield seeking environment. Given a global economy awash with so much debt a greater level of prudence is likely to be seen amongst fund managers in terms of their asset allocation strategies.

• With many emerging market states' debt to GDP ratios being dwarfed by more developed countries, and growth prospects similarly in the EM's favour, EM debt still looks very well placed to generate some demand from funds. This is compounded by the high level of yield on offer vs. that of developed countries.

• The demand for yield remains strong as was shown at the Greece 5yr bond auction. From an emerging market perspective, this is certainly good news in that it suggests that risk aversion to emerging markets may subside slightly given Greece's debt profile.

• A recent article on the FT spoke of US pension funds rotating nearly $100bn into emerging market debt in the next 5yrs as many funds look to diversify away from low yielding US denominated debt. With the JP Morgan EMBI Global Diversified index attaining investment grade status earlier this month, it stands to reason that more funds will be able to rotate into EM debt. This demand could also be further bolstered as many central banks look to diversify out of USD backed debt.

Source: Tradition

Figure 1: Taking a different approach this week. There is not a chart in the world that can tell the story better. While we may have bored you at times over the past 13 months about our ongoing concerns with the US housing market, the statistics below speaks for themselves...

Source: Investment Postcards

Global

By now we should all be well on top of issues in Greece, China, Iceland, Ireland, and to a lesser extent (at least for the short-term because we have more pressing issues) Portugal, Spain and Italy.

An issue that is unfortunately still not front, centre enough on anyone’s mind is the ongoing concerns in the global housing, as well as commercial real estate market.

We have thus taken out time over the past few days to collate data from various sources (but as always relying on the mountain of minute data Dave Rosenberg seems to get through) to bring to you a clearer picture of what the US in particular remains faced with, and why the likes of PIMCO continues to talk about the ‘New Normal’ – and era where the shift from the ‘Great Moderation’ (leveraging, globalisation and now turn to DE-leveraging; DE-globalisation and RE-regulation. (In other words, appreciating that the pressure that continues to exist in the housing sector – and the negative feedback loops caused by underemployment, which we have warned about going back a good 12 months – will need A LOT of time to work its way out of the system).

From David Rosenberg: Supply (both potential and actual) of over 9million homes and condos nationwide. On top of that, an 11%+ record vacancy rate. (While the FT’s Lex Column point out that almost 9% of 53 million outstanding mortgages are either in arrears or in the foreclosure process).

From John Mauldin’s Investors Insights as we see this as one of the critical reads for the year. Quoting: “The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there's some alternative in place, it's going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I'll give you an example. In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined.

One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn't have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That's very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they'll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that's horribly destructive.”

In life we are all faced with choices. Some will be straighter forward than others. The same goes for authorities. The unfortunate bit from Joe Average’s perspective is that the wrong decisions by authorities can often lead to disastrous consequences for the most unsuspecting citizens.

South Africa at this juncture seems faced with some key decisions. The issues around moving to a developmental state are not becoming an easier decision. Importantly, on the fiscal side we seem to be stretching the economy further than we would like under ‘more normal’ circumstances, and importantly, if not corrected at the first opportunity, may leave lasting scars.

From an economic perspective, the Rand seems to be in a precarious position. In the short-term it is no doubt catching tailwinds from the FIFA World Cup and the general global perception that a key shift is taking place from developed to developing, which puts demand for risk on the table.

From a more macro perspective, however, the upcoming Budget poses some key risks, driven in large part by potentially dangerous political decisions. If we do indeed tamper with either SARB independency, or the inflation-targeting mandate, there may be some short-term gain but the potential long-term pain cannot be ignored.

If we try to grow out of the Budget deficit, the current account gets bad again, if we tighten policy, growth remains slow and pressure remains on the SARB. It seems all roads continue to lead to the Rand.