2010 outlook

Dear readers,

We are in the last straight line of what has been a challenging 2009 for every one of us and not only those who have a job in finance. It was an emotional roller coaster where the world crawled through the symbolic eye of the needle in avoiding a depression we only saw back in the 1930s. After that we saw equity markets euphorically rebound from their lows in mid March under the umbrella of massive government worldwide.

Green shoots were added to our vocabulary but we can not shrug off the impression there is a divergence going on between the health of the economy and the state of the stock market. The world is clearly looking for a new equilibrium, and it is obvious it will be at a (much) lower level than we have known earlier this decade.

We admit we underestimated the rebound of the stock market, but we should have known if we had considered the trillions of dollars of liquidity that were poured into the market by governments to keep the financial system afloat. So far our mea culpa of 2009.

Nevertheless we persist in seeing very dark clouds above us. While the stock market is taking a massive advance on economic recovery, the bond market is telling us a completely different story. Yields on short term fixed income paper have been pushed down to almost zero (US T-Bills maturing April 2010 are yielding hardly 7 bps) which forces investors to chase more risky assets or, as Bill Gross of Pimco argued recently “The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks.”

However this almost negative yield level is also indicating that some investors prefer to pay the government to hold their cash in stead of putting their money at work.

It remains the one million dollar question when the Fed and other central banks are going to take back all this liquidity. Maybe from mid 2010 onwards, but it can be (much) later as well. One thing we know already, this will be a painful process for investors. We live at this moment in a very confused environment. On the one hand it is the best of times for investors as central banks offer a “free lunch” to the market, but on the other hand we face the worst of times as the economic fundamentals are still impaired.

One of the major economic challenges will be what will happen in the commercial real estate market. There are some similarities with the residential – subprime market which triggered the Great Credit Crisis of 2007. Back then prices of subprime mortgage bonds, reflected in the ABX Index, were already falling systematically since July 2006. Things deteriorated dramatically over that year and early 2007, HSBC and New Century, two of the major US lenders in that market, gave a first hint they had to make considerable provisions on their mortgage portfolio. It was only at the beginning of August, when two money market funds of BNP Paribas got into trouble, that the distress of the real estate market caught the eye of the public.

Of course, since the beginning of the crisis commercial real estate has been hit hard as well, however there are signs that things are deteriorating. Even the Federal Reserve admits this in its recent Beige Book report.

In the US, year to date there were already 5,772 foreclosures, defaults or bankruptcies representing an amount of $ 123 billion (data: Real Capital Analytics). The major reason is because commercial real estate was highly leveraged, and as a lot of these loans need to be re-financed, the industry is suffering as banks stand on the brakes to continue lending.

To underwrite the statement of Carolyn Maloney, Chairwoman of the Congressional Joint Economic Committee, saying that the commercial real estate market is a ticking time bomb: in the US alone, over $ 2.7 trillion of commercial real estate debt will have to be rolled over in the next 5 years with a peak in 2012 (these numbers do not take into account the additional $ 700 billion – $1.1 trillion of speculative leveraged finance debt). For 2010 between $ 530 and $ 700 billion is due for refinancing (data: Foresight Analytics LLC). According to the FDIC this can bring a total of 700 banks at risk of failure. A disproportionately high number of small and medium-sized banks have sizeable exposure to commercial real estate loans, and delinquency rates at around 7 percent will add further pressure on banks balance sheets that must mark these loans to market.

Financial institutions around the globe are very aware of this next tsunami wave and this is one of the major reasons why banks are so reluctant to lend. The facilities being put in place by central banks are primarily used to restore banks’s balance sheets so as to be robust enough to take the next commercial real estate hit. Lending is only of secondary concern.

Another worrying sign of the commercial real estate situation was the Fed intervention to throw out five commercial market bonds that were pledged as collateral for taxpayer loans to purchase debt earlier in November.

In an effort to clean up bank balance sheets and encourage new lending, the Fed opened its Term Asset-Backed Securities Loan Facility (TALF) to so-called legacy commercial-mortgage bonds. TALF attracts buyers by pumping up returns with low-cost Fed loans. Bonds deemed too risky are rejected. But the latter will limit future appetite for the programme.

All this will continue to weigh as a sword of Damocles on the market in 2010. Will it trigger a huge correction? Maybe, but not necessarily. This is in the hands of the central banks. Only as from the moment they indicate rates will rise again, markets will get nervous.

An interesting report published by the Investment Company Institute, the national association of US investment companies overlooking over $ 11 trillion of assets under management, is showing that cash which was parked on the sideline since the Lehman collapse back in September last year is steadily flowing back to the equity market. Nevertheless the amount that is parked on deposit accounts and money market funds is still well above historical levels.

This teaches us that the stock market remains well supported as any major correction will be used to put money at work. Not because the economic outlook is prosperous, but fund managers are judged by benchmark performances and many of them have missed the rally which took off mid March.

Furthermore the data of the ICI shows especially institutional investors have missed out on the rally, confirming our previous reports that this was a retail driven rally.

This means there is a reasonable possibility that the rally will continue into early 2010, as institutional investors can not afford to remain sidelined.

In the meantime, most probably, we will get further mixed economic data, confirming what John Mauldin still calls a muddle through economy as banks, corporates and consumers continue their deleveraging process.

Around April, when Q1 results come in, it will be a first moment of truth to see whether the preliminary recovery that we have experienced so far is only built upon stockpile adjustments or whether the US consumer shows more resilience. Although considering the fact that Average Joe still needs to bring down its debt ratios and increase it savings it is unlikely that it will come from that side. Therefore any further growth prospects should come from China that continues its path of economic development, on further governmental support.

This brings us to another potential dark cloud, the US government debt. During 2009 the US Treasury had to finance approximately $ 1.8 trillion of debt as a consequence of several bailout packages. For the fiscal year 2010 the White House projects a deficit of roughly $ 1.26 trillion. This is under the assumption that no further bailouts or stimulus packages are needed during next year. Also bear in mind there is another $ 1 trillion to be digested by the bond market for fiscal year 2011 ceteris paribus. (These numbers do not even take into account the additional burden on the US budget due to the new healthcare plans which were approved in Congress earlier this month).This is certainly an environment where the US Treasury can not afford any failed auctions on its bond issuances. Together with a USD which remains under pressure it will be interesting to see how US sovereign debt credit spreads will behave.

There will be no problems at all as long as sovereign wealth funds and other foreign banks continue to buy up US government debt. However from the moment the bond market starts sputtering spreads will widen again. Consider this as a potential black swan event hanging over the market for the next few years with a probability that the market priced at a too low a level the actual risk. This will certainly be a trade where event driven and/or global macro hedge fund managers will continue to look at.

It’s a small step from the US government debt to the USD. Due to the monetary outlook from the Fed, the USD is now used as a borrowing currency in the carry trade, similar to what happened to the JPY over the last 15 years.

We are still waiting for data from the Bank of International Settlements (BIS) to get an idea what the size is of this USD carry trade. Mr. Roubinni earlier this week argued it is 10 times the size of the JPY carry trade. To put this into perspective, according to data from the BIS the total amount of the JPY carry trade was around $ 1.05 trillion!!!

A change in the outlook of US monetary policy will trigger immense volatility in the currency market. In case this happens the borrowed currency starts rising rapidly as every investor involved in the trade has to start buying this currency in order to pay back the loan.

There are several examples of that over the last several years. One to remember was the unwind of the JPY carry trade in September 1999 when the hedge fund LTCM collapsed. In less than a month USDJPY dropped from 122 to almost 100.

Therefore we remain very cautious on recent USD weakness. This can be reverted in a split second, and we consider this one of the major risks of 2010. Even when the current USD carry trade is only twice the amount of the JPY position in 2007, there is a massive systemic risk hanging above the market which can easily push EURUSD towards 1.20 again in a number of weeks. The longer term outlook on the USD however remains very concerning due to the US deficit.

Last but not least the financial state of banks. On both sides of the Atlantic some banks still are in deep trouble but can mask their situation at this moment by a combination of creative accounting and the benefits of a steep yield curve. The head of the IMF, Dominique Stauss-Kahn, expressed similar concerns, arguing that there is a reasonable possibility that 50% of bank losses have not been reported yet, and are hidden in the balance sheets especially among European banks. Only last week the market got shaken up by woes in the Middle East where Dubai World was unable to roll over its debt. Especially major European banks have exposure of up to USD 20 billion to the Emirates state. This is certainly not helpful to the already fragile balance sheets of the financial industry.

If this is a fact 1 of 2 developments could be seen in 2010. Either we might see another wave of nationalisations or, depending on the risk aversion of the markets, banks will have to raise more capital individually. The latter is more likely if we do not return into a Minsky moment like we have seen when AIG and Lehman collapsed during the same week.

To round up cryptically, 2010 will remain a very difficult year, where the cheap funding from central banks act as the Lorelei, one of the Rhine Maidens of the famous Nibelungen song, who rises from the waters trying to lure the ships onto the cliffs with her seductive singing. Despite these temptations it would be wise to keep your ships close to the coast in these stormy weathers.