cedar review july 2011

8/3/2019 Cedar Review July 2011

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July 2011

With the S&P 500 Index up over 30% in relative terms over the past 12 months, one wouldthink the world is firing on all cylinders. In contrast over the same period the supposed safeasset class Gold which is a harbour against economic, political or social fiat currency crisesis also up over 30%. Historically, Gold has been non-correlated to equity market returns butthis relationship has now broken down. One would have to ask why? On each side of thetrade, there is a view that one is right and the other is wrong.The global stock market has been acting like a pendulum of an old grandfather clock with any

positive or negative economic update moving the pendulum one way or another.Within this review, we will explain the many causes of this volatility at present and outlinehow we incorporate these leading economic indicators into our value investment processprior to advising our investors to allocate capital to specific opportunities with the globaluniverse of the stock market.

Fig1 The Investment Cog

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Economic

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The first key theme that is central to equity market volatility at present is:-1. European Sovereign Debt Crisis it is notjust liquidity but more about solvency of the

periphery(Greece,Italy,SpainPortugalandIreland).Last week the Greek parliament voted in favour of further austerity plans in order to receive

the next instalment (12bn) from its original rescue package. The implications for the overallEuro hinge on the outcome in Greece. If Greece defaults on its debt, contagion will spread toother periphery countries like, Portugal, Spain, Italy and Ireland. Greece requires funds priorto July 15th.The financial sector would experience a Lehmans 2 type of event due to French andGerman banks owning a large portion of Greek short-term debt. Current accounting rulesallow you hold these investments at par value on your balance sheet as it is assumed you willreceive your initial capital back upon maturity. If a default was to happen, holders of theseGreek bonds would be required to value to mark-to-market these assets at their true value andsuch take losses. Fresh capital would be required to shore up the balance sheets.Furthermore, within Greece, The Economist reported recently- assuming a 50% haircut on

exposures to marketable Greek sovereign debt, four Greek banks below would wipe outshareholders and require a significantly larger bail-out to recapitalise the banks.

Fig 2 Impact to Greek Banks


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The European member states are working on a plan that will allow Greece restructure its debtto stave off a Greek default on its debt. The French Banking Federation (FBF) issued aproposal which outlines how investors would take losses on bonds held but would not be adefault which would enable French and German banks to maintain their core Tier1 capitalratios without any further requirement for capital.

This proposal (Fig 4 below) highlights that bond holders through a series of complextransactions will receive 100% of their capital and then immediately invest 70% into Greek30 year bonds. Greece receives 50% of this and the balance will be lodged to a SpecialPurpose Vehicle (SPV) and guaranteed. This, in my opinion, is Collateralized Debt Vehicle(CDO) which is one of the main instruments that caused the Financial Crisis. Essentially, theECB would be prolonging the inevitable.The S&P ratings agency dealt a blow to this proposal yesterday, saying the plan would likelyput Greece in selective default. This proposal is unlikely to get off the ground but marketshave responded well to the proposal due to not looking deeper in mechanics. Until Europeanmembers realise this is not all about liquidity but solvency, the likelihood of breakup of theEuro is high.

Fig 4 French Bank Federation rollover proposal


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Now to the question of how the bailout is financed and the risks it carries.2. EFSFFundandfinancing

In May 2010, the Euro member states created the European Financial Stability Facility(EFSF) which is able to issue bonds guaranteed by European Member States up to 440

billion for on-lending to European member states in difficulty. Greece, Portugal and Irelandhave availed of this fund to date. If we were to assume that other countries on the peripheryrequire access to this fund, the EFSF will run out of capital. In March 2011 it was agreed toincrease the size of the fund to 700 billion but this will not occur until2013 with Germanycontributing a third of the increase. Germany has a lot at stake at present as its four largesttrade partners are Portugal, Greece, Italy and Spain. Currently it is running a trade surplus butthe consequences of these periphery countries defaulting would severely impact Germany.In conjunction with the EFSF fund, the ECB (European Central Bank) has of late used itsrediscount window to put more than 350bn at risk to the periphery. Ireland for instance hasreceived more than 180bn of ECB money through their banks or equivalent to 100 per centof our countrys GDP.

According to the IMF estimates, European banks exposure to the periphery constitutes about10 per cent of Europes GDP and 80 per cent of European banks capital. These largerediscount operations have remained well below the public radar whilst exposing the ECB.The ECB capital cushion is no more than 10bn, so you can see it exposes the Europeantaxpayer to considerable risk should the peripheral debt be subject to a large haircut.

3. EurozonemanufacturingGrowthat18monthlowGrowth in the Eurozones manufacturing sector lost steam in June as both exports anddomestic demand slowed, falling to an 18-month low as shown in the Markit ManufacturingPurchasing Managers Index (PMI) survey. The report highlighted that the PMI index fell to

52 from 54.6 in May, its lowest reading since December 2009. A contraction is indicatedwith a level below 50. Italys manufacturing sector shrank for the first time in 20 months,while Spains contracted for a second month in a row. Growth in the German and Frenchsectors slowed considerably, while the UKS manufacturing expansion fell to a 21-monthlow.

4. EuropeanbankstresstestresultsdueinseveralweeksAn exclusive report from Reuters indicated that up to one in 6 European banks is set to fail anEU-wide financial health check. Euro zone sources said the European Banking Authority wasset to announce within weeks that 10-15 of 91 banks being scrutinised had failed.

5. InterbanklendingandLiquidityInterbank lending using European government bonds has reached record levels. Lendingbetween banks without the backing of collateral for any loans has become limited. Last week,lending using European bonds as collateral surpassed records seen during the financial crisisin August 2007( See Fig 3 Short term repurchase lending repo volumes) as highlightedwithin an article by the FT on Monday. The previous daily peak was recorded in July 2007 a month before the onset of the credit crunch.


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Fig 3 Short term repurchase lending repo volumes

*Source FT July 4th 2011*We can infer that lending conditions have not improved and in order to keep economicgrowth moving alone, liquidity plays an important role. This I believe confirms that whilstmarket commentaries create a market place to indicate all is well. Well looking at thisgraph all is not well at present.

6. U.SDebtLevelsAcross the Atlantic, the U.S. has been printing money and supporting its economy throughQuantitative Easing I and II. This has pushed the national debt to over $13 trillion. PresidentBarack Obama is trying to reach a compromise with Republicans lawmakers who are seekingspending cuts before they agree to raise the nations borrowing limit, currently cappedat$14.3 trillion. The treasury has said it has until August 2nd before its ability to pay the U.Sdebt expires.If the U.S is not successful is raising the borrowing limit, the S&P credit rating agency hasindicated that it will cut the U.S credit raring to its lowest level. In the past 55 years, the debtceiling limit has been raised 78 times, often at the last minute.

7. U.SconsumersentimentdeclinesinJuneConsumer sentiment declined in June as expectations about the economy fell, according tothe Thompson Reuters / University of Michigan survey released last Friday.The consumer sentiment gauge fell to 71.5 at the end of June from 74.3 in May, Thesentiment reading, which covers how consumers view their personal finances as well asbusiness and buying conditions averaged about 87 in the year before the start of the recession.These indicators still show the rocky environment that prevails. It is also important to notethat consumers make up 2/3 of the US GDP. If consumers are cautious in spending, economicgrowth is bound to slow.


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9. CorporateProfitsasa%ofGDPNextEarningsQuarterCorporate profits as% ofGDP is 8.3% at present. JohnHussmann illustrates the use of

CorporateProfitsas%ofGDPandshows thenegativecorrelationbetweencurrentprofit

growthandfurthergrowthwithinthefollowinggraphs.

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futuregrowthratesincorporateprofits.ThisispredictingthatCorporateProfitswillfalloff

from todays levels.Graph2belowalsohighlights that corporateprofitasa%ofGDP is

currentlythesixthhighestlevelsince1947puttingitinthe98th

percentile.

Graph3showsaregressionthatshowstheaverageCompoundAnnualGrowthRateintothe

futuretobe0%afteraseriesoflargeperiodsofcorporateprofitgrowth.

Companysearningsquarterahead;Forthesecondquarter,S&P500companiesareexpectedtopostearningsgrowthof13.7%,

downfromanestimatefora19.8%gainmadelastyear.Webelieveearningsestimatesmay

needtobefurtherdowngraded.

Graph1


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Graph

Graph


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10.ConclusionLeading indicators that Cedar Capital follow highlighted and continue to highlight aconsistent slowdown both in Europe and U.S. We believe that the deleveraging of bothpersonal and corporate balance sheets in conjunction with sovereign debt risks is impacting

demand, consumption and investors risk appetite. As the world is consumer driven,disposable income is in short supply at present. Companies have embarked on cost cuttingand laying off staff in order to become more competitive. From here, consumers will play animportant role in the continued return to sustainable economic growth.Stock markets seem inherently to ignore these leading indicators to eek out further returns.Eventually something will have to give and we prefer to monitor the siutation beforeallocating further capital into the markets. Just today European private sector activity wasweaker than forecast in June, hitting a 20-month low level with recoveries slowing inGermany and France. Over the past two months, the region has seen the sharpest slowing ingrowth since just after the collaspse of Lehmans in late 2008. As you can see, there are a lotof headwinds globally which can or could impact equity market returns in the short term. It

is during these periods of speed bumps, I expect to gain opportunities to allocate capital.Patience and disicipline is required in order to chart our way through the pending issuesahead.Fig 6 below outlines how Cedar Capital incorporates all relevant information in order toselect available opportunities.

Fig 6- The Cedar Value Based approach to Investing

Leading

economic

indicators

Investment

Decision

Bottomup

Stock

fundamental

analysis

Macro

environment

conclusion

Markey

Physcology

cedar review july 2011

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