Tuesday, September 13, 2011

The leverage asset trap - A case for lower long term volatility

The leverage asset trap - A case for lower long term volatility

As banks de-levered (mortgages and jobs) into the books of the governments and workers, we now sit with individuals being forced to de-lever personal balance sheets.  So has the world really de-levered or simply moving it around and each person in the chain taking a small write down till it finally overtime reaches it's fair value slightly north of zero?  If so, this process will take years and in the meantime we can expect a bumpy ride, however with each transfer resulting in a lower volatility regime as we saw in the japan debt fallout and that similar to 2004-2007 us pre credit bubble build. Except this time, stocks stay cheap, raw materials stay expensive and bid, interest rates force high yield spreads to compress and a constant currency battle aimed at pushing exports.

Currently this cycle is at the final step before being pushed back up to government.  A new global political debate arises daily on exactly who is left holding the leverage asset balance sheet.  However, impatient bond holders have driven values of the debt to 0, leaving global haircuts on bonds non-negotiable and frantic markets.  Governments now will be forced to hit private holders, sue banks, pull cash from corporates to reach political goals, avoid defaults, create jobs all in the name of "saving our children's future".  No mass scale default will happen.

With so much money moving back and forth along with blame, how do we even begin to come up with a long term fair value for financial assets - FX, Commodity Prices, Interest Rates, Volatility and stocks?

First let’s start with what the market is telling us about the long term in each asset using g= growth, r = recession, tr = trade result

StocksXStocks stay cheap
RatesXGlobal yield hunt
CommodityXBuy to fund growth
FXXSell USD to fund growth

Stocks are cheap, but will probably stay cheap for sometime until record cash rich corporations decide to part with it.  The raw materials for growth are very expensive while the human capital costs are very cheap.  Until a balance is found, corporations will only slowly invest into R&D, technology and hiring.  Only commodity linked companies will benefit from operating leverage EPS, while others engage in price wars for the shrinking spending of de-levering consumers.  In the meantime, the vol of cash is ZERO and that should get priced into the vol market.

Interest rates are clearly following the Japan playbook which in turn will bring on global yield hunt that will unfortunately not spill into equities until the market again gets to very tight credit spreads.  Vol compression and credit spread compression are highly correlated

Commodity prices are expensive.  Growth tools are simply not available for cheap as is human labour.  This leaves the market with higher bars and hurdles.  Until clarity is found on profitability for corporates to invest, expect commodity prices to stay expensive with a fairly stick bid.  A commodity collapse would only bring on more acquisitions as the cost of growth decreases

FX.  The world is hiding in the what is being perceived to be the safest countries, however the printing presses and export pain will only be tolerated for so long.  Expect a large USD squeeze followed by an even greater USD sell-off.  This will shake out many weak USD borrowers while allowing strong corporations to increase short USD positions to take advantage of cheap funding.  If you can’t hide in USD or EUR, then Yuan gets bid, strong Yuan buys commodity - large M&A, bigger firms, bigger market cap, lower vol

Vol  Already pricing in extreme daily moves relative to history, vol is clearly pricing in a bumpy ride for all assets classes.  This is rightfully so, as we now are approaching a possible risk reward snap back. How much reward is in buying vol for a tail event if we are starting from a near assumed default position?

No comments:

Post a Comment