atwel - global macro 7/2011

8/6/2019 Atwel - Global Macro 7/2011

1/18 ATWEL International, s.r.o. www.atwel.com Page 1

As with other investment-driven economic miracles Germany in the 1930, the Soviet Union in the

1950s and 1960s, and Japan in the 1970s and 1980s you started seeing this unsustainable build up in

debt, Pettis said. In the early stagesbuilding the first road is profitable, but what happens when youve

Current edition contains:

1CONSEQUENCES OF A BUDGET IMPASSE

US Dollar looks like the short-term winner in every case.

2IF YOU CANNOT SHORT OATs, SHORT FRENCH BANKS INSTEAD

Shorting French banks is both a good hedge and structural story.

3GLOBAL PMIs

A look at global economy.

4IS THE IRISH DEBT ATTRACTIVE?

Given where it trades on implied-loss basis, we think it is.

MONTHLY INVESTMENT NEWSLETTER

Global Macro Strategy:July 2011



1) CONSEQUENCES OF A BUDGET IMPASSEWithout any exaggeration, the current dispute between Democrats and Republicans in the US is threatening the very

essence of market stability. That is why we have been suggesting over the past month to either stay out of market

completely or hedge positions accordingly. As we are drawing nearer to the August 2nd

, we have stood a witness to

the rise in volatility as more and more market participants have been net buyers of protection in their fear of a

complete meltdown.

We are fully aware that abrupt changes in negotiations can occur at any date / minute which may make this piece

irrelevant. But for sure one should be ready for such occurrence or at least wary of a possibility that resolution may

not happen in the very last moment (if at all) as both parties will be trying to get the best deal.

First, let us write shortly what we think about the whole situation and whether we lean towards the reasoning of

Republicans or Democrats. To those of you, who are not interested in our poor Machiavellian thoughts, we advise to

skip the first section completely and devote your attention to the second one, where we scrutinize the most

probable outcome of this whole impasse.

a) Where do we lean

Firstly, if one looks at the development of budget deficit from the revenue and outlays perspective, it is pretty clear

that todays budget deficit is a result of roughly a 50% drop in revenues and 50% rise in spending. Hence, the refusal

of Republicans to increase revenue seems a bit off. The truth is that Republican Boehner agreed to close some

loopholes but strongly antagonized raising two highest marginal tax rates. Any statutory changes in tax rates were

the main reason why the debate failed. Republicans are rightly worried that while statutory taxes will remain in

place, spending would slowly creep back in over time.



The US budget is also deeply pro-cyclical and we think in case US came back to full employment (result of necessary

macro and microeconomic adjustments), than we would be left only with the structural budget deficit in the vicinity

of 3% (and going forward, result primary of too high and too inefficient healthcare spending US spends about 8% of

GDP on healthcare more than everyone else with worse results).

Naturally, if Obama could choose, he would simply sweep the whole thing off the table and start looking for a

solution once his second presidential term is secured. But that is exactly what Republicans do not want to lethappen. They want Obama involved and they want him to be the icon of budget cuts. The fact is either Obama will

address cuts now or he will be forced to decide after August 2nd

which spending he will prioritize and which will go

down the drain anyways.

b) How to position your portfolio.

As we mentioned above, there is a growing probability that US will experience a significant amount of cuts in

spending. What would the impacts of such move be? As the US economy is known to have a rather small marginal

propensity of imports (estimates range from 0.2-.0.5), any 1% reduction in aggregate demand would be

accompanied by 0.2 - 0.5% decrease in imports and current account balance. Besides, we believe lower aggregate

demand in US would translate into lower world aggregate demand and a marginal fall in oil prices, thus alleviating

additional burden from the current account.



NX = net exports, NS = net savings, Y1 = new equilibrium in case of a country with low marginal propensity to imports, Y2 = new equilibrium in

case of a country with high marginal propensity to imports

That would be structurally great for US Dollar and bad for commodities. Secondly, as US would decrease its current

account deficit and would thus keep sending less dollars abroad, we would not be surprised to see US Dollar liquidity

abroad dry up. Watch the TED spread as our favorite tool for judging whether there is a lack of dollars abroad (USD

Lending rates in Britain less yield on 3M T-Bills).

If the budget deficit reining occurs in an orderly way and both parties find a solution without defaulting nor putting

foreign lenders at an increased risk, we think it is a long-term positive for stocks as US will stand on a much firmer

fiscal trajectory. Should nothing happen and US go into default, stocks would tank and bonds could move either way.

We would favor staying in US Dollar as budget cutting under any circumstance looks like the most likely outcome.

NX

NS

Y

NX2

NX1

NS

NS1

NS2

Y1 Y2



2) IF YOU CANNOT SHORT OATS, SHORT FRENCH BANKSShorting European bonds is an art of its own. On one hand, you are squeezed by politicians trying to outlaw anything

to do with shorting, on the other, futures market or specific ETF products in government bonds of particular country

are grossly underdeveloped. As our broker does not even allow us to short bonds, we had to figure out a way around

that and find the best proxy that gives us short exposure to French bonds.

In order to arrive at a result, we ran a correlation test between monthly percentage change in stock prices regressed

against monthly percentage change in French CDS (we wanted to regress it against the credit risk actually, not the

growth part of the bond yield). It was not really a surprise that highest correlation was found among French banks

and financial institutions (after all, they hold a lot of this paper, dont they?). Still, it is always good to have a

statistical confirmation of your thought.

The reason why we chose France as a scapegoat is due to its problems with current account (and growing

requirement for outside funding), reflecting its issues with socialist policies and balancing the budget as well as due

to other signs of deterioration in competitiveness such as a loss of market share in world exports.



The broadest indicator of competitiveness, the current account, has been deteriorating since 2002. Over past 10

years, it has worsened by more than 4% and we think it will continue to do so as PIGS will be hard pressed by

markets to reform its labor and product markets and Germany will be a tough competitor to beat. In all bluntness,

we perceive France as a socialist relict that will converge with PIGS over time.

Also, we believe the main reason why readings out of French economy have been strong lately is due to domestic

credit expansion, which can be observed especially in housing (while total credit to households grew at 7.54% y/y,

mortgages grew by over 9% y/y compare it with M3 actually falling y/y in Italy).

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

Current Account Deficit as % GDP%

I taly CA deficit (annualized) / GDP Spain CA def icit (annualized) / GDP Port ugal CA def icit (annualized) / GDP

Greece CA deficit (annualized) / GDP France CA deficit (annualized) / GDP



The Economist has recently published updated housing indicators, clearly showing that France, unlike other Western

countries, escaped the house-price adjustment spiral after the 2008 bust and the real estate market has actually

reached new highs in absolute terms just recently. On a price to rent basis, France remains grossly overvalued

leaving banks holding dangerous assets.



Looking at the spread and correlations between Bunds and OATs, it increasingly looks like market has started

distinguishing between these two. It seems to us that market is growing increasingly wary of quality of French debt

as it has ceased trading like a German equivalent.



We believe that despite recent correction, going short a basket of French banks does not have to be such a bad idea

after all. A basket of 4 major French financial institutions is a well-diversified, yet compact opportunity, to bet not

only on problems in European banking sector, but on a country with deteriorating competitiveness

Basket: (2 * BNP FP Equity + 3 * GLE FP Equity + 7 * CS FP Equity + 11 * ACA FP Equity) /4



3) GLOBAL PMIs

In the last Global Macro Monthly, we have introduced our 4 quadrant model that looks at a composite reading of

several growth and inflation leading indicators. Underneath, we are presenting our latest results for the end of June.

The conclusion is that we are still located in an inflation and growth enabling environment (yet with an increased

political risk of deflationary bust if debt ceiling is not lifted).

20%

30%

40%

50%

60%

70%

80%

90%

20% 30% 40% 50% 60% 70% 80% 90%

Leading indicators, each point represents 1 month

x axis - inflationary environment = >50; y axis - economic growth environment =>50

T T-1 History

Inflationary boom

Inflationary bust

Deflationary boom

Deflationary bust



During last month, we have created another decision-making tool, which is based on co-incident PMIs. So while not

having great predictive power, it is giving us a good hint and a convenient overview of where global economies are

located right now.

It is interesting to point out, that manufacturing PMIs are well below 50 in Spain, Italy, Ireland, Greece (though

improving from worse levels) and surprisingly even in Brazil.

y = 0,8791x + 1,5574

R = 0,7303

185%

190%

195%

200%

205%

210%

215%

220%

225%

230%

235%

45% 50% 55% 60% 65% 70% 75% 80% 85%

Leading indicators vs. P/B value of S&P 500

x axis - pro-growth economic environment = >50; y axis - Price to book

Historie T T-7 Linern (Historie)

S&P levn vi

pedbhajcm indiktorm

S&P drah vi

pedbhajcm indiktorm

Japan UK

US

Germany

France

Italy

Spain

Ireland

Greece

Czech Rep.

Poland

Korea

Australia

China

IndiaBrazil

Russia

Eurozone

Global

-6

-4

-2

0

2

4

6

-6 -4 -2 0 2 4 6

World, PMI Manufacturing

June 2011

PMI - deviation from neutral 50

Decelerating boom

Accelerating boom

Worsening bust

Improving bust

m/m

absolutechangeinPMI



If we look at biggest moves in manufacturing PMIs over past month, major economies experienced weakening in

activity. US looks positive on the headline number, yet as most analysts point out, the gains in PMI were realized on

the back of inventory buildup, while new orders were weak.

It is unfortunate that we do not have access to all detailed PMI reports and thus can not make an analysison the leading PMI subindices such as new orders or hiring plans.

Japan

Italy

Germany

Australia

US

-8

-6

-4

-2

0

2

4

6

8

-8 -6 -4 -2 0 2 4 6 8

World, PMI Manufacturing

Biggest changes May - June 2011

PMI - deviation from neutral (50)

Decelerating boom

Accelerating boom

Worsening bust

Improving bust

m/m

absolutechangeinPMI



On the charts below, we are presenting same set of data based on GDP-weighted composite PMIs.

Japan

UKUS

France

Italy

Spain

Ireland

China

BrazilRussia

Hong Kong

Eurozone

Global

-6

-4

-2

0

2

4

6

-6 -4 -2 0 2 4 6

World, PMI Composite

June 2011

PMI - deviation from neutral 50

Decelerating boom

Accelerating boom

Worsening bust

Improving bust

m/m

absolutechangeinPMI

Japan

Italy China

France

-8

-6

-4

-2

0

2

4

6

8

10

12

-8 -6 -4 -2 0 2 4 6 8 10 12

World, PMI Composite

Biggest changes May - June 2011

PMI - deviation from neutral (50)

Decelerating boom

Accelerating boom

Worsening bust

Improving bust

m/

m

absolutechangeinPMI



4) IS THE IRISH DEBT ATTRACTIVE?

According to a Bloomberg article, Sandor Steverink, the Europes best-performing sovereign debt fund manager over

the last decade, asserted that when the Irish debt gets downgraded to junk, it is time to become a buyer. Steverink

said he prefers Irish bonds to Portuguese ones as the countrys debt burden was caused by the banks and the

country doesnt have the structural problems of southern Europes economies. Above all, Ireland also has more

potential to export its way out of trouble. We very much agree with such assessment and believe that once Ireland

gets downgraded to junk, forced sellers will create a wonderful opportunity to buy.

Let us provide you for some facts and explanation, why we think Irish bonds at todays prices are already a good

deal. And in case debt gets downgraded further, the deal will be so much sweeter. As of today, Irish 10Y government

bonds are yielding in excess of 12% p.a. and trade at 60% of par value. Let us look at what is actually priced in?

Going back into history as far as 1997, before Ireland's accession to EMU, Irish public debt traded with roughly

100bps premium to German Bunds. So if Ireland goes through a default of sufficient size so that its debt trajectory ison sound foundation, we believe spreads should compress back to 100bps or possibly even lower. Remember that

Germany is currently bearing public debt worth of 89% of GDP and faces a possibility of having to bail out certain

Landesbanken in the not so distant future.

In 2012, Irish debt will rise to 120% of GDP on the back of further banking sector recapitalization and a budget deficit

reflecting the huge output gap. According to Goldman Sachs report from the end of last year, additional capital

required for Irish banks may reach as much as 35bn over next 5 years, which is roughly 23% of GDP.



If we assume some modest GDP growth of roughly 2-3% in current prices, gradual improvement in the budget deficit

(Ireland is actually on schedule with the IMF budget deficit reduction plan) and NAMA turning into modest profit,

than Irish public debt should end up no higher than 130% of GDP in the 2013/2014 period. Afterwards, it should start

gradually declining on the back of GDP growth led by exports as Ireland has already regained a lot of lost

competitiveness thanks to brutal deflation in wages (the current account is already in surplus and trade surplus is

growing by the day).

Therefore if Ireland were to default in 2013/2014, which marks a confluence of periods when Ireland reaches a

primary surplus (a precondition for successful default as the country will not have to tap debt markets) and runs out

of money, we see roughly two possible outcomes:

a) haircut of 40% while reaching public debt of 80% of GDP 100 bps spread to German Bundsb) haircut of 55% while reaching public debt of 60% of GDP 0 bps spread to German Bunds

We have built a map where Irish debt should be trading given the assumption of haircut and number of years to

default.

Current pricing is more favorable than our assumption of 40% haircut in 2013/2014 and 100 bps spread to Bunds

(currently priced @ 223bps over Bunds). If Ireland got more stringent with is creditors and decided for a 55% haircut,

than current loss-adjusted implied spread over Bunds stands at negative 135 bps, which is still positive yield in

absolute terms, but not truly attractive, as it is 135 bps below our prediction where clean Irish bond should trade. In

order to get our predicted attractive yield, we would wait for the price of Irish 4.5% coupon 2020 bond to fall to

levels around 54-55, or yields equal to 13.50% p.a.

02

468

-30%

-26%

-22%

-18%

-14%

-10%

-6%

-2%

2%

6%

10%

5% 10% 15% 20% 25% 30%35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% Y

ear

stod

efault

Bund

Sp

read

Haircut

Haircut adjusted Implied Bund Spread on Irish 10Y Government Bond%

6%-10% 2%-6% -2%-2% -6%--2% -10%--6%

-14%--10% -18%--14% -22%--18% -26%--22% -30%--26%



Years to default

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43% 9,43%

Haircut

5% 8,62% 8,65% 8,68% 8,71% 8,73% 8,76% 8,78% 8,81% 8,85% 8,88%

10% 7,73% 7,80% 7,86% 7,93% 7,98% 8,05% 8,09% 8,17% 8,25% 8,33%

15% 6,78% 6,89% 6,99% 7,11% 7,19% 7,28% 7,35% 7,48% 7,62% 7,75%

20% 5,80% 5,95% 6,09% 6,25% 6,36% 6,49% 6,57% 6,77% 6,96% 7,16%

25% 4,80% 4,99% 5,16% 5,37% 5,51% 5,69% 5,79% 6,04% 6,30% 6,55%

30% 3,77% 4,01% 4,22% 4,47% 4,65% 4,87% 5,01% 5,31% 5,61% 5,91%

35% 2,72% 2,99% 3,25% 3,53% 3,76% 4,03% 4,24% 4,57% 4,91% 5,24%

40% 1,63% 1,93% 2,23% 2,53% 2,84% 3,17% 3,46% 3,82% 4,17% 4,53%

45% 0,47% 0,80% 1,15% 1,46% 1,86% 2,25% 2,65% 3,02% 3,39% 3,76%

50% -0,79% -0,43% -0,03% 0,28% 0,78% 1,24% 1,78% 2,16% 2,55% 2,93%

55% -2,19% -1,81% -1,35% -1,04% -0,43% 0,11% 0,79% 1,20% 1,61% 2,02%

60% -3,78% -3,37% -2,86% -2,56% -1,83% -1,18% -0,36% 0,10% 0,56% 1,03%

65% -5,62% -5,19% -4,61% -4,33% -3,47% -2,71% -1,75% -1,19% -0,64% -0,08%70% -7,77% -7,31% -6,68% -6,41% -5,42% -4,53% -3,45% -2,74% -2,02% -1,31%

75% -10,31% -9,83% -9,14% -8,87% -7,76% -6,71% -5,56% -4,60% -3,64% -2,69%

80% -13,33% -12,81% -12,07% -11,78% -10,58% -9,34% -8,18% -6,86% -5,54% -4,23%

85% -16,92% -16,35% -15,56% -15,23% -13,96% -12,50% -11,42% -9,60% -7,78% -5,96%

90% -21,18% -20,56% -19,71% -19,31% -18,01% -16,31% -15,40% -12,90% -10,40% -7,90%

95% -26,22% -25,52% -24,63% -24,12% -22,84% -20,85% -20,28% -16,88% -13,47% -10,07%

We also feel that Irish bond has an embedded option in the form of Ireland actually not defaulting on its sovereign

bond, but letting the bank senior bondholders feel the pain and thus avoiding any further bank recapitalization. Net

interest payments will reach 4% of GDP by the end of next year, which is a lot, but not yet self-fulfilling sign of doom.

The best what Europe could do is to refinance Ireland through ESM as it would throw good money after good money.

0,0 1,0 2,0 3,0 4,0 5,0 6,0

Spain

Germany

France

Euro area

United Kingdom

Israel

Hungary

Belgium

Iceland

Ireland

Italy

Portugal

Greece

Net interest payments on general government net debt, 2012% GDP



Unfortunately as is the case with every other trade, there are some risks associated as well. We would keep us

awake at night is the downside risk that European authorities decide to somehow subordinate private investors in

the future.

We know from official statements that unlike the IMF loan, loans under the EFSM (and the EFSF) rankpari passu with

private creditors; that is, in the event of default, payment of EFSM loans does not take particular precedence over

payment of other holders of sovereign debt. The rationale for this is that too many creditors with preferred status(like the IMF) can crowd out private investors wishing to purchase sovereign debt. The presence of preferred IMF

loan ( 22,5bn or roughly 10% of Irish debt outstanding) does not change computations by much, in case of debt

reduction to 60% of GDP, haircut would have to stand at 60%, in case of targeting 80% debt to GDP, haircut would

have to be increased to 43%.


18/18

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atwel - global macro 7/2011

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