atwel - global macro 6/2011

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

1/15 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:

1RISKS ARE MOUNTING UP

Market will have to overcome several barriers over next few months.

2FED SHOULD TIGHTEN BUT IT WILL NOT

We expect Fed to remain easy at least for next six months.

3WHAT ARE THE LEADING INDICATORS TELLING US?

Inflationary pressures in US are abating, credit giving defensive signs.

4EGYPTIAN STOCKS CHEAP COMPARED TO CREDIT

We see 14% upside from current levels.

5END OF FINANCIAL ENGINEERING, RISE OF INDUSTRIAL ENGINEERING

Long US industrial companies.

MONTHLY INVESTMENT NEWSLETTER

Global Macro Strategy:June 2011



1) RISKS ARE MOUNTING UPOver the next six weeks we will go through at least two major events that can radically alter the risk profiles of

portfolios. Despite the current correction has lowered valuations to a interesting level compared to bonds, we would

advise remaining patient for a bit longer before clouds clear out. Namely, we would point out following major risks:

a) A failure to address Greek question

Literally, Greece is running out of money. The first bail-out money Greece received last May is almost spent whilst

banks keep on bleeding deposits. A decision by EU on how Greece will be provided for new funds needs to be

reached as soon as mid-July, otherwise IMF will not be able to release its portion of money (IMF is allowed to lend

only to solvent debtors and without any help from EU, Greece will be broke).

The clash currently going on between France and ECB on one hand and Germans on the other seems to be

temporarily resolved. Germans nodded to Vienna style voluntary restructuring when large holders would agree on

rolling the debt over. The funny thing is that we heard several hedge funds were bidding Greek debt like crazy with a

plan to blackmail such initiative. As Greek bonds are not subject to collective action clause, there has to be a 100%

consent on restructuring. Somebody may turn a good profit, after all. We still need more time to see how the story

ends. Greece is too small to cause any troubles, especially viewed through the lens of world economy. But if CDS on

Spain and Italy keep ballooning up, we will lift our eyebrows.

b) if not Greeks, how about Irish ?

In the North, Irish Finance Minister Michael Noonan has said Ireland will go to its European partners with a plan to

impose significant losses on some senior bondholders in Anglo Irish Bank and Irish Nationwide Building Society.

Ireland which is even more indebted than Greece is another brewing problem for Whos said to be supporting

Noonans bid to burn the seniors? Interestingly, the IMF

c) or US debt ceiling?

August 2nd - that is the date when US should run out money without any new issuance of debt. It has been reported

that some banks are already raising margins on US Treasuries, although we would not believe it too much. It looks

like Republicans are keeping Obama in check and will act like immovable objects unless they get sensible concessions

from the White House and significant spending cuts. Either they succeed and growth forecast in US will be cut for

2012 or US will go into a technical default and markets may run amok for couple of days.

d) TLGP running to the end

As if there were not enough macro risks, the Temporary Liquidity Guarantee Program will run to its end by Q4 this

year. Under this program, Fed issued out super cheap loans to major financial institutions amounting to about

$50bn. When banks will have to refinance, they will have to bid much higher yields for their credit and will have to

de-risk their operations even further.



2) FED SHOULD TIGHTEN, BUT WE DOUBT IT WILLWe have been arguing for a long time that current monetary policy of the Fed Reserve causes more harm than good.

In fact, cost of money at 0% does not make any sense as long as the nominal growth rate is positive. In addition,

according to the original Taylor rule - Fed should have already tightened to 75bps.

Changes in US monetary stance are indeed highly consequential to all asset classes, so getting Fed right is one of

those major tasks out there. Modeling US monetary policy tends to be a tricky exercise, but from what we know, Fed

is usually driven by the patterns of following elements:

a) Output gap

Bernanke is a big believer in output gap and of deflationary forces stemming out of unused parts of economy. Based

on OECD forecasts and historical relationships between core inflation (the inflation metric that Fed is most interested

in as it believes that core inflation is a good predictor of headline inflation) and the output gap, we should see core

inflation fluctuate between 1.0 and 1.5% until mid 2012. These are levels where Fed would feel no pressure on

raising rates at all.



In order to close the gap quicker, US would need higher growth. Unfortunately, the recent data have pointed to avery sluggish readings of US economic activity. On the PMI basis, the growth in US GDP should be around 1.7% y/y,

which is well below trend growth and thus not helping to alleviate the existing output gap.

Also based on the two months data of leading Fed Survey indicators (Empire State Index and Philly Fed's average

readings for May and June at +7.89 and -7.74 respectively), we expect to see Chicago Fed National Activity Index

near -0.52 and -1.4 respectively. Predictive power of the used model shows high dispersion with pretty high standard

deviation of at 0.662. This would imply that final reading of Chicago Fed can be +/- 0.662 within a 68% confidence

interval. Let us just remind you that Chicago Fed National Activity Index readings of less than 1.4 on a three month

basis are historically associated with recessions.

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Output gap, inflationpercentage points

Core inflation, 6 months lag (LHS) Output gap, OECD (RHS)



We remain very cautious with respect to the high frequency numbers as impacts of Fukushima are still unclear. We

have read several reports that point to additional Q3 GDP contribution of 1.7% based on full recovery of US

automotive sector. Another beneficial leading factors are falling prices of oil and gasoline (about 20% over past 2

months), which have not yet fully translated into consumer confidence.

b) Bank lending

Fed typically acts as a balance against commercial banks. When lending runs too quickly, Fed steps in and raises cost

of money. On the positive side, banks have been easing loan standards for small businesses since 2009 and today

banks are net easing. We see similar data from the demand side where small businesses are reporting improving

credit conditions. Positively, we are finally seeing pick-up in lending in the productive side of the economy.

Unfortunately, we cannot really judge how much of this money is staying in US and how much is feeding investments

into emerging markets.

Also, overall bank lending is still posting y/y negative growth. Without US government stimulus, money supply would

be falling. August 2nd will be a significant deadline by when we should learn about potential deficit cuts. As US is

trapped in balance sheet recession (private sector deleveraging), US government needs to pick up the shortfall. It

truly does under two circumstances: a) it spends new stimulus money on growth-accelerating projects; b) additional

budget deficits today will be neutralized by legally-enforced spending cuts in the future should economic growth

improve. Anything apart from this logic will be either detrimental for growth or for US dollar.

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Fed, Senior Loan Officer Survey, Small Businessleft axis = net percentage of banks tightening right axis = net percentage of respondents reporting stronger

demand for loans (inverted axis)

Senior Officer Loan Survey, Small Business Standards Tightened

Net Percentage of Small Businesses Reporting Stronger Demand for C&I Loans

demand lags easier standards by 6 months



c) Expected inflation

In terms of expected inflation, we will look both into short-term and long term expectations. First, we can try to

model short term inflation. Since 2006, we see a very strong relationship between prices of oil and y/y CPI. We ran a

simulation to forecast CPI based on three scenarios - WTI falling by 20USD/b from the levels reached in May 2011,

rising by 20USD/b and staying flat. In all three cases, we should see CPI trend down to no more than 2% y/y by mid

2012, still well in comfort zone of Fed.

Also, long terms inflation expectations derived from TIPS have been coming down rather significantly in past two

months.

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US, Total loans and leasees loans by commercial banksbn

Commerc ia l and indust rai l loans by commerc ia l banks Y/Y growth

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US, Oil based CPI y/y modelpercentage points



d) Balance sheet unwindingAs QE2 has been a form of additional easing, we would expect Fed to start normalizing by unwinding the stimulus

through asset disposals. In case the demand for money picked up and liquidity preference decreased, Fed would

need to unwind even faster. But again, we would need to see demand for loans grow, for which we see little

evidence (nor on the side of households and neither on the side of government).

Market has gotten Fed wrong since the end of recession. We believe there is little chance that Fed will raise by the

year end. Watching the jobs market will be key as jobs are a precondition for sustained economic growth. Until the

end of the year, we would be holders of assets that do well in low rate environment, namely leveraged REITs andgold.

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US, 10Y Inflation expectations, Breakeven rates%



3) WHAT ARE LEADING INDICATORS TELLING US?In order to assess at what point of business cycle we are at, we tend to look at different indicators that should give

us a hint. Generally, we pay attention to PMIs, ECRI indices, Conference Board LEIs, credit spreads, financial

conditions, and macroeconomic indicators, for which we use Aruoba-Diebold-Scotti Business Conditions Index. Its

underlying (seasonally adjusted) economic indicators (weekly initial jobless claims, monthly payroll employment,

industrial production, personal income less transfer payments, manufacturing and trade sales) blend high- and low-

frequency information and stock and flow data.

From the inflation point of view, we follow moves in inflation expectations, real rates, broad commodity prices and

Chinese inflation as a proxy for imported inflation. For all these indicators, we have assigned 100% to a level where a

reading is fully supporting an economic growth or inflation and 0% where the reading is a clear hindrance.

As you can see from the chart below, our daily smoothed indicators point to a slowing of both inflation and

economic activity. However, the slowdown in inflation is more pronounced than slowdown in activity, which should

be positive for stocks. Until we see some turnaround in dynamics of leading indicators, we would advise staying

defensively positioned. We have seen some worrying signs especially in the credit side of the market, where spreads

have been widening quite notably.

We have also attempted to regress S&P with respect to our leading index. By definition, the leading index has to

correlate with ratios and we found Price to Book as most explanatory variable.

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Leading indicators, 1D period, last 6 monts, smoothed MA14

x axis - inflationary conditions = >50; y axis- growth conditions =>50

T T-1 History

Inflationary boom

Deflationaryboom

Inflationary bustDeflat.

bust



y = 0,8845x + 1,5525

R = 0,746

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Leading indicators, P/B for S&P 500

x axis - short term expansion indicator ; y axis - Price to book

S&P cheap with respect to LI

S&P expensive with respect to

LI

currently about 2% cheap



4) EGYPT IS CHEAP COMPARED TO ITS CREDIT

We assume that everyone knows what happened in Egypt in the first quarter of this year. As the protests and turmoil

spread into other countries, fewer investors probably followed on as it got ever more difficult to analyze the

situation. And today, we hear very little about Egypt as the drivers of world markets have moved to different parts of

world and most investors withdrew their funds from Near East.

Since Q1, Egypt has been governed by military and fiscal policy has been basically interim. One has a feeling that

most of the major policies discussed and approved in Egypt aim basically purely at stabilizing the current situation

and goals of economic development will be left to shoulder by new parliament and president that should be elected

in September - November.

We admit that assessing political risk is extremely difficult. Yet what we can do is to gauge how do Egyptian stocks

fare relative to national bonds. Said in other words, if one believes that bond market gets it right, then it is ok to look

at just relative prices. On the chart below, we show that Egyptian stocks have underperformed credit since late 2010by about 14%. We believe that this gap is likely to close over time as valuation multiples get re-rated upwards from

currently depressed levels.

Earnings did come down this year as incomes were affected by riots and drop in GDP. Still, we should not forget that

many Egyptian companies enjoy a decent international footprint and next year, GDP should resume growth. On the

price to book value, Egypt is almost as low as March 2009 when the world was coming to the end.



Also we see low probability of huge swings in the currency as level of international reserves is stabilizing. Egypt's

international reserves at USD27.2bn in end-May were sufficient for 5.7 months of imports of goods & services and

equivalent to 8x the level of Egypt's short-term external debt (as of Dec-2010), 80% of the entire external debt stock

(Dec-10), 84%+ of total bank FX deposits (Feb-11), and 23% of total non-government local currency deposits (Feb-

11). These levels have little connection with currency crises.



5) END OF FINANCIAL ENGINEERING, RISE OF INDUSTRIAL ENGINEERING

Past ten years were commanded by the rise of financial engineering. Big hopes were put into the assumption that

productivity of financial capital can enhance or substitute productivity of other factors of production. As the financial

crisis unraveled, in awe we realized that the assumed diversification and distribution of risks were nothing more than

actually levered bets in disguise.

Luckily, there are increasingly convincing signs that next ten years will be governed the rise of real engineering.

According to McKinsey company, in the next 20 years, gross fixed capital formation, or investments if you wish, shall

rise from 21% to about 25% as a share of global GDP. Such investment demand will naturally put big strain on

commodities and on capital goods.

Some financial participants position themselves to play this theme through bets on commodities. It has been a

popular trade for past decade and many loud voices argue for continuing of this trend. We are not convinced and do

not agree by heart. Betting on commodities is firstly a bet against human ingenuity. For the long this has been alosing bet. We acknowledge that in a short term (maybe 2-5 years, hard to tell), human ingenuity may fall behind the

pace at which natural resources are being depleted. But do not forget, that the Stone Age did not end because

humankind would run out of stones. And the oil age shall not end because we would run out of oil. Betting on higher

commodity prices through futures is also not a perfect approach as one loses on rolling contango.

In discussions with our clients, we have always proposed to rather allocate capital towards miners and producers

who through cost cutting may actually increase their margins and investor can capture entire shifts in commodity

price.



But to give a clear picture of our understanding of the world and role of capital in society, we do tend to prefer

investments into tool producers. We believe productivity increases should be rewarded by the widest margin. If the

problems with scarcity of natural resources are to be solved, the only entity to solve the riddle are companies with

highest portions of R&D as technology is by definition a process that increases efficiency of production by combining

cheaper or more abundant resources into a product of same or better qualities . Such companies are surprisingly not

located in emerging markets, but in countries that are purely driven by total factor productivity. These countries are

US, Japan, Germany, Sweden, Switzerland, Singapore, and Korea. Sector wise, we are talking about industrial andtechnological companies.

Naturally, one could scan the entire universe of industrial stocks and come up with some probably winners like BASF,

Samsung, IBM, etc. But to keep things simple and to give a hint to individual investors who may have access to

Korean market for instance, we did look at traditional US based industrials ETF:IYJ, which gives a very good proxy for

our intended theme. In order to get more comfortable with the ETF, we reweighted it by decreasing weight of GE

into roughly equal weight and created a basket (called .IYJEXGE) that is long 100 shares of ETF:IYJ and short 30

shares of GE.

Looking at the performance of .IYJEXGE basket, we were surprised that it has been outperforming broad S&P500

market for past ten years at a pace of 6% p.a.. In the last two years, there are signs of slight convexity, which at first

sight, could signal overheating.

Compared to long term linear trend in price, .IYJEXGE is roughly 9% stretched to the upside.

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.IYJEXGE / SPX

Entry at linear or parabolic trend function ?



Yet it would be quite to brave say "overvalued" as on the EV/12M EBITDA basis (computed as weighted sum of ratios

for individual companies), we are actually lower than based on a 6 year average.

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overvalued undervalued .IYJEXGE Index

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atwel - global macro 6/2011

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