Monday, 30 September 2013

Trading yields, bike parts and George Orwell's scarf(s). How much is one quadrillion Yen?

The rise in the US yield curve is starting to discourage home owners from refinancing their mortgages.

US 10 and 30yr yield
Last week this blog looked at the trading revenue at various banks in light of my recent research into the risk profiles of various investment banks across the globe. The assumption at the time of writing was that banks in general had cut back on risk profiles in order to:

  1. Stabilize income streams, making a less "lumpy" and more predicable earnings profile
  2. Cut-back on capital usage in order to satisfy Basel III's looming requirements

Now comes a third piece of the puzzle and that is the drop off in volumes/activity especially in the fixed income trading space. This is why data points such as Wells Fargo's laying-off 4,000 employees in mortgage banking (10% of that banks total revenues) matters. Citigroup is doing the same. Remember this all translates to less financial activity and banking is based on "clipping a ticket", thus revenues will be falling. So what can we conclude. The tipping point has already been reached in the cycle, whether the Fed starts tapering in October or January the easy money of refinancing the American housing market has been made.

Next week when the banks start to report I expect there to be some reasonable revenue gaps in their numbers. Analysts have been busy with downgrades ever since 2nd tier Jefferies reported an 85% drop in fixed income revenues in the three months to August compared to the three months to May. Bloomberg are now showing the net income expectations for the US majors to fall by $210m for Citigroup, $128m at Bank of America, $123m at Goldman Sachs and $97m at Morgan Stanley. It's not earth shattering, but it does show that a plateau of sorts has been reached and that when tapering starts the downward trend should continue.

In Australia readers will know that since April I have been suggesting that recent election would bring about increased activity in the infrastructure bond sector. Such predictions fell on deaf ears, but now comes news that the new Treasurer and his finance team are looking into this very notion and hope to bring forward proposals likely to boost demand for said bonds in the coming parliamentary session. I expect there to be various tax breaks to bond holders likely to be in the form of relief on coupons payable etc. If the Australian arms of various major investment banks want to know what they should be devoting resources to I strongly suggest switching some of the equity talent pool to fixed income and also preparing pitch books for Hybrid versions and start booking flights to Canberra. You have been warned. For investors this could be a bonanza of quality yield producing income that should not be avoided.

Japan has recently hit the milestone of one quadrillion Yen in government debt. Even cutting two zeros off that numbers and converting it into US dollars does little to cushion one from the impact of it on a per capita basis.

Japanese Per Capita debt in USD = 1,000,000,000,000,000 / 97.8 x 1/127,650,000 = ~ 80,101

One way to to fix this problem would be to allow future generations, by virtue of population increase share the burden and by "baby-booming" its way out of this trap. Unfortunately the Japanese nation has been reluctant to reproduce at a significant rate and the expectations are now for population decline, meaning that without intervention the debt burden grows on a per capita basis.

Given all this it is expected that the Japanese government will increase their sales tax in order to start repaying some of this money. The theory goes that by printing Yen they will be reflating their way out of some of the debt, but they need to be showing an increase in their revenue base so as to not undermine their efforts in the eyes of the financial markets. This blog's position remains that the Japanese experiment will partially fail as the number of moving parts is just to great to control from a central government. Japan's fate remains precarious at best as its technological lead over its Asian neighbours shrinks leading to a drop off in margins of goods produced. Investors should realise that betting on Toyota etc. is no more or less than a leveraged bet on the demise of the JPY and of growth in the US and Europe.

Hard assets have really performed well since the crisis of 2008. This week you can add to your collection of famous object d'art by buying scarfs warn by George Orwell during the Spanish civil war, including one he was wearing when shot by a fascist sniper.

Eric Blair and his anti-facist scarfs . . . 
This blog has always had a soft spot for all things Orwell, especially his social commentary books (Down and Out in Paris and London, Road to Wigan Pier, etc.), but I am drawing the line at bloody scarfs on the basis that Orwell himself might not have appreciated the Turin shroud quality of such an artefact. I think my own preference would be for a  signed first edition of 1984.

Last week I reported to readers that my beloved Cannondale SuperSix Evo had suffered a catastrophic gear failure. At the time I thought the frame itself, though scratched-up and a bit battered would live to fight another day. My optimism has been dashed when local dealer Cheeky Money (Centennial Park, Sydney) declaring it unsafe for riding. The biggest crack can be seen in these pictures.

Given this I asked Cheeky Monkey to investigate a replacement frame. Readers, will know that my experience of Australian Cannondale distributor "CSG" has been less than enchanting. As I said to the excellent team at Cheeky Monkey I wasn't looking to save money by going around them and sourcing the replacement at the lowest possible prices, rather I just wanted some reasonable alternatives and likely delivery times. CSG offered me a choice of two frames, the first was an older 2011-12 Team Liquidgas frame at RRP -20%. The second was black frame of similar vintage at the same price. By the way that discount is no great deal after I found out that Cannondale started a sale of 2013 frames on Friday September 27 across the globe as they look to get rid of old stock ahead of new team colours etc. being introduced for 2014. That probably means that what I was being offered should have been marked down even further. Having said that, price wasn't a deal breaker on its own. When the rep at Cheeky Monkey said . . . "Mike, you're probably not going to like this . . . ", I chose to not get too upset and instead asked the rep to go back to CSG and ask them to try again given that my connections in Europe would be able to supply me with two superior choices at a better price with a lead time of 48hrs! As I have heard nothing at this stage I have given up on CSG. I did commit to Cheeky Monkey as the builder  so long as they understood that I was being forced to go around them by circumstance rather than choice. They are a good team and I recommend them. Of course if they decided because of politics between themselves and CSG not to build the bike I would take the parts to Atelier De Velo and no doubt get equally as great service. I hate that I've been put in this position as I strongly want to support my LBS suppliers.

So what alternatives am I looking at? Locally I would have to change brands and I've been investigating what's out there. Bike Lab in Bondi Junction has a choice of alternatives and the boss there Liam walked me through various frames he could get. I liked the idea of this black, yellow and white Colnago C59 but would have to get new bars and cranks to fit the frame:

I also spoke to Liam about the Cipollini RB 800 which aesthetically appealed to me, but Liam suggested I wouldn't like the ride and it was perhaps not for the "larger" bodied rider. It's a pity because the finish on the frames is pretty spectacular:

I also spoke to a Specialized dealer about an S-Works Tarmac SL4. The attractiveness about this offer was that the local distributor had multiple colour choices available in my size and in stock. I've heard good things about Specialized warranty here in Australia and it's somewhat tempting. I like the idea of the special order Vincenzo Nibali Ltd. edition "shark of Messina" themed frame:

As for Cannondales it looks like my choices will be the either the new black, green white team frame or the USA themed frame:

I'm leaning towards the red, white and blue theme and setting it up like 2012 US road champion Tim Duggan:

What's not to like? C'mon, we all want a bike with blue bar tape and red hoods, right?


Wednesday, 25 September 2013

Major equipment failure . . . Carbon Fibre disaster . . .

Sometimes the cycling and investing gods get angry with you and when that happens you need to keep your head down and cut your losses fast.

This morning it was the cycling gods who woke up angry with me. I was out the door at 5:45 and cruising the beaches of Sydney. Unfortunately things turned bad when I was climbing out of the valley that is the Bronte Beach area of Sydney. A piece of building wire got spun up into my rear mech and tore the best part of $500's worth of Campagnolo Super Record rear derailleur clear off the back of my Cannondale SuperSix Evo. Here's the result:

The one question that I'm asking is why the $30 derailleur hanger didn't bend or break? I thought the idea was that it broke and saved you what happened to me. Go figure . . . ???

Federal Reserve Bank of New York president William Dudley threw some economic debris on the road of financial markets yesterday when he set out two tests for a taper to start:

Evidence of labour market improvement
Evidence of enough economic momentum to keep the improvement going

“Assuming no change in my assessment of the efficacy and costs associated with the purchase programme, I’d like to see economic news that makes me more confident that we will see continued improvement in the labour market,” said Mr Dudley. “Then I would feel comfortable that the time had come to cut the pace of asset purchases.”

We'd all like Bernanke and the team to put hard numbers on what they mean, but economics is usually under the umbrella of humanities and not sciences at most universities and therefore it remains more of an art than the markets would like. 

Recently I wrote about my surprise about the VaR numbers some banks were running currently. UBS for instance ran a VaR of less than CHF50m on average during the last quarter and it shows in their trading income. That of course is something the market is willing to pay for with better shareprice performance. This blog doesn't see risk as an anathema to sensible banking, in fact it's necessary in order to correctly rank and price financial instruments.

Investment Banks Trading Income

I was somewhat surprised by Deutsche and Barclays reliance on trading given the travails both these institutions have gone through. Maybe I should cut Barclays some slack as they never went to governments for direct support in 2008-9, though they like all banks, got plenty of Central Bank help indirectly. DB though probably still needs to raise capital (tier 1) in order to meet the Basel III requirements. So what do we conclude? Risk taking 2006-7 style is not back, but some banks are not running from the benefits of well maintained trading books. Markets are brittle when it comes to risk . . . as brittle as my rear derailleur . . . we all want better RoE, but few want to be associated with what it might take to get there.

Finally on this rather expensive day it would be remiss of this blog not to mention the changes at Blackberry. Few in finance have not possessed a Blackberry, that indispensable tool of the pre-GFC Investment Banker. It looks as if there are still some prepared to take a risk on the Blackberry architecture (as opposed to the hardware) and are looking to take the Canadian Tech leader private and rebuild it's business by leasing out its' guts. Notable is that the buying syndicate is composed of non-Investment Banks. The hedge funds and private equity groups operating today are full of refugees from the golden towers of Wall St and the City of London. Maybe this is how it should be, because if these institutions go under they are less likely to be systemically destructive and more likely to provide lessons on risk assessment for future generations of economists and bankers. The problem right now is that we work in a risk vacuum and that in itself will soon be tested when central banks start to withdraw stimulus.


Tuesday, 24 September 2013

P.A.C.E. . . . Plays after critical errors or "bounce-back-ability" . . .

How would you feel if someone announced that you were not going to take a job and the investors in the company that had been looking to hire you celebrated by buying the company's stock? That's what happened a week a ago when the  markets cheered Larry Summers pulling out of the race to be the US Fed's next President. Janet Yellen now is the favourite to continue the Bernanke legacy and the reason why the markets cheered originally was because Yellen has been the most dovish member of the current Fed Board.

The Yellen bounce . . . and retracement
This blog wrote about the possibility that the Fed would hold off on the taper that everyone had predicted to happen in September some months ago and therefore was not surprised by Bernanke's failure to slowdown the presses. Right now we've reached a critical point where to paraphrase Shakespeare:

I am in money
Stepp'd in so far that, should I wade no more,
Returning were as tedious as go o'er:
Strange things I have in head, that will to hand;
Which must be acted ere they may be scann'd.
(Macbeth Act 3 , Scene 4)

The taper now is likely to start next month depending on the Non Farm Payrolls. I'd be betting now on a decrease in the stimulus of about 20%. The Fed will not cease all stimulus overnight. Bernanke knows that he has to give the market a chance to bounce back from any shock, no matter how marginal that is likely to be. The most significant move you make in investing, business or in sport is what you do immediately after a mistake. We'll be able to tell more about the "greatness" of the current Fed after the next move than we know now.

I had a meeting today with some friends from Europe. It was interesting to listen to someone not so invested in my current home country. The investment line from planet Europe seems to be that even though the US has had a good run it was not exactly the time to go all-in on broader European equities. As this blog said recently I remain bullish on US dollar assets, but willing to give central Europe (ex-Germany) a bigger allocation of funds. 

Another subject we discussed was Japan. Now normally I prefer to look at Japan as purely a function of a leveraged play on the US, but with their "unlimited" money supply out of sync with the situation we've seen in previous cycles it remains to be seen whether the old axiom of tracking the yield on the US 5 year T-Bond remains true . . . i.e. Yield-up indicates US growth and therefore demand for Japanese products . . . therefore buy the N225.

The UST 5year price fall / yield rally was stopped in it's tracks by the Feds continued money printing, but now given the assumption that the Fed will start a moderate taper I would be reluctant to sell Japanese equities holding outright, unless of course I was trying to flip into an even more leveraged play in the shape of a market like South Korea. Having said that picking an Asian winner at this stage is going to be as tough as investing in India . . . FWD . . . Fraught With Danger.

Since the last published blog Australia has had a change of government and a rally in the AUD. Investors need to know that while the AUD looks to be a pro US stimulus play it is in fact  likely to lose much of its' correlation as the new centre-right government starts to face the fiscal hole left behind by the socialists. The first hole they have been facing has been the hugely overblown National Broadband Network (NBN). The original plan was to roll out fibre to everyone's house and then charge both the content providers and the end users to use the infrastructure. The problem of course with the plan was the fact that Australia is the size of the USA, but with 10% of the population. Therefore the cost of rolling out fibre to everyone's door is astronomical. The original $30bn budget has been long since ditched and now so too will be the monopoly structure of the NBN Co. And this is only one of a handful of projects that need like played out oil wells to be plugged and abandoned. In the meantime the revenues continue to fall and the AUD in it's recent short rally will do nothing but lead the Reserve Bank of Australia and the government to do the following:
  1. Impose restrictions on housing real estate investment by individuals via leverage restrictions
  2. Restrict foreign investors buying into the Australian housing sector
  3. Lower interest rates

This blog remains of the belief that the only sensible cushion to the economy in the current budgetary cycle will be a 85 cent AUD. Anything else will be a political disaster for the government and an institutional disaster for the RBA.

Amazing scenes from the cycling world titles on Sunday. The Team Time Trial was won by Omega Pharma Quickstep by 0.81 of a second. That's just way to close over an hour of cycling and ultimately heart braking for the 2nd placed Orica Greenedge team who have duelled with OPQS all season in these events.

The winners averaged 54kph over the course, which is frightening to think of if you've ever been on a bike on a flat course for an hour. On the weekend I was coming down a 10% hill and only reached 55kph before I backed off, so I can't imagine the speed these guys are able to do. The OGE team riders will have to show some "bounce-back-ability" now as they head into the individual time trial and elite road race and forget about over analysing their ride on Sunday. There's no pint in looking for a critical error when it's that close because all it takes is a slight shift of a dodgy piece of road to knock off the sort of time we're talking about. Thats the thing with cycling on the road as opposed to on a track . . . things are not the same for everyone . . . you just try to minimise the problems the best you can. The situation is the same in investing: don't try and over analyse for an extra single percent of return when you've already achieved your original goal. the margin is just too fine for everyone but the most perfectionist of "riders".


Monday, 9 September 2013

Musing from a bike saddle . . .

It's a good thing to start a Monday knowing the newly elected Prime Minister of your country is a cyclist. And the first morning after the election he was on his bike on a normal bunch ride through Sydney's northern suburbs. The message is positive for everyone planning on getting on a bike and even though some riders might have preferred a different election result they need to recognise that for cycling this is a good thing. As I've often said on this blog being on a bike gives you time to think and reflect on things. Australia for the past 6 years has been governed by a fractious group of political insiders who spent very little time thinking out the consequences of policy and too much time chasing "big ideas" and unrealistic outcomes to understand the benefits of stability on an economy. Maybe if either of the centre-left PM's we had during this period had got on a bike they may still have been in power today.

The world is of course not going to slow down just because you get on a bike for a couple of hours and even though for many ears the Chinese were great advocates of cycling they now prefer the car to support their love of their newly found wealth. China looks like it will start to officially mark down GDP expectations from 7.5% to 7% as it comes to accept that internal demand is not keeping up with expectations. On Friday the latest figures for the balance of trade were published and exports rose 7.2% YoY v. expectations of 5.5% and July’s 5.1%. Imports rose a less than expected 7% YoY, leaving the trade surplus at more than $28 billion.

The Chinese consumer is still cautious and probably waiting for the new leadership to settle in. It doesn't help that the current trial of Bo Xilai continues to dominate the media as this seems to caution all against a more swashbuckling approach to capitalism in general. Whatever the case I go back to a Credit Suisse report from mid June suggesting the GDP growth rate gets down to 6% even though GS, DB and others are still positive on the back of export demand. I suggest investors remain cautious and continue being long USD assets while divesting some profits into the UK and possibly something from France.

I was talking to some people about some risk management work last week which caused me to do some research into the current exposures of the mega banks in terms of their value-at-risk reporting. While not wanting to get into a longer discussion about methodologies I was surprised that VaR numbers seem low by historical standards. Take Citigroup as an example. Now I know that they've gone through a horrible period post the GFC, but given the size of their balance sheet it should be notable to investors that they are running a mere $120m of daily VaR on average during the 2Q13 period and that has been fairly consistent with their very recent history.

Citigroup VaR: Form 10Q extract
Citi uses the 99% one day confidence measure here as required by the regulators, though some banks (e.g. UBS) give  the 95% variation and some weekly information. If you ever feel inclined to look into the risk at these major institutions you just go to the US SEC's website and look at filings of their Form 10Q's. Why is all this important? Well as an investor, risk costs capital. That means that the more risk I have the more capital I need and in raising capital you're probably diluting your return on equity. Now if some regulators get their way banks will be required to raise even more capital for each dollar at risk. Take the UK for example where the government had to nationalise a number of institutions in 2008-09, there Sir John Vickers, who chaired the Independent Commission on Banking suggests that a doubling of core tier 1 capital may be required to sufficiently protect the tax payer from future shocks. In my mind and reading the VaR reports from several banks the various institutions are already well on the way to being in an operational position to cope with regulators increasing said requirements. Given this investors need to understand that banks are less likely to be able to deliver the mid-teen RoE that was previously the norm and as such most of the high beta rally in the financials is over. Investors looking for above trend returns will need to either diversify into institutions more exposed to early cycle returns (Europe) and less on the US. The fact that the UK government will soon start to sell of it's banking assets should be all you need to switch first to France and then finally to the southern economies.

Thinking a little laterally for the moment one wonders what the effect of all the shrinkage in the banking sectors risk taking has had on local economies reliant on their largesse? My old home of Geneva finally starting to see things cool in its' housing market. 

Not exactly giving it away, but things are changing . . .
I can testify to the frightening cost of living there. During my time there real estate prices went crazy due to a slow growth in the housing stock, a flight of bankers and support staff from areas such as the UK, a Europe wide tax scare and regulatory restrictions on foreigners. Now it would seem things are cooling. Transactions throughout the summer period were few and far between as bid-ask spreads widened dramatically, especially in the SF3m plus market range. Most significantly the collateral required for bank loans is changing. Previously 50 or 100 year loans were not uncommon and these were based on individuals being able to pledge their pensions against a mortgage. But, just as bank's have had their cost of capital changed, so to have house buyers by virtue of a halving of the amount of pension that can be used to offset the mortgage. It's just like doubling the amount of tier 1 capital that banks need to hold and the result will be the same, i.e. returns will go down.Therefore if you're long Swiss property now as a speculative hedge you need to think again. If you're living in Geneva and own a place and you're happy, then either work harder or just grin and bare it while you're cycling in the Alps or skiing in Megeve.


Monday, 2 September 2013

Imagine . . .

It's easy to imagine that there's a lot of confusion in markets right now, especially so given the potential risks of involvement in the Syrian debacle. Volatility has been rising leaving investors somewhat exposed to the vagaries of the market. Over here in the Asia Pacific convertible bonds are back on the agenda for financing business. Think about it this way; rates are low and volatility is high. Put these two aspects together and you can get some unbelievable financing deals for your business. Take for example US listed Chinese IT company Qihoo 360 Technology. They issued $600m worth of CB's with a coupon of only 2.5%. The stock is up over 180% this year and to convert the notes it will have to go another 40% higher. Interest on the notes will be payable semiannually in arrears on March 15 and September 15 of each year, beginning March 15, 2014. The notes will mature on September 15, 2018, unless previously repurchased (there's a put option for the CB holder), redeemed or converted in accordance with their terms prior to such date. I'ver never looked at the Qihoo balance sheet, but my guess is that they aren't going to be able to get money at 2.5% at their local bank branch in China. That is the biggest ever CB issued by a US listed China based company, provong once again that a little clever maths can help a business get a better deal.

Given the above I thought it was an extraordinary piece that was published in the Financial Time's Lex column over the weekend. I'm not sure why Lex decided now to warn investors about the dangers of spreadsheets, but they did:

"The era of Big Data is here. More powerful computers make it possible to analyse the oceans of information gathered by barcode scanners, mobile devices, security cameras, credit-card readers and so on."

On more than one occasion this blog has mentioned the importance of ol' cell A1 when deciding what M&A deals did and didn't get done. I refer to cell A1 euphemistically of course because I personally always started with my funding assumptions up there at the top left of my spreadsheet. It will forever remain the case that a slight tweak in the cost of capital has a huge effect on what banks do an don't do and to a great degree it's that cell that CFO's need to be on top of first and foremost if they are to see their institutions thrive. 20 years ago funding was somewhat more certain as the sources of capital were limited. Today of course funding is again somewhat constrained. The Fed, BoE and ECB amongst others have through various forms of QE been underwriting the banking system in the hope that these ultra-low rates will filter through to businesses.

Given the above spreadsheets have filtered down to SME's and should in time enable them to be more precise in how they deal with the questions of maintaining and running their businesses. For a long time now the mega government projects have been dominated by companies with the wherewithal to finance contracts to the satisfaction of governments. The SME's of course have always taken sub-contracting rolls and have had to fund these via overdraft facilities that were onerous on their returns. Now I would suggest that SME's could go around traditional sources for funding via their own version of a PPL in which they effectively go to the public (and public institutioins) and swap some of their performance versus a benchmark contract level for funds at a cheaper rate. If we assume that interest rates stay low for the next few years (even with the threat of the taper in the US) this should allow them to be involved with bigger deals at better rates and return a portion to a yield hungry public. They probably can't issue CB's in the normal sense, but there are alternatives. The key of course for them and the investor is the spreadsheet and that cell numbered A1. Imagine what a syndicate of like-minded SME's could do if they successfully co-operated in such financing. They would effectively be able to challenge the hegemony of several mega infra-structure suppliers and be in a position to bring down the cost to the governments looking to build new infrastructure. It's just a thought, but should serve to counter the surprisingly negative connotations of Lex this morning.

Imagine the best cycling weather possible. Now imagine the perfect course. Where would you be? What bike would you ride? Who would you ride with? If Sydney remains somewhat hostile to cyclists in general it does of course have the compensation of providing absolutely sparkling days. On the weekend I rode both alone and with a friend and even though I was slugglish when I set off on Saturday morning the fact that it was the last day of winter with not a cloud in the sky and a temperature that climbed from 16ºC to 25ºC over the course of the ride meant I still had enough positive energy to get home with a smile on my face.

 For the month I rode 990kms in 24 rides and spent 47hrs in the saddle. I'm slightly dissappointed that I didn't get to 1000kms for the month, but honestly when I stopped after 60kms on the 31 August I'd had about enough. Thinking about it I'd say anyone living in a city of 4million people who's able to find the room and time to ride a 1000km+ in a month is either a genius, crazy or both. I guess I'm close to one of those, but not sure which one yet.

I was interviewed by the Sydney Morning Herald last week. The article was on the continuing wars between drivers and cyclists here in Sydney. The journalist only used one anecdote from me, but I hope it helped people understand what you go through riding a bike in Sydney:

Michael Fagan reckons he cops abuse about twice a week over his preferred mode of transportation. On a scenic ride through the eastern suburbs from Darling Point to Centennial Park early on a recent weekday, the financial consultant encountered a ute whose driver became exasperated with the cyclists' speed as he tailed him through a roundabout.

The driver conveyed his impatience by leaning on the horn. Then he conveyed it again, in words: ''I'll slice you in half, you f---ing poof,'' he yelled.

''That's the intimidation that goes on all the time in Sydney,'' he says.

That's why I'm trying to sign up for some well organised events over the summer. For those of you asking here's my target list:

13 October: Wiggle Cycling Series Hunter Valley Classic - 122.5km Route
20 October: Sydney Spring Cycle - 50km route
3 November: Sydney to Wollongong - 90kms

I want to do the rides connected to the Tour Down Under, but it looks like I'm going to be in Europe at the end of January. I'm looking for some events in December, but might have toventure as far south as Melbourne to get a good ride. Anyone with further suggestions please contact me via the usual channels.