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Subprime Sovereign Europe Still the Focus


Like everyone else, I want to believe that the Greek bailout this time really is ‘done.’ Of course, my main reason for wanting that outcome is that I am weary of writing about all of the deals, which turn out not to be deals, which get trumpeted as deals again, and so on.

Over the weekend, we were assured that there was finally a solution to the Greek crisis. The ECB (and it turns out today, other European central banks) will swap their bonds for new Greek bonds that will not be subject to haircuts. Meanwhile, private bondholders will take a haircut and get new bonds worth a lot less, although this afternoon the head of the IIF (the group responsible for the PSI negotiations) told the BBC that this will only work if CDS owners don’t choose to trigger their payouts. So, as long as private-sector bondholders choose to take less money, this is all good. The IMF is also reportedly contributing less to the deal than had previously been expected. And all of this is subject to approval by a number of legislatures.

So the problems of subprime sovereign Europe have not yet been put wholly to rest. The markets seem unsure on this point. Stocks ended essentially unchanged after hitting new highs in the morning, on continued low volume. Bond yields rose, with the 10-year nominal bond up 5bps to yield 2.06% and 10-year TIPS 2bps higher to yield -0.24%. That would seem to indicate some marginal lessening of tensions, but with volumes thin and equities near-unchanged I think such a read would be premature. The VIX was higher on the day, although it remains lower than it was last week.

Commodities had a banner day, relative to equities, with the DJ-UBS index +1.35%. Precious Metals led the way with a 2.75% gain and Industrial Metals rose 1.6%. Energy, however, will get the headlines. Although Nat Gas blunted the performance of the group, NYMEX Crude rose to $105.50, the highest level since May and 40% above the October lows; Brent reached $121. Gasoline jumped a nickel to $3.0661/gallon, the highest since driving season and the highest print ever for the March 2012 contract.

This seems like the first time in a while that commodities have simply smoked equities, but since the beginning of the year they have kept pace…if you leave out Nat Gas. Our preferred ETF, USCI, is up 8.98% year-to-date compared with 8.32% for the S&P. The correlation has been far too high for our tastes, suggesting that both markets are trading QE3 rather than inflation expectations. But they too are higher: the INFL Deutsche-issued ETN is +5.0% year-to-date.

While all markets move in lock-step, it is hard for me to believe that the earthquake has happened. Whether it’s the earthquake of Greece failing and banks coming clean about their losses therefrom (and a potential unzipping of other subprime sovereigns), or it’s the earthquake of Greece getting bailed out successfully and causing the line of sovereign supplicants to extend around the block, there’s some kind of resolution coming that should fracture, at least for a while, these high correlations. I believe that in such a circumstance, commodity indices are the best-valued and most likely to come on top…but we will see.

However, Bloomberg claims that the S&P is the cheapest relative to bonds it has ever been, since 1962. I enjoy the presumably-unintended bias in construction. Why not say, “Bonds are the most-expensive, relative to stocks, that they have been since 1962?” Both would be true, if the metric they’re pushing (the spread of the ‘earnings yield’ to the 10-year Treasury rate) is the right metric, but one headline implies that stocks are cheap on an absolute basis while the other headline doesn’t imply that. Our equity culture is alive and well, sadly; but there are many more arguments to be made that both bond and stock prices are too high than there are to be made that both are too low. And of course, as I’ve pointed out before, saying that stocks are cheap relative to something else is not the same as saying they are cheap, in the sense they will have better-than-average returns. By the same token, TIPS are extremely cheap relative to nominal bonds, but I would not suggest owning them outright at a -0.25% real yield. So if you want to buy stocks and sell bonds, or you want to buy TIPS and sell bonds, you may have a winning trade…if you weight the trade right. Be assured that the correct weight is not equal notional amounts. That is, if you sell your short-term bond portfolio to buy an equity portfolio dollar-for-dollar, you probably have more risk to markets returning to fair value even though bonds are expensive to stocks.

On Wednesday, after an overnight session filled with updates, clarifications, exceptions, and corrections to the so-called Greece deal, we will get to enjoy the happy news about January Existing Home Sales (Consensus: 4.66mm from 4.61mm). Since the weather in January was better-than-average, it is fair to expect a strong number, which means the market ought to react more to any downside surprise than to an upside surprise. But the magic number is 5 million. Existing Home sales haven’t been there, except for a brief spike in late 2009, since 2007. But prior to 2002, a pace of 5-5.5mm Existing Home Sales was a fairly typical level (see Chart, source Bloomberg), and would imply that properties are finally starting to clear at something like normal rates. The data may be a little messy for a few months as bank REO property gets put back on the market (potentially driving up both inventory and sales numbers), but 5mm is the level to hope for.

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