The Most Painful Part Of The Short Squeeze May Be Yet To Come, JPM Warns
Two weeks ago, we reported that NYSE Short Interest has risen 4.5%, back over 18 billion shares near the historical record highs of July 2008 (and up 7 of the last 9 months).
We said that this dynamic means one of two things:
- Either a central bank intervenes, or a massive forced buy-in event occurs, and unleashes the mother of all short squeezes, sending the S&P500 to new all time highs, or
- Just as the record short interest in July 2008 correctly predicted the biggest financial crisis in history and all those shorts covered at a huge profit, so another historic market collapse is just around the corner.
So far not a single central bank or major policy-making institution has intervened with a major (or for that matter, any) stimulus, but the expectation that one will - be it the G-20 last weekend, China this weekend, the ECB next week or the BOJ the week after - has led to precisely one of the two postulated outcomes: as we reported yesterday, the "mother of all short squeezes" was indeed unleashed, and last week the "most shorted" stocks were up a near record 8.7%, the highest since the furious November 2008 bear market rally.
So does this mean the short squeeze - whether ordinary course of business or engineered by banks to push the price of both the S&P and oil higher so that energy companies can sell equity and repay secured bank loans (as we speculated last week) - is over? According to JPM, not just yet, even though by now the weakest hands have clearly tapped out. In fact, since there has been virtually no rotation into ETFs, the most brutal part of the squeeze may be just ahead. Here's why:
The covering of short equity positions continued over the past week. The short interest in US equity futures declined over the past week as seen in Figure 1.
But its level remains very negative suggesting there is room for further short covering.The short interest on SPY, the biggest equity ETF, at 4.75% stands below its recent peak of 5.43% but it remains elevated vs. its level of 3.54% at the start of the year.Equity ETFs have not yet seen any significant inflows, suggesting that ETF investors have done little in actively reversing the almost $30bn of equity ETFs sold over the previous two months. CTAs, which have been partly responsible for this year’s selloff,are still short equities and they have only covered a third of the short position they opened in January. In contrast, Discretionary Macro hedge funds, Equity L/S, risk parity funds and balanced mutual funds, appear to be modestly long equities, so they are currently benefitting from the equity rally.
Is it possible that the short squeeze can take the S&P another 100 points higher, reaching Goldman's 2016 year-end target even as GAAP EPS have crashed to just over 90, and which would mean that the market when valued on a GAAP basis would be at 22x earnings and the most expensive it has ever been? Of course it is, even if that will make the S&P500 the most overbought, and overvalued in history, and just ripe for the next wave of short selling.
So for all those eager to short the S&P but unsure when to do it, keep an eye on the SPY short interest and CTA net exposure. Breakout failures would mean this week's roundhouse punch to the face of market shorts may be as bad as it gets. On the other hand, if the covering momentum is only just starting, and now it is the ETFers and CTA's turn to pick up the baton, the next move higher in this bear market squeeze could easily take the S&P500 to new all time highs.
Sweden Begins 5 Year Countdown Until It Eliminates Cash
How much louder can the “ban cash” calls get?
Recall it was just last year when we catalogued the growing cacophony of crazies for whom banning physcial currency is the only way to ensure that depositors can’t simply reassert their economic autonomy under a low or zero rate regime..
Put simply, if interest rates get too low, depositors will simply take their money out the bank and put it in the mattress or the safe where, to quote WSJ from last week, “interest rates are always low no matter what central bankers do.
Most recently, Larry Summers called for the abolition of the $100 bill in the US and in Europe the €500 note is to go the way of the dinosaurs.
Perhaps the most telling sign that citizens are starting to panic is that in Japan, they’re selling out of safes. Literally.
“It shows a vague sense of unease,” one Japanese lawmaker who brought up the soaring safe sales in parliament on Monday remarked.
Now, the excuse given for banning big bills is that it combats crime. And maybe it does. But in the end the rationale is simple: if there are no more physical banknotes, people have no economic autonomy. Let’s say consumer spending is stagnating. No problem, take rates to -20%. We bet they’ll start spending then - either that or see their desposits haircut by 20%.
In short, no cash means no effective lower bound and with no lower bound, the economy can be completely centrally planned - for all intents and purposes.
Consumers not spending? No problem. Just tax their excess account balance. Economy overheating? Again, no problem. Raise the interest paid on account holdings to encourage people to stop spending. So with Citi, Harvard, Denmark and Peter Bofinger, member of the German Council Of Economic Experts, all onboard, we’re surprised to hear that Sweden (already one of the leaders in the cashless society movement) is looking to phase out a series of new bank notes it just introduced last year and moved ever closer to the cashless utopia.
“Last year Sweden introduced a series of new banknotes replacing its old kronor notes. But figures suggest these too could be gone from circulation in half a decade if the development towards a cashless society continues,” The Local reports,” continuing that “cash transactions today represent no more than two percent of the value of all payments made in Sweden, [and that estimate] will drop to below 0.5 percent within the next five years.
Some welcome the trend - credit card providers, for instances - others have reservations. “It is happening at a furious rate. And it's important to many older people to be able to use cash. I mean, today it is legal tender and you have to be able to use it until parliament decides otherwise,” Christina Tallberg, chairwoman of Swedish pensioners' organization PRO, told Swedish Radio on Friday.
Well, until parliament or perhaps more appropriately, until The Riksbank and Stefan Ingves decides it. Because at -0.55, it’s a “how much lower can you go type scenario.”
Well, if you go kronor-less, that question ceases to make sense. The "problem" simply goes away.
“Sometimes you have to learn new things. It's a little awkward for a transitional period, but I think it's going to be so simple that you pretty soon realize that this is a lot easier and better than having cash,” said working environment ombudsman Krister Colde of the Commercial Employees' Union (Handels).
Famous last words Krister.
Old Mutual prepares break-up; receives offer for wealth unit from Warburg Pincus and Cinven - report
Story
Old Mutual, the Anglo-South African financial-services giant, is preparing a break-up which may be outlined alongside the group’s annual results next week, Sky News reported. Inside sources cited in the report warned that the plan is not likely to reach fruition for many months and the proposal has not yet been finalised.
The break-up plan involves the formation of several standalone entities - Old Mutual's UK-focused wealth arm, its South Africa-based emerging-markets business, its stake in the South African lender Nedbank and its New York-listed OM Asset Management unit, including the rump of Old Mutual’s holding in the division, the report said.
The buyout firms Warburg Pincus and Cinven are believed already to have jointly made a bid of several billion pounds for Old Mutual Wealth, which operates brands including Old Mutual Global Investors and Quilter Cheviot, the item reported. While a sale of that business appears inevitable, it is not known what the board of Old Mutual intends to do with the other standalone companies, the report said.
Chief Executive Bruce Hemphill is believed to have mandated advisers to kickstart the break-up plan not long after taking up his post last November, the report said. The board is believed to be advised by Rothschild, and in-house brokers Goldman Sachs and Bank of America Merrill Lynch are also expected to participate in any disposals and restructuring activities, the report said.
Old Mutual has a GBP 8.8bn (USD 12.5bn) market cap, the item noted.
Weekly Market Update: Recession? What Recession?
US and European equity markets saw their third straight week of gains as stronger crude prices and the prospect of more easing kept the rebound on track. The ECB has all but guaranteed more easing at its policy meeting on March 10th, and President Draghi reiterated that the ECB has no limits on policy tools that are within its mandate, highlighting the growing downside risks to the euro zone outlook. Russia, Saudi Arabia and an ad-hoc group of other OPEC producers continue to discuss a meeting later this month to finalize plans on freezing crude production at current levels, helping push crude futures close to YTD highs. In China, the PBoC kept the yuan strong and cut the RRR ratio for the first time since 2009. There was a raft of dodgy US economic data, but the very good February jobs report provided a strong counterweight, and by Friday markets were pricing in at least one Fed rate cut this year, as well as a small chance of second rate hike by the fourth quarter. For the week, the DJIA rose 2.2%, the S&P500 gained 2.7%, and the Nasdaq added 2.8%.
US economic data out this week included more subpar manufacturing sector reports (the Feb Chicago PMI), weak January home sales numbers and even a Feb ISM services report that raised questions about the consumer-driven side of the economy, but the strong February US jobs report trumped them all. February non-farm payrolls rose by 242K, the 72nd straight month of uninterrupted job gains, by far the longest streak on record. December and January payrolls were revised higher, putting monthly job gains over the past three months at a very healthy average of 228K. Unemployment remained at 4.9%, equal to the eight-year low seen in January. Somewhat offsetting these very positive components, wages fell by 0.1% versus the 0.5% increase in January, for a 2.2% bump in the annual gain. The Fed's beige book was split, with half the Fed districts reporting economic growth and the other half showing flat to slightly down conditions.
China's PBoC resumed its easing cycle on Monday, cutting the reserve requirement ratio (RRR) by 50 bps, taking the ratio to 17% for the nation's biggest lenders. It was the first cut in the key policy rate since last October, and comes as somewhat of a surprise given that the PBoC had previously said it would rely more on short-term cash injections to maintain liquidity. The PBoC did conduct open-market operations on Monday, however the RRR cut suggests that the short-term liquidity operations have not been as successful as hoped. Note that the announcement came just after the government said 1.8 million workers would be laid off from the steel and coal sectors, in an effort to curb overcapacity, and just ahead of the annual meeting of the National People's Congress, which will discuss the continuing implementation of President Xi's plan for deep structural reforms.
The G20 last weekend met the very low expectations, as leaders agreed yet again that monetary policy was no longer sufficient to address the ills of the world economy and promised to refrain from competitive FX devaluation. China specifically used its role as host of the event to reassure its global partners that it did not intend to further devalue the yuan. The PBoC raised the yuan reference rate to a three-week high by Friday even as they pumped more cash into the domestic economy. After the G20, Chinese officials kept up a steady drumbeat of commentary to the effect that the yuan would remain steady and that another big devaluation was "impossible."
Polling ahead of Britain's June referendum on continued European Union membership appears more or less deadlocked. An ICM poll saw support for and against the EU tied at around 41%, while an ORB poll saw 52% in favor of leaving and 48% saying they would vote to remain in the EU. Prime Minister Cameron began amping up his rhetoric in favor of the "stay" option, highlighting the unknown and possibly very high costs that would come with the choice to leave the EU, just a week after his conservative rival Boris Johnson threw his weight behind the "go" camp. After peaking above 1.4650 at the beginning of February, cable bottomed around 1.3850 on Monday then firmed somewhat, closing out Friday around 1.4250.
The ongoing political and economic crisis in Brazil reached a head on Friday, as police raided the home of Luiz Incio Lula da Silva, the former president who is under investigation in the colossal "Car Wash" graft scheme involving national oil company, Petrobras. Lula was taken into custody for questioning, just a day after reports claimed that Delcdio do Amaral, a senior senator in Lula's Workers' Party, was negotiating a plea deal to testify that Lula was deeply implicated in the scandal. Current President Dilma Rousseff is already facing impeachment proceedings, and it appears that Amaral has the goods on her as well, greatly increasing the risks to her office. Nationwide anti-government protests are scheduled for mid-March, and many analysts suggest the government may not survive for much longer. As the socialist government unravels, markets like what they're seeing: the Bovespa has rallied more than 40% since its January low, adding nearly 18% this week alone. The real has strengthened around 7% on the week, with USD/BRL dropping to around 3.72, its strongest level since last August. Shares of Petrobras rallied ~50% this week.
Crude prices probed YTD highs as futures racked up their third straight weekly gain, with Brent topping $38 and WTI approaching $36. Russia confirmed that the oil production freeze summit will take place later this month, featuring the participation of 15 major OPEC and non-OPEC producers, although parties to the deal were taking pains to reiterate that no production cuts are under discussion - only the production freeze. Markets remained optimistic despite another stunning set of gains in US weekly inventories, with the DoE build about four times the expected amount. Meanwhile, US natural gas futures settled at a 17-year low on Thursday around $1.68 thanks to oversupply and the warm winter in North America.
February auto sales data was relatively strong, providing a counterpoint to the weak US manufacturing theme that continues to obsess US participants. Fiat Chrysler and Ford sales were very strong, although General Motor's headline figure widely missed the mark due to some specific company factors. Ford led the way with a 20.4% gain thanks to an uptick in its fleet business, while sales at Fiat rose 11.8%. GM's sales fell 1.5% due to a decrease in rental sales, although this was largely the result of a planned reduction in rental deliveries.
In M&A news, Intercontinental Exchange said it would compete with Deutsche Boerse to acquire the London Stock Exchange. ICE hasn't given a formal offer to LSE, and no decision has yet been made as to whether to pursue such an offer. Last week, shares of LSE soared 17% after Deutsche Boerse proposed an all-stock deal. Theater chain AMC Entertainment reached a deal to acquire Carmike Cinemas for $30/share in cash, in a total deal valued at $1.1 billion. Honeywell formally abandoned its pursuit of United Technologies, citing the latter's unwillingness to engage in negotiations.
Closing Market Summary: Stocks Register Third Consecutive Weekly AdvanceThe stock market ended an upbeat week on a wobbly note. The S&P 500 added 0.3% after being up 0.8% going into the late afternoon. Despite the late slip from session highs, the benchmark index still registered its third consecutive weekly advance, climbing 2.7% since last Friday.
Today's session featured something for fans of symmetry as stocks started and ended the trading day on a shaky note. The volatile action occurred in the wake of a February Employment Situation Report that left participants wondering what to make of it. On one hand, the report pointed to strong headline growth in payrolls (242,000; consensus 190,000), but on the other hand, average hourly earnings decreased 0.1% (consensus 0.2%), dropping the annualized earnings growth rate to 2.2% year-over-year from 2.5% that was observed in January. This puts the rate back in a lackluster range that has held for years and has negative implications for consumer spending.
That view likely bolstered the market's belief that a surprise rate hike in March is off the table, inviting an intraday rally in stocks. However, this argument gets a bit fuzzier when taking into account today's upward revision to Atlanta Fed's GDP Now forecast for the first quarter, which was raised to 2.2% from 1.9% on March 1. The Atlanta Fed pointed to an increase in expectations for real consumer spending growth (to +3.3% from +3.1%) as the main reason for the improved outlook.
Furthermore, shortly after the jobs report was released, the fed funds futures market saw a shift in the belly of the expectations curve, briefly signaling a 50.1% chance of a rate hike at the September meeting. The curve receded a bit since the morning with the market, at day's end, expecting a 52.0% chance of a hike in November and a 48.9% chance of a move in September. On Monday, the fed funds futures market saw December as the first month entering into the rate hike conversation with the probability of a hike at the corresponding policy meeting running at 54.4%.
Interestingly, the afternoon slide that cut the market's gain in half occurred near the 100-day moving average (1999.8) in the S&P 500 as the index tried to register its first close above that mark since December 31. The benchmark average settled just above that level (by 0.18!) after spiking off its 50-day moving average (1940.5) on Tuesday.
Seven sectors ended the day with gains, paced by materials (+1.2%), utilities (+1.2%), energy (+0.9%), and financials (+0.4%). On the flip side, health care (-0.2%) and consumer discretionary (UNCH) lagged throughout the day while technology (+0.4%) ended just ahead of the broader market as relative strength in chipmakers helped mask some weakness among select top-weighted components. Alphabet (GOOGL 730.22, -1.37), Microsoft (MSFT 52.03, -0.32), and Facebook (FB 108.39, -1.19) lost between 0.2% and 1.1% while the PHLX Semiconductor Index (+1.1%) outperformed after Wells Fargo upgraded the chipmaker sector to ‘Overweight.'
On the earnings front, SOX index component Broadcom (AVGO 146.06, +8.73) surged 6.4% in reaction to better than expected results.
The Friday advance in equities was accompanied by selling in the Treasury market. The 10-yr note ended off its low with its yield up five basis points at 1.88% after testing the 1.90% mark. Today's volatility invited increased volume as more than 1.35 billion shares changed hands at the NYSE floor.
Economic data included the Employment Situation Report and Trade Balance:
- Nonfarm payrolls increased by 242,000 (consensus 190,000) and Private sector payrolls increased by 230,000 (consensus 180,000)
- January nonfarm payrolls revised to 172,000 from 151,000 and January private sector payrolls revised to 182,000 from 158,000
- Unemployment rate was 4.9% (consensus 4.9%) versus 4.9% in January
- The U6 unemployment rate, which accounts for the total unemployed plus persons marginally attached to the labor force and the underemployed, was 9.7% versus 9.9% in January
- Persons unemployed for 27 weeks or more accounted for 27.7% of the unemployed versus 26.9% in January
- January average hourly earnings were down 0.1% (consensus 0.2%) after being up 0.5% in January
- Over the last 12 months, average hourly earnings have risen 2.2% versus 2.5% in January
- The average workweek declined 0.2 to 34.4 hours (consensus 34.6)
- February manufacturing workweek was unchanged at 40.8 hours
- Factory overtime was 3.3 hours for the third month in a row
- The labor force participation rate was 62.9% versus 62.7% in January
- The January Trade Balance report showed a widening in the deficit to $45.7 billion (consensus -$44.0 bln) from a downwardly revised deficit of $44.7 billion (from -$43.4 bln) for December
- Exports were down $3.8 billion from December while imports were down $2.8 billion.
Monday's data will be limited to the 15:00 ET release of the January Consumer Credit report (consensus $16.50 billion).
- S&P 500 -2.2% YTD
- Dow Jones Industrial Average -2.4% YTD
- Russell 2000 -4.8% YTD
- Nasdaq -5.8% YTD
Is the Recovery Real, or Just a Bear-Market Rally?
Stocks recover from the lows seen not too long ago, aided by crude oil’s comeback — and despite rancorous politics.
One might think that political stability is a prerequisite, or at least a positive factor, for a strong stock market. One might be wrong.
In Brazil, the Bovespa was already in rally mode when it shot higher on Friday after Lula—as the former president, Luiz Inácio Lula da Silva, is popularly known—was taken into custody for questioning about the nation’s long-running scandal over the state oil company, Petrobras (ticker: PBR). That, in turn, heightened speculation that the government of Lula’s successor, President Dilma Rousseff, could be toppled.
Brazilian bulls perhaps figure that a change of government might mean that, to paraphrase former President Gerald Ford after Richard Nixon’s resignation, the country’s long, national nightmare may be over. Not likely, given the inflationary recession in which Brazil remains mired (coincidently reminiscent of the post-Watergate U.S. in 1974).
Despite minor details, such as a lousy economy and political chaos, the iShares MSCI Brazil Capped exchange-traded fund (EWZ) popped 5.3% on Friday, capping a rousing 25% gain for the week. And Petrobras’ American depositary receipts jumped 12% on Friday, bringing the week’s gain to a whopping 55%. To be sure, the Brazil ETF is still down 68% from its level five years ago and 75% from its peak in 2008. And even after Petrobras’ massive moves, it was still 93% below its 2008 high.
Back in the U.S.A., the recovery in the stock and credit markets rolled on, undeterred by the spectacle that the race for the White House has become. No need to recap the unprecedented denouncement of the Republican front-runner by the two previous GOP standard bearers, the ongoing investigation into the Democratic former secretary of state’s e-mail server, and her socialist rival’s plan to raise everybody’s taxes and siphon more than $15 trillion from the private sector over the next decade.
None of this seems relevant at this point for the markets. The stock market ended higher for the third straight week. The major averages are up nearly 10% from February lows and closing near nice, round numbers—just over 17,000 for the Dow and just under 2000 for the Standard & Poor’s 500.
The rebound has been a kind of worst-to-first affair, with a left-for-dead offshore driller such as SeaDrill (SDRL) soaring over 100% on Friday alone—which still left it a mere 88% under its 2013 high. Clearly, the rebound of these oil-patch pooches has been turbocharged by the recovery in U.S. benchmark crude oil, to just under $36 a barrel from the mid-$20s at its low last month, which has been paralleled by a range of other commodities, including copper and iron ore.
Along with those dogs, a big winner has been CAT, the ticker for Caterpillar, observes Louise Yamada, the head of the eponymous Louise Yamada Technical Research Advisors. Up from the mid-$50s in late January to $72.84 on Friday, the heavy-equipment maker could run up until it hits resistance around $80, a 44% pop from its lows. Similarly, venerable U.S. Steel (X) had bounced to over $14 by midday on Friday, from a recent low around $8, before slipping back to end the week at $12.98.
The leadership of the beaten-down stocks suggests to Louise that this is most likely a pleasant interlude otherwise known as a bear-market rally. Their bounces suggest some extreme bargain hunting, as well as covering of short-sale bets. Meanwhile, the ongoing strength in defensive stocks, such as consumer staples and utilities, many of which sport fancy, above-market price/earnings ratios, implies that investors are still bracing for more pain ahead.
The previous leaders—the big growth stocks such as Netflix (NFLX) and Amazon.com (AMZN), whose strength masked the declines in the broader market last year—rolled over as they entered 2016. The best go last when the bull market ends, she observes. After Amazon’s tumble from $689 near year end all the way to $482 in early February, it’s back to $575. But $600 looks like about it for the bounce, making this a rally to sell, she concludes.
The Dow and the S&P wound up the week around the low end of the ranges that Louise sees as major upside resistance (17,000 to 17,500 and 2000 to 2050, respectively). The action in financials also has been less than impressive, she continues; the Financial Select Sector SPDR ETF (XLF) is up 13% from its February low, to $22.28, but she doesn’t see the advance carrying past $24. “There are always bear-market rallies that lull us into complacency before the bear claw comes out again to swipe,” she said on Friday. Fair warning.
BRAZIL HASN’T BEEN THE ONLY emerging market in rally mode. And for the first time in a long time, mutual fund investors are getting in. General emerging market mutual funds saw their first inflows in 18 weeks last week, totaling some $196 million, according to EPFR Global data tracked by Citigroup’s EM team. Overall, EM funds saw a small, $15 million outflow, owing to $211 million exiting from Asia funds, mainly China and Hong Kong ETFs.
Those intrepid fund investors may be reacting to the worst underperformance of emerging market equities, relative to U.S. stocks, since the aftermath of the 1997-98 Asian and Russian debt crises. And the reasons for that are well advertised by now: the collapse in commodity prices, along with the surge in the dollar. That means that their export revenues are squeezed, while the burden of their foreign debt—mainly in greenbacks—increases.
But there may be more to the previous aversion to emerging markets. “The assumption that EM policy makers will always get it wrong is held with the same ferocious intensity as the conviction that our Fed will always get it right. In both cases, the belief endures despite powerful evidence to the contrary.” So writes MacroMavens’ Stephanie Pomboy in making the case for beaten-down EM stocks.
Steph says the tide is turning on both fronts. Commodity prices may be bottoming as capacity begins to be cut, evidenced by sharp reductions in capital spending. And while emerging economies are in hock to overseas creditors by $4.5 trillion, she points out that they also have $7.5 trillion in foreign-exchange reserves. That’s a far cry from the mere $620 million in reserves they held in 1998. Indeed, that cache was built to prevent a rerun of the crisis they suffered then.
WHAT’S ALSO OVERLOOKED about the supposed “doomsday” facing commodity producers in the bears’ focus on dollar revenue is that some emerging economies are suffering a lot less in local currencies. While gold is down 34% from its 2011 peak in greenbacks, it’s off just 7% and 11%, respectively, in Australian and Canadian dollars. In South African rand, gold actually is up 51%. And while oil has collapsed near its 2008 lows, valued in Russian rubles it’s up 150% since then.
What this means is that while these commodity-producing nations earn revenue in dollars, their costs are in their own cheap, devalued currencies. So, these emerging market producers are reaping the gains from currency devaluations.
Emerging market stock markets have fallen far more than warranted when you take into account this less-severe decline in commodity prices in terms of EMs’ own currencies. Moreover, Steph vigorously argues that the radical monetary policies of major central banks, such as negative interest rates in Europe and Japan, will put a floor under commodity prices by debasing their currencies. Indeed, the ECB is widely anticipated to unveil more stimulus this week, including a possible further foray into sub-zero territory.
All of which leads her to EM stocks and commodity outfits. “Take the two most hated asset groups out there and put them together! To others, it’s repugnant. To me, it’s just resourceful.”
That includes Chinese stocks. As the Communist Party convenes its annual National People’s Congress on Saturday, the next five-year plan will be finalized, writes global research analyst Peter Donisanu of the Wells Fargo Investment Institute. That could include measures to deal with debt-laden state-owned enterprises and to continue the transformation to a consumption-based, rather than export-driven, economy. More to the point, Steph says that China’s government will do whatever it takes to prevent an economic slowdown that could spur dissent among a population of 1.3 billion, which could become restive if growth falters.
As for Russian stocks, she says that, regardless of one’s opinion of Vladimir Putin, the destruction of their values is way out of line with the drop in oil, even in terms of devalued rubles. The most readily available way to put that thought into practice is via the Market Vectors Russia ETF Trust (RSX). And to gain exposure to the South African economy, there’s the iShares MSCI South Africa ETF (EZA).
A couple of closed-end funds offer similar exposure at steep discounts. The Central Europe, Russia & Turkey fund (CEE), managed by Deutsche Asset Management, closed on Thursday at a 13% discount to its net asset value. And ASA Gold & Precious Metals (ASA) invests in African and North American miners, while trading at a 14% discount. The EZA ETF, meanwhile, is dominated by Naspers, an e-commerce outfit, and so wouldn’t get a direct commodity kick.
Deutsche Bank May Lose Right to Run U.S. Retirement Funds
The U.S. Labor Dept. granted a temporary reprieve but could still impose tougher conditions.
Regulators from London to Seoul have sanctioned Deutsche Bank for misdeeds committed over the past decade. The accumulation of crimes has now taken on a life of its own, prompting new inquiries based on previous episodes. The U.S. Labor Department, for instance, is considering whether the German bank’s two recent convictions for fraud in foreign countries should cost it the ability to manage billions of dollars of Americans’ retirement funds.
In a ruling that has gone mostly unreported outside of official filings, the department tentatively denied Deutsche Bank’s (ticker: DB) bid for an exemption from a rule forbidding money managers convicted of a felony from running U.S. pension money for a time. At stake is Deutsche Bank’s official status as a qualified professional asset manager, or QPAM. The QPAM designation allows an asset manager to assume multiple roles in overseeing government-regulated Erisa pension plans, or those covered by the Employee Retirement Income Security Act of 1974. It’s unusual for Labor to deny an application for an exemption, even temporarily.
But Labor has been under pressure to take stronger action against global financial institutions found guilty of felonies. While most observers believe that it’s very unlikely the department would pull Deutsche’s QPAM status, it is expected to set tougher conditions on the bank. This could further complicate the bank’s efforts to reorganize its U.S. banking operation or, if it were so inclined, to sell its U.S. asset-management units. It’s also another headache for shareholders who have seen their stock lose 86% of its value since 2007, with little immediate chance of a turnaround.
“The QPAM exemption is critical for Deutsche Bank to maintain its business in the United States,” says Charles Field, a San Diego-based attorney for Sanford Heisler Kimpel, a law firm that advises money managers. Pension-fund clients, which filings suggest have roughly $50 billion in assets at Deutsche Bank units, would need to find other managers. More broadly, the bank would find it difficult to provide pension clients and other customers with investment advice, brokerage, custody, lending, and cash-management services. The QPAM designation is a kind of government Good Housekeeping seal of approval, giving a money manager license to offer multiple services without having to get repeated approvals. The loss of it would make pension funds, even those whose money isn’t at Deutsche Bank, reluctant to enter into a transaction with the bank as a counterparty.
A Deutsche Bank spokeswoman said Friday: “We take the concerns in the tentative denial letter very seriously and have been actively engaged with the Department of Labor to address them.”
A FELONY CONVICTION IS supposed to mean a financial institution is barred from running individual retirement accounts or other retirement assets for up to 13 years. However, the biggest banks usually seek an exemption for 10 years, often, as Deutsche Bank has done, by assuring regulators that problems in another part of the bank don’t affect U.S. pension money and that they will fix them. Because big banks are viewed as crucial to the functioning of the world’s financial system, regulators have been reluctant to yank designations such as QPAM.
There are signs, however, that Labor is getting tougher. Last fall, it gave Credit Suisse Group (CS), which had been convicted of conspiring to aid U.S. citizens in tax fraud, a shorter, five-year exemption, forcing the Zurich-based bank to reapply and to undergo more stringent audits and compliance reviews. Prior to its decision, Labor held a rare public hearing on Credit Suisse’s exemption bid, allowing consumer advocate Ralph Nader, among others, to argue that guilty banks shouldn’t be allowed to handle U.S. pension money.
Labor denied Deutsche Bank’s bid for the 10-year exemption in September. The department said granting it was “not in the interest of affected plans and individual retirement accounts, and not protective of those plans and individual retirement accounts.” The application was necessary due to two factors. Deutsche’s U.K. unit, and other big banks, were convicted of manipulating the London interbank offered rate, or Libor, a benchmark interest rate; and Deutsche’s Seoul unit was being investigated on allegations of market manipulation.
Instead, Deutsche Bank was given a nine-month exemption that would begin once the Korean case was resolved. In January, a Seoul court found the bank guilty of market manipulation from an incident in November 2010 and sentenced the former head of its equity derivatives trading in Korea to five years in jail. The executive’s case is under appeal. The bank has to pay a $1.3 million fine and disgorge profits. Although it’s a pittance for a bank with $1.76 trillion in assets, the fine was the highest ever levied on a securities firm in Korea. The bank hasn’t said if it will appeal.
IN GRANTING THE NINE-MONTH exemption, Labor said Deutsche Bank still must show that officers, directors, and employees in its QPAM operations were unaware of or did not receive compensation from the criminal conduct in Korea. Affiliates must develop and implement written policies that assure asset-management decisions are made “independently” of Deutsche Bank. It must also develop training programs, submit to an annual audit, and not impose added fees if clients want to leave.
Although the bank’s lawyers estimated a much smaller $8 billion in U.S. pension assets are directly affected, its QPAM-designated affiliates run larger sums for various clients that could feel some disruption to services. The three main QPAM affiliates seeking exemptions include Deutsche Investment Management Americas, which handles $212 billion, Deutsche Bank Securities, which advises on $5.7 billion, and RREEF America, which runs $30 billion in real estate–related investments, say Securities and Exchange Commission filings.
Federal rules restrict parties “at interest” from handling all of the various activities involved in running pension assets. The QPAM status allows a firm to provide these services without having to prove in each instance that it has no conflicts of interest.
“WHERE ARE THE HEADLINES? I’m really concerned for Deutsche Bank,” says Marcia Wagner, the founder of Wagner Law Group and a pension expert. “The dislocation could create extremely problematic situations, especially when operating as a counterparty and in derivatives markets.”
Deutsche Bank acknowledged the seriousness of the issue in its application. Affiliates would be “effectively eliminated” as asset managers for many Erisa-covered plans and IRAs because “they would be unable to provide the trading efficiencies and breadth of investment choices and potential counterparties” enabled by the QPAM exemption.
The Labor Department issue is part of a cascade of bad news for the bank, whose new co-CEO, John Cryan, has launched a major turnaround effort. Deutsche Bank lost about $7 billion in 2015, when its shares fell 20%. The stock is off 19% this year, more than twice the decline of U.S. financial stocks. The spreads on its credit default swaps, used by counterparties to insure against a default, have been widening, a worrisome sign. Even at a price-earnings ratio of 12, the shares are unappealing.
Cryan has pledged to simplify the bank’s corporate structure and to streamline products, locations, and legal entities. Deutsche Bank has put about $5 billion in reserves to deal with future litigation—nearly twice that of any other major European bank. It has already settled cases stemming from the financial crisis over mortgage disclosures and is the subject of multiple regulatory inquiries.
In all likelihood, Labor will grant the exemption, but with special audits and compliance guides, as it did with Credit Suisse.
“While the worst-case scenario is unlikely, the gapping out of credit spreads and the softness of DB’s shares manifest real concern in the market” about Labor issues, says Sean Egan, managing director of Egan-Jones Ratings, which tracks corporate credit. “We expect senior management and regulators will be able to address this problem before the franchise is materially restricted.” Oft-burned shareholders can only hope he’s right.
More Stimulus Likely From European Central Bank
When European Central Bank meets this week, possibilities include increasing size and duration of sovereign debt purchases.
European stocks—bank shares in particular—could continue to rebound as long as central bankers don’t pull any surprises this week.
The European Central Bank is widely expected to unveil additional stimulus measures Thursday, when its governing council meets in Frankfurt. Investors are counting on it: Disappointment could send stocks into a tailspin.
A sense of calm has returned to Europe’s markets in recent weeks, erasing some of the losses inflicted during an indiscriminate selloff in January and early February. The Stoxx Europe 600 index is down 6.6% in 2016, but that’s 10 percentage points above where it traded just a month ago.
For Europe’s banks, the situation is more critical. With investors fretting about capital levels and profitability, the Stoxx Europe 600’s banks subsector is down more than 15% since Jan. 1, despite recouping almost half of its losses in the past four weeks.
The fragile market situation illustrates the delicate balancing act the ECB faces. After failing to impress markets with modest stimuli in December, its president, Mario Draghi, is under more pressure to hit a home run this time.
What’s worrying the ECB is slowing growth in the euro zone and a weakening inflation outlook. Persistent low inflation and the need to get ahead of the curve could be reason enough for Draghi to act aggressively. It appears likely that the ECB will cut the rate it pays for deposits by 10 basis points, or one-tenth of a percentage point, to minus 0.4%, increasing banks’ cost to park funds with it overnight. It’s a bitter pill, as banks already are struggling to make money in the low interest-rate environment.
The ECB could try to soften the blow. Possibilities include a two-tier deposit rate, with higher rates applied to deposits that exceed the minimum capital requirements. Another option could be a targeted long-term refinancing operation, but most banks don’t require extra liquidity, so the takeup could be modest, and could benefit only vulnerable institutions.
It’s also highly likely that the ECB will step up its asset-purchase program. Currently 60 billion euros ($65.76 billion) a month through March 2017, it could be cranked up by €10 billion to €20 billion a month and extended for a half-year.
Buying large quantities of sovereign debt depresses yields and, theoretically, makes originating loans more rewarding for banks. The yield on German government 10-year bonds has fallen to just 0.2%, versus 1.83% for U.S. Treasuries of similar maturity. Swiss sovereign debt with a 10-year maturity offers negative yields.
There is frequent discussion about extending the monthly purchases to include corporate debt, but this seems unlikely, in part because Europe’s pool of corporate bonds is relatively small and could be vulnerable to distortion. In Germany, for instance, car maker Volkswagen (ticker: VOW.Germany) accounts for 15% of issuance.
Raising the rate it charges for bank deposits at the ECB and boosting asset purchasing seem to be the minimum the markets expect. Anything less is likely to send investors hurrying for the exits. On the other hand, it could take something bold to spark a rally.
Any quantitative easing is likely to weaken the euro against the dollar. The euro has held up pretty well in 2016, trading Friday at $1.095, but it could fall to parity over the medium term.
Regardless of what the ECB does, it might reserve the right to do even more in future. The euro zone economy is up and running, but a little more fine-tuning still might be required.
SHARES OF CAPITA could gain more than 20% in the next 12 months if the outsourcing-services outfit can deliver steady improvement in a low-growth environment.
The London-based company, which provides mostly administration, advisory, and transaction services, trades at a decent value after the market selloff in 2016. At Friday’s close of 10.23 British pounds ($14.54), Capita (CPI.UK) trades for 13.6 times estimates earnings for this year and 12.9 times projections for next year. Rival Accenture (ACN) trades at multiples in the high teens.
Capita’s management targets organic revenue growth of at least 4% this year. That’s down from 5% in 2015, but against a backdrop of sluggish economic growth, it could be a creditable performance. And the guidance could be conservative: The company gets about 75% of its revenue from long-term contracts. So, with those in place already, the target may not be too demanding.
Capita is forecast to earn 75 pence ($1.07) a share this year and 79 pence next year. It made 70 pence in 2015. The stock could be worth £12.50 in 12 months, say Deutsche Bank analysts, suggesting potential upside of more than 22%. Capita also boasts a dividend yield around 3%.