Fathom Risk Reversal

8/8/2019 Fathom Risk Reversal

1/31

Risk reversal?

Quarterly forecast and asset allocation

Q4 2009


2/31

Summary

Two questions dominate the near and medium-term outlook:

Can the real economy justify the rally - or are we in another bubble?

Can sovereigns handle the risk on their balance sheets?

Forever blowing bubbles? we do not see evidence of another bubble; though we do see some clear

evidence of overvaluation.

Exceptions that could prove the rule? Gold

China

Not all sovereigns are equal - introducing Fathoms Sovereign FragilityIndex

2


3/31

Risk reversal? - AAOur central case is for a moderate recovery, with nosharp bounce back square root.

Equity markets hold onto their gains, but do little morethan that.

The rally to date is a consequence of the massiveamounts of liquidity supplied by central banks aroundthe world.

Raising the demand for, and hence the price of riskyassets was always an objective of the QE experiment.

Risks to real economic activity, to equities and tobond prices around our central case lie to thedownside.

Our overall asset allocation remains defensive. Wehave increased the overall fixed-income overweightand moved further out of equities while retaining an

underweight position in cash.

We have marginally reduced the overall riskiness ofthe portfolio. But the decline is smaller than one mightexpect a consequence of significant uncertaintysurrounding sovereign fixed income.

3


4/31

Necessary but not sufficient

One of the key goals of QE was to boost risky assets price is it working too well?

The wealth effects of lower interest rates are a key channel via which monetary policy

works: Higher equity prices reduce the equity cost of finance, encouraging investment

Higher commercial property prices increase the collateral available to businesses toborrow

Higher equity prices increase the wealth of consumers, encouraging consumption

Higher house prices increase the collateral available to consumers, reducing theiraverage cost of borrowing

Cheap credit is a necessary condition for an asset price bubble to form but is itsufficient?

Something else is needed....

A big idea Debt/leverage

Euphoria the one-way bet

4


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7/31

More than the average bear?

7

For a while it looked like history was repeating but then came the rebound

Still too soon to say that this time is different deleveraging cycles can take decades

NB The Nikkei has had 7 20%+ rallies since 1990


8/31

Overbought credit

8

Spreads on corporate credit have narrowed sharply too sharplyaccording to our models

Likely reflects impact of QE, rising share prices and conventionalmonetary policy


9/31

Gearing up for another bubble?

9

Risky assets have done incredibly well since March:

Corp bond spreads have fallen Commercial and residential property prices appear to have bottomed

Risk appetite has risen

Cash holdings are shrinking fast but isnt this what the Fed wanted?

Bond holdings also rising, implies that investors have not thrown caution to the wind

but leverage is rising


10/31

10

Rebalancing?

Collapse in world trade during crisis unprecedented. World trade volumes no longer falling, but are

back at 2005 levels.

A modest correction has taken place during the downturn, spurred on by helpful exchange rate

movements but there is a very long way to go.

What would we need to see to not only justify current equity valuations but allow further significant

gains? A rapid correction of global imbalances takes place over the next two to three years,providing a sound footing for a period of above trend growth that would see

Consumers in Germany, Japan and China finally begin to spend.

Net exports drive growth in the US and the UK


11/31

... running out of steam?

Growth in commodity price looks strong given amountof global trade, as measured by the FTI

US outbound air freight back into negative territory

suggests that demand for high-value added items has

stalledBut strong growth in outbound container traffic fromLA over 90% of LA outbound port traffic bound for

the Far East.

11


12/31

The great inflation?

12

The great inflation argument for gold does not hold much water

We think its about sovereign risk default.


13/31

13

Risk shifting

First they came for the

sub-prime, but the marketsaid nothing...

..then prime...

...then the interbankmarket...

...then bank shares...

...and finally, they came

for the taxpayer.Risk may be like matter can it be destroyed?


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14

Banking crises are a drag

IMF analysis shows that it can typically take a decade to get over a banking crisis;

and the cumulative loss of output can be more than 10% of GDPCurrency crises by contrast are a walk in the park...

-30

-25

-20

-15

-10

-5

0

5

10

-1 0 1 2 3 4 5 6 7

90 percent confidence intervalEstimated mean pathIQR Source: IMF / Fathom

Banking CrisisPercent of precrisis trend; mean difference from year t = 1;first year of crisis at t = 0; years on x-axis

-20

-15

-10

-5

0

5

10

-1 0 1 2 3 4 5 6 7

90 percent confidence interval

IQR

Estimated mean path Source: IMF / Fathom

Currency CrisisPercent of precrisis trend; mean difference from year t = 1;first year of crisis at t = 0; years on x-axis


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15

Financial crises dont come cheap

Uses the Reinhart and Rogoff database

Rise in fiscal deficits reflects declining revenues, rising expenditures, owing to a combination ofbailout costs, higher transfer payments and debt servicing costs.

The average increase in real debt (not as ratio to GDP) is 86%.

The rise following the Great Depression was only 84% - reflects the relatively slower policyresponse

3 Years Following Bank Crises

Cumulative Increase in Real Public Debt

Source: Reuters EcoWin / Fathom

97 98 99 00 01 02 03 04 05 06 07 08 09 10

100

125

150

175

200

225

250

275

300

Jap92

Mex94

Nor87

Col98

Malay97

Phill97

Kor97

Swe91

Thai97

Histavg. =186.3

Spain77

Indo97

Chil80

Fin91

Fiscal Deficits (Central Government Balance) as % of GDP

Country

Argentina 2001 -11.9 (2002)

Chile 1980 -3.2 (1985)

Columbia 1998 -7.4 (1999)Finland 1991 -10.8 (1994)

Indonesia 1997 -3.7 (2001)

Japan 1992 -8.7 (1999)

Korea 1997 -4.8 (1998)

Malaysia 1997 -5.8 (2000)

Mexico 1994 -2.3 (1998)

Norway 1987 -2.5 (1992)

Spain 1977 -3.1 (1977)Sweden 1991 -11.6 (1993)

Thailand 1997 -3.5 (1999)

4.8

-3.61.0

2.1

3.8

4.8

6.5

2.6

-0.7

2.3

0.0

0.7

0.3

5.7

-3.9

7.9

-0.815.4

5.8

8

3.811.8

5.8

9.4

Year Before

the crisis

Peak deficit

(year)

Increase/decrease

in fiscal deficit

Crisis

Year

9.5-2.4


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Conservation of risk

16

Developed economies have taken on a huge amount of debt.

There is no hard and fast rule for how much debt is too much but 100% of GDP seemslike a reasonable metric.

Note developing country debt is falling.

Per cent of GDP

Public Debt

EM Advanced WorldSource: IMF / Fathom

70 75 80 85 90 95 00 05 100

20

40

60

80

100

120


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What could go wrong?

17

Inflation reached an estimated 230,000,000% per annum

but is now said to be below 2%!


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Insolvency?

18

A more plausible concern seems to be the solvency of various governments/countries


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19

Sovereign Fragility Index

Aim is to combine all the various proxies into a single index of sovereignfinancial fragility.

And to make it forward-looking aim is to try and provide an early signalof looming fragility.

G20 panel dataset

Equal weights on all component indicators (prior view)

Weights determined by the data, in a panel regression (model view)

SFI is weighted average of the two

Banking asset/liability series includes both domestic and foreignloans/liabilities

The lags are two to three years on average. So if banking sector assetsare high now, that increases the fragility of the sovereign in two yearstime, for example.


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20

Methodology

Contributions to financial fragility:

Default risk, related to the size of and rate of change in the net

liabilities accruing to the taxpayer, as a share of GDP.

Proxied by:

Net government debt as a share of GDP

Share of external debt in gross government debt

Government budget balance as a share of GDP

Banking sector exposure (ultimately accrues to the

sovereign)Inflation risk, related to the competence and credibility of themacroeconomic policy authorities, particularly the central bank.

Proxied by:

Squared deviations in inflation from target

Volatility of GDP growth

Fragility is captured by the level of real 10 year yields

..and the slope between policy rate and 10yrs


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21

SFI: model resultsA 2% point deviation of inflation from target (ineither direction) or a 4% increase in the volatilityof GDP growth will increase long rates relative toshort rates by 24 bps

A 10% increase in banking sector assets as a

share of GDP will increase long rates relative toshort rates by 16 bps

A 10% point increase in net government debt asa share of GDP will increase long rates relativeto short rates by 146 basis points

A 10% point increase in the budget deficit as a

share of GDP will increase long rates relative toshort rates by 139 basis points, with grossgovernment debt at 50% of GDP (the effectincreases in line with the debt /GDP ratio)

A 10% point increase in external governmentdebt as a share of GDP will increase long rates

relative to short rates by 49 basis pointsSo: fragility will rise sharply in countrieswhere government deficits and debt arerising, banking sector assets are largerelative to GDP, and inflation and GDP arevolatile.

0 50 100 150 200

10% point increase in external

government debt as a share of GDP

10% point increase in budget deficit as a

share of GDP, gross debt at 50% of GDP

10% point increase in net government

debt as a share of GDP

10% point increase in banking sector

assets as a share of GDP

2% point deviation in inflation from

target

Impact of component indicators on the yield curve

(10y - policy rate, basis points)


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22

Interpreting the results

-15

-10

-5

0

5

10

-150

-100

-50

0

50

100

150

Argentina

Australia

Brazil

China

France

Germany

Greece

India

Ireland

Italy

Japan

Mexico

Portugal

Russia

SouthAfrica

SouthKorea

Spain

UnitedKingdom

U

nitedStates

SFI 2010

SFI 2009

real 10y

Change in Sovereign Fragility Index and in real 10-

year government bond yields since 2000

SFI change from 2000 Real 10y GBYchange 2000 - 2009, % points

-12

-7

-2

3

8

-150

-100

-50

0

50

100

150

Argentina

Australia

Brazil

China

France

Germany

Greece

India

Ireland

Italy

Japan

Mexico

Portugal

Russia

SouthAfrica

SouthKorea

Spain

Unit

edKingdom

U

nitedStates

SFI 2010

SFI 2009

yield curve

Change in Sovereign Fragility Index and in slope of the

yield curve (10y GBY - policy rate) since 2000

SFI change from 2000 Change in slope of yield curve 2000 - 2009, % points


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23

Sovereigns at risk - 2010

Greece now stands out, but Ireland far worse (Italy no better). France surprisingly fragile?

UK surpassing Italy and Japan in terms of fragility

US not relatively high, but it is the reserve currency. Taking that into account, it has quite a high

score.

Country Weighted SFI Real 10 Year GBY SpreadChange in Weighted

SFI since 2000

Change in Real 10

year yield since

2000

Argentina 100.96 8.99 4.23 -16.25 -2.70

Australia 43.14 3.83 2.08 -1.95 1.98

Brazil 59.97 8.23 4.72 -7.68 -2.70

China 76.18 11.27 0.87 15.47 9.81France 113.32 3.47 2.47 37.08 -0.11

Germany 102.90 3.02 2.22 20.22 -0.84

Greece 152.70 5.02 5.17 55.57 1.80

India 84.90 -0.72 1.63 13.76 -7.52

Ireland 221.41 6.09 3.74 115.71 5.83

Italy 159.47 3.28 3.06 16.00 0.27

Japan 158.87 2.46 1.05 29.16 -0.08

Mexico 31.41 2.07 3.33 24.97 2.07

Portugal 159.27 5.17 3.25 79.06 2.37

Russia 90.81 -4.84 -1.74 -100.36 -16.88

South Africa 79.28 1.52 2.26 -19.74 -6.96

South Korea 61.56 2.58 3.28 20.92 -1.78

Spain 119.40 4.43 3.02 25.14 2.38

Turkey 41.38 1.66 1.95 -1123.78 14.86

United Kingdom 166.32 1.82 3.52 81.20 -2.67

United States 134.80 4.54 3.54 41.32 1.89

2010


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24

Sovereigns at risk

Argentina and Brazil spike

around the time of theArgentinian default (much

bigger spike in Arg). They

have both come back downsince then, but Arg continuesto be penalised in bondmarkets for its track record

Australia and China have

both seen fragility increase inrecent quarters but from alow base, especially inAustralia.

The Chinese case is more

worrying, given apronounced risk ofdeteriorating public financesif the global recoverydisappoints

0

100

200

300

400

500

600

700

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Argentina: Sovereign Fragility Index

30

32

34

36

38

40

42

44

46

48

50

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Australia: Sovereign Fragility Index

50

60

70

80

90

100

110

120

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Brazil: Sovereign Fragility Index

50

55

60

65

70

75

80

85

90

95

100

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

China: Sovereign Fragility Index


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Sovereigns at risk

France has seen a recent

spike in fragility stillnowhere near UK or Italy

though. Germany looks

stable.Fragility in Greece has beenhigh for some time, and

remains so. Markets arenow questioning whether that

level of fragility is sustainablewithin the euro.

India has seen its fragilityspike in recent quarters, butfrom a low base.

70

75

80

85

90

95

100

105

110

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

France: Sovereign Fragility Index

70

75

80

85

90

95

100

105

110

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Germany: Sovereign Fragility Index

90

100

110

120

130

140

150

160

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Greece: Sovereign Fragility Index

65

67

69

7173

75

77

79

81

83

85

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

India: Sovereign Fragility Index


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Sovereigns at risk

Irelands fragility has soared

from comfortably below Italyto a long way above. Italy

remains fragile now as it has

been for many years butprotected by its key role inthe euro?

Japanese fragility remainshigh but markets are still not

punishing it could be QE?Its saving grace is the lowlevel of external debt.

Mexican fragility is rising butfrom an extremely low base.

Markets take a very dim viewof Mexican debt, reflecting itstrack record.

130

135

140

145

150

155

160

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Italy: Sovereign Fragility Index

100

110

120

130

140

150

160

170

180

190

200

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Ireland: Sovereign Fragility Index

120

125

130

135

140

145

150

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Japan: Sovereign Fragility Index

0

510

15

20

25

30

35

40

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Mexico: Sovereign Fragility Index


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Sovereigns at risk

Portugals fragility is on a

rising trend, having nearlydoubled since 2000 it is

now disturbingly high.

Russia, by contrast, hasseen its fragility fall sharplysince then.

South African fragilityfluctuates around a level just

below the point at which itwould become worrying

South Korea has seen asteady increase in itsfragility, but from a low base

70

8090

100

110

120

130

140

150

160

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Portugal: Sovereign Fragility Index

50

100

150

200

250

300

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Russia: Sovereign Fragility Index

80

90

100

110

120

130

140

150

160

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

SouthAfrica: Sovereign Fragility Index

30

35

40

45

50

55

60

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

South Korea: Sovereign Fragility Index


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Sovereigns at risk

Spains fragility is rising sharply

although it remains lowcompared to UK, Italy or Ireland.

Turkey has moved from off-the-

scale highs down to verysustainable low levels of fragility

but it continues to be penalised

in bond markets for its trackrecord

The UK and the US have bothseen fragility rising steadily since

2002. In the case of the UK, ithas now reached worrying levels

and is set to go further this

year. In the case of the US, it isnot high enough yet to castdoubt on the dollar as reservecurrency but if it keeps rising atits current rate that could

change.

80

85

90

95

100

105

110

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Spain: Sovereign Fragility Index

0

500

1000

1500

2000

2500

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

Turkey: Sovereign Fragility Index

70

80

90

100

110

120

130

140

150

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

UK: Sovereign Fragility Index

80

90

100

110

120

130

140

01/03/2000

01/11/2000

01/07/2001

01/03/2002

01/11/2002

01/07/2003

01/03/2004

01/11/2004

01/07/2005

01/03/2006

01/11/2006

01/07/2007

01/03/2008

01/11/2008

01/07/2009

US: Sovereign Fragility Index


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Summary results

-100 -50 0 50 100 150 200 250

Mexico

Turkey

Australia

Brazil

South Korea

China

South Africa

IndiaRussia

Argentina

Germany

France

Spain

United States

Greece

Japan

Portugal

Italy

United Kingdom

Ireland

Real 10yr (*10)

SFI

Weighted SFI and real 10 year yield

-100 -50 0 50 100 150 200 250

Mexico

Turkey

Australia

Brazil

South Korea

China

South Africa

India

Russia

Argentina

Germany

France

Spain

United States

Greece

Japan

Portugal

Italy

United Kingdom

Ireland

SFI Spread (*10)

Weighted SFI and yield spread


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Sovereigns at risk

The UK and Japan look exposed as does Portugal

Currency devaluation or deflation?Ever-steeper curves could be the result


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SFI Conclusions

Our results suggest that the usual suspects are being harshlypriced

But by contrast, the UK, Ireland, Italy, Japan and to some extentthe US are being too leniently priced by bond markets relative to

their sovereign fragility.

Greece could now be a buy.

The key factors remain the level of debt and the degree of banking

sector exposure

Some data issues remain especially regarding China

The higher the SFI, the steeper the curve. The reverse could also

be true.

Fathom Risk Reversal

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