Hard lending to rational economics. A Hard lending to rational economics. A difficult lesson to learndifficult lesson to learn

Part IIPart IIMacroeconomics of present crisisMacroeconomics of present crisis

Adrian Mitroi, CFA, PhD

Adrian Codirlasu, CFA, PhD

FIAR 2010, FINANCIAL INVESTMENTS DAY Wednesday, May 26th, 2010

2

topicstopics

1.1.Macro policies and stock market, May 2010 Macro policies and stock market, May 2010 -Correlation: stocks, growth, inflation, deficits, exchange and interest rates-Correlation: stocks, growth, inflation, deficits, exchange and interest rates -Cyclical vs. countercyclical; conventional vs. non conventional policies-Cyclical vs. countercyclical; conventional vs. non conventional policies

- Correlation: money, currency, commodities and stock markets - Correlation: money, currency, commodities and stock markets

2. Real economy vs. financial economy, 20102. Real economy vs. financial economy, 2010-Financial sector, a pro cyclical indicator of real economy-Financial sector, a pro cyclical indicator of real economy

-Lending to negative equity; solvability vs. liquidity-Lending to negative equity; solvability vs. liquidity-Real estate market; LT real assets vs. ST financial liabilities-Real estate market; LT real assets vs. ST financial liabilities

3. Macro policies effect on psychology of 3. Macro policies effect on psychology of markets, 201…markets, 201…

-Investment management in down economies-Investment management in down economies-Propensity to spend, save or invest in highly volatile markets-Propensity to spend, save or invest in highly volatile markets

-Risk aversion vs. loss aversion in economic recession-Risk aversion vs. loss aversion in economic recession

3

1. Macro policies and markets1. Macro policies and markets• Low correlation: stock market, growth, inflation budget/trade deficits, exchange and Low correlation: stock market, growth, inflation budget/trade deficits, exchange and

interest rates, money market, currency, stock, debt and commodities marketsinterest rates, money market, currency, stock, debt and commodities markets

Policies:Policies:• CyclicalCyclical: pro cyclical, correlated with overall state of the economy; ex. tightening : pro cyclical, correlated with overall state of the economy; ex. tightening

monetary policy in recession (monetary policy in recession (hawkishhawkish); ); higher than equilibrium-appropriate higher than equilibrium-appropriate exchange rate, fiscal scenarios for VAT and tax rate increaseexchange rate, fiscal scenarios for VAT and tax rate increase

• CountercyclicalCountercyclical: activist (vs. : activist (vs. laissez fairelaissez faire), against current economic tendency, lower ), against current economic tendency, lower monetary rate (monetary rate (dovish), dovish), simulative in economic downturn; ex: progressive tax, simulative in economic downturn; ex: progressive tax, unemployment, unemployment, fiscal proposals for 25% and 15% benefits reductionsfiscal proposals for 25% and 15% benefits reductions

• ConventionalConventional: Monetary rate, RMOs, (ex. strong Ron = tightening), open market: Monetary rate, RMOs, (ex. strong Ron = tightening), open market

• Non conventionalNon conventional: easing cost and availability of funds; fiscal monetization: : easing cost and availability of funds; fiscal monetization:

-aimed at reduced risk spreads, affecting longer term rate across the -aimed at reduced risk spreads, affecting longer term rate across the board, board, independently of their liquidity and credit risk, affecting the market for risk independently of their liquidity and credit risk, affecting the market for risk

free assets, government bonds (QE- ‘free assets, government bonds (QE- ‘quantitative easingquantitative easing’); BCE repos’); BCE repos

-targeted on the risk spread across assets classes, between those whose -targeted on the risk spread across assets classes, between those whose markets are particularly impaired (Greek junks as collateral) and those that markets are particularly impaired (Greek junks as collateral) and those that are more functioning (CE- ‘are more functioning (CE- ‘credit easingcredit easing’); EU/IMF/EC Stability Fund’); EU/IMF/EC Stability Fund

Crisis preparation took a long time; Crisis preparation took a long time; ST liquidity solution probably does not sufficeST liquidity solution probably does not suffice

  GDP (mlns euro/local) Govt debt (% GDP) Govt deficit/surplus (% GDP)Zone 2009 2008 2007 2009 2008 2007 2009 2008 2007Euro zone 8.977.933 9.258.895 9.003.902 78,7 69,4 66 -6,3 -2 -0,6EU 27 11.804.734 12.500.094 12.364.567 73,6 61,6 58,8 -6,8 -2,3 -0,8AUSTRIA 276.892 281.867 270.782 66,5 62,6 59,5 -3,4 -0,4 -0,4BELGIUM 337.758 344.676 334.948 96,7 89,8 84,2 -6 -1,2 -0,2BULGARIA 66.256 66.728 56.520 14,8 14,1 18,2 -3,9 1,8 0,1CYPRUS 16.947 17.248 15.879 56,2 48,4 58,3 -6,1 0,9 3,4CZECH REPUBLIC 3.627.188 3.688.994 3.535.460 35,4 30 29 -5,9 -2,7 -0,7DENMARK 1.657.857 1.737.448 1.691.472 41,6 34,2 27,4 -2,7 3,4 4,8ESTONIA 214.828 251.493 244.504 7,2 4,6 3,83 -1,7 -2,7 2,6FINLAND 170.971 184.179 179.536 44 34,2 35,2 -2,2 4,2 5,2FRANCE 1.919.316 1.948.511 1.895.284 77,6 67,5 63,8 -7,5 -3,3 -2,7GERMANY 2.407.200 2.495.800 2.428.200 73,2 66 65 -3,3 0 0,2GREECE 237.494 239.141 226.437 115,1 99,2 95,7 -13,6 -7,7 -5,1HUNGARY 26.094.824 26.543.252 25.408.080 78,3 72,9 65,9 -4 -3,8 -5IRELAND 163.543 181.816 189.751 64 43,9 25 -14,3 -7,3 0,1ITALY 1.520.870 1.567.851 1.546.177 115,8 106,1 103,5 -5,3 -2,7 -1,5LATVIA 13.244 16.275 14.780 36,1 19,5 9 -9 -4,1 -0,3LITHUANIA 92.353 111.190 98.669            LUXEMBOURG 37.755 39.348 37.466 14,5 13,7 6,7 -0,7 2,9 3,6MALTA 5.712 5.697 5.459 69,1 63,7 61,9 -3,8 -4,5 -2,2NETHERLANDS 570.208 595.883 568.664 60,9 58,2 45,5 -5,3 0,7 0,2POLAND 1.342.612 1.272.838 1.176.737 51 47,2 45 -7,1 -3,7 -1,9PORTUGAL 163.891 166.463 163.891 76,8 66,3 63,6 -9,4 -2,8 -2,6ROMANIA 491.274 514.654 416.007 23,7 13,3 12,6 -8,3 -5,4 -2,5SLOVAKIA 63.332 67.221 61.547 35,7 27,7 29,3 -6,8 -2,3 -1,9SLOVENIA 34.894 37.135 34.568 35,9 22,6 23,4 -5,5 -1,7 0SPAIN 1.051.151 1.088.502 1.052.730 53,2 39,7 36,2 -11,2 -4,1 1,9SWEDEN 3.057.056 3.154.630 3.063.145 42,3 38,3 40,8 -0,5 2,5 3,8

UNITED KINGDOM 1.395.872 1.448.392 1.398.882 68,1 52 44,7 -11,5 -4,9 -2,8

4

5

Private vs. public leverage; which one is better? Private vs. public leverage; which one is better?

• Too much debt is dangerous. During boom, central banks, investment bankers Too much debt is dangerous. During boom, central banks, investment bankers and politicians all signed up to the cult of debt; and politicians all signed up to the cult of debt; SE Asia is the least levered, SE Asia is the least levered, best prepared for sustained economic growth (financial and commercial)best prepared for sustained economic growth (financial and commercial)

• Companies went for balance-sheet "efficiency" - and homeowners, piled on Companies went for balance-sheet "efficiency" - and homeowners, piled on huge mortgages, were caught out, then discover that it is much harder to huge mortgages, were caught out, then discover that it is much harder to deleverage than to leverage up; deleverage than to leverage up; basically, only rented home from the bankbasically, only rented home from the bank

• Globalization doesn't work smoothly by itself. Free movement of capital has Globalization doesn't work smoothly by itself. Free movement of capital has facilitated rapid shifts in cross-border capital flows, currency values and prices facilitated rapid shifts in cross-border capital flows, currency values and prices of commodities; insufficient financial depth (savings and investments/GDP) of commodities; insufficient financial depth (savings and investments/GDP) makes a country vulnerable; makes a country vulnerable; first: save; then: invest; only then: spendfirst: save; then: invest; only then: spend

• Most probable we all, Most probable we all, insufficiently saved, inadequately invested and insufficiently saved, inadequately invested and irrationally spent future cash flows irrationally spent future cash flows (governments, corporations, individuals)(governments, corporations, individuals)

6

Central Banks moves have matteredCentral Banks moves have mattered

• During a normal recession, the Fed, ECB and During a normal recession, the Fed, ECB and otherother central banks responded central banks responded with non conventional monetary policies by buying short-term with non conventional monetary policies by buying short-term governmentgovernment/quality (except for Greek junks) /quality (except for Greek junks) debt from banksdebt from banks

• ProcessProcess drives rates on government debt down; investors seeking a higher rate drives rates on government debt down; investors seeking a higher rate move into other assets, driving other rates down; normally these lower rates move into other assets, driving other rates down; normally these lower rates will will lead to economic bouncebacklead to economic bounceback; ; in recession, fiscal also mattersin recession, fiscal also matters

• AA lower bound to rates advocate lower bound to rates advocatess higher government spending: when monetary higher government spending: when monetary policy is ineffective and private sector can’t be persuaded to spend or borrow policy is ineffective and private sector can’t be persuaded to spend or borrow more, more, the public sector must take its place in the public sector must take its place in supportingsupporting the economy the economy

• Probably the fProbably the fiscal stimulus is the Keynesian answer to the kind of economic iscal stimulus is the Keynesian answer to the kind of economic situation we’re currently insituation we’re currently in, and a good mix with monetary policy, and a good mix with monetary policy

• New normal recession requires CBs to be less concerned on inflation? Milton New normal recession requires CBs to be less concerned on inflation? Milton Friedman for growth and John Maynard Keynes for recession? Friedman for growth and John Maynard Keynes for recession?

Central banks do matter since monetary and Central banks do matter since monetary and fiscal policies look interchangeable, latelyfiscal policies look interchangeable, lately

7

FED (May 2020): -Discount rate (charged to banks, refinancing, psychological): 50 bp-Fed Funds (o/n, benchmark, target, main policy rate): 0-25 bp

8

Conventional vs. nonconventionalConventional vs. nonconventional

• CCommon to all major ommon to all major crisescrises, , is ais a combination of reasonscombination of reasons: overleverage, : overleverage, real estate boom, loose fiscal real estate boom, loose fiscal aand monetary policiesnd monetary policies, overspending, overspending

- debt d- debt difficult decisionsifficult decisions: h: higher tax igher tax oror lower spending lower spending/expenses?/expenses?

• ECB: one size fits all monetary policy has its drawbacks, mostly in a ECB: one size fits all monetary policy has its drawbacks, mostly in a downturn economy. downturn economy. FFrontront runners runners (G) (G) in recovery would rather enjoy an in recovery would rather enjoy an increase once the sustainable growth picks up, but laggards increase once the sustainable growth picks up, but laggards (P, S)(P, S) would would rather see very low raterather see very low ratess for a longer term for a longer term

• MMoral hazard introduced into ecuation oral hazard introduced into ecuation byby EU EU/IMF/EC/IMF/EC stand by bail out for stand by bail out for GreeceGreece was a necessary evil ( was a necessary evil (write offwrite off). Probably, restructuring would ). Probably, restructuring would have been better, but EU is not yet prepared to accept, manage, convincehave been better, but EU is not yet prepared to accept, manage, convince

• Europe’s financial tribulations reflect investors concern that governments Europe’s financial tribulations reflect investors concern that governments have borrowed too much to revive their economies; how do US manage?have borrowed too much to revive their economies; how do US manage?

• No matter how smart and big is the bailout (EU Stabilization Fund), No matter how smart and big is the bailout (EU Stabilization Fund), most important stakeholders have to buy in: population (to sacrifice) most important stakeholders have to buy in: population (to sacrifice) and private investors (to roll over next debt, at reasonable prices)and private investors (to roll over next debt, at reasonable prices)

9

Current phase: sovereign debt pressureCurrent phase: sovereign debt pressure• A bubble in government bonds has been deflated but yields will rise, A bubble in government bonds has been deflated but yields will rise,

inflation, oversupply. Need to print money to pay interest on new debt; inflation, oversupply. Need to print money to pay interest on new debt; result: a slower recovery; result: a slower recovery; growth is a key determinant for deficitsgrowth is a key determinant for deficits

• Add corporate and private debt to government debt / GDP, the prospect Add corporate and private debt to government debt / GDP, the prospect

of economic growth paying all that off is moving further in timeof economic growth paying all that off is moving further in time

• Debt restructuring, could be the new currency devaluation in the Debt restructuring, could be the new currency devaluation in the euro zone if not proper measure takeneuro zone if not proper measure taken;; higher borrowing cost (LT) higher borrowing cost (LT) could lead to higher deficits; EU Stabilization Plan targets MT/LT ratescould lead to higher deficits; EU Stabilization Plan targets MT/LT rates

What is a CDS:What is a CDS:

• Credit-default swaps pay the buyer cash should company fail its debt Credit-default swaps pay the buyer cash should company fail its debt agreements. Increase signals deterioration in credit quality perceptionagreements. Increase signals deterioration in credit quality perception

• A basis point (0.01%) on a credit-default swap contract protecting 10 A basis point (0.01%) on a credit-default swap contract protecting 10 million Euros of debt (except principal) from default for five years is million Euros of debt (except principal) from default for five years is equivalent to 1,000 Euros a year equivalent to 1,000 Euros a year (e.g. on May 7, CDS on European bank (e.g. on May 7, CDS on European bank bonds temporarily soared above levels triggered by the collapse of LB)bonds temporarily soared above levels triggered by the collapse of LB)

Contagion containment is not cureContagion containment is not cure

10

• Similar to physical disease, financial contagion spreads faster in a Similar to physical disease, financial contagion spreads faster in a weakened population [of investors]weakened population [of investors]

• Creditors are also massive debtors. If the value of their assets declines, Creditors are also massive debtors. If the value of their assets declines, the only way they can stay solvent is by reducing their debtthe only way they can stay solvent is by reducing their debt, and the , and the only way they can pay down the debt is by selling assets, which pushes only way they can pay down the debt is by selling assets, which pushes their price down even further, exacerbating the problem and spreading it their price down even further, exacerbating the problem and spreading it to other securities/currency (€)to other securities/currency (€)

Stratégique Gouvernement économiqueStratégique Gouvernement économique: : transition to a more competitive economytransition to a more competitive economy

• The new normal Romanian consumer society skewed industrial structures The new normal Romanian consumer society skewed industrial structures away from exporters to domestic market (sheltered from foreign competition)away from exporters to domestic market (sheltered from foreign competition)

• Dependence on foreign capital; reason and result of poor competitivenessDependence on foreign capital; reason and result of poor competitiveness• Service FX debts from export; policy directed at shifting resources to Service FX debts from export; policy directed at shifting resources to

exportersexporters• Increase/reduce VAT/benefits, and reduce taxes on jobs can shift economy Increase/reduce VAT/benefits, and reduce taxes on jobs can shift economy

from domestic demand to export (from domestic demand to export (mimicking a non inflationary mimicking a non inflationary devaluationdevaluation))

• Separate the new brothers in arms: monetary and fiscal policy; government Separate the new brothers in arms: monetary and fiscal policy; government borrowing up for LT, fiscal policy will direct impact on the yield curve (MT/LT)borrowing up for LT, fiscal policy will direct impact on the yield curve (MT/LT)

Automatic Shock absorbers could be helpful:Automatic Shock absorbers could be helpful:• Monetary absorber: FX and % policies could be adjusted as needed (vs.€)Monetary absorber: FX and % policies could be adjusted as needed (vs.€)• Real economy absorber: flexible labor markets, balance to private vs. budgetReal economy absorber: flexible labor markets, balance to private vs. budget• Fiscal redistribution absorber to balance out economic shocks to exportsFiscal redistribution absorber to balance out economic shocks to exports• W/out fiscal discipline € is doomed; ST compromise has LT drawbacksW/out fiscal discipline € is doomed; ST compromise has LT drawbacks

11

12

2. Real vs. financial/virtual economy2. Real vs. financial/virtual economy• Governments have borrowed too much to revive economies. Probably this is the Governments have borrowed too much to revive economies. Probably this is the

most important cause of present (May 2010) volatility, pushing the limits of fiscal most important cause of present (May 2010) volatility, pushing the limits of fiscal and monetary stimulation. The current mix of policies most likely will be enough to and monetary stimulation. The current mix of policies most likely will be enough to bring economic recession to end; bring economic recession to end; financial prosperity, however, takes timefinancial prosperity, however, takes time

• Banking and financial sector, a lagging, pro cyclical indicator of real economy; Banking and financial sector, a lagging, pro cyclical indicator of real economy; although economy hoped to clearly rebound in 2011, GDP growth is not enoughalthough economy hoped to clearly rebound in 2011, GDP growth is not enough

• Banks will not give loans on concerns of negative equity; pro cyclical attitude: the Banks will not give loans on concerns of negative equity; pro cyclical attitude: the more credit you need, less able you are. Unemployment is a key indicatormore credit you need, less able you are. Unemployment is a key indicator

• Post real estate boom market: real assets vs. financial liabilities: Post real estate boom market: real assets vs. financial liabilities:

Financial stability: Financial stability: bail out countries (Greece) is to keep financing bail out countries (Greece) is to keep financing banks sovereign exposure solvable; banks sovereign exposure solvable; money-printing is just another way money-printing is just another way for governments to silently default on their debt for governments to silently default on their debt

Chindia, Chindia, probably the best market capitalists have socialist ideology and probably the best market capitalists have socialist ideology and US will not make it easier for Europe; EU does not make it easier for EUUS will not make it easier for Europe; EU does not make it easier for EU

13

Liquidity vs. SolvencyLiquidity vs. Solvency

• Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not inter Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not inter changeable. Interest rate risk vs. credit/counterparty riskchangeable. Interest rate risk vs. credit/counterparty risk

• Liquidity provided by central banks can make a difference on ST and MT, but not on Liquidity provided by central banks can make a difference on ST and MT, but not on a LT; markets are becoming completely dependent on Central Banks. a LT; markets are becoming completely dependent on Central Banks. Dark side of Dark side of Euro: Euro: one size fits all could be suboptimal in times of crisisone size fits all could be suboptimal in times of crisis

• Negative equityNegative equity: market value of assets < present value of liabilities: market value of assets < present value of liabilitiesDeleveraging is a mustDeleveraging is a must

• Solvability (long term, renewable ability to borrow) vs. liquidity (short term) Solvability (long term, renewable ability to borrow) vs. liquidity (short term) High debt/GDP, high deficit/GDP, low growth – LT endangered speciesHigh debt/GDP, high deficit/GDP, low growth – LT endangered species

• An absolute economic pecking order:An absolute economic pecking order:

1: recovery 1: recovery

2: growth 2: growth

3: expansion 3: expansion

4: prosperity4: prosperity

14

Political Accounting and MachinationsPolitical Accounting and Machinations• Banks do not trade toxic assets (except with CBs); any trade could trigger a Banks do not trade toxic assets (except with CBs); any trade could trigger a

fair valuation of whole portfolio; ok as long as interest rates go down fair valuation of whole portfolio; ok as long as interest rates go down

• Fair value is history (FAS 157, IAS 39); bad loans of the past 10 years; Fair value is history (FAS 157, IAS 39); bad loans of the past 10 years; capitalization by accounting and papering out the crisis are easy but not capitalization by accounting and papering out the crisis are easy but not enough enough

Goldman Sachs lesson: Goldman Sachs lesson:

• SEC: SEC: “.. built a “conveyer belt” of mortgage deals and then bet against them, “.. built a “conveyer belt” of mortgage deals and then bet against them, “The toxins that Goldman Sachs and others helped inject into our financial “The toxins that Goldman Sachs and others helped inject into our financial system have done incalculable harm to people who have never heard of a system have done incalculable harm to people who have never heard of a synthetic CDO and who have no defenses against the harm that such exotic synthetic CDO and who have no defenses against the harm that such exotic Wall Street creations can cause” Wall Street creations can cause” (as Morgan Stanley did also)(as Morgan Stanley did also)

• GS: GS: “We didn’t have a massive short against the housing market and we “We didn’t have a massive short against the housing market and we certainly did not bet against our clients”. certainly did not bet against our clients”. It made money every single day of It made money every single day of Q1/10, a feat the firm has never accomplished before (as JPMorgan did)Q1/10, a feat the firm has never accomplished before (as JPMorgan did)

Probably over economic recession but still Probably over economic recession but still under solvability and financial crisisunder solvability and financial crisis

15

 

2010, Over recession but still under crisis: Equity Risk and Credit Premiums, May 2010    

   

 Real GDP Growth

Real Earnings Growth +

DividendYield =

Expected Real

Return -

Real Bond Yield =

Implied ERP

Expected Inflation

Expected Nominal Return

US 3,0 3,0 1,8 4,8   1,5 3,3 2,0 6,8

Japan 1,5 1,5 1,7 3,2   0,8 2,4 0,5 3,7

UK 2,8 2,8 3,2 6,0   -1,0 7,0 2,0 8,0

Romania -1 -1   3   2,0   3,0   -1,0 4,0 6,0

  -2,5 -2,5   3   0,5   3,5   -3,0 4,5 5,0

  -5 -5   2,5   -2,5   3,75   -6,3 5,0 2,5

Europe 2,3 2,3 2,9 5,2   -1,0 6,1 2,0 7,2

World 2,5 2,5   2,3   4,8   0,4   4,4 1,8 6,6

16

Currencies and stocksCurrencies and stocks• Then (2009): reverse correlation; when the dollar would fall, stocks Then (2009): reverse correlation; when the dollar would fall, stocks

would rise and vice versawould rise and vice versa; euro was strong, EM currencies, including ; euro was strong, EM currencies, including Ron, were under pressureRon, were under pressure

• Why: CTWhy: CT investors were using a currency that cost almost nothing to investors were using a currency that cost almost nothing to borrow borrow ($,¥) ($,¥) to buy undervalued stocks, with a bias toward emerging to buy undervalued stocks, with a bias toward emerging marketsmarkets; c; combination ombination llift stocks off their 2009 March lows ift stocks off their 2009 March lows

• NowNow (2010) (2010): stocks and the dollar are moving : stocks and the dollar are moving up up in tandem againin tandem again, but , but not downnot down (weak Euro); (weak Euro); a signal for investors to put more money into $ a signal for investors to put more money into $ denominated assetsdenominated assets? a signal to sell Euro denominated assets and buy ? a signal to sell Euro denominated assets and buy into emerging markets (Ron?)into emerging markets (Ron?)

• Countercyclical Dollar and Yen are now less favorite CT currencies, due Countercyclical Dollar and Yen are now less favorite CT currencies, due to their strengthening and overall volatility to their strengthening and overall volatility

• Ron (and other cyclical/emerging markets currencies) only relatively Ron (and other cyclical/emerging markets currencies) only relatively attractive; attractive; if deficit not tamed < 8%, Ron can be under pressureif deficit not tamed < 8%, Ron can be under pressure

17

Dollar, Dollar, EEurouro• The typical paradigm for an export oriented Europe was that a strong dollar The typical paradigm for an export oriented Europe was that a strong dollar //

weak euro is good for trade, weak euro is good for trade, forfor both US and China. both US and China. AA weakening euro weakening euro (a (a political not economic currency) political not economic currency) is of benefit to is of benefit to PIIGSPIIGS, alleviating some of , alleviating some of their excessive deficits and making their products more competitivetheir excessive deficits and making their products more competitive

• RRaw materials, mostly denominated in dollars are making inputs prices more aw materials, mostly denominated in dollars are making inputs prices more expensive adding additional strain on the expected growth differential vs. expensive adding additional strain on the expected growth differential vs. US. This, in turn, will lead probably to an earlier interest rate hikeUS. This, in turn, will lead probably to an earlier interest rate hike, , make make now now dollar assets more attractive dollar assets more attractive

• DDuring the toughest part of the recession, the dolar weakend against most of uring the toughest part of the recession, the dolar weakend against most of other currenciesother currencies. . A A ddepreciatiepreciatingng currency is a good antirecessonary tool currency is a good antirecessonary tool; ; aa low $ exports recession and a strong $ imports growth low $ exports recession and a strong $ imports growth

• Banks are a lagging indicator of economic conditions. Central banks, trying Banks are a lagging indicator of economic conditions. Central banks, trying to protect currency stability and debtorsto protect currency stability and debtors,, would rather sacrifice future, would rather sacrifice future, potential debtorspotential debtors/present depositors/present depositors than curent debtors solvability than curent debtors solvability positionposition

• MMain risks to fiscain risks to fiscaal consolidation stem from plethora of l consolidation stem from plethora of too too optimistic optimistic assumptions and lack of specification of consolidating measuresassumptions and lack of specification of consolidating measures; if EU didn’t ; if EU didn’t have common currency, it would have bigger problems or vice versa? have common currency, it would have bigger problems or vice versa?

18

RonRon• Bolstered by low interest rates Bolstered by low interest rates from from EU, with construction accounting for EU, with construction accounting for more more

than than 15% of GDP15% of GDP, , a building boom created aa building boom created an n unbalanced economyunbalanced economy

• RRecession left with a large economic hole to fill. Wages systematic increase ecession left with a large economic hole to fill. Wages systematic increase coupled with low productivity growth relative to competitorscoupled with low productivity growth relative to competitors - - a major souce of a major souce of competitive disadvantcompetitive disadvantaagege

• SSpending is not a significant value adding economic activitypending is not a significant value adding economic activity

• High Ron DAE and stable/appreciating Ron make EUR borrowing slightly more High Ron DAE and stable/appreciating Ron make EUR borrowing slightly more attractive to households and companies; debt in a depreciating currency is attractive to households and companies; debt in a depreciating currency is more efficient and naturally hedged; vice versa for deposits more efficient and naturally hedged; vice versa for deposits

• OOne way for the country to remain competitive is ne way for the country to remain competitive is to increase productivityto increase productivity and and investments and cut spendinginvestments and cut spending, since it cannot lower prices artificially through , since it cannot lower prices artificially through a a relativerelative stable stable (5%) (5%) exchange rateexchange rate

• Pro cyclicality does matter; strong Ron, low Ron rates, low Euro, strong Dollar Pro cyclicality does matter; strong Ron, low Ron rates, low Euro, strong Dollar are all potentially helping solvability, banks and financial economyare all potentially helping solvability, banks and financial economy

Commodities correlate w/ currenciesCommodities correlate w/ currencies

19

Lately, Euro Lately, Euro looks less looks less countercyclicalcountercyclical

20

Bail outs = sell CDS for freeBail outs = sell CDS for freeBonds = monetize the CDSBonds = monetize the CDS

21

22

3. 3. Macro policies and psychology of marketsMacro policies and psychology of markets• Greatest risk is no risk at all. Greatest risk is no risk at all. Investment management into post recessionary, Investment management into post recessionary,

high volatility low growth environment is difficult: high volatility low growth environment is difficult:

-Can an informed investor make money systematically by exploitation of -Can an informed investor make money systematically by exploitation of behavioral, cognitive and psychological inefficiencies of the market?behavioral, cognitive and psychological inefficiencies of the market?

--Financial behavior analysis relaxes the fundamental analysis requirement for Financial behavior analysis relaxes the fundamental analysis requirement for convergence of price and value. The difference between the two is seldom convergence of price and value. The difference between the two is seldom systematic, systematic, so probably it can be exploited by a rational and disciplined investor so probably it can be exploited by a rational and disciplined investor

-There can be no reward, without risk. Gaining a sustainable advantage over so -There can be no reward, without risk. Gaining a sustainable advantage over so many skilled and knowledgeable competitorsmany skilled and knowledgeable competitors, in a free market, is difficult, in a free market, is difficult

-Managing in bear market is the skill. Bear correlations can easily destroy the -Managing in bear market is the skill. Bear correlations can easily destroy the hard earned returnhard earned return

-Risk aversion vs. loss aversion; by making a loss you can still make money-Risk aversion vs. loss aversion; by making a loss you can still make money

• Propensity to borrow, spend, save or invest under change from crisis; a Propensity to borrow, spend, save or invest under change from crisis; a major rebalance of wealth and social benefits commensurate with productivity and major rebalance of wealth and social benefits commensurate with productivity and economic value added; most likely, economic value added; most likely, some of us have lived better than some of us have lived better than economically sustainableeconomically sustainable

Asset Allocation (Asset Allocation (psi financepsi finance) matters, ) matters, Diversification (classic finance) lessDiversification (classic finance) less

23

Highest velocity ever of a market reaction, Highest velocity ever of a market reaction, May 6, 2010 May 6, 2010

(the panic, the fat finger and the revenge of the machines)(the panic, the fat finger and the revenge of the machines)

24

• A big block of P&G (2:30), followed by another huge A big block of P&G (2:30), followed by another huge block, right before the market crashed, then, nothing, block, right before the market crashed, then, nothing, probably sell orders, big enough to blow all the bids, probably sell orders, big enough to blow all the bids, for a few minutes, buyers just disappearedfor a few minutes, buyers just disappeared

• Existing stop-loss orders on P&G forced selling into a Existing stop-loss orders on P&G forced selling into a no-bid marketno-bid market

• Every $1 change in price in a stock, results in a 7.56 Every $1 change in price in a stock, results in a 7.56 (1/0.132319125) change in DJIA(1/0.132319125) change in DJIA

• Worst timing: stocks had started selling off earlier, Worst timing: stocks had started selling off earlier, panicked. The velocity/severity triggered stop-loss panicked. The velocity/severity triggered stop-loss selling, selling, feeding on itselffeeding on itself

• Even as P&G’s share price was recovering, bids Even as P&G’s share price was recovering, bids were falling rapidly in the other 29 Dow components; were falling rapidly in the other 29 Dow components; at one point was down 997at one point was down 997

We like weekends, but we don’t like Mondays We like weekends, but we don’t like Mondays

25

• EU/FMI financial assistance of 750 billion EU/FMI financial assistance of 750 billion Euros to counter “severe tensions” by Euros to counter “severe tensions” by purchasing government and private debt purchasing government and private debt and restarted a dollar-swap line with FEDand restarted a dollar-swap line with FED

• ECB said it will conduct “interventions” to ECB said it will conduct “interventions” to ensure “depth and liquidity” in markets ensure “depth and liquidity” in markets

• Probably this will lead all central banks Probably this will lead all central banks (apart from China) to have a (apart from China) to have a looser looser monetary policy for longermonetary policy for longer

• Spain’s benchmark stock index, the Spain’s benchmark stock index, the IBEX 35, rose the most on record , rose the most on record

Some Behavioral Traits and Patterns of Investors; Some Behavioral Traits and Patterns of Investors;

more pronounced during economic/market pressuremore pronounced during economic/market pressure Illusion of controlIllusion of control

ConservationismConservationism

Mistaken CausalityMistaken Causality

ExtrapolationExtrapolation

Mental AccountingMental Accounting

Risk CompensationRisk Compensation

FramingFraming

House Money EffectHouse Money Effect

Selective MemorySelective Memory

Protection of BlameProtection of Blame

RationalizationRationalization

Denial Denial

Herd InstinctHerd Instinct

ExtremismExtremism

Ambiguity AversionAmbiguity Aversion

HeuristicsHeuristics

AnchoringAnchoring

HeroicsHeroics

OverconfidenceOverconfidence

Overweighting RecentOverweighting Recent

Stereotyping Stereotyping

Narrow FramingNarrow Framing

Disposition EffectDisposition Effect

Hindsight BiasHindsight Bias

RegretRegret

IdealizationIdealization

AvoidanceAvoidance

Loss AversionLoss Aversion

OptimismOptimism

RepresentativenessRepresentativeness

CategorizationCategorization

Pain of regretPain of regret

Pain of lossPain of loss

Three is a trendThree is a trend 26

The same old sun: easy to be smart on hindsightThe same old sun: easy to be smart on hindsight

OOverver optimism is a optimism is a basic tenet of basic tenet of human human sspeciespecies

In general, people do In general, people do

not spend time not spend time looking and looking and understanding bad understanding bad newsnews

IInvestors would rather nvestors would rather prefer to focus on prefer to focus on the bright side of the bright side of the moon and they the moon and they do not see things do not see things that they do not that they do not expect to seeexpect to see

What you see is what What you see is what you look foryou look for

Where are we now? Where are we now?

27

28

Price does matter, but mostly on the long runPrice does matter, but mostly on the long run

Too big to fail but fit enough to carry trade the easy money

29

Paper out the crisis

May 10th 2010: markets to ECB, FED: pls paper out (0.75 trillion

Euro) this also for the later

30

May 10th 201025%: ~ no salary for 3 months

15%: ~ no pension for 2 months