CDS, Market Turmoil, Asset Allocation
David R. Kotok
November 12, 2011
Let us consider this week’s credit default swap (CDS) debacle in the following manner. People purchased CDS with the understanding that they had a type of insurance policy against the default of a sovereign debtor. Now they have learned that what they thought they had is something they do not have. The European Greek debt deal and the International Swaps and Derivatives Association, www.isda.org (ISDA) have clarified that.
What do they do? They must realign their positions. First, they have to face the reality that they were misinformed or misadvised. They must accept that their position has changed. Second, they must take action.
The spike in yields on sovereign debt of Italy was attributable, only in part, to the Italian political turmoil we are witnessing. The other aspect dealt with CDS on Italian debt. Those holders thought they had one type of CDS protection. They realized from the events in Greece that they had something else.
This is true of other sovereign CDS as well, and this change has roiled the markets. Interest rates have risen as bond prices have fallen. The cost of finance for Italy has gone up to levels that are deemed unsustainable. This is what one would expect with CDS realignment.
Does that mean the world is ending? No. In fact, there is a considerable possibility that the current stock market rally has the outlook correctly discounted, after this turmoil runs its course. If you examine Italy’s budgetary characteristics, you realize the country is headed for a primary surplus in 2013. “Primary surplus means after you deduct interest payments.”
Will Italy be able to complete the plan? Will they be able to implement it? What is going to happen? What about other exogenous shocks? All these questions are fair and they are additive to the uncertainty premium.
Italy may have a difficult issue when it attempts to roll its present debt, and that debt roll of maturities is coming up very quickly. However, with the help of the European Central Bank (ECB) Italy is likely to have some market access and be able to roll that debt on the heels of budgetary action
How will it roll? What will the yields be? These and more questions await answers.
Another crunch is coming up on for the debt roll of Greece. That is why the referendum threat dates were December 4 and December 11: the second half of December is when Greece must roll billions of euro-denominated debt. The authorities in Europe know they need sufficient structure in place so that this debt can roll without market access by Greece. Greece has been shut out of market access. The market believes it is an insolvent sovereign. In addition, there are the continuing operational demands for cash by the Greek government. This money will be provided with institutional lending, through one of the forms we presently see discussed.
Does this mix of European debt roll condemn the US to a recession? We think not.
The United States is not in recession. It is in a very slow-growth environment. Uncertainties are very high and uncertainty premiums are large, but decisions about US portfolios are based upon whether you are betting on recession, or slow growth.
If it is slow growth, stocks are inexpensive and markets are headed higher. That is the position of Cumberland Advisors. If a double-dip recession is coming, then stocks are headed lower and you should not own them.
The course of action to take in global portfolios is a different matter. In our global multi-asset class, we have taken our precious metal positions to 6% of the total deployment. That is very, very high and it is a considerable overweight for us. Precious metals are a tiny weight in global asset allocation under normal circumstances. We use several ETFs to reach that position, and they reflect an amalgamation of precious metal exposure.
We have this precious metal weight very high because, we are able to see a monetary policy transmission effect that reaches into precious metals. That supports our view that precious metals are likely to be priced higher in US dollar terms in the future. There is a considerable time lag between central bank actions and monetary effects and resultant higher precious metal prices; we measure that somewhere between nine and eighteen months.
We do not find the same relationship with commodities. Commodities are driven by other extensive factors in addition to liquidity flows from the creation of credit. Central bank balance sheet expansion has a weak link to commodities in this current environment, where central banks are attempting to provide as much liquidity as possible to avoid systemic meltdown.
When it comes to global stock markets, our international positions in Europe are far below the 24% weight that Europe holds in the benchmark index. Our exposure is limited to Germany, France, the Netherlands, and a broader-based international ETF. For Europe as a whole, we are very much underweight. In our international models, that weight is 11%, with all of it in Northern Europe.
In our global multi-asset class, we have only 3% exposure to the Eurozone stock markets. So clearly, we have a bias against Europe and in favor of other locations around the world, as well as other asset classes. In our global multi-asset class, we have 6%, or twice the exposure, in precious metals than we do in the stock markets of the Eurozone. That is a remarkable statement to make. It reflects the high degree of uncertainty given the times we are experiencing.
David R. Kotok, Chairman and Chief Investment Officer