Ivan Ivanchenko and Kirill Nikiforov of VTB Capital -
Eyeballing the current price action in risky assets, we cannot help but wonder whether the crisis is over or whether, as in "Forrest Gump", somebody switched it off. Indeed, the stellar rise in worldwide equities, rally in commodities and increasing number of advisers pushing to increase risk profile because the second derivative changed the sign all scream that we are on the road to recovery. Well, you cannot beat cash, which has been idly collecting zero returns on the sidelines and is now moving to play "the crisis is over" game. This is exactly what the "engineers" of this rally are trying to achieve: get me and everybody else to spend.
"Hey Joe, the worst is over, the market can't lie - you'd better get out there and find yourself a pretty damn good deal while prices are still depressed!"
"Tempting, but are we out of the woods yet? What about banks? Nobody really knows whether they are solvent, right?"
"Joe, listen, we just conducted extensive stress tests and found out that the financial system is safe and sound, even if the skies collapse - our adverse scenario shows that some banks will need to raise a bit of capital, but mostly all is cool so don't worry about it."
"Sorry, but Nouriel Roubini says that today's reality is already worse than the adverse scenario, so losses are likely underestimated. Won't rising unemployment wear down banks' balance sheets more severely than estimated? And what about that commercial real estate exposure? Besides, the IMF's recent estimates..."
"Listen man, forget Roubini, forget IMF - those guys are losers. Timothy Geithner has given the all clear!"
"Is this the same Geithner who dubbed China a currency manipulator and then pulled out?"
"Whatever! That's irrelevant. The important bit is that the financial system is fixed now. Look at the market: banking stocks are rallying, credit spreads tightening and 3-month dollar LIBOR is below 1%! And the economy is going to turn later this year, as the recently observed green shoots start to blossom."
"A friend of mine showed me a study by the great scholar of financial crises Ken Rogoff which says that after such severe crises, asset market collapses are deep and prolonged. He specifically points out that equity falls an average of 55% from peak to trough in real terms and the downturn takes three and a half years. And you are likely to agree that the current crisis is severe enough for us to be at least on the average, so we still have a long way to go..."
"Those academics! They don't understand anything in markets. Look, the trend is your friend and it's screaming 'BUY' so you'd better get on board - remember markets sniff a recovery way before it shows up in data!"
"Well, this time last year you told me the same and we all know what happened. What's different this time?"
"We now have a new more capable administration, the G20 meeting removed the risk of a currency and debt crisis a la Asia in 1997, and the banks are pumping in tonnes of money to make up for falling leverage in so-called quantitative easing."
"Oh boy, but this credit doesn't actually reach those who need it. Look at yesterday's consumer credit data in the US! Even your second derivative has stayed negative!"
"Joe, trust me, everything it takes to restore consumer credit will be done - we understand it is important. That is why banks won't be allowed off the TARP hook - they will give credit!"
"But wouldn't it be risky to expand credit when unemployment worldwide is growing fast and is unlikely to turn anytime soon? Won't it eventually cause more losses for banks?"
"I am starting to give up on you man - we're going round in circles."
"And what about all those excesses which we accumulated during the latest credit boom? Wouldn't it be rational to think that we have to get rid of them to step onto a new sustainable trend? Besides, in your argument about credit growth, you seem to forget about Nassim Taleb's 10 principles for a black-swan-proof world - curing leverage with more leverage can put off the payday but not prevent it! And who knows what black swans could hit us this year - we never know beforehand."
"Jeez man, you are really blind. Again, global growth is just around the corner - the economic data says it, PhD Copper says it, the best investment gurus say it, and as I mentioned before the markets say it. Hop on or lose out!"
"Thank you but I already missed out on a 40% RTS rally and don't want to catch it here. Bob Farrell used to say that when markets move exponentially, they correct sharply. Well I see overbought conditions and some powerful resistance levels (200-day MAs in S&P) so I'd better stay out."
"Okay, but what about emerging markets? Let's buy Russia, everybody's excited about it!"
"Problem is I live here and can see that Russians are not that optimistic themselves. In fact, they barely participated in the recent rally."
"Well people have first-hand information here and to be honest things are not great to say the least. Perhaps the biggest worry locally is rising non-performing loans - we have not sorted out our banking sector yet. The growing body of bad loans is a serious issue. And not only in Russia, by the way. My fear is that the rising hope of the world - China - is growing a problem of bad loans too. You simply cannot push credit that much in such a poor economic environment."
"Yes, but the Russian Central Bank said that there was no systemic risk."
"True, on its own risk is not big, but if it coincides with another bout of oil price weakness, and therefore pressure on the rouble, and as a result tightening money, it might be really dangerous."
"Dude, what oil price weakness? Look it's going to $60-70."
"I am not so sure. I agree that risk appetite bodes well for oil prices too as funds pour in there as well, but sentiment is a tricky thing - it can change in a moment and then fundamentals will play the major role and near-term fundamentals are poor. Stockpiles are rising to record highs every week and demand is weakening. As for sentiment, remember how gloomy everybody was on Russia back in January-February? And now what - go find a pessimist."
"Yeah, but China is on the bid!"
"Again, reserves creation is definitely a support, but unlikely an ultimate one. After all China is 'only' 9% of the global economy and oil consumption levels are well below those in OECD so it won't substitute 'developed' demand. Plus storage capacity is a question."
This conversation could last forever, especially on the eve of a long weekend, as the arguments on both the cautious and the risk-taking sides are valid. However, the bottom line is that we are walking in the dark here and no amount of evidence can convincingly prove that the markets have turned for good. Nor disprove it. Authorities around the world deserve credit for manufacturing such a nice run: the rally is real and it keeps sucking in fresh cash, thus building on the momentum. Still, at this juncture, with the RTS RSI north 70 and 200-day MA at 946, with oil prices decoupling from fundamentals and with budding issues in the Russian banking system, the risks in our view are on the downside.
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