Investment Management Blog - Montague Capital

Hey it looks like this is one of the first times you are visiting this blog so why not subscribe for free to our Investment Management blog RSS feed and get all of our latest posts straight to your feedreader. Thanks for visiting!

Yesterday’s markets displayed an unaccustomed level of reality.  In falling more than 3% – relatively small beer by the standards of recent volatility and apparently not that much to worry about any more – Wall Street is telling us that it is not that confident that The Plan will get through the House of Representatives before the weekend.  In this morning’s early trading Asia does not seem inclined to oppose that view.  The point is not that a deal won’t get done.  It has to, otherwise the Great Depression is going to look like the Last Night of the Proms.  It is that the compromises required of banks, and their long-term implications for “the Anglo-Saxon business model”, will be drastic and severe.  Furthermore, if McCain couldn’t read the three-page version and agree with its contents in the run-up to last week’s rejection, politicians aren’t going to have approved every element of the 451-page Mark Two version by today.  It was always hopelessly unrealistic to expect that a compromise acceptable to all parties could be achieved in so short a time.  Nothing much short of Sweden’s 1990s nationalisation of its banking system is really likely to prove an affordable, credible, effective and enduring “fix”.  But this is America, the Home of the Quick Buck.  “Me” comes first.  For example, two politicians only gave their support to a vote on The Plan when an amendment to remove excise duty on children’s wooden arrows had been added to the package.  This will save archery makers in the politicians’ home state a princely US$200,000 a year.  Like that was worth putting the whole country at risk for.  While the haggling continues and uncertainty persists, markets are slowly learning that it pays to have a general tendency to err on the side of caution.  The next question becomes to ask how high could markets go when a deal is struck and how long could the euphoria last?  Even though short-selling is banned, enough traders and investors are apparently content to sell real stock that closing out “clothed” short positions can still lead to sharp rises when the broker dealers put the squeeze on.  But another cause for deep concern is now inexorably rearing its ugly head.  We now find ourselves at the start of an extended settlement period for a big chink of credit default swaps contracts.  These are the instruments used by investors to protect themselves against counterparty risk.  Sharp rises in their price tends to signal the imminent demise of the insured risk, such as Lehman Brothers.  If the insured risk does go under, the counterparty is supposed to receive a big insurance payout by way of compensation.  But who funds that payout?  Lehman’s alone is estimated to have run up a potential bill for the writers of its CDSs of as much as US$350bn.  And it is far from being the only counterparty to have been in trouble of late.  To put this in context, the entire Plan is (so far) “only” being priced at US$700bn.  And this probably assumes that banks do get their CDSs honoured in full rather than being defaulted on.  Remember what happened when Lloyds names had to write cheques instead of cashing them?  This is just the teensiest bit bigger than that. ECB president Jean-Claude Trichet summarised what the UK needs to see before there is a real chance of lower interest rates here.  Eurozone inflation fell from 3.8% to 3.6% in September and yet rates were left on hold at 4.5%.  In other words, real interest rates are +0.65%.  In the UK they are +0.30% and, unless inflation has abated here in the last month too, real rates could soon be going negative even without the need for a base rate cut.  The key part of Trichet’s speech was that he said Eurozone inflation risks had not disappeared.  He needs both a lower heading number and confidence that the risks are on a clear downward trend.  November’s Quarterly Inflation Report will tell us which, if either, of those boxes the UK has ticked.