The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

With consumers set to be squeezed after the 2010 election, supermarket shares may not prove to be as defensive as they used to be.  Stockmarket folklore has it that supermarket shares are defensive because people always need to eat and this held true in the days when supermarkets only sold groceries.  But these days supermarkets sell far more than just groceries.  With Tesco taking one pound in every eight spent by British consumers, they will not be able to escape the effects of consumers battenning down.  It is true that food retailers are shifting their offering downmarket in an effort to follow their customers as they trade down in tough times.  However not every food retailer will be able to protect their sales volumes & profits in this way.

Sales of organic produce fell 14% in 2009, indicating that consumers are already trading down, with organic meat sales being hit hard (beef down 25% and chicken down 28%).  Consumers may buy organic & ethically produced food when they feel they can afford it but with the Food Standards Agency stating that there is no scientific evidence that organic food has health benefits, when the squeeze comes consumers will trade back down quickly.

The pain thus far has been felt most by those people who have lost their jobs during the recession.  As interest rates have been cut sharply, the vast majority who are employed have seen their monthly budgets improve as mortgage payments have fallen.  However any post-election tax increases are going to be felt by all 29 mln employed people in the UK (and their families) and this effect will be very broad-based indeed.  The supermarket shopper is going to look to cut back even further and now that the weaker retailers have already gone bust, the one-off boost to the survivors’ sales has already been seen and all are likely to suffer.

The counter-argument to this is that consumers will cut back on eating & drinking out and spend more on their weekly grocery shop instead. This will affect the pub & restaurant sector (which has already de-rated in anticipation and offers better value than supermarket shares).  It remains to be seen what consumers will choose to do when the squeeze is applied by a government seeking to get the budget deficit back under control, but investors should choose to invest where the risks have at least been somewhat discounted and upside is on offer.

However with Tesco, Sainsburys and Morrisons all trading on 13x estimated 2010 earnings, yielding 2.9%, 4.1% and 2.1% respectively, these shares are not a Buy.  If you feel compelled to hold a food retailer then SBRY yields the most and benefits from periodic bouts of takeover speculation.  Much better value is available elsewhere in the market and owners of TSCO, SBRY or MRW should sell out of them as they are too highly rated, still trading within 8% of last year’s highs, and do not offer sufficient upside to compensate for the risk that their sales start to suffer later this year as consumers begin to be squeezed.

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months. 

How do the major oil companies navigate their way from currently searching for, pumping, refining and finally selling oil & gas to consumers to a world which will eventually have to learn to survive on energy from another source.  What is a sensible price (or p/e ratio) to pay for a major Western oil & gas company whose principal line of business will disappear at some point in the future?

At some point in the future the supply of oil & gas will become increasingly restricted (proponents of the Peak Oil theory believe that world production levels have already peaked and are now on a declining trend). Long before we get to a situation where Saudi Arabia and Gazprom/Russia have a stranglehold on oil and gas respectively, the rest of the world will have to have moved beyond petroleum and onto a different resource for their everyday energy needs.

The most likely source of the R&D funds to seek out new types of energy are Western governments and the oil majors themselves; the latter are fully aware of their need to diversify away from oil & gas or else end up being convenience store operators on the sites of their (former) petrol stations.  Just how much money gets thrown at this particular problem is likely to be directly correlated to the oil price (if oil is cheap & plentiful then there is no pressing need to hurry up and research its replacement).

Does this mean we should all sell our shares in BP, Shell and the other oil majors immediately? No.  As with most blue chips, the most sensible investing strategy is to play the trading ranges within a diversified portfolio.

However sensible portfolio diversification means not having too high a percentage of your portfolio in oil & gas companies.  Having no exposure makes no sense either because then you would have nothing to sell if the price of oil suddenly rockets for whatever reason (one oil-price-spike scenario the doomsters love is where the US gets Israel to bomb the Iranian nuclear reactors/processing plants and Iran closes the Strait of Hormuz in retaliation – 90% of the oil exported from the Persian Gulf passes through the Strait of Hormuz on oil tankers).

As a happy side-effect, when the world does eventually move beyond petroleum, carbon emissions will presumably fall off a cliff (millions of petrol-powered cars will no longer emit CO2) which will keep the global warming crowd happy and they will be able to move on to worrying about something else which is of more immediate interest to mankind (they can take their pick from : global poverty, hunger, malaria, girls’ education in the Third World, etc.).  Hopefully the entity which discovers the world’s next source of energy will engage with their charitable side and donate some of (what will undoubtedly be) their enormous future profits to one of these projects; echoing what happened when petroleum succeeded whale-oil and John D. Rockefeller donated some of his Standard Oil fortune to philanthropy.  To this day, ExxonMobil (which is essentially formed out of two of the companies which Standard Oil was broken up into in 1911) is still the most valuable company in the S&P 500 and XOM paid out over $8 bln in dividends last year.

Is there really such a thing as a global market in talent for top executives?

Whilst compensation consultancies (wonderfully dubbed “Ratchet, Ratchet & Bingo” by Warren Buffet) would have us believe that such a market exists for talented individuals and therefore Boards of Directors should benchmark their executive’s pay against global peers (strangely those “global” peers only include highly paid Western managers and not the Salarymen of Japan, nevermind the poorly paid managers in Third World countries), it seems hard to comprehend that most executives would uproot their families (and pull settled children out of schools) and move to another country.  There is also the risk from the employer’s point of view that the new foreign hire will not seamlessly blend into their new company’s culture and mix easily with the existing staff.

It is probably true that newly qualified MBA students are the most willing jobseekers to look globally for a position, but managers who have been in situ for a while are likely to have put down roots in their local communities and would be killed by their spouses for even suggesting moving their 2.2 kids and the family dog to e.g. Singapore.  As a nation, the Dutch seem to have managers who make a success of it abroad (e.g. Marc Bolland of MKS and previously MRW) whilst football managers are very well travelled (Guus Hiddink has managed successfully in many countries).  However it is arguabe that football is not strictly a proper business as it seems to be a hobby for very wealthy owners and a goldmine for talented players.  In that sense football is similar to investment banking in that the players/bankers seem to end up with all the money whilst someone else bears the losses…

Boards should stop wasting money on Ratchet, Ratchet & Bingo and use some common sense instead. These recessionary times provide the perfect opportunity to resist the ever-upward cost of executive compensation packages (the argument runs that surely each of our executives deserves to be paid upper quartile pay or we otherwise admit that, by definition, we have sub-standard managers).

Now that LLOY has wriggled free of the APS and RBS has had no option other than to enter APS, there is uncapped upside in LLOY shares whilst RBS shares still remain effectively capped at 65 pence (due to the terms of the B shares).

Both LLOY and RBS have now sufficiently strengthened their Core Tier 1 capital ratios (to 8.6% and 11.1% respectively) for the market’s focus of attention to turn to recovery possibilities.  RBS have forecast losses for each of the three years 2009, 2010 and 2011 which will eat into their Core Tier 1 capital (and 59 pence NAV) and these losses also imply that RBS will not even start to redeem their outstanding £25.5 bln B shares until 2012 (and then it will probably take RBS at least three years to fully redeem the B shares as they have to be redeemed with fully-taxed profits).  Hence RBS shares are effectively capped at 65 pence until the middle of the next decade because if RBS shares trade above 65 pence then the 7% B-share dividend falls away.  In this case HMT would logically want to convert its B-shares into ords and sell them in the market to realise a profit for the taxpayer.  But £25.5 bln B-shares convert into 51 billion ordinary shares (vs 56.35 bln currently outstanding) and ordinary shareholders will not want to get diluted in this way.  This is a real obstacle in the way of RBS shares progressing above 65 pence anytime over the next 5 years (it is also noteworthy that RBS CEO Stephen Hester’s full £9.6 mln compensation package depends on RBS shares getting to 70 pence).   The only way around the 65 pence cap is for RBS to somehow generate £25.5 bln in Core Tier 1 capital in order to be able to redeem the B shares but launching a rights issue is not the solution as this too will dilute ordinary shareholders (as would a debt-for-equity swap).  RBS may be able to make some money by buying back more of their own debt at a discount but this will only generate a small fraction of the £25.5 bln needed to clear the upside for RBS ordinary shares.  In the meantime RBS are not going bankrupt but RBS shares only become worth buying if they fall back towards their 10 pence low seen in January 2009.

Investors in RBS should switch into LLOY and take up their rights.  There will be plenty of opportunity to bank profits in LLOY and rotate back into RBS over the next 5 years.

As for the other major banks, HSBC are profitable and as a result their Core Tier 1 capital ratio is creeping higher (now 9.0%), but their 80% loan-to-deposit ratio is very conservative.  BARC have recently reported a Core Tier 1 ratio of 8.9% but they seem to be mutating into a global investment bank.  Assuming (for simplicity) the LLOY £13.5 bln rights issue is 1-for-1 at 50 pence, then LLOY post-rights NAV will be approximately 90 pence.  This gives an idea of where LLOY and RBS shares will eventually end up as over the long term bank shares seem to range between 50% and 300% of book value. 

Post Script (7 Dec 2009) : The actual terms of Lloyds’ rights issue were set at 1.34-for-1 at 37 pence.  This results in a Net Asset Value of approximately 73 pence per LLOY share after the rights issue is completed.