August 08, 2009

Market Insights - 8 August 2009

Weekly Snapshot
• U.S. non-farm payrolls fell by 247,000 jobs in July - better than the expected 320,000 (FT)
• U.S. unemployment rate dipped to 9.4% from 9.5% in June (AP)
• Sugar price reaches highest level in 28 years (FT)
• German exports rose at their fastest pace in almost three years in June with a 7% m/m uptick (
• Twitter and Facebook were severely disrupted in coordinated attacks by hackers (BBC)
• U.S. Treasury found that a $75bn mortgage modification program has aided only 9% of eligible borrowers (Economist)
• UBS posted a SFr1.4 billion ($1.3 billion) quarterly net loss (Economist)
• The European Central Bank kept its key policy interest rate at a historical low of 1% (
• The Bank of England keeps interest rates at 0.5% - QE to be extended by another £50bn (FT Alphaville)
• Volume of retail trade down by 0.2% in euro area (Eurostat)
• The U.S. Postal Service lost $2.4 billion (April-June) and expects to loose $7bn by Sept. 30 (AP)
• Industrial producer prices up by 0.3% in euro area (Eurostat)
• U.S. car sales rise 16% in June (FT)
• U.S. Consumer spending rose 0.4% in June (Reuters)
• U.S. Personal income down 1.3% in June (

Chart of the Week
A relatively new addition to market intelligence is the Bloomberg Financial Conditions Index. Created in 2008, it combines yield spreads and indices from the Money Markets, Equity Markets, and Bond Markets into a normalized index. It is considered a useful gauge of bank lending conditions and the overall availability of credit. Currently, the Index is back at the same level as November 2007, an immense improvement over the past 10 months. While its usefulness may be debatable, it can be considered another forward looking indicator. Lending conditions and credit should preclude gains in equities which would in turn give a preview of future conditions in the real economy. If this index has some predictive value, it may be that the real economy would be in better shape within 6-12 months time.


Recommended Read
Please consider: Optimism is not enough for a global recovery

This article is about 2 months old (equivalent to decades for our fellow currency traders) but is as relevant today as it was then. Since that time, US equity markets had an impressive run adding another 10% to the benchmark index. The latest U.S. employment report raises hopes for an end to doom and gloom, having sent U.S. stocks higher still. And yet, it pays to consider Wolfgang M√ľnchau's concerns when he writes:

Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.

ETF Wraps
Last week's information on Exchange Traded Funds (ETFs) appears timely. The growth of ETFs continues as we speak and a recent FT article notes, Investor demand fuels rebound in ETFs. According to data from Barclays Global Investors, assets invested globally in ETFs reached a record high of $862bn.


But more interesting developments are under way now that these new products have been showing increasing popularity among investors. Banks, in particular the private banking sector, who have for years had an easy Spiel with so-called structured products, generating high fees for the banks, have recently been faced with declining fee-income because increasing competition of the lower cost ETFs products. But now, Banks fight back with ETF wraps.

The FT article suggests, some private banks have begun creating new structured products with the use of ETFs. Consider this:

By turning ETFs into structured products, banks can charge annual fees of 1.5 to 1.8 per cent, Mr Rajan said, in excess of total expense ratios for equity and bond ETFs, which range from 0.15 per cent to 0.75 per cent, according to Lipper FMI data.

As we discovered last week, the more recent and more complex ETFs have already begun to ask for higher fees, some of which have been charging up to 1% in expenses. Add the cost of bundling ETF's, who are in itself bundles of different stocks or other assets, and the new "wrap" compares to the cost of Fund of Funds and Fund of Hedge Funds. You should really ask yourself "why pay someone to select funds and pay yet another middle man"? These type of arrangements sound like asking someone to help you select ingredients for a sandwich and prepare that same sandwich on an ongoing basis. After a while, you should know which ham and which cheese you like and you better know how to prepare your own sandwich, particularly in the current economic climate. If you don't or aren't willing to do so, you end up paying a hefty premium for something that shouldn't take that much time, effort or money.

Not to toot my own horn here, but it sounds to me that you are better off asking someone to sit down with you for a couple of hours and find out if your portfolio consists of a "cost-effective" selection of stocks, funds and other assets. In the process you could learn how to find and select some ETFs that would fit your personal investment needs rather than having ongoing charges reduce your entire investment portfolio to a point where the premium paid in ongoing fees won't meet the expectations i.e. superior performance over a benchmark.

As I mentioned last week, ETFs were originally designed to give even small investors an easy way to diversify and buy the entire market index at a minimal cost. If you are an average investor, you should be able to achieve a sensible and well diversified portfolio with just a handful of ETFs. If you have slightly more complex investment needs, it would be well worth spending some time and learning as much as you can so that you can prepare your financial sandwich at any given time.

A Primer on Financial Regulators
The Financial Times recently published an overview of the financial regulators in the United Kingdom, the European Union and the U.S. at: Financial Regulation: who is watching whom

This is a fairly concise overview of how financial services in the developed countries are regulated. All contents and graphics below are from the Financial Times:

United Kingdom – Current

Financial services in the UK are regulated by a tripartite system consisting of the Bank of England (BOE), the Financial Services Authority (FSA) and the Treasury. The BOE monitors systemic risk, the FSA focuses on supervision of financial companies and consumer protection. The Treasury acts as the guardian of the public course.

United Kingdom - New Proposals

Lord Turner, chairman of the FSA, published a review of financial services regulation in March 2009. Alistair Darling, the Chancellor of the Exchequer, adopted many of his recommendations in a blueprint for reform on 8 July 2009. However, many of the proposed changes are unlike to be implemented before June 2010 – the last possible date for the next election – partly because they are opposed by the Conservatives, who published their own “alternative white paper” earlier this month.

European Union – Current

The European Union’s financial services legislation adopts the Lamfalussy arrangements, based on the recommendations of the chair of the EU advisory committee that created it, Baron Alexandre Lamfalussy. Whilst the Parliament, Council and Commission are responsible for drawing up legislation to cover financial institutions, supervision remains a member states responsibility. The CEBS, CEIOPS and CESR coordinate the activities of member states’ supervisors in the three respective areas and liaise directly with the commission.

European Union – New Proposals

The European Commission has proposed an overhaul of Europe’s system for supervising banks and insurers that places an emphasis on micro-prudential and macro-prudential supervision to oversee both individual institutions and the overall banking framework. The current so-called “Level 3 Committee” of supervisors would be given beefed up responsibilities for the banking, insurance and securities sectors.

United States – Current

The United States’ financial framework can be broadly categorised into those institutions that regulate and supervise banks, insurance, commodities and securities. The United States has a complex regulatory framework, with federal and state institutions sharing regulatory responsibility and some federal institutions charged with overlapping responsibility.

United States – New Proposals

Barack Obama, US president, is pushing for reforms to the regulation of the financial system. Among the government’s proposals, the Federal Reserve would have greater supervisory authority over any institution that may pose a threat to the financial system and, if necessary, assume control of them if they fail. This would be supplemented by the introduction of a Council of Regulators charged with advising the Fed under its new role. The proposals also put an emphasis on “looking out for ordinary consumers” with the creation of a Consumer Protection Agency.

In summary, I wanted to emphasize that any proposal for more regulatory agencies and more complex regulation is to be viewed with a healthy dose of skepticism. As I noted in a newsletter earlier this year about the pitfalls of regulatory oversight:

In my experience with financial regulators, both in Europe and the US, there are some fundamental issues that need to change. For starters, regulators have to understand how companies operate, not in theory but in practice. This means that regulators should spend a lot more time on the trading floors and in dealing rooms of the banks rather than pouring over print outs of financial statements who rarely reflect the true nature of the mechanics and risks involved. Real life example: Trading desk A is assigned to one firm within a group of companies, desk B assigned to another firm within the same group but technically and legally operating outside of the regulatory environment. Because desk B does not fall within the regulators realm it goes un-inspected. The fact that business was separated between 2 different desks is good enough reason for regulators to simply not know about those activities of desk B even when Desk B is within the same office and essentially run by the same company. Effective regulation cannot work that way; point in case: Mr. Madoff.

To improve the efficiency of financial regulation, another fundamental change has to take place. Instead of recruiting accountants and lawyers, both of whom are often clueless about the financial instruments they’re supposed to oversee (they only need to understand trading and risk from reading a book), regulators should find ways to attract real talent, real brokers, traders and market practitioners who can feel and smell when something isn’t kosher.

Everyone wants to have better and more efficient regulation but it is rather questionable whether more and bigger is better. After last year's financial implosions, it helps to remember that none of the regulatory frameworks of the three most widely revered regulatory jurisdictions either predicted nor helped prevent the crisis in any way. As a matter of fact, the most complex of all regulatory jurisdictions, the United States, did not just fail in predicting or preventing the second largest financial crisis after the Great Depression, it also allowed scam artists like Mr. Madoff to pull off a decade long financial scheme defrauding investors of some $60 billion, the largest financial fraud in history.

If we are to model a new regulatory framework, we should look towards a system with as little as possible bureaucratic and administrative inefficiencies. It would seem a simpler and more cost effective structure would also be in the interest of tax payers. Let us not forget that there is a substantial cost of regulation; the taxpayer ends up paying for both sides of that cost: i.e. the cost of devising and administrating the regulatory agencies as well as the cost incurred by the financial institutions that are being regulated (in terms of higher fees). In either case, the net result is a reduction in investment returns.

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Good luck & good trading!

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