7 November 2012 | Thunder Road report

Thunder Road
report
Cigarettes and Collateral debt Ponzi showing early signs of developing central banker resistance

Companies mentioned in this report: Imperial Tobacco, BAT, BASF, Air Liquide, Royal Dutch Shell, BP, ExxonMobil, BHP Billiton, Rio Tinto

Cyclical versus defensive indicators, revenue misses during the Q3 earnings season and lower equity markets since the QE3 announcement point to questionable momentum in the post-Lehman central bankmanaged recovery. Europe and Japan are currently in dire situations.
Central banker steps out into real world

Source: The Daily Bail

2013 is shaping up to need another major push on the global reflation trade in the form of colossal amounts of money printing by central banks. When in doubt, its fairly certain that central banks can be counted on to do even more of the same. They are also facing an additional headwind which has been overlooked. Beginning next year, new regulations (DoddFrank, etc) will require an additional one trillion dollars plus of collateral to back the $648 trillion OTC derivatives market. Where does this come from (the usual source?) and, if it doesnt, what would be the impact if large volumes of trades were unwound?
Cyclical versus Defensive Its no surprise that the ratio of the S&P 500 Consumer Discretionary Index versus the S&P 500 Consumer Staples Index saw a strong rebound for more than two years following the collapse of Lehman in late-2008, as the world economy came back from the brink. However, the ratio has yet to push on and make a new high from the levels reached in February 2011 and May 2012 as shown in the next chart.

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| 7 November 2012 | Thunder Road report

S&P 500 Consumer Discretionary vs. S&P 500 Consumer Staples since late-2008
10.00%

5.00%

0.00%

-5.00%

-10.00%

-15.00% Mar-25-2011 May-19-2011 Oct-04-2011 Nov-28-2011 Sep-07-2011 Dec-23-2011 Apr-21-2011 Feb-28-2011 Jan-03-2011 Aug-10-2011 Oct-31-2011 Jan-31-2011 Jun-16-2011 Jul-14-2011 Mar-19-2012 May-11-2012 Aug-02-2012 Aug-29-2012 Sep-26-2012 Jun-08-2012 Oct-23-2012 Jan-24-2012 Feb-21-2012 Apr-16-2012 Jul-06-2012

S&P 500 Sector Indices - Consumer Discretionary Sector Index/S&P 500 Sector Indices - Consumer Staples Sector Index - Index Value

Source: Capital IQ
S&P Consumer Discretionary versus S&P Consumer Staples has been a good leading indicator of major turning points in the S&P 500

While this wasnt a barrier to the S&P making a new high on 14 September 2012, times when Consumer Discretionary is outperforming Consumer Staples, are almost always a signal that the market is going higher. The fact that it isnt, and the ratio has been a great lead indicator for MAJOR turning points in the overall market, could be a warning sign. In the chart below, you can see how it turned down 8 months before the all-time high in the S&P in October 2007 and turned up 4 months before the March 2009 low.
S&P 500 Consumer Discretionary/Consumer Staples and S&P 500 2007-09
5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00% -30.00% -35.00% -40.00% -45.00% Jun-19-2009 Sep-17-2009 Mar-23-2009 Feb-05-2009 May-06-2009 Aug-04-2009 Aug-08-2008 Nov-05-2008 Oct-30-2009 Jun-25-2008 Mar-28-2008 May-12-2008 Sep-23-2008 May-17-2007 Aug-15-2007 Sep-28-2007 Jan-03-2007 Apr-03-2007 Dec-27-2007 Nov-12-2007 Dec-15-2009 Feb-12-2008 Dec-19-2008 Feb-16-2007 Jul-02-2007 1,600.00 1,500.00 1,400.00 1,300.00 1,200.00 1,100.00 1,000.00 900.00 800.00 700.00 600.00

relative S&P 500 Sector Indices - Consumer Discretionary Sector Index/S&P 500 Sector Indices - Consumer Staples Sector Index - Index Value
S&P 500 Index (^SPX) - Index Value

Source: Capital IQ Another cyclical versus defensive indicator in the equity market is telling a similar story of questionable momentum. The chart below shows the ratio of BASF (cyclical) versus Air Liquide (defensive), both of which are global players in the chemicals and industrial gas sectors, respectively:

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| 7 November 2012 | Thunder Road report

BASF versus Air Liquide since late-2008

20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00% Mar-23-2011 Jan-03-2011 Aug-05-2011 Feb-24-2011 Sep-28-2011 Jan-28-2011 Oct-25-2011 May-18-2011 Nov-21-2011 Sep-01-2011 Dec-16-2011 Apr-19-2011 Jun-14-2011 Jul-11-2011 May-30-2012 Apr-03-2012 May-03-2012 Aug-17-2012 Mar-07-2012 Feb-09-2012 Jun-26-2012 Oct-10-2012
Oct-08-2012 Oct-23-2012

BASF SE (DB:BAS)/L'Air Liquide SA (ENXTPA:AI) - Share Pricing

Source: Capital IQ Its also been noticeable how many companies have missed revenue expectations during the Q3 2012 results season. Those that have are in the majority by a roughly 60:40 ratio, although this has been reversed at the earnings line. Big oil stocks (e.g. RDS, BP and ExxonMobil) - which would be beneficiaries of a 2013 reflation trade are showing signs of bottoming out. The same is true for miners, like BHP Billiton and Rio Tinto.
BP vs. All Share 1 Year
10.00%

Rio Tinto vs. All Share 1 Year

15.00% 10.00%

5.00%

5.00% 0.00%

0.00% -5.00% -10.00% -5.00% -15.00% -20.00% -25.00% -15.00% Nov-07-2011 Nov-22-2011 Dec-07-2011 Dec-22-2011 Jan-11-2012 Jul-05-2012 Jul-20-2012 Sep-06-2012 Feb-27-2012 Jun-20-2012 Sep-21-2012 Aug-21-2012 Jan-26-2012 Mar-13-2012 Jun-01-2012 Feb-10-2012 Aug-06-2012 Oct-23-2012 Mar-28-2012 Oct-08-2012 May-01-2012 May-17-2012 Apr-16-2012 -30.00% Nov-07-2011 Nov-22-2011 Dec-07-2011 Dec-22-2011 Jan-11-2012 Jul-05-2012 Jul-20-2012 Sep-06-2012 Feb-27-2012 Jun-20-2012 Jan-26-2012 Feb-10-2012 Aug-06-2012 Mar-28-2012 May-01-2012 May-17-2012 Aug-21-2012 Mar-13-2012 Jun-01-2012 Sep-21-2012 Apr-16-2012

-10.00%

BP plc (LSE:BP.)/FTSE All-Share Index (GBP) (^ASX) - Share Pricing

Rio Tinto plc (LSE:RIO)/FTSE All-Share Index (GBP) (^ASX) - Share Pricing

Source: Capital IQ
Looking for some insurance in uncertain markets

Source: Capital IQ Meanwhile, my thoughts were also drawn towards finding a bit of insurance in defensive stocks which have seen aggressive sell-offs. One which stands out to me is Imperial Tobacco in the UK which reported in line results last week. The yield is 4.9% and prospective (September 2013) PE is 11.2x which compares with the 14.2x of its larger rival, BAT. There are also signs that the more than 70% underperformance versus BAT during the last 5 years is beginning to bottom out.

Sep-13-2012

Jan-13-2012

Jul-23-2012

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| 7 November 2012 | Thunder Road report

Imperial Tobacco vs. All Share 1 Year

15.00%

Imperial Tobacco vs. BAT 5 Years

50.00% 30.00%

10.00%

10.00% -10.00% -30.00%

5.00%

0.00%

-50.00% -70.00%

-5.00%

-90.00% -110.00%

-10.00% -130.00% -15.00% Nov-07-2011 Dec-07-2011 Nov-22-2011 Dec-22-2011 Jan-11-2012 Jul-05-2012 Jul-20-2012 Aug-06-2012 Sep-06-2012 Feb-27-2012 Jun-20-2012 Jan-26-2012 Feb-10-2012 Aug-21-2012 Mar-13-2012 Jun-01-2012 Sep-21-2012 Oct-08-2012 Mar-28-2012 May-01-2012 May-17-2012 Oct-23-2012 Apr-16-2012 -150.00% Jun-27-2011 Jan-27-2011 Sep-07-2011 Apr-08-2011 Jan-21-2009 Aug-28-2009 Apr-02-2009 Nov-06-2008 Aug-27-2008 Apr-02-2008 Nov-10-2009 Jun-18-2009 Jan-18-2008 Jun-16-2008 Sep-02-2010 Jan-25-2010 Jun-22-2010 Nov-12-2010 Nov-17-2011 Feb-01-2012 Apr-16-2012 Apr-08-2010 Nov-05-2007 Jun-29-2012 Sep-11-2012

Imperial Tobacco Group plc (LSE:IMT)/FTSE All-Share Index (GBP) (^ASX) - Share Pricing

Imperial Tobacco Group plc (LSE:IMT)/British American Tobacco plc (LSE:BATS) - Share Pricing

Source: Capital IQ

Source: Capital IQ

With volume/revenue growth becoming harder to come by almost everywhere, I was struck by the price/mix increase of 7% in Imperials latest results for the year to September 2012 (versus 3% a year earlier). Nearly time to front-run central bankers again? The bottom line here is that things arent all going according to plan for the central planners bankers: In the US, Bernanke has repeatedly mentioned the impact of QE on the equity market. Based on the markets reaction to QE3, the pleasure was (almost) all in the anticipation with the S&P 500 peaking the day after the announcement. Maybe its no longer a question of Dont fight the Fed, but purely one of gaming the Fed? In Europe, we not only had much worse than expected October PMIs for Germany and Spain, but there was marked weakness in new orders in Germany, France, Italy and Spain. Germany saw the second biggest decline in export orders since April 2009. The strength of the Yen and its contribution to the deterioration of Japans economy has become highly politicised with extreme pressure for aggressive action being applied by the government on the BoJ. The latest Yen 11 trn (US$138bn) round of QE saw a joint statement issued by the central bank and the Japanese government, the first since the formers independence was granted more than a decade ago.
Central bankers can be relied upon to do one thing

If we go back to the beginning of this crisis, central bankers have been entirely consistent in one respect throughout printing more and more money. If things arent going entirely their way, we can be fairly certain that central bankers will resort to even more of the same. The next Fed meeting takes place on 11-12 December which raises the possibility (probability?) that they will indicate further open-ended monetisation to replace Operation Twist without sterilisation. I dont think people have fully grasped the sheer determination to devalue the dollar. Do you remember these comments from high-profile hedge fund manager, Kyle Bass, speaking at the annual AmeriCatalyst event in late-2011: The governments idea right now is we are going to export our way out of this and when I asked a senior Obama administration official last week how are we going to grow exports if we wont allow nominal wage deflation? And he says, we are just going to kill the dollar. I said okayI mean, thats the only answer. Based on the latest trade data, theres quite some work to be done:

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| 7 November 2012 | Thunder Road report

US International Trade in Goods and Services

Source: US Census Bureau Draghis words from his London speech in July 2012 are ringing in my ears: Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. When BoJ Governor, Masaaki Shirakawa, steps down in April next year (if he lasts that long), his replacement is expected to be from the government - the MoFs Toshiro Muto. Weve just had two rounds of QE in successive months and 2013 is likely to see a far more dovish BoJ Governor. The strategic framework of my global macro view is based on an interpretation of the long wave or Kondratieff Cycle, the existence of which is not even acknowledged by the mainstream. Back-testing it to 1788 (included in a forthcoming report) shows that if you could determine which phase of the long wave you were in, you had an 89% chance of being correctly positioned in terms of asset allocation between equities, government bonds, commodities, real estate and gold. Ive been saving the following quote, which draws an interesting conclusion regarding the long wave and monetisation, since I found it several years ago (with apologies to the author whose name Ive lost):
Monetisation and the long wave

Once the forces of a long wave decline are in motion, they will tend to persist even in the face of substantial money supply injections like a car skidding backward downhill while its wheels continue to spin uselessly in an uphill direction. Eventually, the inflationary forces catch fire again and the car, once again, lurches upward, but with greater difficulty and a higher rate of inflationary friction. Sooner or later, additional money printing produces no economic motion only higher prices and the economy figures its inevitable economic decline. I think that the central banks will go all out to get another lurch forward in economic growth in 2013, with the associated higher rate of inflationary friction. However, as other analysts pointed out, Bernanke linking QE to rising employment is spurious to say the least. Stripping out statistical funny business lets use the ratio of civilian employment to population - we are still only treading water after two QEs and a Twist.
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US Civilian employment to population ratio

Source: St Louis Fed

When questioned further about the rationale for more QE, Bernanke fell back on the hope that a rise in house prices and equity markets might give consumers confidence to spend a bit more. Surprisingly, most commentators seemed to take Bernankes motives at his word, even though there is far more going on here. The deceptive brilliance of QE3 With the fantastic advantage of hindsight, there were already indications at the beginning of August this year that the Fed was going to announce QE3, even though markets didnt begin to anticipate it until the second half of the month. On 2 August 2012, the Wall Street Journal carried a headline NY Fed to Start Repo Operations Friday to Test Capability. Repo operations add liquidity to the banking system as the Fed borrows bonds from banks in return for cash (reserves). This marked a significant change in direction since the Fed hadnt conducted any repos since the depths of the crisis in December 2008. In fact, it had been conducting test reverse repos to give the impression that it might one day withdraw liquidity. Tyler Durden of Zero Hedge argued that it meant that: at least one bank was in dire need of new reserves, all posturing by the Fed to the contrary notwithstanding. Because there simply is no reason for the Fed to launch a repo operation out of the blue
Keeping the bubble inflated

The repo was modest at just US$210m, but Tyler Durden of Zero Hedge argued that it was a sign that a new round of QE was needed to support risk markets. He makes a key point in the following quote about how the FLOW OF NEW CREDIT is vital to keep the Ponzi scheme inflated: The Fed needs to constantly infuse the financial system with new, unsterilized reserves in order to provide bank traders with dry powder needed to ramp risk higher . those who wish to take advantage of the Feds jawboning need to have access to reserves, which via shadow banking conduits, i.e. repos, can be converted to fungible cash, which can then be used to ramp up ES, SPY and other risk aggregates . As it turns out, today we may have just hit the limit on how much banks can do without an actual injection of new reserves by the Fed. Read: a new unsterilized QE programme. After QE3 became reality on 13 September 2012. Lindsey Williams provided some additional insight on the motivations for QE3. Ive referred to Lindsey Williams in previous Thunder Roads because his well-placed source (close to a dynastic family) has made a number of (very) successful predictions for example in mid-2008 that oil would fall from US$140/bbl to US$50/bbl in a matter of months (it went to

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c.US$35/bbl). You can access interviews with Williams back to 2008 at www.lindseywilliams.net. According to Williams, there was a confidential agreement between the Federal Reserve and the banks that the latter would use proceeds from selling Mortgage Backed Securities to the Fed via QE3 to purchase US Treasuries. This makes sense and is very helpful in light of the trillion dollar US deficit when Chinese purchases of Treasuries have slowed to a trickle. But was there yet another reason which ties in with BOTH the need for bank reserves to support risk markets (Durden) and to give the banks firepower to indirectly finance the Federal deficit (Williams)? Im referring here to a current and future shortage of COLLATERAL. Lindsey Williams made an unusual comment regarding another motivation for QE3, i.e. that the Fed needed to hedge the derivative markets. Williams is a layperson in terms of finance, but I think he was referring to what the uber sharp Raoul Pal of Global Macro Investor has been highlighting for months, i.e. as more credit instruments are downgraded (e.g. sovereigns in the Eurozone and banks from all over), there is a growing shortage of high quality collateral to support the US$648 trn OTC derivatives markets, all the exchange traded futures and options and the whole (dysfunctional) system. Its also noticeable how Moodys and S&P are holding Spains rating one notch above junk as the country falls further into the abyss! With the above in mind, it becomes clear that if QE3 had seen the Fed buy Treasuries instead of MBS, the availability of the (joke) highest quality collateral would have been diminshed further. QE3 was DECEPTIVELY BRILLIANT in the way that Bernake and the Fed seemed to kill so many birds with one stone. The corollary of this is that behind the faade, the debt Ponzi is more vulnerable than it looks. Collateral another trillion dollars needed (at least) Courtesy of new regulations, said Ponzi will be in dire need of a big slug of additional collateral during 2013-14 just to keep the whole thing propped up. In a March 2012 Working Paper, Collateral requirements for mandatory central clearing of over-thecounter derivatives, the (Bank for International Settlements) BIS noted that: Central clearing of derivatives traded bilaterally in over-the-counter (OTC) markets is set to become more widespread. This reflects a demand of G20 leaders that all standardised OTC derivatives should be cleared with central counterparties (CCPs) by the end of 2012 .The G20 mandate will therefore affect dramatically the landscape of OTC derivatives clearing, with potentially significant implications for the volume of collateral that market participants will need. Those required to post the additional capital will be major banks, broker dealers and funds. Discussions between the industry, represented by ISDA (International Swaps and Derivatives Association) and regulatory bodies, like the CFTC (Commodity Futures Trading Commission), are in their closing stages and the new requirements will probably take effect during the first half of 2013. While the legislation only applies to new transactions, the duration of 40-50% of OTC derivative contracts is less than one year (and over 60% of interest rate derivatives by far the biggest segment - in the US). To the dismay of market participants, the proposed legislation limits eligible collateral to a narrow range of assets. In the US, for example, this consists of cash, US Treasuries and senior debt of certain US government sponsored entities. The range of estimates for the required additional collateral is wide, but the numbers are very large - at least one trillion dollars. In a letter to the CFTC on 11 July 2012, ISDA commented that: We estimate that the additional margin required by the proposal could be as high as $1.0 trillion and hundreds of billions of additional liquidity would need to be secured for financial entities and dealers. This estimate does not include initial margin for any
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OTC derivatives markets need an infusion of collateral

| 7 November 2012 | Thunder Road report

derivatives other than interest rate products but does include variation margin for all products. ISDA emphasizes that this is a global estimate since it expects regulators in different territories to converge on similar margin requirements. The BIS came to a similar estimate in March 2012: Adding our rough estimates of initial margin requirements for non-dealers to our estimates for the G14 dealers, we find that total initial margins could rise to over US$1 trillion, depending on how they are set. The US Office of the Comptroller of the Currency (OCC) came to an even higher estimate: the initial margin in one year could total $2.56 trillion. As a rough estimate, we assume that approximately 20 percent of swap contracts trade through clearing houses. Under this assumption, our initial margin estimate would be 80 percent of our first estimate, or $2.05 trillion.
What are the implications?

Are banks, dealers and funds going to stump up all of this new collateral? If yes, where are they going to get it and what impact will this have? And if not, are there negative implications for our inflated financial system? These are far from easy questions to answer, although ISDA seems to argue that there is a risk that our financial system bubble could deflate somewhat: We believe the amount of additional collateral requirements and liquidity drain would have an impact on financial markets and economies generally. Collateral and liquidity requirements, may force investors to sell assets, reduce the amount of derivative activity generally, and, thereby, reduce liquidity. We know that the merest hint of deflation frightens central bankers to death. By far the biggest players in the OTC derivatives markets are the Too Big To Fail banks (especially US) the darlings of central bankers. Based on data from the Office of the Comptroller of Currency, commercial banks operating only in the US have US$214.1 trillion of notional OTC derivatives exposure. The vast majority of this is in the hands of the Big 4 JPM, Citi, BoA and GS. My suspicion is that central bankers will be forced to act aggressively to offset some of this risk. But if the Fed, for example, buys additional Treasury and agency bonds via QE, there could be a squeeze in these markets as ISDA argues: Constraining eligible collateral to cash, U.S. Treasuries and senior GSE (governmentsponsored enterprise) obligations would create an exaggerated demand on treasury and agency securities. This would have a direct and artificial impact on the repo markets and related rates, and increase the risk of short squeeze situations arising. Could it be the last hurrah for US government bonds?

Banks have invented collateral transformation

While the new regulations are an attempt to reduce systemic risk, the banks are already well-advanced in finding ways to circumvent the rules which is entirely true to form. This doesnt stop the additional collateral needing to be pledged, but it can swap lower quality collateral for higher quality collateral in a process termed collateral transformation. Sounds bad already, doesnt it? This was from a Bloomberg report on 20 September 2012: At least seven banks plan to let customers swap lower-rated securities that dont meet standards, in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed collateral transformation. The manoeuver allows investors who dont have assets that meet a clearing houses standards to pledge corporate bonds or mortgage-linked securities to a bank in exchange for a loan of Treasuries. The investor then posts the Treasuries - the transformed collateral - to the clearing house.

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The bank earns fees plus interest, and the investor is obliged at some point to return the Treasuries. In effect, the collateral is being rented. My favourite line from the report is the following: Collateral transformation is a client service that does not hide risk, says Jennifer Zuccarelli, a spokeswoman for JPMorgan Chase.

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