Green Shoots and the Carbon Markets

“Green Shoots” and the Carbon Market 17th August 2009 EUA’09: €14.50 Recommendation: Hedge by buying Puts The last few weeks have seen an increasing number of market experts and economists calling the end of the recession and the resumption of an economic growth pattern similar to previous cycles. These are, however, the same market commentators who failed to foresee the imploding credit markets in late 2007. The market reaction to these predictions is best reflected in a 50% rise in the S&P 500 from its March lows. It is our opinion that this rally is illogical and unsustainable. Consequently we are forecasting a huge market correction before the end of autumn; and view the recent gains merely as a sharp rally in a sustained bear market that will lead to further pressure on world economies and reduce demand for Carbon Emission Allowances. Below is a summary of the economic position we find ourselves in and our predictions. The market began this prodigious rally on the back of a number of banks producing profits substantially above analysts’ expectations. A large proportion of these profits arose from highly advantageous settlements resulting from the US government’s bailout of AIG’s outstanding credit default swap obligations and the April 2 rule change of FAS 157 which allowed banks to mark their assets above market value boosting intangible profits. According to an IMF report released in April, global credit losses amount to over $4.1 trillion but to date only $1 trillion of this amount has been recognised. Some banks still maintain high leverage and, if these losses are recognised, the majority of bank equity will be wiped out. Commercial real estate losses have only just started to become a problem and are estimated to be in excess of $3 trillion - of which only 25% has been written down by the financial sector to date.   Emerging markets, including China, recently reported increases in GDP growth; however, the majority of this can be attributed to huge government spending and easy credit policies –one of the main culprits for the global financial crisis. This is similar to giving a drunk a bottle of whisky to cure his alcoholism. China’s two main stock markets are up an incredible 75% and 95% on the back of the government’s stimulus package and are supported by huge amounts of non-performing loans. This is just another bubble waiting to implode. Recent data shows that Chinese exports have fallen by an enormous 23% highlighting the fragility of their export-led growth. The surge in China’s exports was largely driven by US consumption fuelled by the credit boom. How this consumption will be replaced given the precarious financial position of the US consumer and the large unemployment percentage remains a mystery. The S&P 500 price earnings (P/E) ratio recently exceeded 140, equating to more than three times its value at the peak of the world equity markets in 2000. Markets have been driven by banks trading the large pools of liquidity supplied by the Federal Reserve to stimulate the economy that was meant to be leant to struggling firms and individuals. With US unemployment approaching the 10% level, it is unlikely the consumer will reignite the US economy. Recently a staggering 64% of GDP was generated by consumption driven by credit card debt and cashing in on the value of their inflated home prices. House prices in the US need to fall by 30% to revert to their long time mean of three times the annual average salary. The recent dramatic decline in bond issuance by the US Treasury may indicate that the government has reached its limit for debt issuance. We expect this to lead to a rise in long term rates and ultimately raising mortgage rates, only exacerbating our view of a continued recession in the US and the rest of the world.   SOURCE: US Treasury Direct, “Debt To The Penny” Conclusion: Recently the Carbon Markets have been following the equity markets as a proxy for an anticipated improvement in global GDP. We believe that this is a serious error in judgement and advise our clients to consider some kind of hedging strategy to lock in the advances of the last few months. Option volatilities have been sliding over the last few months as illustrated below, thus option prices have been declining. We expect volatilities to reverse this trend as the equity markets reverse their gains. We therefore recommend the purchase of put options to December to lock in the recent gains.