Eric Burroughs

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Big risks everywhere

August 21, 2011

The market volatility of the past two weeks has been astounding. While the broad factors are obvious, markets are not beasts that lend themselves to easy analysis and the nuances really matter here. A few broad factors at play are feeding off each other. All have been discussed and debated, but here’s a rundown on the interplay I see taking shape.

1) Euro breakup not so far-fetched

How do you hedge against the potential collapse of a single currency used in a $13 trillion economic zone plus trillions more of securities and derivatives? Not easily. A splintering or breakup of the euro has gone from unimaginable to a risk that can’t be ignored altogether.  Europe’s inability to get ahead of the crisis now means a sovereign debt crisis is fast becoming a banking one. The solutions — a super sized EFSF rescue fund, Eurobonds, a commitment to fiscal union — are there to be had. But the political will is lacking.

Back to the hedging. The options market is the obvious place to turn, especially deep out-of-the-money options that typically mean you don’t have to pay a lot upfront to protect against a doomsday scenario. For the euro, this has been most apparent in the euro/Swiss franc FX options market where the hedging for downside protection against the euro has been intense. The extreme implied vol skew towards EUR/CHF puts reflects big demand for such protection. The Swiss franc is bearing the brunt of the selling not just because of the franc’s perceived safe-haven status, but also because Asian central bank diversification of dollar holdings has kept euro/dollar surprisingly high for all the single currency’s worries. (So in some ways, the Swiss National Bank can blame its counterparts in Asia for making the pressure on the franc so acute. ) The franc is the Alpine haven as the European project threatens to tear apart at the seems, and the SNB’s attempts to get extremely unconventional in fighting this battle — flooding liquidity and creating negative short-term interest rates — are only partially working. The below surface now shows more demand for short-term EUR/CHF calls in case the SNB succeeds, but the steep skew towards out-of-the-money puts is one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe. When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.

2) U.S. GDP shock, G7 stagnation and tightening fiscal policy

The debate over the S&P downgrade of the USA’s AAA rating masked the bigger even that occurred at about the same time — the shock downward revisions to U.S. GDP. By showing a much weaker recovery coming out of the crisis, the revisions overturned many growth assumptions that fed into many other forecasts made by funds, from interest rates to earnings.  That is the main reason why the stock market reaction was so big: what looked like a relatively healthy recovery was a mirage, and the data pointed to stagnation and a higher risk of a double-dip recession ahead. Earnings expectations were the most at risk from such major revisions, and that’s why consumer and technology related stocks were the most hit in the initial selloff. At this point, the share slide has helped better align prices with expectations for earnings. But the downgrade to earnings is only just kicking in. This wholesale reassessment may have more room to run, and in the process drag shares down further. In historical and forward p/e ratios, the denominator will be falling as fast as the numerator.

Of course, this comes as fiscal policy is tightening in both the United States and Europe, adding to the risks of a prolonged bout of economic stagnation in the G7. Last week’s data showing GDP in Germany and France basically stalled in Q2 adds to the evidence that stagnation is ahead. Growth-loving stock markets are not used to the world’s major economies going through such a period of poor growth. Japan provides a scary example — nominal GDP is at a 20-year low, the Nikkei is 75 percent below its bubble peak — of what stagnation means for stocks, even for a market full of global powerhouses. For example, and this is extremely simplistic, the equivalent level for the S&P compared to its all-time high is 389 vs 1,123 now.

3) Central banks and their ammo

Media talk of recession “fears” miss the point. Recession may happen, but it will probably be mild unless Europe devolves into a full-blown banking crisis. The problem now is that central banks have few resources to lift growth beyond extreme measures that have already generated a lot of controversy. The irony with Bernanke’s QE2 is that it was not really big enough to have a big bang impact of the type he had always suggested for Japan, drawing his lessons from what went wrong in the Great Depression. In economics, half measures are worse than no measures by giving a false sense of hope.

The Bank of Japan’s policies over the years have been a consistent lesson in central banking futility in the face of stagnation and persistent deflation: every recovery, linked mainly to the global economy, was snuffed out in the next recession. As exotic as the BOJ’s policy now appears — buying ETFs and commercial paper on top of JGBs — it does not have a material impact in encouraging demand. Dallas Fed President Richard Fisher has a point when he argues that the economy’s problem is not one of liquidity, but liquidity not being used.  FT Alphaville had a great post on this point last week (linking back to Fisher) about the perverse outcomes when pure cash becomes so dear. The sheer uncertainty of the moment — housing still a mess, euro zone a mess, politics a mess, economy as a whole looking grim — means the credit transmission mechanism is malfunctioning even more than during the 2007-08 crisis (and yes, this may be just one long crisis). Yep, when investors PAY banks to hold their money, that’s a liquidity trap of the sort Japan has lived with for a long time now and shows no sign of escaping. This is a very dangerous negative feedback loop that needs to be broken without equity investors going back to think Bernanke’s got a bigger put than Greenspan. Non-financial companies in the U.S. are sitting on liquid assets that total nearly 7 percent of total assets, the highest since the 1960s, according to the Fed’s flow of funds data. Maybe taxing cash is not a bad idea. It is one idea that Credit Suisse floated for Japan earlier this year.

4) Every person for his/herself

Europe is in a vicious circle where individual actors — think the really big banks — are taking actions to protect themselves, but by doing so are creating dangerous negative feedback loops that have been tough to break. One example of this has been banks hedging their counterparty risks via counterparty valuation adjustment (CVA) desks. The desks actively manage exposures in the OTC derivatives markets to counterparties, including sovereign governments that have used derivatives for hedging (over the past decade France has been an active interest-rate hedger via the swaps market). In the case of sovereigns, hedging is based on market measures such as CDS spreads. But CDS are then used to do the hedging. It’s easy to see how this becomes self-reinforcing and can prompt other investors to hedge or cut their exposures all at the same time. How does a bank as big as Deutsche Bank really hedge itself against Europe as a whole? Not easily. The ECB’s reluctant bond purchases help break this vicious circle. Still, with the gangrene reaching the core of the euro zone, this is a problem that is getting too big to handle.

Beyond banks, central banks are stumbling into individual policy responses. The BOJ’s massive one-day intervention failed, or delayed the inevitable: dollar/yen touched a post-Nixon shock low of 75.94 on Friday. The Japan MOF/BOJ decision came right after the SNB took action on the Swiss franc, which at the time appeared to be a convenient piggybacking than anything coordinated. The SNB has since launched more aggressive measures, with partial success — though the success stems as much from the euro peg rumors than their own liquidity pumping. Then the ECB was forced into buying more euro zone bonds outright, if nothing else because the SNB managed to shift the onus. None of this was coordinated. Nor is there any sign of a coordinated response on the way. A full-blown banking crisis may change that. For the moment, individual actors are reacting in aggressive ways that add to the uncertainty.

5) The unloved dollar and euro

Not helping matters is the deteriorating status of the world’s reserve currency. Indeed, what keeps the euro afloat on a broader basis is that the dollar is suffering too. Hence, gold keeps surging against both — and lately gold has outperformed against the euro more than the dollar, showing how the world is struggling to adjust to an environment where investors/SWFs rebel against the reserve currency and have second thoughts on the other best option. The creaking post-gold standard world is struggling to reassess the landscape of paper currencies in a heavily indebted world. Hard assets are the first to win, but currencies and bonds of strong current account countries — especially in Asia — are also winning. Those inflows may not last if systemic risk really flares over what’s unfolding in Europe. At the end of the day, the world is having trouble dealing with the world’s top two currencies both coming under pressure at the same time when there are not viable alternatives. The yuan is at the start of a decades-long process of opening up, and even then there are doubts. The yen has never attempted to be a reserve currency, nor would the currency of the developed world’s most indebted country achieve such status. More uncertainty.

6) Even China

Even China has its issues. The local government debt problem is a big one, and one borne out of Beijing’s last attempt to stimulate the economy through pell-mell bank lending. If China grows a bit less than it is used to, the debt problem is big enough that banks can’t easily grow their way out of it. Capital injections and write-downs may be needed. That makes it more difficult for China to boost the economy via stimulus that inevitably involves bank lending given China’s crude economic structure that still relies on state-owned banks for channeling credit. China has cracked down on its banks in a big way, but this debt problem needs cleaning up even while trying to achieve more stimulus AND retool the economy towards domestic consumption and away from exports. China is not going to save the world.

Over here in Asia there are no shortage of tensions: standoffs in the South China Sea, China launching its own aircraft carrier, Japan still trying to find a post-LDP political identity, India struggling with an inflation-prone economy and vast divergences. The weakened standing of the United States hurts its ability to mediate these conflicts.

It’s becoming a Hobbesian world of bellum omnium contra omnes, and that means it’s hard not to see big risks everywhere.