Global Investing

Oil price slide – easy come, easy go?

One of the very few positives for the world economy over the second quarter — or at least for the majority of the world that imports oil — has been an almost $40 per barrel plunge in the spot price of Brent crude. As the euro zone crisis, yet another soft patch stateside and a worryingly steep slowdown in the BRICs all combined to pull the demand rug from under the energy markets, the traditional stabilising effects of oil returned to the fray. So much so that by the last week in June, the annual drop in oil prices was a whopping 20%. Apart from putting more money in household and business purses by directly lowering fuel bills and eventually the cost of products with high energy inputs, the drop in oil prices should have a significant impact on headline consumer inflation rates that are already falling well below danger rates seen last year. And for central banks around the world desperate to ease monetary policy and print money again to offset the ravages of deleveraging banks, this is a major relief and will amount to a green light for many — not least the European Central Bank which is now widely expected to cut interest rates again this Thursday.

Of course, disinflation and not deflation is what everyone wants. The latter would disastrous for still highly indebted western economies and would further reinforce comparisons with Japan’s 20 year funk. But on the assumption “Helicopter” Ben Bernanke at the U.S. Federal Reserve and his G20 counterparts are still as committed to fighting deflation at all costs, we can assume more easing is the pipeline — certainly if oil prices continue to oblige.  Latest data for May from the OECD give a good aggregate view across major economies. Annual inflation in the OECD area slowed to 2.1% in the year to May 2012, compared with 2.5% in the year to April 2012 – the lowest rate since January 2011. While this was heavily influenced by oil and food price drops, core prices also dipped below 2% to 1.9% in May.

JP Morgan economists Joseph Lupton and David Hensley, meantime, say their measure of global inflation is set to move below their global central bank target of 2.6% (which they aggregate across 26 countries)  for the first time since September 2010.

After peaking at 3.9%oya in September 2011, global inflation is expected to dip to 2.4%oya this month. If our top-down model is correct, global consumer price inflation could slide to just 2.1% by
year-end, 0.5%-pt lower than both our forecast and central bank targets. The risks are most skewed to the downside for the developed markets (DM), where consumer prices are more
sensitive to moves in oil prices.

The JPM economists say this modeled outcome undercuts their own house forecast and if the model is correct, this could accelerate monetary easing by central banks and boost consumer spending.

If Greece can, why can’t I?

We all know that Greece finally persuaded bondholders to swap their debt for new bonds this year, averting a messy default.

But Greece is not the only country to keep investors biting their nails in 2012 over the value of their holdings – frontier market sovereign borrowers have also been tinkering with their debt payments.

St Kitt’s, also a member of a monetary union in the Eastern Caribbean, like Greece completed a debt exchange offer in March.

Next Week: Managed expectations

Here’s a view of next week from our team’s weekly news planner:

Not unlike England’s performance at the Euro 2012 football tourament, EU summit expectations have been successfully lowered in advance by all concerned and  so it will be hard to disappoint as a result!

The gnawing realization in markets is that the really game-changing steps by Germany on some form of debt pooling now look unlikely before next year’s general election there and so investors may have to hang on tight to what can get done in the meantime if the system is to hold together. Yet for all the understandable policy scepticism, there are a lot of big changes on the table — from banking union, more flexible budget-cutting programs, infrastructure growth pushes, a roadmap at least to euro bonds and a euro finance ministry and the launch of the ESM next month (barring a last-minute torpedo from the German constitutional court at least).  It may be a little too easy to dismiss all that is happening just because there’s not going to be a grand instant fix ready for Monday. The ESM alone should have powerful stabilization powers for markets at least. What’s more, Merkel says ”over my dead body” to Euro bonds in one breath, and then “when conditions are right” in another. Assuming she’s referring to her political body, then even these may not be a million miles away.

But the saga has become as much about politics and personalities now as percentages and public opinion, and so you always have to factor in the chance of a major bust-up or row. Broad agreement itself, as a result, may be a relief for a bit come next week — at least until Thursday’s next Spanish debt auction!

Next week: Half time…

QE, some version of it or even the thought of it, seems to have raised all boats yet again — for a bit at least. You’d not really guess it from all the brinkmanship, crisis management and apocalyptic debates of the past month, but June has so far turned out to be a fairly upbeat month – weirdly. World equities are up more than 6 percent since June, lead by a 20 percent jump in European bank stocks and even a 20 percent jump in depressed Greek stocks. The Spanish may found themselves at the centre of the euro debt storm now, but even 10-year Spanish debt yields have returned to June 1 levels after briefly toying with record highs above 7%  in and around its own bank bailout and the Greek election. And the likes of Italian and Irish borrowing rates are actually down this month.  Ok, all that’s after a lousy May that blew up most of the LTRO-inspired first-quarter market gains. But, on a broad global level at least, stocks are still in the black for the year so far. It was certainly “sell in May” yet again this year, but it’s open question whether you stay away til St Ledgers day in September, as the hoary old adage would have it.

On the euro story, the Greeks didn’t go for the nuclear option last weekend at least and it looks like there are some serious proposals on the EU summit table for next week – talk of banking union, EFSF/ESM bond buying programmes, euro bills if not bonds, EIB infrastructure/project bonds to try and catalyse some growth,  and reasonable flexibility from Berlin and others on bailout austerity demands. The Fed has announced that it will twist again like it did last summer, by extending the Treasury yield curve programme by more than a quarter of a trillion dollars, and there are still hopes of it at least raising the prospect of more direct QE. The BoE is already chomping at that bit, as well as lending direct to SMEs, and most investors expect some further easing from the ECB in the weeks and months ahead.

Of course all that could disappoint once more and expectations are getting pumped up again as per June market performance numbers. The EU summit won’t deliver on everything, but there is some realization at least that they need to talk turkey on ways to prevent repeated rolling creditor strikes locking out governments out of the most basic of financing — only then have those very same creditors shun countries again when they agree to punishing fiscal adjustments. A credible growth plan helps a little but some pooling of debt looks unavoidable unless they seriously want to remain in perma-crisis for the rest of the year and probably many years to come. It may be a step too far before next year’s German elections, but surely even Berlin can now see that the bill gets ever higher the longer they wait.

Stumbling at every hurdle

Financial markets are odd sometimes. For weeks they have fretted about the outcome of the Greek election and its impact on the future of the euro zone as a whole. But today they appeared to dismiss the outcome despite a result that was about as positive as global investors fearful for euro zone stability could have hoped for.  So what gives?

The logic behind the weeks of trepidation was fairly simple and straightforward. After an inconclusive election on May 6, a second Greek poll on June 17 was due to give a definitive picture of whether Greeks wanted to stay in the euro and with all the budgetary conditions necessary to keep EU/IMF bailout funds in place.  If a victory for parties wanting to scrap the bailout agreement and austerity led to a halt of EU/IMF funds, the fear was that Greece would inevitably be forced out of the single currency bloc in time too. And if that unprecedented event happened, then a chain reaction would be hard to avoid.  If one country goes back to its domestic currency, despite all its debts being denominated in euros, investors would then find it impossible not to assume at least some element of euro exit risk for fellow-bailout recipients Portugal and Ireland and possibly even Spain and Italy, where doubts remain about their market access over time.

Extreme tail risk or not, this set the scene for the jittery markets that ensued during the Greek electoral hiatus of May 6- June 17. Athens stocks lost more than 17%;  Spanish 10-year government bonds lost more than 7% and the euro/dollar exchange rate was down almost 4%. etc. The fear of euro-wide contagion was so-great that the Spanish bank bailout in the interim had a little or no positive impact. And with the global economic growth picture weakening in tandem with, and partly because of, the euro mess, then prices reflecting world demand in general were hit hard by concerns that another shock to the European banking system could trigger a reversal of trillions of euros of European bank lending from around the globe. Crude oil dropped almost 14%, broad commodity prices and emerging market equities lost about 8%.

Emerging stocks: when will there be gain after pain?

Emerging equities’ amazing  first quarter rally now seems a distant memory. In fact MSCI’s main emerging markets index recently spent 11 straight weeks in the red, the longest lossmaking stretch in the history of the index.  The reasons are clear — the euro zone is in danger of breakup, growth is dire in the West and stuttering in the East. Weaker oil and metals prices are hitting commodity exporting countries.

But there may be grounds for optimism. According to this graphic from HSBC analyst John Lomax, sharp falls in emerging equity valuations have always in the past been followed by a robust market bounce.

What might swing things? First, the valuation. The  2008 crisis took emerging  equity prices to an average of 8 times forward earnings for the MSCI index, down from almost 14 times before the Lehman crisis. The subsequent rebound from April 2009 saw the MSCI emerging index jump 90 percent. Emerging equities are not quite so cheap today, trading at around 9 times forward 12-month earnings but that is still well below developed peers and their own long-term average.

The (CDS) cost of being in the euro

What’s the damage from being a member of the euro? German credit default swaps, used to insure risk, have spiralled to record highs over 130 basis points, three times the level of a year ago amid the escalating brouhaha over Spain’s banks and Greek elections. U.S. CDS meanwhile remain around 45 bps. That means it costs 45,000 to insure $10 million worth of U.S. investments for five years, compared to $135,000 for Germany. (click the graphics to enlarge)

A smaller but similarly interesting anomaly can be found in central Europe. Take close neighbours, the Czech and Slovak Republics who are so similar they were once the same country. Both have small open  economies, reliant on producing goods for export to Germany.

The difference is that Slovakia joined the euro in 2009.

Back then, with the world grappling with the fallout from the Lehman crisis, Slovakia appeared at a distinct advantage versus the Czech Republic. At the height of the crisis in February 2009, Czech 5-year CDS exploded to 300 bps, well above Slovakia’s levels. But slowly that premium has eroded. A year ago CDS for both countries were quoted at similar levels of around 70 bps.  Now the Czech CDS are quoted at 125 bps, having risen along with everything else, but Slovak CDS have jumped to 250 bps, data from Markit shows. (bonds have not reacted in the same manner — Slovak 1-year debt still yields around 0.8 percent versus 1.4 percent for the Czech Republic; similarly German yields have fallen to zero; for an explanation see here).

Next week: Call and response?

The Greek vote next Sunday now stands front and centre of pretty much all investment thinking, but the problem is that it may still be days and weeks before we get a true picture of what’s happened, whether a government can be formed and what their stance will be. If the new parliament cannot clearly back the existing bailout, even after a bout of  horse-trading, then a game of chicken with Europe ensues.  Eurogroup meets again on Thursday and there’s a German/French/Italy/Spain summit on Friday.  But G20 leaders gather in Mexico as all this is unfolding, so they will certainly be quorate if some sort of global response is required to any initial market shock. What’s more, the FOMC is meeting Tuesday and Wednesday should Bernanke feel the US needs urgent insulation from the fallout regardless of broader action. But it’s certainly not beyond the bounds of reason that coordinated central bank action materializes next week if markets do indeed go skewways after the Greek poll. They have all clearly been consulting on the issue lately via telephone and bilaterals. And the assumption of more QE is there among investors. Three quarters of the 260+ funds polled by BoAMerrill Lynch this month expect another ECB LTRO by the end of Q3 and almost a half expecting more Fed QE over the same time.

And maybe it is this assumption of massive policy response that’s preventing markets capitulating outright. Money is gradually going to ground, but it’s not yet thrown in the towel completely as you can see from major equity indices, volatility gauges and interbank spreads etc. And there are a lot of headwinds everywhere over the next six months, the US election, fiscal cliff, end of operation twist stateside – and that’s in one of the few major western economies that was generating any significant growth this year. In other words, there are no shortage of arguments for another monetary boost. A heavy econ data slate during the week will also reveal just how much the world economy has run into sand this quarter. The standouts are the flash PMIs for June, the US Philly Fed index for June and UK jobs and inflation numbers.

As to the lack of response to last weekend’s Spanish bank bailout, it was weird in many ways that anyone really expected a major rally on this just six days ahead of a Greek vote which could throw the whole bloc into chaos.  Even if you thought the Spanish bailout was good, and it was certainly a necessary if not sufficient step, you would still not return to Spanish debt until the next couple of weeks of events had cleared. So, in that respect, it’s unlikely the market made any real judgement on it either way. The subsequent credit rating cuts from Moody’s have not helped and yields have spiked to the 7% level flashing red lights. But it’s hard to see how any exposed frontline euro market, from Spain to Italy and Ireland to Portugal, can really stabilise ahead of the weekend.  One fear on the Spanish rescue was of private investors’ subordination to EU/IMF creditors in any workout of Spanish debt. But even that too may have been overstated when it comes to the sovereign. For a start, the interest rate charged on the funds means a massive saving for Madrid compared with prevailing market rates and, as Barclays argued, actually increases the overall pie available for any workout, with a possible increase in projected recovery rates compared with the pre-bailout setup.  If that was the big concern, then the subsequent rise in Spanish yields most likely is more Greek than Spanish in origin.

The other WPP protest

So, the CEO of the world’s biggest advertising firm failed to pitch his own pay deal to WPP’s investors.

Wednesday’s vote against the remuneration report which grants Martin Sorrell a 6.8 million pound pay award means shareholders can claim another victory in their (non-binding) efforts to wean executives off pay deals they consider excessive.

Sorrell has resigned himself to some horse-trading between the Board and shareholders in the wake of a vote which was notable for his robust defence of his worth. But of course, it isn’t Sorrell that’s the problem; it’s the possibility of his absence that really worries investors.

Picking your moment

Watching how the mildly positive market reaction to this weekend’s 100 billion euro Spanish bank bailout evaporated within a morning’s trading, it’s curious to look at the timing of the move and what policymakers thought might happen. On one hand, it showed they’d learned something from the previous three sovereign rescues in Greece, Ireland and Portugal by pre-emptively seeking backstop funds for Spain’s banks rather than waiting for the sovereign to be pushed completely out of bond markets before grudgingly seeking help.

But getting a positive market reaction to any euro bailout just six days before the Greek election of June 17 was always going to be nigh-on impossible. If the problem for private creditors is certainty and visibility, then how on earth was that supposed to happen in a week like this? In view of that, it was surprising there was even 6 hours of upside in the first place. In the end, Spanish and broad market prices remain broadly where they were before the bailout was mooted last Thursday — and that probably makes sense given what’s in the diary for the remainder of the month.

So, ok, there was likely a precautionary element to the timing in that the proposed funds for Spanish bank recapitalisation are made available before any threat of post-election chaos in Greece forces their hand anyhow. It may also be that there were oblique political signals being sent by Berlin and Brussels to the Greek electorate that the rest of Europe is prepared for any outcome from Sunday’s vote and won’t be forced into concessions on its existing bailout programme. On the other hand, Greeks may well read the novel structure of the bailout – in that it explicitly targets the banking sector without broader budgetary conditions on the government – as a sign that everything euro is flexible and negotiable.