Research Radar: Greek gloom
Greek gloom dominates the start of the week as new elections there look inevitable and talk of Greek euro exit, or a Grexit” as common market parlance now has it, mounts. All risk assets and securities hinged on global growth have been hit, with China’s weekend reserve ratio easing doing little to offset gloomy data from world’s second biggest economy at the end of last week. World stocks are down heavily and emerging markets are underperforming; the euro has fallen to near 4-month lows below $1.29; safe haven core government debt is bid as euro peripheral debt yields in Italy and Spain push higher; and global growth bellwethers such as crude oil and the Australian dollar are down – the latter below parity against the US dollar for the first time in 5 months.
Financial research reports on Monday and over the weekend were just as gloomy, but plenty of interesting takes:
Bank of New York Mellon’s Simon Derrick’s view of the Greek political impasse concluded “there is at least an evens chance that the latter part of this summer will see what had officially been seen up until last November as an impossibility: a nation leaving the EUR.”
RBS’s Sanjay Mathur reckons that if there is another hung parliament after new Greek elections, implying no significant voter return to the pro-bailout parties, then euro risk soars. “This means, on another hung parliament, that Greek government IOUs could trade as proxy currency as early as July.” If that does not galvanize sufficient parties into accepting Trioka bailout demands at that point, he said that then exit looms. “Opening up the Pandora’s box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response.”
Barclays Sree Kochugovindan talks of a three phase possible deterioration of the euro crisis — one, where solvency concerns and asset market fright are contained to Europe and mostly the fixed income markets of the periphery countries concerned; two, solvency concerns hit the core such as France and Belgium with asset market contagion widening before a series of major policy responses; and three, no major policy response or ECB SMP/LTRO, which leads to Greek default and even exit and global market shock akin to September 2008. “Given the immense cost of a crisis triggered by a Greek exit, we are not expecting the current situation to deteriorate into Phase 2. However, the risks are elevated and with the prospect of second round Greek elections in a few weeks, market jitters are likely to continue.”
Deutsche Bank’s global markets note also focuses on rising risks from Greece and also on the May 31 Irish referendum on the EU fiscal pact. Apart from outlining obvious risks to the Greek financing from a political vacuum, one conclusion Deutsche comes to is that a new EU growth pact may happen sooner than many had figured. “The new situation in Athens forces EU leaders to find common ground faster than we thought.” Another conclusion was that Ireland may consider postponing its referendum, given the risk that a “no” vote may disastrously cut off its access to new EU funds and also given a possible delay in German parliamentary votes on the fiscal deal to June. “Ireland might do well to think about postponing the 31 May referendum.” It called Spain’s sweeping banking reform plan “making progress” but a 15 bln euro government recapitalisaation of the banks “too timid”.
HSBC’s Karen Ward and Simon Wells warn about the long-term impact of continuous quantitative easing by central banks, saying the political relationship between central banks and governments rather than inflationary consequences may be the biggest concern. “The heyday of independent central banking could be drawing to a close.”
GUEST BLOG: A warning on global bonds
This is a guest post from Douglas J. Peebles, Head of Fixed Income at AllianceBernstein. The piece reflects his own opinion and is not endorsed by Reuters. The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
More and more, global bonds are being used as core portfolios for investors seeking an anchor to windward for their stock investments. While this is generally a good thing, some investors are discovering that the decision to go global can have unintended consequences: certain global bond portfolios have much higher volatility than is usually associated with core portfolios.
Bonds generally have two main sources of return: income (the return from coupon payments) and price (return from capital appreciation). Most of a bond’s return usually comes from income, which is a very stable source of returns. A smaller contribution comes from prices changes. This component is smaller, since, unlike equities, bonds have limited upside; they mature at par.
Global bonds add an additional source of potential returns: currency exposure. Currency hedging—which can be implemented simply and cheaply with currency forwards or futures—eliminates the impact of currency changes on bond returns. Nonetheless, many investors choose not to hedge, in the hope that currency exposure can boost returns. They also assume that multiple sources of return will reduce their overall risk. It turns out, though, that neither of these assumptions is correct.
Between 1996 and 2011, a US dollar-hedged global bond portfolio, represented by the Barclays Capital Global Aggregate Bond Index, would have generated nearly identical returns to an unhedged portfolio— 5.9% versus 5.8% annualized. This may come as a surprise to many investors, given the decline we’ve seen in the US dollar.
Furthermore, although currency exposure represented the additional source of potential return, it didn’t reduce volatility, as you might expect. As the display below shows, currency-hedged global bonds have been consistently much less volatile than unhedged global bonds, and even less volatile than US bonds, due to the benefits of economic cycle diversification.
Hard times for EM in QE-less world of higher US yields
Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what’s next for emerging markets? Most observers put this year’s stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That’s kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.
Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that’s an environement in which EM assets tend to underperform.
For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve, pushing the spread between 2-year/10-year Treasuries almost 100 bps wider. Flows to emerging markets dipped sharply, the following graph shows:
Money did continue to flow into emerging local bonds and equities in this period, albeit at a slower pace. But from local bonds the return was negative, HSBC notes. That could be an indication of what’s to come:
The carry trade is not dead yet but the change in tone by the Fed suggests it may have passed its best days.
Headwinds for emerging markets may in fact be greater now than 18 months ago. U.S. growth expectations haven’t budged much HSBC says: the bank expects U.S. growth under 2 percent this year and in 2013. On the other hand emerging market output gaps are much tighter than they were 18 months back and oil prices are higher. That makes the outlook for emerging local currency bonds more challenging, especially as a stronger dollar will give EM currencies less room to rise.
Should ongoing improvements in U.S. data result in further hawkish moves from the Fed and if such changes see U.S. yields rise further, we would expect this to be positive for the dollar vs EM . The combination of a potentially more inflationary backbone and a more challenging backdrop for EM FX might become a headwind for local rates.
Market exhaustion?
It’s curious to see so many asset managers reaffirm their faith in a bullish 2012 for world markets just as a buzzing first quarter comes to a close on Friday with hefty gains in equities and risk assets. Whether or not there is a mechanical review of portfolios at quarter end, it’s certainly a reasonable time for review. The euro zone crisis has of course eased, the ECB has pumped the banks full of cash and the U.S. recovery continues. So, no impending disaster then (unless you subscribe to the increasingly-prevalent hard-landing fears in China). But after 11+ percent gains in world equities in just three months on the back of all this information, you have to wonder where the “new news” is going to come from here. The surprise factor looks over and we’re highly unlikely to get 10%+ gains in global stocks every quarter this year. So, is it time for tired markets to sober up for a while or maybe even reconsider the risk of reversal again? Strategists at JPMorgan Asset Management, at least, reckon the economic news has just lost its oomph.
There are broad signs of exhaustion in markets, which is coinciding with a softening in the data, suggesting that in the short term the moderation in the “risk on” environment may continue.
JPMAM cite the rollover in the Citigroup economic surprises indices, shown below, and also say their own propietary Risk Measurement index — a 39-factor model built on data from money markets, equities, economic data, commodities etc — is flagging more caution.
Time for a pause and bit of a think then, at least until the first-quarter corporate earnings season kicks in next month. And it’s here the next leg of any equities story may have to play out, rather than in the corridors of central banks and finance ministries. Gavyn Davies, Fulcrum Asset Management chairman and formerly BBC chairman and Goldman Sachs economist, reckons the valuation case for equities is pretty strong after a lousy decade — even if government bond yields continue rising. What’s less certain, he says, is whether the historically high share of nominal GDP commanded by after-tax corporate profits can persist. This requires a paradigm shift, one he reckons is bridged by globalisaton trends. One quarter won’t solve that puzzle, but attention may shift in that direction over the coming weeks.
Fresh skirmishes in global currency war
Amid all the furious G7 money printing of recent years, Brazil was the first to sound the air raid siren in the “international currency war” back in 2010 and it continues to cry foul over the past week. With its finance ministry issuing fresh warnings last night over hot-money flows being dropped by western economies on its unsuspecting exporters via currency speculation, Brazil’s central bank then set off its own defensive anti aircraft battery with a surprisingly deep interest rate cut late Wednesday. Having tried everything from taxes on hot foreign inflows to currency market intervention, they are braced for a long war and there’s little sign of the flood of cheap money from the United States, Europe and Japan ending anytime soon. So, if you can’t beat them, do you simply join them?
The prospect of a deepening of this currency conflict — essentially beggar-thy-neighbour devaluation policies designed to keep countries’ share of ebbing world growth intact — was a hot topic this week for Societe Generale’s long-standing global markets bear Albert Edwards. Edwards, who represent’s SG’s “Alternative View”, reckons the biggest development in the currency battle this year has been the sharp retreat of Japan’s yen and this could well drag China into the fray if global growth continues to wither later this year. He highlighted the Japan/China standoff with the following graphic of yen and yuan nominal trade-weighted exchange rates.
Edwards goes on to say that this could, in turn, create another explosive FX standoff between China and the United States if Beijing were to consider devaluation — the opposite of what the protectionist U.S. lobby has been screaming for for years.
“We have long stated that if the Chinese economy looks to be hard landing, as we believe it will, the authorities there will actively consider renminbi devaluation, despite the political consequences of such action.”
“Clearly, the US will not respond well if China chooses to devalue. But China might argue that as its reserves are now declining there is clear downward pressure on its currency and that, after all, the US has asked it to allow market forces to have more of an influence!”
Slipping up on oil and Greece?
Thursday’s crude oil price surge to its highest in almost 4 years (apparently due to a subsequently denied report from Iran of a Saudi pipeline explosion…phew!) illustrates just how anxious and dangerous the energy market has become for world markets yet again this year and HSBC on Friday spotlighted its threat to the global economy and asset prices in a note entitled “Oil is the new Greece”. The point of the neat headline hook was a simple one:
With Greece disappearing, at least temporarily, from the headlines, investors have quickly found a new source of anxiety thanks to the recent surge in oil prices
Just like many investors and strategists over the past month, HSBC rounded up its various assessments of the impact and fallout from higher oil prices, stressing the biggest risk comes from supply disruptions related to the Iran nuclear standoff and that any major political upheaval in the region would threaten significant crude spikes. “Think $150 or even $200 a barrel,” it said. It reckoned the impact on world growth, and hence the broader risk horizon depended on the extent of this supply disruption and the durability and scale of the price rise. Worried equity investors should consider hedging their portfolios by overweighting the energy sector. Obvious winners in currency world would be the Norwegian crown, Malaysian ringitt, Brazil’s real and Russia’s rouble, the bank’s strategists said. The most vulernable units are India’s rupee, Mexican and Philippines pesos and Turkey’s lira.
Earlier this week, strategists at JPMorgan Asset Management said crude oil exposure could be useful to them as a hedge to their relatively neutral positioning on world equities.
We also added exposure to crude oil, as a partial hedge in portfolios. We believe this provides some offset to a neutral stock/bond position, should the global business cycle prove to be stronger than expected. To some extent, it also acts as a “tail hedge” against geopolitical event risk, given the febrile situation in the Middle East.
But the question of whether oil packs as much a threat for world markets as the systemic risks posed by the Greek debt collapse is an interesting one. Certainly the sort of random, nervy price movements late Thursday are reminiscent of the edgier days of the now two-year-old euro crisis. Familiar too is the often unfathomable second-guessing of political developments in the euro zone. Yet for many people oil is just the new, well… oil.
It’s not really gone away over the past 18 months as an all-pervasive menace to the world economy and concerns about peak oil and the long-term decline in global supplies means even the slightest distortion to either supply or demand in future will likely instantly bring it back to the dashboard of all global investors. The 60% surge in crude prices between August 2010 and April 2011 was arguably just as powerful in sapping world economic activity in the second half of last year as the euro crisis was — perhaps moreso. And even as financial markets and economics commentariat talked openly in the final months of 2011 of a western banking and sovereign debt collapse leading to a double-dip recession and even a worldwide depression — crude oil prices never had a weekly close back below $100 for the remainder of the year!
Emerging market local bond rally has more legs
Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.
There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.
Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes:
From an EM perspective there is little reason to fight the rising tide of monetary policy support in the near term. Comparisons to the 2009 global carry trade are unavoidable given the scope of G-4 central bank balance sheet expansion.
So far, around 70 percent of the gains posted by the GBI-EM index have been down to currency appreciation (see here). That could change going forward as some central banks may act to slow FX appreciation. That’s already been happening in Brazil. Gains from the duration trade — derived from interest rate cuts — are also more or less done, analysts reckon, because emerging central banks are more likely from here to keep interest rates on hold than to cut. J.P. Morgan adds:
While we look for approximately 7 percent in additional returns in the GBI-EM for the remainder of the year, the majority of this is due to carry (5 percent) while spiot FX returns should be muted at 1.9 percent and duration returns flat.
Currency hedging — should we bother?
Currency hedging — should we bother?
Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.
Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).
For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).
“The impact of hedging on returns (as opposed to risk) is a zero sum game. The profit a German investor makes on Swiss assets if the franc appreciates is offset by the loss the Swiss investor incurs on German assets… Averaged over all reference currencies and countries, the mean return advantage to hedging both equities and bonds was zero, both over 1900-2011 and 1972-2011.
LBS’ Elroy Dimson and Paul Marsh, who presented the report at a briefing this week, were keen to emphasise hedging has its use. Mainly, it does reduce volatility, hence risk.
However, the study showed that the benefits of hedging on volatility did shrink; On average, hedging reduced equity volatility by 15% over 1900-2011, but by only 7% over 1972-2011. For bonds, the figures were 36% and 30%.
Buy more yen… to increase reserve returns
Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.
However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.
JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.
Instead, it says, they should buy more yen.
“Diversification has targeted cyclical assets such as commodity currencies, which impart more leverage than safety to a portfolio. A much higher allocation to structural funding currencies such as the yen is required for reserve managers concerned with volatility and drawdown,” JPM says in a note to clients.
According to the latest reserve data from the IMF, central banks — which control reserves of over $10 trillion worldwide — hold 60 percent in dollars, 27 percent in euros and 4 percent in sterling and yen respectively.
This would have returned 1.5 percent in the past two years and 2.9 percent in the past five years.
from MacroScope:
When the euro shorts take off
Currency speculators boosted bets against the euro to a record high in the latest week of data (to end December 27) and built up the biggest long dollar position since mid-2010, according to the Commodity Futures Trading Commission. Here -- courtesy of Reuters' graphics whiz Scott Barber, is what happens to the euro when shorts build up:
