Becoming less negative on Europe
Markets are unimpressed today by Europe finally agreeing to bail out Greece for the second time, with European stocks down -0.6% on the day.
But here’s some encouraging news: Credit Suisse has become less negative on Continental European stocks for the first time in almost two years.
The bank has moved to benchmark weighting from 5% underweight for a currency hedged portfolio.
Why?
We think that the ECB is increasingly dovish (and we would not rule out another three-year LTRO after the one on 29 February), which should help weaken the euro; and we now only expect a 1% decline in European credit (down from our previous estimate of a 5% decline); relative to other regions, economic momentum and earnings momentum have troughed. But there is not enough for us to raise weightings to overweight.
In CS’s earnings momentum scorecard, Europe ex-UK has moved up one place, off the bottom of the list, with a total score of -0.1 — above Japan’s -1.2.
On previous occasions when relative Continental European earnings revisions have troughed, Europe ex UK equities have on average outperformed 75% of the time and when they did outperform, it was by 3–5% in the next three to six months (in local currency terms).
Central banks and the next bubble
Central bank balance sheets are expanding at what some say is an alarming pace. Can this cause the next bubble to form and burst?
JP Morgan estimates G4 (U.S., Japan, euro zone and Britain) balance sheets are now around 24% of GDP combined, with around 11% of GDP comprising bonds held for monetary purposes.
“The recent pace of balance sheet expansion is the fastest since the immediate aftermath of Lehman, largely down to the ECB. The increased BOJ purchases, more QE in the UK, and 200 bln euros upwards of increased ECB lending from this month’s LTRO together point to a further $600bln+ rise in G4 central bank balance sheets this year, to around 26% of GDP.”
Outside G4, Switzerland is a country which saw a massive expansion in its central bank balance sheet. And because of its huge holdings, its balance sheet has been very volatile.
The Swiss National Bank suffered a loss of 21 bln francs last year — its biggest ever — due to currency interventions to weaker the Swiss currency. It expects to swing back to a profit of 13 bln francs this year.
Its acting chairman Thomas Jordan himself admitted: “Our profits have been and will be very volatile … because our balance sheet is four to five times as big as it was five years ago.”
Turkey gearing up for rate cuts but not today
Could the Turkish central bank surprise markets again today?
Given its track record, few will dare to place firm bets on the outcome of today’s meeting but the general reckoning for now is that the bank will keep borrowing and lending rates steady and signal no immediate change to its weekly repo rate of 5.75 percent. With year-on-year inflation in the double digits, logic would dictate there is no scope for an easier monetary policy.
But there are reasons to believe the Turkish central bank, whose mindset is essentially dovish, is letting its thoughts stray towards rate cuts. Consider the following:
a) Governor Erdem Basci has already said he does not see the need for further policy tightening b)The lira has strengthened 9 percent this year against the dollar and is back at levels last seen in early September, thanks to almost one billion dollars in foreign flows to the Turkish stock market and well-subscribed bond issues. And crucially c) Global factors are supportive (developed central banks are continuing to pump liquidity and a bailout has finally been agreed for Greece) .
So some analysts are already weighing the likelihood of a pre-emptive rate cut in Turkey. ING analyst Sengul Dagdeviren writes:
Depending on the CBT’s view on capital inflows (ECB LTRO due soon, quantitative easing bias strengthening in G10, and Greece worries diminishing look supportive in that regard), the chance that it could surprise markets by lowering the upper band of the overnight interest rate corridor to 9 percent (down from 12.5 percent) remains.
The key to this will be the lira’s exchange rate.
End of LTRO = end of equity rally 2012?
This year’s global equity rally is unlikely to survive the end of the ECB’s liquidity injections, warns HSBC.
World stocks have jumped 10 percent since the start of 2012, emerging markets are up 15 percent and the index of top European stocks has gained 8 percent. These gains, HSBC says, are almost entirely down to the European Central Bank’s end-December refinancing operation, or LTRO, that injected $500 billion to ease banks’ liquidity worries. The tentative improvement in the U.S. and global growth picture along with beaten-down stock valuations added only limited ammunition to the rally, the bank says.
The findings of HSBC’s analysis? First, past episodes of quantitative easing — Japan in 2001-2004 and the United States, Britain and the euro zone after 2008 – provided a significant fillip to equity markets. U.S. stocks rose an average 6 percent, UK stocks by 8 percent and euro zone markets by 15 percent in the three months following the post-Lehman QE rounds, though in Japan the gains have been short-lived. Second, unexpected changes in monetary policy produced a larger impact on stock prices than the continuation of a previous policy.
And when QE stopped, the effect on stocks was immediately negative. HSBC found:
The periods when the Fed halted QE and allowed its balance sheet to shrink (in August 2009, June to October 2010 and July to October 2011) were all periods of weakness for the stock market.
The ECB is gearing up for another LTRO round in two weeks time. But it will not come as a surprise to markets and there are no plans for more.
HSBC concludes:
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.
Corporate bonds in sweet spot
Anticipation is running high for the ECB’s LTRO 2.0 due on Feb 29.
The first such operation in December has largely benefited peripheral bonds even though estimates show banks used a bulk of their borrowing (seen at just 150-190 bln euros on a net basis) to repay their debt, as the graphic below shows.
At the second LTRO, banks are expected to use the proceeds to pay down their debt further. That is a good news for non-bank corporate credit because banks — busy deleveraging — are more likely to repay existing debt than roll over and existing holders of bank debt will need to look elsewhere to allocate their assets.
“Apart from the shrinking size of (European bank bonds) some investors might want to get out of them anyway and allocate assets somewhere else… Credit spreads are pricing in a very pessimistic scenario. There’s a very good value in non-banking credit,” says Didier Saint-Georges, member of the investment committee at French asset manager Carmignac Gestion.
Emerging Markets: the love story
It is Valentine’s day and emerging markets are certainly feeling the love. Bank of America/Merrill Lynch‘s monthly investor survey shows a ‘stunning’ rise in allocations to emerging markets in February. Forty-four percent of asset allocators are now overweight emerging market equities this month, up from 20 percent in January — the second biggest monthly jump in the past 12 years. Emerging markets are once again investors’ favourite asset class.
Looking ahead, 36 percent of respondents said they would like to overweight emerging markets more than any other region, with investors saying they would underweight all other regions, including the United States. Meanwhile investor faith in China has rebounded with only 2 percent of investors believing the Chinese economy will weaken over the next year, down from 23 percent in January. China also regained its crown of most favoured emerging market in February.
Last year, the main EM index plummeted more than 20 percent as emerging assets fell from favour. So what is the reason for this renewed passion in 2012?
Firstly December’s LTRO — a multi-billion euro liquidity arrow from the cupids at the ECB has revived investor appetite for riskier emerging assets, boosting the index to around six-month highs since the start of the January. A second significant factor behind the resurgence in risk sentiment is that the market is daring once again to hope for an improvement in global growth, says Gary Baker, BofAML Global Research head of European equities strategy.
The big beneficiaries of all this have been emerging markets. It’s not just about liquidity. Clearly the actions of the ECB have been vitally important… but what you’ve also seen is an improvement in global growth optimism. If optimism over growth is improving then there may well be a more fundamental underpinning to the movement.
So is investors’ new-found love for emerging assets a passing flight of fancy or a true sign of commitment?
The significant monthly improvement in market sentiment towards emerging markets and the 44 percent level of investors overweight emerging markets are both events which have historically coincided with short-term underperformance by emerging equities, Baker says.
Greece’s interest burden, post-PSI, will remain huge
It seems Greece has finally reached a deal on austerity measures needed for a bailout. But what about PSI?
(ECB President Mario Draghi just said he heard it was close to a deal. It’s been close for a few weeks though…)
JP Morgan says Greek PSI is hardly going to change the heavy interest burden on the country and the issue of default will inevitably come up.
First of all, Greece’s interest payments are huge.
Greece paid 15.5 bln euros in net interest payments in 2011, 17% of total general revenues. This is the highest among all OECD countries and more than 3 times the OECD average of 5%. It is also more than double the 8% average for other peripheral countries in the euro zone.
The U.S. bank estimates the Greek PSI is going to capture 205bln euros of private bond holders (and perhaps a further 55bln euros if the ECB participated).
Of this 260 bln euros, around 85 bln or a third are held domestically, by Greek social security funds, domestic banks to be largely nationalised post PSI, and the Greek central bank.
Greek ars great but if they dont implement the reforms specially their own pensions funds that are tied to their own greek bonds, their not helping themselves in an already unsustainable situation. they should show some cooperation. If not It may be painful to extract a teeht but if necessary it may be better than keep constant pain within the E¸U and perhaps teh world. Does an economi as large as Argentina can hurt the world if isolated ?
January in the rearview mirror
As January 2012 drifts into the rearview mirror as a bumper month for world markets, one way to capture the year so far is in pictures – thanks to Scott Barber and our graphics team.
The driving force behind the market surge was clearly the latest liquidity/monetary stimuli from the world’s central banks.
The ECB’s near half trillion euros of 3-year loans has stabilised Europe’s ailing banks by flooding them with cheap cash for much lower quality collateral. In the process, it’s also opened up critical funding windows for the banks and allowed some reinvestment of the ECB loans into cash-strapped euro zone goverments. That in turn has seen most euro government borrowing rates fall. It’s also allowed other corporates to come to the capital markets and JP Morgan estimates that euro zone corporate bond sales in January totalled 46 billion euros, the same last year and split equally between financials and non-financials..
But to the extent that the ECB move was aimed primarily at preventing a seizure of the banks, then one measure of success can be seen in the degree to which it steepened government yield curves in Spain and Italy. A positive yield curve, which measures the gap between short-term and long-term interest rates, is effectively commercial banks’ ATM — they make money by simply borrowing short-term and lending long. This chart then shows some normality returning to the benchmark interest structure.
Sparring with Central Banks
Just one look at the whoosh higher in global markets in January and you’d be forgiven smug faith in the hoary old market adage of “Don’t fight the Fed” — or to update the phrase less pithily for the modern, globalised marketplace: “Don’t fight the world’s central banks”. (or “Don’t Battle the Banks”, maybe?)
In tandem with this month’s Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that’s a lot of additional central bank support behind the market rebound. So is betting against this firepower a mug’s game? Well, some investors caution against the chance that the Banks are firing duds.
According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What’s more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.
Low interest rates and liquidity schemes can’t solve what ails the developed world. Societies must accept that in order to alter their current perilous course they must undergo great change, moving away from entitlements to which they have become accustomed. The alternative is weak economic growth, a loss of competitiveness and negative external balances — a loss of face and place in the global hierarchy.
As if to reinforce the underlying point that the developed world faces a protracted reform period that tests political, economic and social priorities, credit rating firm Standard & Poors’ — not the most popular company in corridors of power over the past year — warned on Tuesday that it may downgrade the debt of “a number of highly-rated” Group of 20 countries from 2015 if their governments fail to enact reforms to curb rising healthcare spending and other costs related to ageing populations.
For Pimco, the political and social resistance to this sort of change is already showing itself to be significant both in Europe and the United States. People clearly don’t want to see pensions and benefits cut but politicians have already grown government and sovereign indebtedness close to their maximum. Accommodative central banks that helped them get there only ended up fueling credit, consumption and housing bubbles and distorting the balance of the economy away from production and into an increasingly bloated financial sector. That, clearly, ended in tears as finance itself needed bailing out and compounded the sovereign debt burden.
So if harder, longer-term choices and reforms are now needed, central banks ability to continually reflate the world economy by monetary means alone is at best uncertain, Pimco argues. The risk of major upheavals along the way in Europe, for example, has the potential for major market volatility and economic seizures.
