Global Investing

Put down and Fed up

Given almost biblical gloom about the world economy at the moment, you really have to do a double take looking at Wall Street’s so-called “Fear Index”. The ViX , which is essentially the cost of options on S&P500 equities, acts as a geiger counter for both U.S. and global financial markets.  Measuring implied volatility in the market, the index surges when the demand for options protection against sharp moves in stock prices is high and falls back when investors are sufficiently comfortable with prevailing trends to feel little need to hedge portfolios. In practice — at least over the past 10 years — high volatility typically means sharp market falls and so the ViX goes up when the market is falling and vice versa. And because it’s used in risk models the world over as a proxy for global financial risk, a rising ViX tends to shoo investors away from risky assets while a falling ViX pulls them in — feeding the metronomic risk on/risk off behaviour in world markets and, arguably, exaggerating dangerously pro-cyclical trading and investment strategies.

Well, the “Fear Index” last night hit its lowest level since the global credit crisis erupted five-years ago to the month.  Can that picture of an anxiety-free investment world really be accurate? It’s easy to dismiss it and blame a thousand “technical factors” for its recent precipitous decline.  On the other hand,  it’s also easy to forget the performance of the underlying market has been remarkable too. Year-to-date gains on Wall St this year have been the second best since 1998. And while the U.S. and world economies hit another rough patch over the second quarter, the incoming U.S. economic data is far from universally poor and many economists see activity stabilising again.

But is all that enough for the lowest level of “fear” since the fateful August of 2007? The answer is likely rooted in another sort of “put” outside the options market — the policy “put”, essentially the implied insurance the Fed has offered investors by saying it will act again to print money and buy bonds in a third round of quantitative easing (QE3) if the economy or financial market conditions deteriorate sharply again. Reflecting this “best of both worlds” thinking, the latest monthly survey of fund managers by Bank of America Merrill Lynch says a net 15% more respondents expect the world economy to improve by the end of the year than those who expect it to deteriorate but almost 50 percent still believe the Fed will deliver QE3 before 2012 is out.  In other words, things will likely improve gradually in the months ahead and if they don’t the Fed will be there to catch us.

What could possibly go wrong?? Well, lots — obviously. As Vanguard’s European CIO Jeff Molitor told us here this week: “No one can see around corners.” And the euro crisis of course remains top of the list of bogeymen. But here too the ECB has constructed its own “policy put” of sorts as ECB chief Draghi has pledged to bolster euro sovereign debt markets via the banks’ first ever bout of QE in the event of a request for a support progamme from ailing giants such as Spain and Italy.  What else? Hard landing signs in China? Fresh banking stress globally? All possible. But — all likely to be met with substantial policy reaction from the Fed at least if they hit the US economy badly again and threaten to  push already-high unemployment back up.

So calm is justified then?

Enter November’s U.S. Presidential election. The “Bernanke put”, as with the “Greenspan put” before it,  is rooted in the Fed’s dual mandate to pursue both full employment as well as price stability — a critical post-Depression orientation of the country’s entire macroeconomic policy approach that many economists insist has served the United States well over the past half century but which also riles many others, not least Paul Ryan, Republican presidential candidate Mitt Romney’s newly-appointed running mate for the position of Vice President.

Next Week: “Put” in place?

 

Following are notes from our weekly editorial planner:

Oh the irony. Perhaps the best illustration of how things have changed over the past few weeks is that risk markets now fall when Spain is NOT seeking a sovereign bailout rather than when it is! The 180 degree turn in logic in just two weeks is of course thanks to the “Draghi put” – which, if you believe the ECB chief last week, means open-ended, spread-squeezing bond-buying/QE will be unleashed as soon as countries request support and sign up to a budget monitoring programme. The fact that both Italy and Spain are to a large extent implementing these plans already means the request is more about political humble pie – in Spain’s case at least.  In Italy, Monti most likely would like to bind Italy formally into the current stance. So the upshot is that – assuming the ECB is true to Draghi’s word – any deterioration will be met by unsterilized bond buying – or effectively QE in the euro zone for the first time. That’s not to mention the likelihood of another ECB rate cut and possibility of further LTROs etc. With the FOMC also effectively offering QE3 last week on a further deterioration of economic data stateside, the twin Draghi/Bernanke “put” has placed a safety net under risk markets for now. And it was badly needed as the traditional August political vacuum threatened to leave equally seasonal thin market in sporadic paroxysms. There are dozens of questions and issues and things that can go bump in the night as we get into September, but that’s been the basic cue taken for now.  The  backup in Treasury and bund yields shows this was not all day trading by the number jockeys.  The 5 year bund yield has almost doubled in a fortnight – ok, ok, so it’s still only 0.45%, but the damage that does to you total returns can be huge.

Where does that leave us markets-wise? Let’s stick with the pre-Bumblebee speech benchmark of July 25. Since then,  2-year nominal Spanish government yields have been crushed by more than 300bps… as have spreads over bunds given the latter’s equivalent yields remain slightly negative.  Ten-year Spain is a different story – but even here nominal yields have shed 85bp and the bund spread has shrunk by 100bp.  The Italy story is broadly similar.  Euro stocks are up a whopping 12.5%, global stocks are up almost 7 percent, Wall St has hit its highest since May 1, just a whisker from 2012 highs.  Whatever the long game, the impact has and still is hugely significant. An upturn in global econ data relative to recently lowered expectations – as per Citi’s G10 econ surprise index — has added a minor tailwind but this is a policy play first and foremost.

So, climate change in seasonal flows? Well, it was certainly “sell in May” again this year – but it would have been pretty wise to “buy back in June”. Staying away til St Ledgers day would – assuming we hold current levels til then – left us no better off had we just snoozed through the summer.

A case for market intervention?

As we wait for ECB Mario Draghi to come good on his promise to do all in his power to save the euro,  the case for governments intervening in financial markets is once again to the fore. Draghi’s verbal intervention last week basically opened up a number of fronts. First, he clearly identified the extreme government bond spreads within the euro zone, where Germany and almost half a dozen euro countries can borrow for next to nothing while Spain and Italy pay 4-7%,  as making a mockery of a single monetary policy and that they screwed up the ECB’s monetary policy transmission mechanism.  And second, to the extent that the euro risks collapse if these spreads persist or widen further, Draghi then stated  it’s the ECB’s job to do all it can to close those spreads. No euro = no ECB. It’s existential, in other words. The ECB can hardly be pursuing “price stability” within the euro zone by allowing the single currency to blow up.

Whatever Draghi does about this, however, it’s clear the central bank has set itself up for a long battle to effectively target narrower peripheral euro bond spreads — even if it stops short of an absolute cap.  Is that justified if market brokers do not close these gaps of their own accord?  Or should governments and central banks just blithely accept market pricing as a given even if they doubt their accuracy?  Many will argue that if countries are sticking to promised budgetary programmes, then there is reason to support that by capping borrowing rates. Budget cuts alone will not bring down debts if borrowing rates remain this high because both depress the other key variable of economic growth.

But, as  Belgian economist Paul de Grauwe argued earlier this year,  how can we be sure that the “market” is pricing government debt for Spain and Italy now at around 7% any more accurately than it was when it was happily lending to Greece, Ireland and Portugal for 10 years at ludicrous rates about 3% back in 2005 before the crisis? Most now accept that those sorts of lending rates were nonsensical. Are 7%+ yields just as random? Should governments and the public that accepts the pre-credit crisis lending as grossly excessive now be just as sceptical in a symmetrical world? And should the authorities be as justified in acting to limit those high rates now as much as they should clearly have done something to prevent the unjustifiably low rates that blew the credit bubble everywhere — not just in the euro zone? De Grauwe wrote:

Devil and the deep blue sea

Ok, it’s a big policy week and of course it could either way for markets. An awful lot of ECB and Fed easing expectations may well be in the price already, so some delivery would appear to be important especially now that ECB chief Mario Draghi has set everyone up for fireworks in Frankfurt.

But if it’s even possible to look beyond the meetings for a moment, it’s interesting to see how the other forces are stacked up.

Perhaps the least obvious market statistic as July draws to a close is that, with gains of more than 10 percent, Wall St equities have so far had their best year-to-date since 2003. Who would have thunk it in a summer of market doom and despair.  Now that could be a blessing or a curse for those trying to parse the remainder of the year. Gloomy chartists and uber-bears such as SocGen’s Albert Edwards warn variously of either hyper-negative chart signals on the S&P500, such as the “Ultimate Death Cross”, or claims that the U.S. has already entered recession in the third quarter.

European equities finding some takers

European equities are getting some investor interest again.

As the ongoing debt crisis erodes consumer spending and corporate profits, the euro zone’s share  in investors’ equity portfolios has fallen in the past year –Reuters polls show holdings of euro zone stocks at 25 percent versus over 36 percent a year back.  Cash has fled instead to U.S. stocks, opening up a record valuation gap between the European and U.S. shares. (see graphics below from my colleague Scott Barber). In fact no other region has ever been considered as cheap as the euro zone is now,  a monthly survey by Bank of America/Merrill Lynch found in June.

That could offer investors a powerful incentive to return, especially as there are signs of serious efforts to tackle the crisis by deploying the euro zone’s rescue fund.

Pioneer Investments has moved to an overweight position on European stocks. While Pioneer’s head of global asset allocation research Monica Defend stresses the overweight is a small one compared to, say, its position in emerging markets, she says:

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.

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.

Three snapshots for Monday

The yield on 10-year  U.S. Treasuries, fell to their lowest levels since early October today, breaking decisively below 1.80 percent. That compares to the dividend yield on the S&P 500 of 2.28%.

The European Central Bank kept its government bond-buy programme in hibernation for the ninth week in a row last week. The ECB may come under pressure to act as  yields on Spanish 10-year government bonds rose further above 6% today.

Output at factories in the euro zone unexpectedly fell in March, the latest in a series of disappointing numbers signalling that the bloc’s recession may not be as mild as policymakers hope. On an annual basis, factory output dived 2.2 percent in March, the fourth consecutive monthly slide, Eurostat said, and only Germany, Slovenia and Slovakia were able to post growth in the month.

Poland, the lonely inflation targeter

Is the National Bank of Poland (NBP) the last inflation-targeting central bank still standing?

The bank shocked many today with a quarter point rate rise, naming stubbornly high inflation as the reason, and signalling that more tightening is on its way. The NBP has sounded hawkish in recent weeks but few had actually expected it to carry through its threat to raise rates. Economic indicators of late have been far from cheerful – just hours after the rate rise, data showed Polish car production slumped 30 percent in April from year-ago levels. PMI numbers last week pointed to further deterioration ahead for manufacturing. And sitting as it does on the euro zone’s doorstep, Poland will be far more vulnerable than Brazil or Russia to any new setback in Greece. Its action therefore deserves praise, says Benoit Anne, head of emerging markets strategy at Societe Generale.

(Poland’s central bank) is one of the last orthodox inflation-targeting central banks in the global emerging market central bank universe. They are taking action because they are seeing inflation creeping up and have decided to be proactive.

Three snapshots for Thursday

The European Central Bank kept interest rates on hold on Thursday.  President Mario Draghi urged euro zone governments to agree a growth strategy to go hand in hand with fiscal discipline, but as thousands of Spaniards protested in the streets he gave no sign the bank would do more to address people’s fears about the economy

The divergence between Euro zone countries is starting to impact analyst estimates for earnings. As this chart shows earnings forecasts for Spain and Portugal are seeing more downgrades than Germany or France.

The inflation rate in Turkey rose to 11.1% in April, putting pressure on the central bank to raise interest rates: