Global Investing

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:

Economists now agree that markets were wrong in placing the same risk premium on Greek bonds as on German bonds….the same markets are also wrong in overestimating the risk that the periphery countries will default. Policymakers looking to calm such skittish markets should take note.

You may well argue that if no one wants to lend, then no one wants to lend. But call up most fund managers or potential long-term creditors right now and they will tell you that they will buy Italy and Spain, when policy credibility is blessed by the “market” and rates are already falling. Hmmm. So, who’s setting these prices then? Oxford economist Simon Wren-Lewis in April made his entertaining thoughts on the danger of pandering to notional “vengeful god” of the financial market quite clear.

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.

GUEST BLOG: The missing reform in the Kay Review

Simon Wong is partner at investment firm Governance for Owners, adjunct professor of law at Northwestern University School of Law, and visiting fellow at the London School of Economics. He can be found on Twitter at @SimonCYWong. The opinions expressed reflect his personal views only.

There is much to commend in the Kay Review final report. It contains a rigorous analysis of the causes of short-termism in the UK equity markets and wide-ranging, thoughtful recommendations on the way forward.  Yet, it is surprising that John Kay omitted one crucial reform that would materially affect of the achievability of several of his key recommendations – shortening the chain of intermediaries, eliminating the use of short-term performance metrics for asset managers, and adopting more concentrated portfolios.  What’s missing?  Reconfiguring the structure and governance of pension funds.

A major challenge facing pension funds in the UK and elsewhere is the lack of relevant expertise and knowledge at board and management levels.  Consequently, many rely heavily – some would argue excessively – on external advisers.  I have been told by one UK pensions expert that inadequate knowledge and skills within retirement funds means that  investment consultants are effectively running most small- to medium-sized pension schemes in Britain. Another admits that trustees, many of whom are ordinary lay people with limited investment experience, are often intimidated by asset managers.

Risks loom for South Africa’s bond rally

Investors are wondering how much longer the rally in South Africa’s local bond markets will last.

The market has received inflows of over $7.5 billion year-to-date, having benefited hugely from Citi’s April announcement that it would include South Africa in its elite World Government Bond Index (WGBI).  But like many other emerging markets, South Africa has also gained from international investors’ hunger for higher-yielding bonds. And the central bank’s surprise rate cut last week was the icing on the cake, sending 5-year yields plunging another 30 basis points.

There are some headwinds however. First positioning. Around a third of government bonds are already estimated to be in foreigners’ hands. Second, markets may be pricing in too much policy easing (Forward rate agreements are assigning a 77  percent probability of another 50 bps rate cut within the next six months).  That’s especially so given local wheat and maize prices have been hitting record highs in recent weeks.

Yield-hungry funds lend $2bln to Ukraine

Investors just cannot get enough of emerging market bonds. Ukraine, possibly one of the weakest of the big economies in the developing world, this week returned to global capital markets for the first time in a year , selling $2 billion in 5-year dollar bonds.  Investors placed orders for seven times that amount, lured doubtless by the 9.25 percent yield on offer.

Ukraine’s problems are well known, with fears even that the country could default on debt this year.  The $2 billion will therefore come as a relief. But the dangers are not over yet, which might make its success on bond markets look all the more surprising.

Perhaps not. Emerging dollar debt is this year’s hot-ticket item, generating returns of over 10 percent so far in 2012. Yields in the so-called safe markets such as Germany and United States are negligible; short-term yields are even negative.  So a 9.25 percent yield may look too good to resist.

Next Week: Big Black Cloud

Following are notes from our weekly editorial planning meeting:

Not unlike this year’s British “summer”, the gloom is now all pervasive. Not panicky mind, just gloomy. And there is a significant difference where markets are concerned at least. The former involves surprise and being wrongfooted — but latter has been slow realisation that what were once extreme views on the depth of the credit swamp are fast becoming consensus thinking. The conclusion for many now is that we’re probably stuck in this mire for several more years – anywhere between 5 and 20 years, depending on your favoured doom-monger. Yet, the other thing is that markets also probably positioned in large part for that perma-funk — be it negative yields on core government debt or euro zone equities now with half the p/e ratios of US counterparts. In short, the herd has already  hunkered down and finds it hard to see any horizon. Those who can will resort to short-term tactical plays based on second-guessing government and central bank policy responses (there will likely be more QE or related actions stateside eventually despite hesitancy in the FOMC minutes  and Fed chief Bernanke will likely give a glimpse of that thinking in his congressional testimony next week); or hoping to surf mini econ cycles aided by things like cheaper energy; or hoping to spot one off corporate success stories like a new Apple or somesuch.

So has all hope been snuffed out? The reason for the relapse mid-year depression is only partly related to the political minefield frustrating a resolution of the euro crisis – in some ways, things there look more encouraging policywise than they did two months ago. It stems as much from a realization of just how broken the banks credit creation system remains – a system that had hinged heavily on extensive collateral chains that have now largely been broken or shortened and starved of acceptable high-quality collateral. Curiously, QE – by removing even more of the top quality collateral – may even be exaggerating the problem. Some even say the extreme shortage of this quality “collateral” may require more, not less, government debt in the US and UK and would also benefit from a pooling of euro debt  – but everyone knows how easy all that’s going to be politically.

Despite all this, global markets have remained fairly stable over the past week – in part due to policy hopes underpinning risk markets and in part because there’s not many places left to hide without losing money in “safe-haven” bunkers. World equities are down about 2 percent over the past week,  but still up more than 6 percent from early June. Risk measured by volatility indicesis a smidgen higher too. Oil has firmed back toward $100pb, disappointing everyone apart from oil exporters. Spanish and Italian 10-yr yields are a touch higher. And at least part of the caution everywhere is ae vigil ahead of Chinese Q2 GDP data on Friday – numbers that now almost rival the U.S.  monthly payrolls in global market impact.

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.

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%.