Archive for September, 2012
As readers know, markets enjoyed a period of relative stability across the summer of 2012. Despite the mild nerves shown over the last week or two, that stability has largely continued. But one of the events which has emerged to threaten it of late should serve as a reminder that this should not make us complacent.
Barcelona has voted for independence from Spain. A short year ago this would have seemed unthinkable – not to mention rather ridiculous. It is a classic “black swan” event. Everyone has been worrying about the breakup of the eurozone; no one has worried about the breakup of a European country since the dissolution of Yugoslavia. And as for the breakup of Spain in particular, who would ever have thought of betting on the Catalans over the Basques?
Of course, local politics is still politics. The region of Catalonia has been begging for a central government loan for some time. (It is surely a tribute to humanity’s persistency of spirit that so many of us believe in borrowing our way out of a debt crisis.) Perhaps their threatened secession is no more than a bargaining chip.
From the market reaction so far the threat does not seem too powerful, but it is instructive. This year might have been quiet – so far – but remember what happened in 2011: the Arab spring, the Japanese earthquake and tsunami, the referendum gambit in Greece and subsequent fall of the government … All these things were unpredicted and unforeseen.
Over the next few months, who is to say what might not happen? We wait anxiously for military action against Iran while there is civil war in Syria. Anti-Japanese sentiment in China has had real social and commercial effects. Then there is the enigma of North Korea. The dominant military power in the Pacific is the United States. Could it be possible that, one day, America will have to learn the lesson it taught Britain over Suez: that an indebted nation can only fight with the permission of its creditors?
It doesn’t pay to be too terrified, however. There is more to markets, and economics, than political events and natural disasters. A year after Suez, and Harold Macmillan was telling people they had never had it so good; according to the Barclays Equity Gilt Study, British stocks during the period 1956-1960 delivered a compound annual return of over 13% in real terms.
As we have all been reminded in recent times, volatility can be painful. But left field events cannot be planned for. Difficult as it can sometimes seem, the safest option is to back the fundamentals.
Last week it was the ECB. Yesterday – not to be outdone – it was the Federal Reserve’s turn to give markets a shot in the arm by announcing a new round of asset purchases. The Fed’s own chairman cautioned against expecting too pronounced an effect on the economy, but it didn’t matter: the numbers were large, the scope unexpected and the restatement of resolve to promote the creation of jobs most welcome.
We noted at the beginning of August that markets had seemingly rediscovered the civilized seasonal phenomenon of the “summer lull”. Through August itself that continued. This month, the change in sentiment – encouraged by the open mouth as well as the open market operations of the world’s biggest central banks – has developed into a broadly based re-rating of risk.
Equity markets have risen at a faster pace: the S&P 500 is up 4% month to date at the time or writing. And as the riskier eurozone sovereign market has continued to recover, safe haven governments have lost some of their shine. The ten year gilt price is down 3%. Credit risk has repriced significantly too: the iTraxx Crossover index of higher risk corporate credit pricing has moved from 5.9% at the end of August to 4.6% today. Commodities have bounced, with the Brent crude future up 2% and Bloomberg’s base metals index nearly 13% higher. The euro has risen 4% against the dollar and is somewhat stronger against sterling.
At the same time, economic data – some of which is significant – has continued to be mixed. While industrial production data for August was not as bad as expected in the eurozone, it disappointed in the US, where there have been mixed signals from the employment figures too. Growth in the UK has been showing some signs of recovery, while it came out slightly weaker than expected for Japan. Confidence and activity indicators around the world are similarly patchy.
It has been like this for some time now. Last year, markets were arguably too bearish about our patchy, rather chaotic recovery. If current price behaviour continues, then it might be the case before too long that sentiment could be said to have got ahead of itself.
Longer term, there are risks to consider beyond confidence too. While central banks enjoy their adulation, some may remember the “Greenspan put”. Former Fed chairman Alan Greenspan developed a reputation for cutting interest rates to prop up markets – during the stock market correction of 1998, for example, and after the dotcom / TMT collapse, when there was widespread concern over the potential “wealth effect” of falling markets on American households. Pursuit of this approach in the 2000s is now perceived to have contributed to the subprime crisis and credit crunch.
Central bank action to prop up bond markets and restore confidence in risk could end up inviting similar criticism. Much as it makes a change for markets not to be engulfed in panic and despair, it is surely no coincidence that index linked bonds issued by safe haven economies on both sides of the Atlantic have not fallen by as much as their conventional cousins.
Nonetheless, the year so far has been the first for a long time in which the volatility rollercoaster has showed signs of slowing down. The VIX index – a derivatives-based measure of volatility on the S&P 500 index – has fallen to levels not seen since the summer of 2007. Of course there could be another dip just around the corner. But while the ride has been exciting, there are many who would benefit from at least a short stop.
Towards the end of July, Mario Draghi, President of the European Central Bank, promised to do “whatever it takes to preserve the euro.” For a few weeks, equity markets pushed slowly higher, the euro recovered some of the ground it had lost since the spring, bond market panic began to subside and observers watched nervously for the actual ECB policy.
Yesterday it was announced. The eurozone’s central bank will buy as much short dated government bond debt as it takes “to prevent potentially destructive scenarios.”
There are conditions attached. Bond purchases will be “sterilized” by offsetting the amount bought with liquidity reductions in money markets; in other words, the eurozone’s money supply will not increase. So this is not “quantitative easing”. In fact it can be seen as a corollary to Draghi’s last big move: extending ECB lending to the banking system out to three years last December (an operation which saw interest of almost half a trillion euros on day one).
What makes this necessary, of course, is the power of the bond market to kill economies and the impact this has had on confidence – in the more troubled eurozone countries, and across the world. Thus far Draghi’s announcement has served to consolidate rallies in “peripheral” eurozone debt: 5 year Portuguese interest rates have fallen from over 11% when he made his July announcement, to 7.1% on Wednesday, to 6.1% today; the 2 year yield in Spain has more than halved from over 6% to 2.8% over the same period; Italy’s ten year benchmark has come down from 6.5% to just over 5% – and so on. With luck, this will help turn confidence around in the real economy and allow the world recovery to pick up a little steam.
With luck, because this is far from being a foregone conclusion.
Firstly, there are those with the strongly held conviction that the euro is a concocted deadweight born of an aberrant political vision, irrevocably destined to collapse. For them, Draghi has wielded “a pea shooter rather than a bazooka”; and whatever anybody does now or in the future, “the eurozone is simply doomed.” Restoring confidence where there was none to begin with is an impossible task.
Secondly, confidence is a skittish thing. We saw this last autumn, when positive market reaction to the October talks in Europe was derailed completely by the announcement of a referendum on their outcome in Greece. That country’s emergency creditors are in Athens again this weekend, and will decide over the next few weeks whether or not to advance a further bailout tranche (due next month). Another disaster could very well impact sentiment again.
So good luck to Mario Draghi – but he’s not the only game in town.
This blog observed early in the year that economic data and market confidence were being pulled in two directions. On the one hand, Europe continued to drag along and threaten financial cataclysm. On the other, fear over a double dip recession in the US was unwinding rapidly and signs of improvement in the labour market in particular were giving markets encouragement.
Yesterday’s strong open in New York lifted European markets well above the levels they had reached while anticipating and reacting to the ECB’s rate decision and press conference. This was partly due to a stronger than expected US service sector growth indicator and stable data on unemployment insurance claims. Overnight, the combination of good news from the world’s most significant developed economies saw China’s Shanghai Composite Index rise by almost 4%.
The ECB got all the limelight yesterday. The defence of the eurozone from collapse remains a significant driver of market behaviour. But the failure of the US to grind to a halt is important too. Ultimately, we will know that confidence has truly returned when ECB press conferences aren’t making headlines all over the world.