Archive for June, 2015

Shocks And Undercurrents

The ongoing drama over Greece continues to monopolise the financial world’s attention. We will probably find out how it ends – for the time being – in a day or two. In the meantime it has been easy to lose sight both of other potential sources of political risk and of the macro and market undercurrents which as rational investors we of course believe will come to dominate in the end.

Political risk is a difficult measure to quantify and a shock, by definition, cannot be planned for. However we have had some horrible reminders today that terrorism is grievously on the rise. This morning it was the attack on a factory in France; then a bombing in Tunisia; and a suicide attack on a Kuwaiti mosque during Friday prayers. These acts have all been claimed or inspired by the Islamic State.

The growing confidence and appeal of IS became glaringly obvious at the time of the Charlie Hebdo atrocity in Paris. Concerns have mounted since at the numbers of Muslims in European and other “western” countries who have tried to join IS in the Middle East, and who it is feared have been returning to shed blood in their homelands thereafter. And competition between IS and Al-Qaeda has been escalating in an attempt to establish leadership of global jihad. The rise of terrorism and the occurrence of any attack is lamentable but it is this last point which poses the risk to markets: something on the scale of the Bishopsgate bombing of 1993 or the 9/11 attacks eight years later has become a strategic goal for terror.

Meanwhile, the collapse of peace talks over Yemen last week has seen renewed Saudi bombardment of the country as the civil war there grinds on: the war doubles as a proxy conflict between the Saudis and Iran. Internal Yemeni rivalry between Al-Qaeda and the Islamic State is a complicating factor, as is the US drone campaign there against the former (though this is supposed to have been suspended in recent months). Elsewhere, negotiations continue to secure a commitment from Iran that she will not become a nuclear power; there is little encouragement to date that their objective will be achieved. In other words, the perpetual powder keg which is the Middle East has been getting even more alarming this year.

It seems reasonable to conclude that the risk of short-term setbacks to risk assets has increased in 2015. But what of the underlying fundamentals?

Here the picture is more mixed, which is to say, more positive overall. Attempts have been made to portray some of the major equity markets as dangerously overvalued but they do not stand up to balanced scrutiny. The economic outlook has disappointed in some places – most conspicuously in the US – and improved in others, such as in Europe, where even the threat of a Greek default has not noticeably dented confidence this month.

One area which has seen some movement this quarter has been the safe haven bond markets. There has been a marked sell off. The ten year gilt yield has risen by 60bp, the ten year US Treasury yield is almost 50bp higher and the ten year German bund yield is up by 70bp, having reached a low of 0.075% as recently as April. Upward moves in interest rates from the Federal Reserve, and with more of a local impact the Bank of England, have been drawing nearer for some time. The futures markets are currently pricing in a 25bp hike from both towards the end of the year. By then the disinflationary impact of last year’s fall in the price of crude oil will have unwound completely. Indeed, should the price rise between now and December then energy will become a source of inflation again.

Bond markets have a long way to go in many places, including here in the UK, before they start to close the valuation gap with equity. The earnings yield on the FTSE All Share Index is still almost three times the gross redemption yield on the ten year gilt, having averaged 1.8x over the last 20 years and 1.1x in the decade prior to the credit crunch in 2007. To reach those levels again the gilt yield would have to rise to 3.5% or 5.8% from 2.2% today. Furthermore, stock market observers seem pretty convinced that markets will take the early phase of rate hiking in their stride, largely because this is what happened last time. They might well be right – but this is not how things went the time before that (1994 as opposed to 2004) and since rate rises are such a novel idea these days their rediscovery surely poses some measure of risk.

So while the threat of short-term shocks has increased the possible medium-term headwinds from monetary tightening have been blowing closer too. It is doubtful whether most major stock markets are in bubble territory and likely that economic and reported earnings growth have much further to run. But selling on the records rather than buying on the dips appears the more rational approach at this point in time.

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26/06/2015 at 4:59 pm

Cui Bono?

The continued negotiations over emergency lending to Greece have been an obvious political risk for some time, and one which increased with the change of government there in January. This week’s leading stories have been dominated by the latest down-to-the-wire developments. The shock deferral of a payment due to the IMF until the end of the month was followed by recriminations between the Greek government and its creditors at the highest political level and the IMF team itself has now stormed off from Brussels in despair: EU Prepares For Worst As Greece Drives Finances To Brink (Bloomberg)

We have already looked at the possible consequences, and certain pain, that would ensue following a Greek sovereign default (The Joy Of Negotiating). In any case an indebted Greece would still require emergency funding of some kind in the aftermath of such a default as the bond market would be closed. Its emergency creditors would likely be exactly the same bunch it is dealing with today, or wild card lenders like Russia or China who on the evidence of previous discussions would require security over the nation’s land or other assets that even Greece’s previous government was unwilling to consider.

The Greek public appears to be more alive to the reality of their situation than their government. According to a poll conducted at the beginning of the month, 47 percent disapprove of its brinkmanship (and 74 percent want Greece to remain in the euro).

Even as time truly begins to run out, however, markets are still relatively sanguine about the possibility of default. Peripheral country bond spreads to Germany have widened a bit but remain below levels reached last summer, before Greece resurfaced as an issue. The euro is 3% up on the month to date. Equity markets have shown some nerves but there have been absolutely no signs of panic in the pricing of haven assets such as US Treasuries or gold. This is nothing more than reasonable: Greece is a small economy (GDP of $242bn in 2013 on World Bank numbers, less than 2% of the eurozone total), so the level of contagion occurring naturally from its collapse would be relatively muted.

Which brings us on to the real tragedy of these negotiations: the effect they are having on Greece. Economic sentiment has withered back towards the level it occupied during the final quarters of the country’s last recession in 2013. The banking system has been weakened – again – by the offshoring of deposits. Another recession is guaranteed. This is doubly disastrous when one considers that the budget deficit last year, at €6.4bn, was its lowest since 2000 and down from a peak of €36.2b in 2009. The country had exited recession, was running a primary surplus, meeting its debt obligations and seeing the number of unemployed decline for the first time since 2008. That has all been thrown away. Only yesterday employment data showed that the economy has gone back to shedding jobs. And in a year when European growth and consumer spending have been picking up notably and the currency is internationally weak, Greece’s key tourism industry might well have been expected to put on its strongest showing since the financial crisis. It would be astounding if the heightened uncertainty and bad press arising from the government’s actions have not turned many of those tourists away now.

The bottom line is that Greece needs its credit lines more than its creditors need to spend time playing games with the Greek government. The question the members of that government ought to be asking themselves, again and again, is: who benefits?

Let us leave the last word to an economist quoted in this post’s first linked article:

“People are really fed up with this,” UniCredit SpA Chief Global Economist Erik Nielsen said in a television interview. “They’ve never seen anything so completely ridiculous, frankly speaking, from a debtor country.”

12/06/2015 at 4:10 pm


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